\nITEM 1. CONDENSED FINANCIAL STATEMENTS\nIGNYTE ACQUISITION CORP.\nCONDENSED BALANCE SHEETS\n| June 30, 2021 | December 31, 2020 |\n| (unaudited) |\n| Assets |\n| Cash | $ | 550,470 | $ | 25,425 |\n| Prepaid expense and other current assets | 181,923 | - |\n| Total current assets | 732,393 | 25,425 |\n| Deferred offering costs | - | 81,575 |\n| Cash and securities held in Trust Account | 57,504,345 | - |\n| Total Assets | $ | 58,236,738 | $ | 107,000 |\n| Liabilities and Stockholders' Equity |\n| Current liabilities: |\n| Accrued expenses | $ | 12,656 | $ | - |\n| Due to related party | 51,953 | 310 |\n| Promissory note - related party | - | 80,000 |\n| Total current liabilities | 64,609 | 80,310 |\n| Warrant liabilities | 1,875,000 | - |\n| Total liabilities | 1,939,609 | 80,310 |\n| Commitments and Contingencies(8) |\n| Common stock subject to possible redemption, 5,129,712 shares at redemption value | 51,297,120 | - |\n| Stockholders' Equity: |\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | - | - |\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 2,157,788 shares and 0 shares issued and outstanding (excluding 5,129,712 shares and 0 shares subject to possible redemption) at June 30, 2021 and December 31, 2020, respectively | 216 | 154 |\n| Additional paid-in capital | 4,730,179 | 26,846 |\n| Retained earnings (Accumulated deficit) | 269,614 | ( 310 | ) |\n| Total stockholders' equity | 5,000,009 | 26,690 |\n| Total Liabilities and Stockholders' Equity | $ | 58,236,738 | $ | 107,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n1\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, 2021 | June 30, 2021 |\n| Formation and operating costs | $ | 110,980 | $ | 309,421 |\n| Loss from operations | ( 110,980 | ) | ( 309,421 | ) |\n| Other income |\n| Change in fair value of warrants | 725,000 | 575,000 |\n| Trust interest income | 2,087 | 4,345 |\n| Total other income | 727,087 | 579,345 |\n| Net income | $ | 616,107 | $ | 269,924 |\n| Basic and diluted weighted average shares outstanding, common stock subject to redemption | 5,068,102 | 4,183,046 |\n| Basic and diluted net loss per share | $ | 0.00 | $ | 0.00 |\n| Basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\n| Basic and diluted net loss per share | $ | 0.28 | $ | 0.13 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n2\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY\n| Common Stock | Additional Paid-in Capital | Retained Earnings(Accumulated Deficit) | Total Stockholders' Equity |\n| Shares | Amount |\n| Balance as of December 31, 2020 | 1,537,500 | $ | 154 | $ | 26,846 | $ | ( 310 | ) | $ | 26,690 |\n| Sale of 5,000,000 and 750,000 Units on February 1, 2021 and February 2, 2021 through IPO and over-allotment, respectively | 5,750,000 | 575 | 57,499,425 | - | 57,500,000 |\n| Sale of 2,350,000 and 150,000 Placement Warrants on February 1, 2021 and February 2, 2021, respectively, net of fair value of warrant liabilities | - | - | 50,000 | - | 50,000 |\n| Underwriting fee | - | - | ( 1,150,000 | ) | - | ( 1,150,000 | ) |\n| Other offering expenses | - | - | ( 399,485 | ) | - | ( 399,485 | ) |\n| Net loss | - | - | - | ( 346,183 | ) | ( 346,183 | ) |\n| Common stock subject to possible redemption | ( 5,068,201 | ) | ( 507 | ) | ( 50,680,513 | ) | - | ( 50,681,020 | ) |\n| Balance as of March 31, 2021 | 2,219,398 | 222 | 5,346,273 | ( 346,493 | ) | 5,000,002 |\n| Change in value of common stock subject to possible redemption | ( 61,610 | ) | ( 6 | ) | ( 616,094 | ) | ( 616,100 | ) |\n| Net income | 616,107 | 616,107 |\n| Balance as of June 30, 2021 (unaudited) | 2,157,788 | $ | 216 | $ | 4,730,179 | $ | 269,614 | $ | 5,000,009 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n3\nIGNYTE ACQUISITION CORP.\nUNAUDITED CONDENSED STATEMENT OF CASH FLOWS\n| For the Six Months Ended |\n| June 30, 2021 |\n| Cash flows from Operating Activities: |\n| Net income | $ | 269,924 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Increase in fair value of warrants | ( 575,000 | ) |\n| Interest earned on marketable securities held in Trust Account | ( 4,345 | ) |\n| Changes in current assets and current liabilities: |\n| Prepaid expenses | ( 181,923 | ) |\n| Accrued offering costs and expenses | 12,656 |\n| Due to related party | 51,643 |\n| Net cash used in operating activities | ( 427,045 | ) |\n| Cash Flows from Investing Activities: |\n| Purchase of investment held in Trust Account | ( 57,500,000 | ) |\n| Net cash used in investing activities | ( 57,500,000 | ) |\n| Cash flows from Financing Activities: |\n| Proceeds from Initial Public Offering, net of underwriters' fees | 56,350,000 |\n| Proceeds from private placement | 2,500,000 |\n| Repayment of promissory note to related party | ( 80,000 | ) |\n| Payments of offering costs | ( 317,910 | ) |\n| Net cash provided by financing activities | 58,452,090 |\n| Net change in cash | 525,045 |\n| Cash, beginning of the period | 25,425 |\n| Cash, end of the period | $ | 550,470 |\n| Supplemental disclosure of noncash investing and financing activities: |\n| Initial value of Common stock subject to possible redemption, as revised | $ | 51,023,118 |\n| Change in value of Common stock subject to possible redemption | $ | 274,002 |\n| Initial fair value of warrant liabilities | $ | 2,450,000 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n4\nIGNYTE ACQUISITION CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 1 — Organization and Business Operations\nOrganization and General\nIgnyte Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated as a Delaware corporation on August 6, 2020. The Company was incorporated for the purpose of effecting a merger, stock exchange, asset acquisition, stock purchase, reorganization or other similar business combination with one or more businesses (the “Business Combination”).\nThe Company has selected December 31 as its fiscal year end.\nThe Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.\nAs of June 30, 2021, the Company had not commenced any operations. All activity for the period from August 6, 2020 (inception) through June 30, 2021 relates to the Company's formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income on cash and cash equivalents from the proceeds derived from the IPO.\nThe Company's sponsor is Ignyte Sponsor LLC (the “Sponsor”), a Delaware limited liability company (the “Sponsor”).\nFinancing\nThe registration statement for the Company's IPO was declared effective on January 27, 2021 (the “Effective Date”). On February 1, 2021, the Company consummated the IPO of 5,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units being offered, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 50,000,000 , which is discussed in Note 4.\nSimultaneously with the closing of the IPO, the Company consummated the sale of 2,350,000 Private Placement Warrants (the “Private Placement Warrants”) at a price of $ 1.00 per Private Placement Warrant in a private placement to the Sponsor, generating total gross proceeds of $ 2,350,000 .\nOn February 2, 2021, the underwriters purchased an additional 750,000 Units to exercise its over-allotment option in full at a purchase price of $ 10.00 per Unit, generating gross proceeds of $ 7,500,000 . Simultaneously with the closing of the full exercise of the over-allotment option, the Company completed the private sale of an aggregate of 150,000 Private Placement Warrants to the Sponsor, at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 . A total of $ 7,500,000 was placed in the Trust Account after the payment of $ 150,000 underwriting discount.\nTransaction costs amounted to $ 1,549,485 consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs. In addition, $ 975,465 of cash was held outside of the Trust Account (as defined below) and is available for working capital purposes.\nTrust Account\nFollowing the closing of the IPO, on February 1, 2021, $50,000,000 ($10.00 per Unit) from the net proceeds of the sale of the Units in the IPO and the sale of the Private Placement Warrants was held in a Trust Account (“Trust Account”), and will invest only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, having a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act which invest only in direct U.S. government treasury obligations. Except with respect to interest earned on the funds held in the Trust Account that may be released to the Company to pay income tax obligations, the proceeds from the IPO will not be released from the Trust Account until the earlier of the completion of a Business Combination or the Company's redemption of 100 % of the outstanding Public Shares if it has not completed a Business Combination in the required time period. The proceeds held in the Trust Account may be used as consideration to pay the sellers of a target business with which the Company completes a Business Combination. Any amounts not paid as consideration to the sellers of the target business may be used to finance operations of the target business.\n5\nInitial Business Combination\nIn connection with any proposed Business Combination, the Company will either (1) seek stockholders approval of the initial Business Combination at a meeting called for such purpose at which stockholders may seek to convert their shares, regardless of whether they vote for or against the proposed Business Combination or don't vote at all, into their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), or (2) provide its stockholders with the opportunity to sell their shares to the Company by means of a tender offer (and thereby avoid the need for a stockholder vote) for an amount equal to their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), in each case subject to the limitations described herein. The decision as to whether the Company will seek stockholders approval of a proposed Business Combination or will allow stockholders to sell their shares to the Company in a tender offer will be made by the Company, solely in its discretion,\nThe shares of Common Stock subject to redemption will be recorded at a redemption value and classified as temporary equity upon the completion of the IPO, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the issued and outstanding shares voted are voted in favor of the Business Combination.\nThe Company will have 21 months from the closing of the IPO to complete the initial Business Combination (the “Combination Period”). However, if the Company is unable to complete the initial Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company but net of taxes payable ( and less up to $ 50,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders' rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company's remaining stockholders and the Company's board of directors, liquidate and dissolve, subject (in the case of (ii) and (iii) above) to the Company's obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\nThe Sponsor, officers and directors have agreed (i) to vote any shares owned by them in favor of any proposed Business Combination, (ii) not to convert any shares in connection with a stockholder vote to approve a proposed initial Business Combination or sell any shares to the Company in a tender offer in connection with a proposed initial Business Combination, (iii) that the founders' shares will not participate in any liquidating distributions from the Company's Trust Account upon winding up if a Business Combination is not consummated.\nThe Sponsor has agreed that it will be liable to ensure that the proceeds in the Trust Account are not reduced below $10.00 per share by the claims of target businesses or claims of vendors or other entities that are owed money by the Company for services rendered or contracted for or products sold to the Company. The agreement entered into by the Sponsor specifically provides for two exceptions to the indemnity it has given: it will have no liability (1) as to any claimed amounts owed to a target business or vendor or other entity who has executed an agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account, or (2) as to any claims for indemnification by the underwriters of the Proposed Public Offering against certain liabilities, including liabilities under the Securities Act. However, the Company has not asked its Sponsor to reserve for such indemnification obligations, nor has it independently verified whether the Sponsor has sufficient funds to satisfy its indemnity obligations and believe that the Sponsor's only assets are securities of the Company. Therefore, the Company believes it is unlikely that the Sponsor will be able to satisfy its indemnification obligations if it is required to do so.\nLiquidity and Capital Resources\nAs of June 30, 2021, the Company had $ 550,470 in its operating bank account, and working capital of $ 667,784 .\nPrior to the completion of the Initial Public Offering, the Company's liquidity needs had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $ 80,000 (see Note 6), and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, the Company's Sponsor or an affiliate of the Sponsor or the Company's officers and directors or their affiliates may, but are not obligated to, provide the Company Working Capital Loans (see Note 6). To date, there were no amounts outstanding under any Working Capital Loans.\nBased on the foregoing, management believes that the Company will have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, the Company will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\n6\nNote 2 — Revision of Previously Issued Financial Statements\nOn April 12, 2021, the Staff of the Securities and Exchange Commission together issued a statement regarding the accounting and reporting considerations for warrants issued by special purpose acquisition companies entitled \"Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (\"SPACs\")\" (the \"SEC Statement\"). Specifically, the SEC Statement focused on certain settlement terms and provisions related to certain tender offers following a Business Combination, which terms are similar to those contained in the warrant agreement, dated as of January 27, 2021, between the Company and Continental Stock Transfer & Trust Company, a New York corporation, as warrant agent (the \"Warrant Agreement\").\nHistorically, the warrants were reflected as a component of equity as opposed to liabilities on the balance sheets and the statements of operations did not include the subsequent non-cash changes in estimated fair value of the Warrants, based on the application of FASB ASC Topic 815-40, Derivatives and Hedging, Contracts in Entity's Own Equity (“ASC 815-40). The views expressed in the SEC Staff Statement were not consistent with the Company's historical interpretation of the specific provisions within its warrant agreement and the Company's application of ASC 815-40 to the warrant agreement. the Company reevaluated the accounting treatment of (i) the 2,875,000 Public Warrants and (ii) the 2,500,000 Private Placement Warrants (See Note 4 and Note 5). Based on this reassessment, management determined that the private warrants should be classified as liabilities measured at fair value upon issuance, with subsequent changes in fair value reported in the Company Statement of Operations each reporting period.\nThe Company's management and the audit committee of the Company's Board of Directors concluded that it is appropriate to revise the Company's previously issued audited balance sheet as of February 1, 2021 as previously reported in its Form 8-K.\nThe following tables summarize the effect of the restatement on each balance sheet line item as of the date:\n| As Previously Reported | Adjustment | As Revised |\n| Balance Sheet at February 1, 2021 |\n| Warrant Liabilities | $ | - | $ | 2,303,000 | $ | 2,303,000 |\n| Total Liabilities | 426,200 | 2,303,000 | 2,729,200 |\n| Common stock subject to possible redemption | 45,973,118 | ( 2,303,000 ) | 43,670,118 |\n| Common stock | 194 | 23 | 217 |\n| Additional paid-in capital | 5,004,203 | ( 23 ) | 5,004,180 |\n| Accumulated deficit | $ | ( 4,396 ) | $ | - | $ | ( 4,396 ) |\n| Total Stockholders' Equity | 5,000,001 | - | 5,000,001 |\n| Number of shares subject to redemption | 4,597,312 | ( 230,300 ) | 4,367,012 |\n\nNote 3 — Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. In the opinion of management, the unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the period for the six months ended June 30, 2021 are not necessarily indicative of the results that may be expected through December 31, 2021.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Form 10-K filed by the Company with the SEC.\n7\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended, (the “Securities Act”), as modified by the Jumpstart our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statement with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2021 and December 31, 2020.\nMarketable Securities Held in Trust Account\nAt June 30, 2021, the assets held in the Trust Account were invested in money market funds.\nFair Value Measurements\nFASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. ASC 820 establishes a fair value hierarchy for inputs, which represent the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances.\nThe fair value hierarchy is categorized into three levels based on the inputs as follows:\nLevel 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment.\nLevel 2 — Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by market through correlation or other means.\nLevel 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.\nThe fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash, prepaid assets, and accounts payable are estimated to approximate the carrying values as of December 31, 2020 due to the short maturities of such instruments.\n8\nThe Company’s warrant liabilities are based on a valuation model utilizing management judgment and pricing inputs from observable and unobservable markets with less volume and transaction frequency than active markets. Significant deviations from these estimates and inputs could result in a material change in fair value. In some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement. See Note 7 for additional information on assets and liabilities measured at fair value.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . At June 30, 2021 and December 31, 2020, the Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock feature certain redemption rights that is considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of the Company’s balance sheet.\nNet Income Per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for redeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these shares do not have any redemption features and do not participate in the income earned on the Trust Account.\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, 2021 | June 30, 2021 |\n| Common stock subject to possible redemption |\n| Numerator: net income allocable to common stock subject to possible redemption |\n| Interest income on marketable securities held in trust | $ | 1,862 | $ | 3,876 |\n| Less: interest available to be withdrawn for payment of taxes | - | - |\n| Net income allocable to common stock subject to possible redemption | 1,862 | 3,876 |\n| Denominator: Weighted average redeemable common stock |\n| Redeemable common stock, basic and diluted | 5,068,102 | 4,183,046 |\n| Basic and diluted net income per share, redeemable common stock | $ | - | $ | - |\n| Non-redeemable common stock |\n| Numerator: net income minus redeemable net earnings |\n| Net income | $ | 616,107 | $ | 269,924 |\n| Redeemable net earnings | ( 1,862 ) | ( 3,876 ) |\n| Non-redeemable net income | 614,245 | 266,048 |\n| Denominator: Weighted average non-redeemable basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\n| Basic and diluted net income per share, common stock | $ | 0.28 | $ | 0.13 |\n\n9\nOffering Costs associated with the Initial Public Offering\nThe Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the IPO and were charged to stockholders' equity upon the completion of the IPO. Accordingly, as of February 1, 2021, offering costs in the aggregate of $ 1,549,485 have been charged to stockholders' equity (consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs).\nWarrant Liabilities\nThe Company accounts for the Public Warrants and Private Warrants (as defined in Note 4 and 5) collectively (“Warrants”), as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of issuance of the Warrants and as of each subsequent quarterly period end date while the Warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\nThe Company accounts for the Private Warrants in accordance with ASC 815-40 under which the Private Warrants do not meet the criteria for equity classification and must be recorded as liabilities. The fair value of the Private Warrants has been estimated using the Monte Carlo simulation model. See Note 7 for further discussion of the pertinent terms of the Warrants used to determine the value of the Private Warrants and Representative’s Warrants.\nThe Company evaluated the Public Warrants in accordance with ASC 815-40, “Derivatives and Hedging — Contracts in Entity’s Own Equity” and concluded that they met the criteria for equity classification and are required to be recorded as part a component of additional paid-in capital at the time of issuance.\nIncome Taxes\nThe Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\n10\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception.\nRisks and Uncertainties\nOn January 30, 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus (the ”COVID-19 outbreak”). In March 2020, the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. The full impact of the COVID-19 outbreak continues to evolve. The impact of the COVID-19 outbreak on the Company’s financial position will depend on future developments, including the duration and spread of the outbreak and related advisories and restrictions. These developments and the impact of the COVID-19 outbreak on the financial markets and the overall economy are highly uncertain and cannot be predicted. If the financial markets and/or the overall economy are impacted for an extended period, the Company’s financial position may be materially adversely affected. Additionally, the Company’s ability to complete an initial Business Combination may be materially adversely affected due to significant governmental measures being implemented to contain the COVID-19 outbreak or treat its impact, including travel restrictions, the shutdown of businesses and quarantines, among others, which may limit the Company’s ability to have meetings with potential investors or affect the ability of a potential target company’s personnel, vendors and service providers to negotiate and consummate an initial Business Combination in a timely manner. The Company’s ability to consummate an initial Business Combination may also be dependent on the ability to raise additional equity and debt financing, which may be impacted by the COVID-19 outbreak and the resulting market downturn. The financial statement does not include any adjustments that might result from the outcome of this uncertainty.\nRecent Accounting Standards\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statement.\nNote 4 — Initial Public Offering\nOn February 1, 2021, the Company sold 5,000,000 Units, at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one-half of one warrant to purchase one share of common stock (“Public Warrant”). Each whole Public Warrant entitles the holder to purchase one share of common stock at a price of $ 11.50 per share, subject to adjustment.\nOn February 2, 2021, the Underwriters exercised the over-allotment option in full to purchase 750,000 Units (the “Over-Allotment Units”), generating an aggregate of gross proceeds of $ 7,500,000 , and incurred $ 150,000 in underwriting fees.\nPublic Warrants\nEach whole warrant entitles the holder to purchase one share of Common Stock at a price of $11.50 per share, subject to adjustment as discussed herein. The warrants will become exercisable 30 days after the completion of the Company's initial Business Combination. However, no warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the public warrants is not effective within a specified period following the consummation of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. In the event of such cashless exercise, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose will mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the trading day prior to the date of exercise. The warrants will expire on the fifth anniversary of the completion of an initial Business Combination, at 5:00 p.m., New York City time, or earlier upon redemption or liquidation.\n11\nThe Company may call the warrants for redemption (excluding the Private Placement Warrants and any warrants underlying additional units issued to the Sponsor, initial stockholders, officers, directors or their affiliates in payment of Working Capital Loans made to the Company)\n•\nin whole and not in part;\n•\nat a price of $ 0.01 per warrant;\n•\nat any time after the warrants become exercisable,\n•\nupon not less than 30 days’ prior written notice of redemption to each warrant holder; and\n•\nif, and only if, the reported last sale price of the Common Stock equals or exceeds $ 18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations) for any 20 trading days within a 30-trading day period commencing at any time after the warrants become exercisable and ending on the third business day prior to the notice of redemption to warrant holders; and\n•\nif, and only if, there is a current registration statement in effect with respect to the shares of common stock underlying such warrants.\nIf the Company calls the warrants for redemption as described above, the Company's management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In such event, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose shall mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\nIn addition, if (x) the Company issue additional shares of Common Stock or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $ 9.20 per share of common stock (with such issue price or effective issue price to be determined in good faith by the Company's board of directors, and in the case of any such issuance to the Sponsor, initial stockholders or their affiliates, without taking into account any founders' shares held by them prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the consummation of the initial Business Combination (net of redemptions), and (z) the Market Value is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) the Market Value or (ii) the price at which the Company issues the additional shares of common stock or equity-linked securities.\nNote 5 — Private Placement\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 2,350,000 Private Placement Warrants at a price of $ 1.00 per Private Placement Warrant, for an aggregate purchase price of $ 2,350,000 , in a private placement (the “Private Placement”). Each Private Placement Warrant will entitle the holder to purchase one share of common stock at a price of $11.50 per share, subject to adjustment. The proceeds from the Private Placement Warrants was added to the proceeds from the IPO held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Placement Warrants held in the Trust Account will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Placement Warrants will expire worthless.\nThe Private Placement Warrants are identical to the Warrants underlying the Units sold in the IPO, except that the Private Placement Warrants are non-redeemable and may be exercised on a cashless basis, in each case so long as they continue to be held by the initial purchasers or their permitted transferees. Further, the Sponsor has agreed not to transfer, assign, or sell the Private Placement Warrants (including the shares of Common Stock issuable upon the exercise of the Private Placement Warrants), except to certain permitted transferees, until after the consummation of the Company's initial business combination.\nSimultaneously with the closing of the exercise of the over-allotment option, the Company completed the private sale (the “Private Placement”) of an aggregate of 150,000 private placement warrants (the “Private Placement Warrants”) to Ignyte Sponsor LLC, a Delaware limited liability company (the “Sponsor”), at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 .\n12\nNote 6 — Related Party Transactions\nFounder Shares\nOn August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 (the “Founder Shares”). Up to 187,500 Founder Shares are subject to forfeiture by the Sponsor depending on the extent to which the underwriters' over-allotment option is exercised. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then.\nThe founders' shares were placed into an escrow account maintained in New York, New York by Continental Stock Transfer & Trust Company, acting as escrow agent. Subject to certain limited exceptions, these shares will not be transferred, assigned, sold or released from escrow (subject to certain limited exceptions set forth below) (i) with respect to 50% of such shares, for a period ending on the earlier of the one-year anniversary of the date of the consummation of the initial Business Combination and the date on which the closing price of the Company's common stock equals or exceeds $12.50 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within a 30-trading day period following the consummation of the initial Business Combination and (ii) with respect to the remaining 50% of such shares, for a period ending on the one-year anniversary of the date of the consummation of the initial Business Combination, or earlier, in either case, if, subsequent to the initial Business Combination, the Company consummates a liquidation, merger, stock exchange or other similar transaction which results in all of the Company's stockholders having the right to exchange their shares of common stock for cash, securities or other property.\nPromissory Note — Related Party\nOn November 20, 2020, the Company's executive officers loaned the Company $ 80,000 to be used for a portion of the expenses of the IPO. These loans are non-interest bearing, unsecured and are due at the earlier of June 30, 2021 or the closing of the IPO. As of February 1, 2021, the Company repaid the note in full.\nDue to Related Party\nAs of June 30, 2021, the amount due to related party is $ 51,953 which represent the accrual of administrative service fee $ 51,643 from January 26, 2021 to June 30, 2021 and formation cost $ 310 paid by the Officer.\nRelated Party Loans\nIn order to meet the Company’s working capital needs following the consummation of the IPO the Sponsor, officers, directors initial stockholders or their affiliates may, but are not obligated to, loan the Company funds (“Working Capital Loans”), from time to time or at any time, in whatever amount they deem reasonable in their sole discretion. Each loan would be evidenced by a promissory note. The notes would either be paid upon consummation of the initial Business Combination, without interest, or, at holder’s discretion, up to $ 1,500,000 of the notes may be converted into warrants at a price of $ 1.00 per warrant. The warrants would be identical to the Private Placement Warrants. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. As of June 30, 2021 and December 31, 2020, no such Working Capital Loans were outstanding.\nAdministrative Service Fee\nThe Company has agreed, commencing on the date of the securities of the Company are first listed on The Nasdaq Capital Market (the “Listing Date”), to pay the Sponsor $ 10,000 per month for office space, utilities and secretarial support. Upon completion of the initial Business Combination or the Company's liquidation, the Company will cease paying these monthly fees. The Company accrued $ 51,643 and $ 30,000 for the administrative service fee for the period from the Listing Date to June 30, 2021and for the three months ended June 30, 2021.\nNote 7 — Recurring Fair Value Measurements\nThe following table presents information about the Company's assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2021, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value.\n13\n| June 30, 2021 | Quoted Prices In Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\n| Assets: |\n| U.S. Money Market held in Trust Account | $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\n| $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\n| Liabilities: |\n| Warrant liabilities-Private Placement Warrants | $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\n| $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\n\nThe following table sets forth a summary of the changes in the fair value of the warrant liabilities for the period from August 6, 2020 (Inception) through June 30, 2021:\n| Warrant Liability |\n| Fair value as of February 1, 2021 | $ | 2,303,000 |\n| Issuance of private warrants in connection with over-allotment as of February 2, 2021 | 147,000 |\n| Change in fair value (1) | ( 575,000 ) |\n| Fair value as of June 30, 2021 | $ | 1,875,000 |\n\n(1) Represents the non-cash gain on the change in valuation of Private Warrants and is included in the change in fair value of warrant liability on the statement of operations.\nAt June 30, 2021, the Public Warrants were determined to contain none of the features requiring liability treatment; therefore, the Public warrants were not included in the fair value reporting.\nThe Private Warrants were valued using a Modified Black Scholes Model. The Private Warrants are considered to be a Level 3 fair value measurements due to the use of unobservable inputs. The Black Scholes Model can be modified to value SPAC Private Warrants by discounting the Acquisition Date warrant value to the Valuation Date and multiplying the present value by the probability of a future transaction occurring.\nTransfers to/from Levels 1, 2 and 3 are recognized at the end of the reporting period. There were no transfers between levels for the period from January 1, 2021 through June 30, 2021.\nThe following table provides quantitative information regarding Level 3 fair value measurements for Private Warrants as of June 30, 2021 and February 1, 2021.\n| June 30, 2021 | February 1, 2021 |\n| Exercise price | $ | 11.50 | $ | 11.50 |\n| Share price | $ | 9.68 | $ | 10.00 |\n| Volatility | 14.25 | % | 19.00 | % |\n| Expected life | 5 .00 | 5 .00 |\n| Risk-free rate | 0.87 | % | 0.42 | % |\n| Dividend yield | - | % | - | % |\n\nNote 8 — Commitments and Contingencies\nRegistration Rights\nThe holders of the founders’ shares issued and outstanding on the date of the IPO, as well as the holders of the representative shares, Private Placement Warrants and any warrants the Company’s Sponsor, officers, directors or their affiliates may be issued in payment of Working Capital Loans made to the Company (and all underlying securities), will be entitled to registration rights pursuant to an agreement signed on January 27, 2021. The holders of a majority of these securities are entitled to make up to two demands that the Company registers such securities. The holders of the majority of the founders’ shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the representative shares, Private Placement Warrants and warrants issued to the Company’s Sponsor, officers, directors or their affiliates in payment of Working Capital Loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the Company’s consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggyback” registration only during the seven-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\n14\nUnderwriting Agreement\nThe underwriters have a 45-day option beginning February 1, 2021 to purchase up to an additional 750,000 units to cover over-allotments, if any, at the IPO price less the underwriting discounts.\nThe Company issued to the underwriter (and/or its designees) (the “Representative”) 100,000 shares of common stock for $ 0.0001 per share (the “Representative Shares”). The Company estimated the fair value of the stock to be $ 2,000 based upon the price of the founder shares issued to the Sponsor. The stock were treated as underwriters’ compensation and charged directly to shareholders’ equity. The underwriter (and/or its designees) agreed (i) to waive their conversion rights (or right to participate in any tender offer) with respect to such shares in connection with the completion of our initial business combination and (ii) to waive their rights to liquidating distributions from the trust account with respect to such shares if we fail to complete our initial business combination within 21 months from the closing of this offering.\nOn February 1, 2021, the Company paid a fixed underwriting fee of $ 1,000,000 .\nOn February 2, 2021, the underwriters purchased an additional 750,000 units to exercise its over-allotment option in full. The proceeds of $ 7,500,000 from the over-allotment was deposited in the Trust Account after deducting the underwriting discounts.\nBusiness Combination Marketing Agreement\nThe Company has engaged underwriters as advisors in connection with its Business Combination to assist it in holding meetings with the stockholders to discuss the potential Business Combination and the target business’s attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with the potential Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay the Marketing Fee for such services upon the consummation of the initial Business Combination in an amount equal to, in the aggregate, 3.5 % of the gross proceeds of the IPO, or $ 2,012,500 including the proceeds from the full exercise of the over-allotment option on February 2, 2021.\nRight of First Refusal\nIf the Company determines to pursue any equity, equity-linked, debt or mezzanine financing relating to or in connection with a Business Combination or after a Business Combination, then EarlyBirdCapital shall have the right, but not the obligation, to act as book running manager, placement agent and/or arranger, as the case may be, in any and all such financing or financings and to receive at least 25 % of the aggregate gross spread or fees from any and all such financings. This right of first refusal extends from the February 1, 2021 until the earlier of twelve (12) months after the consummation of an initial Business Combination or the liquidation of the Trust Account if the Company fails to consummate a Business Combination during the required time period.\nNote 9 — Stockholder’s Equity\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 and with such designations, voting and other rights and preferences as may be determined from time to time by the Company's board of directors. At June 30, 2021 and December 31, 2021, there were no shares of preferred stock issued or outstanding.\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. On August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 . Of the 1,437,500 shares of common stock, an aggregate of up to 187,500 shares are subject to forfeiture to the Company for no consideration to the extent that the underwriters' over-allotment option is not exercised in full or in part, so that the initial stockholders will collectively own 20 % of the Company's issued and outstanding common stock after the IPO. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then. In August 2020, the Company also issued to designees of EarlyBirdCapital an aggregate of 100,000 shares of common stock (“representative shares”), at a price of $ 0.0001 per share. As of June 30, 2021 and December 31, 2020, there were 2,157,788 and 1,537,500 shares of common stock issued and outstanding, respectively.\n15\nCommon stockholders of record are entitled to one vote for each share held on all matters to be voted on by stockholders. In connection with any vote held to approve the initial Business Combination, the initial stockholders, as well as all of the Company’s officers and directors, have agreed to vote their respective shares of common stock owned by them immediately prior to the IPO and any shares purchased in the IPO or following the IPO in the open market in favor of the proposed Business Combination.\nNote 10 — Subsequent Events\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the unaudited condensed financial statements were issued.\n16\n\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nReferences to the “Company,” “us,” “our” or “we” refer to Ignyte Acquisition Corp.. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed financial statements and related notes included herein.\nCautionary Note Regarding Forward-Looking Statements\nAll statements other than statements of historical fact included in this Report including, without limitation, statements under this “Management's Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company's financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company's management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company's management. Actual results could differ materially from those contemplated by the forward- looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on the Company's behalf are qualified in their entirety by this paragraph.\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nOverview\nWe are an early-stage blank check company incorporated as a Delaware corporation and formed for the purpose of effecting an initial business combination.\nWe leverage the more than nine decades of combined operational and financial experience of our management team and board of directors who are both established e-commerce entrepreneurs and sophisticated investors. We believe our extensive industry experience and proven ability to source, acquire, grow and revitalize companies will provide our management team with a robust and consistent flow of acquisition opportunities. Our management team and board's broad relationships across multiple networks, including leading consumer and technology company founders, executives of private and public companies, leading M&A investment banks and private equity firms, as well as their ability to engage early with founder-led businesses represents a differentiated advantage to successfully source transaction opportunities. Our team has been immersed in the same ecosystem as the current founders of private companies who are making decisions on how to build currency for future growth and monetization.\nWhile we may pursue an initial business combination target in any business, industry or geographical location, we are focusing our search primarily within the consumer-facing e-commerce sector. We are capitalizing on the ability of our management team to identify, acquire and operate a business or businesses that can benefit from our management team and board's established relationships and operating experience. Our management team has extensive experience in identifying and executing strategic investments and has done so successfully in several sectors, particularly in digital consumer-facing businesses. Over time, we believe that all companies will need to deploy an omni-commerce strategy to succeed, and we will leverage our management team and board's unique experience to successfully develop our business target's omni-commerce.\nResults of Operations\nOur entire activity since inception up to June 30, 2021 relates to our formation, the Initial Public Offering and, since the closing of the Initial Public Offering, a search for a Business Combination candidate. We will not be generating any operating revenues until the closing and completion of our initial Business Combination, at the earliest.\nFor the three months ended June 30, 2021, we had net income of $616,107, which consisted of $2,087 in interest earned on marketable securities held in the Trust Account, and $725,000 in unrealized gain on change in fair value of warrants, offset by $110,980 in formation and operating costs.\nFor the six months ended June 30, 2021, we had net income of $269,924, which consisted of $4,345 in interest earned on marketable securities held in the Trust Account, and $575,000 in unrealized gain on change in fair value of warrants, offset by $309,421 in formation and operating costs.\n17\nLiquidity and Capital Resources\nAs of June 30, 2021, we had $550,470 in its operating bank account, and working capital of $667,784.\nPrior to the completion of the Initial Public Offering, our liquidity needs had been satisfied through a payment from the Sponsor of $25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $80,000, and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of the Sponsor or our officers and directors or their affiliates may, but are not obligated to, provide us Working Capital Loans. To date, there were no amounts outstanding under any Working Capital Loans.\nWe anticipate that the $550,470 outside of the Trust Account as of June 30, 2021, will be sufficient to allow the Company to operate for at least the next 12 months from the issuance of the financial statements, assuming that a Business Combination is not consummated during that time.\nBased on the foregoing, management believes that we will have sufficient working capital and borrowing capacity to meet our needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, we will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\nCritical Accounting Policies and Estimates\nThe preparation of the unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. We have identified the following as our critical accounting policies:\nWarrant Liabilities\nWe account for the Warrants, as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in FASB ASC 815, Derivatives and Hedging ASC 815. The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company's own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company's control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, was conducted at the time of issuance of the Warrants and will continue as of each subsequent quarterly period end date while the Warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company's control) is classified as temporary equity. At all other times, common stock is classified as stockholders' equity. The Company's common stock feature certain redemption rights that is considered to be outside of the Company's control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders' equity section of the Company's balance sheet.\nNet Income Per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for\n18\nredeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these common stock do not have any redemption features and do not participate in the income earned on the Trust Account.\nOff-Balance Sheet Arrangements\nAs of June 30, 2021, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nAs of June 30, 2021, we were not subject to any market or interest rate risk. Following the consummation of our Initial Public Offering, the net proceeds received into the Trust Account, have been invested in U.S. government treasury bills, notes or bonds with a maturity of 180 days or less or in certain money market funds that invest solely in US treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Co-Chief Executive Officers and Chief Financial Officer, to allow timely decisions regarding required disclosure.\nEvaluation of Disclosure Controls and Procedures\nAs required by Rules 13a-15 and 15d-15 under the Exchange Act, our Co-Chief Executive Officers and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2021. Based upon their evaluation, our Co-Chief Executive Officers and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act) continued to be ineffective with respect to the classification of the Company's Warrants as components of equity instead of as derivative liabilities and the re-classification of the Company's Class A ordinary shares between temporary and permanent equity. Any failure to maintain effective disclosure controls could adversely impact our ability to report our financial results on a timely and accurate basis, which could have adverse consequences, including with respect to the continued listing of our securities.\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting\nDuring the fiscal quarter ended March 31, 2021, management identified a material weakness in internal controls related to the accounting for warrants issued in connection with our initial public offering, as described above, which material weakness continued to exist during the most recent fiscal quarter ended June 30, 2021. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\n19\nPART II – OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS.\nNone.\n\nITEM 1A. RISK FACTORS.\nFactors that could cause our actual results to differ materially from those in this report include the risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2020 filed with the SEC on April 15, 2021, as amended on Form 10-K/A filed with the SEC on April 19, 2021. As of the date of this Report there have been no material changes to the risk factors disclosed in our Annual Report filed with the SEC.\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\nNone.\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES.\nNone.\n\nITEM 4. MINE SAFETY DISCLOSURES.\nNot applicable.\n\nITEM 5. OTHER INFORMATION.\nOn May 28, 2021, we received a notice from Nasdaq Regulation, or Nasdaq, indicating that we were not in compliance with Nasdaq Listing Rule 5250(c)(1) as a result of our failure to timely file our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, which we refer to as the Form 10-Q, with the Securities and Exchange Commission, or SEC. The notice provided that we must submit a plan to regain compliance with Nasdaq Listing Rule 5250(c)(1) by July 26, 2021. Alternatively, we were permitted to regain compliance with the Nasdaq listing standards at any time prior to that date by filing the Form 10-Q with the SEC. We subsequently filed the Form 10-Q with the SEC on July 26, 2021.\nOn August 6, 2021, we received a notice from Nasdaq stating that, based on the Form 10-Q filing on July 26, 2021, we had regained compliance with the Nasdaq listing standards.\n\nITEM 6. EXHIBITS.\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| No. | Description of Exhibit |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | Inline XBRL Instance Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n\n| * | Filed herewith. |\n| ** | Furnished. |\n\n20\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| IGNYTE ACQUISITION CORP. |\n| Date: August 16, 2021 | By: | /s/David Rosenburg |\n| David Rosenberg |\n| Co-Chief Executive Officer (Principal Executive Officer) |\n\n\n| IGNYTE ACQUISITION CORP. |\n| Date: August 16, 2021 | By: | /s/ Steven Kaplan |\n| Steven Kaplan |\n| Chief Financial Officer (Principal Financial and Accounting Officer) |\n\n21\n</text>\n\nWhat is the difference between the total net income for both redeemable and non-redeemable common stock and the total offering costs from the IPO in the first half of 2021 in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nITEM 1. CONDENSED FINANCIAL STATEMENTS\\nIGNYTE ACQUISITION CORP.\\nCONDENSED BALANCE SHEETS\\n| June 30, 2021 | December 31, 2020 |\\n| (unaudited) |\\n| Assets |\\n| Cash | $ | 550,470 | $ | 25,425 |\\n| Prepaid expense and other current assets | 181,923 | - |\\n| Total current assets | 732,393 | 25,425 |\\n| Deferred offering costs | - | 81,575 |\\n| Cash and securities held in Trust Account | 57,504,345 | - |\\n| Total Assets | $ | 58,236,738 | $ | 107,000 |\\n| Liabilities and Stockholders' Equity |\\n| Current liabilities: |\\n| Accrued expenses | $ | 12,656 | $ | - |\\n| Due to related party | 51,953 | 310 |\\n| Promissory note - related party | - | 80,000 |\\n| Total current liabilities | 64,609 | 80,310 |\\n| Warrant liabilities | 1,875,000 | - |\\n| Total liabilities | 1,939,609 | 80,310 |\\n| Commitments and Contingencies(8) |\\n| Common stock subject to possible redemption, 5,129,712 shares at redemption value | 51,297,120 | - |\\n| Stockholders' Equity: |\\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | - | - |\\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 2,157,788 shares and 0 shares issued and outstanding (excluding 5,129,712 shares and 0 shares subject to possible redemption) at June 30, 2021 and December 31, 2020, respectively | 216 | 154 |\\n| Additional paid-in capital | 4,730,179 | 26,846 |\\n| Retained earnings (Accumulated deficit) | 269,614 | ( 310 | ) |\\n| Total stockholders' equity | 5,000,009 | 26,690 |\\n| Total Liabilities and Stockholders' Equity | $ | 58,236,738 | $ | 107,000 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n1\\nIGNYTE ACQUISITION CORP.\\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, 2021 | June 30, 2021 |\\n| Formation and operating costs | $ | 110,980 | $ | 309,421 |\\n| Loss from operations | ( 110,980 | ) | ( 309,421 | ) |\\n| Other income |\\n| Change in fair value of warrants | 725,000 | 575,000 |\\n| Trust interest income | 2,087 | 4,345 |\\n| Total other income | 727,087 | 579,345 |\\n| Net income | $ | 616,107 | $ | 269,924 |\\n| Basic and diluted weighted average shares outstanding, common stock subject to redemption | 5,068,102 | 4,183,046 |\\n| Basic and diluted net loss per share | $ | 0.00 | $ | 0.00 |\\n| Basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\\n| Basic and diluted net loss per share | $ | 0.28 | $ | 0.13 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n2\\nIGNYTE ACQUISITION CORP.\\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY\\n| Common Stock | Additional Paid-in Capital | Retained Earnings(Accumulated Deficit) | Total Stockholders' Equity |\\n| Shares | Amount |\\n| Balance as of December 31, 2020 | 1,537,500 | $ | 154 | $ | 26,846 | $ | ( 310 | ) | $ | 26,690 |\\n| Sale of 5,000,000 and 750,000 Units on February 1, 2021 and February 2, 2021 through IPO and over-allotment, respectively | 5,750,000 | 575 | 57,499,425 | - | 57,500,000 |\\n| Sale of 2,350,000 and 150,000 Placement Warrants on February 1, 2021 and February 2, 2021, respectively, net of fair value of warrant liabilities | - | - | 50,000 | - | 50,000 |\\n| Underwriting fee | - | - | ( 1,150,000 | ) | - | ( 1,150,000 | ) |\\n| Other offering expenses | - | - | ( 399,485 | ) | - | ( 399,485 | ) |\\n| Net loss | - | - | - | ( 346,183 | ) | ( 346,183 | ) |\\n| Common stock subject to possible redemption | ( 5,068,201 | ) | ( 507 | ) | ( 50,680,513 | ) | - | ( 50,681,020 | ) |\\n| Balance as of March 31, 2021 | 2,219,398 | 222 | 5,346,273 | ( 346,493 | ) | 5,000,002 |\\n| Change in value of common stock subject to possible redemption | ( 61,610 | ) | ( 6 | ) | ( 616,094 | ) | ( 616,100 | ) |\\n| Net income | 616,107 | 616,107 |\\n| Balance as of June 30, 2021 (unaudited) | 2,157,788 | $ | 216 | $ | 4,730,179 | $ | 269,614 | $ | 5,000,009 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n3\\nIGNYTE ACQUISITION CORP.\\nUNAUDITED CONDENSED STATEMENT OF CASH FLOWS\\n| For the Six Months Ended |\\n| June 30, 2021 |\\n| Cash flows from Operating Activities: |\\n| Net income | $ | 269,924 |\\n| Adjustments to reconcile net income to net cash used in operating activities: |\\n| Increase in fair value of warrants | ( 575,000 | ) |\\n| Interest earned on marketable securities held in Trust Account | ( 4,345 | ) |\\n| Changes in current assets and current liabilities: |\\n| Prepaid expenses | ( 181,923 | ) |\\n| Accrued offering costs and expenses | 12,656 |\\n| Due to related party | 51,643 |\\n| Net cash used in operating activities | ( 427,045 | ) |\\n| Cash Flows from Investing Activities: |\\n| Purchase of investment held in Trust Account | ( 57,500,000 | ) |\\n| Net cash used in investing activities | ( 57,500,000 | ) |\\n| Cash flows from Financing Activities: |\\n| Proceeds from Initial Public Offering, net of underwriters' fees | 56,350,000 |\\n| Proceeds from private placement | 2,500,000 |\\n| Repayment of promissory note to related party | ( 80,000 | ) |\\n| Payments of offering costs | ( 317,910 | ) |\\n| Net cash provided by financing activities | 58,452,090 |\\n| Net change in cash | 525,045 |\\n| Cash, beginning of the period | 25,425 |\\n| Cash, end of the period | $ | 550,470 |\\n| Supplemental disclosure of noncash investing and financing activities: |\\n| Initial value of Common stock subject to possible redemption, as revised | $ | 51,023,118 |\\n| Change in value of Common stock subject to possible redemption | $ | 274,002 |\\n| Initial fair value of warrant liabilities | $ | 2,450,000 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n4\\nIGNYTE ACQUISITION CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 1 — Organization and Business Operations\\nOrganization and General\\nIgnyte Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated as a Delaware corporation on August 6, 2020. The Company was incorporated for the purpose of effecting a merger, stock exchange, asset acquisition, stock purchase, reorganization or other similar business combination with one or more businesses (the “Business Combination”).\\nThe Company has selected December 31 as its fiscal year end.\\nThe Company is an early stage and emerging growth company and, as such, the Company is subject to all of the risks associated with early stage and emerging growth companies.\\nAs of June 30, 2021, the Company had not commenced any operations. All activity for the period from August 6, 2020 (inception) through June 30, 2021 relates to the Company's formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income on cash and cash equivalents from the proceeds derived from the IPO.\\nThe Company's sponsor is Ignyte Sponsor LLC (the “Sponsor”), a Delaware limited liability company (the “Sponsor”).\\nFinancing\\nThe registration statement for the Company's IPO was declared effective on January 27, 2021 (the “Effective Date”). On February 1, 2021, the Company consummated the IPO of 5,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units being offered, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 50,000,000 , which is discussed in Note 4.\\nSimultaneously with the closing of the IPO, the Company consummated the sale of 2,350,000 Private Placement Warrants (the “Private Placement Warrants”) at a price of $ 1.00 per Private Placement Warrant in a private placement to the Sponsor, generating total gross proceeds of $ 2,350,000 .\\nOn February 2, 2021, the underwriters purchased an additional 750,000 Units to exercise its over-allotment option in full at a purchase price of $ 10.00 per Unit, generating gross proceeds of $ 7,500,000 . Simultaneously with the closing of the full exercise of the over-allotment option, the Company completed the private sale of an aggregate of 150,000 Private Placement Warrants to the Sponsor, at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 . A total of $ 7,500,000 was placed in the Trust Account after the payment of $ 150,000 underwriting discount.\\nTransaction costs amounted to $ 1,549,485 consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs. In addition, $ 975,465 of cash was held outside of the Trust Account (as defined below) and is available for working capital purposes.\\nTrust Account\\nFollowing the closing of the IPO, on February 1, 2021, $50,000,000 ($10.00 per Unit) from the net proceeds of the sale of the Units in the IPO and the sale of the Private Placement Warrants was held in a Trust Account (“Trust Account”), and will invest only in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, having a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act which invest only in direct U.S. government treasury obligations. Except with respect to interest earned on the funds held in the Trust Account that may be released to the Company to pay income tax obligations, the proceeds from the IPO will not be released from the Trust Account until the earlier of the completion of a Business Combination or the Company's redemption of 100 % of the outstanding Public Shares if it has not completed a Business Combination in the required time period. The proceeds held in the Trust Account may be used as consideration to pay the sellers of a target business with which the Company completes a Business Combination. Any amounts not paid as consideration to the sellers of the target business may be used to finance operations of the target business.\\n5\\nInitial Business Combination\\nIn connection with any proposed Business Combination, the Company will either (1) seek stockholders approval of the initial Business Combination at a meeting called for such purpose at which stockholders may seek to convert their shares, regardless of whether they vote for or against the proposed Business Combination or don't vote at all, into their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), or (2) provide its stockholders with the opportunity to sell their shares to the Company by means of a tender offer (and thereby avoid the need for a stockholder vote) for an amount equal to their pro rata share of the aggregate amount then on deposit in the Trust Account (net of taxes payable), in each case subject to the limitations described herein. The decision as to whether the Company will seek stockholders approval of a proposed Business Combination or will allow stockholders to sell their shares to the Company in a tender offer will be made by the Company, solely in its discretion,\\nThe shares of Common Stock subject to redemption will be recorded at a redemption value and classified as temporary equity upon the completion of the IPO, in accordance with Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the issued and outstanding shares voted are voted in favor of the Business Combination.\\nThe Company will have 21 months from the closing of the IPO to complete the initial Business Combination (the “Combination Period”). However, if the Company is unable to complete the initial Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem 100% of the outstanding public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company but net of taxes payable ( and less up to $ 50,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders' rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company's remaining stockholders and the Company's board of directors, liquidate and dissolve, subject (in the case of (ii) and (iii) above) to the Company's obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\\nThe Sponsor, officers and directors have agreed (i) to vote any shares owned by them in favor of any proposed Business Combination, (ii) not to convert any shares in connection with a stockholder vote to approve a proposed initial Business Combination or sell any shares to the Company in a tender offer in connection with a proposed initial Business Combination, (iii) that the founders' shares will not participate in any liquidating distributions from the Company's Trust Account upon winding up if a Business Combination is not consummated.\\nThe Sponsor has agreed that it will be liable to ensure that the proceeds in the Trust Account are not reduced below $10.00 per share by the claims of target businesses or claims of vendors or other entities that are owed money by the Company for services rendered or contracted for or products sold to the Company. The agreement entered into by the Sponsor specifically provides for two exceptions to the indemnity it has given: it will have no liability (1) as to any claimed amounts owed to a target business or vendor or other entity who has executed an agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account, or (2) as to any claims for indemnification by the underwriters of the Proposed Public Offering against certain liabilities, including liabilities under the Securities Act. However, the Company has not asked its Sponsor to reserve for such indemnification obligations, nor has it independently verified whether the Sponsor has sufficient funds to satisfy its indemnity obligations and believe that the Sponsor's only assets are securities of the Company. Therefore, the Company believes it is unlikely that the Sponsor will be able to satisfy its indemnification obligations if it is required to do so.\\nLiquidity and Capital Resources\\nAs of June 30, 2021, the Company had $ 550,470 in its operating bank account, and working capital of $ 667,784 .\\nPrior to the completion of the Initial Public Offering, the Company's liquidity needs had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $ 80,000 (see Note 6), and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, the Company's Sponsor or an affiliate of the Sponsor or the Company's officers and directors or their affiliates may, but are not obligated to, provide the Company Working Capital Loans (see Note 6). To date, there were no amounts outstanding under any Working Capital Loans.\\nBased on the foregoing, management believes that the Company will have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, the Company will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\\n6\\nNote 2 — Revision of Previously Issued Financial Statements\\nOn April 12, 2021, the Staff of the Securities and Exchange Commission together issued a statement regarding the accounting and reporting considerations for warrants issued by special purpose acquisition companies entitled \\\"Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (\\\"SPACs\\\")\\\" (the \\\"SEC Statement\\\"). Specifically, the SEC Statement focused on certain settlement terms and provisions related to certain tender offers following a Business Combination, which terms are similar to those contained in the warrant agreement, dated as of January 27, 2021, between the Company and Continental Stock Transfer & Trust Company, a New York corporation, as warrant agent (the \\\"Warrant Agreement\\\").\\nHistorically, the warrants were reflected as a component of equity as opposed to liabilities on the balance sheets and the statements of operations did not include the subsequent non-cash changes in estimated fair value of the Warrants, based on the application of FASB ASC Topic 815-40, Derivatives and Hedging, Contracts in Entity's Own Equity (“ASC 815-40). The views expressed in the SEC Staff Statement were not consistent with the Company's historical interpretation of the specific provisions within its warrant agreement and the Company's application of ASC 815-40 to the warrant agreement. the Company reevaluated the accounting treatment of (i) the 2,875,000 Public Warrants and (ii) the 2,500,000 Private Placement Warrants (See Note 4 and Note 5). Based on this reassessment, management determined that the private warrants should be classified as liabilities measured at fair value upon issuance, with subsequent changes in fair value reported in the Company Statement of Operations each reporting period.\\nThe Company's management and the audit committee of the Company's Board of Directors concluded that it is appropriate to revise the Company's previously issued audited balance sheet as of February 1, 2021 as previously reported in its Form 8-K.\\nThe following tables summarize the effect of the restatement on each balance sheet line item as of the date:\\n| As Previously Reported | Adjustment | As Revised |\\n| Balance Sheet at February 1, 2021 |\\n| Warrant Liabilities | $ | - | $ | 2,303,000 | $ | 2,303,000 |\\n| Total Liabilities | 426,200 | 2,303,000 | 2,729,200 |\\n| Common stock subject to possible redemption | 45,973,118 | ( 2,303,000 ) | 43,670,118 |\\n| Common stock | 194 | 23 | 217 |\\n| Additional paid-in capital | 5,004,203 | ( 23 ) | 5,004,180 |\\n| Accumulated deficit | $ | ( 4,396 ) | $ | - | $ | ( 4,396 ) |\\n| Total Stockholders' Equity | 5,000,001 | - | 5,000,001 |\\n| Number of shares subject to redemption | 4,597,312 | ( 230,300 ) | 4,367,012 |\\n\\nNote 3 — Summary of Significant Accounting Policies\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. In the opinion of management, the unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the period for the six months ended June 30, 2021 are not necessarily indicative of the results that may be expected through December 31, 2021.\\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Form 10-K filed by the Company with the SEC.\\n7\\nEmerging Growth Company\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended, (the “Securities Act”), as modified by the Jumpstart our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statement with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nUse of Estimates\\nThe preparation of unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Actual results could differ from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2021 and December 31, 2020.\\nMarketable Securities Held in Trust Account\\nAt June 30, 2021, the assets held in the Trust Account were invested in money market funds.\\nFair Value Measurements\\nFASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. ASC 820 establishes a fair value hierarchy for inputs, which represent the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances.\\nThe fair value hierarchy is categorized into three levels based on the inputs as follows:\\nLevel 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment.\\nLevel 2 — Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by market through correlation or other means.\\nLevel 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.\\nThe fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash, prepaid assets, and accounts payable are estimated to approximate the carrying values as of December 31, 2020 due to the short maturities of such instruments.\\n8\\nThe Company’s warrant liabilities are based on a valuation model utilizing management judgment and pricing inputs from observable and unobservable markets with less volume and transaction frequency than active markets. Significant deviations from these estimates and inputs could result in a material change in fair value. In some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement. See Note 7 for additional information on assets and liabilities measured at fair value.\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . At June 30, 2021 and December 31, 2020, the Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account.\\nCommon Stock Subject to Possible Redemption\\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock feature certain redemption rights that is considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of the Company’s balance sheet.\\nNet Income Per Common Share\\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for redeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these shares do not have any redemption features and do not participate in the income earned on the Trust Account.\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, 2021 | June 30, 2021 |\\n| Common stock subject to possible redemption |\\n| Numerator: net income allocable to common stock subject to possible redemption |\\n| Interest income on marketable securities held in trust | $ | 1,862 | $ | 3,876 |\\n| Less: interest available to be withdrawn for payment of taxes | - | - |\\n| Net income allocable to common stock subject to possible redemption | 1,862 | 3,876 |\\n| Denominator: Weighted average redeemable common stock |\\n| Redeemable common stock, basic and diluted | 5,068,102 | 4,183,046 |\\n| Basic and diluted net income per share, redeemable common stock | $ | - | $ | - |\\n| Non-redeemable common stock |\\n| Numerator: net income minus redeemable net earnings |\\n| Net income | $ | 616,107 | $ | 269,924 |\\n| Redeemable net earnings | ( 1,862 ) | ( 3,876 ) |\\n| Non-redeemable net income | 614,245 | 266,048 |\\n| Denominator: Weighted average non-redeemable basic and diluted weighted average shares outstanding, common stock | 2,219,398 | 2,053,694 |\\n| Basic and diluted net income per share, common stock | $ | 0.28 | $ | 0.13 |\\n\\n9\\nOffering Costs associated with the Initial Public Offering\\nThe Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the IPO and were charged to stockholders' equity upon the completion of the IPO. Accordingly, as of February 1, 2021, offering costs in the aggregate of $ 1,549,485 have been charged to stockholders' equity (consisting of $1,150,000 of underwriting discount and $ 399,485 of other offering costs).\\nWarrant Liabilities\\nThe Company accounts for the Public Warrants and Private Warrants (as defined in Note 4 and 5) collectively (“Warrants”), as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of issuance of the Warrants and as of each subsequent quarterly period end date while the Warrants are outstanding.\\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\\nThe Company accounts for the Private Warrants in accordance with ASC 815-40 under which the Private Warrants do not meet the criteria for equity classification and must be recorded as liabilities. The fair value of the Private Warrants has been estimated using the Monte Carlo simulation model. See Note 7 for further discussion of the pertinent terms of the Warrants used to determine the value of the Private Warrants and Representative’s Warrants.\\nThe Company evaluated the Public Warrants in accordance with ASC 815-40, “Derivatives and Hedging — Contracts in Entity’s Own Equity” and concluded that they met the criteria for equity classification and are required to be recorded as part a component of additional paid-in capital at the time of issuance.\\nIncome Taxes\\nThe Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes.” Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.\\n10\\nASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company is subject to income tax examinations by major taxing authorities since inception.\\nRisks and Uncertainties\\nOn January 30, 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus (the ”COVID-19 outbreak”). In March 2020, the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. The full impact of the COVID-19 outbreak continues to evolve. The impact of the COVID-19 outbreak on the Company’s financial position will depend on future developments, including the duration and spread of the outbreak and related advisories and restrictions. These developments and the impact of the COVID-19 outbreak on the financial markets and the overall economy are highly uncertain and cannot be predicted. If the financial markets and/or the overall economy are impacted for an extended period, the Company’s financial position may be materially adversely affected. Additionally, the Company’s ability to complete an initial Business Combination may be materially adversely affected due to significant governmental measures being implemented to contain the COVID-19 outbreak or treat its impact, including travel restrictions, the shutdown of businesses and quarantines, among others, which may limit the Company’s ability to have meetings with potential investors or affect the ability of a potential target company’s personnel, vendors and service providers to negotiate and consummate an initial Business Combination in a timely manner. The Company’s ability to consummate an initial Business Combination may also be dependent on the ability to raise additional equity and debt financing, which may be impacted by the COVID-19 outbreak and the resulting market downturn. The financial statement does not include any adjustments that might result from the outcome of this uncertainty.\\nRecent Accounting Standards\\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statement.\\nNote 4 — Initial Public Offering\\nOn February 1, 2021, the Company sold 5,000,000 Units, at a purchase price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one-half of one warrant to purchase one share of common stock (“Public Warrant”). Each whole Public Warrant entitles the holder to purchase one share of common stock at a price of $ 11.50 per share, subject to adjustment.\\nOn February 2, 2021, the Underwriters exercised the over-allotment option in full to purchase 750,000 Units (the “Over-Allotment Units”), generating an aggregate of gross proceeds of $ 7,500,000 , and incurred $ 150,000 in underwriting fees.\\nPublic Warrants\\nEach whole warrant entitles the holder to purchase one share of Common Stock at a price of $11.50 per share, subject to adjustment as discussed herein. The warrants will become exercisable 30 days after the completion of the Company's initial Business Combination. However, no warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the public warrants is not effective within a specified period following the consummation of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. In the event of such cashless exercise, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose will mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the trading day prior to the date of exercise. The warrants will expire on the fifth anniversary of the completion of an initial Business Combination, at 5:00 p.m., New York City time, or earlier upon redemption or liquidation.\\n11\\nThe Company may call the warrants for redemption (excluding the Private Placement Warrants and any warrants underlying additional units issued to the Sponsor, initial stockholders, officers, directors or their affiliates in payment of Working Capital Loans made to the Company)\\n•\\nin whole and not in part;\\n•\\nat a price of $ 0.01 per warrant;\\n•\\nat any time after the warrants become exercisable,\\n•\\nupon not less than 30 days’ prior written notice of redemption to each warrant holder; and\\n•\\nif, and only if, the reported last sale price of the Common Stock equals or exceeds $ 18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations) for any 20 trading days within a 30-trading day period commencing at any time after the warrants become exercisable and ending on the third business day prior to the notice of redemption to warrant holders; and\\n•\\nif, and only if, there is a current registration statement in effect with respect to the shares of common stock underlying such warrants.\\nIf the Company calls the warrants for redemption as described above, the Company's management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In such event, each holder would pay the exercise price by surrendering the warrants for that number of shares of common stock equal to the quotient obtained by dividing (x) the product of the number of shares of common stock underlying the warrants, multiplied by the difference between the exercise price of the warrants and the “fair market value” (defined below) by (y) the fair market value. The “fair market value” for this purpose shall mean the average reported last sale price of the shares of common stock for the 5 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\\nIn addition, if (x) the Company issue additional shares of Common Stock or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $ 9.20 per share of common stock (with such issue price or effective issue price to be determined in good faith by the Company's board of directors, and in the case of any such issuance to the Sponsor, initial stockholders or their affiliates, without taking into account any founders' shares held by them prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the consummation of the initial Business Combination (net of redemptions), and (z) the Market Value is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) the Market Value or (ii) the price at which the Company issues the additional shares of common stock or equity-linked securities.\\nNote 5 — Private Placement\\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 2,350,000 Private Placement Warrants at a price of $ 1.00 per Private Placement Warrant, for an aggregate purchase price of $ 2,350,000 , in a private placement (the “Private Placement”). Each Private Placement Warrant will entitle the holder to purchase one share of common stock at a price of $11.50 per share, subject to adjustment. The proceeds from the Private Placement Warrants was added to the proceeds from the IPO held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Placement Warrants held in the Trust Account will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law) and the Private Placement Warrants will expire worthless.\\nThe Private Placement Warrants are identical to the Warrants underlying the Units sold in the IPO, except that the Private Placement Warrants are non-redeemable and may be exercised on a cashless basis, in each case so long as they continue to be held by the initial purchasers or their permitted transferees. Further, the Sponsor has agreed not to transfer, assign, or sell the Private Placement Warrants (including the shares of Common Stock issuable upon the exercise of the Private Placement Warrants), except to certain permitted transferees, until after the consummation of the Company's initial business combination.\\nSimultaneously with the closing of the exercise of the over-allotment option, the Company completed the private sale (the “Private Placement”) of an aggregate of 150,000 private placement warrants (the “Private Placement Warrants”) to Ignyte Sponsor LLC, a Delaware limited liability company (the “Sponsor”), at a purchase price of $ 1.00 per Private Placement Warrant, generating gross proceeds of $ 150,000 .\\n12\\nNote 6 — Related Party Transactions\\nFounder Shares\\nOn August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 (the “Founder Shares”). Up to 187,500 Founder Shares are subject to forfeiture by the Sponsor depending on the extent to which the underwriters' over-allotment option is exercised. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then.\\nThe founders' shares were placed into an escrow account maintained in New York, New York by Continental Stock Transfer & Trust Company, acting as escrow agent. Subject to certain limited exceptions, these shares will not be transferred, assigned, sold or released from escrow (subject to certain limited exceptions set forth below) (i) with respect to 50% of such shares, for a period ending on the earlier of the one-year anniversary of the date of the consummation of the initial Business Combination and the date on which the closing price of the Company's common stock equals or exceeds $12.50 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within a 30-trading day period following the consummation of the initial Business Combination and (ii) with respect to the remaining 50% of such shares, for a period ending on the one-year anniversary of the date of the consummation of the initial Business Combination, or earlier, in either case, if, subsequent to the initial Business Combination, the Company consummates a liquidation, merger, stock exchange or other similar transaction which results in all of the Company's stockholders having the right to exchange their shares of common stock for cash, securities or other property.\\nPromissory Note — Related Party\\nOn November 20, 2020, the Company's executive officers loaned the Company $ 80,000 to be used for a portion of the expenses of the IPO. These loans are non-interest bearing, unsecured and are due at the earlier of June 30, 2021 or the closing of the IPO. As of February 1, 2021, the Company repaid the note in full.\\nDue to Related Party\\nAs of June 30, 2021, the amount due to related party is $ 51,953 which represent the accrual of administrative service fee $ 51,643 from January 26, 2021 to June 30, 2021 and formation cost $ 310 paid by the Officer.\\nRelated Party Loans\\nIn order to meet the Company’s working capital needs following the consummation of the IPO the Sponsor, officers, directors initial stockholders or their affiliates may, but are not obligated to, loan the Company funds (“Working Capital Loans”), from time to time or at any time, in whatever amount they deem reasonable in their sole discretion. Each loan would be evidenced by a promissory note. The notes would either be paid upon consummation of the initial Business Combination, without interest, or, at holder’s discretion, up to $ 1,500,000 of the notes may be converted into warrants at a price of $ 1.00 per warrant. The warrants would be identical to the Private Placement Warrants. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. As of June 30, 2021 and December 31, 2020, no such Working Capital Loans were outstanding.\\nAdministrative Service Fee\\nThe Company has agreed, commencing on the date of the securities of the Company are first listed on The Nasdaq Capital Market (the “Listing Date”), to pay the Sponsor $ 10,000 per month for office space, utilities and secretarial support. Upon completion of the initial Business Combination or the Company's liquidation, the Company will cease paying these monthly fees. The Company accrued $ 51,643 and $ 30,000 for the administrative service fee for the period from the Listing Date to June 30, 2021and for the three months ended June 30, 2021.\\nNote 7 — Recurring Fair Value Measurements\\nThe following table presents information about the Company's assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2021, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value.\\n13\\n| June 30, 2021 | Quoted Prices In Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Other Unobservable Inputs (Level 3) |\\n| Assets: |\\n| U.S. Money Market held in Trust Account | $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\\n| $ | 57,504,345 | $ | 57,504,345 | $ | - | $ | - |\\n| Liabilities: |\\n| Warrant liabilities-Private Placement Warrants | $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\\n| $ | 1,875,000 | $ | - | $ | - | $ | 1,875,000 |\\n\\nThe following table sets forth a summary of the changes in the fair value of the warrant liabilities for the period from August 6, 2020 (Inception) through June 30, 2021:\\n| Warrant Liability |\\n| Fair value as of February 1, 2021 | $ | 2,303,000 |\\n| Issuance of private warrants in connection with over-allotment as of February 2, 2021 | 147,000 |\\n| Change in fair value (1) | ( 575,000 ) |\\n| Fair value as of June 30, 2021 | $ | 1,875,000 |\\n\\n(1) Represents the non-cash gain on the change in valuation of Private Warrants and is included in the change in fair value of warrant liability on the statement of operations.\\nAt June 30, 2021, the Public Warrants were determined to contain none of the features requiring liability treatment; therefore, the Public warrants were not included in the fair value reporting.\\nThe Private Warrants were valued using a Modified Black Scholes Model. The Private Warrants are considered to be a Level 3 fair value measurements due to the use of unobservable inputs. The Black Scholes Model can be modified to value SPAC Private Warrants by discounting the Acquisition Date warrant value to the Valuation Date and multiplying the present value by the probability of a future transaction occurring.\\nTransfers to/from Levels 1, 2 and 3 are recognized at the end of the reporting period. There were no transfers between levels for the period from January 1, 2021 through June 30, 2021.\\nThe following table provides quantitative information regarding Level 3 fair value measurements for Private Warrants as of June 30, 2021 and February 1, 2021.\\n| June 30, 2021 | February 1, 2021 |\\n| Exercise price | $ | 11.50 | $ | 11.50 |\\n| Share price | $ | 9.68 | $ | 10.00 |\\n| Volatility | 14.25 | % | 19.00 | % |\\n| Expected life | 5 .00 | 5 .00 |\\n| Risk-free rate | 0.87 | % | 0.42 | % |\\n| Dividend yield | - | % | - | % |\\n\\nNote 8 — Commitments and Contingencies\\nRegistration Rights\\nThe holders of the founders’ shares issued and outstanding on the date of the IPO, as well as the holders of the representative shares, Private Placement Warrants and any warrants the Company’s Sponsor, officers, directors or their affiliates may be issued in payment of Working Capital Loans made to the Company (and all underlying securities), will be entitled to registration rights pursuant to an agreement signed on January 27, 2021. The holders of a majority of these securities are entitled to make up to two demands that the Company registers such securities. The holders of the majority of the founders’ shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the representative shares, Private Placement Warrants and warrants issued to the Company’s Sponsor, officers, directors or their affiliates in payment of Working Capital Loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the Company’s consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggyback” registration only during the seven-year period beginning on the Effective Date of the registration statement of which the IPO forms a part. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\\n14\\nUnderwriting Agreement\\nThe underwriters have a 45-day option beginning February 1, 2021 to purchase up to an additional 750,000 units to cover over-allotments, if any, at the IPO price less the underwriting discounts.\\nThe Company issued to the underwriter (and/or its designees) (the “Representative”) 100,000 shares of common stock for $ 0.0001 per share (the “Representative Shares”). The Company estimated the fair value of the stock to be $ 2,000 based upon the price of the founder shares issued to the Sponsor. The stock were treated as underwriters’ compensation and charged directly to shareholders’ equity. The underwriter (and/or its designees) agreed (i) to waive their conversion rights (or right to participate in any tender offer) with respect to such shares in connection with the completion of our initial business combination and (ii) to waive their rights to liquidating distributions from the trust account with respect to such shares if we fail to complete our initial business combination within 21 months from the closing of this offering.\\nOn February 1, 2021, the Company paid a fixed underwriting fee of $ 1,000,000 .\\nOn February 2, 2021, the underwriters purchased an additional 750,000 units to exercise its over-allotment option in full. The proceeds of $ 7,500,000 from the over-allotment was deposited in the Trust Account after deducting the underwriting discounts.\\nBusiness Combination Marketing Agreement\\nThe Company has engaged underwriters as advisors in connection with its Business Combination to assist it in holding meetings with the stockholders to discuss the potential Business Combination and the target business’s attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with the potential Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay the Marketing Fee for such services upon the consummation of the initial Business Combination in an amount equal to, in the aggregate, 3.5 % of the gross proceeds of the IPO, or $ 2,012,500 including the proceeds from the full exercise of the over-allotment option on February 2, 2021.\\nRight of First Refusal\\nIf the Company determines to pursue any equity, equity-linked, debt or mezzanine financing relating to or in connection with a Business Combination or after a Business Combination, then EarlyBirdCapital shall have the right, but not the obligation, to act as book running manager, placement agent and/or arranger, as the case may be, in any and all such financing or financings and to receive at least 25 % of the aggregate gross spread or fees from any and all such financings. This right of first refusal extends from the February 1, 2021 until the earlier of twelve (12) months after the consummation of an initial Business Combination or the liquidation of the Trust Account if the Company fails to consummate a Business Combination during the required time period.\\nNote 9 — Stockholder’s Equity\\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 and with such designations, voting and other rights and preferences as may be determined from time to time by the Company's board of directors. At June 30, 2021 and December 31, 2021, there were no shares of preferred stock issued or outstanding.\\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. On August 12, 2020, the Sponsor paid $ 25,000 , or approximately $ 0.02 per share, to cover certain offering costs in consideration for 1,437,500 shares of Common Stock, par value $ 0.0001 . Of the 1,437,500 shares of common stock, an aggregate of up to 187,500 shares are subject to forfeiture to the Company for no consideration to the extent that the underwriters' over-allotment option is not exercised in full or in part, so that the initial stockholders will collectively own 20 % of the Company's issued and outstanding common stock after the IPO. On February 2, 2021, the underwriter exercised its over-allotment option in full, hence, the 187,500 Founder Shares are no longer subject to forfeiture since then. In August 2020, the Company also issued to designees of EarlyBirdCapital an aggregate of 100,000 shares of common stock (“representative shares”), at a price of $ 0.0001 per share. As of June 30, 2021 and December 31, 2020, there were 2,157,788 and 1,537,500 shares of common stock issued and outstanding, respectively.\\n15\\nCommon stockholders of record are entitled to one vote for each share held on all matters to be voted on by stockholders. In connection with any vote held to approve the initial Business Combination, the initial stockholders, as well as all of the Company’s officers and directors, have agreed to vote their respective shares of common stock owned by them immediately prior to the IPO and any shares purchased in the IPO or following the IPO in the open market in favor of the proposed Business Combination.\\nNote 10 — Subsequent Events\\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the unaudited condensed financial statements were issued.\\n16\\n\\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nReferences to the “Company,” “us,” “our” or “we” refer to Ignyte Acquisition Corp.. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed financial statements and related notes included herein.\\nCautionary Note Regarding Forward-Looking Statements\\nAll statements other than statements of historical fact included in this Report including, without limitation, statements under this “Management's Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company's financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company's management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company's management. Actual results could differ materially from those contemplated by the forward- looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on the Company's behalf are qualified in their entirety by this paragraph.\\nThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\\nOverview\\nWe are an early-stage blank check company incorporated as a Delaware corporation and formed for the purpose of effecting an initial business combination.\\nWe leverage the more than nine decades of combined operational and financial experience of our management team and board of directors who are both established e-commerce entrepreneurs and sophisticated investors. We believe our extensive industry experience and proven ability to source, acquire, grow and revitalize companies will provide our management team with a robust and consistent flow of acquisition opportunities. Our management team and board's broad relationships across multiple networks, including leading consumer and technology company founders, executives of private and public companies, leading M&A investment banks and private equity firms, as well as their ability to engage early with founder-led businesses represents a differentiated advantage to successfully source transaction opportunities. Our team has been immersed in the same ecosystem as the current founders of private companies who are making decisions on how to build currency for future growth and monetization.\\nWhile we may pursue an initial business combination target in any business, industry or geographical location, we are focusing our search primarily within the consumer-facing e-commerce sector. We are capitalizing on the ability of our management team to identify, acquire and operate a business or businesses that can benefit from our management team and board's established relationships and operating experience. Our management team has extensive experience in identifying and executing strategic investments and has done so successfully in several sectors, particularly in digital consumer-facing businesses. Over time, we believe that all companies will need to deploy an omni-commerce strategy to succeed, and we will leverage our management team and board's unique experience to successfully develop our business target's omni-commerce.\\nResults of Operations\\nOur entire activity since inception up to June 30, 2021 relates to our formation, the Initial Public Offering and, since the closing of the Initial Public Offering, a search for a Business Combination candidate. We will not be generating any operating revenues until the closing and completion of our initial Business Combination, at the earliest.\\nFor the three months ended June 30, 2021, we had net income of $616,107, which consisted of $2,087 in interest earned on marketable securities held in the Trust Account, and $725,000 in unrealized gain on change in fair value of warrants, offset by $110,980 in formation and operating costs.\\nFor the six months ended June 30, 2021, we had net income of $269,924, which consisted of $4,345 in interest earned on marketable securities held in the Trust Account, and $575,000 in unrealized gain on change in fair value of warrants, offset by $309,421 in formation and operating costs.\\n17\\nLiquidity and Capital Resources\\nAs of June 30, 2021, we had $550,470 in its operating bank account, and working capital of $667,784.\\nPrior to the completion of the Initial Public Offering, our liquidity needs had been satisfied through a payment from the Sponsor of $25,000 (see Note 6) for the Founder Shares to cover certain offering costs, the loan under an unsecured promissory note from the Sponsor of $80,000, and the net proceeds from the consummation of the Private Placement not held in the Trust Account. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of the Sponsor or our officers and directors or their affiliates may, but are not obligated to, provide us Working Capital Loans. To date, there were no amounts outstanding under any Working Capital Loans.\\nWe anticipate that the $550,470 outside of the Trust Account as of June 30, 2021, will be sufficient to allow the Company to operate for at least the next 12 months from the issuance of the financial statements, assuming that a Business Combination is not consummated during that time.\\nBased on the foregoing, management believes that we will have sufficient working capital and borrowing capacity to meet our needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, we will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination.\\nCritical Accounting Policies and Estimates\\nThe preparation of the unaudited condensed financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. We have identified the following as our critical accounting policies:\\nWarrant Liabilities\\nWe account for the Warrants, as either equity or liability-classified instruments based on an assessment of the specific terms of the Warrants and the applicable authoritative guidance in FASB ASC 815, Derivatives and Hedging ASC 815. The assessment considers whether the Warrants meet all of the requirements for equity classification under ASC 815, including whether the Warrants are indexed to the Company's own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company's control, among other conditions for equity classification. This assessment, which requires the use of professional judgment, was conducted at the time of issuance of the Warrants and will continue as of each subsequent quarterly period end date while the Warrants are outstanding.\\nFor issued or modified warrants that meet all of the criteria for equity classification, such warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, such warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of liability-classified warrants are recognized as a non-cash gain or loss on the statements of operations.\\nCommon Stock Subject to Possible Redemption\\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company's control) is classified as temporary equity. At all other times, common stock is classified as stockholders' equity. The Company's common stock feature certain redemption rights that is considered to be outside of the Company's control and subject to the occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders' equity section of the Company's balance sheet.\\nNet Income Per Common Share\\nNet income per common share is computed by dividing net income by the weighted average number of common stock outstanding for each of the periods. The calculation of diluted net income per common share does not include warrants since the inclusion of such warrants would be anti-dilutive.\\nThe Company's statement of operations includes a presentation of income per share for common stock subject to possible redemption in a manner similar to the two-class method of income per common share. Net income per common share, basic and diluted, for\\n18\\nredeemable common stock is calculated by dividing the interest income earned on the Trust Account, by the weighted average number of redeemable common stock outstanding since original issuance. Net income per common share, basic and diluted, for non-redeemable common stock is calculated by dividing the net income, adjusted for income attributable to redeemable common stock, by the weighted average number of non-redeemable common stock outstanding for the periods. Non-redeemable common stock includes the founder shares as these common stock do not have any redemption features and do not participate in the income earned on the Trust Account.\\nOff-Balance Sheet Arrangements\\nAs of June 30, 2021, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.\\n\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nAs of June 30, 2021, we were not subject to any market or interest rate risk. Following the consummation of our Initial Public Offering, the net proceeds received into the Trust Account, have been invested in U.S. government treasury bills, notes or bonds with a maturity of 180 days or less or in certain money market funds that invest solely in US treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\\nITEM 4. CONTROLS AND PROCEDURES\\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Co-Chief Executive Officers and Chief Financial Officer, to allow timely decisions regarding required disclosure.\\nEvaluation of Disclosure Controls and Procedures\\nAs required by Rules 13a-15 and 15d-15 under the Exchange Act, our Co-Chief Executive Officers and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2021. Based upon their evaluation, our Co-Chief Executive Officers and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act) continued to be ineffective with respect to the classification of the Company's Warrants as components of equity instead of as derivative liabilities and the re-classification of the Company's Class A ordinary shares between temporary and permanent equity. Any failure to maintain effective disclosure controls could adversely impact our ability to report our financial results on a timely and accurate basis, which could have adverse consequences, including with respect to the continued listing of our securities.\\nDisclosure controls and procedures are designed to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.\\nChanges in Internal Control Over Financial Reporting\\nDuring the fiscal quarter ended March 31, 2021, management identified a material weakness in internal controls related to the accounting for warrants issued in connection with our initial public offering, as described above, which material weakness continued to exist during the most recent fiscal quarter ended June 30, 2021. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\\n19\\nPART II – OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS.\\nNone.\\n\\nITEM 1A. RISK FACTORS.\\nFactors that could cause our actual results to differ materially from those in this report include the risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2020 filed with the SEC on April 15, 2021, as amended on Form 10-K/A filed with the SEC on April 19, 2021. As of the date of this Report there have been no material changes to the risk factors disclosed in our Annual Report filed with the SEC.\\n\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\\nNone.\\n\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES.\\nNone.\\n\\nITEM 4. MINE SAFETY DISCLOSURES.\\nNot applicable.\\n\\nITEM 5. OTHER INFORMATION.\\nOn May 28, 2021, we received a notice from Nasdaq Regulation, or Nasdaq, indicating that we were not in compliance with Nasdaq Listing Rule 5250(c)(1) as a result of our failure to timely file our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, which we refer to as the Form 10-Q, with the Securities and Exchange Commission, or SEC. The notice provided that we must submit a plan to regain compliance with Nasdaq Listing Rule 5250(c)(1) by July 26, 2021. Alternatively, we were permitted to regain compliance with the Nasdaq listing standards at any time prior to that date by filing the Form 10-Q with the SEC. We subsequently filed the Form 10-Q with the SEC on July 26, 2021.\\nOn August 6, 2021, we received a notice from Nasdaq stating that, based on the Form 10-Q filing on July 26, 2021, we had regained compliance with the Nasdaq listing standards.\\n\\nITEM 6. EXHIBITS.\\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\\n\\n| No. | Description of Exhibit |\\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS* | Inline XBRL Instance Document |\\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\n\\n| * | Filed herewith. |\\n| ** | Furnished. |\\n\\n20\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| IGNYTE ACQUISITION CORP. |\\n| Date: August 16, 2021 | By: | /s/David Rosenburg |\\n| David Rosenberg |\\n| Co-Chief Executive Officer (Principal Executive Officer) |\\n\\n\\n| IGNYTE ACQUISITION CORP. |\\n| Date: August 16, 2021 | By: | /s/ Steven Kaplan |\\n| Steven Kaplan |\\n| Chief Financial Officer (Principal Financial and Accounting Officer) |\\n\\n21\\n</text>\\n\\nWhat is the difference between the total net income for both redeemable and non-redeemable common stock and the total offering costs from the IPO in the first half of 2021 in dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -1279561.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 31,\n \"input_length\": 18052\n}"}}},{"rowIdx":32,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements (Unaudited)\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(in millions, except par value)\n\n| As of March 31, | As of December 31, |\n| 2021 | 2020 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 1,620 | $ | 1,965 |\n| Marketable securities | 154 | 164 |\n| Funds receivable | 65 | 83 |\n| Prepaid expenses and other current assets | 88 | 102 |\n| Total current assets | 1,927 | 2,314 |\n| Property and equipment, net | 23 | 25 |\n| Right-of-use assets | 39 | 43 |\n| Marketable securities | — | 4 |\n| Other assets | 10 | 11 |\n| Total assets | $ | 1,999 | $ | 2,397 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities: |\n| Accounts payable | $ | 291 | $ | 434 |\n| Merchants payable | 381 | 454 |\n| Refunds liability | 54 | 77 |\n| Accrued liabilities | 309 | 367 |\n| Total current liabilities | 1,035 | 1,332 |\n| Lease liabilities, non-current | 34 | 38 |\n| Total liabilities | 1,069 | 1,370 |\n| Commitments and contingencies (Note 7) |\n| Stockholders’ equity: |\n| Preferred stock, $ 0.0001 par value: 100 shares authorized as of March 31, 2021 and December 31, 2020; No shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\n| Common stock, $ 0.0001 par value: 3,500 ( 3,000 Class A, 500 Class B) shares authorized as of March 31, 2021 and December 31, 2020; 618 ( 501 Class A, 117 Class B) and 587 ( 478 Class A, 109 Class B) shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\n| Additional paid-in capital | 3,243 | 3,210 |\n| Accumulated other comprehensive income (loss) | ( 1 | ) | 1 |\n| Accumulated deficit | ( 2,312 | ) | ( 2,184 | ) |\n| Total stockholders’ equity | 930 | 1,027 |\n| Total liabilities and stockholders’ equity | $ | 1,999 | $ | 2,397 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n1\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(in millions, except per share data)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Revenue | $ | 772 | $ | 440 |\n| Cost of revenue | 335 | 156 |\n| Gross profit | 437 | 284 |\n| Operating expenses: |\n| Sales and marketing | 470 | 295 |\n| Product development | 51 | 25 |\n| General and administrative | 42 | 18 |\n| Total operating expenses | 563 | 338 |\n| Loss from operations | ( 126 | ) | ( 54 | ) |\n| Other income (expense), net: |\n| Interest and other income, net | — | 3 |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | ( 15 | ) |\n| Loss before provision for income taxes | ( 126 | ) | ( 66 | ) |\n| Provision for income taxes | 2 | — |\n| Net loss | ( 128 | ) | ( 66 | ) |\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n2\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\n(in millions)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Other comprehensive loss: |\n| Net unrealized holding losses on derivatives | ( 2 | ) | — |\n| Comprehensive loss | $ | ( 130 | ) | $ | ( 66 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n3\nCONTEXTLOGIC INC.\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(in millions)\n(Unaudited)\n\n| Three Months Ended March 31, 2021 |\n| Common Stock | Additional Paid-in | Accumulated Other | Accumulated | Total Stockholders’ |\n| Shares | Amount | Capital | Comprehensive Income | Deficit | Equity |\n| Balances as of December 31, 2020 | 587 | $ | — | $ | 3,210 | $ | 1 | $ | ( 2,184 | ) | $ | 1,027 |\n| Issuance of common stock upon exercise of options for cash | 2 | — | 1 | — | — | 1 |\n| Issuance of common stock upon settlement of restricted stock units, net of tax | 29 | — | ( 5 | ) | — | — | ( 5 | ) |\n| Stock-based compensation | — | — | 37 | — | — | 37 |\n| Other comprehensive loss, net | — | — | — | ( 2 | ) | — | ( 2 | ) |\n| Net loss | — | — | — | — | ( 128 | ) | ( 128 | ) |\n| Balances as of March 31, 2021 | 618 | $ | — | $ | 3,243 | $ | ( 1 | ) | $ | ( 2,312 | ) | $ | 930 |\n\n\n| Three Months Ended March 31, 2020 |\n| Redeemable Convertible Preferred Stock | Common Stock | Additional Paid-in | Accumulated | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balances as of December 31, 2019 | 422 | $ | 1,536 | 103 | $ | — | $ | — | $ | ( 1,439 | ) | $ | ( 1,439 | ) |\n| Issuance of common stock upon exercise of options for cash | — | — | 3 | — | 1 | — | 1 |\n| Net loss and comprehensive loss | — | — | — | — | — | ( 66 | ) | ( 66 | ) |\n| Balances as of March 31, 2020 | 422 | $ | 1,536 | 106 | $ | — | $ | 1 | $ | ( 1,505 | ) | $ | ( 1,504 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n4\nCONTEXTLOGIC INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(in millions)\n(Unaudited)\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 2 | 2 |\n| Non-cash lease expense | 4 | 2 |\n| Stock-based compensation expense | 37 | — |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\n| Other | ( 3 | ) | — |\n| Changes in operating assets and liabilities: |\n| Funds receivable | 18 | 8 |\n| Prepaid expenses, other current and noncurrent assets | 16 | 7 |\n| Accounts payable | ( 143 | ) | 31 |\n| Merchants payable | ( 73 | ) | ( 122 | ) |\n| Accrued and refund liabilities | ( 69 | ) | 3 |\n| Lease liabilities | ( 4 | ) | ( 2 | ) |\n| Other current and noncurrent liabilities | ( 11 | ) | ( 7 | ) |\n| Net cash used in operating activities | ( 354 | ) | ( 129 | ) |\n| Cash flows from investing activities: |\n| Purchases of marketable securities | ( 53 | ) | ( 73 | ) |\n| Maturities of marketable securities | 67 | 132 |\n| Net cash provided by investing activities | 14 | 59 |\n| Cash flows from financing activities: |\n| Payment of taxes related to RSU settlement and other financing activities, net | ( 5 | ) | 1 |\n| Net cash provided by (used in) financing activities | ( 5 | ) | 1 |\n| Net decrease in cash, cash equivalents and restricted cash | ( 345 | ) | ( 69 | ) |\n| Cash, cash equivalents and restricted cash at beginning of period | 1,965 | 754 |\n| Cash, cash equivalents and restricted cash at end of period | $ | 1,620 | $ | 685 |\n| Reconciliation of cash, cash equivalents, and restricted cash to the condensed consolidated balance sheets: |\n| Cash and cash equivalents | $ | 1,620 | $ | 675 |\n| Restricted cash included in other assets in the condensed consolidated balance sheets | — | 10 |\n| Total cash, cash equivalents and restricted cash | $ | 1,620 | $ | 685 |\n| Supplemental cash flow disclosures: |\n| Cash paid for income taxes, net of refunds | $ | 2 | $ | — |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n5\nCONTEXTLOGIC INC.\nNotes to Unaudited Condensed Consolidated Financial Statements\nNOTE 1. OVERVIEW, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES\nContextLogic Inc. (“Wish” or the “Company”) is an ecommerce company that provides a shopping experience that is mobile-first and discovery-based, which connects merchants’ products to users based on user preferences. The Company generates revenue from marketplace and logistics services provided to merchants.\nThe Company was incorporated in the state of Delaware in June 2010 and is headquartered in San Francisco, California, with operations in Canada, China and the Netherlands.\nInitial Public Offering\nIn December 2020, the Company completed its initial public offering (“IPO”) of Class A common stock, in which it sold 46 million shares. The shares were sold at an IPO price of $ 24.00 per share for net proceeds of approximately $ 1.1 billion, after deducting underwriting discounts and commissions of approximately $ 52 million. Additionally, the Company incurred approximately $ 6 million of offering costs, net of reimbursements. Following the IPO, the Company has two classes of authorized common stock, Class A common stock, which entitles holders to one vote per share, and Class B common stock, which entitles holders to 20 votes per share.\nBasis of Presentation and Consolidation\nThe accompanying condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”). The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements are unaudited, but include all adjustments of a normal recurring nature necessary for a fair presentation of our quarterly results. The consolidated balance sheet as of December 31, 2020 is derived from audited financial statements, however, it does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes in our Annual Report on Form 10-K for the year ended December 31, 2020, which was filed with the Securities and Exchange Commission (“SEC”) on March 25, 2021.\nUse of Estimates\nThe preparation of condensed consolidated financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. These estimates form the basis for judgments the Company makes about the carrying values of its assets and liabilities that are not readily available from other sources. These estimates include, but are not limited to, fair value of financial instruments, useful lives of long-lived assets, fair value of derivative instruments, incremental borrowing rate applied to lease accounting, contingent liabilities, redemption probabilities associated with Wish Cash, allowances for refunds and chargebacks and uncertain tax positions. As of March 31, 2021, the effects of the ongoing COVID-19 pandemic on the Company’s business, results of operations, and financial condition continue to evolve. As a result, many of the Company’s estimates and assumptions required increased judgment and these estimates may change materially in future periods.\nSegments\nThe Company manages its operations and allocates resources as a single operating segment. Further, the Company manages, monitors and reports its financials as a single reporting segment. The Company’s chief operating decision-maker is its Chief Executive Officer who makes operating decisions, assesses financial performance and allocates resources based on condensed consolidated financial information. As such, the Company has determined that it operates in one reportable segment.\n6\nConcentrations of Risk\nCredit Risk — Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, funds receivable, marketable securities and derivative financial instruments. The Company’s cash and cash equivalents are held on deposit with creditworthy institutions. Although the Company’s deposits exceed federally insured limits, the Company has not experienced any losses in such accounts. The Company invests its excess cash in money market accounts, U.S. Treasury notes, U.S. Treasury bills, commercial paper and corporate bonds. The Company is exposed to credit risk in the event of a default by the financial institutions holding its cash, cash equivalents and marketable securities for the amounts reflected on the condensed consolidated balance sheets. The Company’s investment policy limits investments to certain types of debt securities issued by the U.S. government, its agencies and institutions with investment-grade credit ratings and places restrictions on maturities and concentration by type and issuer.\nThe Company's derivative financial instruments expose it to credit risk to the extent that the counterparties may be unable to meet the terms of the arrangement. The Company seeks to mitigate such risk by limiting its counterparties to, and by spreading the risk across, major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored on a monthly basis. The Company is not required to pledge, nor is it entitled to receive, collateral related to its foreign exchange derivative transactions.\nThe Company is exposed to credit risk in the event of a default by its Payment Service Providers (“PSPs”). The Company does not generate revenue from PSPs. Significant changes in the Company’s relationship with its PSPs could adversely affect users’ ability to process transactions on the Company’s marketplaces, thereby impacting the Company’s operating results.\nThe following PSPs each represented 10% or more of the Company’s funds receivable balance:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| PSP 1 | 61 | % | 56 | % |\n| PSP 2 | 27 | % | 27 | % |\n\nServices Risk — The Company serves all of its users using third-party data center and hosting providers. The Company has disaster recovery protocols at the third-party service providers. Even with these procedures for disaster recovery in place, access to the Company’s service could be significantly interrupted, resulting in an adverse effect on its operating results and financial position. No significant interruptions of service were known to have occurred during the three months ended March 31, 2021 and 2020.\nSummary of Significant Accounting Policies\nThere have been no changes to the Company’s significant accounting policies described in its Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021, that have had a material impact on its condensed consolidated financial statements.\nAccounting Pronouncements\nThe Company has reviewed recent accounting pronouncements and concluded they are either not applicable to the business or no material impact is expected on the condensed consolidated financial statements as a result of future adoption.\nNOTE 2. DISAGGREGATION OF REVENUE\nThe Company generates revenue from marketplace and logistics services provided to merchants. Revenue is recognized as the Company transfers control of promised goods or services to its users in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company considers both the merchant and the user to be customers. The Company evaluates whether it is appropriate to recognize revenue on a gross or net basis based upon its evaluation of whether the Company obtains control of the specified goods or services by considering if it is primarily responsible for fulfillment of the promise, has inventory risk, has latitude in establishing pricing and selecting suppliers, among other factors. Based on these factors, marketplace revenue is generally recognized on a net basis and logistics revenue is generally recognized on a gross basis. Revenue excludes any amounts collected on behalf of third parties, including indirect taxes.\nMarketplace revenue includes commission fees collected in connection with user purchases of the merchants’ products. The commission fees vary depending on factors such as user location, demand, product type, and dynamic\n7\npricing. The Company recognizes revenue when a user’s order is processed and the related order information has been made available to the merchant. Commission fees are recognized net of estimated refunds and chargebacks. Marketplace revenue also includes ProductBoost revenue for displaying a merchant’s selected products in preferential locations within the Company’s marketplace. The Company recognizes revenue when the merchants’ selected products are displayed. The Company refers to its marketplace revenue, excluding ProductBoost revenue, as its core marketplace revenue.\nThe Company’s logistics offering for merchants is designed for direct end-to-end single order shipment from a merchant’s location to the user. Logistics services include transportation and delivery of the merchant’s products to the user. Merchants are required to prepay for logistics services on a per order basis. The Company recognizes revenue over time as the merchant simultaneously receives and consumes the logistics services benefit as the services are performed. The Company uses an output method of progress based on days in transit as it best depicts the Company’s progress toward complete satisfaction of the performance obligation.\nThe following table shows the disaggregated revenue for the applicable periods:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Core marketplace revenue | $ | 477 | $ | 340 |\n| ProductBoost revenue | 50 | 44 |\n| Marketplace revenue | 527 | 384 |\n| Logistics revenue | 245 | 56 |\n| Revenue | $ | 772 | $ | 440 |\n\nRefer to Note 11 – Geographical Information for the disaggregated revenue by geographical location.\nNote 3. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENT\nThe Company’s financial instruments consist of cash equivalents, marketable securities, funds receivable, derivative instruments, accounts payable, accrued liabilities and merchants payable. Cash equivalents’ carrying value approximates fair value at the balance sheet dates, due to the short period of time to maturity. Marketable securities and derivative instruments are recognized at fair value. Funds receivable, accounts payable, accrued liabilities and merchants payable carrying values approximate fair value due to the short time to the expected receipt or payment date.\nAssets and liabilities recognized at fair value on a recurring basis in the condensed consolidated balance sheets consisting of cash equivalents, marketable securities and derivative instruments are categorized based upon the level of judgment associated with the inputs used to measure their fair values. Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\n8\nFinancial assets and liabilities subject to fair value measurements on a recurring basis and the level of inputs used in such measurements are as follows:\n\n| March 31, 2021 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (in millions) |\n| Financial assets: |\n| Cash equivalents: |\n| Money market funds | $ | 97 | $ | 97 | $ | — | $ | — |\n| Marketable securities: |\n| U.S. Treasury bills | $ | 35 | $ | — | $ | 35 | $ | — |\n| Commercial paper | 62 | — | 62 | — |\n| Corporate bonds | 52 | — | 52 | — |\n| Non-US government | 5 | — | 5 | — |\n| Total marketable securities | $ | 154 | $ | — | $ | 154 | $ | — |\n| Total financial assets | $ | 251 | $ | 97 | $ | 154 | $ | — |\n| Financial liabilities: |\n| Accrued liabilities: |\n| Derivative liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\n| Total financial liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\n\n\n| December 31, 2020 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (in millions) |\n| Financial assets: |\n| Cash equivalents: |\n| Money market funds | $ | 35 | $ | 35 | $ | — | $ | — |\n| U.S. Treasury bills | 30 | — | 30 | — |\n| Commercial paper | 9 | — | 9 | — |\n| Total cash equivalents | $ | 74 | $ | 35 | $ | 39 | $ | — |\n| Marketable securities: |\n| U.S. Treasury bills | $ | 38 | $ | — | $ | 38 | $ | — |\n| Commercial paper | 49 | — | 49 | — |\n| Corporate bonds | 81 | — | 81 | — |\n| Total marketable securities | $ | 168 | $ | — | $ | 168 | $ | — |\n| Prepaid and other current assets: |\n| Derivative assets | $ | 3 | $ | — | $ | 3 | $ | — |\n| Total financial assets | $ | 245 | $ | 35 | $ | 210 | $ | — |\n| Financial liabilities: |\n| Accrued liabilities: |\n| Derivative liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\n| Total financial liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\n\nThe Company classifies cash equivalents and marketable securities within Level 1 or Level 2 because the Company uses quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. The derivative asset and liability related to the Company’s foreign currency derivative contracts are classified within Level 2 of the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets, including currency spot and forward rates.\n9\nThe following table summarizes the contractual maturities of the Company’s marketable securities:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| Amortized Cost | Estimated Fair Value | Amortized Cost | Estimated Fair Value |\n| (in millions) |\n| Due within one year | $ | 154 | $ | 154 | $ | 164 | $ | 164 |\n| Due after one year through five years | — | — | 4 | 4 |\n| Total marketable securities | $ | 154 | $ | 154 | $ | 168 | $ | 168 |\n\nAll of the Company’s available-for-sale marketable securities are subject to a periodic evaluation for a credit loss allowance and impairment review. The Company did not identify any of its available-for-sale marketable securities requiring an allowance for credit loss or as other-than-temporarily impaired in any of the periods presented. Additionally, the unrealized net gain and net loss on available-for-sale marketable securities as of March 31, 2021 and December 31, 2020 were immaterial.\nNOTE 4. BALANCE SHEET COMPONENTS\nAccrued Liabilities\nAccrued liabilities consist of the following:\n\n| March 31, | December 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Vendor services | $ | 90 | $ | 121 |\n| Deferred revenue | 26 | 37 |\n| Wish Cash liability | 48 | 48 |\n| Other | 145 | 161 |\n| Total accrued liabilities | $ | 309 | $ | 367 |\n\nNOTE 5. DERIVATIVE FINANCIAL INSTRUMENTS\nThe Company conducts business in certain foreign currencies throughout its worldwide operations, and various entities hold monetary assets or liabilities, earn revenues, or incur costs in currencies other than the entity’s functional currency. As a result, the Company is exposed to foreign exchange gains or losses which impact the Company’s operating results. The Company bills its users based on their local currencies, primarily in U.S. dollars and Euros, and the Company makes payments to the merchants in China for products sold on the Wish platform in Renminbi, which creates exposure to currency rate fluctuations. The Company hedges these cash flow exposures to reduce the risk that its earnings and cash flows will be adversely affected by changes in exchange rates. As part of the Company’s foreign currency risk mitigation strategy, the Company enters into derivative contracts and foreign exchange forward contracts with up to twelve months in duration to hedge exposures for variability in U.S.-dollar equivalent of non-U.S.-dollar denominated cash flows associated with its forecasted revenue related transactions.\nThe Company’s derivatives transactions are not collateralized and do not include collateralization agreements with counterparties. The Company does not use derivative financial instruments for speculative or trading purposes.\n10\nVolume of Derivative Activity\nTotal gross notional amounts for outstanding derivatives (recognized at fair value) as of the end of period consist of the following:\n\n| March 31, 2021 | December 31, 2020 |\n| (in millions) |\n| Cash flow hedges | $ | 250 | $ | 600 |\n| Non-designated hedges | 219 | 422 |\n| Total | $ | 469 | $ | 1,022 |\n\nFair Value of Derivative Financial Instruments\n\n| March 31, 2021 | December 31, 2020 |\n| Assets(1) | Liabilities(2) | Assets(1) | Liabilities(2) |\n| (in millions) |\n| Derivative designated as hedging instruments |\n| Cash flow hedges | $ | — | $ | 2 | $ | 3 | $ | 2 |\n| Derivative not designated as hedging instruments |\n| Foreign currency forward contracts | $ | — | $ | — | $ | — | $ | 2 |\n| Total derivatives | $ | — | $ | 2 | $ | 3 | $ | 4 |\n\n(1) Derivative assets are included in prepaid and other current assets in the condensed consolidated balance sheets.\n(2) Derivative liabilities are included in accrued liabilities in the condensed consolidated balance sheets.\nDerivatives in Cash Flow Hedging Relationships\nThe changes in accumulated other comprehensive income resulting from cash flow hedging were as follows:\n\n| As of March 31, 2021 | As of December 31, 2020 |\n| (in millions) |\n| Balance beginning of the period | $ | 2 | $ | — |\n| Other comprehensive income before reclassifications | 7 | 9 |\n| Amounts recognized in core marketplace revenue and reclassified out of accumulated other comprehensive income | ( 9 | ) | ( 7 | ) |\n| Balance at the end of the period | $ | — | $ | 2 |\n\nThe Company recognizes changes in fair value of the cash flow hedges of foreign currency denominated merchants payable in accumulated other comprehensive loss in its consolidated balance sheets until the forecasted transaction occurs. When the forecasted transaction affects earnings, the Company reclassifies the related gain or loss on the cash flow hedge to core marketplace revenue. All amounts in other comprehensive income at period end are expected to be reclassified to earnings within 12 months. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, the Company reclassifies the gain or loss on the related cash flow hedge from accumulated other comprehensive loss to core marketplace revenue. For the three months ended March 31, 2021, there were no net gains or losses recognized in core marketplace revenue relating to hedges of forecasted transactions that did not occur. The Company did not have a hedging program during the three months ended March 31, 2020.\nThe Company classifies cash flows related to its cash flow hedges as operating activities in its condensed consolidated statements of cash flows.\nDerivatives Not Designated as Hedging Instruments\nThe net gains on the change in fair value of the Company’s foreign exchange forward contracts not designated as hedging instruments were approximately $ 4 million for the three months ended March 31, 2021 and were recognized in other income (expense), net in the condensed consolidated statement of operations. The Company did not have a hedging program during the three months ended March 31, 2020.\n11\nThe Company classifies cash flows related to its non-designated hedging instruments as operating activities in its condensed consolidated statements of cash flows.\nNOTE 6. OPERATING LEASES\nThe Company leases its facilities and data center co-locations under operating leases with various expiration dates through 2025 .\nTotal operating lease cost was $ 4 million and $ 3 million for the three months ended March 31, 2021 and 2020, respectively. Short-term lease costs and variable lease costs and sublease income were not material.\nAs of March 31, 2021 and December 31, 2020, the Company’s condensed consolidated balance sheets included right-of-use assets in the amount of $ 39 million and $ 43 million, respectively, and lease liabilities in the amount of $ 14 million and $ 14 million in accrued liabilities, respectively, and $ 34 million and $ 38 million in lease liabilities, non-current, respectively.\nAs of March 31, 2021 and December 31, 2020, the weighted-average remaining lease term was 3.7 years and 3.9 years, respectively, and the weighted-average discount rate used to determine the net present value of the lease liabilities was 6 %.\nSupplemental cash flow information for the Company’s operating leases were as follows:\n\n| March 31, | March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from operating leases | $ | 4 | $ | 3 |\n\nThe maturities of the Company’s operating lease liabilities are as follows:\n\n| March 31, |\n| 2021 |\n| Year ending December 31, | (in millions) |\n| 2021 (remaining nine months) | $ | 12 |\n| 2022 | 15 |\n| 2023 | 11 |\n| 2024 | 10 |\n| 2025 | 5 |\n| Total lease payments | 53 |\n| Less: imputed interest | ( 5 | ) |\n| Present value of lease liabilities | $ | 48 |\n\nNOTE 7. COMMITMENTS AND CONTINGENCIES\nRevolving Credit Facility\nIn November 2020, the Company entered into a five-year $ 280 million senior secured revolving credit facility (the “Revolving Credit Facility”) to, among other things, permit the Company to increase its aggregate commitments by up to $ 100 million, if an accordion option is exercised and provided the Company is able to secure additional lender commitments and satisfy certain other conditions, and to enter into letters of credit from time to time, which reduces its borrowing capacity under the Revolving Credit Facility. Interest on any borrowings under the Revolving Credit Facility accrues at either adjusted LIBOR plus 1.50 % or at an alternative base rate plus 0.50 %, at the Company’s election, and the Company is required to pay a commitment fee that accrues at 0.25 % per annum on the unused portion of the aggregate commitments under the Revolving Credit Facility. The Company is required to pay a fee that accrues at 1.50 % per annum on the average daily amount available to be drawn under any letters of credit outstanding under the Revolving Credit Facility.\n12\nThe Revolving Credit Facility contains customary conditions to borrowing, events of default and covenants, including covenants that restrict the Company’s ability (and the ability of certain of the Company’s subsidiaries) to incur indebtedness, grant liens, make certain fundamental changes and asset sales, make distributions to stockholders, make investments or engage in transactions with affiliates. It also contains a minimum liquidity financial covenant of $ 350 million, which includes unrestricted cash and any available borrowing capacity under the Revolving Credit Facility. The obligations under the Revolving Credit Facility are secured by liens on substantially all of the Company’s domestic assets and are guaranteed by any material domestic subsidiaries, subject to customary exceptions. A standby letter of credit in the amount of approximately $ 10 million has been issued under the Revolving Credit Facility in conjunction with the lease of the Company’s headquarters in San Francisco, California. As of March 31, 2021, the Company had no t made any borrowings under the Revolving Credit Facility and it was in compliance with the related covenants.\nPurchase Obligations\nDuring 2019, the Company amended a marketing arrangement which increased the total commitment under the agreement and extended the arrangement to July 31, 2021. As of March 31, 2021, the remaining commitment under the amended agreement was $ 5 million, which is payable in 2021 .\nEffective September 1, 2019, the Company entered into an amendment to a colocation and cloud services arrangement committing the Company to make payments of $ 120 million for services over 3 years. As of March 31, 2021, the remaining commitment under this amended agreement was approximately $ 35 million and is payable within the next two years .\nLegal Contingencies\nAs of March 31, 2021 and December 31, 2020, there were no legal contingency matters that arose in the ordinary course of business, either individually or in aggregate, that would have a material adverse effect on the financial position, results of operations, or cash flows of the Company. Given the unpredictable nature of legal proceedings, the Company bases its estimate on the information available at the time of the assessment. As additional information becomes available, the Company reassesses the potential liability and may revise the estimate.\nNOTE 8. EQUITY Award activity and STOCK-based compensation\nEquity Award Activity\nA summary of activity under the equity plans and related information is as follows:\n\n| Options Outstanding | RSUs Outstanding |\n| Number of Options | Weighted- Average Exercise Price | Weighted- Average Remaining Contractual Term (In Years) | Number of RSUs |\n| (in millions) | (in millions) |\n| Balances at December 31, 2020 | 75 | $ | 0.234 | 3.2 | 30 |\n| Granted | — | $ | — | 1 |\n| Vested(1) | — | $ | — | ( 3 | ) |\n| Exercised | ( 2 | ) | $ | 0.154 | — |\n| Balances at March 31, 2021(2) | 73 | $ | 0.236 | 3.0 | 28 |\n\n\n| (1) | For the three months ended March 31, 2021, approximately 3 million RSUs vested upon satisfying both the service and liquidity vesting conditions. The shares remained unreleased as of March 31, 2021 due to the lock-up provisions related to the Company’s IPO. |\n\n| (2) | Outstanding RSUs as of March 31, 2021 include 10 million units of CEO Performance Award. |\n\nThe weighted-average grant date fair value of restricted stock units (“RSUs”) granted during the three months ended March 31, 2021 was $ 22.01 per share.\n13\nStock-Based Compensation Expense\nTotal stock-based compensation expense included in the condensed consolidated statements of operations is as follows:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cost of revenue | $ | 5 | $ | — |\n| Sales and marketing | 3 | — |\n| Product development | 15 | — |\n| General and administrative | 14 | — |\n| Total stock-based compensation | $ | 37 | $ | — |\n\nThe Company will recognize the remaining $ 134 million and $ 72 million of unrecognized stock-based compensation expense over a weighted-average period of approximately 1.32 years and 3.84 years related to RSUs and CEO Performance Award, respectively.\nEmployee Stock Purchase Plan\nThe Company’s Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s Class A common stock at a discount through payroll deductions of up to 15 % of eligible compensation, subject to caps of $ 25,000 in any calendar year and 2,500 shares on any purchase date. The ESPP provides for 24 -month offering periods, generally beginning in November and May of each year, and each offering period consists of four six-month purchase periods. The initial offering period began on January 1, 2021 and will end in November 2022. The first purchase under the ESPP will be in May 2021 .\nOn each purchase date, participating employees will purchase Class A common stock at a price per share equal to 85 % of the lesser of the fair market value of the Company’s Class A common stock on (i) the first trading day of the applicable offering period and (2) the last trading day of each purchase period in the applicable offering period. If the stock price of the Company's Class A common stock on any purchase date in an offering period is lower than the stock price on the enrollment date of that offering period, the offering period will immediately reset after the purchase of shares on such purchase date and automatically roll into a new offering period.\nThe Company uses the Black-Scholes option pricing model to determine the fair value of shares to be purchased under the 2020 Employee Stock Purchase Plan (“ESPP”) with the following assumptions on the date of grant:\n\n| Three Months Ended |\n| March 31, 2021 |\n| Expected term (in years) | 0.38 to 1.88 |\n| Risk free interest rate | 0.09% to 0.13% |\n| Volatility | 46.45% to 62.28% |\n| Dividend yield | — |\n| Estimated fair value per ESPP share | $4.14 to $8.05 |\n\nNOTE 9. INCOME TAXES\nThe Company’s tax provision for the interim periods is determined using an estimate of the annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, the Company assesses its estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, the Company makes a cumulative adjustment in the period of change.\nThe Company’s quarterly tax provision and the estimate of the annual effective tax rate is subject to fluctuation due to several factors, including variability in pre-tax earnings, the geographic distribution of the pre-tax earnings, tax law\n14\nchanges, non-deductible expenses, such as stock-based compensation, and changes in the estimate of the valuation allowance.\nThe provision for income taxes was $ 2 million for the three months ended March 31, 2021 and was insignificant for the three months ended March 31, 2020. The year-over-year increase in provision for income taxes was primarily related to international operations. The Company continues to maintain a valuation allowance on its domestic net deferred tax assets which is excluded from the annual effective tax rate estimate.\nThe Company had immaterial unrecognized tax benefits as of March 31, 2021 and December 31, 2020, fully offset by a valuation allowance. These unrecognized tax benefits, if recognized, would no t affect the effective tax rate. No interest or penalties were incurred during the years ended March 31, 2021 and 2020.\nThe Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The Company is not currently under examination by income tax authorities in federal, state or other jurisdictions. All tax returns will remain open for examination by the federal and state authorities for three and four years , respectively, from the date of utilization of any net operating loss or credits. Certain tax years are subject to foreign income tax examinations by tax authorities until the statute of limitations expire.\n15\nNOTE 10. Net loss per share\nBasic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by giving effect to potentially dilutive common stock equivalents outstanding during the period, as their effect would be dilutive. Potentially dilutive common shares include participating securities and shares issuable upon the exercise of stock options, the exercise of common stock warrants, the vesting of RSUs and each purchase under the 2020 ESPP, under the treasury stock method.\nIn loss periods, basic net loss per share and diluted net loss per share are the same, as the effect of potential common shares is anti-dilutive and therefore excluded.\nThe rights, including the liquidation and dividend rights, of the holders of Class A and Class B common stock are identical, except with respect to voting. As the liquidation and dividend rights are identical, the Company’s undistributed earnings or losses are allocated on a proportionate basis among the holders of both Class A and Class B common stock. As a result, the net income (loss) per share attributed to common stockholders will, therefore, be the same for both Class A and Class B common stock on an individual or combined basis.\nThe following table sets forth the computation of basic and diluted net loss per share:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions, except per share data) |\n| Numerator: |\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\n| Denominator: |\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\n\nThe following outstanding shares of potentially dilutive securities were excluded from the computation of diluted net loss per share because including them would have had an anti-dilutive effect:\n\n| As of March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Redeemable convertible preferred stock, all series | — | 422 |\n| Series B warrant | — | 10 |\n| Warrant to purchase common stock | 1 | 1 |\n| Common stock options outstanding | 73 | 77 |\n| Unvested RSUs outstanding(1) | 28 | 44 |\n| Employee Stock Purchase Plan | 1 | — |\n| Total | 103 | 554 |\n\n\n| (1) | Unvested RSUs outstanding as of March 31, 2021 included 10 million units of CEO Performance Award. |\n\n16\nNOTE 11. GEOGRAPHICAL INFORMATION\nThe Company believes it is relevant to disclose geographical revenue information on both a demand basis, determined by the ship-to address of the user, and on a supply basis, determined by the location of the merchants’ operations.\nCore marketplace revenue by geographic area based on the ship-to address of the user is as follows:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Europe | $ | 235 | 49 | % | $ | 159 | 47 | % |\n| North America(1) | 186 | 39 | % | 126 | 37 | % |\n| South America | 18 | 4 | % | 23 | 7 | % |\n| Other | 38 | 8 | % | 32 | 9 | % |\n| Core marketplace revenue | $ | 477 | 100 | % | $ | 340 | 100 | % |\n\n\n| (1) | United States accounted for $ 156 million and $ 103 million of core marketplace revenue for the three months ended March 31, 2021 and 2020, respectively. |\n\nChina accounted for substantially all of marketplace and logistics revenue during the three months ended March 31, 2021 and 2020 based on the location of the merchants’ operations.\nThe Company’s long-lived tangible assets, which consist of property and equipment, net and operating lease right-of-use assets, net, located in the United States were 87 % of the total long-lived tangible assets as of March 31, 2021 and December 31, 2020. The long-lived tangible assets outside the United States were located in China, Canada and the Netherlands.\n17\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with (1) the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and (2) the audited condensed consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2020 included in our Annual Report on Form 10-K filed on March 25, 2021. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the heading \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for our year ended December 31, 2020. See also \"Special Note Regarding Forward-Looking Statements\" above.\nFinancial Results for the Three Months Ended March 31, 2021\n| • | Total revenue was $772 million, an increase of 75% year-over-year. |\n\n| • | Total cost of revenue and expenses were $898 million, including stock-based compensation expense of $37 million and $7 million of employer payroll taxes related to stock-based compensation. |\n\n| • | Loss from operations was $126 million. |\n\n| • | Net loss was $128 million. |\n\n| • | Adjusted EBITDA was a loss of $79 million or 10% of total revenue. |\n\n| • | Cash and cash equivalents and marketable securities were $1.8 billion. |\n\nAs of March 31, 2021, we had an accumulated deficit of $2.3 billion. We expect losses from operations to continue for the foreseeable future as we incur costs and expenses related to brand development, expansion of market share, continued development of our mobile shopping marketplace infrastructure and development of other businesses.\nCOVID-19\nThe outbreak of coronavirus disease 2019 (“COVID-19”) has affected businesses worldwide, as of the date of filing of this Quarterly Report, and continues to impact the major markets in which we operate. The COVID-19 pandemic has resulted in significant governmental measures being implemented to control the spread of the virus, and our operations as well as the operations of our third-party merchants and users have been and will continue to be disrupted by varying individual and governmental responses to COVID-19 around the world, such as business shutdowns, stay-at-home directives, travel restrictions, border closures, and other travel or health-related restrictions as well as by absenteeism, quarantines, self-isolations, office and factory closures, delays on deliveries, and disruptions to ports and other freight infrastructure. These restrictions may cause consumers and businesses to reduce their activities and their spending, have caused a slowdown in the global economy and have had, and may continue to have, a negative impact on our operations. If these conditions continue, sales volumes may decrease and we may, among other issues, experience or continue to experience delays in product development, a decreased ability to support our merchants, disruptions in sales, delivery and logistics, each of which could have a negative impact on our ability to meet shipment commitments and on our revenue and profitability.\nOur Financial Model\nOur business benefits from powerful network effects, fueled by our data advantage and massive scale. As more users join Wish, attracted by our affordable value proposition and shopping experience, we are able to increase revenue potential for our merchants. As more merchants succeed on Wish, more merchants join the platform and grow their businesses with Wish, broadening our product selection, which in turn improves user experience. By developing a strategy focused on users and merchants, we align user and merchant success with the success of our financial model. The growth in users and merchants generates more data, further strengthens our data advantage and creates an even better experience for everyone on our platform, in turn attracting more users and high-quality merchants.\nOur model relies on cost-effectively adding new users, converting those users into buyers and improving engagement and monetization of those buyers on Wish over time as well as adding new merchants, delivering economic success for those merchants, and having those merchants use more of our end-to-end platform.\n18\nKey Financial and Performance Metrics\nIn addition to the measures presented in our condensed consolidated financial statements, we monitor the following key metrics and other financial information to measure our performance, identify trends affecting our business, and make strategic decisions.\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| MAU | 101 | 109 |\n| LTM Active Buyers | 61 | 63 |\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\n| Adjusted EBITDA Margin | (10 | )% | (12 | )% |\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\n\nMonthly Active Users\nWe define MAUs as the number of unique users that visited the Wish platform, either on our mobile app, mobile web, or on a desktop, during the month. MAUs for a given reporting period equal the average of the MAUs for that period. An active user is identified by a unique email-address; a single person can have multiple user accounts via multiple email addresses. The change in MAUs in a reported period captures both the inflow of new users as well as the outflow of existing users who did not visit the platform in a given month. We view the number of MAUs as key driver of revenue growth as well as a key indicator of user engagement and awareness of our brand.\nMAUs decreased approximately 7% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily driven by the decision to de-emphasize user acquisition in some emerging markets outside of Europe and North America where we faced logistical challenges due to the pandemic and to emphasize higher LTV users within the same value-conscious consumer category in many of the more developed markets.\nLTM Active Buyers\nAs of the last date of each reported period, we determine our number of unique active buyers by counting the total number of individual users who have placed at least one order on the Wish platform, either on our mobile app, mobile web, or on a desktop, during the preceding 12 months. We, however, exclude from the computation those buyers whose order is cancelled before the item is shipped and the purchase price is refunded. The number of Active Buyers is an indicator of our ability to attract and monetize a large user base to our platform and of our ability to convert visits into purchases. We believe that increasing our Active Buyers will be a significant driver to our future revenue growth.\nLTM Active Buyers decreased approximately 3% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily due to our actions to de-emphasize low value items, which tend to have high conversion rates but unfavorable economics.\nA Note About Metrics\nThe numbers for some of our metrics, including MAUs, are calculated and tracked with internal tools, which are not independently verified by any third party. We use these metrics to assess the growth and health of our overall business. While these numbers are based on what we believe to be reasonable estimates of our user or merchant base for the applicable period of measurement, there are inherent challenges in measurement as the methodologies used require significant judgment and may be susceptible to algorithm or other technical errors. In addition, we regularly review and adjust our processes for calculating metrics to improve their accuracy, and our estimates may change due to improvements or changes in technology or our methodology.\n19\nNon-GAAP Financial Measures\nAdjusted EBITDA and Adjusted EBITDA Margin\nWe provide Adjusted EBITDA, a non-GAAP financial measure that represents our net income (loss) adjusted to exclude; interest and other income (expense), net (which includes foreign exchange gain or loss, foreign exchange forward contracts gain or loss and gain or loss on one-time non-operating transactions); provision or benefit for income taxes;, depreciation and amortization; stock-based compensation expense and related payroll taxes; remeasurement of redeemable convertible preferred stock warrant liability and other items. Additionally, we provide Adjusted EBITDA Margin, a non-GAAP financial measure that represents Adjusted EBITDA divided by revenue. Below is a reconciliation of Adjusted EBITDA to net loss, the most directly comparable GAAP financial measure.\nWe have included Adjusted EBITDA and Adjusted EBITDA Margin in this report because they are key measures used by our management and board of directors to understand and evaluate our operating performance and trends and how we are allocating internal resources, to prepare and approve our annual budget and to develop short- and long-term operating plans. We also believe that the exclusion of certain items in calculating Adjusted EBITDA can provide a useful measure for period-to-period comparisons of our business as it removes the impact of non-cash items and certain variable charges.\nAdjusted EBITDA has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\n| • | although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements; |\n\n| • | Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; |\n\n| • | Adjusted EBITDA does not consider the impact of stock-based compensation and related payroll taxes; |\n\n| • | Adjusted EBITDA does not reflect tax payments that may represent a reduction in cash available to us; and |\n\n| • | other companies, including companies in our industry, may calculate Adjusted EBITDA differently, which reduces its usefulness as a comparative measure. |\n\nBecause of these limitations, you should consider Adjusted EBITDA and Adjusted EBITDA Margin alongside other financial performance measures, including various cash flow metrics, net income (loss) and our other GAAP results.\nThe following table reflects the reconciliation of net loss to Adjusted EBITDA and net loss as a percentage of revenue to Adjusted EBITDA margin for each of the periods indicated:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Revenue | $ | 772 | $ | 440 |\n| Net loss | (128 | ) | (66 | ) |\n| Net loss as a percentage of revenue | (17 | )% | (15 | )% |\n| Excluding: |\n| Interest and other expense (income), net | — | (3 | ) |\n| Provision for income taxes | 2 | — |\n| Depreciation and amortization | 2 | 2 |\n| Stock-based compensation expense | 37 | — |\n| Employer payroll taxes related to stock-based compensation expense | 7 | — |\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\n| Recurring other items | 1 | 1 |\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\n| Adjusted EBITDA margin | (10 | )% | (12 | )% |\n\n20\nFree Cash Flow\nWe also provide Free Cash Flow, a non-GAAP financial measure that represents net cash provided by (used in) operating activities less purchases of property and equipment. We believe that Free Cash Flow is an important measure since we use third parties to host our services and therefore we do not incur significant capital expenditures to support revenue generating activities.\nFree Cash Flow has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\n| • | it is not a substitute for net cash provided by (used in) operating activities; |\n\n| • | other companies may calculate Free Cash Flow or similarly titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a tool for comparison; and |\n\n| • | the utility of free cash flow is further limited as it does not reflect our future contractual commitments and does not represent the total increase or decrease in our cash balance for any given period. |\n\nBecause of these limitations, you should consider Free Cash Flow alongside other financial performance measures, such as net cash provided by (used in) operating activities, net income (loss) and our other GAAP results.\nThe following table reflects the reconciliation of net cash provided by (used in) operating activities to Free Cash Flow for each of the periods indicated:\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash used in operating activities | $ | (354 | ) | $ | (129 | ) |\n| Less: |\n| Purchases of property and equipment | — | — |\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\n\nResults of Operations\nThe following table shows our results of operations for the periods presented and express the relationship of certain line items as a percentage of revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Revenue | $ | 772 | $ | 440 |\n| Cost of revenue(1) | 335 | 156 |\n| Gross profit | 437 | 284 |\n| Operating expenses: |\n| Sales and marketing(1) | 470 | 295 |\n| Product development(1) | 51 | 25 |\n| General and administrative(1) | 42 | 18 |\n| Total operating expenses | 563 | 338 |\n| Loss from operations | (126 | ) | (54 | ) |\n| Other income (expense), net |\n| Interest and other income, net | — | 3 |\n| Remeasurement of convertible preferred stock warrant liability | — | (15 | ) |\n| Loss before provision for income taxes | (126 | ) | (66 | ) |\n| Provision for income taxes | 2 | — |\n| Net loss | $ | (128 | ) | $ | (66 | ) |\n\n21\n\n| (1) | Includes stock-based compensation expense as follows: |\n\n\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cost of revenue | $ | 5 | $ | — |\n| Sales and marketing | 3 | — |\n| Product development | 15 | — |\n| General and administrative | 14 | — |\n| Total stock-based compensation | $ | 37 | $ | — |\n\nThe following table presents the components of our condensed consolidated statements of operations as a percentage of revenue:\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Revenue | 100 | % | 100 | % |\n| Cost of revenue | 43 | % | 35 | % |\n| Gross profit | 57 | % | 65 | % |\n| Operating expenses: |\n| Sales and marketing | 61 | % | 67 | % |\n| Product development | 7 | % | 6 | % |\n| General and administrative | 6 | % | 4 | % |\n| Total operating expenses | 74 | % | 77 | % |\n| Loss from operations | (17 | )% | (12 | )% |\n| Other income (expense), net: |\n| Interest and other income (expense), net | — | 1 | % |\n| Remeasurement of convertible preferred stock warrant liability | — | (3 | )% |\n| Loss before provision for income taxes | (17 | )% | (15 | )% |\n| Provision for income taxes | — | — |\n| Net loss | (17 | )% | (15 | )% |\n\nComparison of Three Months Ended March 31, 2021 and March 31, 2020\nRevenue\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Core marketplace revenue(1) | $ | 477 | $ | 340 | $ | 137 | 40 | % |\n| ProductBoost revenue | 50 | 44 | 6 | 14 | % |\n| Marketplace revenue | 527 | 384 | 143 | 37 | % |\n| Logistics revenue | 245 | 56 | 189 | 338 | % |\n| Revenue | $ | 772 | $ | 440 | $ | 332 | 75 | % |\n\n\n| (1) | Core marketplace revenue for the three months ended March 31, 2021 included approximately $9 million net gains from our cash flow hedging program. We did not have a hedging program during the three months ended March 31, 2020. |\n\nRevenue increased $332 million, or 75%, to $772 million for the three months ended March 31, 2021 as compared to $440 million for the three months ended March 31, 2020. This increase was attributable to both increased marketplace and logistics revenue.\n22\nMarketplace revenue increased $143 million, or 37% to $527 million for the three months ended March 31, 2021, as compared to $384 million for the three months ended March 31, 2020. This increase was primarily due to our efforts to improve buyer monetization and lower refunds. This increase was also partially driven by increased merchant utilization of our ProductBoost service.\nLogistics revenue increased $189 million, or 338% to $245 million for the three months ended March 31, 2021, as compared to $56 million for the three months ended March 31, 2020. This increase was primarily due to accelerated merchant adoption of our logistics offerings, as well as the expansion of our A+ program, in which Wish manages first mile collection from merchants to warehousing operations all the way to last mile delivery to the buyer.\nCost of Revenue and Gross Margin\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Cost of revenue | $ | 335 | $ | 156 | $ | 179 | 115 | % |\n| Percentage of revenue | 43 | % | 35 | % |\n| Gross Margin | 57 | % | 65 | % |\n\nCost of revenue increased $179 million, or 115%, to $335 million for the three months ended March 31, 2021, as compared to $156 million for the three months ended March 31, 2020, primarily due to costs related to the increased volume of logistics services provided and increased headcount. The increase was also driven by a $6 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs for our employees involved in infrastructure, merchant support, and logistics functions.\nThe gross margin decreased to 57% for the three months ended March 31, 2021 from 65% for the three months ended March 31, 2020, primarily due to increased volume of logistics services provided and the fact that logistics gross margin was at significantly lower rate than marketplace gross margin.\nSales and Marketing\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Sales and marketing | $ | 470 | $ | 295 | $ | 175 | 59 | % |\n| Percentage of revenue | 61 | % | 67 | % |\n\nSales and marketing expense increased $175 million, or 59%, to $470 million for the three months ended March 31, 2021, compared to $295 million for the three months ended March 31, 2020. The increase in sales and marketing expenses consisted primarily of incremental digital advertising spend associated with increased pricing from our largest vendors. To a lesser extent, the increase was also driven by a $4 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in marketing, user support, and business development functions. We anticipate that sales and marketing expenses will continue to be our most significant operating expense in the future and our overall profitability will depend on the success of our investments in sales and marketing.\nProduct Development\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Product development | $ | 51 | $ | 25 | $ | 26 | 104 | % |\n| Percentage of revenue | 7 | % | 6 | % |\n\nProduct development expense increased $26 million, or 104%, to $51 million for the three months ended March 31, 2021, as compared to $25 million for the three months ended March 31, 2020, primarily as a result of an increase in\n23\nemployee-related costs driven by increased headcount and an $18 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in product development activities. The increase was also, to a lesser extent, driven by expenses associated with data warehousing, processing and analytics.\nGeneral and Administrative\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| General and administrative | $ | 42 | $ | 18 | $ | 24 | 133 | % |\n| Percentage of revenue | 6 | % | 4 | % |\n\nGeneral and administrative expense increased $24 million, or 133%, to $42 million for the three months ended March 31, 2021, as compared to $18 million for the three months ended March 31, 2020. The increase was primarily related to a $16 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs and increases in expenses associated with being a publicly listed company.\nRemeasurement of Redeemable Convertible Preferred Stock Warrant Liability\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Remeasurement of redeemable convertible preferred stock warrant liability | $ | — | $ | (15 | ) | $ | 15 | (100 | )% |\n| Percentage of revenue | — | (3 | )% |\n\nThe $15 million expense that we recognized during the three months ended March 31, 2020 was related to the change in fair value of the redeemable convertible preferred stock warrant liability. There was no remeasurement charge recognized during the three months ended March 31, 2021 because immediately prior to the completion of our IPO in December 2020, the outstanding redeemable convertible preferred stock warrant was net exercised. The fair value of the warrant at the time of exercise was reclassified into the Company’s Class A common stock and additional paid-in capital.\nProvision for Income Taxes\n\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | $ | % |\n| (in millions) |\n| Provision for income taxes | $ | 2 | $ | — | $ | 2 | — |\n| Percentage of revenue | — | — |\n\nProvision for income taxes increased $2 million for the three months ended March 31, 2021 compared to the three months ended March 31, 2020. The change in provision for income taxes was due primarily to an increase of taxes for our international operations.\nLiquidity and Capital Resources\nAs of March 31, 2021, we had cash, cash equivalents and marketable securities of $1.8 billion, a majority of which were held in cash deposits and money market funds, and were held for working capital purposes. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to meet our anticipated cash needs for at least the next 12 months. Additional future financing may be necessary to fund our operations and there can be no assurance that, if needed, we will be able to secure additional debt or equity financing on terms acceptable to us or at all, especially in light of the market volatility and uncertainty as a result of the COVID-19 pandemic. Although we believe we have adequate sources of liquidity over the long term, the success of our operations, the global economic outlook, and the pace of\n24\nsustainable growth in our markets, in each case, in light of the market volatility and uncertainty as a result of the COVID-19 pandemic, among other factors, could impact our business and liquidity.\nNovember 2020 Credit Facility\nIn November 2020, we entered into the Revolving Credit Facility which enables us to borrow up to $280 million. The Revolving Credit Facility contains an accordion option which, if exercised and provided we are able to secure additional lender commitments and satisfy certain other conditions, would allow us to increase the aggregate commitments by up to $100 million. As of March 31, 2021, we had not made any borrowings under the Revolving Credit Facility. Refer to Note 7 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Information” for additional details related to the Revolving Credit Facility.\nCash Flows\n\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in millions) |\n| Cash provided by (used in): |\n| Operating activities | $ | (354 | ) | $ | (129 | ) |\n| Investing activities | 14 | 59 |\n| Financing activities | (5 | ) | 1 |\n\nNet Cash Provided by (Used in) Operating Activities\nOur cash flows from operations are largely dependent on the amount of revenue we generate. Net cash provided by operating activities in each period presented has been influenced by changes in funds receivable, prepaid expenses, and other current and noncurrent assets, accounts payable, merchants payable, accrued and refund liabilities, lease liabilities, and other current and noncurrent liabilities.\nNet cash used in our operating activities for the three months ended March 31, 2021 was $354 million. This was primarily driven by our net loss of $128 million and $266 million unfavorable net working capital changes, which was partially offset by non-cash expenses, such as stock-based compensation expense of $37 million. Unfavorable working capital movement was mainly driven by accounts payable and merchants payable. Accounts payable decreased by $143 million primarily due to shorter vendor payment terms. Due to the COVID-19 pandemic, we were able to negotiate favorable payment terms with certain key digital advertising partners (45 days and 60 days). The payment terms with these key digital advertising partners reverted back to 30 days when the favorable terms expired on December 31, 2020. Merchants payable decreased by $73 million primarily driven by lower volumes in the first quarter of 2021 compared to the fourth quarter of 2020 due to seasonality and higher percentage of shipments through our A+ program which accelerated the payment of merchants payable due to higher delivery confirmation rates. Other decreases in unfavorable working capital movement were driven by refunds and accrued liabilities.\nNet cash used in our operating activities for the three months ended March 31, 2020 was $129 million. This was primarily driven by our net loss of $66 million and a $122 million decrease in merchants payable, which was partially offset by non-cash expenses, such as the remeasurement of redeemable convertible preferred stock warrant liability of $15 million, which was further offset by a $31 million increase in accounts payable.\nNet Cash Provided by (Used in) Investing Activities\nOur primary investing activities have consisted of investing excess cash balances in marketable securities.\nNet cash provided by investing activities was $14 million for the three months ended March 31, 2021. This was primarily due to $67 million of maturities of marketable securities, partially offset by $53 million purchases of marketable securities.\nNet cash generated from investing activities was $59 million for the three months ended March 31, 2020. This was primarily due to $132 million maturities of marketable securities, partially offset by $73 million purchases of marketable securities.\n25\nNet Cash Provided by (Used in) Financing Activities\nNet cash used in our financing activities was $5 million for the three months ended March 31, 2021 primarily due to tax payments related to RSU settlement.\nNet cash provided by financing activities was $1 million for the three months ended March 31, 2020 and was related to proceeds from stock option exercises.\nOff Balance Sheet Arrangements\nFor the three months ended March 31, 2021 and 2020, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.\nContingencies\nWe are involved in claims, lawsuits, government investigations, and proceedings arising from the ordinary course of our business. We record a provision for a liability when we believe that it is both probable that a liability has been incurred, and the amount can be reasonably estimated. Significant judgment is required to determine both probability and the estimated amount. Such legal proceedings are inherently unpredictable and subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to be incorrect, it could have a material impact on our results of operations, financial position, and cash flows.\nCritical Accounting Policies\nThe preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those listed below. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.\nOur critical accounting policies are as follows:\n| • | Revenue recognition; |\n\n| • | Operating lease obligations; |\n\n| • | Stock-based compensation; and |\n\n| • | Income taxes. |\n\nOur critical accounting policies are important to the portrayal of our financial condition and results of operations, and require us to make judgments and estimates about matters that are inherently uncertain.\nThere have been no material changes to our critical accounting policies and estimates as compared to those described in our Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021.\nRecent Accounting Pronouncements\nSee Note 1 of Part I, Item 1 of this Quarterly Report on Form 10-Q for a full description of recent accounting pronouncements.\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe have operations both within the U.S. and internationally, and we are exposed to market risks in the ordinary course of our business, including the effects of interest rate changes and foreign currency fluctuations. Information relating to quantitative and qualitative disclosures about these market risks is described below.\n26\nInterest Rate Sensitivity\nCash, cash equivalents and marketable securities as of March 31, 2021 were held primarily in cash deposits and money market funds. The fair value of our cash, cash equivalents, and investments would not be significantly affected by either an increase or decrease in interest rates due mainly to the short-term nature of these instruments. A 100 basis point increase or decrease in our current interest rates would have increased or decreased our interest income by $18 million for the three months ended March 31, 2021.\nForeign Currency Risk\nWe transact business in various foreign countries and are, therefore, subject to risk of foreign currency exchange rate fluctuations. We have established a foreign currency risk management policy to provide process and procedures for managing this risk. We use natural hedging techniques first to net off existing foreign currency exposures. For the remaining exposure, we may enter into short term foreign currency derivative contracts, including forward contracts to hedge exposures associated with monetary assets and liabilities, mainly merchants payable, and cash flows denominated in non-functional currencies.\nThe credit risk of our foreign currency derivative contracts is minimized since contracts are not concentrated with any one financial institution and all contracts are only placed with large financial institutions. The gains and losses on foreign currency derivative contracts generally offset the losses and gains on the assets, liabilities and transactions hedged. The fair value of currency derivative contracts is reported in the condensed consolidated balance sheets. The majority of these foreign exchange contracts expire in less than three months and all expire within one year. Refer to Note 5 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Statements” for more information related to our derivative financial instruments.\nBased on our overall currency rate exposures as of March 31, 2021, including the derivative financial instruments intended to hedge the nonfunctional currency-denominated monetary assets, liabilities and cash flows, and other factors, a 10% appreciation or depreciation of the U.S. dollar from its cross-functional rates would not be expected, in the aggregate, to have a material effect on our financial position, results of operations and cash flows in the near-term.\nInflation Risk\nWe do not believe that inflation has had a material effect on our business, financial condition, or results of operations.\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this report. Based on management’s evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective at a reasonable assurance level.\nIn designing and evaluating our disclosure controls and procedures, management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the three months ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nItem 1. Legal Proceedings.\nInformation with respect to this item may be found in Note 7, Commitments and Contingencies, in our Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q, which information is incorporated herein by reference.\nItem 1A. Risk Factors.\nYou should carefully consider the risks and uncertainties described under the heading \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 (the \"2020 Form 10-K\"), together with all of the other information contained in this Quarterly Report on Form 10-Q, including our condensed consolidated financial statements and related notes, before making a decision to invest in our Class A common stock. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that affect our business. These risk factors could materially and adversely affect our business, financial condition and results of operations, and the market price of our ordinary shares could decline. These risk factors do not identify all risks that we face – our operations could also be affected by factors that are not presently known to us or that we currently consider to be immaterial to our operations. Due to risks and uncertainties, known and unknown, our past financial results may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods. There have been no additional material changes from the risks and uncertainties previously disclosed under the \"Risk Factors\" section in our 2020 Form 10-K.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\n(a) Unregistered Sales of Equity Securities\nNone\n(b) Use of Proceeds\nOur IPO of Class A common stock was effected through a Registration Statement on Form S-1 (File Nos. 333-250531), which was declared or became effective on December 15, 2020. There has been no material change in the use of proceeds from our IPO as described in our final prospectus dated December 15, 2020 filed with the Securities and Exchange Commission, or SEC, pursuant to Rule 424(b) of the Securities Act of 1933, as amended, or the Securities Act.\nItem 6. Exhibits.\n\n| Exhibit Number | Description |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS* | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document. |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File (embedded within the Inline XBRL document) |\n\n\n| * | Filed herewith. |\n\n| ** | Furnished herewith. |\n\n28\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| ContextLogic Inc. |\n| Date: May 12, 2021 | By: | /s/ Rajat Bahri |\n| Rajat Bahri |\n| Chief Financial Offer |\n| (Principal Financial Officer) |\n\n29\n</text>\n\nWhat is the change in percentage of net loss from the three months ended March 31, 2020 to that ended March 31, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1. Financial Statements (Unaudited)\\nCONTEXTLOGIC INC.\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n(in millions, except par value)\\n\\n| As of March 31, | As of December 31, |\\n| 2021 | 2020 |\\n| (Unaudited) |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 1,620 | $ | 1,965 |\\n| Marketable securities | 154 | 164 |\\n| Funds receivable | 65 | 83 |\\n| Prepaid expenses and other current assets | 88 | 102 |\\n| Total current assets | 1,927 | 2,314 |\\n| Property and equipment, net | 23 | 25 |\\n| Right-of-use assets | 39 | 43 |\\n| Marketable securities | — | 4 |\\n| Other assets | 10 | 11 |\\n| Total assets | $ | 1,999 | $ | 2,397 |\\n| Liabilities and Stockholders’ Equity |\\n| Current liabilities: |\\n| Accounts payable | $ | 291 | $ | 434 |\\n| Merchants payable | 381 | 454 |\\n| Refunds liability | 54 | 77 |\\n| Accrued liabilities | 309 | 367 |\\n| Total current liabilities | 1,035 | 1,332 |\\n| Lease liabilities, non-current | 34 | 38 |\\n| Total liabilities | 1,069 | 1,370 |\\n| Commitments and contingencies (Note 7) |\\n| Stockholders’ equity: |\\n| Preferred stock, $ 0.0001 par value: 100 shares authorized as of March 31, 2021 and December 31, 2020; No shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\\n| Common stock, $ 0.0001 par value: 3,500 ( 3,000 Class A, 500 Class B) shares authorized as of March 31, 2021 and December 31, 2020; 618 ( 501 Class A, 117 Class B) and 587 ( 478 Class A, 109 Class B) shares issued and outstanding as of March 31, 2021 and December 31, 2020 | — | — |\\n| Additional paid-in capital | 3,243 | 3,210 |\\n| Accumulated other comprehensive income (loss) | ( 1 | ) | 1 |\\n| Accumulated deficit | ( 2,312 | ) | ( 2,184 | ) |\\n| Total stockholders’ equity | 930 | 1,027 |\\n| Total liabilities and stockholders’ equity | $ | 1,999 | $ | 2,397 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n1\\nCONTEXTLOGIC INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\\n(in millions, except per share data)\\n(Unaudited)\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| Revenue | $ | 772 | $ | 440 |\\n| Cost of revenue | 335 | 156 |\\n| Gross profit | 437 | 284 |\\n| Operating expenses: |\\n| Sales and marketing | 470 | 295 |\\n| Product development | 51 | 25 |\\n| General and administrative | 42 | 18 |\\n| Total operating expenses | 563 | 338 |\\n| Loss from operations | ( 126 | ) | ( 54 | ) |\\n| Other income (expense), net: |\\n| Interest and other income, net | — | 3 |\\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | ( 15 | ) |\\n| Loss before provision for income taxes | ( 126 | ) | ( 66 | ) |\\n| Provision for income taxes | 2 | — |\\n| Net loss | ( 128 | ) | ( 66 | ) |\\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n2\\nCONTEXTLOGIC INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS\\n(in millions)\\n(Unaudited)\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\\n| Other comprehensive loss: |\\n| Net unrealized holding losses on derivatives | ( 2 | ) | — |\\n| Comprehensive loss | $ | ( 130 | ) | $ | ( 66 | ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n3\\nCONTEXTLOGIC INC.\\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\n(in millions)\\n(Unaudited)\\n\\n| Three Months Ended March 31, 2021 |\\n| Common Stock | Additional Paid-in | Accumulated Other | Accumulated | Total Stockholders’ |\\n| Shares | Amount | Capital | Comprehensive Income | Deficit | Equity |\\n| Balances as of December 31, 2020 | 587 | $ | — | $ | 3,210 | $ | 1 | $ | ( 2,184 | ) | $ | 1,027 |\\n| Issuance of common stock upon exercise of options for cash | 2 | — | 1 | — | — | 1 |\\n| Issuance of common stock upon settlement of restricted stock units, net of tax | 29 | — | ( 5 | ) | — | — | ( 5 | ) |\\n| Stock-based compensation | — | — | 37 | — | — | 37 |\\n| Other comprehensive loss, net | — | — | — | ( 2 | ) | — | ( 2 | ) |\\n| Net loss | — | — | — | — | ( 128 | ) | ( 128 | ) |\\n| Balances as of March 31, 2021 | 618 | $ | — | $ | 3,243 | $ | ( 1 | ) | $ | ( 2,312 | ) | $ | 930 |\\n\\n\\n| Three Months Ended March 31, 2020 |\\n| Redeemable Convertible Preferred Stock | Common Stock | Additional Paid-in | Accumulated | Total Stockholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\\n| Balances as of December 31, 2019 | 422 | $ | 1,536 | 103 | $ | — | $ | — | $ | ( 1,439 | ) | $ | ( 1,439 | ) |\\n| Issuance of common stock upon exercise of options for cash | — | — | 3 | — | 1 | — | 1 |\\n| Net loss and comprehensive loss | — | — | — | — | — | ( 66 | ) | ( 66 | ) |\\n| Balances as of March 31, 2020 | 422 | $ | 1,536 | 106 | $ | — | $ | 1 | $ | ( 1,505 | ) | $ | ( 1,504 | ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n4\\nCONTEXTLOGIC INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(in millions)\\n(Unaudited)\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| Cash flows from operating activities: |\\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Depreciation and amortization | 2 | 2 |\\n| Non-cash lease expense | 4 | 2 |\\n| Stock-based compensation expense | 37 | — |\\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\\n| Other | ( 3 | ) | — |\\n| Changes in operating assets and liabilities: |\\n| Funds receivable | 18 | 8 |\\n| Prepaid expenses, other current and noncurrent assets | 16 | 7 |\\n| Accounts payable | ( 143 | ) | 31 |\\n| Merchants payable | ( 73 | ) | ( 122 | ) |\\n| Accrued and refund liabilities | ( 69 | ) | 3 |\\n| Lease liabilities | ( 4 | ) | ( 2 | ) |\\n| Other current and noncurrent liabilities | ( 11 | ) | ( 7 | ) |\\n| Net cash used in operating activities | ( 354 | ) | ( 129 | ) |\\n| Cash flows from investing activities: |\\n| Purchases of marketable securities | ( 53 | ) | ( 73 | ) |\\n| Maturities of marketable securities | 67 | 132 |\\n| Net cash provided by investing activities | 14 | 59 |\\n| Cash flows from financing activities: |\\n| Payment of taxes related to RSU settlement and other financing activities, net | ( 5 | ) | 1 |\\n| Net cash provided by (used in) financing activities | ( 5 | ) | 1 |\\n| Net decrease in cash, cash equivalents and restricted cash | ( 345 | ) | ( 69 | ) |\\n| Cash, cash equivalents and restricted cash at beginning of period | 1,965 | 754 |\\n| Cash, cash equivalents and restricted cash at end of period | $ | 1,620 | $ | 685 |\\n| Reconciliation of cash, cash equivalents, and restricted cash to the condensed consolidated balance sheets: |\\n| Cash and cash equivalents | $ | 1,620 | $ | 675 |\\n| Restricted cash included in other assets in the condensed consolidated balance sheets | — | 10 |\\n| Total cash, cash equivalents and restricted cash | $ | 1,620 | $ | 685 |\\n| Supplemental cash flow disclosures: |\\n| Cash paid for income taxes, net of refunds | $ | 2 | $ | — |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n5\\nCONTEXTLOGIC INC.\\nNotes to Unaudited Condensed Consolidated Financial Statements\\nNOTE 1. OVERVIEW, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES\\nContextLogic Inc. (“Wish” or the “Company”) is an ecommerce company that provides a shopping experience that is mobile-first and discovery-based, which connects merchants’ products to users based on user preferences. The Company generates revenue from marketplace and logistics services provided to merchants.\\nThe Company was incorporated in the state of Delaware in June 2010 and is headquartered in San Francisco, California, with operations in Canada, China and the Netherlands.\\nInitial Public Offering\\nIn December 2020, the Company completed its initial public offering (“IPO”) of Class A common stock, in which it sold 46 million shares. The shares were sold at an IPO price of $ 24.00 per share for net proceeds of approximately $ 1.1 billion, after deducting underwriting discounts and commissions of approximately $ 52 million. Additionally, the Company incurred approximately $ 6 million of offering costs, net of reimbursements. Following the IPO, the Company has two classes of authorized common stock, Class A common stock, which entitles holders to one vote per share, and Class B common stock, which entitles holders to 20 votes per share.\\nBasis of Presentation and Consolidation\\nThe accompanying condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”). The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements are unaudited, but include all adjustments of a normal recurring nature necessary for a fair presentation of our quarterly results. The consolidated balance sheet as of December 31, 2020 is derived from audited financial statements, however, it does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes in our Annual Report on Form 10-K for the year ended December 31, 2020, which was filed with the Securities and Exchange Commission (“SEC”) on March 25, 2021.\\nUse of Estimates\\nThe preparation of condensed consolidated financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. These estimates form the basis for judgments the Company makes about the carrying values of its assets and liabilities that are not readily available from other sources. These estimates include, but are not limited to, fair value of financial instruments, useful lives of long-lived assets, fair value of derivative instruments, incremental borrowing rate applied to lease accounting, contingent liabilities, redemption probabilities associated with Wish Cash, allowances for refunds and chargebacks and uncertain tax positions. As of March 31, 2021, the effects of the ongoing COVID-19 pandemic on the Company’s business, results of operations, and financial condition continue to evolve. As a result, many of the Company’s estimates and assumptions required increased judgment and these estimates may change materially in future periods.\\nSegments\\nThe Company manages its operations and allocates resources as a single operating segment. Further, the Company manages, monitors and reports its financials as a single reporting segment. The Company’s chief operating decision-maker is its Chief Executive Officer who makes operating decisions, assesses financial performance and allocates resources based on condensed consolidated financial information. As such, the Company has determined that it operates in one reportable segment.\\n6\\nConcentrations of Risk\\nCredit Risk — Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, funds receivable, marketable securities and derivative financial instruments. The Company’s cash and cash equivalents are held on deposit with creditworthy institutions. Although the Company’s deposits exceed federally insured limits, the Company has not experienced any losses in such accounts. The Company invests its excess cash in money market accounts, U.S. Treasury notes, U.S. Treasury bills, commercial paper and corporate bonds. The Company is exposed to credit risk in the event of a default by the financial institutions holding its cash, cash equivalents and marketable securities for the amounts reflected on the condensed consolidated balance sheets. The Company’s investment policy limits investments to certain types of debt securities issued by the U.S. government, its agencies and institutions with investment-grade credit ratings and places restrictions on maturities and concentration by type and issuer.\\nThe Company's derivative financial instruments expose it to credit risk to the extent that the counterparties may be unable to meet the terms of the arrangement. The Company seeks to mitigate such risk by limiting its counterparties to, and by spreading the risk across, major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored on a monthly basis. The Company is not required to pledge, nor is it entitled to receive, collateral related to its foreign exchange derivative transactions.\\nThe Company is exposed to credit risk in the event of a default by its Payment Service Providers (“PSPs”). The Company does not generate revenue from PSPs. Significant changes in the Company’s relationship with its PSPs could adversely affect users’ ability to process transactions on the Company’s marketplaces, thereby impacting the Company’s operating results.\\nThe following PSPs each represented 10% or more of the Company’s funds receivable balance:\\n\\n| March 31, | December 31, |\\n| 2021 | 2020 |\\n| PSP 1 | 61 | % | 56 | % |\\n| PSP 2 | 27 | % | 27 | % |\\n\\nServices Risk — The Company serves all of its users using third-party data center and hosting providers. The Company has disaster recovery protocols at the third-party service providers. Even with these procedures for disaster recovery in place, access to the Company’s service could be significantly interrupted, resulting in an adverse effect on its operating results and financial position. No significant interruptions of service were known to have occurred during the three months ended March 31, 2021 and 2020.\\nSummary of Significant Accounting Policies\\nThere have been no changes to the Company’s significant accounting policies described in its Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021, that have had a material impact on its condensed consolidated financial statements.\\nAccounting Pronouncements\\nThe Company has reviewed recent accounting pronouncements and concluded they are either not applicable to the business or no material impact is expected on the condensed consolidated financial statements as a result of future adoption.\\nNOTE 2. DISAGGREGATION OF REVENUE\\nThe Company generates revenue from marketplace and logistics services provided to merchants. Revenue is recognized as the Company transfers control of promised goods or services to its users in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. The Company considers both the merchant and the user to be customers. The Company evaluates whether it is appropriate to recognize revenue on a gross or net basis based upon its evaluation of whether the Company obtains control of the specified goods or services by considering if it is primarily responsible for fulfillment of the promise, has inventory risk, has latitude in establishing pricing and selecting suppliers, among other factors. Based on these factors, marketplace revenue is generally recognized on a net basis and logistics revenue is generally recognized on a gross basis. Revenue excludes any amounts collected on behalf of third parties, including indirect taxes.\\nMarketplace revenue includes commission fees collected in connection with user purchases of the merchants’ products. The commission fees vary depending on factors such as user location, demand, product type, and dynamic\\n7\\npricing. The Company recognizes revenue when a user’s order is processed and the related order information has been made available to the merchant. Commission fees are recognized net of estimated refunds and chargebacks. Marketplace revenue also includes ProductBoost revenue for displaying a merchant’s selected products in preferential locations within the Company’s marketplace. The Company recognizes revenue when the merchants’ selected products are displayed. The Company refers to its marketplace revenue, excluding ProductBoost revenue, as its core marketplace revenue.\\nThe Company’s logistics offering for merchants is designed for direct end-to-end single order shipment from a merchant’s location to the user. Logistics services include transportation and delivery of the merchant’s products to the user. Merchants are required to prepay for logistics services on a per order basis. The Company recognizes revenue over time as the merchant simultaneously receives and consumes the logistics services benefit as the services are performed. The Company uses an output method of progress based on days in transit as it best depicts the Company’s progress toward complete satisfaction of the performance obligation.\\nThe following table shows the disaggregated revenue for the applicable periods:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Core marketplace revenue | $ | 477 | $ | 340 |\\n| ProductBoost revenue | 50 | 44 |\\n| Marketplace revenue | 527 | 384 |\\n| Logistics revenue | 245 | 56 |\\n| Revenue | $ | 772 | $ | 440 |\\n\\nRefer to Note 11 – Geographical Information for the disaggregated revenue by geographical location.\\nNote 3. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENT\\nThe Company’s financial instruments consist of cash equivalents, marketable securities, funds receivable, derivative instruments, accounts payable, accrued liabilities and merchants payable. Cash equivalents’ carrying value approximates fair value at the balance sheet dates, due to the short period of time to maturity. Marketable securities and derivative instruments are recognized at fair value. Funds receivable, accounts payable, accrued liabilities and merchants payable carrying values approximate fair value due to the short time to the expected receipt or payment date.\\nAssets and liabilities recognized at fair value on a recurring basis in the condensed consolidated balance sheets consisting of cash equivalents, marketable securities and derivative instruments are categorized based upon the level of judgment associated with the inputs used to measure their fair values. Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\\n8\\nFinancial assets and liabilities subject to fair value measurements on a recurring basis and the level of inputs used in such measurements are as follows:\\n\\n| March 31, 2021 |\\n| Total | Level 1 | Level 2 | Level 3 |\\n| (in millions) |\\n| Financial assets: |\\n| Cash equivalents: |\\n| Money market funds | $ | 97 | $ | 97 | $ | — | $ | — |\\n| Marketable securities: |\\n| U.S. Treasury bills | $ | 35 | $ | — | $ | 35 | $ | — |\\n| Commercial paper | 62 | — | 62 | — |\\n| Corporate bonds | 52 | — | 52 | — |\\n| Non-US government | 5 | — | 5 | — |\\n| Total marketable securities | $ | 154 | $ | — | $ | 154 | $ | — |\\n| Total financial assets | $ | 251 | $ | 97 | $ | 154 | $ | — |\\n| Financial liabilities: |\\n| Accrued liabilities: |\\n| Derivative liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\\n| Total financial liabilities | $ | 2 | $ | — | $ | 2 | $ | — |\\n\\n\\n| December 31, 2020 |\\n| Total | Level 1 | Level 2 | Level 3 |\\n| (in millions) |\\n| Financial assets: |\\n| Cash equivalents: |\\n| Money market funds | $ | 35 | $ | 35 | $ | — | $ | — |\\n| U.S. Treasury bills | 30 | — | 30 | — |\\n| Commercial paper | 9 | — | 9 | — |\\n| Total cash equivalents | $ | 74 | $ | 35 | $ | 39 | $ | — |\\n| Marketable securities: |\\n| U.S. Treasury bills | $ | 38 | $ | — | $ | 38 | $ | — |\\n| Commercial paper | 49 | — | 49 | — |\\n| Corporate bonds | 81 | — | 81 | — |\\n| Total marketable securities | $ | 168 | $ | — | $ | 168 | $ | — |\\n| Prepaid and other current assets: |\\n| Derivative assets | $ | 3 | $ | — | $ | 3 | $ | — |\\n| Total financial assets | $ | 245 | $ | 35 | $ | 210 | $ | — |\\n| Financial liabilities: |\\n| Accrued liabilities: |\\n| Derivative liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\\n| Total financial liabilities | $ | 4 | $ | — | $ | 4 | $ | — |\\n\\nThe Company classifies cash equivalents and marketable securities within Level 1 or Level 2 because the Company uses quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. The derivative asset and liability related to the Company’s foreign currency derivative contracts are classified within Level 2 of the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets, including currency spot and forward rates.\\n9\\nThe following table summarizes the contractual maturities of the Company’s marketable securities:\\n\\n| March 31, | December 31, |\\n| 2021 | 2020 |\\n| Amortized Cost | Estimated Fair Value | Amortized Cost | Estimated Fair Value |\\n| (in millions) |\\n| Due within one year | $ | 154 | $ | 154 | $ | 164 | $ | 164 |\\n| Due after one year through five years | — | — | 4 | 4 |\\n| Total marketable securities | $ | 154 | $ | 154 | $ | 168 | $ | 168 |\\n\\nAll of the Company’s available-for-sale marketable securities are subject to a periodic evaluation for a credit loss allowance and impairment review. The Company did not identify any of its available-for-sale marketable securities requiring an allowance for credit loss or as other-than-temporarily impaired in any of the periods presented. Additionally, the unrealized net gain and net loss on available-for-sale marketable securities as of March 31, 2021 and December 31, 2020 were immaterial.\\nNOTE 4. BALANCE SHEET COMPONENTS\\nAccrued Liabilities\\nAccrued liabilities consist of the following:\\n\\n| March 31, | December 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Vendor services | $ | 90 | $ | 121 |\\n| Deferred revenue | 26 | 37 |\\n| Wish Cash liability | 48 | 48 |\\n| Other | 145 | 161 |\\n| Total accrued liabilities | $ | 309 | $ | 367 |\\n\\nNOTE 5. DERIVATIVE FINANCIAL INSTRUMENTS\\nThe Company conducts business in certain foreign currencies throughout its worldwide operations, and various entities hold monetary assets or liabilities, earn revenues, or incur costs in currencies other than the entity’s functional currency. As a result, the Company is exposed to foreign exchange gains or losses which impact the Company’s operating results. The Company bills its users based on their local currencies, primarily in U.S. dollars and Euros, and the Company makes payments to the merchants in China for products sold on the Wish platform in Renminbi, which creates exposure to currency rate fluctuations. The Company hedges these cash flow exposures to reduce the risk that its earnings and cash flows will be adversely affected by changes in exchange rates. As part of the Company’s foreign currency risk mitigation strategy, the Company enters into derivative contracts and foreign exchange forward contracts with up to twelve months in duration to hedge exposures for variability in U.S.-dollar equivalent of non-U.S.-dollar denominated cash flows associated with its forecasted revenue related transactions.\\nThe Company’s derivatives transactions are not collateralized and do not include collateralization agreements with counterparties. The Company does not use derivative financial instruments for speculative or trading purposes.\\n10\\nVolume of Derivative Activity\\nTotal gross notional amounts for outstanding derivatives (recognized at fair value) as of the end of period consist of the following:\\n\\n| March 31, 2021 | December 31, 2020 |\\n| (in millions) |\\n| Cash flow hedges | $ | 250 | $ | 600 |\\n| Non-designated hedges | 219 | 422 |\\n| Total | $ | 469 | $ | 1,022 |\\n\\nFair Value of Derivative Financial Instruments\\n\\n| March 31, 2021 | December 31, 2020 |\\n| Assets(1) | Liabilities(2) | Assets(1) | Liabilities(2) |\\n| (in millions) |\\n| Derivative designated as hedging instruments |\\n| Cash flow hedges | $ | — | $ | 2 | $ | 3 | $ | 2 |\\n| Derivative not designated as hedging instruments |\\n| Foreign currency forward contracts | $ | — | $ | — | $ | — | $ | 2 |\\n| Total derivatives | $ | — | $ | 2 | $ | 3 | $ | 4 |\\n\\n(1) Derivative assets are included in prepaid and other current assets in the condensed consolidated balance sheets.\\n(2) Derivative liabilities are included in accrued liabilities in the condensed consolidated balance sheets.\\nDerivatives in Cash Flow Hedging Relationships\\nThe changes in accumulated other comprehensive income resulting from cash flow hedging were as follows:\\n\\n| As of March 31, 2021 | As of December 31, 2020 |\\n| (in millions) |\\n| Balance beginning of the period | $ | 2 | $ | — |\\n| Other comprehensive income before reclassifications | 7 | 9 |\\n| Amounts recognized in core marketplace revenue and reclassified out of accumulated other comprehensive income | ( 9 | ) | ( 7 | ) |\\n| Balance at the end of the period | $ | — | $ | 2 |\\n\\nThe Company recognizes changes in fair value of the cash flow hedges of foreign currency denominated merchants payable in accumulated other comprehensive loss in its consolidated balance sheets until the forecasted transaction occurs. When the forecasted transaction affects earnings, the Company reclassifies the related gain or loss on the cash flow hedge to core marketplace revenue. All amounts in other comprehensive income at period end are expected to be reclassified to earnings within 12 months. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, the Company reclassifies the gain or loss on the related cash flow hedge from accumulated other comprehensive loss to core marketplace revenue. For the three months ended March 31, 2021, there were no net gains or losses recognized in core marketplace revenue relating to hedges of forecasted transactions that did not occur. The Company did not have a hedging program during the three months ended March 31, 2020.\\nThe Company classifies cash flows related to its cash flow hedges as operating activities in its condensed consolidated statements of cash flows.\\nDerivatives Not Designated as Hedging Instruments\\nThe net gains on the change in fair value of the Company’s foreign exchange forward contracts not designated as hedging instruments were approximately $ 4 million for the three months ended March 31, 2021 and were recognized in other income (expense), net in the condensed consolidated statement of operations. The Company did not have a hedging program during the three months ended March 31, 2020.\\n11\\nThe Company classifies cash flows related to its non-designated hedging instruments as operating activities in its condensed consolidated statements of cash flows.\\nNOTE 6. OPERATING LEASES\\nThe Company leases its facilities and data center co-locations under operating leases with various expiration dates through 2025 .\\nTotal operating lease cost was $ 4 million and $ 3 million for the three months ended March 31, 2021 and 2020, respectively. Short-term lease costs and variable lease costs and sublease income were not material.\\nAs of March 31, 2021 and December 31, 2020, the Company’s condensed consolidated balance sheets included right-of-use assets in the amount of $ 39 million and $ 43 million, respectively, and lease liabilities in the amount of $ 14 million and $ 14 million in accrued liabilities, respectively, and $ 34 million and $ 38 million in lease liabilities, non-current, respectively.\\nAs of March 31, 2021 and December 31, 2020, the weighted-average remaining lease term was 3.7 years and 3.9 years, respectively, and the weighted-average discount rate used to determine the net present value of the lease liabilities was 6 %.\\nSupplemental cash flow information for the Company’s operating leases were as follows:\\n\\n| March 31, | March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Operating cash flows from operating leases | $ | 4 | $ | 3 |\\n\\nThe maturities of the Company’s operating lease liabilities are as follows:\\n\\n| March 31, |\\n| 2021 |\\n| Year ending December 31, | (in millions) |\\n| 2021 (remaining nine months) | $ | 12 |\\n| 2022 | 15 |\\n| 2023 | 11 |\\n| 2024 | 10 |\\n| 2025 | 5 |\\n| Total lease payments | 53 |\\n| Less: imputed interest | ( 5 | ) |\\n| Present value of lease liabilities | $ | 48 |\\n\\nNOTE 7. COMMITMENTS AND CONTINGENCIES\\nRevolving Credit Facility\\nIn November 2020, the Company entered into a five-year $ 280 million senior secured revolving credit facility (the “Revolving Credit Facility”) to, among other things, permit the Company to increase its aggregate commitments by up to $ 100 million, if an accordion option is exercised and provided the Company is able to secure additional lender commitments and satisfy certain other conditions, and to enter into letters of credit from time to time, which reduces its borrowing capacity under the Revolving Credit Facility. Interest on any borrowings under the Revolving Credit Facility accrues at either adjusted LIBOR plus 1.50 % or at an alternative base rate plus 0.50 %, at the Company’s election, and the Company is required to pay a commitment fee that accrues at 0.25 % per annum on the unused portion of the aggregate commitments under the Revolving Credit Facility. The Company is required to pay a fee that accrues at 1.50 % per annum on the average daily amount available to be drawn under any letters of credit outstanding under the Revolving Credit Facility.\\n12\\nThe Revolving Credit Facility contains customary conditions to borrowing, events of default and covenants, including covenants that restrict the Company’s ability (and the ability of certain of the Company’s subsidiaries) to incur indebtedness, grant liens, make certain fundamental changes and asset sales, make distributions to stockholders, make investments or engage in transactions with affiliates. It also contains a minimum liquidity financial covenant of $ 350 million, which includes unrestricted cash and any available borrowing capacity under the Revolving Credit Facility. The obligations under the Revolving Credit Facility are secured by liens on substantially all of the Company’s domestic assets and are guaranteed by any material domestic subsidiaries, subject to customary exceptions. A standby letter of credit in the amount of approximately $ 10 million has been issued under the Revolving Credit Facility in conjunction with the lease of the Company’s headquarters in San Francisco, California. As of March 31, 2021, the Company had no t made any borrowings under the Revolving Credit Facility and it was in compliance with the related covenants.\\nPurchase Obligations\\nDuring 2019, the Company amended a marketing arrangement which increased the total commitment under the agreement and extended the arrangement to July 31, 2021. As of March 31, 2021, the remaining commitment under the amended agreement was $ 5 million, which is payable in 2021 .\\nEffective September 1, 2019, the Company entered into an amendment to a colocation and cloud services arrangement committing the Company to make payments of $ 120 million for services over 3 years. As of March 31, 2021, the remaining commitment under this amended agreement was approximately $ 35 million and is payable within the next two years .\\nLegal Contingencies\\nAs of March 31, 2021 and December 31, 2020, there were no legal contingency matters that arose in the ordinary course of business, either individually or in aggregate, that would have a material adverse effect on the financial position, results of operations, or cash flows of the Company. Given the unpredictable nature of legal proceedings, the Company bases its estimate on the information available at the time of the assessment. As additional information becomes available, the Company reassesses the potential liability and may revise the estimate.\\nNOTE 8. EQUITY Award activity and STOCK-based compensation\\nEquity Award Activity\\nA summary of activity under the equity plans and related information is as follows:\\n\\n| Options Outstanding | RSUs Outstanding |\\n| Number of Options | Weighted- Average Exercise Price | Weighted- Average Remaining Contractual Term (In Years) | Number of RSUs |\\n| (in millions) | (in millions) |\\n| Balances at December 31, 2020 | 75 | $ | 0.234 | 3.2 | 30 |\\n| Granted | — | $ | — | 1 |\\n| Vested(1) | — | $ | — | ( 3 | ) |\\n| Exercised | ( 2 | ) | $ | 0.154 | — |\\n| Balances at March 31, 2021(2) | 73 | $ | 0.236 | 3.0 | 28 |\\n\\n\\n| (1) | For the three months ended March 31, 2021, approximately 3 million RSUs vested upon satisfying both the service and liquidity vesting conditions. The shares remained unreleased as of March 31, 2021 due to the lock-up provisions related to the Company’s IPO. |\\n\\n| (2) | Outstanding RSUs as of March 31, 2021 include 10 million units of CEO Performance Award. |\\n\\nThe weighted-average grant date fair value of restricted stock units (“RSUs”) granted during the three months ended March 31, 2021 was $ 22.01 per share.\\n13\\nStock-Based Compensation Expense\\nTotal stock-based compensation expense included in the condensed consolidated statements of operations is as follows:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cost of revenue | $ | 5 | $ | — |\\n| Sales and marketing | 3 | — |\\n| Product development | 15 | — |\\n| General and administrative | 14 | — |\\n| Total stock-based compensation | $ | 37 | $ | — |\\n\\nThe Company will recognize the remaining $ 134 million and $ 72 million of unrecognized stock-based compensation expense over a weighted-average period of approximately 1.32 years and 3.84 years related to RSUs and CEO Performance Award, respectively.\\nEmployee Stock Purchase Plan\\nThe Company’s Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s Class A common stock at a discount through payroll deductions of up to 15 % of eligible compensation, subject to caps of $ 25,000 in any calendar year and 2,500 shares on any purchase date. The ESPP provides for 24 -month offering periods, generally beginning in November and May of each year, and each offering period consists of four six-month purchase periods. The initial offering period began on January 1, 2021 and will end in November 2022. The first purchase under the ESPP will be in May 2021 .\\nOn each purchase date, participating employees will purchase Class A common stock at a price per share equal to 85 % of the lesser of the fair market value of the Company’s Class A common stock on (i) the first trading day of the applicable offering period and (2) the last trading day of each purchase period in the applicable offering period. If the stock price of the Company's Class A common stock on any purchase date in an offering period is lower than the stock price on the enrollment date of that offering period, the offering period will immediately reset after the purchase of shares on such purchase date and automatically roll into a new offering period.\\nThe Company uses the Black-Scholes option pricing model to determine the fair value of shares to be purchased under the 2020 Employee Stock Purchase Plan (“ESPP”) with the following assumptions on the date of grant:\\n\\n| Three Months Ended |\\n| March 31, 2021 |\\n| Expected term (in years) | 0.38 to 1.88 |\\n| Risk free interest rate | 0.09% to 0.13% |\\n| Volatility | 46.45% to 62.28% |\\n| Dividend yield | — |\\n| Estimated fair value per ESPP share | $4.14 to $8.05 |\\n\\nNOTE 9. INCOME TAXES\\nThe Company’s tax provision for the interim periods is determined using an estimate of the annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, the Company assesses its estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, the Company makes a cumulative adjustment in the period of change.\\nThe Company’s quarterly tax provision and the estimate of the annual effective tax rate is subject to fluctuation due to several factors, including variability in pre-tax earnings, the geographic distribution of the pre-tax earnings, tax law\\n14\\nchanges, non-deductible expenses, such as stock-based compensation, and changes in the estimate of the valuation allowance.\\nThe provision for income taxes was $ 2 million for the three months ended March 31, 2021 and was insignificant for the three months ended March 31, 2020. The year-over-year increase in provision for income taxes was primarily related to international operations. The Company continues to maintain a valuation allowance on its domestic net deferred tax assets which is excluded from the annual effective tax rate estimate.\\nThe Company had immaterial unrecognized tax benefits as of March 31, 2021 and December 31, 2020, fully offset by a valuation allowance. These unrecognized tax benefits, if recognized, would no t affect the effective tax rate. No interest or penalties were incurred during the years ended March 31, 2021 and 2020.\\nThe Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The Company is not currently under examination by income tax authorities in federal, state or other jurisdictions. All tax returns will remain open for examination by the federal and state authorities for three and four years , respectively, from the date of utilization of any net operating loss or credits. Certain tax years are subject to foreign income tax examinations by tax authorities until the statute of limitations expire.\\n15\\nNOTE 10. Net loss per share\\nBasic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by giving effect to potentially dilutive common stock equivalents outstanding during the period, as their effect would be dilutive. Potentially dilutive common shares include participating securities and shares issuable upon the exercise of stock options, the exercise of common stock warrants, the vesting of RSUs and each purchase under the 2020 ESPP, under the treasury stock method.\\nIn loss periods, basic net loss per share and diluted net loss per share are the same, as the effect of potential common shares is anti-dilutive and therefore excluded.\\nThe rights, including the liquidation and dividend rights, of the holders of Class A and Class B common stock are identical, except with respect to voting. As the liquidation and dividend rights are identical, the Company’s undistributed earnings or losses are allocated on a proportionate basis among the holders of both Class A and Class B common stock. As a result, the net income (loss) per share attributed to common stockholders will, therefore, be the same for both Class A and Class B common stock on an individual or combined basis.\\nThe following table sets forth the computation of basic and diluted net loss per share:\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in millions, except per share data) |\\n| Numerator: |\\n| Net loss | $ | ( 128 | ) | $ | ( 66 | ) |\\n| Denominator: |\\n| Weighted-average shares used in computing net loss per share, basic and diluted | 619 | 106 |\\n| Net loss per share, basic and diluted | $ | ( 0.21 | ) | $ | ( 0.62 | ) |\\n\\nThe following outstanding shares of potentially dilutive securities were excluded from the computation of diluted net loss per share because including them would have had an anti-dilutive effect:\\n\\n| As of March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Redeemable convertible preferred stock, all series | — | 422 |\\n| Series B warrant | — | 10 |\\n| Warrant to purchase common stock | 1 | 1 |\\n| Common stock options outstanding | 73 | 77 |\\n| Unvested RSUs outstanding(1) | 28 | 44 |\\n| Employee Stock Purchase Plan | 1 | — |\\n| Total | 103 | 554 |\\n\\n\\n| (1) | Unvested RSUs outstanding as of March 31, 2021 included 10 million units of CEO Performance Award. |\\n\\n16\\nNOTE 11. GEOGRAPHICAL INFORMATION\\nThe Company believes it is relevant to disclose geographical revenue information on both a demand basis, determined by the ship-to address of the user, and on a supply basis, determined by the location of the merchants’ operations.\\nCore marketplace revenue by geographic area based on the ship-to address of the user is as follows:\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Europe | $ | 235 | 49 | % | $ | 159 | 47 | % |\\n| North America(1) | 186 | 39 | % | 126 | 37 | % |\\n| South America | 18 | 4 | % | 23 | 7 | % |\\n| Other | 38 | 8 | % | 32 | 9 | % |\\n| Core marketplace revenue | $ | 477 | 100 | % | $ | 340 | 100 | % |\\n\\n\\n| (1) | United States accounted for $ 156 million and $ 103 million of core marketplace revenue for the three months ended March 31, 2021 and 2020, respectively. |\\n\\nChina accounted for substantially all of marketplace and logistics revenue during the three months ended March 31, 2021 and 2020 based on the location of the merchants’ operations.\\nThe Company’s long-lived tangible assets, which consist of property and equipment, net and operating lease right-of-use assets, net, located in the United States were 87 % of the total long-lived tangible assets as of March 31, 2021 and December 31, 2020. The long-lived tangible assets outside the United States were located in China, Canada and the Netherlands.\\n17\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThe following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with (1) the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and (2) the audited condensed consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2020 included in our Annual Report on Form 10-K filed on March 25, 2021. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the heading \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for our year ended December 31, 2020. See also \\\"Special Note Regarding Forward-Looking Statements\\\" above.\\nFinancial Results for the Three Months Ended March 31, 2021\\n| • | Total revenue was $772 million, an increase of 75% year-over-year. |\\n\\n| • | Total cost of revenue and expenses were $898 million, including stock-based compensation expense of $37 million and $7 million of employer payroll taxes related to stock-based compensation. |\\n\\n| • | Loss from operations was $126 million. |\\n\\n| • | Net loss was $128 million. |\\n\\n| • | Adjusted EBITDA was a loss of $79 million or 10% of total revenue. |\\n\\n| • | Cash and cash equivalents and marketable securities were $1.8 billion. |\\n\\nAs of March 31, 2021, we had an accumulated deficit of $2.3 billion. We expect losses from operations to continue for the foreseeable future as we incur costs and expenses related to brand development, expansion of market share, continued development of our mobile shopping marketplace infrastructure and development of other businesses.\\nCOVID-19\\nThe outbreak of coronavirus disease 2019 (“COVID-19”) has affected businesses worldwide, as of the date of filing of this Quarterly Report, and continues to impact the major markets in which we operate. The COVID-19 pandemic has resulted in significant governmental measures being implemented to control the spread of the virus, and our operations as well as the operations of our third-party merchants and users have been and will continue to be disrupted by varying individual and governmental responses to COVID-19 around the world, such as business shutdowns, stay-at-home directives, travel restrictions, border closures, and other travel or health-related restrictions as well as by absenteeism, quarantines, self-isolations, office and factory closures, delays on deliveries, and disruptions to ports and other freight infrastructure. These restrictions may cause consumers and businesses to reduce their activities and their spending, have caused a slowdown in the global economy and have had, and may continue to have, a negative impact on our operations. If these conditions continue, sales volumes may decrease and we may, among other issues, experience or continue to experience delays in product development, a decreased ability to support our merchants, disruptions in sales, delivery and logistics, each of which could have a negative impact on our ability to meet shipment commitments and on our revenue and profitability.\\nOur Financial Model\\nOur business benefits from powerful network effects, fueled by our data advantage and massive scale. As more users join Wish, attracted by our affordable value proposition and shopping experience, we are able to increase revenue potential for our merchants. As more merchants succeed on Wish, more merchants join the platform and grow their businesses with Wish, broadening our product selection, which in turn improves user experience. By developing a strategy focused on users and merchants, we align user and merchant success with the success of our financial model. The growth in users and merchants generates more data, further strengthens our data advantage and creates an even better experience for everyone on our platform, in turn attracting more users and high-quality merchants.\\nOur model relies on cost-effectively adding new users, converting those users into buyers and improving engagement and monetization of those buyers on Wish over time as well as adding new merchants, delivering economic success for those merchants, and having those merchants use more of our end-to-end platform.\\n18\\nKey Financial and Performance Metrics\\nIn addition to the measures presented in our condensed consolidated financial statements, we monitor the following key metrics and other financial information to measure our performance, identify trends affecting our business, and make strategic decisions.\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| MAU | 101 | 109 |\\n| LTM Active Buyers | 61 | 63 |\\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\\n| Adjusted EBITDA Margin | (10 | )% | (12 | )% |\\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\\n\\nMonthly Active Users\\nWe define MAUs as the number of unique users that visited the Wish platform, either on our mobile app, mobile web, or on a desktop, during the month. MAUs for a given reporting period equal the average of the MAUs for that period. An active user is identified by a unique email-address; a single person can have multiple user accounts via multiple email addresses. The change in MAUs in a reported period captures both the inflow of new users as well as the outflow of existing users who did not visit the platform in a given month. We view the number of MAUs as key driver of revenue growth as well as a key indicator of user engagement and awareness of our brand.\\nMAUs decreased approximately 7% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily driven by the decision to de-emphasize user acquisition in some emerging markets outside of Europe and North America where we faced logistical challenges due to the pandemic and to emphasize higher LTV users within the same value-conscious consumer category in many of the more developed markets.\\nLTM Active Buyers\\nAs of the last date of each reported period, we determine our number of unique active buyers by counting the total number of individual users who have placed at least one order on the Wish platform, either on our mobile app, mobile web, or on a desktop, during the preceding 12 months. We, however, exclude from the computation those buyers whose order is cancelled before the item is shipped and the purchase price is refunded. The number of Active Buyers is an indicator of our ability to attract and monetize a large user base to our platform and of our ability to convert visits into purchases. We believe that increasing our Active Buyers will be a significant driver to our future revenue growth.\\nLTM Active Buyers decreased approximately 3% from the three months ended March 31, 2020 to the three months ended March 31, 2021, primarily due to our actions to de-emphasize low value items, which tend to have high conversion rates but unfavorable economics.\\nA Note About Metrics\\nThe numbers for some of our metrics, including MAUs, are calculated and tracked with internal tools, which are not independently verified by any third party. We use these metrics to assess the growth and health of our overall business. While these numbers are based on what we believe to be reasonable estimates of our user or merchant base for the applicable period of measurement, there are inherent challenges in measurement as the methodologies used require significant judgment and may be susceptible to algorithm or other technical errors. In addition, we regularly review and adjust our processes for calculating metrics to improve their accuracy, and our estimates may change due to improvements or changes in technology or our methodology.\\n19\\nNon-GAAP Financial Measures\\nAdjusted EBITDA and Adjusted EBITDA Margin\\nWe provide Adjusted EBITDA, a non-GAAP financial measure that represents our net income (loss) adjusted to exclude; interest and other income (expense), net (which includes foreign exchange gain or loss, foreign exchange forward contracts gain or loss and gain or loss on one-time non-operating transactions); provision or benefit for income taxes;, depreciation and amortization; stock-based compensation expense and related payroll taxes; remeasurement of redeemable convertible preferred stock warrant liability and other items. Additionally, we provide Adjusted EBITDA Margin, a non-GAAP financial measure that represents Adjusted EBITDA divided by revenue. Below is a reconciliation of Adjusted EBITDA to net loss, the most directly comparable GAAP financial measure.\\nWe have included Adjusted EBITDA and Adjusted EBITDA Margin in this report because they are key measures used by our management and board of directors to understand and evaluate our operating performance and trends and how we are allocating internal resources, to prepare and approve our annual budget and to develop short- and long-term operating plans. We also believe that the exclusion of certain items in calculating Adjusted EBITDA can provide a useful measure for period-to-period comparisons of our business as it removes the impact of non-cash items and certain variable charges.\\nAdjusted EBITDA has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\\n| • | although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements; |\\n\\n| • | Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; |\\n\\n| • | Adjusted EBITDA does not consider the impact of stock-based compensation and related payroll taxes; |\\n\\n| • | Adjusted EBITDA does not reflect tax payments that may represent a reduction in cash available to us; and |\\n\\n| • | other companies, including companies in our industry, may calculate Adjusted EBITDA differently, which reduces its usefulness as a comparative measure. |\\n\\nBecause of these limitations, you should consider Adjusted EBITDA and Adjusted EBITDA Margin alongside other financial performance measures, including various cash flow metrics, net income (loss) and our other GAAP results.\\nThe following table reflects the reconciliation of net loss to Adjusted EBITDA and net loss as a percentage of revenue to Adjusted EBITDA margin for each of the periods indicated:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Revenue | $ | 772 | $ | 440 |\\n| Net loss | (128 | ) | (66 | ) |\\n| Net loss as a percentage of revenue | (17 | )% | (15 | )% |\\n| Excluding: |\\n| Interest and other expense (income), net | — | (3 | ) |\\n| Provision for income taxes | 2 | — |\\n| Depreciation and amortization | 2 | 2 |\\n| Stock-based compensation expense | 37 | — |\\n| Employer payroll taxes related to stock-based compensation expense | 7 | — |\\n| Remeasurement of redeemable convertible preferred stock warrant liability | — | 15 |\\n| Recurring other items | 1 | 1 |\\n| Adjusted EBITDA | $ | (79 | ) | $ | (51 | ) |\\n| Adjusted EBITDA margin | (10 | )% | (12 | )% |\\n\\n20\\nFree Cash Flow\\nWe also provide Free Cash Flow, a non-GAAP financial measure that represents net cash provided by (used in) operating activities less purchases of property and equipment. We believe that Free Cash Flow is an important measure since we use third parties to host our services and therefore we do not incur significant capital expenditures to support revenue generating activities.\\nFree Cash Flow has limitations as an analytical measure, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:\\n| • | it is not a substitute for net cash provided by (used in) operating activities; |\\n\\n| • | other companies may calculate Free Cash Flow or similarly titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a tool for comparison; and |\\n\\n| • | the utility of free cash flow is further limited as it does not reflect our future contractual commitments and does not represent the total increase or decrease in our cash balance for any given period. |\\n\\nBecause of these limitations, you should consider Free Cash Flow alongside other financial performance measures, such as net cash provided by (used in) operating activities, net income (loss) and our other GAAP results.\\nThe following table reflects the reconciliation of net cash provided by (used in) operating activities to Free Cash Flow for each of the periods indicated:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cash used in operating activities | $ | (354 | ) | $ | (129 | ) |\\n| Less: |\\n| Purchases of property and equipment | — | — |\\n| Free Cash Flow | $ | (354 | ) | $ | (129 | ) |\\n\\nResults of Operations\\nThe following table shows our results of operations for the periods presented and express the relationship of certain line items as a percentage of revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Revenue | $ | 772 | $ | 440 |\\n| Cost of revenue(1) | 335 | 156 |\\n| Gross profit | 437 | 284 |\\n| Operating expenses: |\\n| Sales and marketing(1) | 470 | 295 |\\n| Product development(1) | 51 | 25 |\\n| General and administrative(1) | 42 | 18 |\\n| Total operating expenses | 563 | 338 |\\n| Loss from operations | (126 | ) | (54 | ) |\\n| Other income (expense), net |\\n| Interest and other income, net | — | 3 |\\n| Remeasurement of convertible preferred stock warrant liability | — | (15 | ) |\\n| Loss before provision for income taxes | (126 | ) | (66 | ) |\\n| Provision for income taxes | 2 | — |\\n| Net loss | $ | (128 | ) | $ | (66 | ) |\\n\\n21\\n\\n| (1) | Includes stock-based compensation expense as follows: |\\n\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cost of revenue | $ | 5 | $ | — |\\n| Sales and marketing | 3 | — |\\n| Product development | 15 | — |\\n| General and administrative | 14 | — |\\n| Total stock-based compensation | $ | 37 | $ | — |\\n\\nThe following table presents the components of our condensed consolidated statements of operations as a percentage of revenue:\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Revenue | 100 | % | 100 | % |\\n| Cost of revenue | 43 | % | 35 | % |\\n| Gross profit | 57 | % | 65 | % |\\n| Operating expenses: |\\n| Sales and marketing | 61 | % | 67 | % |\\n| Product development | 7 | % | 6 | % |\\n| General and administrative | 6 | % | 4 | % |\\n| Total operating expenses | 74 | % | 77 | % |\\n| Loss from operations | (17 | )% | (12 | )% |\\n| Other income (expense), net: |\\n| Interest and other income (expense), net | — | 1 | % |\\n| Remeasurement of convertible preferred stock warrant liability | — | (3 | )% |\\n| Loss before provision for income taxes | (17 | )% | (15 | )% |\\n| Provision for income taxes | — | — |\\n| Net loss | (17 | )% | (15 | )% |\\n\\nComparison of Three Months Ended March 31, 2021 and March 31, 2020\\nRevenue\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Core marketplace revenue(1) | $ | 477 | $ | 340 | $ | 137 | 40 | % |\\n| ProductBoost revenue | 50 | 44 | 6 | 14 | % |\\n| Marketplace revenue | 527 | 384 | 143 | 37 | % |\\n| Logistics revenue | 245 | 56 | 189 | 338 | % |\\n| Revenue | $ | 772 | $ | 440 | $ | 332 | 75 | % |\\n\\n\\n| (1) | Core marketplace revenue for the three months ended March 31, 2021 included approximately $9 million net gains from our cash flow hedging program. We did not have a hedging program during the three months ended March 31, 2020. |\\n\\nRevenue increased $332 million, or 75%, to $772 million for the three months ended March 31, 2021 as compared to $440 million for the three months ended March 31, 2020. This increase was attributable to both increased marketplace and logistics revenue.\\n22\\nMarketplace revenue increased $143 million, or 37% to $527 million for the three months ended March 31, 2021, as compared to $384 million for the three months ended March 31, 2020. This increase was primarily due to our efforts to improve buyer monetization and lower refunds. This increase was also partially driven by increased merchant utilization of our ProductBoost service.\\nLogistics revenue increased $189 million, or 338% to $245 million for the three months ended March 31, 2021, as compared to $56 million for the three months ended March 31, 2020. This increase was primarily due to accelerated merchant adoption of our logistics offerings, as well as the expansion of our A+ program, in which Wish manages first mile collection from merchants to warehousing operations all the way to last mile delivery to the buyer.\\nCost of Revenue and Gross Margin\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Cost of revenue | $ | 335 | $ | 156 | $ | 179 | 115 | % |\\n| Percentage of revenue | 43 | % | 35 | % |\\n| Gross Margin | 57 | % | 65 | % |\\n\\nCost of revenue increased $179 million, or 115%, to $335 million for the three months ended March 31, 2021, as compared to $156 million for the three months ended March 31, 2020, primarily due to costs related to the increased volume of logistics services provided and increased headcount. The increase was also driven by a $6 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs for our employees involved in infrastructure, merchant support, and logistics functions.\\nThe gross margin decreased to 57% for the three months ended March 31, 2021 from 65% for the three months ended March 31, 2020, primarily due to increased volume of logistics services provided and the fact that logistics gross margin was at significantly lower rate than marketplace gross margin.\\nSales and Marketing\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Sales and marketing | $ | 470 | $ | 295 | $ | 175 | 59 | % |\\n| Percentage of revenue | 61 | % | 67 | % |\\n\\nSales and marketing expense increased $175 million, or 59%, to $470 million for the three months ended March 31, 2021, compared to $295 million for the three months ended March 31, 2020. The increase in sales and marketing expenses consisted primarily of incremental digital advertising spend associated with increased pricing from our largest vendors. To a lesser extent, the increase was also driven by a $4 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in marketing, user support, and business development functions. We anticipate that sales and marketing expenses will continue to be our most significant operating expense in the future and our overall profitability will depend on the success of our investments in sales and marketing.\\nProduct Development\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Product development | $ | 51 | $ | 25 | $ | 26 | 104 | % |\\n| Percentage of revenue | 7 | % | 6 | % |\\n\\nProduct development expense increased $26 million, or 104%, to $51 million for the three months ended March 31, 2021, as compared to $25 million for the three months ended March 31, 2020, primarily as a result of an increase in\\n23\\nemployee-related costs driven by increased headcount and an $18 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs, for our employees involved in product development activities. The increase was also, to a lesser extent, driven by expenses associated with data warehousing, processing and analytics.\\nGeneral and Administrative\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| General and administrative | $ | 42 | $ | 18 | $ | 24 | 133 | % |\\n| Percentage of revenue | 6 | % | 4 | % |\\n\\nGeneral and administrative expense increased $24 million, or 133%, to $42 million for the three months ended March 31, 2021, as compared to $18 million for the three months ended March 31, 2020. The increase was primarily related to a $16 million stock-based compensation expense and related employer payroll taxes that we recognized in connection with the settlement of vested RSUs and increases in expenses associated with being a publicly listed company.\\nRemeasurement of Redeemable Convertible Preferred Stock Warrant Liability\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Remeasurement of redeemable convertible preferred stock warrant liability | $ | — | $ | (15 | ) | $ | 15 | (100 | )% |\\n| Percentage of revenue | — | (3 | )% |\\n\\nThe $15 million expense that we recognized during the three months ended March 31, 2020 was related to the change in fair value of the redeemable convertible preferred stock warrant liability. There was no remeasurement charge recognized during the three months ended March 31, 2021 because immediately prior to the completion of our IPO in December 2020, the outstanding redeemable convertible preferred stock warrant was net exercised. The fair value of the warrant at the time of exercise was reclassified into the Company’s Class A common stock and additional paid-in capital.\\nProvision for Income Taxes\\n\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | $ | % |\\n| (in millions) |\\n| Provision for income taxes | $ | 2 | $ | — | $ | 2 | — |\\n| Percentage of revenue | — | — |\\n\\nProvision for income taxes increased $2 million for the three months ended March 31, 2021 compared to the three months ended March 31, 2020. The change in provision for income taxes was due primarily to an increase of taxes for our international operations.\\nLiquidity and Capital Resources\\nAs of March 31, 2021, we had cash, cash equivalents and marketable securities of $1.8 billion, a majority of which were held in cash deposits and money market funds, and were held for working capital purposes. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to meet our anticipated cash needs for at least the next 12 months. Additional future financing may be necessary to fund our operations and there can be no assurance that, if needed, we will be able to secure additional debt or equity financing on terms acceptable to us or at all, especially in light of the market volatility and uncertainty as a result of the COVID-19 pandemic. Although we believe we have adequate sources of liquidity over the long term, the success of our operations, the global economic outlook, and the pace of\\n24\\nsustainable growth in our markets, in each case, in light of the market volatility and uncertainty as a result of the COVID-19 pandemic, among other factors, could impact our business and liquidity.\\nNovember 2020 Credit Facility\\nIn November 2020, we entered into the Revolving Credit Facility which enables us to borrow up to $280 million. The Revolving Credit Facility contains an accordion option which, if exercised and provided we are able to secure additional lender commitments and satisfy certain other conditions, would allow us to increase the aggregate commitments by up to $100 million. As of March 31, 2021, we had not made any borrowings under the Revolving Credit Facility. Refer to Note 7 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Information” for additional details related to the Revolving Credit Facility.\\nCash Flows\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in millions) |\\n| Cash provided by (used in): |\\n| Operating activities | $ | (354 | ) | $ | (129 | ) |\\n| Investing activities | 14 | 59 |\\n| Financing activities | (5 | ) | 1 |\\n\\nNet Cash Provided by (Used in) Operating Activities\\nOur cash flows from operations are largely dependent on the amount of revenue we generate. Net cash provided by operating activities in each period presented has been influenced by changes in funds receivable, prepaid expenses, and other current and noncurrent assets, accounts payable, merchants payable, accrued and refund liabilities, lease liabilities, and other current and noncurrent liabilities.\\nNet cash used in our operating activities for the three months ended March 31, 2021 was $354 million. This was primarily driven by our net loss of $128 million and $266 million unfavorable net working capital changes, which was partially offset by non-cash expenses, such as stock-based compensation expense of $37 million. Unfavorable working capital movement was mainly driven by accounts payable and merchants payable. Accounts payable decreased by $143 million primarily due to shorter vendor payment terms. Due to the COVID-19 pandemic, we were able to negotiate favorable payment terms with certain key digital advertising partners (45 days and 60 days). The payment terms with these key digital advertising partners reverted back to 30 days when the favorable terms expired on December 31, 2020. Merchants payable decreased by $73 million primarily driven by lower volumes in the first quarter of 2021 compared to the fourth quarter of 2020 due to seasonality and higher percentage of shipments through our A+ program which accelerated the payment of merchants payable due to higher delivery confirmation rates. Other decreases in unfavorable working capital movement were driven by refunds and accrued liabilities.\\nNet cash used in our operating activities for the three months ended March 31, 2020 was $129 million. This was primarily driven by our net loss of $66 million and a $122 million decrease in merchants payable, which was partially offset by non-cash expenses, such as the remeasurement of redeemable convertible preferred stock warrant liability of $15 million, which was further offset by a $31 million increase in accounts payable.\\nNet Cash Provided by (Used in) Investing Activities\\nOur primary investing activities have consisted of investing excess cash balances in marketable securities.\\nNet cash provided by investing activities was $14 million for the three months ended March 31, 2021. This was primarily due to $67 million of maturities of marketable securities, partially offset by $53 million purchases of marketable securities.\\nNet cash generated from investing activities was $59 million for the three months ended March 31, 2020. This was primarily due to $132 million maturities of marketable securities, partially offset by $73 million purchases of marketable securities.\\n25\\nNet Cash Provided by (Used in) Financing Activities\\nNet cash used in our financing activities was $5 million for the three months ended March 31, 2021 primarily due to tax payments related to RSU settlement.\\nNet cash provided by financing activities was $1 million for the three months ended March 31, 2020 and was related to proceeds from stock option exercises.\\nOff Balance Sheet Arrangements\\nFor the three months ended March 31, 2021 and 2020, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.\\nContingencies\\nWe are involved in claims, lawsuits, government investigations, and proceedings arising from the ordinary course of our business. We record a provision for a liability when we believe that it is both probable that a liability has been incurred, and the amount can be reasonably estimated. Significant judgment is required to determine both probability and the estimated amount. Such legal proceedings are inherently unpredictable and subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to be incorrect, it could have a material impact on our results of operations, financial position, and cash flows.\\nCritical Accounting Policies\\nThe preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those listed below. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.\\nOur critical accounting policies are as follows:\\n| • | Revenue recognition; |\\n\\n| • | Operating lease obligations; |\\n\\n| • | Stock-based compensation; and |\\n\\n| • | Income taxes. |\\n\\nOur critical accounting policies are important to the portrayal of our financial condition and results of operations, and require us to make judgments and estimates about matters that are inherently uncertain.\\nThere have been no material changes to our critical accounting policies and estimates as compared to those described in our Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 25, 2021.\\nRecent Accounting Pronouncements\\nSee Note 1 of Part I, Item 1 of this Quarterly Report on Form 10-Q for a full description of recent accounting pronouncements.\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\\nWe have operations both within the U.S. and internationally, and we are exposed to market risks in the ordinary course of our business, including the effects of interest rate changes and foreign currency fluctuations. Information relating to quantitative and qualitative disclosures about these market risks is described below.\\n26\\nInterest Rate Sensitivity\\nCash, cash equivalents and marketable securities as of March 31, 2021 were held primarily in cash deposits and money market funds. The fair value of our cash, cash equivalents, and investments would not be significantly affected by either an increase or decrease in interest rates due mainly to the short-term nature of these instruments. A 100 basis point increase or decrease in our current interest rates would have increased or decreased our interest income by $18 million for the three months ended March 31, 2021.\\nForeign Currency Risk\\nWe transact business in various foreign countries and are, therefore, subject to risk of foreign currency exchange rate fluctuations. We have established a foreign currency risk management policy to provide process and procedures for managing this risk. We use natural hedging techniques first to net off existing foreign currency exposures. For the remaining exposure, we may enter into short term foreign currency derivative contracts, including forward contracts to hedge exposures associated with monetary assets and liabilities, mainly merchants payable, and cash flows denominated in non-functional currencies.\\nThe credit risk of our foreign currency derivative contracts is minimized since contracts are not concentrated with any one financial institution and all contracts are only placed with large financial institutions. The gains and losses on foreign currency derivative contracts generally offset the losses and gains on the assets, liabilities and transactions hedged. The fair value of currency derivative contracts is reported in the condensed consolidated balance sheets. The majority of these foreign exchange contracts expire in less than three months and all expire within one year. Refer to Note 5 to our condensed consolidated financial statements in Item 1 of Part I, “Financial Statements” for more information related to our derivative financial instruments.\\nBased on our overall currency rate exposures as of March 31, 2021, including the derivative financial instruments intended to hedge the nonfunctional currency-denominated monetary assets, liabilities and cash flows, and other factors, a 10% appreciation or depreciation of the U.S. dollar from its cross-functional rates would not be expected, in the aggregate, to have a material effect on our financial position, results of operations and cash flows in the near-term.\\nInflation Risk\\nWe do not believe that inflation has had a material effect on our business, financial condition, or results of operations.\\nItem 4. Controls and Procedures.\\nEvaluation of Disclosure Controls and Procedures\\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this report. Based on management’s evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective at a reasonable assurance level.\\nIn designing and evaluating our disclosure controls and procedures, management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the three months ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n27\\nPART II—OTHER INFORMATION\\nItem 1. Legal Proceedings.\\nInformation with respect to this item may be found in Note 7, Commitments and Contingencies, in our Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q, which information is incorporated herein by reference.\\nItem 1A. Risk Factors.\\nYou should carefully consider the risks and uncertainties described under the heading \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 (the \\\"2020 Form 10-K\\\"), together with all of the other information contained in this Quarterly Report on Form 10-Q, including our condensed consolidated financial statements and related notes, before making a decision to invest in our Class A common stock. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that affect our business. These risk factors could materially and adversely affect our business, financial condition and results of operations, and the market price of our ordinary shares could decline. These risk factors do not identify all risks that we face – our operations could also be affected by factors that are not presently known to us or that we currently consider to be immaterial to our operations. Due to risks and uncertainties, known and unknown, our past financial results may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods. There have been no additional material changes from the risks and uncertainties previously disclosed under the \\\"Risk Factors\\\" section in our 2020 Form 10-K.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\n(a) Unregistered Sales of Equity Securities\\nNone\\n(b) Use of Proceeds\\nOur IPO of Class A common stock was effected through a Registration Statement on Form S-1 (File Nos. 333-250531), which was declared or became effective on December 15, 2020. There has been no material change in the use of proceeds from our IPO as described in our final prospectus dated December 15, 2020 filed with the Securities and Exchange Commission, or SEC, pursuant to Rule 424(b) of the Securities Act of 1933, as amended, or the Securities Act.\\nItem 6. Exhibits.\\n\\n| Exhibit Number | Description |\\n| 31.1* | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2* | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 101.INS* | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document. |\\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | Inline XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104* | Cover Page Interactive Data File (embedded within the Inline XBRL document) |\\n\\n\\n| * | Filed herewith. |\\n\\n| ** | Furnished herewith. |\\n\\n28\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| ContextLogic Inc. |\\n| Date: May 12, 2021 | By: | /s/ Rajat Bahri |\\n| Rajat Bahri |\\n| Chief Financial Offer |\\n| (Principal Financial Officer) |\\n\\n29\\n</text>\\n\\nWhat is the change in percentage of net loss from the three months ended March 31, 2020 to that ended March 31, 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -93.93939393939394.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 32,\n \"input_length\": 19489\n}"}}},{"rowIdx":33,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1 - Condensed Consolidated Financial Statements (unaudited)\nAlbertsons Companies, Inc. and Subsidiaries\nCondensed Consolidated Balance Sheets\n(in millions, except share data)\n(unaudited)\n| September 11,2021 | February 27,2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 2,849.8 | $ | 1,717.0 |\n| Receivables, net | 544.7 | 550.9 |\n| Inventories, net | 4,179.1 | 4,301.3 |\n| Other current assets | 414.7 | 418.8 |\n| Total current assets | 7,988.3 | 6,988.0 |\n| Property and equipment, net | 9,201.1 | 9,412.7 |\n| Operating lease right-of-use assets | 5,861.3 | 6,015.6 |\n| Intangible assets, net | 2,181.3 | 2,108.8 |\n| Goodwill | 1,200.2 | 1,183.3 |\n| Other assets | 912.1 | 889.6 |\n| TOTAL ASSETS | $ | 27,344.3 | $ | 26,598.0 |\n| LIABILITIES |\n| Current liabilities |\n| Accounts payable | $ | 3,554.2 | $ | 3,487.3 |\n| Accrued salaries and wages | 1,492.3 | 1,474.7 |\n| Current maturities of long-term debt and finance lease obligations | 211.5 | 212.4 |\n| Current maturities of operating lease obligations | 621.7 | 605.3 |\n| Other current liabilities | 1,190.0 | 1,052.5 |\n| Total current liabilities | 7,069.7 | 6,832.2 |\n| Long-term debt and finance lease obligations | 8,129.1 | 8,101.2 |\n| Long-term operating lease obligations | 5,464.1 | 5,548.0 |\n| Deferred income taxes | 598.3 | 533.7 |\n| Other long-term liabilities | 2,524.1 | 2,659.5 |\n| Commitments and contingencies |\n| Series A convertible preferred stock, $ 0.01 par value; 1,750,000 shares authorized, 924,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 844.3 | 844.3 |\n| Series A-1 convertible preferred stock, $ 0.01 par value; 1,410,000 shares authorized, 826,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 754.8 | 754.8 |\n| STOCKHOLDERS' EQUITY |\n| Undesignated preferred stock, $ 0.01 par value; 96,840,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\n| Class A common stock, $ 0.01 par value; 1,000,000,000 shares authorized, 586,668,103 and 585,574,666 shares issued as of September 11, 2021 and February 27, 2021, respectively | 5.9 | 5.9 |\n| Class A-1 convertible common stock, $ 0.01 par value; 150,000,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\n| Additional paid-in capital | 1,936.1 | 1,898.9 |\n| Treasury stock, at cost, 120,009,647 shares held as of September 11, 2021 and February 27, 2021 | ( 1,907.0 ) | ( 1,907.0 ) |\n| Accumulated other comprehensive income | 78.7 | 63.5 |\n| Retained earnings | 1,846.2 | 1,263.0 |\n| Total stockholders' equity | 1,959.9 | 1,324.3 |\n| TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | $ | 27,344.3 | $ | 26,598.0 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n3\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Operations and Comprehensive Income (in millions, except per share data)(unaudited)\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Net sales and other revenue | $ | 16,505.7 | $ | 15,757.6 | $ | 37,775.1 | $ | 38,509.2 |\n| Cost of sales | 11,788.7 | 11,182.7 | 26,867.1 | 27,162.8 |\n| Gross profit | 4,717.0 | 4,574.9 | 10,908.0 | 11,346.4 |\n| Selling and administrative expenses | 4,231.3 | 4,031.2 | 9,734.9 | 9,800.6 |\n| (Gain) loss on property dispositions and impairment losses, net | ( 0.2 ) | ( 18.3 ) | 0.1 | 12.0 |\n| Operating income | 485.9 | 562.0 | 1,173.0 | 1,533.8 |\n| Interest expense, net | 109.3 | 128.6 | 262.6 | 309.2 |\n| Loss on debt extinguishment | — | 49.1 | — | 49.1 |\n| Other income, net | ( 18.9 ) | ( 11.4 ) | ( 62.4 ) | ( 8.3 ) |\n| Income before income taxes | 395.5 | 395.7 | 972.8 | 1,183.8 |\n| Income tax expense | 100.3 | 111.2 | 232.8 | 313.1 |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\n| Other comprehensive income, net of tax |\n| Recognition of pension gain | 15.1 | 10.1 | 15.2 | 10.9 |\n| Other | — | 0.3 | — | 1.2 |\n| Other comprehensive income | $ | 15.1 | $ | 10.4 | $ | 15.2 | $ | 12.1 |\n| Comprehensive income | $ | 310.3 | $ | 294.9 | $ | 755.2 | $ | 882.8 |\n| Net income per Class A common share |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share | 0.52 | 0.49 | 1.26 | 1.49 |\n| Weighted average Class A common shares outstanding |\n| Basic | 465.3 | 477.3 | 465.2 | 529.2 |\n| Diluted | 573.0 | 582.9 | 470.6 | 583.3 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n4\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Cash Flows(in millions)(unaudited)\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 |\n| Cash flows from operating activities: |\n| Net income | $ | 740.0 | $ | 870.7 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Loss on property dispositions and impairment losses, net | 0.1 | 12.0 |\n| Depreciation and amortization | 883.2 | 808.8 |\n| Operating lease right-of-use assets amortization | 333.0 | 309.3 |\n| LIFO expense | 29.1 | 23.2 |\n| Deferred income tax | 43.0 | 2.8 |\n| Contributions to pension and post-retirement benefit plans, net of (income) expense | ( 47.5 ) | ( 68.9 ) |\n| (Gain) loss on interest rate swaps and commodity hedges, net | ( 7.5 ) | 25.9 |\n| Amortization and write-off of deferred financing costs | 11.1 | 11.2 |\n| Loss on debt extinguishment | — | 49.1 |\n| Equity-based compensation expense | 49.0 | 28.3 |\n| Other | ( 21.2 ) | ( 28.7 ) |\n| Changes in operating assets and liabilities: |\n| Receivables, net | ( 6.4 ) | ( 21.7 ) |\n| Inventories, net | 93.0 | 62.2 |\n| Accounts payable, accrued salaries and wages and other accrued liabilities | 229.2 | 585.4 |\n| Operating lease liabilities | ( 249.3 ) | ( 228.4 ) |\n| Self-insurance assets and liabilities | 36.3 | 24.2 |\n| Other operating assets and liabilities | 22.6 | 255.4 |\n| Net cash provided by operating activities | 2,137.7 | 2,720.8 |\n| Cash flows from investing activities: |\n| Business acquisitions, net of cash acquired | ( 23.5 ) | — |\n| Payments for property, equipment and intangibles, including payments for lease buyouts | ( 822.5 ) | ( 702.9 ) |\n| Proceeds from sale of long-lived assets | 24.6 | 20.6 |\n| Other investing activities | 30.9 | ( 4.8 ) |\n| Net cash used in investing activities | ( 790.5 ) | ( 687.1 ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of long-term debt | — | 3,500.0 |\n| Payments on long-term borrowings | ( 0.5 ) | ( 3,388.5 ) |\n| Payments of obligations under finance leases | ( 32.2 ) | ( 32.9 ) |\n| Payment of redemption premium on debt extinguishment | — | ( 41.4 ) |\n| Payments for debt financing costs | — | ( 15.6 ) |\n| Dividends paid on common stock | ( 93.0 ) | — |\n| Dividends paid on convertible preferred stock | ( 59.1 ) | — |\n| Proceeds from convertible preferred stock | — | 1,680.0 |\n| Third party issuance costs on convertible preferred stock | — | ( 80.9 ) |\n| Treasury stock purchase, at cost | — | ( 1,680.0 ) |\n| Employee tax withholding on vesting of restricted stock units | ( 11.8 ) | ( 6.7 ) |\n| Other financing activities | ( 17.8 ) | ( 14.7 ) |\n| Net cash used in financing activities | ( 214.4 ) | ( 80.7 ) |\n| Net increase in cash and cash equivalents and restricted cash | 1,132.8 | 1,953.0 |\n| Cash and cash equivalents and restricted cash at beginning of period | 1,767.6 | 478.9 |\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n5\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive income | Retained earnings | Total stockholders' equity |\n| Shares | Amount | Shares | Amount |\n| Balance as of February 27, 2021 | 585,574,666 | $ | 5.9 | $ | 1,898.9 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.5 | $ | 1,263.0 | $ | 1,324.3 |\n| Equity-based compensation | — | — | 22.2 | — | — | — | — | 22.2 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 945,942 | — | ( 10.0 ) | — | — | — | — | ( 10.0 ) |\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 36.4 ) | ( 36.4 ) |\n| Net income | — | — | — | — | — | — | 444.8 | 444.8 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 0.1 | — | 0.1 |\n| Other activity | — | — | — | — | — | — | ( 0.1 ) | ( 0.1 ) |\n| Balance as of June 19, 2021 | 586,520,608 | $ | 5.9 | $ | 1,911.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.6 | $ | 1,624.8 | $ | 1,698.4 |\n| Equity-based compensation | — | — | 26.8 | — | — | — | — | 26.8 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 147,495 | — | ( 1.8 ) | — | — | — | — | ( 1.8 ) |\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 27.3 ) | ( 27.3 ) |\n| Net income | — | — | — | — | — | — | 295.2 | 295.2 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 15.1 | — | 15.1 |\n| Balance as of September 11, 2021 | 586,668,103 | $ | 5.9 | $ | 1,936.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 78.7 | $ | 1,846.2 | $ | 1,959.9 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n6\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive loss | Retained earnings | Total stockholders' equity |\n| Shares | Amount | Shares | Amount |\n| Balance as of February 29, 2020 | 582,997,251 | $ | 5.8 | $ | 1,824.3 | 3,671,621 | $ | ( 25.8 ) | $ | ( 118.5 ) | $ | 592.3 | $ | 2,278.1 |\n| Issuance of common stock to Company's parents | 1,312,859 | — | — | — | — | — | — | — |\n| Equity-based compensation | — | — | 19.0 | — | — | — | — | 19.0 |\n| Employee tax withholding on vesting of restricted stock units | — | — | ( 6.2 ) | — | — | — | — | ( 6.2 ) |\n| Repurchase of common stock | — | — | — | 101,611,736 | ( 1,680.0 ) | — | — | ( 1,680.0 ) |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 3.9 ) | ( 3.9 ) |\n| Net income | — | — | — | — | — | — | 586.2 | 586.2 |\n| Other comprehensive income, net of tax | — | — | — | — | — | 1.7 | — | 1.7 |\n| Balance as of June 20, 2020 | 584,310,110 | $ | 5.8 | $ | 1,837.1 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 116.8 ) | $ | 1,174.6 | $ | 1,194.9 |\n| Equity-based compensation | — | — | 9.3 | — | — | — | — | 9.3 |\n| Shares issued and employee tax withholding on vesting of restricted stock units | 22,101 | — | ( 0.5 ) | — | — | — | — | ( 0.5 ) |\n| Equity reclassification | — | — | 30.0 | — | — | — | — | 30.0 |\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 26.9 ) | ( 26.9 ) |\n| Net income | — | — | — | — | — | — | 284.5 | 284.5 |\n| Other comprehensive loss, net of tax | — | — | — | — | — | 10.4 | — | 10.4 |\n| Other activity | — | — | ( 0.1 ) | — | — | — | — | ( 0.1 ) |\n| Balance as of September 12, 2020 | 584,332,211 | $ | 5.8 | $ | 1,875.8 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 106.4 ) | $ | 1,432.2 | $ | 1,501.6 |\n\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\n7\nAlbertsons Companies, Inc. and SubsidiariesNotes to Condensed Consolidated Financial Statements(unaudited)\nNOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying interim Condensed Consolidated Financial Statements include the accounts of Albertsons Companies, Inc. and its subsidiaries (the \"Company\"). All significant intercompany balances and transactions were eliminated. The Condensed Consolidated Balance Sheet as of February 27, 2021 is derived from the Company's annual audited Consolidated Financial Statements, which should be read in conjunction with these Condensed Consolidated Financial Statements and which are included in the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the Securities and Exchange Commission (the \"SEC\") on April 28, 2021. Certain information in footnote disclosures normally included in annual financial statements was condensed or omitted for the interim periods presented in accordance with accounting principles generally accepted in the United States of America (\"GAAP\"). In the opinion of management, the interim data includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The interim results of operations and cash flows are not necessarily indicative of those results and cash flows expected for the year. The Company' s results of operations are for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020.\nSignificant Accounting Policies\nRestricted cash: Restricted cash is included in Other current assets or Other assets depending on the remaining term of the restriction and primarily relates to funds held in escrow. The Company had $ 50.6 million of restricted cash as of September 11, 2021 and February 27, 2021.\nInventories, net: Substantially all of the Company's inventories consist of finished goods valued at the lower of cost or market and net of vendor allowances. The Company uses either item-cost or the retail inventory method to value inventory before application of any last-in, first-out (\"LIFO\") reserve. Interim LIFO inventory costs are based on management's estimates of expected year-end inventory levels and inflation rates. The Company recorded LIFO expense of $ 14.6 million and $ 10.1 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively, and $ 29.1 million and $ 23.2 million for the 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\nEquity-based compensation: Equity-based compensation expense recognized in the Condensed Consolidated Statements of Operations (in millions):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| RSUs | $ | 24.9 | $ | 8.0 | $ | 44.6 | $ | 25.8 |\n| RSAs | 1.9 | 1.3 | 4.4 | 2.5 |\n| Total equity-based compensation expense | $ | 26.8 | $ | 9.3 | $ | 49.0 | $ | 28.3 |\n| Total related tax benefit | $ | 6.4 | $ | 2.0 | $ | 11.5 | $ | 6.6 |\n\nAs of September 11, 2021, there was $ 126.2 million of unrecognized costs related to 11.5 million unvested granted restricted stock units (\"RSUs\"). That cost is expected to be recognized over a weighted average period of 1.8 years. As of September 11, 2021, there was $ 7.3 million of unrecognized costs related to 1.0 million unvested granted restricted common stock (\"RSAs\"). That cost is expected to be recognized over a weighted average period of 1.9 years.\nIncome taxes: Income tax expense was $ 100.3 million, representing a 25.4 % effective tax rate, for the 12 weeks ended September 11, 2021. Income tax expense was $ 111.2 million, representing a 28.1 % effective tax rate, for the\n8\n12 weeks ended September 12, 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the 12 weeks ended September 12, 2020.\nIncome tax expense was $ 232.8 million, representing a 23.9 % effective tax rate, for the 28 weeks ended September 11, 2021. Income tax expense was $ 313.1 million, representing a 26.4 % effective tax rate, for the 28 weeks ended September 12, 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the 28 weeks ended September 11, 2021 and certain nondeductible transaction-related costs incurred during the 28 weeks ended September 12, 2020.\nSegments: The Company and its subsidiaries offer grocery products, general merchandise, health and beauty care products, pharmacy, fuel and other items and services in its stores or through digital channels. The Company's operating divisions are geographically based, have similar economic characteristics and similar expected long-term financial performance. The Company's operating segments and reporting units are its 12 operating divisions, which are reported in one reportable segment. Each reporting unit constitutes a business for which discrete financial information is available and for which management regularly reviews the operating results. Across all operating segments, the Company operates primarily one store format. Each division offers through its stores and digital channels the same general mix of products with similar pricing to similar categories of customers, has similar distribution methods, operates in similar regulatory environments and purchases merchandise from similar or the same vendors.\nRevenue Recognition: Revenues from the retail sale of products are recognized at the point of sale or delivery to the customer, net of returns and sales tax. Pharmacy sales are recorded upon the customer receiving the prescription. Third-party receivables from pharmacy sales were $ 236.0 million and $ 262.5 million as of September 11, 2021 and February 27, 2021, respectively, and are recorded in Receivables, net. For digital related sales, which primarily include home delivery and Drive Up & Go curbside pickup, revenues are recognized upon either pickup in store or delivery to the customer and may include revenue for separately charged delivery services. The Company records a contract liability when rewards are earned by customers in connection with the Company's loyalty programs. As rewards are redeemed or expire, the Company reduces the contract liability and recognizes revenue. The contract liability balance was immaterial as of September 11, 2021 and February 27, 2021.\nThe Company records a contract liability when it sells its own proprietary gift cards. The Company records a sale when the customer redeems the gift card. The Company's gift cards do not expire. The Company reduces the contract liability and records revenue for the unused portion of gift cards (\"breakage\") in proportion to its customers' pattern of redemption, which the Company determined to be the historical redemption rate. The Company's contract liability related to gift cards was $ 76.2 million as of September 11, 2021 and $ 98.1 million as of February 27, 2021. Breakage amounts were immaterial for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\n9\nDisaggregated Revenues\nThe following table represents sales revenue by type of similar product (dollars in millions):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total |\n| Non-perishables (2) | $ | 7,268.5 | 44.0 | % | $ | 7,126.6 | 45.2 | % | $ | 16,538.8 | 43.8 | % | $ | 17,910.4 | 46.5 | % |\n| Perishables (3) | 6,823.2 | 41.3 | 6,654.1 | 42.2 | 15,735.8 | 41.6 | 16,209.7 | 42.1 |\n| Pharmacy | 1,253.4 | 7.6 | 1,171.8 | 7.5 | 2,982.0 | 7.9 | 2,726.7 | 7.1 |\n| Fuel | 918.5 | 5.6 | 570.8 | 3.6 | 1,967.8 | 5.2 | 1,160.0 | 3.0 |\n| Other (4) | 242.1 | 1.5 | 234.3 | 1.5 | 550.7 | 1.5 | 502.4 | 1.3 |\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\n\n(1) Digital related sales are included in the categories to which the revenue pertains.\n(2) Consists primarily of general merchandise, grocery and frozen foods.\n(3) Consists primarily of produce, dairy, meat, deli, floral and seafood.\n(4) Consists primarily of wholesale revenue to third parties, commissions and other miscellaneous revenue.\nRecently issued accounting standards: In June 2020, the FASB issued ASU 2020-06, \"Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity\" (\"ASU 2020-06\"). ASU 2020-06 simplifies the accounting for certain convertible instruments, amends guidance on derivative scope exceptions for contracts in an entity's own equity and modifies the guidance on diluted earnings per share calculations as a result of these changes. ASU 2020-06 will take effect for public entities for annual reporting periods beginning after December 15, 2021, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effect of this standard on its Consolidated Financial Statements.\nNOTE 2 - FAIR VALUE MEASUREMENTS\nThe accounting guidance for fair value established a framework for measuring fair value and established a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability at the measurement date. The three levels are defined as follows:\nLevel 1 - Quoted prices in active markets for identical assets or liabilities;\nLevel 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and\nLevel 3 - Unobservable inputs in which little or no market activity exists, requiring an entity to develop its own assumptions that market participants would use to value the asset or liability.\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\n10\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of September 11, 2021 (in millions):\n| Fair Value Measurements |\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\n| Assets: |\n| Short-term investments (1) | $ | 14.7 | $ | 5.0 | $ | 9.7 | $ | — |\n| Non-current investments (2) | 92.6 | 19.5 | 73.1 | — |\n| Derivative contracts (3) | 10.0 | — | 10.0 | — |\n| Total | $ | 117.3 | $ | 24.5 | $ | 92.8 | $ | — |\n| Liabilities: |\n| Derivative contracts (4) | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\n| Total | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\n\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\n(3) Primarily relates to derivative contracts. Included in Other assets.\n(4) Primarily relates to interest rate swaps. Included in Other current liabilities.\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of February 27, 2021 (in millions):\n| Fair Value Measurements |\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\n| Assets: |\n| Short-term investments (1) | $ | 11.9 | $ | 4.4 | $ | 7.5 | $ | — |\n| Non-current investments (2) | 110.2 | 40.3 | 69.9 | — |\n| Total | $ | 122.1 | $ | 44.7 | $ | 77.4 | $ | — |\n| Liabilities: |\n| Derivative contracts (3) | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\n| Total | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\n\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\n(3) Primarily relates to interest rate swaps. Included in Other current liabilities.\nThe estimated fair value of the Company's debt, including current maturities, was based on Level 2 inputs, being market quotes or values for similar instruments, and interest rates currently available to the Company for the issuance of debt with similar terms and remaining maturities as a discount rate for the remaining principal payments. As of September 11, 2021, the fair value of total debt was $ 8,325.6 million compared to the carrying value of $ 7,815.0 million, excluding debt discounts and deferred financing costs. As of February 27, 2021, the fair value of total debt was $ 8,150.7 million compared to the carrying value of $ 7,815.5 million, excluding debt discounts and deferred financing costs.\n11\nAssets Measured at Fair Value on a Non-Recurring Basis\nThe Company measures certain assets at fair value on a non-recurring basis, including long-lived assets and goodwill, which are evaluated for impairment. Long-lived assets include store-related assets such as property and equipment and certain intangible assets. The inputs used to determine the fair value of long-lived assets and a reporting unit are considered Level 3 measurements due to their subjective nature.\nNOTE 3 - DERIVATIVE FINANCIAL INSTRUMENTS\nThe aggregate notional amount of the Company's interest rate swaps as of September 11, 2021 and February 27, 2021, were $ 1,553.0 million and $ 1,653.0 million, respectively, of which none were designated as cash flow hedges as defined by GAAP.\nActivity related to interest rate swaps consisted of the following (in millions):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\n| Loss on undesignated portion of interest rate swaps | $ | — | $ | ( 0.4 ) | Other income, net |\n\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\n| Loss on undesignated portion of interest rate swaps | $ | ( 0.3 ) | $ | ( 19.4 ) | Other income, net |\n\nNOTE 4 - LONG-TERM DEBT AND FINANCE LEASE OBLIGATIONS\nThe Company's long-term debt and finance lease obligations as of September 11, 2021 and February 27, 2021, net of unamortized debt discounts of $ 43.0 million and $ 44.8 million, respectively, and deferred financing costs of $ 63.6 million and $ 69.8 million, respectively, consisted of the following (in millions):\n| September 11,2021 | February 27,2021 |\n| Senior Unsecured Notes due 2023 to 2030, interest rate range of 3.25 % to 7.50 % | $ | 6,686.5 | $ | 6,680.5 |\n| Safeway Inc. Notes due 2021 to 2031, interest rate range of 4.75 % to 7.45 % | 504.4 | 504.3 |\n| New Albertsons L.P. Notes due 2026 to 2031, interest rate range of 6.52 % to 8.70 % | 470.9 | 469.1 |\n| Other financing obligations | 29.2 | 29.4 |\n| Mortgage notes payable, secured | 17.4 | 17.6 |\n| Finance lease obligations | 632.2 | 612.7 |\n| Total debt | 8,340.6 | 8,313.6 |\n| Less current maturities | ( 211.5 ) | ( 212.4 ) |\n| Long-term portion | $ | 8,129.1 | $ | 8,101.2 |\n\nSenior Unsecured Notes\nOn October 1, 2021, subsequent to the end of the 12 weeks ended September 11, 2021, the Company provided notice to the holders and trustee, of its election to redeem all of the $ 200.0 million aggregate principal amount currently outstanding of the Company's 5.750 % Senior Unsecured Notes due 2025 (the \"2025 Notes\"). The 2025 Notes will be redeemed on November 1, 2021 (the \"Redemption Date\"), using cash on hand, at a redemption price of 101.438 % of the principal amount thereof plus accrued and unpaid interest on the 2025 Notes to, but excluding, the Redemption Date.\n12\nABL Facility\nAs of September 11, 2021 and February 27, 2021, there were no amounts outstanding under the Company's asset-based loan facility (\"ABL Facility\"), and letters of credit (\"LOC\") issued under the LOC sub-facility were $ 323.8 million and $ 354.6 million, respectively.\nNOTE 5 - EMPLOYEE BENEFIT PLANS\nPension and Other Post-Retirement Benefits\nThe following tables provide the components of net pension and post-retirement (income) expense (in millions):\n| 12 weeks ended |\n| Pension | Other post-retirement benefits |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Estimated return on plan assets | $ | ( 24.5 ) | $ | ( 23.7 ) | $ | — | $ | — |\n| Service cost | 5.1 | 3.5 | — | — |\n| Interest cost | 9.7 | 12.6 | 0.1 | 0.1 |\n| Amortization of prior service cost | — | — | — | 0.4 |\n| Amortization of net actuarial loss (gain) | 0.2 | 0.5 | ( 0.1 ) | ( 0.1 ) |\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\n| (Income) expense, net | $ | ( 23.8 ) | $ | ( 4.1 ) | $ | — | $ | 0.4 |\n\n| 28 weeks ended |\n| Pension | Other post-retirement benefits |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Estimated return on plan assets | $ | ( 57.2 ) | $ | ( 55.2 ) | $ | — | $ | — |\n| Service cost | 12.0 | 8.3 | — | — |\n| Interest cost | 22.7 | 29.2 | 0.2 | 0.2 |\n| Amortization of prior service cost | 0.1 | 0.1 | — | 1.0 |\n| Amortization of net actuarial loss (gain) | 0.5 | 1.1 | ( 0.3 ) | ( 0.3 ) |\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\n| (Income) expense, net | $ | ( 36.2 ) | $ | ( 13.5 ) | $ | ( 0.1 ) | $ | 0.9 |\n\nThe Company contributed $ 9.2 million and $ 11.2 million to its defined pension plans and post-retirement benefit plans during the 12 and 28 weeks ended September 11, 2021, respectively. For the 12 and 28 weeks ended September 12, 2020, the Company contributed $ 1.7 million and $ 56.3 million, respectively. At the Company's discretion, additional funds may be contributed to the defined benefit pension plans that are determined to be beneficial to the Company. The Company currently anticipates contributing an additional $ 26.1 million to these plans for the remainder of fiscal 2021.\nDuring the 12 and 28 weeks ended September 11, 2021, the Company purchased a group annuity policy and transferred $ 203.5 million of pension plan assets to an insurance company, thereby reducing the Company's defined benefit pension obligations by $ 205.4 million. As a result of the annuity purchase, the Company recorded a settlement gain of $ 11.1 million during the 12 and 28 weeks ended September 11, 2021.\n13\nDefined Contribution Plans and Supplemental Retirement Plans\nTotal contributions expensed for defined contribution plans (401(k) plans) were $ 26.4 million and $ 16.3 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively. For the 28 weeks ended September 11, 2021 and September 12, 2020, total contributions expensed were $ 42.6 million and $ 38.1 million, respectively.\nMultiemployer Pension Plans\nARP Act: The American Rescue Plan Act (\"ARP Act\") was signed into law on March 11, 2021. The ARP Act establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\"PBGC\") to pay pension benefits through the plan year ending 2051. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive the assistance. The Company is evaluating the interim final rule and has submitted comments during the 30-day comment period. The Company's evaluation includes any potential impact to the Company's Excess Plan as defined in and further described in \"Part II—Item 8. Financial Statements and Supplemental Data—Note 12\" of the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021.\nNOTE 6 - COMMITMENTS AND CONTINGENCIES AND OFF BALANCE SHEET ARRANGEMENTS\nGuarantees\nCalifornia Department of Industrial Relations: On January 21, 2014, the Company entered into a Collateral Substitution Agreement with the California Self-Insurers' Security Fund to provide collateral related to certain California self-insured workers' compensation obligations pursuant to applicable regulations. The collateral not covered by the California Self-Insurers' Security Fund is covered by surety bonds for the benefit of the State of California Office of Self-Insurance Plans. A portion of the surety bonds is covered by irrevocable LOCs. The collateral requirements are adjusted annually based on semi-annual filings of an actuarial study reflecting liabilities as of December 31 of each year reduced by claim closures and settlements. The related LOC was $ 22.6 million as of September 11, 2021 and $ 40.1 million as of February 27, 2021, respectively.\nLease Guarantees: The Company may have liability under certain operating leases that were assigned to third parties. If any of these third parties fail to perform their obligations under the leases, the Company could be responsible for the lease obligation, including as a result of the economic dislocation caused by the response to the COVID-19 pandemic. Because of the wide dispersion among third parties and the variety of remedies available, the Company believes that if an assignee became insolvent, it would not have a material effect on the Company's financial condition, results of operations or cash flows.\nThe Company also provides guarantees, indemnifications and assurances pursuant to contractual obligations in the ordinary course of its business.\nLegal Proceedings\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with\n14\nrespect to certain of the matters described herein cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition.\nThe Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made provisions where the loss contingency is probable and can be reasonably estimated. Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties. Management currently believes that the aggregate range of reasonably possible loss for the Company's exposure in excess of the amount accrued is expected to be immaterial to the Company. It remains possible that despite management's current belief, material differences in actual outcomes or changes in management's evaluation or predictions could arise that could have a material effect on the Company's financial condition, results of operations or cash flows.\nERISA Litigation: Two lawsuits were brought against Safeway Inc. (\"Safeway\") and the Safeway Benefits Plan Committee (the \"Benefit Plans Committee,\" and together with Safeway, the \"Safeway Benefits Plans Defendants\") and other third parties alleging breaches of fiduciary duty under the Employee Retirement Income Security Act of 1974, as amended (\"ERISA\") with respect to Safeway's 401(k) Plan (the \"Safeway 401(k) Plan\"). On July 14, 2016, a complaint was filed in the United States District Court for the Northern District of California by a participant in the Safeway 401(k) Plan individually and on behalf of the Safeway 401(k) Plan. An amended complaint was filed on November 18, 2016. On August 25, 2016, a second complaint was filed in the United States District Court for the Northern District of California by another participant in the Safeway 401(k) Plan individually and on behalf of all others similarly situated against the Safeway Benefits Plans Defendants and against the Safeway 401(k) Plan's former record-keepers. An amended complaint was filed on September 16, 2016, and a second amended complaint was filed on November 21, 2016. In general, both lawsuits alleged that the Safeway Benefits Plans Defendants breached their fiduciary duties under ERISA regarding the selection of investments offered under the Safeway 401(k) Plan and the fees and expenses related to those investments. All parties filed summary judgment motions which were heard and taken under submission on August 16, 2018. Plaintiffs' motions were denied, and defendants' motions were granted in part and denied in part. Bench trials for both matters were set for May 6, 2019. A settlement in principle was reached before trial. On September 13, 2019, settlement papers were filed with the Court along with a motion for preliminary approval of the settlement. A hearing for preliminary approval was set for November 20, 2019, but the Court vacated the hearing. The Court issued an order on March 30, 2020 requesting some minor changes to the notice procedures, and plaintiffs submitted an amended motion for preliminary approval. On September 8, 2020, the Court granted plaintiffs' amended motion, and a final approval hearing was held on April 26, 2021, at which time the Court took the matter under submission. On July 19, 2021, the Court issued a final order approving the settlement. In August 2021, a settlement fund was established with funds from insurers. A settlement administrator is now managing the calculation and payment of settlement provisions to class members.\nFalse Claims Act: The Company has received a civil investigative demand dated February 28, 2020 from the United States Attorney for the Southern District of New York in connection with a False Claims Act (\"FCA\") investigation relating to the Company's dispensing practices regarding insulin pen products. The investigation seeks documents regarding the Company's policies, practices and procedures, as well as dispensing data, among other things. The Company has cooperated with the U.S. Attorney in the investigation. The Company is currently unable to determine the probability of the outcome of this matter or the range of possible loss, if any.\nTwo qui tam actions alleging violations of the FCA have also been filed against the Company and its subsidiaries. Violations of the FCA are subject to treble damages and penalties of up to a specified dollar amount per false claim.\nIn United States ex rel. Proctor v. Safeway, filed in the United States District Court for the Central District of Illinois, the relator alleges that Safeway overcharged federal government healthcare programs by not providing the federal government, as part of its usual and customary prices, the benefit of discounts given to customers in pharmacy membership discount and price-matching programs. The relator filed his complaint under seal on November 11, 2011, and the complaint was unsealed on August 26, 2015. The relator amended the complaint on\n15\nMarch 31, 2016. On June 12, 2020, the Court granted Safeway's motion for summary judgment, holding that the relator could not prove that Safeway acted with the intent required under the FCA, and judgment was issued on June 15, 2020. On July 10, 2020, the relator filed a motion to alter or amend the judgment and to supplement the record, which Safeway opposed. On November 13, 2020, the Court denied relator's motion, and on December 11, 2020, relator filed a notice of appeal. The appeal is now pending in the Seventh Circuit Court of Appeals. Oral argument took place September 9, 2021.\nIn United States ex rel. Schutte and Yarberry v. SuperValu, New Albertson's, Inc., et al., also filed in the Central District of Illinois, the relators allege that defendants (including various subsidiaries of the Company) overcharged federal government healthcare programs by not providing the federal government, as a part of usual and customary prices, the benefit of discounts given to customers who requested that defendants match competitor prices. The complaint was originally filed under seal and amended on November 30, 2015. On August 5, 2019, the Court granted relators' motion for partial summary judgment, holding that price-matched prices are the usual and customary prices for those drugs. On July 1, 2020, the Court granted the defendants' motions for summary judgment and dismissed the case, holding that the relator could not prove that defendants acted with the intent required under the FCA. Judgment was issued on July 2, 2020. On July 9, 2020, the relators filed a notice of appeal. Oral argument was held on January 19, 2021. On August 12, 2021, the Court of Appeals for the Seventh Circuit affirmed the grant of summary judgment in the Company's favor. On September 23, 2021, the relators filed a petition for rehearing en banc with the Seventh Circuit. The Company's response to the petition for rehearing is due by November 9, 2021.\nIn both of the above cases, the federal government previously investigated the relators' allegations and declined to intervene. The relators elected to pursue their respective cases on their own and in each case have alleged FCA damages in excess of $ 100 million before trebling and excluding penalties. The Company is vigorously defending each of these matters and believes each of these cases is without merit. The Company has recorded an estimated liability for these matters.\nOpioid Litigation: The Company is one of dozens of companies that have been named in various lawsuits alleging that defendants contributed to the national opioid epidemic. At present, the Company is named in over 80 suits pending in various state courts as well as in the United States District Court for the Northern District of Ohio, where over 2,000 cases have been consolidated as Multi-District Litigation (\"MDL\") pursuant to 28 U.S.C. §1407. Most of these cases have been stayed pending bellwether trials. At present, the most active case is a matter in New Mexico state court where we have been in active discovery and where a September 2022 trial date has been set. The MDL Court and a state court in Utah are currently considering position statements from the parties in connection with scheduling bellwether trials and it is likely that the Company may be included in one or more of those anticipated bellwether trials. The Company is vigorously defending these matters and believes that these cases are without merit. At this stage in the proceedings, the Company is unable to determine the probability of the outcome of these matters or the range of reasonably possible loss, if any.\nCalifornia Air Resources Board: Upon the inspection by the California Air Resources Board (\"CARB\") of several of the Company's stores in California, it was determined that the Company failed certain paperwork and other administrative requirements. As a result of the inspections, the Company proactively undertook a broad evaluation of the record keeping and administrative practices at all of its stores in California. In connection with this evaluation, the Company retained a third party to conduct an audit and correct deficiencies identified across its California store base. The Company is working with CARB to resolve these compliance issues and comply with governing regulations, and that work is ongoing. CARB has made an opening demand regarding potential fines and penalties. On July 7, 2021, the parties entered into a settlement agreement for which the Company has recorded an estimated liability.\nFACTA: On May 31, 2019, a putative class action complaint entitled Martin v. Safeway was filed in the California Superior Court for the County of Alameda, alleging the Company failed to comply with the Fair and Accurate Credit Transactions Act (\"FACTA\") by printing receipts that failed to adequately mask payment card numbers as\n16\nrequired by FACTA. The plaintiff claims the violation was \"willful\" and exposes the Company to statutory damages provided for in FACTA. The Company has answered the complaint and is vigorously defending the matter. On January 8, 2020, the Company commenced mediation discussions with plaintiff's counsel and reached a settlement in principle on February 24, 2020. The parties will seek court approval of the settlement. The Company has recorded an estimated liability for this matter.\nOther Commitments\nIn the ordinary course of business, the Company enters into various supply contracts to purchase products for resale and purchase and service contracts for fixed asset and information technology commitments. These contracts typically include volume commitments or fixed expiration dates, termination provisions and other standard contractual considerations.\nNOTE 7 - OTHER COMPREHENSIVE INCOME OR LOSS\nTotal comprehensive earnings are defined as all changes in stockholders' equity during a period, other than those from investments by or distributions to the stockholders. Generally, for the Company, total comprehensive income or loss equals net income plus or minus adjustments for pension and other post-retirement liabilities. Total comprehensive earnings represent the activity for a period net of tax.\nWhile total comprehensive earnings are the activity in a period and are largely driven by net earnings in that period, accumulated other comprehensive income or loss (\"AOCI\") represents the cumulative balance of other comprehensive income, net of tax, as of the balance sheet date. Changes in the AOCI balance by component are shown below (in millions):\n| 28 weeks ended September 11, 2021 |\n| Total | Pension and Post-retirement benefit plans | Other |\n| Beginning balance | $ | 63.5 | $ | 61.3 | $ | 2.2 |\n| Other comprehensive income before reclassifications | 34.3 | 34.3 | — |\n| Amounts reclassified from accumulated other comprehensive income | ( 14.0 ) | ( 14.0 ) | — |\n| Tax expense | ( 5.1 ) | ( 5.1 ) | — |\n| Current-period other comprehensive income, net of tax | 15.2 | 15.2 | — |\n| Ending balance | $ | 78.7 | $ | 76.5 | $ | 2.2 |\n\n| 28 weeks ended September 12, 2020 |\n| Total | Pension and Post-retirement benefit plans | Other |\n| Beginning balance | $ | ( 118.5 ) | $ | ( 121.7 ) | $ | 3.2 |\n| Other comprehensive income before reclassifications | 11.1 | 9.6 | 1.5 |\n| Amounts reclassified from accumulated other comprehensive income | 4.9 | 4.9 | — |\n| Tax expense | ( 3.9 ) | ( 3.6 ) | ( 0.3 ) |\n| Current-period other comprehensive income, net of tax | 12.1 | 10.9 | 1.2 |\n| Ending balance | $ | ( 106.4 ) | $ | ( 110.8 ) | $ | 4.4 |\n\n17\nNOTE 8 - NET INCOME PER CLASS A COMMON SHARE\nThe Company calculates basic and diluted net income per Class A common share using the two-class method. The two-class method is an allocation formula that determines net income per Class A common share for each share of Class A common stock and the Company's Series A-1 convertible preferred stock (\"Series A-1 preferred stock\") and Series A convertible preferred stock (\"Series A preferred stock\" and together with the Series A-1 preferred stock, the \"Convertible Preferred Stock\"), a participating security, according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings (distributed and undistributed) are allocated to Class A common shares and Convertible Preferred Stock based on their respective rights to receive dividends. The holders of Convertible Preferred Stock participate in cash dividends that the Company pays on its common stock to the extent that such cash dividends exceed $ 206.25 million per fiscal year. In applying the two-class method to interim periods, the Company allocates income to its quarterly periods independently and discretely from its year-to-date and annual periods. Basic net income per Class A common share is computed by dividing net income allocated to Class A common stockholders by the weighted average number of Class A common shares outstanding for the period, including Class A common shares to be issued with no prior remaining contingencies prior to issuance. Diluted net income per Class A common share is computed based on the weighted average number of shares of Class A common stock outstanding during each period, plus potential Class A common shares considered outstanding during the period, as long as the inclusion of such awards is not antidilutive. Potential Class A common shares consist of unvested RSUs and RSAs and Convertible Preferred Stock, using the more dilutive of either the two-class method or as-converted stock method. Performance-based RSUs are considered dilutive when the related performance criterion has been met.\n18\nThe components of basic and diluted net income per Class A common share were as follows (in millions, except per share data):\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Basic net income per Class A common share |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\n| Accrued dividends on Convertible Preferred Stock | ( 27.3 ) | ( 26.9 ) | ( 63.7 ) | ( 30.8 ) |\n| Earnings allocated to Convertible Preferred Stock | ( 11.0 ) | ( 9.0 ) | ( 84.2 ) | ( 9.0 ) |\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share |\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\n| Accrued dividends on Convertible Preferred Stock | 27.3 | 26.9 | — | 30.8 |\n| Earnings allocated to Convertible Preferred Stock | 11.0 | 9.0 | — | 9.0 |\n| Net income allocated to Class A common stockholders - Diluted | $ | 295.2 | $ | 284.5 | $ | 592.1 | $ | 870.7 |\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\n| Dilutive effect of: |\n| Restricted stock units and awards | 6.1 | 4.0 | 5.4 | 4.3 |\n| Convertible Preferred Stock (2) | 101.6 | 101.6 | — | 49.8 |\n| Weighted average Class A common shares outstanding - Diluted (3) | 573.0 | 582.9 | 470.6 | 583.3 |\n| Diluted net income per Class A common share | $ | 0.52 | $ | 0.49 | $ | 1.26 | $ | 1.49 |\n\n(1) There were 0.3 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 11, 2021 compared to 0.4 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 12, 2020.\n(2) Reflects the number of shares of Convertible Preferred Stock issued, if converted into common stock for the period outstanding. For the 28 weeks ended September 11, 2021, 101.6 million potential common shares outstanding related to Convertible Preferred Stock were antidilutive.\n(3) There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 11, 2021. There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 12, 2020.\n19\nItem 2\n-\nManagement's Discussion and Analysis of Financial Condition and Results of Operations\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\nThis Form 10-Q contains \"forward-looking statements\" within the meaning of the federal securities laws. The \"forward-looking statements\" include our current expectations, assumptions, estimates and projections about our business and our industry. They include statements relating to our future operating or financial performance which the Company believes to be reasonable at this time. You can identify forward-looking statements by the use of words such as \"outlook,\" \"may,\" \"should,\" \"could,\" \"estimates,\" \"predicts,\" \"potential,\" \"continue,\" \"anticipates,\" \"believes,\" \"plans,\" \"expects,\" \"future\" and \"intends\" and similar expressions which are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control and difficult to predict, including, among others, changes in macroeconomic conditions, the retail consumer behavior and environment and the Company's industry, failure to achieve productivity initiatives, increased rates of food price inflation and factors related to the continued impact of the COVID-19 pandemic, about which there are still many unknowns, including its duration, recurrence, new virus strains, status and effectiveness of vaccinations, duration and scope of related government orders, financial assistance programs, mandates and regulations and the extent of the overall impact to our business and the communities we serve. Such risks and uncertainties could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. In evaluating forward-looking statements, you should carefully consider the risks and uncertainties more fully described in the \"Risk Factors\" section or other sections in our reports filed with the SEC including the most recent annual report on Form 10-K and any subsequent periodic reports on Form 10-Q and current reports on Form 8-K. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements and risk factors. Forward-looking statements contained in this Form 10-Q reflect our view only as of the date of this Form 10-Q. We undertake no obligation, other than as required by law, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.\nAs used in this Form 10-Q, unless the context otherwise requires, references to \"Albertsons,\" the \"Company,\" \"we,\" \"us\" and \"our\" refer to Albertsons Companies, Inc. and, where appropriate, its subsidiaries.\nNON-GAAP FINANCIAL MEASURES\nWe define EBITDA as generally accepted accounting principles (\"GAAP\") earnings (net loss) before interest, income taxes, depreciation and amortization. We define Adjusted EBITDA as earnings (net loss) before interest, income taxes, depreciation and amortization, further adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income as GAAP Net income adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income per Class A common share as Adjusted net income divided by the weighted average diluted Class A common shares outstanding, as adjusted to reflect all restricted stock units (\"RSUs\") and restricted common stock (\"RSAs\") outstanding at the end of the period. We define Net Debt as total debt (which includes finance lease obligations and is net of deferred financing costs and original issue discount) minus unrestricted cash and cash equivalents and we define Net Debt Ratio as the ratio of Net Debt to Adjusted EBITDA for the rolling 52 or 53 week period. See \"Results of Operations\" for further discussion and a reconciliation of Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share.\nEBITDA, Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share (collectively, the \"Non-GAAP Measures\") are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures such as Net income, operating income and gross profit. These Non-GAAP Measures exclude\n20\nthe financial impact of items management does not consider in assessing our ongoing core operating performance, and thereby provide useful measures to analysts and investors of our operating performance on a period-to-period basis. Other companies may have different definitions of Non-GAAP Measures and provide for different adjustments, and comparability to our results of operations may be impacted by such differences. We also use Adjusted EBITDA and Net Debt Ratio for board of director and bank compliance reporting. Our presentation of Non-GAAP Measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.\nNon-GAAP Measures should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using Non-GAAP Measures only for supplemental purposes.\n21\nSECOND QUARTER OF FISCAL 2021 OVERVIEW\nGiven the significant variations that occurred in our business during fiscal 2020 due to the COVID-19 pandemic, we provide a supplemental comparison of the 12 and 28 weeks ended September 11, 2021 (\"second quarter of fiscal 2021\" and \"first 28 weeks of fiscal 2021\") to the 12 and 28 weeks ended September 7, 2019 (\"second quarter of fiscal 2019\" and \"first 28 weeks of fiscal 2019\") for certain financial measures to demonstrate the two-year growth in our business in addition to comparisons to the 12 and 28 weeks ended September 12, 2020 (\"second quarter of fiscal 2020\" and \"first 28 weeks of fiscal 2020\").\nAs of September 11, 2021, we operated 2,278 retail food and drug stores with 1,725 pharmacies, 401 associated fuel centers, 22 dedicated distribution centers and 20 manufacturing facilities. With a strong consumer environment, we continue to make significant progress against all of our strategic priorities, including in-store excellence, accelerating our digital and omni-channel capabilities, increasing productivity and strengthening our talent and culture. Identical sales increased 1.5%, excluding fuel, during the second quarter of fiscal 2021, resulting in two-year stacked identical sales growth of 15.3%. We continue to gain market share in food market, and in Multi Outlet (\"MULO\") we are up on a two-year basis and down marginally on a one-year basis. Food market generally includes traditional supermarkets while MULO includes most food market, drug, mass merchants, club, dollar and military stores that sell food.\nUnderscoring our strong omni-channel capabilities that allow customers to complete their shopping with us in any way they want, our digital initiatives continue to resonate with our customers, as evidenced by our sustained sales levels in the second quarter of fiscal 2021, digital sales increasing 5% compared to the second quarter of fiscal 2020 and a two-year stacked growth of 248%. During the second quarter of fiscal 2021, we expanded our Drive Up & Go curbside pickup service to approximately 1,900 locations and offer delivery services across more than 2,000 of our stores. In our delivery service, we have expanded first party locations, and continue to work with third party services to engage with customers on the platform of their choice. In addition to our continuing partnership with Instacart, we have expanded our partnership with DoorDash to offer on-demand grocery delivery service where customers can receive a broad assortment in under one hour. We also recently launched a similar partnership with Uber, where customers can order a full assortment of groceries on the Uber platform.\nWith ongoing benefit enhancements, we continue to achieve significant success with our just for U loyalty program, which drives higher sales and customer retention, with membership growing 17% in the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020, reaching 27.5 million members. Within the program, the number of actively engaged members, those that redeemed fuel or grocery rewards during the second quarter of fiscal 2021, increased by almost 9% compared to the second quarter of fiscal 2020, and our retention rate of actively engaged members was 93% in the second quarter of fiscal 2021.\nDuring the second quarter of fiscal 2021 we continued to roll out our Own Brands across all our banners, launching 85 new products and generating strong growth as our sales penetration increased by 60 basis points to 25.2% compared to the second quarter of fiscal 2020. We also continue to make significant progress on productivity initiatives, including promotional effectiveness, purchasing and procurement, labor efficiency and shrink.\nOur capital allocation strategy balances investing for the future, strengthening our balance sheet and returns to shareholders through a combination of dividends and opportunistic share repurchases. Capital expenditures were approximately $823 million during the first 28 weeks of fiscal 2021 as we opened seven new stores and completed 76 upgrades and remodels. Our balance sheet remains strong with a Net Debt Ratio of 1.3x as of the end of the second quarter of fiscal 2021. Capital returns to shareholders during the first 28 weeks of fiscal 2021 included our $0.10 per share quarterly dividend. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock.\n22\nIn addition, we have continued to partner with the Department of Health and Human Services and local health authorities to administer COVID-19 vaccines to our local communities and, as of October 12, 2021, have administered approximately 7.5 million doses.\nSecond quarter of fiscal 2021 highlights\nIn summary, our financial and operating highlights for the second quarter of fiscal 2021 include:\n•Identical sales increase of 1.5%; two-year identical sales stacked growth was 15.3%\n•Digital sales increased 5%; on a two-year stacked basis digital sales growth was 248%\n•Net income of $295 million, or $0.52 per Class A common share\n•Adjusted net income of $370 million, or $0.64 per Class A common share\n•Adjusted EBITDA of $965 million\n•Opened one new store and completed 43 remodel projects\n•Launched 153 new Drive Up & Go locations\nStores\nThe following table shows stores operating, acquired, opened and closed during the periods presented:\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Stores, beginning of period | 2,278 | 2,252 | 2,277 | 2,252 |\n| Acquired (1) | — | — | 1 | — |\n| Opened | 1 | 2 | 6 | 2 |\n| Closed | (1) | (2) | (6) | (2) |\n| Stores, end of period | 2,278 | 2,252 | 2,278 | 2,252 |\n\n(1) The 28 weeks ended September 11, 2021 includes one store acquired from Kings and Balducci's that transferred to us subsequent to the end of the fourth quarter of fiscal 2020.\nThe following table summarizes our stores by size:\n| Number of stores | Percent of Total | Retail Square Feet (1) |\n| Square Footage | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Less than 30,000 | 223 | 204 | 9.8 | % | 9.1 | % | 5.1 | 4.7 |\n| 30,000 to 50,000 | 786 | 781 | 34.5 | % | 34.6 | % | 32.9 | 32.8 |\n| More than 50,000 | 1,269 | 1,267 | 55.7 | % | 56.3 | % | 75.0 | 74.8 |\n| Total Stores | 2,278 | 2,252 | 100.0 | % | 100.0 | % | 113.0 | 112.3 |\n\n(1) In millions, reflects total square footage of retail stores operating at the end of the period.\n23\nRESULTS OF OPERATIONS\nComparison of Second Quarter of Fiscal 2021 and First 28 Weeks of Fiscal 2021 to Second Quarter of Fiscal 2020 and First 28 Weeks of Fiscal 2020:\nThe following tables and related discussion set forth certain information and comparisons regarding the components of our Condensed Consolidated Statements of Operations for the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021 to the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020 (in millions, except per share data).\n| 12 weeks ended |\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % |\n| Cost of sales | 11,788.7 | 71.4 | 11,182.7 | 71.0 |\n| Gross profit | 4,717.0 | 28.6 | 4,574.9 | 29.0 |\n| Selling and administrative expenses | 4,231.3 | 25.6 | 4,031.2 | 25.6 |\n| Gain on property dispositions and impairment losses, net | (0.2) | — | (18.3) | (0.1) |\n| Operating income | 485.9 | 3.0 | 562.0 | 3.5 |\n| Interest expense, net | 109.3 | 0.7 | 128.6 | 0.8 |\n| Loss on debt extinguishment | — | — | 49.1 | 0.3 |\n| Other income, net | (18.9) | (0.1) | (11.4) | (0.1) |\n| Income before income taxes | 395.5 | 2.4 | 395.7 | 2.5 |\n| Income tax expense | 100.3 | 0.6 | 111.2 | 0.7 |\n| Net income | $ | 295.2 | 1.8 | % | $ | 284.5 | 1.8 | % |\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 |\n| Diluted net income per Class A common share | 0.52 | 0.49 |\n| 28 weeks ended |\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\n| Net sales and other revenue | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\n| Cost of sales | 26,867.1 | 71.1 | 27,162.8 | 70.5 |\n| Gross profit | 10,908.0 | 28.9 | 11,346.4 | 29.5 |\n| Selling and administrative expenses | 9,734.9 | 25.8 | 9,800.6 | 25.5 |\n| Loss on property dispositions and impairment losses, net | 0.1 | — | 12.0 | — |\n| Operating income | 1,173.0 | 3.1 | 1,533.8 | 4.0 |\n| Interest expense, net | 262.6 | 0.7 | 309.2 | 0.8 |\n| Loss on debt extinguishment | — | — | 49.1 | 0.1 |\n| Other income, net | (62.4) | (0.2) | (8.3) | — |\n| Income before income taxes | 972.8 | 2.6 | 1,183.8 | 3.1 |\n| Income tax expense | 232.8 | 0.6 | 313.1 | 0.8 |\n| Net income | $ | 740.0 | 2.0 | % | $ | 870.7 | 2.3 | % |\n| Basic net income per Class A common share | $ | 1.27 | $ | 1.57 |\n| Diluted net income per Class A common share | 1.26 | 1.49 |\n\nNet Sales and Other Revenue\nNet sales and other revenue increased 4.7% to $16,505.7 million for the second quarter of fiscal 2021 from $15,757.6 million for the second quarter of fiscal 2020. The increase in Net sales and other revenue was primarily driven by our 1.5% increase in identical sales, which includes an increase in pharmacy sales, partially from\n24\nadministering COVID-19 vaccines, an increase in sales related to the stores acquired and opened since the second quarter of fiscal 2020 and higher fuel sales.\nNet sales and other revenue decreased 1.9% to $37,775.1 million for the first 28 weeks of fiscal 2021 from $38,509.2 million for the first 28 weeks of fiscal 2020. The decrease in Net sales and other revenue was primarily driven by our 5.3% decrease in identical sales, which was partially offset by an increase in pharmacy sales, primarily from administering COVID-19 vaccines, and an increase in sales related to the stores opened since the first 28 weeks of fiscal 2020 and higher fuel sales.\nIdentical Sales, Excluding Fuel\nIdentical sales include stores operating during the same period in both the current year and the prior year, comparing sales on a daily basis. Direct to consumer digital sales are included in identical sales, and fuel sales are excluded from identical sales. Acquired stores become identical on the one-year anniversary date of the acquisition. Identical sales for the 12 and 28 weeks ended September 11, 2021 and the 12 and 28 weeks ended September 12, 2020, respectively, were:\n| 12 weeks ended | 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\n| Identical sales, excluding fuel | 1.5% | 13.8% | (5.3)% | 21.0% |\n\nGross Profit\nGross profit represents the portion of Net sales and other revenue remaining after deducting Cost of sales during the period, including purchase and distribution costs. These costs include, among other things, purchasing and sourcing costs, inbound freight costs, product quality testing costs, warehouse and distribution costs, Own Brands program costs and digital-related delivery and handling costs. Advertising, promotional expenses and vendor allowances are also components of Cost of sales.\nGross profit margin decreased to 28.6% during the second quarter of fiscal 2021 compared to 29.0% during the second quarter of fiscal 2020. Excluding the impact of fuel, gross profit margin was flat compared to the second quarter of fiscal 2020, primarily due to higher product, supply chain and advertising costs, offset by benefits related to productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines.\nGross profit margin decreased to 28.9% during the first 28 weeks of fiscal 2021 compared to 29.5% during the first 28 weeks of fiscal 2020. Excluding the impact of fuel, gross profit margin increased five basis points compared to the first 28 weeks of fiscal 2020. The increase in gross profit margin was primarily driven by productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by sales deleverage and higher product and supply chain costs.\nSelling and Administrative Expenses\nSelling and administrative expenses consist primarily of store level costs, including wages, employee benefits, rent, depreciation and utilities, in addition to certain back-office expenses related to our corporate and division offices.\nSelling and administrative expenses were 25.6% of Net sales and other revenue during the second quarter of fiscal 2021 and the second quarter of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 55 basis points during the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020. The increase in Selling and administrative expenses as a percentage\n25\nof Net sales and other revenue was primarily attributable to employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\nSelling and administrative expenses increased to 25.8% of Net sales and other revenue during the first 28 weeks of fiscal 2021 compared to 25.5% of Net sales and other revenue for the first 28 weeks of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 90 basis points during the first 28 weeks of fiscal 2021 compared to the first 28 weeks of fiscal 2020. The increase in Selling and administrative expenses as a percentage of Net sales and other revenue was primarily attributable to sales deleverage, together with higher employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening of fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\n(Gain) Loss on Property Dispositions and Impairment Losses, Net\nFor the second quarter of fiscal 2021, net gain on property dispositions and impairment losses was $0.2 million, primarily driven by $6.2 million of gains from the sale of assets, partially offset by $6.0 million of intangible asset impairment. For the second quarter of fiscal 2020, net gain on property dispositions and impairment losses was $18.3 million, primarily driven by $20.0 million of gains from the sale of assets, partially offset by $1.7 million of asset impairments.\nFor the first 28 weeks of fiscal 2021, net loss on property dispositions and impairment losses was $0.1 million, primarily driven by $15.9 million of asset impairments, primarily related to right-of-use assets and intangible assets, partially offset by $15.8 million of gains from the sale of assets. For the first 28 weeks of fiscal 2020, net loss on property dispositions and impairment losses was $12.0 million, primarily driven by $22.8 million of asset impairments, primarily related to right-of-use assets, partially offset by $10.8 million of gains from the sale of assets.\nInterest Expense, Net\nInterest expense, net was $109.3 million during the second quarter of fiscal 2021 compared to $128.6 million during the second quarter of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during the second quarter of fiscal 2021 was 5.4%, excluding deferred financing costs and original issue discount, compared to 6.0% during the second quarter of fiscal 2020.\nInterest expense, net was $262.6 million during the first 28 weeks of fiscal 2021 compared to $309.2 million during the first 28 weeks of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during first 28 weeks of fiscal 2021 was 5.5%, excluding deferred financing costs and original issue discount, compared to 6.0% during the first 28 weeks of fiscal 2020.\n26\nLoss of Debt Extinguishment\nThere was no loss on debt extinguishment during both the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021, compared to loss on debt extinguishment of $49.1 million during both the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020. The loss on debt extinguishment during the second quarter and first 28 weeks of fiscal 2020 primarily consisted of a redemption premium payment and write-off of debt discounts associated with the redemption of the Company's 6.625% Senior Unsecured Notes due 2024 (the \"2024 Notes\").\nOther Income, Net\nFor the second quarter of fiscal 2021, Other income, net was $18.9 million compared to $11.4 million for the second quarter of fiscal 2020. Other income, net during the second quarter of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the second quarter of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment.\nFor the first 28 weeks of fiscal 2021, Other income, net was $62.4 million compared to $8.3 million for the first 28 weeks of fiscal 2020. Other income, net during the first 28 weeks of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense, realized gains from non-operating investments and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the first 28 weeks of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by recognized losses on interest rate swaps and unrealized losses from non-operating investments.\nIncome Taxes\nIncome tax expense was $100.3 million, representing a 25.4% effective tax rate, for the second quarter of fiscal 2021. Income tax expense was $111.2 million, representing a 28.1% effective tax rate, for the second quarter of fiscal 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the second quarter of fiscal 2020.\nIncome tax expense was $232.8 million, representing a 23.9% effective tax rate, for the first 28 weeks of fiscal 2021. Income tax expense was $313.1 million, representing a 26.4% effective tax rate, for the first 28 weeks of fiscal 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the first 28 weeks of fiscal 2021 and certain nondeductible transaction-related costs incurred during the first 28 weeks of fiscal 2020.\nWe currently expect our annual effective tax rate for fiscal 2021 to be in the range of approximately 23% to 24%.\nNet Income and Adjusted Net Income\nNet income was $295.2 million, or $0.52 per Class A common share, during the second quarter of fiscal 2021 compared to $284.5 million, or $0.49 per Class A common share, during the second quarter of fiscal 2020. Adjusted net income was $369.5 million, or $0.64 per Class A common share, during the second quarter of fiscal 2021 compared to $356.4 million, or $0.60 per Class A common share, during the second quarter of fiscal 2020.\nNet income was $740.0 million, or $1.26 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $870.7, or $1.49 per Class A common share, during the first 28 weeks of fiscal 2020. Adjusted net income was $887.0 million, or $1.53 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $1,157.6 million, or $1.95 per Class A common share, during the first 28 weeks of fiscal 2020.\n27\nAdjusted EBITDA\nFor the second quarter of fiscal 2021, Adjusted EBITDA was $965.4 million, or 5.8% of Net sales and other revenue, compared to $948.4 million, or 6.0% of Net sales and other revenue, for the second quarter of fiscal 2020. The increase in Adjusted EBITDA was primarily the result of an increase in Net sales and other revenue, partially offset by an increase in Selling and administrative expenses. For the first 28 weeks of fiscal 2021, Adjusted EBITDA was $2,273.5 million, or 6.0% of Net sales and other revenue, compared to $2,639.4 million, or 6.9% of Net sales and other revenue for the first 28 weeks of fiscal 2020. The decrease in Adjusted EBITDA was primarily the result of a decrease in Net sales and other revenue.\nSupplemental Two-Year Results - Comparison of Second Quarter of Fiscal 2021 to Second Quarter of Fiscal 2019\nThe following table provides a comparison of the second quarter of fiscal 2021 to the second quarter of fiscal 2019 for certain financial measures, including a compounded annual growth rate (\"CAGR\"), to demonstrate the two-year growth in our business. We believe these supplemental comparisons provide meaningful and useful information to investors about the trends in our business relative to pre-COVID-19 pandemic periods. These comparisons should not be reviewed in isolation or considered substitutes for our financial results included elsewhere in this Form 10-Q.\n| Second Quarter of Fiscal 2021 Supplemental Two-Year Results |\n| Identical sales two-year stacked (1) | 15.3 | % |\n| Net income per Class A common share two-year CAGR (2) | 1.0 | % |\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\n| Net income two-year CAGR (2) | 0.1 | % |\n| Adjusted net income two-year CAGR | 93.0 | % |\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\n| Margins: |\n| Gross profit (1) | Increased 85 basis points |\n| Selling and administrative expenses (1) | Decreased 120 basis points |\n\n(1) Excluding fuel.\n(2) The net income per Class A common share two-year CAGR and net income two-year CAGR are impacted by gains related to sale leaseback transactions in the second quarter of fiscal 2019.\nNet sales and other revenue was $16.5 billion during the second quarter of fiscal 2021 compared to $14.2 billion during the second quarter of fiscal 2019. The increase in sales compared to the second quarter of fiscal 2019 was primarily due to the 15.3% increase in two-year stacked identical sales. Identical sales were driven in part by the 248% two-year stacked increase in digital sales.\nGross profit margin was 28.6% during the second quarter of fiscal 2021 compared to 27.8% during the second quarter of fiscal 2019. Excluding the impact of fuel, gross profit margin increased by approximately 85 basis points compared to the second quarter of fiscal 2019, primarily driven by sales leverage, improvements in shrink expense, productivity initiatives and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by growth in digital sales and an increase in supply chain costs and COVID-19 expenses.\n28\nSelling and administrative expenses were 25.6% of sales during the second quarter of fiscal 2021 compared to 26.8% of sales for the second quarter of fiscal 2019. Excluding the impact of fuel, selling and administrative expenses as a percentage of sales decreased approximately 120 basis points primarily due to sales leverage and the execution of productivity initiatives, partially offset by increases in employee costs and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities and increased market driven retail wage rates, higher equity-based compensation expense as well as incremental COVID-19 expenses.\n29\nReconciliation of Non-GAAP Measures\nThe following tables reconcile Net income to Adjusted net income, and Net income per Class A common share to Adjusted net income per Class A common share (in millions, except per share data):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Numerator: |\n| Net income | $ | 295.2 | $ | 284.5 | $ | 294.8 |\n| Adjustments: |\n| (Gain) loss on interest rate and commodity hedges, net (d) | (1.2) | 1.4 | — |\n| Facility closures and transformation (1)(b) | 14.8 | 6.1 | — |\n| Acquisition and integration costs (2)(b) | 3.4 | 2.2 | 7.5 |\n| Equity-based compensation expense (b) | 26.8 | 9.3 | 6.5 |\n| (Gain) loss on property dispositions and impairment losses, net (3) | (0.2) | (18.3) | (435.5) |\n| LIFO expense (a) | 14.6 | 10.1 | 5.8 |\n| Government-mandated incremental COVID-19 pandemic related pay (4)(b) | 18.3 | — | — |\n| Civil disruption related costs (5)(b) | — | (1.9) | — |\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 4.1 | — |\n| Amortization of debt discount and deferred financing costs (c) | 4.7 | 4.7 | 35.4 |\n| Loss on debt extinguishment | — | 49.1 | 23.1 |\n| Amortization of intangible assets resulting from acquisitions (b) | 11.5 | 13.1 | 68.9 |\n| Miscellaneous adjustments (6)(f) | 5.1 | 13.3 | 24.3 |\n| Tax impact of adjustments to Adjusted net income | (23.5) | (21.3) | 68.4 |\n| Adjusted net income | $ | 369.5 | $ | 356.4 | $ | 99.2 |\n| Denominator: |\n| Weighted average Class A common shares outstanding - diluted | 573.0 | 582.9 | 580.6 |\n| Adjustments: |\n| Restricted stock units and awards (7) | 8.1 | 9.6 | 7.6 |\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.1 | 592.5 | 588.2 |\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\n| Supplemental Two-Year CAGR: |\n| Net income two-year CAGR | 0.1 | % |\n| Adjusted net income two-year CAGR | 93.0 | % |\n\n30\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Net income per Class A common share - diluted | $ | 0.52 | $ | 0.49 | $ | 0.51 |\n| Non-GAAP adjustments (8) | 0.13 | 0.12 | (0.33) |\n| Restricted stock units and awards (7) | (0.01) | (0.01) | (0.01) |\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\n| Supplemental Two-Year CAGR: |\n| Net income per Class A common share two-year CAGR | 1.0 | % |\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\n\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Adjusted net income (9) | $ | 369.5 | $ | 356.4 | $ | 99.2 |\n| Tax impact of adjustments to Adjusted net income | 23.5 | 21.3 | (68.4) |\n| Income tax expense | 100.3 | 111.2 | 81.9 |\n| Amortization of debt discount and deferred financing costs (c) | (4.7) | (4.7) | (35.4) |\n| Interest expense, net | 109.3 | 128.6 | 177.5 |\n| Amortization of intangible assets resulting from acquisitions (b) | (11.5) | (13.1) | (68.9) |\n| Depreciation and amortization (e) | 379.0 | 348.7 | 381.7 |\n| Adjusted EBITDA | $ | 965.4 | $ | 948.4 | $ | 567.6 |\n| Supplemental Two-Year CAGR: |\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\n\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\n(4) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\n(5) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\n31\n(6) Miscellaneous adjustments include the following (see table below):\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Non-cash lease-related adjustments | $ | 1.0 | $ | (0.1) | $ | 4.4 |\n| Lease and lease-related costs for surplus and closed stores | 6.5 | 10.8 | 5.2 |\n| Net realized and unrealized (gain) loss on non-operating investments | 12.8 | 0.2 | 10.8 |\n| Other (i) | (15.2) | 2.4 | 3.9 |\n| Total miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\n\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\n(7) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\n(8) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\n(9) See the reconciliation of Net income to Adjusted net income above for further details.\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\n(a) Cost of sales\n(b) Selling and administrative expenses\n(c) Interest expense, net\n(d) (Gain) loss on interest rate and commodity hedges, net:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | (1.2) | $ | 1.0 | $ | — |\n| Other income, net | — | 0.4 | — |\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (1.2) | $ | 1.4 | $ | — |\n\n(e) Depreciation and amortization:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | 36.0 | $ | 40.1 | $ | 38.0 |\n| Selling and administrative expenses | 343.0 | 308.6 | 343.7 |\n| Total Depreciation and amortization | $ | 379.0 | $ | 348.7 | $ | 381.7 |\n\n(f) Miscellaneous adjustments:\n| 12 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Selling and administrative expenses | $ | 3.4 | $ | 9.9 | $ | 9.6 |\n| Other income, net | 1.7 | 3.4 | 14.7 |\n| Total Miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\n\n32\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Numerator: |\n| Net income | $ | 740.0 | $ | 870.7 | $ | 343.8 |\n| Adjustments: |\n| (Gain) loss on interest rate and commodity hedges, net (d) | (7.5) | 25.9 | 0.3 |\n| Facility closures and transformation (1)(b) | 35.6 | 15.9 | — |\n| Acquisition and integration costs (2)(b) | 6.9 | 8.5 | 33.6 |\n| Equity-based compensation expense (b) | 49.0 | 28.3 | 17.6 |\n| Loss (gain) on property dispositions and impairment losses, net (3) | 0.1 | 12.0 | (464.0) |\n| LIFO expense (a) | 29.1 | 23.2 | 16.3 |\n| Discretionary COVID-19 pandemic related costs (4)(b) | — | 89.9 | — |\n| Government-mandated incremental COVID-19 pandemic related pay (5)(b) | 47.4 | — | — |\n| Civil disruption related costs (6)(b) | — | 13.0 | — |\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 24.4 | — |\n| Amortization of debt discount and deferred financing costs (c) | 11.1 | 11.2 | 43.8 |\n| Loss on debt extinguishment | — | 49.1 | 65.8 |\n| Amortization of intangible assets resulting from acquisitions (b) | 27.6 | 30.6 | 161.7 |\n| Miscellaneous adjustments (7)(f) | (5.7) | 47.4 | 33.1 |\n| Tax impact of adjustments to Adjusted net income | (46.6) | (92.5) | 23.7 |\n| Adjusted net income | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\n| Denominator: |\n| Weighted average Class A common shares outstanding - diluted | 470.6 | 583.3 | 580.0 |\n| Adjustments: |\n| Convertible Preferred Stock (8) | 101.6 | — | — |\n| Restricted stock units and awards (9) | 8.8 | 9.2 | 8.2 |\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.0 | 592.5 | 588.2 |\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\n| Supplemental Two-Year CAGR: |\n| Net income two-year CAGR | 46.7 | % |\n| Adjusted net income two-year CAGR | 79.4 | % |\n\n33\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Net income per Class A common share - diluted | $ | 1.26 | $ | 1.49 | $ | 0.59 |\n| Convertible Preferred Stock (8) | 0.03 | — | — |\n| Non-GAAP adjustments (10) | 0.26 | 0.49 | (0.11) |\n| Restricted stock units and awards (9) | (0.02) | (0.03) | (0.01) |\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\n| Supplemental Two-Year CAGR: |\n| Net income per Class A common share two-year CAGR | 46.1 | % |\n| Adjusted net income per Class A common share two-year CAGR | 80.4 | % |\n\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Adjusted net income (11) | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\n| Tax impact of adjustments to Adjusted net income | 46.6 | 92.5 | (23.7) |\n| Income tax expense | 232.8 | 313.1 | 97.6 |\n| Amortization of debt discount and deferred financing costs (c) | (11.1) | (11.2) | (43.8) |\n| Interest expense, net | 262.6 | 309.2 | 402.7 |\n| Amortization of intangible assets resulting from acquisitions (b) | (27.6) | (30.6) | (161.7) |\n| Depreciation and amortization (e) | 883.2 | 808.8 | 897.6 |\n| Adjusted EBITDA | $ | 2,273.5 | $ | 2,639.4 | $ | 1,444.4 |\n| Supplemental Two-Year CAGR: |\n| Adjusted EBITDA two-year CAGR | 25.5 | % |\n\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\n(4) Includes $53 million of charitable contributions to our communities for hunger relief and $36.9 million in final reward payments to front-line associates at the end of the first quarter of fiscal 2020.\n(5) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\n(6) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\n34\n(7) Miscellaneous adjustments include the following (see table below):\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Non-cash lease-related adjustments | $ | 3.1 | $ | 1.9 | $ | 6.3 |\n| Lease and lease-related costs for surplus and closed stores | 16.7 | 29.5 | 12.0 |\n| Net realized and unrealized (gain) loss on non-operating investments | (9.7) | 4.7 | 7.5 |\n| Other (i) | (15.8) | 11.3 | 7.3 |\n| Total miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\n\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\n(8) Represents the conversion of Convertible Preferred Stock to the fully outstanding as-converted Class A common shares as of the end of each respective period, for periods in which the Convertible Preferred Stock is antidilutive under GAAP.\n(9) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\n(10) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\n(11) See the reconciliation of Net income to Adjusted net income above for further details.\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\n(a) Cost of sales\n(b) Selling and administrative expenses\n(c) Interest expense, net\n35\n(d) (Gain) loss on interest rate and commodity hedges, net:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | (7.8) | $ | 6.5 | $ | 0.3 |\n| Other income, net | 0.3 | 19.4 | — |\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (7.5) | $ | 25.9 | $ | 0.3 |\n\n(e) Depreciation and amortization:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Cost of sales | $ | 86.8 | $ | 94.1 | $ | 90.0 |\n| Selling and administrative expenses | 796.4 | 714.7 | 807.6 |\n| Total Depreciation and amortization | $ | 883.2 | $ | 808.8 | $ | 897.6 |\n\n(f) Miscellaneous adjustments:\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\n| Selling and administrative expenses | $ | 10.2 | $ | 34.7 | $ | 16.7 |\n| Other income, net | (15.9) | 12.7 | 16.4 |\n| Total Miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\n\nLIQUIDITY AND CAPITAL RESOURCES\nThe following table sets forth the major sources and uses of cash and cash equivalents and restricted cash for each period (in millions):\n| 28 weeks ended |\n| September 11,2021 | September 12,2020 |\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\n| Cash flows provided by operating activities | 2,137.7 | 2,720.8 |\n| Cash flows used in investing activities | (790.5) | (687.1) |\n| Cash flows used in financing activities | (214.4) | (80.7) |\n\nNet Cash Provided by Operating Activities\nNet cash provided by operating activities was $2,137.7 million for the first 28 weeks of fiscal 2021 compared to $2,720.8 million for the first 28 weeks of fiscal 2020. The decrease in cash flow from operations compared to the first 28 weeks of fiscal 2020 was due to changes in working capital primarily related to accounts payable as our business experienced significantly elevated demand during the first 28 weeks of fiscal 2020 and a deferral of approximately $270 million of the employer-paid portion of social security taxes in the first 28 weeks of fiscal 2020 together with lower EBITDA during the first 28 weeks of fiscal 2021. These decreases were partially offset by less cash paid for interest and income taxes of $94 million and $72 million, respectively, $75 million payment for the UFCW & Employers Midwest Pension Fund settlement in the first 28 weeks of fiscal 2020 and a decrease of $45.1 million in contributions to our defined benefit pension plans and post-retirement benefit plans.\n36\nNet Cash Used by Investing Activities\nNet cash used in investing activities was $790.5 million for the first 28 weeks of fiscal 2021 compared to $687.1 million for the first 28 weeks of fiscal 2020.\nFor the first 28 weeks of fiscal 2021, cash used in investing activities consisted primarily of payments for property and equipment of $822.5 million and payments for business acquisitions of $23.5 million, partially offset by proceeds from the sale of long-lived assets of $24.6 million. Payments for property and equipment in the first 28 weeks of fiscal 2021 included the opening of six new stores, completion of 76 remodels and increased investment in our digital technology. For the first 28 weeks of fiscal 2020, cash used in investing activities consisted primarily of payments for property and equipment of $702.9 million. Payments for property and equipment in the first 28 weeks of fiscal 2020 included the completion of 132 remodels and continued investment in our digital technology. For the full fiscal year of 2021, we expect capital expenditures to be in the range of $1.9 billion to $2.0 billion.\nNet Cash Used in Financing Activities\nNet cash used in financing activities was $214.4 million during the first 28 weeks of fiscal 2021 compared to $80.7 million during the first 28 weeks of fiscal 2020.\nNet cash used in financing activities during the first 28 weeks of fiscal 2021 consisted primarily of dividends paid on our Class A common stock and Convertible Preferred Stock. Net cash used in financing activities during the first 28 weeks of fiscal 2020 consisted primarily of the $1.5 billion issuance of new Senior Unsecured Notes and $1.25 billion aggregate redemption of 2024 Notes and 2025 Notes, the $2.0 billion borrowing and subsequent repayment of the ABL Facility, the issuance of the Convertible Preferred Stock and the repurchase of outstanding Class A common stock.\nLiquidity and Factors Affecting Liquidity\nWe estimate our liquidity needs over the next 12 months to be in the range of $4.75 billion to $5.25 billion, which includes anticipated requirements for incremental working capital, capital expenditures, pension obligations, interest payments and scheduled principal payments of debt, dividends on Class A common stock and Convertible Preferred Stock, operating leases and finance leases. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our ABL Facility, will be adequate to meet our liquidity needs for the next 12 months and for the foreseeable future. We believe we have adequate cash flow to continue to respond effectively to competitive conditions. In addition, we may enter into refinancing and sale leaseback transactions from time to time. There can be no assurance, however, that our business will continue to generate cash flow at or above current levels or that we will maintain our ability to borrow under our ABL Facility.\nThe holders of Convertible Preferred Stock are entitled to a quarterly dividend at a rate per annum of 6.75% of the liquidation preference per share of the Convertible Preferred Stock. On March 15, 2021, June 15, 2021 and September 15, 2021, we declared quarterly cash dividends of $29.5 million, respectively, to holders of the Convertible Preferred Stock, which was paid on March 31, 2021, June 30, 2021 and September 30, 2021, respectively. In addition, the holders of Convertible Preferred Stock will participate in cash dividends that we pay on our common stock to the extent that such cash dividends exceed $206.25 million per fiscal year.\n37\nWe have established a dividend policy pursuant to which we intend to pay a quarterly dividend on our Class A common stock. During the first 28 weeks of fiscal 2021, we paid quarterly cash dividends of $0.10 per share of Class A common stock on May 10, 2021 and August 10, 2021, to stockholders of record as of the close of business on April 26, 2021 and July 26, 2021, respectively. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock, payable on November 12, 2021 to stockholders of record as of the close of business on October 29, 2021.\nAs of September 11, 2021, we had no borrowings outstanding under out ABL Facility and total availability of $3,483.1 million (net of letter of credit usage).\nMultiemployer Pension Plans\nThe American Rescue Plan Act (\"ARP Act\") establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\"PBGC\") to pay pension benefits through the plan year ending 2051. The payment received by the multiemployer plan under this special financial assistance program would not be considered a loan and would not need to be paid back. Any financial assistance received by the multiemployer plan would need to be segregated from the other assets of the multiemployer plans and invested in investment grade bonds or other investments permitted by the PBGC.\nOf the 27 multiemployer plans to which we contribute, 16 plans are classified as \"Critical\" or \"Critical and Declining\" and are potentially eligible for special financial assistance under the ARP Act. Though the amount of financial assistance that each of these 16 plans could receive will vary by plan, we currently estimate that these 16 plans represent over 90% of the $4.7 billion we estimated as our share of the underfunding of the 27 plans. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive assistance. We are evaluating the interim final rule and have submitted comments during the 30-day comment period, and we expect the special financial assistance program to provide funding for the multiemployer plans to which we contribute to remain solvent through the next 25 to 30 years.\nCRITICAL ACCOUNTING POLICIES\nThe preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a fair and consistent manner. See the Critical Accounting Policies section included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, for a discussion of our significant accounting policies.\nRECENTLY ISSUED AND RECENTLY ADOPTED ACCOUNTING STANDARDS\nSee Note 1 - Basis of presentation and summary of significant accounting policies of our unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\n38\nItem 3\n-\nQuantitative and Qualitative Disclosures About Market Risk\nThere have been no material changes in our exposure to market risk from the information provided in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021.\nItem 4 - Controls and Procedures\nBased on their evaluation of our disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934 (the \"Exchange Act\")) as of the end of the period covered by this Form 10-Q, our Principal Executive Officer and Principal Financial Officer concluded our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and is accumulated and communicated to management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of fiscal 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n39\nPART II - OTHER INFORMATION\nItem 1 - Legal Proceedings\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with respect to certain of the matters described in this Form 10-Q cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition. See the matters under the caption Legal Proceedings in Note 6 - Commitments and contingencies and off balance sheet arrangements in the unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\nItem 1A - Risk Factors\nThere have been no material changes to the risk factors previously included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, under the heading \"Risk Factors.\"\nItem 2 - Unregistered Sales of Equity Securities and Use of Proceeds\n(a) Unregistered Sales of Equity Securities\nNone.\n(b) Use of Proceeds\nNone.\n(c) Purchases of Equity Securities\nNone.\nItem 3 - Defaults Upon Senior Securities\nNone.\nItem 4 - Mine Safety Disclosures\nNot Applicable.\nItem 5 - Other Information\nNone.\n40\nItem 6 - Exhibits\n3.1 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of Albertsons Companies, Inc.\n10.1 Employment Agreement, dated as of August 4, 2021, by and between Albertsons Companies, Inc. and Sharon McCollam (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on August 11, 2021)\n31.1 Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\n31.2 Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\n32.1 Certification of the Principal Executive Officer and of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002\nEXHIBIT 101.INS - Inline XBRL Instance Document\nEXHIBIT 101.SCH - Inline XBRL Taxonomy Extension Schema Document\nEXHIBIT 101.CAL - Inline XBRL Taxonomy Extension Calculation Linkbase Document\nEXHIBIT 101.DEF - Inline XBRL Taxonomy Extension Definition Linkbase Document\nEXHIBIT 101.LAB - Inline XBRL Taxonomy Extension Label Linkbase Document\nEXHIBIT 101.PRE - Inline XBRL Taxonomy Extension Presentation Linkbase Document\nEXHIBIT 104 - Cover Page Interactive Data File (embedded within the Inline XBRL document)\n41\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| Albertsons Companies, Inc.(Registrant) |\n| Date: | October 20, 2021 | By: | /s/ Vivek Sankaran |\n| Vivek Sankaran |\n| Chief Executive Officer and Director(Principal Executive Officer) |\n\n| Date: | October 20, 2021 | By: | /s/ Sharon McCollam |\n| Sharon McCollam |\n| President and Chief Financial Officer(Principal Financial Officer) |\n\n42\n</text>\n\nWhat is the rate of increase in total debt as a percentage of total assets from February 27, 2021 to September 11, 2021 in percent?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1 - Condensed Consolidated Financial Statements (unaudited)\\nAlbertsons Companies, Inc. and Subsidiaries\\nCondensed Consolidated Balance Sheets\\n(in millions, except share data)\\n(unaudited)\\n| September 11,2021 | February 27,2021 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 2,849.8 | $ | 1,717.0 |\\n| Receivables, net | 544.7 | 550.9 |\\n| Inventories, net | 4,179.1 | 4,301.3 |\\n| Other current assets | 414.7 | 418.8 |\\n| Total current assets | 7,988.3 | 6,988.0 |\\n| Property and equipment, net | 9,201.1 | 9,412.7 |\\n| Operating lease right-of-use assets | 5,861.3 | 6,015.6 |\\n| Intangible assets, net | 2,181.3 | 2,108.8 |\\n| Goodwill | 1,200.2 | 1,183.3 |\\n| Other assets | 912.1 | 889.6 |\\n| TOTAL ASSETS | $ | 27,344.3 | $ | 26,598.0 |\\n| LIABILITIES |\\n| Current liabilities |\\n| Accounts payable | $ | 3,554.2 | $ | 3,487.3 |\\n| Accrued salaries and wages | 1,492.3 | 1,474.7 |\\n| Current maturities of long-term debt and finance lease obligations | 211.5 | 212.4 |\\n| Current maturities of operating lease obligations | 621.7 | 605.3 |\\n| Other current liabilities | 1,190.0 | 1,052.5 |\\n| Total current liabilities | 7,069.7 | 6,832.2 |\\n| Long-term debt and finance lease obligations | 8,129.1 | 8,101.2 |\\n| Long-term operating lease obligations | 5,464.1 | 5,548.0 |\\n| Deferred income taxes | 598.3 | 533.7 |\\n| Other long-term liabilities | 2,524.1 | 2,659.5 |\\n| Commitments and contingencies |\\n| Series A convertible preferred stock, $ 0.01 par value; 1,750,000 shares authorized, 924,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 844.3 | 844.3 |\\n| Series A-1 convertible preferred stock, $ 0.01 par value; 1,410,000 shares authorized, 826,000 shares issued and outstanding as of September 11, 2021 and February 27, 2021 | 754.8 | 754.8 |\\n| STOCKHOLDERS' EQUITY |\\n| Undesignated preferred stock, $ 0.01 par value; 96,840,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\\n| Class A common stock, $ 0.01 par value; 1,000,000,000 shares authorized, 586,668,103 and 585,574,666 shares issued as of September 11, 2021 and February 27, 2021, respectively | 5.9 | 5.9 |\\n| Class A-1 convertible common stock, $ 0.01 par value; 150,000,000 shares authorized, no shares issued as of September 11, 2021 and February 27, 2021 | — | — |\\n| Additional paid-in capital | 1,936.1 | 1,898.9 |\\n| Treasury stock, at cost, 120,009,647 shares held as of September 11, 2021 and February 27, 2021 | ( 1,907.0 ) | ( 1,907.0 ) |\\n| Accumulated other comprehensive income | 78.7 | 63.5 |\\n| Retained earnings | 1,846.2 | 1,263.0 |\\n| Total stockholders' equity | 1,959.9 | 1,324.3 |\\n| TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | $ | 27,344.3 | $ | 26,598.0 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n3\\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Operations and Comprehensive Income (in millions, except per share data)(unaudited)\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Net sales and other revenue | $ | 16,505.7 | $ | 15,757.6 | $ | 37,775.1 | $ | 38,509.2 |\\n| Cost of sales | 11,788.7 | 11,182.7 | 26,867.1 | 27,162.8 |\\n| Gross profit | 4,717.0 | 4,574.9 | 10,908.0 | 11,346.4 |\\n| Selling and administrative expenses | 4,231.3 | 4,031.2 | 9,734.9 | 9,800.6 |\\n| (Gain) loss on property dispositions and impairment losses, net | ( 0.2 ) | ( 18.3 ) | 0.1 | 12.0 |\\n| Operating income | 485.9 | 562.0 | 1,173.0 | 1,533.8 |\\n| Interest expense, net | 109.3 | 128.6 | 262.6 | 309.2 |\\n| Loss on debt extinguishment | — | 49.1 | — | 49.1 |\\n| Other income, net | ( 18.9 ) | ( 11.4 ) | ( 62.4 ) | ( 8.3 ) |\\n| Income before income taxes | 395.5 | 395.7 | 972.8 | 1,183.8 |\\n| Income tax expense | 100.3 | 111.2 | 232.8 | 313.1 |\\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\\n| Other comprehensive income, net of tax |\\n| Recognition of pension gain | 15.1 | 10.1 | 15.2 | 10.9 |\\n| Other | — | 0.3 | — | 1.2 |\\n| Other comprehensive income | $ | 15.1 | $ | 10.4 | $ | 15.2 | $ | 12.1 |\\n| Comprehensive income | $ | 310.3 | $ | 294.9 | $ | 755.2 | $ | 882.8 |\\n| Net income per Class A common share |\\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\\n| Diluted net income per Class A common share | 0.52 | 0.49 | 1.26 | 1.49 |\\n| Weighted average Class A common shares outstanding |\\n| Basic | 465.3 | 477.3 | 465.2 | 529.2 |\\n| Diluted | 573.0 | 582.9 | 470.6 | 583.3 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n4\\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Cash Flows(in millions)(unaudited)\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 |\\n| Cash flows from operating activities: |\\n| Net income | $ | 740.0 | $ | 870.7 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Loss on property dispositions and impairment losses, net | 0.1 | 12.0 |\\n| Depreciation and amortization | 883.2 | 808.8 |\\n| Operating lease right-of-use assets amortization | 333.0 | 309.3 |\\n| LIFO expense | 29.1 | 23.2 |\\n| Deferred income tax | 43.0 | 2.8 |\\n| Contributions to pension and post-retirement benefit plans, net of (income) expense | ( 47.5 ) | ( 68.9 ) |\\n| (Gain) loss on interest rate swaps and commodity hedges, net | ( 7.5 ) | 25.9 |\\n| Amortization and write-off of deferred financing costs | 11.1 | 11.2 |\\n| Loss on debt extinguishment | — | 49.1 |\\n| Equity-based compensation expense | 49.0 | 28.3 |\\n| Other | ( 21.2 ) | ( 28.7 ) |\\n| Changes in operating assets and liabilities: |\\n| Receivables, net | ( 6.4 ) | ( 21.7 ) |\\n| Inventories, net | 93.0 | 62.2 |\\n| Accounts payable, accrued salaries and wages and other accrued liabilities | 229.2 | 585.4 |\\n| Operating lease liabilities | ( 249.3 ) | ( 228.4 ) |\\n| Self-insurance assets and liabilities | 36.3 | 24.2 |\\n| Other operating assets and liabilities | 22.6 | 255.4 |\\n| Net cash provided by operating activities | 2,137.7 | 2,720.8 |\\n| Cash flows from investing activities: |\\n| Business acquisitions, net of cash acquired | ( 23.5 ) | — |\\n| Payments for property, equipment and intangibles, including payments for lease buyouts | ( 822.5 ) | ( 702.9 ) |\\n| Proceeds from sale of long-lived assets | 24.6 | 20.6 |\\n| Other investing activities | 30.9 | ( 4.8 ) |\\n| Net cash used in investing activities | ( 790.5 ) | ( 687.1 ) |\\n| Cash flows from financing activities: |\\n| Proceeds from issuance of long-term debt | — | 3,500.0 |\\n| Payments on long-term borrowings | ( 0.5 ) | ( 3,388.5 ) |\\n| Payments of obligations under finance leases | ( 32.2 ) | ( 32.9 ) |\\n| Payment of redemption premium on debt extinguishment | — | ( 41.4 ) |\\n| Payments for debt financing costs | — | ( 15.6 ) |\\n| Dividends paid on common stock | ( 93.0 ) | — |\\n| Dividends paid on convertible preferred stock | ( 59.1 ) | — |\\n| Proceeds from convertible preferred stock | — | 1,680.0 |\\n| Third party issuance costs on convertible preferred stock | — | ( 80.9 ) |\\n| Treasury stock purchase, at cost | — | ( 1,680.0 ) |\\n| Employee tax withholding on vesting of restricted stock units | ( 11.8 ) | ( 6.7 ) |\\n| Other financing activities | ( 17.8 ) | ( 14.7 ) |\\n| Net cash used in financing activities | ( 214.4 ) | ( 80.7 ) |\\n| Net increase in cash and cash equivalents and restricted cash | 1,132.8 | 1,953.0 |\\n| Cash and cash equivalents and restricted cash at beginning of period | 1,767.6 | 478.9 |\\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n5\\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive income | Retained earnings | Total stockholders' equity |\\n| Shares | Amount | Shares | Amount |\\n| Balance as of February 27, 2021 | 585,574,666 | $ | 5.9 | $ | 1,898.9 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.5 | $ | 1,263.0 | $ | 1,324.3 |\\n| Equity-based compensation | — | — | 22.2 | — | — | — | — | 22.2 |\\n| Shares issued and employee tax withholding on vesting of restricted stock units | 945,942 | — | ( 10.0 ) | — | — | — | — | ( 10.0 ) |\\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 36.4 ) | ( 36.4 ) |\\n| Net income | — | — | — | — | — | — | 444.8 | 444.8 |\\n| Other comprehensive income, net of tax | — | — | — | — | — | 0.1 | — | 0.1 |\\n| Other activity | — | — | — | — | — | — | ( 0.1 ) | ( 0.1 ) |\\n| Balance as of June 19, 2021 | 586,520,608 | $ | 5.9 | $ | 1,911.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 63.6 | $ | 1,624.8 | $ | 1,698.4 |\\n| Equity-based compensation | — | — | 26.8 | — | — | — | — | 26.8 |\\n| Shares issued and employee tax withholding on vesting of restricted stock units | 147,495 | — | ( 1.8 ) | — | — | — | — | ( 1.8 ) |\\n| Cash dividends declared on common stock | — | — | — | — | — | — | ( 46.5 ) | ( 46.5 ) |\\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 27.3 ) | ( 27.3 ) |\\n| Net income | — | — | — | — | — | — | 295.2 | 295.2 |\\n| Other comprehensive income, net of tax | — | — | — | — | — | 15.1 | — | 15.1 |\\n| Balance as of September 11, 2021 | 586,668,103 | $ | 5.9 | $ | 1,936.1 | 120,009,647 | $ | ( 1,907.0 ) | $ | 78.7 | $ | 1,846.2 | $ | 1,959.9 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n6\\nAlbertsons Companies, Inc. and SubsidiariesCondensed Consolidated Statements of Stockholders' Equity(in millions, except share data)(unaudited)\\n| Class A Common Stock | Additional paid in capital | Treasury Stock | Accumulated other comprehensive loss | Retained earnings | Total stockholders' equity |\\n| Shares | Amount | Shares | Amount |\\n| Balance as of February 29, 2020 | 582,997,251 | $ | 5.8 | $ | 1,824.3 | 3,671,621 | $ | ( 25.8 ) | $ | ( 118.5 ) | $ | 592.3 | $ | 2,278.1 |\\n| Issuance of common stock to Company's parents | 1,312,859 | — | — | — | — | — | — | — |\\n| Equity-based compensation | — | — | 19.0 | — | — | — | — | 19.0 |\\n| Employee tax withholding on vesting of restricted stock units | — | — | ( 6.2 ) | — | — | — | — | ( 6.2 ) |\\n| Repurchase of common stock | — | — | — | 101,611,736 | ( 1,680.0 ) | — | — | ( 1,680.0 ) |\\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 3.9 ) | ( 3.9 ) |\\n| Net income | — | — | — | — | — | — | 586.2 | 586.2 |\\n| Other comprehensive income, net of tax | — | — | — | — | — | 1.7 | — | 1.7 |\\n| Balance as of June 20, 2020 | 584,310,110 | $ | 5.8 | $ | 1,837.1 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 116.8 ) | $ | 1,174.6 | $ | 1,194.9 |\\n| Equity-based compensation | — | — | 9.3 | — | — | — | — | 9.3 |\\n| Shares issued and employee tax withholding on vesting of restricted stock units | 22,101 | — | ( 0.5 ) | — | — | — | — | ( 0.5 ) |\\n| Equity reclassification | — | — | 30.0 | — | — | — | — | 30.0 |\\n| Dividends accrued on convertible preferred stock | — | — | — | — | — | — | ( 26.9 ) | ( 26.9 ) |\\n| Net income | — | — | — | — | — | — | 284.5 | 284.5 |\\n| Other comprehensive loss, net of tax | — | — | — | — | — | 10.4 | — | 10.4 |\\n| Other activity | — | — | ( 0.1 ) | — | — | — | — | ( 0.1 ) |\\n| Balance as of September 12, 2020 | 584,332,211 | $ | 5.8 | $ | 1,875.8 | 105,283,357 | $ | ( 1,705.8 ) | $ | ( 106.4 ) | $ | 1,432.2 | $ | 1,501.6 |\\n\\nThe accompanying notes are an integral part of these Condensed Consolidated Financial Statements.\\n7\\nAlbertsons Companies, Inc. and SubsidiariesNotes to Condensed Consolidated Financial Statements(unaudited)\\nNOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation\\nThe accompanying interim Condensed Consolidated Financial Statements include the accounts of Albertsons Companies, Inc. and its subsidiaries (the \\\"Company\\\"). All significant intercompany balances and transactions were eliminated. The Condensed Consolidated Balance Sheet as of February 27, 2021 is derived from the Company's annual audited Consolidated Financial Statements, which should be read in conjunction with these Condensed Consolidated Financial Statements and which are included in the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the Securities and Exchange Commission (the \\\"SEC\\\") on April 28, 2021. Certain information in footnote disclosures normally included in annual financial statements was condensed or omitted for the interim periods presented in accordance with accounting principles generally accepted in the United States of America (\\\"GAAP\\\"). In the opinion of management, the interim data includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The interim results of operations and cash flows are not necessarily indicative of those results and cash flows expected for the year. The Company' s results of operations are for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020.\\nSignificant Accounting Policies\\nRestricted cash: Restricted cash is included in Other current assets or Other assets depending on the remaining term of the restriction and primarily relates to funds held in escrow. The Company had $ 50.6 million of restricted cash as of September 11, 2021 and February 27, 2021.\\nInventories, net: Substantially all of the Company's inventories consist of finished goods valued at the lower of cost or market and net of vendor allowances. The Company uses either item-cost or the retail inventory method to value inventory before application of any last-in, first-out (\\\"LIFO\\\") reserve. Interim LIFO inventory costs are based on management's estimates of expected year-end inventory levels and inflation rates. The Company recorded LIFO expense of $ 14.6 million and $ 10.1 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively, and $ 29.1 million and $ 23.2 million for the 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\\nEquity-based compensation: Equity-based compensation expense recognized in the Condensed Consolidated Statements of Operations (in millions):\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| RSUs | $ | 24.9 | $ | 8.0 | $ | 44.6 | $ | 25.8 |\\n| RSAs | 1.9 | 1.3 | 4.4 | 2.5 |\\n| Total equity-based compensation expense | $ | 26.8 | $ | 9.3 | $ | 49.0 | $ | 28.3 |\\n| Total related tax benefit | $ | 6.4 | $ | 2.0 | $ | 11.5 | $ | 6.6 |\\n\\nAs of September 11, 2021, there was $ 126.2 million of unrecognized costs related to 11.5 million unvested granted restricted stock units (\\\"RSUs\\\"). That cost is expected to be recognized over a weighted average period of 1.8 years. As of September 11, 2021, there was $ 7.3 million of unrecognized costs related to 1.0 million unvested granted restricted common stock (\\\"RSAs\\\"). That cost is expected to be recognized over a weighted average period of 1.9 years.\\nIncome taxes: Income tax expense was $ 100.3 million, representing a 25.4 % effective tax rate, for the 12 weeks ended September 11, 2021. Income tax expense was $ 111.2 million, representing a 28.1 % effective tax rate, for the\\n8\\n12 weeks ended September 12, 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the 12 weeks ended September 12, 2020.\\nIncome tax expense was $ 232.8 million, representing a 23.9 % effective tax rate, for the 28 weeks ended September 11, 2021. Income tax expense was $ 313.1 million, representing a 26.4 % effective tax rate, for the 28 weeks ended September 12, 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the 28 weeks ended September 11, 2021 and certain nondeductible transaction-related costs incurred during the 28 weeks ended September 12, 2020.\\nSegments: The Company and its subsidiaries offer grocery products, general merchandise, health and beauty care products, pharmacy, fuel and other items and services in its stores or through digital channels. The Company's operating divisions are geographically based, have similar economic characteristics and similar expected long-term financial performance. The Company's operating segments and reporting units are its 12 operating divisions, which are reported in one reportable segment. Each reporting unit constitutes a business for which discrete financial information is available and for which management regularly reviews the operating results. Across all operating segments, the Company operates primarily one store format. Each division offers through its stores and digital channels the same general mix of products with similar pricing to similar categories of customers, has similar distribution methods, operates in similar regulatory environments and purchases merchandise from similar or the same vendors.\\nRevenue Recognition: Revenues from the retail sale of products are recognized at the point of sale or delivery to the customer, net of returns and sales tax. Pharmacy sales are recorded upon the customer receiving the prescription. Third-party receivables from pharmacy sales were $ 236.0 million and $ 262.5 million as of September 11, 2021 and February 27, 2021, respectively, and are recorded in Receivables, net. For digital related sales, which primarily include home delivery and Drive Up & Go curbside pickup, revenues are recognized upon either pickup in store or delivery to the customer and may include revenue for separately charged delivery services. The Company records a contract liability when rewards are earned by customers in connection with the Company's loyalty programs. As rewards are redeemed or expire, the Company reduces the contract liability and recognizes revenue. The contract liability balance was immaterial as of September 11, 2021 and February 27, 2021.\\nThe Company records a contract liability when it sells its own proprietary gift cards. The Company records a sale when the customer redeems the gift card. The Company's gift cards do not expire. The Company reduces the contract liability and records revenue for the unused portion of gift cards (\\\"breakage\\\") in proportion to its customers' pattern of redemption, which the Company determined to be the historical redemption rate. The Company's contract liability related to gift cards was $ 76.2 million as of September 11, 2021 and $ 98.1 million as of February 27, 2021. Breakage amounts were immaterial for the 12 and 28 weeks ended September 11, 2021 and September 12, 2020, respectively.\\n9\\nDisaggregated Revenues\\nThe following table represents sales revenue by type of similar product (dollars in millions):\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total | Amount (1) | % of Total |\\n| Non-perishables (2) | $ | 7,268.5 | 44.0 | % | $ | 7,126.6 | 45.2 | % | $ | 16,538.8 | 43.8 | % | $ | 17,910.4 | 46.5 | % |\\n| Perishables (3) | 6,823.2 | 41.3 | 6,654.1 | 42.2 | 15,735.8 | 41.6 | 16,209.7 | 42.1 |\\n| Pharmacy | 1,253.4 | 7.6 | 1,171.8 | 7.5 | 2,982.0 | 7.9 | 2,726.7 | 7.1 |\\n| Fuel | 918.5 | 5.6 | 570.8 | 3.6 | 1,967.8 | 5.2 | 1,160.0 | 3.0 |\\n| Other (4) | 242.1 | 1.5 | 234.3 | 1.5 | 550.7 | 1.5 | 502.4 | 1.3 |\\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\\n\\n(1) Digital related sales are included in the categories to which the revenue pertains.\\n(2) Consists primarily of general merchandise, grocery and frozen foods.\\n(3) Consists primarily of produce, dairy, meat, deli, floral and seafood.\\n(4) Consists primarily of wholesale revenue to third parties, commissions and other miscellaneous revenue.\\nRecently issued accounting standards: In June 2020, the FASB issued ASU 2020-06, \\\"Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity\\\" (\\\"ASU 2020-06\\\"). ASU 2020-06 simplifies the accounting for certain convertible instruments, amends guidance on derivative scope exceptions for contracts in an entity's own equity and modifies the guidance on diluted earnings per share calculations as a result of these changes. ASU 2020-06 will take effect for public entities for annual reporting periods beginning after December 15, 2021, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effect of this standard on its Consolidated Financial Statements.\\nNOTE 2 - FAIR VALUE MEASUREMENTS\\nThe accounting guidance for fair value established a framework for measuring fair value and established a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability at the measurement date. The three levels are defined as follows:\\nLevel 1 - Quoted prices in active markets for identical assets or liabilities;\\nLevel 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and\\nLevel 3 - Unobservable inputs in which little or no market activity exists, requiring an entity to develop its own assumptions that market participants would use to value the asset or liability.\\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.\\n10\\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of September 11, 2021 (in millions):\\n| Fair Value Measurements |\\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\\n| Assets: |\\n| Short-term investments (1) | $ | 14.7 | $ | 5.0 | $ | 9.7 | $ | — |\\n| Non-current investments (2) | 92.6 | 19.5 | 73.1 | — |\\n| Derivative contracts (3) | 10.0 | — | 10.0 | — |\\n| Total | $ | 117.3 | $ | 24.5 | $ | 92.8 | $ | — |\\n| Liabilities: |\\n| Derivative contracts (4) | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\\n| Total | $ | 26.3 | $ | — | $ | 26.3 | $ | — |\\n\\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\\n(3) Primarily relates to derivative contracts. Included in Other assets.\\n(4) Primarily relates to interest rate swaps. Included in Other current liabilities.\\nThe following table presents assets and liabilities which were measured at fair value on a recurring basis as of February 27, 2021 (in millions):\\n| Fair Value Measurements |\\n| Total | Quoted prices in active markets for identical assets(Level 1) | Significantobservableinputs(Level 2) | Significantunobservableinputs(Level 3) |\\n| Assets: |\\n| Short-term investments (1) | $ | 11.9 | $ | 4.4 | $ | 7.5 | $ | — |\\n| Non-current investments (2) | 110.2 | 40.3 | 69.9 | — |\\n| Total | $ | 122.1 | $ | 44.7 | $ | 77.4 | $ | — |\\n| Liabilities: |\\n| Derivative contracts (3) | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\\n| Total | $ | 40.0 | $ | — | $ | 40.0 | $ | — |\\n\\n(1) Primarily relates to Mutual Funds (Level 1) and Certificates of Deposit (Level 2). Included in Other current assets.\\n(2) Primarily relates to investments in publicly traded stock (Level 1) and U.S. Treasury Notes and Corporate Bonds (Level 2). Included in Other assets.\\n(3) Primarily relates to interest rate swaps. Included in Other current liabilities.\\nThe estimated fair value of the Company's debt, including current maturities, was based on Level 2 inputs, being market quotes or values for similar instruments, and interest rates currently available to the Company for the issuance of debt with similar terms and remaining maturities as a discount rate for the remaining principal payments. As of September 11, 2021, the fair value of total debt was $ 8,325.6 million compared to the carrying value of $ 7,815.0 million, excluding debt discounts and deferred financing costs. As of February 27, 2021, the fair value of total debt was $ 8,150.7 million compared to the carrying value of $ 7,815.5 million, excluding debt discounts and deferred financing costs.\\n11\\nAssets Measured at Fair Value on a Non-Recurring Basis\\nThe Company measures certain assets at fair value on a non-recurring basis, including long-lived assets and goodwill, which are evaluated for impairment. Long-lived assets include store-related assets such as property and equipment and certain intangible assets. The inputs used to determine the fair value of long-lived assets and a reporting unit are considered Level 3 measurements due to their subjective nature.\\nNOTE 3 - DERIVATIVE FINANCIAL INSTRUMENTS\\nThe aggregate notional amount of the Company's interest rate swaps as of September 11, 2021 and February 27, 2021, were $ 1,553.0 million and $ 1,653.0 million, respectively, of which none were designated as cash flow hedges as defined by GAAP.\\nActivity related to interest rate swaps consisted of the following (in millions):\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\\n| Loss on undesignated portion of interest rate swaps | $ | — | $ | ( 0.4 ) | Other income, net |\\n\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | Location of loss recognized from derivatives |\\n| Loss on undesignated portion of interest rate swaps | $ | ( 0.3 ) | $ | ( 19.4 ) | Other income, net |\\n\\nNOTE 4 - LONG-TERM DEBT AND FINANCE LEASE OBLIGATIONS\\nThe Company's long-term debt and finance lease obligations as of September 11, 2021 and February 27, 2021, net of unamortized debt discounts of $ 43.0 million and $ 44.8 million, respectively, and deferred financing costs of $ 63.6 million and $ 69.8 million, respectively, consisted of the following (in millions):\\n| September 11,2021 | February 27,2021 |\\n| Senior Unsecured Notes due 2023 to 2030, interest rate range of 3.25 % to 7.50 % | $ | 6,686.5 | $ | 6,680.5 |\\n| Safeway Inc. Notes due 2021 to 2031, interest rate range of 4.75 % to 7.45 % | 504.4 | 504.3 |\\n| New Albertsons L.P. Notes due 2026 to 2031, interest rate range of 6.52 % to 8.70 % | 470.9 | 469.1 |\\n| Other financing obligations | 29.2 | 29.4 |\\n| Mortgage notes payable, secured | 17.4 | 17.6 |\\n| Finance lease obligations | 632.2 | 612.7 |\\n| Total debt | 8,340.6 | 8,313.6 |\\n| Less current maturities | ( 211.5 ) | ( 212.4 ) |\\n| Long-term portion | $ | 8,129.1 | $ | 8,101.2 |\\n\\nSenior Unsecured Notes\\nOn October 1, 2021, subsequent to the end of the 12 weeks ended September 11, 2021, the Company provided notice to the holders and trustee, of its election to redeem all of the $ 200.0 million aggregate principal amount currently outstanding of the Company's 5.750 % Senior Unsecured Notes due 2025 (the \\\"2025 Notes\\\"). The 2025 Notes will be redeemed on November 1, 2021 (the \\\"Redemption Date\\\"), using cash on hand, at a redemption price of 101.438 % of the principal amount thereof plus accrued and unpaid interest on the 2025 Notes to, but excluding, the Redemption Date.\\n12\\nABL Facility\\nAs of September 11, 2021 and February 27, 2021, there were no amounts outstanding under the Company's asset-based loan facility (\\\"ABL Facility\\\"), and letters of credit (\\\"LOC\\\") issued under the LOC sub-facility were $ 323.8 million and $ 354.6 million, respectively.\\nNOTE 5 - EMPLOYEE BENEFIT PLANS\\nPension and Other Post-Retirement Benefits\\nThe following tables provide the components of net pension and post-retirement (income) expense (in millions):\\n| 12 weeks ended |\\n| Pension | Other post-retirement benefits |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Estimated return on plan assets | $ | ( 24.5 ) | $ | ( 23.7 ) | $ | — | $ | — |\\n| Service cost | 5.1 | 3.5 | — | — |\\n| Interest cost | 9.7 | 12.6 | 0.1 | 0.1 |\\n| Amortization of prior service cost | — | — | — | 0.4 |\\n| Amortization of net actuarial loss (gain) | 0.2 | 0.5 | ( 0.1 ) | ( 0.1 ) |\\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\\n| (Income) expense, net | $ | ( 23.8 ) | $ | ( 4.1 ) | $ | — | $ | 0.4 |\\n\\n| 28 weeks ended |\\n| Pension | Other post-retirement benefits |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Estimated return on plan assets | $ | ( 57.2 ) | $ | ( 55.2 ) | $ | — | $ | — |\\n| Service cost | 12.0 | 8.3 | — | — |\\n| Interest cost | 22.7 | 29.2 | 0.2 | 0.2 |\\n| Amortization of prior service cost | 0.1 | 0.1 | — | 1.0 |\\n| Amortization of net actuarial loss (gain) | 0.5 | 1.1 | ( 0.3 ) | ( 0.3 ) |\\n| Settlement (gain) loss | ( 14.3 ) | 3.0 | — | — |\\n| (Income) expense, net | $ | ( 36.2 ) | $ | ( 13.5 ) | $ | ( 0.1 ) | $ | 0.9 |\\n\\nThe Company contributed $ 9.2 million and $ 11.2 million to its defined pension plans and post-retirement benefit plans during the 12 and 28 weeks ended September 11, 2021, respectively. For the 12 and 28 weeks ended September 12, 2020, the Company contributed $ 1.7 million and $ 56.3 million, respectively. At the Company's discretion, additional funds may be contributed to the defined benefit pension plans that are determined to be beneficial to the Company. The Company currently anticipates contributing an additional $ 26.1 million to these plans for the remainder of fiscal 2021.\\nDuring the 12 and 28 weeks ended September 11, 2021, the Company purchased a group annuity policy and transferred $ 203.5 million of pension plan assets to an insurance company, thereby reducing the Company's defined benefit pension obligations by $ 205.4 million. As a result of the annuity purchase, the Company recorded a settlement gain of $ 11.1 million during the 12 and 28 weeks ended September 11, 2021.\\n13\\nDefined Contribution Plans and Supplemental Retirement Plans\\nTotal contributions expensed for defined contribution plans (401(k) plans) were $ 26.4 million and $ 16.3 million for the 12 weeks ended September 11, 2021 and September 12, 2020, respectively. For the 28 weeks ended September 11, 2021 and September 12, 2020, total contributions expensed were $ 42.6 million and $ 38.1 million, respectively.\\nMultiemployer Pension Plans\\nARP Act: The American Rescue Plan Act (\\\"ARP Act\\\") was signed into law on March 11, 2021. The ARP Act establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\\\"PBGC\\\") to pay pension benefits through the plan year ending 2051. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive the assistance. The Company is evaluating the interim final rule and has submitted comments during the 30-day comment period. The Company's evaluation includes any potential impact to the Company's Excess Plan as defined in and further described in \\\"Part II—Item 8. Financial Statements and Supplemental Data—Note 12\\\" of the Company's Annual Report on Form 10-K for the fiscal year ended February 27, 2021.\\nNOTE 6 - COMMITMENTS AND CONTINGENCIES AND OFF BALANCE SHEET ARRANGEMENTS\\nGuarantees\\nCalifornia Department of Industrial Relations: On January 21, 2014, the Company entered into a Collateral Substitution Agreement with the California Self-Insurers' Security Fund to provide collateral related to certain California self-insured workers' compensation obligations pursuant to applicable regulations. The collateral not covered by the California Self-Insurers' Security Fund is covered by surety bonds for the benefit of the State of California Office of Self-Insurance Plans. A portion of the surety bonds is covered by irrevocable LOCs. The collateral requirements are adjusted annually based on semi-annual filings of an actuarial study reflecting liabilities as of December 31 of each year reduced by claim closures and settlements. The related LOC was $ 22.6 million as of September 11, 2021 and $ 40.1 million as of February 27, 2021, respectively.\\nLease Guarantees: The Company may have liability under certain operating leases that were assigned to third parties. If any of these third parties fail to perform their obligations under the leases, the Company could be responsible for the lease obligation, including as a result of the economic dislocation caused by the response to the COVID-19 pandemic. Because of the wide dispersion among third parties and the variety of remedies available, the Company believes that if an assignee became insolvent, it would not have a material effect on the Company's financial condition, results of operations or cash flows.\\nThe Company also provides guarantees, indemnifications and assurances pursuant to contractual obligations in the ordinary course of its business.\\nLegal Proceedings\\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with\\n14\\nrespect to certain of the matters described herein cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition.\\nThe Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made provisions where the loss contingency is probable and can be reasonably estimated. Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties. Management currently believes that the aggregate range of reasonably possible loss for the Company's exposure in excess of the amount accrued is expected to be immaterial to the Company. It remains possible that despite management's current belief, material differences in actual outcomes or changes in management's evaluation or predictions could arise that could have a material effect on the Company's financial condition, results of operations or cash flows.\\nERISA Litigation: Two lawsuits were brought against Safeway Inc. (\\\"Safeway\\\") and the Safeway Benefits Plan Committee (the \\\"Benefit Plans Committee,\\\" and together with Safeway, the \\\"Safeway Benefits Plans Defendants\\\") and other third parties alleging breaches of fiduciary duty under the Employee Retirement Income Security Act of 1974, as amended (\\\"ERISA\\\") with respect to Safeway's 401(k) Plan (the \\\"Safeway 401(k) Plan\\\"). On July 14, 2016, a complaint was filed in the United States District Court for the Northern District of California by a participant in the Safeway 401(k) Plan individually and on behalf of the Safeway 401(k) Plan. An amended complaint was filed on November 18, 2016. On August 25, 2016, a second complaint was filed in the United States District Court for the Northern District of California by another participant in the Safeway 401(k) Plan individually and on behalf of all others similarly situated against the Safeway Benefits Plans Defendants and against the Safeway 401(k) Plan's former record-keepers. An amended complaint was filed on September 16, 2016, and a second amended complaint was filed on November 21, 2016. In general, both lawsuits alleged that the Safeway Benefits Plans Defendants breached their fiduciary duties under ERISA regarding the selection of investments offered under the Safeway 401(k) Plan and the fees and expenses related to those investments. All parties filed summary judgment motions which were heard and taken under submission on August 16, 2018. Plaintiffs' motions were denied, and defendants' motions were granted in part and denied in part. Bench trials for both matters were set for May 6, 2019. A settlement in principle was reached before trial. On September 13, 2019, settlement papers were filed with the Court along with a motion for preliminary approval of the settlement. A hearing for preliminary approval was set for November 20, 2019, but the Court vacated the hearing. The Court issued an order on March 30, 2020 requesting some minor changes to the notice procedures, and plaintiffs submitted an amended motion for preliminary approval. On September 8, 2020, the Court granted plaintiffs' amended motion, and a final approval hearing was held on April 26, 2021, at which time the Court took the matter under submission. On July 19, 2021, the Court issued a final order approving the settlement. In August 2021, a settlement fund was established with funds from insurers. A settlement administrator is now managing the calculation and payment of settlement provisions to class members.\\nFalse Claims Act: The Company has received a civil investigative demand dated February 28, 2020 from the United States Attorney for the Southern District of New York in connection with a False Claims Act (\\\"FCA\\\") investigation relating to the Company's dispensing practices regarding insulin pen products. The investigation seeks documents regarding the Company's policies, practices and procedures, as well as dispensing data, among other things. The Company has cooperated with the U.S. Attorney in the investigation. The Company is currently unable to determine the probability of the outcome of this matter or the range of possible loss, if any.\\nTwo qui tam actions alleging violations of the FCA have also been filed against the Company and its subsidiaries. Violations of the FCA are subject to treble damages and penalties of up to a specified dollar amount per false claim.\\nIn United States ex rel. Proctor v. Safeway, filed in the United States District Court for the Central District of Illinois, the relator alleges that Safeway overcharged federal government healthcare programs by not providing the federal government, as part of its usual and customary prices, the benefit of discounts given to customers in pharmacy membership discount and price-matching programs. The relator filed his complaint under seal on November 11, 2011, and the complaint was unsealed on August 26, 2015. The relator amended the complaint on\\n15\\nMarch 31, 2016. On June 12, 2020, the Court granted Safeway's motion for summary judgment, holding that the relator could not prove that Safeway acted with the intent required under the FCA, and judgment was issued on June 15, 2020. On July 10, 2020, the relator filed a motion to alter or amend the judgment and to supplement the record, which Safeway opposed. On November 13, 2020, the Court denied relator's motion, and on December 11, 2020, relator filed a notice of appeal. The appeal is now pending in the Seventh Circuit Court of Appeals. Oral argument took place September 9, 2021.\\nIn United States ex rel. Schutte and Yarberry v. SuperValu, New Albertson's, Inc., et al., also filed in the Central District of Illinois, the relators allege that defendants (including various subsidiaries of the Company) overcharged federal government healthcare programs by not providing the federal government, as a part of usual and customary prices, the benefit of discounts given to customers who requested that defendants match competitor prices. The complaint was originally filed under seal and amended on November 30, 2015. On August 5, 2019, the Court granted relators' motion for partial summary judgment, holding that price-matched prices are the usual and customary prices for those drugs. On July 1, 2020, the Court granted the defendants' motions for summary judgment and dismissed the case, holding that the relator could not prove that defendants acted with the intent required under the FCA. Judgment was issued on July 2, 2020. On July 9, 2020, the relators filed a notice of appeal. Oral argument was held on January 19, 2021. On August 12, 2021, the Court of Appeals for the Seventh Circuit affirmed the grant of summary judgment in the Company's favor. On September 23, 2021, the relators filed a petition for rehearing en banc with the Seventh Circuit. The Company's response to the petition for rehearing is due by November 9, 2021.\\nIn both of the above cases, the federal government previously investigated the relators' allegations and declined to intervene. The relators elected to pursue their respective cases on their own and in each case have alleged FCA damages in excess of $ 100 million before trebling and excluding penalties. The Company is vigorously defending each of these matters and believes each of these cases is without merit. The Company has recorded an estimated liability for these matters.\\nOpioid Litigation: The Company is one of dozens of companies that have been named in various lawsuits alleging that defendants contributed to the national opioid epidemic. At present, the Company is named in over 80 suits pending in various state courts as well as in the United States District Court for the Northern District of Ohio, where over 2,000 cases have been consolidated as Multi-District Litigation (\\\"MDL\\\") pursuant to 28 U.S.C. §1407. Most of these cases have been stayed pending bellwether trials. At present, the most active case is a matter in New Mexico state court where we have been in active discovery and where a September 2022 trial date has been set. The MDL Court and a state court in Utah are currently considering position statements from the parties in connection with scheduling bellwether trials and it is likely that the Company may be included in one or more of those anticipated bellwether trials. The Company is vigorously defending these matters and believes that these cases are without merit. At this stage in the proceedings, the Company is unable to determine the probability of the outcome of these matters or the range of reasonably possible loss, if any.\\nCalifornia Air Resources Board: Upon the inspection by the California Air Resources Board (\\\"CARB\\\") of several of the Company's stores in California, it was determined that the Company failed certain paperwork and other administrative requirements. As a result of the inspections, the Company proactively undertook a broad evaluation of the record keeping and administrative practices at all of its stores in California. In connection with this evaluation, the Company retained a third party to conduct an audit and correct deficiencies identified across its California store base. The Company is working with CARB to resolve these compliance issues and comply with governing regulations, and that work is ongoing. CARB has made an opening demand regarding potential fines and penalties. On July 7, 2021, the parties entered into a settlement agreement for which the Company has recorded an estimated liability.\\nFACTA: On May 31, 2019, a putative class action complaint entitled Martin v. Safeway was filed in the California Superior Court for the County of Alameda, alleging the Company failed to comply with the Fair and Accurate Credit Transactions Act (\\\"FACTA\\\") by printing receipts that failed to adequately mask payment card numbers as\\n16\\nrequired by FACTA. The plaintiff claims the violation was \\\"willful\\\" and exposes the Company to statutory damages provided for in FACTA. The Company has answered the complaint and is vigorously defending the matter. On January 8, 2020, the Company commenced mediation discussions with plaintiff's counsel and reached a settlement in principle on February 24, 2020. The parties will seek court approval of the settlement. The Company has recorded an estimated liability for this matter.\\nOther Commitments\\nIn the ordinary course of business, the Company enters into various supply contracts to purchase products for resale and purchase and service contracts for fixed asset and information technology commitments. These contracts typically include volume commitments or fixed expiration dates, termination provisions and other standard contractual considerations.\\nNOTE 7 - OTHER COMPREHENSIVE INCOME OR LOSS\\nTotal comprehensive earnings are defined as all changes in stockholders' equity during a period, other than those from investments by or distributions to the stockholders. Generally, for the Company, total comprehensive income or loss equals net income plus or minus adjustments for pension and other post-retirement liabilities. Total comprehensive earnings represent the activity for a period net of tax.\\nWhile total comprehensive earnings are the activity in a period and are largely driven by net earnings in that period, accumulated other comprehensive income or loss (\\\"AOCI\\\") represents the cumulative balance of other comprehensive income, net of tax, as of the balance sheet date. Changes in the AOCI balance by component are shown below (in millions):\\n| 28 weeks ended September 11, 2021 |\\n| Total | Pension and Post-retirement benefit plans | Other |\\n| Beginning balance | $ | 63.5 | $ | 61.3 | $ | 2.2 |\\n| Other comprehensive income before reclassifications | 34.3 | 34.3 | — |\\n| Amounts reclassified from accumulated other comprehensive income | ( 14.0 ) | ( 14.0 ) | — |\\n| Tax expense | ( 5.1 ) | ( 5.1 ) | — |\\n| Current-period other comprehensive income, net of tax | 15.2 | 15.2 | — |\\n| Ending balance | $ | 78.7 | $ | 76.5 | $ | 2.2 |\\n\\n| 28 weeks ended September 12, 2020 |\\n| Total | Pension and Post-retirement benefit plans | Other |\\n| Beginning balance | $ | ( 118.5 ) | $ | ( 121.7 ) | $ | 3.2 |\\n| Other comprehensive income before reclassifications | 11.1 | 9.6 | 1.5 |\\n| Amounts reclassified from accumulated other comprehensive income | 4.9 | 4.9 | — |\\n| Tax expense | ( 3.9 ) | ( 3.6 ) | ( 0.3 ) |\\n| Current-period other comprehensive income, net of tax | 12.1 | 10.9 | 1.2 |\\n| Ending balance | $ | ( 106.4 ) | $ | ( 110.8 ) | $ | 4.4 |\\n\\n17\\nNOTE 8 - NET INCOME PER CLASS A COMMON SHARE\\nThe Company calculates basic and diluted net income per Class A common share using the two-class method. The two-class method is an allocation formula that determines net income per Class A common share for each share of Class A common stock and the Company's Series A-1 convertible preferred stock (\\\"Series A-1 preferred stock\\\") and Series A convertible preferred stock (\\\"Series A preferred stock\\\" and together with the Series A-1 preferred stock, the \\\"Convertible Preferred Stock\\\"), a participating security, according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings (distributed and undistributed) are allocated to Class A common shares and Convertible Preferred Stock based on their respective rights to receive dividends. The holders of Convertible Preferred Stock participate in cash dividends that the Company pays on its common stock to the extent that such cash dividends exceed $ 206.25 million per fiscal year. In applying the two-class method to interim periods, the Company allocates income to its quarterly periods independently and discretely from its year-to-date and annual periods. Basic net income per Class A common share is computed by dividing net income allocated to Class A common stockholders by the weighted average number of Class A common shares outstanding for the period, including Class A common shares to be issued with no prior remaining contingencies prior to issuance. Diluted net income per Class A common share is computed based on the weighted average number of shares of Class A common stock outstanding during each period, plus potential Class A common shares considered outstanding during the period, as long as the inclusion of such awards is not antidilutive. Potential Class A common shares consist of unvested RSUs and RSAs and Convertible Preferred Stock, using the more dilutive of either the two-class method or as-converted stock method. Performance-based RSUs are considered dilutive when the related performance criterion has been met.\\n18\\nThe components of basic and diluted net income per Class A common share were as follows (in millions, except per share data):\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Basic net income per Class A common share |\\n| Net income | $ | 295.2 | $ | 284.5 | $ | 740.0 | $ | 870.7 |\\n| Accrued dividends on Convertible Preferred Stock | ( 27.3 ) | ( 26.9 ) | ( 63.7 ) | ( 30.8 ) |\\n| Earnings allocated to Convertible Preferred Stock | ( 11.0 ) | ( 9.0 ) | ( 84.2 ) | ( 9.0 ) |\\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 | $ | 1.27 | $ | 1.57 |\\n| Diluted net income per Class A common share |\\n| Net income allocated to Class A common stockholders - Basic | $ | 256.9 | $ | 248.6 | $ | 592.1 | $ | 830.9 |\\n| Accrued dividends on Convertible Preferred Stock | 27.3 | 26.9 | — | 30.8 |\\n| Earnings allocated to Convertible Preferred Stock | 11.0 | 9.0 | — | 9.0 |\\n| Net income allocated to Class A common stockholders - Diluted | $ | 295.2 | $ | 284.5 | $ | 592.1 | $ | 870.7 |\\n| Weighted average Class A common shares outstanding - Basic (1) | 465.3 | 477.3 | 465.2 | 529.2 |\\n| Dilutive effect of: |\\n| Restricted stock units and awards | 6.1 | 4.0 | 5.4 | 4.3 |\\n| Convertible Preferred Stock (2) | 101.6 | 101.6 | — | 49.8 |\\n| Weighted average Class A common shares outstanding - Diluted (3) | 573.0 | 582.9 | 470.6 | 583.3 |\\n| Diluted net income per Class A common share | $ | 0.52 | $ | 0.49 | $ | 1.26 | $ | 1.49 |\\n\\n(1) There were 0.3 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 11, 2021 compared to 0.4 million Class A common shares remaining to be issued for the 12 and 28 weeks ended September 12, 2020.\\n(2) Reflects the number of shares of Convertible Preferred Stock issued, if converted into common stock for the period outstanding. For the 28 weeks ended September 11, 2021, 101.6 million potential common shares outstanding related to Convertible Preferred Stock were antidilutive.\\n(3) There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 11, 2021. There were no potential Class A common shares outstanding related to RSUs and RSAs that were antidilutive for the 12 and 28 weeks ended September 12, 2020.\\n19\\nItem 2\\n-\\nManagement's Discussion and Analysis of Financial Condition and Results of Operations\\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\\nThis Form 10-Q contains \\\"forward-looking statements\\\" within the meaning of the federal securities laws. The \\\"forward-looking statements\\\" include our current expectations, assumptions, estimates and projections about our business and our industry. They include statements relating to our future operating or financial performance which the Company believes to be reasonable at this time. You can identify forward-looking statements by the use of words such as \\\"outlook,\\\" \\\"may,\\\" \\\"should,\\\" \\\"could,\\\" \\\"estimates,\\\" \\\"predicts,\\\" \\\"potential,\\\" \\\"continue,\\\" \\\"anticipates,\\\" \\\"believes,\\\" \\\"plans,\\\" \\\"expects,\\\" \\\"future\\\" and \\\"intends\\\" and similar expressions which are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control and difficult to predict, including, among others, changes in macroeconomic conditions, the retail consumer behavior and environment and the Company's industry, failure to achieve productivity initiatives, increased rates of food price inflation and factors related to the continued impact of the COVID-19 pandemic, about which there are still many unknowns, including its duration, recurrence, new virus strains, status and effectiveness of vaccinations, duration and scope of related government orders, financial assistance programs, mandates and regulations and the extent of the overall impact to our business and the communities we serve. Such risks and uncertainties could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. In evaluating forward-looking statements, you should carefully consider the risks and uncertainties more fully described in the \\\"Risk Factors\\\" section or other sections in our reports filed with the SEC including the most recent annual report on Form 10-K and any subsequent periodic reports on Form 10-Q and current reports on Form 8-K. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements and risk factors. Forward-looking statements contained in this Form 10-Q reflect our view only as of the date of this Form 10-Q. We undertake no obligation, other than as required by law, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.\\nAs used in this Form 10-Q, unless the context otherwise requires, references to \\\"Albertsons,\\\" the \\\"Company,\\\" \\\"we,\\\" \\\"us\\\" and \\\"our\\\" refer to Albertsons Companies, Inc. and, where appropriate, its subsidiaries.\\nNON-GAAP FINANCIAL MEASURES\\nWe define EBITDA as generally accepted accounting principles (\\\"GAAP\\\") earnings (net loss) before interest, income taxes, depreciation and amortization. We define Adjusted EBITDA as earnings (net loss) before interest, income taxes, depreciation and amortization, further adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income as GAAP Net income adjusted to eliminate the effects of items management does not consider in assessing our ongoing core performance. We define Adjusted net income per Class A common share as Adjusted net income divided by the weighted average diluted Class A common shares outstanding, as adjusted to reflect all restricted stock units (\\\"RSUs\\\") and restricted common stock (\\\"RSAs\\\") outstanding at the end of the period. We define Net Debt as total debt (which includes finance lease obligations and is net of deferred financing costs and original issue discount) minus unrestricted cash and cash equivalents and we define Net Debt Ratio as the ratio of Net Debt to Adjusted EBITDA for the rolling 52 or 53 week period. See \\\"Results of Operations\\\" for further discussion and a reconciliation of Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share.\\nEBITDA, Adjusted EBITDA, Adjusted net income and Adjusted net income per Class A common share (collectively, the \\\"Non-GAAP Measures\\\") are performance measures that provide supplemental information we believe is useful to analysts and investors to evaluate our ongoing results of operations, when considered alongside other GAAP measures such as Net income, operating income and gross profit. These Non-GAAP Measures exclude\\n20\\nthe financial impact of items management does not consider in assessing our ongoing core operating performance, and thereby provide useful measures to analysts and investors of our operating performance on a period-to-period basis. Other companies may have different definitions of Non-GAAP Measures and provide for different adjustments, and comparability to our results of operations may be impacted by such differences. We also use Adjusted EBITDA and Net Debt Ratio for board of director and bank compliance reporting. Our presentation of Non-GAAP Measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.\\nNon-GAAP Measures should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using Non-GAAP Measures only for supplemental purposes.\\n21\\nSECOND QUARTER OF FISCAL 2021 OVERVIEW\\nGiven the significant variations that occurred in our business during fiscal 2020 due to the COVID-19 pandemic, we provide a supplemental comparison of the 12 and 28 weeks ended September 11, 2021 (\\\"second quarter of fiscal 2021\\\" and \\\"first 28 weeks of fiscal 2021\\\") to the 12 and 28 weeks ended September 7, 2019 (\\\"second quarter of fiscal 2019\\\" and \\\"first 28 weeks of fiscal 2019\\\") for certain financial measures to demonstrate the two-year growth in our business in addition to comparisons to the 12 and 28 weeks ended September 12, 2020 (\\\"second quarter of fiscal 2020\\\" and \\\"first 28 weeks of fiscal 2020\\\").\\nAs of September 11, 2021, we operated 2,278 retail food and drug stores with 1,725 pharmacies, 401 associated fuel centers, 22 dedicated distribution centers and 20 manufacturing facilities. With a strong consumer environment, we continue to make significant progress against all of our strategic priorities, including in-store excellence, accelerating our digital and omni-channel capabilities, increasing productivity and strengthening our talent and culture. Identical sales increased 1.5%, excluding fuel, during the second quarter of fiscal 2021, resulting in two-year stacked identical sales growth of 15.3%. We continue to gain market share in food market, and in Multi Outlet (\\\"MULO\\\") we are up on a two-year basis and down marginally on a one-year basis. Food market generally includes traditional supermarkets while MULO includes most food market, drug, mass merchants, club, dollar and military stores that sell food.\\nUnderscoring our strong omni-channel capabilities that allow customers to complete their shopping with us in any way they want, our digital initiatives continue to resonate with our customers, as evidenced by our sustained sales levels in the second quarter of fiscal 2021, digital sales increasing 5% compared to the second quarter of fiscal 2020 and a two-year stacked growth of 248%. During the second quarter of fiscal 2021, we expanded our Drive Up & Go curbside pickup service to approximately 1,900 locations and offer delivery services across more than 2,000 of our stores. In our delivery service, we have expanded first party locations, and continue to work with third party services to engage with customers on the platform of their choice. In addition to our continuing partnership with Instacart, we have expanded our partnership with DoorDash to offer on-demand grocery delivery service where customers can receive a broad assortment in under one hour. We also recently launched a similar partnership with Uber, where customers can order a full assortment of groceries on the Uber platform.\\nWith ongoing benefit enhancements, we continue to achieve significant success with our just for U loyalty program, which drives higher sales and customer retention, with membership growing 17% in the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020, reaching 27.5 million members. Within the program, the number of actively engaged members, those that redeemed fuel or grocery rewards during the second quarter of fiscal 2021, increased by almost 9% compared to the second quarter of fiscal 2020, and our retention rate of actively engaged members was 93% in the second quarter of fiscal 2021.\\nDuring the second quarter of fiscal 2021 we continued to roll out our Own Brands across all our banners, launching 85 new products and generating strong growth as our sales penetration increased by 60 basis points to 25.2% compared to the second quarter of fiscal 2020. We also continue to make significant progress on productivity initiatives, including promotional effectiveness, purchasing and procurement, labor efficiency and shrink.\\nOur capital allocation strategy balances investing for the future, strengthening our balance sheet and returns to shareholders through a combination of dividends and opportunistic share repurchases. Capital expenditures were approximately $823 million during the first 28 weeks of fiscal 2021 as we opened seven new stores and completed 76 upgrades and remodels. Our balance sheet remains strong with a Net Debt Ratio of 1.3x as of the end of the second quarter of fiscal 2021. Capital returns to shareholders during the first 28 weeks of fiscal 2021 included our $0.10 per share quarterly dividend. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock.\\n22\\nIn addition, we have continued to partner with the Department of Health and Human Services and local health authorities to administer COVID-19 vaccines to our local communities and, as of October 12, 2021, have administered approximately 7.5 million doses.\\nSecond quarter of fiscal 2021 highlights\\nIn summary, our financial and operating highlights for the second quarter of fiscal 2021 include:\\n•Identical sales increase of 1.5%; two-year identical sales stacked growth was 15.3%\\n•Digital sales increased 5%; on a two-year stacked basis digital sales growth was 248%\\n•Net income of $295 million, or $0.52 per Class A common share\\n•Adjusted net income of $370 million, or $0.64 per Class A common share\\n•Adjusted EBITDA of $965 million\\n•Opened one new store and completed 43 remodel projects\\n•Launched 153 new Drive Up & Go locations\\nStores\\nThe following table shows stores operating, acquired, opened and closed during the periods presented:\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Stores, beginning of period | 2,278 | 2,252 | 2,277 | 2,252 |\\n| Acquired (1) | — | — | 1 | — |\\n| Opened | 1 | 2 | 6 | 2 |\\n| Closed | (1) | (2) | (6) | (2) |\\n| Stores, end of period | 2,278 | 2,252 | 2,278 | 2,252 |\\n\\n(1) The 28 weeks ended September 11, 2021 includes one store acquired from Kings and Balducci's that transferred to us subsequent to the end of the fourth quarter of fiscal 2020.\\nThe following table summarizes our stores by size:\\n| Number of stores | Percent of Total | Retail Square Feet (1) |\\n| Square Footage | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Less than 30,000 | 223 | 204 | 9.8 | % | 9.1 | % | 5.1 | 4.7 |\\n| 30,000 to 50,000 | 786 | 781 | 34.5 | % | 34.6 | % | 32.9 | 32.8 |\\n| More than 50,000 | 1,269 | 1,267 | 55.7 | % | 56.3 | % | 75.0 | 74.8 |\\n| Total Stores | 2,278 | 2,252 | 100.0 | % | 100.0 | % | 113.0 | 112.3 |\\n\\n(1) In millions, reflects total square footage of retail stores operating at the end of the period.\\n23\\nRESULTS OF OPERATIONS\\nComparison of Second Quarter of Fiscal 2021 and First 28 Weeks of Fiscal 2021 to Second Quarter of Fiscal 2020 and First 28 Weeks of Fiscal 2020:\\nThe following tables and related discussion set forth certain information and comparisons regarding the components of our Condensed Consolidated Statements of Operations for the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021 to the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020 (in millions, except per share data).\\n| 12 weeks ended |\\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\\n| Net sales and other revenue | $ | 16,505.7 | 100.0 | % | $ | 15,757.6 | 100.0 | % |\\n| Cost of sales | 11,788.7 | 71.4 | 11,182.7 | 71.0 |\\n| Gross profit | 4,717.0 | 28.6 | 4,574.9 | 29.0 |\\n| Selling and administrative expenses | 4,231.3 | 25.6 | 4,031.2 | 25.6 |\\n| Gain on property dispositions and impairment losses, net | (0.2) | — | (18.3) | (0.1) |\\n| Operating income | 485.9 | 3.0 | 562.0 | 3.5 |\\n| Interest expense, net | 109.3 | 0.7 | 128.6 | 0.8 |\\n| Loss on debt extinguishment | — | — | 49.1 | 0.3 |\\n| Other income, net | (18.9) | (0.1) | (11.4) | (0.1) |\\n| Income before income taxes | 395.5 | 2.4 | 395.7 | 2.5 |\\n| Income tax expense | 100.3 | 0.6 | 111.2 | 0.7 |\\n| Net income | $ | 295.2 | 1.8 | % | $ | 284.5 | 1.8 | % |\\n| Basic net income per Class A common share | $ | 0.55 | $ | 0.52 |\\n| Diluted net income per Class A common share | 0.52 | 0.49 |\\n| 28 weeks ended |\\n| September 11,2021 | % of Sales | September 12,2020 | % of Sales |\\n| Net sales and other revenue | $ | 37,775.1 | 100.0 | % | $ | 38,509.2 | 100.0 | % |\\n| Cost of sales | 26,867.1 | 71.1 | 27,162.8 | 70.5 |\\n| Gross profit | 10,908.0 | 28.9 | 11,346.4 | 29.5 |\\n| Selling and administrative expenses | 9,734.9 | 25.8 | 9,800.6 | 25.5 |\\n| Loss on property dispositions and impairment losses, net | 0.1 | — | 12.0 | — |\\n| Operating income | 1,173.0 | 3.1 | 1,533.8 | 4.0 |\\n| Interest expense, net | 262.6 | 0.7 | 309.2 | 0.8 |\\n| Loss on debt extinguishment | — | — | 49.1 | 0.1 |\\n| Other income, net | (62.4) | (0.2) | (8.3) | — |\\n| Income before income taxes | 972.8 | 2.6 | 1,183.8 | 3.1 |\\n| Income tax expense | 232.8 | 0.6 | 313.1 | 0.8 |\\n| Net income | $ | 740.0 | 2.0 | % | $ | 870.7 | 2.3 | % |\\n| Basic net income per Class A common share | $ | 1.27 | $ | 1.57 |\\n| Diluted net income per Class A common share | 1.26 | 1.49 |\\n\\nNet Sales and Other Revenue\\nNet sales and other revenue increased 4.7% to $16,505.7 million for the second quarter of fiscal 2021 from $15,757.6 million for the second quarter of fiscal 2020. The increase in Net sales and other revenue was primarily driven by our 1.5% increase in identical sales, which includes an increase in pharmacy sales, partially from\\n24\\nadministering COVID-19 vaccines, an increase in sales related to the stores acquired and opened since the second quarter of fiscal 2020 and higher fuel sales.\\nNet sales and other revenue decreased 1.9% to $37,775.1 million for the first 28 weeks of fiscal 2021 from $38,509.2 million for the first 28 weeks of fiscal 2020. The decrease in Net sales and other revenue was primarily driven by our 5.3% decrease in identical sales, which was partially offset by an increase in pharmacy sales, primarily from administering COVID-19 vaccines, and an increase in sales related to the stores opened since the first 28 weeks of fiscal 2020 and higher fuel sales.\\nIdentical Sales, Excluding Fuel\\nIdentical sales include stores operating during the same period in both the current year and the prior year, comparing sales on a daily basis. Direct to consumer digital sales are included in identical sales, and fuel sales are excluded from identical sales. Acquired stores become identical on the one-year anniversary date of the acquisition. Identical sales for the 12 and 28 weeks ended September 11, 2021 and the 12 and 28 weeks ended September 12, 2020, respectively, were:\\n| 12 weeks ended | 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 11,2021 | September 12,2020 |\\n| Identical sales, excluding fuel | 1.5% | 13.8% | (5.3)% | 21.0% |\\n\\nGross Profit\\nGross profit represents the portion of Net sales and other revenue remaining after deducting Cost of sales during the period, including purchase and distribution costs. These costs include, among other things, purchasing and sourcing costs, inbound freight costs, product quality testing costs, warehouse and distribution costs, Own Brands program costs and digital-related delivery and handling costs. Advertising, promotional expenses and vendor allowances are also components of Cost of sales.\\nGross profit margin decreased to 28.6% during the second quarter of fiscal 2021 compared to 29.0% during the second quarter of fiscal 2020. Excluding the impact of fuel, gross profit margin was flat compared to the second quarter of fiscal 2020, primarily due to higher product, supply chain and advertising costs, offset by benefits related to productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines.\\nGross profit margin decreased to 28.9% during the first 28 weeks of fiscal 2021 compared to 29.5% during the first 28 weeks of fiscal 2020. Excluding the impact of fuel, gross profit margin increased five basis points compared to the first 28 weeks of fiscal 2020. The increase in gross profit margin was primarily driven by productivity initiatives, favorable product mix and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by sales deleverage and higher product and supply chain costs.\\nSelling and Administrative Expenses\\nSelling and administrative expenses consist primarily of store level costs, including wages, employee benefits, rent, depreciation and utilities, in addition to certain back-office expenses related to our corporate and division offices.\\nSelling and administrative expenses were 25.6% of Net sales and other revenue during the second quarter of fiscal 2021 and the second quarter of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 55 basis points during the second quarter of fiscal 2021 compared to the second quarter of fiscal 2020. The increase in Selling and administrative expenses as a percentage\\n25\\nof Net sales and other revenue was primarily attributable to employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\\nSelling and administrative expenses increased to 25.8% of Net sales and other revenue during the first 28 weeks of fiscal 2021 compared to 25.5% of Net sales and other revenue for the first 28 weeks of fiscal 2020. Excluding the impact of fuel, Selling and administrative expenses as a percentage of Net sales and other revenue increased 90 basis points during the first 28 weeks of fiscal 2021 compared to the first 28 weeks of fiscal 2020. The increase in Selling and administrative expenses as a percentage of Net sales and other revenue was primarily attributable to sales deleverage, together with higher employee costs, depreciation and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities. The increase in employee costs was the result of additional labor related to reopening of fresh departments, market-driven retail wage rate increases and higher equity-based compensation expense. These increases were partially offset by lower COVID-19 related costs and execution of productivity initiatives.\\n(Gain) Loss on Property Dispositions and Impairment Losses, Net\\nFor the second quarter of fiscal 2021, net gain on property dispositions and impairment losses was $0.2 million, primarily driven by $6.2 million of gains from the sale of assets, partially offset by $6.0 million of intangible asset impairment. For the second quarter of fiscal 2020, net gain on property dispositions and impairment losses was $18.3 million, primarily driven by $20.0 million of gains from the sale of assets, partially offset by $1.7 million of asset impairments.\\nFor the first 28 weeks of fiscal 2021, net loss on property dispositions and impairment losses was $0.1 million, primarily driven by $15.9 million of asset impairments, primarily related to right-of-use assets and intangible assets, partially offset by $15.8 million of gains from the sale of assets. For the first 28 weeks of fiscal 2020, net loss on property dispositions and impairment losses was $12.0 million, primarily driven by $22.8 million of asset impairments, primarily related to right-of-use assets, partially offset by $10.8 million of gains from the sale of assets.\\nInterest Expense, Net\\nInterest expense, net was $109.3 million during the second quarter of fiscal 2021 compared to $128.6 million during the second quarter of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during the second quarter of fiscal 2021 was 5.4%, excluding deferred financing costs and original issue discount, compared to 6.0% during the second quarter of fiscal 2020.\\nInterest expense, net was $262.6 million during the first 28 weeks of fiscal 2021 compared to $309.2 million during the first 28 weeks of fiscal 2020. The decrease in interest expense was primarily attributable to lower average outstanding borrowings and lower average interest rates. The weighted average interest rate during first 28 weeks of fiscal 2021 was 5.5%, excluding deferred financing costs and original issue discount, compared to 6.0% during the first 28 weeks of fiscal 2020.\\n26\\nLoss of Debt Extinguishment\\nThere was no loss on debt extinguishment during both the second quarter of fiscal 2021 and first 28 weeks of fiscal 2021, compared to loss on debt extinguishment of $49.1 million during both the second quarter of fiscal 2020 and first 28 weeks of fiscal 2020. The loss on debt extinguishment during the second quarter and first 28 weeks of fiscal 2020 primarily consisted of a redemption premium payment and write-off of debt discounts associated with the redemption of the Company's 6.625% Senior Unsecured Notes due 2024 (the \\\"2024 Notes\\\").\\nOther Income, Net\\nFor the second quarter of fiscal 2021, Other income, net was $18.9 million compared to $11.4 million for the second quarter of fiscal 2020. Other income, net during the second quarter of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the second quarter of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment.\\nFor the first 28 weeks of fiscal 2021, Other income, net was $62.4 million compared to $8.3 million for the first 28 weeks of fiscal 2020. Other income, net during the first 28 weeks of fiscal 2021 was primarily driven by non-service cost components of net pension and post-retirement expense, realized gains from non-operating investments and income related to our equity investment, partially offset by unrealized losses from non-operating investments. Other income, net during the first 28 weeks of fiscal 2020 was primarily driven by non-service cost components of net pension and post-retirement expense and income related to our equity investment, partially offset by recognized losses on interest rate swaps and unrealized losses from non-operating investments.\\nIncome Taxes\\nIncome tax expense was $100.3 million, representing a 25.4% effective tax rate, for the second quarter of fiscal 2021. Income tax expense was $111.2 million, representing a 28.1% effective tax rate, for the second quarter of fiscal 2020. The decrease in the effective tax rate was primarily driven by nondeductible transaction-related costs incurred during the second quarter of fiscal 2020.\\nIncome tax expense was $232.8 million, representing a 23.9% effective tax rate, for the first 28 weeks of fiscal 2021. Income tax expense was $313.1 million, representing a 26.4% effective tax rate, for the first 28 weeks of fiscal 2020. The decrease in the effective income tax rate was primarily driven by the recognition of discrete state income tax benefits during the first 28 weeks of fiscal 2021 and certain nondeductible transaction-related costs incurred during the first 28 weeks of fiscal 2020.\\nWe currently expect our annual effective tax rate for fiscal 2021 to be in the range of approximately 23% to 24%.\\nNet Income and Adjusted Net Income\\nNet income was $295.2 million, or $0.52 per Class A common share, during the second quarter of fiscal 2021 compared to $284.5 million, or $0.49 per Class A common share, during the second quarter of fiscal 2020. Adjusted net income was $369.5 million, or $0.64 per Class A common share, during the second quarter of fiscal 2021 compared to $356.4 million, or $0.60 per Class A common share, during the second quarter of fiscal 2020.\\nNet income was $740.0 million, or $1.26 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $870.7, or $1.49 per Class A common share, during the first 28 weeks of fiscal 2020. Adjusted net income was $887.0 million, or $1.53 per Class A common share, during the first 28 weeks of fiscal 2021 compared to $1,157.6 million, or $1.95 per Class A common share, during the first 28 weeks of fiscal 2020.\\n27\\nAdjusted EBITDA\\nFor the second quarter of fiscal 2021, Adjusted EBITDA was $965.4 million, or 5.8% of Net sales and other revenue, compared to $948.4 million, or 6.0% of Net sales and other revenue, for the second quarter of fiscal 2020. The increase in Adjusted EBITDA was primarily the result of an increase in Net sales and other revenue, partially offset by an increase in Selling and administrative expenses. For the first 28 weeks of fiscal 2021, Adjusted EBITDA was $2,273.5 million, or 6.0% of Net sales and other revenue, compared to $2,639.4 million, or 6.9% of Net sales and other revenue for the first 28 weeks of fiscal 2020. The decrease in Adjusted EBITDA was primarily the result of a decrease in Net sales and other revenue.\\nSupplemental Two-Year Results - Comparison of Second Quarter of Fiscal 2021 to Second Quarter of Fiscal 2019\\nThe following table provides a comparison of the second quarter of fiscal 2021 to the second quarter of fiscal 2019 for certain financial measures, including a compounded annual growth rate (\\\"CAGR\\\"), to demonstrate the two-year growth in our business. We believe these supplemental comparisons provide meaningful and useful information to investors about the trends in our business relative to pre-COVID-19 pandemic periods. These comparisons should not be reviewed in isolation or considered substitutes for our financial results included elsewhere in this Form 10-Q.\\n| Second Quarter of Fiscal 2021 Supplemental Two-Year Results |\\n| Identical sales two-year stacked (1) | 15.3 | % |\\n| Net income per Class A common share two-year CAGR (2) | 1.0 | % |\\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\\n| Net income two-year CAGR (2) | 0.1 | % |\\n| Adjusted net income two-year CAGR | 93.0 | % |\\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\\n| Margins: |\\n| Gross profit (1) | Increased 85 basis points |\\n| Selling and administrative expenses (1) | Decreased 120 basis points |\\n\\n(1) Excluding fuel.\\n(2) The net income per Class A common share two-year CAGR and net income two-year CAGR are impacted by gains related to sale leaseback transactions in the second quarter of fiscal 2019.\\nNet sales and other revenue was $16.5 billion during the second quarter of fiscal 2021 compared to $14.2 billion during the second quarter of fiscal 2019. The increase in sales compared to the second quarter of fiscal 2019 was primarily due to the 15.3% increase in two-year stacked identical sales. Identical sales were driven in part by the 248% two-year stacked increase in digital sales.\\nGross profit margin was 28.6% during the second quarter of fiscal 2021 compared to 27.8% during the second quarter of fiscal 2019. Excluding the impact of fuel, gross profit margin increased by approximately 85 basis points compared to the second quarter of fiscal 2019, primarily driven by sales leverage, improvements in shrink expense, productivity initiatives and improved pharmacy margins related to administering COVID-19 vaccines, partially offset by growth in digital sales and an increase in supply chain costs and COVID-19 expenses.\\n28\\nSelling and administrative expenses were 25.6% of sales during the second quarter of fiscal 2021 compared to 26.8% of sales for the second quarter of fiscal 2019. Excluding the impact of fuel, selling and administrative expenses as a percentage of sales decreased approximately 120 basis points primarily due to sales leverage and the execution of productivity initiatives, partially offset by increases in employee costs and other expenses related to our investments in our digital and omni-channel capabilities and strategic priorities and increased market driven retail wage rates, higher equity-based compensation expense as well as incremental COVID-19 expenses.\\n29\\nReconciliation of Non-GAAP Measures\\nThe following tables reconcile Net income to Adjusted net income, and Net income per Class A common share to Adjusted net income per Class A common share (in millions, except per share data):\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Numerator: |\\n| Net income | $ | 295.2 | $ | 284.5 | $ | 294.8 |\\n| Adjustments: |\\n| (Gain) loss on interest rate and commodity hedges, net (d) | (1.2) | 1.4 | — |\\n| Facility closures and transformation (1)(b) | 14.8 | 6.1 | — |\\n| Acquisition and integration costs (2)(b) | 3.4 | 2.2 | 7.5 |\\n| Equity-based compensation expense (b) | 26.8 | 9.3 | 6.5 |\\n| (Gain) loss on property dispositions and impairment losses, net (3) | (0.2) | (18.3) | (435.5) |\\n| LIFO expense (a) | 14.6 | 10.1 | 5.8 |\\n| Government-mandated incremental COVID-19 pandemic related pay (4)(b) | 18.3 | — | — |\\n| Civil disruption related costs (5)(b) | — | (1.9) | — |\\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 4.1 | — |\\n| Amortization of debt discount and deferred financing costs (c) | 4.7 | 4.7 | 35.4 |\\n| Loss on debt extinguishment | — | 49.1 | 23.1 |\\n| Amortization of intangible assets resulting from acquisitions (b) | 11.5 | 13.1 | 68.9 |\\n| Miscellaneous adjustments (6)(f) | 5.1 | 13.3 | 24.3 |\\n| Tax impact of adjustments to Adjusted net income | (23.5) | (21.3) | 68.4 |\\n| Adjusted net income | $ | 369.5 | $ | 356.4 | $ | 99.2 |\\n| Denominator: |\\n| Weighted average Class A common shares outstanding - diluted | 573.0 | 582.9 | 580.6 |\\n| Adjustments: |\\n| Restricted stock units and awards (7) | 8.1 | 9.6 | 7.6 |\\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.1 | 592.5 | 588.2 |\\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\\n| Supplemental Two-Year CAGR: |\\n| Net income two-year CAGR | 0.1 | % |\\n| Adjusted net income two-year CAGR | 93.0 | % |\\n\\n30\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Net income per Class A common share - diluted | $ | 0.52 | $ | 0.49 | $ | 0.51 |\\n| Non-GAAP adjustments (8) | 0.13 | 0.12 | (0.33) |\\n| Restricted stock units and awards (7) | (0.01) | (0.01) | (0.01) |\\n| Adjusted net income per Class A common share - diluted | $ | 0.64 | $ | 0.60 | $ | 0.17 |\\n| Supplemental Two-Year CAGR: |\\n| Net income per Class A common share two-year CAGR | 1.0 | % |\\n| Adjusted net income per Class A common share two-year CAGR | 94.0 | % |\\n\\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Adjusted net income (9) | $ | 369.5 | $ | 356.4 | $ | 99.2 |\\n| Tax impact of adjustments to Adjusted net income | 23.5 | 21.3 | (68.4) |\\n| Income tax expense | 100.3 | 111.2 | 81.9 |\\n| Amortization of debt discount and deferred financing costs (c) | (4.7) | (4.7) | (35.4) |\\n| Interest expense, net | 109.3 | 128.6 | 177.5 |\\n| Amortization of intangible assets resulting from acquisitions (b) | (11.5) | (13.1) | (68.9) |\\n| Depreciation and amortization (e) | 379.0 | 348.7 | 381.7 |\\n| Adjusted EBITDA | $ | 965.4 | $ | 948.4 | $ | 567.6 |\\n| Supplemental Two-Year CAGR: |\\n| Adjusted EBITDA two-year CAGR | 30.4 | % |\\n\\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\\n(4) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\\n(5) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\\n31\\n(6) Miscellaneous adjustments include the following (see table below):\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Non-cash lease-related adjustments | $ | 1.0 | $ | (0.1) | $ | 4.4 |\\n| Lease and lease-related costs for surplus and closed stores | 6.5 | 10.8 | 5.2 |\\n| Net realized and unrealized (gain) loss on non-operating investments | 12.8 | 0.2 | 10.8 |\\n| Other (i) | (15.2) | 2.4 | 3.9 |\\n| Total miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\\n\\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\\n(7) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\\n(8) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\\n(9) See the reconciliation of Net income to Adjusted net income above for further details.\\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\\n(a) Cost of sales\\n(b) Selling and administrative expenses\\n(c) Interest expense, net\\n(d) (Gain) loss on interest rate and commodity hedges, net:\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Cost of sales | $ | (1.2) | $ | 1.0 | $ | — |\\n| Other income, net | — | 0.4 | — |\\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (1.2) | $ | 1.4 | $ | — |\\n\\n(e) Depreciation and amortization:\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Cost of sales | $ | 36.0 | $ | 40.1 | $ | 38.0 |\\n| Selling and administrative expenses | 343.0 | 308.6 | 343.7 |\\n| Total Depreciation and amortization | $ | 379.0 | $ | 348.7 | $ | 381.7 |\\n\\n(f) Miscellaneous adjustments:\\n| 12 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Selling and administrative expenses | $ | 3.4 | $ | 9.9 | $ | 9.6 |\\n| Other income, net | 1.7 | 3.4 | 14.7 |\\n| Total Miscellaneous adjustments | $ | 5.1 | $ | 13.3 | $ | 24.3 |\\n\\n32\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Numerator: |\\n| Net income | $ | 740.0 | $ | 870.7 | $ | 343.8 |\\n| Adjustments: |\\n| (Gain) loss on interest rate and commodity hedges, net (d) | (7.5) | 25.9 | 0.3 |\\n| Facility closures and transformation (1)(b) | 35.6 | 15.9 | — |\\n| Acquisition and integration costs (2)(b) | 6.9 | 8.5 | 33.6 |\\n| Equity-based compensation expense (b) | 49.0 | 28.3 | 17.6 |\\n| Loss (gain) on property dispositions and impairment losses, net (3) | 0.1 | 12.0 | (464.0) |\\n| LIFO expense (a) | 29.1 | 23.2 | 16.3 |\\n| Discretionary COVID-19 pandemic related costs (4)(b) | — | 89.9 | — |\\n| Government-mandated incremental COVID-19 pandemic related pay (5)(b) | 47.4 | — | — |\\n| Civil disruption related costs (6)(b) | — | 13.0 | — |\\n| Transaction and reorganization costs related to Convertible Preferred Stock issuance and initial public offering (b) | — | 24.4 | — |\\n| Amortization of debt discount and deferred financing costs (c) | 11.1 | 11.2 | 43.8 |\\n| Loss on debt extinguishment | — | 49.1 | 65.8 |\\n| Amortization of intangible assets resulting from acquisitions (b) | 27.6 | 30.6 | 161.7 |\\n| Miscellaneous adjustments (7)(f) | (5.7) | 47.4 | 33.1 |\\n| Tax impact of adjustments to Adjusted net income | (46.6) | (92.5) | 23.7 |\\n| Adjusted net income | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\\n| Denominator: |\\n| Weighted average Class A common shares outstanding - diluted | 470.6 | 583.3 | 580.0 |\\n| Adjustments: |\\n| Convertible Preferred Stock (8) | 101.6 | — | — |\\n| Restricted stock units and awards (9) | 8.8 | 9.2 | 8.2 |\\n| Adjusted weighted average Class A common shares outstanding - diluted | 581.0 | 592.5 | 588.2 |\\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\\n| Supplemental Two-Year CAGR: |\\n| Net income two-year CAGR | 46.7 | % |\\n| Adjusted net income two-year CAGR | 79.4 | % |\\n\\n33\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Net income per Class A common share - diluted | $ | 1.26 | $ | 1.49 | $ | 0.59 |\\n| Convertible Preferred Stock (8) | 0.03 | — | — |\\n| Non-GAAP adjustments (10) | 0.26 | 0.49 | (0.11) |\\n| Restricted stock units and awards (9) | (0.02) | (0.03) | (0.01) |\\n| Adjusted net income per Class A common share - diluted | $ | 1.53 | $ | 1.95 | $ | 0.47 |\\n| Supplemental Two-Year CAGR: |\\n| Net income per Class A common share two-year CAGR | 46.1 | % |\\n| Adjusted net income per Class A common share two-year CAGR | 80.4 | % |\\n\\nThe following table is a reconciliation of Adjusted net income to Adjusted EBITDA:\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Adjusted net income (11) | $ | 887.0 | $ | 1,157.6 | $ | 275.7 |\\n| Tax impact of adjustments to Adjusted net income | 46.6 | 92.5 | (23.7) |\\n| Income tax expense | 232.8 | 313.1 | 97.6 |\\n| Amortization of debt discount and deferred financing costs (c) | (11.1) | (11.2) | (43.8) |\\n| Interest expense, net | 262.6 | 309.2 | 402.7 |\\n| Amortization of intangible assets resulting from acquisitions (b) | (27.6) | (30.6) | (161.7) |\\n| Depreciation and amortization (e) | 883.2 | 808.8 | 897.6 |\\n| Adjusted EBITDA | $ | 2,273.5 | $ | 2,639.4 | $ | 1,444.4 |\\n| Supplemental Two-Year CAGR: |\\n| Adjusted EBITDA two-year CAGR | 25.5 | % |\\n\\n(1) Includes costs related to closures of operating facilities and third-party consulting fees related to our strategic priorities and associated business transformation.\\n(2) Related to conversion activities and related costs associated with integrating acquired businesses. Also includes expenses related to management fees in prior periods paid in connection with acquisition and financing activities.\\n(3) Primarily due to gains related to sale leaseback transactions in the second quarter of fiscal 2019.\\n(4) Includes $53 million of charitable contributions to our communities for hunger relief and $36.9 million in final reward payments to front-line associates at the end of the first quarter of fiscal 2020.\\n(5) Represents incremental pay that is legislatively required in certain municipalities in which we operate.\\n(6) Primarily includes costs related to store damage, inventory losses and community support as a result of the civil disruption during late May 2020 and early June 2020 in certain markets.\\n34\\n(7) Miscellaneous adjustments include the following (see table below):\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Non-cash lease-related adjustments | $ | 3.1 | $ | 1.9 | $ | 6.3 |\\n| Lease and lease-related costs for surplus and closed stores | 16.7 | 29.5 | 12.0 |\\n| Net realized and unrealized (gain) loss on non-operating investments | (9.7) | 4.7 | 7.5 |\\n| Other (i) | (15.8) | 11.3 | 7.3 |\\n| Total miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\\n\\n(i) Primarily includes adjustments for pension settlement gain, certain legal and regulatory accruals, unconsolidated equity investments and certain contract termination costs.\\n(8) Represents the conversion of Convertible Preferred Stock to the fully outstanding as-converted Class A common shares as of the end of each respective period, for periods in which the Convertible Preferred Stock is antidilutive under GAAP.\\n(9) Represents incremental unvested RSUs and unvested RSAs to adjust the diluted weighted average Class A common shares outstanding during each respective period to the fully outstanding RSUs and RSAs as of the end of each respective period.\\n(10) Reflects the per share impact of Non-GAAP adjustments for each period. See the reconciliation of Net income to Adjusted net income above for further details.\\n(11) See the reconciliation of Net income to Adjusted net income above for further details.\\nNon-GAAP adjustment classifications within the Consolidated Statement of Operations:\\n(a) Cost of sales\\n(b) Selling and administrative expenses\\n(c) Interest expense, net\\n35\\n(d) (Gain) loss on interest rate and commodity hedges, net:\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Cost of sales | $ | (7.8) | $ | 6.5 | $ | 0.3 |\\n| Other income, net | 0.3 | 19.4 | — |\\n| Total (Gain) loss on interest rate and commodity hedges, net | $ | (7.5) | $ | 25.9 | $ | 0.3 |\\n\\n(e) Depreciation and amortization:\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Cost of sales | $ | 86.8 | $ | 94.1 | $ | 90.0 |\\n| Selling and administrative expenses | 796.4 | 714.7 | 807.6 |\\n| Total Depreciation and amortization | $ | 883.2 | $ | 808.8 | $ | 897.6 |\\n\\n(f) Miscellaneous adjustments:\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 | September 7, 2019 Supplemental |\\n| Selling and administrative expenses | $ | 10.2 | $ | 34.7 | $ | 16.7 |\\n| Other income, net | (15.9) | 12.7 | 16.4 |\\n| Total Miscellaneous adjustments | $ | (5.7) | $ | 47.4 | $ | 33.1 |\\n\\nLIQUIDITY AND CAPITAL RESOURCES\\nThe following table sets forth the major sources and uses of cash and cash equivalents and restricted cash for each period (in millions):\\n| 28 weeks ended |\\n| September 11,2021 | September 12,2020 |\\n| Cash and cash equivalents and restricted cash at end of period | $ | 2,900.4 | $ | 2,431.9 |\\n| Cash flows provided by operating activities | 2,137.7 | 2,720.8 |\\n| Cash flows used in investing activities | (790.5) | (687.1) |\\n| Cash flows used in financing activities | (214.4) | (80.7) |\\n\\nNet Cash Provided by Operating Activities\\nNet cash provided by operating activities was $2,137.7 million for the first 28 weeks of fiscal 2021 compared to $2,720.8 million for the first 28 weeks of fiscal 2020. The decrease in cash flow from operations compared to the first 28 weeks of fiscal 2020 was due to changes in working capital primarily related to accounts payable as our business experienced significantly elevated demand during the first 28 weeks of fiscal 2020 and a deferral of approximately $270 million of the employer-paid portion of social security taxes in the first 28 weeks of fiscal 2020 together with lower EBITDA during the first 28 weeks of fiscal 2021. These decreases were partially offset by less cash paid for interest and income taxes of $94 million and $72 million, respectively, $75 million payment for the UFCW & Employers Midwest Pension Fund settlement in the first 28 weeks of fiscal 2020 and a decrease of $45.1 million in contributions to our defined benefit pension plans and post-retirement benefit plans.\\n36\\nNet Cash Used by Investing Activities\\nNet cash used in investing activities was $790.5 million for the first 28 weeks of fiscal 2021 compared to $687.1 million for the first 28 weeks of fiscal 2020.\\nFor the first 28 weeks of fiscal 2021, cash used in investing activities consisted primarily of payments for property and equipment of $822.5 million and payments for business acquisitions of $23.5 million, partially offset by proceeds from the sale of long-lived assets of $24.6 million. Payments for property and equipment in the first 28 weeks of fiscal 2021 included the opening of six new stores, completion of 76 remodels and increased investment in our digital technology. For the first 28 weeks of fiscal 2020, cash used in investing activities consisted primarily of payments for property and equipment of $702.9 million. Payments for property and equipment in the first 28 weeks of fiscal 2020 included the completion of 132 remodels and continued investment in our digital technology. For the full fiscal year of 2021, we expect capital expenditures to be in the range of $1.9 billion to $2.0 billion.\\nNet Cash Used in Financing Activities\\nNet cash used in financing activities was $214.4 million during the first 28 weeks of fiscal 2021 compared to $80.7 million during the first 28 weeks of fiscal 2020.\\nNet cash used in financing activities during the first 28 weeks of fiscal 2021 consisted primarily of dividends paid on our Class A common stock and Convertible Preferred Stock. Net cash used in financing activities during the first 28 weeks of fiscal 2020 consisted primarily of the $1.5 billion issuance of new Senior Unsecured Notes and $1.25 billion aggregate redemption of 2024 Notes and 2025 Notes, the $2.0 billion borrowing and subsequent repayment of the ABL Facility, the issuance of the Convertible Preferred Stock and the repurchase of outstanding Class A common stock.\\nLiquidity and Factors Affecting Liquidity\\nWe estimate our liquidity needs over the next 12 months to be in the range of $4.75 billion to $5.25 billion, which includes anticipated requirements for incremental working capital, capital expenditures, pension obligations, interest payments and scheduled principal payments of debt, dividends on Class A common stock and Convertible Preferred Stock, operating leases and finance leases. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our ABL Facility, will be adequate to meet our liquidity needs for the next 12 months and for the foreseeable future. We believe we have adequate cash flow to continue to respond effectively to competitive conditions. In addition, we may enter into refinancing and sale leaseback transactions from time to time. There can be no assurance, however, that our business will continue to generate cash flow at or above current levels or that we will maintain our ability to borrow under our ABL Facility.\\nThe holders of Convertible Preferred Stock are entitled to a quarterly dividend at a rate per annum of 6.75% of the liquidation preference per share of the Convertible Preferred Stock. On March 15, 2021, June 15, 2021 and September 15, 2021, we declared quarterly cash dividends of $29.5 million, respectively, to holders of the Convertible Preferred Stock, which was paid on March 31, 2021, June 30, 2021 and September 30, 2021, respectively. In addition, the holders of Convertible Preferred Stock will participate in cash dividends that we pay on our common stock to the extent that such cash dividends exceed $206.25 million per fiscal year.\\n37\\nWe have established a dividend policy pursuant to which we intend to pay a quarterly dividend on our Class A common stock. During the first 28 weeks of fiscal 2021, we paid quarterly cash dividends of $0.10 per share of Class A common stock on May 10, 2021 and August 10, 2021, to stockholders of record as of the close of business on April 26, 2021 and July 26, 2021, respectively. On October 18, 2021, subsequent to the end of the second quarter of fiscal 2021, we announced a 20% increase to our quarterly dividend, which is now $0.12 per share of Class A common stock, payable on November 12, 2021 to stockholders of record as of the close of business on October 29, 2021.\\nAs of September 11, 2021, we had no borrowings outstanding under out ABL Facility and total availability of $3,483.1 million (net of letter of credit usage).\\nMultiemployer Pension Plans\\nThe American Rescue Plan Act (\\\"ARP Act\\\") establishes a special financial assistance program for financially troubled multiemployer pension plans. Under the ARP Act, eligible multiemployer plans can apply to receive a one-time cash payment in the amount projected by the Pension Benefit Guaranty Corporation (\\\"PBGC\\\") to pay pension benefits through the plan year ending 2051. The payment received by the multiemployer plan under this special financial assistance program would not be considered a loan and would not need to be paid back. Any financial assistance received by the multiemployer plan would need to be segregated from the other assets of the multiemployer plans and invested in investment grade bonds or other investments permitted by the PBGC.\\nOf the 27 multiemployer plans to which we contribute, 16 plans are classified as \\\"Critical\\\" or \\\"Critical and Declining\\\" and are potentially eligible for special financial assistance under the ARP Act. Though the amount of financial assistance that each of these 16 plans could receive will vary by plan, we currently estimate that these 16 plans represent over 90% of the $4.7 billion we estimated as our share of the underfunding of the 27 plans. On July 9, 2021, the PBGC issued its interim final rule with respect to the special financial assistance program. The PBGC interim final rule provides direction on the application requirements, identifies which plans will have priority, eligibility requirements, the determination of the amount of financial assistance to be provided and establishes conditions and restrictions that apply to plans that receive assistance. We are evaluating the interim final rule and have submitted comments during the 30-day comment period, and we expect the special financial assistance program to provide funding for the multiemployer plans to which we contribute to remain solvent through the next 25 to 30 years.\\nCRITICAL ACCOUNTING POLICIES\\nThe preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a fair and consistent manner. See the Critical Accounting Policies section included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, for a discussion of our significant accounting policies.\\nRECENTLY ISSUED AND RECENTLY ADOPTED ACCOUNTING STANDARDS\\nSee Note 1 - Basis of presentation and summary of significant accounting policies of our unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\\n38\\nItem 3\\n-\\nQuantitative and Qualitative Disclosures About Market Risk\\nThere have been no material changes in our exposure to market risk from the information provided in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021.\\nItem 4 - Controls and Procedures\\nBased on their evaluation of our disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934 (the \\\"Exchange Act\\\")) as of the end of the period covered by this Form 10-Q, our Principal Executive Officer and Principal Financial Officer concluded our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and is accumulated and communicated to management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the second quarter of fiscal 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n39\\nPART II - OTHER INFORMATION\\nItem 1 - Legal Proceedings\\nThe Company is subject from time to time to various claims and lawsuits arising in the ordinary course of business, including lawsuits involving trade practices, lawsuits alleging violations of state and/or federal wage and hour laws (including alleged violations of meal and rest period laws and alleged misclassification issues), real estate disputes as well as other matters. Some of these claims or suits purport or may be determined to be class actions and/or seek substantial damages. It is the opinion of the Company's management that although the amount of liability with respect to certain of the matters described in this Form 10-Q cannot be ascertained at this time, any resulting liability of these and other matters, including any punitive damages, will not have a material adverse effect on the Company's business or financial condition. See the matters under the caption Legal Proceedings in Note 6 - Commitments and contingencies and off balance sheet arrangements in the unaudited interim Condensed Consolidated Financial Statements located elsewhere in this Form 10-Q.\\nItem 1A - Risk Factors\\nThere have been no material changes to the risk factors previously included in our Annual Report on Form 10-K for the fiscal year ended February 27, 2021, filed with the SEC on April 28, 2021, under the heading \\\"Risk Factors.\\\"\\nItem 2 - Unregistered Sales of Equity Securities and Use of Proceeds\\n(a) Unregistered Sales of Equity Securities\\nNone.\\n(b) Use of Proceeds\\nNone.\\n(c) Purchases of Equity Securities\\nNone.\\nItem 3 - Defaults Upon Senior Securities\\nNone.\\nItem 4 - Mine Safety Disclosures\\nNot Applicable.\\nItem 5 - Other Information\\nNone.\\n40\\nItem 6 - Exhibits\\n3.1 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of Albertsons Companies, Inc.\\n10.1 Employment Agreement, dated as of August 4, 2021, by and between Albertsons Companies, Inc. and Sharon McCollam (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on August 11, 2021)\\n31.1 Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\\n31.2 Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002\\n32.1 Certification of the Principal Executive Officer and of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002\\nEXHIBIT 101.INS - Inline XBRL Instance Document\\nEXHIBIT 101.SCH - Inline XBRL Taxonomy Extension Schema Document\\nEXHIBIT 101.CAL - Inline XBRL Taxonomy Extension Calculation Linkbase Document\\nEXHIBIT 101.DEF - Inline XBRL Taxonomy Extension Definition Linkbase Document\\nEXHIBIT 101.LAB - Inline XBRL Taxonomy Extension Label Linkbase Document\\nEXHIBIT 101.PRE - Inline XBRL Taxonomy Extension Presentation Linkbase Document\\nEXHIBIT 104 - Cover Page Interactive Data File (embedded within the Inline XBRL document)\\n41\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| Albertsons Companies, Inc.(Registrant) |\\n| Date: | October 20, 2021 | By: | /s/ Vivek Sankaran |\\n| Vivek Sankaran |\\n| Chief Executive Officer and Director(Principal Executive Officer) |\\n\\n| Date: | October 20, 2021 | By: | /s/ Sharon McCollam |\\n| Sharon McCollam |\\n| President and Chief Financial Officer(Principal Financial Officer) |\\n\\n42\\n</text>\\n\\nWhat is the rate of increase in total debt as a percentage of total assets from February 27, 2021 to September 11, 2021 in percent?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -2.3942768229509377.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 33,\n \"input_length\": 30984\n}"}}},{"rowIdx":34,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nFinancial Statements\nConsolidated Balance Sheets September 30, 2015 (unaudited)\nand December 31, 2014 1\nConsolidated Statements of Operations and Comprehensive Income (Loss) for the\nthree and nine months ended September 30, 2015 and 2014 (unaudited) 2\nConsolidated Statements of Changes in Shareholders' Equity for the three and\nnine months ended September 30, 2015 and 2014 (unaudited) 3\nConsolidated Statements of Cash Flows for the nine months ended\nSeptember 30, 2015 and 2014 (unaudited) 4\nNotes to Consolidated Interim Financial Statements (unaudited) 5\nItem 2. Management's Discussion and Analysis of Financial Condition and\nResults of Operation 30\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 57\nItem 4. Controls and Procedures 58\nPART II\nOTHER INFORMATION\n\n| Item 1. | Legal Proceedings | 58 |\n| Item 1A. | Risk Factors | 58 |\n| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 59 |\n| Item 3. | Defaults Upon Senior Securities | 59 |\n| Item 4. | Mine Safety Disclosures | 59 |\n| Item 5. | Other Information | 59 |\n| Item 6. | Exhibits | 60 |\n\nEVEREST RE GROUP, LTD.\nCONSOLIDATED BALANCE SHEETS\n\n| September 30, | December 31, |\n| (Dollars and share amounts in thousands, except par value per share) | 2015 | 2014 |\n| (unaudited) |\n| ASSETS: |\n| Fixed maturities - available for sale, at market value | $ | 13,490,960 | $ | 13,101,067 |\n| (amortized cost: 2015, $13,301,713; 2014, $12,831,159) |\n| Fixed maturities - available for sale, at fair value | - | 1,509 |\n| Equity securities - available for sale, at market value (cost: 2015, $127,411; 2014, $148,326) | 112,999 | 140,210 |\n| Equity securities - available for sale, at fair value | 1,357,311 | 1,447,820 |\n| Short-term investments | 1,615,045 | 1,705,932 |\n| Other invested assets (cost: 2015, $669,686; 2014, $601,925) | 669,686 | 601,925 |\n| Cash | 401,226 | 437,474 |\n| Total investments and cash | 17,647,227 | 17,435,937 |\n| Accrued investment income | 107,199 | 111,075 |\n| Premiums receivable | 1,663,425 | 1,397,983 |\n| Reinsurance receivables | 831,635 | 670,854 |\n| Funds held by reinsureds | 272,775 | 228,192 |\n| Deferred acquisition costs | 364,947 | 398,408 |\n| Prepaid reinsurance premiums | 193,122 | 154,177 |\n| Income taxes | 270,607 | 184,762 |\n| Other assets | 331,374 | 236,436 |\n| TOTAL ASSETS | $ | 21,682,311 | $ | 20,817,824 |\n| LIABILITIES: |\n| Reserve for losses and loss adjustment expenses | $ | 9,965,963 | $ | 9,720,813 |\n| Future policy benefit reserve | 59,580 | 59,820 |\n| Unearned premium reserve | 1,717,422 | 1,728,745 |\n| Funds held under reinsurance treaties | 83,137 | 3,932 |\n| Commission reserves | 79,904 | 87,990 |\n| Other net payable to reinsurers | 199,528 | 139,841 |\n| Losses in course of payment | 298,577 | 157,527 |\n| 4.868% Senior notes due 6/1/2044 | 400,000 | 400,000 |\n| 6.6% Long term notes due 5/1/2067 | 238,367 | 238,364 |\n| Accrued interest on debt and borrowings | 12,341 | 3,537 |\n| Equity index put option liability | 52,247 | 47,022 |\n| Unsettled securities payable | 65,147 | 41,092 |\n| Other liabilities | 271,086 | 316,469 |\n| Total liabilities | 13,443,299 | 12,945,152 |\n| NONCONTROLLING INTERESTS: |\n| Redeemable noncontrolling interests - Mt. Logan Re | 752,692 | 421,552 |\n| Commitments and contingencies (Note 9) |\n| SHAREHOLDERS' EQUITY: |\n| Preferred shares, par value: $0.01; 50,000 shares authorized; |\n| no shares issued and outstanding | - | - |\n| Common shares, par value: $0.01; 200,000 shares authorized; (2015) 68,585 |\n| and (2014) 68,336 outstanding before treasury shares | 686 | 683 |\n| Additional paid-in capital | 2,094,850 | 2,068,807 |\n| Accumulated other comprehensive income (loss), net of deferred income tax expense |\n| (benefit) of ($2,899) at 2015 and $20,715 at 2014 | (112,231 | ) | 48,317 |\n| Treasury shares, at cost; 25,500 shares (2015) and 23,650 shares (2014) | (2,810,878 | ) | (2,485,897 | ) |\n| Retained earnings | 8,313,893 | 7,819,210 |\n| Total shareholders' equity attributable to Everest Re Group | 7,486,320 | 7,451,120 |\n| TOTAL LIABILITIES, NONCONTROLLING INTERESTS AND SHAREHOLDERS' EQUITY | $ | 21,682,311 | $ | 20,817,824 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n1\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF OPERATIONS\nAND COMPREHENSIVE INCOME (LOSS)\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| (unaudited) | (unaudited) |\n| REVENUES: |\n| Premiums earned | $ | 1,413,640 | $ | 1,389,998 | $ | 4,053,115 | $ | 3,806,805 |\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\n| Net realized capital gains (losses): |\n| Other-than-temporary impairments on fixed maturity securities | (20,445 | ) | (106 | ) | (62,701 | ) | (495 | ) |\n| Other-than-temporary impairments on fixed maturity securities |\n| transferred to other comprehensive income (loss) | - | - | - | - |\n| Other net realized capital gains (losses) | (139,526 | ) | (9,342 | ) | (131,953 | ) | 71,189 |\n| Total net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\n| Total revenues | 1,375,165 | 1,535,880 | 4,275,937 | 4,272,156 |\n| CLAIMS AND EXPENSES: |\n| Incurred losses and loss adjustment expenses | 888,097 | 837,757 | 2,401,223 | 2,192,863 |\n| Commission, brokerage, taxes and fees | 300,048 | 290,519 | 882,132 | 820,208 |\n| Other underwriting expenses | 70,667 | 63,113 | 195,282 | 172,165 |\n| Corporate expenses | 5,924 | 9,958 | 17,312 | 18,802 |\n| Interest, fees and bond issue cost amortization expense | 8,990 | 12,424 | 27,006 | 28,970 |\n| Total claims and expenses | 1,273,726 | 1,213,771 | 3,522,955 | 3,233,008 |\n| INCOME (LOSS) BEFORE TAXES | 101,439 | 322,109 | 752,982 | 1,039,148 |\n| Income tax expense (benefit) | (6,133 | ) | 20,856 | 70,868 | 137,948 |\n| NET INCOME (LOSS) | $ | 107,572 | $ | 301,253 | $ | 682,114 | $ | 901,200 |\n| Net (income) loss attributable to noncontrolling interests | (19,019 | ) | (26,337 | ) | (61,526 | ) | (42,167 | ) |\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\n| Other comprehensive income (loss), net of tax: |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities arising during the period | (91,059 | ) | (74,074 | ) | (144,335 | ) | 65,318 |\n| Reclassification adjustment for realized losses (gains) included in net income (loss) | 24,596 | (5,684 | ) | 59,526 | (1,641 | ) |\n| Total URA(D) on securities arising during the period | (66,463 | ) | (79,758 | ) | (84,809 | ) | 63,677 |\n| Foreign currency translation adjustments | (32,505 | ) | (34,974 | ) | (80,508 | ) | (38,374 | ) |\n| Benefit plan actuarial net gain (loss) for the period | - | - | - | - |\n| Reclassification adjustment for amortization of net (gain) loss included in net income (loss) | 1,556 | 825 | 4,769 | 2,366 |\n| Total benefit plan net gain (loss) for the period | 1,556 | 825 | 4,769 | 2,366 |\n| Total other comprehensive income (loss), net of tax | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| Other comprehensive (income) loss attributable to noncontrolling interests | - | - | - | - |\n| Total other comprehensive income (loss), net of tax attributable to Everest Re Group | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| COMPREHENSIVE INCOME (LOSS) | $ | (8,859 | ) | $ | 161,009 | $ | 460,040 | $ | 886,702 |\n| EARNINGS PER COMMON SHARE ATTRIBUTABLE TO EVEREST RE GROUP: |\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\n| Diluted | 2.00 | 6.00 | 13.92 | 18.47 |\n| Dividends declared | 0.95 | 0.75 | 2.85 | 2.25 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n2\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF\nCHANGES IN SHAREHOLDERS' EQUITY\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except share and dividends per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| (unaudited) | (unaudited) |\n| COMMON SHARES (shares outstanding): |\n| Balance, beginning of period | 44,192,526 | 45,691,015 | 44,685,637 | 47,543,132 |\n| Issued during the period, net | 29,398 | 29,622 | 248,665 | 344,761 |\n| Treasury shares acquired | (1,137,473 | ) | (470,807 | ) | (1,849,851 | ) | (2,638,063 | ) |\n| Balance, end of period | 43,084,451 | 45,249,830 | 43,084,451 | 45,249,830 |\n| COMMON SHARES (par value): |\n| Balance, beginning of period | $ | 685 | $ | 683 | $ | 683 | $ | 680 |\n| Issued during the period, net | 1 | - | 3 | 3 |\n| Balance, end of period | 686 | 683 | 686 | 683 |\n| ADDITIONAL PAID-IN CAPITAL: |\n| Balance, beginning of period | 2,084,636 | 2,052,682 | 2,068,807 | 2,029,774 |\n| Share-based compensation plans | 10,214 | 7,274 | 26,043 | 30,182 |\n| Balance, end of period | 2,094,850 | 2,059,956 | 2,094,850 | 2,059,956 |\n| ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS), |\n| NET OF DEFERRED INCOME TAXES: |\n| Balance, beginning of period | (14,819 | ) | 299,304 | 48,317 | 157,728 |\n| Net increase (decrease) during the period | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\n| Balance, end of period | (112,231 | ) | 185,397 | (112,231 | ) | 185,397 |\n| RETAINED EARNINGS: |\n| Balance, beginning of period | 8,267,038 | 7,281,023 | 7,819,210 | 6,765,967 |\n| Net income (loss) attributable to Everest Re Group | 88,553 | 274,916 | 620,588 | 859,033 |\n| Dividends declared ($0.95 per share in third quarter 2015 and $2.85 year-to-date |\n| per share in 2015 and $0.75 per share in third quarter 2014 and $2.25 |\n| year-to-date per share in 2014) | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\n| Balance, end of period | 8,313,893 | 7,521,966 | 8,313,893 | 7,521,966 |\n| TREASURY SHARES AT COST: |\n| Balance, beginning of period | (2,610,878 | ) | (2,310,824 | ) | (2,485,897 | ) | (1,985,873 | ) |\n| Purchase of treasury shares | (200,000 | ) | (74,991 | ) | (324,981 | ) | (399,942 | ) |\n| Balance, end of period | (2,810,878 | ) | (2,385,815 | ) | (2,810,878 | ) | (2,385,815 | ) |\n| TOTAL SHAREHOLDERS' EQUITY, END OF PERIOD | $ | 7,486,320 | $ | 7,382,187 | $ | 7,486,320 | $ | 7,382,187 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n3\nEVEREST RE GROUP, LTD.\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n\n| Nine Months Ended |\n| September 30, |\n| (Dollars in thousands) | 2015 | 2014 |\n| (unaudited) |\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\n| Net income (loss) | $ | 682,114 | $ | 901,200 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Decrease (increase) in premiums receivable | (274,198 | ) | (255,645 | ) |\n| Decrease (increase) in funds held by reinsureds, net | 33,255 | (6,929 | ) |\n| Decrease (increase) in reinsurance receivables | (202,329 | ) | (256,458 | ) |\n| Decrease (increase) in income taxes | (61,627 | ) | (14,696 | ) |\n| Decrease (increase) in prepaid reinsurance premiums | (46,633 | ) | (101,478 | ) |\n| Increase (decrease) in reserve for losses and loss adjustment expenses | 347,729 | 172,511 |\n| Increase (decrease) in future policy benefit reserve | (240 | ) | (1,879 | ) |\n| Increase (decrease) in unearned premiums | 1,455 | 255,537 |\n| Increase (decrease) in other net payable to reinsurers | 67,550 | 101,984 |\n| Increase (decrease) in losses in course of payment | 142,418 | 165,105 |\n| Change in equity adjustments in limited partnerships | (12,725 | ) | (24,438 | ) |\n| Distribution of limited partnership income | 42,625 | 41,165 |\n| Change in other assets and liabilities, net | 18,573 | (32,114 | ) |\n| Non-cash compensation expense | 16,150 | 14,720 |\n| Amortization of bond premium (accrual of bond discount) | 38,770 | 38,010 |\n| Amortization of underwriting discount on senior notes | 3 | 43 |\n| Net realized capital (gains) losses | 194,654 | (70,694 | ) |\n| Net cash provided by (used in) operating activities | 987,544 | 925,944 |\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\n| Proceeds from fixed maturities matured/called - available for sale, at market value | 1,687,589 | 1,638,278 |\n| Proceeds from fixed maturities matured/called - available for sale, at fair value | - | 875 |\n| Proceeds from fixed maturities sold - available for sale, at market value | 1,146,000 | 1,050,082 |\n| Proceeds from fixed maturities sold - available for sale, at fair value | 1,824 | 23,856 |\n| Proceeds from equity securities sold - available for sale, at market value | 22,120 | 11,174 |\n| Proceeds from equity securities sold - available for sale, at fair value | 439,692 | 452,514 |\n| Distributions from other invested assets | 41,782 | 59,264 |\n| Proceeds from sale of subsidiary (net of cash disposed) | 3,934 | - |\n| Cost of fixed maturities acquired - available for sale, at market value | (3,583,990 | ) | (3,729,423 | ) |\n| Cost of fixed maturities acquired - available for sale, at fair value | (234 | ) | (23,684 | ) |\n| Cost of equity securities acquired - available for sale, at market value | (6,581 | ) | (11,873 | ) |\n| Cost of equity securities acquired - available for sale, at fair value | (460,965 | ) | (262,871 | ) |\n| Cost of other invested assets acquired | (140,923 | ) | (120,911 | ) |\n| Net change in short-term investments | 83,584 | (284,822 | ) |\n| Net change in unsettled securities transactions | (18,242 | ) | 13,496 |\n| Net cash provided by (used in) investing activities | (784,410 | ) | (1,184,045 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\n| Common shares issued during the period, net | 9,896 | 15,465 |\n| Purchase of treasury shares | (324,981 | ) | (399,942 | ) |\n| Net proceeds from issuance of senior notes | - | 400,000 |\n| Third party investment in redeemable noncontrolling interest | 296,848 | 136,200 |\n| Dividends paid to shareholders | (125,905 | ) | (103,034 | ) |\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\n| Net cash provided by (used in) financing activities | (211,375 | ) | 38,355 |\n| EFFECT OF EXCHANGE RATE CHANGES ON CASH | (28,007 | ) | 10,167 |\n| Net increase (decrease) in cash | (36,248 | ) | (209,579 | ) |\n| Cash, beginning of period | 437,474 | 611,382 |\n| Cash, end of period | $ | 401,226 | $ | 401,803 |\n| SUPPLEMENTAL CASH FLOW INFORMATION: |\n| Income taxes paid (recovered) | $ | 123,234 | $ | 146,560 |\n| Interest paid | 18,039 | 15,150 |\n| The accompanying notes are an integral part of the consolidated financial statements. |\n\n4\nNOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)\nFor the Three and Nine Months Ended September 30, 2015 and 2014\n1. GENERAL\nEverest Re Group, Ltd. (\"Group\"), a Bermuda company, through its subsidiaries, principally provides reinsurance and insurance in the U.S., Bermuda and international markets. As used in this document, \"Company\" means Group and its subsidiaries.\nEffective February 27, 2013, the Company established a new subsidiary, Mt. Logan Re Ltd. (\"Mt. Logan Re\") and effective July 1, 2013, Mt. Logan Re established separate segregated accounts and issued non-voting redeemable preferred shares to capitalize the segregated accounts. Accordingly, the financial position and operating results for Mt. Logan Re are consolidated with the Company and the non-controlling interests in Mt. Logan Re's operating results and equity are presented as separate captions in the Company's financial statements.\nEffective July 13, 2015, the Company sold all of the outstanding shares of capital stock of a wholly-owned subsidiary entity, Mt. McKinley Insurance Company (\"Mt. McKinley\"), to Clearwater Insurance Company. The operating results of Mt. McKinley through July 13, 2015 are included within the Company's financial statements.\n2. BASIS OF PRESENTATION\nThe unaudited consolidated financial statements of the Company for the three and nine months ended September 30, 2015 and 2014 include all adjustments, consisting of normal recurring accruals, which, in the opinion of management, are necessary for a fair statement of the results on an interim basis. Certain financial information, which is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (\"GAAP\"), has been omitted since it is not required for interim reporting purposes. The December 31, 2014 consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. The results for the three and nine months ended September 30, 2015 and 2014 are not necessarily indicative of the results for a full year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the years ended December 31, 2014, 2013 and 2012 included in the Company's most recent Form 10-K filing.\nAll intercompany accounts and transactions have been eliminated.\nApplication of Recently Issued Accounting Standard Changes.\nNo accounting standards or guidance have been issued recently that would have a material impact on the Company's financial statements or financial reporting process.\n5\n3. INVESTMENTS\nThe amortized cost, market value and gross unrealized appreciation and depreciation of available for sale, fixed maturity, equity security investments, carried at market value and other-than-temporary impairments (\"OTTI\") in accumulated other comprehensive income (\"AOCI\") are as follows for the periods indicated:\n\n| At September 30, 2015 |\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\n| Fixed maturity securities |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 337,271 | $ | 15,725 | $ | (70 | ) | $ | 352,926 | $ | - |\n| Obligations of U.S. states and political subdivisions | 683,715 | 32,087 | (1,523 | ) | 714,279 | - |\n| Corporate securities | 4,964,570 | 118,763 | (76,396 | ) | 5,006,937 | 2,006 |\n| Asset-backed securities | 437,376 | 2,575 | (1,554 | ) | 438,397 | - |\n| Mortgage-backed securities |\n| Commercial | 277,907 | 7,697 | (795 | ) | 284,809 | - |\n| Agency residential | 2,392,937 | 39,295 | (6,165 | ) | 2,426,067 | - |\n| Non-agency residential | 971 | 53 | (46 | ) | 978 | - |\n| Foreign government securities | 1,285,006 | 60,837 | (44,882 | ) | 1,300,961 | (2 | ) |\n| Foreign corporate securities | 2,921,960 | 115,881 | (72,235 | ) | 2,965,606 | 39 |\n| Total fixed maturity securities | $ | 13,301,713 | $ | 392,913 | $ | (203,666 | ) | $ | 13,490,960 | $ | 2,043 |\n| Equity securities | $ | 127,411 | $ | 3,509 | $ | (17,921 | ) | $ | 112,999 | $ | - |\n\n\n| At December 31, 2014 |\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\n| Fixed maturity securities |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 221,052 | $ | 10,290 | $ | (304 | ) | $ | 231,038 | $ | - |\n| Obligations of U.S. states and political subdivisions | 783,129 | 41,969 | (626 | ) | 824,472 | - |\n| Corporate securities | 4,626,002 | 143,889 | (62,906 | ) | 4,706,985 | (6,910 | ) |\n| Asset-backed securities | 340,761 | 1,691 | (1,230 | ) | 341,222 | - |\n| Mortgage-backed securities |\n| Commercial | 231,439 | 10,675 | (429 | ) | 241,685 | - |\n| Agency residential | 2,157,182 | 37,555 | (11,573 | ) | 2,183,164 | - |\n| Non-agency residential | 2,734 | 54 | (57 | ) | 2,731 | - |\n| Foreign government securities | 1,488,144 | 71,177 | (26,866 | ) | 1,532,455 | - |\n| Foreign corporate securities | 2,980,716 | 109,673 | (53,074 | ) | 3,037,315 | - |\n| Total fixed maturity securities | $ | 12,831,159 | $ | 426,973 | $ | (157,065 | ) | $ | 13,101,067 | $ | (6,910 | ) |\n| Equity securities | $ | 148,326 | $ | 3,831 | $ | (11,947 | ) | $ | 140,210 | $ | - |\n\n(a) Represents the amount of OTTI recognized in AOCI. Amount includes unrealized gains and losses on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date.\n6\nThe amortized cost and market value of fixed maturity securities are shown in the following table by contractual maturity. Mortgage-backed securities are generally more likely to be prepaid than other fixed maturity securities. As the stated maturity of such securities may not be indicative of actual maturities, the totals for mortgage-backed and asset-backed securities are shown separately.\n\n| At September 30, 2015 | At December 31, 2014 |\n| Amortized | Market | Amortized | Market |\n| (Dollars in thousands) | Cost | Value | Cost | Value |\n| Fixed maturity securities – available for sale: |\n| Due in one year or less | $ | 1,080,129 | $ | 1,088,140 | $ | 1,183,247 | $ | 1,189,416 |\n| Due after one year through five years | 5,906,738 | 5,991,760 | 5,646,466 | 5,726,277 |\n| Due after five years through ten years | 2,377,276 | 2,382,188 | 2,270,073 | 2,313,672 |\n| Due after ten years | 828,380 | 878,621 | 999,257 | 1,102,900 |\n| Asset-backed securities | 437,376 | 438,397 | 340,761 | 341,222 |\n| Mortgage-backed securities: |\n| Commercial | 277,906 | 284,809 | 231,439 | 241,685 |\n| Agency residential | 2,392,937 | 2,426,067 | 2,157,182 | 2,183,164 |\n| Non-agency residential | 971 | 978 | 2,734 | 2,731 |\n| Total fixed maturity securities | $ | 13,301,713 | $ | 13,490,960 | $ | 12,831,159 | $ | 13,101,067 |\n\nThe changes in net unrealized appreciation (depreciation) for the Company's investments are derived from the following sources for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Increase (decrease) during the period between the market value and cost |\n| of investments carried at market value, and deferred taxes thereon: |\n| Fixed maturity securities | $ | (71,706 | ) | $ | (87,859 | ) | $ | (89,616 | ) | $ | 70,010 |\n| Fixed maturity securities, other-than-temporary impairment | (253 | ) | (261 | ) | 8,954 | (180 | ) |\n| Equity securities | (4,415 | ) | (3,287 | ) | (6,295 | ) | 3,327 |\n| Change in unrealized appreciation (depreciation), pre-tax | (76,374 | ) | (91,407 | ) | (86,957 | ) | 73,157 |\n| Deferred tax benefit (expense) | 9,919 | 11,649 | 5,563 | (9,480 | ) |\n| Deferred tax benefit (expense), other-than-temporary impairment | (8 | ) | - | (3,415 | ) | - |\n| Change in unrealized appreciation (depreciation), |\n| net of deferred taxes, included in shareholders' equity | $ | (66,463 | ) | $ | (79,758 | ) | $ | (84,809 | ) | $ | 63,677 |\n\nThe Company frequently reviews all of its fixed maturity, available for sale securities for declines in market value and focuses its attention on securities whose fair value has fallen below 80% of their amortized cost at the time of review. The Company then assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company evaluates the current market and interest rate environment as well as specific issuer information. Generally, a change in a security's value caused by a change in the market, interest rate or foreign exchange environment does not constitute an other-than-temporary impairment, but rather a temporary decline in market value. Temporary declines in market value are recorded as unrealized losses in accumulated other comprehensive income (loss). If the Company determines that the decline is other-than-temporary and the Company does not have the intent to sell the security; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis, the carrying value of the investment is written down to fair value. The fair value adjustment that is credit or foreign exchange related is recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss). The fair value adjustment that is non-credit related is recorded as a component of other comprehensive income (loss), net of tax, and is included in accumulated other comprehensive income (loss) in the Company's consolidated balance sheets.\n7\nThe Company's assessments are based on the issuers current and expected future financial position, timeliness with respect to interest and/or principal payments, speed of repayments and any applicable credit enhancements or breakeven constant default rates on mortgage-backed and asset-backed securities, as well as relevant information provided by rating agencies, investment advisors and analysts.\nThe majority of the Company's equity securities available for sale at market value are primarily comprised of mutual fund investments whose underlying securities consist of fixed maturity securities. When a fund's value reflects an unrealized loss, the Company assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company considers the composition of its portfolios and their related markets, reports received from the portfolio managers and discussions with portfolio managers. If the Company determines that the declines are temporary and it has the ability and intent to continue to hold the investments, then the declines are recorded as unrealized losses in accumulated other comprehensive income (loss). If declines are deemed to be other-than-temporary, then the carrying value of the investment is written down to fair value and recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss).\nRetrospective adjustments are employed to recalculate the values of asset-backed securities. All of the Company's asset-backed and mortgage-backed securities have a pass-through structure. Each acquisition lot is reviewed to recalculate the effective yield. The recalculated effective yield is used to derive a book value as if the new yield were applied at the time of acquisition. Outstanding principal factors from the time of acquisition to the adjustment date are used to calculate the prepayment history for all applicable securities. Conditional prepayment rates, computed with life to date factor histories and weighted average maturities, are used in the calculation of projected prepayments for pass-through security types.\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\n\n| Duration of Unrealized Loss at September 30, 2015 By Security Type |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities - available for sale |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 201 | $ | (1 | ) | $ | 1,844 | $ | (69 | ) | $ | 2,045 | $ | (70 | ) |\n| Obligations of U.S. states and political subdivisions | 20,162 | (316 | ) | 35,460 | (1,207 | ) | 55,622 | (1,523 | ) |\n| Corporate securities | 1,323,515 | (51,785 | ) | 425,091 | (24,611 | ) | 1,748,606 | (76,396 | ) |\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\n| Mortgage-backed securities |\n| Commercial | 44,260 | (795 | ) | - | - | 44,260 | (795 | ) |\n| Agency residential | 343,504 | (2,182 | ) | 382,730 | (3,983 | ) | 726,234 | (6,165 | ) |\n| Non-agency residential | 176 | (2 | ) | 44 | (44 | ) | 220 | (46 | ) |\n| Foreign government securities | 299,055 | (22,177 | ) | 183,387 | (22,705 | ) | 482,442 | (44,882 | ) |\n| Foreign corporate securities | 699,077 | (40,165 | ) | 279,126 | (32,070 | ) | 978,203 | (72,235 | ) |\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\n| Equity securities | - | - | 97,871 | (17,921 | ) | 97,871 | (17,921 | ) |\n| Total | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,450,318 | $ | (103,490 | ) | $ | 4,269,794 | $ | (221,587 | ) |\n\n8\n\n| Duration of Unrealized Loss at September 30, 2015 By Maturity |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities |\n| Due in one year or less | $ | 85,547 | $ | (4,021 | ) | $ | 83,375 | $ | (12,950 | ) | $ | 168,922 | $ | (16,971 | ) |\n| Due in one year through five years | 1,220,223 | (50,689 | ) | 577,851 | (41,640 | ) | 1,798,074 | (92,329 | ) |\n| Due in five years through ten years | 924,605 | (51,295 | ) | 208,989 | (20,624 | ) | 1,133,594 | (71,919 | ) |\n| Due after ten years | 111,635 | (8,439 | ) | 54,693 | (5,448 | ) | 166,328 | (13,887 | ) |\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\n| Mortgage-backed securities | 387,940 | (2,979 | ) | 382,774 | (4,027 | ) | 770,714 | (7,006 | ) |\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\n\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at September 30, 2015 were $4,269,794 thousand and $221,587 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at September 30, 2015, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $118,097 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to net unrealized foreign exchange losses, $44,092 thousand, as the U.S. dollar has strengthened against other currencies and unrealized losses in the energy sector, $43,353 thousand, as falling oil prices have disrupted the market values for this sector, particularly for oil exploration, production and servicing companies. The $85,569 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $60,407 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. There was no gross unrealized depreciation for mortgage-backed securities related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover the full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\nThe Company, given the size of its investment portfolio and capital position, does not have the intent to sell these securities; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis. In addition, all securities currently in an unrealized loss position are current with respect to principal and interest payments.\n9\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\n\n| Duration of Unrealized Loss at December 31, 2014 By Security Type |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities - available for sale |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 13,187 | $ | (20 | ) | $ | 26,897 | $ | (284 | ) | $ | 40,084 | $ | (304 | ) |\n| Obligations of U.S. states and political subdivisions | 20,428 | (242 | ) | 18,199 | (384 | ) | 38,627 | (626 | ) |\n| Corporate securities | 1,245,830 | (55,388 | ) | 362,320 | (7,518 | ) | 1,608,150 | (62,906 | ) |\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\n| Mortgage-backed securities |\n| Commercial | 28,191 | (123 | ) | 9,777 | (306 | ) | 37,968 | (429 | ) |\n| Agency residential | 141,807 | (172 | ) | 678,972 | (11,401 | ) | 820,779 | (11,573 | ) |\n| Non-agency residential | - | - | 266 | (57 | ) | 266 | (57 | ) |\n| Foreign government securities | 235,725 | (15,415 | ) | 139,200 | (11,451 | ) | 374,925 | (26,866 | ) |\n| Foreign corporate securities | 567,905 | (36,926 | ) | 290,234 | (16,148 | ) | 858,139 | (53,074 | ) |\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\n| Equity securities | 50,285 | (4,068 | ) | 73,994 | (7,879 | ) | 124,279 | (11,947 | ) |\n| Total | $ | 2,495,611 | $ | (113,584 | ) | $ | 1,599,859 | $ | (55,428 | ) | $ | 4,095,470 | $ | (169,012 | ) |\n\n\n| Duration of Unrealized Loss at December 31, 2014 By Maturity |\n| Less than 12 months | Greater than 12 months | Total |\n| Gross | Gross | Gross |\n| Unrealized | Unrealized | Unrealized |\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\n| Fixed maturity securities |\n| Due in one year or less | $ | 98,021 | $ | (5,166 | ) | $ | 80,002 | $ | (8,174 | ) | $ | 178,023 | $ | (13,340 | ) |\n| Due in one year through five years | 1,233,244 | (68,124 | ) | 518,613 | (12,761 | ) | 1,751,857 | (80,885 | ) |\n| Due in five years through ten years | 679,374 | (28,529 | ) | 187,717 | (10,734 | ) | 867,091 | (39,263 | ) |\n| Due after ten years | 72,436 | (6,172 | ) | 50,518 | (4,116 | ) | 122,954 | (10,288 | ) |\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\n| Mortgage-backed securities | 169,998 | (295 | ) | 689,015 | (11,764 | ) | 859,013 | (12,059 | ) |\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\n\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at December 31, 2014 were $4,095,470 thousand and $169,012 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at December 31, 2014, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $109,516 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to unrealized losses in the energy sector, $58,891 thousand, as falling oil prices disrupted the market values for this sector, particularly for oil exploration, production and servicing companies during the fourth quarter of 2014 and unrealized foreign exchange losses, $34,687 thousand, as the U.S. dollar has strengthened against other currencies. The $47,549 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $42,884 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. The gross unrealized depreciation for mortgage-backed securities included $15 thousand related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover\n10\nthe full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\nThe components of net investment income are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturities | $ | 108,134 | $ | 115,057 | $ | 326,970 | $ | 348,872 |\n| Equity securities | 11,090 | 11,086 | 35,783 | 36,111 |\n| Short-term investments and cash | 381 | 295 | 1,084 | 1,202 |\n| Other invested assets |\n| Limited partnerships | 370 | 21,690 | 13,993 | 25,658 |\n| Other | (242 | ) | 869 | 1,366 | 3,220 |\n| Gross investment income before adjustments | 119,733 | 148,997 | 379,196 | 415,063 |\n| Funds held interest income (expense) | 2,569 | 1,817 | 8,162 | 6,875 |\n| Future policy benefit reserve income (expense) | (300 | ) | (471 | ) | (1,402 | ) | (915 | ) |\n| Gross investment income | 122,002 | 150,343 | 385,956 | 421,023 |\n| Investment expenses | (6,491 | ) | (8,200 | ) | (22,816 | ) | (24,499 | ) |\n| Net investment income | $ | 115,511 | $ | 142,143 | $ | 363,140 | $ | 396,524 |\n\nThe Company records results from limited partnership investments on the equity method of accounting with changes in value reported through net investment income. Due to the timing of receiving financial information from these partnerships, the results are generally reported on a one month or quarter lag. If the Company determines there has been a significant decline in value of a limited partnership during this lag period, a loss will be recorded in the period in which the Company identifies the decline.\nThe Company had contractual commitments to invest up to an additional $469,064 thousand in limited partnerships at September 30, 2015. These commitments will be funded when called in accordance with the partnership agreements, which have investment periods that expire, unless extended, through 2020.\nThe components of net realized capital gains (losses) are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturity securities, market value: |\n| Other-than-temporary impairments | $ | (20,445 | ) | $ | (106 | ) | $ | (62,701 | ) | $ | (495 | ) |\n| Gains (losses) from sales | (5,218 | ) | 7,311 | (15,812 | ) | 3,668 |\n| Fixed maturity securities, fair value: |\n| Gains (losses) from sales | (17 | ) | 82 | 25 | 1,022 |\n| Gains (losses) from fair value adjustments | - | (938 | ) | 56 | (938 | ) |\n| Equity securities, market value: |\n| Gains (losses) from sales | (3,573 | ) | (181 | ) | (4,455 | ) | (1,235 | ) |\n| Equity securities, fair value: |\n| Gains (losses) from sales | (13,646 | ) | (1,823 | ) | (13,041 | ) | (1,873 | ) |\n| Gains (losses) from fair value adjustments | (117,087 | ) | (13,792 | ) | (98,741 | ) | 70,548 |\n| Short-term investments gains (losses) | 15 | (1 | ) | 15 | (3 | ) |\n| Total net realized capital gains (losses) | $ | (159,971 | ) | $ | (9,448 | ) | $ | (194,654 | ) | $ | 70,694 |\n\nThe Company recorded as net realized capital gains (losses) in the consolidated statements of operations and comprehensive income (loss) both fair value re-measurements and write-downs in the value of securities deemed to be impaired on an other-than-temporary basis as displayed in the table above. The Company had no other-than-temporary impaired securities where the impairment had both a credit and non-credit component.\n11\nThe proceeds and split between gross gains and losses, from sales of fixed maturity and equity securities, are presented in the table below for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Proceeds from sales of fixed maturity securities | $ | 414,538 | $ | 446,699 | $ | 1,147,824 | $ | 1,073,938 |\n| Gross gains from sales | 11,826 | 12,821 | 37,525 | 28,828 |\n| Gross losses from sales | (17,061 | ) | (5,428 | ) | (53,312 | ) | (24,138 | ) |\n| Proceeds from sales of equity securities | $ | 156,593 | $ | 150,124 | $ | 461,812 | $ | 463,688 |\n| Gross gains from sales | 5,250 | 2,545 | 18,890 | 13,047 |\n| Gross losses from sales | (22,469 | ) | (4,549 | ) | (36,386 | ) | (16,155 | ) |\n\n4. DERIVATIVES\nThe Company sold seven equity index put option contracts, based on two indices, in 2001 and 2005, which remain outstanding. The Company sold these equity index put options as insurance products with the intent of achieving a profit. These equity index put option contracts meet the definition of a derivative under FASB guidance and the Company's position in these equity index put option contracts is unhedged. Accordingly, these equity index put option contracts are carried at fair value in the consolidated balance sheets with changes in fair value recorded in the consolidated statements of operations and comprehensive income (loss).\nThe Company sold six equity index put option contracts, based on the Standard & Poor's 500 (\"S&P 500\") index, for total consideration, net of commissions, of $22,530 thousand. At September 30, 2015, fair value for these equity index put option contracts was $41,809 thousand. Based on historical index volatilities and trends and the September 30, 2015 S&P 500 index value, the Company estimates the probability that each equity index put option contract of the S&P 500 index falling below the strike price on the exercise date to be less than 23%. The theoretical maximum payouts under these six equity index put option contracts would occur if on each of the exercise dates the S&P 500 index value were zero. At September 30, 2015, the present value of these theoretical maximum payouts using a 3% discount factor was $429,402 thousand. Conversely, if the contracts had all expired on September 30, 2015, with the S&P index at $1,920.03, there would have been no settlement amount.\nThe Company sold one equity index put option contract based on the FTSE 100 index for total consideration, net of commissions, of $6,706 thousand. At September 30, 2015, fair value for this equity index put option contract was $10,438 thousand. Based on historical index volatilities and trends and the September 30, 2015 FTSE 100 index value, the Company estimates the probability that the equity index put option contract of the FTSE 100 index will fall below the strike price on the exercise date to be less than 51%. The theoretical maximum payout under the equity index put option contract would occur if on the exercise date the FTSE 100 index value was zero. At September 30, 2015, the present value of the theoretical maximum payout using a 3% discount factor and current exchange rate was $43,896 thousand. Conversely, if the contract had expired on September 30, 2015, with the FTSE index at ₤6,061.60, there would have been no settlement amount.\nThe fair value of the equity index put options can be found in the Company's consolidated balance sheets as follows:\n\n| (Dollars in thousands) |\n| Derivatives not designated as | Location of fair value | At | At |\n| hedging instruments | in balance sheets | September 30, 2015 | December 31, 2014 |\n| Equity index put option contracts | Equity index put option liability | $ | 52,247 | $ | 47,022 |\n| Total | $ | 52,247 | $ | 47,022 |\n\n12\nThe change in fair value of the equity index put option contracts can be found in the Company's statement of operations and comprehensive income (loss) as follows:\n\n| (Dollars in thousands) | Three Months Ended | Nine Months Ended |\n| Derivatives not designated as | Location of gain (loss) in statements of | September 30, | September 30, |\n| hedging instruments | operations and comprehensive income (loss) | 2015 | 2014 | 2015 | 2014 |\n| Equity index put option contracts | Net derivative gain (loss) | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\n| Total | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\n\n5. FAIR VALUE\nGAAP guidance regarding fair value measurements address how companies should measure fair value when they are required to use fair value measures for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based on the transparency of inputs to the valuation of an asset or liability. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement, with Level 1 being the highest priority and Level 3 being the lowest priority.\nThe levels in the hierarchy are defined as follows:\n\n| Level 1: | Inputs to the valuation methodology are observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in an active market; |\n\n\n| Level 2: | Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; |\n\n\n| Level 3: | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\n\nThe Company's fixed maturity and equity securities are primarily managed by third party investment asset managers. The investment asset managers obtain prices from nationally recognized pricing services. These services seek to utilize market data and observations in their evaluation process. They use pricing applications that vary by asset class and incorporate available market information and when fixed maturity securities do not trade on a daily basis the services will apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. In addition, they use model processes, such as the Option Adjusted Spread model to develop prepayment and interest rate scenarios for securities that have prepayment features.\nIn limited instances where prices are not provided by pricing services or in rare instances when a manager may not agree with the pricing service, price quotes on a non-binding basis are obtained from investment brokers. The investment asset managers do not make any changes to prices received from either the pricing services or the investment brokers. In addition, the investment asset managers have procedures in place to review the reasonableness of the prices from the service providers and may request verification of the prices. In addition, the Company continually performs analytical reviews of price changes and tests the prices on a random basis to an independent pricing source. No material variances were noted during these price validation procedures. In limited situations, where financial markets are inactive or illiquid, the Company may use its own assumptions about future cash flows and risk-adjusted discount rates to determine fair value. Due to the unavailability of prices for one private placement security, the Company valued the security at $6,125 thousand at September 30, 2015 and made no such adjustments at December 31, 2014.\n13\nThe Company internally manages a small public equity portfolio which had a fair value at September 30, 2015 and December 31, 2014 of $226,322 thousand and $196,980 thousand, respectively, and all prices were obtained from publically published sources.\nEquity securities denominated in U.S. currency with quoted prices in active markets for identical assets are categorized as level 1 since the quoted prices are directly observable. Equity securities traded on foreign exchanges are categorized as level 2 due to the added input of a foreign exchange conversion rate to determine fair or market value. The Company uses foreign currency exchange rates published by nationally recognized sources.\nAll categories of fixed maturity securities listed in the tables below are generally categorized as level 2, since a particular security may not have traded but the pricing services are able to use valuation models with observable market inputs such as interest rate yield curves and prices for similar fixed maturity securities in terms of issuer, maturity and seniority. For foreign government securities and foreign corporate securities, the fair values provided by the third party pricing services in local currencies, and where applicable, are converted to U.S. dollars using currency exchange rates from nationally recognized sources.\nThe fixed maturities with fair values categorized as level 3 result when prices are not available from the nationally recognized pricing services. The asset managers will then obtain non-binding price quotes for the securities from brokers. The single broker quotes are provided by market makers or broker-dealers who are recognized as market participants in the markets in which they are providing the quotes. The prices received from brokers are reviewed for reasonableness by the third party asset managers and the Company. If the broker quotes are for foreign denominated securities, the quotes are converted to U.S. dollars using currency exchange rates from nationally recognized sources. Historically, most of the level 3 fixed maturities have resulted from new issuances and the third party prices services have not yet included the issuance in their data base. Generally, in subsequent measurement periods, the issuances will be included in the data base and the fair value will transfer to level 2.\nThe composition and valuation inputs for the presented fixed maturities categories are as follows:\n\n| · | U.S. Treasury securities and obligations of U.S. government agencies and corporations are primarily comprised of U.S. Treasury bonds and the fair value is based on observable market inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields; |\n\n\n| · | Obligations of U.S. states and political subdivisions are comprised of state and municipal bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\n\n\n| · | Corporate securities are primarily comprised of U.S. corporate and public utility bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\n\n\n| · | Asset-backed and mortgage-backed securities fair values are based on observable inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields and cash flow models using observable inputs such as prepayment speeds, collateral performance and default spreads; |\n\n\n| · | Foreign government securities are comprised of global non-U.S. sovereign bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source; |\n\n\n| · | Foreign corporate securities are comprised of global non-U.S. corporate bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source. |\n\n14\nThe Company's liability for equity index put options is categorized as level 3 since there is no active market for these seven long dated equity put options. The fair values for these options are calculated by the Company using an industry accepted pricing model, Black-Scholes. The model inputs and assumptions are: risk free interest rates, equity market indexes values, volatilities and dividend yields and duration. The model results are then adjusted for the Company's credit default swap rate. All of these inputs and assumptions are updated quarterly. One of the option contacts is in British Pound Sterling so the fair value for this contract is converted to U.S. dollars using an exchange rate from a nationally recognized source.\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\n\n| Fair Value Measurement Using: |\n| Quoted Prices |\n| in Active | Significant |\n| Markets for | Other | Significant |\n| Identical | Observable | Unobservable |\n| Assets | Inputs | Inputs |\n| (Dollars in thousands) | September 30, 2015 | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| Fixed maturities, market value |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 352,926 | $ | - | $ | 352,926 | $ | - |\n| Obligations of U.S. States and political subdivisions | 714,279 | - | 714,279 | - |\n| Corporate securities | 5,006,937 | - | 4,999,371 | 7,566 |\n| Asset-backed securities | 438,397 | - | 438,397 | - |\n| Mortgage-backed securities |\n| Commercial | 284,809 | - | 284,809 | - |\n| Agency residential | 2,426,067 | - | 2,426,067 | - |\n| Non-agency residential | 978 | - | 978 | - |\n| Foreign government securities | 1,300,961 | - | 1,300,961 | - |\n| Foreign corporate securities | 2,965,606 | - | 2,959,481 | 6,125 |\n| Total fixed maturities, market value | 13,490,960 | - | 13,477,269 | 13,691 |\n| Fixed maturities, fair value | - | - | - | - |\n| Equity securities, market value | 112,999 | 97,871 | 15,128 | - |\n| Equity securities, fair value | 1,357,311 | 1,267,765 | 89,546 | - |\n| Liabilities: |\n| Equity index put option contracts | $ | 52,247 | $ | - | $ | - | $ | 52,247 |\n\nThere were no transfers between Level 1 and Level 2 for the nine months ended September 30, 2015.\n15\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\n\n| Fair Value Measurement Using: |\n| Quoted Prices |\n| in Active | Significant |\n| Markets for | Other | Significant |\n| Identical | Observable | Unobservable |\n| Assets | Inputs | Inputs |\n| (Dollars in thousands) | December 31, 2014 | (Level 1) | (Level 2) | (Level 3) |\n| Assets: |\n| Fixed maturities, market value |\n| U.S. Treasury securities and obligations of |\n| U.S. government agencies and corporations | $ | 231,038 | $ | - | $ | 231,038 | $ | - |\n| Obligations of U.S. States and political subdivisions | 824,472 | - | 824,472 | - |\n| Corporate securities | 4,706,985 | - | 4,706,985 | - |\n| Asset-backed securities | 341,222 | - | 341,222 | - |\n| Mortgage-backed securities |\n| Commercial | 241,685 | - | 233,088 | 8,597 |\n| Agency residential | 2,183,164 | - | 2,183,164 | - |\n| Non-agency residential | 2,731 | - | 2,731 | - |\n| Foreign government securities | 1,532,455 | - | 1,532,455 | - |\n| Foreign corporate securities | 3,037,315 | - | 3,030,149 | 7,166 |\n| Total fixed maturities, market value | 13,101,067 | - | 13,085,304 | 15,763 |\n| Fixed maturities, fair value | 1,509 | - | 1,509 | - |\n| Equity securities, market value | 140,210 | 124,295 | 15,915 | - |\n| Equity securities, fair value | 1,447,820 | 1,337,396 | 110,424 | - |\n| Liabilities: |\n| Equity index put option contracts | $ | 47,022 | $ | - | $ | - | $ | 47,022 |\n\n16\nThe following tables present the activity under Level 3, fair value measurements using significant unobservable inputs by asset type, for the periods indicated:\n\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\n| Corporate | Foreign | Corporate | Foreign |\n| (Dollars in thousands) | Securities | Corporate | Total | Securities | CMBS | Corporate | Total |\n| Beginning balance | $ | 1,958 | $ | 7,837 | $ | 9,795 | $ | - | $ | 8,597 | $ | 7,166 | $ | 15,763 |\n| Total gains or (losses) (realized/unrealized) |\n| Included in earnings | (8 | ) | 62 | 54 | (4 | ) | - | 177 | 173 |\n| Included in other comprehensive income (loss) | (137 | ) | (1,287 | ) | (1,424 | ) | (139 | ) | - | (1,216 | ) | (1,355 | ) |\n| Purchases, issuances and settlements | 1,723 | - | 1,723 | 3,651 | - | - | 3,651 |\n| Transfers in and/or (out) of Level 3 | 4,030 | (487 | ) | 3,543 | 4,058 | (8,597 | ) | (2 | ) | (4,541 | ) |\n| Ending balance | $ | 7,566 | $ | 6,125 | $ | 13,691 | $ | 7,566 | $ | - | $ | 6,125 | $ | 13,691 |\n| The amount of total gains or losses for the period |\n| included in earnings (or changes in net assets) |\n| attributable to the change in unrealized gains |\n| or losses relating to assets still held |\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\n\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\n| Corporate | Asset-backed | Foreign | Non-agency | Agency | Corporate | Asset-backed | Foreign | Non-agency | Agency |\n| (Dollars in thousands) | Securities | Securities | Corporate | RMBS | RMBS | Total | Securities | Securities | Corporate | RMBS | RMBS | Total |\n| Beginning balance | $ | - | $ | 3,000 | $ | - | $ | 259 | $ | - | $ | 3,259 | $ | - | $ | 5,299 | $ | 481 | $ | 347 | $ | - | $ | 6,127 |\n| Total gains or (losses) (realized/unrealized) |\n| Included in earnings | - | 1,203 | - | 187 | - | 1,390 | - | 1,259 | 18 | 329 | - | 1,606 |\n| Included in other comprehensive income (loss) | 42 | (201 | ) | (62 | ) | (114 | ) | - | (335 | ) | 42 | (126 | ) | (82 | ) | (138 | ) | - | (304 | ) |\n| Purchases, issuances and settlements | 1,274 | 22,797 | 4,517 | (332 | ) | 29,845 | 58,101 | 1,274 | 21,303 | 4,038 | (538 | ) | 29,845 | 55,922 |\n| Transfers in and/or (out) of Level 3 | - | (1,431 | ) | - | - | - | (1,431 | ) | - | (2,367 | ) | - | - | - | (2,367 | ) |\n| Ending balance | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 |\n| The amount of total gains or losses for the period |\n| included in earnings (or changes in net assets) |\n| attributable to the change in unrealized gains |\n| or losses relating to assets still held |\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\nThe net transfers to/(from) level 3, fair value measurements using significant unobservable inputs, of $4,541 thousand and $2,367 thousand of investments for the nine months ended September 30, 2015 and 2014, respectively, primarily relate to securities that were priced using single non-binding broker quotes as of December 31, 2014 and 2013, respectively. The securities were subsequently priced using a recognized pricing service as of September 30, 2015 and 2014, and were classified as level 2 as of those dates.\n17\nThe following table presents the activity under Level 3, fair value measurements using significant unobservable inputs for equity index put option contracts, for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Liabilities: |\n| Balance, beginning of period | $ | 40,819 | $ | 33,309 | $ | 47,022 | $ | 35,423 |\n| Total (gains) or losses (realized/unrealized) |\n| Included in earnings | 11,428 | (1,855 | ) | 5,225 | (3,968 | ) |\n| Included in other comprehensive income (loss) | - | - | - | - |\n| Purchases, issuances and settlements | - | - | - | - |\n| Transfers in and/or (out) of Level 3 | - | - | - | - |\n| Balance, end of period | $ | 52,247 | $ | 31,455 | $ | 52,247 | $ | 31,455 |\n| The amount of total gains or losses for the period included in earnings |\n| (or changes in net assets) attributable to the change in unrealized |\n| gains or losses relating to liabilities still held at the reporting date | $ | - | $ | - | $ | - | $ | - |\n| (Some amounts may not reconcile due to rounding.) |\n\n6. REDEEMABLE NONCONTROLLING INTERESTS – MT. LOGAN RE\nMt. Logan Re is a Class 3 insurer registered in Bermuda effective February 27, 2013 under The Segregated Accounts Companies Act 2000 and 100% of the voting common shares are owned by Group. Separate segregated accounts have been established effective July 1, 2013 and non-voting, redeemable preferred shares have been issued to capitalize the segregated accounts. Each segregated account will invest in a diversified set of catastrophe exposures, diversified by risk/peril and across different geographic regions globally. The financial statements for Mt. Logan Re are consolidated with the Company with adjustments reflected for the third party noncontrolling interests reflected as separate captions in the Company's financial statements.\nThe following table presents the activity for redeemable noncontrolling interests in the consolidated balance sheets for the periods indicated:\n\n| Nine Months Ended | Twelve Months Ended |\n| September 30, | December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| Redeemable noncontrolling interests - Mt. Logan Re, beginning of period | $ | 421,552 | $ | 93,378 |\n| Unaffiliated third party investments during period, net | 336,848 | 279,200 |\n| Net income (loss) attributable to noncontrolling interests | 61,526 | 59,307 |\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\n| Redeemable noncontrolling interests - Mt. Logan Re, end of period | $ | 752,692 | $ | 421,552 |\n| (Some amounts may not reconcile due to rounding.) |\n\nIn addition, the Company has invested $50,000 thousand in the segregated accounts from inception to date.\nThe Company expects its participation level in the segregated funds to fluctuate over time.\n7. CAPITAL TRANSACTIONS\nOn July 9, 2014, the Company renewed its shelf registration statement on Form S-3ASR with the Securities and Exchange Commission (the \"SEC\"), as a Well Known Seasoned Issuer. This shelf registration statement can be used by Group to register common shares, preferred shares, debt securities, warrants, share purchase contracts and share purchase units; by Holdings to register debt securities and by Everest Re Capital Trust III (\"Capital Trust III\") to register trust preferred securities.\n18\n8. EARNINGS PER COMMON SHARE\nBasic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that would occur if options granted under various share-based compensation plans were exercised resulting in the issuance of common shares that would participate in the earnings of the entity.\nNet income (loss) attributable to Everest Re Group per common share has been computed as per below, based upon weighted average common basic and dilutive shares outstanding.\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\n| Net income (loss) attributable to Everest Re Group per share: |\n| Numerator |\n| Net income (loss) attributable to Everest Re Group | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\n| Less: dividends declared-common shares and nonvested common shares | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\n| Undistributed earnings | 46,855 | 240,943 | 494,683 | 755,999 |\n| Percentage allocated to common shareholders (1) | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\n| 46,364 | 238,407 | 489,434 | 748,273 |\n| Add: dividends declared-common shareholders | 41,293 | 33,631 | 124,638 | 101,993 |\n| Numerator for basic and diluted earnings per common share | $ | 87,657 | $ | 272,038 | $ | 614,072 | $ | 850,266 |\n| Denominator |\n| Denominator for basic earnings per weighted-average common shares | 43,361 | 44,941 | 43,728 | 45,615 |\n| Effect of dilutive securities: |\n| Options | 367 | 415 | 392 | 426 |\n| Denominator for diluted earnings per adjusted weighted-average common shares | 43,728 | 45,356 | 44,120 | 46,041 |\n| Per common share net income (loss) |\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\n| Diluted | $ | 2.00 | $ | 6.00 | $ | 13.92 | $ | 18.47 |\n| (1) | Basic weighted-average common shares outstanding | 43,361 | 44,941 | 43,728 | 45,615 |\n| Basic weighted-average common shares outstanding and nonvested common shares expected to vest | 43,820 | 45,419 | 44,197 | 46,086 |\n| Percentage allocated to common shareholders | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n\nThere were no anti-diluted options outstanding for the three and nine months ended September 30, 2015 and 2014.\nAll outstanding options expire on or between February 21, 2017 and September 19, 2022.\n9. CONTINGENCIES\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\n19\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\nThe Company has entered into separate annuity agreements with The Prudential Insurance of America (\"The Prudential\") and an additional unaffiliated life insurance company in which the Company has either purchased annuity contracts or become the assignee of annuity proceeds that are meant to settle claim payment obligations in the future. In both instances, the Company would become contingently liable if either The Prudential or the unaffiliated life insurance company were unable to make payments related to the respective annuity contract.\nThe table below presents the estimated cost to replace all such annuities for which the Company was contingently liable for the periods indicated:\n\n| At September 30, | At December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| The Prudential | $ | 142,661 | $ | 142,653 |\n| Unaffiliated life insurance company | 32,414 | 31,964 |\n\n10. OTHER COMPREHENSIVE INCOME (LOSS)\nThe following tables present the components of comprehensive income (loss) in the consolidated statements of operations for the periods indicated:\n\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities - temporary | $ | (105,356 | ) | $ | 14,558 | $ | (90,798 | ) | $ | (178,878 | ) | $ | 29,004 | $ | (149,874 | ) |\n| URA(D) on securities - OTTI | (253 | ) | (8 | ) | (261 | ) | 8,954 | (3,415 | ) | 5,539 |\n| Reclassification of net realized losses (gains) included in net income (loss) | 29,235 | (4,639 | ) | 24,596 | 82,967 | (23,441 | ) | 59,526 |\n| Foreign currency translation adjustments | (47,298 | ) | 14,793 | (32,505 | ) | (104,542 | ) | 24,034 | (80,508 | ) |\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\n| Reclassification of benefit plan liability amortization included in net income (loss) | 2,393 | (837 | ) | 1,556 | 7,336 | (2,567 | ) | 4,769 |\n| Total other comprehensive income (loss) | $ | (121,279 | ) | $ | 23,867 | $ | (97,412 | ) | $ | (184,163 | ) | $ | 23,615 | $ | (160,548 | ) |\n\n\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\n| Unrealized appreciation (depreciation) (\"URA(D)\") on securities - temporary | $ | (84,122 | ) | $ | 10,309 | $ | (73,813 | ) | $ | 75,275 | $ | (9,777 | ) | $ | 65,498 |\n| URA(D) on securities - OTTI | (261 | ) | - | (261 | ) | (180 | ) | - | (180 | ) |\n| Reclassification of net realized losses (gains) included in net income (loss) | (7,024 | ) | 1,340 | (5,684 | ) | (1,938 | ) | 297 | (1,641 | ) |\n| Foreign currency translation adjustments | (38,998 | ) | 4,024 | (34,974 | ) | (42,998 | ) | 4,624 | (38,374 | ) |\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\n| Reclassification of benefit plan liability amortization included in net income (loss) | 1,269 | (444 | ) | 825 | 3,640 | (1,274 | ) | 2,366 |\n| Total other comprehensive income (loss) | $ | (129,136 | ) | $ | 15,229 | $ | (113,907 | ) | $ | 33,799 | $ | (6,130 | ) | $ | 27,669 |\n\n20\nThe following table presents details of the amounts reclassified from AOCI for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, | Affected line item within the statements of |\n| AOCI component | 2015 | 2014 | 2015 | 2014 | operations and comprehensive income (loss) |\n| (Dollars in thousands) |\n| URA(D) on securities | $ | 29,235 | $ | (7,024 | ) | $ | 82,967 | $ | (1,938 | ) | Other net realized capital gains (losses) |\n| (4,639 | ) | 1,340 | (23,441 | ) | 297 | Income tax expense (benefit) |\n| $ | 24,596 | $ | (5,684 | ) | $ | 59,526 | $ | (1,641 | ) | Net income (loss) |\n| Benefit plan net gain (loss) | $ | 2,393 | $ | 1,269 | $ | 7,336 | $ | 3,640 | Other underwriting expenses |\n| (837 | ) | (444 | ) | (2,567 | ) | (1,274 | ) | Income tax expense (benefit) |\n| $ | 1,556 | $ | 825 | $ | 4,769 | $ | 2,366 | Net income (loss) |\n\nThe following table presents the components of accumulated other comprehensive income (loss), net of tax, in the consolidated balance sheets for the periods indicated:\n\n| Nine Months Ended | Twelve Months Ended |\n| September 30, | December 31, |\n| (Dollars in thousands) | 2015 | 2014 |\n| Beginning balance of URA (D) on securities | $ | 223,250 | $ | 201,154 |\n| Current period change in URA (D) of investments - temporary | (90,348 | ) | 28,767 |\n| Current period change in URA (D) of investments - non-credit OTTI | 5,539 | (6,671 | ) |\n| Ending balance of URA (D) on securities | 138,441 | 223,250 |\n| Beginning balance of foreign currency translation adjustments | (99,947 | ) | (4,530 | ) |\n| Current period change in foreign currency translation adjustments | (80,508 | ) | (95,417 | ) |\n| Ending balance of foreign currency translation adjustments | (180,455 | ) | (99,947 | ) |\n| Beginning balance of benefit plan net gain (loss) | (74,986 | ) | (38,896 | ) |\n| Current period change in benefit plan net gain (loss) | 4,769 | (36,090 | ) |\n| Ending balance of benefit plan net gain (loss) | (70,217 | ) | (74,986 | ) |\n| Ending balance of accumulated other comprehensive income (loss) | $ | (112,231 | ) | $ | 48,317 |\n\n11. CREDIT FACILITIES\nThe Company has two active credit facilities for a total commitment of up to $1,100,000 thousand, providing for the issuance of letters of credit and/or unsecured revolving credit lines. The following table presents the costs incurred in connection with the two credit facilities for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Credit facility fees incurred | $ | 132 | $ | 132 | $ | 431 | $ | 527 |\n\n21\nThe terms and outstanding amounts for each facility are discussed below:\nGroup Credit Facility\nEffective June 22, 2012, Group, Bermuda Re and Everest International entered into a four year, $800,000 thousand senior credit facility with a syndicate of lenders, which amended and restated in its entirety the July 27, 2007, five year, $850,000 thousand senior credit facility. Both the June 22, 2012 and July 27, 2007 senior credit facilities, which have similar terms, are referred to as the \"Group Credit Facility\". Wells Fargo Corporation (\"Wells Fargo Bank\") is the administrative agent for the Group Credit Facility, which consists of two tranches. Tranche one provides up to $200,000 thousand of unsecured revolving credit for liquidity and general corporate purposes, and for the issuance of unsecured standby letters of credit. The interest on the revolving loans shall, at the Company's option, be either (1) the Base Rate (as defined below) or (2) an adjusted London Interbank Offered Rate (\"LIBOR\") plus a margin. The Base Rate is the higher of (a) the prime commercial lending rate established by Wells Fargo Bank, (b) the Federal Funds Rate plus 0.5% per annum or (c) the one month LIBOR Rate plus 1.0% per annum. The amount of margin and the fees payable for the Group Credit Facility depends on Group's senior unsecured debt rating. Tranche two exclusively provides up to $600,000 thousand for the issuance of standby letters of credit on a collateralized basis.\nThe Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth. Minimum net worth is an amount equal to the sum of $4,249,963 thousand plus 25% of consolidated net income for each of Group's fiscal quarters, for which statements are available ending on or after January 1, 2012 and for which consolidated net income is positive, plus 25% of any increase in consolidated net worth during such period attributable to the issuance of ordinary and preferred shares, which at September 30, 2015, was $5,277,454 thousand. As of September 30, 2015, the Company was in compliance with all Group Credit Facility covenants.\nThe following table summarizes the outstanding letters of credit and/or borrowings for the periods indicated:\n\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\n| Wells Fargo Bank Group Credit Facility | Tranche One | $ | 200,000 | $ | - | $ | 200,000 | $ | - |\n| Tranche Two | 600,000 | 456,379 | 12/31/2015 | 600,000 | 444,012 | 12/31/2015 |\n| Total Wells Fargo Bank Group Credit Facility | $ | 800,000 | $ | 456,379 | $ | 800,000 | $ | 444,012 |\n\nBermuda Re Letter of Credit Facility\nEffective December 31, 2014, Bermuda Re renewed its $300,000 thousand letter of credit issuance facility with Citibank N.A. referred to as the \"Bermuda Re Letter of Credit Facility\", which commitment is reconfirmed annually with updated fees. The Bermuda Re Letter of Credit Facility provides for the issuance of up to $300,000 thousand of secured letters of credit to collateralize reinsurance obligations as a non-admitted reinsurer. The interest on drawn letters of credit shall be (A) 0.35% per annum of the principal amount of issued standard letters of credit (expiry of 15 months or less) and (B) 0.45% per annum of the principal amount of issued extended tenor letters of credit (expiry maximum of up to 60 months). The commitment fee on undrawn credit shall be 0.15% per annum.\nThe following table summarizes the outstanding letters of credit for the periods indicated:\n\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\n| Citibank Bilateral Letter of Credit Agreement | $ | 300,000 | $ | 3,672 | 11/24/2015 | $ | 300,000 | $ | 112 | 8/30/2015 |\n| 65,013 | 12/31/2015 | 3,672 | 11/24/2015 |\n| 2,681 | 12/31/2016 | 70,922 | 12/31/2015 |\n| 173 | 8/30/2017 | 2,014 | 12/31/2016 |\n| 119,002 | 9/30/2019 | 149,353 | 12/30/2018 |\n| Total Citibank Bilateral Agreement | $ | 300,000 | $ | 190,541 | $ | 300,000 | $ | 226,073 |\n\n22\nHoldings Credit Facility - Expired\nEffective August 15, 2011, the Company entered into a three year, $150,000 thousand unsecured revolving credit facility, referred to as the \"Holdings Credit Facility\", which expired on August 15, 2014. The Company decided not to renew the Holdings Credit Facility at expiration.\n12. REINSURANCE AND TRUST AGREEMENTS\nCertain subsidiaries of Group have established trust agreements, which effectively use the Company's investments as collateral, as security for assumed losses payable to certain non-affiliated ceding companies. At September 30, 2015, the total amount on deposit in trust accounts was $404,008 thousand.\nOn April 24, 2014, the Company entered into two collateralized reinsurance agreements with Kilimanjaro Re Limited (\"Kilimanjaro\"), a Bermuda based special purpose reinsurer, to provide the Company with catastrophe reinsurance coverage. These agreements are multi-year reinsurance contracts which cover specified named storm and earthquake events. The first agreement provides up to $250,000 thousand of reinsurance coverage from named storms in specified states of the Southeastern United States. The second agreement provides up to $200,000 thousand of reinsurance coverage from named storms in specified states of the Southeast, Mid-Atlantic and Northeast regions of the United States and Puerto Rico as well as reinsurance coverage from earthquakes in specified states of the Southeast, Mid-Atlantic, Northeast and West regions of the United States, Puerto Rico and British Columbia.\nOn November 18, 2014, the Company entered into a collateralized reinsurance agreement with Kilimanjaro Re to provide the Company with catastrophe reinsurance coverage. This agreement is a multi-year reinsurance contract which covers specified earthquake events. The agreement provides up to $500,000 thousand of reinsurance coverage from earthquakes in the United States, Puerto Rico and Canada.\nKilimanjaro has financed the various property catastrophe reinsurance coverage by issuing catastrophe bonds to unrelated, external investors. On April 24, 2014, Kilimanjaro issued $450,000 thousand of variable rate notes (\"Series 2014-1 Notes\"). On November 18, 2014, Kilimanjaro issued $500,000 thousand of variable rate notes (\"Series 2014-2 Notes\"). The proceeds from the issuance of the Series 2014-1 Notes and the Series 2014-2 Notes are held in reinsurance trust throughout the duration of the applicable reinsurance agreements and invested solely in US government money market funds with a rating of at least \"AAAm\" by Standard & Poor's.\n13. SENIOR NOTES\nThe table below displays Holdings' outstanding senior notes. Market value is based on quoted market prices, but due to limited trading activity, these senior notes are considered Level 2 in the fair value hierarchy.\n\n| September 30, 2015 | December 31, 2014 |\n| Consolidated Balance | Consolidated Balance |\n| (Dollars in thousands) | Date Issued | Date Due | Principal Amounts | Sheet Amount | Market Value | Sheet Amount | Market Value |\n| 4.868% Senior notes | 06/05/2014 | 06/01/2044 | $ | 400,000 | $ | 400,000 | $ | 388,768 | $ | 400,000 | $ | 404,892 |\n| 5.40% Senior notes | 10/12/2004 | 10/15/2014 | 250,000 | - | - | - | - |\n\nOn June 5, 2014, Holdings issued $400,000 thousand of 30 year senior notes at 4.868%, which will mature on June 1, 2044. Interest will be paid semi-annually on June 1 and December 1 of each year. The proceeds from the issuance have been used in part to pay off the $250,000 thousand of 5.40% senior notes which matured on October 15, 2014.\n23\nInterest expense incurred in connection with these senior notes is as follows for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Interest expense incurred | $ | 4,868 | $ | 8,256 | $ | 14,604 | $ | 16,385 |\n\n14. LONG TERM SUBORDINATED NOTES\nThe table below displays Holdings' outstanding fixed to floating rate long term subordinated notes. Market value is based on quoted market prices, but due to limited trading activity, these subordinated notes are considered Level 2 in the fair value hierarchy.\n\n| Maturity Date | September 30, 2015 | December 31, 2014 |\n| Original | Consolidated Balance | Consolidated Balance |\n| (Dollars in thousands) | Date Issued | Principal Amount | Scheduled | Final | Sheet Amount | Market Value | Sheet Amount | Market Value |\n| 6.6% Long term subordinated notes | 04/26/2007 | $ | 400,000 | 05/15/2037 | 05/01/2067 | $ | 238,367 | $ | 218,281 | $ | 238,364 | $ | 246,312 |\n\nDuring the fixed rate interest period from May 3, 2007 through May 14, 2017, interest will be at the annual rate of 6.6%, payable semi-annually in arrears on November 15 and May 15 of each year, commencing on November 15, 2007, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. During the floating rate interest period from May 15, 2017 through maturity, interest will be based on the 3 month LIBOR plus 238.5 basis points, reset quarterly, payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. Deferred interest will accumulate interest at the applicable rate compounded semi-annually for periods prior to May 15, 2017, and compounded quarterly for periods from and including May 15, 2017.\nHoldings can redeem the long term subordinated notes prior to May 15, 2017, in whole but not in part at the applicable redemption price, which will equal the greater of (a) 100% of the principal amount being redeemed and (b) the present value of the principal payment on May 15, 2017 and scheduled payments of interest that would have accrued from the redemption date to May 15, 2017 on the long term subordinated notes being redeemed, discounted to the redemption date on a semi-annual basis at a discount rate equal to the treasury rate plus an applicable spread of either 0.25% or 0.50%, in each case plus accrued and unpaid interest. Holdings may redeem the long term subordinated notes on or after May 15, 2017, in whole or in part at 100% of the principal amount plus accrued and unpaid interest; however, redemption on or after the scheduled maturity date and prior to May 1, 2047 is subject to a replacement capital covenant. This covenant is for the benefit of certain senior note holders and it mandates that Holdings receive proceeds from the sale of another subordinated debt issue, of at least similar size, before it may redeem the subordinated notes. Effective upon the maturity of the Company's 5.40% senior notes on October 15, 2014, the Company's 4.868% senior notes, due on June 1, 2044, have become the Company's long term indebtedness that ranks senior to the long term subordinated notes.\nOn March 19, 2009, Group announced the commencement of a cash tender offer for any and all of the 6.60% fixed to floating rate long term subordinated notes. Upon expiration of the tender offer, the Company had reduced its outstanding debt by $161,441 thousand.\nInterest expense incurred in connection with these long term subordinated notes is as follows for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Interest expense incurred | $ | 3,937 | $ | 3,937 | $ | 11,811 | $ | 11,811 |\n\n24\n15. SEGMENT REPORTING\nThe U.S. Reinsurance operation writes property and casualty reinsurance and specialty lines of business, including Marine, Aviation, Surety and Accident and Health (\"A&H\") business, on both a treaty and facultative basis, through reinsurance brokers, as well as directly with ceding companies primarily within the U.S. The International operation writes non-U.S. property and casualty reinsurance through Everest Re's branches in Canada and Singapore and through offices in Brazil, Miami and New Jersey. The Bermuda operation provides reinsurance and insurance to worldwide property and casualty markets through brokers and directly with ceding companies from its Bermuda office and reinsurance to the United Kingdom and European markets through its UK branch and Ireland Re. The Insurance operation writes property and casualty insurance directly and through general agents, brokers and surplus lines brokers within the U.S. and Canada. The Mt. Logan Re segment represents business written for the segregated accounts of Mt. Logan Re, which were formed on July 1, 2013. The Mt. Logan Re business represents a diversified set of catastrophe exposures, diversified by risk/peril and across different geographical regions globally.\nThese segments, with the exception of Mt. Logan Re, are managed independently, but conform with corporate guidelines with respect to pricing, risk management, control of aggregate catastrophe exposures, capital, investments and support operations. Management generally monitors and evaluates the financial performance of these operating segments based upon their underwriting results. The Mt. Logan Re segment is managed independently and seeks to write a diverse portfolio of catastrophe risks for each segregated account to achieve desired risk and return criteria.\nUnderwriting results include earned premium less losses and loss adjustment expenses (\"LAE\") incurred, commission and brokerage expenses and other underwriting expenses. We measure our underwriting results using ratios, in particular loss, commission and brokerage and other underwriting expense ratios, which, respectively, divide incurred losses, commissions and brokerage and other underwriting expenses by premiums earned.\nMt. Logan Re's business is sourced through operating subsidiaries of the Company; however, the activity is only reflected in the Mt. Logan Re segment. For other inter-affiliate reinsurance, business is generally reported within the segment in which the business was first produced, consistent with how the business is managed.\nExcept for Mt. Logan Re, the Company does not maintain separate balance sheet data for its operating segments. Accordingly, the Company does not review and evaluate the financial results of its operating segments based upon balance sheet data.\n25\nThe following tables present the underwriting results for the operating segments for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| U.S. Reinsurance | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 537,483 | $ | 640,660 | $ | 1,464,840 | $ | 1,573,776 |\n| Net written premiums | 511,238 | 615,078 | 1,383,647 | 1,536,114 |\n| Premiums earned | $ | 488,485 | $ | 559,488 | $ | 1,480,427 | $ | 1,478,258 |\n| Incurred losses and LAE | 225,944 | 249,004 | 699,575 | 701,473 |\n| Commission and brokerage | 121,050 | 123,432 | 364,005 | 339,166 |\n| Other underwriting expenses | 13,718 | 12,118 | 37,054 | 33,054 |\n| Underwriting gain (loss) | $ | 127,773 | $ | 174,934 | $ | 379,793 | $ | 404,565 |\n\n\n| Three Months Ended | Nine Months Ended |\n| International | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 354,871 | $ | 406,254 | $ | 966,091 | $ | 1,181,513 |\n| Net written premiums | 318,478 | 352,608 | 896,872 | 977,235 |\n| Premiums earned | $ | 291,396 | $ | 320,020 | $ | 935,228 | $ | 958,399 |\n| Incurred losses and LAE | 229,013 | 236,559 | 630,752 | 604,166 |\n| Commission and brokerage | 70,894 | 73,143 | 226,321 | 215,716 |\n| Other underwriting expenses | 9,128 | 8,758 | 25,292 | 24,683 |\n| Underwriting gain (loss) | $ | (17,639 | ) | $ | 1,560 | $ | 52,863 | $ | 113,834 |\n\n\n| Three Months Ended | Nine Months Ended |\n| Bermuda | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 267,035 | $ | 205,342 | $ | 605,365 | $ | 573,793 |\n| Net written premiums | 251,678 | 189,447 | 557,453 | 548,210 |\n| Premiums earned | $ | 222,240 | $ | 181,754 | $ | 616,241 | $ | 546,699 |\n| Incurred losses and LAE | 154,327 | 108,961 | 372,572 | 310,602 |\n| Commission and brokerage | 52,980 | 48,421 | 151,356 | 140,968 |\n| Other underwriting expenses | 9,457 | 9,360 | 27,045 | 25,805 |\n| Underwriting gain (loss) | $ | 5,476 | $ | 15,012 | $ | 65,268 | $ | 69,324 |\n\n\n| Three Months Ended | Nine Months Ended |\n| Insurance | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 489,124 | $ | 364,111 | $ | 1,173,012 | $ | 911,242 |\n| Net written premiums | 418,960 | 310,690 | 1,022,389 | 802,431 |\n| Premiums earned | $ | 360,742 | $ | 290,518 | $ | 888,711 | $ | 742,038 |\n| Incurred losses and LAE | 262,328 | 239,823 | 662,052 | 557,047 |\n| Commission and brokerage | 50,268 | 40,418 | 127,125 | 114,535 |\n| Other underwriting expenses | 35,677 | 31,311 | 99,232 | 83,672 |\n| Underwriting gain (loss) | $ | 12,469 | $ | (21,034 | ) | $ | 302 | $ | (13,216 | ) |\n\n26\n\n| Three Months Ended | Nine Months Ended |\n| Mt. Logan Re | September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Gross written premiums | $ | 72,200 | $ | 50,334 | $ | 183,694 | $ | 109,163 |\n| Net written premiums | 60,903 | 49,757 | 153,281 | 98,666 |\n| Premiums earned | $ | 50,777 | $ | 38,218 | $ | 132,508 | $ | 81,411 |\n| Incurred losses and LAE | 16,485 | 3,410 | 36,272 | 19,575 |\n| Commission and brokerage | 4,856 | 5,105 | 13,325 | 9,823 |\n| Other underwriting expenses | 2,687 | 1,566 | 6,659 | 4,951 |\n| Underwriting gain (loss) | $ | 26,749 | $ | 28,137 | $ | 76,252 | $ | 47,062 |\n\nThe following table reconciles the underwriting results for the operating segments to income before taxes as reported in the consolidated statements of operations and comprehensive income (loss) for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Underwriting gain (loss) | $ | 154,828 | $ | 198,609 | $ | 574,478 | $ | 621,569 |\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\n| Net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\n| Corporate expenses | (5,924 | ) | (9,958 | ) | (17,312 | ) | (18,802 | ) |\n| Interest, fee and bond issue cost amortization expense | (8,990 | ) | (12,424 | ) | (27,006 | ) | (28,970 | ) |\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\n| Income (loss) before taxes | $ | 101,439 | $ | 322,109 | $ | 752,982 | $ | 1,039,148 |\n\nThe Company produces business in the U.S., Bermuda and internationally. The net income deriving from and assets residing in the individual foreign countries in which the Company writes business are not identifiable in the Company's financial records. Based on gross written premium, the table below presents the largest country, other than the U.S., in which the Company writes business, for the periods indicated:\n\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| United Kingdom gross written premium | $ | 212,039 | $ | 199,052 | $ | 565,143 | $ | 536,928 |\n\nNo other country represented more than 5% of the Company's revenues.\n16. SHARE-BASED COMPENSATION PLANS\nFor the three months ended September 30, 2015, share-based compensation awards granted were 4,720 restricted shares, granted on September 9, 2015, with a fair value of $176.37 per share.\n27\n17. RETIREMENT BENEFITS\nThe Company maintains both qualified and non-qualified defined benefit pension plans and a retiree health plan for its U.S. employees employed prior to April 1, 2010.\nNet periodic benefit cost for U.S. employees included the following components for the periods indicated:\n\n| Pension Benefits | Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Service cost | $ | 3,203 | $ | 2,460 | $ | 9,398 | $ | 7,381 |\n| Interest cost | 2,758 | 2,542 | 7,926 | 7,625 |\n| Expected return on plan assets | (2,904 | ) | (2,822 | ) | (8,710 | ) | (8,468 | ) |\n| Amortization of prior service cost | 4 | 13 | 15 | 38 |\n| Amortization of net (income) loss | 2,312 | 1,173 | 6,824 | 3,356 |\n| FAS 88 settlement charge | - | 5,269 | - | 5,269 |\n| Net periodic benefit cost | $ | 5,373 | $ | 8,635 | $ | 15,453 | $ | 15,201 |\n\n\n| Other Benefits | Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\n| Service cost | $ | 498 | $ | 407 | $ | 1,498 | $ | 1,221 |\n| Interest cost | 329 | 342 | 987 | 1,026 |\n| Amortization of net (income) loss | 76 | 82 | 497 | 246 |\n| Net periodic benefit cost | $ | 903 | $ | 831 | $ | 2,982 | $ | 2,493 |\n\nThe Company did not make any contributions to the qualified pension benefit plan for the three and nine months ended September 30, 2015 and 2014.\n18. INCOME TAXES\nThe Company is domiciled in Bermuda and has significant subsidiaries and/or branches in Canada, Ireland, Singapore, the United Kingdom, and the United States. The Company's Bermuda domiciled subsidiaries are exempt from income taxation under Bermuda law until 2035. Pre-tax income generated by Group's non-Bermuda subsidiaries and the UK branch of Bermuda is subject to applicable federal, foreign, state and local taxes on corporations. Company subsidiaries domiciled in the US as well as the Canadian and Singapore branches of Everest Re generate US pre-tax income (loss). Foreign domiciled subsidiaries, including the UK branch of Bermuda Re, generate non-US pre-tax income (loss). Fluctuations in US and non-US pre-tax income (loss) primarily result from the impact of catastrophe losses and realized investment gains (losses).\nFor interim reporting periods, the company is generally required to use the annualized effective tax rate (\"AETR\") method, as prescribed by ASC 740-270, Interim Reporting, to calculate its income tax provision. Under this method, the AETR is applied to the interim year-to-date pre-tax income to determine the income tax expense or benefit for the year-to-date period. The income tax expense or benefit for a quarter represents the difference between the year-to-date income tax expense or benefit for the current year-to-date period less such amount for the immediately preceding year-to-date period. Management considers the impact of all known events in its estimation of the Company's annual pre-tax income and AETR.\n19. DISPOSITIONS\nOn July 13, 2015, the Company closed its agreement to sell all of the outstanding shares of capital stock of Mt. McKinley, a Delaware domiciled insurance company and wholly-owned subsidiary of the Company to Clearwater Insurance Company, a Delaware domiciled insurance company. The Company received $20,156 thousand in cash for Mt. McKinley and did not recognize any realized gain or loss from the sale.\n28\nConcurrently with the closing, the Company entered into a retrocession treaty with an affiliate of Clearwater Insurance Company. Per the retrocession treaty, the Company retroceded 100% of the liabilities associated with certain Mt. McKinley policies, which had been reinsured by Everest Reinsurance (Bermuda), Ltd. (\"Everest Re Bermuda\"), a wholly-owned subsidiary of the Company. As consideration for entering into the retrocession treaty, Everest Re Bermuda transferred cash of $140,279 thousand, an amount equal to the net loss reserves as of the closing date. The maximum liability retroceded under the retrocession treaty will be $440,279 thousand, equal to the retrocession payment plus $300,000 thousand. The Company will retain liability for any amounts exceeding the maximum liability retroceded under the retrocession treaty.\n20. SUBSEQUENT EVENTS\nThe Company is currently negotiating two additional reinsurance agreements with Kilimanjaro to provide the Company with catastrophe reinsurance coverage. Kilimanjaro will fund the catastrophe reinsurance coverage through the issuance of two classes of catastrophe reinsurance bonds.\n29\n\nITEM 2.\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION\n| Three Months Ended | Percentage | Nine Months Ended | Percentage |\n| September 30, | Increase/ | September 30, | Increase/ |\n| (Dollars in millions) | 2015 | 2014 | (Decrease) | 2015 | 2014 | (Decrease) |\n| Gross written premiums | $ | 1,720.7 | $ | 1,666.7 | 3.2 | % | $ | 4,393.0 | $ | 4,349.5 | 1.0 | % |\n| Net written premiums | 1,561.3 | 1,517.6 | 2.9 | % | 4,013.6 | 3,962.7 | 1.3 | % |\n| REVENUES: |\n| Premiums earned | $ | 1,413.6 | $ | 1,390.0 | 1.7 | % | $ | 4,053.1 | $ | 3,806.8 | 6.5 | % |\n| Net investment income | 115.5 | 142.1 | -18.7 | % | 363.1 | 396.5 | -8.4 | % |\n| Net realized capital gains (losses) | (160.0 | ) | (9.4 | ) | NM | (194.7 | ) | 70.7 | NM |\n| Net derivative gain (loss) | (11.4 | ) | 1.9 | NM | (5.2 | ) | 4.0 | -231.7 | % |\n| Other income (expense) | 17.4 | 11.3 | 53.6 | % | 59.6 | (5.8 | ) | NM |\n| Total revenues | 1,375.2 | 1,535.9 | -10.5 | % | 4,275.9 | 4,272.2 | 0.1 | % |\n| CLAIMS AND EXPENSES: |\n| Incurred losses and loss adjustment expenses | 888.1 | 837.8 | 6.0 | % | 2,401.2 | 2,192.9 | 9.5 | % |\n| Commission, brokerage, taxes and fees | 300.0 | 290.5 | 3.3 | % | 882.1 | 820.2 | 7.5 | % |\n| Other underwriting expenses | 70.7 | 63.1 | 12.0 | % | 195.3 | 172.2 | 13.4 | % |\n| Corporate expenses | 5.9 | 10.0 | -40.5 | % | 17.3 | 18.8 | -7.9 | % |\n| Interest, fees and bond issue cost amortization expense | 9.0 | 12.4 | -27.6 | % | 27.0 | 29.0 | -6.8 | % |\n| Total claims and expenses | 1,273.7 | 1,213.8 | 4.9 | % | 3,523.0 | 3,233.0 | 9.0 | % |\n| INCOME (LOSS) BEFORE TAXES | 101.4 | 322.1 | -68.5 | % | 753.0 | 1,039.1 | -27.5 | % |\n| Income tax expense (benefit) | (6.1 | ) | 20.9 | -129.4 | % | 70.9 | 137.9 | -48.6 | % |\n| NET INCOME (LOSS) | $ | 107.6 | $ | 301.3 | -64.3 | % | $ | 682.1 | $ | 901.2 | -24.3 | % |\n| Net (income) loss attributable to noncontrolling interests | (19.0 | ) | (26.3 | ) | -27.8 | % | (61.5 | ) | (42.2 | ) | 45.9 | % |\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88.6 | $ | 274.9 | -67.8 | % | $ | 620.6 | $ | 859.0 | -27.8 | % |\n| RATIOS: | Point Change | Point Change |\n| Loss ratio | 62.8 | % | 60.3 | % | 2.5 | 59.2 | % | 57.6 | % | 1.6 |\n| Commission and brokerage ratio | 21.2 | % | 20.9 | % | 0.3 | 21.8 | % | 21.5 | % | 0.3 |\n| Other underwriting expense ratio | 5.0 | % | 4.5 | % | 0.5 | 4.8 | % | 4.6 | % | 0.2 |\n| Combined ratio | 89.0 | % | 85.7 | % | 3.3 | 85.8 | % | 83.7 | % | 2.1 |\n| At | At | Percentage |\n| September 30, | December 31, | Increase/ |\n| (Dollars in millions, except per share amounts) | 2015 | 2014 | (Decrease) |\n| Balance sheet data: |\n| Total investments and cash | $ | 17,647.2 | $ | 17,435.9 | 1.2 | % |\n| Total assets | 21,682.3 | 20,817.8 | 4.2 | % |\n| Loss and loss adjustment expense reserves | 9,966.0 | 9,720.8 | 2.5 | % |\n| Total debt | 638.4 | 638.4 | 0.0 | % |\n| Total liabilities | 13,443.3 | 12,945.2 | 3.8 | % |\n| Redeemable noncontrolling interests - Mt. Logan Re | 752.7 | 421.6 | 78.6 | % |\n| Shareholders' equity | 7,486.3 | 7,451.1 | 0.5 | % |\n| Book value per share | 173.76 | 166.75 | 4.2 | % |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional (a) | $ | 848.1 | 60.1 | % | $ | - | 0.0 | % | $ | 848.1 | 60.1 | % |\n| Catastrophes | 40.0 | 2.7 | % | - | 0.0 | % | 40.0 | 2.7 | % |\n| Total | $ | 888.1 | 62.8 | % | $ | - | 0.0 | % | $ | 888.1 | 62.8 | % |\n| 2014 |\n| Attritional (a) | $ | 807.3 | 58.1 | % | $ | 0.5 | 0.0 | % | $ | 807.8 | 58.1 | % |\n| Catastrophes | 30.0 | 2.2 | % | - | 0.0 | % | 30.0 | 2.2 | % |\n| Total | $ | 837.3 | 60.3 | % | $ | 0.5 | 0.0 | % | $ | 837.8 | 60.3 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 40.8 | 2.0 | pts | $ | (0.5 | ) | - | pts | $ | 40.3 | 2.0 | pts |\n| Catastrophes | 10.0 | 0.5 | pts | - | - | pts | 10.0 | 0.4 | pts |\n| Total segment | $ | 50.8 | 2.5 | pts | $ | (0.5 | ) | - | pts | $ | 50.3 | 2.5 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional (a) | $ | 2,332.1 | 57.5 | % | $ | (0.8 | ) | 0.0 | % | $ | 2,331.3 | 57.5 | % |\n| Catastrophes | 80.0 | 2.0 | % | (10.0 | ) | -0.3 | % | 70.0 | 1.7 | % |\n| Total | $ | 2,412.1 | 59.5 | % | $ | (10.8 | ) | -0.3 | % | $ | 2,401.2 | 59.2 | % |\n| 2014 |\n| Attritional (a) | $ | 2,120.8 | 55.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,117.9 | 55.6 | % |\n| Catastrophes | 75.0 | 2.0 | % | - | 0.0 | % | 75.0 | 2.0 | % |\n| Total | $ | 2,195.8 | 57.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,192.9 | 57.6 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 211.3 | 1.8 | pts | $ | 2.1 | 0.1 | pts | $ | 213.4 | 1.9 | pts |\n| Catastrophes | 5.0 | - | pts | (10.0 | ) | (0.3 | ) | pts | (5.0 | ) | (0.3 | ) | pts |\n| Total segment | $ | 216.3 | 1.8 | pts | $ | (7.9 | ) | (0.2 | ) | pts | $ | 208.3 | 1.6 | pts |\n| (a) Attritional losses exclude catastrophe losses. |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| (Dollars in millions) | 2015 | 2014 | 2015 | 2014 |\n| Fixed maturities | $ | 108.1 | $ | 115.1 | $ | 327.0 | $ | 348.9 |\n| Equity securities | 11.1 | 11.1 | 35.8 | 36.1 |\n| Short-term investments and cash | 0.4 | 0.3 | 1.1 | 1.2 |\n| Other invested assets |\n| Limited partnerships | 0.4 | 21.7 | 14.0 | 25.7 |\n| Other | (0.2 | ) | 0.9 | 1.4 | 3.2 |\n| Gross investment income before adjustments | 119.7 | 149.0 | 379.2 | 415.1 |\n| Funds held interest income (expense) | 2.6 | 1.8 | 8.2 | 6.9 |\n| Future policy benefit reserve income (expense) | (0.3 | ) | (0.5 | ) | (1.4 | ) | (0.9 | ) |\n| Gross investment income | 122.0 | 150.3 | 386.0 | 421.0 |\n| Investment expenses | (6.5 | ) | (8.2 | ) | (22.8 | ) | (24.5 | ) |\n| Net investment income | $ | 115.5 | $ | 142.1 | $ | 363.1 | $ | 396.5 |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, | December 31, |\n| 2015 | 2014 |\n| Imbedded pre-tax yield of cash and invested assets | 3.0% | 3.0% |\n| Imbedded after-tax yield of cash and invested assets | 2.5% | 2.6% |\n| Three Months Ended | Nine Months Ended |\n| September 30, | September 30, |\n| 2015 | 2014 | 2015 | 2014 |\n| Annualized pre-tax yield on average cash and invested assets | 2.7% | 3.4% | 2.8% | 3.2% |\n| Annualized after-tax yield on average cash and invested assets | 2.2% | 2.7% | 2.3% | 2.7% |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | 2015 | 2014 | Variance |\n| Gains (losses) from sales: |\n| Fixed maturity securities, market value: |\n| Gains | $ | 11.8 | $ | 12.7 | $ | (0.9 | ) | $ | 37.5 | $ | 27.5 | $ | 10.0 |\n| Losses | (17.0 | ) | (5.5 | ) | (11.5 | ) | (53.3 | ) | (23.9 | ) | (29.4 | ) |\n| Total | (5.2 | ) | 7.3 | (12.5 | ) | (15.8 | ) | 3.7 | (19.5 | ) |\n| Fixed maturity securities, fair value: |\n| Gains | - | 0.1 | (0.1 | ) | - | 1.3 | (1.3 | ) |\n| Losses | - | - | - | - | (0.3 | ) | 0.3 |\n| Total | - | 0.1 | (0.1 | ) | - | 1.0 | (1.0 | ) |\n| Equity securities, market value: |\n| Gains | - | - | - | - | - | - |\n| Losses | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\n| Total | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\n| Equity securities, fair value: |\n| Gains | 5.3 | 2.5 | 2.8 | 18.9 | 13.0 | 5.9 |\n| Losses | (18.9 | ) | (4.4 | ) | (14.5 | ) | (31.9 | ) | (14.9 | ) | (17.0 | ) |\n| Total | (13.6 | ) | (1.9 | ) | (11.7 | ) | (13.0 | ) | (1.9 | ) | (11.1 | ) |\n| Total net realized capital gains (losses) from sales: |\n| Gains | 17.1 | 15.4 | 1.7 | 56.4 | 41.9 | 14.5 |\n| Losses | (39.5 | ) | (10.0 | ) | (29.5 | ) | (89.7 | ) | (40.3 | ) | (49.4 | ) |\n| Total | (22.5 | ) | 5.4 | (27.9 | ) | (33.3 | ) | 1.6 | (34.9 | ) |\n| Other-than-temporary impairments: | (20.4 | ) | (0.1 | ) | (20.3 | ) | (62.7 | ) | (0.5 | ) | (62.2 | ) |\n| Gains (losses) from fair value adjustments: |\n| Fixed maturity securities, fair value | - | (0.9 | ) | 0.9 | 0.1 | (0.9 | ) | 1.0 |\n| Equity securities, fair value | (117.1 | ) | (13.8 | ) | (103.3 | ) | (98.7 | ) | 70.5 | (169.2 | ) |\n| Total | (117.1 | ) | (14.7 | ) | (102.4 | ) | (98.7 | ) | 69.6 | (168.3 | ) |\n| Total net realized capital gains (losses) | $ | (160.0 | ) | $ | (9.4 | ) | $ | (150.6 | ) | $ | (194.7 | ) | $ | 70.7 | $ | (265.4 | ) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 537.5 | $ | 640.7 | $ | (103.2 | ) | -16.1 | % | $ | 1,464.8 | $ | 1,573.8 | $ | (108.9 | ) | -6.9 | % |\n| Net written premiums | 511.2 | 615.1 | (103.8 | ) | -16.9 | % | 1,383.6 | 1,536.1 | (152.5 | ) | -9.9 | % |\n| Premiums earned | $ | 488.5 | $ | 559.5 | $ | (71.0 | ) | -12.7 | % | $ | 1,480.4 | $ | 1,478.3 | $ | 2.2 | 0.1 | % |\n| Incurred losses and LAE | 225.9 | 249.0 | (23.1 | ) | -9.3 | % | 699.6 | 701.5 | (1.9 | ) | -0.3 | % |\n| Commission and brokerage | 121.1 | 123.4 | (2.4 | ) | -1.9 | % | 364.0 | 339.2 | 24.8 | 7.3 | % |\n| Other underwriting expenses | 13.7 | 12.1 | 1.6 | 13.2 | % | 37.1 | 33.1 | 4.0 | 12.1 | % |\n| Underwriting gain (loss) | $ | 127.8 | $ | 174.9 | $ | (47.2 | ) | -27.0 | % | $ | 379.8 | $ | 404.6 | $ | (24.8 | ) | -6.1 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 46.3 | % | 44.5 | % | 1.8 | 47.3 | % | 47.5 | % | (0.2 | ) |\n| Commission and brokerage ratio | 24.8 | % | 22.1 | % | 2.7 | 24.6 | % | 22.9 | % | 1.7 |\n| Other underwriting expense ratio | 2.7 | % | 2.1 | % | 0.6 | 2.4 | % | 2.2 | % | 0.2 |\n| Combined ratio | 73.8 | % | 68.7 | % | 5.1 | 74.3 | % | 72.6 | % | 1.7 |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 225.5 | 46.2 | % | $ | 0.5 | 0.2 | % | $ | 226.0 | 46.4 | % |\n| Catastrophes | 0.2 | 0.0 | % | (0.3 | ) | -0.1 | % | (0.1 | ) | -0.1 | % |\n| Total segment | $ | 225.7 | 46.2 | % | $ | 0.2 | 0.1 | % | $ | 225.9 | 46.3 | % |\n| 2014 |\n| Attritional | $ | 246.7 | 44.1 | % | $ | 1.3 | 0.2 | % | $ | 248.1 | 44.3 | % |\n| Catastrophes | - | 0.0 | % | 0.9 | 0.2 | % | 0.9 | 0.2 | % |\n| Total segment | $ | 246.7 | 44.1 | % | $ | 2.3 | 0.4 | % | $ | 249.0 | 44.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | (21.2 | ) | 2.1 | pts | $ | (0.8 | ) | - | pts | $ | (22.1 | ) | 2.1 | pts |\n| Catastrophes | 0.2 | - | pts | (1.2 | ) | (0.3 | ) | pts | (1.0 | ) | (0.3 | ) | pts |\n| Total segment | $ | (21.0 | ) | 2.1 | pts | $ | (2.1 | ) | (0.3 | ) | pts | $ | (23.1 | ) | 1.8 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 732.4 | 49.5 | % | $ | (24.3 | ) | -1.6 | % | $ | 708.1 | 47.9 | % |\n| Catastrophes | 0.2 | 0.0 | % | (8.8 | ) | -0.6 | % | (8.5 | ) | -0.6 | % |\n| Total segment | $ | 732.6 | 49.5 | % | $ | (33.1 | ) | -2.2 | % | $ | 699.6 | 47.3 | % |\n| 2014 |\n| Attritional | $ | 691.3 | 46.8 | % | $ | 2.3 | 0.2 | % | $ | 693.6 | 46.9 | % |\n| Catastrophes | 6.3 | 0.4 | % | 1.5 | 0.1 | % | 7.8 | 0.5 | % |\n| Total segment | $ | 697.7 | 47.2 | % | $ | 3.8 | 0.3 | % | $ | 701.5 | 47.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 41.1 | 2.7 | pts | $ | (26.6 | ) | (1.8 | ) | pts | $ | 14.5 | 1.0 | pts |\n| Catastrophes | (6.1 | ) | (0.4 | ) | pts | (10.3 | ) | (0.7 | ) | pts | (16.3 | ) | (1.1 | ) | pts |\n| Total segment | $ | 34.9 | 2.3 | pts | $ | (36.9 | ) | (2.5 | ) | pts | $ | (1.9 | ) | (0.2 | ) | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 354.9 | $ | 406.3 | $ | (51.4 | ) | -12.6 | % | $ | 966.1 | $ | 1,181.5 | $ | (215.4 | ) | -18.2 | % |\n| Net written premiums | 318.5 | 352.6 | (34.1 | ) | -9.7 | % | 896.9 | 977.2 | (80.4 | ) | -8.2 | % |\n| Premiums earned | $ | 291.4 | $ | 320.0 | $ | (28.6 | ) | -8.9 | % | $ | 935.2 | $ | 958.4 | $ | (23.2 | ) | -2.4 | % |\n| Incurred losses and LAE | 229.0 | 236.6 | (7.5 | ) | -3.2 | % | 630.8 | 604.2 | 26.6 | 4.4 | % |\n| Commission and brokerage | 70.9 | 73.1 | (2.2 | ) | -3.1 | % | 226.3 | 215.7 | 10.6 | 4.9 | % |\n| Other underwriting expenses | 9.1 | 8.8 | 0.4 | 4.2 | % | 25.3 | 24.7 | 0.6 | 2.5 | % |\n| Underwriting gain (loss) | $ | (17.6 | ) | $ | 1.6 | $ | (19.2 | ) | NM | $ | 52.9 | $ | 113.8 | $ | (61.0 | ) | -53.6 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 78.6 | % | 73.9 | % | 4.7 | 67.4 | % | 63.0 | % | 4.4 |\n| Commission and brokerage ratio | 24.3 | % | 22.9 | % | 1.4 | 24.2 | % | 22.5 | % | 1.7 |\n| Other underwriting expense ratio | 3.2 | % | 2.7 | % | 0.5 | 2.7 | % | 2.6 | % | 0.1 |\n| Combined ratio | 106.1 | % | 99.5 | % | 6.6 | 94.3 | % | 88.1 | % | 6.2 |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 195.5 | 67.1 | % | $ | 0.4 | 0.1 | % | $ | 195.9 | 67.2 | % |\n| Catastrophes | 34.4 | 11.8 | % | (1.3 | ) | -0.4 | % | 33.1 | 11.4 | % |\n| Total segment | $ | 229.9 | 78.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 229.0 | 78.6 | % |\n| 2014 |\n| Attritional | $ | 213.0 | 66.5 | % | $ | (4.6 | ) | -1.4 | % | $ | 208.4 | 65.1 | % |\n| Catastrophes | 29.3 | 9.2 | % | (1.2 | ) | -0.4 | % | 28.1 | 8.8 | % |\n| Total segment | $ | 242.3 | 75.7 | % | $ | (5.8 | ) | -1.8 | % | $ | 236.6 | 73.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | (17.5 | ) | 0.6 | pts | $ | 5.0 | 1.5 | pts | $ | (12.5 | ) | 2.1 | pts |\n| Catastrophes | 5.1 | 2.6 | pts | (0.1 | ) | - | pts | 5.0 | 2.6 | pts |\n| Total segment | $ | (12.4 | ) | 3.2 | pts | $ | 4.9 | 1.5 | pts | $ | (7.5 | ) | 4.7 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 565.2 | 60.4 | % | $ | (2.7 | ) | -0.3 | % | $ | 562.5 | 60.1 | % |\n| Catastrophes | 71.3 | 7.6 | % | (3.1 | ) | -0.3 | % | 68.2 | 7.3 | % |\n| Total segment | $ | 636.6 | 68.0 | % | $ | (5.8 | ) | -0.6 | % | $ | 630.8 | 67.4 | % |\n| 2014 |\n| Attritional | $ | 548.2 | 57.1 | % | $ | (4.7 | ) | -0.5 | % | $ | 543.5 | 56.6 | % |\n| Catastrophes | 63.9 | 6.7 | % | (3.3 | ) | -0.3 | % | 60.6 | 6.4 | % |\n| Total segment | $ | 612.1 | 63.8 | % | $ | (8.0 | ) | -0.8 | % | $ | 604.2 | 63.0 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 17.0 | 3.3 | pts | $ | 2.0 | 0.2 | pts | $ | 19.0 | 3.5 | pts |\n| Catastrophes | 7.4 | 0.9 | pts | 0.2 | - | pts | 7.6 | 0.9 | pts |\n| Total segment | $ | 24.5 | 4.2 | pts | $ | 2.2 | 0.2 | pts | $ | 26.6 | 4.4 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 267.0 | $ | 205.3 | $ | 61.7 | 30.0 | % | $ | 605.4 | $ | 573.8 | $ | 31.6 | 5.5 | % |\n| Net written premiums | 251.7 | 189.4 | 62.2 | 32.8 | % | 557.5 | 548.2 | 9.2 | 1.7 | % |\n| Premiums earned | $ | 222.2 | $ | 181.8 | $ | 40.5 | 22.3 | % | $ | 616.2 | $ | 546.7 | $ | 69.5 | 12.7 | % |\n| Incurred losses and LAE | 154.3 | 109.0 | 45.4 | 41.6 | % | 372.6 | 310.6 | 62.0 | 20.0 | % |\n| Commission and brokerage | 53.0 | 48.4 | 4.6 | 9.4 | % | 151.4 | 141.0 | 10.4 | 7.4 | % |\n| Other underwriting expenses | 9.5 | 9.4 | 0.1 | 1.0 | % | 27.0 | 25.8 | 1.2 | 4.8 | % |\n| Underwriting gain (loss) | $ | 5.5 | $ | 15.0 | $ | (9.5 | ) | -63.5 | % | $ | 65.3 | $ | 69.3 | $ | (4.1 | ) | -5.9 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 69.4 | % | 59.9 | % | 9.5 | 60.5 | % | 56.8 | % | 3.7 |\n| Commission and brokerage ratio | 23.8 | % | 26.6 | % | (2.8 | ) | 24.6 | % | 25.8 | % | (1.2 | ) |\n| Other underwriting expense ratio | 4.3 | % | 5.2 | % | (0.9 | ) | 4.3 | % | 4.7 | % | (0.4 | ) |\n| Combined ratio | 97.5 | % | 91.7 | % | 5.8 | 89.4 | % | 87.3 | % | 2.1 |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 153.4 | 69.0 | % | $ | - | 0.0 | % | $ | 153.4 | 69.0 | % |\n| Catastrophes | - | 0.0 | % | 0.9 | 0.4 | % | 0.9 | 0.4 | % |\n| Total segment | $ | 153.4 | 69.0 | % | $ | 0.9 | 0.4 | % | $ | 154.3 | 69.4 | % |\n| 2014 |\n| Attritional | $ | 108.8 | 59.8 | % | $ | - | 0.0 | % | $ | 108.8 | 59.8 | % |\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\n| Total segment | $ | 108.8 | 59.8 | % | $ | 0.2 | 0.1 | % | $ | 109.0 | 59.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 44.6 | 9.2 | pts | $ | - | - | pts | $ | 44.6 | 9.2 | pts |\n| Catastrophes | - | - | pts | 0.7 | 0.3 | pts | 0.7 | 0.3 | pts |\n| Total segment | $ | 44.6 | 9.2 | pts | $ | 0.7 | 0.3 | pts | $ | 45.4 | 9.5 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 376.5 | 61.1 | % | $ | (5.2 | ) | -0.8 | % | $ | 371.3 | 60.3 | % |\n| Catastrophes | - | 0.0 | % | 1.3 | 0.2 | % | 1.3 | 0.2 | % |\n| Total segment | $ | 376.5 | 61.1 | % | $ | (3.9 | ) | -0.6 | % | $ | 372.6 | 60.5 | % |\n| 2014 |\n| Attritional | $ | 313.7 | 57.4 | % | $ | (5.0 | ) | -0.9 | % | $ | 308.7 | 56.5 | % |\n| Catastrophes | - | 0.0 | % | 1.9 | 0.3 | % | 1.9 | 0.3 | % |\n| Total segment | $ | 313.7 | 57.4 | % | $ | (3.1 | ) | -0.6 | % | $ | 310.6 | 56.8 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 62.8 | 3.7 | pts | $ | (0.2 | ) | 0.1 | pts | $ | 62.6 | 3.8 | pts |\n| Catastrophes | - | - | pts | (0.6 | ) | (0.1 | ) | pts | (0.6 | ) | (0.1 | ) | pts |\n| Total segment | $ | 62.8 | 3.7 | pts | $ | (0.8 | ) | - | pts | $ | 62.0 | 3.7 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 489.1 | $ | 364.1 | $ | 125.0 | 34.3 | % | $ | 1,173.0 | $ | 911.2 | $ | 261.8 | 28.7 | % |\n| Net written premiums | 419.0 | 310.7 | 108.3 | 34.8 | % | 1,022.4 | 802.4 | 220.0 | 27.4 | % |\n| Premiums earned | $ | 360.7 | $ | 290.5 | $ | 70.2 | 24.2 | % | $ | 888.7 | $ | 742.0 | $ | 146.7 | 19.8 | % |\n| Incurred losses and LAE | 262.3 | 239.8 | 22.5 | 9.4 | % | 662.1 | 557.0 | 105.0 | 18.9 | % |\n| Commission and brokerage | 50.3 | 40.4 | 9.9 | 24.4 | % | 127.1 | 114.5 | 12.6 | 11.0 | % |\n| Other underwriting expenses | 35.7 | 31.3 | 4.4 | 13.9 | % | 99.2 | 83.7 | 15.6 | 18.6 | % |\n| Underwriting gain (loss) | $ | 12.5 | $ | (21.0 | ) | $ | 33.5 | -159.3 | % | $ | 0.3 | $ | (13.2 | ) | $ | 13.5 | -102.3 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 72.7 | % | 82.5 | % | (9.8 | ) | 74.5 | % | 75.1 | % | (0.6 | ) |\n| Commission and brokerage ratio | 13.9 | % | 13.9 | % | - | 14.3 | % | 15.4 | % | (1.1 | ) |\n| Other underwriting expense ratio | 9.9 | % | 10.8 | % | (0.9 | ) | 11.2 | % | 11.3 | % | (0.1 | ) |\n| Combined ratio | 96.5 | % | 107.2 | % | (10.7 | ) | 100.0 | % | 101.8 | % | (1.8 | ) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 262.9 | 72.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 262.1 | 72.6 | % |\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\n| Total segment | $ | 262.9 | 72.9 | % | $ | (0.6 | ) | -0.2 | % | $ | 262.3 | 72.7 | % |\n| 2014 |\n| Attritional | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\n| Catastrophes | - | 0.0 | % | - | 0.0 | % | - | 0.0 | % |\n| Total segment | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 26.8 | (8.3 | ) | pts | $ | (4.6 | ) | (1.6 | ) | pts | $ | 22.3 | (9.9 | ) | pts |\n| Catastrophes | - | - | pts | 0.2 | 0.1 | pts | 0.2 | 0.1 | pts |\n| Total segment | $ | 26.8 | (8.3 | ) | pts | $ | (4.3 | ) | (1.5 | ) | pts | $ | 22.5 | (9.8 | ) | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 630.5 | 70.9 | % | $ | 31.5 | 3.6 | % | $ | 662.0 | 74.5 | % |\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\n| Total segment | $ | 630.5 | 70.9 | % | $ | 31.6 | 3.6 | % | $ | 662.1 | 74.5 | % |\n| 2014 |\n| Attritional | $ | 552.5 | 74.5 | % | $ | 4.5 | 0.6 | % | $ | 557.0 | 75.1 | % |\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\n| Total segment | $ | 552.5 | 74.5 | % | $ | 4.6 | 0.6 | % | $ | 557.0 | 75.1 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\n| Catastrophes | - | - | pts | - | - | pts | - | - | pts |\n| Total segment | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\n| Gross written premiums | $ | 72.2 | $ | 50.3 | $ | 21.9 | 43.4 | % | $ | 183.7 | $ | 109.2 | $ | 74.5 | 68.3 | % |\n| Net written premiums | 60.9 | 49.8 | 11.1 | 22.4 | % | 153.3 | 98.7 | 54.6 | 55.4 | % |\n| Premiums earned | $ | 50.8 | $ | 38.2 | $ | 12.6 | 32.9 | % | $ | 132.5 | $ | 81.4 | $ | 51.1 | 62.8 | % |\n| Incurred losses and LAE | 16.5 | 3.4 | 13.1 | NM | 36.3 | 19.6 | 16.7 | 85.3 | % |\n| Commission and brokerage | 4.9 | 5.1 | (0.2 | ) | -4.9 | % | 13.3 | 9.8 | 3.5 | 35.7 | % |\n| Other underwriting expenses | 2.7 | 1.6 | 1.1 | 71.6 | % | 6.7 | 5.0 | 1.7 | 34.5 | % |\n| Underwriting gain (loss) | $ | 26.7 | $ | 28.1 | $ | (1.4 | ) | -4.9 | % | $ | 76.3 | $ | 47.1 | $ | 29.2 | 62.0 | % |\n| Point Chg | Point Chg |\n| Loss ratio | 32.5 | % | 8.9 | % | 23.6 | 27.4 | % | 24.0 | % | 3.4 |\n| Commission and brokerage ratio | 9.6 | % | 13.4 | % | (3.8 | ) | 10.1 | % | 12.1 | % | (2.0 | ) |\n| Other underwriting expense ratio | 5.2 | % | 4.1 | % | 1.1 | 5.0 | % | 6.1 | % | (1.1 | ) |\n| Combined ratio | 47.3 | % | 26.4 | % | 20.9 | 42.5 | % | 42.2 | % | 0.3 |\n| (NM, not meaningful) |\n| (Some amounts may not reconcile due to rounding.) |\n| Three Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 10.7 | 21.1 | % | $ | - | 0.0 | % | $ | 10.7 | 21.1 | % |\n| Catastrophes | 5.4 | 10.5 | % | 0.4 | 0.9 | % | 5.8 | 11.4 | % |\n| Total segment | $ | 16.1 | 31.6 | % | $ | 0.4 | 0.9 | % | $ | 16.5 | 32.5 | % |\n| 2014 |\n| Attritional | $ | 2.7 | 7.2 | % | $ | - | 0.0 | % | $ | 2.7 | 7.2 | % |\n| Catastrophes | 0.7 | 1.7 | % | - | 0.0 | % | 0.7 | 1.7 | % |\n| Total segment | $ | 3.4 | 8.9 | % | $ | - | 0.0 | % | $ | 3.4 | 8.9 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 8.0 | 13.9 | pts | $ | - | - | pts | $ | 8.0 | 13.9 | pts |\n| Catastrophes | 4.7 | 8.8 | pts | 0.4 | 0.9 | pts | 5.1 | 9.7 | pts |\n| Total segment | $ | 12.7 | 22.7 | pts | $ | 0.4 | 0.9 | pts | $ | 13.1 | 23.6 | pts |\n| Nine Months Ended September 30, |\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\n| 2015 |\n| Attritional | $ | 27.4 | 20.7 | % | $ | - | 0.0 | % | $ | 27.4 | 20.7 | % |\n| Catastrophes | 8.4 | 6.4 | % | 0.4 | 0.3 | % | 8.8 | 6.7 | % |\n| Total segment | $ | 35.8 | 27.1 | % | $ | 0.4 | 0.3 | % | $ | 36.3 | 27.4 | % |\n| 2014 |\n| Attritional | $ | 15.0 | 18.4 | % | $ | - | 0.0 | % | $ | 15.0 | 18.4 | % |\n| Catastrophes | 4.7 | 5.8 | % | (0.2 | ) | -0.2 | % | 4.5 | 5.6 | % |\n| Total segment | $ | 19.8 | 24.2 | % | $ | (0.2 | ) | -0.2 | % | $ | 19.6 | 24.0 | % |\n| Variance 2015/2014 |\n| Attritional | $ | 12.4 | 2.3 | pts | $ | - | - | pts | $ | 12.4 | 2.3 | pts |\n| Catastrophes | 3.7 | 0.6 | pts | 0.6 | 0.5 | pts | 4.3 | 1.1 | pts |\n| Total segment | $ | 16.0 | 2.9 | pts | $ | 0.6 | 0.5 | pts | $ | 16.7 | 3.4 | pts |\n| (Some amounts may not reconcile due to rounding.) |\n| (Dollars in millions) | At September 30, 2015 | At December 31, 2014 |\n| Fixed maturities, market value | $ | 13,491.0 | 76.4 | % | $ | 13,101.1 | 75.1 | % |\n| Fixed maturities, fair value | - | 0.0 | % | 1.5 | 0.0 | % |\n| Equity securities, market value | 113.0 | 0.6 | % | 140.2 | 0.8 | % |\n| Equity securities, fair value | 1,357.3 | 7.7 | % | 1,447.8 | 8.3 | % |\n| Short-term investments | 1,615.0 | 9.2 | % | 1,705.9 | 9.8 | % |\n| Other invested assets | 669.7 | 3.8 | % | 601.9 | 3.5 | % |\n| Cash | 401.2 | 2.3 | % | 437.5 | 2.5 | % |\n| Total investments and cash | $ | 17,647.2 | 100.0 | % | $ | 17,435.9 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, 2015 | December 31, 2014 |\n| Fixed income portfolio duration (years) | 3.0 | 2.9 |\n| Fixed income composite credit quality | A1 | A1 |\n| Imbedded end of period yield, pre-tax | 3.0% | 3.0% |\n| Imbedded end of period yield, after-tax | 2.5% | 2.6% |\n| Nine Months Ended | Twelve Months Ended |\n| September 30, 2015 | December 31, 2014 |\n| Fixed income portfolio total return | 1.4% | 3.5% |\n| Barclay's Capital - U.S. aggregate index | 1.1% | 6.0% |\n| Common equity portfolio total return | -5.0% | 10.4% |\n| S&P 500 index | -5.3% | 13.7% |\n| Other invested asset portfolio total return | 4.1% | 11.8% |\n| At September 30, 2015 |\n| Case | IBNR | Total | % of |\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\n| U.S. Reinsurance | $ | 1,290.2 | $ | 2,013.9 | $ | 3,304.1 | 33.2 | % |\n| International | 775.7 | 1,069.5 | 1,845.3 | 18.5 | % |\n| Bermuda | 862.4 | 1,225.5 | 2,087.8 | 20.9 | % |\n| Insurance | 1,001.0 | 1,249.8 | 2,250.8 | 22.6 | % |\n| Mt. Logan Re | 18.4 | 38.7 | 57.1 | 0.6 | % |\n| Total excluding A&E | 3,947.7 | 5,597.4 | 9,545.1 | 95.8 | % |\n| A&E | 236.1 | 184.8 | 420.9 | 4.2 | % |\n| Total including A&E | $ | 4,183.8 | $ | 5,782.2 | $ | 9,966.0 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At December 31, 2014 |\n| Case | IBNR | Total | % of |\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\n| U.S. Reinsurance | $ | 1,409.5 | $ | 1,925.4 | $ | 3,334.9 | 34.3 | % |\n| International | 902.5 | 868.6 | 1,771.0 | 18.2 | % |\n| Bermuda | 783.9 | 1,108.2 | 1,892.0 | 19.5 | % |\n| Insurance | 968.3 | 1,250.4 | 2,218.6 | 22.8 | % |\n| Mt. Logan Re | 13.0 | 15.0 | 28.0 | 0.3 | % |\n| Total excluding A&E | 4,077.1 | 5,167.5 | 9,244.6 | 95.1 | % |\n| A&E | 251.1 | 225.1 | 476.2 | 4.9 | % |\n| Total including A&E | $ | 4,328.2 | $ | 5,392.6 | $ | 9,720.8 | 100.0 | % |\n| (Some amounts may not reconcile due to rounding.) |\n| At | At |\n| September 30, | December 31, |\n| (Dollars in millions) | 2015 | 2014 |\n| Gross reserves | $ | 420.9 | $ | 476.2 |\n| Reinsurance receivable | (113.2 | ) | (18.0 | ) |\n| Net reserves | $ | 307.6 | $ | 458.2 |\n| (Some amounts may not reconcile due to rounding.) |\n| Bermuda Re (1) | Everest Re (2) |\n| At December 31, | At December 31, |\n| (Dollars in millions) | 2014 | 2013 | 2014 | 2013 |\n| Regulatory targeted capital | $ | 2,050.0 | $ | 2,154.6 | $ | 1,209.6 | $ | 1,094.6 |\n| Actual capital | $ | 2,748.0 | $ | 2,712.2 | $ | 2,893.0 | $ | 2,814.3 |\n| Impact of Interest Rate Shift in Basis Points |\n| At September 30, 2015 |\n| -200 | -100 | 0 | 100 | 200 |\n| (Dollars in millions) |\n| Total Market/Fair Value | $ | 15,883.0 | $ | 15,507.1 | $ | 15,106.0 | $ | 14,677.4 | $ | 14,235.5 |\n| Market/Fair Value Change from Base (%) | 5.1 | % | 2.7 | % | 0.0 | % | -2.8 | % | -5.8 | % |\n| Change in Unrealized Appreciation |\n| After-tax from Base ($) | $ | 657.8 | $ | 340.0 | $ | - | $ | (364.4 | ) | $ | (740.2 | ) |\n| Impact of Percentage Change in Equity Fair/Market Values |\n| At September 30, 2015 |\n| (Dollars in millions) | -20% | -10% | 0% | 10% | 20% |\n| Fair/Market Value of the Equity Portfolio | $ | 1,176.2 | $ | 1,323.3 | $ | 1,470.3 | $ | 1,617.3 | $ | 1,764.4 |\n| After-tax Change in Fair/Market Value | $ | (201.7 | ) | $ | (100.9 | ) | $ | - | $ | 100.9 | $ | 201.7 |\n\nITEM 3.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMarket Risk Instruments. See \"Liquidity and Capital Resources - Market Sensitive Instruments\" in PART I – ITEM 2.\n57\nITEM 4.\nCONTROLS AND PROCEDURES\nAs of the end of the period covered by this report, our management carried out an evaluation, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the \"Exchange Act\")). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission's rules and forms. Our management, with the participation of the Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, there has been no such change during the quarter covered by this report.\nPART II\n\nITEM 1.\nLEGAL PROCEEDINGS\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\n\nITEM 1A.\nRISK FACTORS\nNo material changes.\n58\nITEM 2.\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nIssuer Purchases of Equity Securities.\n| Issuer Purchases of Equity Securities |\n| (a) | (b) | (c) | (d) |\n| Maximum Number (or |\n| Total Number of | Approximate Dollar |\n| Shares (or Units) | Value) of Shares (or |\n| Purchased as Part | Units) that May Yet |\n| Total Number of | of Publicly | Be Purchased Under |\n| Shares (or Units) | Average Price Paid | Announced Plans or | the Plans or |\n| Period | Purchased | per Share (or Unit) | Programs | Programs (1) |\n| July 1 - 31, 2015 | 1,756 | $ | 183.2850 | - | 5,631,185 |\n| August 1 - 31, 2015 | 514,629 | $ | 177.4608 | 514,629 | 5,116,556 |\n| September 1 - 30, 2015 | 626,078 | $ | 174.4833 | 622,844 | 4,493,712 |\n| Total | 1,142,463 | $ | - | 1,137,473 | 4,493,712 |\n\n(1) On September 21, 2004, the Company's board of directors approved an amended share repurchase program authorizing the Company and/or its subsidiary Holdings to purchase up to an aggregate of 5,000,000 of the Company's common shares through open market transactions, privately negotiated transactions or both. On July 21, 2008; February 24, 2010; February 22, 2012; May 15, 2013; and November 19, 2014, the Company's executive committee of the Board of Directors has approved subsequent amendments to the share repurchase program authorizing the Company and/or its subsidiary Holdings, to purchase up to a current aggregate of 30,000,000 of the Company's shares (recognizing that the number of shares authorized for repurchase has been reduced by those shares that have already been purchased) in open market transactions, privately negotiated transactions or both.\n\nITEM 3.\nDEFAULTS UPON SENIOR SECURITIES\nNone.\n\nITEM 4.\nMINE SAFETY DISCLOSURES\nNot applicable.\n\nITEM 5\n.\nOTHER INFORMATION\nNone.\n59\nITEM 6.\nEXHIBITS\n\n| Exhibit Index: |\n| Exhibit No. | Description |\n| 31.1 | Section 302 Certification of Dominic J. Addesso |\n| 31.2 | Section 302 Certification of Craig Howie |\n| 32.1 | Section 906 Certification of Dominic J. Addesso and Craig Howie |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase |\n| 101.LAB | XBRL Taxonomy Extension Labels Linkbase |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase |\n\n60\nEverest Re Group, Ltd.\nSignatures\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| Everest Re Group, Ltd. |\n| (Registrant) |\n| /S/ CRAIG HOWIE |\n| Craig Howie |\n| Executive Vice President and |\n| Chief Financial Officer |\n| (Duly Authorized Officer and Principal Financial Officer) |\n\n\n</text>\n\nWhat is the percent change in the total outstanding amount of the Citibank Bilateral Letter of Credit Agreement from September 30, 2015 to December 31, 2014?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1.\\nFinancial Statements\\nConsolidated Balance Sheets September 30, 2015 (unaudited)\\nand December 31, 2014 1\\nConsolidated Statements of Operations and Comprehensive Income (Loss) for the\\nthree and nine months ended September 30, 2015 and 2014 (unaudited) 2\\nConsolidated Statements of Changes in Shareholders' Equity for the three and\\nnine months ended September 30, 2015 and 2014 (unaudited) 3\\nConsolidated Statements of Cash Flows for the nine months ended\\nSeptember 30, 2015 and 2014 (unaudited) 4\\nNotes to Consolidated Interim Financial Statements (unaudited) 5\\nItem 2. Management's Discussion and Analysis of Financial Condition and\\nResults of Operation 30\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 57\\nItem 4. Controls and Procedures 58\\nPART II\\nOTHER INFORMATION\\n\\n| Item 1. | Legal Proceedings | 58 |\\n| Item 1A. | Risk Factors | 58 |\\n| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 59 |\\n| Item 3. | Defaults Upon Senior Securities | 59 |\\n| Item 4. | Mine Safety Disclosures | 59 |\\n| Item 5. | Other Information | 59 |\\n| Item 6. | Exhibits | 60 |\\n\\nEVEREST RE GROUP, LTD.\\nCONSOLIDATED BALANCE SHEETS\\n\\n| September 30, | December 31, |\\n| (Dollars and share amounts in thousands, except par value per share) | 2015 | 2014 |\\n| (unaudited) |\\n| ASSETS: |\\n| Fixed maturities - available for sale, at market value | $ | 13,490,960 | $ | 13,101,067 |\\n| (amortized cost: 2015, $13,301,713; 2014, $12,831,159) |\\n| Fixed maturities - available for sale, at fair value | - | 1,509 |\\n| Equity securities - available for sale, at market value (cost: 2015, $127,411; 2014, $148,326) | 112,999 | 140,210 |\\n| Equity securities - available for sale, at fair value | 1,357,311 | 1,447,820 |\\n| Short-term investments | 1,615,045 | 1,705,932 |\\n| Other invested assets (cost: 2015, $669,686; 2014, $601,925) | 669,686 | 601,925 |\\n| Cash | 401,226 | 437,474 |\\n| Total investments and cash | 17,647,227 | 17,435,937 |\\n| Accrued investment income | 107,199 | 111,075 |\\n| Premiums receivable | 1,663,425 | 1,397,983 |\\n| Reinsurance receivables | 831,635 | 670,854 |\\n| Funds held by reinsureds | 272,775 | 228,192 |\\n| Deferred acquisition costs | 364,947 | 398,408 |\\n| Prepaid reinsurance premiums | 193,122 | 154,177 |\\n| Income taxes | 270,607 | 184,762 |\\n| Other assets | 331,374 | 236,436 |\\n| TOTAL ASSETS | $ | 21,682,311 | $ | 20,817,824 |\\n| LIABILITIES: |\\n| Reserve for losses and loss adjustment expenses | $ | 9,965,963 | $ | 9,720,813 |\\n| Future policy benefit reserve | 59,580 | 59,820 |\\n| Unearned premium reserve | 1,717,422 | 1,728,745 |\\n| Funds held under reinsurance treaties | 83,137 | 3,932 |\\n| Commission reserves | 79,904 | 87,990 |\\n| Other net payable to reinsurers | 199,528 | 139,841 |\\n| Losses in course of payment | 298,577 | 157,527 |\\n| 4.868% Senior notes due 6/1/2044 | 400,000 | 400,000 |\\n| 6.6% Long term notes due 5/1/2067 | 238,367 | 238,364 |\\n| Accrued interest on debt and borrowings | 12,341 | 3,537 |\\n| Equity index put option liability | 52,247 | 47,022 |\\n| Unsettled securities payable | 65,147 | 41,092 |\\n| Other liabilities | 271,086 | 316,469 |\\n| Total liabilities | 13,443,299 | 12,945,152 |\\n| NONCONTROLLING INTERESTS: |\\n| Redeemable noncontrolling interests - Mt. Logan Re | 752,692 | 421,552 |\\n| Commitments and contingencies (Note 9) |\\n| SHAREHOLDERS' EQUITY: |\\n| Preferred shares, par value: $0.01; 50,000 shares authorized; |\\n| no shares issued and outstanding | - | - |\\n| Common shares, par value: $0.01; 200,000 shares authorized; (2015) 68,585 |\\n| and (2014) 68,336 outstanding before treasury shares | 686 | 683 |\\n| Additional paid-in capital | 2,094,850 | 2,068,807 |\\n| Accumulated other comprehensive income (loss), net of deferred income tax expense |\\n| (benefit) of ($2,899) at 2015 and $20,715 at 2014 | (112,231 | ) | 48,317 |\\n| Treasury shares, at cost; 25,500 shares (2015) and 23,650 shares (2014) | (2,810,878 | ) | (2,485,897 | ) |\\n| Retained earnings | 8,313,893 | 7,819,210 |\\n| Total shareholders' equity attributable to Everest Re Group | 7,486,320 | 7,451,120 |\\n| TOTAL LIABILITIES, NONCONTROLLING INTERESTS AND SHAREHOLDERS' EQUITY | $ | 21,682,311 | $ | 20,817,824 |\\n| The accompanying notes are an integral part of the consolidated financial statements. |\\n\\n1\\nEVEREST RE GROUP, LTD.\\nCONSOLIDATED STATEMENTS OF OPERATIONS\\nAND COMPREHENSIVE INCOME (LOSS)\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\\n| (unaudited) | (unaudited) |\\n| REVENUES: |\\n| Premiums earned | $ | 1,413,640 | $ | 1,389,998 | $ | 4,053,115 | $ | 3,806,805 |\\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\\n| Net realized capital gains (losses): |\\n| Other-than-temporary impairments on fixed maturity securities | (20,445 | ) | (106 | ) | (62,701 | ) | (495 | ) |\\n| Other-than-temporary impairments on fixed maturity securities |\\n| transferred to other comprehensive income (loss) | - | - | - | - |\\n| Other net realized capital gains (losses) | (139,526 | ) | (9,342 | ) | (131,953 | ) | 71,189 |\\n| Total net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\\n| Total revenues | 1,375,165 | 1,535,880 | 4,275,937 | 4,272,156 |\\n| CLAIMS AND EXPENSES: |\\n| Incurred losses and loss adjustment expenses | 888,097 | 837,757 | 2,401,223 | 2,192,863 |\\n| Commission, brokerage, taxes and fees | 300,048 | 290,519 | 882,132 | 820,208 |\\n| Other underwriting expenses | 70,667 | 63,113 | 195,282 | 172,165 |\\n| Corporate expenses | 5,924 | 9,958 | 17,312 | 18,802 |\\n| Interest, fees and bond issue cost amortization expense | 8,990 | 12,424 | 27,006 | 28,970 |\\n| Total claims and expenses | 1,273,726 | 1,213,771 | 3,522,955 | 3,233,008 |\\n| INCOME (LOSS) BEFORE TAXES | 101,439 | 322,109 | 752,982 | 1,039,148 |\\n| Income tax expense (benefit) | (6,133 | ) | 20,856 | 70,868 | 137,948 |\\n| NET INCOME (LOSS) | $ | 107,572 | $ | 301,253 | $ | 682,114 | $ | 901,200 |\\n| Net (income) loss attributable to noncontrolling interests | (19,019 | ) | (26,337 | ) | (61,526 | ) | (42,167 | ) |\\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\\n| Other comprehensive income (loss), net of tax: |\\n| Unrealized appreciation (depreciation) (\\\"URA(D)\\\") on securities arising during the period | (91,059 | ) | (74,074 | ) | (144,335 | ) | 65,318 |\\n| Reclassification adjustment for realized losses (gains) included in net income (loss) | 24,596 | (5,684 | ) | 59,526 | (1,641 | ) |\\n| Total URA(D) on securities arising during the period | (66,463 | ) | (79,758 | ) | (84,809 | ) | 63,677 |\\n| Foreign currency translation adjustments | (32,505 | ) | (34,974 | ) | (80,508 | ) | (38,374 | ) |\\n| Benefit plan actuarial net gain (loss) for the period | - | - | - | - |\\n| Reclassification adjustment for amortization of net (gain) loss included in net income (loss) | 1,556 | 825 | 4,769 | 2,366 |\\n| Total benefit plan net gain (loss) for the period | 1,556 | 825 | 4,769 | 2,366 |\\n| Total other comprehensive income (loss), net of tax | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\\n| Other comprehensive (income) loss attributable to noncontrolling interests | - | - | - | - |\\n| Total other comprehensive income (loss), net of tax attributable to Everest Re Group | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\\n| COMPREHENSIVE INCOME (LOSS) | $ | (8,859 | ) | $ | 161,009 | $ | 460,040 | $ | 886,702 |\\n| EARNINGS PER COMMON SHARE ATTRIBUTABLE TO EVEREST RE GROUP: |\\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\\n| Diluted | 2.00 | 6.00 | 13.92 | 18.47 |\\n| Dividends declared | 0.95 | 0.75 | 2.85 | 2.25 |\\n| The accompanying notes are an integral part of the consolidated financial statements. |\\n\\n2\\nEVEREST RE GROUP, LTD.\\nCONSOLIDATED STATEMENTS OF\\nCHANGES IN SHAREHOLDERS' EQUITY\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands, except share and dividends per share amounts) | 2015 | 2014 | 2015 | 2014 |\\n| (unaudited) | (unaudited) |\\n| COMMON SHARES (shares outstanding): |\\n| Balance, beginning of period | 44,192,526 | 45,691,015 | 44,685,637 | 47,543,132 |\\n| Issued during the period, net | 29,398 | 29,622 | 248,665 | 344,761 |\\n| Treasury shares acquired | (1,137,473 | ) | (470,807 | ) | (1,849,851 | ) | (2,638,063 | ) |\\n| Balance, end of period | 43,084,451 | 45,249,830 | 43,084,451 | 45,249,830 |\\n| COMMON SHARES (par value): |\\n| Balance, beginning of period | $ | 685 | $ | 683 | $ | 683 | $ | 680 |\\n| Issued during the period, net | 1 | - | 3 | 3 |\\n| Balance, end of period | 686 | 683 | 686 | 683 |\\n| ADDITIONAL PAID-IN CAPITAL: |\\n| Balance, beginning of period | 2,084,636 | 2,052,682 | 2,068,807 | 2,029,774 |\\n| Share-based compensation plans | 10,214 | 7,274 | 26,043 | 30,182 |\\n| Balance, end of period | 2,094,850 | 2,059,956 | 2,094,850 | 2,059,956 |\\n| ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS), |\\n| NET OF DEFERRED INCOME TAXES: |\\n| Balance, beginning of period | (14,819 | ) | 299,304 | 48,317 | 157,728 |\\n| Net increase (decrease) during the period | (97,412 | ) | (113,907 | ) | (160,548 | ) | 27,669 |\\n| Balance, end of period | (112,231 | ) | 185,397 | (112,231 | ) | 185,397 |\\n| RETAINED EARNINGS: |\\n| Balance, beginning of period | 8,267,038 | 7,281,023 | 7,819,210 | 6,765,967 |\\n| Net income (loss) attributable to Everest Re Group | 88,553 | 274,916 | 620,588 | 859,033 |\\n| Dividends declared ($0.95 per share in third quarter 2015 and $2.85 year-to-date |\\n| per share in 2015 and $0.75 per share in third quarter 2014 and $2.25 |\\n| year-to-date per share in 2014) | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\\n| Balance, end of period | 8,313,893 | 7,521,966 | 8,313,893 | 7,521,966 |\\n| TREASURY SHARES AT COST: |\\n| Balance, beginning of period | (2,610,878 | ) | (2,310,824 | ) | (2,485,897 | ) | (1,985,873 | ) |\\n| Purchase of treasury shares | (200,000 | ) | (74,991 | ) | (324,981 | ) | (399,942 | ) |\\n| Balance, end of period | (2,810,878 | ) | (2,385,815 | ) | (2,810,878 | ) | (2,385,815 | ) |\\n| TOTAL SHAREHOLDERS' EQUITY, END OF PERIOD | $ | 7,486,320 | $ | 7,382,187 | $ | 7,486,320 | $ | 7,382,187 |\\n| The accompanying notes are an integral part of the consolidated financial statements. |\\n\\n3\\nEVEREST RE GROUP, LTD.\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n\\n| Nine Months Ended |\\n| September 30, |\\n| (Dollars in thousands) | 2015 | 2014 |\\n| (unaudited) |\\n| CASH FLOWS FROM OPERATING ACTIVITIES: |\\n| Net income (loss) | $ | 682,114 | $ | 901,200 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Decrease (increase) in premiums receivable | (274,198 | ) | (255,645 | ) |\\n| Decrease (increase) in funds held by reinsureds, net | 33,255 | (6,929 | ) |\\n| Decrease (increase) in reinsurance receivables | (202,329 | ) | (256,458 | ) |\\n| Decrease (increase) in income taxes | (61,627 | ) | (14,696 | ) |\\n| Decrease (increase) in prepaid reinsurance premiums | (46,633 | ) | (101,478 | ) |\\n| Increase (decrease) in reserve for losses and loss adjustment expenses | 347,729 | 172,511 |\\n| Increase (decrease) in future policy benefit reserve | (240 | ) | (1,879 | ) |\\n| Increase (decrease) in unearned premiums | 1,455 | 255,537 |\\n| Increase (decrease) in other net payable to reinsurers | 67,550 | 101,984 |\\n| Increase (decrease) in losses in course of payment | 142,418 | 165,105 |\\n| Change in equity adjustments in limited partnerships | (12,725 | ) | (24,438 | ) |\\n| Distribution of limited partnership income | 42,625 | 41,165 |\\n| Change in other assets and liabilities, net | 18,573 | (32,114 | ) |\\n| Non-cash compensation expense | 16,150 | 14,720 |\\n| Amortization of bond premium (accrual of bond discount) | 38,770 | 38,010 |\\n| Amortization of underwriting discount on senior notes | 3 | 43 |\\n| Net realized capital (gains) losses | 194,654 | (70,694 | ) |\\n| Net cash provided by (used in) operating activities | 987,544 | 925,944 |\\n| CASH FLOWS FROM INVESTING ACTIVITIES: |\\n| Proceeds from fixed maturities matured/called - available for sale, at market value | 1,687,589 | 1,638,278 |\\n| Proceeds from fixed maturities matured/called - available for sale, at fair value | - | 875 |\\n| Proceeds from fixed maturities sold - available for sale, at market value | 1,146,000 | 1,050,082 |\\n| Proceeds from fixed maturities sold - available for sale, at fair value | 1,824 | 23,856 |\\n| Proceeds from equity securities sold - available for sale, at market value | 22,120 | 11,174 |\\n| Proceeds from equity securities sold - available for sale, at fair value | 439,692 | 452,514 |\\n| Distributions from other invested assets | 41,782 | 59,264 |\\n| Proceeds from sale of subsidiary (net of cash disposed) | 3,934 | - |\\n| Cost of fixed maturities acquired - available for sale, at market value | (3,583,990 | ) | (3,729,423 | ) |\\n| Cost of fixed maturities acquired - available for sale, at fair value | (234 | ) | (23,684 | ) |\\n| Cost of equity securities acquired - available for sale, at market value | (6,581 | ) | (11,873 | ) |\\n| Cost of equity securities acquired - available for sale, at fair value | (460,965 | ) | (262,871 | ) |\\n| Cost of other invested assets acquired | (140,923 | ) | (120,911 | ) |\\n| Net change in short-term investments | 83,584 | (284,822 | ) |\\n| Net change in unsettled securities transactions | (18,242 | ) | 13,496 |\\n| Net cash provided by (used in) investing activities | (784,410 | ) | (1,184,045 | ) |\\n| CASH FLOWS FROM FINANCING ACTIVITIES: |\\n| Common shares issued during the period, net | 9,896 | 15,465 |\\n| Purchase of treasury shares | (324,981 | ) | (399,942 | ) |\\n| Net proceeds from issuance of senior notes | - | 400,000 |\\n| Third party investment in redeemable noncontrolling interest | 296,848 | 136,200 |\\n| Dividends paid to shareholders | (125,905 | ) | (103,034 | ) |\\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\\n| Net cash provided by (used in) financing activities | (211,375 | ) | 38,355 |\\n| EFFECT OF EXCHANGE RATE CHANGES ON CASH | (28,007 | ) | 10,167 |\\n| Net increase (decrease) in cash | (36,248 | ) | (209,579 | ) |\\n| Cash, beginning of period | 437,474 | 611,382 |\\n| Cash, end of period | $ | 401,226 | $ | 401,803 |\\n| SUPPLEMENTAL CASH FLOW INFORMATION: |\\n| Income taxes paid (recovered) | $ | 123,234 | $ | 146,560 |\\n| Interest paid | 18,039 | 15,150 |\\n| The accompanying notes are an integral part of the consolidated financial statements. |\\n\\n4\\nNOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)\\nFor the Three and Nine Months Ended September 30, 2015 and 2014\\n1. GENERAL\\nEverest Re Group, Ltd. (\\\"Group\\\"), a Bermuda company, through its subsidiaries, principally provides reinsurance and insurance in the U.S., Bermuda and international markets. As used in this document, \\\"Company\\\" means Group and its subsidiaries.\\nEffective February 27, 2013, the Company established a new subsidiary, Mt. Logan Re Ltd. (\\\"Mt. Logan Re\\\") and effective July 1, 2013, Mt. Logan Re established separate segregated accounts and issued non-voting redeemable preferred shares to capitalize the segregated accounts. Accordingly, the financial position and operating results for Mt. Logan Re are consolidated with the Company and the non-controlling interests in Mt. Logan Re's operating results and equity are presented as separate captions in the Company's financial statements.\\nEffective July 13, 2015, the Company sold all of the outstanding shares of capital stock of a wholly-owned subsidiary entity, Mt. McKinley Insurance Company (\\\"Mt. McKinley\\\"), to Clearwater Insurance Company. The operating results of Mt. McKinley through July 13, 2015 are included within the Company's financial statements.\\n2. BASIS OF PRESENTATION\\nThe unaudited consolidated financial statements of the Company for the three and nine months ended September 30, 2015 and 2014 include all adjustments, consisting of normal recurring accruals, which, in the opinion of management, are necessary for a fair statement of the results on an interim basis. Certain financial information, which is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (\\\"GAAP\\\"), has been omitted since it is not required for interim reporting purposes. The December 31, 2014 consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. The results for the three and nine months ended September 30, 2015 and 2014 are not necessarily indicative of the results for a full year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the years ended December 31, 2014, 2013 and 2012 included in the Company's most recent Form 10-K filing.\\nAll intercompany accounts and transactions have been eliminated.\\nApplication of Recently Issued Accounting Standard Changes.\\nNo accounting standards or guidance have been issued recently that would have a material impact on the Company's financial statements or financial reporting process.\\n5\\n3. INVESTMENTS\\nThe amortized cost, market value and gross unrealized appreciation and depreciation of available for sale, fixed maturity, equity security investments, carried at market value and other-than-temporary impairments (\\\"OTTI\\\") in accumulated other comprehensive income (\\\"AOCI\\\") are as follows for the periods indicated:\\n\\n| At September 30, 2015 |\\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\\n| Fixed maturity securities |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 337,271 | $ | 15,725 | $ | (70 | ) | $ | 352,926 | $ | - |\\n| Obligations of U.S. states and political subdivisions | 683,715 | 32,087 | (1,523 | ) | 714,279 | - |\\n| Corporate securities | 4,964,570 | 118,763 | (76,396 | ) | 5,006,937 | 2,006 |\\n| Asset-backed securities | 437,376 | 2,575 | (1,554 | ) | 438,397 | - |\\n| Mortgage-backed securities |\\n| Commercial | 277,907 | 7,697 | (795 | ) | 284,809 | - |\\n| Agency residential | 2,392,937 | 39,295 | (6,165 | ) | 2,426,067 | - |\\n| Non-agency residential | 971 | 53 | (46 | ) | 978 | - |\\n| Foreign government securities | 1,285,006 | 60,837 | (44,882 | ) | 1,300,961 | (2 | ) |\\n| Foreign corporate securities | 2,921,960 | 115,881 | (72,235 | ) | 2,965,606 | 39 |\\n| Total fixed maturity securities | $ | 13,301,713 | $ | 392,913 | $ | (203,666 | ) | $ | 13,490,960 | $ | 2,043 |\\n| Equity securities | $ | 127,411 | $ | 3,509 | $ | (17,921 | ) | $ | 112,999 | $ | - |\\n\\n\\n| At December 31, 2014 |\\n| Amortized | Unrealized | Unrealized | Market | OTTI in AOCI |\\n| (Dollars in thousands) | Cost | Appreciation | Depreciation | Value | (a) |\\n| Fixed maturity securities |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 221,052 | $ | 10,290 | $ | (304 | ) | $ | 231,038 | $ | - |\\n| Obligations of U.S. states and political subdivisions | 783,129 | 41,969 | (626 | ) | 824,472 | - |\\n| Corporate securities | 4,626,002 | 143,889 | (62,906 | ) | 4,706,985 | (6,910 | ) |\\n| Asset-backed securities | 340,761 | 1,691 | (1,230 | ) | 341,222 | - |\\n| Mortgage-backed securities |\\n| Commercial | 231,439 | 10,675 | (429 | ) | 241,685 | - |\\n| Agency residential | 2,157,182 | 37,555 | (11,573 | ) | 2,183,164 | - |\\n| Non-agency residential | 2,734 | 54 | (57 | ) | 2,731 | - |\\n| Foreign government securities | 1,488,144 | 71,177 | (26,866 | ) | 1,532,455 | - |\\n| Foreign corporate securities | 2,980,716 | 109,673 | (53,074 | ) | 3,037,315 | - |\\n| Total fixed maturity securities | $ | 12,831,159 | $ | 426,973 | $ | (157,065 | ) | $ | 13,101,067 | $ | (6,910 | ) |\\n| Equity securities | $ | 148,326 | $ | 3,831 | $ | (11,947 | ) | $ | 140,210 | $ | - |\\n\\n(a) Represents the amount of OTTI recognized in AOCI. Amount includes unrealized gains and losses on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date.\\n6\\nThe amortized cost and market value of fixed maturity securities are shown in the following table by contractual maturity. Mortgage-backed securities are generally more likely to be prepaid than other fixed maturity securities. As the stated maturity of such securities may not be indicative of actual maturities, the totals for mortgage-backed and asset-backed securities are shown separately.\\n\\n| At September 30, 2015 | At December 31, 2014 |\\n| Amortized | Market | Amortized | Market |\\n| (Dollars in thousands) | Cost | Value | Cost | Value |\\n| Fixed maturity securities – available for sale: |\\n| Due in one year or less | $ | 1,080,129 | $ | 1,088,140 | $ | 1,183,247 | $ | 1,189,416 |\\n| Due after one year through five years | 5,906,738 | 5,991,760 | 5,646,466 | 5,726,277 |\\n| Due after five years through ten years | 2,377,276 | 2,382,188 | 2,270,073 | 2,313,672 |\\n| Due after ten years | 828,380 | 878,621 | 999,257 | 1,102,900 |\\n| Asset-backed securities | 437,376 | 438,397 | 340,761 | 341,222 |\\n| Mortgage-backed securities: |\\n| Commercial | 277,906 | 284,809 | 231,439 | 241,685 |\\n| Agency residential | 2,392,937 | 2,426,067 | 2,157,182 | 2,183,164 |\\n| Non-agency residential | 971 | 978 | 2,734 | 2,731 |\\n| Total fixed maturity securities | $ | 13,301,713 | $ | 13,490,960 | $ | 12,831,159 | $ | 13,101,067 |\\n\\nThe changes in net unrealized appreciation (depreciation) for the Company's investments are derived from the following sources for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Increase (decrease) during the period between the market value and cost |\\n| of investments carried at market value, and deferred taxes thereon: |\\n| Fixed maturity securities | $ | (71,706 | ) | $ | (87,859 | ) | $ | (89,616 | ) | $ | 70,010 |\\n| Fixed maturity securities, other-than-temporary impairment | (253 | ) | (261 | ) | 8,954 | (180 | ) |\\n| Equity securities | (4,415 | ) | (3,287 | ) | (6,295 | ) | 3,327 |\\n| Change in unrealized appreciation (depreciation), pre-tax | (76,374 | ) | (91,407 | ) | (86,957 | ) | 73,157 |\\n| Deferred tax benefit (expense) | 9,919 | 11,649 | 5,563 | (9,480 | ) |\\n| Deferred tax benefit (expense), other-than-temporary impairment | (8 | ) | - | (3,415 | ) | - |\\n| Change in unrealized appreciation (depreciation), |\\n| net of deferred taxes, included in shareholders' equity | $ | (66,463 | ) | $ | (79,758 | ) | $ | (84,809 | ) | $ | 63,677 |\\n\\nThe Company frequently reviews all of its fixed maturity, available for sale securities for declines in market value and focuses its attention on securities whose fair value has fallen below 80% of their amortized cost at the time of review. The Company then assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company evaluates the current market and interest rate environment as well as specific issuer information. Generally, a change in a security's value caused by a change in the market, interest rate or foreign exchange environment does not constitute an other-than-temporary impairment, but rather a temporary decline in market value. Temporary declines in market value are recorded as unrealized losses in accumulated other comprehensive income (loss). If the Company determines that the decline is other-than-temporary and the Company does not have the intent to sell the security; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis, the carrying value of the investment is written down to fair value. The fair value adjustment that is credit or foreign exchange related is recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss). The fair value adjustment that is non-credit related is recorded as a component of other comprehensive income (loss), net of tax, and is included in accumulated other comprehensive income (loss) in the Company's consolidated balance sheets.\\n7\\nThe Company's assessments are based on the issuers current and expected future financial position, timeliness with respect to interest and/or principal payments, speed of repayments and any applicable credit enhancements or breakeven constant default rates on mortgage-backed and asset-backed securities, as well as relevant information provided by rating agencies, investment advisors and analysts.\\nThe majority of the Company's equity securities available for sale at market value are primarily comprised of mutual fund investments whose underlying securities consist of fixed maturity securities. When a fund's value reflects an unrealized loss, the Company assesses whether the decline in value is temporary or other-than-temporary. In making its assessment, the Company considers the composition of its portfolios and their related markets, reports received from the portfolio managers and discussions with portfolio managers. If the Company determines that the declines are temporary and it has the ability and intent to continue to hold the investments, then the declines are recorded as unrealized losses in accumulated other comprehensive income (loss). If declines are deemed to be other-than-temporary, then the carrying value of the investment is written down to fair value and recorded in net realized capital gains (losses) in the Company's consolidated statements of operations and comprehensive income (loss).\\nRetrospective adjustments are employed to recalculate the values of asset-backed securities. All of the Company's asset-backed and mortgage-backed securities have a pass-through structure. Each acquisition lot is reviewed to recalculate the effective yield. The recalculated effective yield is used to derive a book value as if the new yield were applied at the time of acquisition. Outstanding principal factors from the time of acquisition to the adjustment date are used to calculate the prepayment history for all applicable securities. Conditional prepayment rates, computed with life to date factor histories and weighted average maturities, are used in the calculation of projected prepayments for pass-through security types.\\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\\n\\n| Duration of Unrealized Loss at September 30, 2015 By Security Type |\\n| Less than 12 months | Greater than 12 months | Total |\\n| Gross | Gross | Gross |\\n| Unrealized | Unrealized | Unrealized |\\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\\n| Fixed maturity securities - available for sale |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 201 | $ | (1 | ) | $ | 1,844 | $ | (69 | ) | $ | 2,045 | $ | (70 | ) |\\n| Obligations of U.S. states and political subdivisions | 20,162 | (316 | ) | 35,460 | (1,207 | ) | 55,622 | (1,523 | ) |\\n| Corporate securities | 1,323,515 | (51,785 | ) | 425,091 | (24,611 | ) | 1,748,606 | (76,396 | ) |\\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\\n| Mortgage-backed securities |\\n| Commercial | 44,260 | (795 | ) | - | - | 44,260 | (795 | ) |\\n| Agency residential | 343,504 | (2,182 | ) | 382,730 | (3,983 | ) | 726,234 | (6,165 | ) |\\n| Non-agency residential | 176 | (2 | ) | 44 | (44 | ) | 220 | (46 | ) |\\n| Foreign government securities | 299,055 | (22,177 | ) | 183,387 | (22,705 | ) | 482,442 | (44,882 | ) |\\n| Foreign corporate securities | 699,077 | (40,165 | ) | 279,126 | (32,070 | ) | 978,203 | (72,235 | ) |\\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\\n| Equity securities | - | - | 97,871 | (17,921 | ) | 97,871 | (17,921 | ) |\\n| Total | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,450,318 | $ | (103,490 | ) | $ | 4,269,794 | $ | (221,587 | ) |\\n\\n8\\n\\n| Duration of Unrealized Loss at September 30, 2015 By Maturity |\\n| Less than 12 months | Greater than 12 months | Total |\\n| Gross | Gross | Gross |\\n| Unrealized | Unrealized | Unrealized |\\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\\n| Fixed maturity securities |\\n| Due in one year or less | $ | 85,547 | $ | (4,021 | ) | $ | 83,375 | $ | (12,950 | ) | $ | 168,922 | $ | (16,971 | ) |\\n| Due in one year through five years | 1,220,223 | (50,689 | ) | 577,851 | (41,640 | ) | 1,798,074 | (92,329 | ) |\\n| Due in five years through ten years | 924,605 | (51,295 | ) | 208,989 | (20,624 | ) | 1,133,594 | (71,919 | ) |\\n| Due after ten years | 111,635 | (8,439 | ) | 54,693 | (5,448 | ) | 166,328 | (13,887 | ) |\\n| Asset-backed securities | 89,526 | (674 | ) | 44,765 | (880 | ) | 134,291 | (1,554 | ) |\\n| Mortgage-backed securities | 387,940 | (2,979 | ) | 382,774 | (4,027 | ) | 770,714 | (7,006 | ) |\\n| Total fixed maturity securities | $ | 2,819,476 | $ | (118,097 | ) | $ | 1,352,447 | $ | (85,569 | ) | $ | 4,171,923 | $ | (203,666 | ) |\\n\\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at September 30, 2015 were $4,269,794 thousand and $221,587 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at September 30, 2015, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $118,097 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to net unrealized foreign exchange losses, $44,092 thousand, as the U.S. dollar has strengthened against other currencies and unrealized losses in the energy sector, $43,353 thousand, as falling oil prices have disrupted the market values for this sector, particularly for oil exploration, production and servicing companies. The $85,569 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $60,407 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. There was no gross unrealized depreciation for mortgage-backed securities related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover the full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\\nThe Company, given the size of its investment portfolio and capital position, does not have the intent to sell these securities; and it is more likely than not that the Company will not have to sell the security before recovery of its cost basis. In addition, all securities currently in an unrealized loss position are current with respect to principal and interest payments.\\n9\\nThe tables below display the aggregate market value and gross unrealized depreciation of fixed maturity and equity securities, by security type and contractual maturity, in each case subdivided according to length of time that individual securities had been in a continuous unrealized loss position for the periods indicated:\\n\\n| Duration of Unrealized Loss at December 31, 2014 By Security Type |\\n| Less than 12 months | Greater than 12 months | Total |\\n| Gross | Gross | Gross |\\n| Unrealized | Unrealized | Unrealized |\\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\\n| Fixed maturity securities - available for sale |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 13,187 | $ | (20 | ) | $ | 26,897 | $ | (284 | ) | $ | 40,084 | $ | (304 | ) |\\n| Obligations of U.S. states and political subdivisions | 20,428 | (242 | ) | 18,199 | (384 | ) | 38,627 | (626 | ) |\\n| Corporate securities | 1,245,830 | (55,388 | ) | 362,320 | (7,518 | ) | 1,608,150 | (62,906 | ) |\\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\\n| Mortgage-backed securities |\\n| Commercial | 28,191 | (123 | ) | 9,777 | (306 | ) | 37,968 | (429 | ) |\\n| Agency residential | 141,807 | (172 | ) | 678,972 | (11,401 | ) | 820,779 | (11,573 | ) |\\n| Non-agency residential | - | - | 266 | (57 | ) | 266 | (57 | ) |\\n| Foreign government securities | 235,725 | (15,415 | ) | 139,200 | (11,451 | ) | 374,925 | (26,866 | ) |\\n| Foreign corporate securities | 567,905 | (36,926 | ) | 290,234 | (16,148 | ) | 858,139 | (53,074 | ) |\\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\\n| Equity securities | 50,285 | (4,068 | ) | 73,994 | (7,879 | ) | 124,279 | (11,947 | ) |\\n| Total | $ | 2,495,611 | $ | (113,584 | ) | $ | 1,599,859 | $ | (55,428 | ) | $ | 4,095,470 | $ | (169,012 | ) |\\n\\n\\n| Duration of Unrealized Loss at December 31, 2014 By Maturity |\\n| Less than 12 months | Greater than 12 months | Total |\\n| Gross | Gross | Gross |\\n| Unrealized | Unrealized | Unrealized |\\n| (Dollars in thousands) | Market Value | Depreciation | Market Value | Depreciation | Market Value | Depreciation |\\n| Fixed maturity securities |\\n| Due in one year or less | $ | 98,021 | $ | (5,166 | ) | $ | 80,002 | $ | (8,174 | ) | $ | 178,023 | $ | (13,340 | ) |\\n| Due in one year through five years | 1,233,244 | (68,124 | ) | 518,613 | (12,761 | ) | 1,751,857 | (80,885 | ) |\\n| Due in five years through ten years | 679,374 | (28,529 | ) | 187,717 | (10,734 | ) | 867,091 | (39,263 | ) |\\n| Due after ten years | 72,436 | (6,172 | ) | 50,518 | (4,116 | ) | 122,954 | (10,288 | ) |\\n| Asset-backed securities | 192,253 | (1,230 | ) | - | - | 192,253 | (1,230 | ) |\\n| Mortgage-backed securities | 169,998 | (295 | ) | 689,015 | (11,764 | ) | 859,013 | (12,059 | ) |\\n| Total fixed maturity securities | $ | 2,445,326 | $ | (109,516 | ) | $ | 1,525,865 | $ | (47,549 | ) | $ | 3,971,191 | $ | (157,065 | ) |\\n\\nThe aggregate market value and gross unrealized losses related to investments in an unrealized loss position at December 31, 2014 were $4,095,470 thousand and $169,012 thousand, respectively. The market value of securities for the single issuer whose securities comprised the largest unrealized loss position at December 31, 2014, did not exceed 0.2% of the overall market value of the Company's fixed maturity securities. In addition, as indicated on the above table, there was no significant concentration of unrealized losses in any one market sector. The $109,516 thousand of unrealized losses related to fixed maturity securities that have been in an unrealized loss position for less than one year were generally comprised of domestic and foreign corporate securities, as well as foreign government securities. The majority of these unrealized losses are attributable to unrealized losses in the energy sector, $58,891 thousand, as falling oil prices disrupted the market values for this sector, particularly for oil exploration, production and servicing companies during the fourth quarter of 2014 and unrealized foreign exchange losses, $34,687 thousand, as the U.S. dollar has strengthened against other currencies. The $47,549 thousand of unrealized losses related to fixed maturity securities in an unrealized loss position for more than one year related primarily to foreign and domestic corporate securities, foreign government securities and agency residential mortgage-backed securities. Of these unrealized losses, $42,884 thousand related to securities that were rated investment grade by at least one nationally recognized statistical rating organization. The gross unrealized depreciation for mortgage-backed securities included $15 thousand related to sub-prime and alt-A loans. In all instances, there were no projected cash flow shortfalls to recover\\n10\\nthe full book value of the investments and the related interest obligations. The mortgage-backed securities still have excess credit coverage and are current on interest and principal payments.\\nThe components of net investment income are presented in the table below for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Fixed maturities | $ | 108,134 | $ | 115,057 | $ | 326,970 | $ | 348,872 |\\n| Equity securities | 11,090 | 11,086 | 35,783 | 36,111 |\\n| Short-term investments and cash | 381 | 295 | 1,084 | 1,202 |\\n| Other invested assets |\\n| Limited partnerships | 370 | 21,690 | 13,993 | 25,658 |\\n| Other | (242 | ) | 869 | 1,366 | 3,220 |\\n| Gross investment income before adjustments | 119,733 | 148,997 | 379,196 | 415,063 |\\n| Funds held interest income (expense) | 2,569 | 1,817 | 8,162 | 6,875 |\\n| Future policy benefit reserve income (expense) | (300 | ) | (471 | ) | (1,402 | ) | (915 | ) |\\n| Gross investment income | 122,002 | 150,343 | 385,956 | 421,023 |\\n| Investment expenses | (6,491 | ) | (8,200 | ) | (22,816 | ) | (24,499 | ) |\\n| Net investment income | $ | 115,511 | $ | 142,143 | $ | 363,140 | $ | 396,524 |\\n\\nThe Company records results from limited partnership investments on the equity method of accounting with changes in value reported through net investment income. Due to the timing of receiving financial information from these partnerships, the results are generally reported on a one month or quarter lag. If the Company determines there has been a significant decline in value of a limited partnership during this lag period, a loss will be recorded in the period in which the Company identifies the decline.\\nThe Company had contractual commitments to invest up to an additional $469,064 thousand in limited partnerships at September 30, 2015. These commitments will be funded when called in accordance with the partnership agreements, which have investment periods that expire, unless extended, through 2020.\\nThe components of net realized capital gains (losses) are presented in the table below for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Fixed maturity securities, market value: |\\n| Other-than-temporary impairments | $ | (20,445 | ) | $ | (106 | ) | $ | (62,701 | ) | $ | (495 | ) |\\n| Gains (losses) from sales | (5,218 | ) | 7,311 | (15,812 | ) | 3,668 |\\n| Fixed maturity securities, fair value: |\\n| Gains (losses) from sales | (17 | ) | 82 | 25 | 1,022 |\\n| Gains (losses) from fair value adjustments | - | (938 | ) | 56 | (938 | ) |\\n| Equity securities, market value: |\\n| Gains (losses) from sales | (3,573 | ) | (181 | ) | (4,455 | ) | (1,235 | ) |\\n| Equity securities, fair value: |\\n| Gains (losses) from sales | (13,646 | ) | (1,823 | ) | (13,041 | ) | (1,873 | ) |\\n| Gains (losses) from fair value adjustments | (117,087 | ) | (13,792 | ) | (98,741 | ) | 70,548 |\\n| Short-term investments gains (losses) | 15 | (1 | ) | 15 | (3 | ) |\\n| Total net realized capital gains (losses) | $ | (159,971 | ) | $ | (9,448 | ) | $ | (194,654 | ) | $ | 70,694 |\\n\\nThe Company recorded as net realized capital gains (losses) in the consolidated statements of operations and comprehensive income (loss) both fair value re-measurements and write-downs in the value of securities deemed to be impaired on an other-than-temporary basis as displayed in the table above. The Company had no other-than-temporary impaired securities where the impairment had both a credit and non-credit component.\\n11\\nThe proceeds and split between gross gains and losses, from sales of fixed maturity and equity securities, are presented in the table below for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Proceeds from sales of fixed maturity securities | $ | 414,538 | $ | 446,699 | $ | 1,147,824 | $ | 1,073,938 |\\n| Gross gains from sales | 11,826 | 12,821 | 37,525 | 28,828 |\\n| Gross losses from sales | (17,061 | ) | (5,428 | ) | (53,312 | ) | (24,138 | ) |\\n| Proceeds from sales of equity securities | $ | 156,593 | $ | 150,124 | $ | 461,812 | $ | 463,688 |\\n| Gross gains from sales | 5,250 | 2,545 | 18,890 | 13,047 |\\n| Gross losses from sales | (22,469 | ) | (4,549 | ) | (36,386 | ) | (16,155 | ) |\\n\\n4. DERIVATIVES\\nThe Company sold seven equity index put option contracts, based on two indices, in 2001 and 2005, which remain outstanding. The Company sold these equity index put options as insurance products with the intent of achieving a profit. These equity index put option contracts meet the definition of a derivative under FASB guidance and the Company's position in these equity index put option contracts is unhedged. Accordingly, these equity index put option contracts are carried at fair value in the consolidated balance sheets with changes in fair value recorded in the consolidated statements of operations and comprehensive income (loss).\\nThe Company sold six equity index put option contracts, based on the Standard & Poor's 500 (\\\"S&P 500\\\") index, for total consideration, net of commissions, of $22,530 thousand. At September 30, 2015, fair value for these equity index put option contracts was $41,809 thousand. Based on historical index volatilities and trends and the September 30, 2015 S&P 500 index value, the Company estimates the probability that each equity index put option contract of the S&P 500 index falling below the strike price on the exercise date to be less than 23%. The theoretical maximum payouts under these six equity index put option contracts would occur if on each of the exercise dates the S&P 500 index value were zero. At September 30, 2015, the present value of these theoretical maximum payouts using a 3% discount factor was $429,402 thousand. Conversely, if the contracts had all expired on September 30, 2015, with the S&P index at $1,920.03, there would have been no settlement amount.\\nThe Company sold one equity index put option contract based on the FTSE 100 index for total consideration, net of commissions, of $6,706 thousand. At September 30, 2015, fair value for this equity index put option contract was $10,438 thousand. Based on historical index volatilities and trends and the September 30, 2015 FTSE 100 index value, the Company estimates the probability that the equity index put option contract of the FTSE 100 index will fall below the strike price on the exercise date to be less than 51%. The theoretical maximum payout under the equity index put option contract would occur if on the exercise date the FTSE 100 index value was zero. At September 30, 2015, the present value of the theoretical maximum payout using a 3% discount factor and current exchange rate was $43,896 thousand. Conversely, if the contract had expired on September 30, 2015, with the FTSE index at ₤6,061.60, there would have been no settlement amount.\\nThe fair value of the equity index put options can be found in the Company's consolidated balance sheets as follows:\\n\\n| (Dollars in thousands) |\\n| Derivatives not designated as | Location of fair value | At | At |\\n| hedging instruments | in balance sheets | September 30, 2015 | December 31, 2014 |\\n| Equity index put option contracts | Equity index put option liability | $ | 52,247 | $ | 47,022 |\\n| Total | $ | 52,247 | $ | 47,022 |\\n\\n12\\nThe change in fair value of the equity index put option contracts can be found in the Company's statement of operations and comprehensive income (loss) as follows:\\n\\n| (Dollars in thousands) | Three Months Ended | Nine Months Ended |\\n| Derivatives not designated as | Location of gain (loss) in statements of | September 30, | September 30, |\\n| hedging instruments | operations and comprehensive income (loss) | 2015 | 2014 | 2015 | 2014 |\\n| Equity index put option contracts | Net derivative gain (loss) | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\\n| Total | $ | (11,428 | ) | $ | 1,855 | $ | (5,225 | ) | $ | 3,968 |\\n\\n5. FAIR VALUE\\nGAAP guidance regarding fair value measurements address how companies should measure fair value when they are required to use fair value measures for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based on the transparency of inputs to the valuation of an asset or liability. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement, with Level 1 being the highest priority and Level 3 being the lowest priority.\\nThe levels in the hierarchy are defined as follows:\\n\\n| Level 1: | Inputs to the valuation methodology are observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in an active market; |\\n\\n\\n| Level 2: | Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; |\\n\\n\\n| Level 3: | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\\n\\nThe Company's fixed maturity and equity securities are primarily managed by third party investment asset managers. The investment asset managers obtain prices from nationally recognized pricing services. These services seek to utilize market data and observations in their evaluation process. They use pricing applications that vary by asset class and incorporate available market information and when fixed maturity securities do not trade on a daily basis the services will apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. In addition, they use model processes, such as the Option Adjusted Spread model to develop prepayment and interest rate scenarios for securities that have prepayment features.\\nIn limited instances where prices are not provided by pricing services or in rare instances when a manager may not agree with the pricing service, price quotes on a non-binding basis are obtained from investment brokers. The investment asset managers do not make any changes to prices received from either the pricing services or the investment brokers. In addition, the investment asset managers have procedures in place to review the reasonableness of the prices from the service providers and may request verification of the prices. In addition, the Company continually performs analytical reviews of price changes and tests the prices on a random basis to an independent pricing source. No material variances were noted during these price validation procedures. In limited situations, where financial markets are inactive or illiquid, the Company may use its own assumptions about future cash flows and risk-adjusted discount rates to determine fair value. Due to the unavailability of prices for one private placement security, the Company valued the security at $6,125 thousand at September 30, 2015 and made no such adjustments at December 31, 2014.\\n13\\nThe Company internally manages a small public equity portfolio which had a fair value at September 30, 2015 and December 31, 2014 of $226,322 thousand and $196,980 thousand, respectively, and all prices were obtained from publically published sources.\\nEquity securities denominated in U.S. currency with quoted prices in active markets for identical assets are categorized as level 1 since the quoted prices are directly observable. Equity securities traded on foreign exchanges are categorized as level 2 due to the added input of a foreign exchange conversion rate to determine fair or market value. The Company uses foreign currency exchange rates published by nationally recognized sources.\\nAll categories of fixed maturity securities listed in the tables below are generally categorized as level 2, since a particular security may not have traded but the pricing services are able to use valuation models with observable market inputs such as interest rate yield curves and prices for similar fixed maturity securities in terms of issuer, maturity and seniority. For foreign government securities and foreign corporate securities, the fair values provided by the third party pricing services in local currencies, and where applicable, are converted to U.S. dollars using currency exchange rates from nationally recognized sources.\\nThe fixed maturities with fair values categorized as level 3 result when prices are not available from the nationally recognized pricing services. The asset managers will then obtain non-binding price quotes for the securities from brokers. The single broker quotes are provided by market makers or broker-dealers who are recognized as market participants in the markets in which they are providing the quotes. The prices received from brokers are reviewed for reasonableness by the third party asset managers and the Company. If the broker quotes are for foreign denominated securities, the quotes are converted to U.S. dollars using currency exchange rates from nationally recognized sources. Historically, most of the level 3 fixed maturities have resulted from new issuances and the third party prices services have not yet included the issuance in their data base. Generally, in subsequent measurement periods, the issuances will be included in the data base and the fair value will transfer to level 2.\\nThe composition and valuation inputs for the presented fixed maturities categories are as follows:\\n\\n| · | U.S. Treasury securities and obligations of U.S. government agencies and corporations are primarily comprised of U.S. Treasury bonds and the fair value is based on observable market inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields; |\\n\\n\\n| · | Obligations of U.S. states and political subdivisions are comprised of state and municipal bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\\n\\n\\n| · | Corporate securities are primarily comprised of U.S. corporate and public utility bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities, benchmark yields and credit spreads; |\\n\\n\\n| · | Asset-backed and mortgage-backed securities fair values are based on observable inputs such as quoted prices, reported trades, quoted prices for similar issuances or benchmark yields and cash flow models using observable inputs such as prepayment speeds, collateral performance and default spreads; |\\n\\n\\n| · | Foreign government securities are comprised of global non-U.S. sovereign bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source; |\\n\\n\\n| · | Foreign corporate securities are comprised of global non-U.S. corporate bond issuances and the fair values are based on observable market inputs such as quoted market prices, quoted prices for similar securities and models with observable inputs such as benchmark yields and credit spreads and then, where applicable, converted to U.S. dollars using an exchange rate from a nationally recognized source. |\\n\\n14\\nThe Company's liability for equity index put options is categorized as level 3 since there is no active market for these seven long dated equity put options. The fair values for these options are calculated by the Company using an industry accepted pricing model, Black-Scholes. The model inputs and assumptions are: risk free interest rates, equity market indexes values, volatilities and dividend yields and duration. The model results are then adjusted for the Company's credit default swap rate. All of these inputs and assumptions are updated quarterly. One of the option contacts is in British Pound Sterling so the fair value for this contract is converted to U.S. dollars using an exchange rate from a nationally recognized source.\\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\\n\\n| Fair Value Measurement Using: |\\n| Quoted Prices |\\n| in Active | Significant |\\n| Markets for | Other | Significant |\\n| Identical | Observable | Unobservable |\\n| Assets | Inputs | Inputs |\\n| (Dollars in thousands) | September 30, 2015 | (Level 1) | (Level 2) | (Level 3) |\\n| Assets: |\\n| Fixed maturities, market value |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 352,926 | $ | - | $ | 352,926 | $ | - |\\n| Obligations of U.S. States and political subdivisions | 714,279 | - | 714,279 | - |\\n| Corporate securities | 5,006,937 | - | 4,999,371 | 7,566 |\\n| Asset-backed securities | 438,397 | - | 438,397 | - |\\n| Mortgage-backed securities |\\n| Commercial | 284,809 | - | 284,809 | - |\\n| Agency residential | 2,426,067 | - | 2,426,067 | - |\\n| Non-agency residential | 978 | - | 978 | - |\\n| Foreign government securities | 1,300,961 | - | 1,300,961 | - |\\n| Foreign corporate securities | 2,965,606 | - | 2,959,481 | 6,125 |\\n| Total fixed maturities, market value | 13,490,960 | - | 13,477,269 | 13,691 |\\n| Fixed maturities, fair value | - | - | - | - |\\n| Equity securities, market value | 112,999 | 97,871 | 15,128 | - |\\n| Equity securities, fair value | 1,357,311 | 1,267,765 | 89,546 | - |\\n| Liabilities: |\\n| Equity index put option contracts | $ | 52,247 | $ | - | $ | - | $ | 52,247 |\\n\\nThere were no transfers between Level 1 and Level 2 for the nine months ended September 30, 2015.\\n15\\nThe following table presents the fair value measurement levels for all assets and liabilities, which the Company has recorded at fair value (fair and market value) as of the periods indicated:\\n\\n| Fair Value Measurement Using: |\\n| Quoted Prices |\\n| in Active | Significant |\\n| Markets for | Other | Significant |\\n| Identical | Observable | Unobservable |\\n| Assets | Inputs | Inputs |\\n| (Dollars in thousands) | December 31, 2014 | (Level 1) | (Level 2) | (Level 3) |\\n| Assets: |\\n| Fixed maturities, market value |\\n| U.S. Treasury securities and obligations of |\\n| U.S. government agencies and corporations | $ | 231,038 | $ | - | $ | 231,038 | $ | - |\\n| Obligations of U.S. States and political subdivisions | 824,472 | - | 824,472 | - |\\n| Corporate securities | 4,706,985 | - | 4,706,985 | - |\\n| Asset-backed securities | 341,222 | - | 341,222 | - |\\n| Mortgage-backed securities |\\n| Commercial | 241,685 | - | 233,088 | 8,597 |\\n| Agency residential | 2,183,164 | - | 2,183,164 | - |\\n| Non-agency residential | 2,731 | - | 2,731 | - |\\n| Foreign government securities | 1,532,455 | - | 1,532,455 | - |\\n| Foreign corporate securities | 3,037,315 | - | 3,030,149 | 7,166 |\\n| Total fixed maturities, market value | 13,101,067 | - | 13,085,304 | 15,763 |\\n| Fixed maturities, fair value | 1,509 | - | 1,509 | - |\\n| Equity securities, market value | 140,210 | 124,295 | 15,915 | - |\\n| Equity securities, fair value | 1,447,820 | 1,337,396 | 110,424 | - |\\n| Liabilities: |\\n| Equity index put option contracts | $ | 47,022 | $ | - | $ | - | $ | 47,022 |\\n\\n16\\nThe following tables present the activity under Level 3, fair value measurements using significant unobservable inputs by asset type, for the periods indicated:\\n\\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\\n| Corporate | Foreign | Corporate | Foreign |\\n| (Dollars in thousands) | Securities | Corporate | Total | Securities | CMBS | Corporate | Total |\\n| Beginning balance | $ | 1,958 | $ | 7,837 | $ | 9,795 | $ | - | $ | 8,597 | $ | 7,166 | $ | 15,763 |\\n| Total gains or (losses) (realized/unrealized) |\\n| Included in earnings | (8 | ) | 62 | 54 | (4 | ) | - | 177 | 173 |\\n| Included in other comprehensive income (loss) | (137 | ) | (1,287 | ) | (1,424 | ) | (139 | ) | - | (1,216 | ) | (1,355 | ) |\\n| Purchases, issuances and settlements | 1,723 | - | 1,723 | 3,651 | - | - | 3,651 |\\n| Transfers in and/or (out) of Level 3 | 4,030 | (487 | ) | 3,543 | 4,058 | (8,597 | ) | (2 | ) | (4,541 | ) |\\n| Ending balance | $ | 7,566 | $ | 6,125 | $ | 13,691 | $ | 7,566 | $ | - | $ | 6,125 | $ | 13,691 |\\n| The amount of total gains or losses for the period |\\n| included in earnings (or changes in net assets) |\\n| attributable to the change in unrealized gains |\\n| or losses relating to assets still held |\\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\n\\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\\n| Corporate | Asset-backed | Foreign | Non-agency | Agency | Corporate | Asset-backed | Foreign | Non-agency | Agency |\\n| (Dollars in thousands) | Securities | Securities | Corporate | RMBS | RMBS | Total | Securities | Securities | Corporate | RMBS | RMBS | Total |\\n| Beginning balance | $ | - | $ | 3,000 | $ | - | $ | 259 | $ | - | $ | 3,259 | $ | - | $ | 5,299 | $ | 481 | $ | 347 | $ | - | $ | 6,127 |\\n| Total gains or (losses) (realized/unrealized) |\\n| Included in earnings | - | 1,203 | - | 187 | - | 1,390 | - | 1,259 | 18 | 329 | - | 1,606 |\\n| Included in other comprehensive income (loss) | 42 | (201 | ) | (62 | ) | (114 | ) | - | (335 | ) | 42 | (126 | ) | (82 | ) | (138 | ) | - | (304 | ) |\\n| Purchases, issuances and settlements | 1,274 | 22,797 | 4,517 | (332 | ) | 29,845 | 58,101 | 1,274 | 21,303 | 4,038 | (538 | ) | 29,845 | 55,922 |\\n| Transfers in and/or (out) of Level 3 | - | (1,431 | ) | - | - | - | (1,431 | ) | - | (2,367 | ) | - | - | - | (2,367 | ) |\\n| Ending balance | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 | $ | 1,316 | $ | 25,368 | $ | 4,455 | $ | - | $ | 29,845 | $ | 60,984 |\\n| The amount of total gains or losses for the period |\\n| included in earnings (or changes in net assets) |\\n| attributable to the change in unrealized gains |\\n| or losses relating to assets still held |\\n| at the reporting date | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\nThe net transfers to/(from) level 3, fair value measurements using significant unobservable inputs, of $4,541 thousand and $2,367 thousand of investments for the nine months ended September 30, 2015 and 2014, respectively, primarily relate to securities that were priced using single non-binding broker quotes as of December 31, 2014 and 2013, respectively. The securities were subsequently priced using a recognized pricing service as of September 30, 2015 and 2014, and were classified as level 2 as of those dates.\\n17\\nThe following table presents the activity under Level 3, fair value measurements using significant unobservable inputs for equity index put option contracts, for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Liabilities: |\\n| Balance, beginning of period | $ | 40,819 | $ | 33,309 | $ | 47,022 | $ | 35,423 |\\n| Total (gains) or losses (realized/unrealized) |\\n| Included in earnings | 11,428 | (1,855 | ) | 5,225 | (3,968 | ) |\\n| Included in other comprehensive income (loss) | - | - | - | - |\\n| Purchases, issuances and settlements | - | - | - | - |\\n| Transfers in and/or (out) of Level 3 | - | - | - | - |\\n| Balance, end of period | $ | 52,247 | $ | 31,455 | $ | 52,247 | $ | 31,455 |\\n| The amount of total gains or losses for the period included in earnings |\\n| (or changes in net assets) attributable to the change in unrealized |\\n| gains or losses relating to liabilities still held at the reporting date | $ | - | $ | - | $ | - | $ | - |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\n6. REDEEMABLE NONCONTROLLING INTERESTS – MT. LOGAN RE\\nMt. Logan Re is a Class 3 insurer registered in Bermuda effective February 27, 2013 under The Segregated Accounts Companies Act 2000 and 100% of the voting common shares are owned by Group. Separate segregated accounts have been established effective July 1, 2013 and non-voting, redeemable preferred shares have been issued to capitalize the segregated accounts. Each segregated account will invest in a diversified set of catastrophe exposures, diversified by risk/peril and across different geographic regions globally. The financial statements for Mt. Logan Re are consolidated with the Company with adjustments reflected for the third party noncontrolling interests reflected as separate captions in the Company's financial statements.\\nThe following table presents the activity for redeemable noncontrolling interests in the consolidated balance sheets for the periods indicated:\\n\\n| Nine Months Ended | Twelve Months Ended |\\n| September 30, | December 31, |\\n| (Dollars in thousands) | 2015 | 2014 |\\n| Redeemable noncontrolling interests - Mt. Logan Re, beginning of period | $ | 421,552 | $ | 93,378 |\\n| Unaffiliated third party investments during period, net | 336,848 | 279,200 |\\n| Net income (loss) attributable to noncontrolling interests | 61,526 | 59,307 |\\n| Dividends paid on third party investment in redeemable noncontrolling interest | (67,233 | ) | (10,334 | ) |\\n| Redeemable noncontrolling interests - Mt. Logan Re, end of period | $ | 752,692 | $ | 421,552 |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\nIn addition, the Company has invested $50,000 thousand in the segregated accounts from inception to date.\\nThe Company expects its participation level in the segregated funds to fluctuate over time.\\n7. CAPITAL TRANSACTIONS\\nOn July 9, 2014, the Company renewed its shelf registration statement on Form S-3ASR with the Securities and Exchange Commission (the \\\"SEC\\\"), as a Well Known Seasoned Issuer. This shelf registration statement can be used by Group to register common shares, preferred shares, debt securities, warrants, share purchase contracts and share purchase units; by Holdings to register debt securities and by Everest Re Capital Trust III (\\\"Capital Trust III\\\") to register trust preferred securities.\\n18\\n8. EARNINGS PER COMMON SHARE\\nBasic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that would occur if options granted under various share-based compensation plans were exercised resulting in the issuance of common shares that would participate in the earnings of the entity.\\nNet income (loss) attributable to Everest Re Group per common share has been computed as per below, based upon weighted average common basic and dilutive shares outstanding.\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands, except per share amounts) | 2015 | 2014 | 2015 | 2014 |\\n| Net income (loss) attributable to Everest Re Group per share: |\\n| Numerator |\\n| Net income (loss) attributable to Everest Re Group | $ | 88,553 | $ | 274,916 | $ | 620,588 | $ | 859,033 |\\n| Less: dividends declared-common shares and nonvested common shares | (41,698 | ) | (33,973 | ) | (125,905 | ) | (103,034 | ) |\\n| Undistributed earnings | 46,855 | 240,943 | 494,683 | 755,999 |\\n| Percentage allocated to common shareholders (1) | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\\n| 46,364 | 238,407 | 489,434 | 748,273 |\\n| Add: dividends declared-common shareholders | 41,293 | 33,631 | 124,638 | 101,993 |\\n| Numerator for basic and diluted earnings per common share | $ | 87,657 | $ | 272,038 | $ | 614,072 | $ | 850,266 |\\n| Denominator |\\n| Denominator for basic earnings per weighted-average common shares | 43,361 | 44,941 | 43,728 | 45,615 |\\n| Effect of dilutive securities: |\\n| Options | 367 | 415 | 392 | 426 |\\n| Denominator for diluted earnings per adjusted weighted-average common shares | 43,728 | 45,356 | 44,120 | 46,041 |\\n| Per common share net income (loss) |\\n| Basic | $ | 2.02 | $ | 6.05 | $ | 14.04 | $ | 18.64 |\\n| Diluted | $ | 2.00 | $ | 6.00 | $ | 13.92 | $ | 18.47 |\\n| (1) | Basic weighted-average common shares outstanding | 43,361 | 44,941 | 43,728 | 45,615 |\\n| Basic weighted-average common shares outstanding and nonvested common shares expected to vest | 43,820 | 45,419 | 44,197 | 46,086 |\\n| Percentage allocated to common shareholders | 99.0 | % | 98.9 | % | 98.9 | % | 99.0 | % |\\n| (Some amounts may not reconcile due to rounding.) |\\n\\nThere were no anti-diluted options outstanding for the three and nine months ended September 30, 2015 and 2014.\\nAll outstanding options expire on or between February 21, 2017 and September 19, 2022.\\n9. CONTINGENCIES\\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\\n19\\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\\nThe Company has entered into separate annuity agreements with The Prudential Insurance of America (\\\"The Prudential\\\") and an additional unaffiliated life insurance company in which the Company has either purchased annuity contracts or become the assignee of annuity proceeds that are meant to settle claim payment obligations in the future. In both instances, the Company would become contingently liable if either The Prudential or the unaffiliated life insurance company were unable to make payments related to the respective annuity contract.\\nThe table below presents the estimated cost to replace all such annuities for which the Company was contingently liable for the periods indicated:\\n\\n| At September 30, | At December 31, |\\n| (Dollars in thousands) | 2015 | 2014 |\\n| The Prudential | $ | 142,661 | $ | 142,653 |\\n| Unaffiliated life insurance company | 32,414 | 31,964 |\\n\\n10. OTHER COMPREHENSIVE INCOME (LOSS)\\nThe following tables present the components of comprehensive income (loss) in the consolidated statements of operations for the periods indicated:\\n\\n| Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2015 |\\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\\n| Unrealized appreciation (depreciation) (\\\"URA(D)\\\") on securities - temporary | $ | (105,356 | ) | $ | 14,558 | $ | (90,798 | ) | $ | (178,878 | ) | $ | 29,004 | $ | (149,874 | ) |\\n| URA(D) on securities - OTTI | (253 | ) | (8 | ) | (261 | ) | 8,954 | (3,415 | ) | 5,539 |\\n| Reclassification of net realized losses (gains) included in net income (loss) | 29,235 | (4,639 | ) | 24,596 | 82,967 | (23,441 | ) | 59,526 |\\n| Foreign currency translation adjustments | (47,298 | ) | 14,793 | (32,505 | ) | (104,542 | ) | 24,034 | (80,508 | ) |\\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\\n| Reclassification of benefit plan liability amortization included in net income (loss) | 2,393 | (837 | ) | 1,556 | 7,336 | (2,567 | ) | 4,769 |\\n| Total other comprehensive income (loss) | $ | (121,279 | ) | $ | 23,867 | $ | (97,412 | ) | $ | (184,163 | ) | $ | 23,615 | $ | (160,548 | ) |\\n\\n\\n| Three Months Ended September 30, 2014 | Nine Months Ended September 30, 2014 |\\n| (Dollars in thousands) | Before Tax | Tax Effect | Net of Tax | Before Tax | Tax Effect | Net of Tax |\\n| Unrealized appreciation (depreciation) (\\\"URA(D)\\\") on securities - temporary | $ | (84,122 | ) | $ | 10,309 | $ | (73,813 | ) | $ | 75,275 | $ | (9,777 | ) | $ | 65,498 |\\n| URA(D) on securities - OTTI | (261 | ) | - | (261 | ) | (180 | ) | - | (180 | ) |\\n| Reclassification of net realized losses (gains) included in net income (loss) | (7,024 | ) | 1,340 | (5,684 | ) | (1,938 | ) | 297 | (1,641 | ) |\\n| Foreign currency translation adjustments | (38,998 | ) | 4,024 | (34,974 | ) | (42,998 | ) | 4,624 | (38,374 | ) |\\n| Benefit plan actuarial net gain (loss) | - | - | - | - | - | - |\\n| Reclassification of benefit plan liability amortization included in net income (loss) | 1,269 | (444 | ) | 825 | 3,640 | (1,274 | ) | 2,366 |\\n| Total other comprehensive income (loss) | $ | (129,136 | ) | $ | 15,229 | $ | (113,907 | ) | $ | 33,799 | $ | (6,130 | ) | $ | 27,669 |\\n\\n20\\nThe following table presents details of the amounts reclassified from AOCI for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, | Affected line item within the statements of |\\n| AOCI component | 2015 | 2014 | 2015 | 2014 | operations and comprehensive income (loss) |\\n| (Dollars in thousands) |\\n| URA(D) on securities | $ | 29,235 | $ | (7,024 | ) | $ | 82,967 | $ | (1,938 | ) | Other net realized capital gains (losses) |\\n| (4,639 | ) | 1,340 | (23,441 | ) | 297 | Income tax expense (benefit) |\\n| $ | 24,596 | $ | (5,684 | ) | $ | 59,526 | $ | (1,641 | ) | Net income (loss) |\\n| Benefit plan net gain (loss) | $ | 2,393 | $ | 1,269 | $ | 7,336 | $ | 3,640 | Other underwriting expenses |\\n| (837 | ) | (444 | ) | (2,567 | ) | (1,274 | ) | Income tax expense (benefit) |\\n| $ | 1,556 | $ | 825 | $ | 4,769 | $ | 2,366 | Net income (loss) |\\n\\nThe following table presents the components of accumulated other comprehensive income (loss), net of tax, in the consolidated balance sheets for the periods indicated:\\n\\n| Nine Months Ended | Twelve Months Ended |\\n| September 30, | December 31, |\\n| (Dollars in thousands) | 2015 | 2014 |\\n| Beginning balance of URA (D) on securities | $ | 223,250 | $ | 201,154 |\\n| Current period change in URA (D) of investments - temporary | (90,348 | ) | 28,767 |\\n| Current period change in URA (D) of investments - non-credit OTTI | 5,539 | (6,671 | ) |\\n| Ending balance of URA (D) on securities | 138,441 | 223,250 |\\n| Beginning balance of foreign currency translation adjustments | (99,947 | ) | (4,530 | ) |\\n| Current period change in foreign currency translation adjustments | (80,508 | ) | (95,417 | ) |\\n| Ending balance of foreign currency translation adjustments | (180,455 | ) | (99,947 | ) |\\n| Beginning balance of benefit plan net gain (loss) | (74,986 | ) | (38,896 | ) |\\n| Current period change in benefit plan net gain (loss) | 4,769 | (36,090 | ) |\\n| Ending balance of benefit plan net gain (loss) | (70,217 | ) | (74,986 | ) |\\n| Ending balance of accumulated other comprehensive income (loss) | $ | (112,231 | ) | $ | 48,317 |\\n\\n11. CREDIT FACILITIES\\nThe Company has two active credit facilities for a total commitment of up to $1,100,000 thousand, providing for the issuance of letters of credit and/or unsecured revolving credit lines. The following table presents the costs incurred in connection with the two credit facilities for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Credit facility fees incurred | $ | 132 | $ | 132 | $ | 431 | $ | 527 |\\n\\n21\\nThe terms and outstanding amounts for each facility are discussed below:\\nGroup Credit Facility\\nEffective June 22, 2012, Group, Bermuda Re and Everest International entered into a four year, $800,000 thousand senior credit facility with a syndicate of lenders, which amended and restated in its entirety the July 27, 2007, five year, $850,000 thousand senior credit facility. Both the June 22, 2012 and July 27, 2007 senior credit facilities, which have similar terms, are referred to as the \\\"Group Credit Facility\\\". Wells Fargo Corporation (\\\"Wells Fargo Bank\\\") is the administrative agent for the Group Credit Facility, which consists of two tranches. Tranche one provides up to $200,000 thousand of unsecured revolving credit for liquidity and general corporate purposes, and for the issuance of unsecured standby letters of credit. The interest on the revolving loans shall, at the Company's option, be either (1) the Base Rate (as defined below) or (2) an adjusted London Interbank Offered Rate (\\\"LIBOR\\\") plus a margin. The Base Rate is the higher of (a) the prime commercial lending rate established by Wells Fargo Bank, (b) the Federal Funds Rate plus 0.5% per annum or (c) the one month LIBOR Rate plus 1.0% per annum. The amount of margin and the fees payable for the Group Credit Facility depends on Group's senior unsecured debt rating. Tranche two exclusively provides up to $600,000 thousand for the issuance of standby letters of credit on a collateralized basis.\\nThe Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth. Minimum net worth is an amount equal to the sum of $4,249,963 thousand plus 25% of consolidated net income for each of Group's fiscal quarters, for which statements are available ending on or after January 1, 2012 and for which consolidated net income is positive, plus 25% of any increase in consolidated net worth during such period attributable to the issuance of ordinary and preferred shares, which at September 30, 2015, was $5,277,454 thousand. As of September 30, 2015, the Company was in compliance with all Group Credit Facility covenants.\\nThe following table summarizes the outstanding letters of credit and/or borrowings for the periods indicated:\\n\\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\\n| Wells Fargo Bank Group Credit Facility | Tranche One | $ | 200,000 | $ | - | $ | 200,000 | $ | - |\\n| Tranche Two | 600,000 | 456,379 | 12/31/2015 | 600,000 | 444,012 | 12/31/2015 |\\n| Total Wells Fargo Bank Group Credit Facility | $ | 800,000 | $ | 456,379 | $ | 800,000 | $ | 444,012 |\\n\\nBermuda Re Letter of Credit Facility\\nEffective December 31, 2014, Bermuda Re renewed its $300,000 thousand letter of credit issuance facility with Citibank N.A. referred to as the \\\"Bermuda Re Letter of Credit Facility\\\", which commitment is reconfirmed annually with updated fees. The Bermuda Re Letter of Credit Facility provides for the issuance of up to $300,000 thousand of secured letters of credit to collateralize reinsurance obligations as a non-admitted reinsurer. The interest on drawn letters of credit shall be (A) 0.35% per annum of the principal amount of issued standard letters of credit (expiry of 15 months or less) and (B) 0.45% per annum of the principal amount of issued extended tenor letters of credit (expiry maximum of up to 60 months). The commitment fee on undrawn credit shall be 0.15% per annum.\\nThe following table summarizes the outstanding letters of credit for the periods indicated:\\n\\n| (Dollars in thousands) | At September 30, 2015 | At December 31, 2014 |\\n| Bank | Commitment | In Use | Date of Expiry | Commitment | In Use | Date of Expiry |\\n| Citibank Bilateral Letter of Credit Agreement | $ | 300,000 | $ | 3,672 | 11/24/2015 | $ | 300,000 | $ | 112 | 8/30/2015 |\\n| 65,013 | 12/31/2015 | 3,672 | 11/24/2015 |\\n| 2,681 | 12/31/2016 | 70,922 | 12/31/2015 |\\n| 173 | 8/30/2017 | 2,014 | 12/31/2016 |\\n| 119,002 | 9/30/2019 | 149,353 | 12/30/2018 |\\n| Total Citibank Bilateral Agreement | $ | 300,000 | $ | 190,541 | $ | 300,000 | $ | 226,073 |\\n\\n22\\nHoldings Credit Facility - Expired\\nEffective August 15, 2011, the Company entered into a three year, $150,000 thousand unsecured revolving credit facility, referred to as the \\\"Holdings Credit Facility\\\", which expired on August 15, 2014. The Company decided not to renew the Holdings Credit Facility at expiration.\\n12. REINSURANCE AND TRUST AGREEMENTS\\nCertain subsidiaries of Group have established trust agreements, which effectively use the Company's investments as collateral, as security for assumed losses payable to certain non-affiliated ceding companies. At September 30, 2015, the total amount on deposit in trust accounts was $404,008 thousand.\\nOn April 24, 2014, the Company entered into two collateralized reinsurance agreements with Kilimanjaro Re Limited (\\\"Kilimanjaro\\\"), a Bermuda based special purpose reinsurer, to provide the Company with catastrophe reinsurance coverage. These agreements are multi-year reinsurance contracts which cover specified named storm and earthquake events. The first agreement provides up to $250,000 thousand of reinsurance coverage from named storms in specified states of the Southeastern United States. The second agreement provides up to $200,000 thousand of reinsurance coverage from named storms in specified states of the Southeast, Mid-Atlantic and Northeast regions of the United States and Puerto Rico as well as reinsurance coverage from earthquakes in specified states of the Southeast, Mid-Atlantic, Northeast and West regions of the United States, Puerto Rico and British Columbia.\\nOn November 18, 2014, the Company entered into a collateralized reinsurance agreement with Kilimanjaro Re to provide the Company with catastrophe reinsurance coverage. This agreement is a multi-year reinsurance contract which covers specified earthquake events. The agreement provides up to $500,000 thousand of reinsurance coverage from earthquakes in the United States, Puerto Rico and Canada.\\nKilimanjaro has financed the various property catastrophe reinsurance coverage by issuing catastrophe bonds to unrelated, external investors. On April 24, 2014, Kilimanjaro issued $450,000 thousand of variable rate notes (\\\"Series 2014-1 Notes\\\"). On November 18, 2014, Kilimanjaro issued $500,000 thousand of variable rate notes (\\\"Series 2014-2 Notes\\\"). The proceeds from the issuance of the Series 2014-1 Notes and the Series 2014-2 Notes are held in reinsurance trust throughout the duration of the applicable reinsurance agreements and invested solely in US government money market funds with a rating of at least \\\"AAAm\\\" by Standard & Poor's.\\n13. SENIOR NOTES\\nThe table below displays Holdings' outstanding senior notes. Market value is based on quoted market prices, but due to limited trading activity, these senior notes are considered Level 2 in the fair value hierarchy.\\n\\n| September 30, 2015 | December 31, 2014 |\\n| Consolidated Balance | Consolidated Balance |\\n| (Dollars in thousands) | Date Issued | Date Due | Principal Amounts | Sheet Amount | Market Value | Sheet Amount | Market Value |\\n| 4.868% Senior notes | 06/05/2014 | 06/01/2044 | $ | 400,000 | $ | 400,000 | $ | 388,768 | $ | 400,000 | $ | 404,892 |\\n| 5.40% Senior notes | 10/12/2004 | 10/15/2014 | 250,000 | - | - | - | - |\\n\\nOn June 5, 2014, Holdings issued $400,000 thousand of 30 year senior notes at 4.868%, which will mature on June 1, 2044. Interest will be paid semi-annually on June 1 and December 1 of each year. The proceeds from the issuance have been used in part to pay off the $250,000 thousand of 5.40% senior notes which matured on October 15, 2014.\\n23\\nInterest expense incurred in connection with these senior notes is as follows for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Interest expense incurred | $ | 4,868 | $ | 8,256 | $ | 14,604 | $ | 16,385 |\\n\\n14. LONG TERM SUBORDINATED NOTES\\nThe table below displays Holdings' outstanding fixed to floating rate long term subordinated notes. Market value is based on quoted market prices, but due to limited trading activity, these subordinated notes are considered Level 2 in the fair value hierarchy.\\n\\n| Maturity Date | September 30, 2015 | December 31, 2014 |\\n| Original | Consolidated Balance | Consolidated Balance |\\n| (Dollars in thousands) | Date Issued | Principal Amount | Scheduled | Final | Sheet Amount | Market Value | Sheet Amount | Market Value |\\n| 6.6% Long term subordinated notes | 04/26/2007 | $ | 400,000 | 05/15/2037 | 05/01/2067 | $ | 238,367 | $ | 218,281 | $ | 238,364 | $ | 246,312 |\\n\\nDuring the fixed rate interest period from May 3, 2007 through May 14, 2017, interest will be at the annual rate of 6.6%, payable semi-annually in arrears on November 15 and May 15 of each year, commencing on November 15, 2007, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. During the floating rate interest period from May 15, 2017 through maturity, interest will be based on the 3 month LIBOR plus 238.5 basis points, reset quarterly, payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year, subject to Holdings' right to defer interest on one or more occasions for up to ten consecutive years. Deferred interest will accumulate interest at the applicable rate compounded semi-annually for periods prior to May 15, 2017, and compounded quarterly for periods from and including May 15, 2017.\\nHoldings can redeem the long term subordinated notes prior to May 15, 2017, in whole but not in part at the applicable redemption price, which will equal the greater of (a) 100% of the principal amount being redeemed and (b) the present value of the principal payment on May 15, 2017 and scheduled payments of interest that would have accrued from the redemption date to May 15, 2017 on the long term subordinated notes being redeemed, discounted to the redemption date on a semi-annual basis at a discount rate equal to the treasury rate plus an applicable spread of either 0.25% or 0.50%, in each case plus accrued and unpaid interest. Holdings may redeem the long term subordinated notes on or after May 15, 2017, in whole or in part at 100% of the principal amount plus accrued and unpaid interest; however, redemption on or after the scheduled maturity date and prior to May 1, 2047 is subject to a replacement capital covenant. This covenant is for the benefit of certain senior note holders and it mandates that Holdings receive proceeds from the sale of another subordinated debt issue, of at least similar size, before it may redeem the subordinated notes. Effective upon the maturity of the Company's 5.40% senior notes on October 15, 2014, the Company's 4.868% senior notes, due on June 1, 2044, have become the Company's long term indebtedness that ranks senior to the long term subordinated notes.\\nOn March 19, 2009, Group announced the commencement of a cash tender offer for any and all of the 6.60% fixed to floating rate long term subordinated notes. Upon expiration of the tender offer, the Company had reduced its outstanding debt by $161,441 thousand.\\nInterest expense incurred in connection with these long term subordinated notes is as follows for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Interest expense incurred | $ | 3,937 | $ | 3,937 | $ | 11,811 | $ | 11,811 |\\n\\n24\\n15. SEGMENT REPORTING\\nThe U.S. Reinsurance operation writes property and casualty reinsurance and specialty lines of business, including Marine, Aviation, Surety and Accident and Health (\\\"A&H\\\") business, on both a treaty and facultative basis, through reinsurance brokers, as well as directly with ceding companies primarily within the U.S. The International operation writes non-U.S. property and casualty reinsurance through Everest Re's branches in Canada and Singapore and through offices in Brazil, Miami and New Jersey. The Bermuda operation provides reinsurance and insurance to worldwide property and casualty markets through brokers and directly with ceding companies from its Bermuda office and reinsurance to the United Kingdom and European markets through its UK branch and Ireland Re. The Insurance operation writes property and casualty insurance directly and through general agents, brokers and surplus lines brokers within the U.S. and Canada. The Mt. Logan Re segment represents business written for the segregated accounts of Mt. Logan Re, which were formed on July 1, 2013. The Mt. Logan Re business represents a diversified set of catastrophe exposures, diversified by risk/peril and across different geographical regions globally.\\nThese segments, with the exception of Mt. Logan Re, are managed independently, but conform with corporate guidelines with respect to pricing, risk management, control of aggregate catastrophe exposures, capital, investments and support operations. Management generally monitors and evaluates the financial performance of these operating segments based upon their underwriting results. The Mt. Logan Re segment is managed independently and seeks to write a diverse portfolio of catastrophe risks for each segregated account to achieve desired risk and return criteria.\\nUnderwriting results include earned premium less losses and loss adjustment expenses (\\\"LAE\\\") incurred, commission and brokerage expenses and other underwriting expenses. We measure our underwriting results using ratios, in particular loss, commission and brokerage and other underwriting expense ratios, which, respectively, divide incurred losses, commissions and brokerage and other underwriting expenses by premiums earned.\\nMt. Logan Re's business is sourced through operating subsidiaries of the Company; however, the activity is only reflected in the Mt. Logan Re segment. For other inter-affiliate reinsurance, business is generally reported within the segment in which the business was first produced, consistent with how the business is managed.\\nExcept for Mt. Logan Re, the Company does not maintain separate balance sheet data for its operating segments. Accordingly, the Company does not review and evaluate the financial results of its operating segments based upon balance sheet data.\\n25\\nThe following tables present the underwriting results for the operating segments for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| U.S. Reinsurance | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 537,483 | $ | 640,660 | $ | 1,464,840 | $ | 1,573,776 |\\n| Net written premiums | 511,238 | 615,078 | 1,383,647 | 1,536,114 |\\n| Premiums earned | $ | 488,485 | $ | 559,488 | $ | 1,480,427 | $ | 1,478,258 |\\n| Incurred losses and LAE | 225,944 | 249,004 | 699,575 | 701,473 |\\n| Commission and brokerage | 121,050 | 123,432 | 364,005 | 339,166 |\\n| Other underwriting expenses | 13,718 | 12,118 | 37,054 | 33,054 |\\n| Underwriting gain (loss) | $ | 127,773 | $ | 174,934 | $ | 379,793 | $ | 404,565 |\\n\\n\\n| Three Months Ended | Nine Months Ended |\\n| International | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 354,871 | $ | 406,254 | $ | 966,091 | $ | 1,181,513 |\\n| Net written premiums | 318,478 | 352,608 | 896,872 | 977,235 |\\n| Premiums earned | $ | 291,396 | $ | 320,020 | $ | 935,228 | $ | 958,399 |\\n| Incurred losses and LAE | 229,013 | 236,559 | 630,752 | 604,166 |\\n| Commission and brokerage | 70,894 | 73,143 | 226,321 | 215,716 |\\n| Other underwriting expenses | 9,128 | 8,758 | 25,292 | 24,683 |\\n| Underwriting gain (loss) | $ | (17,639 | ) | $ | 1,560 | $ | 52,863 | $ | 113,834 |\\n\\n\\n| Three Months Ended | Nine Months Ended |\\n| Bermuda | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 267,035 | $ | 205,342 | $ | 605,365 | $ | 573,793 |\\n| Net written premiums | 251,678 | 189,447 | 557,453 | 548,210 |\\n| Premiums earned | $ | 222,240 | $ | 181,754 | $ | 616,241 | $ | 546,699 |\\n| Incurred losses and LAE | 154,327 | 108,961 | 372,572 | 310,602 |\\n| Commission and brokerage | 52,980 | 48,421 | 151,356 | 140,968 |\\n| Other underwriting expenses | 9,457 | 9,360 | 27,045 | 25,805 |\\n| Underwriting gain (loss) | $ | 5,476 | $ | 15,012 | $ | 65,268 | $ | 69,324 |\\n\\n\\n| Three Months Ended | Nine Months Ended |\\n| Insurance | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 489,124 | $ | 364,111 | $ | 1,173,012 | $ | 911,242 |\\n| Net written premiums | 418,960 | 310,690 | 1,022,389 | 802,431 |\\n| Premiums earned | $ | 360,742 | $ | 290,518 | $ | 888,711 | $ | 742,038 |\\n| Incurred losses and LAE | 262,328 | 239,823 | 662,052 | 557,047 |\\n| Commission and brokerage | 50,268 | 40,418 | 127,125 | 114,535 |\\n| Other underwriting expenses | 35,677 | 31,311 | 99,232 | 83,672 |\\n| Underwriting gain (loss) | $ | 12,469 | $ | (21,034 | ) | $ | 302 | $ | (13,216 | ) |\\n\\n26\\n\\n| Three Months Ended | Nine Months Ended |\\n| Mt. Logan Re | September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Gross written premiums | $ | 72,200 | $ | 50,334 | $ | 183,694 | $ | 109,163 |\\n| Net written premiums | 60,903 | 49,757 | 153,281 | 98,666 |\\n| Premiums earned | $ | 50,777 | $ | 38,218 | $ | 132,508 | $ | 81,411 |\\n| Incurred losses and LAE | 16,485 | 3,410 | 36,272 | 19,575 |\\n| Commission and brokerage | 4,856 | 5,105 | 13,325 | 9,823 |\\n| Other underwriting expenses | 2,687 | 1,566 | 6,659 | 4,951 |\\n| Underwriting gain (loss) | $ | 26,749 | $ | 28,137 | $ | 76,252 | $ | 47,062 |\\n\\nThe following table reconciles the underwriting results for the operating segments to income before taxes as reported in the consolidated statements of operations and comprehensive income (loss) for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Underwriting gain (loss) | $ | 154,828 | $ | 198,609 | $ | 574,478 | $ | 621,569 |\\n| Net investment income | 115,511 | 142,143 | 363,140 | 396,524 |\\n| Net realized capital gains (losses) | (159,971 | ) | (9,448 | ) | (194,654 | ) | 70,694 |\\n| Net derivative gain (loss) | (11,428 | ) | 1,855 | (5,225 | ) | 3,968 |\\n| Corporate expenses | (5,924 | ) | (9,958 | ) | (17,312 | ) | (18,802 | ) |\\n| Interest, fee and bond issue cost amortization expense | (8,990 | ) | (12,424 | ) | (27,006 | ) | (28,970 | ) |\\n| Other income (expense) | 17,413 | 11,332 | 59,561 | (5,835 | ) |\\n| Income (loss) before taxes | $ | 101,439 | $ | 322,109 | $ | 752,982 | $ | 1,039,148 |\\n\\nThe Company produces business in the U.S., Bermuda and internationally. The net income deriving from and assets residing in the individual foreign countries in which the Company writes business are not identifiable in the Company's financial records. Based on gross written premium, the table below presents the largest country, other than the U.S., in which the Company writes business, for the periods indicated:\\n\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| United Kingdom gross written premium | $ | 212,039 | $ | 199,052 | $ | 565,143 | $ | 536,928 |\\n\\nNo other country represented more than 5% of the Company's revenues.\\n16. SHARE-BASED COMPENSATION PLANS\\nFor the three months ended September 30, 2015, share-based compensation awards granted were 4,720 restricted shares, granted on September 9, 2015, with a fair value of $176.37 per share.\\n27\\n17. RETIREMENT BENEFITS\\nThe Company maintains both qualified and non-qualified defined benefit pension plans and a retiree health plan for its U.S. employees employed prior to April 1, 2010.\\nNet periodic benefit cost for U.S. employees included the following components for the periods indicated:\\n\\n| Pension Benefits | Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Service cost | $ | 3,203 | $ | 2,460 | $ | 9,398 | $ | 7,381 |\\n| Interest cost | 2,758 | 2,542 | 7,926 | 7,625 |\\n| Expected return on plan assets | (2,904 | ) | (2,822 | ) | (8,710 | ) | (8,468 | ) |\\n| Amortization of prior service cost | 4 | 13 | 15 | 38 |\\n| Amortization of net (income) loss | 2,312 | 1,173 | 6,824 | 3,356 |\\n| FAS 88 settlement charge | - | 5,269 | - | 5,269 |\\n| Net periodic benefit cost | $ | 5,373 | $ | 8,635 | $ | 15,453 | $ | 15,201 |\\n\\n\\n| Other Benefits | Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in thousands) | 2015 | 2014 | 2015 | 2014 |\\n| Service cost | $ | 498 | $ | 407 | $ | 1,498 | $ | 1,221 |\\n| Interest cost | 329 | 342 | 987 | 1,026 |\\n| Amortization of net (income) loss | 76 | 82 | 497 | 246 |\\n| Net periodic benefit cost | $ | 903 | $ | 831 | $ | 2,982 | $ | 2,493 |\\n\\nThe Company did not make any contributions to the qualified pension benefit plan for the three and nine months ended September 30, 2015 and 2014.\\n18. INCOME TAXES\\nThe Company is domiciled in Bermuda and has significant subsidiaries and/or branches in Canada, Ireland, Singapore, the United Kingdom, and the United States. The Company's Bermuda domiciled subsidiaries are exempt from income taxation under Bermuda law until 2035. Pre-tax income generated by Group's non-Bermuda subsidiaries and the UK branch of Bermuda is subject to applicable federal, foreign, state and local taxes on corporations. Company subsidiaries domiciled in the US as well as the Canadian and Singapore branches of Everest Re generate US pre-tax income (loss). Foreign domiciled subsidiaries, including the UK branch of Bermuda Re, generate non-US pre-tax income (loss). Fluctuations in US and non-US pre-tax income (loss) primarily result from the impact of catastrophe losses and realized investment gains (losses).\\nFor interim reporting periods, the company is generally required to use the annualized effective tax rate (\\\"AETR\\\") method, as prescribed by ASC 740-270, Interim Reporting, to calculate its income tax provision. Under this method, the AETR is applied to the interim year-to-date pre-tax income to determine the income tax expense or benefit for the year-to-date period. The income tax expense or benefit for a quarter represents the difference between the year-to-date income tax expense or benefit for the current year-to-date period less such amount for the immediately preceding year-to-date period. Management considers the impact of all known events in its estimation of the Company's annual pre-tax income and AETR.\\n19. DISPOSITIONS\\nOn July 13, 2015, the Company closed its agreement to sell all of the outstanding shares of capital stock of Mt. McKinley, a Delaware domiciled insurance company and wholly-owned subsidiary of the Company to Clearwater Insurance Company, a Delaware domiciled insurance company. The Company received $20,156 thousand in cash for Mt. McKinley and did not recognize any realized gain or loss from the sale.\\n28\\nConcurrently with the closing, the Company entered into a retrocession treaty with an affiliate of Clearwater Insurance Company. Per the retrocession treaty, the Company retroceded 100% of the liabilities associated with certain Mt. McKinley policies, which had been reinsured by Everest Reinsurance (Bermuda), Ltd. (\\\"Everest Re Bermuda\\\"), a wholly-owned subsidiary of the Company. As consideration for entering into the retrocession treaty, Everest Re Bermuda transferred cash of $140,279 thousand, an amount equal to the net loss reserves as of the closing date. The maximum liability retroceded under the retrocession treaty will be $440,279 thousand, equal to the retrocession payment plus $300,000 thousand. The Company will retain liability for any amounts exceeding the maximum liability retroceded under the retrocession treaty.\\n20. SUBSEQUENT EVENTS\\nThe Company is currently negotiating two additional reinsurance agreements with Kilimanjaro to provide the Company with catastrophe reinsurance coverage. Kilimanjaro will fund the catastrophe reinsurance coverage through the issuance of two classes of catastrophe reinsurance bonds.\\n29\\n\\nITEM 2.\\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION\\n| Three Months Ended | Percentage | Nine Months Ended | Percentage |\\n| September 30, | Increase/ | September 30, | Increase/ |\\n| (Dollars in millions) | 2015 | 2014 | (Decrease) | 2015 | 2014 | (Decrease) |\\n| Gross written premiums | $ | 1,720.7 | $ | 1,666.7 | 3.2 | % | $ | 4,393.0 | $ | 4,349.5 | 1.0 | % |\\n| Net written premiums | 1,561.3 | 1,517.6 | 2.9 | % | 4,013.6 | 3,962.7 | 1.3 | % |\\n| REVENUES: |\\n| Premiums earned | $ | 1,413.6 | $ | 1,390.0 | 1.7 | % | $ | 4,053.1 | $ | 3,806.8 | 6.5 | % |\\n| Net investment income | 115.5 | 142.1 | -18.7 | % | 363.1 | 396.5 | -8.4 | % |\\n| Net realized capital gains (losses) | (160.0 | ) | (9.4 | ) | NM | (194.7 | ) | 70.7 | NM |\\n| Net derivative gain (loss) | (11.4 | ) | 1.9 | NM | (5.2 | ) | 4.0 | -231.7 | % |\\n| Other income (expense) | 17.4 | 11.3 | 53.6 | % | 59.6 | (5.8 | ) | NM |\\n| Total revenues | 1,375.2 | 1,535.9 | -10.5 | % | 4,275.9 | 4,272.2 | 0.1 | % |\\n| CLAIMS AND EXPENSES: |\\n| Incurred losses and loss adjustment expenses | 888.1 | 837.8 | 6.0 | % | 2,401.2 | 2,192.9 | 9.5 | % |\\n| Commission, brokerage, taxes and fees | 300.0 | 290.5 | 3.3 | % | 882.1 | 820.2 | 7.5 | % |\\n| Other underwriting expenses | 70.7 | 63.1 | 12.0 | % | 195.3 | 172.2 | 13.4 | % |\\n| Corporate expenses | 5.9 | 10.0 | -40.5 | % | 17.3 | 18.8 | -7.9 | % |\\n| Interest, fees and bond issue cost amortization expense | 9.0 | 12.4 | -27.6 | % | 27.0 | 29.0 | -6.8 | % |\\n| Total claims and expenses | 1,273.7 | 1,213.8 | 4.9 | % | 3,523.0 | 3,233.0 | 9.0 | % |\\n| INCOME (LOSS) BEFORE TAXES | 101.4 | 322.1 | -68.5 | % | 753.0 | 1,039.1 | -27.5 | % |\\n| Income tax expense (benefit) | (6.1 | ) | 20.9 | -129.4 | % | 70.9 | 137.9 | -48.6 | % |\\n| NET INCOME (LOSS) | $ | 107.6 | $ | 301.3 | -64.3 | % | $ | 682.1 | $ | 901.2 | -24.3 | % |\\n| Net (income) loss attributable to noncontrolling interests | (19.0 | ) | (26.3 | ) | -27.8 | % | (61.5 | ) | (42.2 | ) | 45.9 | % |\\n| NET INCOME (LOSS) ATTRIBUTABLE TO EVEREST RE GROUP | $ | 88.6 | $ | 274.9 | -67.8 | % | $ | 620.6 | $ | 859.0 | -27.8 | % |\\n| RATIOS: | Point Change | Point Change |\\n| Loss ratio | 62.8 | % | 60.3 | % | 2.5 | 59.2 | % | 57.6 | % | 1.6 |\\n| Commission and brokerage ratio | 21.2 | % | 20.9 | % | 0.3 | 21.8 | % | 21.5 | % | 0.3 |\\n| Other underwriting expense ratio | 5.0 | % | 4.5 | % | 0.5 | 4.8 | % | 4.6 | % | 0.2 |\\n| Combined ratio | 89.0 | % | 85.7 | % | 3.3 | 85.8 | % | 83.7 | % | 2.1 |\\n| At | At | Percentage |\\n| September 30, | December 31, | Increase/ |\\n| (Dollars in millions, except per share amounts) | 2015 | 2014 | (Decrease) |\\n| Balance sheet data: |\\n| Total investments and cash | $ | 17,647.2 | $ | 17,435.9 | 1.2 | % |\\n| Total assets | 21,682.3 | 20,817.8 | 4.2 | % |\\n| Loss and loss adjustment expense reserves | 9,966.0 | 9,720.8 | 2.5 | % |\\n| Total debt | 638.4 | 638.4 | 0.0 | % |\\n| Total liabilities | 13,443.3 | 12,945.2 | 3.8 | % |\\n| Redeemable noncontrolling interests - Mt. Logan Re | 752.7 | 421.6 | 78.6 | % |\\n| Shareholders' equity | 7,486.3 | 7,451.1 | 0.5 | % |\\n| Book value per share | 173.76 | 166.75 | 4.2 | % |\\n| (NM, not meaningful) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional (a) | $ | 848.1 | 60.1 | % | $ | - | 0.0 | % | $ | 848.1 | 60.1 | % |\\n| Catastrophes | 40.0 | 2.7 | % | - | 0.0 | % | 40.0 | 2.7 | % |\\n| Total | $ | 888.1 | 62.8 | % | $ | - | 0.0 | % | $ | 888.1 | 62.8 | % |\\n| 2014 |\\n| Attritional (a) | $ | 807.3 | 58.1 | % | $ | 0.5 | 0.0 | % | $ | 807.8 | 58.1 | % |\\n| Catastrophes | 30.0 | 2.2 | % | - | 0.0 | % | 30.0 | 2.2 | % |\\n| Total | $ | 837.3 | 60.3 | % | $ | 0.5 | 0.0 | % | $ | 837.8 | 60.3 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 40.8 | 2.0 | pts | $ | (0.5 | ) | - | pts | $ | 40.3 | 2.0 | pts |\\n| Catastrophes | 10.0 | 0.5 | pts | - | - | pts | 10.0 | 0.4 | pts |\\n| Total segment | $ | 50.8 | 2.5 | pts | $ | (0.5 | ) | - | pts | $ | 50.3 | 2.5 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional (a) | $ | 2,332.1 | 57.5 | % | $ | (0.8 | ) | 0.0 | % | $ | 2,331.3 | 57.5 | % |\\n| Catastrophes | 80.0 | 2.0 | % | (10.0 | ) | -0.3 | % | 70.0 | 1.7 | % |\\n| Total | $ | 2,412.1 | 59.5 | % | $ | (10.8 | ) | -0.3 | % | $ | 2,401.2 | 59.2 | % |\\n| 2014 |\\n| Attritional (a) | $ | 2,120.8 | 55.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,117.9 | 55.6 | % |\\n| Catastrophes | 75.0 | 2.0 | % | - | 0.0 | % | 75.0 | 2.0 | % |\\n| Total | $ | 2,195.8 | 57.7 | % | $ | (2.9 | ) | -0.1 | % | $ | 2,192.9 | 57.6 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 211.3 | 1.8 | pts | $ | 2.1 | 0.1 | pts | $ | 213.4 | 1.9 | pts |\\n| Catastrophes | 5.0 | - | pts | (10.0 | ) | (0.3 | ) | pts | (5.0 | ) | (0.3 | ) | pts |\\n| Total segment | $ | 216.3 | 1.8 | pts | $ | (7.9 | ) | (0.2 | ) | pts | $ | 208.3 | 1.6 | pts |\\n| (a) Attritional losses exclude catastrophe losses. |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| (Dollars in millions) | 2015 | 2014 | 2015 | 2014 |\\n| Fixed maturities | $ | 108.1 | $ | 115.1 | $ | 327.0 | $ | 348.9 |\\n| Equity securities | 11.1 | 11.1 | 35.8 | 36.1 |\\n| Short-term investments and cash | 0.4 | 0.3 | 1.1 | 1.2 |\\n| Other invested assets |\\n| Limited partnerships | 0.4 | 21.7 | 14.0 | 25.7 |\\n| Other | (0.2 | ) | 0.9 | 1.4 | 3.2 |\\n| Gross investment income before adjustments | 119.7 | 149.0 | 379.2 | 415.1 |\\n| Funds held interest income (expense) | 2.6 | 1.8 | 8.2 | 6.9 |\\n| Future policy benefit reserve income (expense) | (0.3 | ) | (0.5 | ) | (1.4 | ) | (0.9 | ) |\\n| Gross investment income | 122.0 | 150.3 | 386.0 | 421.0 |\\n| Investment expenses | (6.5 | ) | (8.2 | ) | (22.8 | ) | (24.5 | ) |\\n| Net investment income | $ | 115.5 | $ | 142.1 | $ | 363.1 | $ | 396.5 |\\n| (Some amounts may not reconcile due to rounding.) |\\n| At | At |\\n| September 30, | December 31, |\\n| 2015 | 2014 |\\n| Imbedded pre-tax yield of cash and invested assets | 3.0% | 3.0% |\\n| Imbedded after-tax yield of cash and invested assets | 2.5% | 2.6% |\\n| Three Months Ended | Nine Months Ended |\\n| September 30, | September 30, |\\n| 2015 | 2014 | 2015 | 2014 |\\n| Annualized pre-tax yield on average cash and invested assets | 2.7% | 3.4% | 2.8% | 3.2% |\\n| Annualized after-tax yield on average cash and invested assets | 2.2% | 2.7% | 2.3% | 2.7% |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | 2015 | 2014 | Variance |\\n| Gains (losses) from sales: |\\n| Fixed maturity securities, market value: |\\n| Gains | $ | 11.8 | $ | 12.7 | $ | (0.9 | ) | $ | 37.5 | $ | 27.5 | $ | 10.0 |\\n| Losses | (17.0 | ) | (5.5 | ) | (11.5 | ) | (53.3 | ) | (23.9 | ) | (29.4 | ) |\\n| Total | (5.2 | ) | 7.3 | (12.5 | ) | (15.8 | ) | 3.7 | (19.5 | ) |\\n| Fixed maturity securities, fair value: |\\n| Gains | - | 0.1 | (0.1 | ) | - | 1.3 | (1.3 | ) |\\n| Losses | - | - | - | - | (0.3 | ) | 0.3 |\\n| Total | - | 0.1 | (0.1 | ) | - | 1.0 | (1.0 | ) |\\n| Equity securities, market value: |\\n| Gains | - | - | - | - | - | - |\\n| Losses | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\\n| Total | (3.6 | ) | (0.1 | ) | (3.5 | ) | (4.5 | ) | (1.2 | ) | (3.3 | ) |\\n| Equity securities, fair value: |\\n| Gains | 5.3 | 2.5 | 2.8 | 18.9 | 13.0 | 5.9 |\\n| Losses | (18.9 | ) | (4.4 | ) | (14.5 | ) | (31.9 | ) | (14.9 | ) | (17.0 | ) |\\n| Total | (13.6 | ) | (1.9 | ) | (11.7 | ) | (13.0 | ) | (1.9 | ) | (11.1 | ) |\\n| Total net realized capital gains (losses) from sales: |\\n| Gains | 17.1 | 15.4 | 1.7 | 56.4 | 41.9 | 14.5 |\\n| Losses | (39.5 | ) | (10.0 | ) | (29.5 | ) | (89.7 | ) | (40.3 | ) | (49.4 | ) |\\n| Total | (22.5 | ) | 5.4 | (27.9 | ) | (33.3 | ) | 1.6 | (34.9 | ) |\\n| Other-than-temporary impairments: | (20.4 | ) | (0.1 | ) | (20.3 | ) | (62.7 | ) | (0.5 | ) | (62.2 | ) |\\n| Gains (losses) from fair value adjustments: |\\n| Fixed maturity securities, fair value | - | (0.9 | ) | 0.9 | 0.1 | (0.9 | ) | 1.0 |\\n| Equity securities, fair value | (117.1 | ) | (13.8 | ) | (103.3 | ) | (98.7 | ) | 70.5 | (169.2 | ) |\\n| Total | (117.1 | ) | (14.7 | ) | (102.4 | ) | (98.7 | ) | 69.6 | (168.3 | ) |\\n| Total net realized capital gains (losses) | $ | (160.0 | ) | $ | (9.4 | ) | $ | (150.6 | ) | $ | (194.7 | ) | $ | 70.7 | $ | (265.4 | ) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 537.5 | $ | 640.7 | $ | (103.2 | ) | -16.1 | % | $ | 1,464.8 | $ | 1,573.8 | $ | (108.9 | ) | -6.9 | % |\\n| Net written premiums | 511.2 | 615.1 | (103.8 | ) | -16.9 | % | 1,383.6 | 1,536.1 | (152.5 | ) | -9.9 | % |\\n| Premiums earned | $ | 488.5 | $ | 559.5 | $ | (71.0 | ) | -12.7 | % | $ | 1,480.4 | $ | 1,478.3 | $ | 2.2 | 0.1 | % |\\n| Incurred losses and LAE | 225.9 | 249.0 | (23.1 | ) | -9.3 | % | 699.6 | 701.5 | (1.9 | ) | -0.3 | % |\\n| Commission and brokerage | 121.1 | 123.4 | (2.4 | ) | -1.9 | % | 364.0 | 339.2 | 24.8 | 7.3 | % |\\n| Other underwriting expenses | 13.7 | 12.1 | 1.6 | 13.2 | % | 37.1 | 33.1 | 4.0 | 12.1 | % |\\n| Underwriting gain (loss) | $ | 127.8 | $ | 174.9 | $ | (47.2 | ) | -27.0 | % | $ | 379.8 | $ | 404.6 | $ | (24.8 | ) | -6.1 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 46.3 | % | 44.5 | % | 1.8 | 47.3 | % | 47.5 | % | (0.2 | ) |\\n| Commission and brokerage ratio | 24.8 | % | 22.1 | % | 2.7 | 24.6 | % | 22.9 | % | 1.7 |\\n| Other underwriting expense ratio | 2.7 | % | 2.1 | % | 0.6 | 2.4 | % | 2.2 | % | 0.2 |\\n| Combined ratio | 73.8 | % | 68.7 | % | 5.1 | 74.3 | % | 72.6 | % | 1.7 |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 225.5 | 46.2 | % | $ | 0.5 | 0.2 | % | $ | 226.0 | 46.4 | % |\\n| Catastrophes | 0.2 | 0.0 | % | (0.3 | ) | -0.1 | % | (0.1 | ) | -0.1 | % |\\n| Total segment | $ | 225.7 | 46.2 | % | $ | 0.2 | 0.1 | % | $ | 225.9 | 46.3 | % |\\n| 2014 |\\n| Attritional | $ | 246.7 | 44.1 | % | $ | 1.3 | 0.2 | % | $ | 248.1 | 44.3 | % |\\n| Catastrophes | - | 0.0 | % | 0.9 | 0.2 | % | 0.9 | 0.2 | % |\\n| Total segment | $ | 246.7 | 44.1 | % | $ | 2.3 | 0.4 | % | $ | 249.0 | 44.5 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | (21.2 | ) | 2.1 | pts | $ | (0.8 | ) | - | pts | $ | (22.1 | ) | 2.1 | pts |\\n| Catastrophes | 0.2 | - | pts | (1.2 | ) | (0.3 | ) | pts | (1.0 | ) | (0.3 | ) | pts |\\n| Total segment | $ | (21.0 | ) | 2.1 | pts | $ | (2.1 | ) | (0.3 | ) | pts | $ | (23.1 | ) | 1.8 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 732.4 | 49.5 | % | $ | (24.3 | ) | -1.6 | % | $ | 708.1 | 47.9 | % |\\n| Catastrophes | 0.2 | 0.0 | % | (8.8 | ) | -0.6 | % | (8.5 | ) | -0.6 | % |\\n| Total segment | $ | 732.6 | 49.5 | % | $ | (33.1 | ) | -2.2 | % | $ | 699.6 | 47.3 | % |\\n| 2014 |\\n| Attritional | $ | 691.3 | 46.8 | % | $ | 2.3 | 0.2 | % | $ | 693.6 | 46.9 | % |\\n| Catastrophes | 6.3 | 0.4 | % | 1.5 | 0.1 | % | 7.8 | 0.5 | % |\\n| Total segment | $ | 697.7 | 47.2 | % | $ | 3.8 | 0.3 | % | $ | 701.5 | 47.5 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 41.1 | 2.7 | pts | $ | (26.6 | ) | (1.8 | ) | pts | $ | 14.5 | 1.0 | pts |\\n| Catastrophes | (6.1 | ) | (0.4 | ) | pts | (10.3 | ) | (0.7 | ) | pts | (16.3 | ) | (1.1 | ) | pts |\\n| Total segment | $ | 34.9 | 2.3 | pts | $ | (36.9 | ) | (2.5 | ) | pts | $ | (1.9 | ) | (0.2 | ) | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 354.9 | $ | 406.3 | $ | (51.4 | ) | -12.6 | % | $ | 966.1 | $ | 1,181.5 | $ | (215.4 | ) | -18.2 | % |\\n| Net written premiums | 318.5 | 352.6 | (34.1 | ) | -9.7 | % | 896.9 | 977.2 | (80.4 | ) | -8.2 | % |\\n| Premiums earned | $ | 291.4 | $ | 320.0 | $ | (28.6 | ) | -8.9 | % | $ | 935.2 | $ | 958.4 | $ | (23.2 | ) | -2.4 | % |\\n| Incurred losses and LAE | 229.0 | 236.6 | (7.5 | ) | -3.2 | % | 630.8 | 604.2 | 26.6 | 4.4 | % |\\n| Commission and brokerage | 70.9 | 73.1 | (2.2 | ) | -3.1 | % | 226.3 | 215.7 | 10.6 | 4.9 | % |\\n| Other underwriting expenses | 9.1 | 8.8 | 0.4 | 4.2 | % | 25.3 | 24.7 | 0.6 | 2.5 | % |\\n| Underwriting gain (loss) | $ | (17.6 | ) | $ | 1.6 | $ | (19.2 | ) | NM | $ | 52.9 | $ | 113.8 | $ | (61.0 | ) | -53.6 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 78.6 | % | 73.9 | % | 4.7 | 67.4 | % | 63.0 | % | 4.4 |\\n| Commission and brokerage ratio | 24.3 | % | 22.9 | % | 1.4 | 24.2 | % | 22.5 | % | 1.7 |\\n| Other underwriting expense ratio | 3.2 | % | 2.7 | % | 0.5 | 2.7 | % | 2.6 | % | 0.1 |\\n| Combined ratio | 106.1 | % | 99.5 | % | 6.6 | 94.3 | % | 88.1 | % | 6.2 |\\n| (NM, not meaningful) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 195.5 | 67.1 | % | $ | 0.4 | 0.1 | % | $ | 195.9 | 67.2 | % |\\n| Catastrophes | 34.4 | 11.8 | % | (1.3 | ) | -0.4 | % | 33.1 | 11.4 | % |\\n| Total segment | $ | 229.9 | 78.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 229.0 | 78.6 | % |\\n| 2014 |\\n| Attritional | $ | 213.0 | 66.5 | % | $ | (4.6 | ) | -1.4 | % | $ | 208.4 | 65.1 | % |\\n| Catastrophes | 29.3 | 9.2 | % | (1.2 | ) | -0.4 | % | 28.1 | 8.8 | % |\\n| Total segment | $ | 242.3 | 75.7 | % | $ | (5.8 | ) | -1.8 | % | $ | 236.6 | 73.9 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | (17.5 | ) | 0.6 | pts | $ | 5.0 | 1.5 | pts | $ | (12.5 | ) | 2.1 | pts |\\n| Catastrophes | 5.1 | 2.6 | pts | (0.1 | ) | - | pts | 5.0 | 2.6 | pts |\\n| Total segment | $ | (12.4 | ) | 3.2 | pts | $ | 4.9 | 1.5 | pts | $ | (7.5 | ) | 4.7 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 565.2 | 60.4 | % | $ | (2.7 | ) | -0.3 | % | $ | 562.5 | 60.1 | % |\\n| Catastrophes | 71.3 | 7.6 | % | (3.1 | ) | -0.3 | % | 68.2 | 7.3 | % |\\n| Total segment | $ | 636.6 | 68.0 | % | $ | (5.8 | ) | -0.6 | % | $ | 630.8 | 67.4 | % |\\n| 2014 |\\n| Attritional | $ | 548.2 | 57.1 | % | $ | (4.7 | ) | -0.5 | % | $ | 543.5 | 56.6 | % |\\n| Catastrophes | 63.9 | 6.7 | % | (3.3 | ) | -0.3 | % | 60.6 | 6.4 | % |\\n| Total segment | $ | 612.1 | 63.8 | % | $ | (8.0 | ) | -0.8 | % | $ | 604.2 | 63.0 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 17.0 | 3.3 | pts | $ | 2.0 | 0.2 | pts | $ | 19.0 | 3.5 | pts |\\n| Catastrophes | 7.4 | 0.9 | pts | 0.2 | - | pts | 7.6 | 0.9 | pts |\\n| Total segment | $ | 24.5 | 4.2 | pts | $ | 2.2 | 0.2 | pts | $ | 26.6 | 4.4 | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 267.0 | $ | 205.3 | $ | 61.7 | 30.0 | % | $ | 605.4 | $ | 573.8 | $ | 31.6 | 5.5 | % |\\n| Net written premiums | 251.7 | 189.4 | 62.2 | 32.8 | % | 557.5 | 548.2 | 9.2 | 1.7 | % |\\n| Premiums earned | $ | 222.2 | $ | 181.8 | $ | 40.5 | 22.3 | % | $ | 616.2 | $ | 546.7 | $ | 69.5 | 12.7 | % |\\n| Incurred losses and LAE | 154.3 | 109.0 | 45.4 | 41.6 | % | 372.6 | 310.6 | 62.0 | 20.0 | % |\\n| Commission and brokerage | 53.0 | 48.4 | 4.6 | 9.4 | % | 151.4 | 141.0 | 10.4 | 7.4 | % |\\n| Other underwriting expenses | 9.5 | 9.4 | 0.1 | 1.0 | % | 27.0 | 25.8 | 1.2 | 4.8 | % |\\n| Underwriting gain (loss) | $ | 5.5 | $ | 15.0 | $ | (9.5 | ) | -63.5 | % | $ | 65.3 | $ | 69.3 | $ | (4.1 | ) | -5.9 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 69.4 | % | 59.9 | % | 9.5 | 60.5 | % | 56.8 | % | 3.7 |\\n| Commission and brokerage ratio | 23.8 | % | 26.6 | % | (2.8 | ) | 24.6 | % | 25.8 | % | (1.2 | ) |\\n| Other underwriting expense ratio | 4.3 | % | 5.2 | % | (0.9 | ) | 4.3 | % | 4.7 | % | (0.4 | ) |\\n| Combined ratio | 97.5 | % | 91.7 | % | 5.8 | 89.4 | % | 87.3 | % | 2.1 |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 153.4 | 69.0 | % | $ | - | 0.0 | % | $ | 153.4 | 69.0 | % |\\n| Catastrophes | - | 0.0 | % | 0.9 | 0.4 | % | 0.9 | 0.4 | % |\\n| Total segment | $ | 153.4 | 69.0 | % | $ | 0.9 | 0.4 | % | $ | 154.3 | 69.4 | % |\\n| 2014 |\\n| Attritional | $ | 108.8 | 59.8 | % | $ | - | 0.0 | % | $ | 108.8 | 59.8 | % |\\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\\n| Total segment | $ | 108.8 | 59.8 | % | $ | 0.2 | 0.1 | % | $ | 109.0 | 59.9 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 44.6 | 9.2 | pts | $ | - | - | pts | $ | 44.6 | 9.2 | pts |\\n| Catastrophes | - | - | pts | 0.7 | 0.3 | pts | 0.7 | 0.3 | pts |\\n| Total segment | $ | 44.6 | 9.2 | pts | $ | 0.7 | 0.3 | pts | $ | 45.4 | 9.5 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 376.5 | 61.1 | % | $ | (5.2 | ) | -0.8 | % | $ | 371.3 | 60.3 | % |\\n| Catastrophes | - | 0.0 | % | 1.3 | 0.2 | % | 1.3 | 0.2 | % |\\n| Total segment | $ | 376.5 | 61.1 | % | $ | (3.9 | ) | -0.6 | % | $ | 372.6 | 60.5 | % |\\n| 2014 |\\n| Attritional | $ | 313.7 | 57.4 | % | $ | (5.0 | ) | -0.9 | % | $ | 308.7 | 56.5 | % |\\n| Catastrophes | - | 0.0 | % | 1.9 | 0.3 | % | 1.9 | 0.3 | % |\\n| Total segment | $ | 313.7 | 57.4 | % | $ | (3.1 | ) | -0.6 | % | $ | 310.6 | 56.8 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 62.8 | 3.7 | pts | $ | (0.2 | ) | 0.1 | pts | $ | 62.6 | 3.8 | pts |\\n| Catastrophes | - | - | pts | (0.6 | ) | (0.1 | ) | pts | (0.6 | ) | (0.1 | ) | pts |\\n| Total segment | $ | 62.8 | 3.7 | pts | $ | (0.8 | ) | - | pts | $ | 62.0 | 3.7 | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 489.1 | $ | 364.1 | $ | 125.0 | 34.3 | % | $ | 1,173.0 | $ | 911.2 | $ | 261.8 | 28.7 | % |\\n| Net written premiums | 419.0 | 310.7 | 108.3 | 34.8 | % | 1,022.4 | 802.4 | 220.0 | 27.4 | % |\\n| Premiums earned | $ | 360.7 | $ | 290.5 | $ | 70.2 | 24.2 | % | $ | 888.7 | $ | 742.0 | $ | 146.7 | 19.8 | % |\\n| Incurred losses and LAE | 262.3 | 239.8 | 22.5 | 9.4 | % | 662.1 | 557.0 | 105.0 | 18.9 | % |\\n| Commission and brokerage | 50.3 | 40.4 | 9.9 | 24.4 | % | 127.1 | 114.5 | 12.6 | 11.0 | % |\\n| Other underwriting expenses | 35.7 | 31.3 | 4.4 | 13.9 | % | 99.2 | 83.7 | 15.6 | 18.6 | % |\\n| Underwriting gain (loss) | $ | 12.5 | $ | (21.0 | ) | $ | 33.5 | -159.3 | % | $ | 0.3 | $ | (13.2 | ) | $ | 13.5 | -102.3 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 72.7 | % | 82.5 | % | (9.8 | ) | 74.5 | % | 75.1 | % | (0.6 | ) |\\n| Commission and brokerage ratio | 13.9 | % | 13.9 | % | - | 14.3 | % | 15.4 | % | (1.1 | ) |\\n| Other underwriting expense ratio | 9.9 | % | 10.8 | % | (0.9 | ) | 11.2 | % | 11.3 | % | (0.1 | ) |\\n| Combined ratio | 96.5 | % | 107.2 | % | (10.7 | ) | 100.0 | % | 101.8 | % | (1.8 | ) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 262.9 | 72.9 | % | $ | (0.9 | ) | -0.3 | % | $ | 262.1 | 72.6 | % |\\n| Catastrophes | - | 0.0 | % | 0.2 | 0.1 | % | 0.2 | 0.1 | % |\\n| Total segment | $ | 262.9 | 72.9 | % | $ | (0.6 | ) | -0.2 | % | $ | 262.3 | 72.7 | % |\\n| 2014 |\\n| Attritional | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\\n| Catastrophes | - | 0.0 | % | - | 0.0 | % | - | 0.0 | % |\\n| Total segment | $ | 236.1 | 81.2 | % | $ | 3.7 | 1.3 | % | $ | 239.8 | 82.5 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 26.8 | (8.3 | ) | pts | $ | (4.6 | ) | (1.6 | ) | pts | $ | 22.3 | (9.9 | ) | pts |\\n| Catastrophes | - | - | pts | 0.2 | 0.1 | pts | 0.2 | 0.1 | pts |\\n| Total segment | $ | 26.8 | (8.3 | ) | pts | $ | (4.3 | ) | (1.5 | ) | pts | $ | 22.5 | (9.8 | ) | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 630.5 | 70.9 | % | $ | 31.5 | 3.6 | % | $ | 662.0 | 74.5 | % |\\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\\n| Total segment | $ | 630.5 | 70.9 | % | $ | 31.6 | 3.6 | % | $ | 662.1 | 74.5 | % |\\n| 2014 |\\n| Attritional | $ | 552.5 | 74.5 | % | $ | 4.5 | 0.6 | % | $ | 557.0 | 75.1 | % |\\n| Catastrophes | - | 0.0 | % | 0.1 | 0.0 | % | 0.1 | 0.0 | % |\\n| Total segment | $ | 552.5 | 74.5 | % | $ | 4.6 | 0.6 | % | $ | 557.0 | 75.1 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\\n| Catastrophes | - | - | pts | - | - | pts | - | - | pts |\\n| Total segment | $ | 78.0 | (3.6 | ) | pts | $ | 27.0 | 3.0 | pts | $ | 105.0 | (0.6 | ) | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (Dollars in millions) | 2015 | 2014 | Variance | % Change | 2015 | 2014 | Variance | % Change |\\n| Gross written premiums | $ | 72.2 | $ | 50.3 | $ | 21.9 | 43.4 | % | $ | 183.7 | $ | 109.2 | $ | 74.5 | 68.3 | % |\\n| Net written premiums | 60.9 | 49.8 | 11.1 | 22.4 | % | 153.3 | 98.7 | 54.6 | 55.4 | % |\\n| Premiums earned | $ | 50.8 | $ | 38.2 | $ | 12.6 | 32.9 | % | $ | 132.5 | $ | 81.4 | $ | 51.1 | 62.8 | % |\\n| Incurred losses and LAE | 16.5 | 3.4 | 13.1 | NM | 36.3 | 19.6 | 16.7 | 85.3 | % |\\n| Commission and brokerage | 4.9 | 5.1 | (0.2 | ) | -4.9 | % | 13.3 | 9.8 | 3.5 | 35.7 | % |\\n| Other underwriting expenses | 2.7 | 1.6 | 1.1 | 71.6 | % | 6.7 | 5.0 | 1.7 | 34.5 | % |\\n| Underwriting gain (loss) | $ | 26.7 | $ | 28.1 | $ | (1.4 | ) | -4.9 | % | $ | 76.3 | $ | 47.1 | $ | 29.2 | 62.0 | % |\\n| Point Chg | Point Chg |\\n| Loss ratio | 32.5 | % | 8.9 | % | 23.6 | 27.4 | % | 24.0 | % | 3.4 |\\n| Commission and brokerage ratio | 9.6 | % | 13.4 | % | (3.8 | ) | 10.1 | % | 12.1 | % | (2.0 | ) |\\n| Other underwriting expense ratio | 5.2 | % | 4.1 | % | 1.1 | 5.0 | % | 6.1 | % | (1.1 | ) |\\n| Combined ratio | 47.3 | % | 26.4 | % | 20.9 | 42.5 | % | 42.2 | % | 0.3 |\\n| (NM, not meaningful) |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Three Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 10.7 | 21.1 | % | $ | - | 0.0 | % | $ | 10.7 | 21.1 | % |\\n| Catastrophes | 5.4 | 10.5 | % | 0.4 | 0.9 | % | 5.8 | 11.4 | % |\\n| Total segment | $ | 16.1 | 31.6 | % | $ | 0.4 | 0.9 | % | $ | 16.5 | 32.5 | % |\\n| 2014 |\\n| Attritional | $ | 2.7 | 7.2 | % | $ | - | 0.0 | % | $ | 2.7 | 7.2 | % |\\n| Catastrophes | 0.7 | 1.7 | % | - | 0.0 | % | 0.7 | 1.7 | % |\\n| Total segment | $ | 3.4 | 8.9 | % | $ | - | 0.0 | % | $ | 3.4 | 8.9 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 8.0 | 13.9 | pts | $ | - | - | pts | $ | 8.0 | 13.9 | pts |\\n| Catastrophes | 4.7 | 8.8 | pts | 0.4 | 0.9 | pts | 5.1 | 9.7 | pts |\\n| Total segment | $ | 12.7 | 22.7 | pts | $ | 0.4 | 0.9 | pts | $ | 13.1 | 23.6 | pts |\\n| Nine Months Ended September 30, |\\n| Current | Ratio %/ | Prior | Ratio %/ | Total | Ratio %/ |\\n| (Dollars in millions) | Year | Pt Change | Years | Pt Change | Incurred | Pt Change |\\n| 2015 |\\n| Attritional | $ | 27.4 | 20.7 | % | $ | - | 0.0 | % | $ | 27.4 | 20.7 | % |\\n| Catastrophes | 8.4 | 6.4 | % | 0.4 | 0.3 | % | 8.8 | 6.7 | % |\\n| Total segment | $ | 35.8 | 27.1 | % | $ | 0.4 | 0.3 | % | $ | 36.3 | 27.4 | % |\\n| 2014 |\\n| Attritional | $ | 15.0 | 18.4 | % | $ | - | 0.0 | % | $ | 15.0 | 18.4 | % |\\n| Catastrophes | 4.7 | 5.8 | % | (0.2 | ) | -0.2 | % | 4.5 | 5.6 | % |\\n| Total segment | $ | 19.8 | 24.2 | % | $ | (0.2 | ) | -0.2 | % | $ | 19.6 | 24.0 | % |\\n| Variance 2015/2014 |\\n| Attritional | $ | 12.4 | 2.3 | pts | $ | - | - | pts | $ | 12.4 | 2.3 | pts |\\n| Catastrophes | 3.7 | 0.6 | pts | 0.6 | 0.5 | pts | 4.3 | 1.1 | pts |\\n| Total segment | $ | 16.0 | 2.9 | pts | $ | 0.6 | 0.5 | pts | $ | 16.7 | 3.4 | pts |\\n| (Some amounts may not reconcile due to rounding.) |\\n| (Dollars in millions) | At September 30, 2015 | At December 31, 2014 |\\n| Fixed maturities, market value | $ | 13,491.0 | 76.4 | % | $ | 13,101.1 | 75.1 | % |\\n| Fixed maturities, fair value | - | 0.0 | % | 1.5 | 0.0 | % |\\n| Equity securities, market value | 113.0 | 0.6 | % | 140.2 | 0.8 | % |\\n| Equity securities, fair value | 1,357.3 | 7.7 | % | 1,447.8 | 8.3 | % |\\n| Short-term investments | 1,615.0 | 9.2 | % | 1,705.9 | 9.8 | % |\\n| Other invested assets | 669.7 | 3.8 | % | 601.9 | 3.5 | % |\\n| Cash | 401.2 | 2.3 | % | 437.5 | 2.5 | % |\\n| Total investments and cash | $ | 17,647.2 | 100.0 | % | $ | 17,435.9 | 100.0 | % |\\n| (Some amounts may not reconcile due to rounding.) |\\n| At | At |\\n| September 30, 2015 | December 31, 2014 |\\n| Fixed income portfolio duration (years) | 3.0 | 2.9 |\\n| Fixed income composite credit quality | A1 | A1 |\\n| Imbedded end of period yield, pre-tax | 3.0% | 3.0% |\\n| Imbedded end of period yield, after-tax | 2.5% | 2.6% |\\n| Nine Months Ended | Twelve Months Ended |\\n| September 30, 2015 | December 31, 2014 |\\n| Fixed income portfolio total return | 1.4% | 3.5% |\\n| Barclay's Capital - U.S. aggregate index | 1.1% | 6.0% |\\n| Common equity portfolio total return | -5.0% | 10.4% |\\n| S&P 500 index | -5.3% | 13.7% |\\n| Other invested asset portfolio total return | 4.1% | 11.8% |\\n| At September 30, 2015 |\\n| Case | IBNR | Total | % of |\\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\\n| U.S. Reinsurance | $ | 1,290.2 | $ | 2,013.9 | $ | 3,304.1 | 33.2 | % |\\n| International | 775.7 | 1,069.5 | 1,845.3 | 18.5 | % |\\n| Bermuda | 862.4 | 1,225.5 | 2,087.8 | 20.9 | % |\\n| Insurance | 1,001.0 | 1,249.8 | 2,250.8 | 22.6 | % |\\n| Mt. Logan Re | 18.4 | 38.7 | 57.1 | 0.6 | % |\\n| Total excluding A&E | 3,947.7 | 5,597.4 | 9,545.1 | 95.8 | % |\\n| A&E | 236.1 | 184.8 | 420.9 | 4.2 | % |\\n| Total including A&E | $ | 4,183.8 | $ | 5,782.2 | $ | 9,966.0 | 100.0 | % |\\n| (Some amounts may not reconcile due to rounding.) |\\n| At December 31, 2014 |\\n| Case | IBNR | Total | % of |\\n| (Dollars in millions) | Reserves | Reserves | Reserves | Total |\\n| U.S. Reinsurance | $ | 1,409.5 | $ | 1,925.4 | $ | 3,334.9 | 34.3 | % |\\n| International | 902.5 | 868.6 | 1,771.0 | 18.2 | % |\\n| Bermuda | 783.9 | 1,108.2 | 1,892.0 | 19.5 | % |\\n| Insurance | 968.3 | 1,250.4 | 2,218.6 | 22.8 | % |\\n| Mt. Logan Re | 13.0 | 15.0 | 28.0 | 0.3 | % |\\n| Total excluding A&E | 4,077.1 | 5,167.5 | 9,244.6 | 95.1 | % |\\n| A&E | 251.1 | 225.1 | 476.2 | 4.9 | % |\\n| Total including A&E | $ | 4,328.2 | $ | 5,392.6 | $ | 9,720.8 | 100.0 | % |\\n| (Some amounts may not reconcile due to rounding.) |\\n| At | At |\\n| September 30, | December 31, |\\n| (Dollars in millions) | 2015 | 2014 |\\n| Gross reserves | $ | 420.9 | $ | 476.2 |\\n| Reinsurance receivable | (113.2 | ) | (18.0 | ) |\\n| Net reserves | $ | 307.6 | $ | 458.2 |\\n| (Some amounts may not reconcile due to rounding.) |\\n| Bermuda Re (1) | Everest Re (2) |\\n| At December 31, | At December 31, |\\n| (Dollars in millions) | 2014 | 2013 | 2014 | 2013 |\\n| Regulatory targeted capital | $ | 2,050.0 | $ | 2,154.6 | $ | 1,209.6 | $ | 1,094.6 |\\n| Actual capital | $ | 2,748.0 | $ | 2,712.2 | $ | 2,893.0 | $ | 2,814.3 |\\n| Impact of Interest Rate Shift in Basis Points |\\n| At September 30, 2015 |\\n| -200 | -100 | 0 | 100 | 200 |\\n| (Dollars in millions) |\\n| Total Market/Fair Value | $ | 15,883.0 | $ | 15,507.1 | $ | 15,106.0 | $ | 14,677.4 | $ | 14,235.5 |\\n| Market/Fair Value Change from Base (%) | 5.1 | % | 2.7 | % | 0.0 | % | -2.8 | % | -5.8 | % |\\n| Change in Unrealized Appreciation |\\n| After-tax from Base ($) | $ | 657.8 | $ | 340.0 | $ | - | $ | (364.4 | ) | $ | (740.2 | ) |\\n| Impact of Percentage Change in Equity Fair/Market Values |\\n| At September 30, 2015 |\\n| (Dollars in millions) | -20% | -10% | 0% | 10% | 20% |\\n| Fair/Market Value of the Equity Portfolio | $ | 1,176.2 | $ | 1,323.3 | $ | 1,470.3 | $ | 1,617.3 | $ | 1,764.4 |\\n| After-tax Change in Fair/Market Value | $ | (201.7 | ) | $ | (100.9 | ) | $ | - | $ | 100.9 | $ | 201.7 |\\n\\nITEM 3.\\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nMarket Risk Instruments. See \\\"Liquidity and Capital Resources - Market Sensitive Instruments\\\" in PART I – ITEM 2.\\n57\\nITEM 4.\\nCONTROLS AND PROCEDURES\\nAs of the end of the period covered by this report, our management carried out an evaluation, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the \\\"Exchange Act\\\")). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission's rules and forms. Our management, with the participation of the Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, there has been no such change during the quarter covered by this report.\\nPART II\\n\\nITEM 1.\\nLEGAL PROCEEDINGS\\nIn the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company's rights and obligations under insurance and reinsurance agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. These disputes arise from time to time and are ultimately resolved through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company considers the statuses of these proceedings when determining its reserves for unpaid loss and loss adjustment expenses.\\nAside from litigation and arbitrations related to these insurance and reinsurance agreements, the Company is not a party to any other material litigation or arbitration.\\n\\nITEM 1A.\\nRISK FACTORS\\nNo material changes.\\n58\\nITEM 2.\\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nIssuer Purchases of Equity Securities.\\n| Issuer Purchases of Equity Securities |\\n| (a) | (b) | (c) | (d) |\\n| Maximum Number (or |\\n| Total Number of | Approximate Dollar |\\n| Shares (or Units) | Value) of Shares (or |\\n| Purchased as Part | Units) that May Yet |\\n| Total Number of | of Publicly | Be Purchased Under |\\n| Shares (or Units) | Average Price Paid | Announced Plans or | the Plans or |\\n| Period | Purchased | per Share (or Unit) | Programs | Programs (1) |\\n| July 1 - 31, 2015 | 1,756 | $ | 183.2850 | - | 5,631,185 |\\n| August 1 - 31, 2015 | 514,629 | $ | 177.4608 | 514,629 | 5,116,556 |\\n| September 1 - 30, 2015 | 626,078 | $ | 174.4833 | 622,844 | 4,493,712 |\\n| Total | 1,142,463 | $ | - | 1,137,473 | 4,493,712 |\\n\\n(1) On September 21, 2004, the Company's board of directors approved an amended share repurchase program authorizing the Company and/or its subsidiary Holdings to purchase up to an aggregate of 5,000,000 of the Company's common shares through open market transactions, privately negotiated transactions or both. On July 21, 2008; February 24, 2010; February 22, 2012; May 15, 2013; and November 19, 2014, the Company's executive committee of the Board of Directors has approved subsequent amendments to the share repurchase program authorizing the Company and/or its subsidiary Holdings, to purchase up to a current aggregate of 30,000,000 of the Company's shares (recognizing that the number of shares authorized for repurchase has been reduced by those shares that have already been purchased) in open market transactions, privately negotiated transactions or both.\\n\\nITEM 3.\\nDEFAULTS UPON SENIOR SECURITIES\\nNone.\\n\\nITEM 4.\\nMINE SAFETY DISCLOSURES\\nNot applicable.\\n\\nITEM 5\\n.\\nOTHER INFORMATION\\nNone.\\n59\\nITEM 6.\\nEXHIBITS\\n\\n| Exhibit Index: |\\n| Exhibit No. | Description |\\n| 31.1 | Section 302 Certification of Dominic J. Addesso |\\n| 31.2 | Section 302 Certification of Craig Howie |\\n| 32.1 | Section 906 Certification of Dominic J. Addesso and Craig Howie |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase |\\n| 101.LAB | XBRL Taxonomy Extension Labels Linkbase |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase |\\n\\n60\\nEverest Re Group, Ltd.\\nSignatures\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| Everest Re Group, Ltd. |\\n| (Registrant) |\\n| /S/ CRAIG HOWIE |\\n| Craig Howie |\\n| Executive Vice President and |\\n| Chief Financial Officer |\\n| (Duly Authorized Officer and Principal Financial Officer) |\\n\\n\\n</text>\\n\\nWhat is the percent change in the total outstanding amount of the Citibank Bilateral Letter of Credit Agreement from September 30, 2015 to December 31, 2014?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -15.72.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 34,\n \"input_length\": 49245\n}"}}},{"rowIdx":35,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. BUSINESS\nOverview\nHambrecht Asia Acquisition Corp. (“we”, “us”, “our” or the “Company”) is a Cayman Islands blank check company formed on July 18, 2007 to complete a business combination with one or more operating businesses that have its or their primary operations in the PRC. Our efforts in identifying a prospective target business will not be limited to a particular industry. We intend to effect a business combination using cash from the proceeds of our initial public offering and the private placements of the sponsors’ warrants, our capital stock, debt or a combination of cash, stock and debt. On March 7, 2008, we completed a private placement of 1,550,000 warrants (“Founder Warrants”). On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (together the “IPO”). Each unit consists of one share of common stock and one redeemable common stock purchase warrant, resulting in a total of 4,239,300 common shares (“IPO Shares”) and 4,239,300 warrants (“IPO Warrants”) which are publicly held. The units were sold at an offering price of $8.00 per unit and the Founder Warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter.\nThe net proceeds from the IPO and private placement, after deducting certain offering expenses of approximately $2,784,873 (including underwriting discounts of approximately $2,374,008), were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per IPO Share) of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not placed in the trust account. We will not be able to access the amounts held in the trust account until we consummate a business combination, except for up to $700,000 (plus up to an additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest earned on the funds in the trust account, which may be released from the trust to us to be used for working capital. As of June 30, 2009, there was approximately $33,799,000 held in the trust account (or approximately $7.92 per IPO Share), and approximtely $286,000 of interest eanred on the trust account balance had been released to us for working capital purposes.\nInvestment Opportunities in China\nOpportunities for market expansion have emerged for businesses with operations in China due to certain changes in the PRC’s political, economic and social policies as well as certain fundamental changes affecting the PRC and his neighboring countries. We believe that China represents both a favorable environment for making acquisitions and an attractive operating environment for a target business for several reasons, including:\n\n| § | prolonged economic expansion within China, including gross domestic product growth of approximately 16.5% on average over the last 25 years, including 17.7% in 2004, 15.0% in 2005 and 14.7% in 2006 (National Bureau of Statistics of China) (China Statistical Yearbook – 2007, http://www.stats.gov.cn/tjsj/ndsj/2007/indexeh.htm, viewed February 24, 2009); |\n\n\n| § | increased government focus within China on privatizing assets, improving foreign trade and encouraging business and economic activity; |\n\n\n| § | the recent entry of China into the World Trade Organization, the sole global international organization dealing with the rules of trade between nations, which may lead to a reduction on tariffs for industrial products, a reduction in trade restrictions and an increase in trading with the United States. |\n\nWe believe that these factors and others should enable us to acquire a target business with growth potential on favorable terms.\n3\nEffecting a Business Combination\nWe intend to utilize the cash proceeds of the IPO and the private placement, our capital securities, debt or a combination of these as the consideration to be paid in a business combination. While substantially all of the net proceeds of the IPO are allocated to completing a business combination, the proceeds are not otherwise designated for more specific purposes. If the business combination is paid for using equity or debt securities, we may apply the cash released to us from the trust account for general corporate purposes, including for maintenance or expansion of operations of the acquired business or businesses, the payment of principal or interest due on indebtedness incurred in consummating our initial business combination, to fund the purchase of other companies, or for working capital. We may engage in a business combination with a company that does not require significant additional capital but is seeking a public trading market for its shares and that wants to merge with an already public company to add the experience of the public company’s management team to its company and to avoid the risk that market conditions will not be favorable for an initial public offering at the time this offering is ready to be sold, despite the fact that merging with us would require similar disclosures and, potentially, a similar timeframe as an initial public offering. We may seek to effect a business combination with more than one target business, although our limited resources may serve as a practical limitation on our ability to do so.\nPrior to consummation of a business combination, we will seek to have all vendors, prospective target businesses or other entities that we may engage, which we refer to as potential contracted parties or a potential contracted party, execute agreements with us waiving any right, title, interest or claim of any kind in or to any monies held in the trust account for the benefit of our public shareholders. There is no assurance that we will be able to get waivers from our vendors and there is no assurance that such waivers will be enforceable by operation of law or that creditors would be prevented from bringing claims against the trust. In the event that a potential contracted party were to refuse to execute such a waiver, we will execute an agreement with that entity only if our management first determines that we would be unable to obtain, on a reasonable basis, substantially similar services or opportunities from another entity willing to execute such a waiver. Examples of instances where we may engage a third party that refused to execute a waiver would be the engagement of a third party consultant whose particular expertise or skills are believed by management to be superior to those of other consultants that would agree to execute a waiver or a situation where management does not believe it would be able to find a provider of required services willing to provide the waiver. If we are unable to complete a business combination and are forced to dissolve and liquidate, each of our pre-initial public offering shareholders other than Stephen N. Cannon, will, by agreement, be personally liable (each in an amount proportional to the number of shares owned as compared to both of them as a group, except that John Wang and Robert Eu will indemnify us for the portion of the indemnification obligation attributable to the portion of our shares owned by Stephen N. Cannon) to ensure that the proceeds in the trust account are not reduced by the claims of prospective target businesses, vendors or other entities that are owed money by us for services rendered or products sold to us. Under these circumstances, our board of directors would have a fiduciary obligation to our shareholders to bring a claim against each of our pre-initial public offering shareholders other than Stephen N. Cannon to enforce their liability obligation.\nSubject to the requirement that a target business or businesses have a fair market value of at least 80% of the balance in the trust account (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) at the time of our initial business combination, we have virtually unrestricted flexibility in identifying and selecting one or more prospective target businesses.\nWe focus on potential target businesses with valuations between $70 million and $150 million. We believe that our available working capital, together with the issuance of additional equity and/or the issuance of debt, would support the acquisition of such a target business. The mix of additional equity and/or debt would depend on many factors. The proposed funding for any such business combination would be disclosed in the proxy statement relating to the required shareholder approval.\nAfter completion of the IPO, we began contacting investment bankers, private equity firms and other business contacts in order to generate ideas about a suitable business combination. We also received unsolicited inquiries from several investment banking firms, private equity firms and other business intermediaries. We informed these contacts that we were seeking an operating business for our initial business combination. We have not retained an investment banking firm or fairness or valuation advisor to conduct a formal search for a business combination. Criteria for suitability included our management’s assessment of the competitive strengths and weaknesses of the potential business targets, the strength of the management team, and the quality of the assets to be acquired.\n4\nWe may pay fees or compensation to third parties for their efforts in introducing us to potential target businesses. We may seek to engage someone to assist in finding a potential target business if our management feels that they need assistance to find a suitable target business. If a finder approaches us on an unsolicited basis, our management would decide whether to work with that finder (and pay a finders’ fee) depending on the potential target business such finder proposes. Such payments are typically, although not always, calculated as a percentage of the dollar value of the transaction. We have not anticipated use of a particular percentage fee, but instead will seek to negotiate the smallest reasonable percentage fee consistent with the attractiveness of the opportunity and the alternatives, if any, that are then available to us. We may make such payments to entities we engage for this purpose or entities that approach us on an unsolicited basis. Payment of finders’ fees is customarily tied to consummation of a transaction and certainly would be tied to a completed transaction in the case of an unsolicited proposal. Although it is possible that we may pay finders’ fees in the case of an uncompleted transaction, we consider this possibility to be extremely remote. In no event will we pay any of our directors or officers or any entity with which they are affiliated any finder’s fee or other compensation for services rendered to us prior to or in connection with the consummation of a business combination. In addition, none of our officers or directors will receive any finder’s fee, consulting fees or any similar fees from any person or entity in connection with any business combination involving us. Following such business combination, however, our officers or directors may receive compensation or fees including compensation approved by the board of directors for customary director’s fees for our directors that remain following such business combination. Our directors have advised us that they will not take an offer regarding their compensation or fees following a business combination into consideration when determining which target businesses to pursue.\nWe anticipate structuring a business combination to acquire 100% of the equity interests or assets of the target business. We may, however, structure a business combination to acquire less than 100% of such interests or assets of the target business but will not acquire less than a controlling interest (which would be greater than 50% of the voting securities of the target business). If we acquire only a controlling interest in a target business or businesses, the portion of such business that we acquire must have a fair market value equal to at least 80% of the amount in the trust account, (excluding deferred underwriting discounts and commissions and taxes payable), as described above. If we determine to simultaneously acquire several businesses and such businesses are owned by different sellers, we will need for each of such sellers to agree that our purchase of his business is contingent on the simultaneous closings of the other acquisitions, which may make it more difficult for us, and delay our ability, to complete the business combination. With multiple acquisitions, we could also face additional risks, including additional burdens and costs with respect to possible multiple negotiations and due diligence investigations (if there are multiple sellers) and the additional risks associated with the subsequent integration of the operations and services or products of the acquired companies in a single operating business.\nIn recent months, there has been severe volatility and overall significant declines in the international capital markets and a freezing of the international credit markets that together have led to severe constraints in private flows of capital and an acutely negative impact on the operating results of companies in a wide range of industries and geographic sectors. Declining valuations of potential target businesses and uncertainty regarding the future may make it more difficult for us to reach agreement on a business combination that satisfies our requirements and the lack of available credit sources may adversely impact our ability to structure a transaction in the most advantageous manner. In addition, certain of our shareholders may experience pressure to vote against any business combination that we may propose in order to liquidate their investment and free up their capital, without regard to the merits of any such transaction.\n5\nGovernment regulations\nGovernment regulations relating to foreign exchange controls\nThe principal regulation governing foreign exchange in China is the Foreign Currency Administration Rules (IPPS), as amended. Under these rules, the Renminbi, China’s currency, is freely convertible for trade and service related foreign exchange transactions (such as normal purchases and sales of goods and services from providers in foreign countries), but not for direct investment, loan or investment in securities outside of China without the prior approval of the State Administration for Foreign Exchange (“SAFE”) of China. Foreign investment enterprises (“FIEs”) are required to apply to the SAFE for “Foreign Exchange Registration Certificates for FIEs.” Following a business combination, involving a change of equity ownership of a PRC operating entity or through contractual arrangements with a PRC operating entity our subsidiary will likely be an FIE as a result of our ownership structure. With such registration certificates, which need to be renewed annually, FIEs are allowed to open foreign currency accounts including a “basic account” and “capital account.” Currency translation within the scope of the “basic account,” such as remittance of foreign currencies for payment of dividends, can be effected without requiring the approval of the SAFE. However, conversion of currency in the “capital account,” including capital items such as direct investment, loans and securities, still require approval of the SAFE. This prior approval may delay or impair our ability to operate following a business combination. On November 21, 2005, the SAFE issued Circular No. 75 on “Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles.” Circular No. 75 confirms that the use of offshore special purpose vehicles as holding companies for PRC investments are permitted as long as proper foreign exchange registrations are made with the SAFE.\nGovernment regulations relating to taxation\nPrior to January 1, 2008, the standard enterprise income tax rate was 33%, which consisted of a 30% national income tax and a 3% local surcharge, for a company’s domestic and overseas incomes.\nA new tax law, the PRC Enterprise Income Tax Law (“New EIT Law”), took effect on January 1, 2008. Under the new tax law, companies are subject to a uniform tax rate of 25%. The New EIT Law provides a five-year transition period starting from its effective date for those enterprises which were established before the promulgation date of the new tax law and which were entitled to a preferential lower tax rate under the then-effective tax laws or regulations. The New EIT Law significantly curtails tax incentives granted to foreign-invested enterprises under the previous tax law. The New EIT Law, however, (i) reduces the top rate of EIT from 33% to 25%, (ii) permits companies to continue to enjoy their existing tax incentives, subject to certain transitional phase-out rules, and (iii) introduces new tax incentives, subject to various qualification criteria. The New EIT Law and its implementing rules permit certain “high and new technology enterprises” to enjoy a reduced 15% EIT rate. Under the phase-out rules, enterprises established before the promulgation date of the New EIT Law and which were granted preferential EIT treatment under the then effective tax laws or regulations may continue to enjoy their preferential tax treatments until their expiration and will gradually transition to the uniform 25% EIT rate over a five-year transition period.\nAdditionally, under the New EIT Law, an income tax rate for dividends payable to non-PRC investors and derived from sources within the PRC may be increased to 20%. It is currently unclear in what circumstances a source will be considered as located within the PRC.\nThe new tax law provides only a framework of the enterprise tax provisions, leaving many details on the definitions of numerous terms as well as the interpretation and specific applications of various provisions unclear and unspecified.\nCompetition\nIn identifying, evaluating and selecting a target business for a business combination, we may encounter intense competition from other entities having a business objective similar to ours including other blank check companies, private equity groups and leveraged buyout funds, and operating businesses seeking acquisitions. Many of these entities are well established and have extensive experience identifying and effecting business combinations directly or through affiliates. Moreover, many of these competitors possess greater financial, technical, human and other resources than us. While we believe there are numerous potential target businesses with which we could combine, our ability to acquire larger target businesses will be limited by our available financial resources. This inherent limitation gives others an advantage in pursuing the acquisition of a target business. Furthermore:\n\n| § | our obligation to seek shareholder approval of our initial business combination or obtain necessary financial information may delay the consummation of a transaction; |\n\n6\n| § | our obligation to redeem for cash ordinary shares held by our public shareholders who vote against the business combination and exercise their redemption rights may reduce the resources available to us for a business combination; |\n\n\n| § | our outstanding warrants, and the future dilution they potentially represent, may not be viewed favorably by certain target businesses; and |\n\n\n| § | the requirement to acquire an operating business that has a fair market value equal to at least 80% of the balance of the trust account at the time of the acquisition (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) could require us to acquire the assets of several operating businesses at the same time, all of which sales would be contingent on the closings of the other sales, which could make it more difficult to consummate the business combination. |\n\nAny of these factors may place us at a competitive disadvantage in successfully negotiating a business combination.\nEmployees\nWe currently have three officers. These individuals are not obligated to devote any specific number of hours to our business and intend to devote only as much time as they deem necessary to our business. We intend to hire employees and/or consultants, possibly including certain full time employees and/or consultants, in order to assist us in the search, due diligence for and consummation of a business combination.\nEnforcement of Civil Liabilities\nWe are registered under the laws of the Cayman Islands by way of continuation as an exempted company with limited liability. We are registered in the Cayman Islands because of certain benefits associated with being a Cayman Islands corporation, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of foreign exchange control or currency restrictions and the availability of professional and support services. However, the Cayman Islands has a less developed body of securities laws as compared to the United States and provides protections for investors to a significantly lesser extent. In addition, Cayman Islands companies do not have standing to sue before the federal courts of the United States.\nSubstantially all of our assets are located outside the United States. In addition, a majority of our directors and officers are nationals or residents of jurisdictions other than the United States and all or a substantial portion of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon us or these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States. It may also be difficult for you to enforce in U.S. courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us, our officers and directors.\nWe have not appointed any agent to receive service of process with respect to any action brought against us in the United States District Court for the Southern District of New York under the federal securities laws of the United States or of any state in the United States or any action brought against us in the Supreme Court of the State of New York in the County of New York under the securities laws of the State of New York.\nWe believe that there is uncertainty as to whether the courts of the Cayman Islands or the PRC would, respectively, (1) recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States, or (2) entertain original actions brought in the Cayman Islands or the PRC against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.\n\nITEM 1A. RISK FACTORS\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n7\nITEM 1B. UNRESOLVED STAFF COMMENTS\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n\nITEM 2. PROPERTIES\nWe currently maintain our executive offices at 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong. The cost for this space is included in the $7,500 per-month fee paid to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support. We believe, based on rents and fees for similar services in Hong Kong, that the fees that will be charged by Hambrecht Eu Capital Management LLC is at least as favorable as we could have obtained from unaffiliated persons.\n\nITEM 3. LEGAL PROCEEDINGS\nThere is no litigation currently pending or threatened against us or any of our directors in their capacity as such.\n\nITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS\nNo matters were submitted to a vote of our shareholders during the quarter ended June 30, 2009.\n8\nPART II\n\nITEM 5. MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.\nMarket Price Information\nThe shares of our common stock, warrants and units are traded on the OTC Bulletin Board, or OTCBB, under the symbols “HMAQF,” “HMAWF” and “HMAUF,” respectively. Each unit consists of one ordinary share and one warrant. Each warrant entitles the holder to purchase one ordinary share at a price of $5.00 commencing on the later of our consummation of a business combination or one year from the date of the IPO prospectus, provided in each case that there is an effective registration statement covering the ordinary shares underlying the warrants in effect. The warrants will expire five years from the date of the IPO, unless earlier redeemed. Our common stock and warrants commenced to trade separately from April 9, 2008.\nThe following table sets forth, for the calendar quarters indicated, the quarterly high and low bid information prices for our common stock, warrants and units as reported on the OTCBB, such over the counter market quotation reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.\n\n| Units | Ordinary Shares | Warrants |\n| High | Low | High | Low | High | Low |\n| Third Quarter of 2009 | $ | 7.65 | $ | 7.52 | $ | 7.98 | $ | 7.58 | $ | 0.16 | $ | 0.11 |\n| Second Quarter of 2009 | $ | 7.25 | $ | 7.25 | $ | 7.65 | $ | 7.35 | $ | 0.55 | $ | 0.05 |\n| First Quarter of 2009 | $ | 7.90 | $ | 7.00 | $ | 7.49 | $ | 7.10 | $ | 0.20 | $ | 0.05 |\n| Fourth Quarter of 2008 | $ | 7.15 | $ | 6.50 | $ | 7.00 | $ | 6.21 | $ | 0.42 | $ | 0.13 |\n| Third Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.37 | $ | 6.85 | $ | 0.73 | $ | 0.50 |\n| Second Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.16 | $ | 6.95 | $ | 0.85 | $ | 0.60 |\n| First Quarter of 2008 | $ | 8.15 | $ | 7.85 | - | - | - | - |\n\nNumber of Holders of Common Stock.\nThe number of holders of record of our Common Stock on January 21, 2010 was 10, which does not include beneficial owners of our securities.\nDividends.\nThere were no cash dividends or other cash distributions made by us during the fiscal year ended June 30, 2009. Future dividend policy will be determined by our Board of Directors based on our earnings, financial condition, capital requirements and other then existing conditions. It is anticipated that cash dividends will not be paid to the holders of our common stock in the foreseeable future.\n9\nRecent Sales of Unregistered Securities.\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that were subsequently redeemed because the underwriters did not fully exercise their over-allotment option) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee. Such shares were issued in connection with our organization pursuant to the exemption from registration contained in Section 4(2) of the Securities Act as they were sold in transactions not involving a public offering to a limited number of sophisticated, wealthy individuals. No underwriting commissions or offering discounts were paid with respect to such sales.\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of $10,193.35 or $0.022 per share. All such transfers were exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\n| Name | Ordinary Shares | Warrants |\n| John Wang | 230,000 | 0 |\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\n| Robert J. Eu | 173,275 | 0 |\n| AEX Enterprises Limited(3) | 88,333 | 0 |\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\n| AEX Capital, LLC(7) | 0 | 441,666 |\n| Total: | 1,059,824 | 1,550,000 |\n\n10\n\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\n\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\n\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\n\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\n\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\n\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\n\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\n\nRepurchases of Equity Securities.\nNone.\nUse of Proceeds\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units. Each unit consists of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. The units were sold at an offering price of $8.00 per unit and the warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter. The securities sold in our initial public offering were registered under the Securities Act of 1933 on a registration statement on Form S-1 (No. 333-146147). The Securities and Exchange Commission declared the registration statement effective on March 7, 2008.\nWe incurred a total of $2,374,008 in underwriting discounts and commissions, of which $1,187,004 has been placed in the trust account. Such portion of the underwriter’s compensation will only be paid to the underwriters in the event that we consummate a business combination. The total expenses in connection with the sale of our warrants in the private placement and the initial public offering were $2,784,873.\nAfter deducting the underwriting discounts and commissions and the offering expenses, the total net proceeds to us from the private placement and the initial public offering were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per unit sold in our initial public offering) of the proceeds from the initial public offering and the private placement was placed in a Trust Account for our benefit and the remaining proceeds are available to be used to provide for business, legal and accounting due diligence on prospective business combinations and continuing general and administrative expenses. The Trust Account contains $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The amounts held in the trust account may only be used by us upon the consummation of a business combination, except that we may use up to $700,000 (or $1,050,000 if approved by our shareholders) of the interest earned on the trust account to fund our working capital prior to a business combination. As of June 30, 2009, there was $ 33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\n\nITEM 6. SELECTED FINANCIAL DATA\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\n11\nITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following discussion should be read in conjunction with the financial statements and related notes contained herein and the information included in our other filings with the SEC. This discussion includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements in this Transition Report on Form 10-K other than statements of historical fact are forward-looking statements. These forward-looking statements involve known and unknown risks and uncertainties. Our actual results may differ materially from those projected or assumed in such forward-looking statements. Among the factors that could cause actual results to differ materially are our being a development stage company with no operating history, our dependence on key personnel some of whom may join us following a business combination, our personnel allocating their time to other businesses and potentially having conflicts of interest with our business, our potentially being unable to obtain additional financing to complete a business combination and the ownership of our securities being concentrated. All forward-looking statements included in this document are made as of the date of this report, based on information available to us as of such date. We assume no obligation to update any forward-looking statement.\nOverview\nWe are a blank check company formed under the laws of the Cayman Islands on July 18, 2007. We were formed to acquire one or more operating businesses through a merger, stock exchange, asset acquisition or similar business combination or control through contractual arrangements having its primary operations in the People’s Republic of China, or PRC. We will not seek to acquire a business with its primary operations outside of the PRC.\nThe company has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010 However if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. In order to extend the period of March 12, 2011, (i) public shareholders must approve the extension and (ii) public shareholders owning no more than one share less than 30% of the shares sold in this offering may have exercised their redemption rights.\nResults of Operations for the Six Month Transition Period Ended June 30, 2009\nWe incurred a net loss of $87,677 for the six month period ended June 30, 2009 due to both a decrease in the interest earned on the Trust Account which did not exceed our expenses for the period, and an increase in expenses related to professional services. Until we enter into a business combination, we will not have any operating revenues.\nOverall, for the six month period ended June 30, 2009, we incurred $25,002 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $114,868.\nFor the six months ended June 30, 2009, our trust account earned interest of $97,193 and our funds outside of the trust account did not earn interest income.\nResults of Operations for the Six Month Period Ended June 30, 2008\nWe had a net gain of $11,449 for the six month period ended June 30, 2008.\nOverall for six month period ended June 30, 2008, we incurred $16,668 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $95,015.\n12\nFor the six months ended June 30, 2008, our trust account earned interest of $173,106.\nResults of Operations for the Year Ended December 31, 2008\nWe reported net income of $236,505 for the year ended December 31, 2008 due to interest earned on the trust account. Until we enter into a business combination, we will not have any operating revenues.\nFor the year ended December 31, 2008, we incurred $37,503 of insurance expense from the amortization of our pre-paid D&O insurance policy, $97,500 of rent, administrative services and secretary support expense and other operating costs of $132,384.\nFor the year ended December 31, 2008, our trust account earned gross interest of $510,361. $239,110 of this interest was withdrawn from the trust account to fund working capital and $271,251 remained in the trust account.\nResults of Operations for the Year Ended December 31, 2007\nWe reported a net loss of $21,736 for the year ended December 31, 2007 due to start-up expenses. Until we enter into a business combination, we will not have any operating revenues.\nFor the year ended December 31, 2007, we incurred $15,000 of rent as well as formation and administrative costs of $6,736.\nFor the year ended December 31, 2007, we did not earn any interest from our trust account.\nLiquidity and Capital Resources\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants to AEX Enterprises Limited, a company controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Robert Eu’s father-in-law, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, each an entity controlled by William Hambrecht, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr., and Marbella Capital Partners Ltd., a company owned by John Wang, our Chief Executive Officer, and received net proceeds of $1,550,000. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised a portion of their over-allotment option, for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (collectively the “IPO”). Each unit in the public offering consisted of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. Our common stock and warrants started trading separately as of April 9, 2008.\nThe net proceeds from the sale of our warrants and units, after deducting certain offering expenses of approximately $2,784,873, including underwriting discounts of approximately $2,374,008, were approximately $32,679,527. Approximately $33,527,396 of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not held in the trust account. Except for up to $700,000 (plus up to and additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest that is earned on the funds contained in the trust account that may be released to us to be used as working capital, we will not be able to access the amounts held in the trust until we consummate a business combination. The amounts held outside of the trust account are available to be used by us to provide for business, legal and accounting due diligence on prospective acquisitions and continuing general and administrative expenses. From July 18, 2007 (the date of our inception) through June 30, 2009, we had operating expenses of $473,993. From January 1, 2009 through June 30, 2009, we had operating expenses of $184,870. The net proceeds deposited into the trust fund remain on deposit in the trust account earning interest. Other than $700,000 (or $1,050,000 if approved by our shareholders) in interest which we may use to fund working capital, the amounts held in the trust account may only be used by us upon the consummation of a business combination. As of December 31, 2008, we had 33,798,651 held in the trust account and as of June 30, 2009 there was $33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Additionally, as of June 30, 2009, we had $30,271 outside the trust account to fund our working capital requirements. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\n13\nWe will use substantially all of the net proceeds of our IPO to acquire one or more target businesses, and will use a portion of the interest earned on the trust account together with the funds not held in trust to identify and evaluate prospective target businesses, to select one or more target businesses, and to structure, negotiate and consummate the business combination. We do not believe we will need to raise additional funds following our IPO in order to meet the expenditures required for operating our business. However, we may need to raise additional funds through a private offering of debt or equity securities if such funds were required to consummate a business combination. Such debt securities may include a working capital revolving debt facility or a longer term debt facility. Subject to compliance with applicable securities laws, we would only consummate such financing simultaneously with the consummation of a business combination.\nCommencing on November 15, 2007, we began incurring a fee of approximately $7,500 per month for office space.\nOff-Balance Sheet Arrangements\nWe have never entered into any off-balance sheet financing arrangements and have never established any special purpose entities. We have not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets.\nContractual Obligations\nWe do not have any long term debt, capital lease obligations, operating lease obligations, purchase obligations or other long term liabilities, except for our agreement with Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support pursuant to which we pay a monthly fee of $7,500.\n\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nMarket risk is the sensitivity of income to changes in interest rates, foreign exchanges, commodity prices, equity prices, and other market-driven rates or prices. We are not presently engaged in and, if a suitable business target is not identified by us prior to the prescribed liquidation date of the trust fund, we may not engage in, any substantive commercial business. Accordingly, we are not and, until such time as we consummate a business combination, we will not be, exposed to risks associated with foreign exchange rates, commodity prices, equity prices or other market-driven rates or prices. The net proceeds of our IPO held in the trust fund have been invested only in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act of 1940. Given our limited risk in our exposure to money market funds, we do not view the interest rate risk to be significant.\n\nITEM 8. FINANCIAL AND SUPPLEMENTAL DATA\nFinancial statements are attached hereto beginning with page F-1\n\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\nNone.\n14\nITEM 9A(T). CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nAn evaluation of the effectiveness of our disclosure controls and procedures as of June 30, 2009 was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report.\nDisclosure Controls and Procedures are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. During the most recently completed fiscal quarter, there has been no significant change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nManagement’s Report on Internal Control Over Financial Reporting\nOur internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our board of directors to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external reporting purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that in reasonable detail accurately reflect the transactions and dispositions of our assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of our financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorization of our board of directors and management; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the criteria established in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of June 30, 2009.\nThis Transition Report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this Transition Report.\n\nITEM 9B. OTHER INFORMATION\nNone.\n15\nPART III\n\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE\nDirectors and Executive Officer\nOur current directors and executive officers are as follows:\n| Name | Age | Position |\n| John Wang | 39 | Chief Executive Officer, President and Director |\n| Robert J. Eu | 46 | Chairman of the Board, |\n| Hao Wu | 35 | Chief Financial Officer, Secretary and Director |\n| Hong Xiang Liu | 44 | Director |\n\nJohn Wang has been our Chief Executive Officer, President and a director since our inception. Mr. Wang has over twelve years of investment banking and consulting experience. Since November 2004, Mr. Wang has been the Managing Director of Marbella Capital Partners Ltd., a financial advisory firm based in Shanghai which he founded. From January 2000 to November 2004, he helped develop and establish the U.S. operations of SBI USA as Executive Vice President of SBI E2-Capital (HK) Limited and was a Managing Director and Chief Operating Officer of SBI E2-Capital (USA) Ltd. Prior to SBI, from 1997 to 1999, he managed Accenture Consulting’s Greater China communications, media, and high tech strategy practice, where he acted as consultant to China Mobile’s IPO in 1997, among other high profile projects. From 1994 to 1997 he was also the lead telecom analyst covering Greater China and Southeast Asia for Pyramid Research, a Cambridge Massachusetts based emerging market telecom research firm that is part of the Economist Intelligence Unit. Last year, he advised on four late-stage deals that closed, of which one has already gone public in Hong Kong and another, Yingli Green Energy (NYSE: YGE), completed its IPO and listing on the New York Stock Exchange on June 8, 2007. Mr. Wang currently sits on the Board of Hong Kong Stock Exchange listed Wuyi International Pharmaceutical Company Limited (HKSE: 1889). Mr. Wang holds a Bachelor of Arts degree in international relations from Tufts University and is a graduate of the Washington International Studies Program at St. Catherine’s College at Oxford University. He has an M.A.L.D. in international law and business from The Fletcher School of Law and Diplomacy and is a graduate of the Private Equity course at Harvard Business School.\nRobert J. Eu has been our Chairman of the Board, Secretary and director since our inception. He has been our Chief Financial Officer since February 21, 2008. Since 1998, Mr. Eu has served as a Managing Director for W.R. Hambrecht + Co., LLC (“WR Hambrecht + Co”) a San Francisco-based investment bank. Mr. Eu founded WR Hambrecht + Co’s investment banking practice in Asia in 2003. Prior to WR Hambrecht + Co, Mr. Eu was a Managing Director of H&Q Asia Pacific from 1992 until 1998, an affiliate of Hambrecht & Quist, where he co-founded its Hong Kong office and China investment practice. In 1996, Mr. Eu led the buy-out and de-listing of Eu Yang Sang (Hong Kong) Limited from the Hong Kong stock exchange and the company is now listed on the Singapore Stock Exchange (SGX:EYSI). Mr. Eu has been a director of Eu Yang Sang since 1997. In 1992, prior to working at H&Q Asia Pacific, Mr. Eu was the Business Development Manager for Eu Yang Sang (Hong Kong) Limited, a manufacturer and retailer of Traditional Chinese medicine. Mr. Eu has been a director and the Chairman of AEX Enterprises Limited (“AEX Enterprises”) since 2003. AEX Enterprises’ primary operating subsidiary is Boom Securities (H.K.) Limited (“Boom Securities”). Boom Securities is a licensed broker / dealer regulated by the Securities and Futures Commission (SFC) of Hong Kong and headquartered in Hong Kong. Mr. Eu worked for Citibank from 1987 until 1992 in the Private Banking Group in Hong Kong. Mr. Eu is a graduate of Northwestern University with a B.A. in History.\nHao Wu has been our Chief Financial Officer, Secretary and Director since September 4, 2009. He has been the Executive Vice President of Marbella Capital Partners, a boutique California/Shanghai based investment and advisory company that focuses on investing on Chinese deals in the growth and late stage, since January 2008. Prior to that, he was the finance director in B&Q Holding Co. Ltd., a leading home improvement retail company in China, from July 2006 until December 2007. Prior to B&Q, Mr. Wu worked for Fortune Tech group Co. Ltd. as the finance director from March 2004 until June 2006. He started his career in Unilever China as a management trainee. David holds a Bachelor of Science degree from the management school of Shanghai Jiao Tong University. Mr. Wu is employed by Marbella Capital Partners, which is controlled by John Wang, our Chief Executive Officer and a Director. Mr. Wu is not a party to any transactions listed in Item 404(a) of Regulation S\n16\nHong Xiang Liu has been one of our directors since September 4, 2009. He has been the director of Jiangsu Performing Art & Culture Enterprises Inc. Ltd., a real estate developer in China, Jiangsu province, since July 2007. Prior to this, he was the Chief Executive Officer and Executive Director of Tongda Energy Limited, a piped gas provider & operator in 11 cities across China, from October 2002 until July 2007. From 1988 to September 2002, Mr. Liu held various positions in China Construction Bank. His last appointment was as Vice General manager of the Enterprise Banking Department, China Construction Bank, Beijing Branch. Mr. Liu received his Bachelor of Engineering (Infrastructure Management) from Tianjin University and was accredited as a senior economist by China Construction Bank in 1998. Mr. Liu is not a party to any transactions listed in Item 404(a) of Regulation S-K.\nBoard Committees\nThe board of directors is currently composed of four individuals and we do not have any committees, and, therefore, the entire board of directors performs the functions of the Audit Committee. It is intended that the board of directors will establish an Audit Committee upon the consummation of a business combination. The board of directors will take all reasonable actions to ensure that one of the members of the Audit Committee will be an “audit committee financial expert,” as such term is defined in the rules of the Securities and Exchange Commission. We are currently listed on the OTC Bulletin Board and are therefore not required to have a nominating committee or a compensation committee. We will evaluate establishing such committees in the future. There have been no changes to the procedures by which stockholders may recommend nominees to our board of directors.\nCode of Ethics\nWe currently do not have a formal code of ethics. Upon consummation of a business combination, we intend to adopt a code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller or persons performing similar functions.\nSection 16(a) Beneficial Ownership Reporting Compliance\nSection 16(a) of the Securities Exchange Act requires our directors, executive officers and persons who own more than 10% of our common stock to file reports of ownership and changes in ownership of our common stock with the Securities and Exchange Commission. Directors, executive officers and persons who own more than 10% of our common stock are required by Securities and Exchange Commission regulations to furnish to us copies of all Section 16(a) forms they file.\nBased solely on our review of such forms furnished to us and written representations from certain reporting persons, we believe that all filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with during 2009.\nLegal Proceedings\nJohn Wang, our Chief Executive Officer and President, who had been named a defendant in two lawsuits which were dismissed by the court in a summary judgement for the defendants. John Wang had been named as a defendant along with two other named individuals, SBI-USA, LLC, a U.S. investment firm, and several of SBI-USA’s subsidiaries. The lawsuits alleged several claims, including violation of federal civil RICO statutes, securities fraud, breach of escrow agreement and breach of fiduciary duty. The plaintiffs generally alleged that SBI-USA, through one of the other named defendants, breached the terms of an escrow agreement and distributed shares of common stock held for the benefit of a third party to the detriment of the plaintiffs. The complaints did not specify the damages sought but one suit claimed damages in excess of $1,600,000 and the other includes claims for damages in excess of $400,000. The first lawsuit was filed on June 8, 2007 and the second lawsuit was filed on December 7, 2007. Mr. Wang does not know if any additional lawsuits will be filed. Mr. Wang and the other defendants denied any wrongdoing in connection with the allegations in the complaints. On March 14, 2008, the lawsuits were dismissed by the court in a summary judgment for the defendants. The plaintiffs have filed a notice of their intent to appeal, and to date have requested and received extensions of time from the court to file a formal appeal brief, but have yet to do so.\n17\n\nITEM 11. EXECUTIVE COMPENSATION\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth B. Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\nOther than the fees paid to Hambrecht Eu Capital Management LLC, we do not currently pay any cash fees to our officers and directors, nor do we pay their expenses in attending board meetings.\n\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT\nThe following table sets forth information regarding the beneficial ownership of our ordinary shares as of January 21, 2010 by:\n\n| § | each person known by us to be the beneficial owner of more than 5% of our outstanding ordinary shares; |\n\n\n| § | each of our officers and directors; and |\n\n\n| § | all our officers and directors as a group. |\n\nUnless otherwise indicated, we believe that all persons named in the table have sole voting and investment power with respect to all ordinary shares beneficially owned by them.\n| Number of Ordinary | Approx. Percentage |\n| Shares | of Outstanding |\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\n| John Wang(2) | 270,000 | 5.1 | % |\n| Robert J. Eu(3) | 261,608 | 4.9 | % |\n| Stephen N. Cannon(4) | 173,275 | 3.3 | % |\n| Hao Wu | — | — |\n| Hong Xiang Liu | — | — |\n| William R. Hambrecht(5) | 354,941 | 6.7 | % |\n| W.R. Hambrecht + Co., LLC(6) | 178,275 | 3.4 | % |\n| Shea Ventures LLC(7) | 88,333 | 1.7 | % |\n| Marbella Capital Partners Ltd.(8) | 40,000 | * |\n| AEX Enterprises Limited(9) | 88,333 | 1.7 | % |\n| Hambrecht 1980 Revocable Trust(10) | 88,333 | 1.7 | % |\n| Loeb Arbitrage Management, LLC(11) | 483,872 | 9.13 | % |\n| HBK Investments L.P. (12) | 423,900 | 8.0 | % |\n| Integrated Core Strategies (US) LLC (13) | 520,500 | 9.8 | % |\n| Genesis Capital Advisors LLC. (14) | 367,500 | 6.9 | % |\n\n18\n| Number of Ordinary | Approx. Percentage |\n| Shares | of Outstanding |\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\n| Bulldog Investors (15) | 300,000 | 5.7 | % |\n| Yarika Partners, L.P. (16) | 284,225 | 5.4 | % |\n| All directors and executive officer as a group (4 individuals) | 704,883 | 13.3 | % |\n\n* Less than 1%\n(1). Except as otherwise provided below, the address for each of our beneficial owners is 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong.\n(2). The number of shares beneficially owned includes the ordinary shares held by Marbella Capital Partners.\n(3). Includes ordinary shares held by AEX Enterprises Limited.\n(4). The ordinary shares beneficially owned by Stephen N. Cannon are held by the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\n(5). Consists of ordinary shares held by W.R. Hambrecht + Co., LLC, AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust.\n(6). William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\n(7). Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. Its address is P.O. Box 489, 655 Brea Canyon Rd. Walnut, CA 91788.\n(8). John Wang is the controlling person of Marbella Capital Partners Ltd.\n(9). Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. Its address is Suite 802, 8/F AIA Tower, 183 Electric Road, North Point, Hong Kong.\n(10). William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\n(11). Based on a 13G filed on November 10, 2009. The business address of Loeb Arbirtage Management, LLC is 61 Broadway, 24th Floor, New York, NY 10006. Loeb Arbirtage Management, LLC is a registered investment adviser. Loeb Arbirtage Management, LLC may invest on behalf of itself and clients for which it has investment discretion. Loeb Arbitrage Fund’s general partner is Loeb Arbitrage Management, LLC. Loeb Offshore Fund Ltd.’s registered investment advisor is Loeb Offshore Management, LLC.\n(12). Based on a 13G/A filed on January 28, 2009. The business address of HBK Investments L.P. is 2101 Cedar Springs Road Suite 700, Dallas, TX 75201. HBK Investments L.P. has delegated discretion to vote and dispose of the Securities to HBK Services LLC. HBK Services may, from time to time, delegate discretion to vote and dispose of certain of the securities to HBK New York LLC, a Delaware limited liability company, HBK Virginia LLC, a Delaware limited liability company, and/or HBK Europe Management LLP, a limited liability partnership organized under the laws of the United Kingdom (collectively, the “Subadvisors”). Each of HBK Services and the Subadvisors is under common control with HBK Investments L.P. Jamiel A. Akhtar, Richard L. Booth, David C. Haley, Lawrence H. Lebowitz, and William E. Rose are each managing members of HBK Management LLC.\n19\n(13). Based on a 13G/A filed on January 29, 2009. The business address of Integrated Core Strategies (US) LLC is c/o Millennium Management, LLC 666 Fifth Avenue 8th Floor, New York, NY 10103. Millennium Management LLC, a Delaware limited liability company (“Millennium Management”), is the general partner of the managing member of Integrated Core Strategies and may be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies. Israel A. Englander is the managing member of Millennium Management. Consequently, Mr. Englander may also be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies.\n(14). Based on a 13G/A filed on February 17, 2009. The business address of Genesis Capital Advisors LLC is 255 Huguenot Street, Suite 1103, New Rochelle, NY 10801. Jaime Hartman, Ethan Benovitz and Daniel Saks are the managing members of Genesis. As a result, Messrs. Hartman, Benovitz and Saks may be deemed to have shared voting control and investment discretion over securities deemed to be beneficially owned by Genesis.\n(15). Based on a 13G filed on August 1, 2008. The business address of Bulldog Investors is Park 80 West, Plaza Two, Saddle Brook, NJ 07663. Phillip Goldstein and Andrew Dakos are principals of Bulldog Investors.\n(16). Based on a 13G filed on October 21, 2009. The business address of Yakira Parterns, L.P. is 991 Post Road East Westport, CT 06880. Mr. Bruce M. Kallins is the managing member of Yakira Partners, L.P.\nAll 1,059,825 Founder Shares owned by our Founders have been placed in escrow with Continental Stock Transfer & Trust Company, as escrow agent, pursuant to an escrow agreement.\n\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTORS INDEPENDENCE\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that we redeemed on March 31, 2008 because the IPO underwriters did not exercise their over-allotment option in full) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of 10,193.35 or $0.022 per share.\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\n20\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\n\n| Name | Ordinary Shares | Warrants |\n| John Wang | 230,000 | 0 |\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\n| Robert J. Eu | 173,275 | 0 |\n| AEX Enterprises Limited(3) | 88,333 | 0 |\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\n| AEX Capital, LLC(7) | 0 | 441,666 |\n| Total: | 1,059,824 | 1,550,000 |\n\n\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\n\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\n\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\n\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\n\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\n\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\n\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\n\nPursuant to a registration rights agreement between us and our pre-initial public offering shareholders and warrant holders such shareholders and warrant holders will be entitled to certain registration rights. Specifically, (i) the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of a business combination; and (ii) the ordinary shares will be entitled to certain registration rights one year from the consummation of a business combination. We are only required to use our best efforts to cause a registration statement relating to the resale of such securities to be declared effective and, once effective, only to use our best efforts to maintain the effectiveness of the registration statement. The holders of warrants do not have the rights or privileges of holders of our ordinary shares or any voting rights until such holders exercise their respective warrants and receive ordinary shares. Certain persons and entities that receive any of the above described securities from our founders will, under certain circumstances, be entitled to the registration rights described herein. We will bear the expenses incurred in connection with the filing of any such registration statements. In the event that we breach our obligations under the registration rights agreement, we could be obligated to purchase the securities owned by our pre-initial public offering shareholders for the then fair market value of the securities.\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\nWe will reimburse our officers and directors for any reasonable out-of-pocket business expenses incurred by them in connection with certain activities on our behalf such as identifying and investigating possible target businesses and business combinations. Subject to availability of proceeds not placed in the trust account and the interest income on the balance in the trust account to be released to us from time to time, there is no limit on the amount of out-of-pocket expenses that could be incurred. This formula was a result of a negotiation between us and the underwriters and was meant to help maximize the amount of money in the trust account that would be returned to the investors if we do not consummate a business combination within the permitted time. Our board of directors will review and approve all expense reimbursements made to our directors with the interested director or directors abstaining from such review and approval. To the extent such out-of-pocket expenses exceed the available proceeds not deposited in the trust account, such out-of-pocket expenses would not be reimbursed by us unless we consummate a business combination.\n21\nOther than the $7,500 per month administrative fee and reimbursable out-of-pocket expenses payable to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, no fees of any kind, including finders and consulting fees, will be paid to any of our directors who owned our ordinary shares prior to our IPO, or to any of their respective affiliates for services rendered to us prior to or with respect to the business combination.\nAfter a business combination, any of our directors who remain with us may be paid consulting, management or other fees from the combined company with any and all amounts being fully disclosed to shareholders, to the extent then known, in the proxy solicitation materials furnished to our shareholders. It is unlikely that the amount of such compensation will be known at the time of a shareholder meeting held to consider a business combination, as it will be up to the directors of the post-combination business to determine executive and director compensation. In this event, such compensation will be publicly disclosed at the time of its determination in a Current Report on Form 8-K, as required by the SEC.\nAll ongoing and future transactions between us and any of our directors or their respective affiliates, including loans by our directors, will be on terms believed by us at that time, based upon other similar arrangements known to us, to be no less favorable than are available from unaffiliated third parties. Such transactions or loans, including any forgiveness of loans, will require prior approval in each instance by a majority of our uninterested “independent” directors, to the extent we have independent directors, or the members of our board who do not have an interest in the transaction, in either case who had access, at our expense, to our attorneys or independent legal counsel. It is our intention to obtain estimates from unaffiliated third parties for similar goods or services to ascertain whether such transactions with affiliates are on terms that are no less favorable to us than are otherwise available from such unaffiliated third parties. If a transaction with an affiliated third party were found to be on terms less favorable to us than with an unaffiliated third party, we would not engage in such transaction.\nDirector Independence\nOur Board of Directors has not determined if any of our directors qualifies as independent. Our Board of Directors will make a determination about independence after the business combination is consummated. We do not have an audit committee, nominating committee or compensation committee and therefore the entire Board of Directors performs those functions for us.\n\nITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES\nRothstein Kass & Company, P.C. audited our financial statements for the years ended June 30, 2009; December 31, 2008 and 2007:\nAudit Fees\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2009, including fees associated with the audit of the annual financial statements for the fiscal year ended June 30, 2009 and the reviews of the Company’s quarterly reports on Form 10-Q.\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2008, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2008 and the reviews of the Company’s quarterly reports on Form 10-Q.\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $80,000 in 2007, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2007, the audit of the financial statements as of August 31, 2007, the audit of the Company’s balance sheet at March 18, 2008 included in the Current Report on Form 8-K, and for services performed in connection with the Company’s registration statement on Form S-1 initially filed in 2007.\n22\nAudit-Related Fees\nRothstein Kass & Company, P.C. did not bill any fees for services rendered to us during fiscal years 2009, 2008 and 2007 for Audit-related services in connection with the audit or review of our financial statements.\nTax Fees\nRothstein Kass & Company, P.C. did not bill any fees for tax services, including tax compliance, tax advice, and tax planning, during fiscal years 2009, 2008 and 2007.\nAll Other Fees\nThere were no fees billed by Rothstein Kass & Company, P.C. for other professional services rendered during the fiscal years 2009, 2008 or 2007.\nPre-Approval of Services\nWe do not have an audit committee. As a result, our board of directors performs the duties of an audit committee. Our board of directors evaluates and approves in advance the scope and cost of the engagement of an auditor before the auditor renders the audit and non-audit services. We do not rely on pre-approval policies and procedures.\n23\nPART IV\n\nITEM 15. EXHIBITS\n| (a) | (1) | Financial Statements |\n\nBalance Sheets\nStatement of Operations\nStatement of Shareholders’ Equity\nStatement of Cash Flows\n| (2) | Schedules |\n\nNone.\n| (b) | Exhibits |\n\nThe following Exhibits are filed as part of this report\n| Exhibit No. | Description |\n| 3.1 | Memorandum of Association (1) |\n| 3.2 | Amended and Restated Articles of Association (1) |\n| 4.1 | Specimen Unit Certificate (1) |\n| 4.2 | Specimen Common Share Certificate (1) |\n| 4.3 | Specimen Public Warrant Certificate (1) |\n| 4.4 | Specimen Private Warrant Certificate (1) |\n| 4.5 | Form of Warrant Agreement between Continental Stock Transfer & Trust Company and the Registrant (1) |\n| 4.6 | Form of Unit Purchase Option (1) |\n| 10.1 | Form of Letter Agreement by John Wang (1) |\n| 10.2 | Form of Letter Agreement by Robert J. Eu (1) |\n| 10.3 | Form of Letter Agreement by Stephen N. Cannon (1) |\n| 10.4 | Form of Letter Agreement by Lee S. Ting (1) |\n| 10.5 | Form of Letter Agreement by AEX Enterprises Limited (1) |\n| 10.6 | Form of Letter Agreement by Feng Zhang (1) |\n| 10.7 | Investment Management Trust Agreement between Continental Stock Transfer & Trust Company and the Registrant |\n| 10.8 | Form of Securities Escrow Agreement between the Registrant, Continental Stock Transfer & Trust Company, the founding shareholders and the founders (1) |\n| 10.9 | Form of Services Agreement between the Registrant and Hambrecht Eu Capital Management LLC (1) |\n| 10.10 | Form of Registration Rights Agreement among the Registrant, the founding shareholders and the founders (1) |\n| 10.11 | Revolving Credit Agreement between the Registrant and Robert Eu (1) |\n| 10.12 | Promissory Note between Registrant and Robert Eu (1) |\n| 10.13 | Form of Warrant Purchase Agreement between the Registrant and AEX Enterprises Limited (1) |\n| 10.14 | Form of Right of First Refusal Agreement between the Registrant, Marbella Capital Partners and AEX Enterprises Limited (1) |\n| 31.1 | Certification of the Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\n| 31.2 | Certification of the Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\n| 32.1 | Certification of the Chief Executive Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of the Chief Financial Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n\n(1) Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (File No. 333-146147).\n24\nSIGNATURES\nPursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant had duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| January 22, 2010 | HAMBRECHT ASIA ACQUISITION CORP. |\n| By: | /s/ John Wang |\n| John Wang |\n| Chief Executive Officer, President and Director |\n| (Principal Executive Officer) |\n| January 22, 2010 | By: | /s/ Hao Wu |\n| Hao Wu |\n| Chief Financial Officer, Secretary and Director |\n| (Principal Financial and Accounting Officer) |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.\n| January 22, 2010 | By: | /s/ John Wang |\n| John Wang |\n| Chief Executive Officer, President and |\n| Director (Principal Executive Officer) |\n| January 22, 2010 | By: | /s/ Robert J. Eu |\n| Robert J. Eu |\n| Chairman of Board |\n| January 22, 2010 | By: | /s/ Hao Wu |\n| Hao Wu |\n| Chief Financial Officer, Secretary and Director |\n| (Principal Financial and Accounting Officer) |\n| January 22, 2010 | By: | /s/ Hong Xiang Liu |\n| Hong Xiang Liu |\n| Director |\n\n25\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nINDEX TO FINANCIAL STATEMENTS\n| Page |\n| Report of Independent Registered Public Accounting Firm | F-2 |\n| Financial Statements: |\n| Balance Sheets | F-3 |\n| Statements of Operations | F-4 |\n| Statements of Shareholders’ Equity | F-5 |\n| Statements of Cash Flows | F-6 |\n| Notes to Financial Statements | F-7 |\n\nF-1\nReport of Independent Registered Public Accounting Firm\nTo the Board of Directors and Stockholders of\nHambrecht Asia Acquisition Corporation\nWe have audited the accompanying balance sheets of Hambrecht Asia Acquisition Corporation (a corporation in the development stage) (the “Company”) as of June 30, 2009 and December 31, 2008 and 2007, and the related statements of operations and cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of June 30, 2009 and December 31, 2008, and the results of its operations and its cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009, in conformity with U.S. generally accepted accounting principles.\nThe accompanying financial statements have been prepared assuming that Hambrecht Asia Acquisition Corporation will continue as a going concern. As discussed in Note 7 to the financial statements, Hambrecht Asia Acquisition Corporation will face a mandatory liquidation if a business combination is not consummated by March 12, 2010, which raises substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\nRoseland, New Jersey\nJanuary 22, 2010\n/s/ Rothstein Kass & Company, P.C.\nF-2\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nBalance Sheets\n| June 30,2009 | December 31, 2008 | December 31, 2007 |\n| ASSETS |\n| Current assets |\n| Cash | $ | 30,271 | $ | 100,312 | $ | 101,671 |\n| Prepaid expenses | 95,686 | 108,330 | 183,254 |\n| Total current assets | 125,957 | 208,642 | 284,925 |\n| Other asset | — |\n| Investments held in the trust account | 33,838,155 | 33,798,651 |\n| Total assets | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\n| LIABILITIES AND SHAREHOLDERS’ EQUITY |\n| Current liabilities |\n| Accrued expenses | $ | 76,275 | $ | 31,780 | $ | — |\n| Note payable, shareholder | 281,661 |\n| — |\n| Total current liabilities | 76,275 | 31,780 | 281,661 |\n| Long-term liabilities |\n| Deferred underwriting fees, net of $356,101 subject to forfeiture in the event of possible redemption | 830,903 | 830,903 | — |\n| Ordinary shares, subject to possible redemption, (1,271,788 shares at redemption value of $7.92 per share) | 10,072,561 | 10,072,561 | — |\n| Shareholders’ equity |\n| Ordinary shares, $.001 par value, 50,000,000 shares authorized; 5,299,125, 5,299,125 and 1,150,000 shares issued and outstanding as of June 30, 2009, December 31, 2008 and December 31, 2007 (which includes 1,271,788, 1,271,788 shares and 0 shares respectively subject to possible redemption) | 5,299 | 5,299 | 1,150 |\n| Additional paid-in capital | 22,851,981 | 22,851,981 | 23,850 |\n| Earnings (deficit) accumulated during the development stage | 127,093 | 214,769 | (21,736 | ) |\n| Total shareholders’ equity | 22,984,373 | 23,072,049 | 3,264 |\n| Total liabilities and shareholders’ equity | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\n\nSee accompanying notes to financial statements.\nF-3\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Operations\n\n| For the Period Ended June 30, 2009 (six months) | For the Period Ended June 30, 2008 (six months) (unaudited) | Period from July 18,2007 (inception) to June 30,2009 | For the Year ended December 31,2008 | Period from July 18, 2007 to December 31,2007 |\n| Revenues | $ | — | $ | — | $ | — | $ | — | $ | — |\n| Formation and administrative costs | 184,870 | 156,683 | 473,993 | 267,387 | 21,736 |\n| Loss from operations | (184,870 | ) | (156,683 | ) | (473,993 | ) | (267,387 | ) | (21,736 | ) |\n| Interest income, net | 97,193 | 168,133 | 601,085 | 503,892 | — |\n| Net income (loss) | (87,677 | ) | 11,449 | 127,093 | 236,505 | (21,736 | ) |\n| Weighted average number of ordinary shares subject to possible redemption, basic and diluted | 1,271,788 | 808,223 | 793,378 | 1,037,742 | — |\n| Income (loss) per ordinary share subject to possible redemption, basic and diluted | $ | (0.07 | ) | $ | 0.01 | $ | 0.16 | $ | — | $ | — |\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption) , basic | 4,027,337 | 3,789,581 | 3,085,775 | 3,503,402 | 1,150,000 |\n| Income (loss) per ordinary share not subject to possible redemption, basic | $ | (0.02 | ) | $ | 0.00 | $ | 0.04 | $ | 0.07 | $ | (0.02 | ) |\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption), diluted | 4,027,337 | 5,164,193 | 4,267,656 | 5,213,337 | 1,150,000 |\n| Income (loss) per ordinary share not subject to possible redemption, diluted | $ | (0.02 | ) | $ | 0.00 | $ | 0.03 | $ | 0.05 | $ | (0.02 | ) |\n\nSee accompanying notes to financial statements.\nF-4\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Shareholders’ Equity\nFor the Period July 18, 2007 (date of inception) to June 30, 2009\n| Ordinary Shares | Earnings |\n| Shares | Amount | Additional Paid-in Capital | (Deficit) Accumulated During the Development Stage | TotalShareholders’ Equity |\n| Balances at July 18, 2007 | — | $ | — | $ | — | $ | — | $ | — |\n| Sale of units issued to founders on July 18, 2007 at approximately $0.02 per share | 1,150,000 | 1,150 | 23,850 | 25,000 |\n| Net loss | (21,736 | ) | (21,736 | ) |\n| Balances at December 31, 2007 | 1,150,000 | $ | 1,150 | $ | 23,850 | $ | (21,736 | ) | $ | 3,264 |\n| Proceeds from sale of warrants in a private placement to initial shareholders | 1,550,000 | 1,550,000 |\n| Sale of 4,000,000 units at $8.00 per unit in the public offering, net of underwriters’ discount and offering expenses (1,199,999 shares subject to possible redemption) | 4,000,000 | 4,000 | 29,550,348 | 29,554,348 |\n| Sale of 239,300 units at $8.00 per unit in the public offering from partial exercise of underwriters’ overallotment option, net of underwriters’ discount and offering expenses (71,789 shares subject to possible redemption) | 239,300 | 239 | 1,800,344 | 1,800,583 |\n| Forfeiture of founders shares from partial exercise of underwriters’ overallotment option | (90,175 | ) | (90 | ) | (90 | ) |\n| Proceeds subject to possible redemption of 1,271,788 shares at a redemption value of $7.92 per share | (10,072,561 | ) | (10,072,561 | ) |\n| Net income | 236,505 | 236,505 |\n| Balances at December 31, 2008 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 214,769 | $ | 23,072,049 |\n| Net loss | (87,677 | ) | (87,677 | ) |\n| Balances at June 30, 2009 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 127,093 | $ | 22,984,373 |\n\nSee accompanying notes to financial statements.\nF-5\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nStatements of Cash Flows\n| For the PeriodEnded June 30,2009 (sixmonths) | For the PeriodEnded June 30,2008 (sixmonths) (unaudited) | Period from July18,2007(inception) toJune 30,2009 | For the Yearended December31,2008 | Period from July18, 2007 toDecember31,2007 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | (87,677 | ) | $ | 11,449 | $ | 127,093 | $ | 236,505 | $ | (21,736 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\n| Change in operating assets and liabilities: |\n| Accrued expenses | 44,494 | 94,063 | 76,275 | 31,780 |\n| Prepaid expenses and other current asset | 12,644 | 49,922 | (95,686 | ) | (108,330 | ) |\n| Net cash provided by (used in) operating activities | (30,538 | ) | 155,434 | 107,682 | 159,955 | (21,736 | ) |\n| Cash used in investing activities: |\n| Proceeds from the public offering deposited in trust account | — | (33,527,400 | ) | (33,527,400 | ) | (33,527,400 | ) | — |\n| Interest income re-invested in trust account | (85,836 | ) | (173,102 | ) | (510,361 | ) | (510,361 | ) | — |\n| Redemption from the trust account | 46,332 | 65,709 | 285,442 | 239,110 | — |\n| Net cash used in investing activities | (39,504 | ) | (33,634,793 | ) | (33,838,155 | ) | (33,798,651 | ) | — |\n| Cash flows from financing activities: |\n| Proceeds from sale of ordinary shares to founders | — | — | 25,000 | — | 25,000 |\n| Proceeds from shareholder’s note payable | $ | — | $ | — | $ | 281,661 | $ | — | $ | 281,661 |\n| Proceeds from warrants purchased in private placement | — | 1,550,000 | 1,550,000 | 1,550,000 | — |\n| Proceeds from initial public offering | $ | — | $ | 32,000,000 | $ | 32,000,000 | $ | 32,000,000 | $ | — |\n| Proceeds from exercise of underwriters overallotment option | — | 1,914,400 | 1,914,400 | 1,914,400 | — |\n| Repayment of shareholder’s note payable | — | — | (281,661 | ) | (281,661 | ) | — |\n| Payment of underwriters’ fee and offering cost of initial public offering | — | (1,728,656 | ) | (1,728,656 | ) | (1,545,402 | ) | (183,254 | ) |\n| Net cash provided by financing activities | — | 33,454,083 | 33,760,744 | 33,637,337 | 123,407 |\n| Net increase (decrease) in cash | (70,042 | ) | (25,276 | ) | 30,271 | (1,359 | ) | 101,671 |\n| Cash at beginning of the period | 100,312 | 101,671 | — | 101,671 | — |\n| Cash at end of the period | $ | 30,271 | $ | 76,395 | $ | 30,271 | $ | 100,312 | $ | 101,671 |\n| Supplemental schedule of non-cash financing activities: |\n| Deferred underwriting fees, net | $ | — | $ | 830,903 | $ | 830,903 | $ | 830,903 | $ | — |\n| Ordinary shares subject to possible redemption | $ | — | $ | 10,072,561 | $ | 10,072,561 | $ | 10,072,561 | $ | — |\n\nSee accompanying notes to financial statements.\nF-6\nHambrecht Asia Acquisition Corp.\n(a corporation in the development stage)\nNotes to Financial Statements\nNOTE 1—ORGANIZATION AND BUSINESS OPERATIONS\nHambrecht Asia Acquisition Corp. (a corporation in the development stage) (the “Company”) was incorporated in the Cayman Islands on July 18, 2007 with an authorized share capital of 50,000,000 ordinary shares (par value $0.001 per share). The Company’s founders contributed $25,000 to the formation of the Company and were issued 1,150,000 ordinary shares. The Company was formed to acquire, through a stock exchange, asset acquisition or other similar business combination, one or more operating businesses having its primary operations located in the People’s Republic of China (“Business Combination”). The Company is considered to be in the development stage as defined in “Accounting and Reporting By Development Stage Enterprises”, and is subject to the risks associated with activities of development stage companies. The Company’s operations, if a Business Combination is consummated outside the United States, will be subject to local government regulations and to the uncertainties of the economic and political conditions of those areas.\nOn December 9, 2009 the Board of Directors of Hambrecht Asia Acquisition Corp. (the \"Company\") authorized a change in the Company's fiscal year end to June 30 from December 31. The Company reports its financial results for the six month transition period of December 31, 2008 through June 30, 2009 on a Transition Report on Form 10-K. After filing the Transition Report, the Company’s next fiscal year end will be June 30, 2010.\nAs of June 30, 2009, the Company had not commenced any operations or generated any revenues. All activity from the period July 18, 2007 (date of inception) through March 31, 2008 relates to the Company’s formation and its initial public offering as described below. Subsequent to that date to the present the Company has sought a target business to acquire. The Company will not generate any operating revenue until after the completion of the Business combination, at the earliest. The Company currently generates non-operating income from interest income earned on the investments held in a trust account (the “Trust Account”), from the proceeds derived from the public offering.\nThe registration statement for the Company’s initial public offering (the “Offering”) described in Note 3 was declared effective on March 7, 2008. The Company consummated the Offering on March 12, 2008 and immediately prior to such Offering, sold an aggregate of 1,550,000 warrants at $1.00 per warrant to certain officers and affiliates of the Company in a private placement (the “Private Placement”) described in Note 4. On March 31 2008, the underwriters of the Offering exercised their over-allotment option for a total of an additional 239,300 units. The net proceeds of the Offering and the Private Placement are intended to be generally applied toward consummating a business combination with one or more operating businesses having their primary operations in the People’s Republic of China (“Business Combination”). Net proceeds of $33,537,396 from the Offering, including the exercise of the underwriters’ over-allotment option, and the Private Placement are held in a Trust Account and will only be released to the Company upon the earlier of: (i) the consummation of a business combination; or (ii) the Company’s liquidation, except to satisfy shareholder conversion rights. The Trust Account includes the deferred underwriting discount from the Offering of up to $1,187,004 which will be paid to the underwriters upon consummation of a business combination, as described in Note 6. Additionally, up to an aggregate of $700,000, plus up to an additional $350,000 during the Extended Period (as described below) if approved by shareholders, of interest earned on the Trust Account balance (net of any taxes paid or payable) may be released to the Company to fund operating activities. Through June 30, 2009, approximately $286,000 of interest earned on the Trust Account balance has been released to the Company.\nOn September 4, 2009, the Company issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. The Company, after signing a definitive agreement for the acquisition of a target business, is required to submit such transaction for shareholder approval. In the event that shareholders owning 30% or more of the shares sold in the Offering vote against the business combination and exercise their conversion rights described below, the business combination will not be consummated. All of the Company’s shareholders prior to the Offering, have agreed to vote their pre-initial public offering ordinary shares in accordance with the vote of the majority of the shares voted by all shareholders of the Company who purchased their shares in the Offering or the aftermarket (“Public Shareholders”) with respect to any business combination. After consummation of a business combination, these voting safeguards will no longer be applicable.\nF-7\nIn the event that the Company does not complete a business combination by March 12, 2010, or March 12, 2011 if extension is approved by the shareholders, the Company will be dissolved and the proceeds held in the Trust Account, plus certain interest, less certain costs, will be distributed to the Company’s public shareholders. If the Company receives Public Shareholder approval for the Extended Period and holders of 30% or more of the shares held by Public Shareholders do not vote against the Extended Period and elect to convert their ordinary shares in connection with the vote for the Extended Period, the Company will then have an additional 12 months in which to complete the initial business combination. If the Extended Period is approved, the Company will still be required to seek Public Shareholder approval before completing a business combination. In the event there is no business combination within the 24-month deadline (assuming the Extended Period is not approved) described above, the Company will dissolve and distribute to its Public Shareholders, in proportion to their respective equity interests, the amount held in the Trust Account, and any remaining net assets, after the distribution of the Trust Account. The Company’s corporate existence will automatically cease at the end of the 36-month period if the Company has not received shareholder approval for an initial business combination. In the event of liquidation, the per share value of the residual assets remaining available for distribution (including Trust Account assets) may be less than the initial public offering price per share in the Offering.\nWith respect to a business combination which is approved and consummated or a vote on the Extended Period which is approved, any Public Shareholders who voted against the business combination or Extended Period may contemporaneously with or prior to such vote exercise their conversion right and their ordinary shares would be cancelled and returned to the status of authorized but unissued shares. The per share conversion price will equal the amount in the Trust Account (including interest therein), calculated as of two business days prior to the consummation of the proposed business combination or vote on Extended Period, divided by the number of common shares sold in the Offering and partial exercise of the over-allotment option.\nA Public Shareholder’s election to convert ordinary shares in connection with the vote on the Extended Period will only be honored if the Extended Period is approved. Public Shareholders who vote their shares against the Extended Period and exercise their conversion rights, will not be able to vote these shares with respect to the initial business combination. All other Public Shareholders will be able to vote on the initial business combination.\nNOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation:\nThe accompanying financial statements are presented in U.S. dollars and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and pursuant to the accounting and disclosure rules and regulations of the Securities and Exchange Commission (the ‘SEC”). In the opinion of management, the accompanying financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the Company’s financial statements.\nInvestments held in the Trust Account:\nThe amounts held in the Trust Account as of June 30, 2009 represent substantially all of the proceeds of the Offering plus partial exercise of the underwriters’ over-allotment option, the private placement and interest earned on the trust to date, and are classified as restricted assets since such amounts can only be used by the Company in connection with the consummation of a Business Combination. The funds held in the Trust Account are invested in a money market fund that invests in US and state government and government agency debt securities.\nF-8\nFair value of financial instruments:\nThe Company does not enter into financial instruments for trading or speculative purposes. The carrying amounts of financial instruments classified as current assets and current liabilities as disclosed in the accompanying balance sheets, approximate their fair value due to their short maturities.\nUse of estimates:\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nIncome taxes:\nUnder current Cayman Islands laws, the Company is not subject to income taxes or capital gains, and there is no Cayman Islands withholding tax imposed upon payments of dividends by the Company to its shareholders. In the future, the Company’s tax rate will be impacted by acquisitions of non-Cayman subsidiaries governed by the respective local income tax laws. Accordingly, no provision for income taxes has been made in the accompanying statements of operations.\nEffective January 1, 2007, the Company adopted the provisions of “Accounting for Uncertainty in Income Taxes”. There were no unrecognized tax benefits as of June 30, 2009. The provision prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties at June 30, 2009. Management is currently unaware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nOrdinary shares subject to possible redemption:\nAs discussed in Note 1, the Company will only proceed with a Business Combination if: (1) it is approved by a majority of the votes cast by the Company’s public shareholders; and (2) public shareholders holding less than 30% (1,271,788) of the ordinary shares sold in the Offering and partial exercise of the over-allotment option, choose to exercise their redemption rights thereby receiving their per share interest in the Trust Account. In accordance with FASB’s Emerging Issues Task Force (EITF) Topic No. D-98, “Classification and Measurement of Redeemable Securities”, the Company has classified 1,271,788 shares of its ordinary shares outside of permanent equity as “Ordinary shares subject to redemption,” at a redemption price of $7.92 per share as of June 30, 2009 . The Company will recognize changes in the conversion value as they occur and will adjust the carrying value of the ordinary shares subject to conversion to be equal to its conversion value at the end of each reporting period.\nIncome (loss) per ordinary share:\nBasic income per common share is computed by dividing net income by the weighted average common shares outstanding for the period. Diluted income per common share reflects the potential dilution that could occur if warrants were to be exercised or converted or otherwise resulted in the issuance of ordinary shares that then shared in the earnings of the entity.\nFor the period ended (six months) June 30, 2009, and for the period from July 18, 2007 (inception) to June 30, 2009, the Company had potentially dilutive securities in the form of 7,129,125 warrants, and 5,299,125 warrants issued as part of the Units (as defined below) in the Offering. Of the total warrants outstanding for the periods then ended, approximately 2,328,422 and 1,181,881, respectively, represent incremental shares of ordinary share, based on their assumed redemption, to be included in the weighted average number of shares of ordinary share outstanding (not subject to possible redemption) for the calculation of diluted income per ordinary share. The Company uses the “treasury stock method” to calculate potential dilutive shares, as if they were redeemed for ordinary share at the beginning of the period.\nF-9\nThe Company’s statements of operations includes a presentation of income per ordinary share subject to possible redemption in a manner similar to the two-class method of income per share. Basic and diluted income amount for the maximum number of shares subject to possible redemption is calculated by dividing the net interest attributable to common shares subject to redemption by the weighted average number of shares subject to possible redemption. Basic and diluted net income (loss) per share amount for the shares outstanding not subject to possible redemption is calculated by dividing the net income (loss) exclusive of the net interest income attributable to ordinary share subject to redemption by the weighted average number of shares not subject to possible redemption.\nNewly Adopted Accounting Pronouncements:\nIn December 2007, the FASB issued “Business Combinations”, which requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors, and other users, all of the information they need to evaluate and understand the nature and financial effect of the business combination. “Business Combinations” will be effective for acquisitions with a date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We will apply “Business Combinations” for any of our applicable acquisitions beginning January 1, 2009.\nIn December 2007, the FASB issued “Noncontrolling Interests in Consolidated Financial Statements”, which requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity; the inclusion of the amount of net income attributable to the noncontrolling interest in consolidated income on the face of the income statement; and a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. This guidance will be effective for the fiscal years beginning on or after December 15, 2008. We will apply to any applicable transactions beginning January 1, 2009.\nIn March 2008, the FASB issued “Disclosures about Derivative Instruments and Hedging Activities”, which is intended to improve financial standards for derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. Entities are required to provide enhanced disclosures about: (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years beginning after November 15, 2008, with early adoption encouraged. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial position; however, it could impact future transactions entered into by the Company.\nOn April 9, 2009, the FASB issued the guidance of “Interim Disclosures about Fair Value of Financial Instruments” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. The guidance also amends Accounting Principles Board Opinion-Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. The guidance shall be effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this if certain requirements are met. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\nF-10\nOn April 9, 2009, the FASB issued the guidance of “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, to affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction; clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active; eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The guidance instead requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence. In addition, this guidance requires an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of it and to quantify its effects, if practicable. This guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 if certain requirements are met. It must be applied prospectively and retrospective application is not permitted. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\nOn April 9, 2009, the FASB issued “Recognition and Presentation of Other-Than-Temporary Impairments”, to be intended to bring consistency to the timing of impairment recognition, and provide improved disclosures about the credit and noncredit components of impaired debt securities that are not expected to be sold. The measure of impairment in comprehensive income remains fair value. The guidance also requires increased and more timely disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. This guidance shall be effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Earlier adoption for periods ending before March 15, 2009, is not permitted. If an entity elects to adopt early either “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, or “Interim Disclosures about Fair Value of Financial Instruments”, the entity also is required to adopt early this guidance. Additionally, if an entity elects to adopt early , it is required to adopt “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption did not have a significant impact on the Company’s financial statement or footnotes.\nOn May 28, 2009, the FASB issued the guidance regarding subsequent events, which we adopted on a prospective basis beginning April 1, 2009. The guidance is intended to establish general standards of accounting and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for selecting that date. The application of the pronouncement did not have an impact on our financial position, results of operations or cash flows. These financial statements were approved by management and were issued on January 22, 2010. Subsequent events have been evaluated through this date.\nRecently Issued Accounting Pronouncements\nIn June 2009, the Financial Accounting Standards Board issued the statement of “Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles This statement confirmed that the FASB Accounting Standards Codification (the “Codification”) will become the single official source of authoritative U.S. GAAP (other than guidance issued by the SEC), superseding existing FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force (“EITF”), and related literature. After that date, only one level of authoritative U.S. GAAP will exist. All other literature will be considered non-authoritative. The Codification does not change U.S. GAAP; instead, it introduces a new structure that is organized in an easily accessible, user-friendly online research system. The Codification, which changes the referencing of financial standards, becomes effective for interim and annual periods ending on or after September 15, 2009.. The Company has adopted this standard and did not have any substantive impact on our financial statements or related footnotes.\nManagement does not believe that any other recently issued, but no yet effective accounting standards, if currently adopted, would have a material effect on the accompanying financial statements.\nNOTE 3—PUBLIC OFFERING\nOn March 7, 2008, the Company sold 4,000,000 units in the Offering at a price of $8.00 per unit. On March 31, 2008, the Company consummated the closing of an additional 239,300 units which were subject to the over-allotment option. Each unit consists of one share of the Company’s ordinary shares, $0.001 par value, and one warrant. Each warrant will entitle the holder to purchase from the Company one of the Company’s ordinary shares at an exercise price of $5.00 per share commencing on the later of: (i) The consummation of the Business Combination, or (ii) March 7, 2009. The warrants will be exercisable only if the Company continues to provide for an effective registration statement covering the ordinary shares issueable upon exercise of the warrants. In no event will the holder of a warrant be entitled to receive a net cash settlement or other consideration in lieu of physical settlement in shares of the Company’s ordinary shares.\nF-11\nThe warrants expire on March 7, 2013, unless earlier redeemed. The warrants included in the units sold in the Offering are redeemable, at the Company’s option, in whole and not in part at a price of $0.01 per warrant upon a minimum of 30 days’ notice after the warrants become exercisable, only in the event that the last sale price of the ordinary shares exceeds $11.50 per share for any 20 trading days within a 30-trading day period.\nThe purchased warrants are recognized in additional paid-in-capital within shareholders’ equity since, under the terms of the warrants, the Company cannot be required to settle or redeem them for cash.\nNOTE 4—RELATED PARTY TRANSACTIONS\nThe Company has agreed to pay Hambrecht-Eu Capital, a company owned and managed by the Company’s Chairman of the Board, Chief Financial Officer and Secretary, $7,500 per month for office space and general and administrative services including secretarial support commencing on November 15, 2007 and continuing (i) until the consummation by the Company of a business combination (as described in Note 1), (ii) 18 months from commencement of the Offering if the Company does not effect a Business Combination, (iii) 24 months from the consummation of the Offering if a letter of intent, agreement in principle or definitive agreement, has been executed within 18 months of commencement of the Offering and the Company has not effected a business combination, or (iv) 36 months from the consummation of the Offering if an extension has been approved by the Company’s shareholders under certain circumstances.\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of the Company’s founders and the Company’s Chairman, Chief Financial Officer and Secretary and William R. Hambrecht, Robert Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, purchased an aggregate of 1,550,000 warrants at a price of $1.00 per warrant ($1,550,000 in the aggregate) in a private placement immediately prior to the initial public offering (“private placement warrants”). Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds from the sale of the private placement warrants were added to the proceeds from the Offering and are held in the Trust Account pending the Company’s consummation of a Business Combination. If the Company does not complete a Business Combination that meets the criteria described in the Offering, then the $1,550,000 purchase price of the private placement warrants will become part of any liquidating distribution to the Company’s public shareholders following the Company’s liquidation and dissolution and the private placement warrants will expire worthless.\nThe private placement warrants will be non-redeemable so long as they are held by the original holders of the warrants, the pre-initial public offering shareholders and directors or their permitted transferees. In addition, pursuant to the registration rights agreement, the holders of the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of the initial business combination and the warrants may be exercised on a cashless basis if held by the original holder, the pre-initial public offering shareholder and director or their permitted transferees. With those exceptions, the private placement warrants have terms and provisions that are otherwise identical to those of the warrants sold as part of the units in the Offering.\nThe sale of private placement warrants did not result in the recognition of stock-based compensation expense because the private placement warrants were sold at or above fair market value.\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC, the Hambrecht 1980 Revocable Trust, Shea Ventures LLC and Marbella Capital Partners Ltd. have agreed, subject to certain exceptions, not to transfer, assign or sell any of its private placement warrants until after the Company consummates a Business Combination. However, prior to the consummation of a business combination, the original holders of the warrants will be permitted to transfer their private placement warrants in certain limited circumstances, such as to the Company’s officers and directors, and other persons or entities associated with such persons, but the transferees receiving such private placement warrants will be subject to the same sale restrictions imposed on such entity.\nF-12\nRobert Eu, one of the Company’s founders, had provided to the Company advances totaling approximately $282,000 to pay a portion of the expenses of the Offering for the SEC registration fee, FINRA registration fee, and accounting and legal fees and expenses. The note was payable on demand with interest at 4% per annum. The note, plus interest of approximately $5,000, was repaid out of the proceeds of the Offering on March 12, 2008.\nNOTE 5—FAIR VALUE MEASUREMENTS\nThe Company complies with Fair Value Measurements, for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\nThe following tables present information about the Company’s assets that are measured at fair value on a recurring basis as of June 30, 2009 and December 31, 2008, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are observable such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and includes situations where there is little, if any, market activity for the asset or liability:\nFair Value of Financial Assets as of June 30, 2009\n| Description | June 30, 2009 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Assets: |\n| Cash equivalents | $ | 30,271 | $ | 30,271 | $ | — | $ | — |\n| Cash equivalents held in Trust Account | 33,838,155 | 33,838,155 | — | — |\n| Total | $ | 33,868,426 | $ | 33,868,426 | $ | — | $ | — |\n\nFair Value of Financial Assets as of December 31, 2008\n| Description | December 31, 2008 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Assets: |\n| Cash equivalents | $ | 100,312 | $ | 100,312 | $ | — | $ | — |\n| Cash equivalents held in Trust Account | 33,798,651 | 33,798,651 | — | — |\n| Total | $ | 33,898,963 | $ | 33,898,963 | $ | — | $ | — |\n\nF-13\nThe fair values of the Company’s cash equivalents and cash and cash equivalents held on the Trust Account are determined through market, observable and corroborated sources.\nNOTE 6— COMMITMENTS AND UNDERWRITERS’ COMPENSATION\nThe Company consummated the Offering on March 12, 2008 and paid to the underwriters a $1,120,000 underwriting fee, representing 3.5% of the gross proceeds, and is committed to pay up to an additional $1,120,000, currently held in the Trust Account, representing an additional deferred underwriting fee of 3.5%, payable upon the Company’s consummation of a Business Combination.\nOn March 31, 2008, the underwriters exercised their over-allotment option and purchased from the Company an additional 239,300 units. The Company paid to the underwriters a $67,004 underwriting discount, representing 3.5% of the over-allotment gross proceeds, and is committed to pay up to an additional $67,004, currently held in the Trust Account, representing an additional deferred underwriting discount of 3.5%, payable upon the Company’s consummation of a Business Combination.\nThe Company also issued and sold to the underwriters on the closing date an option, as an additional compensation to purchase up to an aggregate of 280,000 units for an aggregate purchase price of $100. The Option shall be exercisable, in whole or in part, commencing on the later of the consummation of a Business Combination or six months from March 7, 2008 and expiring on March 7, 2013 at an initial exercise price of $10.00 per Unit.\nThe Company has determined based upon a Black-Scholes- Merton option pricing model, that the estimated fair value of the option on the date of sale would be approximately $3.36 per unit or an aggregate of approximately $941,000, assuming an expected term of five years, estimated volatility of 51.51% and a risk-free interest rate of 3.38%. Given the parameters used in the computation of the value of the option change over time, the actual fair value of the option on the date of sale is expected to be different from the estimated fair value computed above.\nThe volatility calculation of 51.51% is based on the latest five year average prior to the Offering, volatility of 62 companies drawn from the Shanghai Stock Exchange Composite Index that had market capitalizations between $70 million and $150 million. Because the Company does not have a trading history, the Company estimated the potential volatility of its ordinary share price, which will depend on a number of factors which cannot be ascertained at this time. The Company used the annualized volatility of the historical volatilities for a period of time equal in length to the term of the option because the Company believes that the volatility of these companies is a reasonable benchmark to use in estimating the expected volatility for the Company’s ordinary share post-Business Combination. Although an expected life of five years was taken into account for purposes of assigning value to this option, if the Company does not consummate a Business Combination within the prescribed time period and liquidates, this option would become worthless.\nPursuant to Rule 2710(g)(1) of FINRA Conduct Rule, the option to purchase 280,000 units is deemed to be underwriting compensation and therefore upon exercise, the underlying ordinary shares and warrants are subject to a 180-day lock-up. Additionally, the option may not be sold, transferred, assigned, pledged or hypothecated for a one-year period (including the foregoing 180-day period) following the date of the Offering.\nNOTE 7 — GOING CONCERN\nOn September 4, 2009, the Company has issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010.\nF-14\nThe consummation of the business combination is subject to, among other things, execution of a definitive agreement and required stockholder approval. There can be no assurance that a business combination will be consummated. However, if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. If we are unable to complete the business combination by March 12, 2010, or March 12, 2011 if extension period approved, our purposes and powers will be limited to dissolving, liquidating and winding up. Also contained in our articles of association is the requirement that our board of directors, to the fullest extent permitted by law, consider a resolution to dissolve our company at that time. Consistent with such obligations, our board of directors will seek shareholder approval for any such plan of distribution, and our pre-initial public offering shareholders and directors have agreed to vote in favor of such dissolution and liquidation. This provision will be amended only in connection with, and upon consummation of, its initial business combination by such date. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern and is required to liquidate.\nF-15\n\n</text>\n\nWhat is the total capital generated by the company through various activities from July 18, 2007 to June 30, 2009, excluding net income and assuming the interest income re-invested in the trust account was paid out to increase capital instead of being reinvested, in USD?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nITEM 1. BUSINESS\\nOverview\\nHambrecht Asia Acquisition Corp. (“we”, “us”, “our” or the “Company”) is a Cayman Islands blank check company formed on July 18, 2007 to complete a business combination with one or more operating businesses that have its or their primary operations in the PRC. Our efforts in identifying a prospective target business will not be limited to a particular industry. We intend to effect a business combination using cash from the proceeds of our initial public offering and the private placements of the sponsors’ warrants, our capital stock, debt or a combination of cash, stock and debt. On March 7, 2008, we completed a private placement of 1,550,000 warrants (“Founder Warrants”). On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (together the “IPO”). Each unit consists of one share of common stock and one redeemable common stock purchase warrant, resulting in a total of 4,239,300 common shares (“IPO Shares”) and 4,239,300 warrants (“IPO Warrants”) which are publicly held. The units were sold at an offering price of $8.00 per unit and the Founder Warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter.\\nThe net proceeds from the IPO and private placement, after deducting certain offering expenses of approximately $2,784,873 (including underwriting discounts of approximately $2,374,008), were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per IPO Share) of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not placed in the trust account. We will not be able to access the amounts held in the trust account until we consummate a business combination, except for up to $700,000 (plus up to an additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest earned on the funds in the trust account, which may be released from the trust to us to be used for working capital. As of June 30, 2009, there was approximately $33,799,000 held in the trust account (or approximately $7.92 per IPO Share), and approximtely $286,000 of interest eanred on the trust account balance had been released to us for working capital purposes.\\nInvestment Opportunities in China\\nOpportunities for market expansion have emerged for businesses with operations in China due to certain changes in the PRC’s political, economic and social policies as well as certain fundamental changes affecting the PRC and his neighboring countries. We believe that China represents both a favorable environment for making acquisitions and an attractive operating environment for a target business for several reasons, including:\\n\\n| § | prolonged economic expansion within China, including gross domestic product growth of approximately 16.5% on average over the last 25 years, including 17.7% in 2004, 15.0% in 2005 and 14.7% in 2006 (National Bureau of Statistics of China) (China Statistical Yearbook – 2007, http://www.stats.gov.cn/tjsj/ndsj/2007/indexeh.htm, viewed February 24, 2009); |\\n\\n\\n| § | increased government focus within China on privatizing assets, improving foreign trade and encouraging business and economic activity; |\\n\\n\\n| § | the recent entry of China into the World Trade Organization, the sole global international organization dealing with the rules of trade between nations, which may lead to a reduction on tariffs for industrial products, a reduction in trade restrictions and an increase in trading with the United States. |\\n\\nWe believe that these factors and others should enable us to acquire a target business with growth potential on favorable terms.\\n3\\nEffecting a Business Combination\\nWe intend to utilize the cash proceeds of the IPO and the private placement, our capital securities, debt or a combination of these as the consideration to be paid in a business combination. While substantially all of the net proceeds of the IPO are allocated to completing a business combination, the proceeds are not otherwise designated for more specific purposes. If the business combination is paid for using equity or debt securities, we may apply the cash released to us from the trust account for general corporate purposes, including for maintenance or expansion of operations of the acquired business or businesses, the payment of principal or interest due on indebtedness incurred in consummating our initial business combination, to fund the purchase of other companies, or for working capital. We may engage in a business combination with a company that does not require significant additional capital but is seeking a public trading market for its shares and that wants to merge with an already public company to add the experience of the public company’s management team to its company and to avoid the risk that market conditions will not be favorable for an initial public offering at the time this offering is ready to be sold, despite the fact that merging with us would require similar disclosures and, potentially, a similar timeframe as an initial public offering. We may seek to effect a business combination with more than one target business, although our limited resources may serve as a practical limitation on our ability to do so.\\nPrior to consummation of a business combination, we will seek to have all vendors, prospective target businesses or other entities that we may engage, which we refer to as potential contracted parties or a potential contracted party, execute agreements with us waiving any right, title, interest or claim of any kind in or to any monies held in the trust account for the benefit of our public shareholders. There is no assurance that we will be able to get waivers from our vendors and there is no assurance that such waivers will be enforceable by operation of law or that creditors would be prevented from bringing claims against the trust. In the event that a potential contracted party were to refuse to execute such a waiver, we will execute an agreement with that entity only if our management first determines that we would be unable to obtain, on a reasonable basis, substantially similar services or opportunities from another entity willing to execute such a waiver. Examples of instances where we may engage a third party that refused to execute a waiver would be the engagement of a third party consultant whose particular expertise or skills are believed by management to be superior to those of other consultants that would agree to execute a waiver or a situation where management does not believe it would be able to find a provider of required services willing to provide the waiver. If we are unable to complete a business combination and are forced to dissolve and liquidate, each of our pre-initial public offering shareholders other than Stephen N. Cannon, will, by agreement, be personally liable (each in an amount proportional to the number of shares owned as compared to both of them as a group, except that John Wang and Robert Eu will indemnify us for the portion of the indemnification obligation attributable to the portion of our shares owned by Stephen N. Cannon) to ensure that the proceeds in the trust account are not reduced by the claims of prospective target businesses, vendors or other entities that are owed money by us for services rendered or products sold to us. Under these circumstances, our board of directors would have a fiduciary obligation to our shareholders to bring a claim against each of our pre-initial public offering shareholders other than Stephen N. Cannon to enforce their liability obligation.\\nSubject to the requirement that a target business or businesses have a fair market value of at least 80% of the balance in the trust account (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) at the time of our initial business combination, we have virtually unrestricted flexibility in identifying and selecting one or more prospective target businesses.\\nWe focus on potential target businesses with valuations between $70 million and $150 million. We believe that our available working capital, together with the issuance of additional equity and/or the issuance of debt, would support the acquisition of such a target business. The mix of additional equity and/or debt would depend on many factors. The proposed funding for any such business combination would be disclosed in the proxy statement relating to the required shareholder approval.\\nAfter completion of the IPO, we began contacting investment bankers, private equity firms and other business contacts in order to generate ideas about a suitable business combination. We also received unsolicited inquiries from several investment banking firms, private equity firms and other business intermediaries. We informed these contacts that we were seeking an operating business for our initial business combination. We have not retained an investment banking firm or fairness or valuation advisor to conduct a formal search for a business combination. Criteria for suitability included our management’s assessment of the competitive strengths and weaknesses of the potential business targets, the strength of the management team, and the quality of the assets to be acquired.\\n4\\nWe may pay fees or compensation to third parties for their efforts in introducing us to potential target businesses. We may seek to engage someone to assist in finding a potential target business if our management feels that they need assistance to find a suitable target business. If a finder approaches us on an unsolicited basis, our management would decide whether to work with that finder (and pay a finders’ fee) depending on the potential target business such finder proposes. Such payments are typically, although not always, calculated as a percentage of the dollar value of the transaction. We have not anticipated use of a particular percentage fee, but instead will seek to negotiate the smallest reasonable percentage fee consistent with the attractiveness of the opportunity and the alternatives, if any, that are then available to us. We may make such payments to entities we engage for this purpose or entities that approach us on an unsolicited basis. Payment of finders’ fees is customarily tied to consummation of a transaction and certainly would be tied to a completed transaction in the case of an unsolicited proposal. Although it is possible that we may pay finders’ fees in the case of an uncompleted transaction, we consider this possibility to be extremely remote. In no event will we pay any of our directors or officers or any entity with which they are affiliated any finder’s fee or other compensation for services rendered to us prior to or in connection with the consummation of a business combination. In addition, none of our officers or directors will receive any finder’s fee, consulting fees or any similar fees from any person or entity in connection with any business combination involving us. Following such business combination, however, our officers or directors may receive compensation or fees including compensation approved by the board of directors for customary director’s fees for our directors that remain following such business combination. Our directors have advised us that they will not take an offer regarding their compensation or fees following a business combination into consideration when determining which target businesses to pursue.\\nWe anticipate structuring a business combination to acquire 100% of the equity interests or assets of the target business. We may, however, structure a business combination to acquire less than 100% of such interests or assets of the target business but will not acquire less than a controlling interest (which would be greater than 50% of the voting securities of the target business). If we acquire only a controlling interest in a target business or businesses, the portion of such business that we acquire must have a fair market value equal to at least 80% of the amount in the trust account, (excluding deferred underwriting discounts and commissions and taxes payable), as described above. If we determine to simultaneously acquire several businesses and such businesses are owned by different sellers, we will need for each of such sellers to agree that our purchase of his business is contingent on the simultaneous closings of the other acquisitions, which may make it more difficult for us, and delay our ability, to complete the business combination. With multiple acquisitions, we could also face additional risks, including additional burdens and costs with respect to possible multiple negotiations and due diligence investigations (if there are multiple sellers) and the additional risks associated with the subsequent integration of the operations and services or products of the acquired companies in a single operating business.\\nIn recent months, there has been severe volatility and overall significant declines in the international capital markets and a freezing of the international credit markets that together have led to severe constraints in private flows of capital and an acutely negative impact on the operating results of companies in a wide range of industries and geographic sectors. Declining valuations of potential target businesses and uncertainty regarding the future may make it more difficult for us to reach agreement on a business combination that satisfies our requirements and the lack of available credit sources may adversely impact our ability to structure a transaction in the most advantageous manner. In addition, certain of our shareholders may experience pressure to vote against any business combination that we may propose in order to liquidate their investment and free up their capital, without regard to the merits of any such transaction.\\n5\\nGovernment regulations\\nGovernment regulations relating to foreign exchange controls\\nThe principal regulation governing foreign exchange in China is the Foreign Currency Administration Rules (IPPS), as amended. Under these rules, the Renminbi, China’s currency, is freely convertible for trade and service related foreign exchange transactions (such as normal purchases and sales of goods and services from providers in foreign countries), but not for direct investment, loan or investment in securities outside of China without the prior approval of the State Administration for Foreign Exchange (“SAFE”) of China. Foreign investment enterprises (“FIEs”) are required to apply to the SAFE for “Foreign Exchange Registration Certificates for FIEs.” Following a business combination, involving a change of equity ownership of a PRC operating entity or through contractual arrangements with a PRC operating entity our subsidiary will likely be an FIE as a result of our ownership structure. With such registration certificates, which need to be renewed annually, FIEs are allowed to open foreign currency accounts including a “basic account” and “capital account.” Currency translation within the scope of the “basic account,” such as remittance of foreign currencies for payment of dividends, can be effected without requiring the approval of the SAFE. However, conversion of currency in the “capital account,” including capital items such as direct investment, loans and securities, still require approval of the SAFE. This prior approval may delay or impair our ability to operate following a business combination. On November 21, 2005, the SAFE issued Circular No. 75 on “Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles.” Circular No. 75 confirms that the use of offshore special purpose vehicles as holding companies for PRC investments are permitted as long as proper foreign exchange registrations are made with the SAFE.\\nGovernment regulations relating to taxation\\nPrior to January 1, 2008, the standard enterprise income tax rate was 33%, which consisted of a 30% national income tax and a 3% local surcharge, for a company’s domestic and overseas incomes.\\nA new tax law, the PRC Enterprise Income Tax Law (“New EIT Law”), took effect on January 1, 2008. Under the new tax law, companies are subject to a uniform tax rate of 25%. The New EIT Law provides a five-year transition period starting from its effective date for those enterprises which were established before the promulgation date of the new tax law and which were entitled to a preferential lower tax rate under the then-effective tax laws or regulations. The New EIT Law significantly curtails tax incentives granted to foreign-invested enterprises under the previous tax law. The New EIT Law, however, (i) reduces the top rate of EIT from 33% to 25%, (ii) permits companies to continue to enjoy their existing tax incentives, subject to certain transitional phase-out rules, and (iii) introduces new tax incentives, subject to various qualification criteria. The New EIT Law and its implementing rules permit certain “high and new technology enterprises” to enjoy a reduced 15% EIT rate. Under the phase-out rules, enterprises established before the promulgation date of the New EIT Law and which were granted preferential EIT treatment under the then effective tax laws or regulations may continue to enjoy their preferential tax treatments until their expiration and will gradually transition to the uniform 25% EIT rate over a five-year transition period.\\nAdditionally, under the New EIT Law, an income tax rate for dividends payable to non-PRC investors and derived from sources within the PRC may be increased to 20%. It is currently unclear in what circumstances a source will be considered as located within the PRC.\\nThe new tax law provides only a framework of the enterprise tax provisions, leaving many details on the definitions of numerous terms as well as the interpretation and specific applications of various provisions unclear and unspecified.\\nCompetition\\nIn identifying, evaluating and selecting a target business for a business combination, we may encounter intense competition from other entities having a business objective similar to ours including other blank check companies, private equity groups and leveraged buyout funds, and operating businesses seeking acquisitions. Many of these entities are well established and have extensive experience identifying and effecting business combinations directly or through affiliates. Moreover, many of these competitors possess greater financial, technical, human and other resources than us. While we believe there are numerous potential target businesses with which we could combine, our ability to acquire larger target businesses will be limited by our available financial resources. This inherent limitation gives others an advantage in pursuing the acquisition of a target business. Furthermore:\\n\\n| § | our obligation to seek shareholder approval of our initial business combination or obtain necessary financial information may delay the consummation of a transaction; |\\n\\n6\\n| § | our obligation to redeem for cash ordinary shares held by our public shareholders who vote against the business combination and exercise their redemption rights may reduce the resources available to us for a business combination; |\\n\\n\\n| § | our outstanding warrants, and the future dilution they potentially represent, may not be viewed favorably by certain target businesses; and |\\n\\n\\n| § | the requirement to acquire an operating business that has a fair market value equal to at least 80% of the balance of the trust account at the time of the acquisition (excluding deferred underwriting discounts and commissions of $1,187,004 and taxes payable) could require us to acquire the assets of several operating businesses at the same time, all of which sales would be contingent on the closings of the other sales, which could make it more difficult to consummate the business combination. |\\n\\nAny of these factors may place us at a competitive disadvantage in successfully negotiating a business combination.\\nEmployees\\nWe currently have three officers. These individuals are not obligated to devote any specific number of hours to our business and intend to devote only as much time as they deem necessary to our business. We intend to hire employees and/or consultants, possibly including certain full time employees and/or consultants, in order to assist us in the search, due diligence for and consummation of a business combination.\\nEnforcement of Civil Liabilities\\nWe are registered under the laws of the Cayman Islands by way of continuation as an exempted company with limited liability. We are registered in the Cayman Islands because of certain benefits associated with being a Cayman Islands corporation, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of foreign exchange control or currency restrictions and the availability of professional and support services. However, the Cayman Islands has a less developed body of securities laws as compared to the United States and provides protections for investors to a significantly lesser extent. In addition, Cayman Islands companies do not have standing to sue before the federal courts of the United States.\\nSubstantially all of our assets are located outside the United States. In addition, a majority of our directors and officers are nationals or residents of jurisdictions other than the United States and all or a substantial portion of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon us or these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States. It may also be difficult for you to enforce in U.S. courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us, our officers and directors.\\nWe have not appointed any agent to receive service of process with respect to any action brought against us in the United States District Court for the Southern District of New York under the federal securities laws of the United States or of any state in the United States or any action brought against us in the Supreme Court of the State of New York in the County of New York under the securities laws of the State of New York.\\nWe believe that there is uncertainty as to whether the courts of the Cayman Islands or the PRC would, respectively, (1) recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States, or (2) entertain original actions brought in the Cayman Islands or the PRC against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.\\n\\nITEM 1A. RISK FACTORS\\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\\n7\\nITEM 1B. UNRESOLVED STAFF COMMENTS\\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\\n\\nITEM 2. PROPERTIES\\nWe currently maintain our executive offices at 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong. The cost for this space is included in the $7,500 per-month fee paid to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support. We believe, based on rents and fees for similar services in Hong Kong, that the fees that will be charged by Hambrecht Eu Capital Management LLC is at least as favorable as we could have obtained from unaffiliated persons.\\n\\nITEM 3. LEGAL PROCEEDINGS\\nThere is no litigation currently pending or threatened against us or any of our directors in their capacity as such.\\n\\nITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS\\nNo matters were submitted to a vote of our shareholders during the quarter ended June 30, 2009.\\n8\\nPART II\\n\\nITEM 5. MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.\\nMarket Price Information\\nThe shares of our common stock, warrants and units are traded on the OTC Bulletin Board, or OTCBB, under the symbols “HMAQF,” “HMAWF” and “HMAUF,” respectively. Each unit consists of one ordinary share and one warrant. Each warrant entitles the holder to purchase one ordinary share at a price of $5.00 commencing on the later of our consummation of a business combination or one year from the date of the IPO prospectus, provided in each case that there is an effective registration statement covering the ordinary shares underlying the warrants in effect. The warrants will expire five years from the date of the IPO, unless earlier redeemed. Our common stock and warrants commenced to trade separately from April 9, 2008.\\nThe following table sets forth, for the calendar quarters indicated, the quarterly high and low bid information prices for our common stock, warrants and units as reported on the OTCBB, such over the counter market quotation reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.\\n\\n| Units | Ordinary Shares | Warrants |\\n| High | Low | High | Low | High | Low |\\n| Third Quarter of 2009 | $ | 7.65 | $ | 7.52 | $ | 7.98 | $ | 7.58 | $ | 0.16 | $ | 0.11 |\\n| Second Quarter of 2009 | $ | 7.25 | $ | 7.25 | $ | 7.65 | $ | 7.35 | $ | 0.55 | $ | 0.05 |\\n| First Quarter of 2009 | $ | 7.90 | $ | 7.00 | $ | 7.49 | $ | 7.10 | $ | 0.20 | $ | 0.05 |\\n| Fourth Quarter of 2008 | $ | 7.15 | $ | 6.50 | $ | 7.00 | $ | 6.21 | $ | 0.42 | $ | 0.13 |\\n| Third Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.37 | $ | 6.85 | $ | 0.73 | $ | 0.50 |\\n| Second Quarter of 2008 | $ | 7.90 | $ | 7.60 | $ | 7.16 | $ | 6.95 | $ | 0.85 | $ | 0.60 |\\n| First Quarter of 2008 | $ | 8.15 | $ | 7.85 | - | - | - | - |\\n\\nNumber of Holders of Common Stock.\\nThe number of holders of record of our Common Stock on January 21, 2010 was 10, which does not include beneficial owners of our securities.\\nDividends.\\nThere were no cash dividends or other cash distributions made by us during the fiscal year ended June 30, 2009. Future dividend policy will be determined by our Board of Directors based on our earnings, financial condition, capital requirements and other then existing conditions. It is anticipated that cash dividends will not be paid to the holders of our common stock in the foreseeable future.\\n9\\nRecent Sales of Unregistered Securities.\\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that were subsequently redeemed because the underwriters did not fully exercise their over-allotment option) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee. Such shares were issued in connection with our organization pursuant to the exemption from registration contained in Section 4(2) of the Securities Act as they were sold in transactions not involving a public offering to a limited number of sophisticated, wealthy individuals. No underwriting commissions or offering discounts were paid with respect to such sales.\\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of $10,193.35 or $0.022 per share. All such transfers were exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\\n| Name | Ordinary Shares | Warrants |\\n| John Wang | 230,000 | 0 |\\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\\n| Robert J. Eu | 173,275 | 0 |\\n| AEX Enterprises Limited(3) | 88,333 | 0 |\\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\\n| AEX Capital, LLC(7) | 0 | 441,666 |\\n| Total: | 1,059,824 | 1,550,000 |\\n\\n10\\n\\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\\n\\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\\n\\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\\n\\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\\n\\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\\n\\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\\n\\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\\n\\nRepurchases of Equity Securities.\\nNone.\\nUse of Proceeds\\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised their over-allotment option for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units. Each unit consists of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. The units were sold at an offering price of $8.00 per unit and the warrants we sold at an offering price of $1.00 per warrant, generating total gross proceeds of $35,464,400. Broadband Capital Management LLC acted as lead underwriter. The securities sold in our initial public offering were registered under the Securities Act of 1933 on a registration statement on Form S-1 (No. 333-146147). The Securities and Exchange Commission declared the registration statement effective on March 7, 2008.\\nWe incurred a total of $2,374,008 in underwriting discounts and commissions, of which $1,187,004 has been placed in the trust account. Such portion of the underwriter’s compensation will only be paid to the underwriters in the event that we consummate a business combination. The total expenses in connection with the sale of our warrants in the private placement and the initial public offering were $2,784,873.\\nAfter deducting the underwriting discounts and commissions and the offering expenses, the total net proceeds to us from the private placement and the initial public offering were approximately $32,679,527. Approximately $33,527,396 (or approximately $7.91 per unit sold in our initial public offering) of the proceeds from the initial public offering and the private placement was placed in a Trust Account for our benefit and the remaining proceeds are available to be used to provide for business, legal and accounting due diligence on prospective business combinations and continuing general and administrative expenses. The Trust Account contains $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The amounts held in the trust account may only be used by us upon the consummation of a business combination, except that we may use up to $700,000 (or $1,050,000 if approved by our shareholders) of the interest earned on the trust account to fund our working capital prior to a business combination. As of June 30, 2009, there was $ 33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\\n\\nITEM 6. SELECTED FINANCIAL DATA\\nAs a smaller reporting company, we are not required to include this information in our transition report on Form 10-K.\\n11\\nITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nThe following discussion should be read in conjunction with the financial statements and related notes contained herein and the information included in our other filings with the SEC. This discussion includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements in this Transition Report on Form 10-K other than statements of historical fact are forward-looking statements. These forward-looking statements involve known and unknown risks and uncertainties. Our actual results may differ materially from those projected or assumed in such forward-looking statements. Among the factors that could cause actual results to differ materially are our being a development stage company with no operating history, our dependence on key personnel some of whom may join us following a business combination, our personnel allocating their time to other businesses and potentially having conflicts of interest with our business, our potentially being unable to obtain additional financing to complete a business combination and the ownership of our securities being concentrated. All forward-looking statements included in this document are made as of the date of this report, based on information available to us as of such date. We assume no obligation to update any forward-looking statement.\\nOverview\\nWe are a blank check company formed under the laws of the Cayman Islands on July 18, 2007. We were formed to acquire one or more operating businesses through a merger, stock exchange, asset acquisition or similar business combination or control through contractual arrangements having its primary operations in the People’s Republic of China, or PRC. We will not seek to acquire a business with its primary operations outside of the PRC.\\nThe company has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010 However if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. In order to extend the period of March 12, 2011, (i) public shareholders must approve the extension and (ii) public shareholders owning no more than one share less than 30% of the shares sold in this offering may have exercised their redemption rights.\\nResults of Operations for the Six Month Transition Period Ended June 30, 2009\\nWe incurred a net loss of $87,677 for the six month period ended June 30, 2009 due to both a decrease in the interest earned on the Trust Account which did not exceed our expenses for the period, and an increase in expenses related to professional services. Until we enter into a business combination, we will not have any operating revenues.\\nOverall, for the six month period ended June 30, 2009, we incurred $25,002 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $114,868.\\nFor the six months ended June 30, 2009, our trust account earned interest of $97,193 and our funds outside of the trust account did not earn interest income.\\nResults of Operations for the Six Month Period Ended June 30, 2008\\nWe had a net gain of $11,449 for the six month period ended June 30, 2008.\\nOverall for six month period ended June 30, 2008, we incurred $16,668 of insurance expense from the amortization of our pre-paid D&O insurance policy, $45,000 of rent expense and other operating costs of $95,015.\\n12\\nFor the six months ended June 30, 2008, our trust account earned interest of $173,106.\\nResults of Operations for the Year Ended December 31, 2008\\nWe reported net income of $236,505 for the year ended December 31, 2008 due to interest earned on the trust account. Until we enter into a business combination, we will not have any operating revenues.\\nFor the year ended December 31, 2008, we incurred $37,503 of insurance expense from the amortization of our pre-paid D&O insurance policy, $97,500 of rent, administrative services and secretary support expense and other operating costs of $132,384.\\nFor the year ended December 31, 2008, our trust account earned gross interest of $510,361. $239,110 of this interest was withdrawn from the trust account to fund working capital and $271,251 remained in the trust account.\\nResults of Operations for the Year Ended December 31, 2007\\nWe reported a net loss of $21,736 for the year ended December 31, 2007 due to start-up expenses. Until we enter into a business combination, we will not have any operating revenues.\\nFor the year ended December 31, 2007, we incurred $15,000 of rent as well as formation and administrative costs of $6,736.\\nFor the year ended December 31, 2007, we did not earn any interest from our trust account.\\nLiquidity and Capital Resources\\nOn March 7, 2008, we completed a private placement of 1,550,000 warrants to AEX Enterprises Limited, a company controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Robert Eu’s father-in-law, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, each an entity controlled by William Hambrecht, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr., and Marbella Capital Partners Ltd., a company owned by John Wang, our Chief Executive Officer, and received net proceeds of $1,550,000. On March 12, 2008, we consummated our initial public offering of 4,000,000 units. On March 31, 2008, the underwriters of our initial public offering exercised a portion of their over-allotment option, for a total of an additional 239,300 units (over and above the 4,000,000 units sold in the initial public offering) for an aggregate offering of 4,239,300 units (collectively the “IPO”). Each unit in the public offering consisted of one share of common stock and one redeemable common stock purchase warrant. Each warrant entitles the holder to purchase from us one share of our common stock at an exercise price of $5.00. Our common stock and warrants started trading separately as of April 9, 2008.\\nThe net proceeds from the sale of our warrants and units, after deducting certain offering expenses of approximately $2,784,873, including underwriting discounts of approximately $2,374,008, were approximately $32,679,527. Approximately $33,527,396 of the proceeds from the IPO and the private placement was placed in a trust account for our benefit, which includes $1,187,004 of the underwriter’s compensation which will be paid to them only in the event of a business combination. The remaining $339,135 was not held in the trust account. Except for up to $700,000 (plus up to and additional $350,000 if approved by our shareholders in connection with the extension of the period in which we must complete our initial business combination to March 12, 2011) in interest that is earned on the funds contained in the trust account that may be released to us to be used as working capital, we will not be able to access the amounts held in the trust until we consummate a business combination. The amounts held outside of the trust account are available to be used by us to provide for business, legal and accounting due diligence on prospective acquisitions and continuing general and administrative expenses. From July 18, 2007 (the date of our inception) through June 30, 2009, we had operating expenses of $473,993. From January 1, 2009 through June 30, 2009, we had operating expenses of $184,870. The net proceeds deposited into the trust fund remain on deposit in the trust account earning interest. Other than $700,000 (or $1,050,000 if approved by our shareholders) in interest which we may use to fund working capital, the amounts held in the trust account may only be used by us upon the consummation of a business combination. As of December 31, 2008, we had 33,798,651 held in the trust account and as of June 30, 2009 there was $33,838,155 held in the trust account, which includes deferred underwriting fees of $1,187,004. Additionally, as of June 30, 2009, we had $30,271 outside the trust account to fund our working capital requirements. Through June 30, 2009, approximately $286,000 of interest earned on the trust account balance has been released to us for working capital purpose.\\n13\\nWe will use substantially all of the net proceeds of our IPO to acquire one or more target businesses, and will use a portion of the interest earned on the trust account together with the funds not held in trust to identify and evaluate prospective target businesses, to select one or more target businesses, and to structure, negotiate and consummate the business combination. We do not believe we will need to raise additional funds following our IPO in order to meet the expenditures required for operating our business. However, we may need to raise additional funds through a private offering of debt or equity securities if such funds were required to consummate a business combination. Such debt securities may include a working capital revolving debt facility or a longer term debt facility. Subject to compliance with applicable securities laws, we would only consummate such financing simultaneously with the consummation of a business combination.\\nCommencing on November 15, 2007, we began incurring a fee of approximately $7,500 per month for office space.\\nOff-Balance Sheet Arrangements\\nWe have never entered into any off-balance sheet financing arrangements and have never established any special purpose entities. We have not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets.\\nContractual Obligations\\nWe do not have any long term debt, capital lease obligations, operating lease obligations, purchase obligations or other long term liabilities, except for our agreement with Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, for office space, administrative services and secretarial support pursuant to which we pay a monthly fee of $7,500.\\n\\nITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nMarket risk is the sensitivity of income to changes in interest rates, foreign exchanges, commodity prices, equity prices, and other market-driven rates or prices. We are not presently engaged in and, if a suitable business target is not identified by us prior to the prescribed liquidation date of the trust fund, we may not engage in, any substantive commercial business. Accordingly, we are not and, until such time as we consummate a business combination, we will not be, exposed to risks associated with foreign exchange rates, commodity prices, equity prices or other market-driven rates or prices. The net proceeds of our IPO held in the trust fund have been invested only in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act of 1940. Given our limited risk in our exposure to money market funds, we do not view the interest rate risk to be significant.\\n\\nITEM 8. FINANCIAL AND SUPPLEMENTAL DATA\\nFinancial statements are attached hereto beginning with page F-1\\n\\nITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE\\nNone.\\n14\\nITEM 9A(T). CONTROLS AND PROCEDURES\\nDisclosure Controls and Procedures\\nAn evaluation of the effectiveness of our disclosure controls and procedures as of June 30, 2009 was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report.\\nDisclosure Controls and Procedures are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. During the most recently completed fiscal quarter, there has been no significant change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\nManagement’s Report on Internal Control Over Financial Reporting\\nOur internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our board of directors to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external reporting purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that in reasonable detail accurately reflect the transactions and dispositions of our assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of our financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorization of our board of directors and management; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.\\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the criteria established in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of June 30, 2009.\\nThis Transition Report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this Transition Report.\\n\\nITEM 9B. OTHER INFORMATION\\nNone.\\n15\\nPART III\\n\\nITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE\\nDirectors and Executive Officer\\nOur current directors and executive officers are as follows:\\n| Name | Age | Position |\\n| John Wang | 39 | Chief Executive Officer, President and Director |\\n| Robert J. Eu | 46 | Chairman of the Board, |\\n| Hao Wu | 35 | Chief Financial Officer, Secretary and Director |\\n| Hong Xiang Liu | 44 | Director |\\n\\nJohn Wang has been our Chief Executive Officer, President and a director since our inception. Mr. Wang has over twelve years of investment banking and consulting experience. Since November 2004, Mr. Wang has been the Managing Director of Marbella Capital Partners Ltd., a financial advisory firm based in Shanghai which he founded. From January 2000 to November 2004, he helped develop and establish the U.S. operations of SBI USA as Executive Vice President of SBI E2-Capital (HK) Limited and was a Managing Director and Chief Operating Officer of SBI E2-Capital (USA) Ltd. Prior to SBI, from 1997 to 1999, he managed Accenture Consulting’s Greater China communications, media, and high tech strategy practice, where he acted as consultant to China Mobile’s IPO in 1997, among other high profile projects. From 1994 to 1997 he was also the lead telecom analyst covering Greater China and Southeast Asia for Pyramid Research, a Cambridge Massachusetts based emerging market telecom research firm that is part of the Economist Intelligence Unit. Last year, he advised on four late-stage deals that closed, of which one has already gone public in Hong Kong and another, Yingli Green Energy (NYSE: YGE), completed its IPO and listing on the New York Stock Exchange on June 8, 2007. Mr. Wang currently sits on the Board of Hong Kong Stock Exchange listed Wuyi International Pharmaceutical Company Limited (HKSE: 1889). Mr. Wang holds a Bachelor of Arts degree in international relations from Tufts University and is a graduate of the Washington International Studies Program at St. Catherine’s College at Oxford University. He has an M.A.L.D. in international law and business from The Fletcher School of Law and Diplomacy and is a graduate of the Private Equity course at Harvard Business School.\\nRobert J. Eu has been our Chairman of the Board, Secretary and director since our inception. He has been our Chief Financial Officer since February 21, 2008. Since 1998, Mr. Eu has served as a Managing Director for W.R. Hambrecht + Co., LLC (“WR Hambrecht + Co”) a San Francisco-based investment bank. Mr. Eu founded WR Hambrecht + Co’s investment banking practice in Asia in 2003. Prior to WR Hambrecht + Co, Mr. Eu was a Managing Director of H&Q Asia Pacific from 1992 until 1998, an affiliate of Hambrecht & Quist, where he co-founded its Hong Kong office and China investment practice. In 1996, Mr. Eu led the buy-out and de-listing of Eu Yang Sang (Hong Kong) Limited from the Hong Kong stock exchange and the company is now listed on the Singapore Stock Exchange (SGX:EYSI). Mr. Eu has been a director of Eu Yang Sang since 1997. In 1992, prior to working at H&Q Asia Pacific, Mr. Eu was the Business Development Manager for Eu Yang Sang (Hong Kong) Limited, a manufacturer and retailer of Traditional Chinese medicine. Mr. Eu has been a director and the Chairman of AEX Enterprises Limited (“AEX Enterprises”) since 2003. AEX Enterprises’ primary operating subsidiary is Boom Securities (H.K.) Limited (“Boom Securities”). Boom Securities is a licensed broker / dealer regulated by the Securities and Futures Commission (SFC) of Hong Kong and headquartered in Hong Kong. Mr. Eu worked for Citibank from 1987 until 1992 in the Private Banking Group in Hong Kong. Mr. Eu is a graduate of Northwestern University with a B.A. in History.\\nHao Wu has been our Chief Financial Officer, Secretary and Director since September 4, 2009. He has been the Executive Vice President of Marbella Capital Partners, a boutique California/Shanghai based investment and advisory company that focuses on investing on Chinese deals in the growth and late stage, since January 2008. Prior to that, he was the finance director in B&Q Holding Co. Ltd., a leading home improvement retail company in China, from July 2006 until December 2007. Prior to B&Q, Mr. Wu worked for Fortune Tech group Co. Ltd. as the finance director from March 2004 until June 2006. He started his career in Unilever China as a management trainee. David holds a Bachelor of Science degree from the management school of Shanghai Jiao Tong University. Mr. Wu is employed by Marbella Capital Partners, which is controlled by John Wang, our Chief Executive Officer and a Director. Mr. Wu is not a party to any transactions listed in Item 404(a) of Regulation S\\n16\\nHong Xiang Liu has been one of our directors since September 4, 2009. He has been the director of Jiangsu Performing Art & Culture Enterprises Inc. Ltd., a real estate developer in China, Jiangsu province, since July 2007. Prior to this, he was the Chief Executive Officer and Executive Director of Tongda Energy Limited, a piped gas provider & operator in 11 cities across China, from October 2002 until July 2007. From 1988 to September 2002, Mr. Liu held various positions in China Construction Bank. His last appointment was as Vice General manager of the Enterprise Banking Department, China Construction Bank, Beijing Branch. Mr. Liu received his Bachelor of Engineering (Infrastructure Management) from Tianjin University and was accredited as a senior economist by China Construction Bank in 1998. Mr. Liu is not a party to any transactions listed in Item 404(a) of Regulation S-K.\\nBoard Committees\\nThe board of directors is currently composed of four individuals and we do not have any committees, and, therefore, the entire board of directors performs the functions of the Audit Committee. It is intended that the board of directors will establish an Audit Committee upon the consummation of a business combination. The board of directors will take all reasonable actions to ensure that one of the members of the Audit Committee will be an “audit committee financial expert,” as such term is defined in the rules of the Securities and Exchange Commission. We are currently listed on the OTC Bulletin Board and are therefore not required to have a nominating committee or a compensation committee. We will evaluate establishing such committees in the future. There have been no changes to the procedures by which stockholders may recommend nominees to our board of directors.\\nCode of Ethics\\nWe currently do not have a formal code of ethics. Upon consummation of a business combination, we intend to adopt a code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller or persons performing similar functions.\\nSection 16(a) Beneficial Ownership Reporting Compliance\\nSection 16(a) of the Securities Exchange Act requires our directors, executive officers and persons who own more than 10% of our common stock to file reports of ownership and changes in ownership of our common stock with the Securities and Exchange Commission. Directors, executive officers and persons who own more than 10% of our common stock are required by Securities and Exchange Commission regulations to furnish to us copies of all Section 16(a) forms they file.\\nBased solely on our review of such forms furnished to us and written representations from certain reporting persons, we believe that all filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with during 2009.\\nLegal Proceedings\\nJohn Wang, our Chief Executive Officer and President, who had been named a defendant in two lawsuits which were dismissed by the court in a summary judgement for the defendants. John Wang had been named as a defendant along with two other named individuals, SBI-USA, LLC, a U.S. investment firm, and several of SBI-USA’s subsidiaries. The lawsuits alleged several claims, including violation of federal civil RICO statutes, securities fraud, breach of escrow agreement and breach of fiduciary duty. The plaintiffs generally alleged that SBI-USA, through one of the other named defendants, breached the terms of an escrow agreement and distributed shares of common stock held for the benefit of a third party to the detriment of the plaintiffs. The complaints did not specify the damages sought but one suit claimed damages in excess of $1,600,000 and the other includes claims for damages in excess of $400,000. The first lawsuit was filed on June 8, 2007 and the second lawsuit was filed on December 7, 2007. Mr. Wang does not know if any additional lawsuits will be filed. Mr. Wang and the other defendants denied any wrongdoing in connection with the allegations in the complaints. On March 14, 2008, the lawsuits were dismissed by the court in a summary judgment for the defendants. The plaintiffs have filed a notice of their intent to appeal, and to date have requested and received extensions of time from the court to file a formal appeal brief, but have yet to do so.\\n17\\n\\nITEM 11. EXECUTIVE COMPENSATION\\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth B. Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\\nOther than the fees paid to Hambrecht Eu Capital Management LLC, we do not currently pay any cash fees to our officers and directors, nor do we pay their expenses in attending board meetings.\\n\\nITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT\\nThe following table sets forth information regarding the beneficial ownership of our ordinary shares as of January 21, 2010 by:\\n\\n| § | each person known by us to be the beneficial owner of more than 5% of our outstanding ordinary shares; |\\n\\n\\n| § | each of our officers and directors; and |\\n\\n\\n| § | all our officers and directors as a group. |\\n\\nUnless otherwise indicated, we believe that all persons named in the table have sole voting and investment power with respect to all ordinary shares beneficially owned by them.\\n| Number of Ordinary | Approx. Percentage |\\n| Shares | of Outstanding |\\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\\n| John Wang(2) | 270,000 | 5.1 | % |\\n| Robert J. Eu(3) | 261,608 | 4.9 | % |\\n| Stephen N. Cannon(4) | 173,275 | 3.3 | % |\\n| Hao Wu | — | — |\\n| Hong Xiang Liu | — | — |\\n| William R. Hambrecht(5) | 354,941 | 6.7 | % |\\n| W.R. Hambrecht + Co., LLC(6) | 178,275 | 3.4 | % |\\n| Shea Ventures LLC(7) | 88,333 | 1.7 | % |\\n| Marbella Capital Partners Ltd.(8) | 40,000 | * |\\n| AEX Enterprises Limited(9) | 88,333 | 1.7 | % |\\n| Hambrecht 1980 Revocable Trust(10) | 88,333 | 1.7 | % |\\n| Loeb Arbitrage Management, LLC(11) | 483,872 | 9.13 | % |\\n| HBK Investments L.P. (12) | 423,900 | 8.0 | % |\\n| Integrated Core Strategies (US) LLC (13) | 520,500 | 9.8 | % |\\n| Genesis Capital Advisors LLC. (14) | 367,500 | 6.9 | % |\\n\\n18\\n| Number of Ordinary | Approx. Percentage |\\n| Shares | of Outstanding |\\n| Name and Address of Beneficial Owner(1) | Beneficially Owned | Ordinary Shares |\\n| Bulldog Investors (15) | 300,000 | 5.7 | % |\\n| Yarika Partners, L.P. (16) | 284,225 | 5.4 | % |\\n| All directors and executive officer as a group (4 individuals) | 704,883 | 13.3 | % |\\n\\n* Less than 1%\\n(1). Except as otherwise provided below, the address for each of our beneficial owners is 13/F Tower 2, New World Tower, 18 Queens Road Central, Hong Kong.\\n(2). The number of shares beneficially owned includes the ordinary shares held by Marbella Capital Partners.\\n(3). Includes ordinary shares held by AEX Enterprises Limited.\\n(4). The ordinary shares beneficially owned by Stephen N. Cannon are held by the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\\n(5). Consists of ordinary shares held by W.R. Hambrecht + Co., LLC, AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust.\\n(6). William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\\n(7). Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. Its address is P.O. Box 489, 655 Brea Canyon Rd. Walnut, CA 91788.\\n(8). John Wang is the controlling person of Marbella Capital Partners Ltd.\\n(9). Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. Its address is Suite 802, 8/F AIA Tower, 183 Electric Road, North Point, Hong Kong.\\n(10). William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. Its address is Pier 1, Bay 3, San Francisco, CA 94111.\\n(11). Based on a 13G filed on November 10, 2009. The business address of Loeb Arbirtage Management, LLC is 61 Broadway, 24th Floor, New York, NY 10006. Loeb Arbirtage Management, LLC is a registered investment adviser. Loeb Arbirtage Management, LLC may invest on behalf of itself and clients for which it has investment discretion. Loeb Arbitrage Fund’s general partner is Loeb Arbitrage Management, LLC. Loeb Offshore Fund Ltd.’s registered investment advisor is Loeb Offshore Management, LLC.\\n(12). Based on a 13G/A filed on January 28, 2009. The business address of HBK Investments L.P. is 2101 Cedar Springs Road Suite 700, Dallas, TX 75201. HBK Investments L.P. has delegated discretion to vote and dispose of the Securities to HBK Services LLC. HBK Services may, from time to time, delegate discretion to vote and dispose of certain of the securities to HBK New York LLC, a Delaware limited liability company, HBK Virginia LLC, a Delaware limited liability company, and/or HBK Europe Management LLP, a limited liability partnership organized under the laws of the United Kingdom (collectively, the “Subadvisors”). Each of HBK Services and the Subadvisors is under common control with HBK Investments L.P. Jamiel A. Akhtar, Richard L. Booth, David C. Haley, Lawrence H. Lebowitz, and William E. Rose are each managing members of HBK Management LLC.\\n19\\n(13). Based on a 13G/A filed on January 29, 2009. The business address of Integrated Core Strategies (US) LLC is c/o Millennium Management, LLC 666 Fifth Avenue 8th Floor, New York, NY 10103. Millennium Management LLC, a Delaware limited liability company (“Millennium Management”), is the general partner of the managing member of Integrated Core Strategies and may be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies. Israel A. Englander is the managing member of Millennium Management. Consequently, Mr. Englander may also be deemed to have shared voting control and investment discretion over securities owned by Integrated Core Strategies.\\n(14). Based on a 13G/A filed on February 17, 2009. The business address of Genesis Capital Advisors LLC is 255 Huguenot Street, Suite 1103, New Rochelle, NY 10801. Jaime Hartman, Ethan Benovitz and Daniel Saks are the managing members of Genesis. As a result, Messrs. Hartman, Benovitz and Saks may be deemed to have shared voting control and investment discretion over securities deemed to be beneficially owned by Genesis.\\n(15). Based on a 13G filed on August 1, 2008. The business address of Bulldog Investors is Park 80 West, Plaza Two, Saddle Brook, NJ 07663. Phillip Goldstein and Andrew Dakos are principals of Bulldog Investors.\\n(16). Based on a 13G filed on October 21, 2009. The business address of Yakira Parterns, L.P. is 991 Post Road East Westport, CT 06880. Mr. Bruce M. Kallins is the managing member of Yakira Partners, L.P.\\nAll 1,059,825 Founder Shares owned by our Founders have been placed in escrow with Continental Stock Transfer & Trust Company, as escrow agent, pursuant to an escrow agreement.\\n\\nITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTORS INDEPENDENCE\\nOn July 18, 2007, John Wang, Robert J. Eu and Stephen N. Cannon purchased an aggregate of 1,150,000 of our ordinary shares (which includs 90,174 ordinary shares that we redeemed on March 31, 2008 because the IPO underwriters did not exercise their over-allotment option in full) for an aggregate purchase price of $25,000. Mr. Cannon subsequently transferred all of the shares he purchased to the Cannon Family Irrevocable Trust, of which Mr. Cannon is the sole trustee.\\nOn February 21, 2008, John Wang, Robert Eu and the Cannon Family Irrevocable Trust transferred an aggregate of 463,334 shares to W.R. Hambrecht + Co., LLC, Shea Ventures LLC, Marbella Capital Partners Ltd., AEX Enterprises Limited and the Hambrecht 1980 Revocable Trust, each of which entities is an accredited investor for an aggregate purchase price of 10,193.35 or $0.022 per share.\\nOn March 7, 2008, AEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and William R. Hambrecht, Mr. Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, agreed to invest an aggregate of $1,550,000 in us in the form of private placement warrants to purchase 1,550,000 ordinary shares at a price of $1.00 per warrant. Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is the trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of the voting shares of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds of the sale of the warrants were placed in the trust account established for our benefit in connection with our IPO.\\nOn March 31, 2008, following the partial exercise of the over-allotment option by the underwriters of the IPO, we cancelled an aggregate of 90,174 ordinary shares held by Robert J. Eu, Cannon Family Irrevocable Trust and WR Hambrecht + Co., LLC.\\nOn December 21, 2008, AEX Enterprises Limited transferred an aggregate of 441,666 warrants to AEX Capital, LLC, for no consideration. Such transfer was exempt from registration pursuant to Sections 4(1) and 4(2) of the Securities Act, due to the limited number of individuals involved, their status as accredited investors and transfer restrictions and legends on the share certificates.\\n20\\nIn each of the foregoing sales of securities the purchasers were our officers and directors or affiliates of our officers and directors and therefore had access to all relevant information about us when choosing to invest in our securities. As of January 21, 2010, these securities were held by the persons or entities as set forth in the following table:\\n\\n| Name | Ordinary Shares | Warrants |\\n| John Wang | 230,000 | 0 |\\n| W.R. Hambrecht + Co., LLC(1) | 178,275 | 25,000 |\\n| Cannon Family Irrevocable Trust (2) | 173,275 | 0 |\\n| Robert J. Eu | 173,275 | 0 |\\n| AEX Enterprises Limited(3) | 88,333 | 0 |\\n| Hambrecht 1980 Revocable Trust(4) | 88,333 | 441,667 |\\n| Shea Ventures LLC(5) | 88,333 | 441,667 |\\n| Marbella Capital Partners Ltd.(6) | 40,000 | 200,000 |\\n| AEX Capital, LLC(7) | 0 | 441,666 |\\n| Total: | 1,059,824 | 1,550,000 |\\n\\n\\n| (1) | William R. Hambrecht is the controlling person of W.R. Hambrecht + Co., LLC. |\\n\\n| (2) | Mr. Cannon is the sole Trustee of Cannon Family Irrevocable Trust. |\\n\\n| (3) | Elizabeth B. Hambrecht, Robert Eu’s wife, and William R. Hambrecht control AEX Enterprises Limited. |\\n\\n| (4) | William R. Hambrecht is the trustee of the Hambrecht 1980 Revocable Trust. |\\n\\n| (5) | Edmund H. Shea Jr. is the controlling person of Shea Ventures LLC. |\\n\\n| (6) | John Wang is the controlling person of Marbella Capital Partners Ltd. |\\n\\n| (7) | Elizabeth B. Hambrecht, Robert Eu’s wife, and Robert J. Eu control AEX Capital, LLC. |\\n\\nPursuant to a registration rights agreement between us and our pre-initial public offering shareholders and warrant holders such shareholders and warrant holders will be entitled to certain registration rights. Specifically, (i) the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of a business combination; and (ii) the ordinary shares will be entitled to certain registration rights one year from the consummation of a business combination. We are only required to use our best efforts to cause a registration statement relating to the resale of such securities to be declared effective and, once effective, only to use our best efforts to maintain the effectiveness of the registration statement. The holders of warrants do not have the rights or privileges of holders of our ordinary shares or any voting rights until such holders exercise their respective warrants and receive ordinary shares. Certain persons and entities that receive any of the above described securities from our founders will, under certain circumstances, be entitled to the registration rights described herein. We will bear the expenses incurred in connection with the filing of any such registration statements. In the event that we breach our obligations under the registration rights agreement, we could be obligated to purchase the securities owned by our pre-initial public offering shareholders for the then fair market value of the securities.\\nWe agreed to pay Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, a total of $7,500 per month for office space, administrative services and secretarial support for the period from November 15, 2007 until the earlier of our consummation of a business combination or our liquidation. This arrangement was agreed to by Hambrecht Eu Capital Management LLC for our benefit and is not intended to provide Mr. Eu compensation. We believe that such fees are at least as favorable as we could have obtained from an unaffiliated third party.\\nWe will reimburse our officers and directors for any reasonable out-of-pocket business expenses incurred by them in connection with certain activities on our behalf such as identifying and investigating possible target businesses and business combinations. Subject to availability of proceeds not placed in the trust account and the interest income on the balance in the trust account to be released to us from time to time, there is no limit on the amount of out-of-pocket expenses that could be incurred. This formula was a result of a negotiation between us and the underwriters and was meant to help maximize the amount of money in the trust account that would be returned to the investors if we do not consummate a business combination within the permitted time. Our board of directors will review and approve all expense reimbursements made to our directors with the interested director or directors abstaining from such review and approval. To the extent such out-of-pocket expenses exceed the available proceeds not deposited in the trust account, such out-of-pocket expenses would not be reimbursed by us unless we consummate a business combination.\\n21\\nOther than the $7,500 per month administrative fee and reimbursable out-of-pocket expenses payable to Hambrecht Eu Capital Management LLC, an affiliate of Robert Eu, one of our founders and our Chairman, Chief Financial Officer and Secretary, and Elizabeth Hambrecht, Mr. Eu’s wife, no fees of any kind, including finders and consulting fees, will be paid to any of our directors who owned our ordinary shares prior to our IPO, or to any of their respective affiliates for services rendered to us prior to or with respect to the business combination.\\nAfter a business combination, any of our directors who remain with us may be paid consulting, management or other fees from the combined company with any and all amounts being fully disclosed to shareholders, to the extent then known, in the proxy solicitation materials furnished to our shareholders. It is unlikely that the amount of such compensation will be known at the time of a shareholder meeting held to consider a business combination, as it will be up to the directors of the post-combination business to determine executive and director compensation. In this event, such compensation will be publicly disclosed at the time of its determination in a Current Report on Form 8-K, as required by the SEC.\\nAll ongoing and future transactions between us and any of our directors or their respective affiliates, including loans by our directors, will be on terms believed by us at that time, based upon other similar arrangements known to us, to be no less favorable than are available from unaffiliated third parties. Such transactions or loans, including any forgiveness of loans, will require prior approval in each instance by a majority of our uninterested “independent” directors, to the extent we have independent directors, or the members of our board who do not have an interest in the transaction, in either case who had access, at our expense, to our attorneys or independent legal counsel. It is our intention to obtain estimates from unaffiliated third parties for similar goods or services to ascertain whether such transactions with affiliates are on terms that are no less favorable to us than are otherwise available from such unaffiliated third parties. If a transaction with an affiliated third party were found to be on terms less favorable to us than with an unaffiliated third party, we would not engage in such transaction.\\nDirector Independence\\nOur Board of Directors has not determined if any of our directors qualifies as independent. Our Board of Directors will make a determination about independence after the business combination is consummated. We do not have an audit committee, nominating committee or compensation committee and therefore the entire Board of Directors performs those functions for us.\\n\\nITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES\\nRothstein Kass & Company, P.C. audited our financial statements for the years ended June 30, 2009; December 31, 2008 and 2007:\\nAudit Fees\\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2009, including fees associated with the audit of the annual financial statements for the fiscal year ended June 30, 2009 and the reviews of the Company’s quarterly reports on Form 10-Q.\\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $55,000 in 2008, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2008 and the reviews of the Company’s quarterly reports on Form 10-Q.\\nFees for audit services provided by Rothstein Kass & Company, P.C. totaled approximately $80,000 in 2007, including fees associated with the audit of the annual financial statements for the fiscal year ended December 31, 2007, the audit of the financial statements as of August 31, 2007, the audit of the Company’s balance sheet at March 18, 2008 included in the Current Report on Form 8-K, and for services performed in connection with the Company’s registration statement on Form S-1 initially filed in 2007.\\n22\\nAudit-Related Fees\\nRothstein Kass & Company, P.C. did not bill any fees for services rendered to us during fiscal years 2009, 2008 and 2007 for Audit-related services in connection with the audit or review of our financial statements.\\nTax Fees\\nRothstein Kass & Company, P.C. did not bill any fees for tax services, including tax compliance, tax advice, and tax planning, during fiscal years 2009, 2008 and 2007.\\nAll Other Fees\\nThere were no fees billed by Rothstein Kass & Company, P.C. for other professional services rendered during the fiscal years 2009, 2008 or 2007.\\nPre-Approval of Services\\nWe do not have an audit committee. As a result, our board of directors performs the duties of an audit committee. Our board of directors evaluates and approves in advance the scope and cost of the engagement of an auditor before the auditor renders the audit and non-audit services. We do not rely on pre-approval policies and procedures.\\n23\\nPART IV\\n\\nITEM 15. EXHIBITS\\n| (a) | (1) | Financial Statements |\\n\\nBalance Sheets\\nStatement of Operations\\nStatement of Shareholders’ Equity\\nStatement of Cash Flows\\n| (2) | Schedules |\\n\\nNone.\\n| (b) | Exhibits |\\n\\nThe following Exhibits are filed as part of this report\\n| Exhibit No. | Description |\\n| 3.1 | Memorandum of Association (1) |\\n| 3.2 | Amended and Restated Articles of Association (1) |\\n| 4.1 | Specimen Unit Certificate (1) |\\n| 4.2 | Specimen Common Share Certificate (1) |\\n| 4.3 | Specimen Public Warrant Certificate (1) |\\n| 4.4 | Specimen Private Warrant Certificate (1) |\\n| 4.5 | Form of Warrant Agreement between Continental Stock Transfer & Trust Company and the Registrant (1) |\\n| 4.6 | Form of Unit Purchase Option (1) |\\n| 10.1 | Form of Letter Agreement by John Wang (1) |\\n| 10.2 | Form of Letter Agreement by Robert J. Eu (1) |\\n| 10.3 | Form of Letter Agreement by Stephen N. Cannon (1) |\\n| 10.4 | Form of Letter Agreement by Lee S. Ting (1) |\\n| 10.5 | Form of Letter Agreement by AEX Enterprises Limited (1) |\\n| 10.6 | Form of Letter Agreement by Feng Zhang (1) |\\n| 10.7 | Investment Management Trust Agreement between Continental Stock Transfer & Trust Company and the Registrant |\\n| 10.8 | Form of Securities Escrow Agreement between the Registrant, Continental Stock Transfer & Trust Company, the founding shareholders and the founders (1) |\\n| 10.9 | Form of Services Agreement between the Registrant and Hambrecht Eu Capital Management LLC (1) |\\n| 10.10 | Form of Registration Rights Agreement among the Registrant, the founding shareholders and the founders (1) |\\n| 10.11 | Revolving Credit Agreement between the Registrant and Robert Eu (1) |\\n| 10.12 | Promissory Note between Registrant and Robert Eu (1) |\\n| 10.13 | Form of Warrant Purchase Agreement between the Registrant and AEX Enterprises Limited (1) |\\n| 10.14 | Form of Right of First Refusal Agreement between the Registrant, Marbella Capital Partners and AEX Enterprises Limited (1) |\\n| 31.1 | Certification of the Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\\n| 31.2 | Certification of the Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended |\\n| 32.1 | Certification of the Chief Executive Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | Certification of the Chief Financial Officers pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n\\n(1) Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (File No. 333-146147).\\n24\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant had duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n| January 22, 2010 | HAMBRECHT ASIA ACQUISITION CORP. |\\n| By: | /s/ John Wang |\\n| John Wang |\\n| Chief Executive Officer, President and Director |\\n| (Principal Executive Officer) |\\n| January 22, 2010 | By: | /s/ Hao Wu |\\n| Hao Wu |\\n| Chief Financial Officer, Secretary and Director |\\n| (Principal Financial and Accounting Officer) |\\n\\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.\\n| January 22, 2010 | By: | /s/ John Wang |\\n| John Wang |\\n| Chief Executive Officer, President and |\\n| Director (Principal Executive Officer) |\\n| January 22, 2010 | By: | /s/ Robert J. Eu |\\n| Robert J. Eu |\\n| Chairman of Board |\\n| January 22, 2010 | By: | /s/ Hao Wu |\\n| Hao Wu |\\n| Chief Financial Officer, Secretary and Director |\\n| (Principal Financial and Accounting Officer) |\\n| January 22, 2010 | By: | /s/ Hong Xiang Liu |\\n| Hong Xiang Liu |\\n| Director |\\n\\n25\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nINDEX TO FINANCIAL STATEMENTS\\n| Page |\\n| Report of Independent Registered Public Accounting Firm | F-2 |\\n| Financial Statements: |\\n| Balance Sheets | F-3 |\\n| Statements of Operations | F-4 |\\n| Statements of Shareholders’ Equity | F-5 |\\n| Statements of Cash Flows | F-6 |\\n| Notes to Financial Statements | F-7 |\\n\\nF-1\\nReport of Independent Registered Public Accounting Firm\\nTo the Board of Directors and Stockholders of\\nHambrecht Asia Acquisition Corporation\\nWe have audited the accompanying balance sheets of Hambrecht Asia Acquisition Corporation (a corporation in the development stage) (the “Company”) as of June 30, 2009 and December 31, 2008 and 2007, and the related statements of operations and cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.\\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of June 30, 2009 and December 31, 2008, and the results of its operations and its cash flows for the six months ended June 30, 2009, the year ended December 31, 2008, the period from July 18, 2007 (date of inception) to December 31, 2007 and the periods from July 18, 2007 (date of inception) to June 30, 2009, and shareholders’ equity for the period from July 18, 2007 (date of inception) to June 30, 2009, in conformity with U.S. generally accepted accounting principles.\\nThe accompanying financial statements have been prepared assuming that Hambrecht Asia Acquisition Corporation will continue as a going concern. As discussed in Note 7 to the financial statements, Hambrecht Asia Acquisition Corporation will face a mandatory liquidation if a business combination is not consummated by March 12, 2010, which raises substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\\nRoseland, New Jersey\\nJanuary 22, 2010\\n/s/ Rothstein Kass & Company, P.C.\\nF-2\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nBalance Sheets\\n| June 30,2009 | December 31, 2008 | December 31, 2007 |\\n| ASSETS |\\n| Current assets |\\n| Cash | $ | 30,271 | $ | 100,312 | $ | 101,671 |\\n| Prepaid expenses | 95,686 | 108,330 | 183,254 |\\n| Total current assets | 125,957 | 208,642 | 284,925 |\\n| Other asset | — |\\n| Investments held in the trust account | 33,838,155 | 33,798,651 |\\n| Total assets | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\\n| LIABILITIES AND SHAREHOLDERS’ EQUITY |\\n| Current liabilities |\\n| Accrued expenses | $ | 76,275 | $ | 31,780 | $ | — |\\n| Note payable, shareholder | 281,661 |\\n| — |\\n| Total current liabilities | 76,275 | 31,780 | 281,661 |\\n| Long-term liabilities |\\n| Deferred underwriting fees, net of $356,101 subject to forfeiture in the event of possible redemption | 830,903 | 830,903 | — |\\n| Ordinary shares, subject to possible redemption, (1,271,788 shares at redemption value of $7.92 per share) | 10,072,561 | 10,072,561 | — |\\n| Shareholders’ equity |\\n| Ordinary shares, $.001 par value, 50,000,000 shares authorized; 5,299,125, 5,299,125 and 1,150,000 shares issued and outstanding as of June 30, 2009, December 31, 2008 and December 31, 2007 (which includes 1,271,788, 1,271,788 shares and 0 shares respectively subject to possible redemption) | 5,299 | 5,299 | 1,150 |\\n| Additional paid-in capital | 22,851,981 | 22,851,981 | 23,850 |\\n| Earnings (deficit) accumulated during the development stage | 127,093 | 214,769 | (21,736 | ) |\\n| Total shareholders’ equity | 22,984,373 | 23,072,049 | 3,264 |\\n| Total liabilities and shareholders’ equity | $ | 33,964,112 | $ | 34,007,293 | $ | 284,925 |\\n\\nSee accompanying notes to financial statements.\\nF-3\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nStatements of Operations\\n\\n| For the Period Ended June 30, 2009 (six months) | For the Period Ended June 30, 2008 (six months) (unaudited) | Period from July 18,2007 (inception) to June 30,2009 | For the Year ended December 31,2008 | Period from July 18, 2007 to December 31,2007 |\\n| Revenues | $ | — | $ | — | $ | — | $ | — | $ | — |\\n| Formation and administrative costs | 184,870 | 156,683 | 473,993 | 267,387 | 21,736 |\\n| Loss from operations | (184,870 | ) | (156,683 | ) | (473,993 | ) | (267,387 | ) | (21,736 | ) |\\n| Interest income, net | 97,193 | 168,133 | 601,085 | 503,892 | — |\\n| Net income (loss) | (87,677 | ) | 11,449 | 127,093 | 236,505 | (21,736 | ) |\\n| Weighted average number of ordinary shares subject to possible redemption, basic and diluted | 1,271,788 | 808,223 | 793,378 | 1,037,742 | — |\\n| Income (loss) per ordinary share subject to possible redemption, basic and diluted | $ | (0.07 | ) | $ | 0.01 | $ | 0.16 | $ | — | $ | — |\\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption) , basic | 4,027,337 | 3,789,581 | 3,085,775 | 3,503,402 | 1,150,000 |\\n| Income (loss) per ordinary share not subject to possible redemption, basic | $ | (0.02 | ) | $ | 0.00 | $ | 0.04 | $ | 0.07 | $ | (0.02 | ) |\\n| Weighted average number of ordinary shares outstanding (not subject to possible redemption), diluted | 4,027,337 | 5,164,193 | 4,267,656 | 5,213,337 | 1,150,000 |\\n| Income (loss) per ordinary share not subject to possible redemption, diluted | $ | (0.02 | ) | $ | 0.00 | $ | 0.03 | $ | 0.05 | $ | (0.02 | ) |\\n\\nSee accompanying notes to financial statements.\\nF-4\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nStatements of Shareholders’ Equity\\nFor the Period July 18, 2007 (date of inception) to June 30, 2009\\n| Ordinary Shares | Earnings |\\n| Shares | Amount | Additional Paid-in Capital | (Deficit) Accumulated During the Development Stage | TotalShareholders’ Equity |\\n| Balances at July 18, 2007 | — | $ | — | $ | — | $ | — | $ | — |\\n| Sale of units issued to founders on July 18, 2007 at approximately $0.02 per share | 1,150,000 | 1,150 | 23,850 | 25,000 |\\n| Net loss | (21,736 | ) | (21,736 | ) |\\n| Balances at December 31, 2007 | 1,150,000 | $ | 1,150 | $ | 23,850 | $ | (21,736 | ) | $ | 3,264 |\\n| Proceeds from sale of warrants in a private placement to initial shareholders | 1,550,000 | 1,550,000 |\\n| Sale of 4,000,000 units at $8.00 per unit in the public offering, net of underwriters’ discount and offering expenses (1,199,999 shares subject to possible redemption) | 4,000,000 | 4,000 | 29,550,348 | 29,554,348 |\\n| Sale of 239,300 units at $8.00 per unit in the public offering from partial exercise of underwriters’ overallotment option, net of underwriters’ discount and offering expenses (71,789 shares subject to possible redemption) | 239,300 | 239 | 1,800,344 | 1,800,583 |\\n| Forfeiture of founders shares from partial exercise of underwriters’ overallotment option | (90,175 | ) | (90 | ) | (90 | ) |\\n| Proceeds subject to possible redemption of 1,271,788 shares at a redemption value of $7.92 per share | (10,072,561 | ) | (10,072,561 | ) |\\n| Net income | 236,505 | 236,505 |\\n| Balances at December 31, 2008 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 214,769 | $ | 23,072,049 |\\n| Net loss | (87,677 | ) | (87,677 | ) |\\n| Balances at June 30, 2009 | 5,299,125 | $ | 5,299 | $ | 22,851,981 | $ | 127,093 | $ | 22,984,373 |\\n\\nSee accompanying notes to financial statements.\\nF-5\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nStatements of Cash Flows\\n| For the PeriodEnded June 30,2009 (sixmonths) | For the PeriodEnded June 30,2008 (sixmonths) (unaudited) | Period from July18,2007(inception) toJune 30,2009 | For the Yearended December31,2008 | Period from July18, 2007 toDecember31,2007 |\\n| Cash flows from operating activities: |\\n| Net income (loss) | $ | (87,677 | ) | $ | 11,449 | $ | 127,093 | $ | 236,505 | $ | (21,736 | ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\\n| Change in operating assets and liabilities: |\\n| Accrued expenses | 44,494 | 94,063 | 76,275 | 31,780 |\\n| Prepaid expenses and other current asset | 12,644 | 49,922 | (95,686 | ) | (108,330 | ) |\\n| Net cash provided by (used in) operating activities | (30,538 | ) | 155,434 | 107,682 | 159,955 | (21,736 | ) |\\n| Cash used in investing activities: |\\n| Proceeds from the public offering deposited in trust account | — | (33,527,400 | ) | (33,527,400 | ) | (33,527,400 | ) | — |\\n| Interest income re-invested in trust account | (85,836 | ) | (173,102 | ) | (510,361 | ) | (510,361 | ) | — |\\n| Redemption from the trust account | 46,332 | 65,709 | 285,442 | 239,110 | — |\\n| Net cash used in investing activities | (39,504 | ) | (33,634,793 | ) | (33,838,155 | ) | (33,798,651 | ) | — |\\n| Cash flows from financing activities: |\\n| Proceeds from sale of ordinary shares to founders | — | — | 25,000 | — | 25,000 |\\n| Proceeds from shareholder’s note payable | $ | — | $ | — | $ | 281,661 | $ | — | $ | 281,661 |\\n| Proceeds from warrants purchased in private placement | — | 1,550,000 | 1,550,000 | 1,550,000 | — |\\n| Proceeds from initial public offering | $ | — | $ | 32,000,000 | $ | 32,000,000 | $ | 32,000,000 | $ | — |\\n| Proceeds from exercise of underwriters overallotment option | — | 1,914,400 | 1,914,400 | 1,914,400 | — |\\n| Repayment of shareholder’s note payable | — | — | (281,661 | ) | (281,661 | ) | — |\\n| Payment of underwriters’ fee and offering cost of initial public offering | — | (1,728,656 | ) | (1,728,656 | ) | (1,545,402 | ) | (183,254 | ) |\\n| Net cash provided by financing activities | — | 33,454,083 | 33,760,744 | 33,637,337 | 123,407 |\\n| Net increase (decrease) in cash | (70,042 | ) | (25,276 | ) | 30,271 | (1,359 | ) | 101,671 |\\n| Cash at beginning of the period | 100,312 | 101,671 | — | 101,671 | — |\\n| Cash at end of the period | $ | 30,271 | $ | 76,395 | $ | 30,271 | $ | 100,312 | $ | 101,671 |\\n| Supplemental schedule of non-cash financing activities: |\\n| Deferred underwriting fees, net | $ | — | $ | 830,903 | $ | 830,903 | $ | 830,903 | $ | — |\\n| Ordinary shares subject to possible redemption | $ | — | $ | 10,072,561 | $ | 10,072,561 | $ | 10,072,561 | $ | — |\\n\\nSee accompanying notes to financial statements.\\nF-6\\nHambrecht Asia Acquisition Corp.\\n(a corporation in the development stage)\\nNotes to Financial Statements\\nNOTE 1—ORGANIZATION AND BUSINESS OPERATIONS\\nHambrecht Asia Acquisition Corp. (a corporation in the development stage) (the “Company”) was incorporated in the Cayman Islands on July 18, 2007 with an authorized share capital of 50,000,000 ordinary shares (par value $0.001 per share). The Company’s founders contributed $25,000 to the formation of the Company and were issued 1,150,000 ordinary shares. The Company was formed to acquire, through a stock exchange, asset acquisition or other similar business combination, one or more operating businesses having its primary operations located in the People’s Republic of China (“Business Combination”). The Company is considered to be in the development stage as defined in “Accounting and Reporting By Development Stage Enterprises”, and is subject to the risks associated with activities of development stage companies. The Company’s operations, if a Business Combination is consummated outside the United States, will be subject to local government regulations and to the uncertainties of the economic and political conditions of those areas.\\nOn December 9, 2009 the Board of Directors of Hambrecht Asia Acquisition Corp. (the \\\"Company\\\") authorized a change in the Company's fiscal year end to June 30 from December 31. The Company reports its financial results for the six month transition period of December 31, 2008 through June 30, 2009 on a Transition Report on Form 10-K. After filing the Transition Report, the Company’s next fiscal year end will be June 30, 2010.\\nAs of June 30, 2009, the Company had not commenced any operations or generated any revenues. All activity from the period July 18, 2007 (date of inception) through March 31, 2008 relates to the Company’s formation and its initial public offering as described below. Subsequent to that date to the present the Company has sought a target business to acquire. The Company will not generate any operating revenue until after the completion of the Business combination, at the earliest. The Company currently generates non-operating income from interest income earned on the investments held in a trust account (the “Trust Account”), from the proceeds derived from the public offering.\\nThe registration statement for the Company’s initial public offering (the “Offering”) described in Note 3 was declared effective on March 7, 2008. The Company consummated the Offering on March 12, 2008 and immediately prior to such Offering, sold an aggregate of 1,550,000 warrants at $1.00 per warrant to certain officers and affiliates of the Company in a private placement (the “Private Placement”) described in Note 4. On March 31 2008, the underwriters of the Offering exercised their over-allotment option for a total of an additional 239,300 units. The net proceeds of the Offering and the Private Placement are intended to be generally applied toward consummating a business combination with one or more operating businesses having their primary operations in the People’s Republic of China (“Business Combination”). Net proceeds of $33,537,396 from the Offering, including the exercise of the underwriters’ over-allotment option, and the Private Placement are held in a Trust Account and will only be released to the Company upon the earlier of: (i) the consummation of a business combination; or (ii) the Company’s liquidation, except to satisfy shareholder conversion rights. The Trust Account includes the deferred underwriting discount from the Offering of up to $1,187,004 which will be paid to the underwriters upon consummation of a business combination, as described in Note 6. Additionally, up to an aggregate of $700,000, plus up to an additional $350,000 during the Extended Period (as described below) if approved by shareholders, of interest earned on the Trust Account balance (net of any taxes paid or payable) may be released to the Company to fund operating activities. Through June 30, 2009, approximately $286,000 of interest earned on the Trust Account balance has been released to the Company.\\nOn September 4, 2009, the Company issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. The Company, after signing a definitive agreement for the acquisition of a target business, is required to submit such transaction for shareholder approval. In the event that shareholders owning 30% or more of the shares sold in the Offering vote against the business combination and exercise their conversion rights described below, the business combination will not be consummated. All of the Company’s shareholders prior to the Offering, have agreed to vote their pre-initial public offering ordinary shares in accordance with the vote of the majority of the shares voted by all shareholders of the Company who purchased their shares in the Offering or the aftermarket (“Public Shareholders”) with respect to any business combination. After consummation of a business combination, these voting safeguards will no longer be applicable.\\nF-7\\nIn the event that the Company does not complete a business combination by March 12, 2010, or March 12, 2011 if extension is approved by the shareholders, the Company will be dissolved and the proceeds held in the Trust Account, plus certain interest, less certain costs, will be distributed to the Company’s public shareholders. If the Company receives Public Shareholder approval for the Extended Period and holders of 30% or more of the shares held by Public Shareholders do not vote against the Extended Period and elect to convert their ordinary shares in connection with the vote for the Extended Period, the Company will then have an additional 12 months in which to complete the initial business combination. If the Extended Period is approved, the Company will still be required to seek Public Shareholder approval before completing a business combination. In the event there is no business combination within the 24-month deadline (assuming the Extended Period is not approved) described above, the Company will dissolve and distribute to its Public Shareholders, in proportion to their respective equity interests, the amount held in the Trust Account, and any remaining net assets, after the distribution of the Trust Account. The Company’s corporate existence will automatically cease at the end of the 36-month period if the Company has not received shareholder approval for an initial business combination. In the event of liquidation, the per share value of the residual assets remaining available for distribution (including Trust Account assets) may be less than the initial public offering price per share in the Offering.\\nWith respect to a business combination which is approved and consummated or a vote on the Extended Period which is approved, any Public Shareholders who voted against the business combination or Extended Period may contemporaneously with or prior to such vote exercise their conversion right and their ordinary shares would be cancelled and returned to the status of authorized but unissued shares. The per share conversion price will equal the amount in the Trust Account (including interest therein), calculated as of two business days prior to the consummation of the proposed business combination or vote on Extended Period, divided by the number of common shares sold in the Offering and partial exercise of the over-allotment option.\\nA Public Shareholder’s election to convert ordinary shares in connection with the vote on the Extended Period will only be honored if the Extended Period is approved. Public Shareholders who vote their shares against the Extended Period and exercise their conversion rights, will not be able to vote these shares with respect to the initial business combination. All other Public Shareholders will be able to vote on the initial business combination.\\nNOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation:\\nThe accompanying financial statements are presented in U.S. dollars and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and pursuant to the accounting and disclosure rules and regulations of the Securities and Exchange Commission (the ‘SEC”). In the opinion of management, the accompanying financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the Company’s financial statements.\\nInvestments held in the Trust Account:\\nThe amounts held in the Trust Account as of June 30, 2009 represent substantially all of the proceeds of the Offering plus partial exercise of the underwriters’ over-allotment option, the private placement and interest earned on the trust to date, and are classified as restricted assets since such amounts can only be used by the Company in connection with the consummation of a Business Combination. The funds held in the Trust Account are invested in a money market fund that invests in US and state government and government agency debt securities.\\nF-8\\nFair value of financial instruments:\\nThe Company does not enter into financial instruments for trading or speculative purposes. The carrying amounts of financial instruments classified as current assets and current liabilities as disclosed in the accompanying balance sheets, approximate their fair value due to their short maturities.\\nUse of estimates:\\nThe preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\\nIncome taxes:\\nUnder current Cayman Islands laws, the Company is not subject to income taxes or capital gains, and there is no Cayman Islands withholding tax imposed upon payments of dividends by the Company to its shareholders. In the future, the Company’s tax rate will be impacted by acquisitions of non-Cayman subsidiaries governed by the respective local income tax laws. Accordingly, no provision for income taxes has been made in the accompanying statements of operations.\\nEffective January 1, 2007, the Company adopted the provisions of “Accounting for Uncertainty in Income Taxes”. There were no unrecognized tax benefits as of June 30, 2009. The provision prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties at June 30, 2009. Management is currently unaware of any issues under review that could result in significant payments, accruals or material deviation from its position.\\nOrdinary shares subject to possible redemption:\\nAs discussed in Note 1, the Company will only proceed with a Business Combination if: (1) it is approved by a majority of the votes cast by the Company’s public shareholders; and (2) public shareholders holding less than 30% (1,271,788) of the ordinary shares sold in the Offering and partial exercise of the over-allotment option, choose to exercise their redemption rights thereby receiving their per share interest in the Trust Account. In accordance with FASB’s Emerging Issues Task Force (EITF) Topic No. D-98, “Classification and Measurement of Redeemable Securities”, the Company has classified 1,271,788 shares of its ordinary shares outside of permanent equity as “Ordinary shares subject to redemption,” at a redemption price of $7.92 per share as of June 30, 2009 . The Company will recognize changes in the conversion value as they occur and will adjust the carrying value of the ordinary shares subject to conversion to be equal to its conversion value at the end of each reporting period.\\nIncome (loss) per ordinary share:\\nBasic income per common share is computed by dividing net income by the weighted average common shares outstanding for the period. Diluted income per common share reflects the potential dilution that could occur if warrants were to be exercised or converted or otherwise resulted in the issuance of ordinary shares that then shared in the earnings of the entity.\\nFor the period ended (six months) June 30, 2009, and for the period from July 18, 2007 (inception) to June 30, 2009, the Company had potentially dilutive securities in the form of 7,129,125 warrants, and 5,299,125 warrants issued as part of the Units (as defined below) in the Offering. Of the total warrants outstanding for the periods then ended, approximately 2,328,422 and 1,181,881, respectively, represent incremental shares of ordinary share, based on their assumed redemption, to be included in the weighted average number of shares of ordinary share outstanding (not subject to possible redemption) for the calculation of diluted income per ordinary share. The Company uses the “treasury stock method” to calculate potential dilutive shares, as if they were redeemed for ordinary share at the beginning of the period.\\nF-9\\nThe Company’s statements of operations includes a presentation of income per ordinary share subject to possible redemption in a manner similar to the two-class method of income per share. Basic and diluted income amount for the maximum number of shares subject to possible redemption is calculated by dividing the net interest attributable to common shares subject to redemption by the weighted average number of shares subject to possible redemption. Basic and diluted net income (loss) per share amount for the shares outstanding not subject to possible redemption is calculated by dividing the net income (loss) exclusive of the net interest income attributable to ordinary share subject to redemption by the weighted average number of shares not subject to possible redemption.\\nNewly Adopted Accounting Pronouncements:\\nIn December 2007, the FASB issued “Business Combinations”, which requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors, and other users, all of the information they need to evaluate and understand the nature and financial effect of the business combination. “Business Combinations” will be effective for acquisitions with a date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We will apply “Business Combinations” for any of our applicable acquisitions beginning January 1, 2009.\\nIn December 2007, the FASB issued “Noncontrolling Interests in Consolidated Financial Statements”, which requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity; the inclusion of the amount of net income attributable to the noncontrolling interest in consolidated income on the face of the income statement; and a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. This guidance will be effective for the fiscal years beginning on or after December 15, 2008. We will apply to any applicable transactions beginning January 1, 2009.\\nIn March 2008, the FASB issued “Disclosures about Derivative Instruments and Hedging Activities”, which is intended to improve financial standards for derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. Entities are required to provide enhanced disclosures about: (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years beginning after November 15, 2008, with early adoption encouraged. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial position; however, it could impact future transactions entered into by the Company.\\nOn April 9, 2009, the FASB issued the guidance of “Interim Disclosures about Fair Value of Financial Instruments” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. The guidance also amends Accounting Principles Board Opinion-Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. The guidance shall be effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this if certain requirements are met. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\\nF-10\\nOn April 9, 2009, the FASB issued the guidance of “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, to affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction; clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active; eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The guidance instead requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence. In addition, this guidance requires an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of it and to quantify its effects, if practicable. This guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 if certain requirements are met. It must be applied prospectively and retrospective application is not permitted. The adoption of this guidance did not have a significant impact on the Company’s financial statements or related footnotes.\\nOn April 9, 2009, the FASB issued “Recognition and Presentation of Other-Than-Temporary Impairments”, to be intended to bring consistency to the timing of impairment recognition, and provide improved disclosures about the credit and noncredit components of impaired debt securities that are not expected to be sold. The measure of impairment in comprehensive income remains fair value. The guidance also requires increased and more timely disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. This guidance shall be effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Earlier adoption for periods ending before March 15, 2009, is not permitted. If an entity elects to adopt early either “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, or “Interim Disclosures about Fair Value of Financial Instruments”, the entity also is required to adopt early this guidance. Additionally, if an entity elects to adopt early , it is required to adopt “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”. This guidance does not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, this guidance requires comparative disclosures only for periods ending after initial adoption. The adoption did not have a significant impact on the Company’s financial statement or footnotes.\\nOn May 28, 2009, the FASB issued the guidance regarding subsequent events, which we adopted on a prospective basis beginning April 1, 2009. The guidance is intended to establish general standards of accounting and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for selecting that date. The application of the pronouncement did not have an impact on our financial position, results of operations or cash flows. These financial statements were approved by management and were issued on January 22, 2010. Subsequent events have been evaluated through this date.\\nRecently Issued Accounting Pronouncements\\nIn June 2009, the Financial Accounting Standards Board issued the statement of “Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles This statement confirmed that the FASB Accounting Standards Codification (the “Codification”) will become the single official source of authoritative U.S. GAAP (other than guidance issued by the SEC), superseding existing FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force (“EITF”), and related literature. After that date, only one level of authoritative U.S. GAAP will exist. All other literature will be considered non-authoritative. The Codification does not change U.S. GAAP; instead, it introduces a new structure that is organized in an easily accessible, user-friendly online research system. The Codification, which changes the referencing of financial standards, becomes effective for interim and annual periods ending on or after September 15, 2009.. The Company has adopted this standard and did not have any substantive impact on our financial statements or related footnotes.\\nManagement does not believe that any other recently issued, but no yet effective accounting standards, if currently adopted, would have a material effect on the accompanying financial statements.\\nNOTE 3—PUBLIC OFFERING\\nOn March 7, 2008, the Company sold 4,000,000 units in the Offering at a price of $8.00 per unit. On March 31, 2008, the Company consummated the closing of an additional 239,300 units which were subject to the over-allotment option. Each unit consists of one share of the Company’s ordinary shares, $0.001 par value, and one warrant. Each warrant will entitle the holder to purchase from the Company one of the Company’s ordinary shares at an exercise price of $5.00 per share commencing on the later of: (i) The consummation of the Business Combination, or (ii) March 7, 2009. The warrants will be exercisable only if the Company continues to provide for an effective registration statement covering the ordinary shares issueable upon exercise of the warrants. In no event will the holder of a warrant be entitled to receive a net cash settlement or other consideration in lieu of physical settlement in shares of the Company’s ordinary shares.\\nF-11\\nThe warrants expire on March 7, 2013, unless earlier redeemed. The warrants included in the units sold in the Offering are redeemable, at the Company’s option, in whole and not in part at a price of $0.01 per warrant upon a minimum of 30 days’ notice after the warrants become exercisable, only in the event that the last sale price of the ordinary shares exceeds $11.50 per share for any 20 trading days within a 30-trading day period.\\nThe purchased warrants are recognized in additional paid-in-capital within shareholders’ equity since, under the terms of the warrants, the Company cannot be required to settle or redeem them for cash.\\nNOTE 4—RELATED PARTY TRANSACTIONS\\nThe Company has agreed to pay Hambrecht-Eu Capital, a company owned and managed by the Company’s Chairman of the Board, Chief Financial Officer and Secretary, $7,500 per month for office space and general and administrative services including secretarial support commencing on November 15, 2007 and continuing (i) until the consummation by the Company of a business combination (as described in Note 1), (ii) 18 months from commencement of the Offering if the Company does not effect a Business Combination, (iii) 24 months from the consummation of the Offering if a letter of intent, agreement in principle or definitive agreement, has been executed within 18 months of commencement of the Offering and the Company has not effected a business combination, or (iv) 36 months from the consummation of the Offering if an extension has been approved by the Company’s shareholders under certain circumstances.\\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC and the Hambrecht 1980 Revocable Trust, companies controlled by Elizabeth B. Hambrecht, wife of Robert Eu, one of the Company’s founders and the Company’s Chairman, Chief Financial Officer and Secretary and William R. Hambrecht, Robert Eu’s father-in-law, Shea Ventures LLC, a company controlled by Edmund H. Shea Jr. and Marbella Capital Partners Ltd., a company controlled by John Wang, our Chief Executive Officer, purchased an aggregate of 1,550,000 warrants at a price of $1.00 per warrant ($1,550,000 in the aggregate) in a private placement immediately prior to the initial public offering (“private placement warrants”). Elizabeth B. Hambrecht owns approximately 25% and William R. Hambrecht controls (through a trust of which he is trustee) approximately 38% of the voting shares of AEX Enterprises Limited. William Hambrecht is a controlling person of W.R. Hambrecht + Co., LLC and is the trustee of the Hambrecht 1980 Revocable Trust. The proceeds from the sale of the private placement warrants were added to the proceeds from the Offering and are held in the Trust Account pending the Company’s consummation of a Business Combination. If the Company does not complete a Business Combination that meets the criteria described in the Offering, then the $1,550,000 purchase price of the private placement warrants will become part of any liquidating distribution to the Company’s public shareholders following the Company’s liquidation and dissolution and the private placement warrants will expire worthless.\\nThe private placement warrants will be non-redeemable so long as they are held by the original holders of the warrants, the pre-initial public offering shareholders and directors or their permitted transferees. In addition, pursuant to the registration rights agreement, the holders of the private placement warrants and the underlying ordinary shares will be entitled to certain registration rights immediately after the consummation of the initial business combination and the warrants may be exercised on a cashless basis if held by the original holder, the pre-initial public offering shareholder and director or their permitted transferees. With those exceptions, the private placement warrants have terms and provisions that are otherwise identical to those of the warrants sold as part of the units in the Offering.\\nThe sale of private placement warrants did not result in the recognition of stock-based compensation expense because the private placement warrants were sold at or above fair market value.\\nAEX Enterprises Limited, W.R. Hambrecht + Co., LLC, the Hambrecht 1980 Revocable Trust, Shea Ventures LLC and Marbella Capital Partners Ltd. have agreed, subject to certain exceptions, not to transfer, assign or sell any of its private placement warrants until after the Company consummates a Business Combination. However, prior to the consummation of a business combination, the original holders of the warrants will be permitted to transfer their private placement warrants in certain limited circumstances, such as to the Company’s officers and directors, and other persons or entities associated with such persons, but the transferees receiving such private placement warrants will be subject to the same sale restrictions imposed on such entity.\\nF-12\\nRobert Eu, one of the Company’s founders, had provided to the Company advances totaling approximately $282,000 to pay a portion of the expenses of the Offering for the SEC registration fee, FINRA registration fee, and accounting and legal fees and expenses. The note was payable on demand with interest at 4% per annum. The note, plus interest of approximately $5,000, was repaid out of the proceeds of the Offering on March 12, 2008.\\nNOTE 5—FAIR VALUE MEASUREMENTS\\nThe Company complies with Fair Value Measurements, for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\\nThe following tables present information about the Company’s assets that are measured at fair value on a recurring basis as of June 30, 2009 and December 31, 2008, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are observable such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and includes situations where there is little, if any, market activity for the asset or liability:\\nFair Value of Financial Assets as of June 30, 2009\\n| Description | June 30, 2009 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\\n| Assets: |\\n| Cash equivalents | $ | 30,271 | $ | 30,271 | $ | — | $ | — |\\n| Cash equivalents held in Trust Account | 33,838,155 | 33,838,155 | — | — |\\n| Total | $ | 33,868,426 | $ | 33,868,426 | $ | — | $ | — |\\n\\nFair Value of Financial Assets as of December 31, 2008\\n| Description | December 31, 2008 | Quoted Prices in Active Markets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\\n| Assets: |\\n| Cash equivalents | $ | 100,312 | $ | 100,312 | $ | — | $ | — |\\n| Cash equivalents held in Trust Account | 33,798,651 | 33,798,651 | — | — |\\n| Total | $ | 33,898,963 | $ | 33,898,963 | $ | — | $ | — |\\n\\nF-13\\nThe fair values of the Company’s cash equivalents and cash and cash equivalents held on the Trust Account are determined through market, observable and corroborated sources.\\nNOTE 6— COMMITMENTS AND UNDERWRITERS’ COMPENSATION\\nThe Company consummated the Offering on March 12, 2008 and paid to the underwriters a $1,120,000 underwriting fee, representing 3.5% of the gross proceeds, and is committed to pay up to an additional $1,120,000, currently held in the Trust Account, representing an additional deferred underwriting fee of 3.5%, payable upon the Company’s consummation of a Business Combination.\\nOn March 31, 2008, the underwriters exercised their over-allotment option and purchased from the Company an additional 239,300 units. The Company paid to the underwriters a $67,004 underwriting discount, representing 3.5% of the over-allotment gross proceeds, and is committed to pay up to an additional $67,004, currently held in the Trust Account, representing an additional deferred underwriting discount of 3.5%, payable upon the Company’s consummation of a Business Combination.\\nThe Company also issued and sold to the underwriters on the closing date an option, as an additional compensation to purchase up to an aggregate of 280,000 units for an aggregate purchase price of $100. The Option shall be exercisable, in whole or in part, commencing on the later of the consummation of a Business Combination or six months from March 7, 2008 and expiring on March 7, 2013 at an initial exercise price of $10.00 per Unit.\\nThe Company has determined based upon a Black-Scholes- Merton option pricing model, that the estimated fair value of the option on the date of sale would be approximately $3.36 per unit or an aggregate of approximately $941,000, assuming an expected term of five years, estimated volatility of 51.51% and a risk-free interest rate of 3.38%. Given the parameters used in the computation of the value of the option change over time, the actual fair value of the option on the date of sale is expected to be different from the estimated fair value computed above.\\nThe volatility calculation of 51.51% is based on the latest five year average prior to the Offering, volatility of 62 companies drawn from the Shanghai Stock Exchange Composite Index that had market capitalizations between $70 million and $150 million. Because the Company does not have a trading history, the Company estimated the potential volatility of its ordinary share price, which will depend on a number of factors which cannot be ascertained at this time. The Company used the annualized volatility of the historical volatilities for a period of time equal in length to the term of the option because the Company believes that the volatility of these companies is a reasonable benchmark to use in estimating the expected volatility for the Company’s ordinary share post-Business Combination. Although an expected life of five years was taken into account for purposes of assigning value to this option, if the Company does not consummate a Business Combination within the prescribed time period and liquidates, this option would become worthless.\\nPursuant to Rule 2710(g)(1) of FINRA Conduct Rule, the option to purchase 280,000 units is deemed to be underwriting compensation and therefore upon exercise, the underlying ordinary shares and warrants are subject to a 180-day lock-up. Additionally, the option may not be sold, transferred, assigned, pledged or hypothecated for a one-year period (including the foregoing 180-day period) following the date of the Offering.\\nNOTE 7 — GOING CONCERN\\nOn September 4, 2009, the Company has issued a press release announcing that it has entered into a letter of intent with a company for a business combination. The target is a company with its principal business operations in the People’s Republic of China. Pursuant to the Company’s Amended and Restated Memorandum and Articles of Association, the execution of the letter of intent affords the Company a six-month extension for completion of a business combination, until March 12, 2010.\\nF-14\\nThe consummation of the business combination is subject to, among other things, execution of a definitive agreement and required stockholder approval. There can be no assurance that a business combination will be consummated. However, if we anticipate that we will not be able to consummate a business combination by March 12, 2010, we may seek shareholder approval to extend the period of time to consummate a business combination until March 12, 2011. If we are unable to complete the business combination by March 12, 2010, or March 12, 2011 if extension period approved, our purposes and powers will be limited to dissolving, liquidating and winding up. Also contained in our articles of association is the requirement that our board of directors, to the fullest extent permitted by law, consider a resolution to dissolve our company at that time. Consistent with such obligations, our board of directors will seek shareholder approval for any such plan of distribution, and our pre-initial public offering shareholders and directors have agreed to vote in favor of such dissolution and liquidation. This provision will be amended only in connection with, and upon consummation of, its initial business combination by such date. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern and is required to liquidate.\\nF-15\\n\\n</text>\\n\\nWhat is the total capital generated by the company through various activities from July 18, 2007 to June 30, 2009, excluding net income and assuming the interest income re-invested in the trust account was paid out to increase capital instead of being reinvested, in USD?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 68083947.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 35,\n \"input_length\": 31804\n}"}}},{"rowIdx":36,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1 Financial Statements\nFast Lane Holdings, Inc.\nBalance Sheet\n\n| As of March 31, 2019 (Unaudited) | As of December 31, 2018 |\n| TOTAL ASSETS | $ | - | $ | - |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| CURRENT LIABILITIES: |\n| Accrued expenses | $ | 300 | $ | 5,550 |\n| Total current liabilities | 300 | 5,550 |\n| TOTAL LIABILITIES | $ | 300 | $ | 5,550 |\n| STOCKHOLDERS' DEFICIT: |\n| Preferred stock ($.001 par value, 20,000,000 shares authorized, 5,000 issued and outstanding as of March 31, 2019 and December 31, 2018) | 5 | 5 |\n| Common stock ($.001 par value, 500,000,000 shares authorized, 72,948,316 issued and outstanding as of March 31, 2019 and December 31, 2018) | 72,948 | 72,948 |\n| Additional paid in capital | (66,401) | (72,648) |\n| Accumulated deficit | (6,852) | (5,855) |\n| Total Stockholders' deficit | (300) | (5,550) |\n| TOTAL LIABILITIES &STOCKHOLDERS’ DEFICIT | $ | - | $ | - |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 4 |\n\n\n| Fast Lane Holdings, Inc. Statement of Operations (Unaudited) |\n| For Three Months Ended March 31, 2019 |\n| Operating expenses |\n| General and administrative expenses | $ | 997 |\n| Total operating expenses | 997 |\n| Net loss | $ | (997) |\n| Basic and Diluted net loss per common share | $ | (0.00) |\n| Weighted average number of common shares outstanding - Basic and Diluted | 72,948,316 |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 5 |\n\n\n| Fast Lane Holdings, Inc. Statement of Changes in Stockholders' Deficit For the period from December 6, 2018 (date of inception) to March 31, 2019 (Unaudited) |\n| Preferred Shares (Series A) | Par Value Preferred Shares (Series A) | Common Shares | Par Value Common Shares | Additional Paid-in Capital | Accumulated Deficit | Total |\n| Date of Inception, December 6, 2018 | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\n| Shares issued in Reorganization | 5,000 | 5 | 72,948,316 | 72,948 | (72,953) | - | - |\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 305 | - | 305 |\n| Net loss | - | - | - | - | (5,855) | (5,855) |\n| Balances, December 31, 2018 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (72,648) | $ | (5,855) | $ | (5,550) |\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 6,247 | - | 6,247 |\n| Net loss | - | - | - | - | - | (997) | (997) |\n| Balances, March 31, 2019 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (66,401) | $ | (6,852) | $ | (300) |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 6 |\n\nFast Lane Holdings, Inc.\nStatement of Cash Flows\n(Unaudited)\n\n| For the Three Months Ended March 31, 2019 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net loss | $ | (997) |\n| Adjustment to reconcile net loss to net cash used in operating activities: |\n| Expenses contributed to capital | 6,247 |\n| Changes in current assets and liabilities: |\n| Accrued expenses | (5,250) |\n| Net cash used in operating activities | - |\n| Net change in cash | $ | - |\n| Beginning cash balance | - |\n| Ending cash balance | $ | - |\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\n| Interest paid | $ | - |\n| Income taxes paid | $ | - |\n\nThe accompanying notes are an integral part of these unaudited financial statements.\n\n| 7 |\n\nFast Lane Holdings, Inc.\nNotes to Unaudited Financial Statements\nNote 1 – Organization and Description of Business\nFast Lane Holdings, Inc. (we, us, our, or the \"Company\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holding, Inc. and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”).\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed a holding company reorganization pursuant to Section 251(g) of the DGCL by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant\nMotorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. Concurrently, the Company cancelled all of its stock held in GMOS Delaware.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\nThe Company has elected December 31st as its year end.\nNote 2 – Summary of Significant Accounting Policies\nBasis of Presentation\nThis summary of significant accounting policies is presented to assist in understanding the Company's financial statements. These accounting policies conform to accounting principles, generally accepted in the United States of America, and have been consistently applied in the preparation of the financial statements.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In the opinion of management, all adjustments necessary in order to make the financial statements not misleading have been included. Actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents at March 31, 2019 and December 31, 2018 were $0 for both periods.\n\n| 8 |\n\nIncome Taxes\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” Under the asset and liability method of ASC 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that the Company will not realize tax assets through future operations. No deferred tax assets or liabilities were recognized at March 31, 2019 and December 31, 2018.\nBasic Earnings (Loss) Per Share\nThe Company computes basic and diluted earnings (loss) per share in accordance with ASC Topic 260, Earnings per Share. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share reflects the potential dilution that could occur if stock options and other commitments to issue common stock were exercised or equity awards vest resulting in the issuance of common stock that could share in the earnings of the Company.\nThe Company does not have any potentially dilutive instruments as of March 31, 2019 and, thus, anti-dilution issues are not applicable.\nFair Value of Financial Instruments\nThe Company’s balance sheet includes certain financial instruments. The carrying amounts of current assets and current liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization.\nASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:\n- Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.\n- Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.\n- Level 3 - Inputs that are both significant to the fair value measurement and unobservable.\nFair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of March 31, 2019. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values due to the short-term nature of these instruments. These financial instruments include accrued expenses.\n\n| 9 |\n\nRelated Parties\nThe Company follows ASC 850, Related Party Disclosures, for the identification of related parties and disclosure of related party transactions.\nShare-Based Compensation\nASC 718, “Compensation – Stock Compensation”, prescribes accounting and reporting standards for all share-based payment transactions in which employee services are acquired. Transactions include incurring liabilities, or issuing or offering to issue shares, options, and other equity instruments such as employee stock ownership plans and stock appreciation rights. Share-based payments to employees, including grants of employee stock options, are recognized as compensation expense in the financial statements based on their fair values. That expense is recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).\nThe Company accounts for stock-based compensation issued to non-employees and consultants in accordance with the provisions of ASC 505-50, “Equity – Based Payments to Non-Employees.” Measurement of share-based payment transactions with non-employees is based on the fair value of whichever is more reliably measurable: (a) the goods or services received; or (b) the equity instruments issued. The fair value of the share-based payment transaction is determined at the earlier of performance commitment date or performance completion date.\nThe Company had no stock-based compensation plans as of March 31, 2019.\nThe Company’s stock based compensation for the periods ended March 31, 2019 and December 31, 2018 was $0 for both periods.\nRecently Issued Accounting Pronouncements\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 is amended by ASU 2018-01, ASU2018-10, ASU 2018-11, ASU 2018-20 and ASU 2019-01, which FASB issued in January 2018, July 2018, July 2018, December 2018 and March 2019, respectively (collectively, the amended ASU 2016-02). The amended ASU 2016-02 requires lessees to recognize on the balance sheet a right-of-use asset, representing its right to use the underlying asset for the lease term, and a lease liability for all leases with terms greater than 12 months. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from current GAAP. The amended ASU 2016-02 retains a distinction between finance leases (i.e. capital leases under current GAAP) and operating leases. The classification criteria for distinguishing between finance leases and operating leases will be substantially similar to the classification criteria for distinguishing between capital leases and operating leases under current GAAP. The amended ASU 2016-02 also requires qualitative and quantitative disclosures designed to assess the amount, timing, and uncertainty of cash flows arising from leases. A modified retrospective transition approach is permitted to be used when an entity adopts the amended ASU 2016-02, which includes a number of optional practical expedients that entities may elect to apply.\nWe have no assets and or leases and do not believe we will be impacted in the foreseeable future by the newly adopted accounting standard(s) mentioned above.\nThe Company has implemented all new accounting pronouncements that are in effect and that may impact its financial statements and does not believe that there are any other new pronouncements that have been issued that might have a material impact on its financial position or results of operations.\nNote 3 – Going Concern\nThe Company’s financial statements are prepared in accordance with generally accepted accounting principles applicable to a going concern that contemplates the realization of assets and liquidation of liabilities in the normal course of business.\nThe Company demonstrates adverse conditions that raise substantial doubt about the Company's ability to continue as a going concern for one year following the issuance of these financial statements. These adverse conditions are negative financial trends, specifically operating loss, working capital deficiency, and other adverse key financial ratios.\nThe Company has not established any source of revenue to cover its operating costs. Management plans to fund operating expenses with related party contributions to capital. There is no assurance that management's plan will be successful. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets, or the amounts and classification of liabilities that might be necessary in the event that the Company cannot continue as a going concern.\nNote 4 – Income Taxes\nThe Company has not recognized an income tax benefit for its operating losses generated based on uncertainties concerning its ability to generate taxable income in future periods. The tax benefit for the period presented is offset by a valuation allowance established against deferred tax assets arising from the net operating losses, the realization of which could not be considered more likely than not. In future periods, tax benefits and related deferred tax assets will be recognized when management considers realization of such amounts to be more likely than not. As of March 31, 2019, the Company has incurred a net loss of approximately $6,852 which resulted in a net operating loss for income tax purposes. The loss results in a deferred tax asset of approximately $1,439 at the effective statutory rate of 21%. The deferred tax asset has been off-set by an equal valuation allowance. Given our inception on December 6, 2018, and our fiscal year end of December 31, 2018, we have completed only one taxable fiscal year.\nNote 5 – Commitments and Contingencies\nThe Company follows ASC 450-20, Loss Contingencies, to report accounting for contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated. There were no commitments or contingencies as of March 31, 2019.\nNote 6 – Accrued Expenses\nAccrued expenses totaled $300 as of March 31, 2019 and $5,550 as of December 31, 2018 and consisted primarily of professional fees for both periods.\nNote 7 – Shareholder Equity\nPreferred Stock\nThe authorized preferred stock of the Company consists of 20,000,000 shares with a par value of $0.001. There are 5,000,000 shares of Series “A” convertible Preferred Stock issued and outstanding as of March 31, 2019 and December 31, 2018.\nOn June 29, 2018, the Company issued 2,550 shares of Series “A” convertible Preferred Stock to Giant Consulting Services, LLC (“GCS”), a Wyoming Limited Liability Company, for helping the Company locate an acquisition or merger candidate. Jeffrey DeNunzio is the controlling member and Paul Moody, our sole director, is the Manager of GCS. The preferred stock is convertible into one share of common stock. The preferred stock has no voting rights in the Company other than the right to vote upon a change to its class rights, privileges or designations by the majority vote of the Series “A” convertible preferred class shareholders. The Board of Directors may, in the future, issue additional classes of preferred stock which shall have attributes and rights as determined by the Board of Directors at that time.\nCommon Stock\nThe authorized common stock of the Company consists of 500,000,000 shares with a par value of $0.001. There were 72,948,316 shares of common stock issued and outstanding as of March 31, 2019 and December 31, 2018.\nOn June 29, 2018, 60,000,000 common shares were issued by GMOS Nevada to GCS for development of the Company’s business plan.\nOn December 28, 2018, each share of capital stock of GMOS Delaware issued and outstanding immediately prior to the holding company reorganization was automatically converted into one fully paid and non-assessable share of capital stock of the Company.\nThe outstanding common shares were originally issued by GMOS Nevada prior to reorganization and are now listed as converted shares for the Company.\nAdditional Paid-In Capital\nThe Company’s sole officer and director, Paul Moody, paid expenses on behalf of the company totaling $305 as of December 31, 2018. During the three months ended March 31, 2019, Mr. Moody paid expenses on behalf of the company totaling $6,247. The $6,552 in total payments are considered a contribution to the company with no expectation of repayment and is posted as additional paid-in capital.\nNote 8 – Related-Party Transactions\nOffice Space\nWe utilize the home office space and equipment of our management at no cost.\nNote 9 – Subsequent Events\nManagement has reviewed financial transactions for the Company subsequent to the quarter ended March 31, 2019 and has found that there was nothing material to disclose.\n\n| 10 |\n\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations is designed to provide a reader of the financial statements with a narrative report on our financial condition, results of operations, and liquidity. This discussion and analysis should be read in conjunction with the attached unaudited Financial Statements and notes thereto and our Registration Statement on Form 10-12G, which contains audited Financial Statements and notes thereto for the period ended December 31, 2018. The following discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Please also see the cautionary language at the beginning of this Quarterly Report regarding forward-looking statements.\nCorporate History\nFast Lane Holdings, Inc. (we, us, our, or the \"Company\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”) with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holdings, Inc.; and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. .\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed the holding company reorganization by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant Motorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. The Company was given a new CUSIP Number by CUSIP Global Services for its common stock of 31189D109. Concurrently, the Company cancelled all of its stock held in GMOS Delaware resulting in GMOS Delaware becoming a stand-alone company.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\n| 11 |\n\nBusiness Overview\nThe Company, based on current and proposed business activities, is considered a “blank check” company. The SEC defines a “blank check” company as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51)-1 of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies or other entity or person.” Pursuant to Rule 12b-2 promulgated under the Exchange Act, the Company also qualifies as a shell company, because it has no or nominal assets (other than cash) and no or nominal operations. In addition, many states have enacted statutes, rules, and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions.\nIn addition, the Company is an “emerging growth company” (“EGC”), that is exempt from certain financial disclosure and governance requirements for up to five years as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), that eases restrictions on the sale of securities, and increases the number of stockholders a company must have before becoming subject to the SEC’s reporting and disclosure rules. We have elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(2) of the Jobs Act, that allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates.\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018 and March 31, 2019, the Company had not yet commenced any substantive operations.\nWe do not currently engage in any business activities that provide cash flow. The costs of investigating and analyzing business combinations and opportunities for the next 12 months and beyond such time will be paid with money in our treasury, if any, or with additional amounts, as necessary, to be loaned to or invested in us by our stockholders, management, or other investors. At this time, we are entirely reliant upon cash contributions made by our officers and directors to pay for any and all expenses.\n\n| 12 |\n\nWe have negative working capital, a stockholder deficit, and have no source of revenues. These conditions raise substantial doubt about our ability to continue as a going concern. For the foreseeable future, we will be devoting our efforts to exploring and evaluating business opportunities, which may include merger or acquisition candidates. Our ability to continue as a going concern is dependent upon our ability to develop additional sources of capital, locate and complete a merger with another company or otherwise commence business operations, and ultimately, achieve profitable operations.\nLiquidity and Capital Resources\nWe have no known demands or commitments and are not aware of any events or uncertainties as of March 31, 2019 that will result in or that are reasonably likely to materially increase or decrease our current liquidity.\nAs of March 31, 2019, the Company had no assets. The Company’s current liabilities as March 31, 2019 totaled $250, which consisted of accrued expenses.\nThe Company had no cash flows from operating activities for the three months ended March 31, 2019. The Company has generated no revenues since inception. The Company is dependent upon the receipt of capital investment or other financing to fund its ongoing operations and to execute its business plan. In addition, the Company is dependent upon certain related parties to provide continued funding and capital resources. If continued funding and capital resources are unavailable at reasonable terms, the Company may not be able to implement its plan of operations. The Company can provide no assurance that it can continue to satisfy its cash requirements for at least the next twelve months.\nResults of Operations\nThe Company has not conducted any substantive operations since inception. The Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business.\nFor the three months ended March 31, 2019, the Company had a net loss of $922, which consisted of general and administrative expenses.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors.\n\n| 13 |\n\nEmerging Growth Company\nAs an EGC under the JOBS Act, the Company has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of our election, our financial statements may not be comparable to companies that comply with public company effective dates.\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\n\nEvaluation of Disclosure Controls and Procedures\nPaul Moody is our sole officer and director.\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, Paul Moody, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2019, the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer, Paul Moody, concluded that because of material weakness in our internal control over financial reporting, our disclosure controls and procedures were not effective as of March 31, 2019.\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitations, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and our principal financial officer, to allow timely decisions regarding required disclosure.\nChances in Internal Control over Financial Reporting\nDuring the fiscal quarter ended March 31, 2019, there was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n\n| 14 |\n\nPART II OTHER INFORMATION\n\nItem 1. Legal Proceedings\nThere are no material pending legal proceedings as defined by Item 103 of Regulation S-K, to which we are a party or of which any of our property is the subject, other than ordinary routine litigation incidental to the Company’s business.\n\nItem 1A. Risk Factors\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone.\n\nItem 3. Defaults Upon Senior Securities\nNone.\n\nItem 4. Mine Safety Disclosures\nNone.\n\nItem 5. Other Information\nNone.\n\n| 15 |\n\n\nItem 6. Exhibits\nThe following exhibits are filed herewith as a part of this report.\n\n| Exhibit Number | Description |\n| 3.1 | Certificate of Incorporation, which was filed as Exhibit 3.1 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\n| 3.2 | Bylaws, which were filed as Exhibit 3.2 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\n| 31.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934* |\n| 32.1 | Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Chapter 63 of Title 18 of the United States Code* |\n| 101.INS | XBRL Instance Document * |\n| 101.SCH | XBRL Taxonomy Extension Schema Document * |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document * |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document * |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document * |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document * |\n\n*filed herewith\n\n| 16 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Fast Lane HOLDINGS, INC. |\n| Date: May 10, 2019 | By: | /s/ Paul Moody |\n| Paul Moody |\n| Chief Executive Officer, and Chief Financial Officer |\n\n17\n\n</text>\n\nWhat is the percentage change in the company's net operating loss for income tax purposes from December 31, 2018 to March 31, 2019?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1 Financial Statements\\nFast Lane Holdings, Inc.\\nBalance Sheet\\n\\n| As of March 31, 2019 (Unaudited) | As of December 31, 2018 |\\n| TOTAL ASSETS | $ | - | $ | - |\\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\\n| CURRENT LIABILITIES: |\\n| Accrued expenses | $ | 300 | $ | 5,550 |\\n| Total current liabilities | 300 | 5,550 |\\n| TOTAL LIABILITIES | $ | 300 | $ | 5,550 |\\n| STOCKHOLDERS' DEFICIT: |\\n| Preferred stock ($.001 par value, 20,000,000 shares authorized, 5,000 issued and outstanding as of March 31, 2019 and December 31, 2018) | 5 | 5 |\\n| Common stock ($.001 par value, 500,000,000 shares authorized, 72,948,316 issued and outstanding as of March 31, 2019 and December 31, 2018) | 72,948 | 72,948 |\\n| Additional paid in capital | (66,401) | (72,648) |\\n| Accumulated deficit | (6,852) | (5,855) |\\n| Total Stockholders' deficit | (300) | (5,550) |\\n| TOTAL LIABILITIES &STOCKHOLDERS’ DEFICIT | $ | - | $ | - |\\n\\nThe accompanying notes are an integral part of these unaudited financial statements.\\n\\n| 4 |\\n\\n\\n| Fast Lane Holdings, Inc. Statement of Operations (Unaudited) |\\n| For Three Months Ended March 31, 2019 |\\n| Operating expenses |\\n| General and administrative expenses | $ | 997 |\\n| Total operating expenses | 997 |\\n| Net loss | $ | (997) |\\n| Basic and Diluted net loss per common share | $ | (0.00) |\\n| Weighted average number of common shares outstanding - Basic and Diluted | 72,948,316 |\\n\\nThe accompanying notes are an integral part of these unaudited financial statements.\\n\\n| 5 |\\n\\n\\n| Fast Lane Holdings, Inc. Statement of Changes in Stockholders' Deficit For the period from December 6, 2018 (date of inception) to March 31, 2019 (Unaudited) |\\n| Preferred Shares (Series A) | Par Value Preferred Shares (Series A) | Common Shares | Par Value Common Shares | Additional Paid-in Capital | Accumulated Deficit | Total |\\n| Date of Inception, December 6, 2018 | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - |\\n| Shares issued in Reorganization | 5,000 | 5 | 72,948,316 | 72,948 | (72,953) | - | - |\\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 305 | - | 305 |\\n| Net loss | - | - | - | - | (5,855) | (5,855) |\\n| Balances, December 31, 2018 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (72,648) | $ | (5,855) | $ | (5,550) |\\n| Expenses paid on behalf of the Company and contributed to capital | - | - | - | - | 6,247 | - | 6,247 |\\n| Net loss | - | - | - | - | - | (997) | (997) |\\n| Balances, March 31, 2019 | 5,000 | $ | 5 | 72,948,316 | $ | 72,948 | $ | (66,401) | $ | (6,852) | $ | (300) |\\n\\nThe accompanying notes are an integral part of these unaudited financial statements.\\n\\n| 6 |\\n\\nFast Lane Holdings, Inc.\\nStatement of Cash Flows\\n(Unaudited)\\n\\n| For the Three Months Ended March 31, 2019 |\\n| CASH FLOWS FROM OPERATING ACTIVITIES |\\n| Net loss | $ | (997) |\\n| Adjustment to reconcile net loss to net cash used in operating activities: |\\n| Expenses contributed to capital | 6,247 |\\n| Changes in current assets and liabilities: |\\n| Accrued expenses | (5,250) |\\n| Net cash used in operating activities | - |\\n| Net change in cash | $ | - |\\n| Beginning cash balance | - |\\n| Ending cash balance | $ | - |\\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\\n| Interest paid | $ | - |\\n| Income taxes paid | $ | - |\\n\\nThe accompanying notes are an integral part of these unaudited financial statements.\\n\\n| 7 |\\n\\nFast Lane Holdings, Inc.\\nNotes to Unaudited Financial Statements\\nNote 1 – Organization and Description of Business\\nFast Lane Holdings, Inc. (we, us, our, or the \\\"Company\\\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holding, Inc. and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”).\\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed a holding company reorganization pursuant to Section 251(g) of the DGCL by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant\\nMotorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. Concurrently, the Company cancelled all of its stock held in GMOS Delaware.\\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\\nThe Company has elected December 31st as its year end.\\nNote 2 – Summary of Significant Accounting Policies\\nBasis of Presentation\\nThis summary of significant accounting policies is presented to assist in understanding the Company's financial statements. These accounting policies conform to accounting principles, generally accepted in the United States of America, and have been consistently applied in the preparation of the financial statements.\\nUse of Estimates\\nThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In the opinion of management, all adjustments necessary in order to make the financial statements not misleading have been included. Actual results could differ from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents at March 31, 2019 and December 31, 2018 were $0 for both periods.\\n\\n| 8 |\\n\\nIncome Taxes\\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” Under the asset and liability method of ASC 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that the Company will not realize tax assets through future operations. No deferred tax assets or liabilities were recognized at March 31, 2019 and December 31, 2018.\\nBasic Earnings (Loss) Per Share\\nThe Company computes basic and diluted earnings (loss) per share in accordance with ASC Topic 260, Earnings per Share. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share reflects the potential dilution that could occur if stock options and other commitments to issue common stock were exercised or equity awards vest resulting in the issuance of common stock that could share in the earnings of the Company.\\nThe Company does not have any potentially dilutive instruments as of March 31, 2019 and, thus, anti-dilution issues are not applicable.\\nFair Value of Financial Instruments\\nThe Company’s balance sheet includes certain financial instruments. The carrying amounts of current assets and current liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization.\\nASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:\\n- Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.\\n- Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.\\n- Level 3 - Inputs that are both significant to the fair value measurement and unobservable.\\nFair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of March 31, 2019. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values due to the short-term nature of these instruments. These financial instruments include accrued expenses.\\n\\n| 9 |\\n\\nRelated Parties\\nThe Company follows ASC 850, Related Party Disclosures, for the identification of related parties and disclosure of related party transactions.\\nShare-Based Compensation\\nASC 718, “Compensation – Stock Compensation”, prescribes accounting and reporting standards for all share-based payment transactions in which employee services are acquired. Transactions include incurring liabilities, or issuing or offering to issue shares, options, and other equity instruments such as employee stock ownership plans and stock appreciation rights. Share-based payments to employees, including grants of employee stock options, are recognized as compensation expense in the financial statements based on their fair values. That expense is recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).\\nThe Company accounts for stock-based compensation issued to non-employees and consultants in accordance with the provisions of ASC 505-50, “Equity – Based Payments to Non-Employees.” Measurement of share-based payment transactions with non-employees is based on the fair value of whichever is more reliably measurable: (a) the goods or services received; or (b) the equity instruments issued. The fair value of the share-based payment transaction is determined at the earlier of performance commitment date or performance completion date.\\nThe Company had no stock-based compensation plans as of March 31, 2019.\\nThe Company’s stock based compensation for the periods ended March 31, 2019 and December 31, 2018 was $0 for both periods.\\nRecently Issued Accounting Pronouncements\\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 is amended by ASU 2018-01, ASU2018-10, ASU 2018-11, ASU 2018-20 and ASU 2019-01, which FASB issued in January 2018, July 2018, July 2018, December 2018 and March 2019, respectively (collectively, the amended ASU 2016-02). The amended ASU 2016-02 requires lessees to recognize on the balance sheet a right-of-use asset, representing its right to use the underlying asset for the lease term, and a lease liability for all leases with terms greater than 12 months. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from current GAAP. The amended ASU 2016-02 retains a distinction between finance leases (i.e. capital leases under current GAAP) and operating leases. The classification criteria for distinguishing between finance leases and operating leases will be substantially similar to the classification criteria for distinguishing between capital leases and operating leases under current GAAP. The amended ASU 2016-02 also requires qualitative and quantitative disclosures designed to assess the amount, timing, and uncertainty of cash flows arising from leases. A modified retrospective transition approach is permitted to be used when an entity adopts the amended ASU 2016-02, which includes a number of optional practical expedients that entities may elect to apply.\\nWe have no assets and or leases and do not believe we will be impacted in the foreseeable future by the newly adopted accounting standard(s) mentioned above.\\nThe Company has implemented all new accounting pronouncements that are in effect and that may impact its financial statements and does not believe that there are any other new pronouncements that have been issued that might have a material impact on its financial position or results of operations.\\nNote 3 – Going Concern\\nThe Company’s financial statements are prepared in accordance with generally accepted accounting principles applicable to a going concern that contemplates the realization of assets and liquidation of liabilities in the normal course of business.\\nThe Company demonstrates adverse conditions that raise substantial doubt about the Company's ability to continue as a going concern for one year following the issuance of these financial statements. These adverse conditions are negative financial trends, specifically operating loss, working capital deficiency, and other adverse key financial ratios.\\nThe Company has not established any source of revenue to cover its operating costs. Management plans to fund operating expenses with related party contributions to capital. There is no assurance that management's plan will be successful. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets, or the amounts and classification of liabilities that might be necessary in the event that the Company cannot continue as a going concern.\\nNote 4 – Income Taxes\\nThe Company has not recognized an income tax benefit for its operating losses generated based on uncertainties concerning its ability to generate taxable income in future periods. The tax benefit for the period presented is offset by a valuation allowance established against deferred tax assets arising from the net operating losses, the realization of which could not be considered more likely than not. In future periods, tax benefits and related deferred tax assets will be recognized when management considers realization of such amounts to be more likely than not. As of March 31, 2019, the Company has incurred a net loss of approximately $6,852 which resulted in a net operating loss for income tax purposes. The loss results in a deferred tax asset of approximately $1,439 at the effective statutory rate of 21%. The deferred tax asset has been off-set by an equal valuation allowance. Given our inception on December 6, 2018, and our fiscal year end of December 31, 2018, we have completed only one taxable fiscal year.\\nNote 5 – Commitments and Contingencies\\nThe Company follows ASC 450-20, Loss Contingencies, to report accounting for contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated. There were no commitments or contingencies as of March 31, 2019.\\nNote 6 – Accrued Expenses\\nAccrued expenses totaled $300 as of March 31, 2019 and $5,550 as of December 31, 2018 and consisted primarily of professional fees for both periods.\\nNote 7 – Shareholder Equity\\nPreferred Stock\\nThe authorized preferred stock of the Company consists of 20,000,000 shares with a par value of $0.001. There are 5,000,000 shares of Series “A” convertible Preferred Stock issued and outstanding as of March 31, 2019 and December 31, 2018.\\nOn June 29, 2018, the Company issued 2,550 shares of Series “A” convertible Preferred Stock to Giant Consulting Services, LLC (“GCS”), a Wyoming Limited Liability Company, for helping the Company locate an acquisition or merger candidate. Jeffrey DeNunzio is the controlling member and Paul Moody, our sole director, is the Manager of GCS. The preferred stock is convertible into one share of common stock. The preferred stock has no voting rights in the Company other than the right to vote upon a change to its class rights, privileges or designations by the majority vote of the Series “A” convertible preferred class shareholders. The Board of Directors may, in the future, issue additional classes of preferred stock which shall have attributes and rights as determined by the Board of Directors at that time.\\nCommon Stock\\nThe authorized common stock of the Company consists of 500,000,000 shares with a par value of $0.001. There were 72,948,316 shares of common stock issued and outstanding as of March 31, 2019 and December 31, 2018.\\nOn June 29, 2018, 60,000,000 common shares were issued by GMOS Nevada to GCS for development of the Company’s business plan.\\nOn December 28, 2018, each share of capital stock of GMOS Delaware issued and outstanding immediately prior to the holding company reorganization was automatically converted into one fully paid and non-assessable share of capital stock of the Company.\\nThe outstanding common shares were originally issued by GMOS Nevada prior to reorganization and are now listed as converted shares for the Company.\\nAdditional Paid-In Capital\\nThe Company’s sole officer and director, Paul Moody, paid expenses on behalf of the company totaling $305 as of December 31, 2018. During the three months ended March 31, 2019, Mr. Moody paid expenses on behalf of the company totaling $6,247. The $6,552 in total payments are considered a contribution to the company with no expectation of repayment and is posted as additional paid-in capital.\\nNote 8 – Related-Party Transactions\\nOffice Space\\nWe utilize the home office space and equipment of our management at no cost.\\nNote 9 – Subsequent Events\\nManagement has reviewed financial transactions for the Company subsequent to the quarter ended March 31, 2019 and has found that there was nothing material to disclose.\\n\\n| 10 |\\n\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations is designed to provide a reader of the financial statements with a narrative report on our financial condition, results of operations, and liquidity. This discussion and analysis should be read in conjunction with the attached unaudited Financial Statements and notes thereto and our Registration Statement on Form 10-12G, which contains audited Financial Statements and notes thereto for the period ended December 31, 2018. The following discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Please also see the cautionary language at the beginning of this Quarterly Report regarding forward-looking statements.\\nCorporate History\\nFast Lane Holdings, Inc. (we, us, our, or the \\\"Company\\\") was incorporated on December 6, 2018 in the State of Delaware. The Company was created for the sole purpose of participating in a Delaware holding company reorganization pursuant to Section 251(g) of the General Corporation Law of the state of Delaware, (the “DGCL”) with Giant Motorsports Delaware Inc. (“GMOS Delaware”), a Delaware corporation incorporated on December 6, 2018 and parent company of Fast Lane Holdings, Inc.; and Giant Motorsports Merger Sub, Inc., a Delaware corporation incorporated on December 6, 2018 and a wholly owned subsidiary of Fast Lane Holdings, Inc. .\\nOn December 6, 2018, Paul Moody was appointed Chief Executive Officer, Chief Financial Officer, and Director of Fast Lane Holdings, Inc., Giant Motorsports Delaware, Inc. and Giant Motorsports Merger Sub, Inc.\\nOn December 28, 2018, Giant Motorsports, Inc. (“GMOS Nevada”), a Nevada corporation merged with and into GMOS Delaware, a wholly owned subsidiary of GMOS Nevada with GMOS Delaware as the surviving corporation. The sole purpose to merge GMOS Nevada with and into GMOS Delaware was to re-domesticate GMOS Nevada from Nevada to Delaware.\\nOn December 28, 2018, Giant Motorsports Delaware, Inc. completed the holding company reorganization by merging with and into its indirect wholly owned subsidiary known as Giant Motorsports Merger Sub, Inc. with Giant Motorsports Delaware, Inc. as the surviving corporation and becoming a wholly owned subsidiary of Fast Lane Holdings, Inc. Fast Lane Holdings, Inc. as successor issuer to Giant Motorsports, Inc. continued to trade in the OTC MarketPlace under the previous ticker symbol “GMOS” until the new ticker symbol “FLHI” for the Company was released into the OTC MarketPlace on January 10, 2019. The Company was given a new CUSIP Number by CUSIP Global Services for its common stock of 31189D109. Concurrently, the Company cancelled all of its stock held in GMOS Delaware resulting in GMOS Delaware becoming a stand-alone company.\\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018, the Company had not yet commenced any operations.\\n| 11 |\\n\\nBusiness Overview\\nThe Company, based on current and proposed business activities, is considered a “blank check” company. The SEC defines a “blank check” company as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51)-1 of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies or other entity or person.” Pursuant to Rule 12b-2 promulgated under the Exchange Act, the Company also qualifies as a shell company, because it has no or nominal assets (other than cash) and no or nominal operations. In addition, many states have enacted statutes, rules, and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions.\\nIn addition, the Company is an “emerging growth company” (“EGC”), that is exempt from certain financial disclosure and governance requirements for up to five years as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), that eases restrictions on the sale of securities, and increases the number of stockholders a company must have before becoming subject to the SEC’s reporting and disclosure rules. We have elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(2) of the Jobs Act, that allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates.\\nThe Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business. As of December 31, 2018 and March 31, 2019, the Company had not yet commenced any substantive operations.\\nWe do not currently engage in any business activities that provide cash flow. The costs of investigating and analyzing business combinations and opportunities for the next 12 months and beyond such time will be paid with money in our treasury, if any, or with additional amounts, as necessary, to be loaned to or invested in us by our stockholders, management, or other investors. At this time, we are entirely reliant upon cash contributions made by our officers and directors to pay for any and all expenses.\\n\\n| 12 |\\n\\nWe have negative working capital, a stockholder deficit, and have no source of revenues. These conditions raise substantial doubt about our ability to continue as a going concern. For the foreseeable future, we will be devoting our efforts to exploring and evaluating business opportunities, which may include merger or acquisition candidates. Our ability to continue as a going concern is dependent upon our ability to develop additional sources of capital, locate and complete a merger with another company or otherwise commence business operations, and ultimately, achieve profitable operations.\\nLiquidity and Capital Resources\\nWe have no known demands or commitments and are not aware of any events or uncertainties as of March 31, 2019 that will result in or that are reasonably likely to materially increase or decrease our current liquidity.\\nAs of March 31, 2019, the Company had no assets. The Company’s current liabilities as March 31, 2019 totaled $250, which consisted of accrued expenses.\\nThe Company had no cash flows from operating activities for the three months ended March 31, 2019. The Company has generated no revenues since inception. The Company is dependent upon the receipt of capital investment or other financing to fund its ongoing operations and to execute its business plan. In addition, the Company is dependent upon certain related parties to provide continued funding and capital resources. If continued funding and capital resources are unavailable at reasonable terms, the Company may not be able to implement its plan of operations. The Company can provide no assurance that it can continue to satisfy its cash requirements for at least the next twelve months.\\nResults of Operations\\nThe Company has not conducted any substantive operations since inception. The Company intends to serve as a vehicle to affect an asset acquisition, merger, exchange of capital stock or other business combination with a domestic or foreign business.\\nFor the three months ended March 31, 2019, the Company had a net loss of $922, which consisted of general and administrative expenses.\\nOff-Balance Sheet Arrangements\\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors.\\n\\n| 13 |\\n\\nEmerging Growth Company\\nAs an EGC under the JOBS Act, the Company has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of our election, our financial statements may not be comparable to companies that comply with public company effective dates.\\n\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\\n\\nEvaluation of Disclosure Controls and Procedures\\nPaul Moody is our sole officer and director.\\nUnder the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, Paul Moody, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2019, the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer, Paul Moody, concluded that because of material weakness in our internal control over financial reporting, our disclosure controls and procedures were not effective as of March 31, 2019.\\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitations, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and our principal financial officer, to allow timely decisions regarding required disclosure.\\nChances in Internal Control over Financial Reporting\\nDuring the fiscal quarter ended March 31, 2019, there was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\n\\n| 14 |\\n\\nPART II OTHER INFORMATION\\n\\nItem 1. Legal Proceedings\\nThere are no material pending legal proceedings as defined by Item 103 of Regulation S-K, to which we are a party or of which any of our property is the subject, other than ordinary routine litigation incidental to the Company’s business.\\n\\nItem 1A. Risk Factors\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide the information required by this Item.\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nNone.\\n\\nItem 3. Defaults Upon Senior Securities\\nNone.\\n\\nItem 4. Mine Safety Disclosures\\nNone.\\n\\nItem 5. Other Information\\nNone.\\n\\n| 15 |\\n\\n\\nItem 6. Exhibits\\nThe following exhibits are filed herewith as a part of this report.\\n\\n| Exhibit Number | Description |\\n| 3.1 | Certificate of Incorporation, which was filed as Exhibit 3.1 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\\n| 3.2 | Bylaws, which were filed as Exhibit 3.2 to our Registration Statement on Form 10-12G/A filed with the Securities and Exchange Commission on April 24, 2019, and is incorporated herein by reference thereto. |\\n| 31.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934* |\\n| 32.1 | Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Chapter 63 of Title 18 of the United States Code* |\\n| 101.INS | XBRL Instance Document * |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document * |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document * |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document * |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document * |\\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document * |\\n\\n*filed herewith\\n\\n| 16 |\\n\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| Fast Lane HOLDINGS, INC. |\\n| Date: May 10, 2019 | By: | /s/ Paul Moody |\\n| Paul Moody |\\n| Chief Executive Officer, and Chief Financial Officer |\\n\\n17\\n\\n</text>\\n\\nWhat is the percentage change in the company's net operating loss for income tax purposes from December 31, 2018 to March 31, 2019?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 17.02818104184458.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 36,\n \"input_length\": 7651\n}"}}},{"rowIdx":37,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nPart 1. Financial Information.\nItem 1. Financial Statements.\n\n| March 31, 2019 | December 31, 2018* |\n| ASSETS |\n| Investments: |\n| Investments available for sale: |\n| Fixed maturities, at fair value (amortized cost $158,812,233 and $160,895,869) | $ | 163,906,663 | $ | 160,960,784 |\n| Equity securities, at fair value (cost $34,883,412 and $34,885,107) | 82,450,417 | 67,664,482 |\n| Equity securities, at cost | 12,133,745 | 12,118,617 |\n| Mortgage loans on real estate at amortized cost | 10,703,553 | 9,069,111 |\n| Investment real estate | 51,530,162 | 52,518,577 |\n| Notes receivable | 26,595,336 | 23,717,312 |\n| Policy loans | 9,117,979 | 9,204,222 |\n| Total investments | 356,437,855 | 335,253,105 |\n| Cash and cash equivalents | 19,049,555 | 20,150,162 |\n| Accrued investment income | 1,887,094 | 2,119,882 |\n| Reinsurance receivables: |\n| Future policy benefits | 26,091,199 | 26,117,936 |\n| Policy claims and other benefits | 4,142,345 | 4,053,882 |\n| Cost of insurance acquired | 5,428,250 | 5,622,227 |\n| Property and equipment, net of accumulated depreciation | 581,680 | 688,567 |\n| Income tax receivable | - | 279,333 |\n| Other assets | 355,673 | 1,263,242 |\n| Total assets | $ | 413,973,651 | $ | 395,548,336 |\n| LIABILITIES & SHAREHOLDERS' EQUITY |\n| Liabilities: |\n| Policy liabilities and accruals: |\n| Future policyholder benefits | $ | 252,418,038 | $ | 253,852,368 |\n| Policy claims and benefits payable | 4,335,480 | 4,267,481 |\n| Other policyholder funds | 430,413 | 372,072 |\n| Dividend and endowment accumulations | 14,586,502 | 14,608,838 |\n| Income taxes payable | 333,283 | - |\n| Deferred income taxes | 13,231,079 | 9,113,480 |\n| Other liabilities | 6,105,232 | 6,257,387 |\n| Total liabilities | 291,440,027 | 288,471,626 |\n| Shareholders' equity: |\n| Common stock - no par value, stated value $.001 per share. Authorized 7,000,000 shares - 3,296,547 and 3,295,870 shares outstanding | 3,297 | 3,296 |\n| Additional paid-in capital | 36,585,277 | 36,567,865 |\n| Retained earnings | 81,353,780 | 69,708,901 |\n| Accumulated other comprehensive income | 3,949,134 | 62,495 |\n| Total UTG shareholders' equity | 121,891,488 | 106,342,557 |\n| Noncontrolling interests | 642,136 | 734,153 |\n| Total shareholders' equity | 122,533,624 | 107,076,710 |\n| Total liabilities and shareholders' equity | $ | 413,973,651 | $ | 395,548,336 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Revenue: |\n| Premiums and policy fees | $ | 2,503,205 | $ | 2,649,971 |\n| Ceded reinsurance premiums and policy fees | (517,055 | ) | (738,965 | ) |\n| Net investment income | 3,112,024 | 3,068,118 |\n| Other income | 63,838 | 60,935 |\n| Revenue before net investment gains (losses) | 5,162,012 | 5,040,059 |\n| Net investment gains (losses): |\n| Other-than-temporary impairments | - | - |\n| Other realized investment gains, net | 1,113,698 | 534,242 |\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\n| Total net investment gains (losses) | 15,901,329 | 4,663,478 |\n| Total revenue | 21,063,341 | 9,703,537 |\n| Benefits and other expenses: |\n| Benefits, claims and settlement expenses: |\n| Life | 3,427,200 | 4,168,794 |\n| Ceded reinsurance benefits and claims | (474,622 | ) | (688,412 | ) |\n| Annuity | 197,670 | 256,884 |\n| Dividends to policyholders | 103,599 | 126,999 |\n| Commissions and amortization of deferred policy acquisition costs | (24,542 | ) | (40,571 | ) |\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\n| Operating expenses | 2,144,389 | 2,085,819 |\n| Total benefits and other expenses | 5,567,671 | 6,111,029 |\n| Income before income taxes | 15,495,670 | 3,592,508 |\n| Income tax expense | 3,697,058 | 905,763 |\n| Net income | 11,798,612 | 2,686,745 |\n| Net income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\n| Net income attributable to common shareholders | $ | $ 11,644,879 | $ | $ 2,657,245 |\n| Amounts attributable to common shareholders |\n| Basic income per share | $ | $ 3.53 | $ | $ 0.80 |\n| Diluted income per share | $ | $ 3.53 | $ | $ 0.80 |\n| Basic weighted average shares outstanding | 3,297,353 | 3,325,111 |\n| Diluted weighted average shares outstanding | 3,297,353 | 3,325,111 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Net income | $ | 11,798,612 | $ | 2,686,745 |\n| Other comprehensive income (loss): |\n| Unrealized holding gains (losses) arising during period, pre-tax | 4,934,851 | (4,285,303 | ) |\n| Tax (expense) benefit on unrealized holding gains (losses) arising during the period | (1,036,319 | ) | 899,914 |\n| Unrealized holding gains (losses) arising during period, net of tax | 3,898,532 | (3,385,389 | ) |\n| Less reclassification adjustment for gains included in net income | (15,055 | ) | - |\n| Tax expense for gains included in net income | 3,162 | - |\n| Reclassification adjustment for gains included in net income, net of tax | (11,893 | ) | - |\n| Subtotal: Other comprehensive income (loss), net of tax | 3,886,639 | (3,385,389 | ) |\n| Comprehensive income (loss) | 15,685,251 | (698,644 | ) |\n| Less comprehensive income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\n| Comprehensive income (loss) attributable to UTG, Inc. | $ | 15,531,518 | $ | (728,144 | ) |\n\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\n| Balance at December 31, 2018 | $ | 3,296 | 36,567,865 | 69,708,901 | 62,495 | 734,153 | $ | 107,076,710 |\n| Common stock issued during year | 8 | 229,792 | - | - | - | 229,800 |\n| Treasury shares acquired | (7 | ) | (212,380 | ) | - | - | - | (212,387 | ) |\n| Net income attributable to common shareholders | - | - | 11,644,879 | - | - | 11,644,879 |\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | 3,886,639 | - | 3,886,639 |\n| Contributions | - | - | - | - | - | - |\n| Distributions | - | - | - | - | (245,750 | ) | (245,750 | ) |\n| Gain attributable to noncontrolling interest | - | - | - | - | 153,733 | 153,733 |\n| Balance at March 31, 2019 | $ | 3,297 | 36,585,277 | 81,353,780 | 3,949,134 | 642,136 | $ | 122,533,624 |\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\n| Balance at December 31, 2017 | $ | 3,333 | 37,536,164 | 39,040,456 | 32,952,338 | 899,227 | $ | 110,431,518 |\n| Adoption of Accounting Standards Update No 2016-01 | - | - | 18,277,328 | (18,277,328 | ) | - | - |\n| January 1, 2018 | 3,333 | 37,536,164 | 57,317,784 | 14,675,010 | 899,227 | 110,431,518 |\n| Common stock issued during year | 9 | 229,991 | - | - | - | 230,000 |\n| Treasury shares acquired | (24 | ) | (600,216 | ) | - | - | - | (600,240 | ) |\n| Net income attributable to common shareholders | - | - | 2,657,245 | - | - | 2,657,245 |\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | (3,385,389 | ) | - | (3,385,389 | ) |\n| Contributions | - | - | - | - | - | - |\n| Distributions | - | - | - | - | (146 | ) | (146 | ) |\n| Gain attributable to noncontrolling interest | - | - | - | - | 29,500 | 29,500 |\n| Balance at March 31, 2018 | $ | 3,318 | 37,165,939 | 59,975,029 | 11,289,621 | 928,581 | $ | 109,362,488 |\n\n| Three Months Ended |\n| March 31, | March 31, |\n| 2019 | 2018 |\n| Cash flows from operating activities: |\n| Net income attributable to common shareholders | $ | 11,644,879 | $ | 2,657,245 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Amortization (accretion) of investments | (39,703 | ) | 17,036 |\n| Realized investment gains, net | (1,113,698 | ) | (534,242 | ) |\n| Change in fair value of equity securities | (14,787,631 | ) | (4,129,236 | ) |\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\n| Depreciation | 323,406 | 275,143 |\n| Net income attributable to noncontrolling interest | 153,733 | 29,500 |\n| Charges for mortality and administration of universal life and annuity products | (1,619,743 | ) | (1,650,201 | ) |\n| Interest credited to account balances | 1,029,303 | 883,563 |\n| Change in accrued investment income | 232,788 | (357,576 | ) |\n| Change in reinsurance receivables | (61,726 | ) | 35,546 |\n| Change in policy liabilities and accruals | (772,518 | ) | (6,961 | ) |\n| Change in income taxes receivable (payable) | 612,616 | 12,974 |\n| Change in other assets and liabilities, net | 3,839,857 | 5,894,257 |\n| Net cash provided by (used in) operating activities | (364,460 | ) | 3,328,564 |\n| Cash flows from investing activities: |\n| Proceeds from investments sold and matured: |\n| Fixed maturities available for sale | 2,023,974 | 14,515 |\n| Equity securities | 33,075 | 103,298 |\n| Mortgage loans | 1,945,760 | 2,009,715 |\n| Real estate | 3,045,226 | 7,941,649 |\n| Notes receivable | 1,537,984 | 563,926 |\n| Policy loans | 410,831 | 366,847 |\n| Short-term investments | - | 850,000 |\n| Total proceeds from investments sold and matured | 8,996,850 | 11,849,950 |\n| Cost of investments acquired: |\n| Fixed maturities available for sale | - | (4,971,517 | ) |\n| Equity securities | (46,509 | ) | (7,957,471 | ) |\n| Mortgage loans | (3,575,500 | ) | - |\n| Real estate | (1,174,688 | ) | (6,006,130 | ) |\n| Notes receivable | (4,416,008 | ) | - |\n| Policy loans | (324,587 | ) | (405,337 | ) |\n| Short-term investments | - | (850,000 | ) |\n| Total cost of investments acquired | (9,537,292 | ) | (20,190,455 | ) |\n| Net cash used in investing activities | (540,442 | ) | (8,340,505 | ) |\n| Cash flows from financing activities: |\n| Policyholder contract deposits | 1,264,011 | 1,149,533 |\n| Policyholder contract withdrawals | (1,231,379 | ) | (1,245,743 | ) |\n| Purchase of treasury stock | (212,387 | ) | (600,240 | ) |\n| Issuance of stock | 229,800 | 230,000 |\n| Non controlling contributions (distributions) of consolidated subsidiary | (245,750 | ) | (146 | ) |\n| Net cash used in financing activities | (195,705 | ) | (466,596 | ) |\n| Net decrease in cash and cash equivalents | (1,100,607 | ) | (5,478,537 | ) |\n| Cash and cash equivalents at beginning of period | 20,150,162 | 25,434,199 |\n| Cash and cash equivalents at end of period | $ | 19,049,555 | $ | 19,955,662 |\n\nUTG, Inc. Notes to Condensed Consolidated Financial Statements\nNote 1 – Basis of Presentation\nThe accompanying Condensed Consolidated Balance Sheet as of December 31, 2018, which has been derived from audited consolidated financial statements, and the unaudited interim Condensed Consolidated Financial Statements include the accounts of UTG, Inc. (the “Parent”) and its subsidiaries (collectively with the Parent, the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. The accompanying Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 8 of regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for audited annual financial statements. The information furnished includes all adjustments and accruals of a normal recurring nature, which in the opinion of Management, are necessary for a fair presentation of the results for the interim periods. The unaudited Condensed Consolidated Financial Statements included herein and these related notes should be read in conjunction with the Company’s consolidated financial statements, and the notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. The Company’s results of operations for the three-month period ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019 or for any other future period.\nThis document at times will refer to the Registrant’s largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC (“FSF”), a Kentucky corporation, and First Southern Bancorp, Inc. (“FSBI”), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank (“FSNB”). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG’s largest shareholder through his ownership control of FSF, FSBI and affiliates. At March 31, 2019, Mr. Correll owns or controls directly and indirectly approximately 65.26% of UTG’s outstanding stock. UTG’s life insurance subsidiary, Universal Guaranty Life Insurance Company (“UG”), has several wholly-owned and majority-owned subsidiaries. The subsidiaries were formed to hold certain real estate investments. The real estate investments were placed into the limited liability companies and partnerships to provide additional protection to the policyholders and to UG.\nNote 2 – Recently Issued Accounting Standards\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\nNote 3 – Investments Available for Sale Securities – Fixed Maturity Securities The Company’s insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments they are permitted to make, and the amount of funds that may be used for any one type of investment.\n| March 31, 2019 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\n| Investments available for sale: |\n| Fixed maturities |\n| U.S. Government and govt. agencies and authorities | $ | 25,652,896 | $ | 221,161 | $ | (98,738 | ) | $ | 25,775,319 |\n| U.S. special revenue and assessments | 16,350,071 | 545,717 | 0 | 16,895,788 |\n| All other corporate bonds | 116,809,266 | 5,163,923 | (737,633 | ) | 121,235,556 |\n| $ | 158,812,233 | $ | 5,930,801 | $ | (836,371 | ) | $ | 163,906,663 |\n| December 31, 2018 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\n| Investments available for sale: |\n| Fixed maturities |\n| U.S. Government and govt. agencies and authorities | $ | 25,649,410 | $ | 149,006 | $ | (138,222 | ) | $ | 25,660,194 |\n| U.S. special revenue and assessments | 16,350,486 | 334,300 | (4,406 | ) | 16,680,380 |\n| All other corporate bonds | 118,895,973 | 2,569,287 | (2,845,050 | ) | 118,620,210 |\n| $ | 160,895,869 | $ | 3,052,593 | $ | (2,987,678 | ) | $ | 160,960,784 |\n\n| Fixed Maturities Available for Sale March 31, 2019 | Amortized Cost | Fair Value |\n| Due in one year or less | $ | 6,498,983 | $ | 6,525,131 |\n| Due after one year through five years | 51,055,408 | 53,028,854 |\n| Due after five years through ten years | 50,690,937 | 53,501,649 |\n| Due after ten years | 50,566,905 | 50,851,029 |\n| Total | $ | 158,812,233 | $ | 163,906,663 |\n\n| March 31, 2019 | Less than 12 months | 12 months or longer | Total |\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\n| U.S. Government and govt. agencies and authorities | $ | - | - | 5,578,536 | (98,738 | ) | 5,578,536 | $ | (98,738 | ) |\n| All other corporate bonds | 3,555,300 | (6,923 | ) | 26,553,550 | (730,710 | ) | 30,108,850 | (737,633 | ) |\n| Total fixed maturities | $ | 3,555,300 | (6,923 | ) | 32,132,086 | (829,448 | ) | 35,687,386 | $ | (836,371 | ) |\n| December 31, 2018 | Less than 12 months | 12 months or longer | Total |\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\n| U.S. Government and govt. agencies and authorities | $ | 6,429,700 | (49,904 | ) | 1,592,679 | (88,318 | ) | 8,022,379 | $ | (138,222 | ) |\n| U.S. special revenue and assessments | 4,023,920 | (4,406 | ) | - | - | 4,023,920 | (4,406 | ) |\n| All other corporate bonds | 49,270,729 | (2,033,507 | ) | 15,337,739 | (811,543 | ) | 64,608,468 | (2,845,050 | ) |\n| Total fixed maturities | $ | 59,724,349 | (2,087,817 | ) | 16,930,418 | (899,861 | ) | 76,654,767 | $ | (2,987,678 | ) |\n\n| Less than 12 months | 12 months or longer | Total |\n| As of March 31, 2019 |\n| Fixed maturities | 2 | 14 | 16 |\n| As of December 31, 2018 |\n| Fixed maturities | 30 | 10 | 40 |\n\nSubstantially all of the unrealized losses on fixed maturities and equity securities at March 31, 2019 and December 31, 2018 are attributable to changes in market interest rates and general disruptions in the credit market subsequent to purchase. The Company does not currently intend to sell nor does it expect to be required to sell any of the securities in an unrealized loss position. Based upon the Company’s expected continuation of receipt of contractually required principal and interest payments and its intent and ability to retain the securities until price recovery, as well as the Company’s evaluation of other relevant factors, the Company deems these securities to be temporarily impaired as of March 31, 2019 and December 31, 2018. Net Investment Gains (Losses)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Realized gains on available-for-sale investments: |\n| Sales of fixed maturities | $ | 15,055 | $ | - |\n| Sales of equity securities | - | - |\n| Sales of real estate | 1,098,643 | - |\n| Other | - | 534,242 |\n| Total realized gains | 1,113,698 | 534,242 |\n| Realized losses on available-for-sale investments: |\n| Sales of fixed maturities | - | - |\n| Sales of equity securities | - | - |\n| Sales of real estate | - | - |\n| Other-than-temporary impairments | - | - |\n| Other | - | - |\n| Total realized losses | - | - |\n| Net realized investment gains (losses) | 1,113,698 | 534,242 |\n| Change in fair value of equity securities: |\n| Realized gains (losses) on equity securities sold during the period | - | - |\n| Change in fair value of equity securities held at the end of the period | 14,787,631 | 4,129,236 |\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\n| Net investment gains (losses) | $ | 15,901,329 | $ | 4,663,478 |\n| Change in net unrealized gains (losses) on available-for-sale investments included in other comprehensive income: |\n| Fixed maturities | $ | 4,934,851 | $ | (4,285,303 | ) |\n| Equity securities | - | - |\n| Net increase (decrease) | $ | 4,934,851 | $ | (4,285,303 | ) |\n\nOther-Than-Temporary Impairments The Company regularly reviews its investment securities for factors that may indicate that a decline in fair value of an investment is other than temporary. The factors considered by Management in its regular review to identify and recognize other-than-temporary impairment losses on fixed maturities include, but are not limited to: the length of time and extent to which the fair value has been less than cost; the Company’s intent to sell, or be required to sell, the debt security before the anticipated recovery of its remaining amortized cost basis; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; subordinated credit support, whether the issuer of a debt security has remained current on principal and interest payments; current expected cash flows; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions, including the effect of changes in market interest rates. If the Company intends to sell a debt security, or it is more likely than not that it would be required to sell a debt security before the recovery of its amortized cost basis, the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date would be recognized by a charge to other-than-temporary losses in the Condensed Consolidated Statements of Operations. Management regularly reviews its real estate portfolio in comparison to appraisal valuations and current market conditions for indications of other-than-temporary impairments. If a decline in value is judged by Management to be other-than-temporary, a loss is recognized by a charge to other-than-temporary impairment losses in the Consolidated Statements of Operations. The Company did not recognize any other-than-temporary impairments during the first quarter of 2018 or 2019. Cost Method Investments The Company held equity investments with an aggregate cost of $12,133,745 and $12,118,617 at March 31, 2019 and December 31, 2018, respectively. These equity investments were not reported at fair value because it is not practicable to estimate their fair values due to insufficient information being available. Management did not identify any events or changes in circumstances that might have a significant adverse effect on the reported value of those investments. Based on Management's evaluation of the expected cash flow of the investments, and the Company's ability and intent to hold the investments for a reasonable period of time, the Company does not deem an other-than-temporary impairment necessary at March 31, 2019.\nMortgage Loans The Company, from time to time, acquires mortgage loans through participation agreements with FSNB. FSNB has been able to provide the Company with additional expertise and experience in underwriting commercial and residential mortgage loans, which provide more attractive yields than the traditional bond market. The Company is able to receive participations from FSNB for three primary reasons: 1) FSNB has already reached its maximum lending limit to a single borrower, but the borrower is still considered a suitable risk; 2) the interest rate on a particular loan may be fixed for a long period that is more suitable for UG given its asset-liability structure; and 3) FSNB’s loan growth might at times outpace its deposit growth, resulting in FSNB participating such excess loan growth rather than turning customers away. For originated loans, the Company’s Management is responsible for the final approval of such loans after evaluation. Before a new loan is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. These criteria include, but are not limited to, a credit report, personal financial information such as outstanding debt, sources of income, and personal equity. Once the loan is approved, the Company directly funds the loan to the borrower. The Company bears all risk of loss associated with the terms of the mortgage with the borrower. During the first quarter of 2019 and 2018, the Company acquired $3,575,500 and $0 in mortgage loans, respectively. FSNB services the majority of the Company’s mortgage loan portfolio. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan.\n| 2019 | 2018 |\n| Maximum rate | Minimum rate | Maximum rate | Minimum rate |\n| Farm Loans | 5.00% | 5.00% | 5.00% | 5.00% |\n| Commercial Loans | 7.50% | 4.00% | 7.50% | 4.00% |\n| Residential Loans | 8.00% | 8.00% | 8.00% | 8.00% |\n\nMost mortgage loans are first position loans. Loans issued are generally limited to no more than 80% of the appraised value of the property. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans. Letters are sent to each mortgagee when the loan becomes 30 days or more delinquent. Management is provided with a monthly listing of loans that are 60 days or more past due along with a brief description of what steps are being taken to resolve the delinquency. All loans 90 days or more past due are placed on a non-performing status and classified as delinquent loans. Quarterly, coinciding with external financial reporting, the Company reviews each delinquent loan and determines how each delinquent loan should be classified. Management believes the current internal controls surrounding the mortgage loan selection process provide a quality portfolio with minimal risk of foreclosure and/or negative financial impact. Changes in the current economy could have a negative impact on the loans, including the financial stability of the borrowers, the borrowers’ ability to pay or to refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices. Interest accruals are analyzed based on the likelihood of repayment. In no event will interest continue to accrue when accrued interest along with the outstanding principal exceeds the net realizable value of the property. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. A mortgage loan reserve is established and adjusted based on Management's quarterly analysis of the portfolio and any deterioration in value of the underlying property which would reduce the net realizable value of the property below its current carrying value. The mortgage loan reserve was $0 at March 31, 2019 and December 31, 2018.\n| March 31, 2019 | December 31, 2018 |\n| In good standing | $ | 8,829,640 | $ | 7,169,272 |\n| Overdue interest over 90 days | 1,873,913 | 1,899,839 |\n| Total mortgage loans | $ | 10,703,553 | $ | 9,069,111 |\n\nInvestment Real Estate Real estate acquired through foreclosure, consisting of properties obtained through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, is reported on an individual asset basis at the lower of cost or fair value, less disposal costs. Fair value is determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. When properties are acquired through foreclosure, any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is recognized and charged to the Consolidated Statements of Operations. Based upon Management’s evaluation of the real estate acquired through foreclosure, additional expense is recorded when necessary in an amount sufficient to reflect any declines in estimated fair value. Gains and losses recognized on the disposition of the properties are recorded as realized gains and losses in the Condensed Consolidated Statements of Operations. Notes Receivable Notes receivable represent collateral loans and promissory notes issued by the Company and are reported at their unpaid principal balances, adjusted for valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected. The valuation allowance as of March 31, 2019 and December 31, 2018 was $0. Interest accruals are analyzed based on the likelihood of repayment. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. Before a new note is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. Once the note is approved, the Company directly funds the note to the borrower. Several of the notes have participation agreements in place, whereas the Company has reduced its investment in the note receivable by participating a portion of the note to a third party. Similar to the mortgage loans, FSNB services several of the notes receivable. The Company, and the participants in the notes, share in the risk of loss associated with the terms of the note with the borrower, based upon their ownership percentage in the note. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans.\nNote 4 – Fair Value Measurements The Company measures its assets and liabilities recorded at fair value in the Condensed Consolidated Balance Sheets based on the framework set forth in the GAAP fair value accounting guidance. The framework establishes a fair value hierarchy of three levels based upon the transparency of information used in measuring the fair value of assets or liabilities as of the measurement date. The fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three categories. Level 1 – Valuation is based upon quoted prices for identical assets or liabilities in active markets that the Company is able to access. Level 1 fair value is not subject to valuation adjustments. Level 2 – Valuation is based upon quoted prices for similar assets and liabilities in active markets or quoted prices for identical or similar instruments in markets that are not active. In addition, the Company may use various valuation techniques or pricing models that use observable inputs to measure fair value. Level 3 – Valuation is based upon unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the Company’s own assumptions about the inputs that market participants would use in pricing the asset or liability. The Company determines the existence of an active market for an asset or liability based on its judgment as to whether transactions for the asset or liability occur in such market with sufficient frequency and volume to provide reliable pricing information. If the Company concludes that there has been a significant decrease in the volume and level of activity for an investment in relation to normal market activity for such investment, adjustments to transactions and quoted prices are made to estimate fair value. The inputs used in the valuation techniques employed by the Company are provided by nationally recognized pricing services, external investment managers and internal resources. To assess these inputs, the Company’s review process includes, but is not limited to, quantitative analysis including benchmarking, initial and ongoing evaluations of methodologies used by external parties to calculate fair value, and ongoing evaluations of fair value estimates based on the Company’s knowledge and monitoring of market conditions. The Company periodically reviews the pricing service provider’s policies and procedures for valuing securities. The assumptions underlying the valuations from external service providers, including unobservable inputs, are generally not readily available as this information is often deemed proprietary. Accordingly, the Company is unable to obtain comprehensive information regarding these assumptions and methodologies. The Company’s investments in fixed maturity securities available for sale, equity securities and trading securities assets and liabilities are carried at fair value. The following are the Company’s methodologies and valuation techniques for assets and liabilities measured at fair value. Fixed maturities available for sale mainly consist of U.S. treasury securities and corporate debt securities. The Company employs a market approach to the valuation of securities where there are sufficient market transactions involving identical or comparable assets. If sufficient market data is not available for identical or comparable assets, the Company uses an income approach to valuation. The majority of the financial instruments included in fixed maturity securities available for sale are evaluated utilizing observable inputs; accordingly, they are categorized in either Level 1 or Level 2 of the fair value hierarchy. However, in instances where significant inputs utilized in valuation of the securities are unobservable, the securities are categorized in Level 3 of the fair value hierarchy. Corporate securities primarily include fixed rate corporate bonds. Inputs utilized in connection with the Company’s valuation techniques relating to this class of securities include recently executed transactions, market price quotations, benchmark yields and issuer spreads. Corporate securities are categorized in Level 2 of the fair value hierarchy. U.S. treasury securities are based on quoted prices in active markets and are generally categorized in Level 1 of the fair value hierarchy. Equity securities consist of common and preferred stocks mainly in private equity investments, financial institutions and publicly traded corporations. Equity securities for which there is sufficient market data are categorized as Level 1 or 2 in the fair value hierarchy. For the equity securities in which quoted market prices are not available, the Company uses industry standard pricing methodologies, including discounted cash flow models that may incorporate various inputs such as payment expectations, risk of the investment, market data, and health of the underlying company. The inputs are based upon Management's assumptions and available market information. When evidence is believed to support a change to the carrying value from the transaction price, adjustments are made to reflect the expected cash flows, material events and market data. These investments are included in Level 3 of the fair value hierarchy.\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Fixed Maturities, available for sale | $ | 25,775,319 | $ | 137,696,500 | $ | 434,844 | $ | 163,906,663 |\n| Equity Securities | 37,355,757 | 12,176,923 | 32,917,737 | 82,450,417 |\n| Total | $ | 63,131,076 | $ | 149,873,423 | $ | 33,352,581 | $ | 246,357,080 |\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Fixed Maturities, available for sale | $ | 25,660,194 | $ | 134,865,746 | $ | 434,844 | $ | 160,960,784 |\n| Equity Securities | 27,634,283 | 10,557,031 | 29,473,168 | 67,664,482 |\n| Total | $ | 53,294,477 | $ | 145,422,777 | $ | 29,908,012 | $ | 228,625,266 |\n\n| Fixed Maturities, Available for Sale | Equity Securities | Total |\n| Balance at December 31, 2018 | $ | 434,844 | $ | 29,473,168 | $ | 29,908,012 |\n| Total unrealized gain or (losses): |\n| Included in net income (loss) | - | 3,444,569 | 3,444,569 |\n| Included in other comprehensive income | - | - | - |\n| Purchases | - | - | - |\n| Sales | - | - | - |\n| Balance at March 31, 2019 | $ | 434,844 | $ | 32,917,737 | $ | 33,352,581 |\n| March 31, 2019 | December 31, 2018 |\n| Change in fair value of equity securities included in net income (loss) relating to assets held | $ | 3,444,569 | $ | 4,633,751 |\n\nThe Level 3 securities include collateralized debt obligations of trust preferred securities issued by banks and insurance companies and certain equity securities with unobservable inputs. The Company computed fair value of Level 3 equity investments based on a review of current financial information, earnings trends and similar companies in the same industries. There were no transfers in or out of Level 3 as of March 31, 2019. Transfers occur when there is a change in the availability of observable market information. Certain assets are not carried at fair value on a recurring basis, including investments such as mortgage loans and policy loans. Accordingly, such investments are only included in the fair value hierarchy disclosure when the investment is subject to re-measurement at fair value after initial recognition and the resulting re-measurement is reflected in the Consolidated Financial Statements.\n| March 31, 2019 | December 31, 2018 |\n| Assets | Carrying Amount | Estimated Fair Value | Carrying Amount | Estimated Fair Value |\n| Equity securities | $ | 12,133,745 | $ | 12,133,745 | $ | 12,118,617 | $ | 12,118,617 |\n| Mortgage loans on real estate | 10,703,553 | 10,703,553 | 9,069,111 | 9,069,111 |\n| Investment real estate | 51,530,162 | 51,530,162 | 52,518,577 | 52,518,577 |\n| Notes receivable | 26,595,336 | 26,595,336 | 23,717,312 | 23,717,312 |\n| Policy loans | 9,117,979 | 9,117,979 | 9,204,222 | 9,204,222 |\n| Cash and cash equivalents | 19,049,555 | 19,049,555 | 20,150,162 | 20,150,162 |\n\nThe above estimated fair value amounts have been determined based upon the following valuation methodologies. Considerable judgment was required to interpret market data in order to develop these estimates. Accordingly, the estimates are not necessarily indicative of the amounts which could be realized in a current market exchange. The use of different market assumptions or estimation methodologies may have a material effect on the fair value amounts. The fair values of mortgage loans on real estate are estimated using discounted cash flow analyses and interest rates being offered for similar loans to borrowers with similar credit ratings. The inputs used to measure the fair value of our mortgage loans on real estate are classified as Level 3 within the fair value hierarchy. A portion of the mortgage loans balance consists of discounted mortgage loans. The Company has historically purchased non-performing discounted mortgage loans at a deep discount through an auction process led by the Federal Government. In general, the discounted loans are non-performing and there is a significant amount of uncertainty surrounding the timing and amount of cash flows to be received by the Company. Accordingly, the Company records its investment in the discounted loans at its original purchase price, which Management believes approximates fair value. The inputs used to measure the fair value of our discounted mortgage loans are classified as Level 3 within the fair value hierarchy Investment real estate is recorded at the lower of the net investment in the real estate or the fair value of the real estate less costs to sell. The determination of fair value assessments are performed on a periodic, non-recurring basis by external appraisal and assessment of property values by Management. The inputs used to measure the fair value of our investment real estate are classified as Level 3 within the fair value hierarchy. Notes receivable are carried at their unpaid principal balances, which approximates fair value. The inputs used to measure the fair value of the loans are classified as Level 3 within the fair value hierarchy. Policy loans are carried at the aggregate unpaid principal balances in the Condensed Consolidated Balance Sheets which approximate fair value, and earn interest at rates ranging from 4% to 8%. Individual policy liabilities in all cases equal or exceed outstanding policy loan balances. The inputs used to measure the fair value of our policy loans are classified as Level 3 within the fair value hierarchy. The carrying amount of cash and cash equivalents in the Condensed Consolidated Balance Sheets approximates fair value given the highly liquid nature of the instruments. The inputs used to measure the fair value of our cash and cash equivalents are classified as Level 1 within the fair value hierarchy. The carrying amount of short term investments in the Condensed Consolidated Balance Sheets approximates fair value. The inputs used to measure the fair value of our short term investments are classified as Level 3 within the fair value hierarchy.\nNote 5 – Credit Arrangements\n| Instrument | Issue Date | Maturity Date | Revolving Credit Limit | December 31, 2018 | Borrowings | Repayments | March 31, 2019 |\n| Lines of Credit: |\n| UTG | 11/20/2013 | 11/20/2019 | $ | 8,000,000 | - | - | - | - |\n| UG | 6/2/2015 | 5/10/2019 | 10,000,000 | - | - | - | - |\n\nThe UTG line of credit carries interest at a fixed rate of 5.125% and is payable monthly. As collateral, UTG has pledged 100% of the common voting stock of its wholly owned subsidiary, Universal Guaranty Life Insurance Company. The Company is currently in the process of renewing this line of credit. During May of 2018, the Federal Home Loan Bank approved UG’s Cash Management Advance Application (“CMA”). The CMA gives the Company the option of selecting a variable rate of interest for up to 90 days or a fixed rate for a maximum of 30 days. The variable rate CMA is prepayable at any time without a fee, while the fixed CMA is not prepayable prior to maturity. The Company is currently in the process of renewing the CMA.\nNote 6 – Shareholders’ Equity Stock Repurchase Program – The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. At a meeting of the Board of Directors in September of 2018, the Board of Directors of UTG authorized the repurchase of up to an additional $1.5 million of UTG's common stock, for a total repurchase of up to $16.0 million of UTG's common stock in the open market or in privately negotiated transactions. Company Management has broad authority to operate the program, including the discretion of whether to purchase shares and the ability to suspend or terminate the program. Open market purchases are made based on the last available market price but may be limited. During the three months ended March 31, 2019, the Company repurchased 6,955 shares through the stock repurchase program for $212,387. Through March 31, 2019, UTG has spent $14,076,115 million in the acquisition of 1,147,061 shares under this program. During 2019, the Company issued 7,632 shares of stock to management and employees as compensation at a cost of $229,800. These awards are determined at the discretion of the Board of Directors. Earnings Per Share Calculations Earnings per share are based on the weighted average number of common shares outstanding during each period. For the three months ended March 31, 2019 and 2018, diluted earnings per share were the same as basic earnings per share since the Company had no dilutive instruments outstanding.\nNote 7 – Commitments and Contingencies The insurance industry has experienced a number of civil jury verdicts which have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. In the normal course of business, the Company is involved from time to time in various legal actions and other state and federal proceedings. Management is of the opinion that the ultimate disposition of the matters will not have a materially adverse effect on the Company’s results of operations or financial position. Under the insurance guaranty fund laws in most states, insurance companies doing business in a participating state can be assessed up to prescribed limits for policyholder losses incurred by insolvent or failed insurance companies. Although the Company cannot predict the amount of any future assessments, most insurance guaranty fund laws currently provide that an assessment may be excused or deferred if it would threaten an insurer's financial strength. Mandatory assessments may be partially recovered through a reduction in future premium tax in some states. The Company does not believe such assessments will be materially different from amounts already provided for in the condensed consolidated financial statements, though the Company has no control over such assessments.\n| Total Funding Commitment | Unfunded Commitment |\n| RLF III, LLC | $ | 4,000,000 | $ | 398,120 |\n| Sovereign’s Capital, LP Fund I | 500,000 | 24,493 |\n| Sovereign's Capital, LP Fund II | 1,000,000 | 240,566 |\n| Sovereign's Capital, LP Fund III | 1,000,000 | 900,000 |\n| Barton Springs Music, LLC | 1,750,000 | 1,158,500 |\n| Master Mineral Holdings III, LP | 4,000,000 | 530,312 |\n\nDuring 2006, the Company committed to invest in RLF III, LLC (“RLF”), which makes land-based investments in undervalued assets. RLF makes capital calls as funds are needed for continued land purchases. During 2012, the Company committed to invest in Sovereign’s Capital, LP Fund I (“Sovereign’s”), which invests in companies in emerging markets. Sovereign’s makes capital calls to investors as funds are needed. During 2015, the Company committed to invest in Sovereign’s Capital, LP Fund II (“Sovereign’s II”), which invests in companies in emerging markets. Sovereign’s II makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Sovereign’s Capital, LP Fund III (“Sovereign’s III”), which invests in companies in emerging markets. Sovereign’s III makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Barton Springs Music, LLC (“Barton”), which invests in music royalties. Barton makes capital calls to its investors as funds are needed to acquire the royalty rights. During 2018, the Company committed to invest in Master Mineral Holdings III, LP (“MMH”), which purchases land for leasing opportunities to those looking to harvest natural resources. MMH makes capital calls to its investors as funds are needed for continued land purchases.\nNote 8 – Other Cash Flow Disclosures\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Interest | $ | - | $ | - |\n| Federal income tax | - | - |\n\nNote 9 – Concentrations of Credit Risk The Company maintains cash balances in financial institutions that at times may exceed federally insured limits. The Company maintains its primary operating cash accounts with First Southern National Bank, an affiliate of the largest shareholder of UTG, Mr. Jesse Correll, the Company’s CEO and Chairman. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. Because UTG serves primarily individuals located in four states, the ability of our customers to pay their insurance premiums is impacted by the economic conditions in these areas. As of March 31, 2019 and 2018 , approximately 55% and 56%, respectively, of the Company’s total direct premium was collected from Illinois, Ohio, Texas and West Virginia. Thus, results of operations are heavily dependent upon the strength of these economies. The Company reinsures that portion of insurance risk which is in excess of its retention limits. Retention limits range up to $125,000 per life. Life insurance ceded represented 20% of total life insurance in force at March 31, 2019 and December 31, 2018, respectively. Insurance ceded represented 24% and 29% of premium income for the three months ended March 31, 2019 and 2018, respectively. The Company would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations. The Company owns a variety of investments associated with the oil and gas industry. These investments represent approximately 28% and 25% of the Company's total invested assets as of March 31, 2019 and December 31, 2018, respectively.\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThe following is Management's discussion and analysis of the financial condition and results of operations of UTG, Inc. and its subsidiaries (collectively with the Parent, the \"Company\"). The following discussion of the financial condition and results of operations of the Company should be read in conjunction with, and is qualified in its entirety by reference to, the Consolidated Financial Statements of the Company and the related Notes thereto appearing in the Company's annual report on Form 10-K for the year ended December 31, 2018, as filed with the Securities and Exchange Commission, and our unaudited Condensed Consolidated Financial Statements and related Notes thereto appearing elsewhere in this quarterly report.\nCautionary Statement Regarding Forward-Looking Statements\nThis report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based our forward-looking statements on our current expectations and projections about future events. Our forward-looking statements include information about possible or assumed future results of operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as the growth of our business and operations, our business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Also, when we use words such as \"anticipate,\" \"believe,\" \"estimate,\" \"expect,\" \"intend,\" \"plan,\" \"probably,\" or similar expressions, we are making forward-looking statements.\nNumerous risks and uncertainties may impact the matters addressed by our forward-looking statements, any of which could negatively and materially affect our future financial results and performance.\nAlthough we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements that are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved. In light of these risks, uncertainties and assumptions, any forward-looking event discussed in this report may not occur. Our forward-looking statements speak only as of the date made, and we undertake no obligation to update or review any forward-looking statement, whether as a result of new information, future events or other developments, unless the securities laws require us to do so.\nOverview\nUTG, Inc., a Delaware corporation, is a life insurance holding company. The Company's dominant business is individual life insurance, which includes the servicing of existing insurance policies in force, the acquisition of other companies in the life insurance business and the administration and processing of life insurance business for other entities. The Company's focus for the future includes growing the administrative portion of the business.\nCritical Accounting Policies\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ significantly from those estimates. The Company has identified certain estimates that involve a higher degree of judgment and are subject to a significant degree of variability. The Company's critical accounting policies and the related estimates considered most significant by Management are disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2018. Management has identified the accounting policies related to cost of insurance acquired, assumptions and judgments utilized in determining if declines in fair values of investments are other-than-temporary, and valuation methods for investments that are not actively traded as those, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Condensed Consolidated Financial Statements and this Management's Discussion and Analysis.\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\nResults of Operations\nOn a consolidated basis, the Company reported net income attributable to common shareholders' of approximately $11.6 million and $2.7 million for the three-month periods ended March 31, 2019 and 2018, respectively.\nRevenues\nThe Company reported total revenues of approximately $21.1 million for the three-month period ended March 31, 2019, an increase of approximately $11.4 million as compared to the same period in 2018. The variance in total revenues from the prior year to the current year is mainly attributable to the increase in the change in the fair value of equity securities.\nPremium and policy fee revenues, net of reinsurance, were comparable for the three-months ended March 31, 2019 and 2018. The Company writes minimal new business. Premium and policy fee revenues, net of reinsurance, represented 10% and 20% of the Company's revenues as of March 31, 2019 and 2018, respectively.\nThe following table summarizes the Company's investment performance.\n\n| Three Months Ended March 31, |\n| 2019 | 2018 |\n| Net investment income | $ | 3,112,024 | $ | 3,068,118 |\n| Net investment gains | $ | 15,901,329 | $ | 4,663,478 |\n| Change in net unrealized investment gains (losses) on available-for-sale securities, pre-tax | $ | 4,934,851 | $ | (4,285,303 | ) |\n\nThe following table reflects net investment income of the Company:\n\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Fixed maturities available for sale | $ | 1,589,985 | $ | 1,837,844 |\n| Equity securities | 668,108 | 532,067 |\n| Trading securities | (111,693 | ) | - |\n| Mortgage loans | 118,612 | 214,558 |\n| Real estate | 784,532 | 449,546 |\n| Notes receivable | 435,155 | 386,782 |\n| Policy loans | 141,552 | 150,081 |\n| Short-term | 41,364 | 48,172 |\n| Cash and cash equivalents | - | 12,434 |\n| Total consolidated investment income | 3,667,615 | 3,631,484 |\n| Investment expenses | (555,591 | ) | (563,366 | ) |\n| Consolidated net investment income | $ | 3,112,024 | $ | 3,068,118 |\n\nNet investment income represented 15% and 32% of the Company's total revenues as of March 31, 2019 and 2018, respectively. Net investment was comparable in the majority of the investment categories when comparing the first quarter 2019 activity to the same quarter in 2018.\nInvestment income from the real estate investment portfolio is up approximately $335,000 in the current year as compared to the same period in the prior year. The increase is not attributable to one specific investment or event. Several of the Company's real estate holdings produced more income in the current your as compared to the same period in the prior year. Income is expected to vary from quarter to quarter depending on the activity occurring in relation to each property.\nThe Company reported net investment gains of approximately $15.9 million and $4.7 million for the three-month periods ended March 31, 2019 and 2018, respectively. Realized investment gains of approximately $1.1 million and $534,000 were recognized by the Company during the first quarter of 2019 and 2018, respectively. These gains are the result of the Company selling a parcel of real estate in 2018 and 2019.\nRealized investment gains are the result of one-time events and are expected to vary from quarter to quarter.\nThe 2019 investment gains mainly consist of approximately $14.8 million in unrealized gains related to the change in the fair value of equity securities. For the same period in 2018, the Company reported approximately $4.1 million of unrealized gains related to the change in the fair value of equity securities.\nThe Company has seen significant unrealized gains on its equity investments during 2018 and 2019. A significant portion of these gains are from two equity holdings, both in the area of oil and gas. While the Company has had very strong unrealized gains during 2018 and 2019, a pull back in the stock market, particularly in the oil and gas arena, could slow these gains or even result in future period unrealized losses. Management believes these equity investments continue to be solid investments for the Company and have further growth potential; however, changes in market conditions could cause volatility in market prices.\nIn summary, the Company's basis for future revenue growth is expected to come from the following primary sources: conservation of business currently in-force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources to enhance these opportunities.\nExpenses\nThe Company reported total benefits and other expenses of approximately $5.6 million for the three-month period ended March 31, 2019, a decrease of approximately 9% from the same period in 2018. Benefits, claims and settlement expenses represented approximately 59% and 63% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively. The other major expense category of the Company is operating expenses, which represented approximately 39% and 34% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively.\nLife benefits, claims and settlement expenses, net of reinsurance benefits and claims, decreased approximately 16% in the three-month period ended March 31, 2019, compared to the same period in 2018. Policy claims vary from period to period and therefore, fluctuations in mortality are to be expected and are not considered unusual by Management.\nNet amortization of cost of insurance acquired decreased 4% during the three-month period ended March 31, 2019 compared to the same period in 2018. Cost of insurance acquired is established when an insurance company is acquired or when the Company acquires a block of in-force business. The Company assigns a portion of its cost to the right to receive future profits from insurance contracts existing at the date of the acquisition. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The interest rates may vary due to risk analysis performed at the time of acquisition on the business acquired. The Company utilizes a 12% discount rate on the remaining unamortized business. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Amortization of cost of insurance acquired is particularly sensitive to changes in interest rate spreads and persistency of certain blocks of insurance in-force. This expense is expected to decrease, unless the Company acquires a new block of business.\nOperating expenses increased approximately 3% in the three-month period ended March 31, 2019 as compared to the same period in 2018. Overall, expenses were comparable in all of the major expense categories.\nManagement continues to place significant emphasis on expense monitoring and cost containment. Maintaining administrative efficiencies directly impacts net income.\nFinancial Condition\nInvestment Information\nInvestments represent approximately 86% and 85% of total assets at March 31, 2019 and December 31, 2018, respectively. Accordingly, investments are the largest asset group of the Company. The Company's insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments that it is permitted to make and the amount of funds that may be used for any one type of investment. In light of these statutes and regulations, the majority of the Company's investment portfolio is invested in a diverse set of securities.\nAs of March 31, 2019, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets, shareholders' equity or results from operations. To provide additional flexibility and liquidity, the Company has identified all fixed maturity securities as \"investments available for sale\". Investments available-for-sale are carried at market, with changes in market value charged directly to shareholders' equity. Changes in the market value of available for sale securities resulted in a net unrealized gain of approximately $3.9 million and a net unrealized loss of approximately $3.4 million for the three-month periods ended March 31, 2019 and 2018, respectively. The variance in the net unrealized gains and losses is the result of normal market fluctuations and lower interest rates.\nCapital Resources\nTotal shareholders' equity increased by approximately 14% as of March 31, 2019 compared to December 31, 2018. The increase is mainly attributable to an increase in retained earnings, which is the result of the current year net income reported by the Company.\nThe Company's investments are predominately in fixed maturity investments such as bonds, which provide sufficient return to cover future obligations. The Company carries all of its fixed maturity holdings as available for sale, which are reported in the Condensed Consolidated Financial Statements at their market value.\nLiquidity\nThe Company has two principal needs for cash - the insurance company's contractual obligations to policyholders and the payment of operating expenses. Cash and cash equivalents represented 5% total assets as of March 31, 2019 and December 31, 2018. Fixed maturities as a percentage of total assets were approximately 40% and 41% as of March 31, 2019 and December 31, 2018, respectively.\nThe Company currently has access to funds for operating liquidity. UTG has an $8 million revolving credit note with Illinois National Bank. At March 31, 2019, the Company had no outstanding borrowings against the UTG line of credit. UG has a $10 million line of credit with the Federal Home Loan Bank. At March 31, 2019, the Company had no outstanding borrowings against the UG line of credit\nFuture policy benefits are primarily long-term in nature and therefore, the Company's investments are predominantly in long-term fixed maturity investments such as bonds and mortgage loans which provide sufficient return to cover these obligations. Many of the Company's products contain surrender charges and other features which reward persistency and penalize the early withdrawal of funds.\nFor the three months ended March 31, 2019 and 2018, operating activities used cash of approximately $364,000 and provided cash of approximately $3.3 million, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years.\nThe Company used cash in investing activities of approximately $540,000 and $8.3 million for the three month periods ended March 31, 2019 and 2018, respectively. The net cash provided by or used in investing activities is expected to vary from quarter to quarter depending on market conditions and Management’s ability to find and negotiate favorable investment contracts.\nUTG is a holding Company that has no day-to-day operations of its own. Funds required to meet its expenses, generally costs associated with maintaining the Company in good standing with states in which it does business are primarily provided by its subsidiaries. On a parent only basis, UTG's cash flow is dependent on Management fees received from its insurance subsidiary, stockholder dividends from its subsidiary and earnings received on cash balances. At March 31, 2019, substantially all of the consolidated shareholders' equity represented net assets of its subsidiary. The Company's insurance subsidiary has maintained adequate statutory capital and surplus. The payment of cash dividends to shareholders by UTG is not legally restricted. However, the state insurance department regulates insurance Company dividend payments where the Company is domiciled. No dividends were paid to shareholders in 2018 or the three-month period ended March 31, 2019.\nUG is an Ohio domiciled insurance company, which requires notification within five business days to the insurance commissioner following the declaration of any ordinary dividend and at least ten calendar days prior to payment of such dividend. Ordinary dividends are defined as the greater of: a) prior year statutory net income or b) 10% of statutory capital and surplus. For the year ended December 31, 2018, UG had statutory net income of approximately $6.2 million. At December 31, 2018 UG's statutory capital and surplus amounted to approximately $60 million. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation. During 2018 , UG paid UTG ordinary dividends of $5 million. During the second quarter of 2019, UG paid UTG a dividend of $2 million. UTG used the dividends received during 2018 and 2019 for general operations of the Company.\n\nITEM 4. CONTROLS AND PROCEDURES\nThe Company maintains a set of disclosure controls and procedures designed to ensure that information required to be disclosed in reports that it files or submits under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. In addition, the disclosure controls and procedures ensure that information required to be disclosed is accumulated and communicated to Management, including the principal executive officer and principal financial officer, allowing timely decisions regarding required disclosure. Under the supervision and with the participation of our Management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.\nPART II. OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nNONE\n\nITEM 1A. RISK FACTORS\nNONE\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nNONE\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNONE\n\nITEM 4. MINE SAFETY DISCLOSURES\nNONE\n\nITEM 5. OTHER INFORMATION\nNONE\n\nITEM 6. EXHIBITS\n\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| **101 | Interactive Data File |\n\n*Filed herewith\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\nUTG, INC.\n(Registrant)\n\n| Date: | May 14, 2019 | By | /s/ James P. Rousey |\n| James P. Rousey |\n| President and Director |\n\n\n| Date: | May 14, 2019 | By | /s/ Theodore C. Miller |\n| Theodore C. Miller |\n| Senior Vice President |\n| and Chief Financial Officer |\n\nEXHIBIT INDEX\n\n| Exhibit Number | Description |\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| **101 | Interactive Data File |\n\n* Filed herewith\n\n</text>\n\nWhat is the return on equity (ROE) for the year ended March 31, 2019, considering the net income for the three months ended March 31, 2019, and total shareholders' equity at the end of 2019 and 2018 in percentages?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nPart 1. Financial Information.\\nItem 1. Financial Statements.\\n\\n| March 31, 2019 | December 31, 2018* |\\n| ASSETS |\\n| Investments: |\\n| Investments available for sale: |\\n| Fixed maturities, at fair value (amortized cost $158,812,233 and $160,895,869) | $ | 163,906,663 | $ | 160,960,784 |\\n| Equity securities, at fair value (cost $34,883,412 and $34,885,107) | 82,450,417 | 67,664,482 |\\n| Equity securities, at cost | 12,133,745 | 12,118,617 |\\n| Mortgage loans on real estate at amortized cost | 10,703,553 | 9,069,111 |\\n| Investment real estate | 51,530,162 | 52,518,577 |\\n| Notes receivable | 26,595,336 | 23,717,312 |\\n| Policy loans | 9,117,979 | 9,204,222 |\\n| Total investments | 356,437,855 | 335,253,105 |\\n| Cash and cash equivalents | 19,049,555 | 20,150,162 |\\n| Accrued investment income | 1,887,094 | 2,119,882 |\\n| Reinsurance receivables: |\\n| Future policy benefits | 26,091,199 | 26,117,936 |\\n| Policy claims and other benefits | 4,142,345 | 4,053,882 |\\n| Cost of insurance acquired | 5,428,250 | 5,622,227 |\\n| Property and equipment, net of accumulated depreciation | 581,680 | 688,567 |\\n| Income tax receivable | - | 279,333 |\\n| Other assets | 355,673 | 1,263,242 |\\n| Total assets | $ | 413,973,651 | $ | 395,548,336 |\\n| LIABILITIES & SHAREHOLDERS' EQUITY |\\n| Liabilities: |\\n| Policy liabilities and accruals: |\\n| Future policyholder benefits | $ | 252,418,038 | $ | 253,852,368 |\\n| Policy claims and benefits payable | 4,335,480 | 4,267,481 |\\n| Other policyholder funds | 430,413 | 372,072 |\\n| Dividend and endowment accumulations | 14,586,502 | 14,608,838 |\\n| Income taxes payable | 333,283 | - |\\n| Deferred income taxes | 13,231,079 | 9,113,480 |\\n| Other liabilities | 6,105,232 | 6,257,387 |\\n| Total liabilities | 291,440,027 | 288,471,626 |\\n| Shareholders' equity: |\\n| Common stock - no par value, stated value $.001 per share. Authorized 7,000,000 shares - 3,296,547 and 3,295,870 shares outstanding | 3,297 | 3,296 |\\n| Additional paid-in capital | 36,585,277 | 36,567,865 |\\n| Retained earnings | 81,353,780 | 69,708,901 |\\n| Accumulated other comprehensive income | 3,949,134 | 62,495 |\\n| Total UTG shareholders' equity | 121,891,488 | 106,342,557 |\\n| Noncontrolling interests | 642,136 | 734,153 |\\n| Total shareholders' equity | 122,533,624 | 107,076,710 |\\n| Total liabilities and shareholders' equity | $ | 413,973,651 | $ | 395,548,336 |\\n\\n| Three Months Ended |\\n| March 31, | March 31, |\\n| 2019 | 2018 |\\n| Revenue: |\\n| Premiums and policy fees | $ | 2,503,205 | $ | 2,649,971 |\\n| Ceded reinsurance premiums and policy fees | (517,055 | ) | (738,965 | ) |\\n| Net investment income | 3,112,024 | 3,068,118 |\\n| Other income | 63,838 | 60,935 |\\n| Revenue before net investment gains (losses) | 5,162,012 | 5,040,059 |\\n| Net investment gains (losses): |\\n| Other-than-temporary impairments | - | - |\\n| Other realized investment gains, net | 1,113,698 | 534,242 |\\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\\n| Total net investment gains (losses) | 15,901,329 | 4,663,478 |\\n| Total revenue | 21,063,341 | 9,703,537 |\\n| Benefits and other expenses: |\\n| Benefits, claims and settlement expenses: |\\n| Life | 3,427,200 | 4,168,794 |\\n| Ceded reinsurance benefits and claims | (474,622 | ) | (688,412 | ) |\\n| Annuity | 197,670 | 256,884 |\\n| Dividends to policyholders | 103,599 | 126,999 |\\n| Commissions and amortization of deferred policy acquisition costs | (24,542 | ) | (40,571 | ) |\\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\\n| Operating expenses | 2,144,389 | 2,085,819 |\\n| Total benefits and other expenses | 5,567,671 | 6,111,029 |\\n| Income before income taxes | 15,495,670 | 3,592,508 |\\n| Income tax expense | 3,697,058 | 905,763 |\\n| Net income | 11,798,612 | 2,686,745 |\\n| Net income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\\n| Net income attributable to common shareholders | $ | $ 11,644,879 | $ | $ 2,657,245 |\\n| Amounts attributable to common shareholders |\\n| Basic income per share | $ | $ 3.53 | $ | $ 0.80 |\\n| Diluted income per share | $ | $ 3.53 | $ | $ 0.80 |\\n| Basic weighted average shares outstanding | 3,297,353 | 3,325,111 |\\n| Diluted weighted average shares outstanding | 3,297,353 | 3,325,111 |\\n\\n| Three Months Ended |\\n| March 31, | March 31, |\\n| 2019 | 2018 |\\n| Net income | $ | 11,798,612 | $ | 2,686,745 |\\n| Other comprehensive income (loss): |\\n| Unrealized holding gains (losses) arising during period, pre-tax | 4,934,851 | (4,285,303 | ) |\\n| Tax (expense) benefit on unrealized holding gains (losses) arising during the period | (1,036,319 | ) | 899,914 |\\n| Unrealized holding gains (losses) arising during period, net of tax | 3,898,532 | (3,385,389 | ) |\\n| Less reclassification adjustment for gains included in net income | (15,055 | ) | - |\\n| Tax expense for gains included in net income | 3,162 | - |\\n| Reclassification adjustment for gains included in net income, net of tax | (11,893 | ) | - |\\n| Subtotal: Other comprehensive income (loss), net of tax | 3,886,639 | (3,385,389 | ) |\\n| Comprehensive income (loss) | 15,685,251 | (698,644 | ) |\\n| Less comprehensive income attributable to noncontrolling interests | (153,733 | ) | (29,500 | ) |\\n| Comprehensive income (loss) attributable to UTG, Inc. | $ | 15,531,518 | $ | (728,144 | ) |\\n\\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\\n| Balance at December 31, 2018 | $ | 3,296 | 36,567,865 | 69,708,901 | 62,495 | 734,153 | $ | 107,076,710 |\\n| Common stock issued during year | 8 | 229,792 | - | - | - | 229,800 |\\n| Treasury shares acquired | (7 | ) | (212,380 | ) | - | - | - | (212,387 | ) |\\n| Net income attributable to common shareholders | - | - | 11,644,879 | - | - | 11,644,879 |\\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | 3,886,639 | - | 3,886,639 |\\n| Contributions | - | - | - | - | - | - |\\n| Distributions | - | - | - | - | (245,750 | ) | (245,750 | ) |\\n| Gain attributable to noncontrolling interest | - | - | - | - | 153,733 | 153,733 |\\n| Balance at March 31, 2019 | $ | 3,297 | 36,585,277 | 81,353,780 | 3,949,134 | 642,136 | $ | 122,533,624 |\\n| Common Stock | Additional Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income | Noncontrolling Interest | Total Shareholders' Equity |\\n| Balance at December 31, 2017 | $ | 3,333 | 37,536,164 | 39,040,456 | 32,952,338 | 899,227 | $ | 110,431,518 |\\n| Adoption of Accounting Standards Update No 2016-01 | - | - | 18,277,328 | (18,277,328 | ) | - | - |\\n| January 1, 2018 | 3,333 | 37,536,164 | 57,317,784 | 14,675,010 | 899,227 | 110,431,518 |\\n| Common stock issued during year | 9 | 229,991 | - | - | - | 230,000 |\\n| Treasury shares acquired | (24 | ) | (600,216 | ) | - | - | - | (600,240 | ) |\\n| Net income attributable to common shareholders | - | - | 2,657,245 | - | - | 2,657,245 |\\n| Unrealized holding income on securities net of noncontrolling interest and reclassification adjustment and taxes | - | - | - | (3,385,389 | ) | - | (3,385,389 | ) |\\n| Contributions | - | - | - | - | - | - |\\n| Distributions | - | - | - | - | (146 | ) | (146 | ) |\\n| Gain attributable to noncontrolling interest | - | - | - | - | 29,500 | 29,500 |\\n| Balance at March 31, 2018 | $ | 3,318 | 37,165,939 | 59,975,029 | 11,289,621 | 928,581 | $ | 109,362,488 |\\n\\n| Three Months Ended |\\n| March 31, | March 31, |\\n| 2019 | 2018 |\\n| Cash flows from operating activities: |\\n| Net income attributable to common shareholders | $ | 11,644,879 | $ | 2,657,245 |\\n| Adjustments to reconcile net income to net cash used in operating activities: |\\n| Amortization (accretion) of investments | (39,703 | ) | 17,036 |\\n| Realized investment gains, net | (1,113,698 | ) | (534,242 | ) |\\n| Change in fair value of equity securities | (14,787,631 | ) | (4,129,236 | ) |\\n| Amortization of cost of insurance acquired | 193,977 | 201,516 |\\n| Depreciation | 323,406 | 275,143 |\\n| Net income attributable to noncontrolling interest | 153,733 | 29,500 |\\n| Charges for mortality and administration of universal life and annuity products | (1,619,743 | ) | (1,650,201 | ) |\\n| Interest credited to account balances | 1,029,303 | 883,563 |\\n| Change in accrued investment income | 232,788 | (357,576 | ) |\\n| Change in reinsurance receivables | (61,726 | ) | 35,546 |\\n| Change in policy liabilities and accruals | (772,518 | ) | (6,961 | ) |\\n| Change in income taxes receivable (payable) | 612,616 | 12,974 |\\n| Change in other assets and liabilities, net | 3,839,857 | 5,894,257 |\\n| Net cash provided by (used in) operating activities | (364,460 | ) | 3,328,564 |\\n| Cash flows from investing activities: |\\n| Proceeds from investments sold and matured: |\\n| Fixed maturities available for sale | 2,023,974 | 14,515 |\\n| Equity securities | 33,075 | 103,298 |\\n| Mortgage loans | 1,945,760 | 2,009,715 |\\n| Real estate | 3,045,226 | 7,941,649 |\\n| Notes receivable | 1,537,984 | 563,926 |\\n| Policy loans | 410,831 | 366,847 |\\n| Short-term investments | - | 850,000 |\\n| Total proceeds from investments sold and matured | 8,996,850 | 11,849,950 |\\n| Cost of investments acquired: |\\n| Fixed maturities available for sale | - | (4,971,517 | ) |\\n| Equity securities | (46,509 | ) | (7,957,471 | ) |\\n| Mortgage loans | (3,575,500 | ) | - |\\n| Real estate | (1,174,688 | ) | (6,006,130 | ) |\\n| Notes receivable | (4,416,008 | ) | - |\\n| Policy loans | (324,587 | ) | (405,337 | ) |\\n| Short-term investments | - | (850,000 | ) |\\n| Total cost of investments acquired | (9,537,292 | ) | (20,190,455 | ) |\\n| Net cash used in investing activities | (540,442 | ) | (8,340,505 | ) |\\n| Cash flows from financing activities: |\\n| Policyholder contract deposits | 1,264,011 | 1,149,533 |\\n| Policyholder contract withdrawals | (1,231,379 | ) | (1,245,743 | ) |\\n| Purchase of treasury stock | (212,387 | ) | (600,240 | ) |\\n| Issuance of stock | 229,800 | 230,000 |\\n| Non controlling contributions (distributions) of consolidated subsidiary | (245,750 | ) | (146 | ) |\\n| Net cash used in financing activities | (195,705 | ) | (466,596 | ) |\\n| Net decrease in cash and cash equivalents | (1,100,607 | ) | (5,478,537 | ) |\\n| Cash and cash equivalents at beginning of period | 20,150,162 | 25,434,199 |\\n| Cash and cash equivalents at end of period | $ | 19,049,555 | $ | 19,955,662 |\\n\\nUTG, Inc. Notes to Condensed Consolidated Financial Statements\\nNote 1 – Basis of Presentation\\nThe accompanying Condensed Consolidated Balance Sheet as of December 31, 2018, which has been derived from audited consolidated financial statements, and the unaudited interim Condensed Consolidated Financial Statements include the accounts of UTG, Inc. (the “Parent”) and its subsidiaries (collectively with the Parent, the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. The accompanying Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 8 of regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for audited annual financial statements. The information furnished includes all adjustments and accruals of a normal recurring nature, which in the opinion of Management, are necessary for a fair presentation of the results for the interim periods. The unaudited Condensed Consolidated Financial Statements included herein and these related notes should be read in conjunction with the Company’s consolidated financial statements, and the notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. The Company’s results of operations for the three-month period ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019 or for any other future period.\\nThis document at times will refer to the Registrant’s largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC (“FSF”), a Kentucky corporation, and First Southern Bancorp, Inc. (“FSBI”), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank (“FSNB”). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG’s largest shareholder through his ownership control of FSF, FSBI and affiliates. At March 31, 2019, Mr. Correll owns or controls directly and indirectly approximately 65.26% of UTG’s outstanding stock. UTG’s life insurance subsidiary, Universal Guaranty Life Insurance Company (“UG”), has several wholly-owned and majority-owned subsidiaries. The subsidiaries were formed to hold certain real estate investments. The real estate investments were placed into the limited liability companies and partnerships to provide additional protection to the policyholders and to UG.\\nNote 2 – Recently Issued Accounting Standards\\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\\nNote 3 – Investments Available for Sale Securities – Fixed Maturity Securities The Company’s insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments they are permitted to make, and the amount of funds that may be used for any one type of investment.\\n| March 31, 2019 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\\n| Investments available for sale: |\\n| Fixed maturities |\\n| U.S. Government and govt. agencies and authorities | $ | 25,652,896 | $ | 221,161 | $ | (98,738 | ) | $ | 25,775,319 |\\n| U.S. special revenue and assessments | 16,350,071 | 545,717 | 0 | 16,895,788 |\\n| All other corporate bonds | 116,809,266 | 5,163,923 | (737,633 | ) | 121,235,556 |\\n| $ | 158,812,233 | $ | 5,930,801 | $ | (836,371 | ) | $ | 163,906,663 |\\n| December 31, 2018 | Original or Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value |\\n| Investments available for sale: |\\n| Fixed maturities |\\n| U.S. Government and govt. agencies and authorities | $ | 25,649,410 | $ | 149,006 | $ | (138,222 | ) | $ | 25,660,194 |\\n| U.S. special revenue and assessments | 16,350,486 | 334,300 | (4,406 | ) | 16,680,380 |\\n| All other corporate bonds | 118,895,973 | 2,569,287 | (2,845,050 | ) | 118,620,210 |\\n| $ | 160,895,869 | $ | 3,052,593 | $ | (2,987,678 | ) | $ | 160,960,784 |\\n\\n| Fixed Maturities Available for Sale March 31, 2019 | Amortized Cost | Fair Value |\\n| Due in one year or less | $ | 6,498,983 | $ | 6,525,131 |\\n| Due after one year through five years | 51,055,408 | 53,028,854 |\\n| Due after five years through ten years | 50,690,937 | 53,501,649 |\\n| Due after ten years | 50,566,905 | 50,851,029 |\\n| Total | $ | 158,812,233 | $ | 163,906,663 |\\n\\n| March 31, 2019 | Less than 12 months | 12 months or longer | Total |\\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\\n| U.S. Government and govt. agencies and authorities | $ | - | - | 5,578,536 | (98,738 | ) | 5,578,536 | $ | (98,738 | ) |\\n| All other corporate bonds | 3,555,300 | (6,923 | ) | 26,553,550 | (730,710 | ) | 30,108,850 | (737,633 | ) |\\n| Total fixed maturities | $ | 3,555,300 | (6,923 | ) | 32,132,086 | (829,448 | ) | 35,687,386 | $ | (836,371 | ) |\\n| December 31, 2018 | Less than 12 months | 12 months or longer | Total |\\n| Fair value | Unrealized losses | Fair value | Unrealized losses | Fair value | Unrealized losses |\\n| U.S. Government and govt. agencies and authorities | $ | 6,429,700 | (49,904 | ) | 1,592,679 | (88,318 | ) | 8,022,379 | $ | (138,222 | ) |\\n| U.S. special revenue and assessments | 4,023,920 | (4,406 | ) | - | - | 4,023,920 | (4,406 | ) |\\n| All other corporate bonds | 49,270,729 | (2,033,507 | ) | 15,337,739 | (811,543 | ) | 64,608,468 | (2,845,050 | ) |\\n| Total fixed maturities | $ | 59,724,349 | (2,087,817 | ) | 16,930,418 | (899,861 | ) | 76,654,767 | $ | (2,987,678 | ) |\\n\\n| Less than 12 months | 12 months or longer | Total |\\n| As of March 31, 2019 |\\n| Fixed maturities | 2 | 14 | 16 |\\n| As of December 31, 2018 |\\n| Fixed maturities | 30 | 10 | 40 |\\n\\nSubstantially all of the unrealized losses on fixed maturities and equity securities at March 31, 2019 and December 31, 2018 are attributable to changes in market interest rates and general disruptions in the credit market subsequent to purchase. The Company does not currently intend to sell nor does it expect to be required to sell any of the securities in an unrealized loss position. Based upon the Company’s expected continuation of receipt of contractually required principal and interest payments and its intent and ability to retain the securities until price recovery, as well as the Company’s evaluation of other relevant factors, the Company deems these securities to be temporarily impaired as of March 31, 2019 and December 31, 2018. Net Investment Gains (Losses)\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Realized gains on available-for-sale investments: |\\n| Sales of fixed maturities | $ | 15,055 | $ | - |\\n| Sales of equity securities | - | - |\\n| Sales of real estate | 1,098,643 | - |\\n| Other | - | 534,242 |\\n| Total realized gains | 1,113,698 | 534,242 |\\n| Realized losses on available-for-sale investments: |\\n| Sales of fixed maturities | - | - |\\n| Sales of equity securities | - | - |\\n| Sales of real estate | - | - |\\n| Other-than-temporary impairments | - | - |\\n| Other | - | - |\\n| Total realized losses | - | - |\\n| Net realized investment gains (losses) | 1,113,698 | 534,242 |\\n| Change in fair value of equity securities: |\\n| Realized gains (losses) on equity securities sold during the period | - | - |\\n| Change in fair value of equity securities held at the end of the period | 14,787,631 | 4,129,236 |\\n| Change in fair value of equity securities | 14,787,631 | 4,129,236 |\\n| Net investment gains (losses) | $ | 15,901,329 | $ | 4,663,478 |\\n| Change in net unrealized gains (losses) on available-for-sale investments included in other comprehensive income: |\\n| Fixed maturities | $ | 4,934,851 | $ | (4,285,303 | ) |\\n| Equity securities | - | - |\\n| Net increase (decrease) | $ | 4,934,851 | $ | (4,285,303 | ) |\\n\\nOther-Than-Temporary Impairments The Company regularly reviews its investment securities for factors that may indicate that a decline in fair value of an investment is other than temporary. The factors considered by Management in its regular review to identify and recognize other-than-temporary impairment losses on fixed maturities include, but are not limited to: the length of time and extent to which the fair value has been less than cost; the Company’s intent to sell, or be required to sell, the debt security before the anticipated recovery of its remaining amortized cost basis; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; subordinated credit support, whether the issuer of a debt security has remained current on principal and interest payments; current expected cash flows; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions, including the effect of changes in market interest rates. If the Company intends to sell a debt security, or it is more likely than not that it would be required to sell a debt security before the recovery of its amortized cost basis, the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date would be recognized by a charge to other-than-temporary losses in the Condensed Consolidated Statements of Operations. Management regularly reviews its real estate portfolio in comparison to appraisal valuations and current market conditions for indications of other-than-temporary impairments. If a decline in value is judged by Management to be other-than-temporary, a loss is recognized by a charge to other-than-temporary impairment losses in the Consolidated Statements of Operations. The Company did not recognize any other-than-temporary impairments during the first quarter of 2018 or 2019. Cost Method Investments The Company held equity investments with an aggregate cost of $12,133,745 and $12,118,617 at March 31, 2019 and December 31, 2018, respectively. These equity investments were not reported at fair value because it is not practicable to estimate their fair values due to insufficient information being available. Management did not identify any events or changes in circumstances that might have a significant adverse effect on the reported value of those investments. Based on Management's evaluation of the expected cash flow of the investments, and the Company's ability and intent to hold the investments for a reasonable period of time, the Company does not deem an other-than-temporary impairment necessary at March 31, 2019.\\nMortgage Loans The Company, from time to time, acquires mortgage loans through participation agreements with FSNB. FSNB has been able to provide the Company with additional expertise and experience in underwriting commercial and residential mortgage loans, which provide more attractive yields than the traditional bond market. The Company is able to receive participations from FSNB for three primary reasons: 1) FSNB has already reached its maximum lending limit to a single borrower, but the borrower is still considered a suitable risk; 2) the interest rate on a particular loan may be fixed for a long period that is more suitable for UG given its asset-liability structure; and 3) FSNB’s loan growth might at times outpace its deposit growth, resulting in FSNB participating such excess loan growth rather than turning customers away. For originated loans, the Company’s Management is responsible for the final approval of such loans after evaluation. Before a new loan is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. These criteria include, but are not limited to, a credit report, personal financial information such as outstanding debt, sources of income, and personal equity. Once the loan is approved, the Company directly funds the loan to the borrower. The Company bears all risk of loss associated with the terms of the mortgage with the borrower. During the first quarter of 2019 and 2018, the Company acquired $3,575,500 and $0 in mortgage loans, respectively. FSNB services the majority of the Company’s mortgage loan portfolio. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan.\\n| 2019 | 2018 |\\n| Maximum rate | Minimum rate | Maximum rate | Minimum rate |\\n| Farm Loans | 5.00% | 5.00% | 5.00% | 5.00% |\\n| Commercial Loans | 7.50% | 4.00% | 7.50% | 4.00% |\\n| Residential Loans | 8.00% | 8.00% | 8.00% | 8.00% |\\n\\nMost mortgage loans are first position loans. Loans issued are generally limited to no more than 80% of the appraised value of the property. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans. Letters are sent to each mortgagee when the loan becomes 30 days or more delinquent. Management is provided with a monthly listing of loans that are 60 days or more past due along with a brief description of what steps are being taken to resolve the delinquency. All loans 90 days or more past due are placed on a non-performing status and classified as delinquent loans. Quarterly, coinciding with external financial reporting, the Company reviews each delinquent loan and determines how each delinquent loan should be classified. Management believes the current internal controls surrounding the mortgage loan selection process provide a quality portfolio with minimal risk of foreclosure and/or negative financial impact. Changes in the current economy could have a negative impact on the loans, including the financial stability of the borrowers, the borrowers’ ability to pay or to refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices. Interest accruals are analyzed based on the likelihood of repayment. In no event will interest continue to accrue when accrued interest along with the outstanding principal exceeds the net realizable value of the property. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. A mortgage loan reserve is established and adjusted based on Management's quarterly analysis of the portfolio and any deterioration in value of the underlying property which would reduce the net realizable value of the property below its current carrying value. The mortgage loan reserve was $0 at March 31, 2019 and December 31, 2018.\\n| March 31, 2019 | December 31, 2018 |\\n| In good standing | $ | 8,829,640 | $ | 7,169,272 |\\n| Overdue interest over 90 days | 1,873,913 | 1,899,839 |\\n| Total mortgage loans | $ | 10,703,553 | $ | 9,069,111 |\\n\\nInvestment Real Estate Real estate acquired through foreclosure, consisting of properties obtained through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, is reported on an individual asset basis at the lower of cost or fair value, less disposal costs. Fair value is determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. When properties are acquired through foreclosure, any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is recognized and charged to the Consolidated Statements of Operations. Based upon Management’s evaluation of the real estate acquired through foreclosure, additional expense is recorded when necessary in an amount sufficient to reflect any declines in estimated fair value. Gains and losses recognized on the disposition of the properties are recorded as realized gains and losses in the Condensed Consolidated Statements of Operations. Notes Receivable Notes receivable represent collateral loans and promissory notes issued by the Company and are reported at their unpaid principal balances, adjusted for valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected. The valuation allowance as of March 31, 2019 and December 31, 2018 was $0. Interest accruals are analyzed based on the likelihood of repayment. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. Before a new note is issued, the applicant is subject to certain criteria set forth by Company Management to ensure quality control. Once the note is approved, the Company directly funds the note to the borrower. Several of the notes have participation agreements in place, whereas the Company has reduced its investment in the note receivable by participating a portion of the note to a third party. Similar to the mortgage loans, FSNB services several of the notes receivable. The Company, and the participants in the notes, share in the risk of loss associated with the terms of the note with the borrower, based upon their ownership percentage in the note. The Company has in place a monitoring system to provide Management with information regarding potential troubled loans.\\nNote 4 – Fair Value Measurements The Company measures its assets and liabilities recorded at fair value in the Condensed Consolidated Balance Sheets based on the framework set forth in the GAAP fair value accounting guidance. The framework establishes a fair value hierarchy of three levels based upon the transparency of information used in measuring the fair value of assets or liabilities as of the measurement date. The fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three categories. Level 1 – Valuation is based upon quoted prices for identical assets or liabilities in active markets that the Company is able to access. Level 1 fair value is not subject to valuation adjustments. Level 2 – Valuation is based upon quoted prices for similar assets and liabilities in active markets or quoted prices for identical or similar instruments in markets that are not active. In addition, the Company may use various valuation techniques or pricing models that use observable inputs to measure fair value. Level 3 – Valuation is based upon unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the Company’s own assumptions about the inputs that market participants would use in pricing the asset or liability. The Company determines the existence of an active market for an asset or liability based on its judgment as to whether transactions for the asset or liability occur in such market with sufficient frequency and volume to provide reliable pricing information. If the Company concludes that there has been a significant decrease in the volume and level of activity for an investment in relation to normal market activity for such investment, adjustments to transactions and quoted prices are made to estimate fair value. The inputs used in the valuation techniques employed by the Company are provided by nationally recognized pricing services, external investment managers and internal resources. To assess these inputs, the Company’s review process includes, but is not limited to, quantitative analysis including benchmarking, initial and ongoing evaluations of methodologies used by external parties to calculate fair value, and ongoing evaluations of fair value estimates based on the Company’s knowledge and monitoring of market conditions. The Company periodically reviews the pricing service provider’s policies and procedures for valuing securities. The assumptions underlying the valuations from external service providers, including unobservable inputs, are generally not readily available as this information is often deemed proprietary. Accordingly, the Company is unable to obtain comprehensive information regarding these assumptions and methodologies. The Company’s investments in fixed maturity securities available for sale, equity securities and trading securities assets and liabilities are carried at fair value. The following are the Company’s methodologies and valuation techniques for assets and liabilities measured at fair value. Fixed maturities available for sale mainly consist of U.S. treasury securities and corporate debt securities. The Company employs a market approach to the valuation of securities where there are sufficient market transactions involving identical or comparable assets. If sufficient market data is not available for identical or comparable assets, the Company uses an income approach to valuation. The majority of the financial instruments included in fixed maturity securities available for sale are evaluated utilizing observable inputs; accordingly, they are categorized in either Level 1 or Level 2 of the fair value hierarchy. However, in instances where significant inputs utilized in valuation of the securities are unobservable, the securities are categorized in Level 3 of the fair value hierarchy. Corporate securities primarily include fixed rate corporate bonds. Inputs utilized in connection with the Company’s valuation techniques relating to this class of securities include recently executed transactions, market price quotations, benchmark yields and issuer spreads. Corporate securities are categorized in Level 2 of the fair value hierarchy. U.S. treasury securities are based on quoted prices in active markets and are generally categorized in Level 1 of the fair value hierarchy. Equity securities consist of common and preferred stocks mainly in private equity investments, financial institutions and publicly traded corporations. Equity securities for which there is sufficient market data are categorized as Level 1 or 2 in the fair value hierarchy. For the equity securities in which quoted market prices are not available, the Company uses industry standard pricing methodologies, including discounted cash flow models that may incorporate various inputs such as payment expectations, risk of the investment, market data, and health of the underlying company. The inputs are based upon Management's assumptions and available market information. When evidence is believed to support a change to the carrying value from the transaction price, adjustments are made to reflect the expected cash flows, material events and market data. These investments are included in Level 3 of the fair value hierarchy.\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Assets |\\n| Fixed Maturities, available for sale | $ | 25,775,319 | $ | 137,696,500 | $ | 434,844 | $ | 163,906,663 |\\n| Equity Securities | 37,355,757 | 12,176,923 | 32,917,737 | 82,450,417 |\\n| Total | $ | 63,131,076 | $ | 149,873,423 | $ | 33,352,581 | $ | 246,357,080 |\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Assets |\\n| Fixed Maturities, available for sale | $ | 25,660,194 | $ | 134,865,746 | $ | 434,844 | $ | 160,960,784 |\\n| Equity Securities | 27,634,283 | 10,557,031 | 29,473,168 | 67,664,482 |\\n| Total | $ | 53,294,477 | $ | 145,422,777 | $ | 29,908,012 | $ | 228,625,266 |\\n\\n| Fixed Maturities, Available for Sale | Equity Securities | Total |\\n| Balance at December 31, 2018 | $ | 434,844 | $ | 29,473,168 | $ | 29,908,012 |\\n| Total unrealized gain or (losses): |\\n| Included in net income (loss) | - | 3,444,569 | 3,444,569 |\\n| Included in other comprehensive income | - | - | - |\\n| Purchases | - | - | - |\\n| Sales | - | - | - |\\n| Balance at March 31, 2019 | $ | 434,844 | $ | 32,917,737 | $ | 33,352,581 |\\n| March 31, 2019 | December 31, 2018 |\\n| Change in fair value of equity securities included in net income (loss) relating to assets held | $ | 3,444,569 | $ | 4,633,751 |\\n\\nThe Level 3 securities include collateralized debt obligations of trust preferred securities issued by banks and insurance companies and certain equity securities with unobservable inputs. The Company computed fair value of Level 3 equity investments based on a review of current financial information, earnings trends and similar companies in the same industries. There were no transfers in or out of Level 3 as of March 31, 2019. Transfers occur when there is a change in the availability of observable market information. Certain assets are not carried at fair value on a recurring basis, including investments such as mortgage loans and policy loans. Accordingly, such investments are only included in the fair value hierarchy disclosure when the investment is subject to re-measurement at fair value after initial recognition and the resulting re-measurement is reflected in the Consolidated Financial Statements.\\n| March 31, 2019 | December 31, 2018 |\\n| Assets | Carrying Amount | Estimated Fair Value | Carrying Amount | Estimated Fair Value |\\n| Equity securities | $ | 12,133,745 | $ | 12,133,745 | $ | 12,118,617 | $ | 12,118,617 |\\n| Mortgage loans on real estate | 10,703,553 | 10,703,553 | 9,069,111 | 9,069,111 |\\n| Investment real estate | 51,530,162 | 51,530,162 | 52,518,577 | 52,518,577 |\\n| Notes receivable | 26,595,336 | 26,595,336 | 23,717,312 | 23,717,312 |\\n| Policy loans | 9,117,979 | 9,117,979 | 9,204,222 | 9,204,222 |\\n| Cash and cash equivalents | 19,049,555 | 19,049,555 | 20,150,162 | 20,150,162 |\\n\\nThe above estimated fair value amounts have been determined based upon the following valuation methodologies. Considerable judgment was required to interpret market data in order to develop these estimates. Accordingly, the estimates are not necessarily indicative of the amounts which could be realized in a current market exchange. The use of different market assumptions or estimation methodologies may have a material effect on the fair value amounts. The fair values of mortgage loans on real estate are estimated using discounted cash flow analyses and interest rates being offered for similar loans to borrowers with similar credit ratings. The inputs used to measure the fair value of our mortgage loans on real estate are classified as Level 3 within the fair value hierarchy. A portion of the mortgage loans balance consists of discounted mortgage loans. The Company has historically purchased non-performing discounted mortgage loans at a deep discount through an auction process led by the Federal Government. In general, the discounted loans are non-performing and there is a significant amount of uncertainty surrounding the timing and amount of cash flows to be received by the Company. Accordingly, the Company records its investment in the discounted loans at its original purchase price, which Management believes approximates fair value. The inputs used to measure the fair value of our discounted mortgage loans are classified as Level 3 within the fair value hierarchy Investment real estate is recorded at the lower of the net investment in the real estate or the fair value of the real estate less costs to sell. The determination of fair value assessments are performed on a periodic, non-recurring basis by external appraisal and assessment of property values by Management. The inputs used to measure the fair value of our investment real estate are classified as Level 3 within the fair value hierarchy. Notes receivable are carried at their unpaid principal balances, which approximates fair value. The inputs used to measure the fair value of the loans are classified as Level 3 within the fair value hierarchy. Policy loans are carried at the aggregate unpaid principal balances in the Condensed Consolidated Balance Sheets which approximate fair value, and earn interest at rates ranging from 4% to 8%. Individual policy liabilities in all cases equal or exceed outstanding policy loan balances. The inputs used to measure the fair value of our policy loans are classified as Level 3 within the fair value hierarchy. The carrying amount of cash and cash equivalents in the Condensed Consolidated Balance Sheets approximates fair value given the highly liquid nature of the instruments. The inputs used to measure the fair value of our cash and cash equivalents are classified as Level 1 within the fair value hierarchy. The carrying amount of short term investments in the Condensed Consolidated Balance Sheets approximates fair value. The inputs used to measure the fair value of our short term investments are classified as Level 3 within the fair value hierarchy.\\nNote 5 – Credit Arrangements\\n| Instrument | Issue Date | Maturity Date | Revolving Credit Limit | December 31, 2018 | Borrowings | Repayments | March 31, 2019 |\\n| Lines of Credit: |\\n| UTG | 11/20/2013 | 11/20/2019 | $ | 8,000,000 | - | - | - | - |\\n| UG | 6/2/2015 | 5/10/2019 | 10,000,000 | - | - | - | - |\\n\\nThe UTG line of credit carries interest at a fixed rate of 5.125% and is payable monthly. As collateral, UTG has pledged 100% of the common voting stock of its wholly owned subsidiary, Universal Guaranty Life Insurance Company. The Company is currently in the process of renewing this line of credit. During May of 2018, the Federal Home Loan Bank approved UG’s Cash Management Advance Application (“CMA”). The CMA gives the Company the option of selecting a variable rate of interest for up to 90 days or a fixed rate for a maximum of 30 days. The variable rate CMA is prepayable at any time without a fee, while the fixed CMA is not prepayable prior to maturity. The Company is currently in the process of renewing the CMA.\\nNote 6 – Shareholders’ Equity Stock Repurchase Program – The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. At a meeting of the Board of Directors in September of 2018, the Board of Directors of UTG authorized the repurchase of up to an additional $1.5 million of UTG's common stock, for a total repurchase of up to $16.0 million of UTG's common stock in the open market or in privately negotiated transactions. Company Management has broad authority to operate the program, including the discretion of whether to purchase shares and the ability to suspend or terminate the program. Open market purchases are made based on the last available market price but may be limited. During the three months ended March 31, 2019, the Company repurchased 6,955 shares through the stock repurchase program for $212,387. Through March 31, 2019, UTG has spent $14,076,115 million in the acquisition of 1,147,061 shares under this program. During 2019, the Company issued 7,632 shares of stock to management and employees as compensation at a cost of $229,800. These awards are determined at the discretion of the Board of Directors. Earnings Per Share Calculations Earnings per share are based on the weighted average number of common shares outstanding during each period. For the three months ended March 31, 2019 and 2018, diluted earnings per share were the same as basic earnings per share since the Company had no dilutive instruments outstanding.\\nNote 7 – Commitments and Contingencies The insurance industry has experienced a number of civil jury verdicts which have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. In the normal course of business, the Company is involved from time to time in various legal actions and other state and federal proceedings. Management is of the opinion that the ultimate disposition of the matters will not have a materially adverse effect on the Company’s results of operations or financial position. Under the insurance guaranty fund laws in most states, insurance companies doing business in a participating state can be assessed up to prescribed limits for policyholder losses incurred by insolvent or failed insurance companies. Although the Company cannot predict the amount of any future assessments, most insurance guaranty fund laws currently provide that an assessment may be excused or deferred if it would threaten an insurer's financial strength. Mandatory assessments may be partially recovered through a reduction in future premium tax in some states. The Company does not believe such assessments will be materially different from amounts already provided for in the condensed consolidated financial statements, though the Company has no control over such assessments.\\n| Total Funding Commitment | Unfunded Commitment |\\n| RLF III, LLC | $ | 4,000,000 | $ | 398,120 |\\n| Sovereign’s Capital, LP Fund I | 500,000 | 24,493 |\\n| Sovereign's Capital, LP Fund II | 1,000,000 | 240,566 |\\n| Sovereign's Capital, LP Fund III | 1,000,000 | 900,000 |\\n| Barton Springs Music, LLC | 1,750,000 | 1,158,500 |\\n| Master Mineral Holdings III, LP | 4,000,000 | 530,312 |\\n\\nDuring 2006, the Company committed to invest in RLF III, LLC (“RLF”), which makes land-based investments in undervalued assets. RLF makes capital calls as funds are needed for continued land purchases. During 2012, the Company committed to invest in Sovereign’s Capital, LP Fund I (“Sovereign’s”), which invests in companies in emerging markets. Sovereign’s makes capital calls to investors as funds are needed. During 2015, the Company committed to invest in Sovereign’s Capital, LP Fund II (“Sovereign’s II”), which invests in companies in emerging markets. Sovereign’s II makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Sovereign’s Capital, LP Fund III (“Sovereign’s III”), which invests in companies in emerging markets. Sovereign’s III makes capital calls to investors as funds are needed. During 2018, the Company committed to invest in Barton Springs Music, LLC (“Barton”), which invests in music royalties. Barton makes capital calls to its investors as funds are needed to acquire the royalty rights. During 2018, the Company committed to invest in Master Mineral Holdings III, LP (“MMH”), which purchases land for leasing opportunities to those looking to harvest natural resources. MMH makes capital calls to its investors as funds are needed for continued land purchases.\\nNote 8 – Other Cash Flow Disclosures\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Interest | $ | - | $ | - |\\n| Federal income tax | - | - |\\n\\nNote 9 – Concentrations of Credit Risk The Company maintains cash balances in financial institutions that at times may exceed federally insured limits. The Company maintains its primary operating cash accounts with First Southern National Bank, an affiliate of the largest shareholder of UTG, Mr. Jesse Correll, the Company’s CEO and Chairman. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. Because UTG serves primarily individuals located in four states, the ability of our customers to pay their insurance premiums is impacted by the economic conditions in these areas. As of March 31, 2019 and 2018 , approximately 55% and 56%, respectively, of the Company’s total direct premium was collected from Illinois, Ohio, Texas and West Virginia. Thus, results of operations are heavily dependent upon the strength of these economies. The Company reinsures that portion of insurance risk which is in excess of its retention limits. Retention limits range up to $125,000 per life. Life insurance ceded represented 20% of total life insurance in force at March 31, 2019 and December 31, 2018, respectively. Insurance ceded represented 24% and 29% of premium income for the three months ended March 31, 2019 and 2018, respectively. The Company would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations. The Company owns a variety of investments associated with the oil and gas industry. These investments represent approximately 28% and 25% of the Company's total invested assets as of March 31, 2019 and December 31, 2018, respectively.\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThe following is Management's discussion and analysis of the financial condition and results of operations of UTG, Inc. and its subsidiaries (collectively with the Parent, the \\\"Company\\\"). The following discussion of the financial condition and results of operations of the Company should be read in conjunction with, and is qualified in its entirety by reference to, the Consolidated Financial Statements of the Company and the related Notes thereto appearing in the Company's annual report on Form 10-K for the year ended December 31, 2018, as filed with the Securities and Exchange Commission, and our unaudited Condensed Consolidated Financial Statements and related Notes thereto appearing elsewhere in this quarterly report.\\nCautionary Statement Regarding Forward-Looking Statements\\nThis report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based our forward-looking statements on our current expectations and projections about future events. Our forward-looking statements include information about possible or assumed future results of operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as the growth of our business and operations, our business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Also, when we use words such as \\\"anticipate,\\\" \\\"believe,\\\" \\\"estimate,\\\" \\\"expect,\\\" \\\"intend,\\\" \\\"plan,\\\" \\\"probably,\\\" or similar expressions, we are making forward-looking statements.\\nNumerous risks and uncertainties may impact the matters addressed by our forward-looking statements, any of which could negatively and materially affect our future financial results and performance.\\nAlthough we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements that are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved. In light of these risks, uncertainties and assumptions, any forward-looking event discussed in this report may not occur. Our forward-looking statements speak only as of the date made, and we undertake no obligation to update or review any forward-looking statement, whether as a result of new information, future events or other developments, unless the securities laws require us to do so.\\nOverview\\nUTG, Inc., a Delaware corporation, is a life insurance holding company. The Company's dominant business is individual life insurance, which includes the servicing of existing insurance policies in force, the acquisition of other companies in the life insurance business and the administration and processing of life insurance business for other entities. The Company's focus for the future includes growing the administrative portion of the business.\\nCritical Accounting Policies\\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ significantly from those estimates. The Company has identified certain estimates that involve a higher degree of judgment and are subject to a significant degree of variability. The Company's critical accounting policies and the related estimates considered most significant by Management are disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2018. Management has identified the accounting policies related to cost of insurance acquired, assumptions and judgments utilized in determining if declines in fair values of investments are other-than-temporary, and valuation methods for investments that are not actively traded as those, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Condensed Consolidated Financial Statements and this Management's Discussion and Analysis.\\nDuring the three months ended March 31, 2019, there were no additions to or changes in the critical accounting policies disclosed in the 2018 Form 10-K.\\nResults of Operations\\nOn a consolidated basis, the Company reported net income attributable to common shareholders' of approximately $11.6 million and $2.7 million for the three-month periods ended March 31, 2019 and 2018, respectively.\\nRevenues\\nThe Company reported total revenues of approximately $21.1 million for the three-month period ended March 31, 2019, an increase of approximately $11.4 million as compared to the same period in 2018. The variance in total revenues from the prior year to the current year is mainly attributable to the increase in the change in the fair value of equity securities.\\nPremium and policy fee revenues, net of reinsurance, were comparable for the three-months ended March 31, 2019 and 2018. The Company writes minimal new business. Premium and policy fee revenues, net of reinsurance, represented 10% and 20% of the Company's revenues as of March 31, 2019 and 2018, respectively.\\nThe following table summarizes the Company's investment performance.\\n\\n| Three Months Ended March 31, |\\n| 2019 | 2018 |\\n| Net investment income | $ | 3,112,024 | $ | 3,068,118 |\\n| Net investment gains | $ | 15,901,329 | $ | 4,663,478 |\\n| Change in net unrealized investment gains (losses) on available-for-sale securities, pre-tax | $ | 4,934,851 | $ | (4,285,303 | ) |\\n\\nThe following table reflects net investment income of the Company:\\n\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Fixed maturities available for sale | $ | 1,589,985 | $ | 1,837,844 |\\n| Equity securities | 668,108 | 532,067 |\\n| Trading securities | (111,693 | ) | - |\\n| Mortgage loans | 118,612 | 214,558 |\\n| Real estate | 784,532 | 449,546 |\\n| Notes receivable | 435,155 | 386,782 |\\n| Policy loans | 141,552 | 150,081 |\\n| Short-term | 41,364 | 48,172 |\\n| Cash and cash equivalents | - | 12,434 |\\n| Total consolidated investment income | 3,667,615 | 3,631,484 |\\n| Investment expenses | (555,591 | ) | (563,366 | ) |\\n| Consolidated net investment income | $ | 3,112,024 | $ | 3,068,118 |\\n\\nNet investment income represented 15% and 32% of the Company's total revenues as of March 31, 2019 and 2018, respectively. Net investment was comparable in the majority of the investment categories when comparing the first quarter 2019 activity to the same quarter in 2018.\\nInvestment income from the real estate investment portfolio is up approximately $335,000 in the current year as compared to the same period in the prior year. The increase is not attributable to one specific investment or event. Several of the Company's real estate holdings produced more income in the current your as compared to the same period in the prior year. Income is expected to vary from quarter to quarter depending on the activity occurring in relation to each property.\\nThe Company reported net investment gains of approximately $15.9 million and $4.7 million for the three-month periods ended March 31, 2019 and 2018, respectively. Realized investment gains of approximately $1.1 million and $534,000 were recognized by the Company during the first quarter of 2019 and 2018, respectively. These gains are the result of the Company selling a parcel of real estate in 2018 and 2019.\\nRealized investment gains are the result of one-time events and are expected to vary from quarter to quarter.\\nThe 2019 investment gains mainly consist of approximately $14.8 million in unrealized gains related to the change in the fair value of equity securities. For the same period in 2018, the Company reported approximately $4.1 million of unrealized gains related to the change in the fair value of equity securities.\\nThe Company has seen significant unrealized gains on its equity investments during 2018 and 2019. A significant portion of these gains are from two equity holdings, both in the area of oil and gas. While the Company has had very strong unrealized gains during 2018 and 2019, a pull back in the stock market, particularly in the oil and gas arena, could slow these gains or even result in future period unrealized losses. Management believes these equity investments continue to be solid investments for the Company and have further growth potential; however, changes in market conditions could cause volatility in market prices.\\nIn summary, the Company's basis for future revenue growth is expected to come from the following primary sources: conservation of business currently in-force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources to enhance these opportunities.\\nExpenses\\nThe Company reported total benefits and other expenses of approximately $5.6 million for the three-month period ended March 31, 2019, a decrease of approximately 9% from the same period in 2018. Benefits, claims and settlement expenses represented approximately 59% and 63% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively. The other major expense category of the Company is operating expenses, which represented approximately 39% and 34% of the Company's total expenses for the three-month periods ended March 31, 2019 and 2018, respectively.\\nLife benefits, claims and settlement expenses, net of reinsurance benefits and claims, decreased approximately 16% in the three-month period ended March 31, 2019, compared to the same period in 2018. Policy claims vary from period to period and therefore, fluctuations in mortality are to be expected and are not considered unusual by Management.\\nNet amortization of cost of insurance acquired decreased 4% during the three-month period ended March 31, 2019 compared to the same period in 2018. Cost of insurance acquired is established when an insurance company is acquired or when the Company acquires a block of in-force business. The Company assigns a portion of its cost to the right to receive future profits from insurance contracts existing at the date of the acquisition. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The interest rates may vary due to risk analysis performed at the time of acquisition on the business acquired. The Company utilizes a 12% discount rate on the remaining unamortized business. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Amortization of cost of insurance acquired is particularly sensitive to changes in interest rate spreads and persistency of certain blocks of insurance in-force. This expense is expected to decrease, unless the Company acquires a new block of business.\\nOperating expenses increased approximately 3% in the three-month period ended March 31, 2019 as compared to the same period in 2018. Overall, expenses were comparable in all of the major expense categories.\\nManagement continues to place significant emphasis on expense monitoring and cost containment. Maintaining administrative efficiencies directly impacts net income.\\nFinancial Condition\\nInvestment Information\\nInvestments represent approximately 86% and 85% of total assets at March 31, 2019 and December 31, 2018, respectively. Accordingly, investments are the largest asset group of the Company. The Company's insurance subsidiary is regulated by insurance statutes and regulations as to the type of investments that it is permitted to make and the amount of funds that may be used for any one type of investment. In light of these statutes and regulations, the majority of the Company's investment portfolio is invested in a diverse set of securities.\\nAs of March 31, 2019, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets, shareholders' equity or results from operations. To provide additional flexibility and liquidity, the Company has identified all fixed maturity securities as \\\"investments available for sale\\\". Investments available-for-sale are carried at market, with changes in market value charged directly to shareholders' equity. Changes in the market value of available for sale securities resulted in a net unrealized gain of approximately $3.9 million and a net unrealized loss of approximately $3.4 million for the three-month periods ended March 31, 2019 and 2018, respectively. The variance in the net unrealized gains and losses is the result of normal market fluctuations and lower interest rates.\\nCapital Resources\\nTotal shareholders' equity increased by approximately 14% as of March 31, 2019 compared to December 31, 2018. The increase is mainly attributable to an increase in retained earnings, which is the result of the current year net income reported by the Company.\\nThe Company's investments are predominately in fixed maturity investments such as bonds, which provide sufficient return to cover future obligations. The Company carries all of its fixed maturity holdings as available for sale, which are reported in the Condensed Consolidated Financial Statements at their market value.\\nLiquidity\\nThe Company has two principal needs for cash - the insurance company's contractual obligations to policyholders and the payment of operating expenses. Cash and cash equivalents represented 5% total assets as of March 31, 2019 and December 31, 2018. Fixed maturities as a percentage of total assets were approximately 40% and 41% as of March 31, 2019 and December 31, 2018, respectively.\\nThe Company currently has access to funds for operating liquidity. UTG has an $8 million revolving credit note with Illinois National Bank. At March 31, 2019, the Company had no outstanding borrowings against the UTG line of credit. UG has a $10 million line of credit with the Federal Home Loan Bank. At March 31, 2019, the Company had no outstanding borrowings against the UG line of credit\\nFuture policy benefits are primarily long-term in nature and therefore, the Company's investments are predominantly in long-term fixed maturity investments such as bonds and mortgage loans which provide sufficient return to cover these obligations. Many of the Company's products contain surrender charges and other features which reward persistency and penalize the early withdrawal of funds.\\nFor the three months ended March 31, 2019 and 2018, operating activities used cash of approximately $364,000 and provided cash of approximately $3.3 million, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years.\\nThe Company used cash in investing activities of approximately $540,000 and $8.3 million for the three month periods ended March 31, 2019 and 2018, respectively. The net cash provided by or used in investing activities is expected to vary from quarter to quarter depending on market conditions and Management’s ability to find and negotiate favorable investment contracts.\\nUTG is a holding Company that has no day-to-day operations of its own. Funds required to meet its expenses, generally costs associated with maintaining the Company in good standing with states in which it does business are primarily provided by its subsidiaries. On a parent only basis, UTG's cash flow is dependent on Management fees received from its insurance subsidiary, stockholder dividends from its subsidiary and earnings received on cash balances. At March 31, 2019, substantially all of the consolidated shareholders' equity represented net assets of its subsidiary. The Company's insurance subsidiary has maintained adequate statutory capital and surplus. The payment of cash dividends to shareholders by UTG is not legally restricted. However, the state insurance department regulates insurance Company dividend payments where the Company is domiciled. No dividends were paid to shareholders in 2018 or the three-month period ended March 31, 2019.\\nUG is an Ohio domiciled insurance company, which requires notification within five business days to the insurance commissioner following the declaration of any ordinary dividend and at least ten calendar days prior to payment of such dividend. Ordinary dividends are defined as the greater of: a) prior year statutory net income or b) 10% of statutory capital and surplus. For the year ended December 31, 2018, UG had statutory net income of approximately $6.2 million. At December 31, 2018 UG's statutory capital and surplus amounted to approximately $60 million. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation. During 2018 , UG paid UTG ordinary dividends of $5 million. During the second quarter of 2019, UG paid UTG a dividend of $2 million. UTG used the dividends received during 2018 and 2019 for general operations of the Company.\\n\\nITEM 4. CONTROLS AND PROCEDURES\\nThe Company maintains a set of disclosure controls and procedures designed to ensure that information required to be disclosed in reports that it files or submits under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. In addition, the disclosure controls and procedures ensure that information required to be disclosed is accumulated and communicated to Management, including the principal executive officer and principal financial officer, allowing timely decisions regarding required disclosure. Under the supervision and with the participation of our Management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.\\nPART II. OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nNONE\\n\\nITEM 1A. RISK FACTORS\\nNONE\\n\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nNONE\\n\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\\nNONE\\n\\nITEM 4. MINE SAFETY DISCLOSURES\\nNONE\\n\\nITEM 5. OTHER INFORMATION\\nNONE\\n\\nITEM 6. EXHIBITS\\n\\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| **101 | Interactive Data File |\\n\\n*Filed herewith\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\nUTG, INC.\\n(Registrant)\\n\\n| Date: | May 14, 2019 | By | /s/ James P. Rousey |\\n| James P. Rousey |\\n| President and Director |\\n\\n\\n| Date: | May 14, 2019 | By | /s/ Theodore C. Miller |\\n| Theodore C. Miller |\\n| Senior Vice President |\\n| and Chief Financial Officer |\\n\\nEXHIBIT INDEX\\n\\n| Exhibit Number | Description |\\n| *31.1 | Certification of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| *31.2 | Certification of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| *32.1 | Certificate of Jesse T. Correll, Chief Executive Officer and Chairman of the Board of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| *32.2 | Certificate of Theodore C. Miller, Chief Financial Officer, Senior Vice President and Corporate Secretary of UTG, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| **101 | Interactive Data File |\\n\\n* Filed herewith\\n\\n</text>\\n\\nWhat is the return on equity (ROE) for the year ended March 31, 2019, considering the net income for the three months ended March 31, 2019, and total shareholders' equity at the end of 2019 and 2018 in percentages?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 41.11.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 37,\n \"input_length\": 18914\n}"}}},{"rowIdx":38,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nPART I. FINANCIAL INFORMATION\nItem 1. Financial Statements.\nQUADRO ACQUISITION ONE CORP.\nCONDENSED BALANCE SHEETS\n\n| June 30, 2023 | December 31, 2022 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash | $ | — | $ | 964 |\n| Prepaid expenses | — | 33,402 |\n| Total current assets | — | 34,366 |\n| Cash and investments held in Trust Account | 26,731,243 | 233,304,515 |\n| Total Assets | $ | 26,731,243 | $ | 233,338,881 |\n| Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit |\n| Current liabilities: |\n| Accounts payable | $ | 436,656 | $ | 107,269 |\n| Accrued expenses | 145,452 | 29,718 |\n| Extension loan - related party | 270,000 | — |\n| Advance from related parties | 188,722 | — |\n| Note payable - related party | 400,000 | 318,700 |\n| Total current liabilities | 1,440,830 | 455,687 |\n| Derivative liabilities - warrants | 809,673 | 30,167 |\n| Deferred underwriting commissions | 2,817,500 | 2,817,500 |\n| Total liabilities | 5,068,003 | 3,303,354 |\n| Commitments and Contingencies |\n| Class A ordinary shares subject to possible redemption, $ 0.001 par value; 2,548,153 and 23,000,000 shares at approximately $ 10.45 and $ 10.14 per share redemption value as of June 30, 2023 and December 31, 2022, respectively | 26,631,243 | 233,204,515 |\n| Shareholders’ Deficit: |\n| Class A ordinary shares, $ 0.001 par value; 200,000,000 shares authorized; 6,250,000 and 0 non-redeemable shares issued or outstanding as of June 30, 2023 and December 31, 2022, respectively | 6,250 | — |\n| Class B ordinary shares, $ 0.001 par value; 10,000,000 shares authorized; 0 and 6,250,000 shares issued and outstanding as of June 30, 2023 and December 31, 2022, respectively | — | 6,250 |\n| Accumulated deficit | ( 4,974,253 | ) | ( 3,175,238 | ) |\n| Total shareholders’ deficit | ( 4,968,003 | ) | ( 3,168,988 | ) |\n| Total Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit | $ | 26,731,243 | $ | 233,338,881 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n1\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\n\n| For the Three Months Ended June 30, | For the Six Months Ended June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Operating expenses |\n| General and administrative expenses | $ | 160,237 | $ | 106,509 | $ | 749,509 | $ | 299,896 |\n| Loss from operations | ( 160,237 | ) | ( 106,509 | ) | ( 749,509 | ) | ( 299,896 | ) |\n| Other income: |\n| Change in fair value of derivative assets and liabilities | ( 538,173 | ) | 863,544 | ( 779,506 | ) | 5,117,082 |\n| Income from investments held in Trust Account | 240,284 | — | 1,681,266 | — |\n| Unrealized gain from investments held in Trust Account | — | 292,182 | — | 312,752 |\n| Net (loss) income | $ | ( 458,126 | ) | $ | 1,049,217 | $ | 152,251 | $ | 5,129,938 |\n| Weighted average shares outstanding of Class A ordinary shares, basic and diluted | 8,798,153 | 23,000,000 | 13,551,176 | 23,000,000 |\n| Basic and diluted net (loss) income per share, Class A ordinary shares | $ | ( 0.05 | ) | $ | 0.04 | $ | 0.01 | $ | 0.18 |\n| Weighted average shares outstanding of Class B ordinary shares, basic and diluted | — | 6,250,000 | 1,041,667 | 6,250,000 |\n| Basic and diluted net (loss) income per share, Class B ordinary shares | $ | — | $ | 0.04 | $ | 0.01 | $ | 0.18 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n2\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2022 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 3,175,238 | ) | $ | ( 3,168,988 | ) |\n| Conversion of Class B ordinary shares to Class A ordinary shares | 6,250,000 | 6,250 | ( 6,250,000 | ) | ( 6,250 | ) | — | — | — |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 1,560,982 | ) | ( 1,560,982 | ) |\n| Net income | — | — | — | — | — | 610,377 | 610,377 |\n| Balance - March 31, 2023 (unaudited) | 6,250,000 | 6,250 | — | — | — | ( 4,125,843 | ) | ( 4,119,593 | ) |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 390,284 | ) | ( 390,284 | ) |\n| Net loss | — | — | — | — | — | ( 458,126 | ) | ( 458,126 | ) |\n| Balance - June 30, 2023 (unaudited) | 6,250,000 | $ | 6,250 | — | $ | — | $ | — | $ | ( 4,974,253 | ) | $ | ( 4,968,003 | ) |\n\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\n\n| Ordinary Shares | Additional | Total |\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\n| Balance - December 31, 2021 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 13,769,504 | ) | $ | ( 13,763,254 | ) |\n| Net income | — | — | — | — | — | 4,080,721 | 4,080,721 |\n| Balance - March 31, 2022 (unaudited) | — | — | 6,250,000 | 6,250 | — | ( 9,688,783 | ) | ( 9,682,533 | ) |\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 251,264 | ) | ( 251,264 | ) |\n| Net income | — | — | — | — | — | 1,049,217 | 1,049,217 |\n| Balance - June 30, 2022 (unaudited) | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 8,890,830 | ) | $ | ( 8,884,580 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n3\nQUADRO ACQUISITION ONE CORP.\nUNAUDITED CONDENSED STATEMENTS OF CASH FLOWS\n\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Cash Flows from Operating Activities: |\n| Net income | $ | 152,251 | $ | 5,129,938 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Change in fair value of derivative assets and liabilities | 779,506 | ( 5,117,082 | ) |\n| Income from cash and investments held in Trust Account | ( 1,681,266 | ) | — |\n| Unrealized gain from investments held in Trust Account | — | ( 312,752 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses | 33,402 | 105,379 |\n| Accounts payable | 346,708 | 12,240 |\n| Accounts payable - related party | ( 17,321 | ) | ( 17,321 | ) |\n| Accrued expenses | 115,734 | ( 60,094 | ) |\n| Net cash used in operating activities | ( 270,986 | ) | ( 259,692 | ) |\n| Cash Flows from Investing Activities: |\n| Cash deposited in Trust Account | ( 270,000 | ) | — |\n| Cash withdrawn from Trust Account in connection with redemption | 208,524,538 | — |\n| Net cash provided by investing activities | 208,254,538 | — |\n| Cash Flows from Financing Activities: |\n| Proceeds from related party advance | 188,722 | — |\n| Proceeds from extension loan | 270,000 | — |\n| Proceeds from note payable to related party | 81,300 | — |\n| Proceeds from promissory note to related party | — | 318,700 |\n| Offering costs paid | — | ( 70,000 | ) |\n| Redemption of Ordinary shares | ( 208,524,538 | ) | — |\n| Net cash used in financing activities | ( 207,984,516 | ) | 248,700 |\n| Net change in cash | ( 964 | ) | ( 10,992 | ) |\n| Cash - beginning of the period | 964 | 63,676 |\n| Cash - end of the period | $ | — | $ | 52,684 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n4\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 1 - Description of Organization, Business Operations and Going Concern\nQuadro Acquisition One Corp. (the “Company”, formerly known as Kismet Acquisition Two Corp.) is a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. The Company was incorporated for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation, contractual control arrangement with, purchasing all or substantially all of the assets of, or engaging in any other similar initial business combination with one or more businesses or entities that the Company has not yet identified (“Business Combination”).\nAs of June 30, 2023, the Company had not yet commenced operations. All activity for the period from September 15, 2020 (inception) through June 30, 2023, relates to the Company’s formation and the initial public offering (the “Initial Public Offering” or “IPO”), which is described below, and since the Initial Public Offering, the search for a potential target. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company generates non-operating income in the form of interest income on investments held in Trust Account (as defined below) from the proceeds derived from the Initial Public Offering and the sale of the Private Placement Warrants (as defined below).\nThe Company’s sponsor was Kismet Sponsor Limited, a British Virgin Islands company (the “Prior Sponsor”). The Registration Statement for the Initial Public Offering on Form S-1 initially filed with the U.S. Securities and Exchange Commission (“SEC”) on January 26, 2021, as amended (File No. 333- 252419), was declared effective on February 17, 2021 (the “Registration Statement”). On February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 units (the “Units” and, with respect to the Class A Ordinary shares included in the Units sold, the “Public Shares”), including 3,000,000 additional Units to cover over-allotments (the “Over-Allotment Units”), at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions (see Note 6).\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the private placement (“Private Placement”) of 4,400,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”), at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 (see Note 4).\nOn June 15, 2022, the Prior Sponsor transferred 6,250,000 Class B ordinary shares and 4,400,000 Private Placement Warrants held by the Prior Sponsor to Quadro Sponsor LLC, a Delaware limited liability company and wholly owned subsidiary of the Prior Sponsor (the “New Sponsor” or “Sponsor”). On June 30, 2022, the Prior Sponsor transferred all the membership interests of the New Sponsor to Quadro IH DMCC (“Quadro”), a company registered in Dubai Multi Commodities Centre in the United Arab Emirates (the “Sponsor Transaction”). In connection with the Sponsor Transaction, the Prior Sponsor also assigned to the New Sponsor all of its rights and obligations under the (i) Letter Agreement, dated as of February 17, 2021, (ii) Registration Rights Agreement (as defined in Note 5) and (iii) Promissory Note (as defined below). In addition, the Company and Kismet Capital Group LLC (“Kismet LLC”) mutually terminated the Administrative Services Agreement, dated February 17, 2021 (the “Administrative Services Agreement”). As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee to Kismet LLC pursuant to the Administrative Services Agreement.\nUpon the closing of the Initial Public Offering and the Private Placement, $ 230.0 million ($ 10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement were placed in a trust account (“Trust Account”) with Continental Stock Transfer & Trust Company (“Continental”) acting as trustee and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act of 1940 (the “Investment Company Act”), which invest only in direct U.S. government treasury obligations, as determined by the Company, until the earlier of (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of its Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The Company’s initial Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the net assets held in the Trust Account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the Trust Account) at the time the Company signs a definitive agreement in connection with the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\n5\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Company will provide its holders of the Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The Public Shareholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially at $ 10.00 per share, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The per-share amount to be distributed to Public Shareholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriters (see Note 6). These Public Shares were recorded at a redemption value and classified as temporary equity upon the completion of the Initial Public Offering, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”). In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and a majority of the shares are voted in favor of the Business Combination. If a shareholder vote is not required by law and the Company does not decide to hold a shareholder vote for business or other legal reasons, the Company will, pursuant to the amended and restated memorandum and articles of association which were adopted by the Company upon the consummation of the Initial Public Offering (the “Memorandum and Articles of Association”), conduct the redemptions pursuant to the tender offer rules of the SEC, and file tender offer documents with the SEC prior to completing a Business Combination. If, however, a shareholder approval of the transactions is required by law, or the Company decides to obtain shareholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. Additionally, each Public Shareholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction. If the Company seeks shareholder approval in connection with a Business Combination, the holder of the Founder Shares (as defined in Note 5) prior to the Initial Public Offering (the “Initial Shareholder”) agreed to vote its Founder Shares and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination. In addition, the Initial Shareholder agreed to waive its redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of a Business Combination.\nNotwithstanding the foregoing, the Memorandum and Articles of Association provides that a Public Shareholder, together with any affiliate of such shareholder or any other person with whom such shareholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 20 % or more of the Class A Ordinary shares sold in the Initial Public Offering, without the prior consent of the Company.\nThe Company’s Sponsor, executive officers, directors and director nominees agreed not to propose an amendment to the Memorandum and Articles of Association that would affect the substance or timing of the Company’s obligation to provide for the redemption of its Public Shares in connection with a Business Combination or to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Shareholders with the opportunity to redeem their Class A ordinary shares in conjunction with any such amendment.\nThe Company initially had until February 22, 2023 (the “Original Termination Date”) to complete the initial Business Combination. On February 20, 2023, the Company held the 2023 Extraordinary General Meeting at which the shareholders of the Company approved to extend the date by which the Company must consummate an initial Business Combination to April 22, 2023 and to allow the Company’s board, without another shareholder vote, to extend Combination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”).\nIn connection with the Extension, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account (together with the Initial Extension Loan, the “Extension Loans”). On each of May 11, 2023 and June 6, 2023, the Company deposited an additional $ 60,000 , for an aggregate of $ 120,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to June 22, 2023. On each of June 30, 2023 and July 11, 2023, the Company deposited an additional $ 30,000 , for an aggregate of $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to July 22, 2023. On August 7, 2023, the Company deposited an additional $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial business combination to August 22, 2023.\nIn connection with the Extension, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million.\nOn January 31, 2023, the Company issued an aggregate of 6,250,000 Class A ordinary shares to the Sponsor, upon the conversion of an equal number of Class B ordinary shares held by the Sponsor (the “Conversion”). The 6,250,000 Class A ordinary shares issued in connection with the Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial Business Combination as described in the prospectus for the Company’s initial public offering. Following the Conversion, there are 29,250,000 Class A ordinary shares issued and outstanding and no Class B ordinary shares issued and outstanding. As a result of the Conversion, the Sponsor held 21.4 % of the outstanding Class A ordinary shares.\n6\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nOn February 10, 2023, the Company instructed Continental to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of the Company’s initial Business Combination or the Company’s liquidation. As a result, following the liquidation of investments in the Trust Account, the remaining proceeds from the Initial Public Offering and Private Placement are no longer invested in U.S. government securities or money market funds.\nIf the Company is unable to complete a Business Combination by August 22, 2023 (or November 22, 2023 if the Company fully extends the time to complete a Business Combination, the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem all Public Shares then outstanding at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including any amounts representing interest earned on the Trust Account, less any interest released to the Company for the payment of taxes, if any (and less up to $ 100,000 in interest reserved for expenses in connection with the Company’s dissolution), divided by the number of then outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any), and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the Company’s board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\nIn connection with the redemption of 100 % of the Company’s outstanding Public Shares for a portion of the funds held in the Trust Account, each holder will receive a full pro rata portion of the amount then in the Trust Account, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s taxes payable (less up to $ 100,000 of interest to pay dissolution expenses).\nThe Initial Shareholder agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Initial Shareholder should acquire Public Shares in or after the Initial Public Offering, it will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters agreed to waive their rights to their deferred underwriting commission (see Note 6) held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period, and, in such event, such amounts will be included with the funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only $10.00 per share initially held in the Trust Account. In order to protect the amounts held in the Trust Account, the Sponsor agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or a prospective target business with which the Company has entered into a written letter of intent, confidentiality or other similar agreement or business combination agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $10.00 per Public Share and (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account, if less than $10.00 per share due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to any claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the Trust Account (whether or not such waiver is enforceable) nor will it apply to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). In the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\n7\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nLiquidity and Going Concern\nAs of June 30, 2023, the Company had $ 0 in its operating bank account and working capital deficit of approximately $ 1.4 million.\nThe Company’s liquidity needs to date have been satisfied through a contribution of $ 25,000 from the Prior Sponsor to cover certain expenses in exchange for the issuance of the Founder Shares, a loan of approximately $ 111,000 from the Prior Sponsor pursuant to the IPO Note (as defined in Note 5), and a portion of the proceeds from the consummation of the Private Placement not held in the Trust Account. The Company repaid the IPO Note in full on February 24, 2021. In addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans (as defined in Note 5). As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any Working Capital Loans.\nOn April 13, 2022, the Company issued an unsecured promissory note in the amount of up to $ 200,000 to the Prior Sponsor (the “Promissory Note”). On May 25, 2022, the Company and the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\nThe Company may need to raise additional capital through loans or additional investments from its Sponsor, its officers or directors or their affiliates. The Company’s officers, directors and Sponsor, or their affiliates, may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with the Company’s assessment of going concern considerations in accordance with FASB ASC Topic 205-40, “Presentation of Financial Statements - Going Concern” (“ASC 205-40”), management has determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. Management continues to seek to complete a Business Combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after November 22, 2023. The accompanying financial statements do not include any adjustment that might be necessary if the Company is unable to continue as a going concern.\nNote 2 - Basis of Presentation and Summary of Significant Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, certain disclosures included in the annual financial statements have been condensed or omitted from the accompanying unaudited condensed financial statements as they are not required for interim financial statements under GAAP and the rules of the SEC. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the three and six months ended June 30, 2023 are not necessarily indicative of the results that may be expected through December 31, 2023 or any future period.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Annual Report on Form 10-K for the fiscal year ended December 31, 2022, as filed by the Company with the SEC on April 18, 2023 (the “2022 Annual Report”).\n8\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the accompanying unaudited condensed financial statements with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the accompanying unaudited condensed financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of revenues and expenses during the reporting periods. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the accompanying unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. One of the more significant accounting estimates included in the accompanying unaudited condensed financial statements is the determination of the fair value of the derivative liabilities. Accordingly, the actual results could differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company had no cash equivalents as of June 30, 2023 and December 31, 2022.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, regularly exceed the Federal Deposit Insurance Corporation coverage limit of $ 250,000 . Any loss incurred or a lack of access to such funds could have a significant adverse impact on the Company’s financial condition, results of operations, and cash flows.\nCash and Investments Held in the Trust Account\nThe Company classifies its U.S. Treasury and equivalent securities as held to maturity in accordance with FASB Accounting Standard Codification (“ASC”) Topic 320, “Investments – Debt and Equity Securities.” Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. Held-to-maturity treasury securities are recorded at amortized cost on the accompanying consolidated balance sheets and adjusted for the amortization or accretion of premiums or discounts.\nAt June 30, 2023, substantially all of the assets held in the Trust Account were held in cash. At December 31, 2022, substantially all of the assets held in the Trust Account were held in money market funds which invest primarily in U.S. Treasury securities. The money market funds are presented at fair value within the accompanying consolidated balance sheets, and fair value of the investments in the Trust Account is equal to the amortized cost basis of the money market funds.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities which qualify as financial instruments under the FASB ASC Topic 820, “Fair Value Measurements,” equal or approximate the carrying amounts represented in the condensed balance sheets.\n9\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nFair Value Measurements\n“Fair value” is defined as “the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date.” GAAP establishes a three-tier fair value hierarchy, which prioritizes inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers consist of:\n\n| ● | Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets; |\n\n\n| ● | Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and |\n\n\n| ● | Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\n\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\nDerivative Liabilities\nThe Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. The Company evaluates all of its financial instruments, including issued warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC 480 and ASC 815-15. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\nThe Company accounts for its warrants issued in connection with its Initial Public Offering and Private Placement and units that may be issued in connection with a forward purchase agreement (the “Forward Purchase Units”) as derivative liabilities in accordance with ASC 815-40. Accordingly, the Company recognizes the instruments as liabilities at fair value and adjusts the instruments to fair value at the end of each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative liabilities is recognized in the Company’s unaudited condensed statements of operations. The fair value of warrants issued in connection with the Initial Public Offering was initially measured using Monte-Carlo simulation and has subsequently been measured on the market price of such warrants at each measurement date when separately listed and traded. The fair value of warrants issued in connection with the Private Placement was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the Forward Purchase Units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\nOffering Costs Associated with the Initial Public Offering\nOffering costs consisted of legal, accounting, underwriting fees and other costs incurred through the Initial Public Offering that were directly related to the Initial Public Offering. Offering costs are allocated to the separable financial instruments issued in the Initial Public Offering based on a relative fair value basis, compared to total proceeds received. Offering costs associated with derivative liabilities are expensed as incurred, presented as non-operating expenses in the statements of operations in the period that the costs occurred. Offering costs associated with the Class A ordinary shares were charged against the carrying value of the Class A ordinary shares upon the completion of the Initial Public Offering. The Company classifies deferred underwriting commissions as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. The Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ deficit section of the accompanying condensed balance sheets, respectively.\n10\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the security. Effective with the closing of the Initial Public Offering, the Company recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nShare-Based Compensation\nThe Company complies with the accounting and disclosure requirement of ASC Topic 718, “Compensation – Stock Compensation.” Share-based compensation to employees and non-employees is recognized over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The Company recognizes the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. The Company issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial Business Combination and will expire in five years after the date on which they first become exercisable. The Company has determined that the consummation of an initial Business Combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\nIncome Taxes\nFASB ASC Topic 740, “Income Taxes,” prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company’s management determined that the Cayman Islands is the Company’s only major tax jurisdiction. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2023 and December 31, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThere is currently no taxation imposed on income by the Government of the Cayman Islands. In accordance with Cayman federal income tax regulations, income taxes are not levied on the Company. Consequently, income taxes are not reflected in the accompanying unaudited condensed financial statements. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nNet (Loss) Income per Ordinary Share\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” The Company has two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants underlying the Units sold in the Initial Public Offering and the Private Placement Warrants to purchase an aggregate of 12,066,667 Class A ordinary shares since their exercise is contingent upon future events. As a result, diluted net (loss) income per share is the same as basic net (loss) income per share for the three and six months ended June 30, 2023 and 2022. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\n11\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe table below presents a reconciliation of the numerator and denominator used to compute basic and diluted net (loss) income per share for each class of Ordinary Shares:\n\n| For the Three Months Ended June 30, |\n| 2023 | 2022 |\n| Class A | Class B | Class A | Class B |\n| Numerator: |\n| Allocation of net (loss) income | $ | ( 458,126 | ) | $ | — | $ | 825,025 | $ | 224,192 |\n| Denominator: |\n| Weighted average ordinary shares outstanding, basic and diluted | 8,798,153 | — | 23,000,000 | 6,250,000 |\n| Basic and diluted net (loss) income per ordinary share | $ | ( 0.05 | ) | $ | — | $ | 0.04 | $ | 0.04 |\n\n\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Class A | Class B | Class A | Class B |\n| Numerator: |\n| Allocation of net income | $ | 141,383 | $ | 10,868 | $ | 4,033,797 | $ | 1,096,141 |\n| Denominator: |\n| Weighted average ordinary shares outstanding, basic and diluted | 13,551,176 | 1,041,667 | 23,000,000 | 6,250,000 |\n| Basic and diluted net income per ordinary share | $ | 0.01 | $ | 0.01 | $ | 0.18 | $ | 0.18 |\n\nRecent Accounting Pronouncements\nThe Company’s management does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\nNote 3 - Initial Public Offering\nOn February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 Units, including 3,000,000 Over-Allotment Units, at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions.\nEach Unit consists of one Class A ordinary share and one-third of one redeemable warrant (“Public Warrant”). Each whole Public Warrant will entitle the holder to purchase one Class A ordinary share at an exercise price of $ 11.50 per share, subject to adjustment (see Note 7).\nNote 4 - Private Placement\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the Private Placement of 4,400,000 Private Placement Warrants, at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 . On June 15, 2022, the Prior Sponsor transferred 4,400,000 Private Placement Warrants to the New Sponsor.\nEach whole Private Placement Warrant is exercisable for one whole Class A ordinary share at a price of $ 11.50 per share. A portion of the proceeds from the sale of the Private Placement Warrants to the Prior Sponsor was added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the Private Placement Warrants will expire worthless. The Private Placement Warrants will be non-redeemable for cash and exercisable on a cashless basis so long as they are held by the Sponsor or its permitted transferees.\nThe Sponsor agreed, subject to limited exceptions, not to transfer, assign or sell any of its Private Placement Warrants until 30 days after the completion of the initial Business Combination.\n12\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 5 - Related Party Transactions\nForward Purchase Agreement\nIn connection with the consummation of the Initial Public Offering, the Company entered into a forward purchase agreement (the “Forward Purchase Agreement”) with the Prior Sponsor, which provides for the purchase of $ 20.0 million Forward Purchase Units, which at the option of the Prior Sponsor, can be increased to $ 50.0 million, with each Forward Purchase Unit consisting of one Class A ordinary share (the “Forward Purchase Shares”) and one-third of one warrant to purchase one Class A ordinary share at $ 11.50 per share (the “Forward Purchase Warrants,” together with the Forward Purchase Units and the Forward Purchase Shares, the “Forward Purchase Securities”), for a purchase price of $ 10.00 per Forward Purchase Unit, in a private placement to occur concurrently with the closing of the initial Business Combination. The purchase under the Forward Purchase Agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the Public Shareholders. The Forward Purchase Securities will be issued only in connection with the closing of the initial Business Combination. The proceeds from the sale of Forward Purchase Securities may be used as part of the consideration to the sellers in the initial Business Combination, expenses in connection with the initial Business Combination or for working capital in the post-transaction company. The Company does not intend to implement the forward purchase agreement, and on April 17, 2023, the Company sent a notice of mutual termination of the forward purchase agreement to the prior sponsor. The Company classified the Forward Purchase Units as derivative instruments on the accompanying condensed balance sheets. The initial value of the Forward Purchase Units was insignificant, and the Company recognized a loss in the change in the fair value of the derivative assets (liabilities) of approximately $ 0 and $ 0 for the three and six months ended June 30, 2023, respectively, and approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\nFounder Shares\nOn September 21, 2020, the Company issued 4,812,500 Class B ordinary shares, par value $ 0.001 per share (the “Founder Shares”) to the Prior Sponsor. On September 23, 2020, the Prior Sponsor paid an aggregate of $ 25,000 for certain expenses on behalf of the Company in exchange for issuance of the Founder Shares. On January 25, 2021, the Company effected a stock dividend of 1,437,500 shares with respect to Class B ordinary shares, resulting in an aggregate of 6,250,000 Founder Shares outstanding. The Prior Sponsor agreed to forfeit up to an aggregate of 750,000 Founder Shares, on a pro rata basis, to the extent that the option to purchase additional Units was not exercised in full by the underwriters, so that the Founder Shares would represent 20 % of the Company’s issued and outstanding shares after the Initial Public Offering plus the 2,000,000 Forward Purchase Shares underlying the Forward Purchase Units (which at the option of the Prior Sponsor can be increased to up to 5,000,000 Forward Purchase Shares). On February 22, 2021, the underwriter fully exercised its over-allotment option; thus, these 750,000 Founder Shares were no longer subject to forfeiture.\nOn June 15, 2022, the Prior Sponsor transferred all 6,250,000 Founder Shares to the New Sponsor.\nThe New Sponsor agreed not to transfer, assign or sell any of its Founder Shares until the earlier to occur of (i) one year after the date of the consummation of the initial Business Combination, or earlier if, subsequent to the initial Business Combination, (x) the last reported sale price of the Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination or (y) the Company consummates a subsequent liquidation, merger, stock exchange or other similar transaction which results in all of the shareholders having the right to exchange their Ordinary shares for cash, securities or other property.\nRelated Party Loans\nOn September 23, 2020, the Prior Sponsor agreed to loan the Company up to $ 250,000 to cover costs related to the Initial Public Offering pursuant to a promissory note, which was later amended on January 22, 2021 (the “IPO Note”). The IPO Note was non-interest bearing, unsecured and due upon the closing of the Initial Public Offering. As of February 22, 2021, the Company borrowed approximately $ 111,000 under the IPO Note. The Company repaid the IPO Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to the Company.\n13\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor, members of the Company’s founding team or any of their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lenders’ discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $ 1.50 per warrant. The warrants would be identical to the Private Placement Warrants. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. As of June 30, 2023 and December 31, 2022, the Company had no borrowings under any Working Capital Loans.\nOn April 13, 2022, the Company issued the Promissory Note to the Prior Sponsor for an aggregate of up to $ 200,000 . On May 25, 2022, the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest, may be prepaid at any time and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\nExtension Loan\nPursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account. As of June 30, 2023, the Company has drawn $ 270,000 on the Extension Loan and deposited it into the Trust Account.\nRelated Party Advance\nFor the three and six months ended June 30, 2023, the Sponsor had paid $ 164,081 and $ 188,722 , respectively, of expenses on behalf on Company, which are included in advance from related parties in the accompanying condensed balance sheets as of June 30, 2023.\nAdministrative Services Agreement\nCommencing on February 17, 2021, through the earlier of consummation of the initial Business Combination and the liquidation, the Company agreed to pay Kismet LLC, an affiliate of the Prior Sponsor, $ 10,000 per month for office space, utilities, secretarial support and administrative services.\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee pursuant to the Administrative Services Agreement.\nDirector Compensation\nCommencing on February 18, 2021, the Company paid its initial directors $ 40,000 each. On May 25, 2022, Mr. Verdi Israelyan, a former director, waived his right to receive a payment of $ 40,000 . The Company also granted two of its independent directors, Messrs. Tompsett and Zilber, an option each to purchase 40,000 Class A ordinary shares at an exercise price of $ 10.00 per share, which will vest upon the consummation of the initial Business Combination and will expire five years after the date on which it first became exercisable Further, following the approval of the Extension, the compensation committee of the Company’s board of directors has approved the transfers by the Sponsor of (a) 15,000 Founder Shares to each of Messrs. Zilber and Tourevski and (b) 20,000 Founder Shares to Mr. Tompsett as additional compensation, which transfers will take place prior to the closing of the initial Business Combination. Both the Founder Shares and the options granted to the directors are subject to forfeiture in the event a director ceases to serve on the Company’s board prior to the closing of a Business Combination. In addition, the Sponsor, executive officers and directors, or any of their respective affiliates will be reimbursed for any out-of-pocket expenses incurred in connection with activities on the Company’s behalf such as identifying potential target businesses and performing due diligence on suitable Business Combinations. The Company’s audit committee reviews, on a quarterly basis, all payments that are made to the Sponsor, officers or directors, or the Company’s or their affiliates.\nOn May 25, 2022, one of the Company’s former directors waived his right to receive a payment of $ 40,000 and the Company recorded approximately $ 0 of director compensation during three and six months ended June 30, 2023 , and approximately $( 12,000 ) and $ 3,000 of director compensation during the three and six months ended June 30, 2022, respectively. As of June 30, 2023 and December 31, 2022, the Company had no amounts outstanding in relation to the director compensation.\n14\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nDeparture and Appointment of Officers\nOn June 30, 2022, concurrently with the Sponsor Transaction, Ivan Tavrin, Chief Executive Officer and Chairman of the Company’s board of directors, resigned as Chairman and Chief Executive Officer of the Company, and as the Company’s principal financial and accounting officer.\nEffective June 30, 2022, the Company’s board of directors appointed Mr. Dimitri Elkin to serve as the Company’s Chief Executive Officer. Mr. Elkin is also serving as the Company’s principal financial and accounting officer.\nOn September 5, 2022, Verdi Israelyan, resigned from the board of directors of the Company. Mr. Israelyan resignation was not the result of any dispute or disagreement with the Company or the Company’s board of directors on any matter relating to the Company’s operations, policies or practices. On March 27, 2023, the board of directors elected Konstantin Tourevski as a director and as a member of the audit committees to fill the vacancy caused by the resignation of Mr. Israelyan.\nNote 6 - Commitments and Contingencies\nRegistration Rights\nThe holders of the Founder Shares and Private Placement Warrants (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans) were entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021 (the “Registration Rights Agreement”). The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements. On June 30, 2022, in connection with the Sponsor Transaction, the Prior Sponsor assigned to the New Sponsor all of its rights and obligations under the Registration Rights Agreement.\nPursuant to the Forward Purchase Agreement, the Company agreed to use its commercially reasonable efforts (i) to file within 30 days after the closing of the initial Business Combination a registration statement with the SEC for a secondary offering of the Forward Purchase Shares and the Forward Purchase Warrants (and underlying Class A Ordinary Shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on the Prior Sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the Forward Purchase Agreement provides for “piggy-back” registration rights to the holders of Forward Purchase Securities to include their securities in other registration statements filed by the Company.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional Units at the Initial Public Offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\nThe underwriters were entitled to an underwriting discount of $ 0.20 per Unit, or $ 4.6 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $ 0.35 per Unit, or approximately $ 8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $ 5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. The Company recognized the portion allocated to Public Shares of approximately $ 5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $ 0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The accompanying unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n15\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nIn February 2022, a military conflict started between Russia and Ukraine. The ongoing military conflict between Russia and Ukraine has provoked strong reactions from the United States, the United Kingdom, the European Union and various other countries around the world, including the imposition of broad financial and economic sanctions against Russia. Further, the precise effects of the ongoing military conflict and these sanctions on the global economies remain uncertain as of the date of the accompanying unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of the accompanying unaudited condensed financial statements.\nNote 7 - Warrants\nAs of June 30, 2023 and December 31, 2022, 7,666,667 Public Warrants and 4,400,000 Private Placement Warrants were outstanding.\nPublic Warrants may only be exercised for a whole number of Class A Ordinary Shares. No fractional Public Warrants will be issued upon separation of the Units and only whole Public Warrants will trade. The Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering; provided in each case that the Company has an effective registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the Public Warrants and a current prospectus relating to them is available and such shares are registered, qualified or exempt from registration under the securities, or blue sky, laws of the state of residence of the holder (or the Company permits holders to exercise their warrants on a cashless basis under certain circumstances). The Company agreed that as soon as practicable, but in no event later than 15 business days after the closing of the initial Business Combination, the Company will use commercially reasonable efforts to file with the SEC and have an effective registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants and to maintain a current prospectus relating to those Class A Ordinary Shares until the warrants expire or are redeemed, as specified in the warrant agreement. If a registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants is not effective by the 60th day after the closing of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company will have failed to maintain an effective registration statement, exercise warrants on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act or another exemption. Notwithstanding the above, if the Class A Ordinary Shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” and, in the event the Company so elects, the Company will not be required to file or maintain in effect a registration statement, and in the event the Company does not so elect, it will use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\nThe warrants have an exercise price of $11.50 per share, subject to adjustments, and will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. In addition, if (x) the Company issues additional Class A Ordinary Shares or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $9.20 per Class A Ordinary Share (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or an affiliate of the Sponsor, without taking into account any Founder Shares held by the Sponsor or an affiliate of the Sponsor, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the completion of the initial Business Combination (net of redemptions), and (z) the volume-weighted average trading price of the Class A Ordinary Shares during the 20 trading day period starting on the trading day prior to the day on which the Company completes its initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the higher of the Market Value and the Newly Issued Price, and the $10.00 and $18.00 per share redemption trigger prices described under “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $18.00” and “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $10.00” will be adjusted (to the nearest cent) to be equal to 100% and 180% of the higher of the Market Value and the Newly Issued Price, respectively.\n16\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A Ordinary Shares issuable upon exercise of the Private Placement Warrants will not be transferable, assignable or sellable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants will be non-redeemable so long as they are held by the initial purchaser or such purchaser’s permitted transferees. If the Private Placement Warrants are held by someone other than the Initial Shareholder or its permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 18.00\nOnce the warrants become exercisable, the Company may call the outstanding warrants (excluding the Private Placement Warrants), in whole and not in part, at a price of $ 0.01 per warrant:\n\n| ● | upon a minimum of 30 days’ prior written notice of redemption; and |\n\n\n| ● | if, and only if, the last reported sale price of the Class A Ordinary Shares equals or exceeds $ 18.00 per share (as adjusted) for any 20 trading days within a 30 trading day period ending three business days before the Company sends the notice of redemption to the warrant holders (the “Reference Value”). |\n\nThe Company will not redeem the warrants as described above unless a registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the warrants is then effective and a current prospectus relating to those Class A Ordinary Shares is available throughout the 30-trading day redemption period.\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 10.00\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants, in whole and not in part, at a price of $ 0.10 per warrant:\n\n| ● | upon a minimum of 30 days’ prior written notice of redemption provided that holders will be able to exercise their warrants on a cashless basis prior to redemption and receive that number of Class A Ordinary Shares to be determined by reference to an agreed table based on the redemption date and the “fair market value” of Class A Ordinary Shares; and |\n\n\n| ● | if, and only if, and only if, the Reference Value equals or exceeds $ 10.00 per Public Share (as adjusted), and |\n\n\n| ● | if the Reference Value is less than $ 18.00 per share (as adjusted), the Private Placement Warrants must also be concurrently called for redemption on the same terms as the outstanding Public Warrants, as described above. |\n\nThe “fair market value” of Class A Ordinary Shares for the above purpose shall mean the volume-weighted average price of the Class A Ordinary Shares for the 10 trading days immediately following the date on which the notice of redemption is sent to the holders of warrants. In no event will the warrants be exercisable in connection with this redemption feature for more than 0.361 Class A Ordinary Shares per warrant (subject to adjustment).\nIn no event will the Company be required to net cash settle any warrant. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\n17\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 8 - Class A Ordinary Shares Subject to Possible Redemption\nThe Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of future events. The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.001 per share. Holders of the Class A ordinary shares are entitled to one vote for each share. In connection with such shareholders’ meeting, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million. As of June 30, 2023 and December 31, 2022, there were 2,548,153 and 23,000,000 Class A Ordinary Shares outstanding, respectively, which were all subject to possible redemption and are classified outside of permanent equity in the accompanying condensed balance sheets.\nThe Class A Ordinary Shares subject to possible redemption reflected on the accompanying condensed balance sheets are reconciled on the following table:\n\n| Gross proceeds received from Initial Public Offering | $ | 230,000,000 |\n| Less: |\n| Fair value of Public Warrants at issuance | ( 6,823,334 | ) |\n| Offering costs allocated to Class A ordinary shares | ( 12,685,596 | ) |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 19,508,930 |\n| Class A ordinary shares subject to possible redemption as of December 31, 2021 | 230,000,000 |\n| Plus: |\n| Waiver of Class A ordinary shares issuance costs | 5,077,217 |\n| Less: |\n| Accretion on Class A ordinary shares subject to possible redemption | ( 1,872,702 | ) |\n| Class A ordinary shares subject to possible redemption as of December 31, 2022 | 233,204,515 |\n| Less: |\n| Redemptions | ( 208,524,538 | ) |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 1,560,982 |\n| Class A ordinary shares subject to possible redemption as of March 31, 2023 | 26,240,959 |\n| Plus: |\n| Accretion on Class A ordinary shares subject to possible redemption | 390,284 |\n| Class A ordinary shares subject to possible redemption as of June 30, 2023 | $ | 26,631,243 |\n\nNote 9 - Shareholders’ Deficit\nClass A Ordinary Shares\nThe Company is authorized to issue 200,000,000 Class A Ordinary Shares with a par value of $ 0.001 per share. Holders of the Class A Ordinary Shares are entitled to one vote for each share. As of June 30, 2023 and December 31, 2022, there were 6,250,000 and 0 Class A Ordinary Shares issued and outstanding, excluding 2,548,153 and 23,000,000 which were subject to possible redemption and included as temporary equity, respectively (see Note 8).\nClass B Ordinary Shares\nThe Company is authorized to issue 10,000,000 Class B Ordinary Shares with a par value of $ 0.001 per share. As of June 30, 2023 and December 31, 2022, there were 0 and 6,250,000 Class B Ordinary Shares issued and outstanding, respectively.\nOrdinary shareholders of record are entitled to one vote for each share held on all matters to be voted on by shareholders. Except as described below, holders of Class A ordinary shares and holders of Class B ordinary shares vote together as a single class on all matters submitted to a vote of the shareholders except as required by law.\nThe Class B ordinary shares will automatically convert into Class A ordinary shares at the time of the initial Business Combination or earlier at the option of the holders thereof at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as-converted basis, 20 % of the sum of (i) the total number of the Ordinary Shares issued and outstanding upon completion of the Initial Public Offering, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued by the Company in connection with or in relation to the completion of the initial Business Combination (including the Forward Purchase Shares, but not the Forward Purchase Warrants), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Warrants issued to the Sponsor or any of its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\n18\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nNote 10 - Fair Value Measurements\nThe following tables present information about the Company’s assets and liabilities that are measured at fair value on a recurring basis as of June 30, 2023 and December 31, 2022 and indicates the fair value hierarchy of the valuation techniques that the Company utilized to determine such fair value.\n\n| Fair Value Measured as of June 30, 2023 |\n| Level 1 | Level 2 | Level 3 |\n| Liabilities: |\n| Derivative liabilities - Public Warrants | $ | — | $ | 514,433 | $ | — |\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 295,240 | $ | — |\n\n\n| Fair Value Measured as of December 31, 2022 |\n| Level 1 | Level 2 | Level 3 |\n| Assets |\n| Investments held in Trust Account - U.S. Treasury Securities | $ | 233,304,515 | $ | — | $ | — |\n| Liabilities: |\n| Derivative liabilities - Public Warrants | $ | — | $ | 19,167 | $ | — |\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 11,000 | $ | — |\n\nTransfers to/from Levels 1, 2, and 3 are recognized in the beginning of the reporting period. The estimated fair value of the Public Warrants was transferred from a Level 3 measurement to a Level 1 fair value measurement in April 2021, when the Public Warrants were separately listed and traded. The estimated fair value of the Private Placement Warrants was transferred from a Level 3 measurement to a Level 2 fair value measurement during the year ended December 31, 2021. The estimated fair value of the Public Warrants transferred to a Level 2 measurement during the quarter ending December 31, 2022 due to low trading volume. There were no transfers to/from Levels 1, 2, and 3 during the three and six months ended June 30, 2023.\nLevel 1 assets include investments in mutual funds that invest solely in U.S. government securities. The Company uses inputs such as actual trade data, quoted market prices from dealers or brokers, and other similar sources to determine the fair value of its investments.\nThe fair value of the Public Warrants was initially measured using a Monte-Carlo simulation and has subsequently been measured based on the market price of such warrants at each measurement date when separately listed and traded. The fair value of the Private Placement Warrants was initially measured using a Black-Scholes Option Pricing Model and subsequently using the market value of the Public Warrants. For the three months ended June 30, 2023 and 2022, the Company recognized a decrease/(increase) in the fair value of derivative warrant liabilities of approximately $( 538,000 ) and $ 845,000 , and approximately $( 780,000 ) and $ 5.1 million for the six months ended June 30, 2023 and 2022, respectively, presented on the accompanying condensed statements of operations.\nThe Company utilized John C. Hull’s Options, Futures, and Other Derivatives model to estimate the fair value of the Forward Purchase Units at each measurement date up until September 30, 2023. As the Company does not intend to implement the forward purchase agreement, the Company determined the fair value of the Forward Purchase Units as of June 30, 2023 and December 31, 2022 was deminimis. There was no change in fair value of the Forward Purchase Units for the three and six months ended June 30, 2023. The Company recognized expense in the change in fair value of the Forward Purchase Units of approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\n19\nQUADRO ACQUISITION ONE CORP.\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nThe change in the fair value of the Level 3 derivative warrant liabilities for three and six months ended March 31, 2022 is summarized as follows:\n\n| Derivative assets (liabilities) as of January 1, 2022 | $ | 88,970 |\n| Change in fair value of derivative assets and liabilities | 30,204 |\n| Derivative assets (liabilities) as of March 31, 2022 | 119,174 |\n| Change in fair value of derivative assets and liabilities | 18,877 |\n| Derivative assets (liabilities) as of June 30, 2022 | $ | 138,051 |\n\nNote 11 - Subsequent Events\nManagement has evaluated subsequent events to determine if events or transactions occurring after the balance sheet date through the date the accompanying unaudited condensed financial statements were issued. Based upon this review, the Company did not, other than the below, identify any subsequent event that would have required adjustment or disclosure in the accompanying unaudited condensed financial statements.\nOn July 11, 2023 and August 7, 2023, pursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan an additional contribution of $ 30,000 and $ 60,000 , respectively, into the trust to extend the date of which it has to consummate an initial business combination to August 22, 2023.\n20\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nReferences to the “Company,” “Quadro Acquisition One Corp.,” “our,” “us” or “we” refer to Quadro Acquisition One Corp. (formerly known as Kismet Acquisition Two Corp.). The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto under “Item 1. Financial Statements”. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nCautionary Note Regarding Forward-Looking Statements\nAll statements other than statements of historical fact included in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2023 (this “Report”) including, without limitation, statements under this “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or our management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph.\nOverview\nWe are a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. We were incorporated for the purpose of engaging in an initial business combination with one or more businesses. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies.\nOur sponsor is Quadro Sponsor LLC, a Delaware limited liability company. The registration statement for our initial public offering was declared effective on February 17, 2021. On February 22, 2021, we consummated our initial public offering of 23,000,000 units, including 3,000,000 additional units to cover the underwriters’ over-allotment option, at $10.00 per unit, generating gross proceeds of $230.0 million, and incurring offering costs of approximately $13.1 million, of which approximately $8.1 million was for deferred underwriting commissions.\nSimultaneously with the closing of our initial public offering, we consummated the private placement of 4,400,000 warrants, at a price of $1.50 per private placement warrant, to our prior sponsor, generating gross proceeds of $6.6 million, and incurring offering costs of approximately $7,000.\nUpon the closing of the initial public offering and the private placement, $230.0 million ($10.00 per unit) of the net proceeds of the initial public offering and a portion of the proceeds of the private placement were placed in a trust account, with Continental acting as trustee, and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act, which invest only in direct U.S. government treasury obligations, as determined by us, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the trust account as described below.\nOn February 10, 2023, we instructed Continental to liquidate the investments held in the trust account and instead to hold the funds in the trust account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of our initial business combination or our liquidation. As a result, following the liquidation of investments in the trust account, the remaining proceeds from the initial public offering and private placement are no longer invested in U.S. government securities or money market funds.\nOur management has broad discretion with respect to the specific application of the net proceeds of our initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied generally toward consummating a business combination. Our initial business combination must be with one or more operating businesses or assets with a fair market value equal to at least 80% of the net assets held in the trust account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the trust account) at the time we sign a definitive agreement in connection with the initial business combination. However, we will only complete a business combination if the post-transaction company owns or acquires 50% or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\nIf we are unable to complete a business combination by the Termination Date, we will (i) cease all operations except for the purpose of winding up; (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned on the funds held in the trust account and not previously released to us to pay our taxes that were paid by us or are payable by us, if any (less up to $100,000 of interest to pay dissolution expenses), divided by the number of the then-outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any); and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\n21\nRecent Developments\nOn January 31, 2023, we issued an aggregate of 6,250,000 Class A ordinary shares to the sponsor, upon the conversion of an equal number of Class B ordinary shares held by the sponsor in the Founder Conversion. The 6,250,000 Class A ordinary shares issued in connection with the Founder Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Founder Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial business combination as described in the prospectus for the initial public offering.\nOn February 20, 2023, we held the 2023 Extraordinary General Meeting at which our shareholders approved an amendment to our amended and restated memorandum and articles of association to extend the date by which we must consummate an initial business combination to April 22, 2023, and to allow our board, without another shareholder vote, to extend the Termination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”). In connection with the vote to approve the Extension Amendment, the holders of 20,451,847 Class A ordinary shares properly exercised their right to redeem their shares for cash at a redemption price of approximately $10.20 per share, for an aggregate redemption amount of approximately $208,524,538, in connection with the Extension Amendment.\nIn connection with the Extension, our sponsor or its designees contributed to us as a loan the initial contribution of $120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the Extension ending on April 22, 2023. Our sponsor will also loan us extension contributions of $60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial business combination, which amount will be deposited into the trust account (together with the Initial Extension Loan, the “Extension Loans”). The amount of the Extension Loans will not bear interest and will be repayable by us to the sponsor or its designees upon consummation of an initial business combination. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the Extension Loans, but no proceeds held in the trust account would be used to repay the Extension Loans.\nFollowing the Founder Conversion and the redemptions in connection with the Extension, there were 8,798,153 Class A ordinary shares issued and outstanding and no Class B Ordinary Shares issued and outstanding.\nAt the 2023 Extraordinary General Meeting, our shareholders also approved our company’s name change from Kismet Acquisition Two Corp. to Quadro Acquisition One Corp. to better reflect the Sponsor Transaction.\nOn March 27, 2023, our board of directors elected Konstantin Tourevski as a director and as a member of the audit committee to fill the vacancy caused by the resignation of Verdi Israelyan.\nLiquidity and Capital Resources\nAs of June 30, 2023, we had $0 in our operating bank account and working capital deficit of approximately $1.4 million.\nOur liquidity needs to date have been satisfied through a contribution of $25,000 from the prior sponsor to cover certain expenses in exchange for the issuance of the founder shares, a loan of approximately $111,000 from the prior sponsor pursuant to the First Note originally issued on September 23, 2020 and amended on January 22, 2021, and a portion of the proceeds from the consummation of the private placement not held in the trust account. We repaid the First Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to us. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, provide us working capital loans in order to finance transaction costs in connection with a business combination. As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any working capital loans.\n22\nOn April 13, 2022, we issued the Second Note, a promissory note in the amount of up to $200,000 to the prior sponsor. On May 25, 2022, we and the prior sponsor amended and restated the Second Note and increased the principal amount to $400,000. The promissory note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the prior sponsor assigned all of its rights and obligations under the promissory note to our sponsor in connection with the Sponsor Transaction. As of June 30, 2023, we have fully drawn $400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $400,000 and $319,000 were outstanding under the Promissory Note, respectively.\nWe may need to raise additional capital through loans or additional investments from our sponsor, our officers or directors or their affiliates. Our sponsor, officers, directors and or their affiliates, may, but are not obligated to, loan our company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. We cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with our assessment of going concern considerations in accordance with ASC Topic 205-40, “Presentation of Financial Statements – Going Concern,” we have determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. Management continues to seek to complete a business combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate by November 22, 2023.\nContractual Obligations\nAdministrative Services Agreement\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, except that, commencing on February 17, 2021, through the earlier of consummation of the initial business combination and the liquidation, we agreed to pay Kismet LLC, an affiliate of our prior sponsor, $10,000 per month for office space, utilities, secretarial support and administrative services.\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $10,000 monthly fee pursuant to the Administrative Services Agreement.\nResults of Operations\nOur entire activity since inception up to June 30, 2023, was in preparation for our formation and our initial public offering, and since the completion of our initial public offering, the search for business combination candidates. We will not be generating any operating revenues until the closing and completion of our initial business combination at the earliest.\nFor the three months ended June 30, 2023, we had net loss of approximately $458,000, which consisted of a non-operating loss of approximately $538,000 resulting from the change in fair value of derivative assets and liabilities and approximately $160,000 general and administrative expenses, partially offset by approximately $240,000 of income from investments held in trust account.\nFor the three months ended June 30, 2022, we had net income of approximately $1.0 million, which consisted of a non-operating gain of approximately $864,000 resulting from the change in fair value of derivative assets and liabilities and approximately $292,000 of net gain on the investments held in the Trust Account, partially offset by approximately $107,000 general and administrative expenses.\nFor the six months ended June 30, 2023, we had net income of approximately $152,000, which consisted of approximately $1.7 million of income from investments held in trust account, partially offset by a non-operating loss of approximately $780,000 resulting from the change in fair value of derivative assets and liabilities and approximately $750,000 general and administrative expenses.\nFor the six months ended June 30, 2022, we had net income of approximately $5.1 million, which consisted of a non-operating gain of approximately $5.1 million resulting from the change in fair value of derivative assets and liabilities and approximately $313,000 of net gain on the investments held in the Trust Account, partially offset by approximately $300,000 general and administrative expenses.\n23\nCommitments and Contingencies\nRegistration Rights\nThe holders of the founder shares, private placement warrants, and warrants that may be issued upon conversion of working capital loans (and any Class A ordinary shares issuable upon the exercise of the private placement warrants and warrants that may be issued upon conversion of working capital loans) are entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021. The holders of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial business combination. We will bear the expenses incurred in connection with the filing of any such registration statements.\nPursuant to the forward purchase agreement (described below), we agreed to use our commercially reasonable efforts (i) to file within 30 days after the closing of the initial business combination a registration statement with the SEC for a secondary offering of the forward purchase shares and the forward purchase warrants (and underlying Class A ordinary shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on which our sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the forward purchase agreement provides for “piggy-back” registration rights to the holders of forward purchase securities to include their securities in other registration statements filed by us.\nForward Purchase Agreement\nIn connection with the consummation of our initial public offering, we entered into a forward purchase agreement with our prior sponsor, which provides for the purchase of $20.0 million of forward purchase units, which at the option of our prior sponsor can be increased to $50.0 million, with each forward purchase unit consisting of one Class A ordinary share and one-third of one warrant to purchase one Class A ordinary share at $11.50 per share, for a purchase price of $10.00 per forward purchase unit, in a private placement to occur concurrently with the closing of the initial business combination. The purchase under the forward purchase agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the public shareholders. The forward purchase securities will be issued only in connection with the closing of the initial business combination. The proceeds from the sale of forward purchase securities may be used as part of the consideration to the sellers in the initial business combination, expenses in connection with the initial business combination or for working capital in the post-transaction company. We do not intend to implement the forward purchase agreement, and on April 17, 2023, we sent a notice of mutual termination of the forward purchase agreement to the prior sponsor.\nUnderwriting Agreement\nWe granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional units at our initial public offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\nThe underwriters were entitled to an underwriting discount of $0.20 per unit, or approximately $4.6 million in the aggregate, paid upon the closing of our initial public offering. In addition, $0.35 per unit, or approximately $8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete an initial business combination, subject to the terms of the underwriting agreement.\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. We recognized the portion allocated to Public Shares of approximately $5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\n24\nCritical Accounting Policies and Estimates\nDerivative Assets and Liabilities\nWe do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC Topic 815-15, “Derivatives and Hedging”. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\nWe account for our public warrants, private placement warrants and forward purchase units as derivative assets/liabilities in accordance with ASC 815-40, “Derivatives and Hedging”. Accordingly, we recognize the warrants and forward purchase units as assets/liabilities at fair value and adjust the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative assets and liabilities is recognized in our statements of operations. The fair value of our public warrants was initially measured using Monte-Carlo simulation and subsequently been measured on the market price of such warrants when separately listed and traded at each measurement date. The fair value of the private placement warrants was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the forward purchase units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\nClass A Ordinary Shares Subject to Possible Redemption\nWe account for the Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC 480. Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ deficit section of the condensed balance sheets under “Item 1. Financial Statements”.\nWe recognize changes in redemption value immediately as they occur and adjust the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. Effective with the closing of the initial public offering, we recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\nNet (Loss) Income per Ordinary Share\nWe comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” We have two classes of shares, Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants issued in connection with our initial public offering and the private placement to purchase an aggregate of 12,066,667 Class A ordinary shares because their exercise is contingent upon future events. Accretion associated with the redeemable Class A ordinary shares is excluded from (losses) earnings per share as the redemption value approximates fair value.\n25\nShare-Based Compensation\nWe comply with the accounting and disclosure requirement of ASC Topic 718, “Compensation - Stock Compensation.” We record share-based compensation to employees and non-employees over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. We recognize the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. We issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial business combination and will expire in five years after the date on which they first become exercisable. We have determined that the consummation of an initial business combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\nOff-Balance Sheet Arrangements and Contractual Obligations\nAs of June 30, 2023, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations.\nJOBS Act\nThe JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, the financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\nAdditionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.\nFactors That May Adversely Affect our Results of Operations\nOur results of operations and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, downturns in the financial markets or in economic conditions, increases in oil prices, inflation, increases in interest rates, supply chain disruptions, declines in consumer confidence and spending, the ongoing effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict the likelihood of one or more of the above events, their duration or magnitude or the extent to which they may negatively impact our business and our ability to complete an initial business combination.\n26\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act, and are not required to provide the information otherwise required under this item.\n\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are controls and other procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer (our “Certifying Officer”), to allow timely decisions regarding required disclosure.\nAs of June 30, 2023, as required by Rules 13a-15 and 15d-15 under the Exchange Act, our principal executive officer and principal financial and accounting officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective because of a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. Specifically, the Company’s management has concluded that our control around the interpretation and accounting for extinguishment of a significant contingent obligation was not effectively designed or maintained. In light of this material weakness, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the unaudited condensed financial statements included in this Quarterly Report on Form 10-Q present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\nWe do not expect that our disclosure controls and procedures will prevent all errors and all instances of fraud. Disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Further, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and the benefits must be considered relative to their costs. Because of the inherent limitations in all disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that we have detected all our control deficiencies and instances of fraud, if any. The design of disclosure controls and procedures also is based partly on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\nChanges in Internal Control Over Financial Reporting\nOther than the above, there have been no changes to our internal control over financial reporting during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II - OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\n\nItem 1A. Risk Factors.\nAs a smaller reporting company under Rule 12b-2 of the Exchange Act, we are not required to include risk factors in this Report. However, as of the date of this Report, other than as set forth below, there have been no material changes with respect to those risk factors previously disclosed in our (i) Registration Statement, (ii) Annual Report on Form 10-K for the year ended December 31, 2021, as filed with the SEC on March 31, 2022, (iii) Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2021, June 30, 2021, September 30, 2021, March 31, 2022, June 30, 2022 and September 30, 2022, as filed with the SEC on June 25, 2021, August 13, 2021, November 22, 2021, May 9, 2022, August 15, 2022, and November 14, 2022, respectively, (iv) Definitive Proxy Statement on Schedule 14A, as filed with the SEC on January 31, 2023, and (v) our 2022 Annual Report. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risks could arise that may also affect our business or ability to consummate an initial Business Combination. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original Trust Account investments, which could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\nThe funds in the Trust Account had, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or the liquidation of the Company. Following such liquidation, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original trust account investments. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any, and certain other expenses as permitted. As a result, our decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\nMarket conditions, economic uncertainty or downturns could adversely affect our business, financial condition, operating results and our ability to consummate a Business Combination.\nIn recent years, the United States and other markets have experienced cyclical or episodic downturns, and worldwide economic conditions remain uncertain, including as a result of the COVID-19 pandemic, supply chain disruptions, the Ukraine-Russia conflict, instability in the U.S. and global banking systems, rising fuel prices, increasing interest rates or foreign exchange rates and high inflation and the possibility of a recession. A significant downturn in economic conditions may make it more difficult for us to consummate a Business Combination.\n28\nWe cannot predict the timing, strength, or duration of any future economic slowdown or any subsequent recovery generally, or in any industry. If the conditions in the general economy and the markets in which we operate worsen from present levels, our business, financial condition, operating results and our ability to consummate a Business Combination could be adversely affected. For example, in January 2023, the outstanding national debt of the U.S. government reached its statutory limit. The U.S. Department of the Treasury (the “Treasury Department”) has announced that, since then, it has been using extraordinary measures to prevent the U.S. government’s default on its payment obligations, and to extend the time that the U.S. government has to raise its statutory debt limit or otherwise resolve its funding situation. The failure by Congress to raise the federal debt ceiling could have severe repercussions within the U.S. and to global credit and financial markets. If Congress does not raise the debt ceiling, the U.S. government could default on its payment obligations, or experience delays in making payments when due. A payment default or delay by the U.S. government, or continued uncertainty surrounding the U.S. debt ceiling, could result in a variety of adverse effects for financial markets, market participants and U.S. and global economic conditions. In addition, U.S. debt ceiling and budget deficit concerns have increased the possibility a downgrade in the credit rating of the U.S. government and could result in economic slowdowns or a recession in the U.S. Although U.S. lawmakers have passed legislation to raise the federal debt ceiling on multiple occasions, ratings agencies have lowered or threatened to lower the long-term sovereign credit rating on the United States as a result of disputes over the debt ceiling. The impact of a potential downgrade to the U.S. government’s sovereign credit rating or its perceived creditworthiness could adversely affect economic conditions, as well as our business, financial condition, operating results and our ability to consummate a Business Combination.\nIf our initial Business Combination involves a company organized under the laws of a state of the United States, it is possible a 1% U.S. federal excise tax will be imposed on us in connection with redemptions of our common stock after or in connection with such initial Business Combination.\nOn August 16, 2022, the Inflation Reduction Act of 2022 became law in the United States, which, among other things, imposes a 1% excise tax on the fair market value of certain repurchases (including certain redemptions) of stock by publicly traded domestic (i.e., United States) corporations (and certain non-U.S. corporations treated as “surrogate foreign corporations”). The excise tax will apply to stock repurchases occurring in 2023 and beyond. The amount of the excise tax is generally 1% of the fair market value of the shares of stock repurchased at the time of the repurchase. The Treasury Department has been given authority to provide regulations and other guidance to carry out, and prevent the abuse or avoidance of, the excise tax; however, only limited guidance has been issued to date.\nAs an entity incorporated as a Cayman Islands exempted company, the 1% excise tax is not expected to apply to redemptions of our Class A ordinary shares (absent any regulations and other additional guidance that may be issued in the future with retroactive effect).\nHowever, in connection with an initial Business Combination involving a company organized under the laws of the United States, it is possible that we domesticate and continue as a Delaware corporation prior to certain redemptions and, because our securities are trading on the Nasdaq Capital Market, it is possible that we will be subject to the excise tax with respect to any subsequent redemptions, including redemptions in connection with the initial Business Combination, that are treated as repurchases for this purpose (other than, pursuant to recently issued guidance from the Treasury Department, redemptions in complete liquidation of the company). In all cases, the extent of the excise tax that may be incurred will depend on a number of factors, including the fair market value of our stock redeemed, the extent such redemptions could be treated as dividends and not repurchases, and the content of any regulations and other additional guidance from the Treasury Department that may be issued and applicable to the redemptions. Issuances of stock by a repurchasing corporation in a year in which such corporation repurchases stock may reduce the amount of excise tax imposed with respect to such repurchase. The excise tax is imposed on the repurchasing corporation itself, not the stockholders from which stock is repurchased. The imposition of the excise tax as a result of redemptions in connection with the initial Business Combination could, however, reduce the amount of cash available to pay redemptions or reduce the cash contribution to the target business in connection with our initial Business Combination, which could cause the other shareholders of the combined company to economically bear the impact of such excise tax.\n29\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone. For a description of the use of proceeds generated in our Initial Public Offering and the Private Placement, see Part II, Item 2 of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, as filed with the SEC on June 25, 2021. There has been no material change in the planned use of the proceeds from our Initial Public Offering and the Private Placement as described in the Registration Statement.\n\nItem 3. Defaults Upon Senior Securities.\nNone.\n\nItem 4. Mine Safety Disclosures\nNot applicable.\n\nItem 5. Other Information.\nNone.\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Report.\n\n| Exhibit Number | Description of Exhibit |\n| 31.1 | Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 31.2 | Certification of the Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 32.1 | Certification of the Principal Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\n| 32.2 | Certification of the Principal Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\n| 101.INS | Inline XBRL Instance Document.* |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document.* |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document.* |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document.* |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document.* |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document.* |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101).* |\n\n\n| * | Filed herewith. |\n\n\n| ** | Furnished herewith. |\n\n30\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Dated: August 14, 2023 | QUADRO ACQUISITION ONE CORP. |\n| By: | /s/ Dimitri Elkin |\n| Name: | Dimitri Elkin |\n| Title: | Chief Executive Officer |\n\n31\n\n</text>\n\nWhat is the total amount of loans that the company borrowed and to be repaid by June 30, 2023, including the IPO Note, Working Capital Loans, Promissory Note, Extension Loan, and Related Party Advance in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nPART I. FINANCIAL INFORMATION\\nItem 1. Financial Statements.\\nQUADRO ACQUISITION ONE CORP.\\nCONDENSED BALANCE SHEETS\\n\\n| June 30, 2023 | December 31, 2022 |\\n| (Unaudited) |\\n| Assets |\\n| Current assets: |\\n| Cash | $ | — | $ | 964 |\\n| Prepaid expenses | — | 33,402 |\\n| Total current assets | — | 34,366 |\\n| Cash and investments held in Trust Account | 26,731,243 | 233,304,515 |\\n| Total Assets | $ | 26,731,243 | $ | 233,338,881 |\\n| Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit |\\n| Current liabilities: |\\n| Accounts payable | $ | 436,656 | $ | 107,269 |\\n| Accrued expenses | 145,452 | 29,718 |\\n| Extension loan - related party | 270,000 | — |\\n| Advance from related parties | 188,722 | — |\\n| Note payable - related party | 400,000 | 318,700 |\\n| Total current liabilities | 1,440,830 | 455,687 |\\n| Derivative liabilities - warrants | 809,673 | 30,167 |\\n| Deferred underwriting commissions | 2,817,500 | 2,817,500 |\\n| Total liabilities | 5,068,003 | 3,303,354 |\\n| Commitments and Contingencies |\\n| Class A ordinary shares subject to possible redemption, $ 0.001 par value; 2,548,153 and 23,000,000 shares at approximately $ 10.45 and $ 10.14 per share redemption value as of June 30, 2023 and December 31, 2022, respectively | 26,631,243 | 233,204,515 |\\n| Shareholders’ Deficit: |\\n| Class A ordinary shares, $ 0.001 par value; 200,000,000 shares authorized; 6,250,000 and 0 non-redeemable shares issued or outstanding as of June 30, 2023 and December 31, 2022, respectively | 6,250 | — |\\n| Class B ordinary shares, $ 0.001 par value; 10,000,000 shares authorized; 0 and 6,250,000 shares issued and outstanding as of June 30, 2023 and December 31, 2022, respectively | — | 6,250 |\\n| Accumulated deficit | ( 4,974,253 | ) | ( 3,175,238 | ) |\\n| Total shareholders’ deficit | ( 4,968,003 | ) | ( 3,168,988 | ) |\\n| Total Liabilities, Class A Ordinary Shares Subject to Possible Redemption and Shareholders’ Deficit | $ | 26,731,243 | $ | 233,338,881 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n1\\nQUADRO ACQUISITION ONE CORP.\\nUNAUDITED CONDENSED STATEMENTS OF OPERATIONS\\n\\n| For the Three Months Ended June 30, | For the Six Months Ended June 30, |\\n| 2023 | 2022 | 2023 | 2022 |\\n| Operating expenses |\\n| General and administrative expenses | $ | 160,237 | $ | 106,509 | $ | 749,509 | $ | 299,896 |\\n| Loss from operations | ( 160,237 | ) | ( 106,509 | ) | ( 749,509 | ) | ( 299,896 | ) |\\n| Other income: |\\n| Change in fair value of derivative assets and liabilities | ( 538,173 | ) | 863,544 | ( 779,506 | ) | 5,117,082 |\\n| Income from investments held in Trust Account | 240,284 | — | 1,681,266 | — |\\n| Unrealized gain from investments held in Trust Account | — | 292,182 | — | 312,752 |\\n| Net (loss) income | $ | ( 458,126 | ) | $ | 1,049,217 | $ | 152,251 | $ | 5,129,938 |\\n| Weighted average shares outstanding of Class A ordinary shares, basic and diluted | 8,798,153 | 23,000,000 | 13,551,176 | 23,000,000 |\\n| Basic and diluted net (loss) income per share, Class A ordinary shares | $ | ( 0.05 | ) | $ | 0.04 | $ | 0.01 | $ | 0.18 |\\n| Weighted average shares outstanding of Class B ordinary shares, basic and diluted | — | 6,250,000 | 1,041,667 | 6,250,000 |\\n| Basic and diluted net (loss) income per share, Class B ordinary shares | $ | — | $ | 0.04 | $ | 0.01 | $ | 0.18 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n2\\nQUADRO ACQUISITION ONE CORP.\\nUNAUDITED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\\n\\n| Ordinary Shares | Additional | Total |\\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\\n| Balance - December 31, 2022 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 3,175,238 | ) | $ | ( 3,168,988 | ) |\\n| Conversion of Class B ordinary shares to Class A ordinary shares | 6,250,000 | 6,250 | ( 6,250,000 | ) | ( 6,250 | ) | — | — | — |\\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 1,560,982 | ) | ( 1,560,982 | ) |\\n| Net income | — | — | — | — | — | 610,377 | 610,377 |\\n| Balance - March 31, 2023 (unaudited) | 6,250,000 | 6,250 | — | — | — | ( 4,125,843 | ) | ( 4,119,593 | ) |\\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 390,284 | ) | ( 390,284 | ) |\\n| Net loss | — | — | — | — | — | ( 458,126 | ) | ( 458,126 | ) |\\n| Balance - June 30, 2023 (unaudited) | 6,250,000 | $ | 6,250 | — | $ | — | $ | — | $ | ( 4,974,253 | ) | $ | ( 4,968,003 | ) |\\n\\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\\n\\n| Ordinary Shares | Additional | Total |\\n| Class A | Class B | Paid-in | Accumulated | Shareholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Deficit |\\n| Balance - December 31, 2021 | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 13,769,504 | ) | $ | ( 13,763,254 | ) |\\n| Net income | — | — | — | — | — | 4,080,721 | 4,080,721 |\\n| Balance - March 31, 2022 (unaudited) | — | — | 6,250,000 | 6,250 | — | ( 9,688,783 | ) | ( 9,682,533 | ) |\\n| Accretion on Class A ordinary shares subject to possible redemption amount | — | — | — | — | — | ( 251,264 | ) | ( 251,264 | ) |\\n| Net income | — | — | — | — | — | 1,049,217 | 1,049,217 |\\n| Balance - June 30, 2022 (unaudited) | — | $ | — | 6,250,000 | $ | 6,250 | $ | — | $ | ( 8,890,830 | ) | $ | ( 8,884,580 | ) |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n3\\nQUADRO ACQUISITION ONE CORP.\\nUNAUDITED CONDENSED STATEMENTS OF CASH FLOWS\\n\\n| For the Six Months Ended June 30, |\\n| 2023 | 2022 |\\n| Cash Flows from Operating Activities: |\\n| Net income | $ | 152,251 | $ | 5,129,938 |\\n| Adjustments to reconcile net income to net cash used in operating activities: |\\n| Change in fair value of derivative assets and liabilities | 779,506 | ( 5,117,082 | ) |\\n| Income from cash and investments held in Trust Account | ( 1,681,266 | ) | — |\\n| Unrealized gain from investments held in Trust Account | — | ( 312,752 | ) |\\n| Changes in operating assets and liabilities: |\\n| Prepaid expenses | 33,402 | 105,379 |\\n| Accounts payable | 346,708 | 12,240 |\\n| Accounts payable - related party | ( 17,321 | ) | ( 17,321 | ) |\\n| Accrued expenses | 115,734 | ( 60,094 | ) |\\n| Net cash used in operating activities | ( 270,986 | ) | ( 259,692 | ) |\\n| Cash Flows from Investing Activities: |\\n| Cash deposited in Trust Account | ( 270,000 | ) | — |\\n| Cash withdrawn from Trust Account in connection with redemption | 208,524,538 | — |\\n| Net cash provided by investing activities | 208,254,538 | — |\\n| Cash Flows from Financing Activities: |\\n| Proceeds from related party advance | 188,722 | — |\\n| Proceeds from extension loan | 270,000 | — |\\n| Proceeds from note payable to related party | 81,300 | — |\\n| Proceeds from promissory note to related party | — | 318,700 |\\n| Offering costs paid | — | ( 70,000 | ) |\\n| Redemption of Ordinary shares | ( 208,524,538 | ) | — |\\n| Net cash used in financing activities | ( 207,984,516 | ) | 248,700 |\\n| Net change in cash | ( 964 | ) | ( 10,992 | ) |\\n| Cash - beginning of the period | 964 | 63,676 |\\n| Cash - end of the period | $ | — | $ | 52,684 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\\n4\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 1 - Description of Organization, Business Operations and Going Concern\\nQuadro Acquisition One Corp. (the “Company”, formerly known as Kismet Acquisition Two Corp.) is a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. The Company was incorporated for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation, contractual control arrangement with, purchasing all or substantially all of the assets of, or engaging in any other similar initial business combination with one or more businesses or entities that the Company has not yet identified (“Business Combination”).\\nAs of June 30, 2023, the Company had not yet commenced operations. All activity for the period from September 15, 2020 (inception) through June 30, 2023, relates to the Company’s formation and the initial public offering (the “Initial Public Offering” or “IPO”), which is described below, and since the Initial Public Offering, the search for a potential target. The Company will not generate any operating revenues until after the completion of its initial Business Combination, at the earliest. The Company generates non-operating income in the form of interest income on investments held in Trust Account (as defined below) from the proceeds derived from the Initial Public Offering and the sale of the Private Placement Warrants (as defined below).\\nThe Company’s sponsor was Kismet Sponsor Limited, a British Virgin Islands company (the “Prior Sponsor”). The Registration Statement for the Initial Public Offering on Form S-1 initially filed with the U.S. Securities and Exchange Commission (“SEC”) on January 26, 2021, as amended (File No. 333- 252419), was declared effective on February 17, 2021 (the “Registration Statement”). On February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 units (the “Units” and, with respect to the Class A Ordinary shares included in the Units sold, the “Public Shares”), including 3,000,000 additional Units to cover over-allotments (the “Over-Allotment Units”), at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions (see Note 6).\\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the private placement (“Private Placement”) of 4,400,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”), at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 (see Note 4).\\nOn June 15, 2022, the Prior Sponsor transferred 6,250,000 Class B ordinary shares and 4,400,000 Private Placement Warrants held by the Prior Sponsor to Quadro Sponsor LLC, a Delaware limited liability company and wholly owned subsidiary of the Prior Sponsor (the “New Sponsor” or “Sponsor”). On June 30, 2022, the Prior Sponsor transferred all the membership interests of the New Sponsor to Quadro IH DMCC (“Quadro”), a company registered in Dubai Multi Commodities Centre in the United Arab Emirates (the “Sponsor Transaction”). In connection with the Sponsor Transaction, the Prior Sponsor also assigned to the New Sponsor all of its rights and obligations under the (i) Letter Agreement, dated as of February 17, 2021, (ii) Registration Rights Agreement (as defined in Note 5) and (iii) Promissory Note (as defined below). In addition, the Company and Kismet Capital Group LLC (“Kismet LLC”) mutually terminated the Administrative Services Agreement, dated February 17, 2021 (the “Administrative Services Agreement”). As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee to Kismet LLC pursuant to the Administrative Services Agreement.\\nUpon the closing of the Initial Public Offering and the Private Placement, $ 230.0 million ($ 10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement were placed in a trust account (“Trust Account”) with Continental Stock Transfer & Trust Company (“Continental”) acting as trustee and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act of 1940 (the “Investment Company Act”), which invest only in direct U.S. government treasury obligations, as determined by the Company, until the earlier of (i) the completion of a Business Combination and (ii) the distribution of the Trust Account as described below.\\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of its Initial Public Offering and the sale of Private Placement Warrants, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The Company’s initial Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the net assets held in the Trust Account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the Trust Account) at the time the Company signs a definitive agreement in connection with the initial Business Combination. However, the Company will only complete a Business Combination if the post-transaction company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\\n5\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe Company will provide its holders of the Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The Public Shareholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account (initially at $ 10.00 per share, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). The per-share amount to be distributed to Public Shareholders who redeem their Public Shares will not be reduced by the deferred underwriting commissions the Company will pay to the underwriters (see Note 6). These Public Shares were recorded at a redemption value and classified as temporary equity upon the completion of the Initial Public Offering, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”). In such case, the Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 upon such consummation of a Business Combination and a majority of the shares are voted in favor of the Business Combination. If a shareholder vote is not required by law and the Company does not decide to hold a shareholder vote for business or other legal reasons, the Company will, pursuant to the amended and restated memorandum and articles of association which were adopted by the Company upon the consummation of the Initial Public Offering (the “Memorandum and Articles of Association”), conduct the redemptions pursuant to the tender offer rules of the SEC, and file tender offer documents with the SEC prior to completing a Business Combination. If, however, a shareholder approval of the transactions is required by law, or the Company decides to obtain shareholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. Additionally, each Public Shareholder may elect to redeem their Public Shares irrespective of whether they vote for or against the proposed transaction. If the Company seeks shareholder approval in connection with a Business Combination, the holder of the Founder Shares (as defined in Note 5) prior to the Initial Public Offering (the “Initial Shareholder”) agreed to vote its Founder Shares and any Public Shares purchased during or after the Initial Public Offering in favor of a Business Combination. In addition, the Initial Shareholder agreed to waive its redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of a Business Combination.\\nNotwithstanding the foregoing, the Memorandum and Articles of Association provides that a Public Shareholder, together with any affiliate of such shareholder or any other person with whom such shareholder is acting in concert or as a “group” (as defined under Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), will be restricted from redeeming its shares with respect to more than an aggregate of 20 % or more of the Class A Ordinary shares sold in the Initial Public Offering, without the prior consent of the Company.\\nThe Company’s Sponsor, executive officers, directors and director nominees agreed not to propose an amendment to the Memorandum and Articles of Association that would affect the substance or timing of the Company’s obligation to provide for the redemption of its Public Shares in connection with a Business Combination or to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the Public Shareholders with the opportunity to redeem their Class A ordinary shares in conjunction with any such amendment.\\nThe Company initially had until February 22, 2023 (the “Original Termination Date”) to complete the initial Business Combination. On February 20, 2023, the Company held the 2023 Extraordinary General Meeting at which the shareholders of the Company approved to extend the date by which the Company must consummate an initial Business Combination to April 22, 2023 and to allow the Company’s board, without another shareholder vote, to extend Combination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”).\\nIn connection with the Extension, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account (together with the Initial Extension Loan, the “Extension Loans”). On each of May 11, 2023 and June 6, 2023, the Company deposited an additional $ 60,000 , for an aggregate of $ 120,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to June 22, 2023. On each of June 30, 2023 and July 11, 2023, the Company deposited an additional $ 30,000 , for an aggregate of $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial Business Combination to July 22, 2023. On August 7, 2023, the Company deposited an additional $ 60,000 into the Trust Account to extend the date by which it has to consummate an initial business combination to August 22, 2023.\\nIn connection with the Extension, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million.\\nOn January 31, 2023, the Company issued an aggregate of 6,250,000 Class A ordinary shares to the Sponsor, upon the conversion of an equal number of Class B ordinary shares held by the Sponsor (the “Conversion”). The 6,250,000 Class A ordinary shares issued in connection with the Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial Business Combination as described in the prospectus for the Company’s initial public offering. Following the Conversion, there are 29,250,000 Class A ordinary shares issued and outstanding and no Class B ordinary shares issued and outstanding. As a result of the Conversion, the Sponsor held 21.4 % of the outstanding Class A ordinary shares.\\n6\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nOn February 10, 2023, the Company instructed Continental to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of the Company’s initial Business Combination or the Company’s liquidation. As a result, following the liquidation of investments in the Trust Account, the remaining proceeds from the Initial Public Offering and Private Placement are no longer invested in U.S. government securities or money market funds.\\nIf the Company is unable to complete a Business Combination by August 22, 2023 (or November 22, 2023 if the Company fully extends the time to complete a Business Combination, the “Combination Period”), the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem all Public Shares then outstanding at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including any amounts representing interest earned on the Trust Account, less any interest released to the Company for the payment of taxes, if any (and less up to $ 100,000 in interest reserved for expenses in connection with the Company’s dissolution), divided by the number of then outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any), and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the Company’s board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\\nIn connection with the redemption of 100 % of the Company’s outstanding Public Shares for a portion of the funds held in the Trust Account, each holder will receive a full pro rata portion of the amount then in the Trust Account, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s taxes payable (less up to $ 100,000 of interest to pay dissolution expenses).\\nThe Initial Shareholder agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Initial Shareholder should acquire Public Shares in or after the Initial Public Offering, it will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete a Business Combination within the Combination Period. The underwriters agreed to waive their rights to their deferred underwriting commission (see Note 6) held in the Trust Account in the event the Company does not complete a Business Combination within the Combination Period, and, in such event, such amounts will be included with the funds held in the Trust Account that will be available to fund the redemption of the Public Shares. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be only $10.00 per share initially held in the Trust Account. In order to protect the amounts held in the Trust Account, the Sponsor agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or a prospective target business with which the Company has entered into a written letter of intent, confidentiality or other similar agreement or business combination agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $10.00 per Public Share and (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account, if less than $10.00 per share due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to any claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the Trust Account (whether or not such waiver is enforceable) nor will it apply to any claims under the Company’s indemnity of the underwriters of the Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). In the event that an executed waiver is deemed to be unenforceable against a third party, the Sponsor will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the Sponsor will have to indemnify the Trust Account due to claims of creditors by endeavoring to have vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\\n7\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nLiquidity and Going Concern\\nAs of June 30, 2023, the Company had $ 0 in its operating bank account and working capital deficit of approximately $ 1.4 million.\\nThe Company’s liquidity needs to date have been satisfied through a contribution of $ 25,000 from the Prior Sponsor to cover certain expenses in exchange for the issuance of the Founder Shares, a loan of approximately $ 111,000 from the Prior Sponsor pursuant to the IPO Note (as defined in Note 5), and a portion of the proceeds from the consummation of the Private Placement not held in the Trust Account. The Company repaid the IPO Note in full on February 24, 2021. In addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans (as defined in Note 5). As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any Working Capital Loans.\\nOn April 13, 2022, the Company issued an unsecured promissory note in the amount of up to $ 200,000 to the Prior Sponsor (the “Promissory Note”). On May 25, 2022, the Company and the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\\nThe Company may need to raise additional capital through loans or additional investments from its Sponsor, its officers or directors or their affiliates. The Company’s officers, directors and Sponsor, or their affiliates, may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with the Company’s assessment of going concern considerations in accordance with FASB ASC Topic 205-40, “Presentation of Financial Statements - Going Concern” (“ASC 205-40”), management has determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. Management continues to seek to complete a Business Combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after November 22, 2023. The accompanying financial statements do not include any adjustment that might be necessary if the Company is unable to continue as a going concern.\\nNote 2 - Basis of Presentation and Summary of Significant Accounting Policies\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the SEC. Accordingly, certain disclosures included in the annual financial statements have been condensed or omitted from the accompanying unaudited condensed financial statements as they are not required for interim financial statements under GAAP and the rules of the SEC. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments, which include only normal recurring adjustments necessary for the fair statement of the balances and results for the periods presented. Operating results for the three and six months ended June 30, 2023 are not necessarily indicative of the results that may be expected through December 31, 2023 or any future period.\\nThe accompanying unaudited condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Annual Report on Form 10-K for the fiscal year ended December 31, 2022, as filed by the Company with the SEC on April 18, 2023 (the “2022 Annual Report”).\\n8\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nEmerging Growth Company\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the accompanying unaudited condensed financial statements with another public company that is neither an emerging growth company nor an emerging growth company that has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nUse of Estimates\\nThe preparation of the accompanying unaudited condensed financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed financial statements and the reported amounts of revenues and expenses during the reporting periods. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the accompanying unaudited condensed financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. One of the more significant accounting estimates included in the accompanying unaudited condensed financial statements is the determination of the fair value of the derivative liabilities. Accordingly, the actual results could differ from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company had no cash equivalents as of June 30, 2023 and December 31, 2022.\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, regularly exceed the Federal Deposit Insurance Corporation coverage limit of $ 250,000 . Any loss incurred or a lack of access to such funds could have a significant adverse impact on the Company’s financial condition, results of operations, and cash flows.\\nCash and Investments Held in the Trust Account\\nThe Company classifies its U.S. Treasury and equivalent securities as held to maturity in accordance with FASB Accounting Standard Codification (“ASC”) Topic 320, “Investments – Debt and Equity Securities.” Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. Held-to-maturity treasury securities are recorded at amortized cost on the accompanying consolidated balance sheets and adjusted for the amortization or accretion of premiums or discounts.\\nAt June 30, 2023, substantially all of the assets held in the Trust Account were held in cash. At December 31, 2022, substantially all of the assets held in the Trust Account were held in money market funds which invest primarily in U.S. Treasury securities. The money market funds are presented at fair value within the accompanying consolidated balance sheets, and fair value of the investments in the Trust Account is equal to the amortized cost basis of the money market funds.\\nFair Value of Financial Instruments\\nThe fair value of the Company’s assets and liabilities which qualify as financial instruments under the FASB ASC Topic 820, “Fair Value Measurements,” equal or approximate the carrying amounts represented in the condensed balance sheets.\\n9\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nFair Value Measurements\\n“Fair value” is defined as “the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date.” GAAP establishes a three-tier fair value hierarchy, which prioritizes inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers consist of:\\n\\n| ● | Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets; |\\n\\n\\n| ● | Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and |\\n\\n\\n| ● | Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\\n\\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\\nDerivative Liabilities\\nThe Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. The Company evaluates all of its financial instruments, including issued warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC 480 and ASC 815-15. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\\nThe Company accounts for its warrants issued in connection with its Initial Public Offering and Private Placement and units that may be issued in connection with a forward purchase agreement (the “Forward Purchase Units”) as derivative liabilities in accordance with ASC 815-40. Accordingly, the Company recognizes the instruments as liabilities at fair value and adjusts the instruments to fair value at the end of each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative liabilities is recognized in the Company’s unaudited condensed statements of operations. The fair value of warrants issued in connection with the Initial Public Offering was initially measured using Monte-Carlo simulation and has subsequently been measured on the market price of such warrants at each measurement date when separately listed and traded. The fair value of warrants issued in connection with the Private Placement was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the Forward Purchase Units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\\nOffering Costs Associated with the Initial Public Offering\\nOffering costs consisted of legal, accounting, underwriting fees and other costs incurred through the Initial Public Offering that were directly related to the Initial Public Offering. Offering costs are allocated to the separable financial instruments issued in the Initial Public Offering based on a relative fair value basis, compared to total proceeds received. Offering costs associated with derivative liabilities are expensed as incurred, presented as non-operating expenses in the statements of operations in the period that the costs occurred. Offering costs associated with the Class A ordinary shares were charged against the carrying value of the Class A ordinary shares upon the completion of the Initial Public Offering. The Company classifies deferred underwriting commissions as non-current liabilities as their liquidation is not reasonably expected to require the use of current assets or require the creation of current liabilities.\\nClass A Ordinary Shares Subject to Possible Redemption\\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. The Company’s Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ deficit section of the accompanying condensed balance sheets, respectively.\\n10\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the security. Effective with the closing of the Initial Public Offering, the Company recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\\nShare-Based Compensation\\nThe Company complies with the accounting and disclosure requirement of ASC Topic 718, “Compensation – Stock Compensation.” Share-based compensation to employees and non-employees is recognized over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The Company recognizes the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. The Company issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial Business Combination and will expire in five years after the date on which they first become exercisable. The Company has determined that the consummation of an initial Business Combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\\nIncome Taxes\\nFASB ASC Topic 740, “Income Taxes,” prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company’s management determined that the Cayman Islands is the Company’s only major tax jurisdiction. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2023 and December 31, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\\nThere is currently no taxation imposed on income by the Government of the Cayman Islands. In accordance with Cayman federal income tax regulations, income taxes are not levied on the Company. Consequently, income taxes are not reflected in the accompanying unaudited condensed financial statements. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\\nNet (Loss) Income per Ordinary Share\\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” The Company has two classes of shares, which are referred to as Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants underlying the Units sold in the Initial Public Offering and the Private Placement Warrants to purchase an aggregate of 12,066,667 Class A ordinary shares since their exercise is contingent upon future events. As a result, diluted net (loss) income per share is the same as basic net (loss) income per share for the three and six months ended June 30, 2023 and 2022. Accretion associated with the redeemable Class A ordinary shares is excluded from earnings per share as the redemption value approximates fair value.\\n11\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe table below presents a reconciliation of the numerator and denominator used to compute basic and diluted net (loss) income per share for each class of Ordinary Shares:\\n\\n| For the Three Months Ended June 30, |\\n| 2023 | 2022 |\\n| Class A | Class B | Class A | Class B |\\n| Numerator: |\\n| Allocation of net (loss) income | $ | ( 458,126 | ) | $ | — | $ | 825,025 | $ | 224,192 |\\n| Denominator: |\\n| Weighted average ordinary shares outstanding, basic and diluted | 8,798,153 | — | 23,000,000 | 6,250,000 |\\n| Basic and diluted net (loss) income per ordinary share | $ | ( 0.05 | ) | $ | — | $ | 0.04 | $ | 0.04 |\\n\\n\\n| For the Six Months Ended June 30, |\\n| 2023 | 2022 |\\n| Class A | Class B | Class A | Class B |\\n| Numerator: |\\n| Allocation of net income | $ | 141,383 | $ | 10,868 | $ | 4,033,797 | $ | 1,096,141 |\\n| Denominator: |\\n| Weighted average ordinary shares outstanding, basic and diluted | 13,551,176 | 1,041,667 | 23,000,000 | 6,250,000 |\\n| Basic and diluted net income per ordinary share | $ | 0.01 | $ | 0.01 | $ | 0.18 | $ | 0.18 |\\n\\nRecent Accounting Pronouncements\\nThe Company’s management does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\\nNote 3 - Initial Public Offering\\nOn February 22, 2021, the Company consummated its Initial Public Offering of 23,000,000 Units, including 3,000,000 Over-Allotment Units, at $ 10.00 per Unit, generating gross proceeds of $ 230.0 million, and incurring offering costs of approximately $ 13.1 million, of which approximately $ 8.1 million was for deferred underwriting commissions.\\nEach Unit consists of one Class A ordinary share and one-third of one redeemable warrant (“Public Warrant”). Each whole Public Warrant will entitle the holder to purchase one Class A ordinary share at an exercise price of $ 11.50 per share, subject to adjustment (see Note 7).\\nNote 4 - Private Placement\\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the Private Placement of 4,400,000 Private Placement Warrants, at a price of $ 1.50 per Private Placement Warrant with the Prior Sponsor, generating gross proceeds of $ 6.6 million, and incurring offering costs of approximately $ 7,000 . On June 15, 2022, the Prior Sponsor transferred 4,400,000 Private Placement Warrants to the New Sponsor.\\nEach whole Private Placement Warrant is exercisable for one whole Class A ordinary share at a price of $ 11.50 per share. A portion of the proceeds from the sale of the Private Placement Warrants to the Prior Sponsor was added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the Private Placement Warrants will expire worthless. The Private Placement Warrants will be non-redeemable for cash and exercisable on a cashless basis so long as they are held by the Sponsor or its permitted transferees.\\nThe Sponsor agreed, subject to limited exceptions, not to transfer, assign or sell any of its Private Placement Warrants until 30 days after the completion of the initial Business Combination.\\n12\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 5 - Related Party Transactions\\nForward Purchase Agreement\\nIn connection with the consummation of the Initial Public Offering, the Company entered into a forward purchase agreement (the “Forward Purchase Agreement”) with the Prior Sponsor, which provides for the purchase of $ 20.0 million Forward Purchase Units, which at the option of the Prior Sponsor, can be increased to $ 50.0 million, with each Forward Purchase Unit consisting of one Class A ordinary share (the “Forward Purchase Shares”) and one-third of one warrant to purchase one Class A ordinary share at $ 11.50 per share (the “Forward Purchase Warrants,” together with the Forward Purchase Units and the Forward Purchase Shares, the “Forward Purchase Securities”), for a purchase price of $ 10.00 per Forward Purchase Unit, in a private placement to occur concurrently with the closing of the initial Business Combination. The purchase under the Forward Purchase Agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the Public Shareholders. The Forward Purchase Securities will be issued only in connection with the closing of the initial Business Combination. The proceeds from the sale of Forward Purchase Securities may be used as part of the consideration to the sellers in the initial Business Combination, expenses in connection with the initial Business Combination or for working capital in the post-transaction company. The Company does not intend to implement the forward purchase agreement, and on April 17, 2023, the Company sent a notice of mutual termination of the forward purchase agreement to the prior sponsor. The Company classified the Forward Purchase Units as derivative instruments on the accompanying condensed balance sheets. The initial value of the Forward Purchase Units was insignificant, and the Company recognized a loss in the change in the fair value of the derivative assets (liabilities) of approximately $ 0 and $ 0 for the three and six months ended June 30, 2023, respectively, and approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\\nFounder Shares\\nOn September 21, 2020, the Company issued 4,812,500 Class B ordinary shares, par value $ 0.001 per share (the “Founder Shares”) to the Prior Sponsor. On September 23, 2020, the Prior Sponsor paid an aggregate of $ 25,000 for certain expenses on behalf of the Company in exchange for issuance of the Founder Shares. On January 25, 2021, the Company effected a stock dividend of 1,437,500 shares with respect to Class B ordinary shares, resulting in an aggregate of 6,250,000 Founder Shares outstanding. The Prior Sponsor agreed to forfeit up to an aggregate of 750,000 Founder Shares, on a pro rata basis, to the extent that the option to purchase additional Units was not exercised in full by the underwriters, so that the Founder Shares would represent 20 % of the Company’s issued and outstanding shares after the Initial Public Offering plus the 2,000,000 Forward Purchase Shares underlying the Forward Purchase Units (which at the option of the Prior Sponsor can be increased to up to 5,000,000 Forward Purchase Shares). On February 22, 2021, the underwriter fully exercised its over-allotment option; thus, these 750,000 Founder Shares were no longer subject to forfeiture.\\nOn June 15, 2022, the Prior Sponsor transferred all 6,250,000 Founder Shares to the New Sponsor.\\nThe New Sponsor agreed not to transfer, assign or sell any of its Founder Shares until the earlier to occur of (i) one year after the date of the consummation of the initial Business Combination, or earlier if, subsequent to the initial Business Combination, (x) the last reported sale price of the Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination or (y) the Company consummates a subsequent liquidation, merger, stock exchange or other similar transaction which results in all of the shareholders having the right to exchange their Ordinary shares for cash, securities or other property.\\nRelated Party Loans\\nOn September 23, 2020, the Prior Sponsor agreed to loan the Company up to $ 250,000 to cover costs related to the Initial Public Offering pursuant to a promissory note, which was later amended on January 22, 2021 (the “IPO Note”). The IPO Note was non-interest bearing, unsecured and due upon the closing of the Initial Public Offering. As of February 22, 2021, the Company borrowed approximately $ 111,000 under the IPO Note. The Company repaid the IPO Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to the Company.\\n13\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor, members of the Company’s founding team or any of their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the Trust Account. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans but no proceeds held in the Trust Account would be used to repay the Working Capital Loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lenders’ discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $ 1.50 per warrant. The warrants would be identical to the Private Placement Warrants. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. As of June 30, 2023 and December 31, 2022, the Company had no borrowings under any Working Capital Loans.\\nOn April 13, 2022, the Company issued the Promissory Note to the Prior Sponsor for an aggregate of up to $ 200,000 . On May 25, 2022, the Prior Sponsor amended the Promissory Note agreement and increased the principal amount to $ 400,000 . The Promissory Note bears no interest, may be prepaid at any time and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the Prior Sponsor assigned all of its rights and obligations under the Promissory Note to the New Sponsor in connection with the Sponsor Transaction. As of June 30, 2023, the Company has fully drawn $ 400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $ 400,000 and $ 319,000 were outstanding under the Promissory Note, respectively.\\nExtension Loan\\nPursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan the initial contribution of $ 120,000 in February 2023 for the portion of the extension ending on April 22, 2023. The Sponsor will also loan the company extension contributions of $ 60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial Business Combination, which amount will be deposited into the Trust Account. As of June 30, 2023, the Company has drawn $ 270,000 on the Extension Loan and deposited it into the Trust Account.\\nRelated Party Advance\\nFor the three and six months ended June 30, 2023, the Sponsor had paid $ 164,081 and $ 188,722 , respectively, of expenses on behalf on Company, which are included in advance from related parties in the accompanying condensed balance sheets as of June 30, 2023.\\nAdministrative Services Agreement\\nCommencing on February 17, 2021, through the earlier of consummation of the initial Business Combination and the liquidation, the Company agreed to pay Kismet LLC, an affiliate of the Prior Sponsor, $ 10,000 per month for office space, utilities, secretarial support and administrative services.\\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $ 10,000 monthly fee pursuant to the Administrative Services Agreement.\\nDirector Compensation\\nCommencing on February 18, 2021, the Company paid its initial directors $ 40,000 each. On May 25, 2022, Mr. Verdi Israelyan, a former director, waived his right to receive a payment of $ 40,000 . The Company also granted two of its independent directors, Messrs. Tompsett and Zilber, an option each to purchase 40,000 Class A ordinary shares at an exercise price of $ 10.00 per share, which will vest upon the consummation of the initial Business Combination and will expire five years after the date on which it first became exercisable Further, following the approval of the Extension, the compensation committee of the Company’s board of directors has approved the transfers by the Sponsor of (a) 15,000 Founder Shares to each of Messrs. Zilber and Tourevski and (b) 20,000 Founder Shares to Mr. Tompsett as additional compensation, which transfers will take place prior to the closing of the initial Business Combination. Both the Founder Shares and the options granted to the directors are subject to forfeiture in the event a director ceases to serve on the Company’s board prior to the closing of a Business Combination. In addition, the Sponsor, executive officers and directors, or any of their respective affiliates will be reimbursed for any out-of-pocket expenses incurred in connection with activities on the Company’s behalf such as identifying potential target businesses and performing due diligence on suitable Business Combinations. The Company’s audit committee reviews, on a quarterly basis, all payments that are made to the Sponsor, officers or directors, or the Company’s or their affiliates.\\nOn May 25, 2022, one of the Company’s former directors waived his right to receive a payment of $ 40,000 and the Company recorded approximately $ 0 of director compensation during three and six months ended June 30, 2023 , and approximately $( 12,000 ) and $ 3,000 of director compensation during the three and six months ended June 30, 2022, respectively. As of June 30, 2023 and December 31, 2022, the Company had no amounts outstanding in relation to the director compensation.\\n14\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nDeparture and Appointment of Officers\\nOn June 30, 2022, concurrently with the Sponsor Transaction, Ivan Tavrin, Chief Executive Officer and Chairman of the Company’s board of directors, resigned as Chairman and Chief Executive Officer of the Company, and as the Company’s principal financial and accounting officer.\\nEffective June 30, 2022, the Company’s board of directors appointed Mr. Dimitri Elkin to serve as the Company’s Chief Executive Officer. Mr. Elkin is also serving as the Company’s principal financial and accounting officer.\\nOn September 5, 2022, Verdi Israelyan, resigned from the board of directors of the Company. Mr. Israelyan resignation was not the result of any dispute or disagreement with the Company or the Company’s board of directors on any matter relating to the Company’s operations, policies or practices. On March 27, 2023, the board of directors elected Konstantin Tourevski as a director and as a member of the audit committees to fill the vacancy caused by the resignation of Mr. Israelyan.\\nNote 6 - Commitments and Contingencies\\nRegistration Rights\\nThe holders of the Founder Shares and Private Placement Warrants (and any Class A ordinary shares issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans) were entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021 (the “Registration Rights Agreement”). The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial Business Combination. The Company will bear the expenses incurred in connection with the filing of any such registration statements. On June 30, 2022, in connection with the Sponsor Transaction, the Prior Sponsor assigned to the New Sponsor all of its rights and obligations under the Registration Rights Agreement.\\nPursuant to the Forward Purchase Agreement, the Company agreed to use its commercially reasonable efforts (i) to file within 30 days after the closing of the initial Business Combination a registration statement with the SEC for a secondary offering of the Forward Purchase Shares and the Forward Purchase Warrants (and underlying Class A Ordinary Shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on the Prior Sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the Forward Purchase Agreement provides for “piggy-back” registration rights to the holders of Forward Purchase Securities to include their securities in other registration statements filed by the Company.\\nUnderwriting Agreement\\nThe Company granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional Units at the Initial Public Offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\\nThe underwriters were entitled to an underwriting discount of $ 0.20 per Unit, or $ 4.6 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $ 0.35 per Unit, or approximately $ 8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $ 5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. The Company recognized the portion allocated to Public Shares of approximately $ 5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $ 0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\\nRisks and Uncertainties\\nManagement continues to evaluate the impact of the COVID-19 pandemic on the industry and has concluded that while it is reasonably possible that the virus could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The accompanying unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\\n15\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nIn February 2022, a military conflict started between Russia and Ukraine. The ongoing military conflict between Russia and Ukraine has provoked strong reactions from the United States, the United Kingdom, the European Union and various other countries around the world, including the imposition of broad financial and economic sanctions against Russia. Further, the precise effects of the ongoing military conflict and these sanctions on the global economies remain uncertain as of the date of the accompanying unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of the accompanying unaudited condensed financial statements.\\nNote 7 - Warrants\\nAs of June 30, 2023 and December 31, 2022, 7,666,667 Public Warrants and 4,400,000 Private Placement Warrants were outstanding.\\nPublic Warrants may only be exercised for a whole number of Class A Ordinary Shares. No fractional Public Warrants will be issued upon separation of the Units and only whole Public Warrants will trade. The Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering; provided in each case that the Company has an effective registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the Public Warrants and a current prospectus relating to them is available and such shares are registered, qualified or exempt from registration under the securities, or blue sky, laws of the state of residence of the holder (or the Company permits holders to exercise their warrants on a cashless basis under certain circumstances). The Company agreed that as soon as practicable, but in no event later than 15 business days after the closing of the initial Business Combination, the Company will use commercially reasonable efforts to file with the SEC and have an effective registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants and to maintain a current prospectus relating to those Class A Ordinary Shares until the warrants expire or are redeemed, as specified in the warrant agreement. If a registration statement covering the Class A Ordinary Shares issuable upon exercise of the warrants is not effective by the 60th day after the closing of the initial Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company will have failed to maintain an effective registration statement, exercise warrants on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act or another exemption. Notwithstanding the above, if the Class A Ordinary Shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” and, in the event the Company so elects, the Company will not be required to file or maintain in effect a registration statement, and in the event the Company does not so elect, it will use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\\nThe warrants have an exercise price of $11.50 per share, subject to adjustments, and will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation. In addition, if (x) the Company issues additional Class A Ordinary Shares or equity-linked securities for capital raising purposes in connection with the closing of the initial Business Combination at an issue price or effective issue price of less than $9.20 per Class A Ordinary Share (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or an affiliate of the Sponsor, without taking into account any Founder Shares held by the Sponsor or an affiliate of the Sponsor, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of the initial Business Combination on the date of the completion of the initial Business Combination (net of redemptions), and (z) the volume-weighted average trading price of the Class A Ordinary Shares during the 20 trading day period starting on the trading day prior to the day on which the Company completes its initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the higher of the Market Value and the Newly Issued Price, and the $10.00 and $18.00 per share redemption trigger prices described under “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $18.00” and “Redemption of warrants when the price per Class A Ordinary Share equals or exceeds $10.00” will be adjusted (to the nearest cent) to be equal to 100% and 180% of the higher of the Market Value and the Newly Issued Price, respectively.\\n16\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A Ordinary Shares issuable upon exercise of the Private Placement Warrants will not be transferable, assignable or sellable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants will be non-redeemable so long as they are held by the initial purchaser or such purchaser’s permitted transferees. If the Private Placement Warrants are held by someone other than the Initial Shareholder or its permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 18.00\\nOnce the warrants become exercisable, the Company may call the outstanding warrants (excluding the Private Placement Warrants), in whole and not in part, at a price of $ 0.01 per warrant:\\n\\n| ● | upon a minimum of 30 days’ prior written notice of redemption; and |\\n\\n\\n| ● | if, and only if, the last reported sale price of the Class A Ordinary Shares equals or exceeds $ 18.00 per share (as adjusted) for any 20 trading days within a 30 trading day period ending three business days before the Company sends the notice of redemption to the warrant holders (the “Reference Value”). |\\n\\nThe Company will not redeem the warrants as described above unless a registration statement under the Securities Act covering the Class A Ordinary Shares issuable upon exercise of the warrants is then effective and a current prospectus relating to those Class A Ordinary Shares is available throughout the 30-trading day redemption period.\\nRedemption of Warrants When the Price per Class A Ordinary Share Equals or Exceeds $ 10.00\\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants, in whole and not in part, at a price of $ 0.10 per warrant:\\n\\n| ● | upon a minimum of 30 days’ prior written notice of redemption provided that holders will be able to exercise their warrants on a cashless basis prior to redemption and receive that number of Class A Ordinary Shares to be determined by reference to an agreed table based on the redemption date and the “fair market value” of Class A Ordinary Shares; and |\\n\\n\\n| ● | if, and only if, and only if, the Reference Value equals or exceeds $ 10.00 per Public Share (as adjusted), and |\\n\\n\\n| ● | if the Reference Value is less than $ 18.00 per share (as adjusted), the Private Placement Warrants must also be concurrently called for redemption on the same terms as the outstanding Public Warrants, as described above. |\\n\\nThe “fair market value” of Class A Ordinary Shares for the above purpose shall mean the volume-weighted average price of the Class A Ordinary Shares for the 10 trading days immediately following the date on which the notice of redemption is sent to the holders of warrants. In no event will the warrants be exercisable in connection with this redemption feature for more than 0.361 Class A Ordinary Shares per warrant (subject to adjustment).\\nIn no event will the Company be required to net cash settle any warrant. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\\n17\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 8 - Class A Ordinary Shares Subject to Possible Redemption\\nThe Class A ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to the occurrence of future events. The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.001 per share. Holders of the Class A ordinary shares are entitled to one vote for each share. In connection with such shareholders’ meeting, shareholders holding 20,451,847 Class A ordinary shares exercised their right to redeem those shares for cash at an approximate price of $ 10.20 per share for an aggregate of approximately $ 208.5 million. As of June 30, 2023 and December 31, 2022, there were 2,548,153 and 23,000,000 Class A Ordinary Shares outstanding, respectively, which were all subject to possible redemption and are classified outside of permanent equity in the accompanying condensed balance sheets.\\nThe Class A Ordinary Shares subject to possible redemption reflected on the accompanying condensed balance sheets are reconciled on the following table:\\n\\n| Gross proceeds received from Initial Public Offering | $ | 230,000,000 |\\n| Less: |\\n| Fair value of Public Warrants at issuance | ( 6,823,334 | ) |\\n| Offering costs allocated to Class A ordinary shares | ( 12,685,596 | ) |\\n| Plus: |\\n| Accretion on Class A ordinary shares subject to possible redemption | 19,508,930 |\\n| Class A ordinary shares subject to possible redemption as of December 31, 2021 | 230,000,000 |\\n| Plus: |\\n| Waiver of Class A ordinary shares issuance costs | 5,077,217 |\\n| Less: |\\n| Accretion on Class A ordinary shares subject to possible redemption | ( 1,872,702 | ) |\\n| Class A ordinary shares subject to possible redemption as of December 31, 2022 | 233,204,515 |\\n| Less: |\\n| Redemptions | ( 208,524,538 | ) |\\n| Plus: |\\n| Accretion on Class A ordinary shares subject to possible redemption | 1,560,982 |\\n| Class A ordinary shares subject to possible redemption as of March 31, 2023 | 26,240,959 |\\n| Plus: |\\n| Accretion on Class A ordinary shares subject to possible redemption | 390,284 |\\n| Class A ordinary shares subject to possible redemption as of June 30, 2023 | $ | 26,631,243 |\\n\\nNote 9 - Shareholders’ Deficit\\nClass A Ordinary Shares\\nThe Company is authorized to issue 200,000,000 Class A Ordinary Shares with a par value of $ 0.001 per share. Holders of the Class A Ordinary Shares are entitled to one vote for each share. As of June 30, 2023 and December 31, 2022, there were 6,250,000 and 0 Class A Ordinary Shares issued and outstanding, excluding 2,548,153 and 23,000,000 which were subject to possible redemption and included as temporary equity, respectively (see Note 8).\\nClass B Ordinary Shares\\nThe Company is authorized to issue 10,000,000 Class B Ordinary Shares with a par value of $ 0.001 per share. As of June 30, 2023 and December 31, 2022, there were 0 and 6,250,000 Class B Ordinary Shares issued and outstanding, respectively.\\nOrdinary shareholders of record are entitled to one vote for each share held on all matters to be voted on by shareholders. Except as described below, holders of Class A ordinary shares and holders of Class B ordinary shares vote together as a single class on all matters submitted to a vote of the shareholders except as required by law.\\nThe Class B ordinary shares will automatically convert into Class A ordinary shares at the time of the initial Business Combination or earlier at the option of the holders thereof at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as-converted basis, 20 % of the sum of (i) the total number of the Ordinary Shares issued and outstanding upon completion of the Initial Public Offering, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued by the Company in connection with or in relation to the completion of the initial Business Combination (including the Forward Purchase Shares, but not the Forward Purchase Warrants), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Warrants issued to the Sponsor or any of its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\\n18\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nNote 10 - Fair Value Measurements\\nThe following tables present information about the Company’s assets and liabilities that are measured at fair value on a recurring basis as of June 30, 2023 and December 31, 2022 and indicates the fair value hierarchy of the valuation techniques that the Company utilized to determine such fair value.\\n\\n| Fair Value Measured as of June 30, 2023 |\\n| Level 1 | Level 2 | Level 3 |\\n| Liabilities: |\\n| Derivative liabilities - Public Warrants | $ | — | $ | 514,433 | $ | — |\\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 295,240 | $ | — |\\n\\n\\n| Fair Value Measured as of December 31, 2022 |\\n| Level 1 | Level 2 | Level 3 |\\n| Assets |\\n| Investments held in Trust Account - U.S. Treasury Securities | $ | 233,304,515 | $ | — | $ | — |\\n| Liabilities: |\\n| Derivative liabilities - Public Warrants | $ | — | $ | 19,167 | $ | — |\\n| Derivative liabilities - Private Placement Warrants | $ | — | $ | 11,000 | $ | — |\\n\\nTransfers to/from Levels 1, 2, and 3 are recognized in the beginning of the reporting period. The estimated fair value of the Public Warrants was transferred from a Level 3 measurement to a Level 1 fair value measurement in April 2021, when the Public Warrants were separately listed and traded. The estimated fair value of the Private Placement Warrants was transferred from a Level 3 measurement to a Level 2 fair value measurement during the year ended December 31, 2021. The estimated fair value of the Public Warrants transferred to a Level 2 measurement during the quarter ending December 31, 2022 due to low trading volume. There were no transfers to/from Levels 1, 2, and 3 during the three and six months ended June 30, 2023.\\nLevel 1 assets include investments in mutual funds that invest solely in U.S. government securities. The Company uses inputs such as actual trade data, quoted market prices from dealers or brokers, and other similar sources to determine the fair value of its investments.\\nThe fair value of the Public Warrants was initially measured using a Monte-Carlo simulation and has subsequently been measured based on the market price of such warrants at each measurement date when separately listed and traded. The fair value of the Private Placement Warrants was initially measured using a Black-Scholes Option Pricing Model and subsequently using the market value of the Public Warrants. For the three months ended June 30, 2023 and 2022, the Company recognized a decrease/(increase) in the fair value of derivative warrant liabilities of approximately $( 538,000 ) and $ 845,000 , and approximately $( 780,000 ) and $ 5.1 million for the six months ended June 30, 2023 and 2022, respectively, presented on the accompanying condensed statements of operations.\\nThe Company utilized John C. Hull’s Options, Futures, and Other Derivatives model to estimate the fair value of the Forward Purchase Units at each measurement date up until September 30, 2023. As the Company does not intend to implement the forward purchase agreement, the Company determined the fair value of the Forward Purchase Units as of June 30, 2023 and December 31, 2022 was deminimis. There was no change in fair value of the Forward Purchase Units for the three and six months ended June 30, 2023. The Company recognized expense in the change in fair value of the Forward Purchase Units of approximately $ 19,000 and $ 49,000 for the three and six months ended June 30, 2022, respectively.\\n19\\nQUADRO ACQUISITION ONE CORP.\\nNOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\\nThe change in the fair value of the Level 3 derivative warrant liabilities for three and six months ended March 31, 2022 is summarized as follows:\\n\\n| Derivative assets (liabilities) as of January 1, 2022 | $ | 88,970 |\\n| Change in fair value of derivative assets and liabilities | 30,204 |\\n| Derivative assets (liabilities) as of March 31, 2022 | 119,174 |\\n| Change in fair value of derivative assets and liabilities | 18,877 |\\n| Derivative assets (liabilities) as of June 30, 2022 | $ | 138,051 |\\n\\nNote 11 - Subsequent Events\\nManagement has evaluated subsequent events to determine if events or transactions occurring after the balance sheet date through the date the accompanying unaudited condensed financial statements were issued. Based upon this review, the Company did not, other than the below, identify any subsequent event that would have required adjustment or disclosure in the accompanying unaudited condensed financial statements.\\nOn July 11, 2023 and August 7, 2023, pursuant to the Extension, as described in Note 1, the Sponsor or its designees contributed to the Company as a loan an additional contribution of $ 30,000 and $ 60,000 , respectively, into the trust to extend the date of which it has to consummate an initial business combination to August 22, 2023.\\n20\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\\nReferences to the “Company,” “Quadro Acquisition One Corp.,” “our,” “us” or “we” refer to Quadro Acquisition One Corp. (formerly known as Kismet Acquisition Two Corp.). The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto under “Item 1. Financial Statements”. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\\nCautionary Note Regarding Forward-Looking Statements\\nAll statements other than statements of historical fact included in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2023 (this “Report”) including, without limitation, statements under this “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. When used in this Report, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or our management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph.\\nOverview\\nWe are a blank check company incorporated as a Cayman Islands exempted company on September 15, 2020. We were incorporated for the purpose of engaging in an initial business combination with one or more businesses. We are an emerging growth company and, as such, we are subject to all of the risks associated with emerging growth companies.\\nOur sponsor is Quadro Sponsor LLC, a Delaware limited liability company. The registration statement for our initial public offering was declared effective on February 17, 2021. On February 22, 2021, we consummated our initial public offering of 23,000,000 units, including 3,000,000 additional units to cover the underwriters’ over-allotment option, at $10.00 per unit, generating gross proceeds of $230.0 million, and incurring offering costs of approximately $13.1 million, of which approximately $8.1 million was for deferred underwriting commissions.\\nSimultaneously with the closing of our initial public offering, we consummated the private placement of 4,400,000 warrants, at a price of $1.50 per private placement warrant, to our prior sponsor, generating gross proceeds of $6.6 million, and incurring offering costs of approximately $7,000.\\nUpon the closing of the initial public offering and the private placement, $230.0 million ($10.00 per unit) of the net proceeds of the initial public offering and a portion of the proceeds of the private placement were placed in a trust account, with Continental acting as trustee, and invested in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act, which invest only in direct U.S. government treasury obligations, as determined by us, until the earlier of: (i) the completion of a business combination and (ii) the distribution of the trust account as described below.\\nOn February 10, 2023, we instructed Continental to liquidate the investments held in the trust account and instead to hold the funds in the trust account in an interest-bearing demand deposit account at Morgan Stanley, with Continental continuing to act as trustee, until the earlier of the consummation of our initial business combination or our liquidation. As a result, following the liquidation of investments in the trust account, the remaining proceeds from the initial public offering and private placement are no longer invested in U.S. government securities or money market funds.\\nOur management has broad discretion with respect to the specific application of the net proceeds of our initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied generally toward consummating a business combination. Our initial business combination must be with one or more operating businesses or assets with a fair market value equal to at least 80% of the net assets held in the trust account (excluding the deferred underwriting commissions and taxes payable, if any, on the income accrued on the trust account) at the time we sign a definitive agreement in connection with the initial business combination. However, we will only complete a business combination if the post-transaction company owns or acquires 50% or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act.\\nIf we are unable to complete a business combination by the Termination Date, we will (i) cease all operations except for the purpose of winding up; (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned on the funds held in the trust account and not previously released to us to pay our taxes that were paid by us or are payable by us, if any (less up to $100,000 of interest to pay dissolution expenses), divided by the number of the then-outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any); and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law.\\n21\\nRecent Developments\\nOn January 31, 2023, we issued an aggregate of 6,250,000 Class A ordinary shares to the sponsor, upon the conversion of an equal number of Class B ordinary shares held by the sponsor in the Founder Conversion. The 6,250,000 Class A ordinary shares issued in connection with the Founder Conversion are subject to the same restrictions as applied to the Class B ordinary shares before the Founder Conversion, including, among others, certain transfer restrictions, waiver of redemption rights and the obligation to vote in favor of an initial business combination as described in the prospectus for the initial public offering.\\nOn February 20, 2023, we held the 2023 Extraordinary General Meeting at which our shareholders approved an amendment to our amended and restated memorandum and articles of association to extend the date by which we must consummate an initial business combination to April 22, 2023, and to allow our board, without another shareholder vote, to extend the Termination Date on a monthly basis up to seven times for an additional one month each time until November 22, 2023, or a total of up to nine months after the Original Termination Date (the “Extension”). In connection with the vote to approve the Extension Amendment, the holders of 20,451,847 Class A ordinary shares properly exercised their right to redeem their shares for cash at a redemption price of approximately $10.20 per share, for an aggregate redemption amount of approximately $208,524,538, in connection with the Extension Amendment.\\nIn connection with the Extension, our sponsor or its designees contributed to us as a loan the initial contribution of $120,000 (the “Initial Extension Loan”) in February 2023 for the portion of the Extension ending on April 22, 2023. Our sponsor will also loan us extension contributions of $60,000 per month for each subsequent calendar month (commencing on April 22, 2023 and on the 22nd day of each subsequent month) until November 22, 2023, or portion thereof, that is needed to complete an initial business combination, which amount will be deposited into the trust account (together with the Initial Extension Loan, the “Extension Loans”). The amount of the Extension Loans will not bear interest and will be repayable by us to the sponsor or its designees upon consummation of an initial business combination. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the Extension Loans, but no proceeds held in the trust account would be used to repay the Extension Loans.\\nFollowing the Founder Conversion and the redemptions in connection with the Extension, there were 8,798,153 Class A ordinary shares issued and outstanding and no Class B Ordinary Shares issued and outstanding.\\nAt the 2023 Extraordinary General Meeting, our shareholders also approved our company’s name change from Kismet Acquisition Two Corp. to Quadro Acquisition One Corp. to better reflect the Sponsor Transaction.\\nOn March 27, 2023, our board of directors elected Konstantin Tourevski as a director and as a member of the audit committee to fill the vacancy caused by the resignation of Verdi Israelyan.\\nLiquidity and Capital Resources\\nAs of June 30, 2023, we had $0 in our operating bank account and working capital deficit of approximately $1.4 million.\\nOur liquidity needs to date have been satisfied through a contribution of $25,000 from the prior sponsor to cover certain expenses in exchange for the issuance of the founder shares, a loan of approximately $111,000 from the prior sponsor pursuant to the First Note originally issued on September 23, 2020 and amended on January 22, 2021, and a portion of the proceeds from the consummation of the private placement not held in the trust account. We repaid the First Note in full on February 24, 2021. Subsequent to the repayment, the facility was no longer available to us. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, provide us working capital loans in order to finance transaction costs in connection with a business combination. As of June 30, 2023 and December 31, 2022, there were no amounts outstanding under any working capital loans.\\n22\\nOn April 13, 2022, we issued the Second Note, a promissory note in the amount of up to $200,000 to the prior sponsor. On May 25, 2022, we and the prior sponsor amended and restated the Second Note and increased the principal amount to $400,000. The promissory note bears no interest and is due and payable within one year from the date of the first drawdown of the amended and restated note, or June 7, 2023. On June 30, 2022, the prior sponsor assigned all of its rights and obligations under the promissory note to our sponsor in connection with the Sponsor Transaction. As of June 30, 2023, we have fully drawn $400,000 under the Promissory Note. As of June 30, 2023 and December 31, 2022, approximately $400,000 and $319,000 were outstanding under the Promissory Note, respectively.\\nWe may need to raise additional capital through loans or additional investments from our sponsor, our officers or directors or their affiliates. Our sponsor, officers, directors and or their affiliates, may, but are not obligated to, loan our company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, reducing overhead expenses, and extending the terms and due dates of certain accrued expenses and other liabilities. We cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all. In connection with our assessment of going concern considerations in accordance with ASC Topic 205-40, “Presentation of Financial Statements – Going Concern,” we have determined that the liquidity condition, mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. Management continues to seek to complete a business combination prior to the mandatory liquidation date. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate by November 22, 2023.\\nContractual Obligations\\nAdministrative Services Agreement\\nWe do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, except that, commencing on February 17, 2021, through the earlier of consummation of the initial business combination and the liquidation, we agreed to pay Kismet LLC, an affiliate of our prior sponsor, $10,000 per month for office space, utilities, secretarial support and administrative services.\\nOn June 30, 2022, in connection with the Sponsor Transaction, the Company and Kismet LLC mutually terminated the Administrative Services Agreement. As a result, the Company is no longer obligated to pay a $10,000 monthly fee pursuant to the Administrative Services Agreement.\\nResults of Operations\\nOur entire activity since inception up to June 30, 2023, was in preparation for our formation and our initial public offering, and since the completion of our initial public offering, the search for business combination candidates. We will not be generating any operating revenues until the closing and completion of our initial business combination at the earliest.\\nFor the three months ended June 30, 2023, we had net loss of approximately $458,000, which consisted of a non-operating loss of approximately $538,000 resulting from the change in fair value of derivative assets and liabilities and approximately $160,000 general and administrative expenses, partially offset by approximately $240,000 of income from investments held in trust account.\\nFor the three months ended June 30, 2022, we had net income of approximately $1.0 million, which consisted of a non-operating gain of approximately $864,000 resulting from the change in fair value of derivative assets and liabilities and approximately $292,000 of net gain on the investments held in the Trust Account, partially offset by approximately $107,000 general and administrative expenses.\\nFor the six months ended June 30, 2023, we had net income of approximately $152,000, which consisted of approximately $1.7 million of income from investments held in trust account, partially offset by a non-operating loss of approximately $780,000 resulting from the change in fair value of derivative assets and liabilities and approximately $750,000 general and administrative expenses.\\nFor the six months ended June 30, 2022, we had net income of approximately $5.1 million, which consisted of a non-operating gain of approximately $5.1 million resulting from the change in fair value of derivative assets and liabilities and approximately $313,000 of net gain on the investments held in the Trust Account, partially offset by approximately $300,000 general and administrative expenses.\\n23\\nCommitments and Contingencies\\nRegistration Rights\\nThe holders of the founder shares, private placement warrants, and warrants that may be issued upon conversion of working capital loans (and any Class A ordinary shares issuable upon the exercise of the private placement warrants and warrants that may be issued upon conversion of working capital loans) are entitled to registration rights pursuant to a registration rights agreement dated February 17, 2021. The holders of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of the initial business combination. We will bear the expenses incurred in connection with the filing of any such registration statements.\\nPursuant to the forward purchase agreement (described below), we agreed to use our commercially reasonable efforts (i) to file within 30 days after the closing of the initial business combination a registration statement with the SEC for a secondary offering of the forward purchase shares and the forward purchase warrants (and underlying Class A ordinary shares), (ii) to cause such registration statement to be declared effective promptly thereafter but in no event later than sixty (60) days after the initial filing, and (iii) to maintain the effectiveness of such registration statement until the earliest of (A) the date on which our sponsor or its assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the forward purchase agreement provides for “piggy-back” registration rights to the holders of forward purchase securities to include their securities in other registration statements filed by us.\\nForward Purchase Agreement\\nIn connection with the consummation of our initial public offering, we entered into a forward purchase agreement with our prior sponsor, which provides for the purchase of $20.0 million of forward purchase units, which at the option of our prior sponsor can be increased to $50.0 million, with each forward purchase unit consisting of one Class A ordinary share and one-third of one warrant to purchase one Class A ordinary share at $11.50 per share, for a purchase price of $10.00 per forward purchase unit, in a private placement to occur concurrently with the closing of the initial business combination. The purchase under the forward purchase agreement is required to be made regardless of whether any Class A ordinary shares are redeemed by the public shareholders. The forward purchase securities will be issued only in connection with the closing of the initial business combination. The proceeds from the sale of forward purchase securities may be used as part of the consideration to the sellers in the initial business combination, expenses in connection with the initial business combination or for working capital in the post-transaction company. We do not intend to implement the forward purchase agreement, and on April 17, 2023, we sent a notice of mutual termination of the forward purchase agreement to the prior sponsor.\\nUnderwriting Agreement\\nWe granted the underwriters a 45-day option from February 17, 2021, to purchase up to 3,000,000 additional units at our initial public offering price less the underwriting discounts and commissions. On February 22, 2021, the underwriters fully exercised their over-allotment option.\\nThe underwriters were entitled to an underwriting discount of $0.20 per unit, or approximately $4.6 million in the aggregate, paid upon the closing of our initial public offering. In addition, $0.35 per unit, or approximately $8.1 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. The deferred fee will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete an initial business combination, subject to the terms of the underwriting agreement.\\nOn August 11, 2022 and September 6, 2022, two of the underwriters in the initial public offering irrevocably waived their rights to receive an aggregate of approximately $5.2 million of deferred underwriting discounts due under the underwriting agreements consummated in connection with the initial public offering. We recognized the portion allocated to Public Shares of approximately $5.0 million as an adjustment to the carrying value of the Class A ordinary shares subject to possible redemption and the remaining balance of approximately $0.2 million as a gain from extinguishment of deferred underwriting commissions allocated to derivative warrant liabilities.\\n24\\nCritical Accounting Policies and Estimates\\nDerivative Assets and Liabilities\\nWe do not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. We evaluate all of our financial instruments, including issued stock purchase warrants, to determine if such instruments are derivatives or contain features that qualify as embedded derivatives, pursuant to ASC Topic 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and ASC Topic 815-15, “Derivatives and Hedging”. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period.\\nWe account for our public warrants, private placement warrants and forward purchase units as derivative assets/liabilities in accordance with ASC 815-40, “Derivatives and Hedging”. Accordingly, we recognize the warrants and forward purchase units as assets/liabilities at fair value and adjust the instruments to fair value at each reporting period. The liabilities are subject to re-measurement at each balance sheet date until exercised, and any change in fair value of derivative assets and liabilities is recognized in our statements of operations. The fair value of our public warrants was initially measured using Monte-Carlo simulation and subsequently been measured on the market price of such warrants when separately listed and traded at each measurement date. The fair value of the private placement warrants was initially measured using Black-Scholes Option Pricing Model and subsequently using the market value of the public warrants. The fair value of the forward purchase units has been measured using the John C Hull’s Options, Futures and Other Derivatives model at each measurement date.\\nClass A Ordinary Shares Subject to Possible Redemption\\nWe account for the Class A ordinary shares subject to possible redemption in accordance with the guidance in ASC 480. Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, as of June 30, 2023 and December 31, 2022, 2,548,153 and 23,000,000 Class A Ordinary Shares subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ deficit section of the condensed balance sheets under “Item 1. Financial Statements”.\\nWe recognize changes in redemption value immediately as they occur and adjust the carrying value of the Class A ordinary shares subject to possible redemption to equal the redemption value at the end of each reporting period. Effective with the closing of the initial public offering, we recognized the accretion from initial book value to redemption amount, which resulted in charges against additional paid-in capital (to the extent available) and accumulated deficit.\\nNet (Loss) Income per Ordinary Share\\nWe comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” We have two classes of shares, Class A ordinary shares and Class B ordinary shares. Income and losses are shared pro rata between the two classes of shares. Net (loss) income per ordinary share is calculated by dividing the net (loss) income by the weighted average number of ordinary shares outstanding for the respective period.\\nThe calculation of diluted net (loss) income per ordinary share does not consider the effect of the warrants issued in connection with our initial public offering and the private placement to purchase an aggregate of 12,066,667 Class A ordinary shares because their exercise is contingent upon future events. Accretion associated with the redeemable Class A ordinary shares is excluded from (losses) earnings per share as the redemption value approximates fair value.\\n25\\nShare-Based Compensation\\nWe comply with the accounting and disclosure requirement of ASC Topic 718, “Compensation - Stock Compensation.” We record share-based compensation to employees and non-employees over the requisite service period based on the estimated grant-date fair value of the awards. Share-based awards with graded-vesting schedules are recognized on a straight-line basis over the requisite service period for each separately vesting portion of the award. We recognize the expense for share-based compensation awards subject to performance-based milestone vesting over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the expected satisfaction of the performance conditions at each reporting date. Share-based compensation will be recognized in general and administrative expense in the statements of operations. We issued option awards that contain both a performance condition and service condition. The option awards vest upon the consummation of the initial business combination and will expire in five years after the date on which they first become exercisable. We have determined that the consummation of an initial business combination is a performance condition subject to significant uncertainty. As such, the achievement of the performance is not deemed to be probable of achievement until the consummation of the event, and therefore no compensation has been recognized for the period from inception to June 30, 2023.\\nRecent Accounting Pronouncements\\nManagement does not believe that any recently issued, but not yet effective, accounting standards updates, if currently adopted, would have a material effect on the accompanying unaudited condensed financial statements.\\nOff-Balance Sheet Arrangements and Contractual Obligations\\nAs of June 30, 2023, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations.\\nJOBS Act\\nThe JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, the financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\\nAdditionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.\\nFactors That May Adversely Affect our Results of Operations\\nOur results of operations and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, downturns in the financial markets or in economic conditions, increases in oil prices, inflation, increases in interest rates, supply chain disruptions, declines in consumer confidence and spending, the ongoing effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict the likelihood of one or more of the above events, their duration or magnitude or the extent to which they may negatively impact our business and our ability to complete an initial business combination.\\n26\\n\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\\nWe are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act, and are not required to provide the information otherwise required under this item.\\n\\nItem 4. Controls and Procedures.\\nEvaluation of Disclosure Controls and Procedures\\nDisclosure controls and procedures are controls and other procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer (our “Certifying Officer”), to allow timely decisions regarding required disclosure.\\nAs of June 30, 2023, as required by Rules 13a-15 and 15d-15 under the Exchange Act, our principal executive officer and principal financial and accounting officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective because of a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. Specifically, the Company’s management has concluded that our control around the interpretation and accounting for extinguishment of a significant contingent obligation was not effectively designed or maintained. In light of this material weakness, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the unaudited condensed financial statements included in this Quarterly Report on Form 10-Q present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\\nWe do not expect that our disclosure controls and procedures will prevent all errors and all instances of fraud. Disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Further, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and the benefits must be considered relative to their costs. Because of the inherent limitations in all disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that we have detected all our control deficiencies and instances of fraud, if any. The design of disclosure controls and procedures also is based partly on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.\\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\\nChanges in Internal Control Over Financial Reporting\\nOther than the above, there have been no changes to our internal control over financial reporting during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n27\\nPART II - OTHER INFORMATION\\n\\nItem 1. Legal Proceedings.\\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\\n\\nItem 1A. Risk Factors.\\nAs a smaller reporting company under Rule 12b-2 of the Exchange Act, we are not required to include risk factors in this Report. However, as of the date of this Report, other than as set forth below, there have been no material changes with respect to those risk factors previously disclosed in our (i) Registration Statement, (ii) Annual Report on Form 10-K for the year ended December 31, 2021, as filed with the SEC on March 31, 2022, (iii) Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2021, June 30, 2021, September 30, 2021, March 31, 2022, June 30, 2022 and September 30, 2022, as filed with the SEC on June 25, 2021, August 13, 2021, November 22, 2021, May 9, 2022, August 15, 2022, and November 14, 2022, respectively, (iv) Definitive Proxy Statement on Schedule 14A, as filed with the SEC on January 31, 2023, and (v) our 2022 Annual Report. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risks could arise that may also affect our business or ability to consummate an initial Business Combination. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the investments held in the Trust Account and instead to hold the funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original Trust Account investments, which could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\\nThe funds in the Trust Account had, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we have instructed the trustee, on February 10, 2023, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley until the earlier of the consummation of our initial Business Combination or the liquidation of the Company. Following such liquidation, we may receive less interest on the funds held in the Trust Account than the interest we would have received pursuant to our original trust account investments. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any, and certain other expenses as permitted. As a result, our decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in an interest bearing demand deposit account at Morgan Stanley could reduce the dollar amount our public shareholders would receive upon any redemption or liquidation of the Company.\\nMarket conditions, economic uncertainty or downturns could adversely affect our business, financial condition, operating results and our ability to consummate a Business Combination.\\nIn recent years, the United States and other markets have experienced cyclical or episodic downturns, and worldwide economic conditions remain uncertain, including as a result of the COVID-19 pandemic, supply chain disruptions, the Ukraine-Russia conflict, instability in the U.S. and global banking systems, rising fuel prices, increasing interest rates or foreign exchange rates and high inflation and the possibility of a recession. A significant downturn in economic conditions may make it more difficult for us to consummate a Business Combination.\\n28\\nWe cannot predict the timing, strength, or duration of any future economic slowdown or any subsequent recovery generally, or in any industry. If the conditions in the general economy and the markets in which we operate worsen from present levels, our business, financial condition, operating results and our ability to consummate a Business Combination could be adversely affected. For example, in January 2023, the outstanding national debt of the U.S. government reached its statutory limit. The U.S. Department of the Treasury (the “Treasury Department”) has announced that, since then, it has been using extraordinary measures to prevent the U.S. government’s default on its payment obligations, and to extend the time that the U.S. government has to raise its statutory debt limit or otherwise resolve its funding situation. The failure by Congress to raise the federal debt ceiling could have severe repercussions within the U.S. and to global credit and financial markets. If Congress does not raise the debt ceiling, the U.S. government could default on its payment obligations, or experience delays in making payments when due. A payment default or delay by the U.S. government, or continued uncertainty surrounding the U.S. debt ceiling, could result in a variety of adverse effects for financial markets, market participants and U.S. and global economic conditions. In addition, U.S. debt ceiling and budget deficit concerns have increased the possibility a downgrade in the credit rating of the U.S. government and could result in economic slowdowns or a recession in the U.S. Although U.S. lawmakers have passed legislation to raise the federal debt ceiling on multiple occasions, ratings agencies have lowered or threatened to lower the long-term sovereign credit rating on the United States as a result of disputes over the debt ceiling. The impact of a potential downgrade to the U.S. government’s sovereign credit rating or its perceived creditworthiness could adversely affect economic conditions, as well as our business, financial condition, operating results and our ability to consummate a Business Combination.\\nIf our initial Business Combination involves a company organized under the laws of a state of the United States, it is possible a 1% U.S. federal excise tax will be imposed on us in connection with redemptions of our common stock after or in connection with such initial Business Combination.\\nOn August 16, 2022, the Inflation Reduction Act of 2022 became law in the United States, which, among other things, imposes a 1% excise tax on the fair market value of certain repurchases (including certain redemptions) of stock by publicly traded domestic (i.e., United States) corporations (and certain non-U.S. corporations treated as “surrogate foreign corporations”). The excise tax will apply to stock repurchases occurring in 2023 and beyond. The amount of the excise tax is generally 1% of the fair market value of the shares of stock repurchased at the time of the repurchase. The Treasury Department has been given authority to provide regulations and other guidance to carry out, and prevent the abuse or avoidance of, the excise tax; however, only limited guidance has been issued to date.\\nAs an entity incorporated as a Cayman Islands exempted company, the 1% excise tax is not expected to apply to redemptions of our Class A ordinary shares (absent any regulations and other additional guidance that may be issued in the future with retroactive effect).\\nHowever, in connection with an initial Business Combination involving a company organized under the laws of the United States, it is possible that we domesticate and continue as a Delaware corporation prior to certain redemptions and, because our securities are trading on the Nasdaq Capital Market, it is possible that we will be subject to the excise tax with respect to any subsequent redemptions, including redemptions in connection with the initial Business Combination, that are treated as repurchases for this purpose (other than, pursuant to recently issued guidance from the Treasury Department, redemptions in complete liquidation of the company). In all cases, the extent of the excise tax that may be incurred will depend on a number of factors, including the fair market value of our stock redeemed, the extent such redemptions could be treated as dividends and not repurchases, and the content of any regulations and other additional guidance from the Treasury Department that may be issued and applicable to the redemptions. Issuances of stock by a repurchasing corporation in a year in which such corporation repurchases stock may reduce the amount of excise tax imposed with respect to such repurchase. The excise tax is imposed on the repurchasing corporation itself, not the stockholders from which stock is repurchased. The imposition of the excise tax as a result of redemptions in connection with the initial Business Combination could, however, reduce the amount of cash available to pay redemptions or reduce the cash contribution to the target business in connection with our initial Business Combination, which could cause the other shareholders of the combined company to economically bear the impact of such excise tax.\\n29\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNone. For a description of the use of proceeds generated in our Initial Public Offering and the Private Placement, see Part II, Item 2 of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, as filed with the SEC on June 25, 2021. There has been no material change in the planned use of the proceeds from our Initial Public Offering and the Private Placement as described in the Registration Statement.\\n\\nItem 3. Defaults Upon Senior Securities.\\nNone.\\n\\nItem 4. Mine Safety Disclosures\\nNot applicable.\\n\\nItem 5. Other Information.\\nNone.\\n\\nItem 6. Exhibits\\nThe following exhibits are filed as part of, or incorporated by reference into, this Report.\\n\\n| Exhibit Number | Description of Exhibit |\\n| 31.1 | Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\\n| 31.2 | Certification of the Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\\n| 32.1 | Certification of the Principal Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\\n| 32.2 | Certification of the Principal Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |\\n| 101.INS | Inline XBRL Instance Document.* |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document.* |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document.* |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document.* |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document.* |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document.* |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101).* |\\n\\n\\n| * | Filed herewith. |\\n\\n\\n| ** | Furnished herewith. |\\n\\n30\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| Dated: August 14, 2023 | QUADRO ACQUISITION ONE CORP. |\\n| By: | /s/ Dimitri Elkin |\\n| Name: | Dimitri Elkin |\\n| Title: | Chief Executive Officer |\\n\\n31\\n\\n</text>\\n\\nWhat is the total amount of loans that the company borrowed and to be repaid by June 30, 2023, including the IPO Note, Working Capital Loans, Promissory Note, Extension Loan, and Related Party Advance in dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 969722.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 38,\n \"input_length\": 30349\n}"}}},{"rowIdx":39,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nPART I. FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nEV Energy Partners, L.P.\nCondensed Consolidated Balance Sheets\n(In thousands, except number of units)\n(Unaudited)\n\n| June 30, | December 31, |\n| 2011 | 2010 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 26,392 | $ | 23,127 |\n| Accounts receivable: |\n| Oil, natural gas and natural gas liquids revenues | 36,600 | 27,742 |\n| Related party | 3,967 | – |\n| Other | 300 | 441 |\n| Derivative asset | 51,215 | 55,100 |\n| Assets held for sale | 11,402 | – |\n| Other current assets | 1,047 | 1,158 |\n| Total current assets | 130,923 | 107,568 |\n| Oil and natural gas properties, net of accumulated depreciation, depletion and amortization; June 30, 2011, $210,073; December 31, 2010, $176,897 | 1,300,294 | 1,324,240 |\n| Other property, net of accumulated depreciation and amortization; June 30, 2011, $536; December 31, 2010, $465 | 1,495 | 1,567 |\n| Long–term derivative asset | 26,576 | 51,497 |\n| Other assets | 7,533 | 1,885 |\n| Total assets | $ | 1,466,821 | $ | 1,486,757 |\n| LIABILITIES AND OWNERS’ EQUITY |\n| Current liabilities: |\n| Accounts payable and accrued liabilities: |\n| Third party | $ | 27,642 | $ | 20,678 |\n| Related party | – | 182 |\n| Liabilities related to assets held for sale | 2,895 | – |\n| Derivative liability | 1,178 | 1,943 |\n| Total current liabilities | 31,715 | 22,803 |\n| Asset retirement obligations | 68,266 | 67,175 |\n| Long–term debt | 480,183 | 619,000 |\n| Long–term liabilities | 988 | 3,048 |\n| Long–term derivative liability | 6,594 | 784 |\n| Commitments and contingencies |\n| Owners’ equity: |\n| Common unitholders – 34,173,650 units and 30,510,313 units issued and outstanding as of June 30, 2011 and December 31, 2010, respectively | 887,843 | 779,327 |\n| General partner interest | (8,768 | ) | (5,380 | ) |\n| Total owners’ equity | 879,075 | 773,947 |\n| Total liabilities and owners’ equity | $ | 1,466,821 | $ | 1,486,757 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n2\nEV Energy Partners, L.P.\nCondensed Consolidated Statements of Operations\n(In thousands, except per unit data)\n(Unaudited)\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Revenues: |\n| Oil, natural gas and natural gas liquids revenues | $ | 68,109 | $ | 39,431 | $ | 127,730 | $ | 78,027 |\n| Transportation and marketing–related revenues | 1,484 | 1,476 | 2,885 | 3,054 |\n| Total revenues | 69,593 | 40,907 | 130,615 | 81,081 |\n| Operating costs and expenses: |\n| Lease operating expenses | 17,949 | 14,869 | 35,311 | 26,301 |\n| Cost of purchased natural gas | 1,120 | 1,095 | 2,170 | 2,315 |\n| Dry hole and exploration costs | 441 | – | 844 | – |\n| Production taxes | 3,119 | 1,673 | 5,770 | 3,800 |\n| Asset retirement obligations accretion expense | 970 | 764 | 1,936 | 1,274 |\n| Depreciation, depletion and amortization | 18,443 | 13,436 | 36,007 | 25,520 |\n| General and administrative expenses | 7,132 | 5,825 | 15,725 | 10,549 |\n| Impairment of oil and natural gas properties | 5,078 | – | 6,666 | – |\n| Gain on sale of oil and natural gas properties | – | (4,388 | ) | – | (3,824 | ) |\n| Total operating costs and expenses | 54,252 | 33,274 | 104,429 | 65,935 |\n| Operating income | 15,341 | 7,633 | 26,186 | 15,146 |\n| Other income (expense), net: |\n| Realized gains on derivatives, net | 14,242 | 13,901 | 27,784 | 21,866 |\n| Unrealized gains (losses) on derivatives, net | 17,422 | (2,158 | ) | (35,633 | ) | 30,502 |\n| Interest expense | (8,124 | ) | (3,269 | ) | (13,283 | ) | (5,372 | ) |\n| Other income, net | 313 | 252 | 233 | 393 |\n| Total other income (expense), net | 23,853 | 8,726 | (20,899 | ) | 47,389 |\n| Income before income taxes | 39,194 | 16,359 | 5,287 | 62,535 |\n| Income taxes | (31 | ) | (79 | ) | (113 | ) | (131 | ) |\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\n| General partner’s interest in net income, including incentive distribution rights | $ | 3,728 | $ | 2,624 | $ | 5,982 | $ | 5,836 |\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | $ | 56,568 |\n| Net income (loss) per limited partner unit: |\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Weighted average limited partner units outstanding: |\n| Basic | 34,294 | 27,210 | 33,002 | 26,403 |\n| Diluted | 34,534 | 27,264 | 33,002 | 26,438 |\n| Distributions declared per unit | $ | 0.761 | $ | 0.757 | $ | 1.521 | $ | 1.513 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n3\nEV Energy Partners, L.P.\nCondensed Consolidated Statements of Changes in Owners’ Equity\n(In thousands, except number of units)\n(Unaudited)\n\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\n| Balance, December 31, 2010 | $ | 779,327 | $ | (5,380 | ) | $ | 773,947 |\n| Conversion of 80,534 vested phantom units | 3,508 | – | 3,508 |\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $308 | 146,800 | – | 146,800 |\n| Contributions from general partner | – | 3,191 | 3,191 |\n| Distributions | (49,291 | ) | (6,682 | ) | (55,973 | ) |\n| Equity–based compensation | 2,428 | – | 2,428 |\n| Net income | 5,071 | 103 | 5,174 |\n| Balance, June 30, 2011 | $ | 887,843 | $ | (8,768 | ) | $ | 879,075 |\n\n\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\n| Balance, December 31, 2009 | $ | 548,160 | $ | (729 | ) | $ | 547,431 |\n| Conversion of 84,842 vested phantom units | 2,580 | – | 2,580 |\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $154 | 92,616 | – | 92,616 |\n| Contributions from general partner | – | 1,977 | 1,977 |\n| Distributions | (38,284 | ) | (5,149 | ) | (43,433 | ) |\n| Equity–based compensation | 827 | – | 827 |\n| Net income | 61,156 | 1,248 | 62,404 |\n| Balance, June 30, 2010 | $ | 667,055 | $ | (2,653 | ) | $ | 664,402 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n4\nEV Energy Partners, L.P. Condensed Consolidated Statements of Cash Flows (In thousands) (Unaudited)\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Cash flows from operating activities: |\n| Net income | $ | 5,174 | $ | 62,404 |\n| Adjustments to reconcile net income to net cash flows provided by operating activities: |\n| Asset retirement obligations accretion expense | 1,936 | 1,274 |\n| Depreciation, depletion and amortization | 36,007 | 25,520 |\n| Equity–based compensation cost | 3,877 | 2,103 |\n| Impairment of oil and natural gas properties | 6,666 | – |\n| Gain on sale of oil and natural gas properties | – | (3,824 | ) |\n| Noncash derivative activity | 30,951 | (30,502 | ) |\n| Amortization of discount on long–term debt | 183 | – |\n| Amortization of deferred loan costs | 554 | 275 |\n| Other, net | 56 | (1 | ) |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | (12,866 | ) | (4,098 | ) |\n| Other current assets | 111 | 2,625 |\n| Accounts payable and accrued liabilities | 7,630 | 879 |\n| Long–term liabilities | – | (734 | ) |\n| Other, net | (149 | ) | (119 | ) |\n| Net cash flows provided by operating activities | 80,130 | 55,802 |\n| Cash flows from investing activities: |\n| Acquisition of oil and natural gas properties | 3,101 | (147,769 | ) |\n| Development of oil and natural gas properties | (33,686 | ) | (8,170 | ) |\n| Proceeds from sale of oil and natural gas properties | 1,170 | 4,471 |\n| Settlements from acquired derivatives | 2,834 | – |\n| Earnest money received for sale of oil and natural gas properties | 900 | – |\n| Net cash flows used in investing activities | (25,681 | ) | (151,468 | ) |\n| Cash flows from financing activities: |\n| Long–term debt borrowings | – | 138,000 |\n| Repayment of long–term debt borrowings | (431,500 | ) | (95,000 | ) |\n| Proceeds from debt offering | 292,500 | – |\n| Loan costs incurred | (6,202 | ) | (8 | ) |\n| Proceeds from public equity offering | 147,108 | 92,770 |\n| Offering costs | (308 | ) | (154 | ) |\n| Contributions from general partner | 3,191 | 1,977 |\n| Distributions paid | (55,973 | ) | (43,433 | ) |\n| Net cash flows (used in) provided by financing activities | (51,184 | ) | 94,152 |\n| Increase (decrease) in cash and cash equivalents | 3,265 | (1,514 | ) |\n| Cash and cash equivalents – beginning of period | 23,127 | 18,806 |\n| Cash and cash equivalents – end of period | $ | 26,392 | $ | 17,292 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n5\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements\nNOTE 1. ORGANIZATION AND NATURE OF BUSINESS\nNature of Operations\nEV Energy Partners, L.P. (“we,” “our” or “us”) is a publicly held limited partnership that engages in the acquisition, development and production of oil and natural gas properties. Our general partner is EV Energy GP, L.P. (“EV Energy GP”), a Delaware limited partnership, and the general partner of our general partner is EV Management, LLC (“EV Management”), a Delaware limited liability company. EV Management is a wholly owned subsidiary of EnerVest, Ltd. (“EnerVest”), a Texas limited partnership. EnerVest and its affiliates also have a significant interest in us through their 71.25% ownership of EV Energy GP which, in turn, owns a 2% general partner interest in us and all of our incentive distribution rights.\nBasis of Presentation\nOur unaudited condensed consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. We believe that the presentations and disclosures herein are adequate to make the information not misleading. The unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the interim periods. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. These interim financial statements should be read in conjunction with our Annual Report on Form 10–K for the year ended December 31, 2010.\nAll intercompany accounts and transactions have been eliminated in consolidation. In the Notes to Unaudited Condensed Consolidated Financial Statements, all dollar and unit amounts in tabulations are in thousands of dollars and units, respectively, unless otherwise indicated.\nNOTE 2. EQUITY–BASED COMPENSATION\nWe grant various forms of equity–based awards to employees, consultants and directors of EV Management and its affiliates who perform services for us. These equity–based awards consist primarily of phantom units and performance units.\nWe account for the phantom units issued prior to 2009 as liability awards, and the fair value of these phantom units is remeasured at the end of each reporting period based on the current market price of our common units until settlement. Prior to settlement, compensation cost is recognized for these phantom units based on the proportionate amount of the requisite service period that has been rendered to date. We account for the phantom units issued beginning in 2009 as equity awards, and we estimated the fair value of these phantom units using the Black–Scholes option pricing model. We account for the performance units as equity awards, and we estimated the fair value of these performance units using the Monte Carlo simulation model.\nThe following table presents the compensation costs recognized in our unaudited condensed consolidated statements of operations:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Liability awards | $ | 526 | $ | 608 | $ | 1,449 | $ | 1,276 |\n| Equity awards | 1,214 | 429 | 2,428 | 827 |\n| Total | $ | 1,740 | $ | 1,037 | $ | 3,877 | $ | 2,103 |\n\nThese costs are included in “General and administrative expenses” in our unaudited condensed consolidated statements of operations.\nIn January 2011, the performance criterion was achieved with respect to the remaining 0.1 million performance units.\n6\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nAs of June 30, 2011, total unrecognized compensation costs related to the unvested liability awards and equity awards and the period over which they are expected to be recognized are as follows:\n\n| Unrecognized Compensation Expense | Weighted Average Period (in years) |\n| Liability awards | $ | 3,355 | 1.5 |\n| Equity awards | 15,175 | 3.2 |\n\nNOTE 3. ACQUISITIONS\nIn April 2011, we received a final purchase price settlement of $1.9 million related to our acquisition of oil and natural gas properties in the Mid–Continent area in September 2010.\nIn June 2011, we received a final purchase price settlement of $2.2 million related to our acquisition of oil and natural gas properties in the Barnett Shale in December 2010.\nIn June 2011, we, along with certain institutional partnerships managed by EnerVest, acquired additional oil and natural gas properties in the Barnett Shale. We acquired a 31.02% proportional interest in these properties for $1.0 million.\nNOTE 4. RISK MANAGEMENT\nOur business activities expose us to risks associated with changes in the market price of oil, natural gas and natural gas liquids. In addition, our floating rate credit facility exposes us to risks associated with changes in interest rates. As such, future earnings are subject to fluctuation due to changes in the market prices of oil, natural gas and natural gas liquids and interest rates. We use derivatives to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids and interest rates. Our policies do not permit the use of derivatives for speculative purposes.\nWe have elected not to designate any of our derivatives as hedging instruments. Accordingly, changes in the fair value of our derivatives are recorded immediately to net income as “Unrealized gains (losses) on derivatives, net” in our unaudited condensed consolidated statements of operations.\nAs of June 30, 2011, we had entered into oil commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\n| Swaps – July 2011 through December 2011 | 209.4 | $ | 95.01 | $ | $ |\n| Collars – July 2011 through December 2011 | 236.6 | 105.66 | 156.16 |\n| Swaps –2012 | 625.7 | 96.45 |\n| Collars – 2012 | 456.8 | 104.54 | 156.77 |\n| Swaps –2013 | 994.5 | 86.46 |\n| Swaps – 2014 | 897.2 | 91.90 |\n\n7\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nAs of June 30, 2011, we had entered into natural gas commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MmmBtus) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\n| Swaps – July 2011 through December 2011 | 8,322.9 | $ | 6.67 | $ | $ |\n| Collars – July 2011 through December 2011 | 3,330.6 | 7.54 | 9.90 |\n| Swaps –2012 | 14,307.6 | 6.84 |\n| Collars – 2012 | 6,618.7 | 7.94 | 9.90 |\n| Swaps – 2013 | 18,797.5 | 5.77 |\n| Swaps – 2014 | 14,600.0 | 5.75 |\n| Swaps – 2015 | 14,600.0 | 6.00 |\n\nAs of June 30, 2011, we had entered into natural gas liquids commodity contracts with the following terms:\n\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price |\n| Ethane (MBbls): |\n| Swaps – July 2011 through December 2011 | 188.6 | $ | 20.06 |\n| Propane (MBbls): |\n| Swaps – July 2011 through December 2011 | 112.7 | 49.77 |\n\nAs of June 30, 2011, we had entered into natural gas basis swaps with the following terms:\n\n| Period Covered | Floating Index 1 | Floating Index 2 | Hedged Volume (MmmBtus) | Spread |\n| July 2011 through December 2011 | NYMEX | Dominion Appalachia | 174.4 | $ | 0.1975 |\n| July 2011 through December 2011 | NYMEX | Appalachia Columbia | 47.7 | 0.1500 |\n\nAs of June 30, 2011, we had entered into interest rate swaps with the following terms:\n\n| Period Covered | Notional Amount | Floating Rate | Fixed Rate |\n| July 2011 – July 2012 | $ | 90,000 | 1 Month LIBOR | 4.157 | % |\n| July 2011 – September 2012 | 40,000 | 1 Month LIBOR | 2.145 | % |\n| July 2012 – July 2015 | 110,000 | 1 Month LIBOR | 3.315 | % |\n\n8\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nThe fair value of these derivatives was as follows:\n\n| Asset Derivatives | Liability Derivatives |\n| June 30, 2011 | December 31, 2010 | June 30, 2011 | December 31, 2010 |\n| Commodity contracts | $ | 89,564 | $ | 123,655 | $ | 10,620 | $ | 7,633 |\n| Interest rate swaps | – | – | 8,925 | 12,152 |\n| Total fair value | 89,564 | 123,655 | 19,545 | 19,785 |\n| Netting arrangements | (11,773 | ) | (17,058 | ) | (11,773 | ) | (17,058 | ) |\n| Net recorded fair value | $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\n| Location of derivatives in our unaudited condensed consolidated balance sheets: |\n| Derivative asset | $ | 51,215 | $ | 55,100 | $ | – | $ | – |\n| Long–term derivative asset | 26,576 | 51,497 | – | – |\n| Derivative liability | – | – | 1,178 | 1,943 |\n| Long–term derivative liability | – | – | 6,594 | 784 |\n| $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\n\nThe following table presents the impact of derivatives and their location within the unaudited condensed consolidated statements of operations:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Realized gains on derivatives, net: |\n| Commodity contracts (1) | $ | 11,388 | $ | 16,044 | $ | 27,070 | $ | 26,167 |\n| Interest rate swaps (2) | 2,854 | (2,143 | ) | 714 | (4,301 | ) |\n| Total | $ | 14,242 | $ | 13,901 | $ | 27,784 | $ | 21,866 |\n| Unrealized gains (losses) on derivatives, net: |\n| Commodity contracts | $ | 20,380 | $ | (1,189 | ) | $ | (34,181 | ) | $ | 32,701 |\n| Interest rate swaps (2) | (2,958 | ) | (969 | ) | (1,452 | ) | (2,199 | ) |\n| Total | $ | 17,422 | $ | (2,158 | ) | $ | (35,633 | ) | $ | 30,502 |\n\n\n| (1) | Realized gains for the three months and six months ended June 30, 2011 exclude $1.4 million and $2.9 million, respectively, related to the initial value of derivatives acquired in our December 2010 acquisition of oil and natural gas properties that have been relieved through the settlement of such derivatives. |\n\n\n| (2) | In June 2011, we terminated three of our interest rate swaps and reclassified the $4.7 million non–cash gain from “Unrealized gains (losses) on derivatives, net” to “Realized gains on derivatives, net.” |\n\n9\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nNOTE 5. FAIR VALUE MEASUREMENTS\nRecurring Basis\nThe following table presents the fair value hierarchy table for our assets and liabilities that are required to be measured at fair value on a recurring basis:\n\n| Fair Value at Reporting Date Using: |\n| June 30, 2011 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Derivative assets: |\n| Commodity contracts | $ | 89,564 | $ | – | $ | 89,564 | $ | – |\n| Derivative liabilities: |\n| Commodity contracts | $ | 10,620 | $ | – | $ | 10,620 | $ | – |\n| Interest rate swaps | 8,925 | – | 8,925 | – |\n| Total derivative liabilities | $ | 19,545 | $ | – | $ | 19,545 | $ | – |\n| Fair Value at Reporting Date Using: |\n| December 31, 2010 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\n| Derivative assets: |\n| Commodity contracts | $ | 123,655 | $ | – | $ | 123,655 | $ | – |\n| Derivative liabilities: |\n| Commodity contracts | $ | 7,633 | $ | – | $ | 7,633 | $ | – |\n| Interest rate swaps | 12,152 | – | 12,152 | – |\n| Total derivative liabilities | $ | 19,785 | $ | – | $ | 19,785 | $ | – |\n\nOur derivatives consist of over–the–counter (“OTC”) contracts which are not traded on a public exchange. These derivatives are indexed to active trading hubs for the underlying commodity and are commonly used in the energy industry and offered by a number of financial institutions and large energy companies.\nAs the fair value of these derivatives is based on inputs using market prices obtained from independent brokers or determined using quantitative models that use as their basis readily observable market parameters that are actively quoted and can be validated through external sources, including third party pricing services, brokers and market transactions, we have categorized these derivatives as Level 2. We value these derivatives based on observable market data for similar instruments. This observable data includes the forward curves for commodity prices based on quoted market prices and prospective volatility factors related to changes in the forward curves and yield curves based on money market rates and interest rate swap data. Our estimates of fair value have been determined at discrete points in time based on relevant market data. These estimates involve uncertainty and cannot be determined with precision. There were no changes in valuation techniques or related inputs in the three months ended June 30, 2011.\nNonrecurring Basis\nIn March 2011, in conjunction with the sale of oil and natural gas properties, we incurred impairment charges of $1.5 million as oil and natural gas properties with a net cost basis of $2.7 million were written down to their fair value of $1.2 million.\n10\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nIn June 2011, we incurred impairment charges of $5.2 million as oil and natural gas properties with a net cost basis of $13.7 million were written down to their fair value of $8.5 million.\nFinancial Instruments\nThe estimated fair values of our financial instruments have been determined at discrete points in time based on relevant market information. Our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, derivatives and long–term debt. The carrying amounts of our financial instruments other than derivatives and long–term debt approximate fair value because of the short–term nature of the items. Derivatives are recorded at fair value (see Note 4). The carrying value of debt outstanding under our credit facility approximates fair value because the credit facility’s variable interest rate resets frequently and approximates current market rates available to us. As of June 30, 2011, the estimated fair value of our senior notes due 2019 was $303.0 million, which differs from the carrying value of $292.7 million. The fair value of our senior notes due 2019 was estimated using quoted markets prices based on trades of such debt as of June 30, 2011.\nNOTE 6. ASSET RETIREMENT OBLIGATIONS\nWe record an asset retirement obligation (“ARO”) and capitalize the asset retirement cost in oil and natural gas properties in the period in which the retirement obligation is incurred based upon the fair value of an obligation to perform site reclamation, dismantle facilities or plug and abandon wells. After recording these amounts, the ARO is accreted to its future estimated value using an assumed cost of funds and the additional capitalized costs are depreciated on a unit–of–production basis. The changes in the aggregate ARO are as follows:\n\n| Balance as of December 31, 2010 | $ | 68,430 |\n| Liabilities incurred | 311 |\n| Accretion expense | 1,936 |\n| Revisions in estimated cash flows | 3,118 |\n| Settlements and divestitures | (4,275 | ) |\n| Balance as of June 30, 2011 | $ | 69,520 |\n\nAs of both June 30, 2011 and December 31, 2010, $1.3 million of our ARO is classified as current and is included in “Accounts payable and accrued liabilities” in our unaudited condensed consolidated balance sheets.\nNOTE 7. LONG–TERM DEBT\nLong–term debt consisted of the following:\n\n| June 30, 2011 | December 31, 2010 |\n| Credit facility | $ | 187,500 | $ | 619,000 |\n| 8.0% senior notes due 2019 | 300,000 | – |\n| Unamortized discount | (7,317 | ) | – |\n| Long–term debt | $ | 480,183 | $ | 619,000 |\n\nCredit Facility\nOn April 26, 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility are secured by a first priority lien on substantially all of our assets and the assets of our subsidiaries. We may use borrowings under the facility for acquiring and developing oil and natural gas properties, for working capital purposes, for general corporate purposes and for funding distributions to partners. We also may use up to $100.0 million of available borrowing capacity for letters of credit. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. As of June 30, 2011, we were in compliance with these financial covenants.\n11\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nBorrowings under the facility bear interest at a floating rate based on, at our election, a base rate or the London Inter–Bank Offered Rate plus applicable premiums based on the percent of the borrowing base that we have outstanding (weighted average effective interest rate of 3.49% at June 30, 2011).\nBorrowings under the facility may not exceed a “borrowing base” determined by the lenders under the facility based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base under the facility was $600.0 million. The borrowing base is subject to scheduled redeterminations as of April 1 and October 1 of each year with an additional redetermination once per calendar year at our request or at the request of the lenders and with one calculation that may be made at our request during each calendar year in connection with material acquisitions or divestitures of properties.\n8.0% Senior Notes due 2019\nOn March 22, 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019 (the “Notes”) at an offering price equal to 100% of par. The Notes were sold in a private placement to eligible purchasers in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended.\nWe received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness under our existing credit facility. The discount and the offering expenses are being amortized over the life of the Notes. The amortization is included in “Interest expense” on our unaudited condensed consolidated statements of operations.\nThe Notes were issued under an indenture dated March 22, 2011, (the “Indenture”), mature April 15, 2019, and bear interest at 8.0%. Interest is payable semi–annually beginning October 15, 2011. The Notes are general unsecured obligations and are effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the collateral securing such indebtedness.\nThe Notes are unconditionally guaranteed, jointly and severally, on a senior unsecured basis, by all of our existing subsidiaries other than EV Energy Finance Corp. (“Finance”), which is a co–issuer of the Notes. Neither we nor Finance have material independent assets or operations apart from the assets and operations of our subsidiaries.\nThe Indenture provides that, prior to April 15, 2014, we may redeem up to 35% of the aggregate principal amount of the Notes with the net proceeds of a public or private equity offering at a redemption price of 108.0% of the principal amount redeemed, plus accrued and unpaid interest, provided that:\n\n| · | at least 65% of the aggregate principal amount of Notes issued under the Indenture remains outstanding immediately after the occurrence of such redemption; and |\n\n\n| · | the redemption occurs within 180 days of the date of the closing of such public or private equity offering. |\n\nOn and after April 15, 2015, we may redeem all or a part of the Notes, at the redemption prices (expressed as percentages of principal amount) set forth below, plus accrued and unpaid interest, if any, on the Notes to be redeemed to the applicable redemption date, if redeemed during the twelve–month period beginning on April 15 of the years indicated below:\n\n| Year | Percentage |\n| 2015 | 104.0 | % |\n| 2016 | 102.0 | % |\n| 2017 and thereafter | 100.0 | % |\n\n12\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nPrior to April 15, 2015, we may redeem all or part of the Notes at a redemption price equal to the sum of:\n\n| · | the principal amount thereof, plus |\n\n\n| · | the Make Whole Premium (as defined in the Indenture) at the redemption date, plus accrued and unpaid interest, if any, to the redemption date. |\n\nThe Indenture also provides that, if a change of control (as defined in the Indenture) occurs, the holders have a right to require us to repurchase all or part of the Notes at a redemption price equal to 101%, plus accrued and unpaid interest.\nThe Indenture contains covenants that, among other things, limit our ability to: (i) pay distributions on, purchase or redeem our common units or redeem our subordinated debt; (ii) make investments; (iii) incur or guarantee additional indebtedness or issue certain types of equity securities; (iv) create certain liens; (v) sell assets; (vi) consolidate, merge or transfer all or substantially all of our assets; (vii) enter into intercompany agreements that restrict distributions or other payments from our restricted subsidiaries to us; (viii) engage in transactions with affiliates; and (ix) create unrestricted subsidiaries.\nNOTE 8. COMMITMENTS AND CONTINGENCIES\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements, and no amounts have been accrued at June 30, 2011 or December 31, 2010.\nNOTE 9. OWNERS’ EQUITY\nUnits Outstanding\nAt June 30, 2011, owner’s equity consists of 34,173,650 common units, representing a 98% limited partnership interest in us, and a 2% general partnership interest.\nIssuance of Units\nIn January 2011, the following equity–based awards vested:\n\n| Phantom units accounted for as liability awards (1) | 80,534 |\n| Phantom units accounted for as equity awards | 70,610 |\n| Performance units | 80,000 |\n| Total units vested | 231,144 |\n| Performance units settled in cash | (17,807 | ) |\n| Units converted to common units | 213,337 |\n\n\n| (1) | These phantom units vested at a fair value of $3.5 million. |\n\nIn conjunction with the vesting of these units, we received a contribution of $0.2 million by our general partner to maintain its 2% interest in us.\nOn March 9, 2011, we closed a public offering of 3.45 million of our common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\n13\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nCash Distributions\nThe following sets forth the distributions we paid during the six months ended June 30, 2011:\n\n| Date Paid | Period Covered | Distribution per Unit | Total Distribution |\n| February 14, 2011 | October 1, 2010 – December 31, 2010 | $ | 0.759 | $ | 26,477 |\n| May 13, 2011 | January 1, 2011 – March 31, 2011 | 0.760 | 29,496 |\n| $ | 55,973 |\n\nOn July 28, 2011, the board of directors of EV Management declared a $0.761 per unit distribution for the second quarter of 2011 on all common units. The distribution of $29.5 million is to be paid on August 12, 2011 to unitholders of record at the close of business on August 8, 2011.\nNOTE 10. NET INCOME (LOSS) PER LIMITED PARTNER UNIT\nThe following sets forth the calculation of net income (loss) per limited partner unit:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\n| Less: |\n| Incentive distribution rights | (2,945 | ) | (2,298 | ) | (5,879 | ) | (4,588 | ) |\n| General partner’s 2% interest in net income | (783 | ) | (326 | ) | (103 | ) | (1,248 | ) |\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | 56,568 |\n| Weighted average limited partner units outstanding: |\n| Common units | 34,174 | 27,060 | 32,880 | 26,249 |\n| Performance units (1) | 120 | 150 | 122 | 154 |\n| Denominator for basic net income (loss) per limited partner unit | 34,294 | 27,210 | 33,002 | 26,403 |\n| Dilutive phantom units (2) | 240 | 54 | – | 35 |\n| Total | 34,534 | 27,264 | 33,002 | 26,438 |\n| Net income (loss) per limited partner unit: |\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\n\n\n| (1) | Our earned but unvested performance units are considered to be participating securities for purposes of calculating our net income (loss) per limited partner unit and, accordingly, are included in the basic computation as such. |\n\n\n| (2) | Phantom units accounted for as equity awards totaling 0.5 million units were not included in the computation of diluted net income (loss) per limited partner unit because the effect would have been anti-dilutive for the six months ended June 30, 2011. |\n\nNOTE 11. RELATED PARTY TRANSACTIONS\nPursuant to an omnibus agreement, we paid EnerVest $2.8 million and $2.3 million in the three months ended June 30, 2011 and 2010, respectively, and $5.5 million and $4.3 million in the six months ended June 30, 2011 and 2010, respectively, in monthly administrative fees for providing us general and administrative services. These fees are based on an allocation of charges between EnerVest and us based on the estimated use of such services by each party, and we believe that the allocation method employed by EnerVest is reasonable and reflective of the estimated level of costs we would have incurred on a standalone basis. These fees are included in general and administrative expenses in our unaudited condensed consolidated statements of operations.\n14\nEV Energy Partners, L.P.\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\nWe have entered into operating agreements with EnerVest whereby a wholly owned subsidiary of EnerVest acts as contract operator of the oil and natural gas wells and related gathering systems and production facilities in which we own an interest. We reimbursed EnerVest $3.4 million and $3.2 million in the three months ended June 30, 2011 and 2010, respectively, and $7.2 million and $5.7 million in the six months ended June 30, 2011 and 2010, respectively, for direct expenses incurred in the operation of our wells and related gathering systems and production facilities and for the allocable share of the costs of EnerVest employees who performed services on our properties. As the vast majority of such expenses are charged to us on an actual basis (i.e., no mark–up or subsidy is charged or received by EnerVest), we believe that the aforementioned services were provided to us at fair and reasonable rates relative to the prevailing market and are representative of the costs that would have been incurred on a standalone basis. These costs are included in lease operating expenses in our unaudited condensed consolidated statements of operations. Additionally, in its role as contract operator, this EnerVest subsidiary also collects proceeds from oil and natural gas sales and distributes them to us and other working interest owners.\nNOTE 12. OTHER SUPPLEMENTAL INFORMATION\nSupplemental cash flows and non–cash transactions were as follows:\n\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Supplemental cash flows information: |\n| Cash paid for interest | $ | 5,595 | $ | 4,755 |\n| Cash paid for income taxes | 250 | 245 |\n| Non–cash transactions: |\n| Costs for development of oil and natural gas properties in accounts payable and accrued liabilities | 5,241 | 2,533 |\n\nNOTE 13. NEW ACCOUNTING STANDARDS\nIn May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011–04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the International Accounting Standards Board on fair value measurement, and has resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The provisions of ASU 2011–04 are applicable to interim and annual reporting periods subsequent to December 15, 2011. We will adopt the new requirements for our Form 10–K for the year ending December 31, 2011.\nNo other new accounting pronouncements issued or effective during the six months ended June 30, 2011 have had or are expected to have a material impact on our unaudited condensed consolidated financial statements.\nNOTE 14. SUBSEQUENT EVENT\nIn July 2011, we sold oil and natural gas properties for $8.5 million. We received a non–refundable deposit of $0.9 million in June 2011 and the remainder of the proceeds upon the closing of the sale. These oil and natural gas properties and the related ARO have been classified as “Assets held for sale” and “Liabilities related to assets held for sale” on our unaudited consolidated condensed balance sheet.\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\nWe evaluated subsequent events for appropriate accounting and disclosure through the date these unaudited condensed consolidated financial statements were issued.\n15\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto, as well as our Annual Report on Form 10–K for the year ended December 31, 2010.\nOVERVIEW\nWe are a Delaware limited partnership formed in April 2006 by EnerVest to acquire, produce and develop oil and natural gas properties. Our general partner is EV Energy GP, a Delaware limited partnership, and the general partner of our general partner is EV Management, a Delaware limited liability company.\nOur properties are located in the Barnett Shale, the Appalachian Basin (primarily in Ohio and West Virginia), the Mid-Continent area in Oklahoma, Texas, Arkansas, Kansas and Louisiana, the San Juan Basin, the Monroe Field in Louisiana, the Permian Basin, Central and East Texas (which includes the Austin Chalk area), and Michigan. As of December 31, 2010, we had estimated net proved reserves of 12.9 MMBbls of oil, 27.5 MMBbls of natural gas liquids and 575.2 Bcf of natural gas, or 817.3 Bcfe, and a standardized measure of $1,020.2 million.\nCURRENT DEVELOPMENTS\nIn March 2011, we closed a public offering of 3.45 million common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019. We received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness outstanding under our credit facility.\nIn April 2011, we entered into a second amended and restated $1.0 billion credit facility that expires in April 2016. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. The borrowing base, which was initially set at $600.0 million, is subject to scheduled redeterminations every six months beginning October 1, 2011.\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\nBUSINESS ENVIRONMENT\nOur primary business objective is to provide stability and growth in cash distributions per unit over time. The amount of cash we can distribute on our units principally depends upon the amount of cash generated from our operations, which will fluctuate from quarter to quarter based on, among other things:\n| · | the prices at which we will sell our oil, natural gas liquids and natural gas production; |\n\n\n| · | our ability to hedge commodity prices; |\n\n\n| · | the amount of oil, natural gas liquids and natural gas we produce; and |\n\n\n| · | the level of our operating and administrative costs. |\n\nOil and natural gas prices are expected to be volatile in the future. Factors affecting the price of oil include worldwide economic conditions, geopolitical activities, worldwide supply disruptions, weather conditions, actions taken by the Organization of Petroleum Exporting Countries and the value of the U.S. dollar in international currency markets. Factors affecting the price of natural gas include the discovery of substantial accumulations of natural gas in unconventional reservoirs due to technological advancements necessary to commercially produce these unconventional reserves, North American weather conditions, industrial and consumer demand for natural gas, storage levels of natural gas and the availability and accessibility of natural gas deposits in North America.\n16\nIn order to mitigate the impact of changes in oil and natural gas prices on our cash flows, we are a party to derivatives, and we intend to enter into derivatives in the future to reduce the impact of oil and natural gas price volatility on our cash flows. By removing a significant portion of this price volatility on our future oil and natural gas production through December 2015, we have mitigated, but not eliminated, the potential effects of changing oil and natural gas prices on our cash flows from operations for those periods. If commodity prices are depressed for an extended period of time, it could alter our acquisition and development plans, and adversely affect our growth strategy and ability to access additional capital in the capital markets.\nThe primary factors affecting our production levels are capital availability, our ability to make accretive acquisitions, the success of our drilling program and our inventory of drilling prospects. In addition, as initial reservoir pressures are depleted, production from our wells decreases. We attempt to overcome this natural decline through a combination of drilling and acquisitions. Our future growth will depend on our ability to continue to add reserves through drilling and acquisitions in excess of production. We will maintain our focus on the costs to add reserves through drilling and acquisitions as well as the costs necessary to produce such reserves. Our ability to add reserves through drilling is dependent on our capital resources and can be limited by many factors, including our ability to timely obtain drilling permits and regulatory approvals. Any delays in drilling, completion or connection to gathering lines of our new wells will negatively impact our production, which may have an adverse effect on our revenues and, as a result, cash available for distribution.\nWe focus our efforts on increasing oil and natural gas reserves and production while controlling costs at a level that is appropriate for long–term operations. Our future cash flows from operations are dependent upon our ability to manage our overall cost structure.\nRESULTS OF OPERATIONS\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2011 | 2010 | 2011 | 2010 |\n| Production data: |\n| Oil (MBbls) | 241 | 171 | 449 | 297 |\n| Natural gas liquids (MBbls) | 272 | 178 | 542 | 360 |\n| Natural gas (MMcf) | 6,999 | 4,734 | 14,003 | 8,719 |\n| Net production (MMcfe) | 10,080 | 6,831 | 19,951 | 12,665 |\n| Average sales price per unit: |\n| Oil (Bbl) | $ | 98.63 | $ | 73.20 | $ | 94.58 | $ | 73.73 |\n| Natural gas liquids (Bbl) | 54.80 | 40.23 | 51.45 | 42.91 |\n| Natural gas (Mcf) | 4.20 | 4.16 | 4.10 | 4.66 |\n| Mcfe | 6.76 | 5.77 | 6.40 | 6.16 |\n| Average unit cost per Mcfe: |\n| Production costs: |\n| Lease operating expenses | $ | 1.78 | $ | 2.18 | $ | 1.77 | $ | 2.08 |\n| Production taxes | 0.31 | 0.24 | 0.29 | 0.30 |\n| Total | 2.09 | 2.42 | 2.06 | 2.38 |\n| Asset retirement obligations accretion expense | 0.10 | 0.11 | 0.10 | 0.10 |\n| Depreciation, depletion and amortization | 1.83 | 1.97 | 1.80 | 2.02 |\n| General and administrative expenses | 0.71 | 0.85 | 0.79 | 0.83 |\n\n17\nThree Months Ended June 30, 2011 Compared with the Three Months Ended June 30, 2010\nNet income for the three months ended June 30, 2011 was $39.2 million compared with $16.3 million for the three months ended June 30, 2010. This improvement reflects (i) a $28.7 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil, natural gas and natural gas liquids and (ii) a $19.6 million increase in non–cash changes in the fair value of our derivatives, partially offset by (iii) an $11.5 million increase in operating expenses mainly related to the properties acquired in 2010, (iv) an impairment loss of $5.1 million related to the write–down of oil and natural gas properties to their fair value (compared with a $4.4 million gain on the sale of oil and natural gas properties in the three months ended June 30, 2010), and (v) a $4.9 million increase in interest expense.\nOil, natural gas and natural gas liquids revenues for the three months ended June 30, 2011 totaled $68.1 million, an increase of $28.7 million compared with the three months ended June 30, 2010. This increase was the result of $21.6 million related to increased production and $7.1 million related to higher prices for oil, natural gas and natural gas liquids.\nLease operating expenses for the three months ended June 30, 2011 increased $3.1 million compared with the three months ended June 30, 2010 primarily as the result of $5.8 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $0.4 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.34 per Mcfe) of lease operating expenses in the three months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the three months ended June 30, 2010. Lease operating expenses per Mcfe were $1.78 in the three months ended June 30, 2011 compared with $2.18 in the three months ended June 30, 2010. Production taxes, which are generally based on a percentage of our oil, natural gas and natural gas liquids revenues, for the three months ended June 30, 2011 increased $1.4 million compared with the three months ended June 30, 2010 primarily as the result of $1.0 million due to increased production and $0.4 million due to higher average realized prices. Production taxes for the three months ended June 30, 2011 were $0.31 per Mcfe compared with $0.24 per Mcfe for the three months ended June 30, 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 increased $0.2 million compared with the three months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 was $0.10 per Mcfe compared with $0.11 per Mcfe for the three months ended June 30, 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 increased $5.0 million compared with the three months ended June 30, 2010 primarily due to $5.9 million from higher production offset by a decrease of $0.9 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 was $1.83 per Mcfe compared with $1.97 per Mcfe for the three months ended June 30, 2010.\nGeneral and administrative expenses for the three months ended June 30, 2011 totaled $7.1 million, an increase of $1.3 million compared with the three months ended June 30, 2010. This increase is primarily the result of $1.0 million of higher compensation costs primarily related to our equity–based compensation plans and $0.5 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010 partially offset by a $0.2 million decrease in acquisition due diligence costs. General and administrative expenses were $0.71 per Mcfe in the three months ended June 30, 2011 compared with $0.85 per Mcfe in the three months ended June 30, 2010.\nDuring the three months ended June 30, 2011, we incurred impairment charges of $5.1 million to write down oil and natural gas properties to their fair value. During the three months ended June 30, 2011 and 2010, we recorded cash settlements of $9.5 million and $13.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception. Unrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the three months ended June 30, 2011, the fair value of our open derivatives increased from a net asset of $49.3 million at March 31, 2011 to a net asset of $70.0 million at June 30, 2011. In the three months ended June 30, 2010, the fair value of our open derivatives decreased from a net asset of $125.8 million at March 31, 2010 to a net asset of $123.6 million at June 30, 2010.\n18\nInterest expense for the three months ended June 30, 2011 increased $4.9 million compared with the three months ended June 30, 2010 primarily due to increases of $2.4 million from a higher weighted average long–term debt balance and $2.5 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\nSix Months Ended June 30, 2011 Compared with the Six Months Ended June 30, 2010\nNet income for the six months ended June 30, 2011 was $5.2 million compared with $62.4 million for the six months ended June 30, 2010. This change reflects (i) a $49.5 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil and natural gas liquids and (ii) a $5.9 million increase in realized gains on derivatives, partially offset by (iii) a.$66.1 million decrease in non–cash changes in the fair value of our derivatives, (iv) a $28.0 million increase in operating expenses mainly related to the properties acquired in 2010, (v) a $7.9 million increase in interest expense and (vi) an impairment loss of $6.7 million related to the write–down of oil and natural gas properties to their fair value (compared with a $3.8 million gain on the sale of oil and natural gas properties in the six months ended June 30, 2010).\nOil, natural gas and natural gas liquids revenues for the six months ended June 30, 2011 totaled $127.7 million, an increase of $49.7 million compared with the six months ended June 30, 2010. This increase was the result of $45.3 million related to increased production and $4.4 million related to higher prices for oil and natural gas liquids.\nLease operating expenses for the six months ended June 30, 2011 increased $9.0 million compared with the six months ended June 30, 2010 primarily as the result of $12.9 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $1.5 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.18 per Mcfe) of lease operating expenses in the six months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the six months ended June 30, 2010. Lease operating expenses per Mcfe were $1.77 in the six months ended June 30, 2011 compared with $2.08 in the six months ended June 30, 2010. Production taxes for the six months ended June 30, 2011 increased $2.0 million compared with the six months ended June 30, 2010 primarily as the result of $2.1 million due to increased production partially offset by $0.1 million due to lower average realized prices for natural gas. Production taxes for the six months ended June 30, 2011 were $0.29 per Mcfe compared with $0.30 per Mcfe for the six months ended June 30, 2010. Asset retirement obligations accretion expense for the six months ended June 30, 2011 increased $0.7 million compared with the six months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for both the six months ended June 30, 2011 and June 30, 2010 was $0.10 per Mcfe. Depreciation, depletion and amortization for the six months ended June 30, 2011 increased $10.5 million compared with the six months ended June 30, 2010 primarily due to $13.1 million from higher production offset by a decrease of $2.8 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the six months ended June 30, 2011 was $1.80 per Mcfe compared with $2.02 per Mcfe for the six months ended June 30, 2010.\nGeneral and administrative expenses for the six months ended June 30, 2011 totaled $15.7 million, an increase of $5.2 million compared with the six months ended June 30, 2010. This increase is primarily the result of (i) $3.5 million of higher compensation costs primarily related to our equity–based compensation plans, (ii) $1.3 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010, and (iii) an overall increase in costs related to our significant growth. General and administrative expenses were $0.79 per Mcfe in the six months ended June 30, 2011 compared with $0.83 per Mcfe in the six months ended June 30, 2010.\nDuring the six months ended June 30, 2011, we incurred impairment charges of $6.7 million to write down oil and natural gas properties to their fair value. During the six months ended June 30, 2011 and 2010, we recorded cash settlements of $23.1 million and $21.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception.\n19\nUnrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the six months ended June 30, 2011, the fair value of our open derivatives decreased from a net asset of $103.9 million at December 31, 2010 to a net asset of $70.0 million at June 30, 2011. In the six months ended June 30, 2010, the fair value of our open derivatives increased from a net asset of $93.1 million at December 31, 2009 to a net asset of $123.6 million at June 30, 2010.\nInterest expense for the six months ended June 30, 2011 increased $7.9 million compared with the six months ended June 30, 2010 primarily due to an increase of $5.8 million from a higher weighted average long–term debt balance and an increase of $2.1 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\nLIQUIDITY AND CAPITAL RESOURCES\nHistorically, our primary sources of liquidity and capital have been issuances of equity and debt securities, borrowings under our credit facility and cash flows from operations. Our primary uses of cash have been acquisitions of oil and natural gas properties and related assets, development of our oil and natural gas properties, distributions to our partners and working capital needs. For 2011, we believe that cash on hand and net cash flows generated from operations will be adequate to fund our capital budget and satisfy our short–term liquidity needs. We may also utilize various financing sources available to us, including the issuance of equity or debt securities through public offerings or private placements, to fund our acquisitions and long–term liquidity needs. Our ability to complete future offerings of equity or debt securities and the timing of these offerings will depend upon various factors including prevailing market conditions and our financial condition.\nIn the past we accessed the equity and debt markets to finance our significant acquisitions. While we have been successful in accessing the public equity and debt markets earlier this year and in prior years, any disruptions in the financial markets may limit our ability to access the public equity or debt markets in the future.\nLong–term Debt\nIn April 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility may not exceed a “borrowing base” determined by the lenders based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base was $600.0 million, and we had $187.5 million outstanding.\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior notes due 2019 and received net proceeds of approximately $291.6 million. We used the net proceeds to repay indebtedness outstanding under our credit facility. As of June 30, 2011, we had $300.0 million of notes outstanding. These notes are recorded on our unaudited condensed consolidated balance sheet as $292.7 million, which is net of the unamortized discount of $7.3 million.\nFor additional information about our long–term debt, such as interest rates and covenants, please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein.\nCash and Short–term Investments\nAt June 30, 2011, we had $26.4 million of cash and short–term investments, which included $22.0 million of short–term investments. With regard to our short–term investments, we invest in money market accounts with major financial institutions.\nCounterparty Exposure\nAt June 30, 2011, our open derivative contracts were in a net receivable position with a fair value of $70.0 million. All of our derivative contracts are with major financial institutions who are also lenders under our credit facility. Should one of these financial counterparties not perform, we may not realize the benefit of some of our derivative contracts and we could incur a loss. As of June 30, 2011, all of our counterparties have performed pursuant to their commodity derivative contracts.\n20\nCash Flows\nCash flows provided (used) by type of activity were as follows:\n\n| Six Months Ended June 30, |\n| 2011 | 2010 |\n| Operating activities | $ | 80,130 | $ | 55,802 |\n| Investing activities | (25,681 | ) | (151,468 | ) |\n| Financing activities | (51,184 | ) | 94,152 |\n\nOperating Activities\nCash flows from operating activities were $80.1 million and $55.8 million in the six months ended June 30, 2011 and 2010, respectively. The increase was primarily due to higher production and prices for oil and natural gas liquids, partially offset by higher operating expenses.\nInvesting Activities\nOur principal recurring investing activity is the acquisition and development of oil and natural gas properties. During the six months ended June 30, 2011, we spent $1.0 million for the acquisition of oil and natural gas properties and $33.7 million for development of our oil and natural gas properties. In addition, we received $4.1 million in final purchase price settlements, $2.8 million from settlements of derivatives acquired in our December 2010 acquisition of oil and natural gas properties and $1.2 million in proceeds from the sale of oil and natural gas properties.\nDuring the six months ended June 30, 2010, we spent $147.8 million on the acquisitions of oil and natural gas properties and $8.2 million for the development of our oil and natural gas properties. In addition, we received $4.5 million from the sales of oil and natural gas properties.\nFinancing Activities\nDuring the six months ended June 30, 2011, we received net proceeds of $146.8 million from our public equity offering in March 2011, and we received contributions of $3.2 million from our general partner in order to maintain its 2% interest in us. We also received net proceeds of $291.6 million from our debt offering in March 2011, after deducting offering expenses of $0.9 million. We used the proceeds from these offerings to repay $431.5 million of borrowings outstanding under our credit facility. In addition, we paid distributions of $56.0 million to holders of our common units and our general partner and $5.3 million in loan costs related to our new $1.0 billion credit facility.\nDuring the six months ended June 30, 2010, we received net proceeds of $92.6 million from our public equity offering in February 2010, and we received contributions of $2.0 million from our general partner in order to maintain its 2% interest in us. We borrowed $138.0 million under our credit facility to finance our acquisition of oil and natural gas properties in March 2010 and we repaid $95.0 million of borrowings outstanding under our credit facility with proceeds from our public equity offering and cash flows from operations. In addition, we paid distributions of $43.4 million to holders of our common units and our general partner.\nFORWARD–LOOKING STATEMENTS\nThis Form 10–Q contains forward–looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act (each a “forward–looking statement”). These forward–looking statements relate to, among other things, the following:\n\n| · | our future financial and operating performance and results; |\n\n\n| · | our business strategy; |\n\n\n| · | our estimated net proved reserves and standardized measure; |\n\n\n| · | market prices; |\n\n21\n\n| · | our future derivative activities; and |\n\n\n| · | our plans and forecasts. |\n\nWe have based these forward–looking statements on our current assumptions, expectations and projections about future events.\nThe words “anticipate,” “believe,” “ensure,” “expect,” “if,” “intend,” “estimate,” “project,” “forecasts,” “predict,” “outlook,” “aim,” “will,” “could,” “should,” “would,” “may,” “likely” and similar expressions, and the negative thereof, are intended to identify forward–looking statements. These statements discuss future expectations, contain projections of results of operations or of financial condition or state other “forward–looking” information. We do not undertake any obligation to update or revise publicly any forward–looking statements, except as required by law. These statements also involve risks and uncertainties that could cause our actual results or financial condition to materially differ from our expectations in this Form 10–Q including, but not limited to:\n\n| · | fluctuations in prices of oil and natural gas; |\n\n\n| · | significant disruptions in the financial markets; |\n\n\n| · | future capital requirements and availability of financing; |\n\n\n| · | uncertainty inherent in estimating our reserves; |\n\n\n| · | risks associated with drilling and operating wells; |\n\n\n| · | discovery, acquisition, development and replacement of oil and natural gas reserves; |\n\n\n| · | cash flows and liquidity; |\n\n\n| · | timing and amount of future production of oil and natural gas; |\n\n\n| · | availability of drilling and production equipment; |\n\n\n| · | marketing of oil and natural gas; |\n\n\n| · | developments in oil and natural gas producing countries; |\n\n\n| · | competition; |\n\n\n| · | general economic conditions; |\n\n\n| · | governmental regulations; |\n\n\n| · | receipt of amounts owed to us by purchasers of our production and counterparties to our derivative financial instrument contracts; |\n\n\n| · | hedging decisions, including whether or not to enter into derivative financial instruments; |\n\n\n| · | events similar to those of September 11, 2001; |\n\n\n| · | actions of third party co–owners of interest in properties in which we also own an interest; |\n\n\n| · | fluctuations in interest rates and the value of the U.S. dollar in international currency markets; and |\n\n\n| · | our ability to effectively integrate companies and properties that we acquire. |\n\n22\nAll of our forward–looking information is subject to risks and uncertainties that could cause actual results to differ materially from the results expected. Although it is not possible to identify all factors, these risks and uncertainties include the risk factors and the timing of any of those risk factors identified in the “Risk Factors” section included in Item 1A of our Annual Report on Form 10–K for the year ended December 31, 2010. This document is available through our web site or through the SEC’s Electronic Data Gathering and Analysis Retrieval System at http://www.sec.gov.\nOur revenues, operating results, financial condition and ability to borrow funds or obtain additional capital depend substantially on prevailing prices for oil and natural gas. Declines in oil or natural gas prices may materially adversely affect our financial condition, liquidity, ability to obtain financing and operating results. Lower oil or natural gas prices also may reduce the amount of oil or natural gas that we can produce economically. A decline in oil and/or natural gas prices could have a material adverse effect on the estimated value and estimated quantities of our oil and natural gas reserves, our ability to fund our operations and our financial condition, cash flows, results of operations and access to capital. Historically, oil and natural gas prices and markets have been volatile, with prices fluctuating widely, and they are likely to continue to be volatile.\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe are exposed to certain market risks that are inherent in our financial statements that arise in the normal course of business. We may enter into derivative instruments to manage or reduce market risk, but do not enter into derivative agreements for speculative purposes.\nWe do not designate these or plan to designate future derivative instruments as hedges for accounting purposes. Accordingly, the changes in the fair value of these instruments are recognized currently in earnings.\nCommodity Price Risk\nOur major market risk exposure is to prices for oil, natural gas and natural gas liquids. These prices have historically been volatile. As such, future earnings are subject to change due to changes in these prices. Realized prices are primarily driven by the prevailing worldwide price for oil and regional spot prices for natural gas production. We have used, and expect to continue to use, oil, natural gas and natural gas liquids commodity contracts to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids. Pursuant to our risk management policy, we engage in these activities as a hedging mechanism against price volatility associated with pre–existing or anticipated sales of oil, natural gas and natural gas liquids.\nWe have entered into commodity contracts to hedge significant amounts of our anticipated oil, natural gas and natural gas liquids production through December 2015. As of June 30, 2011, we have commodity contracts covering approximately 53% of our production attributable to our estimated net proved reserves from July 2011 through December 2015, as estimated in our reserve report prepared by third party engineers using prices, costs and other assumptions required by SEC rules. Our actual production will vary from the amounts estimated in our reserve reports, perhaps materially.\nThe fair value of our commodity contracts and basis swaps at June 30, 2011 was a net asset of $78.9 million. A 10% change in oil, natural gas and natural gas liquids prices with all other factors held constant would result in a change in the fair value (generally correlated to our estimated future net cash flows from such instruments) of our oil and natural gas commodity contracts and basis swaps of approximately $60 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\nInterest Rate Risk\nOur floating rate credit facility also exposes us to risks associated with changes in interest rates and as such, future earnings are subject to change due to changes in these interest rates. If interest rates on our facility increased by 1%, interest expense for the six months ended June 30, 2011 would have increased by approximately $1.8 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\n23\nITEM 4. CONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nIn accordance with Exchange Act Rule 13a–15 and 15d–15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2011 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\nChange in Internal Controls Over Financial Reporting\nThere have not been any changes in our internal controls over financial reporting that occurred during the quarterly period ended June 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.\nPART II. OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements.\n\nITEM 1A. RISK FACTORS\nThere have been no material changes with respect to the risk factors disclosed in our Annual Report on Form 10–K for the year ended December 31, 2010.\n\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nNone.\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\nITEM 4. (Removed and Reserved)\n\nITEM 5. OTHER INFORMATION\nNone.\n\nITEM 6. EXHIBITS\nThe exhibits listed below are filed or furnished as part of this report:\n\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\n\n\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\n\n24\n\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\n\n\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\n\n\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\n\n\n| ++101 | Interactive Data Files |\n\n\n| + | Filed herewith |\n\n\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\n\n25\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| EV Energy Partners, L.P. |\n| (Registrant) |\n| Date: August 9, 2011 | By: | /s/ MICHAEL E. MERCER |\n| Michael E. Mercer |\n| Senior Vice President and Chief Financial Officer |\n\n26\nEXHIBIT INDEX\n\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\n\n\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\n\n\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\n\n\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\n\n\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\n\n\n| ++101 | Interactive Data Files |\n\n+ Filed herewith\n\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\n\n\n</text>\n\nWhat is the total capital cost, combining both the offering cost of the senior notes and interest payment in the first year, in million dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nPART I. FINANCIAL INFORMATION\\nITEM 1. FINANCIAL STATEMENTS\\nEV Energy Partners, L.P.\\nCondensed Consolidated Balance Sheets\\n(In thousands, except number of units)\\n(Unaudited)\\n\\n| June 30, | December 31, |\\n| 2011 | 2010 |\\n| ASSETS |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 26,392 | $ | 23,127 |\\n| Accounts receivable: |\\n| Oil, natural gas and natural gas liquids revenues | 36,600 | 27,742 |\\n| Related party | 3,967 | – |\\n| Other | 300 | 441 |\\n| Derivative asset | 51,215 | 55,100 |\\n| Assets held for sale | 11,402 | – |\\n| Other current assets | 1,047 | 1,158 |\\n| Total current assets | 130,923 | 107,568 |\\n| Oil and natural gas properties, net of accumulated depreciation, depletion and amortization; June 30, 2011, $210,073; December 31, 2010, $176,897 | 1,300,294 | 1,324,240 |\\n| Other property, net of accumulated depreciation and amortization; June 30, 2011, $536; December 31, 2010, $465 | 1,495 | 1,567 |\\n| Long–term derivative asset | 26,576 | 51,497 |\\n| Other assets | 7,533 | 1,885 |\\n| Total assets | $ | 1,466,821 | $ | 1,486,757 |\\n| LIABILITIES AND OWNERS’ EQUITY |\\n| Current liabilities: |\\n| Accounts payable and accrued liabilities: |\\n| Third party | $ | 27,642 | $ | 20,678 |\\n| Related party | – | 182 |\\n| Liabilities related to assets held for sale | 2,895 | – |\\n| Derivative liability | 1,178 | 1,943 |\\n| Total current liabilities | 31,715 | 22,803 |\\n| Asset retirement obligations | 68,266 | 67,175 |\\n| Long–term debt | 480,183 | 619,000 |\\n| Long–term liabilities | 988 | 3,048 |\\n| Long–term derivative liability | 6,594 | 784 |\\n| Commitments and contingencies |\\n| Owners’ equity: |\\n| Common unitholders – 34,173,650 units and 30,510,313 units issued and outstanding as of June 30, 2011 and December 31, 2010, respectively | 887,843 | 779,327 |\\n| General partner interest | (8,768 | ) | (5,380 | ) |\\n| Total owners’ equity | 879,075 | 773,947 |\\n| Total liabilities and owners’ equity | $ | 1,466,821 | $ | 1,486,757 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n2\\nEV Energy Partners, L.P.\\nCondensed Consolidated Statements of Operations\\n(In thousands, except per unit data)\\n(Unaudited)\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Revenues: |\\n| Oil, natural gas and natural gas liquids revenues | $ | 68,109 | $ | 39,431 | $ | 127,730 | $ | 78,027 |\\n| Transportation and marketing–related revenues | 1,484 | 1,476 | 2,885 | 3,054 |\\n| Total revenues | 69,593 | 40,907 | 130,615 | 81,081 |\\n| Operating costs and expenses: |\\n| Lease operating expenses | 17,949 | 14,869 | 35,311 | 26,301 |\\n| Cost of purchased natural gas | 1,120 | 1,095 | 2,170 | 2,315 |\\n| Dry hole and exploration costs | 441 | – | 844 | – |\\n| Production taxes | 3,119 | 1,673 | 5,770 | 3,800 |\\n| Asset retirement obligations accretion expense | 970 | 764 | 1,936 | 1,274 |\\n| Depreciation, depletion and amortization | 18,443 | 13,436 | 36,007 | 25,520 |\\n| General and administrative expenses | 7,132 | 5,825 | 15,725 | 10,549 |\\n| Impairment of oil and natural gas properties | 5,078 | – | 6,666 | – |\\n| Gain on sale of oil and natural gas properties | – | (4,388 | ) | – | (3,824 | ) |\\n| Total operating costs and expenses | 54,252 | 33,274 | 104,429 | 65,935 |\\n| Operating income | 15,341 | 7,633 | 26,186 | 15,146 |\\n| Other income (expense), net: |\\n| Realized gains on derivatives, net | 14,242 | 13,901 | 27,784 | 21,866 |\\n| Unrealized gains (losses) on derivatives, net | 17,422 | (2,158 | ) | (35,633 | ) | 30,502 |\\n| Interest expense | (8,124 | ) | (3,269 | ) | (13,283 | ) | (5,372 | ) |\\n| Other income, net | 313 | 252 | 233 | 393 |\\n| Total other income (expense), net | 23,853 | 8,726 | (20,899 | ) | 47,389 |\\n| Income before income taxes | 39,194 | 16,359 | 5,287 | 62,535 |\\n| Income taxes | (31 | ) | (79 | ) | (113 | ) | (131 | ) |\\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\\n| General partner’s interest in net income, including incentive distribution rights | $ | 3,728 | $ | 2,624 | $ | 5,982 | $ | 5,836 |\\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | $ | 56,568 |\\n| Net income (loss) per limited partner unit: |\\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\\n| Weighted average limited partner units outstanding: |\\n| Basic | 34,294 | 27,210 | 33,002 | 26,403 |\\n| Diluted | 34,534 | 27,264 | 33,002 | 26,438 |\\n| Distributions declared per unit | $ | 0.761 | $ | 0.757 | $ | 1.521 | $ | 1.513 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n3\\nEV Energy Partners, L.P.\\nCondensed Consolidated Statements of Changes in Owners’ Equity\\n(In thousands, except number of units)\\n(Unaudited)\\n\\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\\n| Balance, December 31, 2010 | $ | 779,327 | $ | (5,380 | ) | $ | 773,947 |\\n| Conversion of 80,534 vested phantom units | 3,508 | – | 3,508 |\\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $308 | 146,800 | – | 146,800 |\\n| Contributions from general partner | – | 3,191 | 3,191 |\\n| Distributions | (49,291 | ) | (6,682 | ) | (55,973 | ) |\\n| Equity–based compensation | 2,428 | – | 2,428 |\\n| Net income | 5,071 | 103 | 5,174 |\\n| Balance, June 30, 2011 | $ | 887,843 | $ | (8,768 | ) | $ | 879,075 |\\n\\n\\n| Common Unitholders | General Partner Interest | Total Owners’ Equity |\\n| Balance, December 31, 2009 | $ | 548,160 | $ | (729 | ) | $ | 547,431 |\\n| Conversion of 84,842 vested phantom units | 2,580 | – | 2,580 |\\n| Proceeds from public equity offering, net of underwriters discount and offering costs of $154 | 92,616 | – | 92,616 |\\n| Contributions from general partner | – | 1,977 | 1,977 |\\n| Distributions | (38,284 | ) | (5,149 | ) | (43,433 | ) |\\n| Equity–based compensation | 827 | – | 827 |\\n| Net income | 61,156 | 1,248 | 62,404 |\\n| Balance, June 30, 2010 | $ | 667,055 | $ | (2,653 | ) | $ | 664,402 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n4\\nEV Energy Partners, L.P. Condensed Consolidated Statements of Cash Flows (In thousands) (Unaudited)\\n| Six Months Ended June 30, |\\n| 2011 | 2010 |\\n| Cash flows from operating activities: |\\n| Net income | $ | 5,174 | $ | 62,404 |\\n| Adjustments to reconcile net income to net cash flows provided by operating activities: |\\n| Asset retirement obligations accretion expense | 1,936 | 1,274 |\\n| Depreciation, depletion and amortization | 36,007 | 25,520 |\\n| Equity–based compensation cost | 3,877 | 2,103 |\\n| Impairment of oil and natural gas properties | 6,666 | – |\\n| Gain on sale of oil and natural gas properties | – | (3,824 | ) |\\n| Noncash derivative activity | 30,951 | (30,502 | ) |\\n| Amortization of discount on long–term debt | 183 | – |\\n| Amortization of deferred loan costs | 554 | 275 |\\n| Other, net | 56 | (1 | ) |\\n| Changes in operating assets and liabilities: |\\n| Accounts receivable | (12,866 | ) | (4,098 | ) |\\n| Other current assets | 111 | 2,625 |\\n| Accounts payable and accrued liabilities | 7,630 | 879 |\\n| Long–term liabilities | – | (734 | ) |\\n| Other, net | (149 | ) | (119 | ) |\\n| Net cash flows provided by operating activities | 80,130 | 55,802 |\\n| Cash flows from investing activities: |\\n| Acquisition of oil and natural gas properties | 3,101 | (147,769 | ) |\\n| Development of oil and natural gas properties | (33,686 | ) | (8,170 | ) |\\n| Proceeds from sale of oil and natural gas properties | 1,170 | 4,471 |\\n| Settlements from acquired derivatives | 2,834 | – |\\n| Earnest money received for sale of oil and natural gas properties | 900 | – |\\n| Net cash flows used in investing activities | (25,681 | ) | (151,468 | ) |\\n| Cash flows from financing activities: |\\n| Long–term debt borrowings | – | 138,000 |\\n| Repayment of long–term debt borrowings | (431,500 | ) | (95,000 | ) |\\n| Proceeds from debt offering | 292,500 | – |\\n| Loan costs incurred | (6,202 | ) | (8 | ) |\\n| Proceeds from public equity offering | 147,108 | 92,770 |\\n| Offering costs | (308 | ) | (154 | ) |\\n| Contributions from general partner | 3,191 | 1,977 |\\n| Distributions paid | (55,973 | ) | (43,433 | ) |\\n| Net cash flows (used in) provided by financing activities | (51,184 | ) | 94,152 |\\n| Increase (decrease) in cash and cash equivalents | 3,265 | (1,514 | ) |\\n| Cash and cash equivalents – beginning of period | 23,127 | 18,806 |\\n| Cash and cash equivalents – end of period | $ | 26,392 | $ | 17,292 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n5\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements\\nNOTE 1. ORGANIZATION AND NATURE OF BUSINESS\\nNature of Operations\\nEV Energy Partners, L.P. (“we,” “our” or “us”) is a publicly held limited partnership that engages in the acquisition, development and production of oil and natural gas properties. Our general partner is EV Energy GP, L.P. (“EV Energy GP”), a Delaware limited partnership, and the general partner of our general partner is EV Management, LLC (“EV Management”), a Delaware limited liability company. EV Management is a wholly owned subsidiary of EnerVest, Ltd. (“EnerVest”), a Texas limited partnership. EnerVest and its affiliates also have a significant interest in us through their 71.25% ownership of EV Energy GP which, in turn, owns a 2% general partner interest in us and all of our incentive distribution rights.\\nBasis of Presentation\\nOur unaudited condensed consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. We believe that the presentations and disclosures herein are adequate to make the information not misleading. The unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the interim periods. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. These interim financial statements should be read in conjunction with our Annual Report on Form 10–K for the year ended December 31, 2010.\\nAll intercompany accounts and transactions have been eliminated in consolidation. In the Notes to Unaudited Condensed Consolidated Financial Statements, all dollar and unit amounts in tabulations are in thousands of dollars and units, respectively, unless otherwise indicated.\\nNOTE 2. EQUITY–BASED COMPENSATION\\nWe grant various forms of equity–based awards to employees, consultants and directors of EV Management and its affiliates who perform services for us. These equity–based awards consist primarily of phantom units and performance units.\\nWe account for the phantom units issued prior to 2009 as liability awards, and the fair value of these phantom units is remeasured at the end of each reporting period based on the current market price of our common units until settlement. Prior to settlement, compensation cost is recognized for these phantom units based on the proportionate amount of the requisite service period that has been rendered to date. We account for the phantom units issued beginning in 2009 as equity awards, and we estimated the fair value of these phantom units using the Black–Scholes option pricing model. We account for the performance units as equity awards, and we estimated the fair value of these performance units using the Monte Carlo simulation model.\\nThe following table presents the compensation costs recognized in our unaudited condensed consolidated statements of operations:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Liability awards | $ | 526 | $ | 608 | $ | 1,449 | $ | 1,276 |\\n| Equity awards | 1,214 | 429 | 2,428 | 827 |\\n| Total | $ | 1,740 | $ | 1,037 | $ | 3,877 | $ | 2,103 |\\n\\nThese costs are included in “General and administrative expenses” in our unaudited condensed consolidated statements of operations.\\nIn January 2011, the performance criterion was achieved with respect to the remaining 0.1 million performance units.\\n6\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nAs of June 30, 2011, total unrecognized compensation costs related to the unvested liability awards and equity awards and the period over which they are expected to be recognized are as follows:\\n\\n| Unrecognized Compensation Expense | Weighted Average Period (in years) |\\n| Liability awards | $ | 3,355 | 1.5 |\\n| Equity awards | 15,175 | 3.2 |\\n\\nNOTE 3. ACQUISITIONS\\nIn April 2011, we received a final purchase price settlement of $1.9 million related to our acquisition of oil and natural gas properties in the Mid–Continent area in September 2010.\\nIn June 2011, we received a final purchase price settlement of $2.2 million related to our acquisition of oil and natural gas properties in the Barnett Shale in December 2010.\\nIn June 2011, we, along with certain institutional partnerships managed by EnerVest, acquired additional oil and natural gas properties in the Barnett Shale. We acquired a 31.02% proportional interest in these properties for $1.0 million.\\nNOTE 4. RISK MANAGEMENT\\nOur business activities expose us to risks associated with changes in the market price of oil, natural gas and natural gas liquids. In addition, our floating rate credit facility exposes us to risks associated with changes in interest rates. As such, future earnings are subject to fluctuation due to changes in the market prices of oil, natural gas and natural gas liquids and interest rates. We use derivatives to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids and interest rates. Our policies do not permit the use of derivatives for speculative purposes.\\nWe have elected not to designate any of our derivatives as hedging instruments. Accordingly, changes in the fair value of our derivatives are recorded immediately to net income as “Unrealized gains (losses) on derivatives, net” in our unaudited condensed consolidated statements of operations.\\nAs of June 30, 2011, we had entered into oil commodity contracts with the following terms:\\n\\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\\n| Swaps – July 2011 through December 2011 | 209.4 | $ | 95.01 | $ | $ |\\n| Collars – July 2011 through December 2011 | 236.6 | 105.66 | 156.16 |\\n| Swaps –2012 | 625.7 | 96.45 |\\n| Collars – 2012 | 456.8 | 104.54 | 156.77 |\\n| Swaps –2013 | 994.5 | 86.46 |\\n| Swaps – 2014 | 897.2 | 91.90 |\\n\\n7\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nAs of June 30, 2011, we had entered into natural gas commodity contracts with the following terms:\\n\\n| Period Covered | Hedged Volume (MmmBtus) | Weighted Average Fixed Price | Weighted Average Floor Price | Weighted Average Ceiling Price |\\n| Swaps – July 2011 through December 2011 | 8,322.9 | $ | 6.67 | $ | $ |\\n| Collars – July 2011 through December 2011 | 3,330.6 | 7.54 | 9.90 |\\n| Swaps –2012 | 14,307.6 | 6.84 |\\n| Collars – 2012 | 6,618.7 | 7.94 | 9.90 |\\n| Swaps – 2013 | 18,797.5 | 5.77 |\\n| Swaps – 2014 | 14,600.0 | 5.75 |\\n| Swaps – 2015 | 14,600.0 | 6.00 |\\n\\nAs of June 30, 2011, we had entered into natural gas liquids commodity contracts with the following terms:\\n\\n| Period Covered | Hedged Volume (MBbls) | Weighted Average Fixed Price |\\n| Ethane (MBbls): |\\n| Swaps – July 2011 through December 2011 | 188.6 | $ | 20.06 |\\n| Propane (MBbls): |\\n| Swaps – July 2011 through December 2011 | 112.7 | 49.77 |\\n\\nAs of June 30, 2011, we had entered into natural gas basis swaps with the following terms:\\n\\n| Period Covered | Floating Index 1 | Floating Index 2 | Hedged Volume (MmmBtus) | Spread |\\n| July 2011 through December 2011 | NYMEX | Dominion Appalachia | 174.4 | $ | 0.1975 |\\n| July 2011 through December 2011 | NYMEX | Appalachia Columbia | 47.7 | 0.1500 |\\n\\nAs of June 30, 2011, we had entered into interest rate swaps with the following terms:\\n\\n| Period Covered | Notional Amount | Floating Rate | Fixed Rate |\\n| July 2011 – July 2012 | $ | 90,000 | 1 Month LIBOR | 4.157 | % |\\n| July 2011 – September 2012 | 40,000 | 1 Month LIBOR | 2.145 | % |\\n| July 2012 – July 2015 | 110,000 | 1 Month LIBOR | 3.315 | % |\\n\\n8\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nThe fair value of these derivatives was as follows:\\n\\n| Asset Derivatives | Liability Derivatives |\\n| June 30, 2011 | December 31, 2010 | June 30, 2011 | December 31, 2010 |\\n| Commodity contracts | $ | 89,564 | $ | 123,655 | $ | 10,620 | $ | 7,633 |\\n| Interest rate swaps | – | – | 8,925 | 12,152 |\\n| Total fair value | 89,564 | 123,655 | 19,545 | 19,785 |\\n| Netting arrangements | (11,773 | ) | (17,058 | ) | (11,773 | ) | (17,058 | ) |\\n| Net recorded fair value | $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\\n| Location of derivatives in our unaudited condensed consolidated balance sheets: |\\n| Derivative asset | $ | 51,215 | $ | 55,100 | $ | – | $ | – |\\n| Long–term derivative asset | 26,576 | 51,497 | – | – |\\n| Derivative liability | – | – | 1,178 | 1,943 |\\n| Long–term derivative liability | – | – | 6,594 | 784 |\\n| $ | 77,791 | $ | 106,597 | $ | 7,772 | $ | 2,727 |\\n\\nThe following table presents the impact of derivatives and their location within the unaudited condensed consolidated statements of operations:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Realized gains on derivatives, net: |\\n| Commodity contracts (1) | $ | 11,388 | $ | 16,044 | $ | 27,070 | $ | 26,167 |\\n| Interest rate swaps (2) | 2,854 | (2,143 | ) | 714 | (4,301 | ) |\\n| Total | $ | 14,242 | $ | 13,901 | $ | 27,784 | $ | 21,866 |\\n| Unrealized gains (losses) on derivatives, net: |\\n| Commodity contracts | $ | 20,380 | $ | (1,189 | ) | $ | (34,181 | ) | $ | 32,701 |\\n| Interest rate swaps (2) | (2,958 | ) | (969 | ) | (1,452 | ) | (2,199 | ) |\\n| Total | $ | 17,422 | $ | (2,158 | ) | $ | (35,633 | ) | $ | 30,502 |\\n\\n\\n| (1) | Realized gains for the three months and six months ended June 30, 2011 exclude $1.4 million and $2.9 million, respectively, related to the initial value of derivatives acquired in our December 2010 acquisition of oil and natural gas properties that have been relieved through the settlement of such derivatives. |\\n\\n\\n| (2) | In June 2011, we terminated three of our interest rate swaps and reclassified the $4.7 million non–cash gain from “Unrealized gains (losses) on derivatives, net” to “Realized gains on derivatives, net.” |\\n\\n9\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nNOTE 5. FAIR VALUE MEASUREMENTS\\nRecurring Basis\\nThe following table presents the fair value hierarchy table for our assets and liabilities that are required to be measured at fair value on a recurring basis:\\n\\n| Fair Value at Reporting Date Using: |\\n| June 30, 2011 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\\n| Derivative assets: |\\n| Commodity contracts | $ | 89,564 | $ | – | $ | 89,564 | $ | – |\\n| Derivative liabilities: |\\n| Commodity contracts | $ | 10,620 | $ | – | $ | 10,620 | $ | – |\\n| Interest rate swaps | 8,925 | – | 8,925 | – |\\n| Total derivative liabilities | $ | 19,545 | $ | – | $ | 19,545 | $ | – |\\n| Fair Value at Reporting Date Using: |\\n| December 31, 2010 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) |\\n| Derivative assets: |\\n| Commodity contracts | $ | 123,655 | $ | – | $ | 123,655 | $ | – |\\n| Derivative liabilities: |\\n| Commodity contracts | $ | 7,633 | $ | – | $ | 7,633 | $ | – |\\n| Interest rate swaps | 12,152 | – | 12,152 | – |\\n| Total derivative liabilities | $ | 19,785 | $ | – | $ | 19,785 | $ | – |\\n\\nOur derivatives consist of over–the–counter (“OTC”) contracts which are not traded on a public exchange. These derivatives are indexed to active trading hubs for the underlying commodity and are commonly used in the energy industry and offered by a number of financial institutions and large energy companies.\\nAs the fair value of these derivatives is based on inputs using market prices obtained from independent brokers or determined using quantitative models that use as their basis readily observable market parameters that are actively quoted and can be validated through external sources, including third party pricing services, brokers and market transactions, we have categorized these derivatives as Level 2. We value these derivatives based on observable market data for similar instruments. This observable data includes the forward curves for commodity prices based on quoted market prices and prospective volatility factors related to changes in the forward curves and yield curves based on money market rates and interest rate swap data. Our estimates of fair value have been determined at discrete points in time based on relevant market data. These estimates involve uncertainty and cannot be determined with precision. There were no changes in valuation techniques or related inputs in the three months ended June 30, 2011.\\nNonrecurring Basis\\nIn March 2011, in conjunction with the sale of oil and natural gas properties, we incurred impairment charges of $1.5 million as oil and natural gas properties with a net cost basis of $2.7 million were written down to their fair value of $1.2 million.\\n10\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nIn June 2011, we incurred impairment charges of $5.2 million as oil and natural gas properties with a net cost basis of $13.7 million were written down to their fair value of $8.5 million.\\nFinancial Instruments\\nThe estimated fair values of our financial instruments have been determined at discrete points in time based on relevant market information. Our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, derivatives and long–term debt. The carrying amounts of our financial instruments other than derivatives and long–term debt approximate fair value because of the short–term nature of the items. Derivatives are recorded at fair value (see Note 4). The carrying value of debt outstanding under our credit facility approximates fair value because the credit facility’s variable interest rate resets frequently and approximates current market rates available to us. As of June 30, 2011, the estimated fair value of our senior notes due 2019 was $303.0 million, which differs from the carrying value of $292.7 million. The fair value of our senior notes due 2019 was estimated using quoted markets prices based on trades of such debt as of June 30, 2011.\\nNOTE 6. ASSET RETIREMENT OBLIGATIONS\\nWe record an asset retirement obligation (“ARO”) and capitalize the asset retirement cost in oil and natural gas properties in the period in which the retirement obligation is incurred based upon the fair value of an obligation to perform site reclamation, dismantle facilities or plug and abandon wells. After recording these amounts, the ARO is accreted to its future estimated value using an assumed cost of funds and the additional capitalized costs are depreciated on a unit–of–production basis. The changes in the aggregate ARO are as follows:\\n\\n| Balance as of December 31, 2010 | $ | 68,430 |\\n| Liabilities incurred | 311 |\\n| Accretion expense | 1,936 |\\n| Revisions in estimated cash flows | 3,118 |\\n| Settlements and divestitures | (4,275 | ) |\\n| Balance as of June 30, 2011 | $ | 69,520 |\\n\\nAs of both June 30, 2011 and December 31, 2010, $1.3 million of our ARO is classified as current and is included in “Accounts payable and accrued liabilities” in our unaudited condensed consolidated balance sheets.\\nNOTE 7. LONG–TERM DEBT\\nLong–term debt consisted of the following:\\n\\n| June 30, 2011 | December 31, 2010 |\\n| Credit facility | $ | 187,500 | $ | 619,000 |\\n| 8.0% senior notes due 2019 | 300,000 | – |\\n| Unamortized discount | (7,317 | ) | – |\\n| Long–term debt | $ | 480,183 | $ | 619,000 |\\n\\nCredit Facility\\nOn April 26, 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility are secured by a first priority lien on substantially all of our assets and the assets of our subsidiaries. We may use borrowings under the facility for acquiring and developing oil and natural gas properties, for working capital purposes, for general corporate purposes and for funding distributions to partners. We also may use up to $100.0 million of available borrowing capacity for letters of credit. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. As of June 30, 2011, we were in compliance with these financial covenants.\\n11\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nBorrowings under the facility bear interest at a floating rate based on, at our election, a base rate or the London Inter–Bank Offered Rate plus applicable premiums based on the percent of the borrowing base that we have outstanding (weighted average effective interest rate of 3.49% at June 30, 2011).\\nBorrowings under the facility may not exceed a “borrowing base” determined by the lenders under the facility based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base under the facility was $600.0 million. The borrowing base is subject to scheduled redeterminations as of April 1 and October 1 of each year with an additional redetermination once per calendar year at our request or at the request of the lenders and with one calculation that may be made at our request during each calendar year in connection with material acquisitions or divestitures of properties.\\n8.0% Senior Notes due 2019\\nOn March 22, 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019 (the “Notes”) at an offering price equal to 100% of par. The Notes were sold in a private placement to eligible purchasers in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended.\\nWe received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness under our existing credit facility. The discount and the offering expenses are being amortized over the life of the Notes. The amortization is included in “Interest expense” on our unaudited condensed consolidated statements of operations.\\nThe Notes were issued under an indenture dated March 22, 2011, (the “Indenture”), mature April 15, 2019, and bear interest at 8.0%. Interest is payable semi–annually beginning October 15, 2011. The Notes are general unsecured obligations and are effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the collateral securing such indebtedness.\\nThe Notes are unconditionally guaranteed, jointly and severally, on a senior unsecured basis, by all of our existing subsidiaries other than EV Energy Finance Corp. (“Finance”), which is a co–issuer of the Notes. Neither we nor Finance have material independent assets or operations apart from the assets and operations of our subsidiaries.\\nThe Indenture provides that, prior to April 15, 2014, we may redeem up to 35% of the aggregate principal amount of the Notes with the net proceeds of a public or private equity offering at a redemption price of 108.0% of the principal amount redeemed, plus accrued and unpaid interest, provided that:\\n\\n| · | at least 65% of the aggregate principal amount of Notes issued under the Indenture remains outstanding immediately after the occurrence of such redemption; and |\\n\\n\\n| · | the redemption occurs within 180 days of the date of the closing of such public or private equity offering. |\\n\\nOn and after April 15, 2015, we may redeem all or a part of the Notes, at the redemption prices (expressed as percentages of principal amount) set forth below, plus accrued and unpaid interest, if any, on the Notes to be redeemed to the applicable redemption date, if redeemed during the twelve–month period beginning on April 15 of the years indicated below:\\n\\n| Year | Percentage |\\n| 2015 | 104.0 | % |\\n| 2016 | 102.0 | % |\\n| 2017 and thereafter | 100.0 | % |\\n\\n12\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nPrior to April 15, 2015, we may redeem all or part of the Notes at a redemption price equal to the sum of:\\n\\n| · | the principal amount thereof, plus |\\n\\n\\n| · | the Make Whole Premium (as defined in the Indenture) at the redemption date, plus accrued and unpaid interest, if any, to the redemption date. |\\n\\nThe Indenture also provides that, if a change of control (as defined in the Indenture) occurs, the holders have a right to require us to repurchase all or part of the Notes at a redemption price equal to 101%, plus accrued and unpaid interest.\\nThe Indenture contains covenants that, among other things, limit our ability to: (i) pay distributions on, purchase or redeem our common units or redeem our subordinated debt; (ii) make investments; (iii) incur or guarantee additional indebtedness or issue certain types of equity securities; (iv) create certain liens; (v) sell assets; (vi) consolidate, merge or transfer all or substantially all of our assets; (vii) enter into intercompany agreements that restrict distributions or other payments from our restricted subsidiaries to us; (viii) engage in transactions with affiliates; and (ix) create unrestricted subsidiaries.\\nNOTE 8. COMMITMENTS AND CONTINGENCIES\\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements, and no amounts have been accrued at June 30, 2011 or December 31, 2010.\\nNOTE 9. OWNERS’ EQUITY\\nUnits Outstanding\\nAt June 30, 2011, owner’s equity consists of 34,173,650 common units, representing a 98% limited partnership interest in us, and a 2% general partnership interest.\\nIssuance of Units\\nIn January 2011, the following equity–based awards vested:\\n\\n| Phantom units accounted for as liability awards (1) | 80,534 |\\n| Phantom units accounted for as equity awards | 70,610 |\\n| Performance units | 80,000 |\\n| Total units vested | 231,144 |\\n| Performance units settled in cash | (17,807 | ) |\\n| Units converted to common units | 213,337 |\\n\\n\\n| (1) | These phantom units vested at a fair value of $3.5 million. |\\n\\nIn conjunction with the vesting of these units, we received a contribution of $0.2 million by our general partner to maintain its 2% interest in us.\\nOn March 9, 2011, we closed a public offering of 3.45 million of our common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\\n13\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nCash Distributions\\nThe following sets forth the distributions we paid during the six months ended June 30, 2011:\\n\\n| Date Paid | Period Covered | Distribution per Unit | Total Distribution |\\n| February 14, 2011 | October 1, 2010 – December 31, 2010 | $ | 0.759 | $ | 26,477 |\\n| May 13, 2011 | January 1, 2011 – March 31, 2011 | 0.760 | 29,496 |\\n| $ | 55,973 |\\n\\nOn July 28, 2011, the board of directors of EV Management declared a $0.761 per unit distribution for the second quarter of 2011 on all common units. The distribution of $29.5 million is to be paid on August 12, 2011 to unitholders of record at the close of business on August 8, 2011.\\nNOTE 10. NET INCOME (LOSS) PER LIMITED PARTNER UNIT\\nThe following sets forth the calculation of net income (loss) per limited partner unit:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Net income | $ | 39,163 | $ | 16,280 | $ | 5,174 | $ | 62,404 |\\n| Less: |\\n| Incentive distribution rights | (2,945 | ) | (2,298 | ) | (5,879 | ) | (4,588 | ) |\\n| General partner’s 2% interest in net income | (783 | ) | (326 | ) | (103 | ) | (1,248 | ) |\\n| Limited partners’ interest in net income (loss) | $ | 35,435 | $ | 13,656 | $ | (808 | ) | 56,568 |\\n| Weighted average limited partner units outstanding: |\\n| Common units | 34,174 | 27,060 | 32,880 | 26,249 |\\n| Performance units (1) | 120 | 150 | 122 | 154 |\\n| Denominator for basic net income (loss) per limited partner unit | 34,294 | 27,210 | 33,002 | 26,403 |\\n| Dilutive phantom units (2) | 240 | 54 | – | 35 |\\n| Total | 34,534 | 27,264 | 33,002 | 26,438 |\\n| Net income (loss) per limited partner unit: |\\n| Basic | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\\n| Diluted | $ | 1.03 | $ | 0.50 | $ | (0.02 | ) | $ | 2.14 |\\n\\n\\n| (1) | Our earned but unvested performance units are considered to be participating securities for purposes of calculating our net income (loss) per limited partner unit and, accordingly, are included in the basic computation as such. |\\n\\n\\n| (2) | Phantom units accounted for as equity awards totaling 0.5 million units were not included in the computation of diluted net income (loss) per limited partner unit because the effect would have been anti-dilutive for the six months ended June 30, 2011. |\\n\\nNOTE 11. RELATED PARTY TRANSACTIONS\\nPursuant to an omnibus agreement, we paid EnerVest $2.8 million and $2.3 million in the three months ended June 30, 2011 and 2010, respectively, and $5.5 million and $4.3 million in the six months ended June 30, 2011 and 2010, respectively, in monthly administrative fees for providing us general and administrative services. These fees are based on an allocation of charges between EnerVest and us based on the estimated use of such services by each party, and we believe that the allocation method employed by EnerVest is reasonable and reflective of the estimated level of costs we would have incurred on a standalone basis. These fees are included in general and administrative expenses in our unaudited condensed consolidated statements of operations.\\n14\\nEV Energy Partners, L.P.\\nNotes to Unaudited Condensed Consolidated Financial Statements (continued)\\nWe have entered into operating agreements with EnerVest whereby a wholly owned subsidiary of EnerVest acts as contract operator of the oil and natural gas wells and related gathering systems and production facilities in which we own an interest. We reimbursed EnerVest $3.4 million and $3.2 million in the three months ended June 30, 2011 and 2010, respectively, and $7.2 million and $5.7 million in the six months ended June 30, 2011 and 2010, respectively, for direct expenses incurred in the operation of our wells and related gathering systems and production facilities and for the allocable share of the costs of EnerVest employees who performed services on our properties. As the vast majority of such expenses are charged to us on an actual basis (i.e., no mark–up or subsidy is charged or received by EnerVest), we believe that the aforementioned services were provided to us at fair and reasonable rates relative to the prevailing market and are representative of the costs that would have been incurred on a standalone basis. These costs are included in lease operating expenses in our unaudited condensed consolidated statements of operations. Additionally, in its role as contract operator, this EnerVest subsidiary also collects proceeds from oil and natural gas sales and distributes them to us and other working interest owners.\\nNOTE 12. OTHER SUPPLEMENTAL INFORMATION\\nSupplemental cash flows and non–cash transactions were as follows:\\n\\n| Six Months Ended June 30, |\\n| 2011 | 2010 |\\n| Supplemental cash flows information: |\\n| Cash paid for interest | $ | 5,595 | $ | 4,755 |\\n| Cash paid for income taxes | 250 | 245 |\\n| Non–cash transactions: |\\n| Costs for development of oil and natural gas properties in accounts payable and accrued liabilities | 5,241 | 2,533 |\\n\\nNOTE 13. NEW ACCOUNTING STANDARDS\\nIn May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011–04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the International Accounting Standards Board on fair value measurement, and has resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The provisions of ASU 2011–04 are applicable to interim and annual reporting periods subsequent to December 15, 2011. We will adopt the new requirements for our Form 10–K for the year ending December 31, 2011.\\nNo other new accounting pronouncements issued or effective during the six months ended June 30, 2011 have had or are expected to have a material impact on our unaudited condensed consolidated financial statements.\\nNOTE 14. SUBSEQUENT EVENT\\nIn July 2011, we sold oil and natural gas properties for $8.5 million. We received a non–refundable deposit of $0.9 million in June 2011 and the remainder of the proceeds upon the closing of the sale. These oil and natural gas properties and the related ARO have been classified as “Assets held for sale” and “Liabilities related to assets held for sale” on our unaudited consolidated condensed balance sheet.\\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\\nWe evaluated subsequent events for appropriate accounting and disclosure through the date these unaudited condensed consolidated financial statements were issued.\\n15\\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto, as well as our Annual Report on Form 10–K for the year ended December 31, 2010.\\nOVERVIEW\\nWe are a Delaware limited partnership formed in April 2006 by EnerVest to acquire, produce and develop oil and natural gas properties. Our general partner is EV Energy GP, a Delaware limited partnership, and the general partner of our general partner is EV Management, a Delaware limited liability company.\\nOur properties are located in the Barnett Shale, the Appalachian Basin (primarily in Ohio and West Virginia), the Mid-Continent area in Oklahoma, Texas, Arkansas, Kansas and Louisiana, the San Juan Basin, the Monroe Field in Louisiana, the Permian Basin, Central and East Texas (which includes the Austin Chalk area), and Michigan. As of December 31, 2010, we had estimated net proved reserves of 12.9 MMBbls of oil, 27.5 MMBbls of natural gas liquids and 575.2 Bcf of natural gas, or 817.3 Bcfe, and a standardized measure of $1,020.2 million.\\nCURRENT DEVELOPMENTS\\nIn March 2011, we closed a public offering of 3.45 million common units at an offering price of $44.42 per common unit. We received net proceeds of $149.8 million, including a contribution of $3.0 million by our general partner to maintain its 2% interest in us. We used a portion of the net proceeds to repay indebtedness outstanding under our credit facility.\\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior unsecured notes due 2019. We received net proceeds of $291.6 million, after deducting the discount of $7.5 million and offering expenses of $0.9 million. We used the net proceeds to repay indebtedness outstanding under our credit facility.\\nIn April 2011, we entered into a second amended and restated $1.0 billion credit facility that expires in April 2016. The facility requires the maintenance of a current ratio (as defined in the facility) of greater than 1.0 and a ratio of total debt to earnings plus interest expense, taxes, depreciation, depletion and amortization expense and exploration expense of no greater than 4.25 to 1.0. The borrowing base, which was initially set at $600.0 million, is subject to scheduled redeterminations every six months beginning October 1, 2011.\\nIn July 2011, we agreed, subject to the execution of a final purchase and sale agreement, to acquire oil and natural gas properties from certain institutional partnerships managed by EnerVest for $34.3 million, subject to customary closing conditions and purchase price adjustments. The acquisition is expected to close in August 2011.\\nBUSINESS ENVIRONMENT\\nOur primary business objective is to provide stability and growth in cash distributions per unit over time. The amount of cash we can distribute on our units principally depends upon the amount of cash generated from our operations, which will fluctuate from quarter to quarter based on, among other things:\\n| · | the prices at which we will sell our oil, natural gas liquids and natural gas production; |\\n\\n\\n| · | our ability to hedge commodity prices; |\\n\\n\\n| · | the amount of oil, natural gas liquids and natural gas we produce; and |\\n\\n\\n| · | the level of our operating and administrative costs. |\\n\\nOil and natural gas prices are expected to be volatile in the future. Factors affecting the price of oil include worldwide economic conditions, geopolitical activities, worldwide supply disruptions, weather conditions, actions taken by the Organization of Petroleum Exporting Countries and the value of the U.S. dollar in international currency markets. Factors affecting the price of natural gas include the discovery of substantial accumulations of natural gas in unconventional reservoirs due to technological advancements necessary to commercially produce these unconventional reserves, North American weather conditions, industrial and consumer demand for natural gas, storage levels of natural gas and the availability and accessibility of natural gas deposits in North America.\\n16\\nIn order to mitigate the impact of changes in oil and natural gas prices on our cash flows, we are a party to derivatives, and we intend to enter into derivatives in the future to reduce the impact of oil and natural gas price volatility on our cash flows. By removing a significant portion of this price volatility on our future oil and natural gas production through December 2015, we have mitigated, but not eliminated, the potential effects of changing oil and natural gas prices on our cash flows from operations for those periods. If commodity prices are depressed for an extended period of time, it could alter our acquisition and development plans, and adversely affect our growth strategy and ability to access additional capital in the capital markets.\\nThe primary factors affecting our production levels are capital availability, our ability to make accretive acquisitions, the success of our drilling program and our inventory of drilling prospects. In addition, as initial reservoir pressures are depleted, production from our wells decreases. We attempt to overcome this natural decline through a combination of drilling and acquisitions. Our future growth will depend on our ability to continue to add reserves through drilling and acquisitions in excess of production. We will maintain our focus on the costs to add reserves through drilling and acquisitions as well as the costs necessary to produce such reserves. Our ability to add reserves through drilling is dependent on our capital resources and can be limited by many factors, including our ability to timely obtain drilling permits and regulatory approvals. Any delays in drilling, completion or connection to gathering lines of our new wells will negatively impact our production, which may have an adverse effect on our revenues and, as a result, cash available for distribution.\\nWe focus our efforts on increasing oil and natural gas reserves and production while controlling costs at a level that is appropriate for long–term operations. Our future cash flows from operations are dependent upon our ability to manage our overall cost structure.\\nRESULTS OF OPERATIONS\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2011 | 2010 | 2011 | 2010 |\\n| Production data: |\\n| Oil (MBbls) | 241 | 171 | 449 | 297 |\\n| Natural gas liquids (MBbls) | 272 | 178 | 542 | 360 |\\n| Natural gas (MMcf) | 6,999 | 4,734 | 14,003 | 8,719 |\\n| Net production (MMcfe) | 10,080 | 6,831 | 19,951 | 12,665 |\\n| Average sales price per unit: |\\n| Oil (Bbl) | $ | 98.63 | $ | 73.20 | $ | 94.58 | $ | 73.73 |\\n| Natural gas liquids (Bbl) | 54.80 | 40.23 | 51.45 | 42.91 |\\n| Natural gas (Mcf) | 4.20 | 4.16 | 4.10 | 4.66 |\\n| Mcfe | 6.76 | 5.77 | 6.40 | 6.16 |\\n| Average unit cost per Mcfe: |\\n| Production costs: |\\n| Lease operating expenses | $ | 1.78 | $ | 2.18 | $ | 1.77 | $ | 2.08 |\\n| Production taxes | 0.31 | 0.24 | 0.29 | 0.30 |\\n| Total | 2.09 | 2.42 | 2.06 | 2.38 |\\n| Asset retirement obligations accretion expense | 0.10 | 0.11 | 0.10 | 0.10 |\\n| Depreciation, depletion and amortization | 1.83 | 1.97 | 1.80 | 2.02 |\\n| General and administrative expenses | 0.71 | 0.85 | 0.79 | 0.83 |\\n\\n17\\nThree Months Ended June 30, 2011 Compared with the Three Months Ended June 30, 2010\\nNet income for the three months ended June 30, 2011 was $39.2 million compared with $16.3 million for the three months ended June 30, 2010. This improvement reflects (i) a $28.7 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil, natural gas and natural gas liquids and (ii) a $19.6 million increase in non–cash changes in the fair value of our derivatives, partially offset by (iii) an $11.5 million increase in operating expenses mainly related to the properties acquired in 2010, (iv) an impairment loss of $5.1 million related to the write–down of oil and natural gas properties to their fair value (compared with a $4.4 million gain on the sale of oil and natural gas properties in the three months ended June 30, 2010), and (v) a $4.9 million increase in interest expense.\\nOil, natural gas and natural gas liquids revenues for the three months ended June 30, 2011 totaled $68.1 million, an increase of $28.7 million compared with the three months ended June 30, 2010. This increase was the result of $21.6 million related to increased production and $7.1 million related to higher prices for oil, natural gas and natural gas liquids.\\nLease operating expenses for the three months ended June 30, 2011 increased $3.1 million compared with the three months ended June 30, 2010 primarily as the result of $5.8 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $0.4 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.34 per Mcfe) of lease operating expenses in the three months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the three months ended June 30, 2010. Lease operating expenses per Mcfe were $1.78 in the three months ended June 30, 2011 compared with $2.18 in the three months ended June 30, 2010. Production taxes, which are generally based on a percentage of our oil, natural gas and natural gas liquids revenues, for the three months ended June 30, 2011 increased $1.4 million compared with the three months ended June 30, 2010 primarily as the result of $1.0 million due to increased production and $0.4 million due to higher average realized prices. Production taxes for the three months ended June 30, 2011 were $0.31 per Mcfe compared with $0.24 per Mcfe for the three months ended June 30, 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 increased $0.2 million compared with the three months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for the three months ended June 30, 2011 was $0.10 per Mcfe compared with $0.11 per Mcfe for the three months ended June 30, 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 increased $5.0 million compared with the three months ended June 30, 2010 primarily due to $5.9 million from higher production offset by a decrease of $0.9 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the three months ended June 30, 2011 was $1.83 per Mcfe compared with $1.97 per Mcfe for the three months ended June 30, 2010.\\nGeneral and administrative expenses for the three months ended June 30, 2011 totaled $7.1 million, an increase of $1.3 million compared with the three months ended June 30, 2010. This increase is primarily the result of $1.0 million of higher compensation costs primarily related to our equity–based compensation plans and $0.5 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010 partially offset by a $0.2 million decrease in acquisition due diligence costs. General and administrative expenses were $0.71 per Mcfe in the three months ended June 30, 2011 compared with $0.85 per Mcfe in the three months ended June 30, 2010.\\nDuring the three months ended June 30, 2011, we incurred impairment charges of $5.1 million to write down oil and natural gas properties to their fair value. During the three months ended June 30, 2011 and 2010, we recorded cash settlements of $9.5 million and $13.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception. Unrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the three months ended June 30, 2011, the fair value of our open derivatives increased from a net asset of $49.3 million at March 31, 2011 to a net asset of $70.0 million at June 30, 2011. In the three months ended June 30, 2010, the fair value of our open derivatives decreased from a net asset of $125.8 million at March 31, 2010 to a net asset of $123.6 million at June 30, 2010.\\n18\\nInterest expense for the three months ended June 30, 2011 increased $4.9 million compared with the three months ended June 30, 2010 primarily due to increases of $2.4 million from a higher weighted average long–term debt balance and $2.5 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\\nSix Months Ended June 30, 2011 Compared with the Six Months Ended June 30, 2010\\nNet income for the six months ended June 30, 2011 was $5.2 million compared with $62.4 million for the six months ended June 30, 2010. This change reflects (i) a $49.5 million increase in revenues due to increased production primarily from our acquisitions of oil and natural gas properties in 2010 and higher prices for oil and natural gas liquids and (ii) a $5.9 million increase in realized gains on derivatives, partially offset by (iii) a.$66.1 million decrease in non–cash changes in the fair value of our derivatives, (iv) a $28.0 million increase in operating expenses mainly related to the properties acquired in 2010, (v) a $7.9 million increase in interest expense and (vi) an impairment loss of $6.7 million related to the write–down of oil and natural gas properties to their fair value (compared with a $3.8 million gain on the sale of oil and natural gas properties in the six months ended June 30, 2010).\\nOil, natural gas and natural gas liquids revenues for the six months ended June 30, 2011 totaled $127.7 million, an increase of $49.7 million compared with the six months ended June 30, 2010. This increase was the result of $45.3 million related to increased production and $4.4 million related to higher prices for oil and natural gas liquids.\\nLease operating expenses for the six months ended June 30, 2011 increased $9.0 million compared with the six months ended June 30, 2010 primarily as the result of $12.9 million related to our 2010 acquisitions and our expanded development drilling program partially offset by $1.5 million due to a lower unit cost per Mcfe for our December 2010 acquisition of oil and natural gas properties in the Barnett Shale and $2.3 million ($0.18 per Mcfe) of lease operating expenses in the six months ended June 30, 2010 associated with oil in tanks acquired in the March 2010 acquisition that was sold in the six months ended June 30, 2010. Lease operating expenses per Mcfe were $1.77 in the six months ended June 30, 2011 compared with $2.08 in the six months ended June 30, 2010. Production taxes for the six months ended June 30, 2011 increased $2.0 million compared with the six months ended June 30, 2010 primarily as the result of $2.1 million due to increased production partially offset by $0.1 million due to lower average realized prices for natural gas. Production taxes for the six months ended June 30, 2011 were $0.29 per Mcfe compared with $0.30 per Mcfe for the six months ended June 30, 2010. Asset retirement obligations accretion expense for the six months ended June 30, 2011 increased $0.7 million compared with the six months ended June 30, 2010 primarily due to the oil and natural gas properties that we acquired in 2010. Asset retirement obligations accretion expense for both the six months ended June 30, 2011 and June 30, 2010 was $0.10 per Mcfe. Depreciation, depletion and amortization for the six months ended June 30, 2011 increased $10.5 million compared with the six months ended June 30, 2010 primarily due to $13.1 million from higher production offset by a decrease of $2.8 million due to a lower average DD&A rate per unit. The lower average DD&A rate per unit reflects the effect of our acquisitions of oil and natural gas properties in 2010. Depreciation, depletion and amortization for the six months ended June 30, 2011 was $1.80 per Mcfe compared with $2.02 per Mcfe for the six months ended June 30, 2010.\\nGeneral and administrative expenses for the six months ended June 30, 2011 totaled $15.7 million, an increase of $5.2 million compared with the six months ended June 30, 2010. This increase is primarily the result of (i) $3.5 million of higher compensation costs primarily related to our equity–based compensation plans, (ii) $1.3 million of higher fees paid to EnerVest under the omnibus agreement due to an increase in operations from our acquisitions of oil and natural gas properties in 2010, and (iii) an overall increase in costs related to our significant growth. General and administrative expenses were $0.79 per Mcfe in the six months ended June 30, 2011 compared with $0.83 per Mcfe in the six months ended June 30, 2010.\\nDuring the six months ended June 30, 2011, we incurred impairment charges of $6.7 million to write down oil and natural gas properties to their fair value. During the six months ended June 30, 2011 and 2010, we recorded cash settlements of $23.1 million and $21.9 million, respectively, as realized gains on derivatives, net, as the contract prices for our derivatives exceeded the underlying market price for that period. In June 2011, we also terminated three of our interest rate swaps and recorded a non–cash realized gain of $4.7 million, which represented the value of these interest rate swaps on the date of termination. The terminated interest rate swaps were rolled over into three new interest rate swaps with a value of $5.2 million at inception.\\n19\\nUnrealized gains (losses) on derivatives, net represent the change in the fair value of our open derivatives during the period. In the six months ended June 30, 2011, the fair value of our open derivatives decreased from a net asset of $103.9 million at December 31, 2010 to a net asset of $70.0 million at June 30, 2011. In the six months ended June 30, 2010, the fair value of our open derivatives increased from a net asset of $93.1 million at December 31, 2009 to a net asset of $123.6 million at June 30, 2010.\\nInterest expense for the six months ended June 30, 2011 increased $7.9 million compared with the six months ended June 30, 2010 primarily due to an increase of $5.8 million from a higher weighted average long–term debt balance and an increase of $2.1 million due to a higher weighted average effective interest rate attributable to our 8% senior notes due 2019.\\nLIQUIDITY AND CAPITAL RESOURCES\\nHistorically, our primary sources of liquidity and capital have been issuances of equity and debt securities, borrowings under our credit facility and cash flows from operations. Our primary uses of cash have been acquisitions of oil and natural gas properties and related assets, development of our oil and natural gas properties, distributions to our partners and working capital needs. For 2011, we believe that cash on hand and net cash flows generated from operations will be adequate to fund our capital budget and satisfy our short–term liquidity needs. We may also utilize various financing sources available to us, including the issuance of equity or debt securities through public offerings or private placements, to fund our acquisitions and long–term liquidity needs. Our ability to complete future offerings of equity or debt securities and the timing of these offerings will depend upon various factors including prevailing market conditions and our financial condition.\\nIn the past we accessed the equity and debt markets to finance our significant acquisitions. While we have been successful in accessing the public equity and debt markets earlier this year and in prior years, any disruptions in the financial markets may limit our ability to access the public equity or debt markets in the future.\\nLong–term Debt\\nIn April 2011, we replaced our existing $700.0 million credit facility with a $1.0 billion credit facility that expires in April 2016. Borrowings under the facility may not exceed a “borrowing base” determined by the lenders based on our oil and natural gas reserves. As of June 30, 2011, the borrowing base was $600.0 million, and we had $187.5 million outstanding.\\nIn March 2011, we issued $300.0 million in aggregate principal amount of 8.0% senior notes due 2019 and received net proceeds of approximately $291.6 million. We used the net proceeds to repay indebtedness outstanding under our credit facility. As of June 30, 2011, we had $300.0 million of notes outstanding. These notes are recorded on our unaudited condensed consolidated balance sheet as $292.7 million, which is net of the unamortized discount of $7.3 million.\\nFor additional information about our long–term debt, such as interest rates and covenants, please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein.\\nCash and Short–term Investments\\nAt June 30, 2011, we had $26.4 million of cash and short–term investments, which included $22.0 million of short–term investments. With regard to our short–term investments, we invest in money market accounts with major financial institutions.\\nCounterparty Exposure\\nAt June 30, 2011, our open derivative contracts were in a net receivable position with a fair value of $70.0 million. All of our derivative contracts are with major financial institutions who are also lenders under our credit facility. Should one of these financial counterparties not perform, we may not realize the benefit of some of our derivative contracts and we could incur a loss. As of June 30, 2011, all of our counterparties have performed pursuant to their commodity derivative contracts.\\n20\\nCash Flows\\nCash flows provided (used) by type of activity were as follows:\\n\\n| Six Months Ended June 30, |\\n| 2011 | 2010 |\\n| Operating activities | $ | 80,130 | $ | 55,802 |\\n| Investing activities | (25,681 | ) | (151,468 | ) |\\n| Financing activities | (51,184 | ) | 94,152 |\\n\\nOperating Activities\\nCash flows from operating activities were $80.1 million and $55.8 million in the six months ended June 30, 2011 and 2010, respectively. The increase was primarily due to higher production and prices for oil and natural gas liquids, partially offset by higher operating expenses.\\nInvesting Activities\\nOur principal recurring investing activity is the acquisition and development of oil and natural gas properties. During the six months ended June 30, 2011, we spent $1.0 million for the acquisition of oil and natural gas properties and $33.7 million for development of our oil and natural gas properties. In addition, we received $4.1 million in final purchase price settlements, $2.8 million from settlements of derivatives acquired in our December 2010 acquisition of oil and natural gas properties and $1.2 million in proceeds from the sale of oil and natural gas properties.\\nDuring the six months ended June 30, 2010, we spent $147.8 million on the acquisitions of oil and natural gas properties and $8.2 million for the development of our oil and natural gas properties. In addition, we received $4.5 million from the sales of oil and natural gas properties.\\nFinancing Activities\\nDuring the six months ended June 30, 2011, we received net proceeds of $146.8 million from our public equity offering in March 2011, and we received contributions of $3.2 million from our general partner in order to maintain its 2% interest in us. We also received net proceeds of $291.6 million from our debt offering in March 2011, after deducting offering expenses of $0.9 million. We used the proceeds from these offerings to repay $431.5 million of borrowings outstanding under our credit facility. In addition, we paid distributions of $56.0 million to holders of our common units and our general partner and $5.3 million in loan costs related to our new $1.0 billion credit facility.\\nDuring the six months ended June 30, 2010, we received net proceeds of $92.6 million from our public equity offering in February 2010, and we received contributions of $2.0 million from our general partner in order to maintain its 2% interest in us. We borrowed $138.0 million under our credit facility to finance our acquisition of oil and natural gas properties in March 2010 and we repaid $95.0 million of borrowings outstanding under our credit facility with proceeds from our public equity offering and cash flows from operations. In addition, we paid distributions of $43.4 million to holders of our common units and our general partner.\\nFORWARD–LOOKING STATEMENTS\\nThis Form 10–Q contains forward–looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act (each a “forward–looking statement”). These forward–looking statements relate to, among other things, the following:\\n\\n| · | our future financial and operating performance and results; |\\n\\n\\n| · | our business strategy; |\\n\\n\\n| · | our estimated net proved reserves and standardized measure; |\\n\\n\\n| · | market prices; |\\n\\n21\\n\\n| · | our future derivative activities; and |\\n\\n\\n| · | our plans and forecasts. |\\n\\nWe have based these forward–looking statements on our current assumptions, expectations and projections about future events.\\nThe words “anticipate,” “believe,” “ensure,” “expect,” “if,” “intend,” “estimate,” “project,” “forecasts,” “predict,” “outlook,” “aim,” “will,” “could,” “should,” “would,” “may,” “likely” and similar expressions, and the negative thereof, are intended to identify forward–looking statements. These statements discuss future expectations, contain projections of results of operations or of financial condition or state other “forward–looking” information. We do not undertake any obligation to update or revise publicly any forward–looking statements, except as required by law. These statements also involve risks and uncertainties that could cause our actual results or financial condition to materially differ from our expectations in this Form 10–Q including, but not limited to:\\n\\n| · | fluctuations in prices of oil and natural gas; |\\n\\n\\n| · | significant disruptions in the financial markets; |\\n\\n\\n| · | future capital requirements and availability of financing; |\\n\\n\\n| · | uncertainty inherent in estimating our reserves; |\\n\\n\\n| · | risks associated with drilling and operating wells; |\\n\\n\\n| · | discovery, acquisition, development and replacement of oil and natural gas reserves; |\\n\\n\\n| · | cash flows and liquidity; |\\n\\n\\n| · | timing and amount of future production of oil and natural gas; |\\n\\n\\n| · | availability of drilling and production equipment; |\\n\\n\\n| · | marketing of oil and natural gas; |\\n\\n\\n| · | developments in oil and natural gas producing countries; |\\n\\n\\n| · | competition; |\\n\\n\\n| · | general economic conditions; |\\n\\n\\n| · | governmental regulations; |\\n\\n\\n| · | receipt of amounts owed to us by purchasers of our production and counterparties to our derivative financial instrument contracts; |\\n\\n\\n| · | hedging decisions, including whether or not to enter into derivative financial instruments; |\\n\\n\\n| · | events similar to those of September 11, 2001; |\\n\\n\\n| · | actions of third party co–owners of interest in properties in which we also own an interest; |\\n\\n\\n| · | fluctuations in interest rates and the value of the U.S. dollar in international currency markets; and |\\n\\n\\n| · | our ability to effectively integrate companies and properties that we acquire. |\\n\\n22\\nAll of our forward–looking information is subject to risks and uncertainties that could cause actual results to differ materially from the results expected. Although it is not possible to identify all factors, these risks and uncertainties include the risk factors and the timing of any of those risk factors identified in the “Risk Factors” section included in Item 1A of our Annual Report on Form 10–K for the year ended December 31, 2010. This document is available through our web site or through the SEC’s Electronic Data Gathering and Analysis Retrieval System at http://www.sec.gov.\\nOur revenues, operating results, financial condition and ability to borrow funds or obtain additional capital depend substantially on prevailing prices for oil and natural gas. Declines in oil or natural gas prices may materially adversely affect our financial condition, liquidity, ability to obtain financing and operating results. Lower oil or natural gas prices also may reduce the amount of oil or natural gas that we can produce economically. A decline in oil and/or natural gas prices could have a material adverse effect on the estimated value and estimated quantities of our oil and natural gas reserves, our ability to fund our operations and our financial condition, cash flows, results of operations and access to capital. Historically, oil and natural gas prices and markets have been volatile, with prices fluctuating widely, and they are likely to continue to be volatile.\\n\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nWe are exposed to certain market risks that are inherent in our financial statements that arise in the normal course of business. We may enter into derivative instruments to manage or reduce market risk, but do not enter into derivative agreements for speculative purposes.\\nWe do not designate these or plan to designate future derivative instruments as hedges for accounting purposes. Accordingly, the changes in the fair value of these instruments are recognized currently in earnings.\\nCommodity Price Risk\\nOur major market risk exposure is to prices for oil, natural gas and natural gas liquids. These prices have historically been volatile. As such, future earnings are subject to change due to changes in these prices. Realized prices are primarily driven by the prevailing worldwide price for oil and regional spot prices for natural gas production. We have used, and expect to continue to use, oil, natural gas and natural gas liquids commodity contracts to reduce our risk of changes in the prices of oil, natural gas and natural gas liquids. Pursuant to our risk management policy, we engage in these activities as a hedging mechanism against price volatility associated with pre–existing or anticipated sales of oil, natural gas and natural gas liquids.\\nWe have entered into commodity contracts to hedge significant amounts of our anticipated oil, natural gas and natural gas liquids production through December 2015. As of June 30, 2011, we have commodity contracts covering approximately 53% of our production attributable to our estimated net proved reserves from July 2011 through December 2015, as estimated in our reserve report prepared by third party engineers using prices, costs and other assumptions required by SEC rules. Our actual production will vary from the amounts estimated in our reserve reports, perhaps materially.\\nThe fair value of our commodity contracts and basis swaps at June 30, 2011 was a net asset of $78.9 million. A 10% change in oil, natural gas and natural gas liquids prices with all other factors held constant would result in a change in the fair value (generally correlated to our estimated future net cash flows from such instruments) of our oil and natural gas commodity contracts and basis swaps of approximately $60 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\\nInterest Rate Risk\\nOur floating rate credit facility also exposes us to risks associated with changes in interest rates and as such, future earnings are subject to change due to changes in these interest rates. If interest rates on our facility increased by 1%, interest expense for the six months ended June 30, 2011 would have increased by approximately $1.8 million. Please see “Item 1. Condensed Consolidated Financial Statements (Unaudited)” contained herein for additional information.\\n23\\nITEM 4. CONTROLS AND PROCEDURES\\nEvaluation of Disclosure Controls and Procedures\\nIn accordance with Exchange Act Rule 13a–15 and 15d–15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2011 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.\\nChange in Internal Controls Over Financial Reporting\\nThere have not been any changes in our internal controls over financial reporting that occurred during the quarterly period ended June 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.\\nPART II. OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nWe are involved in disputes or legal actions arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material effect on our unaudited condensed consolidated financial statements.\\n\\nITEM 1A. RISK FACTORS\\nThere have been no material changes with respect to the risk factors disclosed in our Annual Report on Form 10–K for the year ended December 31, 2010.\\n\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nNone.\\n\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\\nNone.\\nITEM 4. (Removed and Reserved)\\n\\nITEM 5. OTHER INFORMATION\\nNone.\\n\\nITEM 6. EXHIBITS\\nThe exhibits listed below are filed or furnished as part of this report:\\n\\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\\n\\n\\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\\n\\n24\\n\\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\\n\\n\\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\\n\\n\\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\\n\\n\\n| ++101 | Interactive Data Files |\\n\\n\\n| + | Filed herewith |\\n\\n\\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\\n\\n25\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| EV Energy Partners, L.P. |\\n| (Registrant) |\\n| Date: August 9, 2011 | By: | /s/ MICHAEL E. MERCER |\\n| Michael E. Mercer |\\n| Senior Vice President and Chief Financial Officer |\\n\\n26\\nEXHIBIT INDEX\\n\\n| 10.1 | Credit Agreement, dated as of April 26, 2011 by and among EV Energy Partners, L.P., EV Properties, L.P., and JPMorgan Chase Bank, N.A. as Administrative Agent for the lenders named therein. (Incorporated by reference from Exhibit 10.1 to EV Energy Partners L.P.’s current report on Form 8–K filed with the SEC on April 29, 2011). |\\n\\n\\n| +31.1 | Rule 13a-14(a)/15d–14(a) Certification of Chief Executive Officer. |\\n\\n\\n| +31.2 | Rule 13a-14(a)/15d–14(a) Certification of Chief Financial Officer. |\\n\\n\\n| +32.1 | Section 1350 Certification of Chief Executive Officer |\\n\\n\\n| +32.2 | Section 1350 Certification of Chief Financial Officer |\\n\\n\\n| ++101 | Interactive Data Files |\\n\\n+ Filed herewith\\n\\n| ++ | Pursuant to Rule 406T of Regulation S–T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability. |\\n\\n\\n</text>\\n\\nWhat is the total capital cost, combining both the offering cost of the senior notes and interest payment in the first year, in million dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 32.4.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 39,\n \"input_length\": 21246\n}"}}},{"rowIdx":40,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nPART I. Financial Information\nItem 1. Financial Statements\nConsolidated Condensed Statements of Operations\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars and shares in millions, except per-share data)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Revenue (Note 2) | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n| Costs, expenses, and other: |\n| Cost of sales | 1,579.1 | 1,430.8 | 5,081.7 | 5,262.6 |\n| Research and development | 1,802.9 | 1,705.3 | 5,194.9 | 5,032.4 |\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 4,797.2 | 4,839.6 |\n| Acquired in-process research and development and development milestones (Note 3) | 62.4 | 177.6 | 668.4 | 532.4 |\n| Asset impairment, restructuring, and other special charges (Note 5) | 206.5 | — | 206.5 | 211.6 |\n| Other–net, (income) expense (Note 11) | 111.0 | 635.9 | 580.9 | 124.3 |\n| 5,376.1 | 5,527.5 | 16,529.6 | 16,002.9 |\n| Income before income taxes | 1,565.5 | 1,245.3 | 4,710.0 | 4,315.6 |\n| Income taxes (Note 7) | 113.8 | 135.2 | 402.9 | 460.0 |\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\n| Earnings per share: |\n| Basic | $ | 1.61 | $ | 1.22 | $ | 4.78 | $ | 4.25 |\n| Diluted | $ | 1.61 | $ | 1.22 | $ | 4.76 | $ | 4.23 |\n| Shares used in calculation of earnings per share: |\n| Basic | 900.7 | 906.7 | 901.8 | 907.7 |\n| Diluted | 903.8 | 910.8 | 904.5 | 911.7 |\n\nSee notes to consolidated condensed financial statements.\n5\nConsolidated Condensed Statements of Comprehensive Income\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\n| Other comprehensive income (loss), net of tax (Note 10) | ( 8.1 ) | 114.4 | 47.3 | 323.7 |\n| Comprehensive income | $ | 1,443.6 | $ | 1,224.5 | $ | 4,354.4 | $ | 4,179.3 |\n\nSee notes to consolidated condensed financial statements.\n6\nConsolidated Condensed Balance Sheets\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n| September 30, 2022 | December 31, 2021 |\n| Assets | (Unaudited) |\n| Current Assets |\n| Cash and cash equivalents (Note 6) | $ | 2,617.4 | $ | 3,818.5 |\n| Short-term investments (Note 6) | 124.7 | 90.1 |\n| Accounts receivable, net of allowances of $ 17.7 (2022) and $ 22.5 (2021) | 6,715.3 | 6,672.8 |\n| Other receivables | 1,609.5 | 1,454.4 |\n| Inventories | 3,831.1 | 3,886.0 |\n| Prepaid expenses and other | 2,741.9 | 2,530.6 |\n| Total current assets | 17,639.9 | 18,452.4 |\n| Investments (Note 6) | 2,574.6 | 3,212.6 |\n| Goodwill | 3,891.6 | 3,892.0 |\n| Other intangibles, net | 7,124.1 | 7,691.9 |\n| Deferred tax assets | 2,384.3 | 2,489.3 |\n| Property and equipment, net of accumulated depreciation of $ 10,074.0 (2022) and $ 9,976.7 (2021) | 9,311.3 | 8,985.1 |\n| Other noncurrent assets | 4,535.7 | 4,082.7 |\n| Total assets | $ | 47,461.5 | $ | 48,806.0 |\n| Liabilities and Equity |\n| Current Liabilities |\n| Short-term borrowings and current maturities of long-term debt | $ | 1,744.6 | $ | 1,538.3 |\n| Accounts payable | 1,683.2 | 1,670.6 |\n| Employee compensation | 984.1 | 958.1 |\n| Sales rebates and discounts | 8,568.4 | 6,845.8 |\n| Dividends payable | — | 885.5 |\n| Income taxes payable | 685.6 | 126.9 |\n| Other current liabilities | 1,986.9 | 3,027.5 |\n| Total current liabilities | 15,652.8 | 15,052.7 |\n| Other Liabilities |\n| Long-term debt | 14,143.8 | 15,346.4 |\n| Accrued retirement benefits (Note 8) | 1,832.5 | 1,954.1 |\n| Long-term income taxes payable | 3,641.7 | 3,920.0 |\n| Deferred tax liabilities | 171.9 | 1,733.7 |\n| Other noncurrent liabilities | 1,852.9 | 1,644.3 |\n| Total other liabilities | 21,642.8 | 24,598.5 |\n| Commitments and Contingencies (Note 9) |\n| Eli Lilly and Company Shareholders' Equity |\n| Common stock | 594.1 | 596.3 |\n| Additional paid-in capital | 6,829.0 | 6,833.4 |\n| Retained earnings | 10,006.5 | 8,958.5 |\n| Employee benefit trust | ( 3,013.2 ) | ( 3,013.2 ) |\n| Accumulated other comprehensive loss (Note 10) | ( 4,295.8 ) | ( 4,343.1 ) |\n| Cost of common stock in treasury | ( 50.5 ) | ( 52.7 ) |\n| Total Eli Lilly and Company shareholders' equity | 10,070.1 | 8,979.2 |\n| Noncontrolling interests | 95.8 | 175.6 |\n| Total equity | 10,165.9 | 9,154.8 |\n| Total liabilities and equity | $ | 47,461.5 | $ | 48,806.0 |\n\nSee notes to consolidated condensed financial statements.\n7\nConsolidated Condensed Statements of Equity\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n| Equity of Eli Lilly and Company Shareholders |\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\n| Shares | Amount | Shares | Amount |\n| Balance at July 1, 2021 | 957,038 | $ | 598.1 | $ | 6,669.2 | $ | 8,530.1 | $ | ( 3,013.2 ) | $ | ( 6,287.1 ) | 463 | $ | ( 52.7 ) | $ | 219.1 |\n| Net income (loss) | 1,110.1 | ( 22.6 ) |\n| Other comprehensive income, net of tax | 114.4 |\n| Issuance of stock under employee stock plans, net | 14 | 0.1 | ( 1.3 ) |\n| Stock-based compensation | 90.1 |\n| Other | ( 0.8 ) | 0.6 |\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\n| Balance at July 1, 2022 | 950,619 | $ | 594.1 | $ | 6,746.0 | $ | 8,556.0 | $ | ( 3,013.2 ) | $ | ( 4,287.7 ) | 450 | $ | ( 50.5 ) | $ | 114.5 |\n| Net income (loss) | 1,451.7 | ( 15.7 ) |\n| Other comprehensive loss, net of tax | ( 8.1 ) |\n| Issuance of stock under employee stock plans, net | 8 | ( 2.1 ) |\n| Stock-based compensation | 85.1 |\n| Other | ( 1.2 ) | ( 3.0 ) |\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\n\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\nSee notes to consolidated condensed financial statements.\n8\n| Equity of Eli Lilly and Company Shareholders |\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\n| Shares | Amount | Shares | Amount |\n| Balance at January 1, 2021 | 957,077 | $ | 598.2 | $ | 6,778.5 | $ | 7,830.2 | $ | ( 3,013.2 ) | $ | ( 6,496.4 ) | 487 | $ | ( 55.7 ) | $ | 183.6 |\n| Net income | 3,855.6 | 25.2 |\n| Other comprehensive income, net of tax | 323.7 |\n| Cash dividends declared per share: $ 1.70 | ( 1,542.9 ) |\n| Retirement of treasury shares | ( 2,467 ) | ( 1.5 ) | ( 498.5 ) | ( 2,467 ) | 500.0 |\n| Purchase of treasury shares | 2,467 | ( 500.0 ) |\n| Issuance of stock under employee stock plans, net | 2,442 | 1.5 | ( 287.1 ) | ( 24 ) | 3.0 |\n| Stock-based compensation | 267.5 |\n| Other | ( 0.9 ) | ( 5.0 ) | ( 11.7 ) |\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\n| Balance at January 1, 2022 | 954,116 | $ | 596.3 | $ | 6,833.4 | $ | 8,958.5 | $ | ( 3,013.2 ) | $ | ( 4,343.1 ) | 463 | $ | ( 52.7 ) | $ | 175.6 |\n| Net income (loss) | 4,307.1 | ( 63.7 ) |\n| Other comprehensive income, net of tax | 47.3 |\n| Cash dividends declared per share: $ 1.96 | ( 1,765.9 ) |\n| Retirement of treasury shares | ( 5,607 ) | ( 3.5 ) | ( 1,496.5 ) | ( 5,607 ) | 1,500.0 |\n| Purchase of treasury shares | 5,607 | ( 1,500.0 ) |\n| Issuance of stock under employee stock plans, net | 2,118 | 1.3 | ( 282.6 ) | ( 13 ) | 2.2 |\n| Stock-based compensation | 278.2 |\n| Other | 3.3 | ( 16.1 ) |\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\n\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\nSee notes to consolidated condensed financial statements.\n9\nConsolidated Condensed Statements of Cash Flows\n(Unaudited)\nELI LILLY AND COMPANY AND SUBSIDIARIES\n(Dollars in millions)\n\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Cash Flows from Operating Activities |\n| Net income | $ | 4,307.1 | $ | 3,855.6 |\n| Adjustments to Reconcile Net Income to Cash Flows from Operating Activities: |\n| Depreciation and amortization | 1,147.5 | 1,101.9 |\n| Change in deferred income taxes | ( 2,195.6 ) | ( 709.8 ) |\n| Debt extinguishment loss (Note 6) | — | 405.2 |\n| Stock-based compensation expense | 278.2 | 267.5 |\n| Net investment (gains) losses | 676.4 | ( 271.1 ) |\n| Acquired in-process research and development | 252.0 | 498.3 |\n| Other changes in operating assets and liabilities, net of acquisitions and divestitures | 821.5 | ( 548.1 ) |\n| Other non-cash operating activities, net | 217.6 | 504.7 |\n| Net Cash Provided by Operating Activities | 5,504.7 | 5,104.2 |\n| Cash Flows from Investing Activities |\n| Net purchases of property and equipment | ( 1,353.6 ) | ( 1,018.4 ) |\n| Proceeds from sales and maturities of short-term investments | 83.1 | 46.6 |\n| Purchases of short-term investments | ( 65.0 ) | ( 27.9 ) |\n| Proceeds from sales of noncurrent investments | 251.6 | 537.2 |\n| Purchases of noncurrent investments | ( 474.1 ) | ( 710.1 ) |\n| Cash paid for acquisitions, net of cash acquired (Note 3) | — | ( 747.4 ) |\n| Purchases of in-process research and development | ( 574.8 ) | ( 460.6 ) |\n| Other investing activities, net | ( 268.3 ) | ( 2.7 ) |\n| Net Cash Used for Investing Activities | ( 2,401.1 ) | ( 2,383.3 ) |\n| Cash Flows from Financing Activities |\n| Dividends paid | ( 2,651.4 ) | ( 2,313.5 ) |\n| Net change in short-term borrowings | 1,741.3 | ( 1.5 ) |\n| Proceeds from issuance of long-term debt | — | 2,410.8 |\n| Repayments of long-term debt | ( 1,560.0 ) | ( 1,905.3 ) |\n| Purchases of common stock | ( 1,500.0 ) | ( 500.0 ) |\n| Other financing activities, net | ( 295.2 ) | ( 295.3 ) |\n| Net Cash Used for Financing Activities | ( 4,265.3 ) | ( 2,604.8 ) |\n| Effect of exchange rate changes on cash and cash equivalents | ( 39.4 ) | 15.0 |\n| Net decrease in cash and cash equivalents | ( 1,201.1 ) | 131.1 |\n| Cash and cash equivalents at January 1 | 3,818.5 | 3,657.1 |\n| Cash and Cash Equivalents at September 30 | $ | 2,617.4 | $ | 3,788.2 |\n\nSee notes to consolidated condensed financial statements.\n10\nNotes to Consolidated Condensed Financial Statements\n(Tables present dollars in millions, except per-share data)\nNote 1: Basis of Presentation and Implementation of New Financial Accounting Standard\nWe have prepared the accompanying unaudited consolidated condensed financial statements in accordance with the requirements of Form 10-Q and, therefore, they do not include all information and footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States (GAAP). In our opinion, the consolidated condensed financial statements reflect all adjustments (including those that are normal and recurring) that are necessary for a fair presentation of the results of operations for the periods shown. In preparing financial statements in conformity with GAAP, we must make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures at the date of the financial statements and during the reporting period. Actual results could differ from those estimates.\nThe information included in this Quarterly Report on Form 10-Q should be read in conjunction with our consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2021. We issue our financial statements by filing them with the Securities and Exchange Commission and have evaluated subsequent events up to the time of the filing of this Quarterly Report on Form 10-Q.\nCertain reclassifications have been made to prior periods in the consolidated condensed financial statements and accompanying notes to conform with the current presentation.\nAll per-share amounts, unless otherwise noted in the footnotes, are presented on a diluted basis; that is, based on the weighted-average number of common shares outstanding plus the effect of incremental shares from our stock-based compensation programs.\nWe operate as a single operating segment engaged in the discovery, development, manufacturing, marketing, and sales of pharmaceutical products worldwide. A global research and development organization and a supply chain organization are responsible for the discovery, development, manufacturing, and supply of our products. Regional commercial organizations market, distribute, and sell the products. The business is also supported by global corporate staff functions. Our determination that we operate as a single segment is consistent with the financial information regularly reviewed by the chief operating decision maker for purposes of evaluating performance, allocating resources, setting incentive compensation targets, and planning and forecasting for future periods.\nResearch and Development Expenses and Acquired In-Process Research and Development (IPR&D) and Development Milestones\nResearch and development costs are expensed as incurred. Research and development costs consist of expenses incurred in performing research and development activities, including but not limited to, compensation and benefits, facilities and overhead expense, clinical trial expense, and fees paid to contract research organizations.\nAcquired IPR&D and development milestones include the initial costs of externally developed IPR&D projects, acquired directly in a transaction other than a business combination, that do not have an alternative future use. Additionally, milestone payment obligations related to these transactions that are incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs.\nImplementation of New Financial Accounting Standard\nAccounting Standards Update 2021-01, Reference Rate Reform, provides for temporary optional expedients and exceptions in applying current GAAP to contracts, hedging relationships, and other transactions affected by the transition from the use of the London Interbank Offered Rate (LIBOR) to an alternative reference rate. The standard is currently applicable to contracts entered into before January 1, 2023. We adopted the standard in the first quarter of 2022. The adoption did not have a material impact on our consolidated condensed financial statements.\n11\nNote 2: Revenue\nThe following table summarizes our revenue recognized in our consolidated condensed statements of operations:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net product revenue | $ | 6,119.2 | $ | 6,189.0 | $ | 19,123.0 | $ | 18,579.5 |\n| Collaboration and other revenue(1) | 822.4 | 583.8 | 2,116.6 | 1,739.0 |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n\n(1) Collaboration and other revenue associated with prior period transfers of intellectual property was $ 43.3 million and $ 130.9 million during the three and nine months ended September 30, 2022, respectively, and $ 62.1 million and $ 136.1 million during the three and nine months ended September 30, 2021, respectively.\nWe recognize revenue primarily from two different types of contracts, product sales to customers (net product revenue) and collaborations and other arrangements. Revenue recognized from collaborations and other arrangements includes our share of profits from the collaborations, as well as royalties, upfront and milestone payments we receive under these types of contracts. See Note 4 for additional information related to our collaborations and other arrangements. Collaboration and other revenue disclosed above includes the revenue from the Jardiance® and Trajenta® families of products resulting from our collaboration with Boehringer Ingelheim discussed in Note 4. Substantially all of the remainder of collaboration and other revenue is related to contracts accounted for as contracts with customers.\nAdjustments to Revenue\nAdjustments to increase revenue recognized as a result of changes in estimates for our most significant United States (U.S.) sales returns, rebates, and discounts liability balances for products shipped in previous periods were 3 percent of U.S. revenue for the three months ended September 30, 2022 and less than 1 percent of U.S. revenue during the nine months ended September 30, 2022 and the three and nine months ended September 30, 2021.\nContract Liabilities\nOur contract liabilities result from arrangements where we have received payment in advance of performance under the contract and do not include sales returns, rebates, and discounts. Changes in contract liabilities are generally due to either receipt of additional advance payments or our performance under the contract.\nThe following table summarizes contract liability balances:\n| September 30, 2022 | December 31, 2021 |\n| Contract liabilities | $ | 232.5 | $ | 262.6 |\n\nDuring the three and nine months ended September 30, 2022 and 2021, revenue recognized from contract liabilities as of the beginning of the respective year was not material. Revenue expected to be recognized in the future from contract liabilities as the related performance obligations are satisfied is not expected to be material in any one year.\n12\nDisaggregation of Revenue\nThe following table summarizes revenue by product for the three months ended September 30, 2022 and 2021:\n| Three Months Ended September 30, |\n| 2022 | 2021 |\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\n| Revenue—to unaffiliated customers: |\n| Diabetes: |\n| Trulicity® | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,201.4 | $ | 398.8 | $ | 1,600.1 |\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 221.2 | 169.2 | 390.4 |\n| Humalog® (2) | 248.1 | 198.8 | 447.0 | 347.3 | 279.4 | 626.7 |\n| Humulin® | 169.5 | 68.7 | 238.2 | 193.4 | 93.4 | 286.7 |\n| Basaglar® | 124.8 | 68.1 | 193.0 | 114.7 | 78.1 | 192.8 |\n| Mounjaro® | 97.3 | 90.0 | 187.3 | — | — | — |\n| Other diabetes | 79.7 | 94.0 | 173.4 | 65.0 | 112.2 | 177.4 |\n| Total diabetes | 2,488.6 | 1,174.0 | 3,662.6 | 2,143.0 | 1,131.1 | 3,274.1 |\n| Oncology: |\n| Verzenio® | 414.8 | 202.9 | 617.7 | 199.6 | 135.9 | 335.5 |\n| Cyramza® | 87.5 | 144.6 | 232.1 | 84.8 | 168.6 | 253.4 |\n| Erbitux® | 126.3 | 18.7 | 144.9 | 114.0 | 20.3 | 134.3 |\n| Alimta® | 64.6 | 54.8 | 119.4 | 297.2 | 159.8 | 457.0 |\n| Tyvyt® | — | 76.8 | 76.8 | — | 125.6 | 125.6 |\n| Other oncology | 39.5 | 62.8 | 102.4 | 35.3 | 65.1 | 100.3 |\n| Total oncology | 732.7 | 560.6 | 1,293.3 | 730.9 | 675.3 | 1,406.1 |\n| Immunology: |\n| Taltz® | 493.8 | 186.1 | 679.9 | 422.2 | 170.9 | 593.1 |\n| Olumiant® (3) | 22.9 | 160.0 | 182.9 | 194.0 | 212.9 | 406.9 |\n| Other immunology | — | 3.6 | 3.6 | — | 4.9 | 4.9 |\n| Total immunology | 516.7 | 349.7 | 866.4 | 616.2 | 388.7 | 1,004.9 |\n| Neuroscience: |\n| Emgality® | 114.0 | 54.6 | 168.5 | 99.9 | 40.1 | 140.0 |\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 13.0 | 88.7 | 101.7 |\n| Cymbalta® | 7.8 | 54.9 | 62.7 | 7.0 | 125.1 | 132.0 |\n| Other neuroscience | 16.0 | 44.5 | 60.6 | 24.7 | 51.6 | 76.5 |\n| Total neuroscience | 145.8 | 227.4 | 373.2 | 144.6 | 305.5 | 450.2 |\n| Other: |\n| COVID-19 antibodies(4) | 386.6 | — | 386.6 | 215.5 | 1.6 | 217.1 |\n| Forteo® | 112.7 | 64.4 | 177.1 | 109.6 | 91.3 | 200.9 |\n| Cialis® | 8.1 | 107.7 | 115.7 | ( 6.5 ) | 137.4 | 130.9 |\n| Other | 30.9 | 35.7 | 66.6 | 36.3 | 52.4 | 88.8 |\n| Total other | 538.3 | 207.8 | 746.0 | 354.9 | 282.7 | 637.7 |\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 3,989.6 | $ | 2,783.3 | $ | 6,772.8 |\n\nNumbers may not add due to rounding.\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\n(2) Humalog revenue includes insulin lispro.\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to Emergency Use Authorization (EUA) or similar regulatory authorizations.\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n13\nThe following table summarizes revenue by product for the nine months ended September 30, 2022 and 2021:\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\n| Revenue—to unaffiliated customers: |\n| Diabetes: |\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 3,465.7 | $ | 1,122.5 | $ | 4,588.2 |\n| Humalog(1) | 855.8 | 656.4 | 1,512.3 | 1,009.0 | 842.3 | 1,851.3 |\n| Jardiance(2) | 831.4 | 622.4 | 1,453.7 | 566.8 | 492.1 | 1,058.9 |\n| Humulin | 562.3 | 223.1 | 785.4 | 633.5 | 290.3 | 923.8 |\n| Basaglar | 339.9 | 218.8 | 558.7 | 423.3 | 226.8 | 650.1 |\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | — | — |\n| Other diabetes | 195.6 | 276.5 | 472.2 | 185.7 | 302.6 | 488.3 |\n| Total diabetes | 7,057.3 | 3,431.6 | 10,489.0 | 6,284.0 | 3,276.6 | 9,560.6 |\n| Oncology: |\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 582.1 | 363.7 | 945.8 |\n| Cyramza | 259.3 | 434.3 | 693.6 | 266.3 | 496.3 | 762.5 |\n| Alimta | 490.5 | 200.5 | 691.1 | 911.9 | 714.7 | 1,626.6 |\n| Erbitux | 361.0 | 47.4 | 408.3 | 357.7 | 45.9 | 403.7 |\n| Tyvyt | — | 235.8 | 235.8 | — | 340.2 | 340.2 |\n| Other oncology | 124.1 | 186.5 | 310.6 | 83.7 | 169.9 | 253.6 |\n| Total oncology | 2,335.4 | 1,679.6 | 4,015.0 | 2,201.7 | 2,130.7 | 4,332.4 |\n| Immunology: |\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,071.6 | 493.8 | 1,565.4 |\n| Olumiant(3) | 104.6 | 520.1 | 624.7 | 236.5 | 572.6 | 809.1 |\n| Other immunology | 0.1 | 12.1 | 12.1 | 15.2 | 14.5 | 29.7 |\n| Total immunology | 1,317.3 | 1,093.8 | 2,411.0 | 1,323.3 | 1,080.9 | 2,404.2 |\n| Neuroscience: |\n| Emgality | 330.8 | 144.4 | 475.2 | 313.5 | 102.2 | 415.7 |\n| Zyprexa | 26.2 | 235.5 | 261.7 | 28.3 | 264.5 | 292.8 |\n| Cymbalta | 25.0 | 194.3 | 219.3 | 30.3 | 454.0 | 484.3 |\n| Other neuroscience | 62.0 | 142.7 | 204.7 | 81.0 | 154.0 | 235.0 |\n| Total neuroscience | 444.0 | 716.9 | 1,160.9 | 453.1 | 974.7 | 1,427.8 |\n| Other: |\n| COVID-19 antibodies(4) | 1,970.9 | 14.7 | 1,985.5 | 949.5 | 226.7 | 1,176.2 |\n| Cialis | 25.8 | 454.7 | 480.4 | ( 3.1 ) | 541.8 | 538.7 |\n| Forteo | 261.4 | 191.7 | 453.0 | 330.1 | 287.7 | 617.8 |\n| Other | 119.4 | 125.1 | 244.8 | 96.5 | 164.3 | 260.8 |\n| Total other | 2,377.5 | 786.2 | 3,163.7 | 1,373.0 | 1,220.5 | 2,593.5 |\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 11,635.1 | $ | 8,683.4 | $ | 20,318.5 |\n\nNumbers may not add due to rounding.\n(1) Humalog revenue includes insulin lispro.\n(2) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n14\nThe following table summarizes revenue by geographical area:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Revenue—to unaffiliated customers(1): |\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | $ | 13,531.5 | $ | 11,635.1 |\n| Europe | 1,056.4 | 1,098.6 | 3,224.8 | 3,629.6 |\n| Japan | 487.7 | 595.0 | 1,352.3 | 1,832.2 |\n| China | 343.4 | 400.3 | 1,102.0 | 1,285.0 |\n| Other foreign countries | 632.0 | 689.4 | 2,029.1 | 1,936.7 |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\n\nNumbers may not add due to rounding.\n(1) Revenue is attributed to the countries based on the location of the customer.\nNote 3: Acquisitions\nWe engage in various forms of business development activities to enhance our product pipeline, including acquisitions, collaborations, investments, and licensing arrangements. In connection with these arrangements, our partners may be entitled to future royalties and/or commercial milestones based on sales should products be approved for commercialization and/or milestones based on the successful progress of compounds through the development process.\nIn January 2021, we completed the acquisition of Prevail Therapeutics Inc. (Prevail). This transaction, as further discussed below in Acquisition of a Business, was accounted for as a business combination under the acquisition method of accounting. Under this method, the assets acquired and liabilities assumed were recorded at their respective fair values as of the acquisition date in our consolidated condensed financial statements. The determination of estimated fair value required management to make significant estimates and assumptions. The excess of the purchase price over the fair value of the acquired net assets, where applicable, has been recorded as goodwill. The results of operations of this acquisition is included in our consolidated condensed financial statements from the date of acquisition.\nWe also acquired assets in development which are further discussed below in Asset Acquisitions. Upon each acquisition, the cost allocated to acquired IPR&D is immediately expensed if the compound has no alternative future use. Milestone payment obligations incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs. We recognized acquired IPR&D and development milestone charges of $ 62.4 million and $ 668.4 million for the three and nine months ended September 30, 2022, respectively, and $ 177.6 million and $ 532.4 million for the three and nine months ended September 30, 2021, respectively.\nAcquisition of a Business\nPrevail Acquisition\nOverview of Transaction\nIn January 2021, we acquired all shares of Prevail for a purchase price that included $ 22.50 per share in cash (or an aggregate of $ 747.4 million, net of cash acquired) plus one non-tradable contingent value right (CVR) per share. The CVR entitles Prevail stockholders up to an additional $ 4.00 per share in cash (or an aggregate of approximately $ 160 million) payable, subject to certain terms and conditions, upon the first regulatory approval of a Prevail product in one of the following countries: U.S., Japan, United Kingdom, Germany, France, Italy, or Spain. To achieve the full value of the CVR, such regulatory approval must occur by December 31, 2024. If such regulatory approval occurs after December 31, 2024, the value of the CVR will be reduced by approximately 8.3 cents per month until December 1, 2028, at which point the CVR will expire without payment.\nUnder the terms of the agreement, we acquired potentially disease-modifying AAV9-based gene therapies for patients with neurodegenerative diseases. The acquisition established a new modality for drug discovery and development, extending our research efforts through the creation of a gene therapy program that is being anchored by Prevail's portfolio of assets. The lead gene therapies in clinical development that we acquired were PR001 for patients with Parkinson's disease with GBA1 mutations and neuronopathic Gaucher disease and PR006 for patients with frontotemporal dementia with GRN mutations. Both PR001 and PR006 were granted Fast Track designation from the U.S. Food and Drug Administration (FDA).\n15\nAssets Acquired and Liabilities Assumed\nThe following table summarizes the amounts recognized for assets acquired and liabilities assumed as of the acquisition date:\n| Estimated Fair Value at January 22, 2021 |\n| Cash | $ | 90.5 |\n| Acquired IPR&D(1) | 824.0 |\n| Goodwill(2) | 126.8 |\n| Deferred tax liabilities | ( 106.0 ) |\n| Other assets and liabilities, net | ( 31.5 ) |\n| Acquisition date fair value of consideration transferred | 903.8 |\n| Less: |\n| Cash acquired | ( 90.5 ) |\n| Fair value of CVR liability(3) | ( 65.9 ) |\n| Cash paid, net of cash acquired | $ | 747.4 |\n\n(1) Acquired IPR&D intangibles primarily relate to PR001. In the third quarter of 2022, we impaired the intangible asset related to PR001. See Note 5 for additional information.\n(2) The goodwill recognized from this acquisition is not deductible for tax purposes.\n(3) See Note 6 for a discussion on the estimation of the CVR liability.\nWe are unable to provide the results of operations for the three and nine months ended September 30, 2022 and 2021 attributable to Prevail as those operations were substantially integrated into our legacy business.\nPro forma information has not been included as this acquisition did not have a material impact on our consolidated condensed statements of operations for the three and nine months ended September 30, 2021.\nAsset Acquisitions\nThe following table summarizes our significant asset acquisitions during the nine months ended September 30, 2022 and 2021:\n| Counterparty | Compound(s), Therapy or Asset | Acquisition Month | Phase of Development(1) | Acquired IPR&D Expense |\n| BioMarin Pharmaceutical Inc. | Priority Review Voucher | February 2022 | Not applicable | $ | 110.0 |\n| Rigel Pharmaceuticals, Inc. | R552, a receptor-interacting serine/threonine-protein kinase 1 (RIPK1) inhibitor, for the potential treatment of autoimmune and inflammatory diseases | March 2021 | Phase I | 125.0 |\n| Precision Biosciences, Inc. | Potential in vivo therapies for genetic disorders | January 2021 | Pre-clinical | 107.8 |\n\n(1) The phase of development presented is as of the date of the arrangement and represents the phase of development of the most advanced asset acquired, where applicable.\nIn connection with our acquisition of Petra Pharma Corporation (Petra), we were required to make milestone payments to Petra shareholders contingent upon the occurrence of certain future events linked to the success of the mutant-selective PI3Kα inhibitor. In the second quarter of 2022, we entered into agreements with substantially all Petra shareholders to acquire their rights to receive any future milestone payments in exchange for a one-time payment. As a result of these agreements, we recognized a charge of $ 333.8 million as a development milestone during the nine months ended September 30, 2022. Any remaining contingent milestones payments linked to the success of the mutant-selective PI3Kα are not expected to be material. We recognized no other significant development milestones during the three and nine months ended September 30, 2022 and 2021.\n16\nSubsequent Event - Akouos, Inc. (Akouos) Acquisition\nOn October 17, 2022, we entered into a definitive agreement to acquire Akouos. Pursuant to the terms of the agreement, we have commenced a tender offer to acquire all outstanding shares of Akouos for a purchase price of $ 12.50 per share in cash (an aggregate of approximately $ 487 million), payable at closing, plus one non-tradable CVR per share that will entitle the holder to receive up to an additional $ 3.00 per CVR in cash (an aggregate of up to approximately $ 123 million) upon the achievement of certain specified milestones. The acquisition will expand our gene therapy portfolio to include potential treatments for hearing loss and other inner ear conditions. The acquisition is not subject to any financing condition and is expected to close in the fourth quarter of 2022, subject to customary closing conditions, including receipt of required antitrust clearance and the tender of a majority of the outstanding shares of Akouos's common stock.\nNote 4: Collaborations and Other Arrangements\nWe often enter into collaborative and other similar arrangements to develop and commercialize drug candidates. Collaborative activities may include research and development, marketing and selling (including promotional activities and physician detailing), manufacturing, and distribution. These arrangements often require milestone as well as royalty or profit-share payments, contingent upon the occurrence of certain future events linked to the success of the asset in development, as well as expense reimbursements from or payments to the collaboration partner. See Note 2 for amounts of collaboration and other revenue recognized from these types of arrangements.\nOperating expenses for costs incurred pursuant to these arrangements are reported in their respective expense line item, net of any payments due to or reimbursements due from our collaboration partners, with such reimbursements being recognized at the time the party becomes obligated to pay. Each collaboration is unique in nature, and our more significant arrangements are discussed below.\nBoehringer Ingelheim Diabetes Collaboration\nWe and Boehringer Ingelheim have a global agreement to jointly develop and commercialize a portfolio of diabetes compounds. Currently included in the collaboration are Boehringer Ingelheim's oral diabetes products: Jardiance, Glyxambi, Synjardy, Trijardy XR, Trajenta, and Jentadueto® as well as our basal insulin, Basaglar. Glyxambi, Synjardy, and Trijardy XR are included in the Jardiance product family. Jentadueto is included in the Trajenta product family.\nIn connection with the regulatory approvals of Jardiance, Trajenta, and Basaglar in the U.S., Europe, and Japan, milestone payments made for Jardiance and Trajenta were capitalized as intangible assets and are being amortized to cost of sales, and milestone payments received for Basaglar were recorded as contract liabilities and are being amortized to collaboration and other revenue. The milestones pertaining to Jardiance and Trajenta are being amortized through their respective term under the collaboration, which, depending on country or region, is determined based on the latest to occur of (a) a defined number of years following launch date, (b) the expiration of the compound patent, or (c) the expiration of marketing authorization exclusivity. The milestones pertaining to Basaglar are being amortized through 2029. The table below summarizes the net milestones capitalized with respect to the Jardiance and Trajenta families of products and the net milestones deferred with respect to Basaglar as of September 30, 2022 and December 31, 2021:\n| Net Milestones Capitalized (Deferred)(1) |\n| September 30, 2022 | December 31, 2021 |\n| Jardiance | $ | 121.2 | $ | 136.1 |\n| Trajenta | 69.6 | 88.5 |\n| Basaglar | ( 135.3 ) | ( 149.3 ) |\n\n(1) This represents the amounts that have been capitalized (deferred) from the start of this collaboration through the end of the reporting period, net of amount amortized.\n17\nFor the Jardiance product family, we and Boehringer Ingelheim share equally the ongoing development and commercialization costs in the most significant markets, and we record our portion of the development and commercialization costs as research and development expense and marketing, selling, and administrative expense, respectively. We receive a royalty on net sales of Boehringer Ingelheim's products in the most significant markets and recognize the royalty as collaboration and other revenue. Boehringer Ingelheim is entitled to potential performance payments depending on the net sales of the Jardiance product family; therefore, our reported revenue for Jardiance may be reduced by any potential performance payments we make related to this product family. The royalty received by us related to the Jardiance product family may also be increased or decreased depending on whether net sales for this product family exceed or fall below certain thresholds. We pay to Boehringer Ingelheim a royalty on net sales for Basaglar in the U.S. We record our sales of Basaglar to third parties as net product revenue with the royalty payments made to Boehringer Ingelheim recorded as cost of sales.\nThe following table summarizes our collaboration and other revenue recognized with respect to the Jardiance and Trajenta families of products and net product revenue recognized with respect to Basaglar:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Jardiance | $ | 573.3 | $ | 390.4 | $ | 1,453.7 | $ | 1,058.9 |\n| Basaglar | 193.0 | 192.8 | 558.7 | 650.1 |\n| Trajenta | 103.8 | 96.1 | 293.0 | 279.9 |\n\nOlumiant\nWe have a worldwide license and collaboration agreement with Incyte Corporation (Incyte), which provides us the development and commercialization rights to baricitinib, branded and trademarked as Olumiant, and certain follow-on compounds, for the treatment of inflammatory and autoimmune diseases and COVID-19. Incyte has the right to receive tiered, double digit royalty payments on worldwide net sales with rates ranging up to 20 percent. Incyte has the right to receive an additional royalty ranging up to the low teens on worldwide net sales for the treatment of COVID-19 that exceed a specified aggregate worldwide net sales threshold. The agreement calls for payments by us to Incyte associated with certain development, success-based regulatory, and sales-based milestones.\nIn connection with the regulatory approvals of Olumiant in the U.S., Europe, and Japan, as well as achievement of a sales-based milestone, milestone payments of $ 330.0 million and $ 260.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period.\nAs of September 30, 2022, Incyte is eligible to receive up to $ 100.0 million of additional payments from us in potential sales-based milestones.\nWe record our sales of Olumiant, including sales of baricitinib that were made pursuant to EUA or similar regulatory authorizations, to third parties as net product revenue with the royalty payments made to Incyte recorded as cost of sales. The following table summarizes our net product revenue recognized with respect to Olumiant:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Olumiant | $ | 182.9 | $ | 406.9 | $ | 624.7 | $ | 809.1 |\n\n18\nCOVID-19 Antibodies\nWe have a worldwide license and collaboration agreement with AbCellera Biologics Inc. (AbCellera) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including bamlanivimab and bebtelovimab, for which we hold development and commercialization rights. AbCellera has the right to receive tiered royalty payments on worldwide net sales of bamlanivimab and bebtelovimab with percentages ranging in the mid-teens to mid-twenties. Royalty payments made to AbCellera are recorded as cost of sales.\nWe have a license and collaboration agreement with Shanghai Junshi Biosciences Co., Ltd. (Junshi Biosciences) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including etesevimab, for which we hold development and commercialization rights outside of mainland China and the Special Administrative Regions of Hong Kong and Macau, and for which Junshi Biosciences currently maintains all rights in mainland China and the Special Administrative Regions of Hong Kong and Macau. Junshi Biosciences has the right to receive royalty payments in the mid-teens on our net sales of etesevimab. Junshi Biosciences received certain development, success-based regulatory and sales-based milestones. Capitalized regulatory and sales-based milestones were fully amortized to cost of sales as of September 30, 2022.\nPursuant to EUAs or similar regulatory authorizations, we recognized net product revenue associated with our sales of our COVID-19 antibodies of $ 386.6 million and $ 1.99 billion for the three and nine months ended September 30, 2022, respectively, and $ 217.1 million and $ 1.18 billion for the three and nine months ended September 30, 2021, respectively.\nSintilimab Injection\nWe have a collaboration agreement with Innovent Biologics, Inc. (Innovent) to jointly develop and commercialize sintilimab injection in China, where it is branded and trademarked as Tyvyt. In connection with regulatory approvals for Tyvyt in China, milestone payments of $ 120.0 million and $ 40.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period. As of September 30, 2022, Innovent is eligible to receive up to $ 115.0 million in success-based regulatory and sales-based milestones.\nWe record our sales of Tyvyt to third parties as net product revenue, with payments made to Innovent for its portion of the gross margin reported as cost of sales. We report as collaboration and other revenue our portion of the gross margin for Tyvyt sales made by Innovent to third parties. The following table summarizes our revenue recognized in China with respect to Tyvyt:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Tyvyt | $ | 76.8 | $ | 125.6 | $ | 235.8 | $ | 340.2 |\n\nIn 2020, we obtained an exclusive license for sintilimab injection from Innovent for geographies outside of China, which was subsequently terminated and rights have reverted to Innovent in October 2022.\nLebrikizumab\nWe have a worldwide license agreement with F. Hoffmann-La Roche Ltd and Genentech, Inc. (collectively, Roche), which provides us the worldwide development and commercialization rights to lebrikizumab. Roche has the right to receive tiered royalty payments on future worldwide net sales ranging in percentages from high single digits to high teens if the product is successfully commercialized. As of September 30, 2022, Roche is eligible to receive up to $ 180.0 million of payments from us contingent upon the achievement of success-based regulatory milestones and up to $ 1.03 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab.\nWe have a license agreement with Almirall, S.A. (Almirall), under which Almirall licensed the rights to develop and commercialize lebrikizumab for the treatment or prevention of dermatology indications, including, but not limited to, atopic dermatitis in Europe. We have the right to receive tiered royalty payments on future net sales in Europe ranging in percentages from low double digits to low twenties if the product is successfully commercialized. As of September 30, 2022, we are eligible to receive additional payments of $ 85.0 million from Almirall contingent upon the achievement of success-based regulatory milestones and up to $ 1.25 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab. There were no remaining contract liabilities as of September 30, 2022. As of December 31, 2021, contract liabilities were not material. During the three and nine months ended September 30, 2022 and 2021, collaboration and other revenue recognized was not material.\n19\nNote 5: Asset Impairment, Restructuring, and Other Special Charges\nThe components of the charges included in asset impairment, restructuring, and other special charges in our consolidated condensed statements of operations are described below.\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Severance | $ | — | $ | — | $ | — | $ | 11.5 |\n| Asset impairment and other special charges | 206.5 | — | 206.5 | 200.1 |\n| Total asset impairment, restructuring, and other special charges | $ | 206.5 | $ | — | $ | 206.5 | $ | 211.6 |\n\nAsset impairment, restructuring, and other special charges recognized during the three and nine months ended September 30, 2022 were primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001), acquired in the Prevail acquisition, as a result of changes in key assumptions used in the valuation due to delays in estimated launch timing.\nAsset impairment, restructuring, and other special charges recognized during the nine months ended September 30, 2021 were primarily related to an intangible asset impairment of $ 108.1 million resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail.\nWe recognized a net inventory impairment charge related to our COVID-19 antibodies of $ 435.1 million during the nine months ended September 30, 2021 in cost of sales in our consolidated condensed statements of operations. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\nNote 6: Financial Instruments\nFinancial instruments that potentially subject us to credit risk consist principally of trade receivables and interest-bearing investments. Wholesale distributors of life science products account for a substantial portion of our trade receivables; collateral is generally not required. We seek to mitigate the risk associated with this concentration through our ongoing credit-review procedures and insurance. A large portion of our cash is held by a few major financial institutions. We monitor our exposures with these institutions and do not expect any of these institutions to fail to meet their obligations. In accordance with documented corporate risk-management policies, we monitor the amount of credit exposure to any one financial institution or corporate issuer. We are exposed to credit-related losses in the event of nonperformance by counterparties to risk-management instruments but do not expect any counterparties to fail to meet their obligations given their investment grade credit ratings.\nWe consider all highly liquid investments with a maturity of three months or less from the date of purchase to be cash equivalents. The cost of these investments approximates fair value.\nOur equity investments are accounted for using three different methods depending on the type of equity investment:\n•Investments in companies over which we have significant influence but not a controlling interest are accounted for using the equity method, with our share of earnings or losses reported in other-net, (income) expense.\n•For equity investments that do not have readily determinable fair values, we measure these investments at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of the same issuer. Any change in recorded value is recorded in other-net, (income) expense.\n•Our public equity investments are measured and carried at fair value. Any change in fair value is recognized in other-net, (income) expense.\nWe review equity investments other than public equity investments for indications of impairment and observable price changes on a regular basis.\n20\nOur derivative activities are initiated within the guidelines of documented corporate risk-management policies and are intended to offset losses and gains on the assets, liabilities, and transactions being hedged. Management reviews the correlation and effectiveness of our derivatives on a quarterly basis.\nFor derivative instruments that are designated and qualify as fair value hedges, the derivative instrument is marked to market, with gains and losses recognized currently in income to offset the respective losses and gains recognized on the underlying exposure. For derivative instruments that are designated and qualify as cash flow hedges, gains and losses are reported as a component of accumulated other comprehensive loss and reclassified into earnings in the same period the hedged transaction affects earnings. For derivative and non-derivative instruments that are designated and qualify as net investment hedges, the foreign currency translation gains or losses due to spot rate fluctuations are reported as a component of accumulated other comprehensive loss. Derivative contracts that are not designated as hedging instruments are recorded at fair value with the gain or loss recognized in earnings during the period of change.\nWe may enter into foreign currency forward or option contracts to reduce the effect of fluctuating currency exchange rates (principally the euro, British pound, Chinese yuan, and Japanese yen). Foreign currency derivatives used for hedging are put in place using the same or like currencies and duration as the underlying exposures. Forward and option contracts are principally used to manage exposures arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. These contracts are recorded at fair value with the gain or loss recognized in other–net, (income) expense. We may enter into foreign currency forward and option contracts and currency swaps as fair value hedges of firm commitments. Forward contracts generally have maturities not exceeding 12 months. At September 30, 2022, we had outstanding foreign currency forward commitments to purchase 1.69 billion U.S. dollars and sell 1.71 billion euro; commitments to purchase 2.24 billion euro and sell 2.24 billion U.S. dollars; commitments to purchase 239.5 million U.S. dollars and sell 1.63 billion Chinese yuan; commitments to purchase 82.1 million U.S. dollars and sell 11.86 billion Japanese yen; and commitments to purchase 182.1 million British pounds and sell 206.9 million U.S. dollars, which all have settlement dates within 180 days.\nForeign currency exchange risk is also managed through the use of foreign currency debt, cross-currency interest rate swaps, and foreign currency forward contracts. Our foreign currency-denominated notes had carrying amounts of $ 6.23 billion and $ 7.90 billion as of September 30, 2022 and December 31, 2021, respectively, of which $ 4.94 billion and $ 5.79 billion have been designated as, and are effective as, economic hedges of net investments in certain of our foreign operations as of September 30, 2022 and December 31, 2021, respectively. At September 30, 2022, we had outstanding cross-currency swaps with notional amounts of $ 1.56 billion swapping U.S. dollars to euro and $ 1.00 billion swapping Swiss francs to U.S. dollars which have settlement dates ranging through 2028. Our cross-currency interest rate swaps, for which a majority convert a portion of our U.S. dollar-denominated fixed-rate debt to foreign-denominated fixed-rate debt, have also been designated as, and are effective as, economic hedges of net investments. At September 30, 2022, we had outstanding foreign currency forward contracts to sell 1.34 billion euro with settlement dates ranging through 2023, which have been designated as, and are effective as, economic hedges of net investments.\nIn the normal course of business, our operations are exposed to fluctuations in interest rates which can vary the costs of financing, investing, and operating. We seek to address a portion of these risks through a controlled program of risk management that includes the use of derivative financial instruments. The objective of controlling these risks is to limit the impact of fluctuations in interest rates on earnings. Our primary interest-rate risk exposure results from changes in short-term U.S. dollar interest rates. In an effort to manage interest-rate exposures, we strive to achieve an acceptable balance between fixed- and floating-rate debt and investment positions and may enter into interest rate swaps or collars to help maintain that balance.\nInterest rate swaps or collars that convert our fixed-rate debt to a floating rate are designated as fair value hedges of the underlying instruments. Interest rate swaps or collars that convert floating-rate debt to a fixed rate are designated as cash flow hedges. Interest expense on the debt is adjusted to include the payments made or received under the swap agreements. Cash proceeds from or payments to counterparties resulting from the termination of interest rate swaps are classified as operating activities in our consolidated condensed statements of cash flows. At September 30, 2022, substantially all of our total long-term debt is at a fixed rate. We have converted approximately 10 percent of our long-term fixed-rate notes to floating rates through the use of interest rate swaps.\n21\nWe also may enter into forward-starting interest rate swaps, which we designate as cash flow hedges, as part of any anticipated future debt issuances in order to reduce the risk of cash flow volatility from future changes in interest rates. The change in fair value of these instruments is recorded as part of other comprehensive income (loss) and, upon completion of a debt issuance and termination of the swap, is amortized to interest expense over the life of the underlying debt. As of September 30, 2022, the total notional amounts of forward-starting interest rate contracts in designated cash flow hedging instruments were $ 1.75 billion, which have settlement dates ranging between 2023 and 2025.\nEffective September 15, 2022, we increased our 364-day credit facility from $ 2.00 billion to $ 4.00 billion, which will expire in September 2023, and is available to support our commercial paper program. We have not drawn against the $ 4.00 billion 364-day credit facility as of September 30, 2022.\nIn September 2021, we issued euro-denominated notes consisting of € 600.0 million of 0.50 percent fixed-rate notes due in September 2033, with interest to be paid annually. The net proceeds from the offering have been, and will continue to be, used to fund, in whole or in part, eligible projects designed to advance one or more of our environmental, social, and governance objectives.\nIn September 2021, we issued euro-denominated notes consisting of € 500.0 million of 1.125 percent fixed-rate notes due in September 2051 and € 700.0 million of 1.375 percent fixed-rate notes due in September 2061, with interest to be paid annually, and British pound-denominated notes consisting of £ 250.0 million of 1.625 percent fixed-rate notes due in September 2043, with interest to be paid annually. We paid $ 1.91 billion of the net cash proceeds from the offering to purchase and redeem certain higher interest rate U.S. dollar-denominated notes with an aggregate principal amount of $ 1.50 billion, resulting in a debt extinguishment loss of $ 405.2 million. This loss was included in other net, (income) expense in our consolidated condensed statement of operations during the three and nine months ended September 30, 2021. The $ 1.50 billion principal amount of higher interest rate U.S. dollar-denominated notes that were redeemed primarily included $ 541.8 million of 3.95 percent notes due 2049, $ 408.7 million of 4.15 percent notes due 2059, and $ 219.4 million of 3.375 percent notes due 2029. We used the remaining net proceeds from the offering to prefund certain 2022 debt maturities and for general corporate purposes.\nThe Effect of Risk-Management Instruments on the Consolidated Condensed Statements of Operations\nThe following effects of risk-management instruments were recognized in other–net, (income) expense:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Fair value hedges: |\n| Effect from hedged fixed-rate debt | $ | ( 62.9 ) | $ | ( 10.1 ) | $ | ( 215.7 ) | $ | ( 60.5 ) |\n| Effect from interest rate contracts | 62.9 | 10.1 | 215.7 | 60.5 |\n| Cash flow hedges: |\n| Effective portion of losses on interest rate contracts reclassified from accumulated other comprehensive loss | 4.1 | 4.2 | 12.3 | 12.5 |\n| Cross-currency interest rate swaps | 33.1 | 10.0 | 75.0 | 58.1 |\n| Net (gains) losses on foreign currency exchange contracts not designated as hedging instruments | 129.6 | 50.8 | 280.7 | 110.6 |\n| Total | $ | 166.8 | $ | 65.0 | $ | 368.0 | $ | 181.2 |\n\nDuring the three and nine months ended September 30, 2022 and 2021, the amortization of losses related to the portion of our risk management hedging instruments, fair value hedges, and cash flow hedges that was excluded from the assessment of effectiveness was not material.\n22\nThe Effect of Risk-Management Instruments on Other Comprehensive Income (Loss)\nThe effective portion of risk-management instruments that was recognized in other comprehensive income (loss) is as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net investment hedges: |\n| Foreign currency-denominated notes | $ | 435.1 | $ | 119.0 | $ | 822.8 | $ | 268.8 |\n| Cross-currency interest rate swaps | 92.1 | 66.7 | 171.4 | 170.8 |\n| Foreign currency forward contracts | 107.8 | — | 121.4 | — |\n| Cash flow hedges: |\n| Forward-starting interest rate swaps | 57.5 | 19.4 | 337.7 | 149.3 |\n| Cross-currency interest rate swaps | 19.9 | 3.1 | 38.4 | 22.5 |\n\nDuring the next 12 months, we expect to reclassify $ 16.7 million of pretax net losses on cash flow hedges from accumulated other comprehensive loss to other–net, (income) expense. During the three and nine months ended September 30, 2022 and 2021, the amounts excluded from the assessment of hedge effectiveness recognized in other comprehensive income (loss) were not material.\n23\nFair Value of Financial Instruments\nThe following tables summarize certain fair value information at September 30, 2022 and December 31, 2021 for assets and liabilities measured at fair value on a recurring basis, as well as the carrying amount and amortized cost of certain other investments:\n| Fair Value Measurements Using |\n| CarryingAmount | Cost(1) | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| September 30, 2022 |\n| Cash equivalents | $ | 1,246.8 | $ | 1,246.8 | $ | 1,239.2 | $ | 7.6 | $ | — | $ | 1,246.8 |\n| Short-term investments: |\n| U.S. government and agency securities | $ | 43.0 | $ | 43.5 | $ | 43.0 | $ | — | $ | — | $ | 43.0 |\n| Corporate debt securities | 51.7 | 51.8 | — | 51.7 | — | 51.7 |\n| Asset-backed securities | 3.0 | 3.0 | — | 3.0 | — | 3.0 |\n| Other securities | 27.0 | 27.0 | — | 14.8 | 12.2 | 27.0 |\n| Short-term investments | $ | 124.7 |\n| Noncurrent investments: |\n| U.S. government and agency securities | $ | 131.4 | $ | 148.3 | $ | 131.4 | $ | — | $ | — | $ | 131.4 |\n| Corporate debt securities | 206.4 | 232.5 | — | 206.4 | — | 206.4 |\n| Mortgage-backed securities | 143.1 | 156.1 | — | 143.1 | — | 143.1 |\n| Asset-backed securities | 43.6 | 45.5 | — | 43.6 | — | 43.6 |\n| Other securities | 152.5 | 96.3 | — | 39.5 | 113.0 | 152.5 |\n| Marketable equity securities | 549.1 | 416.1 | 549.1 | — | — | 549.1 |\n| Equity investments without readily determinable fair values(2) | 583.7 |\n| Equity method investments(2) | 764.8 |\n| Noncurrent investments | $ | 2,574.6 |\n| December 31, 2021 |\n| Cash equivalents | $ | 2,379.5 | $ | 2,379.5 | $ | 2,361.0 | $ | 18.5 | $ | — | $ | 2,379.5 |\n| Short-term investments: |\n| U.S. government and agency securities | $ | 25.7 | $ | 25.6 | $ | 25.7 | $ | — | $ | — | $ | 25.7 |\n| Corporate debt securities | 43.7 | 43.7 | — | 43.7 | — | 43.7 |\n| Mortgage-backed securities | 0.2 | 0.2 | — | 0.2 | — | 0.2 |\n| Asset-backed securities | 6.2 | 6.2 | — | 6.2 | — | 6.2 |\n| Other securities | 14.3 | 14.3 | — | — | 14.3 | 14.3 |\n| Short-term investments | $ | 90.1 |\n| Noncurrent investments: |\n| U.S. government and agency securities | $ | 137.0 | $ | 136.8 | $ | 137.0 | $ | — | $ | — | $ | 137.0 |\n| Corporate debt securities | 235.3 | 232.7 | — | 235.3 | — | 235.3 |\n| Mortgage-backed securities | 109.8 | 108.1 | — | 109.8 | — | 109.8 |\n| Asset-backed securities | 23.1 | 23.1 | — | 23.1 | — | 23.1 |\n| Other securities | 108.1 | 22.2 | — | — | 108.1 | 108.1 |\n| Marketable equity securities | 1,279.7 | 487.0 | 1,279.7 | — | — | 1,279.7 |\n| Equity investments without readily determinable fair values(2) | 548.1 |\n| Equity method investments(2) | 771.5 |\n| Noncurrent investments | $ | 3,212.6 |\n\n(1) For available-for-sale debt securities, amounts disclosed represent the securities' amortized cost.\n(2) Fair value disclosures are not applicable for equity method investments and investments accounted for under the measurement alternative for equity investments.\n24\n| Fair Value Measurements Using |\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| Short-term commercial paper borrowings |\n| September 30, 2022 | $ | ( 1,741.3 ) | $ | — | $ | ( 1,738.0 ) | $ | — | $ | ( 1,738.0 ) |\n| December 31, 2021 | — | — | — | — | — |\n| Long-term debt, including current portion |\n| September 30, 2022 | $ | ( 14,147.1 ) | $ | — | $ | ( 11,848.6 ) | $ | — | $ | ( 11,848.6 ) |\n| December 31, 2021 | ( 16,884.7 ) | — | ( 18,157.7 ) | — | ( 18,157.7 ) |\n\n25\n| Fair Value Measurements Using |\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\n| September 30, 2022 |\n| Risk-management instruments: |\n| Interest rate contracts designated as fair value hedges: |\n| Other noncurrent liabilities | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) |\n| Interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 355.2 | — | 355.2 | — | 355.2 |\n| Cross-currency interest rate contracts designated as net investment hedges: |\n| Other receivables | 81.6 | — | 81.6 | — | 81.6 |\n| Other noncurrent assets | 116.9 | — | 116.9 | — | 116.9 |\n| Cross-currency interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 8.3 | — | 8.3 | — | 8.3 |\n| Other noncurrent liabilities | ( 12.9 ) | — | ( 12.9 ) | — | ( 12.9 ) |\n| Foreign exchange contracts designated as net investment hedges: |\n| Other receivables | 108.2 | — | 108.2 | — | 108.2 |\n| Other current liabilities | ( 2.9 ) | — | ( 2.9 ) | — | ( 2.9 ) |\n| Foreign exchange contracts not designated as hedging instruments: |\n| Other receivables | 48.1 | — | 48.1 | — | 48.1 |\n| Other current liabilities | ( 93.5 ) | — | ( 93.5 ) | — | ( 93.5 ) |\n| Contingent consideration liability: |\n| Other noncurrent liabilities | ( 42.1 ) | — | — | ( 42.1 ) | ( 42.1 ) |\n| December 31, 2021 |\n| Risk-management instruments: |\n| Interest rate contracts designated as fair value hedges: |\n| Other receivables | $ | 4.8 | $ | — | $ | 4.8 | $ | — | $ | 4.8 |\n| Other noncurrent assets | 78.3 | — | 78.3 | — | 78.3 |\n| Other noncurrent liabilities | ( 7.6 ) | — | ( 7.6 ) | — | ( 7.6 ) |\n| Interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 49.2 | — | 49.2 | — | 49.2 |\n| Other noncurrent liabilities | ( 31.7 ) | — | ( 31.7 ) | — | ( 31.7 ) |\n| Cross-currency interest rate contracts designated as net investment hedges: |\n| Other noncurrent assets | 31.3 | — | 31.3 | — | 31.3 |\n| Other current liabilities | ( 1.2 ) | — | ( 1.2 ) | — | ( 1.2 ) |\n| Cross-currency interest rate contracts designated as cash flow hedges: |\n| Other noncurrent assets | 33.2 | — | 33.2 | — | 33.2 |\n| Other noncurrent liabilities | ( 1.3 ) | — | ( 1.3 ) | — | ( 1.3 ) |\n| Foreign exchange contracts not designated as hedging instruments: |\n| Other receivables | 9.9 | — | 9.9 | — | 9.9 |\n| Other current liabilities | ( 35.3 ) | — | ( 35.3 ) | — | ( 35.3 ) |\n| Contingent consideration liabilities: |\n| Other noncurrent liabilities | ( 70.5 ) | — | — | ( 70.5 ) | ( 70.5 ) |\n\n26\nRisk-management instruments above are disclosed on a gross basis. There are various rights of setoff associated with certain of the risk-management instruments above that are subject to enforceable master netting arrangements or similar agreements. Although various rights of setoff and master netting arrangements or similar agreements may exist with the individual counterparties to the risk-management instruments above, individually, these financial rights are not material.\nWe determine our Level 1 and Level 2 fair value measurements based on a market approach using quoted market values, significant other observable inputs for identical or comparable assets or liabilities, or discounted cash flow analyses. Level 3 fair value measurements for other investment securities are determined using unobservable inputs, including the investments' cost adjusted for impairments and price changes from orderly transactions. Fair values are not readily available for certain equity investments measured under the measurement alternative.\nAs of September 30, 2022, we had approximately $ 854 million of unfunded commitments to invest in venture capital funds, which we anticipate will be paid over a period of up to 10 years.\nContingent consideration liability relates to our liability arising in connection with the CVR issued as a result of the Prevail acquisition. The fair value of the CVR liability was estimated using a discounted cash flow analysis and Level 3 inputs, including projections representative of a market participant's view of the expected cash payment associated with the first potential regulatory approval of a Prevail compound in the applicable countries based on probabilities of technical success, timing of the potential approval events for the compounds, and an estimated discount rate. See Note 3 for additional information related to the CVR arrangement.\nThe table below summarizes the contractual maturities of our investments in debt securities measured at fair value as of September 30, 2022:\n| Maturities by Period |\n| Total | Less Than1 Year | 1-5Years | 6-10Years | More Than10 Years |\n| Fair value of debt securities | $ | 622.2 | $ | 97.7 | $ | 197.8 | $ | 121.0 | $ | 205.7 |\n\nThe net gains (losses) recognized in our consolidated condensed statements of operations for equity securities were $( 123.3 ) million and $( 667.6 ) million for the three and nine months ended September 30, 2022, respectively, and $( 246.8 ) million and $ 270.1 million for the three and nine months ended September 30, 2021, respectively. The net gains (losses) recognized for the three and nine months ended September 30, 2022 and 2021 on equity securities sold during the respective periods were not material.\nWe adjust our equity investments without readily determinable fair values based upon changes in the equity instruments' values resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Downward adjustments resulting from an impairment are recorded based upon impairment considerations, including the financial condition and near term prospects of the issuer, general market conditions, and industry specific factors. Adjustments recorded for the three and nine months ended September 30, 2022 and 2021 were not material.\nA summary of the amount of unrealized gains and losses in accumulated other comprehensive loss and the fair value of available-for-sale securities in an unrealized gain or loss position follows:\n| September 30, 2022 | December 31, 2021 |\n| Unrealized gross gains | $ | 0.1 | $ | 9.7 |\n| Unrealized gross losses | 51.6 | 5.2 |\n| Fair value of securities in an unrealized gain position | 13.8 | 250.7 |\n| Fair value of securities in an unrealized loss position | 578.8 | 290.2 |\n\nWe periodically assess our investment in available-for-sale securities for impairment losses and credit losses. The amount of credit losses are determined by comparing the difference between the present value of future cash flows expected to be collected on these securities and the amortized cost. Factors considered in assessing credit losses include the position in the capital structure, vintage and amount of collateral, delinquency rates, current credit support, and geographic concentration. Impairment and credit losses related to available-for-sale securities were not material for the three and nine months ended September 30, 2022 and 2021.\n27\nAs of September 30, 2022, the available-for-sale securities in an unrealized loss position include primarily fixed-rate debt securities of varying maturities, which are sensitive to changes in the yield curve and other market conditions. Approximately 95 percent of the fixed-rate debt securities in a loss position are investment-grade debt securities. As of September 30, 2022, we do not intend to sell, and it is not more likely than not that we will be required to sell, the securities in a loss position before the market values recover or the underlying cash flows have been received, and there is no indication of a material default on interest or principal payments for our debt securities.\nActivity related to our available-for-sale securities was as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Proceeds from sales | $ | 50.5 | $ | 49.6 | $ | 115.6 | $ | 137.3 |\n| Realized gross gains on sales | — | 0.4 | 0.2 | 2.2 |\n| Realized gross losses on sales | 7.5 | 0.3 | 9.0 | 1.1 |\n\nRealized gains and losses on sales of available-for-sale investments are computed based upon specific identification of the initial cost adjusted for any other-than-temporary declines in fair value that were recorded in earnings.\nAccounts Receivable Factoring Arrangements\nWe have entered into accounts receivable factoring agreements with financial institutions to sell certain of our non-U.S. accounts receivable. These transactions are accounted for as sales and result in a reduction in accounts receivable because the agreements transfer effective control over, and risk related to, the receivables to the buyers. Our factoring agreements do not allow for recourse in the event of uncollectibility, and we do not retain any interest in the underlying accounts receivable once sold. We derecognized $ 356.8 million and $ 550.5 million of accounts receivable as of September 30, 2022 and December 31, 2021, respectively, under these factoring arrangements. The costs of factoring such accounts receivable on our consolidated condensed results of operations for the three and nine months ended September 30, 2022 and 2021 were not material.\nNote 7: Income Taxes\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the Tax Cuts and Jobs Act (2017 Tax Act) that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\nThe U.S. examination of tax years 2016-2018 began in the fourth quarter of 2019 and remains ongoing. The resolution of this audit period will likely extend beyond the next 12 months.\n28\nNote 8: Retirement Benefits\nNet pension and retiree health benefit (income) cost included the following components:\n| Defined Benefit Pension Plans |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Components of net periodic benefit cost: |\n| Service cost | $ | 87.1 | $ | 92.5 | $ | 264.4 | $ | 277.8 |\n| Interest cost | 98.9 | 84.5 | 299.0 | 253.6 |\n| Expected return on plan assets | ( 235.1 ) | ( 237.5 ) | ( 711.6 ) | ( 712.7 ) |\n| Amortization of prior service cost | 0.6 | 1.0 | 1.9 | 3.2 |\n| Recognized actuarial loss | 85.3 | 121.9 | 256.8 | 366.3 |\n| Net periodic benefit cost | $ | 36.8 | $ | 62.4 | $ | 110.5 | $ | 188.2 |\n\n| Retiree Health Benefit Plans |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Components of net periodic benefit income: |\n| Service cost | $ | 11.7 | $ | 12.4 | $ | 35.0 | $ | 37.0 |\n| Interest cost | 9.4 | 8.1 | 28.4 | 24.4 |\n| Expected return on plan assets | ( 38.0 ) | ( 36.5 ) | ( 114.1 ) | ( 109.6 ) |\n| Amortization of prior service benefit | ( 13.7 ) | ( 14.9 ) | ( 41.1 ) | ( 44.7 ) |\n| Recognized actuarial loss | 0.2 | 0.8 | 0.7 | 2.4 |\n| Net periodic benefit income | $ | ( 30.4 ) | $ | ( 30.1 ) | $ | ( 91.1 ) | $ | ( 90.5 ) |\n\nNote 9: Contingencies\nWe are involved in various lawsuits, claims, government investigations and other legal proceedings that arise in the ordinary course of business. These claims or proceedings can involve various types of parties, including governments, competitors, customers, suppliers, service providers, licensees, employees, or shareholders, among others. These matters may involve patent infringement, antitrust, securities, pricing, sales and marketing practices, environmental, commercial, contractual rights, licensing obligations, health and safety matters, consumer fraud, employment matters, product liability and insurance coverage, among others. The resolution of these matters often develops over a long period of time and expectations can change as a result of new findings, rulings, appeals or settlement arrangements. Legal proceedings that are significant or that we believe could become significant or material are described below.\nWe believe the legal proceedings in which we are named as defendants are without merit and we are defending against them vigorously. It is not possible to determine the final outcome of these matters, and we cannot reasonably estimate the maximum potential exposure or the range of possible loss in excess of amounts accrued for any of these matters; however, we believe that the resolution of all such matters will not have a material adverse effect on our consolidated financial position or liquidity, but could possibly be material to our consolidated results of operations in any one accounting period.\nLitigation accruals, environmental liabilities, and the related estimated insurance recoverables are reflected on a gross basis as liabilities and assets, respectively, on our consolidated condensed balance sheets. With respect to the product liability claims currently asserted against us, we have accrued for our estimated exposures to the extent they are both probable and reasonably estimable based on the information available to us. We accrue for certain product liability claims incurred but not filed to the extent we can formulate a reasonable estimate of their costs. We estimate these expenses based primarily on historical claims experience and data regarding product usage. Legal defense costs expected to be incurred in connection with significant product liability loss contingencies are accrued when both probable and reasonably estimable.\nBecause of the nature of pharmaceutical products, it is possible that we could become subject to large numbers of additional product liability and related claims in the future. Due to a very restrictive market for litigation liability insurance, we are self-insured for litigation liability losses for all our currently and previously marketed products.\n29\nPatent Litigation\nAlimta European Patent Litigation\nIn Europe, Alimta (pemetrexed) was protected by a patent through June 2021. A number of legal proceedings that were initiated prior to patent expiration are ongoing.\nEmgality Patent Litigation\nWe are a named defendant in litigation filed by Teva Pharmaceuticals International GMBH and Teva Pharmaceuticals USA, Inc. (collectively, Teva) in the U.S. District Court for the District of Massachusetts seeking a ruling that various claims in three different Teva patents would be infringed by our launch and continued sales of Emgality for the prevention of migraine in adults. Trial began in October 2022. In June 2021, we were named as a defendant in a second litigation filed by Teva in the U.S. District Court for the District of Massachusetts seeking a ruling that two of Teva's patents, which are directed toward use of the active ingredient in Emgality to treat migraine, would be infringed by our continued sales of Emgality. We challenged these two patents by filing requests for Inter Partes Review with the Patent Trial and Appeal Board (PTAB) and in October 2022, the PTAB granted our requests.The corresponding district court litigation is stayed while this PTAB proceeding is ongoing.\nJardiance Patent Litigation\nIn November 2018, Boehringer Ingelheim, our partner in marketing and development of Jardiance, initiated U.S. patent litigation in the U.S. District Court of Delaware alleging infringement arising from submissions of Abbreviated New Drug Applications (ANDA) by a number of generic companies seeking approval to market generic versions of Jardiance, Glyxambi, and Synjardy in accordance with the procedures set out in the Drug Price Competition and Patent Term Restoration Act of 1984 (the Hatch-Waxman Act). Particularly with respect to Jardiance, the generic companies' ANDAs seek approval to market generic versions of Jardiance prior to the expiration of the relevant patents, and allege that certain patents, including in some allegations the compound patent, are invalid or would not be infringed. We are not a party to this litigation. This litigation has been stayed.\nTaltz Patent Litigation\nIn April 2021, we petitioned the High Court of Ireland to declare invalid a patent that Novartis Pharma AG (Novartis) purchased from Genentech, Inc. in 2020. Novartis responded by filing a claim against us alleging patent infringement related to our commercialization of Taltz and seeking damages for past infringement and an injunction against future infringement.\nIn April 2021, Novartis petitioned the Court of Rome Intellectual Property Division for a preliminary injunction (PI) against us related to our commercialization of Taltz in Italy. In May 2021, We commenced patent revocation proceedings against Novartis before the Court of Milan’s IP Division where we also sought a declaration of non-infringement. Novartis counter-claimed for patent infringement and sought a permanent injunction. A hearing on the PI request before the Court of Rome Intellectual Property Division took place in May 2022 and in July 2022, the court rejected Novartis' request.\nIn November 2021, Novartis petitioned the Swiss Federal Patent Court for a PI and a permanent injunction in main infringement proceedings against us related to our commercialization of Taltz in Switzerland. We petitioned the court to revoke the patent and for a declaration of non-infringement. In April 2022, Novartis withdrew its PI request.\nIn January 2022, we commenced an action in the Hague District Court asking for a judgment that a Novartis Dutch patent is not infringed by our commercialization of Taltz in the Netherlands and is invalid. In October 2022, Novartis filed a counterclaim for infringement and sought a permanent injunction.\nIn October 2022, we entered into a settlement and mutual release agreement with Novartis, which resolves the above-described disputes. Without any admission of liability or wrongdoing, we and Novartis have agreed to mutual releases for past claims and mutual covenants not to sue the other in relation to Taltz and the patents Novartis purchased from Genentech.\n30\nZyprexa Canada Patent Litigation\nBeginning in the mid-2000s, several generic companies in Canada challenged the validity of our Zyprexa compound patent. In 2012, the Canadian Federal Court of Appeals denied our appeal of a lower court's decision that certain patent claims were invalid for lack of utility. In 2013, Apotex Inc. and Apotex Pharmachem Inc. (collectively, Apotex) brought claims against us in the Ontario Superior Court of Justice at Toronto for damages related to our enforcement of the Zyprexa compound patent under Canadian regulations governing patented drugs. Apotex seeks compensation based on novel legal theories under the Statute of Monopolies, Trademark Act, and common law. In March 2021, the Ontario Superior Court granted our motion for summary judgment, thereby dismissing Apotex's case. Apotex appealed that ruling to the Court of Appeal for Ontario in April 2021. In August 2022, the Court dismissed the appeal and in October 2022, Apotex appealed the decision. This matter is ongoing.\nProduct Liability Litigation\nByetta® Product Liability\nWe have been named as a defendant in over 500 Byetta product liability lawsuits in the U.S. that were first initiated in March 2009 and involved over 800 plaintiffs. These lawsuits have been filed in various state and federal jurisdictions, including California state court (coordinated in Los Angeles County Superior Court), and various federal courts, the majority of which are coordinated in a multi-district litigation (MDL) in the U.S. District Court for the Southern District of California. The majority of these suits contain allegations that Byetta caused or contributed to the plaintiffs' cancer (primarily pancreatic cancer or thyroid cancer). The federal MDL and coordinated California state trial courts granted summary judgment in our favor on claims pertaining to pancreatic cancer, and the plaintiffs have dismissed Lilly from their appeal of the MDL ruling (the parties still await the order of judgment in the Los Angeles County Superior Court). Most of the MDL and state court lawsuits have been dismissed as of November 2022.\nEnvironmental Proceedings\nUnder the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as \"Superfund,\" we have been designated as one of several potentially responsible parties with respect to the cleanup of fewer than 10 sites. Under Superfund, each responsible party may be jointly and severally liable for the entire amount of the cleanup.\nOther Matters\n340B Litigation and Investigations\nWe are the plaintiff in a lawsuit filed in January 2021 in the U.S. District Court for the Southern District of Indiana against the U.S. Department of Health and Human Services (HHS), the Secretary of HHS, the Health Resources and Services Administration (HRSA), and the Administrator of HRSA. The lawsuit challenges the HHS's December 30, 2020 advisory opinion stating that drug manufacturers are required to deliver discounts under the 340B program to all contract pharmacies. We seek a declaratory judgment that the defendants violated the Administrative Procedures Act and the U.S. Constitution, a preliminary injunction enjoining implementation of the administrative dispute resolution process created by defendants and, with it, their application of the advisory opinion, and other related relief. In March 2021, the court entered an order preliminarily enjoining the government's enforcement of the administrative dispute resolution process against us. In May 2021, HRSA notified us that it determined that our policy was contrary to the 340B statute. In response, in May 2021, we filed a motion for preliminary injunction and temporary restraining order requesting that the U.S. District Court for the Southern District of Indiana enjoin defendants from taking any action against us relating to the 340B drug pricing program until after the court issues a final judgment on the aforementioned litigation. In May 2021, the court denied our motion for a temporary restraining order but deferred resolution of our motion for preliminary injunction. In June 2021, the defendants withdrew the HHS December 30, 2020 advisory opinion. In July 2021, the court held oral argument on the parties' cross motions for summary judgment, the defendants' motion to dismiss, and our motion for preliminary injunction related to HRSA's May 2021 enforcement letter. In October 2021, the court denied the defendants' motion to dismiss, and granted in part and denied in part the parties' cross motions for summary judgment. Both parties filed notices of appeal related to the court's summary judgment order. Oral argument took place in October 2022 in the U.S. Court of Appeals for the Seventh Circuit. This matter is ongoing.\nIn January 2021, we, along with other pharmaceutical manufacturers, were named as a defendant in a petition currently pending before the HHS Administrative Dispute Resolution Panel. Petitioner seeks declaratory and other injunctive relief related to the 340B program. As described above, the U.S. District Court for the Southern District of Indiana has entered a preliminary injunction enjoining the government's enforcement of this administrative dispute resolution process against us.\n31\nIn July 2021, we, along with Sanofi-Aventis U.S., LLC (Sanofi), Novo Nordisk Inc. (Novo Nordisk), and AstraZeneca Pharmaceuticals LP, were named as a defendant in a purported class action lawsuit filed in the U.S. District Court for the Western District of New York by Mosaic Health, Inc. alleging antitrust and unjust enrichment claims related to the defendants' 340B distribution programs. We, with Sanofi and Novo Nordisk, filed a motion to dismiss the lawsuit, which was granted in September 2022. In October 2022, the plaintiffs filed a motion for leave to amend their complaint. This matter is ongoing.\nWe received a civil investigative subpoena in February 2021 from the Office of the Attorney General for the State of Vermont relating to the sale of pharmaceutical products to Vermont covered entities under the 340B program. We are cooperating with this subpoena.\nBranchburg Manufacturing Facility\nIn May 2021, we received a subpoena from the U.S. Department of Justice requesting the production of certain documents relating to our manufacturing site in Branchburg, New Jersey. We are cooperating with the subpoena.\nBrazil Litigation – Cosmopolis Facility\nLabor Attorney Litigation\nFirst initiated in 2008, our subsidiary in Brazil, Eli Lilly do Brasil Limitada (Lilly Brasil), is named in a Public Civil Action brought by the Labor Public Attorney (LPA) for the 15th Region in the Labor Court of Paulinia, State of Sao Paulo, Brazil, (the Labor Court) alleging possible harm to employees and former employees caused by alleged exposure to soil and groundwater contaminants at a former Lilly Brasil manufacturing facility in Cosmopolis, Brazil, operated by the company between 1977 and 2003. In May 2014, the Labor Court judge ruled against Lilly Brasil, ordering it to undertake several remedial and compensatory actions including health coverage for a class of individuals and certain of their children. In July 2018, the appeals court (TRT) generally affirmed our appeal of the Labor Court's ruling, which included a liquidated award of 300 million Brazilian real, which, when adjusted for inflation and the addition of pre and post judgment interest using the current Central Bank of Brazil's special system of clearance and custody rate, is approximately one billion Brazilian real (approximately $ 185 million as of September 30, 2022). In August 2019, Lilly Brasil filed an appeal to the superior labor court (TST) and in June 2021, the TRT published its decision on the admissibility of Lilly Brasil's appeal, allowing the majority of the elements, which were allowed to proceed in June 2021; elements not proceeding are subject to an interlocutory appeal to the TST that was filed in June 2021. In September 2019, the TRT stayed a number of elements of its trial court decision pending the determination of Lilly Brasil's appeal to the TST.\nIn June 2019 and September 2020, the LPA filed applications in the Labor Court for enforcement of certain remedies granted by the TRT in its July 2018 decision, requested restrictions on Lilly Brasil’s assets in Brazil, and required Lilly Brasil and Antibióticos do Brasil Ltda. (ABL) to submit a list of potential beneficiaries of the Public Civil Action. In July 2019, the Labor Court issued a ruling requiring a freeze of Lilly Brasil’s immovable property or, alternatively, a security deposit or lien of 500 million Brazilian real, which ruling was subsequently limited in scope and the security was reduced to 100 million Brazilian real. ABL and LPA appealed the June 2021 Labor Court ruling to the TST, which appeal is under review. The Labor Court is currently assessing the status of Lilly Brasil’s and ABL’s compliance with such portion of the July 2018 TRT decision and an inspection in the industrial plant is expected. These matters are ongoing.\nIndividual Former Employee Litigation\nLilly Brasil is also named in over 20 pending lawsuits filed in the Labor Court by individual former employees making similar claims. These individual lawsuits are at various stages in the litigation process.\nPuerto Rico Tax Matter\nIn May 2013, the Municipality of Carolina in Puerto Rico (Municipality) filed a lawsuit against us alleging noncompliance with respect to a contract with the Municipality and seeking a declaratory judgment. In December 2020, the Puerto Rico Appellate Court (AP) reversed the summary judgment previously granted by the Court of First Instance (CFI) in our favor, dismissing the Municipality's complaint in its entirety. The AP remanded the case to the CFI for trial on the merits. The trial began in May 2022; however, the Municipality filed a new motion requesting the CFI to award damages. The request was denied by the CFI in our favor and the Municipality filed for revision at the AP, which we opposed, staying the case. This matter is ongoing.\n32\nEastern District of Pennsylvania Pricing (Average Manufacturer Price) Inquiry\nIn November 2014, we, along with another pharmaceutical manufacturer, were named as co-defendants in United States et al. ex rel. Streck v. Takeda Pharm. Am., Inc., et al., which was filed in November 2014 and unsealed in the U.S. District Court for the Northern District of Illinois. The complaint alleges that the defendants should have treated certain credits from distributors as retroactive price increases and included such increases in calculating average manufacturer prices. Following a trial in August 2022, the jury returned a verdict in favor of the plaintiff. The case is proceeding with post-trial motions after which the court will enter final judgment in the case. This matter is ongoing.\nHealth Choice Alliance\nWe are named as a defendant in two lawsuits filed in Texas and New Jersey state courts in October 2019 seeking damages under the Texas Medicaid Fraud Prevention Act and New Jersey Medicaid False Claims Act, respectively, for certain patient support programs related to our products Humalog, Humulin, and Forteo. The Texas state court action has been stayed. The New Jersey state court action was dismissed with prejudice pending an ongoing appeal before the Appellate Division of the New Jersey Superior Court. This matter is ongoing.\nPricing Litigation\nIn December 2017 and February 2018, we, along with Sanofi and Novo Nordisk, were named as defendants in a consolidated purported class action lawsuit, In re. Insulin Pricing Litigation and in MSP Recovery Claims, Series, LLC et al. v. Sanofi Aventis U.S. LLC et al., both filed in the U.S. District Court for the District of New Jersey. The cases relate to insulin pricing and seek damages or other relief under various theories, including state consumer protection laws, common law fraud, unjust enrichment, and the Federal Racketeer Influenced and Corrupt Organization Act (federal RICO Act). In both cases, the court dismissed claims under the federal RICO Act and certain state laws. In April 2021, the plaintiffs in In re. Insulin Pricing Litigation amended their complaint to allege additional state law claims for civil conspiracy and violations of state RICO statutes. The court allowed the Arizona RICO statute and certain state civil conspiracy law claims to proceed. Additionally in 2020, we, along with Sanofi, Novo Nordisk, CVS, Express Scripts, and Optum, have been sued in a putative class action, FWK Holdings, LLC v. Novo Nordisk Inc., et al., filed in the same court, for alleged violations of the federal RICO Act as well as the New Jersey RICO Act and antitrust law. The same group of defendants, along with Medco Health and United Health Group, also have been sued in other purported class actions in the same court, Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al. and Value Drug Co. v. Eli Lilly & Co. et al., which were both initiated in March 2020, with the plaintiffs seeking damages for alleged violations of the federal RICO Act. In September 2020, the U.S. District Court for the District of New Jersey granted plaintiffs' motion to consolidate FWK Holdings, LLC v. Novo Nordisk Inc., et al., Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al., and Value Drug Co. v. Eli Lilly & Co. et al. In July 2021, the U.S. District Court for the District of New Jersey dismissed the three antitrust claims alleged by plaintiffs in the consolidated litigation and denied dismissal of the federal RICO Act claims.\nIn October 2018, the Minnesota Attorney General's Office initiated litigation against us, Sanofi, and Novo Nordisk, State of Minnesota v. Sanofi-Aventis U.S. LLC et al., in the U.S. District Court for the District of New Jersey, seeking damages for unjust enrichment, violations of various Minnesota state consumer protection laws, and the federal RICO Act. In March 2021, the U.S. District Court for the District of New Jersey dismissed with prejudice the Minnesota Attorney General's federal RICO claims and false advertising claims under state law; the consumer fraud and other related state law claims remain ongoing. Additionally, in May 2019, the Kentucky Attorney General's Office filed a complaint against us, Sanofi, and Novo Nordisk, Commonwealth of Kentucky v. Novo Nordisk, Inc. et al., in Kentucky state court, alleging violations of the Kentucky consumer protection law, false advertising, and unjust enrichment.\nIn June 2021, the Mississippi Attorney General's Office initiated litigation against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark, and United/Optum in the Hinds County, Mississippi Chancery Court, alleging state law consumer protection, unjust enrichment, and civil conspiracy claims. After the case was removed to federal court, we, along with the other defendants, filed a motion to dismiss the lawsuit, which was denied. This matter is ongoing.\nIn May 2022, the state of Arkansas filed suit against us Sanofi, Novo Nordisk, ESI, CVS/Caremark/Aetna, and Optum, asserting state law consumer protection, civil conspiracy, and unjust enrichment claims. The case has been removed to federal court and is ongoing.\nIn September 2022, the County of Albany, New York filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark and United/Optum asserting violations of federal RICO statute and state law claims for deceptive trade practices, unjust enrichment, and civil conspiracy. This matter is ongoing.\n33\nIn September 2022, the State of Montana filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, Medco Health Solutions, CVS/Caremark and Optum asserting violations of the Montana Unfair Practices and Consumer Protection Act, unjust enrichment, and civil conspiracy. This matter is ongoing.\nInvestigations, Subpoenas, and Inquiries\nIn connection with the pricing and sale of our insulin and other products, we have been subject to various investigations and received subpoenas, civil investigative demand requests, information requests, interrogatories, and other inquiries from various governmental entities. These include subpoenas from the New York and Vermont Attorney General Offices, civil investigative demands from the Washington, New Mexico, Colorado, Illinois, Ohio Attorney General Offices, the Department of Justice and the Federal Trade Commission, as well as information requests from the Mississippi, Washington D.C., California, Florida, Hawaii, and Nevada Attorney General Offices. In January 2022, the Michigan Attorney General filed a petition in Michigan state court seeking authorization to investigate Lilly for potential violations of the Michigan Consumer Protection Act (MCPA), and a complaint seeking a declaratory judgment that the Attorney General has authority to investigate Lilly's sale of insulin under the MCPA. The court authorized the proposed investigation and the issuance of civil investigative subpoenas. In April 2022, the parties entered into a stipulation providing that the State will not issue any civil investigative subpoena to us under the MCPA until the declaratory judgment action is resolved. In July 2022, the court dismissed the case in its entirety. The Michigan Attorney General filed a notice of appeal and an application to obtain review by the Michigan Supreme Court, which remain pending.\nWe received a request in January 2019 from the House of Representatives' Committee on Oversight and Reform seeking commercial information and business records related to the pricing of insulin products, among other issues. We also received similar requests from the Senate Finance Committee and the Senate Committee on Health, Education, Labor, and Pensions, and separate requests from the House Committee on Energy and Commerce majority and minority members. In January 2021, the Senate Finance Committee released a report summarizing the findings of its investigation. In December 2021 the House of Representatives' Committee on Oversight and Reform majority and minority staffs released separate reports with findings from their investigations into drug pricing, including of insulin products.\nWe are cooperating with all of the aforementioned investigations, subpoenas, and inquiries.\nResearch Corporation Technologies, Inc.\nIn April 2016, we were named as a defendant in litigation filed by Research Corporation Technologies, Inc. (RCT) in the U.S. District Court for the District of Arizona. RCT is seeking damages for breach of contract, unjust enrichment, and conversion related to processes used to manufacture certain products, including Humalog and Humulin. In October 2021, the court issued a summary judgment decision finding in favor of RCT on certain issues, including with respect to a disputed royalty. Both parties filed motions for reconsideration, which were denied. We filed supplemental summary judgment motions. A trial date has not been set. Potential damages payable under the litigation, if finally awarded after an appeal, could be material but are not currently reasonably estimable. This matter is ongoing.\n34\nNote 10: Other Comprehensive Income (Loss)\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the three months ended September 30, 2022 and 2021:\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at July 1, 2022 | $ | ( 1,844.2 ) | $ | ( 27.9 ) | $ | ( 2,443.2 ) | $ | 27.6 | $ | ( 4,287.7 ) |\n| Other comprehensive income (loss) before reclassifications | ( 165.1 ) | ( 24.9 ) | 47.8 | 63.0 | ( 79.2 ) |\n| Net amount reclassified from accumulated other comprehensive loss | — | 13.5 | 57.2 | 0.4 | 71.1 |\n| Net other comprehensive income (loss) | ( 165.1 ) | ( 11.4 ) | 105.0 | 63.4 | ( 8.1 ) |\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\n\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at July 1, 2021 | $ | ( 1,516.2 ) | $ | 9.1 | $ | ( 4,569.9 ) | $ | ( 210.1 ) | $ | ( 6,287.1 ) |\n| Other comprehensive income (loss) before reclassifications | ( 8.0 ) | ( 2.4 ) | 18.6 | 16.8 | 25.0 |\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.1 | 86.0 | 3.3 | 89.4 |\n| Net other comprehensive income (loss) | ( 8.0 ) | ( 2.3 ) | 104.6 | 20.1 | 114.4 |\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\n\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the nine months ended September 30, 2022 and 2021:\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at January 1, 2022 | $ | ( 1,550.2 ) | $ | 3.7 | $ | ( 2,583.6 ) | $ | ( 213.0 ) | $ | ( 4,343.1 ) |\n| Other comprehensive income (loss) before reclassifications | ( 459.7 ) | ( 55.5 ) | 72.9 | 297.2 | ( 145.1 ) |\n| Net amount reclassified from accumulated other comprehensive loss | 0.6 | 12.5 | 172.5 | 6.8 | 192.4 |\n| Net other comprehensive income (loss) | ( 459.1 ) | ( 43.0 ) | 245.4 | 304.0 | 47.3 |\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\n\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\n| Balance at January 1, 2021 | $ | ( 1,427.5 ) | $ | 14.8 | $ | ( 4,751.0 ) | $ | ( 332.7 ) | $ | ( 6,496.4 ) |\n| Other comprehensive income (loss) before reclassifications | ( 96.7 ) | ( 8.8 ) | 27.2 | 132.8 | 54.5 |\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.8 | 258.5 | 9.9 | 269.2 |\n| Net other comprehensive income (loss) | ( 96.7 ) | ( 8.0 ) | 285.7 | 142.7 | 323.7 |\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\n\n35\nThe tax effects on the net activity related to each component of other comprehensive income (loss) were as follows:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| Tax benefit (expense) | 2022 | 2021 | 2022 | 2021 |\n| Foreign currency translation gains/losses | $ | ( 133.3 ) | $ | ( 39.0 ) | $ | ( 234.2 ) | $ | ( 92.3 ) |\n| Unrealized net gains/losses on securities | 3.4 | 0.8 | 13.1 | 3.8 |\n| Defined benefit pension and retiree health benefit plans | ( 22.4 ) | ( 28.2 ) | ( 73.2 ) | ( 79.7 ) |\n| Effective portion of cash flow hedges | ( 16.9 ) | ( 5.4 ) | ( 80.8 ) | ( 37.9 ) |\n| Benefit (expense) for income taxes allocated to other comprehensive income (loss) items | $ | ( 169.2 ) | $ | ( 71.8 ) | $ | ( 375.1 ) | $ | ( 206.1 ) |\n\nExcept for the tax effects of foreign currency translation gains and losses related to our foreign currency-denominated notes, cross-currency interest rate swaps, and other foreign currency exchange contracts designated as net investment hedges (see Note 6), income taxes were not provided for foreign currency translation. Generally, the assets and liabilities of foreign operations are translated into U.S. dollars using the current exchange rate. For those operations, changes in exchange rates generally do not affect cash flows; therefore, resulting translation adjustments are made in shareholders' equity rather than in the consolidated condensed statements of operations.\nReclassifications out of accumulated other comprehensive loss were as follows:\n| Details about Accumulated Other Comprehensive Loss Components | Three Months Ended September 30, | Nine Months Ended September 30, | Affected Line Item in the Consolidated Condensed Statements of Operations |\n| 2022 | 2021 | 2022 | 2021 |\n| Amortization of retirement benefit items: |\n| Prior service benefits, net | $ | ( 13.1 ) | $ | ( 13.9 ) | $ | ( 39.2 ) | $ | ( 41.5 ) | Other–net, (income) expense |\n| Actuarial losses, net | 85.5 | 122.7 | 257.5 | 368.7 | Other–net, (income) expense |\n| Total before tax | 72.4 | 108.8 | 218.3 | 327.2 |\n| Tax benefit | ( 15.2 ) | ( 22.8 ) | ( 45.8 ) | ( 68.7 ) | Income taxes |\n| Net of tax | 57.2 | 86.0 | 172.5 | 258.5 |\n| Other, net of tax | 13.9 | 3.4 | 19.9 | 10.7 | Other–net, (income) expense |\n| Total reclassifications, net of tax | $ | 71.1 | $ | 89.4 | $ | 192.4 | $ | 269.2 |\n\nNote 11: Other–Net, (Income) Expense\nOther–net, (income) expense consisted of the following:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Interest expense | $ | 81.5 | $ | 83.6 | $ | 247.6 | $ | 258.4 |\n| Interest income | ( 20.1 ) | ( 7.0 ) | ( 37.3 ) | ( 18.0 ) |\n| Net investment (gains) losses on equity securities (Note 6) | 123.3 | 246.8 | 667.6 | ( 270.1 ) |\n| Retirement benefit plans | ( 92.4 ) | ( 72.6 ) | ( 280.0 ) | ( 217.1 ) |\n| Debt extinguishment loss (Note 6) | — | 405.2 | — | 405.2 |\n| Other (income) expense | 18.7 | ( 20.1 ) | ( 17.0 ) | ( 34.1 ) |\n| Other–net, (income) expense | $ | 111.0 | $ | 635.9 | $ | 580.9 | $ | 124.3 |\n\n36\nItem 2. Management's Discussion and Analysis of Results of Operations and Financial Condition\nResults of Operations\n(Tables present dollars in millions, except per-share data)\nGeneral\nManagement's discussion and analysis of results of operations and financial condition is intended to assist the reader in understanding and assessing significant changes and trends related to the results of operations and financial position of our consolidated company. This discussion and analysis should be read in conjunction with the consolidated condensed financial statements and accompanying footnotes in Part I, Item 1 of this Quarterly Report on Form 10-Q. Certain statements in this Part I, Item 2 of this Quarterly Report on Form 10-Q constitute forward-looking statements. Various risks and uncertainties, including those discussed in \"Forward-Looking Statements\" in this Quarterly Report on Form 10-Q and \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021, may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements.\nExecutive Overview\nThis section provides an overview of our financial results, recent product and late-stage pipeline developments, and other matters affecting our company and the pharmaceutical industry. Earnings per share (EPS) data are presented on a diluted basis.\nCOVID-19 Pandemic\nIn response to the COVID-19 pandemic, we have focused on maintaining a supply of our medicines; reducing the strain on the medical system; developing treatments for COVID-19; protecting the health, safety, and well-being of our employees; supporting our communities; and ensuring affordability of and access to our medicines, particularly insulin.\nWe have received various regulatory authorizations, including Emergency Use Authorizations (EUA), for our COVID-19 therapies. We supplied the United States (U.S.) government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders. The U.S. Food and Drug Administration (FDA) has revised, and may in the future revise, any EUA for our COVID-19 therapies in response to the prevalence of variants against which our therapies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants.\nThe COVID-19 pandemic has, and may continue to, adversely impact our business and operations. Strain on global transportation, logistics, manufacturing, and labor markets, including as aggravated by the pandemic and global unrest, the focus of resources on COVID-19, protective measures implemented to control the spread of COVID-19, and an increase in overall demand in our industry for certain resources and medicines, resulting in changed buying patterns, increased costs, and constrained supply, have negatively impacted and may continue to negatively impact the development, manufacturing, supply, distribution, and sales of our medicines.\nThe degree to which the COVID-19 pandemic and related challenges impact the development, manufacturing, supply, distribution, and sale of our medicines will depend on developments that are highly uncertain and beyond our knowledge or control.\n37\nProduct Supply\nContinued strong demand for Trulicity® in U.S. and international markets, partially due to the ongoing limited availability of competitor therapies, has challenged, and is expected to continue to challenge, our ability to meet demand in most international markets. In the U.S., as demand for Trulicity has continued to exceed historical levels, we anticipate tight supplies will persist until additional manufacturing capacity is operationalized, and U.S. wholesalers may experience intermittent restocking delays of Trulicity orders. Outside the U.S., we have implemented certain actions to minimize the impact to existing patients, but we expect to experience intermittent disruptions in our supply of Trulicity in international markets.\nIn addition, the uptake of Mounjaro® for type 2 diabetes following its launch in the U.S. has been very strong. We continue to carefully monitor demand, incretin competitor availability, and supply with a focus on access for Type 2 diabetes patients.\nWe anticipate that additional internal and contracted manufacturing capacity will become fully operational around the world in the next several years, with significant expansion in 2023, as part of our ongoing efforts to meet the significant demand for our incretin medicines.\nSee \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021 for additional information on risk factors that could impact our business and operations.\nFinancial Results\nThe following table summarizes our key operating results:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n| Gross margin | 5,362.5 | 5,342.0 | — | 16,157.9 | 15,055.9 | 7 |\n| Gross margin as a percent of revenue | 77.3 | % | 78.9 | % | 76.1 | % | 74.1 | % |\n| Research and development | $ | 1,802.9 | $ | 1,705.3 | 6 | $ | 5,194.9 | $ | 5,032.4 | 3 |\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 2 | 4,797.2 | 4,839.6 | (1) |\n| Acquired in-process research and development (IPR&D) and development milestones | 62.4 | 177.6 | (65) | 668.4 | 532.4 | 26 |\n| Asset impairment, restructuring, and other special charges | 206.5 | — | NM | 206.5 | 211.6 | (2) |\n| Other–net, (income) expense | 111.0 | 635.9 | (83) | 580.9 | 124.3 | NM |\n| Net income | 1,451.7 | 1,110.1 | 31 | 4,307.1 | 3,855.6 | 12 |\n| EPS - diluted | 1.61 | 1.22 | 32 | 4.76 | 4.23 | 13 |\n\nNM - not meaningful\nRevenue increased for the three and nine months ended September 30, 2022, driven by increased volume, partially offset by lower realized prices and the unfavorable impact of foreign exchange rates. Research and development expenses increased for the three and nine months ended September 30, 2022, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses increased for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\n38\nThe following highlighted items also affect comparisons of our financial results for the three and nine months ended September 30, 2022 and 2021:\n2022\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\n•We recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher.\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\n•We recognized charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing.\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\n•We recognized $123.3 million and $667.6 million of net investment losses on equity securities for the three and nine months ended September 30, 2022, respectively.\n2021\nCost of Sales (See Note 5 to the consolidated condensed financial statements)\n•We recognized a net inventory impairment charge related to our COVID-19 antibodies of $435.1 million for the nine months ended September 30, 2021. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\n•We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges resulting from business development transactions with Rigel Pharmaceuticals, Inc. (Rigel) and Precision Biosciences, Inc. (Precision).\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\n•We recognized charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail Therapeutics Inc. (Prevail).\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\n•We recognized a debt extinguishment loss of $405.2 million related to the repurchase of debt for the three and nine months ended September 30, 2021.\n•We recognized $246.8 million of net investment losses on equity securities for the three months ended September 30, 2021. We recognized $270.1 million of net investment gains on equity securities for the nine months ended September 30, 2021.\n39\nLate-Stage Pipeline\nOur long-term success depends on our ability to continually discover or acquire, develop, and commercialize innovative new medicines. We currently have approximately 45 new medicine candidates in clinical development or under regulatory review, and a larger number of projects in the discovery phase.\nThe following certain new molecular entities (NMEs) are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NMEs, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\n| Compound | Indication | Status | Developments |\n| Diabetes |\n| Tirzepatide (Mounjaro) | Type 2 diabetes | Approved | Approved in the U.S. in the second quarter of 2022 and in Europe and Japan in the third quarter of 2022. |\n| Heart failure with preserved ejection fraction | Phase III | Phase III trials are ongoing. |\n| Obesity | Phase III | Granted FDA Fast Track designation(1) in October 2022. Announced in the second quarter of 2022 that the initial Phase III trial met co-primary and all key secondary endpoints. Phase III trials are ongoing. |\n| Obstructive sleep apnea | Phase III | Phase III trial initiated in the third quarter of 2022. |\n| Nonalcoholic steatohepatitis | Phase II | Phase II trial is ongoing. |\n| Basal Insulin-Fc | Type 1 and 2 diabetes | Phase III | Phase III trials initiated in the first, second, and third quarters of 2022. |\n| Orforglipron (GLP-1R NPA) | Obesity | Phase II | Phase II trials are ongoing. |\n| Type 2 diabetes |\n| Retatrutide (GGG Tri-Agonist) | Obesity | Phase II | Phase II trials are ongoing. |\n| Type 2 diabetes |\n| Immunology |\n| Lebrikizumab(2) | Atopic dermatitis | Submitted | Granted FDA Fast Track designation(1). Submitted in the U.S. in the third quarter of 2022 and in Europe in October 2022. Phase III trials are ongoing. |\n| Mirikizumab | Ulcerative colitis | Submitted | Submitted in the U.S. in first quarter of 2022 and in Europe and Japan in the second quarter of 2022. |\n| Crohn's Disease | Phase III | Phase III trials are ongoing. |\n| ANGPTL3 siRNA | Cardiovascular disease | Phase II | Phase II trial initiated in the third quarter of 2022. |\n| BTLA MAB Agonist | Systemic lupus erythematosus | Phase II | Phase II trial initiated in the second quarter of 2022. |\n| CXCR1/2 Ligands Monoclonal Antibody | Hidradenitis suppurativa | Phase II | Phase II trial is ongoing. |\n| Peresolimab (PD-1 MAB Agonist) | Rheumatoid arthritis | Phase II | Phase II trial is ongoing. |\n| Rezpegaldesleukin (IL-2 Conjugate) | Systemic lupus erythematosus | Phase II | Phase II trial is ongoing. |\n\n40\n| Compound | Indication | Status | Developments |\n| Neuroscience |\n| Donanemab | Early Alzheimer's disease | Submitted | Granted FDA Breakthrough Therapy designation(3). Submitted in the U.S. in the second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trials are ongoing. |\n| Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\n| Remternetug | Early Alzheimer's disease | Phase III | Phase III trial initiated in the third quarter of 2022. |\n| Solanezumab | Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\n| GBA1 Gene Therapy (PR001) | Parkinson's disease | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\n| GRN Gene Therapy (PR006) | Frontotemporal dementia | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\n| O-GlcNAcase Inh | Alzheimer's disease | Phase II | Phase II trial is ongoing. |\n| SSTR4 Agonist | Pain | Phase II | Phase II trials are ongoing. |\n| TRPA1 Antagonist | Pain | Phase II | Phase II trials are ongoing. |\n| PACAP38 Antibody | Migraine | Discontinued | In the third quarter of 2022 based on the results of the Phase II trial, we discontinued development. |\n| Oncology |\n| Selpercatinib (Retevmo®) | Lung cancer | Approved(4) | Phase III trials are ongoing. In the third quarter of 2022, the FDA granted accelerated approval in tumor-agnostic RET fusion-positive advanced or metastatic solid tumors and traditional approval in locally advanced or metastatic RET fusion-positive non-small cell lung cancer. |\n| Thyroid cancer | Approved(4) | Phase III trial is ongoing. |\n| Pirtobrutinib (LOXO-305) | Mantle cell lymphoma | Submitted | Submitted in the U.S. in second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trial is ongoing. |\n| Chronic lymphocytic leukemia | Phase III | Phase III trials are ongoing. |\n| B-cell malignancies | Phase II | Phase II trial is ongoing. |\n| Imlunestrant | ER+HER2- metastatic breast cancer | Phase III | Phase III trial is ongoing. |\n\n(1) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\n(2) In collaboration with Almirall, S.A. in Europe.\n(3) Breakthrough Therapy designation is designed to expedite the development and review of potential medicines that are intended to treat a serious condition where preliminary clinical evidence indicates that the treatment may demonstrate substantial improvement over available therapy on a clinically significant endpoint.\n(4) Continued approval may be contingent on verification and description of clinical benefit in confirmatory Phase III trials.\n41\nOur pipeline also contains several new indication line extension (NILEX) products. The following certain NILEX products for use in the indication described are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NILEX products, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\n| Compound | Indication | Status | Developments |\n| Diabetes |\n| Empagliflozin (Jardiance®)(1) | Heart failure with preserved ejection fraction | Approved | Approved in the U.S. and Europe in the first quarter of 2022 and in Japan in the second quarter of 2022. |\n| Chronic kidney disease | Phase III | Granted FDA Fast Track designation(2). In the first quarter of 2022 the Independent Data Monitoring Committee recommended stopping the Phase III trial early due to clear positive efficacy. |\n| Immunology |\n| Baricitinib (Olumiant®) | Alopecia areata | Approved | Approved in the U.S., Europe, and Japan in the second quarter of 2022. |\n| COVID-19 | Approved | Approved in the U.S. in the second quarter of 2022. |\n| Oncology |\n| Abemaciclib (Verzenio®) | Prostate cancer | Phase III | Phase III trials are ongoing. |\n\n(1) In collaboration with Boehringer Ingelheim.\n(2) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\nOther Matters\nPatent Matters\nWe depend on patents or other forms of intellectual property protection for most of our revenue, cash flows, and earnings.\nFollowing the June 2021 loss of patent exclusivity for Alimta® in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. This decline in revenue has had and will have a material adverse effect on our consolidated results of operations and cash flows. See Note 9 to the consolidated condensed financial statements for a description of legal proceedings currently pending regarding certain of our patents.\nOur compound patents for Humalog® (insulin lispro) have expired in the U.S. and major international markets, and we have also introduced lower-priced versions of Humalog as part of our insulin affordability solutions. A competitor has a similar version of insulin lispro in the U.S. and in certain European markets. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\nOur formulation and use patents for Forteo® have expired in major markets. We expect further decline in revenue as a result of the entry of generic and biosimilar competition due to the loss of patent exclusivity in major markets.\nForeign Currency Exchange Rates\nAs a global company, we face foreign currency risk exposure from fluctuating currency exchange rates, primarily the U.S. dollar against the euro, Japanese yen, and Chinese yuan. While we seek to manage a portion of these exposures through hedging and other risk management techniques, significant fluctuations in currency rates can have a material impact, either positive or negative, on our consolidated results of operations in any given period. During the three and nine months ended September 30, 2022, revenue was unfavorably impacted by 4 percent and 3 percent, respectively, due to foreign exchange rates. While there is uncertainty in the future movements in foreign exchange rates, fluctuations in these rates have, and we currently expect in the near-term future will, adversely impact our consolidated results of operations and cash flows.\n42\nTrends Affecting Pharmaceutical Pricing, Reimbursement, and Access\nGlobal concern over access to and affordability of pharmaceutical products continues to drive regulatory and legislative debate and action, as well as worldwide cost containment efforts by governmental authorities. Such measures include the use of mandated discounts, price reporting requirements, mandated reference prices, restrictive formularies, changes to available intellectual property protections, as well as other efforts. In August 2022, the U.S. government enacted the Inflation Reduction Act (IRA). Among other measures, the IRA will allow the U.S. Department of Health and Human Services to effectively set prices for certain single-source drugs and biologics reimbursed under Medicare Part B and Part D. Generally, these government prices apply nine (medicines approved under a New Drug Application) or thirteen (medicines approved under a Biologics License Application) years following initial FDA approval and will be capped at a statutory ceiling price that is likely to represent a significant discount from average prices to wholesalers and direct purchasers. It is too soon to tell how the U.S. government will set these prices as the law specifies a ceiling price, but not a minimum or floor price. One or more significant Lilly products may be selected, which would have the effect of accelerating revenue erosion prior to patent expiry. The effect of reducing prices and reimbursement for certain of our products could significantly impact our business and consolidated results of operations.\nOther of the IRA’s provisions provide for penalties on drug manufacturers that increase prices of certain Medicare Part B and Part D medicines at a rate greater than the rate of inflation and replace the Part D coverage gap discount program with a new manufacturer discounting program. Manufacturers that fail to comply with the IRA may be subject to various penalties, including civil monetary penalties. The IRA takes effect progressively starting in 2023, with the first government set prices effective in 2026. The IRA may meaningfully influence our and pharmaceutical industry business strategies. In particular it may reduce the attractiveness of investment in small molecule innovation. Provisions of the IRA may be subject to legal challenges or other reformation, and the full effect of the IRA on our business and the pharmaceutical industry remains uncertain. Additional policies, regulations, legislation, or enforcement, including those proposed and/or pursued by the U.S. Congress and executive branch of the U.S. administration and other regulatory authorities worldwide, could adversely impact our business and consolidated results of operations.\nConsolidation of private payors in the U.S. has also significantly impacted the market for pharmaceuticals by increasing payor leverage in negotiating manufacturer price concessions and pharmacy reimbursement rates. Furthermore, restrictive or unfavorable pricing, coverage, or reimbursement determinations for our medicines or product candidates by governments, regulatory agencies, courts, or private payers, such as the Centers for Medicare & Medicaid Services' National Coverage Determination for monoclonal antibodies for the treatment of Alzheimer's Disease, may adversely impact our business and consolidated results of operations. We expect that these actions may intensify and could particularly affect certain products, such as insulin, as governments manage and emerge from the COVID-19 pandemic, which could adversely affect our business. In addition, we are engaged in litigation and investigations related to our 340B program and access to insulin that, if resolved adversely to us, could negatively impact our business and consolidated results of operations. It is not currently possible to predict the overall potential adverse impact to us or the general pharmaceutical industry of continued cost containment efforts worldwide.\nEvolving regulatory priorities have also intensified governmental scrutiny of our operations and our industry, including with respect to current Good Manufacturing Practices, quality assurance, and similar regulations, and increased focus on business combinations in our industry. Any regulatory issues concerning these matters could lead to regulatory and legal actions, product recalls and seizures, fines and penalties, interruption of production leading to product shortages, import bans or denials of import certifications, delays or denials in the approvals of new products or supplemental approvals of current products pending resolution of the issues, impediments to the completion of business combinations, and reputational harm, any of which would adversely affect our business.\nSee \"Business - Regulations and Private Payer Actions Affecting Pharmaceutical Pricing, Reimbursement, and Access\" in Part I, Item 1 and \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 9 to the consolidated condensed financial statements.\n43\nTax Matters\nWe are subject to income taxes and various other taxes in the U.S. and in many foreign jurisdictions; therefore, changes in both domestic and international tax laws or regulations have affected and may affect our effective tax rate, results of operations, and cash flows. In 2017, the U.S. enacted the Tax Cuts and Jobs Act (the 2017 Tax Act), which contains a provision that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022. Previously, these expenses could be deducted in the year incurred. The implementation of this provision has increased, and is expected to continue to increase, our 2022 cash payments of income taxes and subsequently decrease our cash payments of income taxes moderately over the five-year amortization period. We expect the implementation of this provision to impact our 2022 cash payments of income taxes by up to $1.50 billion. For the three and nine months ended September 30, 2022, the implementation of this provision favorably impacted other tax items that decreased our effective tax rate by approximately 4 percentage points. If this provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022, we expect our effective tax rate to be approximately 13 percent to 14 percent for 2022.\nThe U.S. and countries around the world are actively considering and enacting tax law changes. Tax proposals have been introduced by the U.S. Congress and the U.S. administration containing significant changes, including increases to the tax rates at which both domestic and foreign income of U.S. companies would be taxed. In addition, tax authorities in the U.S. and other jurisdictions in which we do business routinely examine our tax returns and are intensifying their scrutiny and examinations of profit allocations among jurisdictions. Further, actions taken with respect to tax-related matters by associations, such as the Organisation for Economic Co-operation and Development and the European Commission, could influence tax laws in countries in which we operate. Changes to existing tax law and increased scrutiny by tax authorities in the U.S. and other jurisdictions could adversely impact our future consolidated results of operations and cash flows.\nAcquisitions\nWe opportunistically invest in external research and technologies that we believe complement and strengthen our own efforts. These investments can take many forms, including acquisitions, collaborations, investments, and licensing arrangements. We view our business development activity as a way to enhance our pipeline and strengthen our business.\nSee Note 3 to the consolidated condensed financial statements for further discussion regarding our recent acquisitions.\n44\nRevenue\nThe following table summarizes our revenue activity by region:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | 11 | $ | 13,531.5 | $ | 11,635.1 | 16 |\n| Outside U.S. | 2,519.4 | 2,783.3 | (9) | 7,708.1 | 8,683.4 | (11) |\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n\nNumbers may not add due to rounding.\nThe following are components of the change in revenue compared with the prior year:\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 vs. 2021 | 2022 vs. 2021 |\n| U.S. | Outside U.S. | Consolidated | U.S. | Outside U.S. | Consolidated |\n| Volume | 15 | % | 13 | % | 14 | % | 20 | % | 7 | % | 15 | % |\n| Price | (4) | (12) | (7) | (4) | (11) | (7) |\n| Foreign exchange rates | — | (11) | (4) | — | (7) | (3) |\n| Percent change | 11 | % | (9) | % | 2 | % | 16 | % | (11) | % | 5 | % |\n\nNumbers may not add due to rounding.\nIn the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by COVID-19 antibodies, Trulicity, Verzenio, Jardiance, Taltz®, and Mounjaro, partially offset by decreased volume for Alimta, resulting from the entry of multiple generics in the second quarter of 2022, and for Olumiant, due to the decline in utilization for COVID-19 treatment. In the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by Humalog, due to a list price reduction of insulin lispro injection and unfavorable segment mix, and by Trulicity, due to unfavorable segment mix and higher contracted rebates. In the U.S. for the three months ended September 30, 2022, the decrease in realized prices for Trulicity was partially offset by changes to estimates for rebates and discounts.\nOutside the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by Verzenio, Trulicity, Tyvyt®, Jardiance, and Taltz, partially offset by Alimta and Cymbalta® resulting from generic competition. Additionally outside the U.S. for the three and nine months ended September 30, 2022, we recognized revenue related to a sales collaboration agreement for the right to sell and distribute Mounjaro in Japan. Outside the U.S. for the nine months ended September 30, 2022, the increase in volume was also partially offset by decreased sales of COVID-19 antibodies and the sale of the rights to Cialis® in China in the second quarter of 2021. Outside the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by the impact of government pricing in China from the National Reimbursement Drug List (NRDL) formulary for certain products, particularly Tyvyt and Verzenio, and volume-based procurement (VBP) for Humalog.\n45\n| Three Months Ended September 30, |\n| 2022 | 2021 |\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\n| Trulicity | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,600.1 | 16 |\n| Taltz | 493.8 | 186.1 | 679.9 | 593.1 | 15 |\n| Verzenio | 414.8 | 202.9 | 617.7 | 335.5 | 84 |\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 390.4 | 47 |\n| Humalog(2) | 248.1 | 198.8 | 447.0 | 626.7 | (29) |\n| COVID-19 antibodies(3) | 386.6 | — | 386.6 | 217.1 | 78 |\n| Humulin® | 169.5 | 68.7 | 238.2 | 286.7 | (17) |\n| Cyramza® | 87.5 | 144.6 | 232.1 | 253.4 | (8) |\n| Basaglar® | 124.8 | 68.1 | 193.0 | 192.8 | — |\n| Mounjaro | 97.3 | 90.0 | 187.3 | — | NM |\n| Olumiant(4) | 22.9 | 160.0 | 182.9 | 406.9 | (55) |\n| Forteo | 112.7 | 64.4 | 177.1 | 200.9 | (12) |\n| Emgality® | 114.0 | 54.6 | 168.5 | 140.0 | 20 |\n| Erbitux® | 126.3 | 18.7 | 144.9 | 134.3 | 8 |\n| Alimta | 64.6 | 54.8 | 119.4 | 457.0 | (74) |\n| Cialis | 8.1 | 107.7 | 115.7 | 130.9 | (12) |\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 101.7 | (20) |\n| Tyvyt | — | 76.8 | 76.8 | 125.6 | (39) |\n| Cymbalta | 7.8 | 54.9 | 62.7 | 132.0 | (53) |\n| Other products | 166.1 | 240.5 | 406.7 | 447.7 | (9) |\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 6,772.8 | 2 |\n\nNumbers may not add due to rounding.\nNM - not meaningful\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\n(2) Humalog revenue includes insulin lispro.\n(3) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\n46\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 4,588.2 | 20 |\n| COVID-19 antibodies(1) | 1,970.9 | 14.7 | 1,985.5 | 1,176.2 | 69 |\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,565.4 | 13 |\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 945.8 | 77 |\n| Humalog(2) | 855.8 | 656.4 | 1,512.3 | 1,851.3 | (18) |\n| Jardiance(3) | 831.4 | 622.4 | 1,453.7 | 1,058.9 | 37 |\n| Humulin | 562.3 | 223.1 | 785.4 | 923.8 | (15) |\n| Cyramza | 259.3 | 434.3 | 693.6 | 762.5 | (9) |\n| Alimta | 490.5 | 200.5 | 691.1 | 1,626.6 | (58) |\n| Olumiant(4) | 104.6 | 520.1 | 624.7 | 809.1 | (23) |\n| Basaglar | 339.9 | 218.8 | 558.7 | 650.1 | (14) |\n| Cialis | 25.8 | 454.7 | 480.4 | 538.7 | (11) |\n| Emgality | 330.8 | 144.4 | 475.2 | 415.7 | 14 |\n| Forteo | 261.4 | 191.7 | 453.0 | 617.8 | (27) |\n| Erbitux | 361.0 | 47.4 | 408.3 | 403.7 | 1 |\n| Zyprexa | 26.2 | 235.5 | 261.7 | 292.8 | (11) |\n| Tyvyt | — | 235.8 | 235.8 | 340.2 | (31) |\n| Cymbalta | 25.0 | 194.3 | 219.3 | 484.3 | (55) |\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | NM |\n| Other products | 501.1 | 743.0 | 1,244.2 | 1,267.3 | (2) |\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 20,318.5 | 5 |\n\nNumbers may not add due to rounding.\nNM - not meaningful\n(1) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\n(2) Humalog revenue includes insulin lispro.\n(3) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\nRevenue of Trulicity, a treatment for type 2 diabetes and to reduce the risk of major adverse cardiovascular events in adult patients with type 2 diabetes and established cardiovascular disease or multiple cardiovascular risk factors, increased 18 percent in the U.S. during the three months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices. The lower realized prices in the U.S. for the three months ended September 30, 2022 were due to unfavorable segment mix and higher contracted rebates, partially offset by changes to estimates for rebates and discounts. Revenue in the U.S. increased 20 percent during the nine months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices due to unfavorable segment mix and higher contracted rebates. Revenue outside the U.S. increased 8 percent and 19 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates and, to a lesser extent, lower realized prices.\n47\nRevenue of COVID-19 antibodies, treatments for mild to moderate COVID-19 for higher-risk patients and for post-exposure prophylaxis in certain individuals for the prevention of SARS-CoV-2 infection, was $386.6 million and $1.97 billion in the U.S. during the three and nine months ended September 30, 2022, respectively. Revenue outside the U.S. was not material during the three and nine months ended September 30, 2022. The availability of superior or competitive therapies, including therapies that can be administered more easily, or preventative measures, such as vaccines, coupled with the unpredictable nature of pandemics, have and could further negatively impact or eliminate demand for these COVID-19 antibodies. The FDA has revised, and may in the future revise, any EUA for our COVID-19 antibodies in response to the prevalence of variants against which our antibodies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants. We supplied the U.S. government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders.\nRevenue of Taltz, a treatment for moderate-to-severe plaque psoriasis, active psoriatic arthritis, ankylosing spondylitis, and active non-radiographic axial spondyloarthritis, increased 17 percent and 13 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices. Revenue outside the U.S. increased 9 percent and 14 percent during the three and nine months ended September 30, 2022, respectively, driven by increased volume, partially offset by unfavorable impact of foreign exchange rates and lower realized prices.\nRevenue of Verzenio, a treatment for HR+, HER2- metastatic breast cancer and high risk early breast cancer, increased $215.1 million and $518.4 million in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. Revenue outside the U.S. increased 49 percent and 58 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices due to the impact of the NRDL formulary in China and the unfavorable impact of foreign exchange rates.\nRevenue of Humalog, an injectable human insulin analog for the treatment of diabetes, decreased 29 percent and 15 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to a list price reduction of insulin lispro injection and unfavorable segment mix. Revenue outside the U.S. decreased 29 percent and 22 percent during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to the impact of VBP in China and the unfavorable impact of foreign exchange rates. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\nRevenue of Jardiance, a treatment for type 2 diabetes, to reduce the risk of cardiovascular death in adult patients with type 2 diabetes and established cardiovascular disease, and to reduce the risk of cardiovascular death and hospitalization for heart failure in adults with heart failure, regardless of left ventricular ejection fraction, increased 59 percent and 47 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. The increase in revenue in the U.S. during the three months ended September 30, 2022 was also driven by changes to estimates for rebates and discounts. Revenue outside the U.S. increased 31 percent and 26 percent during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates. See Note 4 to the consolidated condensed financial statements for information regarding our collaboration with Boehringer Ingelheim involving Jardiance.\nRevenue of Alimta, a treatment for various cancers, decreased 78 percent and 46 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by decreased demand due to the entry of multiple generics in the second quarter of 2022. Revenue outside the U.S. decreased 66 percent and 72 percent during the three and nine months ended September 30, 2022, respectively, largely driven by decreased demand due to generic competition. Following the June 2021 loss of patent exclusivity for Alimta in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. See \"Executive Overview - Other Matters- Patent Matters\" for additional information.\n48\nGross Margin, Costs, and Expenses\nGross margin as a percent of revenue decreased 1.6 percentage points to 77.3 percent and increased 2.0 percentage points to 76.1 percent for the three and nine months ended September 30, 2022, respectively. The decrease in the gross margin percent for the three months ended September 30, 2022 was primarily driven by a benefit in the gross margin for the three months ended September 30, 2021 due to the partial reversal of inventory impairment charges related to our COVID-19 antibodies that were recognized in the first and second quarters of 2021. The partial reversal of inventory impairment charges related to our COVID-19 antibodies was driven by an unexpected increase in our COVID-19 antibodies sales as the COVID-19 pandemic evolved during the third quarter of 2021. The increase in gross margin percent for the nine months ended September 30, 2022 was primarily driven by a net inventory impairment charge related to our COVID-19 antibodies recognized in 2021. Additionally, for the three and nine months ended September 30, 2022, lower realized prices and increased expenses due to inflation and logistics costs were offset by favorable product mix, including the impact of lower sales of Olumiant for the treatment of COVID-19, and the favorable impact of foreign exchange rates.\nResearch and development expenses increased 6 percent to $1.80 billion and 3 percent to $5.19 billion for the three and nine months ended September 30, 2022, respectively, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates.\nMarketing, selling, and administrative expenses increased 2 percent to $1.61 billion for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased 1 percent to $4.80 billion for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\nWe plan to take compensatory actions to improve retention and address wage inflation which will impact our costs and consolidated results of operations.\nWe recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher. We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges from business development transactions with Rigel and Precision. See Note 3 to the consolidated condensed financial statements for additional information.\nWe recognized asset impairment, restructuring, and other special charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing. There were no asset impairment, restructuring, and other special charges recognized for the three months ended September 30, 2021. We recognized asset impairment, restructuring, and other special charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza, as well as acquisition and integration costs associated with the acquisition of Prevail. See Note 5 to the consolidated condensed financial statements for additional information.\nOther–net, (income) expense was expense of $111.0 million and $580.9 million for the three and nine months ended September 30, 2022, respectively, compared with expense of $635.9 million and $124.3 million for the three and nine months ended September 30, 2021, respectively. The decrease in other expense for the three months ended September 30, 2022 was primarily driven by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021, as well as lower net investment losses on equity securities in 2022 compared to 2021. The increase in other expense for the nine months ended September 30, 2022 was primarily driven by net investment losses on equity securities in 2022 compared with net investment gains on equity securities in 2021, partially offset by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021.\n49\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the 2017 Tax Act that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\nFinancial Condition and Liquidity\nWe believe our available cash and cash equivalents, together with our ability to generate operating cash flow and our access to short-term and long-term borrowings, are sufficient to fund our existing and planned capital requirements. For a discussion of our capital requirements, see \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nWe plan to invest more than $2 billion over several years in two new facilities in Lebanon, Indiana to manufacture existing and future products and more than $1 billion over several years in a new facility in Concord, North Carolina to manufacture parenteral (injectable) products and devices. We plan to invest more than 400 million euro over several years in a new facility in Limerick, Ireland to expand our manufacturing network for biologic active ingredients. These investments, and other capital investments that support our operations, will result in capital expenditures being higher than recent historical levels for the next several years.\nCash and cash equivalents decreased to $2.62 billion as of September 30, 2022, compared with $3.82 billion as of December 31, 2021. Refer to the consolidated condensed statements of cash flows for additional information on the significant sources and uses of cash for the nine months ended September 30, 2022 and 2021.\nIn addition to our cash and cash equivalents, we held total investments of $2.70 billion and $3.30 billion as of September 30, 2022 and December 31, 2021, respectively. See Note 6 to the consolidated condensed financial statements for additional information.\nAs of September 30, 2022, total debt was $15.89 billion, a decrease of $996.3 million compared with $16.88 billion as of December 31, 2021. See Note 6 to the consolidated condensed financial statements for additional information.\nAs of September 30, 2022, we had a total of $7.26 billion of unused committed bank credit facilities, $7.00 billion of which is available to support our commercial paper program. We believe that amounts accessible through existing commercial paper markets should be adequate to fund short-term borrowing needs.\nDuring the nine months ended September 30, 2022, we repurchased $1.50 billion of shares under our $5.00 billion share repurchase program authorized in May 2021. As of September 30, 2022, we had $3.25 billion remaining under this program.\nDuring the nine months ended September 30, 2022, we paid dividends of $2.65 billion, or $2.94 per share, to our shareholders. In October 2022, we declared a dividend for the fourth quarter of 2022 of $0.98 per share on outstanding common stock. The dividend of approximately $882 million is payable on December 9, 2022 to shareholders of record at the close of business on November 15, 2022.\nSee \"Executive Overview - Other Matters - Patent Matters\" for information regarding recent losses of patent protection.\nBoth domestically and abroad, we continue to monitor the potential impacts of the economic environment; the creditworthiness of our wholesalers and other customers, including foreign government-backed agencies and suppliers; the uncertain impact of health care legislation; various international government funding levels; and fluctuations in interest rates, foreign currency exchange rates (see \"Executive Overview - Other Matters - Foreign Currency Exchange Rates\"), and fair values of equity securities.\n50\nCritical Accounting Estimates\nFor a discussion of our critical accounting estimates, refer to \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 and the notes to our consolidated financial statements in Part II, Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 1 to the consolidated condensed financial statements. There have been no material changes to our critical accounting estimates since our Annual Report on Form 10-K for the year ended December 31, 2021.\nAvailable Information on our Website\nWe make available through our company website, free of charge, our company filings with the Securities and Exchange Commission (SEC) as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. The reports we make available include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, registration statements, and any amendments to those documents.\nThe website link to our SEC filings is investor.lilly.com/financial-information/sec-filings.\nWe routinely post important information for investors in the “Investors” section of our website, www.lilly.com. We may use our website as a means of disclosing material, non-public information and for complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor the “Investors” section of our website, in addition to following our press releases, filings with the SEC, public conference calls, presentations, and webcasts. We may also use social media channels to communicate with investors and the public about our business, products and other matters, and those communications could be deemed to be material information. The information contained on, or that may be accessed through, our website or social media channels, is not incorporated by reference into, and is not a part of, this Quarterly Report on Form 10-Q.\n51\nItem 4. Controls and Procedures\n(a)Evaluation of Disclosure Controls and Procedures. Under applicable Securities and Exchange Commission (SEC) regulations, management of a reporting company, with the participation of the principal executive officer and principal financial officer, must periodically evaluate the company's \"disclosure controls and procedures,\" which are defined generally as controls and other procedures of a reporting company designed to ensure that information required to be disclosed by the reporting company in its periodic reports filed with the SEC (such as this Quarterly Report on Form 10-Q) is recorded, processed, summarized, and reported on a timely basis.\nOur management, with the participation of David A. Ricks, president and chief executive officer, and Anat Ashkenazi, executive vice president and chief financial officer, evaluated our disclosure controls and procedures (as such terms are defined in our Annual Report on Form 10-K for the year ended December 31, 2021) as of September 30, 2022, and concluded that they were effective.\n(b)Changes in Internal Controls. During the third quarter of 2022, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n52\nPART II. Other Information\nItem 1. Legal Proceedings\nWe are a party to various currently pending legal actions, government investigations, and environmental proceedings. See Note 9 to the consolidated condensed financial statements for information on various legal proceedings.\nThis Item should be read in conjunction with \"Legal Proceedings\" in Part I, Item 3 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nItem 1A. Risk Factors\nOur material risk factors are disclosed in \"Risk Factors\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2021.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nInformation relating to the principal market for our common stock and related shareholder matters is described in \"Management's Discussion and Analysis of Results of Operations and Financial Condition\" in Part II, Item 7 and in \"Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\" in Part III, Item 12 of our Annual Report on Form 10-K for the year ended December 31, 2021.\nThe following table summarizes the activity related to repurchases of our equity securities during the three months ended September 30, 2022:\n| Period | Total Number ofShares Purchased(in thousands) | Average Price Paid per Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(in thousands) | Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (in millions) |\n| July 2022 | — | $ | — | — | $ | 3,250.0 |\n| August 2022 | — | — | — | 3,250.0 |\n| September 2022 | — | — | — | 3,250.0 |\n| Total | — | — | — |\n\nDuring the three months ended September 30, 2022, we did not repurchase any shares under our $5.00 billion share repurchase program authorized in May 2021.\n53\nItem 6. Exhibits\nThe following documents are filed as a part of this Quarterly Report:\n| Exhibit | Description |\n| EXHIBIT 3.1 | Amended Articles of Incorporation are incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\n| EXHIBIT 3.2 | Bylaws, as amended, are incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\n| EXHIBIT 10.1 | Form of Performance Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 10.2 | Form of Shareholder Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 10.3 | Form of Relative Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\n| EXHIBIT 31.1 | Rule 13a-14(a) Certification of David A. Ricks, Chair, President, and Chief Executive Officer |\n| EXHIBIT 31.2 | Rule 13a-14(a) Certification of Anat Ashkenazi, Executive Vice President and Chief Financial Officer |\n| EXHIBIT 32. | Section 1350 Certification |\n| EXHIBIT 101. | Interactive Data Files (embedded within the Inline XBRL document) |\n| EXHIBIT 104. | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\nLong-term debt instruments under which the total amount of securities authorized does not exceed 10 percent of our consolidated assets are not filed as exhibits to this Quarterly Report. We will furnish a copy of these agreements to the Securities and Exchange Commission upon request.\nSignatures\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.\n| ELI LILLY AND COMPANY |\n| (Registrant) |\n| Date: | November 1, 2022 | /s/ Anat Ashkenazi |\n| Anat Ashkenazi |\n| Executive Vice President and Chief Financial Officer |\n| Date: | November 1, 2022 | /s/ Donald A. Zakrowski |\n| Donald A. Zakrowski |\n| Senior Vice President, Finance, and Chief Accounting Officer |\n\n54\n</text>\n\nWhat is the difference in net income as a percentage of cash provided by operating activities between the years 2022 and 2021 in percentages?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nPART I. Financial Information\\nItem 1. Financial Statements\\nConsolidated Condensed Statements of Operations\\n(Unaudited)\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n(Dollars and shares in millions, except per-share data)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Revenue (Note 2) | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\\n| Costs, expenses, and other: |\\n| Cost of sales | 1,579.1 | 1,430.8 | 5,081.7 | 5,262.6 |\\n| Research and development | 1,802.9 | 1,705.3 | 5,194.9 | 5,032.4 |\\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 4,797.2 | 4,839.6 |\\n| Acquired in-process research and development and development milestones (Note 3) | 62.4 | 177.6 | 668.4 | 532.4 |\\n| Asset impairment, restructuring, and other special charges (Note 5) | 206.5 | — | 206.5 | 211.6 |\\n| Other–net, (income) expense (Note 11) | 111.0 | 635.9 | 580.9 | 124.3 |\\n| 5,376.1 | 5,527.5 | 16,529.6 | 16,002.9 |\\n| Income before income taxes | 1,565.5 | 1,245.3 | 4,710.0 | 4,315.6 |\\n| Income taxes (Note 7) | 113.8 | 135.2 | 402.9 | 460.0 |\\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\\n| Earnings per share: |\\n| Basic | $ | 1.61 | $ | 1.22 | $ | 4.78 | $ | 4.25 |\\n| Diluted | $ | 1.61 | $ | 1.22 | $ | 4.76 | $ | 4.23 |\\n| Shares used in calculation of earnings per share: |\\n| Basic | 900.7 | 906.7 | 901.8 | 907.7 |\\n| Diluted | 903.8 | 910.8 | 904.5 | 911.7 |\\n\\nSee notes to consolidated condensed financial statements.\\n5\\nConsolidated Condensed Statements of Comprehensive Income\\n(Unaudited)\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n(Dollars in millions)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net income | $ | 1,451.7 | $ | 1,110.1 | $ | 4,307.1 | $ | 3,855.6 |\\n| Other comprehensive income (loss), net of tax (Note 10) | ( 8.1 ) | 114.4 | 47.3 | 323.7 |\\n| Comprehensive income | $ | 1,443.6 | $ | 1,224.5 | $ | 4,354.4 | $ | 4,179.3 |\\n\\nSee notes to consolidated condensed financial statements.\\n6\\nConsolidated Condensed Balance Sheets\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n(Dollars in millions)\\n| September 30, 2022 | December 31, 2021 |\\n| Assets | (Unaudited) |\\n| Current Assets |\\n| Cash and cash equivalents (Note 6) | $ | 2,617.4 | $ | 3,818.5 |\\n| Short-term investments (Note 6) | 124.7 | 90.1 |\\n| Accounts receivable, net of allowances of $ 17.7 (2022) and $ 22.5 (2021) | 6,715.3 | 6,672.8 |\\n| Other receivables | 1,609.5 | 1,454.4 |\\n| Inventories | 3,831.1 | 3,886.0 |\\n| Prepaid expenses and other | 2,741.9 | 2,530.6 |\\n| Total current assets | 17,639.9 | 18,452.4 |\\n| Investments (Note 6) | 2,574.6 | 3,212.6 |\\n| Goodwill | 3,891.6 | 3,892.0 |\\n| Other intangibles, net | 7,124.1 | 7,691.9 |\\n| Deferred tax assets | 2,384.3 | 2,489.3 |\\n| Property and equipment, net of accumulated depreciation of $ 10,074.0 (2022) and $ 9,976.7 (2021) | 9,311.3 | 8,985.1 |\\n| Other noncurrent assets | 4,535.7 | 4,082.7 |\\n| Total assets | $ | 47,461.5 | $ | 48,806.0 |\\n| Liabilities and Equity |\\n| Current Liabilities |\\n| Short-term borrowings and current maturities of long-term debt | $ | 1,744.6 | $ | 1,538.3 |\\n| Accounts payable | 1,683.2 | 1,670.6 |\\n| Employee compensation | 984.1 | 958.1 |\\n| Sales rebates and discounts | 8,568.4 | 6,845.8 |\\n| Dividends payable | — | 885.5 |\\n| Income taxes payable | 685.6 | 126.9 |\\n| Other current liabilities | 1,986.9 | 3,027.5 |\\n| Total current liabilities | 15,652.8 | 15,052.7 |\\n| Other Liabilities |\\n| Long-term debt | 14,143.8 | 15,346.4 |\\n| Accrued retirement benefits (Note 8) | 1,832.5 | 1,954.1 |\\n| Long-term income taxes payable | 3,641.7 | 3,920.0 |\\n| Deferred tax liabilities | 171.9 | 1,733.7 |\\n| Other noncurrent liabilities | 1,852.9 | 1,644.3 |\\n| Total other liabilities | 21,642.8 | 24,598.5 |\\n| Commitments and Contingencies (Note 9) |\\n| Eli Lilly and Company Shareholders' Equity |\\n| Common stock | 594.1 | 596.3 |\\n| Additional paid-in capital | 6,829.0 | 6,833.4 |\\n| Retained earnings | 10,006.5 | 8,958.5 |\\n| Employee benefit trust | ( 3,013.2 ) | ( 3,013.2 ) |\\n| Accumulated other comprehensive loss (Note 10) | ( 4,295.8 ) | ( 4,343.1 ) |\\n| Cost of common stock in treasury | ( 50.5 ) | ( 52.7 ) |\\n| Total Eli Lilly and Company shareholders' equity | 10,070.1 | 8,979.2 |\\n| Noncontrolling interests | 95.8 | 175.6 |\\n| Total equity | 10,165.9 | 9,154.8 |\\n| Total liabilities and equity | $ | 47,461.5 | $ | 48,806.0 |\\n\\nSee notes to consolidated condensed financial statements.\\n7\\nConsolidated Condensed Statements of Equity\\n(Unaudited)\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n| Equity of Eli Lilly and Company Shareholders |\\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\\n| Shares | Amount | Shares | Amount |\\n| Balance at July 1, 2021 | 957,038 | $ | 598.1 | $ | 6,669.2 | $ | 8,530.1 | $ | ( 3,013.2 ) | $ | ( 6,287.1 ) | 463 | $ | ( 52.7 ) | $ | 219.1 |\\n| Net income (loss) | 1,110.1 | ( 22.6 ) |\\n| Other comprehensive income, net of tax | 114.4 |\\n| Issuance of stock under employee stock plans, net | 14 | 0.1 | ( 1.3 ) |\\n| Stock-based compensation | 90.1 |\\n| Other | ( 0.8 ) | 0.6 |\\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\\n| Balance at July 1, 2022 | 950,619 | $ | 594.1 | $ | 6,746.0 | $ | 8,556.0 | $ | ( 3,013.2 ) | $ | ( 4,287.7 ) | 450 | $ | ( 50.5 ) | $ | 114.5 |\\n| Net income (loss) | 1,451.7 | ( 15.7 ) |\\n| Other comprehensive loss, net of tax | ( 8.1 ) |\\n| Issuance of stock under employee stock plans, net | 8 | ( 2.1 ) |\\n| Stock-based compensation | 85.1 |\\n| Other | ( 1.2 ) | ( 3.0 ) |\\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\\n\\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\\nSee notes to consolidated condensed financial statements.\\n8\\n| Equity of Eli Lilly and Company Shareholders |\\n| (Dollars in millions, except per-share data, and shares in thousands) | Common Stock | AdditionalPaid-inCapital | RetainedEarnings | Employee Benefit Trust | Accumulated Other Comprehensive Loss | Common Stock in Treasury(1) | Noncontrolling Interests |\\n| Shares | Amount | Shares | Amount |\\n| Balance at January 1, 2021 | 957,077 | $ | 598.2 | $ | 6,778.5 | $ | 7,830.2 | $ | ( 3,013.2 ) | $ | ( 6,496.4 ) | 487 | $ | ( 55.7 ) | $ | 183.6 |\\n| Net income | 3,855.6 | 25.2 |\\n| Other comprehensive income, net of tax | 323.7 |\\n| Cash dividends declared per share: $ 1.70 | ( 1,542.9 ) |\\n| Retirement of treasury shares | ( 2,467 ) | ( 1.5 ) | ( 498.5 ) | ( 2,467 ) | 500.0 |\\n| Purchase of treasury shares | 2,467 | ( 500.0 ) |\\n| Issuance of stock under employee stock plans, net | 2,442 | 1.5 | ( 287.1 ) | ( 24 ) | 3.0 |\\n| Stock-based compensation | 267.5 |\\n| Other | ( 0.9 ) | ( 5.0 ) | ( 11.7 ) |\\n| Balance at September 30, 2021 | 957,052 | $ | 598.2 | $ | 6,758.0 | $ | 9,639.4 | $ | ( 3,013.2 ) | $ | ( 6,172.7 ) | 463 | $ | ( 52.7 ) | $ | 197.1 |\\n| Balance at January 1, 2022 | 954,116 | $ | 596.3 | $ | 6,833.4 | $ | 8,958.5 | $ | ( 3,013.2 ) | $ | ( 4,343.1 ) | 463 | $ | ( 52.7 ) | $ | 175.6 |\\n| Net income (loss) | 4,307.1 | ( 63.7 ) |\\n| Other comprehensive income, net of tax | 47.3 |\\n| Cash dividends declared per share: $ 1.96 | ( 1,765.9 ) |\\n| Retirement of treasury shares | ( 5,607 ) | ( 3.5 ) | ( 1,496.5 ) | ( 5,607 ) | 1,500.0 |\\n| Purchase of treasury shares | 5,607 | ( 1,500.0 ) |\\n| Issuance of stock under employee stock plans, net | 2,118 | 1.3 | ( 282.6 ) | ( 13 ) | 2.2 |\\n| Stock-based compensation | 278.2 |\\n| Other | 3.3 | ( 16.1 ) |\\n| Balance at September 30, 2022 | 950,627 | $ | 594.1 | $ | 6,829.0 | $ | 10,006.5 | $ | ( 3,013.2 ) | $ | ( 4,295.8 ) | 450 | $ | ( 50.5 ) | $ | 95.8 |\\n\\n(1) As of September 30, 2022, there was $ 3.25 billion remaining under our $ 5.00 billion share repurchase program authorized in May 2021.\\nSee notes to consolidated condensed financial statements.\\n9\\nConsolidated Condensed Statements of Cash Flows\\n(Unaudited)\\nELI LILLY AND COMPANY AND SUBSIDIARIES\\n(Dollars in millions)\\n\\n| Nine Months Ended September 30, |\\n| 2022 | 2021 |\\n| Cash Flows from Operating Activities |\\n| Net income | $ | 4,307.1 | $ | 3,855.6 |\\n| Adjustments to Reconcile Net Income to Cash Flows from Operating Activities: |\\n| Depreciation and amortization | 1,147.5 | 1,101.9 |\\n| Change in deferred income taxes | ( 2,195.6 ) | ( 709.8 ) |\\n| Debt extinguishment loss (Note 6) | — | 405.2 |\\n| Stock-based compensation expense | 278.2 | 267.5 |\\n| Net investment (gains) losses | 676.4 | ( 271.1 ) |\\n| Acquired in-process research and development | 252.0 | 498.3 |\\n| Other changes in operating assets and liabilities, net of acquisitions and divestitures | 821.5 | ( 548.1 ) |\\n| Other non-cash operating activities, net | 217.6 | 504.7 |\\n| Net Cash Provided by Operating Activities | 5,504.7 | 5,104.2 |\\n| Cash Flows from Investing Activities |\\n| Net purchases of property and equipment | ( 1,353.6 ) | ( 1,018.4 ) |\\n| Proceeds from sales and maturities of short-term investments | 83.1 | 46.6 |\\n| Purchases of short-term investments | ( 65.0 ) | ( 27.9 ) |\\n| Proceeds from sales of noncurrent investments | 251.6 | 537.2 |\\n| Purchases of noncurrent investments | ( 474.1 ) | ( 710.1 ) |\\n| Cash paid for acquisitions, net of cash acquired (Note 3) | — | ( 747.4 ) |\\n| Purchases of in-process research and development | ( 574.8 ) | ( 460.6 ) |\\n| Other investing activities, net | ( 268.3 ) | ( 2.7 ) |\\n| Net Cash Used for Investing Activities | ( 2,401.1 ) | ( 2,383.3 ) |\\n| Cash Flows from Financing Activities |\\n| Dividends paid | ( 2,651.4 ) | ( 2,313.5 ) |\\n| Net change in short-term borrowings | 1,741.3 | ( 1.5 ) |\\n| Proceeds from issuance of long-term debt | — | 2,410.8 |\\n| Repayments of long-term debt | ( 1,560.0 ) | ( 1,905.3 ) |\\n| Purchases of common stock | ( 1,500.0 ) | ( 500.0 ) |\\n| Other financing activities, net | ( 295.2 ) | ( 295.3 ) |\\n| Net Cash Used for Financing Activities | ( 4,265.3 ) | ( 2,604.8 ) |\\n| Effect of exchange rate changes on cash and cash equivalents | ( 39.4 ) | 15.0 |\\n| Net decrease in cash and cash equivalents | ( 1,201.1 ) | 131.1 |\\n| Cash and cash equivalents at January 1 | 3,818.5 | 3,657.1 |\\n| Cash and Cash Equivalents at September 30 | $ | 2,617.4 | $ | 3,788.2 |\\n\\nSee notes to consolidated condensed financial statements.\\n10\\nNotes to Consolidated Condensed Financial Statements\\n(Tables present dollars in millions, except per-share data)\\nNote 1: Basis of Presentation and Implementation of New Financial Accounting Standard\\nWe have prepared the accompanying unaudited consolidated condensed financial statements in accordance with the requirements of Form 10-Q and, therefore, they do not include all information and footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States (GAAP). In our opinion, the consolidated condensed financial statements reflect all adjustments (including those that are normal and recurring) that are necessary for a fair presentation of the results of operations for the periods shown. In preparing financial statements in conformity with GAAP, we must make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures at the date of the financial statements and during the reporting period. Actual results could differ from those estimates.\\nThe information included in this Quarterly Report on Form 10-Q should be read in conjunction with our consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2021. We issue our financial statements by filing them with the Securities and Exchange Commission and have evaluated subsequent events up to the time of the filing of this Quarterly Report on Form 10-Q.\\nCertain reclassifications have been made to prior periods in the consolidated condensed financial statements and accompanying notes to conform with the current presentation.\\nAll per-share amounts, unless otherwise noted in the footnotes, are presented on a diluted basis; that is, based on the weighted-average number of common shares outstanding plus the effect of incremental shares from our stock-based compensation programs.\\nWe operate as a single operating segment engaged in the discovery, development, manufacturing, marketing, and sales of pharmaceutical products worldwide. A global research and development organization and a supply chain organization are responsible for the discovery, development, manufacturing, and supply of our products. Regional commercial organizations market, distribute, and sell the products. The business is also supported by global corporate staff functions. Our determination that we operate as a single segment is consistent with the financial information regularly reviewed by the chief operating decision maker for purposes of evaluating performance, allocating resources, setting incentive compensation targets, and planning and forecasting for future periods.\\nResearch and Development Expenses and Acquired In-Process Research and Development (IPR&D) and Development Milestones\\nResearch and development costs are expensed as incurred. Research and development costs consist of expenses incurred in performing research and development activities, including but not limited to, compensation and benefits, facilities and overhead expense, clinical trial expense, and fees paid to contract research organizations.\\nAcquired IPR&D and development milestones include the initial costs of externally developed IPR&D projects, acquired directly in a transaction other than a business combination, that do not have an alternative future use. Additionally, milestone payment obligations related to these transactions that are incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs.\\nImplementation of New Financial Accounting Standard\\nAccounting Standards Update 2021-01, Reference Rate Reform, provides for temporary optional expedients and exceptions in applying current GAAP to contracts, hedging relationships, and other transactions affected by the transition from the use of the London Interbank Offered Rate (LIBOR) to an alternative reference rate. The standard is currently applicable to contracts entered into before January 1, 2023. We adopted the standard in the first quarter of 2022. The adoption did not have a material impact on our consolidated condensed financial statements.\\n11\\nNote 2: Revenue\\nThe following table summarizes our revenue recognized in our consolidated condensed statements of operations:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net product revenue | $ | 6,119.2 | $ | 6,189.0 | $ | 19,123.0 | $ | 18,579.5 |\\n| Collaboration and other revenue(1) | 822.4 | 583.8 | 2,116.6 | 1,739.0 |\\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\\n\\n(1) Collaboration and other revenue associated with prior period transfers of intellectual property was $ 43.3 million and $ 130.9 million during the three and nine months ended September 30, 2022, respectively, and $ 62.1 million and $ 136.1 million during the three and nine months ended September 30, 2021, respectively.\\nWe recognize revenue primarily from two different types of contracts, product sales to customers (net product revenue) and collaborations and other arrangements. Revenue recognized from collaborations and other arrangements includes our share of profits from the collaborations, as well as royalties, upfront and milestone payments we receive under these types of contracts. See Note 4 for additional information related to our collaborations and other arrangements. Collaboration and other revenue disclosed above includes the revenue from the Jardiance® and Trajenta® families of products resulting from our collaboration with Boehringer Ingelheim discussed in Note 4. Substantially all of the remainder of collaboration and other revenue is related to contracts accounted for as contracts with customers.\\nAdjustments to Revenue\\nAdjustments to increase revenue recognized as a result of changes in estimates for our most significant United States (U.S.) sales returns, rebates, and discounts liability balances for products shipped in previous periods were 3 percent of U.S. revenue for the three months ended September 30, 2022 and less than 1 percent of U.S. revenue during the nine months ended September 30, 2022 and the three and nine months ended September 30, 2021.\\nContract Liabilities\\nOur contract liabilities result from arrangements where we have received payment in advance of performance under the contract and do not include sales returns, rebates, and discounts. Changes in contract liabilities are generally due to either receipt of additional advance payments or our performance under the contract.\\nThe following table summarizes contract liability balances:\\n| September 30, 2022 | December 31, 2021 |\\n| Contract liabilities | $ | 232.5 | $ | 262.6 |\\n\\nDuring the three and nine months ended September 30, 2022 and 2021, revenue recognized from contract liabilities as of the beginning of the respective year was not material. Revenue expected to be recognized in the future from contract liabilities as the related performance obligations are satisfied is not expected to be material in any one year.\\n12\\nDisaggregation of Revenue\\nThe following table summarizes revenue by product for the three months ended September 30, 2022 and 2021:\\n| Three Months Ended September 30, |\\n| 2022 | 2021 |\\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\\n| Revenue—to unaffiliated customers: |\\n| Diabetes: |\\n| Trulicity® | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,201.4 | $ | 398.8 | $ | 1,600.1 |\\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 221.2 | 169.2 | 390.4 |\\n| Humalog® (2) | 248.1 | 198.8 | 447.0 | 347.3 | 279.4 | 626.7 |\\n| Humulin® | 169.5 | 68.7 | 238.2 | 193.4 | 93.4 | 286.7 |\\n| Basaglar® | 124.8 | 68.1 | 193.0 | 114.7 | 78.1 | 192.8 |\\n| Mounjaro® | 97.3 | 90.0 | 187.3 | — | — | — |\\n| Other diabetes | 79.7 | 94.0 | 173.4 | 65.0 | 112.2 | 177.4 |\\n| Total diabetes | 2,488.6 | 1,174.0 | 3,662.6 | 2,143.0 | 1,131.1 | 3,274.1 |\\n| Oncology: |\\n| Verzenio® | 414.8 | 202.9 | 617.7 | 199.6 | 135.9 | 335.5 |\\n| Cyramza® | 87.5 | 144.6 | 232.1 | 84.8 | 168.6 | 253.4 |\\n| Erbitux® | 126.3 | 18.7 | 144.9 | 114.0 | 20.3 | 134.3 |\\n| Alimta® | 64.6 | 54.8 | 119.4 | 297.2 | 159.8 | 457.0 |\\n| Tyvyt® | — | 76.8 | 76.8 | — | 125.6 | 125.6 |\\n| Other oncology | 39.5 | 62.8 | 102.4 | 35.3 | 65.1 | 100.3 |\\n| Total oncology | 732.7 | 560.6 | 1,293.3 | 730.9 | 675.3 | 1,406.1 |\\n| Immunology: |\\n| Taltz® | 493.8 | 186.1 | 679.9 | 422.2 | 170.9 | 593.1 |\\n| Olumiant® (3) | 22.9 | 160.0 | 182.9 | 194.0 | 212.9 | 406.9 |\\n| Other immunology | — | 3.6 | 3.6 | — | 4.9 | 4.9 |\\n| Total immunology | 516.7 | 349.7 | 866.4 | 616.2 | 388.7 | 1,004.9 |\\n| Neuroscience: |\\n| Emgality® | 114.0 | 54.6 | 168.5 | 99.9 | 40.1 | 140.0 |\\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 13.0 | 88.7 | 101.7 |\\n| Cymbalta® | 7.8 | 54.9 | 62.7 | 7.0 | 125.1 | 132.0 |\\n| Other neuroscience | 16.0 | 44.5 | 60.6 | 24.7 | 51.6 | 76.5 |\\n| Total neuroscience | 145.8 | 227.4 | 373.2 | 144.6 | 305.5 | 450.2 |\\n| Other: |\\n| COVID-19 antibodies(4) | 386.6 | — | 386.6 | 215.5 | 1.6 | 217.1 |\\n| Forteo® | 112.7 | 64.4 | 177.1 | 109.6 | 91.3 | 200.9 |\\n| Cialis® | 8.1 | 107.7 | 115.7 | ( 6.5 ) | 137.4 | 130.9 |\\n| Other | 30.9 | 35.7 | 66.6 | 36.3 | 52.4 | 88.8 |\\n| Total other | 538.3 | 207.8 | 746.0 | 354.9 | 282.7 | 637.7 |\\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 3,989.6 | $ | 2,783.3 | $ | 6,772.8 |\\n\\nNumbers may not add due to rounding.\\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\\n(2) Humalog revenue includes insulin lispro.\\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to Emergency Use Authorization (EUA) or similar regulatory authorizations.\\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\\n13\\nThe following table summarizes revenue by product for the nine months ended September 30, 2022 and 2021:\\n| Nine Months Ended September 30, |\\n| 2022 | 2021 |\\n| U.S. | Outside U.S. | Total | U.S. | Outside U.S. | Total |\\n| Revenue—to unaffiliated customers: |\\n| Diabetes: |\\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 3,465.7 | $ | 1,122.5 | $ | 4,588.2 |\\n| Humalog(1) | 855.8 | 656.4 | 1,512.3 | 1,009.0 | 842.3 | 1,851.3 |\\n| Jardiance(2) | 831.4 | 622.4 | 1,453.7 | 566.8 | 492.1 | 1,058.9 |\\n| Humulin | 562.3 | 223.1 | 785.4 | 633.5 | 290.3 | 923.8 |\\n| Basaglar | 339.9 | 218.8 | 558.7 | 423.3 | 226.8 | 650.1 |\\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | — | — |\\n| Other diabetes | 195.6 | 276.5 | 472.2 | 185.7 | 302.6 | 488.3 |\\n| Total diabetes | 7,057.3 | 3,431.6 | 10,489.0 | 6,284.0 | 3,276.6 | 9,560.6 |\\n| Oncology: |\\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 582.1 | 363.7 | 945.8 |\\n| Cyramza | 259.3 | 434.3 | 693.6 | 266.3 | 496.3 | 762.5 |\\n| Alimta | 490.5 | 200.5 | 691.1 | 911.9 | 714.7 | 1,626.6 |\\n| Erbitux | 361.0 | 47.4 | 408.3 | 357.7 | 45.9 | 403.7 |\\n| Tyvyt | — | 235.8 | 235.8 | — | 340.2 | 340.2 |\\n| Other oncology | 124.1 | 186.5 | 310.6 | 83.7 | 169.9 | 253.6 |\\n| Total oncology | 2,335.4 | 1,679.6 | 4,015.0 | 2,201.7 | 2,130.7 | 4,332.4 |\\n| Immunology: |\\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,071.6 | 493.8 | 1,565.4 |\\n| Olumiant(3) | 104.6 | 520.1 | 624.7 | 236.5 | 572.6 | 809.1 |\\n| Other immunology | 0.1 | 12.1 | 12.1 | 15.2 | 14.5 | 29.7 |\\n| Total immunology | 1,317.3 | 1,093.8 | 2,411.0 | 1,323.3 | 1,080.9 | 2,404.2 |\\n| Neuroscience: |\\n| Emgality | 330.8 | 144.4 | 475.2 | 313.5 | 102.2 | 415.7 |\\n| Zyprexa | 26.2 | 235.5 | 261.7 | 28.3 | 264.5 | 292.8 |\\n| Cymbalta | 25.0 | 194.3 | 219.3 | 30.3 | 454.0 | 484.3 |\\n| Other neuroscience | 62.0 | 142.7 | 204.7 | 81.0 | 154.0 | 235.0 |\\n| Total neuroscience | 444.0 | 716.9 | 1,160.9 | 453.1 | 974.7 | 1,427.8 |\\n| Other: |\\n| COVID-19 antibodies(4) | 1,970.9 | 14.7 | 1,985.5 | 949.5 | 226.7 | 1,176.2 |\\n| Cialis | 25.8 | 454.7 | 480.4 | ( 3.1 ) | 541.8 | 538.7 |\\n| Forteo | 261.4 | 191.7 | 453.0 | 330.1 | 287.7 | 617.8 |\\n| Other | 119.4 | 125.1 | 244.8 | 96.5 | 164.3 | 260.8 |\\n| Total other | 2,377.5 | 786.2 | 3,163.7 | 1,373.0 | 1,220.5 | 2,593.5 |\\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 11,635.1 | $ | 8,683.4 | $ | 20,318.5 |\\n\\nNumbers may not add due to rounding.\\n(1) Humalog revenue includes insulin lispro.\\n(2) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\\n(3) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\\n(4) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\\n14\\nThe following table summarizes revenue by geographical area:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Revenue—to unaffiliated customers(1): |\\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | $ | 13,531.5 | $ | 11,635.1 |\\n| Europe | 1,056.4 | 1,098.6 | 3,224.8 | 3,629.6 |\\n| Japan | 487.7 | 595.0 | 1,352.3 | 1,832.2 |\\n| China | 343.4 | 400.3 | 1,102.0 | 1,285.0 |\\n| Other foreign countries | 632.0 | 689.4 | 2,029.1 | 1,936.7 |\\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | $ | 21,239.6 | $ | 20,318.5 |\\n\\nNumbers may not add due to rounding.\\n(1) Revenue is attributed to the countries based on the location of the customer.\\nNote 3: Acquisitions\\nWe engage in various forms of business development activities to enhance our product pipeline, including acquisitions, collaborations, investments, and licensing arrangements. In connection with these arrangements, our partners may be entitled to future royalties and/or commercial milestones based on sales should products be approved for commercialization and/or milestones based on the successful progress of compounds through the development process.\\nIn January 2021, we completed the acquisition of Prevail Therapeutics Inc. (Prevail). This transaction, as further discussed below in Acquisition of a Business, was accounted for as a business combination under the acquisition method of accounting. Under this method, the assets acquired and liabilities assumed were recorded at their respective fair values as of the acquisition date in our consolidated condensed financial statements. The determination of estimated fair value required management to make significant estimates and assumptions. The excess of the purchase price over the fair value of the acquired net assets, where applicable, has been recorded as goodwill. The results of operations of this acquisition is included in our consolidated condensed financial statements from the date of acquisition.\\nWe also acquired assets in development which are further discussed below in Asset Acquisitions. Upon each acquisition, the cost allocated to acquired IPR&D is immediately expensed if the compound has no alternative future use. Milestone payment obligations incurred prior to regulatory approval of the compound are expensed when the event triggering an obligation to pay the milestone occurs. We recognized acquired IPR&D and development milestone charges of $ 62.4 million and $ 668.4 million for the three and nine months ended September 30, 2022, respectively, and $ 177.6 million and $ 532.4 million for the three and nine months ended September 30, 2021, respectively.\\nAcquisition of a Business\\nPrevail Acquisition\\nOverview of Transaction\\nIn January 2021, we acquired all shares of Prevail for a purchase price that included $ 22.50 per share in cash (or an aggregate of $ 747.4 million, net of cash acquired) plus one non-tradable contingent value right (CVR) per share. The CVR entitles Prevail stockholders up to an additional $ 4.00 per share in cash (or an aggregate of approximately $ 160 million) payable, subject to certain terms and conditions, upon the first regulatory approval of a Prevail product in one of the following countries: U.S., Japan, United Kingdom, Germany, France, Italy, or Spain. To achieve the full value of the CVR, such regulatory approval must occur by December 31, 2024. If such regulatory approval occurs after December 31, 2024, the value of the CVR will be reduced by approximately 8.3 cents per month until December 1, 2028, at which point the CVR will expire without payment.\\nUnder the terms of the agreement, we acquired potentially disease-modifying AAV9-based gene therapies for patients with neurodegenerative diseases. The acquisition established a new modality for drug discovery and development, extending our research efforts through the creation of a gene therapy program that is being anchored by Prevail's portfolio of assets. The lead gene therapies in clinical development that we acquired were PR001 for patients with Parkinson's disease with GBA1 mutations and neuronopathic Gaucher disease and PR006 for patients with frontotemporal dementia with GRN mutations. Both PR001 and PR006 were granted Fast Track designation from the U.S. Food and Drug Administration (FDA).\\n15\\nAssets Acquired and Liabilities Assumed\\nThe following table summarizes the amounts recognized for assets acquired and liabilities assumed as of the acquisition date:\\n| Estimated Fair Value at January 22, 2021 |\\n| Cash | $ | 90.5 |\\n| Acquired IPR&D(1) | 824.0 |\\n| Goodwill(2) | 126.8 |\\n| Deferred tax liabilities | ( 106.0 ) |\\n| Other assets and liabilities, net | ( 31.5 ) |\\n| Acquisition date fair value of consideration transferred | 903.8 |\\n| Less: |\\n| Cash acquired | ( 90.5 ) |\\n| Fair value of CVR liability(3) | ( 65.9 ) |\\n| Cash paid, net of cash acquired | $ | 747.4 |\\n\\n(1) Acquired IPR&D intangibles primarily relate to PR001. In the third quarter of 2022, we impaired the intangible asset related to PR001. See Note 5 for additional information.\\n(2) The goodwill recognized from this acquisition is not deductible for tax purposes.\\n(3) See Note 6 for a discussion on the estimation of the CVR liability.\\nWe are unable to provide the results of operations for the three and nine months ended September 30, 2022 and 2021 attributable to Prevail as those operations were substantially integrated into our legacy business.\\nPro forma information has not been included as this acquisition did not have a material impact on our consolidated condensed statements of operations for the three and nine months ended September 30, 2021.\\nAsset Acquisitions\\nThe following table summarizes our significant asset acquisitions during the nine months ended September 30, 2022 and 2021:\\n| Counterparty | Compound(s), Therapy or Asset | Acquisition Month | Phase of Development(1) | Acquired IPR&D Expense |\\n| BioMarin Pharmaceutical Inc. | Priority Review Voucher | February 2022 | Not applicable | $ | 110.0 |\\n| Rigel Pharmaceuticals, Inc. | R552, a receptor-interacting serine/threonine-protein kinase 1 (RIPK1) inhibitor, for the potential treatment of autoimmune and inflammatory diseases | March 2021 | Phase I | 125.0 |\\n| Precision Biosciences, Inc. | Potential in vivo therapies for genetic disorders | January 2021 | Pre-clinical | 107.8 |\\n\\n(1) The phase of development presented is as of the date of the arrangement and represents the phase of development of the most advanced asset acquired, where applicable.\\nIn connection with our acquisition of Petra Pharma Corporation (Petra), we were required to make milestone payments to Petra shareholders contingent upon the occurrence of certain future events linked to the success of the mutant-selective PI3Kα inhibitor. In the second quarter of 2022, we entered into agreements with substantially all Petra shareholders to acquire their rights to receive any future milestone payments in exchange for a one-time payment. As a result of these agreements, we recognized a charge of $ 333.8 million as a development milestone during the nine months ended September 30, 2022. Any remaining contingent milestones payments linked to the success of the mutant-selective PI3Kα are not expected to be material. We recognized no other significant development milestones during the three and nine months ended September 30, 2022 and 2021.\\n16\\nSubsequent Event - Akouos, Inc. (Akouos) Acquisition\\nOn October 17, 2022, we entered into a definitive agreement to acquire Akouos. Pursuant to the terms of the agreement, we have commenced a tender offer to acquire all outstanding shares of Akouos for a purchase price of $ 12.50 per share in cash (an aggregate of approximately $ 487 million), payable at closing, plus one non-tradable CVR per share that will entitle the holder to receive up to an additional $ 3.00 per CVR in cash (an aggregate of up to approximately $ 123 million) upon the achievement of certain specified milestones. The acquisition will expand our gene therapy portfolio to include potential treatments for hearing loss and other inner ear conditions. The acquisition is not subject to any financing condition and is expected to close in the fourth quarter of 2022, subject to customary closing conditions, including receipt of required antitrust clearance and the tender of a majority of the outstanding shares of Akouos's common stock.\\nNote 4: Collaborations and Other Arrangements\\nWe often enter into collaborative and other similar arrangements to develop and commercialize drug candidates. Collaborative activities may include research and development, marketing and selling (including promotional activities and physician detailing), manufacturing, and distribution. These arrangements often require milestone as well as royalty or profit-share payments, contingent upon the occurrence of certain future events linked to the success of the asset in development, as well as expense reimbursements from or payments to the collaboration partner. See Note 2 for amounts of collaboration and other revenue recognized from these types of arrangements.\\nOperating expenses for costs incurred pursuant to these arrangements are reported in their respective expense line item, net of any payments due to or reimbursements due from our collaboration partners, with such reimbursements being recognized at the time the party becomes obligated to pay. Each collaboration is unique in nature, and our more significant arrangements are discussed below.\\nBoehringer Ingelheim Diabetes Collaboration\\nWe and Boehringer Ingelheim have a global agreement to jointly develop and commercialize a portfolio of diabetes compounds. Currently included in the collaboration are Boehringer Ingelheim's oral diabetes products: Jardiance, Glyxambi, Synjardy, Trijardy XR, Trajenta, and Jentadueto® as well as our basal insulin, Basaglar. Glyxambi, Synjardy, and Trijardy XR are included in the Jardiance product family. Jentadueto is included in the Trajenta product family.\\nIn connection with the regulatory approvals of Jardiance, Trajenta, and Basaglar in the U.S., Europe, and Japan, milestone payments made for Jardiance and Trajenta were capitalized as intangible assets and are being amortized to cost of sales, and milestone payments received for Basaglar were recorded as contract liabilities and are being amortized to collaboration and other revenue. The milestones pertaining to Jardiance and Trajenta are being amortized through their respective term under the collaboration, which, depending on country or region, is determined based on the latest to occur of (a) a defined number of years following launch date, (b) the expiration of the compound patent, or (c) the expiration of marketing authorization exclusivity. The milestones pertaining to Basaglar are being amortized through 2029. The table below summarizes the net milestones capitalized with respect to the Jardiance and Trajenta families of products and the net milestones deferred with respect to Basaglar as of September 30, 2022 and December 31, 2021:\\n| Net Milestones Capitalized (Deferred)(1) |\\n| September 30, 2022 | December 31, 2021 |\\n| Jardiance | $ | 121.2 | $ | 136.1 |\\n| Trajenta | 69.6 | 88.5 |\\n| Basaglar | ( 135.3 ) | ( 149.3 ) |\\n\\n(1) This represents the amounts that have been capitalized (deferred) from the start of this collaboration through the end of the reporting period, net of amount amortized.\\n17\\nFor the Jardiance product family, we and Boehringer Ingelheim share equally the ongoing development and commercialization costs in the most significant markets, and we record our portion of the development and commercialization costs as research and development expense and marketing, selling, and administrative expense, respectively. We receive a royalty on net sales of Boehringer Ingelheim's products in the most significant markets and recognize the royalty as collaboration and other revenue. Boehringer Ingelheim is entitled to potential performance payments depending on the net sales of the Jardiance product family; therefore, our reported revenue for Jardiance may be reduced by any potential performance payments we make related to this product family. The royalty received by us related to the Jardiance product family may also be increased or decreased depending on whether net sales for this product family exceed or fall below certain thresholds. We pay to Boehringer Ingelheim a royalty on net sales for Basaglar in the U.S. We record our sales of Basaglar to third parties as net product revenue with the royalty payments made to Boehringer Ingelheim recorded as cost of sales.\\nThe following table summarizes our collaboration and other revenue recognized with respect to the Jardiance and Trajenta families of products and net product revenue recognized with respect to Basaglar:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Jardiance | $ | 573.3 | $ | 390.4 | $ | 1,453.7 | $ | 1,058.9 |\\n| Basaglar | 193.0 | 192.8 | 558.7 | 650.1 |\\n| Trajenta | 103.8 | 96.1 | 293.0 | 279.9 |\\n\\nOlumiant\\nWe have a worldwide license and collaboration agreement with Incyte Corporation (Incyte), which provides us the development and commercialization rights to baricitinib, branded and trademarked as Olumiant, and certain follow-on compounds, for the treatment of inflammatory and autoimmune diseases and COVID-19. Incyte has the right to receive tiered, double digit royalty payments on worldwide net sales with rates ranging up to 20 percent. Incyte has the right to receive an additional royalty ranging up to the low teens on worldwide net sales for the treatment of COVID-19 that exceed a specified aggregate worldwide net sales threshold. The agreement calls for payments by us to Incyte associated with certain development, success-based regulatory, and sales-based milestones.\\nIn connection with the regulatory approvals of Olumiant in the U.S., Europe, and Japan, as well as achievement of a sales-based milestone, milestone payments of $ 330.0 million and $ 260.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period.\\nAs of September 30, 2022, Incyte is eligible to receive up to $ 100.0 million of additional payments from us in potential sales-based milestones.\\nWe record our sales of Olumiant, including sales of baricitinib that were made pursuant to EUA or similar regulatory authorizations, to third parties as net product revenue with the royalty payments made to Incyte recorded as cost of sales. The following table summarizes our net product revenue recognized with respect to Olumiant:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Olumiant | $ | 182.9 | $ | 406.9 | $ | 624.7 | $ | 809.1 |\\n\\n18\\nCOVID-19 Antibodies\\nWe have a worldwide license and collaboration agreement with AbCellera Biologics Inc. (AbCellera) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including bamlanivimab and bebtelovimab, for which we hold development and commercialization rights. AbCellera has the right to receive tiered royalty payments on worldwide net sales of bamlanivimab and bebtelovimab with percentages ranging in the mid-teens to mid-twenties. Royalty payments made to AbCellera are recorded as cost of sales.\\nWe have a license and collaboration agreement with Shanghai Junshi Biosciences Co., Ltd. (Junshi Biosciences) to co-develop therapeutic antibodies for the potential prevention and treatment of COVID-19, including etesevimab, for which we hold development and commercialization rights outside of mainland China and the Special Administrative Regions of Hong Kong and Macau, and for which Junshi Biosciences currently maintains all rights in mainland China and the Special Administrative Regions of Hong Kong and Macau. Junshi Biosciences has the right to receive royalty payments in the mid-teens on our net sales of etesevimab. Junshi Biosciences received certain development, success-based regulatory and sales-based milestones. Capitalized regulatory and sales-based milestones were fully amortized to cost of sales as of September 30, 2022.\\nPursuant to EUAs or similar regulatory authorizations, we recognized net product revenue associated with our sales of our COVID-19 antibodies of $ 386.6 million and $ 1.99 billion for the three and nine months ended September 30, 2022, respectively, and $ 217.1 million and $ 1.18 billion for the three and nine months ended September 30, 2021, respectively.\\nSintilimab Injection\\nWe have a collaboration agreement with Innovent Biologics, Inc. (Innovent) to jointly develop and commercialize sintilimab injection in China, where it is branded and trademarked as Tyvyt. In connection with regulatory approvals for Tyvyt in China, milestone payments of $ 120.0 million and $ 40.0 million were capitalized as intangible assets as of September 30, 2022 and December 31, 2021, respectively, and are being amortized to cost of sales through the term of the collaboration. This represents the cumulative amounts that have been capitalized from the start of this collaboration through the end of each reporting period. As of September 30, 2022, Innovent is eligible to receive up to $ 115.0 million in success-based regulatory and sales-based milestones.\\nWe record our sales of Tyvyt to third parties as net product revenue, with payments made to Innovent for its portion of the gross margin reported as cost of sales. We report as collaboration and other revenue our portion of the gross margin for Tyvyt sales made by Innovent to third parties. The following table summarizes our revenue recognized in China with respect to Tyvyt:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Tyvyt | $ | 76.8 | $ | 125.6 | $ | 235.8 | $ | 340.2 |\\n\\nIn 2020, we obtained an exclusive license for sintilimab injection from Innovent for geographies outside of China, which was subsequently terminated and rights have reverted to Innovent in October 2022.\\nLebrikizumab\\nWe have a worldwide license agreement with F. Hoffmann-La Roche Ltd and Genentech, Inc. (collectively, Roche), which provides us the worldwide development and commercialization rights to lebrikizumab. Roche has the right to receive tiered royalty payments on future worldwide net sales ranging in percentages from high single digits to high teens if the product is successfully commercialized. As of September 30, 2022, Roche is eligible to receive up to $ 180.0 million of payments from us contingent upon the achievement of success-based regulatory milestones and up to $ 1.03 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab.\\nWe have a license agreement with Almirall, S.A. (Almirall), under which Almirall licensed the rights to develop and commercialize lebrikizumab for the treatment or prevention of dermatology indications, including, but not limited to, atopic dermatitis in Europe. We have the right to receive tiered royalty payments on future net sales in Europe ranging in percentages from low double digits to low twenties if the product is successfully commercialized. As of September 30, 2022, we are eligible to receive additional payments of $ 85.0 million from Almirall contingent upon the achievement of success-based regulatory milestones and up to $ 1.25 billion in a series of sales-based milestones, contingent upon the commercial success of lebrikizumab. There were no remaining contract liabilities as of September 30, 2022. As of December 31, 2021, contract liabilities were not material. During the three and nine months ended September 30, 2022 and 2021, collaboration and other revenue recognized was not material.\\n19\\nNote 5: Asset Impairment, Restructuring, and Other Special Charges\\nThe components of the charges included in asset impairment, restructuring, and other special charges in our consolidated condensed statements of operations are described below.\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Severance | $ | — | $ | — | $ | — | $ | 11.5 |\\n| Asset impairment and other special charges | 206.5 | — | 206.5 | 200.1 |\\n| Total asset impairment, restructuring, and other special charges | $ | 206.5 | $ | — | $ | 206.5 | $ | 211.6 |\\n\\nAsset impairment, restructuring, and other special charges recognized during the three and nine months ended September 30, 2022 were primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001), acquired in the Prevail acquisition, as a result of changes in key assumptions used in the valuation due to delays in estimated launch timing.\\nAsset impairment, restructuring, and other special charges recognized during the nine months ended September 30, 2021 were primarily related to an intangible asset impairment of $ 108.1 million resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail.\\nWe recognized a net inventory impairment charge related to our COVID-19 antibodies of $ 435.1 million during the nine months ended September 30, 2021 in cost of sales in our consolidated condensed statements of operations. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\\nNote 6: Financial Instruments\\nFinancial instruments that potentially subject us to credit risk consist principally of trade receivables and interest-bearing investments. Wholesale distributors of life science products account for a substantial portion of our trade receivables; collateral is generally not required. We seek to mitigate the risk associated with this concentration through our ongoing credit-review procedures and insurance. A large portion of our cash is held by a few major financial institutions. We monitor our exposures with these institutions and do not expect any of these institutions to fail to meet their obligations. In accordance with documented corporate risk-management policies, we monitor the amount of credit exposure to any one financial institution or corporate issuer. We are exposed to credit-related losses in the event of nonperformance by counterparties to risk-management instruments but do not expect any counterparties to fail to meet their obligations given their investment grade credit ratings.\\nWe consider all highly liquid investments with a maturity of three months or less from the date of purchase to be cash equivalents. The cost of these investments approximates fair value.\\nOur equity investments are accounted for using three different methods depending on the type of equity investment:\\n•Investments in companies over which we have significant influence but not a controlling interest are accounted for using the equity method, with our share of earnings or losses reported in other-net, (income) expense.\\n•For equity investments that do not have readily determinable fair values, we measure these investments at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of the same issuer. Any change in recorded value is recorded in other-net, (income) expense.\\n•Our public equity investments are measured and carried at fair value. Any change in fair value is recognized in other-net, (income) expense.\\nWe review equity investments other than public equity investments for indications of impairment and observable price changes on a regular basis.\\n20\\nOur derivative activities are initiated within the guidelines of documented corporate risk-management policies and are intended to offset losses and gains on the assets, liabilities, and transactions being hedged. Management reviews the correlation and effectiveness of our derivatives on a quarterly basis.\\nFor derivative instruments that are designated and qualify as fair value hedges, the derivative instrument is marked to market, with gains and losses recognized currently in income to offset the respective losses and gains recognized on the underlying exposure. For derivative instruments that are designated and qualify as cash flow hedges, gains and losses are reported as a component of accumulated other comprehensive loss and reclassified into earnings in the same period the hedged transaction affects earnings. For derivative and non-derivative instruments that are designated and qualify as net investment hedges, the foreign currency translation gains or losses due to spot rate fluctuations are reported as a component of accumulated other comprehensive loss. Derivative contracts that are not designated as hedging instruments are recorded at fair value with the gain or loss recognized in earnings during the period of change.\\nWe may enter into foreign currency forward or option contracts to reduce the effect of fluctuating currency exchange rates (principally the euro, British pound, Chinese yuan, and Japanese yen). Foreign currency derivatives used for hedging are put in place using the same or like currencies and duration as the underlying exposures. Forward and option contracts are principally used to manage exposures arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. These contracts are recorded at fair value with the gain or loss recognized in other–net, (income) expense. We may enter into foreign currency forward and option contracts and currency swaps as fair value hedges of firm commitments. Forward contracts generally have maturities not exceeding 12 months. At September 30, 2022, we had outstanding foreign currency forward commitments to purchase 1.69 billion U.S. dollars and sell 1.71 billion euro; commitments to purchase 2.24 billion euro and sell 2.24 billion U.S. dollars; commitments to purchase 239.5 million U.S. dollars and sell 1.63 billion Chinese yuan; commitments to purchase 82.1 million U.S. dollars and sell 11.86 billion Japanese yen; and commitments to purchase 182.1 million British pounds and sell 206.9 million U.S. dollars, which all have settlement dates within 180 days.\\nForeign currency exchange risk is also managed through the use of foreign currency debt, cross-currency interest rate swaps, and foreign currency forward contracts. Our foreign currency-denominated notes had carrying amounts of $ 6.23 billion and $ 7.90 billion as of September 30, 2022 and December 31, 2021, respectively, of which $ 4.94 billion and $ 5.79 billion have been designated as, and are effective as, economic hedges of net investments in certain of our foreign operations as of September 30, 2022 and December 31, 2021, respectively. At September 30, 2022, we had outstanding cross-currency swaps with notional amounts of $ 1.56 billion swapping U.S. dollars to euro and $ 1.00 billion swapping Swiss francs to U.S. dollars which have settlement dates ranging through 2028. Our cross-currency interest rate swaps, for which a majority convert a portion of our U.S. dollar-denominated fixed-rate debt to foreign-denominated fixed-rate debt, have also been designated as, and are effective as, economic hedges of net investments. At September 30, 2022, we had outstanding foreign currency forward contracts to sell 1.34 billion euro with settlement dates ranging through 2023, which have been designated as, and are effective as, economic hedges of net investments.\\nIn the normal course of business, our operations are exposed to fluctuations in interest rates which can vary the costs of financing, investing, and operating. We seek to address a portion of these risks through a controlled program of risk management that includes the use of derivative financial instruments. The objective of controlling these risks is to limit the impact of fluctuations in interest rates on earnings. Our primary interest-rate risk exposure results from changes in short-term U.S. dollar interest rates. In an effort to manage interest-rate exposures, we strive to achieve an acceptable balance between fixed- and floating-rate debt and investment positions and may enter into interest rate swaps or collars to help maintain that balance.\\nInterest rate swaps or collars that convert our fixed-rate debt to a floating rate are designated as fair value hedges of the underlying instruments. Interest rate swaps or collars that convert floating-rate debt to a fixed rate are designated as cash flow hedges. Interest expense on the debt is adjusted to include the payments made or received under the swap agreements. Cash proceeds from or payments to counterparties resulting from the termination of interest rate swaps are classified as operating activities in our consolidated condensed statements of cash flows. At September 30, 2022, substantially all of our total long-term debt is at a fixed rate. We have converted approximately 10 percent of our long-term fixed-rate notes to floating rates through the use of interest rate swaps.\\n21\\nWe also may enter into forward-starting interest rate swaps, which we designate as cash flow hedges, as part of any anticipated future debt issuances in order to reduce the risk of cash flow volatility from future changes in interest rates. The change in fair value of these instruments is recorded as part of other comprehensive income (loss) and, upon completion of a debt issuance and termination of the swap, is amortized to interest expense over the life of the underlying debt. As of September 30, 2022, the total notional amounts of forward-starting interest rate contracts in designated cash flow hedging instruments were $ 1.75 billion, which have settlement dates ranging between 2023 and 2025.\\nEffective September 15, 2022, we increased our 364-day credit facility from $ 2.00 billion to $ 4.00 billion, which will expire in September 2023, and is available to support our commercial paper program. We have not drawn against the $ 4.00 billion 364-day credit facility as of September 30, 2022.\\nIn September 2021, we issued euro-denominated notes consisting of € 600.0 million of 0.50 percent fixed-rate notes due in September 2033, with interest to be paid annually. The net proceeds from the offering have been, and will continue to be, used to fund, in whole or in part, eligible projects designed to advance one or more of our environmental, social, and governance objectives.\\nIn September 2021, we issued euro-denominated notes consisting of € 500.0 million of 1.125 percent fixed-rate notes due in September 2051 and € 700.0 million of 1.375 percent fixed-rate notes due in September 2061, with interest to be paid annually, and British pound-denominated notes consisting of £ 250.0 million of 1.625 percent fixed-rate notes due in September 2043, with interest to be paid annually. We paid $ 1.91 billion of the net cash proceeds from the offering to purchase and redeem certain higher interest rate U.S. dollar-denominated notes with an aggregate principal amount of $ 1.50 billion, resulting in a debt extinguishment loss of $ 405.2 million. This loss was included in other net, (income) expense in our consolidated condensed statement of operations during the three and nine months ended September 30, 2021. The $ 1.50 billion principal amount of higher interest rate U.S. dollar-denominated notes that were redeemed primarily included $ 541.8 million of 3.95 percent notes due 2049, $ 408.7 million of 4.15 percent notes due 2059, and $ 219.4 million of 3.375 percent notes due 2029. We used the remaining net proceeds from the offering to prefund certain 2022 debt maturities and for general corporate purposes.\\nThe Effect of Risk-Management Instruments on the Consolidated Condensed Statements of Operations\\nThe following effects of risk-management instruments were recognized in other–net, (income) expense:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Fair value hedges: |\\n| Effect from hedged fixed-rate debt | $ | ( 62.9 ) | $ | ( 10.1 ) | $ | ( 215.7 ) | $ | ( 60.5 ) |\\n| Effect from interest rate contracts | 62.9 | 10.1 | 215.7 | 60.5 |\\n| Cash flow hedges: |\\n| Effective portion of losses on interest rate contracts reclassified from accumulated other comprehensive loss | 4.1 | 4.2 | 12.3 | 12.5 |\\n| Cross-currency interest rate swaps | 33.1 | 10.0 | 75.0 | 58.1 |\\n| Net (gains) losses on foreign currency exchange contracts not designated as hedging instruments | 129.6 | 50.8 | 280.7 | 110.6 |\\n| Total | $ | 166.8 | $ | 65.0 | $ | 368.0 | $ | 181.2 |\\n\\nDuring the three and nine months ended September 30, 2022 and 2021, the amortization of losses related to the portion of our risk management hedging instruments, fair value hedges, and cash flow hedges that was excluded from the assessment of effectiveness was not material.\\n22\\nThe Effect of Risk-Management Instruments on Other Comprehensive Income (Loss)\\nThe effective portion of risk-management instruments that was recognized in other comprehensive income (loss) is as follows:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net investment hedges: |\\n| Foreign currency-denominated notes | $ | 435.1 | $ | 119.0 | $ | 822.8 | $ | 268.8 |\\n| Cross-currency interest rate swaps | 92.1 | 66.7 | 171.4 | 170.8 |\\n| Foreign currency forward contracts | 107.8 | — | 121.4 | — |\\n| Cash flow hedges: |\\n| Forward-starting interest rate swaps | 57.5 | 19.4 | 337.7 | 149.3 |\\n| Cross-currency interest rate swaps | 19.9 | 3.1 | 38.4 | 22.5 |\\n\\nDuring the next 12 months, we expect to reclassify $ 16.7 million of pretax net losses on cash flow hedges from accumulated other comprehensive loss to other–net, (income) expense. During the three and nine months ended September 30, 2022 and 2021, the amounts excluded from the assessment of hedge effectiveness recognized in other comprehensive income (loss) were not material.\\n23\\nFair Value of Financial Instruments\\nThe following tables summarize certain fair value information at September 30, 2022 and December 31, 2021 for assets and liabilities measured at fair value on a recurring basis, as well as the carrying amount and amortized cost of certain other investments:\\n| Fair Value Measurements Using |\\n| CarryingAmount | Cost(1) | Quoted Prices in Active Markets for Identical Assets(Level 1) | Significant OtherObservable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\\n| September 30, 2022 |\\n| Cash equivalents | $ | 1,246.8 | $ | 1,246.8 | $ | 1,239.2 | $ | 7.6 | $ | — | $ | 1,246.8 |\\n| Short-term investments: |\\n| U.S. government and agency securities | $ | 43.0 | $ | 43.5 | $ | 43.0 | $ | — | $ | — | $ | 43.0 |\\n| Corporate debt securities | 51.7 | 51.8 | — | 51.7 | — | 51.7 |\\n| Asset-backed securities | 3.0 | 3.0 | — | 3.0 | — | 3.0 |\\n| Other securities | 27.0 | 27.0 | — | 14.8 | 12.2 | 27.0 |\\n| Short-term investments | $ | 124.7 |\\n| Noncurrent investments: |\\n| U.S. government and agency securities | $ | 131.4 | $ | 148.3 | $ | 131.4 | $ | — | $ | — | $ | 131.4 |\\n| Corporate debt securities | 206.4 | 232.5 | — | 206.4 | — | 206.4 |\\n| Mortgage-backed securities | 143.1 | 156.1 | — | 143.1 | — | 143.1 |\\n| Asset-backed securities | 43.6 | 45.5 | — | 43.6 | — | 43.6 |\\n| Other securities | 152.5 | 96.3 | — | 39.5 | 113.0 | 152.5 |\\n| Marketable equity securities | 549.1 | 416.1 | 549.1 | — | — | 549.1 |\\n| Equity investments without readily determinable fair values(2) | 583.7 |\\n| Equity method investments(2) | 764.8 |\\n| Noncurrent investments | $ | 2,574.6 |\\n| December 31, 2021 |\\n| Cash equivalents | $ | 2,379.5 | $ | 2,379.5 | $ | 2,361.0 | $ | 18.5 | $ | — | $ | 2,379.5 |\\n| Short-term investments: |\\n| U.S. government and agency securities | $ | 25.7 | $ | 25.6 | $ | 25.7 | $ | — | $ | — | $ | 25.7 |\\n| Corporate debt securities | 43.7 | 43.7 | — | 43.7 | — | 43.7 |\\n| Mortgage-backed securities | 0.2 | 0.2 | — | 0.2 | — | 0.2 |\\n| Asset-backed securities | 6.2 | 6.2 | — | 6.2 | — | 6.2 |\\n| Other securities | 14.3 | 14.3 | — | — | 14.3 | 14.3 |\\n| Short-term investments | $ | 90.1 |\\n| Noncurrent investments: |\\n| U.S. government and agency securities | $ | 137.0 | $ | 136.8 | $ | 137.0 | $ | — | $ | — | $ | 137.0 |\\n| Corporate debt securities | 235.3 | 232.7 | — | 235.3 | — | 235.3 |\\n| Mortgage-backed securities | 109.8 | 108.1 | — | 109.8 | — | 109.8 |\\n| Asset-backed securities | 23.1 | 23.1 | — | 23.1 | — | 23.1 |\\n| Other securities | 108.1 | 22.2 | — | — | 108.1 | 108.1 |\\n| Marketable equity securities | 1,279.7 | 487.0 | 1,279.7 | — | — | 1,279.7 |\\n| Equity investments without readily determinable fair values(2) | 548.1 |\\n| Equity method investments(2) | 771.5 |\\n| Noncurrent investments | $ | 3,212.6 |\\n\\n(1) For available-for-sale debt securities, amounts disclosed represent the securities' amortized cost.\\n(2) Fair value disclosures are not applicable for equity method investments and investments accounted for under the measurement alternative for equity investments.\\n24\\n| Fair Value Measurements Using |\\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\\n| Short-term commercial paper borrowings |\\n| September 30, 2022 | $ | ( 1,741.3 ) | $ | — | $ | ( 1,738.0 ) | $ | — | $ | ( 1,738.0 ) |\\n| December 31, 2021 | — | — | — | — | — |\\n| Long-term debt, including current portion |\\n| September 30, 2022 | $ | ( 14,147.1 ) | $ | — | $ | ( 11,848.6 ) | $ | — | $ | ( 11,848.6 ) |\\n| December 31, 2021 | ( 16,884.7 ) | — | ( 18,157.7 ) | — | ( 18,157.7 ) |\\n\\n25\\n| Fair Value Measurements Using |\\n| CarryingAmount | Quoted Prices in Active Markets for Identical Assets(Level 1) | SignificantOther Observable Inputs(Level 2) | SignificantUnobservableInputs(Level 3) | FairValue |\\n| September 30, 2022 |\\n| Risk-management instruments: |\\n| Interest rate contracts designated as fair value hedges: |\\n| Other noncurrent liabilities | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) | $ | — | $ | ( 140.2 ) |\\n| Interest rate contracts designated as cash flow hedges: |\\n| Other noncurrent assets | 355.2 | — | 355.2 | — | 355.2 |\\n| Cross-currency interest rate contracts designated as net investment hedges: |\\n| Other receivables | 81.6 | — | 81.6 | — | 81.6 |\\n| Other noncurrent assets | 116.9 | — | 116.9 | — | 116.9 |\\n| Cross-currency interest rate contracts designated as cash flow hedges: |\\n| Other noncurrent assets | 8.3 | — | 8.3 | — | 8.3 |\\n| Other noncurrent liabilities | ( 12.9 ) | — | ( 12.9 ) | — | ( 12.9 ) |\\n| Foreign exchange contracts designated as net investment hedges: |\\n| Other receivables | 108.2 | — | 108.2 | — | 108.2 |\\n| Other current liabilities | ( 2.9 ) | — | ( 2.9 ) | — | ( 2.9 ) |\\n| Foreign exchange contracts not designated as hedging instruments: |\\n| Other receivables | 48.1 | — | 48.1 | — | 48.1 |\\n| Other current liabilities | ( 93.5 ) | — | ( 93.5 ) | — | ( 93.5 ) |\\n| Contingent consideration liability: |\\n| Other noncurrent liabilities | ( 42.1 ) | — | — | ( 42.1 ) | ( 42.1 ) |\\n| December 31, 2021 |\\n| Risk-management instruments: |\\n| Interest rate contracts designated as fair value hedges: |\\n| Other receivables | $ | 4.8 | $ | — | $ | 4.8 | $ | — | $ | 4.8 |\\n| Other noncurrent assets | 78.3 | — | 78.3 | — | 78.3 |\\n| Other noncurrent liabilities | ( 7.6 ) | — | ( 7.6 ) | — | ( 7.6 ) |\\n| Interest rate contracts designated as cash flow hedges: |\\n| Other noncurrent assets | 49.2 | — | 49.2 | — | 49.2 |\\n| Other noncurrent liabilities | ( 31.7 ) | — | ( 31.7 ) | — | ( 31.7 ) |\\n| Cross-currency interest rate contracts designated as net investment hedges: |\\n| Other noncurrent assets | 31.3 | — | 31.3 | — | 31.3 |\\n| Other current liabilities | ( 1.2 ) | — | ( 1.2 ) | — | ( 1.2 ) |\\n| Cross-currency interest rate contracts designated as cash flow hedges: |\\n| Other noncurrent assets | 33.2 | — | 33.2 | — | 33.2 |\\n| Other noncurrent liabilities | ( 1.3 ) | — | ( 1.3 ) | — | ( 1.3 ) |\\n| Foreign exchange contracts not designated as hedging instruments: |\\n| Other receivables | 9.9 | — | 9.9 | — | 9.9 |\\n| Other current liabilities | ( 35.3 ) | — | ( 35.3 ) | — | ( 35.3 ) |\\n| Contingent consideration liabilities: |\\n| Other noncurrent liabilities | ( 70.5 ) | — | — | ( 70.5 ) | ( 70.5 ) |\\n\\n26\\nRisk-management instruments above are disclosed on a gross basis. There are various rights of setoff associated with certain of the risk-management instruments above that are subject to enforceable master netting arrangements or similar agreements. Although various rights of setoff and master netting arrangements or similar agreements may exist with the individual counterparties to the risk-management instruments above, individually, these financial rights are not material.\\nWe determine our Level 1 and Level 2 fair value measurements based on a market approach using quoted market values, significant other observable inputs for identical or comparable assets or liabilities, or discounted cash flow analyses. Level 3 fair value measurements for other investment securities are determined using unobservable inputs, including the investments' cost adjusted for impairments and price changes from orderly transactions. Fair values are not readily available for certain equity investments measured under the measurement alternative.\\nAs of September 30, 2022, we had approximately $ 854 million of unfunded commitments to invest in venture capital funds, which we anticipate will be paid over a period of up to 10 years.\\nContingent consideration liability relates to our liability arising in connection with the CVR issued as a result of the Prevail acquisition. The fair value of the CVR liability was estimated using a discounted cash flow analysis and Level 3 inputs, including projections representative of a market participant's view of the expected cash payment associated with the first potential regulatory approval of a Prevail compound in the applicable countries based on probabilities of technical success, timing of the potential approval events for the compounds, and an estimated discount rate. See Note 3 for additional information related to the CVR arrangement.\\nThe table below summarizes the contractual maturities of our investments in debt securities measured at fair value as of September 30, 2022:\\n| Maturities by Period |\\n| Total | Less Than1 Year | 1-5Years | 6-10Years | More Than10 Years |\\n| Fair value of debt securities | $ | 622.2 | $ | 97.7 | $ | 197.8 | $ | 121.0 | $ | 205.7 |\\n\\nThe net gains (losses) recognized in our consolidated condensed statements of operations for equity securities were $( 123.3 ) million and $( 667.6 ) million for the three and nine months ended September 30, 2022, respectively, and $( 246.8 ) million and $ 270.1 million for the three and nine months ended September 30, 2021, respectively. The net gains (losses) recognized for the three and nine months ended September 30, 2022 and 2021 on equity securities sold during the respective periods were not material.\\nWe adjust our equity investments without readily determinable fair values based upon changes in the equity instruments' values resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Downward adjustments resulting from an impairment are recorded based upon impairment considerations, including the financial condition and near term prospects of the issuer, general market conditions, and industry specific factors. Adjustments recorded for the three and nine months ended September 30, 2022 and 2021 were not material.\\nA summary of the amount of unrealized gains and losses in accumulated other comprehensive loss and the fair value of available-for-sale securities in an unrealized gain or loss position follows:\\n| September 30, 2022 | December 31, 2021 |\\n| Unrealized gross gains | $ | 0.1 | $ | 9.7 |\\n| Unrealized gross losses | 51.6 | 5.2 |\\n| Fair value of securities in an unrealized gain position | 13.8 | 250.7 |\\n| Fair value of securities in an unrealized loss position | 578.8 | 290.2 |\\n\\nWe periodically assess our investment in available-for-sale securities for impairment losses and credit losses. The amount of credit losses are determined by comparing the difference between the present value of future cash flows expected to be collected on these securities and the amortized cost. Factors considered in assessing credit losses include the position in the capital structure, vintage and amount of collateral, delinquency rates, current credit support, and geographic concentration. Impairment and credit losses related to available-for-sale securities were not material for the three and nine months ended September 30, 2022 and 2021.\\n27\\nAs of September 30, 2022, the available-for-sale securities in an unrealized loss position include primarily fixed-rate debt securities of varying maturities, which are sensitive to changes in the yield curve and other market conditions. Approximately 95 percent of the fixed-rate debt securities in a loss position are investment-grade debt securities. As of September 30, 2022, we do not intend to sell, and it is not more likely than not that we will be required to sell, the securities in a loss position before the market values recover or the underlying cash flows have been received, and there is no indication of a material default on interest or principal payments for our debt securities.\\nActivity related to our available-for-sale securities was as follows:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Proceeds from sales | $ | 50.5 | $ | 49.6 | $ | 115.6 | $ | 137.3 |\\n| Realized gross gains on sales | — | 0.4 | 0.2 | 2.2 |\\n| Realized gross losses on sales | 7.5 | 0.3 | 9.0 | 1.1 |\\n\\nRealized gains and losses on sales of available-for-sale investments are computed based upon specific identification of the initial cost adjusted for any other-than-temporary declines in fair value that were recorded in earnings.\\nAccounts Receivable Factoring Arrangements\\nWe have entered into accounts receivable factoring agreements with financial institutions to sell certain of our non-U.S. accounts receivable. These transactions are accounted for as sales and result in a reduction in accounts receivable because the agreements transfer effective control over, and risk related to, the receivables to the buyers. Our factoring agreements do not allow for recourse in the event of uncollectibility, and we do not retain any interest in the underlying accounts receivable once sold. We derecognized $ 356.8 million and $ 550.5 million of accounts receivable as of September 30, 2022 and December 31, 2021, respectively, under these factoring arrangements. The costs of factoring such accounts receivable on our consolidated condensed results of operations for the three and nine months ended September 30, 2022 and 2021 were not material.\\nNote 7: Income Taxes\\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the Tax Cuts and Jobs Act (2017 Tax Act) that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\\nThe U.S. examination of tax years 2016-2018 began in the fourth quarter of 2019 and remains ongoing. The resolution of this audit period will likely extend beyond the next 12 months.\\n28\\nNote 8: Retirement Benefits\\nNet pension and retiree health benefit (income) cost included the following components:\\n| Defined Benefit Pension Plans |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Components of net periodic benefit cost: |\\n| Service cost | $ | 87.1 | $ | 92.5 | $ | 264.4 | $ | 277.8 |\\n| Interest cost | 98.9 | 84.5 | 299.0 | 253.6 |\\n| Expected return on plan assets | ( 235.1 ) | ( 237.5 ) | ( 711.6 ) | ( 712.7 ) |\\n| Amortization of prior service cost | 0.6 | 1.0 | 1.9 | 3.2 |\\n| Recognized actuarial loss | 85.3 | 121.9 | 256.8 | 366.3 |\\n| Net periodic benefit cost | $ | 36.8 | $ | 62.4 | $ | 110.5 | $ | 188.2 |\\n\\n| Retiree Health Benefit Plans |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Components of net periodic benefit income: |\\n| Service cost | $ | 11.7 | $ | 12.4 | $ | 35.0 | $ | 37.0 |\\n| Interest cost | 9.4 | 8.1 | 28.4 | 24.4 |\\n| Expected return on plan assets | ( 38.0 ) | ( 36.5 ) | ( 114.1 ) | ( 109.6 ) |\\n| Amortization of prior service benefit | ( 13.7 ) | ( 14.9 ) | ( 41.1 ) | ( 44.7 ) |\\n| Recognized actuarial loss | 0.2 | 0.8 | 0.7 | 2.4 |\\n| Net periodic benefit income | $ | ( 30.4 ) | $ | ( 30.1 ) | $ | ( 91.1 ) | $ | ( 90.5 ) |\\n\\nNote 9: Contingencies\\nWe are involved in various lawsuits, claims, government investigations and other legal proceedings that arise in the ordinary course of business. These claims or proceedings can involve various types of parties, including governments, competitors, customers, suppliers, service providers, licensees, employees, or shareholders, among others. These matters may involve patent infringement, antitrust, securities, pricing, sales and marketing practices, environmental, commercial, contractual rights, licensing obligations, health and safety matters, consumer fraud, employment matters, product liability and insurance coverage, among others. The resolution of these matters often develops over a long period of time and expectations can change as a result of new findings, rulings, appeals or settlement arrangements. Legal proceedings that are significant or that we believe could become significant or material are described below.\\nWe believe the legal proceedings in which we are named as defendants are without merit and we are defending against them vigorously. It is not possible to determine the final outcome of these matters, and we cannot reasonably estimate the maximum potential exposure or the range of possible loss in excess of amounts accrued for any of these matters; however, we believe that the resolution of all such matters will not have a material adverse effect on our consolidated financial position or liquidity, but could possibly be material to our consolidated results of operations in any one accounting period.\\nLitigation accruals, environmental liabilities, and the related estimated insurance recoverables are reflected on a gross basis as liabilities and assets, respectively, on our consolidated condensed balance sheets. With respect to the product liability claims currently asserted against us, we have accrued for our estimated exposures to the extent they are both probable and reasonably estimable based on the information available to us. We accrue for certain product liability claims incurred but not filed to the extent we can formulate a reasonable estimate of their costs. We estimate these expenses based primarily on historical claims experience and data regarding product usage. Legal defense costs expected to be incurred in connection with significant product liability loss contingencies are accrued when both probable and reasonably estimable.\\nBecause of the nature of pharmaceutical products, it is possible that we could become subject to large numbers of additional product liability and related claims in the future. Due to a very restrictive market for litigation liability insurance, we are self-insured for litigation liability losses for all our currently and previously marketed products.\\n29\\nPatent Litigation\\nAlimta European Patent Litigation\\nIn Europe, Alimta (pemetrexed) was protected by a patent through June 2021. A number of legal proceedings that were initiated prior to patent expiration are ongoing.\\nEmgality Patent Litigation\\nWe are a named defendant in litigation filed by Teva Pharmaceuticals International GMBH and Teva Pharmaceuticals USA, Inc. (collectively, Teva) in the U.S. District Court for the District of Massachusetts seeking a ruling that various claims in three different Teva patents would be infringed by our launch and continued sales of Emgality for the prevention of migraine in adults. Trial began in October 2022. In June 2021, we were named as a defendant in a second litigation filed by Teva in the U.S. District Court for the District of Massachusetts seeking a ruling that two of Teva's patents, which are directed toward use of the active ingredient in Emgality to treat migraine, would be infringed by our continued sales of Emgality. We challenged these two patents by filing requests for Inter Partes Review with the Patent Trial and Appeal Board (PTAB) and in October 2022, the PTAB granted our requests.The corresponding district court litigation is stayed while this PTAB proceeding is ongoing.\\nJardiance Patent Litigation\\nIn November 2018, Boehringer Ingelheim, our partner in marketing and development of Jardiance, initiated U.S. patent litigation in the U.S. District Court of Delaware alleging infringement arising from submissions of Abbreviated New Drug Applications (ANDA) by a number of generic companies seeking approval to market generic versions of Jardiance, Glyxambi, and Synjardy in accordance with the procedures set out in the Drug Price Competition and Patent Term Restoration Act of 1984 (the Hatch-Waxman Act). Particularly with respect to Jardiance, the generic companies' ANDAs seek approval to market generic versions of Jardiance prior to the expiration of the relevant patents, and allege that certain patents, including in some allegations the compound patent, are invalid or would not be infringed. We are not a party to this litigation. This litigation has been stayed.\\nTaltz Patent Litigation\\nIn April 2021, we petitioned the High Court of Ireland to declare invalid a patent that Novartis Pharma AG (Novartis) purchased from Genentech, Inc. in 2020. Novartis responded by filing a claim against us alleging patent infringement related to our commercialization of Taltz and seeking damages for past infringement and an injunction against future infringement.\\nIn April 2021, Novartis petitioned the Court of Rome Intellectual Property Division for a preliminary injunction (PI) against us related to our commercialization of Taltz in Italy. In May 2021, We commenced patent revocation proceedings against Novartis before the Court of Milan’s IP Division where we also sought a declaration of non-infringement. Novartis counter-claimed for patent infringement and sought a permanent injunction. A hearing on the PI request before the Court of Rome Intellectual Property Division took place in May 2022 and in July 2022, the court rejected Novartis' request.\\nIn November 2021, Novartis petitioned the Swiss Federal Patent Court for a PI and a permanent injunction in main infringement proceedings against us related to our commercialization of Taltz in Switzerland. We petitioned the court to revoke the patent and for a declaration of non-infringement. In April 2022, Novartis withdrew its PI request.\\nIn January 2022, we commenced an action in the Hague District Court asking for a judgment that a Novartis Dutch patent is not infringed by our commercialization of Taltz in the Netherlands and is invalid. In October 2022, Novartis filed a counterclaim for infringement and sought a permanent injunction.\\nIn October 2022, we entered into a settlement and mutual release agreement with Novartis, which resolves the above-described disputes. Without any admission of liability or wrongdoing, we and Novartis have agreed to mutual releases for past claims and mutual covenants not to sue the other in relation to Taltz and the patents Novartis purchased from Genentech.\\n30\\nZyprexa Canada Patent Litigation\\nBeginning in the mid-2000s, several generic companies in Canada challenged the validity of our Zyprexa compound patent. In 2012, the Canadian Federal Court of Appeals denied our appeal of a lower court's decision that certain patent claims were invalid for lack of utility. In 2013, Apotex Inc. and Apotex Pharmachem Inc. (collectively, Apotex) brought claims against us in the Ontario Superior Court of Justice at Toronto for damages related to our enforcement of the Zyprexa compound patent under Canadian regulations governing patented drugs. Apotex seeks compensation based on novel legal theories under the Statute of Monopolies, Trademark Act, and common law. In March 2021, the Ontario Superior Court granted our motion for summary judgment, thereby dismissing Apotex's case. Apotex appealed that ruling to the Court of Appeal for Ontario in April 2021. In August 2022, the Court dismissed the appeal and in October 2022, Apotex appealed the decision. This matter is ongoing.\\nProduct Liability Litigation\\nByetta® Product Liability\\nWe have been named as a defendant in over 500 Byetta product liability lawsuits in the U.S. that were first initiated in March 2009 and involved over 800 plaintiffs. These lawsuits have been filed in various state and federal jurisdictions, including California state court (coordinated in Los Angeles County Superior Court), and various federal courts, the majority of which are coordinated in a multi-district litigation (MDL) in the U.S. District Court for the Southern District of California. The majority of these suits contain allegations that Byetta caused or contributed to the plaintiffs' cancer (primarily pancreatic cancer or thyroid cancer). The federal MDL and coordinated California state trial courts granted summary judgment in our favor on claims pertaining to pancreatic cancer, and the plaintiffs have dismissed Lilly from their appeal of the MDL ruling (the parties still await the order of judgment in the Los Angeles County Superior Court). Most of the MDL and state court lawsuits have been dismissed as of November 2022.\\nEnvironmental Proceedings\\nUnder the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as \\\"Superfund,\\\" we have been designated as one of several potentially responsible parties with respect to the cleanup of fewer than 10 sites. Under Superfund, each responsible party may be jointly and severally liable for the entire amount of the cleanup.\\nOther Matters\\n340B Litigation and Investigations\\nWe are the plaintiff in a lawsuit filed in January 2021 in the U.S. District Court for the Southern District of Indiana against the U.S. Department of Health and Human Services (HHS), the Secretary of HHS, the Health Resources and Services Administration (HRSA), and the Administrator of HRSA. The lawsuit challenges the HHS's December 30, 2020 advisory opinion stating that drug manufacturers are required to deliver discounts under the 340B program to all contract pharmacies. We seek a declaratory judgment that the defendants violated the Administrative Procedures Act and the U.S. Constitution, a preliminary injunction enjoining implementation of the administrative dispute resolution process created by defendants and, with it, their application of the advisory opinion, and other related relief. In March 2021, the court entered an order preliminarily enjoining the government's enforcement of the administrative dispute resolution process against us. In May 2021, HRSA notified us that it determined that our policy was contrary to the 340B statute. In response, in May 2021, we filed a motion for preliminary injunction and temporary restraining order requesting that the U.S. District Court for the Southern District of Indiana enjoin defendants from taking any action against us relating to the 340B drug pricing program until after the court issues a final judgment on the aforementioned litigation. In May 2021, the court denied our motion for a temporary restraining order but deferred resolution of our motion for preliminary injunction. In June 2021, the defendants withdrew the HHS December 30, 2020 advisory opinion. In July 2021, the court held oral argument on the parties' cross motions for summary judgment, the defendants' motion to dismiss, and our motion for preliminary injunction related to HRSA's May 2021 enforcement letter. In October 2021, the court denied the defendants' motion to dismiss, and granted in part and denied in part the parties' cross motions for summary judgment. Both parties filed notices of appeal related to the court's summary judgment order. Oral argument took place in October 2022 in the U.S. Court of Appeals for the Seventh Circuit. This matter is ongoing.\\nIn January 2021, we, along with other pharmaceutical manufacturers, were named as a defendant in a petition currently pending before the HHS Administrative Dispute Resolution Panel. Petitioner seeks declaratory and other injunctive relief related to the 340B program. As described above, the U.S. District Court for the Southern District of Indiana has entered a preliminary injunction enjoining the government's enforcement of this administrative dispute resolution process against us.\\n31\\nIn July 2021, we, along with Sanofi-Aventis U.S., LLC (Sanofi), Novo Nordisk Inc. (Novo Nordisk), and AstraZeneca Pharmaceuticals LP, were named as a defendant in a purported class action lawsuit filed in the U.S. District Court for the Western District of New York by Mosaic Health, Inc. alleging antitrust and unjust enrichment claims related to the defendants' 340B distribution programs. We, with Sanofi and Novo Nordisk, filed a motion to dismiss the lawsuit, which was granted in September 2022. In October 2022, the plaintiffs filed a motion for leave to amend their complaint. This matter is ongoing.\\nWe received a civil investigative subpoena in February 2021 from the Office of the Attorney General for the State of Vermont relating to the sale of pharmaceutical products to Vermont covered entities under the 340B program. We are cooperating with this subpoena.\\nBranchburg Manufacturing Facility\\nIn May 2021, we received a subpoena from the U.S. Department of Justice requesting the production of certain documents relating to our manufacturing site in Branchburg, New Jersey. We are cooperating with the subpoena.\\nBrazil Litigation – Cosmopolis Facility\\nLabor Attorney Litigation\\nFirst initiated in 2008, our subsidiary in Brazil, Eli Lilly do Brasil Limitada (Lilly Brasil), is named in a Public Civil Action brought by the Labor Public Attorney (LPA) for the 15th Region in the Labor Court of Paulinia, State of Sao Paulo, Brazil, (the Labor Court) alleging possible harm to employees and former employees caused by alleged exposure to soil and groundwater contaminants at a former Lilly Brasil manufacturing facility in Cosmopolis, Brazil, operated by the company between 1977 and 2003. In May 2014, the Labor Court judge ruled against Lilly Brasil, ordering it to undertake several remedial and compensatory actions including health coverage for a class of individuals and certain of their children. In July 2018, the appeals court (TRT) generally affirmed our appeal of the Labor Court's ruling, which included a liquidated award of 300 million Brazilian real, which, when adjusted for inflation and the addition of pre and post judgment interest using the current Central Bank of Brazil's special system of clearance and custody rate, is approximately one billion Brazilian real (approximately $ 185 million as of September 30, 2022). In August 2019, Lilly Brasil filed an appeal to the superior labor court (TST) and in June 2021, the TRT published its decision on the admissibility of Lilly Brasil's appeal, allowing the majority of the elements, which were allowed to proceed in June 2021; elements not proceeding are subject to an interlocutory appeal to the TST that was filed in June 2021. In September 2019, the TRT stayed a number of elements of its trial court decision pending the determination of Lilly Brasil's appeal to the TST.\\nIn June 2019 and September 2020, the LPA filed applications in the Labor Court for enforcement of certain remedies granted by the TRT in its July 2018 decision, requested restrictions on Lilly Brasil’s assets in Brazil, and required Lilly Brasil and Antibióticos do Brasil Ltda. (ABL) to submit a list of potential beneficiaries of the Public Civil Action. In July 2019, the Labor Court issued a ruling requiring a freeze of Lilly Brasil’s immovable property or, alternatively, a security deposit or lien of 500 million Brazilian real, which ruling was subsequently limited in scope and the security was reduced to 100 million Brazilian real. ABL and LPA appealed the June 2021 Labor Court ruling to the TST, which appeal is under review. The Labor Court is currently assessing the status of Lilly Brasil’s and ABL’s compliance with such portion of the July 2018 TRT decision and an inspection in the industrial plant is expected. These matters are ongoing.\\nIndividual Former Employee Litigation\\nLilly Brasil is also named in over 20 pending lawsuits filed in the Labor Court by individual former employees making similar claims. These individual lawsuits are at various stages in the litigation process.\\nPuerto Rico Tax Matter\\nIn May 2013, the Municipality of Carolina in Puerto Rico (Municipality) filed a lawsuit against us alleging noncompliance with respect to a contract with the Municipality and seeking a declaratory judgment. In December 2020, the Puerto Rico Appellate Court (AP) reversed the summary judgment previously granted by the Court of First Instance (CFI) in our favor, dismissing the Municipality's complaint in its entirety. The AP remanded the case to the CFI for trial on the merits. The trial began in May 2022; however, the Municipality filed a new motion requesting the CFI to award damages. The request was denied by the CFI in our favor and the Municipality filed for revision at the AP, which we opposed, staying the case. This matter is ongoing.\\n32\\nEastern District of Pennsylvania Pricing (Average Manufacturer Price) Inquiry\\nIn November 2014, we, along with another pharmaceutical manufacturer, were named as co-defendants in United States et al. ex rel. Streck v. Takeda Pharm. Am., Inc., et al., which was filed in November 2014 and unsealed in the U.S. District Court for the Northern District of Illinois. The complaint alleges that the defendants should have treated certain credits from distributors as retroactive price increases and included such increases in calculating average manufacturer prices. Following a trial in August 2022, the jury returned a verdict in favor of the plaintiff. The case is proceeding with post-trial motions after which the court will enter final judgment in the case. This matter is ongoing.\\nHealth Choice Alliance\\nWe are named as a defendant in two lawsuits filed in Texas and New Jersey state courts in October 2019 seeking damages under the Texas Medicaid Fraud Prevention Act and New Jersey Medicaid False Claims Act, respectively, for certain patient support programs related to our products Humalog, Humulin, and Forteo. The Texas state court action has been stayed. The New Jersey state court action was dismissed with prejudice pending an ongoing appeal before the Appellate Division of the New Jersey Superior Court. This matter is ongoing.\\nPricing Litigation\\nIn December 2017 and February 2018, we, along with Sanofi and Novo Nordisk, were named as defendants in a consolidated purported class action lawsuit, In re. Insulin Pricing Litigation and in MSP Recovery Claims, Series, LLC et al. v. Sanofi Aventis U.S. LLC et al., both filed in the U.S. District Court for the District of New Jersey. The cases relate to insulin pricing and seek damages or other relief under various theories, including state consumer protection laws, common law fraud, unjust enrichment, and the Federal Racketeer Influenced and Corrupt Organization Act (federal RICO Act). In both cases, the court dismissed claims under the federal RICO Act and certain state laws. In April 2021, the plaintiffs in In re. Insulin Pricing Litigation amended their complaint to allege additional state law claims for civil conspiracy and violations of state RICO statutes. The court allowed the Arizona RICO statute and certain state civil conspiracy law claims to proceed. Additionally in 2020, we, along with Sanofi, Novo Nordisk, CVS, Express Scripts, and Optum, have been sued in a putative class action, FWK Holdings, LLC v. Novo Nordisk Inc., et al., filed in the same court, for alleged violations of the federal RICO Act as well as the New Jersey RICO Act and antitrust law. The same group of defendants, along with Medco Health and United Health Group, also have been sued in other purported class actions in the same court, Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al. and Value Drug Co. v. Eli Lilly & Co. et al., which were both initiated in March 2020, with the plaintiffs seeking damages for alleged violations of the federal RICO Act. In September 2020, the U.S. District Court for the District of New Jersey granted plaintiffs' motion to consolidate FWK Holdings, LLC v. Novo Nordisk Inc., et al., Rochester Drug Co-Operative Inc. v. Eli Lilly & Co. et al., and Value Drug Co. v. Eli Lilly & Co. et al. In July 2021, the U.S. District Court for the District of New Jersey dismissed the three antitrust claims alleged by plaintiffs in the consolidated litigation and denied dismissal of the federal RICO Act claims.\\nIn October 2018, the Minnesota Attorney General's Office initiated litigation against us, Sanofi, and Novo Nordisk, State of Minnesota v. Sanofi-Aventis U.S. LLC et al., in the U.S. District Court for the District of New Jersey, seeking damages for unjust enrichment, violations of various Minnesota state consumer protection laws, and the federal RICO Act. In March 2021, the U.S. District Court for the District of New Jersey dismissed with prejudice the Minnesota Attorney General's federal RICO claims and false advertising claims under state law; the consumer fraud and other related state law claims remain ongoing. Additionally, in May 2019, the Kentucky Attorney General's Office filed a complaint against us, Sanofi, and Novo Nordisk, Commonwealth of Kentucky v. Novo Nordisk, Inc. et al., in Kentucky state court, alleging violations of the Kentucky consumer protection law, false advertising, and unjust enrichment.\\nIn June 2021, the Mississippi Attorney General's Office initiated litigation against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark, and United/Optum in the Hinds County, Mississippi Chancery Court, alleging state law consumer protection, unjust enrichment, and civil conspiracy claims. After the case was removed to federal court, we, along with the other defendants, filed a motion to dismiss the lawsuit, which was denied. This matter is ongoing.\\nIn May 2022, the state of Arkansas filed suit against us Sanofi, Novo Nordisk, ESI, CVS/Caremark/Aetna, and Optum, asserting state law consumer protection, civil conspiracy, and unjust enrichment claims. The case has been removed to federal court and is ongoing.\\nIn September 2022, the County of Albany, New York filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, CVS/Caremark and United/Optum asserting violations of federal RICO statute and state law claims for deceptive trade practices, unjust enrichment, and civil conspiracy. This matter is ongoing.\\n33\\nIn September 2022, the State of Montana filed a suit against us, Sanofi, Novo Nordisk, Evernorth/ESI, Medco Health Solutions, CVS/Caremark and Optum asserting violations of the Montana Unfair Practices and Consumer Protection Act, unjust enrichment, and civil conspiracy. This matter is ongoing.\\nInvestigations, Subpoenas, and Inquiries\\nIn connection with the pricing and sale of our insulin and other products, we have been subject to various investigations and received subpoenas, civil investigative demand requests, information requests, interrogatories, and other inquiries from various governmental entities. These include subpoenas from the New York and Vermont Attorney General Offices, civil investigative demands from the Washington, New Mexico, Colorado, Illinois, Ohio Attorney General Offices, the Department of Justice and the Federal Trade Commission, as well as information requests from the Mississippi, Washington D.C., California, Florida, Hawaii, and Nevada Attorney General Offices. In January 2022, the Michigan Attorney General filed a petition in Michigan state court seeking authorization to investigate Lilly for potential violations of the Michigan Consumer Protection Act (MCPA), and a complaint seeking a declaratory judgment that the Attorney General has authority to investigate Lilly's sale of insulin under the MCPA. The court authorized the proposed investigation and the issuance of civil investigative subpoenas. In April 2022, the parties entered into a stipulation providing that the State will not issue any civil investigative subpoena to us under the MCPA until the declaratory judgment action is resolved. In July 2022, the court dismissed the case in its entirety. The Michigan Attorney General filed a notice of appeal and an application to obtain review by the Michigan Supreme Court, which remain pending.\\nWe received a request in January 2019 from the House of Representatives' Committee on Oversight and Reform seeking commercial information and business records related to the pricing of insulin products, among other issues. We also received similar requests from the Senate Finance Committee and the Senate Committee on Health, Education, Labor, and Pensions, and separate requests from the House Committee on Energy and Commerce majority and minority members. In January 2021, the Senate Finance Committee released a report summarizing the findings of its investigation. In December 2021 the House of Representatives' Committee on Oversight and Reform majority and minority staffs released separate reports with findings from their investigations into drug pricing, including of insulin products.\\nWe are cooperating with all of the aforementioned investigations, subpoenas, and inquiries.\\nResearch Corporation Technologies, Inc.\\nIn April 2016, we were named as a defendant in litigation filed by Research Corporation Technologies, Inc. (RCT) in the U.S. District Court for the District of Arizona. RCT is seeking damages for breach of contract, unjust enrichment, and conversion related to processes used to manufacture certain products, including Humalog and Humulin. In October 2021, the court issued a summary judgment decision finding in favor of RCT on certain issues, including with respect to a disputed royalty. Both parties filed motions for reconsideration, which were denied. We filed supplemental summary judgment motions. A trial date has not been set. Potential damages payable under the litigation, if finally awarded after an appeal, could be material but are not currently reasonably estimable. This matter is ongoing.\\n34\\nNote 10: Other Comprehensive Income (Loss)\\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the three months ended September 30, 2022 and 2021:\\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\\n| Balance at July 1, 2022 | $ | ( 1,844.2 ) | $ | ( 27.9 ) | $ | ( 2,443.2 ) | $ | 27.6 | $ | ( 4,287.7 ) |\\n| Other comprehensive income (loss) before reclassifications | ( 165.1 ) | ( 24.9 ) | 47.8 | 63.0 | ( 79.2 ) |\\n| Net amount reclassified from accumulated other comprehensive loss | — | 13.5 | 57.2 | 0.4 | 71.1 |\\n| Net other comprehensive income (loss) | ( 165.1 ) | ( 11.4 ) | 105.0 | 63.4 | ( 8.1 ) |\\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\\n\\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\\n| Balance at July 1, 2021 | $ | ( 1,516.2 ) | $ | 9.1 | $ | ( 4,569.9 ) | $ | ( 210.1 ) | $ | ( 6,287.1 ) |\\n| Other comprehensive income (loss) before reclassifications | ( 8.0 ) | ( 2.4 ) | 18.6 | 16.8 | 25.0 |\\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.1 | 86.0 | 3.3 | 89.4 |\\n| Net other comprehensive income (loss) | ( 8.0 ) | ( 2.3 ) | 104.6 | 20.1 | 114.4 |\\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\\n\\nThe following tables summarize the activity related to each component of other comprehensive income (loss) during the nine months ended September 30, 2022 and 2021:\\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\\n| Balance at January 1, 2022 | $ | ( 1,550.2 ) | $ | 3.7 | $ | ( 2,583.6 ) | $ | ( 213.0 ) | $ | ( 4,343.1 ) |\\n| Other comprehensive income (loss) before reclassifications | ( 459.7 ) | ( 55.5 ) | 72.9 | 297.2 | ( 145.1 ) |\\n| Net amount reclassified from accumulated other comprehensive loss | 0.6 | 12.5 | 172.5 | 6.8 | 192.4 |\\n| Net other comprehensive income (loss) | ( 459.1 ) | ( 43.0 ) | 245.4 | 304.0 | 47.3 |\\n| Balance at September 30, 2022 | $ | ( 2,009.3 ) | $ | ( 39.3 ) | $ | ( 2,338.2 ) | $ | 91.0 | $ | ( 4,295.8 ) |\\n\\n| (Amounts presented net of taxes) | Foreign Currency Translation Gains (Losses) | Unrealized Net Gains (Losses) on Securities | Defined Benefit Pension and Retiree Health Benefit Plans | Effective Portion of Cash Flow Hedges | Accumulated Other Comprehensive Loss |\\n| Balance at January 1, 2021 | $ | ( 1,427.5 ) | $ | 14.8 | $ | ( 4,751.0 ) | $ | ( 332.7 ) | $ | ( 6,496.4 ) |\\n| Other comprehensive income (loss) before reclassifications | ( 96.7 ) | ( 8.8 ) | 27.2 | 132.8 | 54.5 |\\n| Net amount reclassified from accumulated other comprehensive loss | — | 0.8 | 258.5 | 9.9 | 269.2 |\\n| Net other comprehensive income (loss) | ( 96.7 ) | ( 8.0 ) | 285.7 | 142.7 | 323.7 |\\n| Balance at September 30, 2021 | $ | ( 1,524.2 ) | $ | 6.8 | $ | ( 4,465.3 ) | $ | ( 190.0 ) | $ | ( 6,172.7 ) |\\n\\n35\\nThe tax effects on the net activity related to each component of other comprehensive income (loss) were as follows:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| Tax benefit (expense) | 2022 | 2021 | 2022 | 2021 |\\n| Foreign currency translation gains/losses | $ | ( 133.3 ) | $ | ( 39.0 ) | $ | ( 234.2 ) | $ | ( 92.3 ) |\\n| Unrealized net gains/losses on securities | 3.4 | 0.8 | 13.1 | 3.8 |\\n| Defined benefit pension and retiree health benefit plans | ( 22.4 ) | ( 28.2 ) | ( 73.2 ) | ( 79.7 ) |\\n| Effective portion of cash flow hedges | ( 16.9 ) | ( 5.4 ) | ( 80.8 ) | ( 37.9 ) |\\n| Benefit (expense) for income taxes allocated to other comprehensive income (loss) items | $ | ( 169.2 ) | $ | ( 71.8 ) | $ | ( 375.1 ) | $ | ( 206.1 ) |\\n\\nExcept for the tax effects of foreign currency translation gains and losses related to our foreign currency-denominated notes, cross-currency interest rate swaps, and other foreign currency exchange contracts designated as net investment hedges (see Note 6), income taxes were not provided for foreign currency translation. Generally, the assets and liabilities of foreign operations are translated into U.S. dollars using the current exchange rate. For those operations, changes in exchange rates generally do not affect cash flows; therefore, resulting translation adjustments are made in shareholders' equity rather than in the consolidated condensed statements of operations.\\nReclassifications out of accumulated other comprehensive loss were as follows:\\n| Details about Accumulated Other Comprehensive Loss Components | Three Months Ended September 30, | Nine Months Ended September 30, | Affected Line Item in the Consolidated Condensed Statements of Operations |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Amortization of retirement benefit items: |\\n| Prior service benefits, net | $ | ( 13.1 ) | $ | ( 13.9 ) | $ | ( 39.2 ) | $ | ( 41.5 ) | Other–net, (income) expense |\\n| Actuarial losses, net | 85.5 | 122.7 | 257.5 | 368.7 | Other–net, (income) expense |\\n| Total before tax | 72.4 | 108.8 | 218.3 | 327.2 |\\n| Tax benefit | ( 15.2 ) | ( 22.8 ) | ( 45.8 ) | ( 68.7 ) | Income taxes |\\n| Net of tax | 57.2 | 86.0 | 172.5 | 258.5 |\\n| Other, net of tax | 13.9 | 3.4 | 19.9 | 10.7 | Other–net, (income) expense |\\n| Total reclassifications, net of tax | $ | 71.1 | $ | 89.4 | $ | 192.4 | $ | 269.2 |\\n\\nNote 11: Other–Net, (Income) Expense\\nOther–net, (income) expense consisted of the following:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Interest expense | $ | 81.5 | $ | 83.6 | $ | 247.6 | $ | 258.4 |\\n| Interest income | ( 20.1 ) | ( 7.0 ) | ( 37.3 ) | ( 18.0 ) |\\n| Net investment (gains) losses on equity securities (Note 6) | 123.3 | 246.8 | 667.6 | ( 270.1 ) |\\n| Retirement benefit plans | ( 92.4 ) | ( 72.6 ) | ( 280.0 ) | ( 217.1 ) |\\n| Debt extinguishment loss (Note 6) | — | 405.2 | — | 405.2 |\\n| Other (income) expense | 18.7 | ( 20.1 ) | ( 17.0 ) | ( 34.1 ) |\\n| Other–net, (income) expense | $ | 111.0 | $ | 635.9 | $ | 580.9 | $ | 124.3 |\\n\\n36\\nItem 2. Management's Discussion and Analysis of Results of Operations and Financial Condition\\nResults of Operations\\n(Tables present dollars in millions, except per-share data)\\nGeneral\\nManagement's discussion and analysis of results of operations and financial condition is intended to assist the reader in understanding and assessing significant changes and trends related to the results of operations and financial position of our consolidated company. This discussion and analysis should be read in conjunction with the consolidated condensed financial statements and accompanying footnotes in Part I, Item 1 of this Quarterly Report on Form 10-Q. Certain statements in this Part I, Item 2 of this Quarterly Report on Form 10-Q constitute forward-looking statements. Various risks and uncertainties, including those discussed in \\\"Forward-Looking Statements\\\" in this Quarterly Report on Form 10-Q and \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021, may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements.\\nExecutive Overview\\nThis section provides an overview of our financial results, recent product and late-stage pipeline developments, and other matters affecting our company and the pharmaceutical industry. Earnings per share (EPS) data are presented on a diluted basis.\\nCOVID-19 Pandemic\\nIn response to the COVID-19 pandemic, we have focused on maintaining a supply of our medicines; reducing the strain on the medical system; developing treatments for COVID-19; protecting the health, safety, and well-being of our employees; supporting our communities; and ensuring affordability of and access to our medicines, particularly insulin.\\nWe have received various regulatory authorizations, including Emergency Use Authorizations (EUA), for our COVID-19 therapies. We supplied the United States (U.S.) government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders. The U.S. Food and Drug Administration (FDA) has revised, and may in the future revise, any EUA for our COVID-19 therapies in response to the prevalence of variants against which our therapies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants.\\nThe COVID-19 pandemic has, and may continue to, adversely impact our business and operations. Strain on global transportation, logistics, manufacturing, and labor markets, including as aggravated by the pandemic and global unrest, the focus of resources on COVID-19, protective measures implemented to control the spread of COVID-19, and an increase in overall demand in our industry for certain resources and medicines, resulting in changed buying patterns, increased costs, and constrained supply, have negatively impacted and may continue to negatively impact the development, manufacturing, supply, distribution, and sales of our medicines.\\nThe degree to which the COVID-19 pandemic and related challenges impact the development, manufacturing, supply, distribution, and sale of our medicines will depend on developments that are highly uncertain and beyond our knowledge or control.\\n37\\nProduct Supply\\nContinued strong demand for Trulicity® in U.S. and international markets, partially due to the ongoing limited availability of competitor therapies, has challenged, and is expected to continue to challenge, our ability to meet demand in most international markets. In the U.S., as demand for Trulicity has continued to exceed historical levels, we anticipate tight supplies will persist until additional manufacturing capacity is operationalized, and U.S. wholesalers may experience intermittent restocking delays of Trulicity orders. Outside the U.S., we have implemented certain actions to minimize the impact to existing patients, but we expect to experience intermittent disruptions in our supply of Trulicity in international markets.\\nIn addition, the uptake of Mounjaro® for type 2 diabetes following its launch in the U.S. has been very strong. We continue to carefully monitor demand, incretin competitor availability, and supply with a focus on access for Type 2 diabetes patients.\\nWe anticipate that additional internal and contracted manufacturing capacity will become fully operational around the world in the next several years, with significant expansion in 2023, as part of our ongoing efforts to meet the significant demand for our incretin medicines.\\nSee \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021 for additional information on risk factors that could impact our business and operations.\\nFinancial Results\\nThe following table summarizes our key operating results:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\\n| Gross margin | 5,362.5 | 5,342.0 | — | 16,157.9 | 15,055.9 | 7 |\\n| Gross margin as a percent of revenue | 77.3 | % | 78.9 | % | 76.1 | % | 74.1 | % |\\n| Research and development | $ | 1,802.9 | $ | 1,705.3 | 6 | $ | 5,194.9 | $ | 5,032.4 | 3 |\\n| Marketing, selling, and administrative | 1,614.2 | 1,577.9 | 2 | 4,797.2 | 4,839.6 | (1) |\\n| Acquired in-process research and development (IPR&D) and development milestones | 62.4 | 177.6 | (65) | 668.4 | 532.4 | 26 |\\n| Asset impairment, restructuring, and other special charges | 206.5 | — | NM | 206.5 | 211.6 | (2) |\\n| Other–net, (income) expense | 111.0 | 635.9 | (83) | 580.9 | 124.3 | NM |\\n| Net income | 1,451.7 | 1,110.1 | 31 | 4,307.1 | 3,855.6 | 12 |\\n| EPS - diluted | 1.61 | 1.22 | 32 | 4.76 | 4.23 | 13 |\\n\\nNM - not meaningful\\nRevenue increased for the three and nine months ended September 30, 2022, driven by increased volume, partially offset by lower realized prices and the unfavorable impact of foreign exchange rates. Research and development expenses increased for the three and nine months ended September 30, 2022, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses increased for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\\n38\\nThe following highlighted items also affect comparisons of our financial results for the three and nine months ended September 30, 2022 and 2021:\\n2022\\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\\n•We recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher.\\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\\n•We recognized charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing.\\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\\n•We recognized $123.3 million and $667.6 million of net investment losses on equity securities for the three and nine months ended September 30, 2022, respectively.\\n2021\\nCost of Sales (See Note 5 to the consolidated condensed financial statements)\\n•We recognized a net inventory impairment charge related to our COVID-19 antibodies of $435.1 million for the nine months ended September 30, 2021. As part of our response to the COVID-19 pandemic, and at the request of the U.S. and international governments, we invested in large-scale manufacturing of COVID-19 antibodies at risk, in order to ensure rapid access to patients around the world. As the COVID-19 pandemic evolved during 2021, we incurred a net inventory impairment charge primarily due to the combination of changes to demand from U.S. and international governments, including changes to our agreement with the U.S. government, and near-term expiry dates of COVID-19 antibodies.\\nAcquired IPR&D and Development Milestones (See Note 3 to the consolidated condensed financial statements)\\n•We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges resulting from business development transactions with Rigel Pharmaceuticals, Inc. (Rigel) and Precision Biosciences, Inc. (Precision).\\nAsset Impairment, Restructuring, and Other Special Charges (See Note 5 to the consolidated condensed financial statements)\\n•We recognized charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza®, as well as acquisition and integration costs associated with the acquisition of Prevail Therapeutics Inc. (Prevail).\\nOther-Net, (Income) Expense (See Note 11 to the consolidated condensed financial statements)\\n•We recognized a debt extinguishment loss of $405.2 million related to the repurchase of debt for the three and nine months ended September 30, 2021.\\n•We recognized $246.8 million of net investment losses on equity securities for the three months ended September 30, 2021. We recognized $270.1 million of net investment gains on equity securities for the nine months ended September 30, 2021.\\n39\\nLate-Stage Pipeline\\nOur long-term success depends on our ability to continually discover or acquire, develop, and commercialize innovative new medicines. We currently have approximately 45 new medicine candidates in clinical development or under regulatory review, and a larger number of projects in the discovery phase.\\nThe following certain new molecular entities (NMEs) are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NMEs, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\\n| Compound | Indication | Status | Developments |\\n| Diabetes |\\n| Tirzepatide (Mounjaro) | Type 2 diabetes | Approved | Approved in the U.S. in the second quarter of 2022 and in Europe and Japan in the third quarter of 2022. |\\n| Heart failure with preserved ejection fraction | Phase III | Phase III trials are ongoing. |\\n| Obesity | Phase III | Granted FDA Fast Track designation(1) in October 2022. Announced in the second quarter of 2022 that the initial Phase III trial met co-primary and all key secondary endpoints. Phase III trials are ongoing. |\\n| Obstructive sleep apnea | Phase III | Phase III trial initiated in the third quarter of 2022. |\\n| Nonalcoholic steatohepatitis | Phase II | Phase II trial is ongoing. |\\n| Basal Insulin-Fc | Type 1 and 2 diabetes | Phase III | Phase III trials initiated in the first, second, and third quarters of 2022. |\\n| Orforglipron (GLP-1R NPA) | Obesity | Phase II | Phase II trials are ongoing. |\\n| Type 2 diabetes |\\n| Retatrutide (GGG Tri-Agonist) | Obesity | Phase II | Phase II trials are ongoing. |\\n| Type 2 diabetes |\\n| Immunology |\\n| Lebrikizumab(2) | Atopic dermatitis | Submitted | Granted FDA Fast Track designation(1). Submitted in the U.S. in the third quarter of 2022 and in Europe in October 2022. Phase III trials are ongoing. |\\n| Mirikizumab | Ulcerative colitis | Submitted | Submitted in the U.S. in first quarter of 2022 and in Europe and Japan in the second quarter of 2022. |\\n| Crohn's Disease | Phase III | Phase III trials are ongoing. |\\n| ANGPTL3 siRNA | Cardiovascular disease | Phase II | Phase II trial initiated in the third quarter of 2022. |\\n| BTLA MAB Agonist | Systemic lupus erythematosus | Phase II | Phase II trial initiated in the second quarter of 2022. |\\n| CXCR1/2 Ligands Monoclonal Antibody | Hidradenitis suppurativa | Phase II | Phase II trial is ongoing. |\\n| Peresolimab (PD-1 MAB Agonist) | Rheumatoid arthritis | Phase II | Phase II trial is ongoing. |\\n| Rezpegaldesleukin (IL-2 Conjugate) | Systemic lupus erythematosus | Phase II | Phase II trial is ongoing. |\\n\\n40\\n| Compound | Indication | Status | Developments |\\n| Neuroscience |\\n| Donanemab | Early Alzheimer's disease | Submitted | Granted FDA Breakthrough Therapy designation(3). Submitted in the U.S. in the second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trials are ongoing. |\\n| Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\\n| Remternetug | Early Alzheimer's disease | Phase III | Phase III trial initiated in the third quarter of 2022. |\\n| Solanezumab | Preclinical Alzheimer's disease | Phase III | Phase III trial is ongoing. |\\n| GBA1 Gene Therapy (PR001) | Parkinson's disease | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\\n| GRN Gene Therapy (PR006) | Frontotemporal dementia | Phase II | Granted FDA Fast Track designation(1). Phase II trial is ongoing. |\\n| O-GlcNAcase Inh | Alzheimer's disease | Phase II | Phase II trial is ongoing. |\\n| SSTR4 Agonist | Pain | Phase II | Phase II trials are ongoing. |\\n| TRPA1 Antagonist | Pain | Phase II | Phase II trials are ongoing. |\\n| PACAP38 Antibody | Migraine | Discontinued | In the third quarter of 2022 based on the results of the Phase II trial, we discontinued development. |\\n| Oncology |\\n| Selpercatinib (Retevmo®) | Lung cancer | Approved(4) | Phase III trials are ongoing. In the third quarter of 2022, the FDA granted accelerated approval in tumor-agnostic RET fusion-positive advanced or metastatic solid tumors and traditional approval in locally advanced or metastatic RET fusion-positive non-small cell lung cancer. |\\n| Thyroid cancer | Approved(4) | Phase III trial is ongoing. |\\n| Pirtobrutinib (LOXO-305) | Mantle cell lymphoma | Submitted | Submitted in the U.S. in second quarter of 2022. Received Priority Review designation under the accelerated approval pathway. Phase III trial is ongoing. |\\n| Chronic lymphocytic leukemia | Phase III | Phase III trials are ongoing. |\\n| B-cell malignancies | Phase II | Phase II trial is ongoing. |\\n| Imlunestrant | ER+HER2- metastatic breast cancer | Phase III | Phase III trial is ongoing. |\\n\\n(1) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\\n(2) In collaboration with Almirall, S.A. in Europe.\\n(3) Breakthrough Therapy designation is designed to expedite the development and review of potential medicines that are intended to treat a serious condition where preliminary clinical evidence indicates that the treatment may demonstrate substantial improvement over available therapy on a clinically significant endpoint.\\n(4) Continued approval may be contingent on verification and description of clinical benefit in confirmatory Phase III trials.\\n41\\nOur pipeline also contains several new indication line extension (NILEX) products. The following certain NILEX products for use in the indication described are currently in Phase II or Phase III clinical trials or have been submitted for regulatory review or have received regulatory approval in the U.S., Europe, or Japan. The following table reflects the status of these NILEX products, including certain other developments since our Annual Report on Form 10-K for the year ended December 31, 2021.\\n| Compound | Indication | Status | Developments |\\n| Diabetes |\\n| Empagliflozin (Jardiance®)(1) | Heart failure with preserved ejection fraction | Approved | Approved in the U.S. and Europe in the first quarter of 2022 and in Japan in the second quarter of 2022. |\\n| Chronic kidney disease | Phase III | Granted FDA Fast Track designation(2). In the first quarter of 2022 the Independent Data Monitoring Committee recommended stopping the Phase III trial early due to clear positive efficacy. |\\n| Immunology |\\n| Baricitinib (Olumiant®) | Alopecia areata | Approved | Approved in the U.S., Europe, and Japan in the second quarter of 2022. |\\n| COVID-19 | Approved | Approved in the U.S. in the second quarter of 2022. |\\n| Oncology |\\n| Abemaciclib (Verzenio®) | Prostate cancer | Phase III | Phase III trials are ongoing. |\\n\\n(1) In collaboration with Boehringer Ingelheim.\\n(2) Fast Track designation is designed to facilitate the development and expedite the review of medicines to treat serious conditions and fill an unmet medical need.\\nOther Matters\\nPatent Matters\\nWe depend on patents or other forms of intellectual property protection for most of our revenue, cash flows, and earnings.\\nFollowing the June 2021 loss of patent exclusivity for Alimta® in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. This decline in revenue has had and will have a material adverse effect on our consolidated results of operations and cash flows. See Note 9 to the consolidated condensed financial statements for a description of legal proceedings currently pending regarding certain of our patents.\\nOur compound patents for Humalog® (insulin lispro) have expired in the U.S. and major international markets, and we have also introduced lower-priced versions of Humalog as part of our insulin affordability solutions. A competitor has a similar version of insulin lispro in the U.S. and in certain European markets. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\\nOur formulation and use patents for Forteo® have expired in major markets. We expect further decline in revenue as a result of the entry of generic and biosimilar competition due to the loss of patent exclusivity in major markets.\\nForeign Currency Exchange Rates\\nAs a global company, we face foreign currency risk exposure from fluctuating currency exchange rates, primarily the U.S. dollar against the euro, Japanese yen, and Chinese yuan. While we seek to manage a portion of these exposures through hedging and other risk management techniques, significant fluctuations in currency rates can have a material impact, either positive or negative, on our consolidated results of operations in any given period. During the three and nine months ended September 30, 2022, revenue was unfavorably impacted by 4 percent and 3 percent, respectively, due to foreign exchange rates. While there is uncertainty in the future movements in foreign exchange rates, fluctuations in these rates have, and we currently expect in the near-term future will, adversely impact our consolidated results of operations and cash flows.\\n42\\nTrends Affecting Pharmaceutical Pricing, Reimbursement, and Access\\nGlobal concern over access to and affordability of pharmaceutical products continues to drive regulatory and legislative debate and action, as well as worldwide cost containment efforts by governmental authorities. Such measures include the use of mandated discounts, price reporting requirements, mandated reference prices, restrictive formularies, changes to available intellectual property protections, as well as other efforts. In August 2022, the U.S. government enacted the Inflation Reduction Act (IRA). Among other measures, the IRA will allow the U.S. Department of Health and Human Services to effectively set prices for certain single-source drugs and biologics reimbursed under Medicare Part B and Part D. Generally, these government prices apply nine (medicines approved under a New Drug Application) or thirteen (medicines approved under a Biologics License Application) years following initial FDA approval and will be capped at a statutory ceiling price that is likely to represent a significant discount from average prices to wholesalers and direct purchasers. It is too soon to tell how the U.S. government will set these prices as the law specifies a ceiling price, but not a minimum or floor price. One or more significant Lilly products may be selected, which would have the effect of accelerating revenue erosion prior to patent expiry. The effect of reducing prices and reimbursement for certain of our products could significantly impact our business and consolidated results of operations.\\nOther of the IRA’s provisions provide for penalties on drug manufacturers that increase prices of certain Medicare Part B and Part D medicines at a rate greater than the rate of inflation and replace the Part D coverage gap discount program with a new manufacturer discounting program. Manufacturers that fail to comply with the IRA may be subject to various penalties, including civil monetary penalties. The IRA takes effect progressively starting in 2023, with the first government set prices effective in 2026. The IRA may meaningfully influence our and pharmaceutical industry business strategies. In particular it may reduce the attractiveness of investment in small molecule innovation. Provisions of the IRA may be subject to legal challenges or other reformation, and the full effect of the IRA on our business and the pharmaceutical industry remains uncertain. Additional policies, regulations, legislation, or enforcement, including those proposed and/or pursued by the U.S. Congress and executive branch of the U.S. administration and other regulatory authorities worldwide, could adversely impact our business and consolidated results of operations.\\nConsolidation of private payors in the U.S. has also significantly impacted the market for pharmaceuticals by increasing payor leverage in negotiating manufacturer price concessions and pharmacy reimbursement rates. Furthermore, restrictive or unfavorable pricing, coverage, or reimbursement determinations for our medicines or product candidates by governments, regulatory agencies, courts, or private payers, such as the Centers for Medicare & Medicaid Services' National Coverage Determination for monoclonal antibodies for the treatment of Alzheimer's Disease, may adversely impact our business and consolidated results of operations. We expect that these actions may intensify and could particularly affect certain products, such as insulin, as governments manage and emerge from the COVID-19 pandemic, which could adversely affect our business. In addition, we are engaged in litigation and investigations related to our 340B program and access to insulin that, if resolved adversely to us, could negatively impact our business and consolidated results of operations. It is not currently possible to predict the overall potential adverse impact to us or the general pharmaceutical industry of continued cost containment efforts worldwide.\\nEvolving regulatory priorities have also intensified governmental scrutiny of our operations and our industry, including with respect to current Good Manufacturing Practices, quality assurance, and similar regulations, and increased focus on business combinations in our industry. Any regulatory issues concerning these matters could lead to regulatory and legal actions, product recalls and seizures, fines and penalties, interruption of production leading to product shortages, import bans or denials of import certifications, delays or denials in the approvals of new products or supplemental approvals of current products pending resolution of the issues, impediments to the completion of business combinations, and reputational harm, any of which would adversely affect our business.\\nSee \\\"Business - Regulations and Private Payer Actions Affecting Pharmaceutical Pricing, Reimbursement, and Access\\\" in Part I, Item 1 and \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 9 to the consolidated condensed financial statements.\\n43\\nTax Matters\\nWe are subject to income taxes and various other taxes in the U.S. and in many foreign jurisdictions; therefore, changes in both domestic and international tax laws or regulations have affected and may affect our effective tax rate, results of operations, and cash flows. In 2017, the U.S. enacted the Tax Cuts and Jobs Act (the 2017 Tax Act), which contains a provision that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022. Previously, these expenses could be deducted in the year incurred. The implementation of this provision has increased, and is expected to continue to increase, our 2022 cash payments of income taxes and subsequently decrease our cash payments of income taxes moderately over the five-year amortization period. We expect the implementation of this provision to impact our 2022 cash payments of income taxes by up to $1.50 billion. For the three and nine months ended September 30, 2022, the implementation of this provision favorably impacted other tax items that decreased our effective tax rate by approximately 4 percentage points. If this provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022, we expect our effective tax rate to be approximately 13 percent to 14 percent for 2022.\\nThe U.S. and countries around the world are actively considering and enacting tax law changes. Tax proposals have been introduced by the U.S. Congress and the U.S. administration containing significant changes, including increases to the tax rates at which both domestic and foreign income of U.S. companies would be taxed. In addition, tax authorities in the U.S. and other jurisdictions in which we do business routinely examine our tax returns and are intensifying their scrutiny and examinations of profit allocations among jurisdictions. Further, actions taken with respect to tax-related matters by associations, such as the Organisation for Economic Co-operation and Development and the European Commission, could influence tax laws in countries in which we operate. Changes to existing tax law and increased scrutiny by tax authorities in the U.S. and other jurisdictions could adversely impact our future consolidated results of operations and cash flows.\\nAcquisitions\\nWe opportunistically invest in external research and technologies that we believe complement and strengthen our own efforts. These investments can take many forms, including acquisitions, collaborations, investments, and licensing arrangements. We view our business development activity as a way to enhance our pipeline and strengthen our business.\\nSee Note 3 to the consolidated condensed financial statements for further discussion regarding our recent acquisitions.\\n44\\nRevenue\\nThe following table summarizes our revenue activity by region:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | Percent Change | 2022 | 2021 | Percent Change |\\n| U.S. | $ | 4,422.1 | $ | 3,989.6 | 11 | $ | 13,531.5 | $ | 11,635.1 | 16 |\\n| Outside U.S. | 2,519.4 | 2,783.3 | (9) | 7,708.1 | 8,683.4 | (11) |\\n| Revenue | $ | 6,941.6 | $ | 6,772.8 | 2 | $ | 21,239.6 | $ | 20,318.5 | 5 |\\n\\nNumbers may not add due to rounding.\\nThe following are components of the change in revenue compared with the prior year:\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 vs. 2021 | 2022 vs. 2021 |\\n| U.S. | Outside U.S. | Consolidated | U.S. | Outside U.S. | Consolidated |\\n| Volume | 15 | % | 13 | % | 14 | % | 20 | % | 7 | % | 15 | % |\\n| Price | (4) | (12) | (7) | (4) | (11) | (7) |\\n| Foreign exchange rates | — | (11) | (4) | — | (7) | (3) |\\n| Percent change | 11 | % | (9) | % | 2 | % | 16 | % | (11) | % | 5 | % |\\n\\nNumbers may not add due to rounding.\\nIn the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by COVID-19 antibodies, Trulicity, Verzenio, Jardiance, Taltz®, and Mounjaro, partially offset by decreased volume for Alimta, resulting from the entry of multiple generics in the second quarter of 2022, and for Olumiant, due to the decline in utilization for COVID-19 treatment. In the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by Humalog, due to a list price reduction of insulin lispro injection and unfavorable segment mix, and by Trulicity, due to unfavorable segment mix and higher contracted rebates. In the U.S. for the three months ended September 30, 2022, the decrease in realized prices for Trulicity was partially offset by changes to estimates for rebates and discounts.\\nOutside the U.S. for the three and nine months ended September 30, 2022, the increase in volume was primarily driven by Verzenio, Trulicity, Tyvyt®, Jardiance, and Taltz, partially offset by Alimta and Cymbalta® resulting from generic competition. Additionally outside the U.S. for the three and nine months ended September 30, 2022, we recognized revenue related to a sales collaboration agreement for the right to sell and distribute Mounjaro in Japan. Outside the U.S. for the nine months ended September 30, 2022, the increase in volume was also partially offset by decreased sales of COVID-19 antibodies and the sale of the rights to Cialis® in China in the second quarter of 2021. Outside the U.S. for the three and nine months ended September 30, 2022, the decrease in realized prices was primarily driven by the impact of government pricing in China from the National Reimbursement Drug List (NRDL) formulary for certain products, particularly Tyvyt and Verzenio, and volume-based procurement (VBP) for Humalog.\\n45\\n| Three Months Ended September 30, |\\n| 2022 | 2021 |\\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\\n| Trulicity | $ | 1,418.3 | $ | 432.0 | $ | 1,850.4 | $ | 1,600.1 | 16 |\\n| Taltz | 493.8 | 186.1 | 679.9 | 593.1 | 15 |\\n| Verzenio | 414.8 | 202.9 | 617.7 | 335.5 | 84 |\\n| Jardiance(1) | 350.9 | 222.4 | 573.3 | 390.4 | 47 |\\n| Humalog(2) | 248.1 | 198.8 | 447.0 | 626.7 | (29) |\\n| COVID-19 antibodies(3) | 386.6 | — | 386.6 | 217.1 | 78 |\\n| Humulin® | 169.5 | 68.7 | 238.2 | 286.7 | (17) |\\n| Cyramza® | 87.5 | 144.6 | 232.1 | 253.4 | (8) |\\n| Basaglar® | 124.8 | 68.1 | 193.0 | 192.8 | — |\\n| Mounjaro | 97.3 | 90.0 | 187.3 | — | NM |\\n| Olumiant(4) | 22.9 | 160.0 | 182.9 | 406.9 | (55) |\\n| Forteo | 112.7 | 64.4 | 177.1 | 200.9 | (12) |\\n| Emgality® | 114.0 | 54.6 | 168.5 | 140.0 | 20 |\\n| Erbitux® | 126.3 | 18.7 | 144.9 | 134.3 | 8 |\\n| Alimta | 64.6 | 54.8 | 119.4 | 457.0 | (74) |\\n| Cialis | 8.1 | 107.7 | 115.7 | 130.9 | (12) |\\n| Zyprexa® | 8.0 | 73.4 | 81.4 | 101.7 | (20) |\\n| Tyvyt | — | 76.8 | 76.8 | 125.6 | (39) |\\n| Cymbalta | 7.8 | 54.9 | 62.7 | 132.0 | (53) |\\n| Other products | 166.1 | 240.5 | 406.7 | 447.7 | (9) |\\n| Revenue | $ | 4,422.1 | $ | 2,519.4 | $ | 6,941.6 | $ | 6,772.8 | 2 |\\n\\nNumbers may not add due to rounding.\\nNM - not meaningful\\n(1) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.\\n(2) Humalog revenue includes insulin lispro.\\n(3) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\\n46\\n| Nine Months Ended September 30, |\\n| 2022 | 2021 |\\n| Product | U.S. | Outside U.S. | Total | Total | Percent Change |\\n| Trulicity | $ | 4,162.4 | $ | 1,341.1 | $ | 5,503.5 | $ | 4,588.2 | 20 |\\n| COVID-19 antibodies(1) | 1,970.9 | 14.7 | 1,985.5 | 1,176.2 | 69 |\\n| Taltz | 1,212.6 | 561.6 | 1,774.2 | 1,565.4 | 13 |\\n| Verzenio | 1,100.5 | 575.1 | 1,675.6 | 945.8 | 77 |\\n| Humalog(2) | 855.8 | 656.4 | 1,512.3 | 1,851.3 | (18) |\\n| Jardiance(3) | 831.4 | 622.4 | 1,453.7 | 1,058.9 | 37 |\\n| Humulin | 562.3 | 223.1 | 785.4 | 923.8 | (15) |\\n| Cyramza | 259.3 | 434.3 | 693.6 | 762.5 | (9) |\\n| Alimta | 490.5 | 200.5 | 691.1 | 1,626.6 | (58) |\\n| Olumiant(4) | 104.6 | 520.1 | 624.7 | 809.1 | (23) |\\n| Basaglar | 339.9 | 218.8 | 558.7 | 650.1 | (14) |\\n| Cialis | 25.8 | 454.7 | 480.4 | 538.7 | (11) |\\n| Emgality | 330.8 | 144.4 | 475.2 | 415.7 | 14 |\\n| Forteo | 261.4 | 191.7 | 453.0 | 617.8 | (27) |\\n| Erbitux | 361.0 | 47.4 | 408.3 | 403.7 | 1 |\\n| Zyprexa | 26.2 | 235.5 | 261.7 | 292.8 | (11) |\\n| Tyvyt | — | 235.8 | 235.8 | 340.2 | (31) |\\n| Cymbalta | 25.0 | 194.3 | 219.3 | 484.3 | (55) |\\n| Mounjaro | 109.9 | 93.3 | 203.2 | — | NM |\\n| Other products | 501.1 | 743.0 | 1,244.2 | 1,267.3 | (2) |\\n| Revenue | $ | 13,531.5 | $ | 7,708.1 | $ | 21,239.6 | $ | 20,318.5 | 5 |\\n\\nNumbers may not add due to rounding.\\nNM - not meaningful\\n(1) COVID-19 antibodies include sales for bamlanivimab administered alone, for bamlanivimab and etesevimab administered together, and for bebtelovimab and were made pursuant to EUAs or similar regulatory authorizations.\\n(2) Humalog revenue includes insulin lispro.\\n(3) Jardiance revenue includes Glyxambi, Synjardy, and Trijardy XR.\\n(4) Olumiant revenue includes sales for baricitinib that were made pursuant to EUA or similar regulatory authorizations.\\nRevenue of Trulicity, a treatment for type 2 diabetes and to reduce the risk of major adverse cardiovascular events in adult patients with type 2 diabetes and established cardiovascular disease or multiple cardiovascular risk factors, increased 18 percent in the U.S. during the three months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices. The lower realized prices in the U.S. for the three months ended September 30, 2022 were due to unfavorable segment mix and higher contracted rebates, partially offset by changes to estimates for rebates and discounts. Revenue in the U.S. increased 20 percent during the nine months ended September 30, 2022, driven by increased demand, partially offset by lower realized prices due to unfavorable segment mix and higher contracted rebates. Revenue outside the U.S. increased 8 percent and 19 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates and, to a lesser extent, lower realized prices.\\n47\\nRevenue of COVID-19 antibodies, treatments for mild to moderate COVID-19 for higher-risk patients and for post-exposure prophylaxis in certain individuals for the prevention of SARS-CoV-2 infection, was $386.6 million and $1.97 billion in the U.S. during the three and nine months ended September 30, 2022, respectively. Revenue outside the U.S. was not material during the three and nine months ended September 30, 2022. The availability of superior or competitive therapies, including therapies that can be administered more easily, or preventative measures, such as vaccines, coupled with the unpredictable nature of pandemics, have and could further negatively impact or eliminate demand for these COVID-19 antibodies. The FDA has revised, and may in the future revise, any EUA for our COVID-19 antibodies in response to the prevalence of variants against which our antibodies have varying degrees of efficacy, including the new BQ variants. Based on early data, we do not believe that bebtelovimab will neutralize against the new BQ variants. We supplied the U.S. government approximately 810,000 doses of bebtelovimab during the nine months ended September 30, 2022. Beginning in the third quarter of 2022 and in collaboration with the U.S. government, we have made bebtelovimab commercially available for purchase by U.S. states/territories, hospitals, and certain other providers. We do not anticipate any further U.S. government orders.\\nRevenue of Taltz, a treatment for moderate-to-severe plaque psoriasis, active psoriatic arthritis, ankylosing spondylitis, and active non-radiographic axial spondyloarthritis, increased 17 percent and 13 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices. Revenue outside the U.S. increased 9 percent and 14 percent during the three and nine months ended September 30, 2022, respectively, driven by increased volume, partially offset by unfavorable impact of foreign exchange rates and lower realized prices.\\nRevenue of Verzenio, a treatment for HR+, HER2- metastatic breast cancer and high risk early breast cancer, increased $215.1 million and $518.4 million in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. Revenue outside the U.S. increased 49 percent and 58 percent during the three and nine months ended September 30, 2022, respectively, driven by increased demand, partially offset by lower realized prices due to the impact of the NRDL formulary in China and the unfavorable impact of foreign exchange rates.\\nRevenue of Humalog, an injectable human insulin analog for the treatment of diabetes, decreased 29 percent and 15 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to a list price reduction of insulin lispro injection and unfavorable segment mix. Revenue outside the U.S. decreased 29 percent and 22 percent during the three and nine months ended September 30, 2022, respectively, driven by lower realized prices due to the impact of VBP in China and the unfavorable impact of foreign exchange rates. Due to the impact of competition and pricing pressure in the U.S. and some international markets, we expect that lower revenue due to realized price decline will continue over time.\\nRevenue of Jardiance, a treatment for type 2 diabetes, to reduce the risk of cardiovascular death in adult patients with type 2 diabetes and established cardiovascular disease, and to reduce the risk of cardiovascular death and hospitalization for heart failure in adults with heart failure, regardless of left ventricular ejection fraction, increased 59 percent and 47 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand. The increase in revenue in the U.S. during the three months ended September 30, 2022 was also driven by changes to estimates for rebates and discounts. Revenue outside the U.S. increased 31 percent and 26 percent during the three and nine months ended September 30, 2022, respectively, primarily driven by increased demand, partially offset by the unfavorable impact of foreign exchange rates. See Note 4 to the consolidated condensed financial statements for information regarding our collaboration with Boehringer Ingelheim involving Jardiance.\\nRevenue of Alimta, a treatment for various cancers, decreased 78 percent and 46 percent in the U.S. during the three and nine months ended September 30, 2022, respectively, primarily driven by decreased demand due to the entry of multiple generics in the second quarter of 2022. Revenue outside the U.S. decreased 66 percent and 72 percent during the three and nine months ended September 30, 2022, respectively, largely driven by decreased demand due to generic competition. Following the June 2021 loss of patent exclusivity for Alimta in Europe and Japan, we faced, and expect to continue to face, generic competition that has rapidly and severely eroded revenue, and we expect will continue to erode revenue from current levels. In addition, as a result of the entry of multiple generics in the U.S. following the loss of patent and pediatric exclusivity in May 2022, we began facing, and expect to continue to face, additional generic competition that has eroded revenue, and we expect will continue to rapidly and severely erode revenue from current levels. See \\\"Executive Overview - Other Matters- Patent Matters\\\" for additional information.\\n48\\nGross Margin, Costs, and Expenses\\nGross margin as a percent of revenue decreased 1.6 percentage points to 77.3 percent and increased 2.0 percentage points to 76.1 percent for the three and nine months ended September 30, 2022, respectively. The decrease in the gross margin percent for the three months ended September 30, 2022 was primarily driven by a benefit in the gross margin for the three months ended September 30, 2021 due to the partial reversal of inventory impairment charges related to our COVID-19 antibodies that were recognized in the first and second quarters of 2021. The partial reversal of inventory impairment charges related to our COVID-19 antibodies was driven by an unexpected increase in our COVID-19 antibodies sales as the COVID-19 pandemic evolved during the third quarter of 2021. The increase in gross margin percent for the nine months ended September 30, 2022 was primarily driven by a net inventory impairment charge related to our COVID-19 antibodies recognized in 2021. Additionally, for the three and nine months ended September 30, 2022, lower realized prices and increased expenses due to inflation and logistics costs were offset by favorable product mix, including the impact of lower sales of Olumiant for the treatment of COVID-19, and the favorable impact of foreign exchange rates.\\nResearch and development expenses increased 6 percent to $1.80 billion and 3 percent to $5.19 billion for the three and nine months ended September 30, 2022, respectively, primarily driven by higher development expenses for late-stage assets, partially offset by lower development expenses for COVID-19 antibodies and the favorable impact of foreign exchange rates.\\nMarketing, selling, and administrative expenses increased 2 percent to $1.61 billion for the three months ended September 30, 2022, primarily driven by increased costs associated with the launch of Mounjaro, partially offset by the favorable impact of foreign exchange rates. Marketing, selling, and administrative expenses decreased 1 percent to $4.80 billion for the nine months ended September 30, 2022, primarily driven by the favorable impact of foreign exchange rates as well as reduced marketing costs in the first half of 2022, partially offset by increased costs associated with the launch of Mounjaro.\\nWe plan to take compensatory actions to improve retention and address wage inflation which will impact our costs and consolidated results of operations.\\nWe recognized $62.4 million and $668.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2022, respectively. The charges for the nine months ended September 30, 2022 included the buy-out of substantially all future obligations that were contingent upon the occurrence of certain events linked to the success of our mutant-selective PI3kα inhibitor and a purchase of a Priority Review Voucher. We recognized $177.6 million and $532.4 million of acquired IPR&D and development milestones for the three and nine months ended September 30, 2021, respectively. The charges for the nine months ended September 30, 2021 included acquired IPR&D charges from business development transactions with Rigel and Precision. See Note 3 to the consolidated condensed financial statements for additional information.\\nWe recognized asset impairment, restructuring, and other special charges of $206.5 million for the three and nine months ended September 30, 2022, primarily related to an intangible asset impairment for GBA1 Gene Therapy (PR001) due to changes in estimated launch timing. There were no asset impairment, restructuring, and other special charges recognized for the three months ended September 30, 2021. We recognized asset impairment, restructuring, and other special charges of $211.6 million for the nine months ended September 30, 2021, primarily related to an intangible asset impairment resulting from the sale of the rights to Qbrexza, as well as acquisition and integration costs associated with the acquisition of Prevail. See Note 5 to the consolidated condensed financial statements for additional information.\\nOther–net, (income) expense was expense of $111.0 million and $580.9 million for the three and nine months ended September 30, 2022, respectively, compared with expense of $635.9 million and $124.3 million for the three and nine months ended September 30, 2021, respectively. The decrease in other expense for the three months ended September 30, 2022 was primarily driven by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021, as well as lower net investment losses on equity securities in 2022 compared to 2021. The increase in other expense for the nine months ended September 30, 2022 was primarily driven by net investment losses on equity securities in 2022 compared with net investment gains on equity securities in 2021, partially offset by a debt extinguishment loss of $405.2 million related to the repurchase of debt in 2021.\\n49\\nThe effective tax rates were 7.3 percent and 8.6 percent for the three and nine months ended September 30, 2022, respectively, reflecting the favorable tax impact of the implementation of a provision in the 2017 Tax Act that requires capitalization and amortization of research and development expenses for tax purposes starting in 2022, net investment losses on equity securities, and an intangible asset impairment charge. We expect our effective tax rate to be approximately 13 percent to 14 percent for 2022 if the capitalization and amortization of research and development expenses provision of the 2017 Tax Act is deferred or repealed by the U.S. Congress effective for 2022.\\nThe effective tax rate was 10.9 percent for the three months ended September 30, 2021, reflecting the favorable tax impact of a debt extinguishment loss and of net investment losses on equity securities, partially offset by a net discrete tax detriment. The effective tax rate was 10.7 percent for the nine months ended September 30, 2021, reflecting the favorable tax impact of a net discrete tax benefit, a debt extinguishment loss, and a net inventory impairment charge related to our COVID-19 antibodies.\\nFinancial Condition and Liquidity\\nWe believe our available cash and cash equivalents, together with our ability to generate operating cash flow and our access to short-term and long-term borrowings, are sufficient to fund our existing and planned capital requirements. For a discussion of our capital requirements, see \\\"Management's Discussion and Analysis of Results of Operations and Financial Condition\\\" in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2021.\\nWe plan to invest more than $2 billion over several years in two new facilities in Lebanon, Indiana to manufacture existing and future products and more than $1 billion over several years in a new facility in Concord, North Carolina to manufacture parenteral (injectable) products and devices. We plan to invest more than 400 million euro over several years in a new facility in Limerick, Ireland to expand our manufacturing network for biologic active ingredients. These investments, and other capital investments that support our operations, will result in capital expenditures being higher than recent historical levels for the next several years.\\nCash and cash equivalents decreased to $2.62 billion as of September 30, 2022, compared with $3.82 billion as of December 31, 2021. Refer to the consolidated condensed statements of cash flows for additional information on the significant sources and uses of cash for the nine months ended September 30, 2022 and 2021.\\nIn addition to our cash and cash equivalents, we held total investments of $2.70 billion and $3.30 billion as of September 30, 2022 and December 31, 2021, respectively. See Note 6 to the consolidated condensed financial statements for additional information.\\nAs of September 30, 2022, total debt was $15.89 billion, a decrease of $996.3 million compared with $16.88 billion as of December 31, 2021. See Note 6 to the consolidated condensed financial statements for additional information.\\nAs of September 30, 2022, we had a total of $7.26 billion of unused committed bank credit facilities, $7.00 billion of which is available to support our commercial paper program. We believe that amounts accessible through existing commercial paper markets should be adequate to fund short-term borrowing needs.\\nDuring the nine months ended September 30, 2022, we repurchased $1.50 billion of shares under our $5.00 billion share repurchase program authorized in May 2021. As of September 30, 2022, we had $3.25 billion remaining under this program.\\nDuring the nine months ended September 30, 2022, we paid dividends of $2.65 billion, or $2.94 per share, to our shareholders. In October 2022, we declared a dividend for the fourth quarter of 2022 of $0.98 per share on outstanding common stock. The dividend of approximately $882 million is payable on December 9, 2022 to shareholders of record at the close of business on November 15, 2022.\\nSee \\\"Executive Overview - Other Matters - Patent Matters\\\" for information regarding recent losses of patent protection.\\nBoth domestically and abroad, we continue to monitor the potential impacts of the economic environment; the creditworthiness of our wholesalers and other customers, including foreign government-backed agencies and suppliers; the uncertain impact of health care legislation; various international government funding levels; and fluctuations in interest rates, foreign currency exchange rates (see \\\"Executive Overview - Other Matters - Foreign Currency Exchange Rates\\\"), and fair values of equity securities.\\n50\\nCritical Accounting Estimates\\nFor a discussion of our critical accounting estimates, refer to \\\"Management's Discussion and Analysis of Results of Operations and Financial Condition\\\" in Part II, Item 7 and the notes to our consolidated financial statements in Part II, Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2021. See also Note 1 to the consolidated condensed financial statements. There have been no material changes to our critical accounting estimates since our Annual Report on Form 10-K for the year ended December 31, 2021.\\nAvailable Information on our Website\\nWe make available through our company website, free of charge, our company filings with the Securities and Exchange Commission (SEC) as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. The reports we make available include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, registration statements, and any amendments to those documents.\\nThe website link to our SEC filings is investor.lilly.com/financial-information/sec-filings.\\nWe routinely post important information for investors in the “Investors” section of our website, www.lilly.com. We may use our website as a means of disclosing material, non-public information and for complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor the “Investors” section of our website, in addition to following our press releases, filings with the SEC, public conference calls, presentations, and webcasts. We may also use social media channels to communicate with investors and the public about our business, products and other matters, and those communications could be deemed to be material information. The information contained on, or that may be accessed through, our website or social media channels, is not incorporated by reference into, and is not a part of, this Quarterly Report on Form 10-Q.\\n51\\nItem 4. Controls and Procedures\\n(a)Evaluation of Disclosure Controls and Procedures. Under applicable Securities and Exchange Commission (SEC) regulations, management of a reporting company, with the participation of the principal executive officer and principal financial officer, must periodically evaluate the company's \\\"disclosure controls and procedures,\\\" which are defined generally as controls and other procedures of a reporting company designed to ensure that information required to be disclosed by the reporting company in its periodic reports filed with the SEC (such as this Quarterly Report on Form 10-Q) is recorded, processed, summarized, and reported on a timely basis.\\nOur management, with the participation of David A. Ricks, president and chief executive officer, and Anat Ashkenazi, executive vice president and chief financial officer, evaluated our disclosure controls and procedures (as such terms are defined in our Annual Report on Form 10-K for the year ended December 31, 2021) as of September 30, 2022, and concluded that they were effective.\\n(b)Changes in Internal Controls. During the third quarter of 2022, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n52\\nPART II. Other Information\\nItem 1. Legal Proceedings\\nWe are a party to various currently pending legal actions, government investigations, and environmental proceedings. See Note 9 to the consolidated condensed financial statements for information on various legal proceedings.\\nThis Item should be read in conjunction with \\\"Legal Proceedings\\\" in Part I, Item 3 of our Annual Report on Form 10-K for the year ended December 31, 2021.\\nItem 1A. Risk Factors\\nOur material risk factors are disclosed in \\\"Risk Factors\\\" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2021. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2021.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nInformation relating to the principal market for our common stock and related shareholder matters is described in \\\"Management's Discussion and Analysis of Results of Operations and Financial Condition\\\" in Part II, Item 7 and in \\\"Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\\\" in Part III, Item 12 of our Annual Report on Form 10-K for the year ended December 31, 2021.\\nThe following table summarizes the activity related to repurchases of our equity securities during the three months ended September 30, 2022:\\n| Period | Total Number ofShares Purchased(in thousands) | Average Price Paid per Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(in thousands) | Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (in millions) |\\n| July 2022 | — | $ | — | — | $ | 3,250.0 |\\n| August 2022 | — | — | — | 3,250.0 |\\n| September 2022 | — | — | — | 3,250.0 |\\n| Total | — | — | — |\\n\\nDuring the three months ended September 30, 2022, we did not repurchase any shares under our $5.00 billion share repurchase program authorized in May 2021.\\n53\\nItem 6. Exhibits\\nThe following documents are filed as a part of this Quarterly Report:\\n| Exhibit | Description |\\n| EXHIBIT 3.1 | Amended Articles of Incorporation are incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\\n| EXHIBIT 3.2 | Bylaws, as amended, are incorporated by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K filed on May 4, 2022 |\\n| EXHIBIT 10.1 | Form of Performance Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\\n| EXHIBIT 10.2 | Form of Shareholder Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\\n| EXHIBIT 10.3 | Form of Relative Value Award under the 2002 Lilly Stock Plan (with non-compete)(1) |\\n| EXHIBIT 31.1 | Rule 13a-14(a) Certification of David A. Ricks, Chair, President, and Chief Executive Officer |\\n| EXHIBIT 31.2 | Rule 13a-14(a) Certification of Anat Ashkenazi, Executive Vice President and Chief Financial Officer |\\n| EXHIBIT 32. | Section 1350 Certification |\\n| EXHIBIT 101. | Interactive Data Files (embedded within the Inline XBRL document) |\\n| EXHIBIT 104. | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\nLong-term debt instruments under which the total amount of securities authorized does not exceed 10 percent of our consolidated assets are not filed as exhibits to this Quarterly Report. We will furnish a copy of these agreements to the Securities and Exchange Commission upon request.\\nSignatures\\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| ELI LILLY AND COMPANY |\\n| (Registrant) |\\n| Date: | November 1, 2022 | /s/ Anat Ashkenazi |\\n| Anat Ashkenazi |\\n| Executive Vice President and Chief Financial Officer |\\n| Date: | November 1, 2022 | /s/ Donald A. Zakrowski |\\n| Donald A. Zakrowski |\\n| Senior Vice President, Finance, and Chief Accounting Officer |\\n\\n54\\n</text>\\n\\nWhat is the difference in net income as a percentage of cash provided by operating activities between the years 2022 and 2021 in percentages?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 2.7062535908033993.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 40,\n \"input_length\": 45623\n}"}}},{"rowIdx":41,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements (unaudited).\n4\nEmbark Technology, Inc.\nCondensed Consolidated Balance Sheets\n(in thousands, except share and per share data)\n(unaudited)\n| March 31,2022 | December 31,2021 |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 244,488 | $ | 264,615 |\n| Restricted cash, short-term | 65 | 130 |\n| Prepaid expenses and other current assets | 12,005 | 12,746 |\n| Total current assets | 256,558 | 277,491 |\n| Restricted cash, long-term | 812 | 275 |\n| Property, equipment and software, net | 11,086 | 9,637 |\n| Operating lease right-of-use assets | 6,099 | — |\n| Other assets | 3,722 | 3,596 |\n| Total assets | $ | 278,277 | $ | 290,999 |\n| Liabilities and stockholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 4,099 | $ | 2,497 |\n| Accrued expenses and other current liabilities | 6,151 | 3,142 |\n| Current portion of operating lease liabilities | 1,948 | — |\n| Short-term notes payable | 357 | 358 |\n| Total current liabilities | 12,555 | 5,997 |\n| Long-term notes payable | 641 | 722 |\n| Warrant liability | 27,264 | 49,419 |\n| Non-current portion of operating lease liabilities | 4,438 | — |\n| Other long-term liability | 111 | 50 |\n| Long-term deferred rent | — | 177 |\n| Total liabilities | 45,009 | 56,365 |\n| Commitments and contingencies (Note 10) |\n| Stockholders’ equity: |\n| Preferred stock, $ 0.0001 par value; 10,000,000 shares authorized, none issued and none outstanding as of March 31, 2022 and December 31, 2021 | — | — |\n| Class A common stock, $ 0.0001 par value; 4,000,000,000 shares authorized, 362,832,986 shares issued as of March 31, 2022; 4,000,000,000 shares authorized, 362,832,986 shares issued as of December 31, 2021 | 36 | 36 |\n| Class B common stock, $ 0.0001 par value; 100,000,000 shares authorized, 87,078,981 shares issued as of March 31, 2022 and December 31, 2021 | 9 | 9 |\n| Additional paid-in capital | 434,573 | 417,492 |\n| Accumulated deficit | ( 201,350 ) | ( 182,903 ) |\n| Total stockholders’ equity | 233,268 | 234,634 |\n| Total liabilities and stockholders’ equity | $ | 278,277 | $ | 290,999 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n5\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Operations\n(in thousands, except share and per share data)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Operating expenses: |\n| Research and development | $ | 18,695 | $ | 6,231 |\n| General and administrative | 21,926 | 2,290 |\n| Total operating expenses | 40,621 | 8,521 |\n| Loss from operations | ( 40,621 ) | ( 8,521 ) |\n| Other income (expense): |\n| Change in fair value of warrant liability | 22,156 | — |\n| Other income | 26 | 9 |\n| Interest income | 13 | 30 |\n| Interest expense | ( 21 ) | — |\n| Loss before provision for income taxes | ( 18,447 ) | ( 8,482 ) |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss attributable to common stockholders, basic and diluted | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss per share attributable to common stockholders: |\n| Basic and diluted, Class A and Class B | $ | ( 0.04 ) | $ | ( 0.18 ) |\n| Weighted-average shares used in computing net loss per share attributable to common stockholders: |\n| Basic and diluted | 452,623,022 | 47,538,331 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n6\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Comprehensive Loss\n(in thousands)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Other comprehensive loss (net of tax): |\n| Unrealized losses on available-for-sale securities, net | — | ( 19 ) |\n| Comprehensive loss | $ | ( 18,447 ) | $ | ( 8,501 ) |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n7\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\n(in thousands, except number of shares)\n(unaudited)\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balance at January 1, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 417,492 | $ | ( 182,903 ) | $ | — | $ | 234,634 |\n| Shares issued upon exercise of stock options | — | — | — | — | — | — | — | — | — | — | — | 372 | — | — | 372 |\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 11 | — | — | 11 |\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 16,698 | — | — | 16,698 |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 18,447 ) | — | ( 18,447 ) |\n| Balance at March 31, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 434,573 | $ | ( 201,350 ) | $ | — | $ | 233,268 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n8\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\n(in thousands, except number of shares)\n(unaudited)\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balance at January 1, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 141,216,455 | $ | — | — | $ | — | — | $ | — | — | $ | 129,449 | $ | ( 58,690 ) | $ | 45 | $ | 70,805 |\n| Shares issued upon exercise of stock options | — | — | — | — | 1,244,349 | — | — | — | — | — | — | 94 | — | — | 94 |\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 5 | — | — | 5 |\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 598 | — | — | 598 |\n| Issuance of common stock warrants | — | — | — | — | — | — | — | — | — | — | — | 83 | — | — | 83 |\n| Other comprehensive loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 19 ) | ( 19 ) |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 8,482 ) | — | ( 8,482 ) |\n| Balance at March 31, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 142,460,804 | $ | — | — | $ | — | — | $ | — | — | $ | 130,229 | $ | ( 67,172 ) | $ | 26 | $ | 63,084 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n9\nEmbark Technology, Inc.\nCondensed Consolidated Statements of Cash Flows\n(in thousands)\n(unaudited)\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Cash flows from operating activities |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation and amortization | 383 | 222 |\n| Amortization expense - right-of-use assets - operating leases | 488 | — |\n| Stock-based compensation, net of amounts capitalized | 16,602 | 562 |\n| Issuance of warrants for services | — | 83 |\n| Change in fair value of warrants | ( 22,156 ) | — |\n| Net amortization of premiums and accretion of discounts on investments | — | 120 |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses and other current assets | 682 | 29 |\n| Other assets | ( 126 ) | ( 65 ) |\n| Accounts payable | 1,644 | 264 |\n| Other long-term liabilities | 60 | — |\n| Accrued expenses and other current liabilities | 2,645 | 476 |\n| Net cash used in operating activities | ( 18,225 ) | ( 6,791 ) |\n| Cash flows from investing activities |\n| Maturities of investments | — | 18,243 |\n| Purchase of property, equipment and software | ( 1,717 ) | ( 973 ) |\n| Net cash provided by (used in) investing activities | ( 1,717 ) | 17,270 |\n| Cash flows from financing activities |\n| Payment towards notes payable | ( 81 ) | ( 66 ) |\n| Proceeds from exercise of stock options | 372 | 94 |\n| Repurchase of early exercised stock options | ( 4 ) | — |\n| Net cash provided by (used in) financing activities | 287 | 28 |\n| Net increase (decrease) in cash, cash equivalents and restricted cash | ( 19,655 ) | 10,507 |\n| Cash, cash equivalents and restricted cash at beginning of period | 265,020 | 11,460 |\n| Cash, cash equivalents and restricted cash at end of period | $ | 245,365 | $ | 21,967 |\n| Supplemental disclosures of cash flow information: |\n| Cash paid during the year for interest | $ | 18 | $ | 16 |\n| Supplemental schedule of noncash investing and financing activities |\n| Acquisition of property, equipment and software in accounts payable | $ | 284 | $ | 176 |\n| Acquisition of trucks by assuming notes payable | $ | — | $ | 278 |\n| Right-of-use assets obtained in exchange for lease obligations | $ | 6,587 | $ | — |\n| Stock-based compensation capitalized into internally developed software | $ | 156 | $ | 36 |\n| Vesting of early exercised stock options | $ | 15 | $ | 5 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n10\nNotes to Condensed Consolidated Financial Statements\n1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION\nEmbark Technology, Inc. was originally incorporated in Delaware on September 25, 2020 under the name Northern Genesis Acquisition Corp. II (“NGA”). The Company was formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On November 10, 2021 (the “Closing Date”), the Company (at such time named Northern Genesis Acquisition Corp. II) consummated the business combination (the “Business Combination”) pursuant to the Agreement and Plan of Merger, dated June 22, 2021 with the pre-Business Combination company, Embark Trucks, Inc. (“Embark Trucks”). In connection with the consummation of the Business Combination, the Company changed its name from Northern Genesis Acquisition Corp. II to Embark Technology, Inc. and became the parent entity of Embark Trucks.\nThe Merger was accounted for as a reverse recapitalization with Embark as the accounting acquirer and NGA as the acquired company for accounting purposes. Accordingly, all historical financial information presented in the financial statements represent the accounts of Embark as if Embark is the predecessor to the Company. The shares and net loss per common share, prior to the Merger, have been retroactively restated as shares reflecting the exchange ratio established in the Merger (approximately 2.98 shares of Company Class A common stock for 1 share of Embark Class A common stock).\nThe principal activities of Embark Technology, Inc. (“Embark” or the “Company”) include design and development of autonomous driving software for the truck freight industry. The Company is headquartered in San Francisco, California and was incorporated in the State of Delaware in 2016. Other than Embark Trucks, the Company has no subsidiaries as of March 31, 2022.\nThe Company has devoted substantially all of its resources to develop its autonomous truck technology, to enable and expand its route models - transfer point and direct-to-customer, to expand its partnerships with shippers and carriers, to raising capital, and providing general and administrative support for these operations. The Company has not generated revenues from its principal operations through March 31, 2022.\nPrior to the Merger, NGA ordinary shares and warrants were traded on the New York Stock Exchange (“NYSE”) under the ticker symbols “NGAB” and “NGAB.WS”, respectively. On the Closing Date, the Company’s Class A common stock and warrants began trading on the NASDAQ under the ticker symbols “EMBK” and “EMBKW”, respectively. One of the primary purposes of the Merger was to provide a platform for Embark Trucks to gain access to the U.S. capital markets.\nBasis of Presentation\nThe accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and pursuant to the regulations of the U.S. Securities and Exchange Commission (“SEC”).\nUnaudited Interim Financial Information\nThese interim Unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited financial statements and notes thereto contained in Embark’s Annual Report. The condensed consolidated balance sheet at December 31, 2021, has been derived from the audited financial statements at that date, but does not include all disclosures, including notes, required by GAAP for complete financial statements. In management’s opinion, the unaudited interim financial statements have been prepared on the same basis as the annual financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2022 and the Company’s results of operations and cash flows for the three months ended March 31, 2022 and 2021. The interim results are not necessarily indicative of the results for any future interim period or for the entire year.\nBusiness Combination\nThe Company entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, as part of the Business Combination, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks. In connection with the consummation of the Business Combination, the separate\n11\ncorporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that Embark’s financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results were a net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $ 27.3 million and $ 49.4 million, respectively.\nLiquidity and Capital Resources\nOn November 10, 2021, Embark consummated the Business Combination, generating net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million.\nThe Company has incurred losses from operations since inception. The Company incurred net losses of $ 18.4 million and $ 8.5 million for the three months ended March 31, 2022 and 2021, respectively, and accumulated deficit amounts to $ 201.4 million and $ 182.9 million as of March 31, 2022 and December 31, 2021, respectively. Net cash used in operating activities was $ 18.2 million and $ 6.8 million for the three months ended March 31, 2022 and 2021, respectively.\nThe Company’s liquidity is based on its ability to enhance its operating cash flow position, obtain capital financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures. As of March 31, 2022 and December 31, 2021, the Company’s balance of cash and cash equivalents was $ 244.5 million and $ 264.6 million, respectively.\nBased on cash flow projections from operating and financing activities and existing balance of cash and cash equivalents and investments, management is of the opinion that the Company has sufficient funds for sustainable operations, and it will be able to meet its payment obligations from operations and debt related commitments for at least one year from the issuance date of these financial statements. Based on the above considerations, the Company’s financial statements have been prepared on a going concern basis, which contemplates the realization of assets and liquidation of liabilities during the normal course of operations.\nThe Company’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable the Company to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes- Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but\n12\nany such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nSegment Information\nUnder Accounting Standards Codification (“ASC 280”), Segment Reporting, operating segments are defined as components of an enterprise where discrete financial information is available that is evaluated regularly by the chief operating decision-maker (“CODM”), in deciding how to allocate resources and in assessing performance. The Company operates in one segment, the truck business unit, which is focused on enhancing self-driving truck software technology. Therefore, the Company’s chief executive officer, who is also the CODM, makes decisions and manages the Company’s operations as a single operating segment for purposes of allocating resources and evaluating financial performance. All long-lived assets are maintained in, and all losses are attributable to, the United States of America.\nConcentration of Risks\nEmbark’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents and restricted cash. Embark maintains its cash and cash equivalents, restricted cash and investments with high-quality financial institutions with investment-grade ratings. A majority of the cash balances are with U.S. banks and are insured to the extent defined by the Federal Deposit Insurance Corporation.\nImpact of COVID-19\nThe outbreak of the novel coronavirus COVID-19, which was declared a global pandemic by the World Health Organization on March 11, 2020 has led to adverse impacts on the U.S. and global economies and has impacted and continues to impact the Company’s supply chain, and operations. Even though the Company has taken measures to adapt to operating in this challenging environment, the pandemic could further affect the Company’s operations and the operations of, partners, suppliers and vendors due to additional shelter- in-place and other governmental orders, facility closures, travel and logistics restrictions, or other factors as circumstances continue to evolve. In response to this pandemic, many jurisdictions in which the Company operates issued stay-at-home orders and other measures aimed at slowing the spread of the virus. While the Company remains open in accordance with guidance from local authorities, the Company experienced a temporary pause in testing of its research and development truck fleet and operations in response to the stay- at-home orders in calendar year 2021. The impacts from stay-at-home orders and other updated local government indoor operation measures are no longer impacting the Company’s operations in 2021, however, there remains uncertainty around the potential disruptions the pandemic could cause looking forward. The Company has instituted policies across its offices to ensure compliance with these updated guidelines. At current, these changes have not impacted the Company’s operations. In response to the Delta and Omicron variants, local governments updated their guidelines for indoor operations. Therefore, the related financial impact and duration cannot be reasonably estimated at this time.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the balance sheet date, as well as reported amounts of expenses during the reporting period.\nThe Company’s most significant estimates and judgments involve the useful lives of long-lived assets, the recoverability of long-lived assets, the incremental borrowing rate (“IBR”) applied in lease accounting, the capitalization of software development costs, the valuation of the Company’s stock-based compensation, including the valuation of warrants to purchase the Company’s stock and the valuation allowance for income taxes. Management bases its estimates on historical experience and on various other assumptions believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from those estimates.\n13\nCash, Cash Equivalents and Restricted Cash\nThe Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. As of March 31, 2022 and December 31, 2021, the Company had $ 244.5 million and $ 264.6 million of cash and cash equivalents, respectively.\nThe Company maintains letters of credit to secure leases of the Company’s offices and facilities. A portion of the Company’s cash is collateralized in conjunction with the letter of credit and is classified as restricted cash on the Company’s condensed consolidated balance sheets. As of March 31, 2022 and December 31, 2021, the Company had $ 0.9 million and $ 0.4 million in restricted cash, respectively. At the end of each year of the lease, the face amount of the letter of credit is reduced by a fixed amount of approximately $ 0.1 million and reclassified into cash and cash equivalents on the Company’s condensed consolidated balance sheets. The Company determines short-term or long-term classification based on the expected duration of the restriction.\nThe reconciliation of cash and cash equivalents and restricted cash and cash equivalents to amounts presented in the condensed consolidated statements of cash flows are as follows (in thousands):\n| As of March 31, | As of December 31, |\n| 2022 | 2021 | 2021 |\n| Cash and cash equivalents | 244,488 | 21,562 | 264,615 |\n| Restricted cash, short-term | 65 | 65 | 130 |\n| Restricted cash, long-term | 812 | 340 | 275 |\n| Total cash, cash equivalents and restricted cash | 245,365 | 21,967 | 265,020 |\n\nFair Value of Financial Instruments\nThe Company’s financial instruments consist of cash and cash equivalents, restricted cash, prepaid expenses and other current assets, accounts payable and accrued expenses, short-term and long-term notes payable and other current liabilities. The assets and liabilities that were measured at fair value on a recurring basis are cash equivalents and warrant liabilities. The Company believes that the carrying values of the remaining financial instruments approximate their fair values. The Company applies fair value accounting in accordance with ASC 820, Fair Value Measurements for valuation of financial instruments. ASC 820 provides a framework for measuring fair value under GAAP that expands disclosures about fair value measurements, establishes a fair value hierarchy, and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of the fair value hierarchy are summarized as follows:\nLevel 1 — Fair value is based on observable inputs such as quoted prices for identical assets or liabilities in active markets.\nLevel 2 — Fair value is determined using quoted prices for similar assets or liabilities in active markets or quoted prices for identical or similar assets or liabilities in markets that are not active or are directly or indirectly observable.\nLevel 3 — Fair value is determined using one or more significant inputs that are unobservable in active markets at the measurement date, such as an option pricing model, discounted cash flow, or similar technique.\nPublic and Private Warrants\nAs part of NGA’s initial public offering on October 13, 2020, NGA issued to third party investors 41.4 million units, consisting of one share of Class A common stock of NGA and one-third of one warrant, at a price of $ 10.00 per unit. Each whole warrant entitles the holder to purchase one share of Class A common stock at an exercise price of $ 11.50 per share (the \"Public Warrants\"). Further, NGA completed the private sale of 6.7 million warrants to NGA's sponsor at a purchase price of $ 1.50 per warrant (the \"Private Warrants\"). Each Private Warrant allows the sponsor to purchase one share of Class A common stock at $ 11.50 per share. Subsequent to the Business Combination, 13.8 million Public Warrants and 6.7 million Private Warrants remained outstanding as of March 31, 2022.\n14\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A common stock issuable upon the exercise of the Private Placement Warrants did not become transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants are exercisable on a cashless basis and are non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Placement Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Placement Warrants are redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\nThe Company evaluated the Public and Private Warrants under ASC 815-40, Derivatives and Hedging-Contracts in Entity's Own Equity, and concluded that they do not meet the criteria to be classified in stockholders' equity. Since the Public and Private Warrants meet the definition of a derivative under ASC 815, the Company recorded these warrants as liabilities on the balance sheet at fair value upon the closing of the Business Combination, with subsequent changes in their respective fair values recognized in the condensed consolidated statement of operations and comprehensive income (loss) at each reporting date.\nConvertible Notes and Derivatives\nThe Company accounts for its derivatives in accordance with, ASC 815-10, Derivatives and Hedging, or ASC 815-15, Embedded Derivatives, depending on the nature of the derivative instrument. ASC 815 requires each contract that is not a derivative in its entirety be assessed to determine whether it contains embedded derivatives that are required to be bifurcated and accounted for as a derivative financial instrument. The embedded derivative is bifurcated from the host contract and accounted for as a freestanding derivative if the combined instrument is not accounted for in its entirety at fair value with changes in fair value recorded in earnings, the terms of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms as the embedded derivative would qualify as a derivative instrument. Embedded derivatives are measured at fair value and remeasured at each subsequent reporting period, and recorded within convertible notes, net on the accompanying Balance Sheets and changes in fair value recorded in other expense within the Statements of Operations. Upon the consummation of the Merger, the related convertible note liability was extinguished. As of March 31, 2022, the Company held no derivative instruments.\nProperty, Equipment and Software\nProperty, equipment and software is stated at cost less accumulated depreciation. Repair and maintenance costs are expensed as incurred. Depreciation and amortization are recorded on a straight-line basis over each asset’s estimated useful life.\n| Property, Equipment and Software | Useful life (years) |\n| Machinery and equipment | 5 years |\n| Electronic equipment | 3 years |\n| Vehicles and vehicle hardware | 3 – 7 years |\n| Leasehold improvements | Shorter of useful life or lease term |\n| Furniture and fixtures | 7 years |\n| Developed software | 2 – 4 years |\n\nLeases\nThe Company determines if a contract contains a lease at inception of the arrangement based on whether the Company has the right to obtain substantially all of the economic benefits from the use of an identified asset and whether the Company has the right to direct the use of an identified asset in exchange for consideration, which relates to an asset which the Company does not own. Right of use (“ROU”) assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. ROU assets are recognized as the lease liability, adjusted for lease incentives received. Lease liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is the Company’s incremental borrowing rate (“IBR”), because the interest rate implicit in most of its leases is not readily determinable. The IBR is a hypothetical rate based on the Company’s understanding of what its credit rating would be to borrow and resulting interest we would pay to borrow an amount equal to the lease\n15\npayments in a similar economic environment over the lease term on a collateralized basis. Lease payments may be fixed or variable; however, only fixed payments or in-substance fixed payments are included in the Company’s lease liability calculation. Variable lease payments may include costs such as common area maintenance, utilities, real estate taxes or other costs. Variable lease payments are recognized in operating expenses in the period in which the obligation for those payments are incurred.\nOperating leases are included in operating lease ROU assets, operating lease liabilities, current and operating lease liabilities, non-current on the Company’s condensed consolidated balance sheets. For operating leases, lease expense is recognized on a straight-line basis in operations over the lease term. The Company elected the practical expedient not to separate non-lease components from lease components, therefore, the Company accounts for lease and non-lease components as a single lease component. The Company also elected the short-term lease recognition practical expedient for all leases that qualify.\nImpairment of Long-Lived Assets\nThe Company reviews its long-lived assets for impairment annually, or whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. The Company assesses the recoverability of these assets by comparing the carrying amount of such assets or asset group to the future undiscounted cash flows it expects the assets or asset group to generate. The Company recognizes an impairment loss if the sum of the expected long-term undiscounted cash flows that the long-lived asset is expected to generate is less than the carrying amount of the long-lived asset being evaluated.\nIncome Taxes\nThe Company accounts for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.\nA valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. Due to the Company’s lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance as of March 31, 2022 and December 31, 2021. Uncertain tax positions taken or expected to be taken in a tax return are accounted for using the more likely than not threshold for financial statement recognition and measurement.\nStock-based Compensation\nStock-based compensation expense related to stock option awards, restricted stock units (“RSUs”) and performance stock units (“PSUs”) granted to employees, directors and non-employees based on estimated grant-date fair values. For stock option awards, the Company uses the straight-line method to allocate compensation expense to reporting periods over each optionee’s requisite service period, which is generally the vesting period, and estimates the fair value of share-based awards to employees and directors using the Black-Scholes option- pricing model. The Black-Scholes model requires the input of subjective assumptions, including expected volatility, expected dividend yield, expected term, risk-free rate of return and the stock price of the underlying common shares on the date of grant. The fair value of each RSU is based on the fair value of the Company’s common stock on the date of grant. The related stock-based compensation is recognized on a graded vesting basis as the RSU awards are associated with a performance condition. For PSU awards, the Company uses the graded vesting to allocate compensation expense, as the PSU awards are associated with market conditions, over the holder’s derived service period, and estimates the fair value of the PSU awards using the Monte Carlo simulation. The Company accounts for the effect of forfeitures as they occur.\nInternal Use Software\nThe Company capitalizes certain costs associated with creating and enhancing internally developed software related to the Company’s technology infrastructure and such costs are recorded within property, equipment and software, net. These costs include personnel and related employee benefit expenses for employees who are directly associated with and who devote time to software development projects. Software development costs that do not qualify for capitalization are expensed as incurred and recorded in research and development expense in the Statements of Operations and comprehensive income (loss).\n16\nSoftware development activities typically consist of three stages: (1) the planning phase; (2) the application and infrastructure development stage; and (3) the post implementation stage. Costs incurred in the planning and post implementation phases, including costs associated with training and repairs and maintenance of the developed technologies, are expensed as incurred. The Company capitalizes costs associated with software developed when the preliminary project stage is completed, management implicitly or explicitly authorizes and commits to funding the project and it is probable that the project will be completed and perform as intended. Costs incurred in the application and infrastructure development phases, including significant enhancements and upgrades, are capitalized. Capitalization ends once a project is substantially complete, and the software is ready for its intended purpose. Software development costs are depreciated using a straight-line method over the estimated useful life, commencing when the software is ready for its intended use. The straight-line recognition method approximates the manner in which the expected benefit will be derived. Internal use software is tested for impairment in accordance with the Company’s long- lived assets impairment policy.\nResearch and Development Expense\nResearch and development expense consist of outsourced engineering services, allocated facilities costs, depreciation, internal engineering and development expenses, materials, labor and stock-based compensation related to development of the Company’s products and services. Research and development costs are expensed as incurred except for amounts capitalized to internal-use software.\nGeneral, and Administrative Expenses\nGeneral, and administrative expense consist of personnel costs, allocated facilities expenses, depreciation and amortization, travel, and business development costs.\nChange in fair value of warrant liability\nChange in fair value of warrant liability represents the change in fair value of Public, Private, Working Capital and Forward Purchase Agreement (“FPA”) Warrants. For each reporting period, Embark will determine the fair value of the warrant liability, and record a corresponding non-cash benefit or non-cash charge, due to a decrease or increase, respectively, in the calculated warrant liability.\nOther Income\nAs part of the Company’s research and development activities, we contract with shippers and freight carriers to transfer freight between the Company’s transfer hubs in return for cash consideration. Transferring freight with the Company’s research and development truck fleet are not and will not be considered an output of the Company’s ordinary activities. Consideration received from such arrangements is presented as other income in the Company’s Condensed Consolidated Statement of Operations.\nInterest Income\nInterest income primarily consists of investment and interest income from marketable securities, long- term investments and the Company’s cash and cash equivalents.\nInterest Expense\nInterest expense consisted primarily of interest on the Company’s various truck financing arrangements.\nNet Loss Per Share\nPrior to the Merger and prior to effecting the recapitalization, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock. The rights of the holders of Class A and Class B common stock are identical, including the liquidation and dividend rights, except with respect to electing members of the Board of Directors and voting rights. As the liquidation and dividend rights are identical, undistributed earnings and losses are allocated on a proportionate basis and the resulting net loss per share attributable to common stockholders are the same for both Class A and Class B common stock on an individual and combined basis.\n17\nBasic and diluted net loss per share attributable to common stockholders is presented in conformity with the two-class method required for participating securities. Net loss is attributed to common stockholders and participating securities based on their participation rights. Net loss attributable to common stockholders is not allocated to the redeemable convertible preferred stock as the holders of the redeemable convertible preferred stock do not have a contractual obligation to share in any losses. No dividends were declared or paid for the three months ended March 31, 2022 and March 31, 2021. No preferred stock was outstanding as of March 31, 2022.\nUnder the two-class method, basic net loss per share attributable to common stockholders is computed by dividing the net loss attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period.\nDiluted earnings per share attributable to common stockholders adjusts basic earnings per share for the potentially dilutive impact of redeemable convertible preferred stock, stock options, and warrants. As the Company has reported losses for all periods presented, all potentially dilutive securities including preferred stock, stock options, and warrants, are antidilutive and accordingly, basic net loss per share equals diluted net loss per share.\nComprehensive Income (Loss)\nComprehensive income (loss) is defined as the total change in stockholders’ equity during the period other than from transactions with stockholders. Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) is comprised of unrealized gains or losses on investments classified as available-for-sale.\nRecently Adopted Accounting Pronouncements\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. The Company adopted “ASC 842” on January 1, 2022, using the modified retrospective transition method, specifically the \"Comparatives under ASC 840 approach\", and used the effective date as the date of initial application. The Company elected the “package of practical expedients,” which permits Embark not to reassess under ASC 842 its prior conclusions about lease identification, lease classification and initial direct costs. The Company also elected the use of hindsight in determining the lease term and in assessing impairment of the entity’s right-of-use assets. Upon adoption of the new leasing standard on January 1, 2022, the Company recognized right-of-use assets of $ 4.4 million and lease liabilities of $ 4.5 million, respectively, which are related to its various operating leases (Note 10). The difference between the right-of-use assets and lease liabilities is primarily attributed to the elimination of deferred rent. There was no adjustment to the opening balance of accumulated deficit as a result of the adoption of ASC 842.\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, which is intended to simplify various aspects related to accounting for income taxes. The adoption of ASU 2019-12 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\nIn May 2021, the FASB issued ASU 2021-04, Modification of equity-classified written call options. ASU 2021-04 provides clarification and reduces diversity in an issuer’s accounting for certain modifications or exchanges of freestanding equity-classified written call options, such as warrants, that remain equity classified after modification or exchange. This guidance will be effective for us on January 1, 2022 with early adoption permitted and will be applied prospectively. The adoption of ASU 2021-04 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\nRecently Issued Accounting Pronouncements\nAs an emerging growth company (“EGC”), the Jumpstart Our Business Startups Act (“JOBS Act”) allows the Company to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are applicable to private companies. The Company has elected to use this extended transition period under the JOBS Act until such time the Company is no longer considered to be an EGC. The adoption dates discussed below reflect this election.\n18\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments, which, together with subsequent amendments, amends the requirement on the measurement and recognition of expected credit losses for financial assets held. ASU 2016-13 is effective for the Company beginning January 1, 2023, with early adoption permitted. The Company is currently in the process of evaluating the effects of this pronouncement on the Company’s financial statements and does not expect it to have a material impact on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06, Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815- 40): Accounting for convertible instruments and contracts in an entity’s own equity. The ASU simplifies accounting for convertible instruments by removing certain separation models required under current GAAP. The ASU also removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it revises the guidance in ASC 260, Earnings Per Share, to require entities to calculate diluted earnings per share for convertible instruments by using the if-converted method. The amendments are effective for the Company beginning January 1, 2024, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently assessing the impact of this standard on its consolidated financial statements.\nIn October 2020, the FASB issued ASU No. 2020-10, Codification Improvements, which updates various codification topics by clarifying or improving disclosure requirements to align with the SEC’s regulations. For the Company, the ASU No. 2020-10 will be effective for annual reporting periods beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. The Company is currently evaluating the impact the adoption of this standard on its consolidated financial statements.\n3. BALANCE SHEET COMPONENTS\nPrepaid Expenses and Other Current Assets\nPrepaid expenses and other current assets consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Prepaid insurance | $ | 6,890 | $ | 7,459 |\n| Prepaid software | 2,224 | 2,564 |\n| Income tax receivable | 494 | 494 |\n| Short-term deposits | 570 | 448 |\n| Prepaid salary | 476 | 279 |\n| Prepaid warrant | 876 | 936 |\n| Other | 475 | 566 |\n| Total prepaid expenses and other current assets | $ | 12,005 | $ | 12,746 |\n\n19\nProperty, Equipment and Software\nProperty, equipment and software consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Machinery and equipment | $ | 406 | $ | 344 |\n| Electronic equipment | 578 | 413 |\n| Vehicles and vehicle hardware | 6,929 | 6,268 |\n| Leasehold improvements | 278 | 258 |\n| Developed software | 6,108 | 5,184 |\n| Other | 27 | 26 |\n| Property, equipment and software, gross | 14,326 | 12,493 |\n| Less: accumulated depreciation and amortization | ( 3,240 ) | ( 2,856 ) |\n| Total property, equipment and software, net | $ | 11,086 | $ | 9,637 |\n\nDepreciation and amortization expense for the three months ended March 31, 2022 and 2021 was $ 0.4 million and $ 0.2 million, respectively.\nOther Assets\nOther assets consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Intangible assets | $ | 3 | $ | 4 |\n| Long-term deposits | 3,719 | 3,592 |\n| Total Other Assets | $ | 3,722 | $ | 3,596 |\n\nAccrued Expenses and Other Current Liabilities\nAccrued expenses and other current liabilities consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\n| March 31,2022 | December 31,2021 |\n| (unaudited) |\n| Accrued payroll expenses | $ | 3,189 | $ | 823 |\n| Accrued legal expenses | 696 | 124 |\n| Accrued transaction costs | 1,092 | 1,092 |\n| Other | 1,174 | 1,103 |\n| Total accrued expenses and other current liabilities | $ | 6,151 | $ | 3,142 |\n\n4. FAIR VALUE MEASUREMENTS\n20\nThe carrying value and fair value of the Company’s financial instruments as of March 31, 2022 and December 31, 2021, respectively, are as follows:\n| As of March 31, 2022(in thousands) |\n| Level 1 | Level 2 | Level 3 | Total |\n| (unaudited) |\n| Assets |\n| Cash equivalents: |\n| United States money market funds | $ | 13,349 | $ | — | $ | — | $ | 13,349 |\n| Liabilities |\n| Warrant liabilities - FPA warrants | $ | 760 | $ | — | $ | — | $ | 760 |\n| Warrant liabilities - public warrants | $ | 15,732 | $ | — | $ | — | $ | 15,732 |\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 2,480 | $ | 2,480 |\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 8,292 | $ | 8,292 |\n\n| As of December 31, 2021(in thousands) |\n| Level 1 | Level 2 | Level 3 | Total |\n| Assets |\n| Cash equivalents: |\n| United States money market funds | $ | 22,349 | $ | — | $ | — | $ | 22,349 |\n| Liabilities |\n| Warrant liabilities - FPA warrants | $ | 1,337 | $ | — | $ | — | $ | 1,337 |\n| Warrant liabilities - public warrants | $ | 27,669 | $ | — | $ | — | $ | 27,669 |\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 4,700 | $ | 4,700 |\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 15,714 | $ | 15,714 |\n\nAs of March 31, 2022, there was no transfer from Level 2 to Level 3. As of December 31, 2021, transfers from Level 2 to Level 3 of the fair value hierarchy were $ 15.5 million for Private and Public Warrants.\nThe fair value of the above liability classified Public, Private, Working Capital and FPA Warrants have been measured based on the listed market price of such warrants on November 10, 2021. The FPA warrants and public warrants were valued using the public price as of March 31, 2022. The Private and Working Capital warrants were fair valued using the Black Scholes Option Pricing Model as of March 31, 2022. For the three months ended March 31, 2022, the Company recognized income in the condensed consolidated statement of operations resulting from a change in the fair value of warrants of approximately $ 22.2 million, presented as other income (expense) on the accompanying condensed consolidated statement of operations.\n5. STOCKHOLDERS’ EQUITY\nShares Authorized and Issued\nAs of March 31, 2022, the Company had authorized a total of 4,110,000,000 shares for issuance with 4,000,000,000 shares designated as Class A common stock, 100,000,000 shares designated as Class B common stock and 10,000,000 shares designated as preferred stock.\nAs of March 31, 2022, the Company had 362,832,986 issued as Class A common stock and 87,078,981 issued as Class B common stock.\n21\nPreferred Stock\nAs of March 31, 2022, there were 10,000,000 shares of preferred stock authorized and no shares of preferred and founders preferred stock was issued or outstanding. The Company’s preferred stock, as of March 31, 2022, does not contain any mandatory redemption features, nor are they redeemable at the option of the holder.\nClass A and Class B Common Stock\nThe Company’s Board of Directors has authorized two class of common stock, Class A and Class B. Holders of Class A and Class B common stock are not entitled to preemptive or other similar subscription rights to purchase any of Embark Technology’s securities.\nClass A common stock is neither convertible nor redeemable. Class B common stock is convertible into Class A common stock. Unless Embark Technology’s board of directors determines otherwise, Embark Technology will issue all of Embark Technology’s capital stock in certificated form. The Embark Founders held all outstanding shares of Class B common stock up on consummation of the Business Combination.\nIn connection with the merger with NGA on November 10, 2021, the Embark Founders exchanged 87,078,981 shares of Founder's common stock, which were entitled to one vote per share, into the same number of shares of Class B common stock, which are entitled to ten votes per share. The Company recorded the incremental value of $ 13.6 million associated with this transaction as stock-based compensation in general and administrative expenses.\nThe significant rights, privileges and preferences of common stock as of March 31, 2022 are as follows:\nLiquidation Preference\nIf Embark Technology is involved in voluntary or involuntary liquidation, dissolution or winding up of Embark’s affairs, or a similar event, each holder of Embark Common Stock will participate pro rata in all assets remaining after payment of liabilities, subject to prior distribution rights of Embark Technology preferred stock, if any, then outstanding.\nDividends\nEach holder of shares of Embark Common Stock is entitled to the payment of dividends and other distributions as may be declared by the Board from time to time out of Embark’s assets or funds legally available for dividends or other distributions. These rights are subject to the preferential rights of the holders of Embark’s Preferred Stock, if any, and any contractual limitations on Embark’s ability to declare and pay dividends.\nVoting\nEach holder of Class A common stock is entitled to one vote per share on each matter submitted to a vote of stockholders, as provided by the Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II (the “Charter”). Each holder of Class B common stock is entitled to ten votes per share on each matter submitted to a vote of stockholders, as provided by the Embark Charter. Following the Business Combination, holders of Class B Common Stock have the ability to control the business affairs of Embark. Embark’s Amended and Restated Bylaws (the “Bylaws”) provide that the holders of a majority of the capital stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, will constitute a quorum at all meetings of the stockholders for the transaction of business. When a quorum is present, the affirmative vote of a majority of the votes cast is required to take action, unless otherwise specified by law, the Bylaws or the Charter, and except for the election of directors, which is determined by a plurality vote. There are no cumulative voting rights.\n6. WARRANTS\n22\nAs of March 31, 2022, the following warrants were issued and outstanding:\n| Description | Classification | Issue Date | Warrants Outstanding | Fair Value Price Per Share | Exercise Price per Share | Expiration |\n| FPA warrants (1) | Liability | November 10, 2021 | 666,663 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\n| Public warrants | Liability | November 10, 2021 | 13,799,936 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\n| Private warrants | Liability | November 10, 2021 | 6,686,667 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\n| Working capital warrants | Liability | November 10, 2021 | 2,000,000 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\n\n(1)FPA are the “Forward Purchase Agreements” entered into, or amended and restated, by NGA on April 21, 2021\nThe Company determined the FPA, Public, Private and Working Capital warrants to be classified as a liability and fair valued the warrants on the issuance date using the publicly available price for the warrants, of $ 41.2 million. The fair value of the FPA and Public warrants were remeasured as of the reporting date with the change in value reflected as part of Other Expense.\nThe fair value of $ 27.3 million of Private and Working Capital warrants was determined using the Black-Scholes option valuation model using the following assumptions for values as of March 31, 2022:\n| Risk – free interest rate | 2.43 % |\n| Expected term (in years) | 4.61 |\n| Expected dividend yield | 0 % |\n| Expected volatility | 45.0 % |\n\nThe Company estimates the volatility of its warrants based on a combination of volatility from the Company’s traded warrants and from historical volatility of select peer company’s common stock that matches the expected remaining life of the warrants. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected remaining life of the warrants. The expected life of the warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which the Company anticipates remaining at zero .\n7. STOCK-BASED COMPENSATION EXPENSE\nStock Option Plan\nIn connection with the Business Combination, the Company adopted the 2021 Incentive Award Plan (the “2021 Plan”), under which the Company grants cash and equity incentive awards to directors, employees (including named executive officers) and consultants in order to attract, motivate and retain the talent for which the Company competes. The Company terminated the 2016 Stock Plan, provided that the outstanding awards previously granted under the 2016 Plan continue to remain outstanding under the 2016 Plan. Under the 2021 Plan, as of March 31, 2022, the Company has authorized to issue a maximum number of 58,713,535 shares of Class A common stock, with annual increases beginning January 1, 2022 and ending on and including January 1, 2031 of 5 % of the aggregate number of shares of Class A common stock outstanding on the last day of the preceding calendar year.\nEmbark Trucks adopted the 2016 Stock Plan in October 2016 (the “2016 Plan”). The 2016 Plan authorized the grant of incentive stock options, non-statutory stock options, and restricted stock awards to employees, directors, and consultants. The 2016 Plan also initially reserved 993,542 shares of common stock ( 8,941,878 shares post-split in June 2018) for issuance and designated forfeited option shares to be returned to the option reserve. Options may be early exercised and are exercisable for a term of 10 years from the date of grant. As of March 31, 2022, the Company had registered 79,742,504 shares to be reserved for option grants, RSUs and PSUs previously issued under the 2016 Plan. The Company will not issue additional awards under the 2016 Plan.\n23\nStock Option Valuation\nThe Company utilizes the Black-Scholes option pricing model for estimating the fair value of options granted, which requires the input of highly subjective assumptions.\nThe Company calculates the fair value of each option grant on the grant date using the following assumptions:\nExpected Term — The Company uses the simplified method when calculating expected term due to insufficient historical exercise data.\nExpected Volatility — As the Company’s shares are not actively traded, the volatility is based on a benchmark of comparable companies within the automotive and energy storage industries.\nExpected Dividend Yield — The dividend rate used is zero as the Company does not have a history of paying dividends on its common stock and does not anticipate doing so in the foreseeable future.\nRisk-Free Interest Rate — The interest rates used are based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Risk-free interest rate | n/a | 0.55 – 1.10 % |\n| Expected term (in years) | n/a | 5.47 – 6.07 |\n| Expected dividend yield | n/a | 0 % |\n| Expected volatility | n/a | 36.88 – 51.52 % |\n\nThe company did not grant any stock options for the three months ended March 31, 2022.\nOption Activity\nChanges in stock options are as follows:\n| Number ofOutstanding Options | Weighted Average Exercise Price Per Share | WeightedAverageRemaining Contractual Term (years) | AggregateIntrinsic (in thousands) |\n| Outstanding at December 31, 2021 | 25,358,455 | $ | 0.20 | 6.9 | $ | 215,093 |\n| Exercised | ( 3,615,572 ) | 0.11 | $ | 20,770 |\n| Repurchased | 13,984 | 0.29 |\n| Cancelled | ( 277,235 ) | 0.59 |\n| Outstanding at March 31, 2022 | 21,479,632 | $ | 0.21 | 6.7 | $ | 121,910 |\n| Vested and exercisable as of March 31, 2022 | 15,271,274 | $ | 0.13 | 6.0 | $ | 88,014 |\n\nThe aggregate intrinsic value in the above table is calculated as the difference between the estimated fair value of the Company's common stock price and the exercise price of the stock options. The company did not grant any stock options for the three months ended March 31, 2022. The weighted average grant date fair value per share for the stock option grants during the three months ended March 31, 2021 was $ 1.88 . As of March 31, 2022, the total unrecognized compensation related to unvested stock option awards granted was $ 5.02 million, which the Company expects to recognize over a weighted-average period of approximately 2.4 years.\nRestricted Stock Units\nPrior to the Business Combination, Embark Trucks also granted employees RSUs which are subject to performance and service-based vesting conditions. As the Company went public upon the completion of the Business Combination in November 2021, the performance condition had been met. The RSUs generally vest over either a four year period with\n24\n25 % of the awarded vesting after the first-year anniversary and one-thirty sixth of the remainder of the award vesting monthly thereafter. Vesting is contingent upon such employee’s continued service on such vesting date. RSUs are generally subject to forfeiture if employment terminates prior to the release of vesting restrictions. The Company may grant RSUs with different vesting terms from time to time.\nFor the three months ended March 31, 2022, the Company recognized $ 12.9 million stock-based expense associated with such RSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such RSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 41.0 million unrecognized stock-based compensation expense related to outstanding RSUs granted to employees, with a weighted-average remaining vesting period of 3.9 years.\nA summary of the Company’s RSU activities and related information is as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 9,616,774 | $ | 8.44 |\n| Forfeited | ( 111,572 ) | 8.96 |\n| Vested | ( 187,977 ) | 8.36 |\n| Balance as of March 31, 2022 | 9,317,225 | $ | 8.43 |\n\nPerformance Stock Units\nDuring 2021, Embark Trucks granted PSUs to its employees. The PSUs are subject to certain market and performance-based conditions which require the Company to become a registered public company and meet market conditions that are based on the Company achieving six different valuation tranches as derived from the achievement of escalating share price thresholds of $ 20.00 , $ 35.00 , $ 50.00 , $ 65.00 , $ 80.00 and $ 100.00 (calculated based on the 90-day volume weighted average price or, in the event of a change in control, the fair market value based on the terms of such change in control) following the first anniversary of the consummation of the Business Combination. The market condition can be achieved over ten years in relation to the pre-money valuation prior to the Business Combination. Once the performance condition has been achieved or is considered probably of being achieved, the related stock-based compensation is recognized based on a graded attribution method.\nFor the three months ended March 31, 2022, the Company recognized $ 2.6 million stock-based expense associated with such PSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such PSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 81.0 million unrecognized stock-based compensation expense related to outstanding PSUs granted to employees, with a weighted-average remaining vesting period of 8.1 years.\nThe Company’s PSUs activity for the three months ended March 31, 2022 was as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 44,715,756 | $ | 1.97 |\n| Granted | — | — |\n| Forfeited | — | — |\n| Vested | — | — |\n| Balance as of March 31, 2022 | 44,715,756 | $ | 1.97 |\n\nCommon Stock Units\nThe Company is obligated to issue shares of Class A common stock upon the vesting of certain restricted stock awards that resulted from Embark Trucks warrants that were issued prior to the Business Combination. Pursuant to the terms of\n25\nthese warrant awards, the restricted stock awards were issued for services at the time of consummation of the Business Combination, and are subject to service vesting terms, with the shares being subject to cancellation. The pre-Business Combination warrants were exercised in their entirety on a cashless basis, with the unvested shares being excluded from the stockholders’ equity and becoming subject to the service vesting condition going forward. Early exercises are reclassified to additional paid-in capital as the Company’s cancellation right lapses. The number of unvested shares of Class A common stock were 1,347,848 as of March 31, 2022.\nAs of March 31, 2022, there was $ 3.8 million unrecognized stock-based compensation expense related to outstanding Common Stock Units (“CSUs”) granted to non-employees, with a weighted-average remaining vesting period of 2.16 years.\nThe Company's CSUs activity for the three months ended March 31, 2022 was as follows:\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\n| Balance as of December 31, 2021 | 1,481,065 | $ | 2.48 |\n| Granted | — | — |\n| Forfeited | — | $ | — |\n| Vested | ( 133,217 ) | 2.48 |\n| Balance as of March 31, 2022 | 1,347,848 | $ | 2.48 |\n\nThe following table presents the impact of stock-based compensation expense on the condensed consolidated statements of operations for the three months ended March 31, 2022 and 2021, respectively (in thousands):\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Research and development | $ | 3,765 | $ | 311 |\n| General, and administrative | 12,837 | 251 |\n| Total stock-based compensation expense | $ | 16,602 | $ | 562 |\n\nTotal stock-based compensation that was capitalized into internally developed software asset was $ 0.2 million and nil during the three months ended March 31, 2022 and 2021, respectively.\n8. RETIREMENT SAVINGS PLAN\nThe Company sponsored a savings plan available to all eligible employees, which qualifies under Section 401(k) of the Internal Revenue Code. Employees may contribute to the plan amounts of their pre-tax salary subject to statutory limitations. The Company does not currently offer a match and has not provided a match as of March 31, 2022.\n9. NOTES PAYABLE\nOn February 18, 2021 and January 5, 2021, the Company entered into financing agreement to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million and $ 0.1 million at an interest rate equal to 6.99 % and 7.50 % per annum, with a maturity date of April 1, 2026 and January 19, 2027, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\nOn February 19, 2018, January 28, 2019, and May 23, 2019, the Company entered into financing agreements to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.3 million, $ 0.4 million, and $ 0.5 million at an interest rate equal to 8.25 % per annum, with a maturity date of March 5, 2023, February 14, 2024, and June 12, 2024, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\n26\nThe Company entered into a financing agreement on August 2, 2016 to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million at an interest rate equal to 12.5 % per annum, with a maturity date of August 9, 2020. The Company makes equal monthly installment payments over the term of the financing arrangement, which is allocated between interest and principal.\nNotes payable as of March 31, 2022 and December 31, 2021 are $ 1.0 million and $ 1.1 million, respectively.\nThe following table presents future payments of principal as of March 31, 2022 (in thousands):\n| Years Ended December 31, | Amounts |\n| 2022 (remaining nine months) | $ | 273 |\n| 2023 | 313 |\n| 2024 | 176 |\n| 2025 | 111 |\n| 2026 and thereafter | 125 |\n| Total future payments | $ | 998 |\n\n10. COMMITMENTS AND CONTINGENCIES\nLegal Proceedings\nThe Company is subject to legal and regulatory actions that arise from time to time in the ordinary course of business. The assessment as to whether a loss is probable or reasonably possible, and as to whether such loss or a range of such loss is estimable, often involves significant judgment about future events. In the opinion of management, all such matters are not expected to have a material effect on the financial position, results of operations or cash flows of the Company. However, the outcome of litigation is inherently uncertain. There is no material pending or threatened litigation against the Company that remains outstanding as of March 31, 2022 and December 31, 2021.\nOperating leases\nThe Company’s leases primarily include corporate offices. The lease term of operating leases vary from less than a year to seven years . The Company has leases that include one or more options to extend the lease term to a total term of ten years as well as options to terminate the lease within one year. The Company’s lease terms may include options to extend or terminate the lease when it is reasonably certain that it will exercise such options. The Company’s lease agreements generally do not contain any residual value guarantees or restrictive covenants.\nThe components of lease expense were as follows (in thousands):\n| Three Months Ended March 31, 2022 |\n| Lease cost |\n| Operating lease cost | $ | 600 |\n| Short-term lease cost (1) | 102 |\n| Total lease cost | $ | 702 |\n\n(1) The Company elected to account for short-term leases in accordance with ASC 842. ASC 842 defines a short-term lease as a lease whose lease term, at commencement, is 12 months or less and that does not include a purchase option whose exercise is reasonable certain. The Company will recognize the lease payments in profit or loss on a straight-line basis over the lease term.\n27\nSupplemental cash flow information related to leases was as follows (in thousands):\n| Three Months Ended March 31, 2022 |\n| Other Information |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows used in operating leases | $ | 477 |\n| Right-of-use assets obtained in exchange for lease obligations |\n| Operating lease liabilities | $ | 6,587 |\n\nSupplemental balance sheet information related to leases was as follows (in thousands, except lease term and discount rate):\n| March 31,2022 |\n| Assets |\n| Operating lease right-of-use assets | $ | 6,099 |\n| Liabilities |\n| Operating lease liability, current | $ | 1,948 |\n| Operating lease liability, non-current | $ | 4,438 |\n| Total operating lease liability | $ | 6,386 |\n\n| March 31,2022 |\n| Weighted Average Lease Term (in years) |\n| Operating Leases | 3.38 |\n| Weighted Average Discount Rate |\n| Operating Leases | 5.69 | % |\n\nTotal future minimum lease payments over the term of the lease as of March 31, 2022, are as follows (in thousands):\n| Years Ended December 31, | Operating leases |\n| 2022 (remaining nine months) | 1,723 |\n| 2023 | 2,108 |\n| 2024 | 1,976 |\n| 2025 | 548 |\n| 2026 | 563 |\n| 2027 and thereafter | 142 |\n| Total undiscounted lease payments | $ | 7,060 |\n| Less: imputed interest | ( 674 ) |\n| Total lease liabilities | $ | 6,386 |\n\nAs of March 31, 2022, the Company entered into additional operating leases for an office and a truck transfer point of $ 25.8 million, and $ 0.6 million respectively. These operating leases will commence in fiscal 2022 with lease terms of seven years and five years respectively, and contain options to renew and extend the terms of up to 60 months and 12 for each renewal, respectively.\n28\n11. NET LOSS PER SHARE\nThe following table sets forth the computation of the basic and diluted net loss per share attributable to common stockholders for the three months ended March 31, 2022 and 2021, respectively (in thousands, except share and per share data).\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Numerator: |\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Net loss attributable to common stockholders | $ | ( 18,447 ) | $ | ( 8,482 ) |\n| Denominator: |\n| Net loss per share attributable to Class A and Class B common stockholders, basic and diluted | $ | ( 0.04 ) | $ | ( 0.18 ) |\n| Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted | 452,623,022 | 47,538,331 |\n| Class A | 365,544,041 | n/a* |\n| Class B | 87,078,981 | n/a* |\n\n*Prior to the Merger and prior to effecting the recapitalization in 2021, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock.\nSince the Company was in a loss position for all periods presented, basic net loss per share is the same as diluted net loss per share for all periods as the inclusion of all potential common shares outstanding would have been anti-dilutive.\nThe following weighted-average outstanding common stock equivalents were excluded from the computation of diluted net loss per share attributable to common stockholders for the periods presented because including them would have been anti-dilutive.\n| March 31, |\n| 2022 | 2021 |\n| Founders Preferred shares | — | 162,558 |\n| Series A-1 convertible preferred shares | — | 3,654,873 |\n| Series A-2 convertible preferred shares | — | 5,372,703 |\n| Series A-3 convertible preferred shares | — | 2,485,296 |\n| Series A-4 convertible preferred shares | — | 590,688 |\n| Series A-5 convertible preferred shares | — | 2,680,236 |\n| Series A-6 convertible preferred shares | — | 3,647,817 |\n| Series A-7 convertible preferred shares | — | 15,139,917 |\n| Series B convertible preferred shares | — | 32,834,601 |\n| Series C convertible preferred shares | — | 20,949,454 |\n| Outstanding options | 21,479,632 | 8,975,275 |\n| Warrants issued and outstanding | 23,153,266 | 857,142 |\n| Restricted stock units | 9,317,225 | — |\n| Common stock units | 1,347,848 | — |\n| Performance stock units | 44,715,756 | — |\n| Total | 100,013,727 | 97,350,560 |\n\n12. SUBSEQUENT EVENTS\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark\n29\nTechnology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly sufferance financial harm as a result.\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-reference matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonable estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\n30\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes appearing elsewhere in this Quarterly Report on Form 10-Q and the Annual Report. In addition to the historical financial information, this discussion contains forward-looking statements that involve risk, assumptions and uncertainties, such as statements of our plans, objectives, expectations, intentions, forecasts and projections. Our actual results and the timing of selected events could differ materially from those discussed in these forward-looking statements as a result of several factors. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in the section titled “Forward-Looking Statements” above, and in the section entitled “Risk Factors” in the Annual Report.\nOverview\nEmbark develops technologically advanced autonomous driving software for the truck freight industry and offers a carefully constructed business model that is expected to provide the industry with the most attractive path to adopting autonomous driving. Specifically, Embark has developed a Software as a Service (“SaaS”) platform designed to interoperate with a broad range of truck OEM platforms, forgoing complicated and logistically challenging truck building or hardware manufacturing operations in favor of focusing on a superior driving technology. At scale, domestic fleets will be able to access Embark technology via a subscription software license selected as an option at the time they specify the build of new semi-trucks.\nHeadquartered in San Francisco, California, Embark’s history as the industry’s longest running autonomous truck driving program is replete with technological firsts that include, but are not limited to:\n•the first coast-to-coast autonomous truck drive,\n•the first to reach 100,000 autonomous miles on public roads, and\n•the first to successfully open autonomous transfer points for human- autonomous vehicle (“AV”) handoff.\nEmbark’s founding team includes roboticists and its broader team includes numerous computer scientists, many with advanced degrees and experience at other leading robotics and autonomous vehicle companies and academic programs. Embark intends to rapidly scale its engineering team to build on its industry-leading technology position.\nEmbark has also spent considerable time and effort refining its business model. Embark is initially deploying its technology in a very focused manner, targeting freight highway miles between transfer points located next to metropolitan areas in the lower “Sunbelt” region of the U.S., leaving the “last mile” of driving to and from the transfer points to the industry’s highly skilled human drivers. Embark’s strategy is distinct from other industry players which seek to provide more complicated “end to end” autonomous driving that would entirely displace human drivers and potentially place these companies in competition with the industry’s carriers. Unlike those competitors, Embark anticipates working with the industry’s existing players to help them bring autonomous driving technology to market on their own terms. In addition, Embark believes its solution will be the safest and most reliable in the industry because of its disciplined geographic focus and emphasis on software development, which stands in contrast to Embark’s competitors that focus on multiple markets simultaneously, manufacturing autonomous trucks and/or competing directly with semi-truck OEMs or legacy carriers.\nEmbark currently targets the growing $730 billion U.S. truck freight market, and its initial commercial phase targets 236 billion serviceable miles within this market. The freight industry that Embark serves has had to face significant pressures from the growth of e-commerce and the well-documented shortage of skilled drivers, and therefore has powerful incentives to adopt autonomous driving solutions to both improve capacity and reduce costs. In addition, Embark’s cooperative model has already had traction with many of the industry’s leading fleets.\nThe Business Combination\nEmbark entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, pursuant to the Merger Agreement, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks (the “Business Combination”). In connection with the consummation of the Business Combination, the separate corporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\n31\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that our financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results are a net increase in cash of $243.9 million, net of transaction costs for the Business Combination of $70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $27.3 million and $49.4 million, respectively. The Company recorded the change in fair value in warrant liabilities were recorded in the other income (expense) on the condensed consolidated statement of operations.\nAs a result of the Business Combination, Embark became an SEC-registered and Nasdaq-listed company, which required Embark to hire additional personnel and implement procedures and processes to address public company regulatory requirements and customary practices. Embark incurs additional annual expenses as a public company for, among other things, directors’ and officers’ liability insurance, director fees, and additional internal and external accounting, legal and administrative resources.\nRecent Developments Affecting Comparability\nCOVID-19 Impact and the Conflict in Ukraine\nIn March 2020, the World Health Organization declared the 2019 novel coronavirus (“COVID-19”) a global pandemic. In the United States, as part of government-imposed restrictions, Embark was forced to temporarily pause fleet testing and operations in 2020. Embark also implemented a work-from-home policy for most of its non-operations team. However, a select group of workers remained on-site to continue advancing testing work for its test fleet. Since then, Embark has resumed its fleet testing and operations and has increased headcount to match its research and development requirements.\nThe future impact of the COVID-19 pandemic on Embark’s operational and financial performance will depend on certain developments, including the duration and end of the pandemic and the occurrence of future outbreaks from new variants, impact on Embark’s research and development efforts, and effect on Embark’s suppliers, all of which are uncertain and cannot be predicted. Public and private sector policies and initiatives to reduce the transmission of COVID-19 and disruptions to Embark’s operations and the operations of Embark’s third-party suppliers, along with the related global slowdown in economic activity, may result in increased costs. It is possible that the COVID-19 pandemic, the measures that have been taken or that may be taken by the federal, state, local authorities and businesses affected by government-mandated business closures, vaccination mandates and the resulting economic impact may materially and adversely affect Embark’s business, results of operations, cash flows and financial positions.\nWhile we have limited direct business exposure in Russia, Belarus and Ukraine, the Russian military actions and the resulting sanctions could adversely affect the global economy, as well as further disrupt the supply chain. A major disruption in the global economy and supply chain could have a material adverse effect on our business, partners, prospects, financial condition, results of operations, and cash flows. The extent and duration of the military action, sanctions, and resulting market and/or supply disruptions are impossible to predict, but could be substantial.\nKey Factors Affecting Embark’s Operating Performance\nEmbark’s financial condition, results of operations, and future success depend on several factors that present significant opportunities for Embark but also pose risks and challenges, including those set forth the section entitled “Risk Factors” in this quarterly report, the section entitled “Risk Factors” in the Annual Report and in as set forth below:\nEmbark’s Ability to Achieve Key Technical Milestones and Deliver a Commercial Product\nEmbark’s growth will depend on the introduction of Embark Driver and Embark Guardian products which will drive demand from potential customers. Embark has developed a platform agnostic interface, Embark Universal Interface, which will serve as the foundation to utilize Embark Driver and Guardian products in trucks manufactured by a broad range of OEMs. Embark’s ability to introduce its products will be driven by a variety of factors including Embark’s research and development fleet size, the number of autonomous miles driven (measured as the number of miles driven by Embark’s research & development fleet as well as partner fleet autonomous miles), and the ability to provide a safe and sustainable\n32\nsolution based on information gathered from the operation of Embark’s research and development fleet. Embark develops most key technologies in-house to achieve a rapid pace of innovation and tests it extensively through research and development fleet operations. Embark expects an increase in research and development fleet size in the foreseeable future to allow it to strategically focus on innovations, which it believes will help solidify its overall solution to customers and partners. To date, Embark has not generated any revenue and until its products reach commercialization, autonomous miles driven will be comprised of autonomous miles driven by its research and development fleet and the fleet of its partners. Embark believes that as the number of autonomous miles driven increases, the data will continually feed improvements to the platform, allowing it to innovate and introduce new products to the market and increase adoption of its products in the future.\nEmbark’s Ability to Expand its Coverage Map Across the United States\nEmbark’s long-term growth potential will benefit from strategic network expansion across the United States. Network breadth is measured by the number of transfer points on Embark’s coverage map, which are representative of the cities which Embark plans to support. Embark expects to achieve significant network growth by partnering with key real-estate partners which will enable it to quickly bring their properties into its coverage map. Additionally, Embark will partner with carriers and shippers who currently move, or have in the past moved, a significant amount of freight on Embark’s network to add their properties to the network. Embark believes that expanding its network will enable it to create a significant and sustainable competitive advantage. Embark believes that the continued growth of its partnerships will improve user experience and drive more users to its platform, which it believes will allow it to further densify its coverage map and reinforce rapid network growth. Embark will apply a highly scalable model nationally, with a tailored approach to each state, driven by the regulatory environment and local market dynamics. Embark believes that this will allow it to expand rapidly and efficiently across different geographies, while maintaining a high level of control over the specific strategy within each state.\nEmbark’s Ability to Expand its Partner Network\nThe growth of Embark’s business model is focused on driving the adoption of its technical products and maximizing their use across Embark’s partners’ operations. This is achieved by working closely with carrier management teams to prepare them to deploy and scale autonomous trucks. In April 2021, Embark formally announced the Embark Partner Development Program (PDP), which serves as the basis of its partnership network. The PDP is comprised of carriers and shippers from across the freight ecosystem working with Embark to refine and scale Embark’s offerings. Most recently, Embark announced the industry-first Truck Transfer Program to place Embark technology in the hands of Knight-Swift drivers.\nAdoption and Support of Autonomous Technology in the Freight Industry\nEmbark’s business model is supported by a large addressable market that Embark believes will benefit from the introduction of autonomous trucking technology. The freight industry is currently facing significant challenges, notably driver shortages and utilization limitations, which it believes it will address through its product offerings. Embark has identified participants from across the freight ecosystem who have expressed support for Embark’s offerings and the potential solutions they provide to the challenges they are facing.\nWhile Embark has confirmed general market support, the long-term success of its business model is dependent on broad scale adoption and support of autonomous trucking technology. Embark has engaged with notable partners in the freight industry who Embark believes will lead the industry in adopting autonomous vehicle technology. As Embark onboards more partners, it will increase miles driven by partners, which Embark believes will serve to validate its product offerings and generate interest and confidence from other partners. Embark believes customers will be motivated to integrate Embark’s technology to be price competitive with other freight participants who have achieved efficiencies with it.\nKey Components of Embark’s Results of Operations\nThe following discussion describes certain line items in Embark’s condensed consolidated statements of operations.\n33\nOperating Expenses\nOperating expenses consist of research and development expenses and general and administrative expenses. Personnel-related costs are the most significant component of Embark’s operating expenses and include salaries, benefits, and stock-based compensation expenses.\nEmbark’s full-time employee headcount in research and development has grown from 172 as of December 31, 2021 to 242 as of March 31, 2022 and in general and administrative functions has grown from 59 as of December 31, 2021 to 62 as of March 31, 2022. Embark expects to continue to hire new employees to support our growth. The timing of these additional hires could materially affect Embark’s operating expenses in any particular period.\nEmbark expects to continue to invest substantial resources to support its growth and anticipates that each of the following categories of operating expenses will increase in absolute dollar amounts for the foreseeable future.\nResearch and Development Expenses\nResearch and development expenses consist primarily of salaries, employee benefits, stock-based compensation expenses and travel expenses related to Embark’s engineers performing research and development activities to originate, develop and enhance Embark’s products. Additional expenses include consulting charges, component purchases, software licenses and other costs for performing research and development on Embark’s software products.\nGeneral and Administrative Expenses\nGeneral and administrative expenses consist primarily of salaries, employee benefits, stock-based compensation expenses, and travel expenses related to Embark’s executives, finance team, and the administrative employees. They also consists of legal, accounting, consulting, and professional fees, rent and lease expenses pertaining to Embark’s offices, business insurance costs and other costs. Embark expects its general and administrative expenses to increase for the foreseeable future as it scales headcount with the growth of its business, and as a result of operating as a public company, including as a result of compliance with the rules and regulations of the SEC, legal, audit, tax and other administrative and professional services.\nResults of Operations\nThe results of operations presented below should be reviewed in conjunction with the financial statements and notes included elsewhere in this Quarterly Report on Form 10-Q. The following table sets forth Embark’s results of operations data for the periods presented (in thousands):\nComparisons for the three months ended March 31, 2022 and 2021\nThe following table sets forth Embark’s condensed consolidated results of operations data for the periods presented (in thousands):\n| Three Months Ended | $ | % |\n| 2022 | 2021 | Change | Change |\n| Operating expenses: |\n| Research and development | $ | 18,695 | $ | 6,231 | $ | 12,464 | 200.0 | % |\n| General and administrative | 21,926 | 2,290 | 19,636 | 857.5 | % |\n| Total operating expenses | 40,621 | 8,521 | 32,100 | 376.7 | % |\n| Loss from operations | (40,621) | (8,521) | (32,100) | 376.7 | % |\n| Other income, net | 22,174 | 39 | 22,135 | N.M. |\n| Loss before provision for income taxes | (18,447) | (8,482) | (9,965) | 117.5 | % |\n| Provision for income taxes | — | — | — | N.M. |\n| Net loss | $ | (18,447) | $ | (8,482) | $ | (9,965) | 117.5 | % |\n\n_________________________________________________\nN.M. — Percentage change not meaningful\n34\nResearch and Development Expenses\nResearch and development expense increased by $12.5 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $8.8 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to continued expansion of Embark’s research and development team, a $0.2 million increase in infrastructure expenditure related to increased R&D activities, a $0.3 million increase in prototype truck hardware expenses, a $1.8 million increase in general R&D costs primarily driven by engineering software & subscription costs and a $0.2 million increase in computer and equipment expenditure related to an increase in Embark’s research and development team.\nGeneral and Administrative Expense\nGeneral and administrative expense increased by $19.6 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $16.5 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to growth in the business, a $0.5 million increase in occupancy expenses related to additional leases, a $0.2 million increase in fleet operation expenses due to increased activity, a $0.6 million increase in insurance expenses and a $0.3 million increase in travel and events expenditure.\nOther income (expense), net\nOther income increased by $22.1 million in the three months ended March 31, 2022 compared to the three months ended March 31, 2021. The increase was primarily due to the change in the estimated fair value of Public, Private, Working Capital and FPA Warrants of $22.2 million.\nLiquidity and Capital Resources\nSince Embark’s inception, it has financed its operations primarily through the sale of shares of common stock and preferred stock.\nIn connection with the Business Combination, a convertible promissory note (the “Convertible Note”) issued by Embark in April 2021 was converted in exchange for 3,774,951 shares of Embark Class A common stock. As of March 31, 2022, Embark had outstanding debt of $1.0 million from a financing of freight trucks that it utilizes for research and development. Embark makes monthly installment payments on its truck financing arrangements. The truck financings have varying maturities between March 2023 and January 2027. Embark’s principal uses of cash in recent periods have been to fund its operations, invest in research and development, repay borrowings, and make investments in accordance with its investments policy.\nEmbark believes existing cash and other components of working capital will be sufficient to meet its needs for at least the next 12 months. Embark’s long-term capital requirements will depend on many factors including timing and extent of spending to support research and development efforts as well as general and administrative activities for the business. If, at any time, Embark determines it requires more capital to execute upon its business plan, and /or that market conditions are favorable, Embark may seek additional equity or debt financing. Additionally, in the event Embark may in the future enter into arrangements to acquire or invest in related products, technologies, software and services, and Embark may need to seek additional equity or debt financing to support such growth. As of March 31, 2022, there were future minimum lease payments of $7.1 million.\nEmbark currently transports shipments using its research and development truck fleet, demonstrating proof of concept and paving the way for commercialization and revenue generating operations in the future. However, Embark has not earned any revenue to date, and had $244.5 million in cash and cash equivalents and an accumulated deficit of $201.4 million as of March 31, 2022. To the extent Embark is unable to commercialize its technology as expected, its liquidity may be negatively impacted.\nEmbark’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable Embark to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\n35\nThe following table shows Embark’s cash flows from operating activities, investing activities and financing activities for the stated periods:\n| Three Months Ended March 31, |\n| 2022 | 2021 |\n| Net cash (used in) provided by: | (unaudited) |\n| Operating activities | $ | (18,225) | $ | (6,791) |\n| Investing activities | $ | (1,717) | $ | 17,270 |\n| Financing activities | $ | 287 | $ | 28 |\n\nOperating Activities\nNet cash used in operating activities for the three months ended March 31, 2022 was $18.2 million, an increase of $11.4 million from $6.8 million for the three months ended March 31, 2021. The increase was primarily due to an increase of $10.0 million net loss for the three months ended March 31, 2022 compared to the three months ended March 31, 2021. In addition, the increase was partially attributable to $5.7 million of non-cash adjustments to net loss, including $0.6 million of depreciation and amortization, $22.2 million of change in fair value of warrant liability, as well as $16.0 million of stock-based compensation, and partially offset by $4.2 million net cash increase by changes in Embark’s operating assets and liabilities, which was primarily attributable to accounts payable, accrued expenses and other current liabilities primarily due to overall growth and timing of payables.\nInvesting Activities\nNet cash used in investing activities for the three months ended March 31, 2022 was $1.7 million, a decrease of $19.0 million from $17.3 million of net cash provided by investing activities for the three months ended March 31, 2021. The decrease was primarily due to a decrease of $18.2 million in proceeds received from maturities of investments, and an increase in purchase of property, equipment, and software of $0.7 million.\nFinancing Activities\nNet cash provided by financing activities for the three months ended March 31, 2022 was $0.3 million compared to $28,000 of net cash used in investing activities for the three months ended March 31, 2021. The increase was primarily due to an increase of $0.3 million in proceeds received from the exercise of employee stock options.\nFinancing Arrangements\nThere have been no material changes outside the ordinary course of business in Embark’s financing arrangements as previously disclosed in Embark’s Annual Report.\nOff-Balance Sheet Arrangements\nEmbark did not have any off-balance sheet arrangements as of March 31, 2022.\nCritical Accounting Policies and Significant Management Estimates\nThe preparation financial statements in conformity with generally accepted accounting principles requires management to make judgments, estimates and assumptions in the preparation of Embark’s financial statements and accompanying notes. Actual results could differ from those estimates. There have been no material changes to Embark’s critical accounting policies or estimates during the three months ended March 31, 2022, from those discussed in Embark’s Annual Report.\nRecent Accounting Pronouncements\n36\nFor information on recently issued accounting pronouncements, refer to Note 2. Summary of Significant Accounting Policies in Embark’s condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.\nJOBS Act Accounting Election\nEmbark is an emerging growth company (EGC), as defined in the JOBS Act. Under the JOBS Act, EGCs can delay adopting new or revised accounting standards until such time as those standards apply to private companies. Embark intends to elect to adopt new or revised accounting standards under private company adoption timelines. Accordingly, the timing of Embark’s adoption of new or revised accounting standards will not be the same as other public companies that are not emerging growth companies or that have opted out of using such extended transition period.\nItem 3. Quantitative and Qualitative Disclosures About Market.\nEmbark is exposed to certain market risks as part of its ongoing business operations.\nCredit Risk\nEmbark is exposed to credit risk on its investment portfolio. Investments that potentially subject us to credit risk consist principally of cash and investments in debt securities. Embark places cash and cash equivalents with financial institutions with high credit standing and excess cash in marketable investment grade debt securities.\nInterest Rate Risk\nEmbark is exposed to interest rate risk on its investment portfolio. Investments that potentially subject Embark to interest rate risk consist principally of cash and investments in debt securities. As of March 31, 2022, Embark has cash and cash equivalents of $244.5 million, consisting of U.S. Treasury securities and interest-bearing money market accounts for which the fair market value would be affected by changes in the general level of U.S. interest rates. However, due to the short-term maturities and the low-risk profile of Embark’s investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of its cash, cash equivalents, and investments.\nInflation Risk\nEmbark is exposed to impact of wage inflation, and has experienced wage inflation during 2021. Although wages have increased during 2021, and the continuing supply chain crisis and geopolitical conflict in Ukraine may contribute to continuing inflation, Embark does not believe that inflation has had a material effect on its business, results of operations, or financial condition. If Embark’s costs were to become subject to more significant inflationary pressures before we commercialize and sell our technology, we will not be able to offset such higher costs through price increases. Embark’s inability to do so could harm its business, results of operations, and financial condition.\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nOur management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our CEO and CFO concluded that, as of March 31, 2022, due to the material weakness described in the Annual Report, our disclosure controls and procedures were not effective.\nAs disclosed in Part II, Item 9A, “Controls and Procedures” in our Annual Report, we identified a material weakness in our internal control over financial reporting resulting from a lack of sufficient number of qualified personnel within our accounting function who possessed an appropriate level of expertise to effectively perform the following functions:\n•identify, select and apply GAAP sufficiently to provide reasonable assurance that transactions were being appropriately recorded; and\n37\n•assess risk and design appropriate control activities over information technology systems and financial and reporting processes necessary to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements.\nStatus of remediation efforts\nIn response to the material weaknesses identified and described above, our management, with the oversight of the Audit Committee of our Board of Directors, will continue through 2022 to dedicate significant efforts and resources to further improve our control environment and to take steps to remediate these material weaknesses.\nChanges in Internal Control Over Financial Reporting\nExcept for changes in connection with our implementation of the remediation measures or as described above, there were no changes in our internal control over financial reporting during the three months ended March 31, 2022, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n38\nPart II - OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time, Embark may be involved in actions, claims, suits, and other proceedings in the ordinary course of its business. In addition, from time to time, third parties may in the future assert intellectual property infringement claims against Embark in the form of letters and other forms of communication. Litigation or any other legal or administrative proceeding, regardless of the outcome, can result in substantial cost and diversion of its resources, including its management’s time and attention. Such matters are subject to uncertainty and there can be no assurance that such legal proceedings will not have a material adverse effect on our business, the results of operations, financial position or cash flows.\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark Technology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly suffered financial harm as a result.\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-referenced matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonably estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\nItem 1A. Risk Factors\nThere are no material changes to the risk factors discussed in Embark’s Annual Report under the heading “Risk Factors.” You should carefully consider these risks, together with management’s discussion and analysis of Embark’s financial condition and results of operations in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q. If any of the events contemplated should occur, Embark’s business, results of operations, financial condition and cash flows could suffer significantly.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone.\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot Applicable.\nItem 5. Other Information\nNone.\n39\nItem 6. Exhibits\n| Incorporated by Reference |\n| ExhibitNumber | Description | Form | File No. | Date | Exhibit | Filed Herewith |\n| 2.1+ | Agreement and Plan of Merger, dated as of June 22, 2021, by and among Northern Genesis Acquisition Corp. II, NGAB Merger Sub Inc. and Embark Trucks Inc. | 8-K | 001-39881 | 6/23/2021 | 2.1 |\n| 3.1 | Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II. | 8-K | 001-39881 | 11/17/2021 | 3.1 |\n| 3.2 | Amended and Restated Bylaws of Embark Technology, Inc. | 8-K | 001-39881 | 11/17/2021 | 3.2 |\n| 4.1 | Specimen Warrant Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.5 |\n| 4.2 | Specimen Class A Common Stock Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.6 |\n| 4.3 | Warrant Agreement, dated as of January 12, 2021, by and among Northern Genesis Acquisition Corp. II and Continental Stock Transfer & Trust Company, as warrant agent. | 8-K | 001-39881 | 1/19/2021 | 4.1 |\n| 31.1** | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 31.2** | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 32.1** | Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRIL document. | X |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | X |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | X |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | X |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. | X |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | X |\n| 104 | Cover Page Interactive Data File - the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL Document. | X |\n\n________________________\n* Filed herewith.\n** Furnished herewith. The certifications attached as Exhibit 31.1, Exhibit 31.2 and Exhibit 32.1 that accompanies this Quarterly Report on Form 10-Q is deemed furnished and not filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Embark Technology, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q, irrespective of any general incorporation language contained in such filing.\n+ Schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The Registrant agrees to furnish supplementally a copy of any omitted schedule or exhibit to the SEC upon request.\n40\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, on May 11, 2022.\n| EMBARK TECHNOLOGY, INC. |\n| By: | /s/ Alex Rodrigues |\n| Name: | Alex Rodrigues |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n\n| EMBARK TECHNOLOGY, INC. |\n| By: | /s/ Richard Hawwa |\n| Name: | Richard Hawwa |\n| Title: | Chief Financial Officer |\n| (Principal Financial and Principal Accounting) |\n\n41\n</text>\n\nWhat is the year on year percentage change in the Accumulated Deficit for the first quarter of 2022 compared to the first quarter of 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1. Financial Statements (unaudited).\\n4\\nEmbark Technology, Inc.\\nCondensed Consolidated Balance Sheets\\n(in thousands, except share and per share data)\\n(unaudited)\\n| March 31,2022 | December 31,2021 |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 244,488 | $ | 264,615 |\\n| Restricted cash, short-term | 65 | 130 |\\n| Prepaid expenses and other current assets | 12,005 | 12,746 |\\n| Total current assets | 256,558 | 277,491 |\\n| Restricted cash, long-term | 812 | 275 |\\n| Property, equipment and software, net | 11,086 | 9,637 |\\n| Operating lease right-of-use assets | 6,099 | — |\\n| Other assets | 3,722 | 3,596 |\\n| Total assets | $ | 278,277 | $ | 290,999 |\\n| Liabilities and stockholders’ equity |\\n| Current liabilities: |\\n| Accounts payable | $ | 4,099 | $ | 2,497 |\\n| Accrued expenses and other current liabilities | 6,151 | 3,142 |\\n| Current portion of operating lease liabilities | 1,948 | — |\\n| Short-term notes payable | 357 | 358 |\\n| Total current liabilities | 12,555 | 5,997 |\\n| Long-term notes payable | 641 | 722 |\\n| Warrant liability | 27,264 | 49,419 |\\n| Non-current portion of operating lease liabilities | 4,438 | — |\\n| Other long-term liability | 111 | 50 |\\n| Long-term deferred rent | — | 177 |\\n| Total liabilities | 45,009 | 56,365 |\\n| Commitments and contingencies (Note 10) |\\n| Stockholders’ equity: |\\n| Preferred stock, $ 0.0001 par value; 10,000,000 shares authorized, none issued and none outstanding as of March 31, 2022 and December 31, 2021 | — | — |\\n| Class A common stock, $ 0.0001 par value; 4,000,000,000 shares authorized, 362,832,986 shares issued as of March 31, 2022; 4,000,000,000 shares authorized, 362,832,986 shares issued as of December 31, 2021 | 36 | 36 |\\n| Class B common stock, $ 0.0001 par value; 100,000,000 shares authorized, 87,078,981 shares issued as of March 31, 2022 and December 31, 2021 | 9 | 9 |\\n| Additional paid-in capital | 434,573 | 417,492 |\\n| Accumulated deficit | ( 201,350 ) | ( 182,903 ) |\\n| Total stockholders’ equity | 233,268 | 234,634 |\\n| Total liabilities and stockholders’ equity | $ | 278,277 | $ | 290,999 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n5\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Operations\\n(in thousands, except share and per share data)\\n(unaudited)\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Operating expenses: |\\n| Research and development | $ | 18,695 | $ | 6,231 |\\n| General and administrative | 21,926 | 2,290 |\\n| Total operating expenses | 40,621 | 8,521 |\\n| Loss from operations | ( 40,621 ) | ( 8,521 ) |\\n| Other income (expense): |\\n| Change in fair value of warrant liability | 22,156 | — |\\n| Other income | 26 | 9 |\\n| Interest income | 13 | 30 |\\n| Interest expense | ( 21 ) | — |\\n| Loss before provision for income taxes | ( 18,447 ) | ( 8,482 ) |\\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Net loss attributable to common stockholders, basic and diluted | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Net loss per share attributable to common stockholders: |\\n| Basic and diluted, Class A and Class B | $ | ( 0.04 ) | $ | ( 0.18 ) |\\n| Weighted-average shares used in computing net loss per share attributable to common stockholders: |\\n| Basic and diluted | 452,623,022 | 47,538,331 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n6\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Comprehensive Loss\\n(in thousands)\\n(unaudited)\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Other comprehensive loss (net of tax): |\\n| Unrealized losses on available-for-sale securities, net | — | ( 19 ) |\\n| Comprehensive loss | $ | ( 18,447 ) | $ | ( 8,501 ) |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n7\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\\n(in thousands, except number of shares)\\n(unaudited)\\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\\n| Balance at January 1, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 417,492 | $ | ( 182,903 ) | $ | — | $ | 234,634 |\\n| Shares issued upon exercise of stock options | — | — | — | — | — | — | — | — | — | — | — | 372 | — | — | 372 |\\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 11 | — | — | 11 |\\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 16,698 | — | — | 16,698 |\\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 18,447 ) | — | ( 18,447 ) |\\n| Balance at March 31, 2022 | — | $ | — | — | $ | — | — | $ | — | 362,832,986 | $ | 36 | 87,078,781 | $ | 9 | 23,153,266 | $ | 434,573 | $ | ( 201,350 ) | $ | — | $ | 233,268 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n8\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Preferred Stock and Stockholder’s Equity\\n(in thousands, except number of shares)\\n(unaudited)\\n| Preferred Stock | Founders Preferred Stock | Common Stock | Class A | Class B | Warrants | Additional Paid-in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income (Loss) | TotalStockholders'Equity |\\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\\n| Balance at January 1, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 141,216,455 | $ | — | — | $ | — | — | $ | — | — | $ | 129,449 | $ | ( 58,690 ) | $ | 45 | $ | 70,805 |\\n| Shares issued upon exercise of stock options | — | — | — | — | 1,244,349 | — | — | — | — | — | — | 94 | — | — | 94 |\\n| Vesting of early exercised options | — | — | — | — | — | — | — | — | — | — | — | 5 | — | — | 5 |\\n| Stock-based compensation | — | — | — | — | — | — | — | — | — | — | — | 598 | — | — | 598 |\\n| Issuance of common stock warrants | — | — | — | — | — | — | — | — | — | — | — | 83 | — | — | 83 |\\n| Other comprehensive loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 19 ) | ( 19 ) |\\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | ( 8,482 ) | — | ( 8,482 ) |\\n| Balance at March 31, 2021 | 260,582,311 | $ | 1 | 484,912 | $ | — | 142,460,804 | $ | — | — | $ | — | — | $ | — | — | $ | 130,229 | $ | ( 67,172 ) | $ | 26 | $ | 63,084 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n9\\nEmbark Technology, Inc.\\nCondensed Consolidated Statements of Cash Flows\\n(in thousands)\\n(unaudited)\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Cash flows from operating activities |\\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Depreciation and amortization | 383 | 222 |\\n| Amortization expense - right-of-use assets - operating leases | 488 | — |\\n| Stock-based compensation, net of amounts capitalized | 16,602 | 562 |\\n| Issuance of warrants for services | — | 83 |\\n| Change in fair value of warrants | ( 22,156 ) | — |\\n| Net amortization of premiums and accretion of discounts on investments | — | 120 |\\n| Changes in operating assets and liabilities: |\\n| Prepaid expenses and other current assets | 682 | 29 |\\n| Other assets | ( 126 ) | ( 65 ) |\\n| Accounts payable | 1,644 | 264 |\\n| Other long-term liabilities | 60 | — |\\n| Accrued expenses and other current liabilities | 2,645 | 476 |\\n| Net cash used in operating activities | ( 18,225 ) | ( 6,791 ) |\\n| Cash flows from investing activities |\\n| Maturities of investments | — | 18,243 |\\n| Purchase of property, equipment and software | ( 1,717 ) | ( 973 ) |\\n| Net cash provided by (used in) investing activities | ( 1,717 ) | 17,270 |\\n| Cash flows from financing activities |\\n| Payment towards notes payable | ( 81 ) | ( 66 ) |\\n| Proceeds from exercise of stock options | 372 | 94 |\\n| Repurchase of early exercised stock options | ( 4 ) | — |\\n| Net cash provided by (used in) financing activities | 287 | 28 |\\n| Net increase (decrease) in cash, cash equivalents and restricted cash | ( 19,655 ) | 10,507 |\\n| Cash, cash equivalents and restricted cash at beginning of period | 265,020 | 11,460 |\\n| Cash, cash equivalents and restricted cash at end of period | $ | 245,365 | $ | 21,967 |\\n| Supplemental disclosures of cash flow information: |\\n| Cash paid during the year for interest | $ | 18 | $ | 16 |\\n| Supplemental schedule of noncash investing and financing activities |\\n| Acquisition of property, equipment and software in accounts payable | $ | 284 | $ | 176 |\\n| Acquisition of trucks by assuming notes payable | $ | — | $ | 278 |\\n| Right-of-use assets obtained in exchange for lease obligations | $ | 6,587 | $ | — |\\n| Stock-based compensation capitalized into internally developed software | $ | 156 | $ | 36 |\\n| Vesting of early exercised stock options | $ | 15 | $ | 5 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n10\\nNotes to Condensed Consolidated Financial Statements\\n1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION\\nEmbark Technology, Inc. was originally incorporated in Delaware on September 25, 2020 under the name Northern Genesis Acquisition Corp. II (“NGA”). The Company was formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On November 10, 2021 (the “Closing Date”), the Company (at such time named Northern Genesis Acquisition Corp. II) consummated the business combination (the “Business Combination”) pursuant to the Agreement and Plan of Merger, dated June 22, 2021 with the pre-Business Combination company, Embark Trucks, Inc. (“Embark Trucks”). In connection with the consummation of the Business Combination, the Company changed its name from Northern Genesis Acquisition Corp. II to Embark Technology, Inc. and became the parent entity of Embark Trucks.\\nThe Merger was accounted for as a reverse recapitalization with Embark as the accounting acquirer and NGA as the acquired company for accounting purposes. Accordingly, all historical financial information presented in the financial statements represent the accounts of Embark as if Embark is the predecessor to the Company. The shares and net loss per common share, prior to the Merger, have been retroactively restated as shares reflecting the exchange ratio established in the Merger (approximately 2.98 shares of Company Class A common stock for 1 share of Embark Class A common stock).\\nThe principal activities of Embark Technology, Inc. (“Embark” or the “Company”) include design and development of autonomous driving software for the truck freight industry. The Company is headquartered in San Francisco, California and was incorporated in the State of Delaware in 2016. Other than Embark Trucks, the Company has no subsidiaries as of March 31, 2022.\\nThe Company has devoted substantially all of its resources to develop its autonomous truck technology, to enable and expand its route models - transfer point and direct-to-customer, to expand its partnerships with shippers and carriers, to raising capital, and providing general and administrative support for these operations. The Company has not generated revenues from its principal operations through March 31, 2022.\\nPrior to the Merger, NGA ordinary shares and warrants were traded on the New York Stock Exchange (“NYSE”) under the ticker symbols “NGAB” and “NGAB.WS”, respectively. On the Closing Date, the Company’s Class A common stock and warrants began trading on the NASDAQ under the ticker symbols “EMBK” and “EMBKW”, respectively. One of the primary purposes of the Merger was to provide a platform for Embark Trucks to gain access to the U.S. capital markets.\\nBasis of Presentation\\nThe accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and pursuant to the regulations of the U.S. Securities and Exchange Commission (“SEC”).\\nUnaudited Interim Financial Information\\nThese interim Unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited financial statements and notes thereto contained in Embark’s Annual Report. The condensed consolidated balance sheet at December 31, 2021, has been derived from the audited financial statements at that date, but does not include all disclosures, including notes, required by GAAP for complete financial statements. In management’s opinion, the unaudited interim financial statements have been prepared on the same basis as the annual financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2022 and the Company’s results of operations and cash flows for the three months ended March 31, 2022 and 2021. The interim results are not necessarily indicative of the results for any future interim period or for the entire year.\\nBusiness Combination\\nThe Company entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, as part of the Business Combination, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks. In connection with the consummation of the Business Combination, the separate\\n11\\ncorporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that Embark’s financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results were a net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $ 27.3 million and $ 49.4 million, respectively.\\nLiquidity and Capital Resources\\nOn November 10, 2021, Embark consummated the Business Combination, generating net increase in cash of $ 243.9 million, net of transaction costs for the Business Combination of $ 70.2 million.\\nThe Company has incurred losses from operations since inception. The Company incurred net losses of $ 18.4 million and $ 8.5 million for the three months ended March 31, 2022 and 2021, respectively, and accumulated deficit amounts to $ 201.4 million and $ 182.9 million as of March 31, 2022 and December 31, 2021, respectively. Net cash used in operating activities was $ 18.2 million and $ 6.8 million for the three months ended March 31, 2022 and 2021, respectively.\\nThe Company’s liquidity is based on its ability to enhance its operating cash flow position, obtain capital financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures. As of March 31, 2022 and December 31, 2021, the Company’s balance of cash and cash equivalents was $ 244.5 million and $ 264.6 million, respectively.\\nBased on cash flow projections from operating and financing activities and existing balance of cash and cash equivalents and investments, management is of the opinion that the Company has sufficient funds for sustainable operations, and it will be able to meet its payment obligations from operations and debt related commitments for at least one year from the issuance date of these financial statements. Based on the above considerations, the Company’s financial statements have been prepared on a going concern basis, which contemplates the realization of assets and liquidation of liabilities during the normal course of operations.\\nThe Company’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable the Company to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\\nEmerging Growth Company\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes- Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but\\n12\\nany such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nSegment Information\\nUnder Accounting Standards Codification (“ASC 280”), Segment Reporting, operating segments are defined as components of an enterprise where discrete financial information is available that is evaluated regularly by the chief operating decision-maker (“CODM”), in deciding how to allocate resources and in assessing performance. The Company operates in one segment, the truck business unit, which is focused on enhancing self-driving truck software technology. Therefore, the Company’s chief executive officer, who is also the CODM, makes decisions and manages the Company’s operations as a single operating segment for purposes of allocating resources and evaluating financial performance. All long-lived assets are maintained in, and all losses are attributable to, the United States of America.\\nConcentration of Risks\\nEmbark’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents and restricted cash. Embark maintains its cash and cash equivalents, restricted cash and investments with high-quality financial institutions with investment-grade ratings. A majority of the cash balances are with U.S. banks and are insured to the extent defined by the Federal Deposit Insurance Corporation.\\nImpact of COVID-19\\nThe outbreak of the novel coronavirus COVID-19, which was declared a global pandemic by the World Health Organization on March 11, 2020 has led to adverse impacts on the U.S. and global economies and has impacted and continues to impact the Company’s supply chain, and operations. Even though the Company has taken measures to adapt to operating in this challenging environment, the pandemic could further affect the Company’s operations and the operations of, partners, suppliers and vendors due to additional shelter- in-place and other governmental orders, facility closures, travel and logistics restrictions, or other factors as circumstances continue to evolve. In response to this pandemic, many jurisdictions in which the Company operates issued stay-at-home orders and other measures aimed at slowing the spread of the virus. While the Company remains open in accordance with guidance from local authorities, the Company experienced a temporary pause in testing of its research and development truck fleet and operations in response to the stay- at-home orders in calendar year 2021. The impacts from stay-at-home orders and other updated local government indoor operation measures are no longer impacting the Company’s operations in 2021, however, there remains uncertainty around the potential disruptions the pandemic could cause looking forward. The Company has instituted policies across its offices to ensure compliance with these updated guidelines. At current, these changes have not impacted the Company’s operations. In response to the Delta and Omicron variants, local governments updated their guidelines for indoor operations. Therefore, the related financial impact and duration cannot be reasonably estimated at this time.\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nUse of Estimates\\nThe preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the balance sheet date, as well as reported amounts of expenses during the reporting period.\\nThe Company’s most significant estimates and judgments involve the useful lives of long-lived assets, the recoverability of long-lived assets, the incremental borrowing rate (“IBR”) applied in lease accounting, the capitalization of software development costs, the valuation of the Company’s stock-based compensation, including the valuation of warrants to purchase the Company’s stock and the valuation allowance for income taxes. Management bases its estimates on historical experience and on various other assumptions believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from those estimates.\\n13\\nCash, Cash Equivalents and Restricted Cash\\nThe Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. As of March 31, 2022 and December 31, 2021, the Company had $ 244.5 million and $ 264.6 million of cash and cash equivalents, respectively.\\nThe Company maintains letters of credit to secure leases of the Company’s offices and facilities. A portion of the Company’s cash is collateralized in conjunction with the letter of credit and is classified as restricted cash on the Company’s condensed consolidated balance sheets. As of March 31, 2022 and December 31, 2021, the Company had $ 0.9 million and $ 0.4 million in restricted cash, respectively. At the end of each year of the lease, the face amount of the letter of credit is reduced by a fixed amount of approximately $ 0.1 million and reclassified into cash and cash equivalents on the Company’s condensed consolidated balance sheets. The Company determines short-term or long-term classification based on the expected duration of the restriction.\\nThe reconciliation of cash and cash equivalents and restricted cash and cash equivalents to amounts presented in the condensed consolidated statements of cash flows are as follows (in thousands):\\n| As of March 31, | As of December 31, |\\n| 2022 | 2021 | 2021 |\\n| Cash and cash equivalents | 244,488 | 21,562 | 264,615 |\\n| Restricted cash, short-term | 65 | 65 | 130 |\\n| Restricted cash, long-term | 812 | 340 | 275 |\\n| Total cash, cash equivalents and restricted cash | 245,365 | 21,967 | 265,020 |\\n\\nFair Value of Financial Instruments\\nThe Company’s financial instruments consist of cash and cash equivalents, restricted cash, prepaid expenses and other current assets, accounts payable and accrued expenses, short-term and long-term notes payable and other current liabilities. The assets and liabilities that were measured at fair value on a recurring basis are cash equivalents and warrant liabilities. The Company believes that the carrying values of the remaining financial instruments approximate their fair values. The Company applies fair value accounting in accordance with ASC 820, Fair Value Measurements for valuation of financial instruments. ASC 820 provides a framework for measuring fair value under GAAP that expands disclosures about fair value measurements, establishes a fair value hierarchy, and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of the fair value hierarchy are summarized as follows:\\nLevel 1 — Fair value is based on observable inputs such as quoted prices for identical assets or liabilities in active markets.\\nLevel 2 — Fair value is determined using quoted prices for similar assets or liabilities in active markets or quoted prices for identical or similar assets or liabilities in markets that are not active or are directly or indirectly observable.\\nLevel 3 — Fair value is determined using one or more significant inputs that are unobservable in active markets at the measurement date, such as an option pricing model, discounted cash flow, or similar technique.\\nPublic and Private Warrants\\nAs part of NGA’s initial public offering on October 13, 2020, NGA issued to third party investors 41.4 million units, consisting of one share of Class A common stock of NGA and one-third of one warrant, at a price of $ 10.00 per unit. Each whole warrant entitles the holder to purchase one share of Class A common stock at an exercise price of $ 11.50 per share (the \\\"Public Warrants\\\"). Further, NGA completed the private sale of 6.7 million warrants to NGA's sponsor at a purchase price of $ 1.50 per warrant (the \\\"Private Warrants\\\"). Each Private Warrant allows the sponsor to purchase one share of Class A common stock at $ 11.50 per share. Subsequent to the Business Combination, 13.8 million Public Warrants and 6.7 million Private Warrants remained outstanding as of March 31, 2022.\\n14\\nThe Private Placement Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Placement Warrants and the Class A common stock issuable upon the exercise of the Private Placement Warrants did not become transferable, assignable or salable until 30 days after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Placement Warrants are exercisable on a cashless basis and are non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Placement Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Placement Warrants are redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\\nThe Company evaluated the Public and Private Warrants under ASC 815-40, Derivatives and Hedging-Contracts in Entity's Own Equity, and concluded that they do not meet the criteria to be classified in stockholders' equity. Since the Public and Private Warrants meet the definition of a derivative under ASC 815, the Company recorded these warrants as liabilities on the balance sheet at fair value upon the closing of the Business Combination, with subsequent changes in their respective fair values recognized in the condensed consolidated statement of operations and comprehensive income (loss) at each reporting date.\\nConvertible Notes and Derivatives\\nThe Company accounts for its derivatives in accordance with, ASC 815-10, Derivatives and Hedging, or ASC 815-15, Embedded Derivatives, depending on the nature of the derivative instrument. ASC 815 requires each contract that is not a derivative in its entirety be assessed to determine whether it contains embedded derivatives that are required to be bifurcated and accounted for as a derivative financial instrument. The embedded derivative is bifurcated from the host contract and accounted for as a freestanding derivative if the combined instrument is not accounted for in its entirety at fair value with changes in fair value recorded in earnings, the terms of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms as the embedded derivative would qualify as a derivative instrument. Embedded derivatives are measured at fair value and remeasured at each subsequent reporting period, and recorded within convertible notes, net on the accompanying Balance Sheets and changes in fair value recorded in other expense within the Statements of Operations. Upon the consummation of the Merger, the related convertible note liability was extinguished. As of March 31, 2022, the Company held no derivative instruments.\\nProperty, Equipment and Software\\nProperty, equipment and software is stated at cost less accumulated depreciation. Repair and maintenance costs are expensed as incurred. Depreciation and amortization are recorded on a straight-line basis over each asset’s estimated useful life.\\n| Property, Equipment and Software | Useful life (years) |\\n| Machinery and equipment | 5 years |\\n| Electronic equipment | 3 years |\\n| Vehicles and vehicle hardware | 3 – 7 years |\\n| Leasehold improvements | Shorter of useful life or lease term |\\n| Furniture and fixtures | 7 years |\\n| Developed software | 2 – 4 years |\\n\\nLeases\\nThe Company determines if a contract contains a lease at inception of the arrangement based on whether the Company has the right to obtain substantially all of the economic benefits from the use of an identified asset and whether the Company has the right to direct the use of an identified asset in exchange for consideration, which relates to an asset which the Company does not own. Right of use (“ROU”) assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. ROU assets are recognized as the lease liability, adjusted for lease incentives received. Lease liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is the Company’s incremental borrowing rate (“IBR”), because the interest rate implicit in most of its leases is not readily determinable. The IBR is a hypothetical rate based on the Company’s understanding of what its credit rating would be to borrow and resulting interest we would pay to borrow an amount equal to the lease\\n15\\npayments in a similar economic environment over the lease term on a collateralized basis. Lease payments may be fixed or variable; however, only fixed payments or in-substance fixed payments are included in the Company’s lease liability calculation. Variable lease payments may include costs such as common area maintenance, utilities, real estate taxes or other costs. Variable lease payments are recognized in operating expenses in the period in which the obligation for those payments are incurred.\\nOperating leases are included in operating lease ROU assets, operating lease liabilities, current and operating lease liabilities, non-current on the Company’s condensed consolidated balance sheets. For operating leases, lease expense is recognized on a straight-line basis in operations over the lease term. The Company elected the practical expedient not to separate non-lease components from lease components, therefore, the Company accounts for lease and non-lease components as a single lease component. The Company also elected the short-term lease recognition practical expedient for all leases that qualify.\\nImpairment of Long-Lived Assets\\nThe Company reviews its long-lived assets for impairment annually, or whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. The Company assesses the recoverability of these assets by comparing the carrying amount of such assets or asset group to the future undiscounted cash flows it expects the assets or asset group to generate. The Company recognizes an impairment loss if the sum of the expected long-term undiscounted cash flows that the long-lived asset is expected to generate is less than the carrying amount of the long-lived asset being evaluated.\\nIncome Taxes\\nThe Company accounts for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.\\nA valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. Due to the Company’s lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance as of March 31, 2022 and December 31, 2021. Uncertain tax positions taken or expected to be taken in a tax return are accounted for using the more likely than not threshold for financial statement recognition and measurement.\\nStock-based Compensation\\nStock-based compensation expense related to stock option awards, restricted stock units (“RSUs”) and performance stock units (“PSUs”) granted to employees, directors and non-employees based on estimated grant-date fair values. For stock option awards, the Company uses the straight-line method to allocate compensation expense to reporting periods over each optionee’s requisite service period, which is generally the vesting period, and estimates the fair value of share-based awards to employees and directors using the Black-Scholes option- pricing model. The Black-Scholes model requires the input of subjective assumptions, including expected volatility, expected dividend yield, expected term, risk-free rate of return and the stock price of the underlying common shares on the date of grant. The fair value of each RSU is based on the fair value of the Company’s common stock on the date of grant. The related stock-based compensation is recognized on a graded vesting basis as the RSU awards are associated with a performance condition. For PSU awards, the Company uses the graded vesting to allocate compensation expense, as the PSU awards are associated with market conditions, over the holder’s derived service period, and estimates the fair value of the PSU awards using the Monte Carlo simulation. The Company accounts for the effect of forfeitures as they occur.\\nInternal Use Software\\nThe Company capitalizes certain costs associated with creating and enhancing internally developed software related to the Company’s technology infrastructure and such costs are recorded within property, equipment and software, net. These costs include personnel and related employee benefit expenses for employees who are directly associated with and who devote time to software development projects. Software development costs that do not qualify for capitalization are expensed as incurred and recorded in research and development expense in the Statements of Operations and comprehensive income (loss).\\n16\\nSoftware development activities typically consist of three stages: (1) the planning phase; (2) the application and infrastructure development stage; and (3) the post implementation stage. Costs incurred in the planning and post implementation phases, including costs associated with training and repairs and maintenance of the developed technologies, are expensed as incurred. The Company capitalizes costs associated with software developed when the preliminary project stage is completed, management implicitly or explicitly authorizes and commits to funding the project and it is probable that the project will be completed and perform as intended. Costs incurred in the application and infrastructure development phases, including significant enhancements and upgrades, are capitalized. Capitalization ends once a project is substantially complete, and the software is ready for its intended purpose. Software development costs are depreciated using a straight-line method over the estimated useful life, commencing when the software is ready for its intended use. The straight-line recognition method approximates the manner in which the expected benefit will be derived. Internal use software is tested for impairment in accordance with the Company’s long- lived assets impairment policy.\\nResearch and Development Expense\\nResearch and development expense consist of outsourced engineering services, allocated facilities costs, depreciation, internal engineering and development expenses, materials, labor and stock-based compensation related to development of the Company’s products and services. Research and development costs are expensed as incurred except for amounts capitalized to internal-use software.\\nGeneral, and Administrative Expenses\\nGeneral, and administrative expense consist of personnel costs, allocated facilities expenses, depreciation and amortization, travel, and business development costs.\\nChange in fair value of warrant liability\\nChange in fair value of warrant liability represents the change in fair value of Public, Private, Working Capital and Forward Purchase Agreement (“FPA”) Warrants. For each reporting period, Embark will determine the fair value of the warrant liability, and record a corresponding non-cash benefit or non-cash charge, due to a decrease or increase, respectively, in the calculated warrant liability.\\nOther Income\\nAs part of the Company’s research and development activities, we contract with shippers and freight carriers to transfer freight between the Company’s transfer hubs in return for cash consideration. Transferring freight with the Company’s research and development truck fleet are not and will not be considered an output of the Company’s ordinary activities. Consideration received from such arrangements is presented as other income in the Company’s Condensed Consolidated Statement of Operations.\\nInterest Income\\nInterest income primarily consists of investment and interest income from marketable securities, long- term investments and the Company’s cash and cash equivalents.\\nInterest Expense\\nInterest expense consisted primarily of interest on the Company’s various truck financing arrangements.\\nNet Loss Per Share\\nPrior to the Merger and prior to effecting the recapitalization, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock. The rights of the holders of Class A and Class B common stock are identical, including the liquidation and dividend rights, except with respect to electing members of the Board of Directors and voting rights. As the liquidation and dividend rights are identical, undistributed earnings and losses are allocated on a proportionate basis and the resulting net loss per share attributable to common stockholders are the same for both Class A and Class B common stock on an individual and combined basis.\\n17\\nBasic and diluted net loss per share attributable to common stockholders is presented in conformity with the two-class method required for participating securities. Net loss is attributed to common stockholders and participating securities based on their participation rights. Net loss attributable to common stockholders is not allocated to the redeemable convertible preferred stock as the holders of the redeemable convertible preferred stock do not have a contractual obligation to share in any losses. No dividends were declared or paid for the three months ended March 31, 2022 and March 31, 2021. No preferred stock was outstanding as of March 31, 2022.\\nUnder the two-class method, basic net loss per share attributable to common stockholders is computed by dividing the net loss attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period.\\nDiluted earnings per share attributable to common stockholders adjusts basic earnings per share for the potentially dilutive impact of redeemable convertible preferred stock, stock options, and warrants. As the Company has reported losses for all periods presented, all potentially dilutive securities including preferred stock, stock options, and warrants, are antidilutive and accordingly, basic net loss per share equals diluted net loss per share.\\nComprehensive Income (Loss)\\nComprehensive income (loss) is defined as the total change in stockholders’ equity during the period other than from transactions with stockholders. Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) is comprised of unrealized gains or losses on investments classified as available-for-sale.\\nRecently Adopted Accounting Pronouncements\\nIn February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. The Company adopted “ASC 842” on January 1, 2022, using the modified retrospective transition method, specifically the \\\"Comparatives under ASC 840 approach\\\", and used the effective date as the date of initial application. The Company elected the “package of practical expedients,” which permits Embark not to reassess under ASC 842 its prior conclusions about lease identification, lease classification and initial direct costs. The Company also elected the use of hindsight in determining the lease term and in assessing impairment of the entity’s right-of-use assets. Upon adoption of the new leasing standard on January 1, 2022, the Company recognized right-of-use assets of $ 4.4 million and lease liabilities of $ 4.5 million, respectively, which are related to its various operating leases (Note 10). The difference between the right-of-use assets and lease liabilities is primarily attributed to the elimination of deferred rent. There was no adjustment to the opening balance of accumulated deficit as a result of the adoption of ASC 842.\\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, which is intended to simplify various aspects related to accounting for income taxes. The adoption of ASU 2019-12 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\\nIn May 2021, the FASB issued ASU 2021-04, Modification of equity-classified written call options. ASU 2021-04 provides clarification and reduces diversity in an issuer’s accounting for certain modifications or exchanges of freestanding equity-classified written call options, such as warrants, that remain equity classified after modification or exchange. This guidance will be effective for us on January 1, 2022 with early adoption permitted and will be applied prospectively. The adoption of ASU 2021-04 is effective for the Company beginning January 1, 2022. The adoption of this standard did not have a material impact to its financial statements.\\nRecently Issued Accounting Pronouncements\\nAs an emerging growth company (“EGC”), the Jumpstart Our Business Startups Act (“JOBS Act”) allows the Company to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are applicable to private companies. The Company has elected to use this extended transition period under the JOBS Act until such time the Company is no longer considered to be an EGC. The adoption dates discussed below reflect this election.\\n18\\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments, which, together with subsequent amendments, amends the requirement on the measurement and recognition of expected credit losses for financial assets held. ASU 2016-13 is effective for the Company beginning January 1, 2023, with early adoption permitted. The Company is currently in the process of evaluating the effects of this pronouncement on the Company’s financial statements and does not expect it to have a material impact on its consolidated financial statements.\\nIn August 2020, the FASB issued ASU 2020-06, Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815- 40): Accounting for convertible instruments and contracts in an entity’s own equity. The ASU simplifies accounting for convertible instruments by removing certain separation models required under current GAAP. The ASU also removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it revises the guidance in ASC 260, Earnings Per Share, to require entities to calculate diluted earnings per share for convertible instruments by using the if-converted method. The amendments are effective for the Company beginning January 1, 2024, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently assessing the impact of this standard on its consolidated financial statements.\\nIn October 2020, the FASB issued ASU No. 2020-10, Codification Improvements, which updates various codification topics by clarifying or improving disclosure requirements to align with the SEC’s regulations. For the Company, the ASU No. 2020-10 will be effective for annual reporting periods beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. The Company is currently evaluating the impact the adoption of this standard on its consolidated financial statements.\\n3. BALANCE SHEET COMPONENTS\\nPrepaid Expenses and Other Current Assets\\nPrepaid expenses and other current assets consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\\n| March 31,2022 | December 31,2021 |\\n| (unaudited) |\\n| Prepaid insurance | $ | 6,890 | $ | 7,459 |\\n| Prepaid software | 2,224 | 2,564 |\\n| Income tax receivable | 494 | 494 |\\n| Short-term deposits | 570 | 448 |\\n| Prepaid salary | 476 | 279 |\\n| Prepaid warrant | 876 | 936 |\\n| Other | 475 | 566 |\\n| Total prepaid expenses and other current assets | $ | 12,005 | $ | 12,746 |\\n\\n19\\nProperty, Equipment and Software\\nProperty, equipment and software consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\\n| March 31,2022 | December 31,2021 |\\n| (unaudited) |\\n| Machinery and equipment | $ | 406 | $ | 344 |\\n| Electronic equipment | 578 | 413 |\\n| Vehicles and vehicle hardware | 6,929 | 6,268 |\\n| Leasehold improvements | 278 | 258 |\\n| Developed software | 6,108 | 5,184 |\\n| Other | 27 | 26 |\\n| Property, equipment and software, gross | 14,326 | 12,493 |\\n| Less: accumulated depreciation and amortization | ( 3,240 ) | ( 2,856 ) |\\n| Total property, equipment and software, net | $ | 11,086 | $ | 9,637 |\\n\\nDepreciation and amortization expense for the three months ended March 31, 2022 and 2021 was $ 0.4 million and $ 0.2 million, respectively.\\nOther Assets\\nOther assets consist of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\\n| March 31,2022 | December 31,2021 |\\n| (unaudited) |\\n| Intangible assets | $ | 3 | $ | 4 |\\n| Long-term deposits | 3,719 | 3,592 |\\n| Total Other Assets | $ | 3,722 | $ | 3,596 |\\n\\nAccrued Expenses and Other Current Liabilities\\nAccrued expenses and other current liabilities consisted of the following as of March 31, 2022 and December 31, 2021, respectively (in thousands):\\n| March 31,2022 | December 31,2021 |\\n| (unaudited) |\\n| Accrued payroll expenses | $ | 3,189 | $ | 823 |\\n| Accrued legal expenses | 696 | 124 |\\n| Accrued transaction costs | 1,092 | 1,092 |\\n| Other | 1,174 | 1,103 |\\n| Total accrued expenses and other current liabilities | $ | 6,151 | $ | 3,142 |\\n\\n4. FAIR VALUE MEASUREMENTS\\n20\\nThe carrying value and fair value of the Company’s financial instruments as of March 31, 2022 and December 31, 2021, respectively, are as follows:\\n| As of March 31, 2022(in thousands) |\\n| Level 1 | Level 2 | Level 3 | Total |\\n| (unaudited) |\\n| Assets |\\n| Cash equivalents: |\\n| United States money market funds | $ | 13,349 | $ | — | $ | — | $ | 13,349 |\\n| Liabilities |\\n| Warrant liabilities - FPA warrants | $ | 760 | $ | — | $ | — | $ | 760 |\\n| Warrant liabilities - public warrants | $ | 15,732 | $ | — | $ | — | $ | 15,732 |\\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 2,480 | $ | 2,480 |\\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 8,292 | $ | 8,292 |\\n\\n| As of December 31, 2021(in thousands) |\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Assets |\\n| Cash equivalents: |\\n| United States money market funds | $ | 22,349 | $ | — | $ | — | $ | 22,349 |\\n| Liabilities |\\n| Warrant liabilities - FPA warrants | $ | 1,337 | $ | — | $ | — | $ | 1,337 |\\n| Warrant liabilities - public warrants | $ | 27,669 | $ | — | $ | — | $ | 27,669 |\\n| Warrant liabilities - working capital warrants | $ | — | $ | — | $ | 4,700 | $ | 4,700 |\\n| Warrant liabilities - private warrants | $ | — | $ | — | $ | 15,714 | $ | 15,714 |\\n\\nAs of March 31, 2022, there was no transfer from Level 2 to Level 3. As of December 31, 2021, transfers from Level 2 to Level 3 of the fair value hierarchy were $ 15.5 million for Private and Public Warrants.\\nThe fair value of the above liability classified Public, Private, Working Capital and FPA Warrants have been measured based on the listed market price of such warrants on November 10, 2021. The FPA warrants and public warrants were valued using the public price as of March 31, 2022. The Private and Working Capital warrants were fair valued using the Black Scholes Option Pricing Model as of March 31, 2022. For the three months ended March 31, 2022, the Company recognized income in the condensed consolidated statement of operations resulting from a change in the fair value of warrants of approximately $ 22.2 million, presented as other income (expense) on the accompanying condensed consolidated statement of operations.\\n5. STOCKHOLDERS’ EQUITY\\nShares Authorized and Issued\\nAs of March 31, 2022, the Company had authorized a total of 4,110,000,000 shares for issuance with 4,000,000,000 shares designated as Class A common stock, 100,000,000 shares designated as Class B common stock and 10,000,000 shares designated as preferred stock.\\nAs of March 31, 2022, the Company had 362,832,986 issued as Class A common stock and 87,078,981 issued as Class B common stock.\\n21\\nPreferred Stock\\nAs of March 31, 2022, there were 10,000,000 shares of preferred stock authorized and no shares of preferred and founders preferred stock was issued or outstanding. The Company’s preferred stock, as of March 31, 2022, does not contain any mandatory redemption features, nor are they redeemable at the option of the holder.\\nClass A and Class B Common Stock\\nThe Company’s Board of Directors has authorized two class of common stock, Class A and Class B. Holders of Class A and Class B common stock are not entitled to preemptive or other similar subscription rights to purchase any of Embark Technology’s securities.\\nClass A common stock is neither convertible nor redeemable. Class B common stock is convertible into Class A common stock. Unless Embark Technology’s board of directors determines otherwise, Embark Technology will issue all of Embark Technology’s capital stock in certificated form. The Embark Founders held all outstanding shares of Class B common stock up on consummation of the Business Combination.\\nIn connection with the merger with NGA on November 10, 2021, the Embark Founders exchanged 87,078,981 shares of Founder's common stock, which were entitled to one vote per share, into the same number of shares of Class B common stock, which are entitled to ten votes per share. The Company recorded the incremental value of $ 13.6 million associated with this transaction as stock-based compensation in general and administrative expenses.\\nThe significant rights, privileges and preferences of common stock as of March 31, 2022 are as follows:\\nLiquidation Preference\\nIf Embark Technology is involved in voluntary or involuntary liquidation, dissolution or winding up of Embark’s affairs, or a similar event, each holder of Embark Common Stock will participate pro rata in all assets remaining after payment of liabilities, subject to prior distribution rights of Embark Technology preferred stock, if any, then outstanding.\\nDividends\\nEach holder of shares of Embark Common Stock is entitled to the payment of dividends and other distributions as may be declared by the Board from time to time out of Embark’s assets or funds legally available for dividends or other distributions. These rights are subject to the preferential rights of the holders of Embark’s Preferred Stock, if any, and any contractual limitations on Embark’s ability to declare and pay dividends.\\nVoting\\nEach holder of Class A common stock is entitled to one vote per share on each matter submitted to a vote of stockholders, as provided by the Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II (the “Charter”). Each holder of Class B common stock is entitled to ten votes per share on each matter submitted to a vote of stockholders, as provided by the Embark Charter. Following the Business Combination, holders of Class B Common Stock have the ability to control the business affairs of Embark. Embark’s Amended and Restated Bylaws (the “Bylaws”) provide that the holders of a majority of the capital stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, will constitute a quorum at all meetings of the stockholders for the transaction of business. When a quorum is present, the affirmative vote of a majority of the votes cast is required to take action, unless otherwise specified by law, the Bylaws or the Charter, and except for the election of directors, which is determined by a plurality vote. There are no cumulative voting rights.\\n6. WARRANTS\\n22\\nAs of March 31, 2022, the following warrants were issued and outstanding:\\n| Description | Classification | Issue Date | Warrants Outstanding | Fair Value Price Per Share | Exercise Price per Share | Expiration |\\n| FPA warrants (1) | Liability | November 10, 2021 | 666,663 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\\n| Public warrants | Liability | November 10, 2021 | 13,799,936 | $ | 1.14 | $ | 11.50 | November 10, 2026 |\\n| Private warrants | Liability | November 10, 2021 | 6,686,667 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\\n| Working capital warrants | Liability | November 10, 2021 | 2,000,000 | $ | 1.24 | $ | 11.50 | November 10, 2026 |\\n\\n(1)FPA are the “Forward Purchase Agreements” entered into, or amended and restated, by NGA on April 21, 2021\\nThe Company determined the FPA, Public, Private and Working Capital warrants to be classified as a liability and fair valued the warrants on the issuance date using the publicly available price for the warrants, of $ 41.2 million. The fair value of the FPA and Public warrants were remeasured as of the reporting date with the change in value reflected as part of Other Expense.\\nThe fair value of $ 27.3 million of Private and Working Capital warrants was determined using the Black-Scholes option valuation model using the following assumptions for values as of March 31, 2022:\\n| Risk – free interest rate | 2.43 % |\\n| Expected term (in years) | 4.61 |\\n| Expected dividend yield | 0 % |\\n| Expected volatility | 45.0 % |\\n\\nThe Company estimates the volatility of its warrants based on a combination of volatility from the Company’s traded warrants and from historical volatility of select peer company’s common stock that matches the expected remaining life of the warrants. The risk-free interest rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected remaining life of the warrants. The expected life of the warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which the Company anticipates remaining at zero .\\n7. STOCK-BASED COMPENSATION EXPENSE\\nStock Option Plan\\nIn connection with the Business Combination, the Company adopted the 2021 Incentive Award Plan (the “2021 Plan”), under which the Company grants cash and equity incentive awards to directors, employees (including named executive officers) and consultants in order to attract, motivate and retain the talent for which the Company competes. The Company terminated the 2016 Stock Plan, provided that the outstanding awards previously granted under the 2016 Plan continue to remain outstanding under the 2016 Plan. Under the 2021 Plan, as of March 31, 2022, the Company has authorized to issue a maximum number of 58,713,535 shares of Class A common stock, with annual increases beginning January 1, 2022 and ending on and including January 1, 2031 of 5 % of the aggregate number of shares of Class A common stock outstanding on the last day of the preceding calendar year.\\nEmbark Trucks adopted the 2016 Stock Plan in October 2016 (the “2016 Plan”). The 2016 Plan authorized the grant of incentive stock options, non-statutory stock options, and restricted stock awards to employees, directors, and consultants. The 2016 Plan also initially reserved 993,542 shares of common stock ( 8,941,878 shares post-split in June 2018) for issuance and designated forfeited option shares to be returned to the option reserve. Options may be early exercised and are exercisable for a term of 10 years from the date of grant. As of March 31, 2022, the Company had registered 79,742,504 shares to be reserved for option grants, RSUs and PSUs previously issued under the 2016 Plan. The Company will not issue additional awards under the 2016 Plan.\\n23\\nStock Option Valuation\\nThe Company utilizes the Black-Scholes option pricing model for estimating the fair value of options granted, which requires the input of highly subjective assumptions.\\nThe Company calculates the fair value of each option grant on the grant date using the following assumptions:\\nExpected Term — The Company uses the simplified method when calculating expected term due to insufficient historical exercise data.\\nExpected Volatility — As the Company’s shares are not actively traded, the volatility is based on a benchmark of comparable companies within the automotive and energy storage industries.\\nExpected Dividend Yield — The dividend rate used is zero as the Company does not have a history of paying dividends on its common stock and does not anticipate doing so in the foreseeable future.\\nRisk-Free Interest Rate — The interest rates used are based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Risk-free interest rate | n/a | 0.55 – 1.10 % |\\n| Expected term (in years) | n/a | 5.47 – 6.07 |\\n| Expected dividend yield | n/a | 0 % |\\n| Expected volatility | n/a | 36.88 – 51.52 % |\\n\\nThe company did not grant any stock options for the three months ended March 31, 2022.\\nOption Activity\\nChanges in stock options are as follows:\\n| Number ofOutstanding Options | Weighted Average Exercise Price Per Share | WeightedAverageRemaining Contractual Term (years) | AggregateIntrinsic (in thousands) |\\n| Outstanding at December 31, 2021 | 25,358,455 | $ | 0.20 | 6.9 | $ | 215,093 |\\n| Exercised | ( 3,615,572 ) | 0.11 | $ | 20,770 |\\n| Repurchased | 13,984 | 0.29 |\\n| Cancelled | ( 277,235 ) | 0.59 |\\n| Outstanding at March 31, 2022 | 21,479,632 | $ | 0.21 | 6.7 | $ | 121,910 |\\n| Vested and exercisable as of March 31, 2022 | 15,271,274 | $ | 0.13 | 6.0 | $ | 88,014 |\\n\\nThe aggregate intrinsic value in the above table is calculated as the difference between the estimated fair value of the Company's common stock price and the exercise price of the stock options. The company did not grant any stock options for the three months ended March 31, 2022. The weighted average grant date fair value per share for the stock option grants during the three months ended March 31, 2021 was $ 1.88 . As of March 31, 2022, the total unrecognized compensation related to unvested stock option awards granted was $ 5.02 million, which the Company expects to recognize over a weighted-average period of approximately 2.4 years.\\nRestricted Stock Units\\nPrior to the Business Combination, Embark Trucks also granted employees RSUs which are subject to performance and service-based vesting conditions. As the Company went public upon the completion of the Business Combination in November 2021, the performance condition had been met. The RSUs generally vest over either a four year period with\\n24\\n25 % of the awarded vesting after the first-year anniversary and one-thirty sixth of the remainder of the award vesting monthly thereafter. Vesting is contingent upon such employee’s continued service on such vesting date. RSUs are generally subject to forfeiture if employment terminates prior to the release of vesting restrictions. The Company may grant RSUs with different vesting terms from time to time.\\nFor the three months ended March 31, 2022, the Company recognized $ 12.9 million stock-based expense associated with such RSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such RSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 41.0 million unrecognized stock-based compensation expense related to outstanding RSUs granted to employees, with a weighted-average remaining vesting period of 3.9 years.\\nA summary of the Company’s RSU activities and related information is as follows:\\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\\n| Balance as of December 31, 2021 | 9,616,774 | $ | 8.44 |\\n| Forfeited | ( 111,572 ) | 8.96 |\\n| Vested | ( 187,977 ) | 8.36 |\\n| Balance as of March 31, 2022 | 9,317,225 | $ | 8.43 |\\n\\nPerformance Stock Units\\nDuring 2021, Embark Trucks granted PSUs to its employees. The PSUs are subject to certain market and performance-based conditions which require the Company to become a registered public company and meet market conditions that are based on the Company achieving six different valuation tranches as derived from the achievement of escalating share price thresholds of $ 20.00 , $ 35.00 , $ 50.00 , $ 65.00 , $ 80.00 and $ 100.00 (calculated based on the 90-day volume weighted average price or, in the event of a change in control, the fair market value based on the terms of such change in control) following the first anniversary of the consummation of the Business Combination. The market condition can be achieved over ten years in relation to the pre-money valuation prior to the Business Combination. Once the performance condition has been achieved or is considered probably of being achieved, the related stock-based compensation is recognized based on a graded attribution method.\\nFor the three months ended March 31, 2022, the Company recognized $ 2.6 million stock-based expense associated with such PSUs. For the three months ended March 31, 2021, the Company did not recognize any stock-based expense associated with such PSUs as the performance condition had not been satisfied until November 10, 2021. As of March 31, 2022, there was $ 81.0 million unrecognized stock-based compensation expense related to outstanding PSUs granted to employees, with a weighted-average remaining vesting period of 8.1 years.\\nThe Company’s PSUs activity for the three months ended March 31, 2022 was as follows:\\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\\n| Balance as of December 31, 2021 | 44,715,756 | $ | 1.97 |\\n| Granted | — | — |\\n| Forfeited | — | — |\\n| Vested | — | — |\\n| Balance as of March 31, 2022 | 44,715,756 | $ | 1.97 |\\n\\nCommon Stock Units\\nThe Company is obligated to issue shares of Class A common stock upon the vesting of certain restricted stock awards that resulted from Embark Trucks warrants that were issued prior to the Business Combination. Pursuant to the terms of\\n25\\nthese warrant awards, the restricted stock awards were issued for services at the time of consummation of the Business Combination, and are subject to service vesting terms, with the shares being subject to cancellation. The pre-Business Combination warrants were exercised in their entirety on a cashless basis, with the unvested shares being excluded from the stockholders’ equity and becoming subject to the service vesting condition going forward. Early exercises are reclassified to additional paid-in capital as the Company’s cancellation right lapses. The number of unvested shares of Class A common stock were 1,347,848 as of March 31, 2022.\\nAs of March 31, 2022, there was $ 3.8 million unrecognized stock-based compensation expense related to outstanding Common Stock Units (“CSUs”) granted to non-employees, with a weighted-average remaining vesting period of 2.16 years.\\nThe Company's CSUs activity for the three months ended March 31, 2022 was as follows:\\n| Number of Shares | Weighted AverageGrant date FairValue Per Share |\\n| Balance as of December 31, 2021 | 1,481,065 | $ | 2.48 |\\n| Granted | — | — |\\n| Forfeited | — | $ | — |\\n| Vested | ( 133,217 ) | 2.48 |\\n| Balance as of March 31, 2022 | 1,347,848 | $ | 2.48 |\\n\\nThe following table presents the impact of stock-based compensation expense on the condensed consolidated statements of operations for the three months ended March 31, 2022 and 2021, respectively (in thousands):\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Research and development | $ | 3,765 | $ | 311 |\\n| General, and administrative | 12,837 | 251 |\\n| Total stock-based compensation expense | $ | 16,602 | $ | 562 |\\n\\nTotal stock-based compensation that was capitalized into internally developed software asset was $ 0.2 million and nil during the three months ended March 31, 2022 and 2021, respectively.\\n8. RETIREMENT SAVINGS PLAN\\nThe Company sponsored a savings plan available to all eligible employees, which qualifies under Section 401(k) of the Internal Revenue Code. Employees may contribute to the plan amounts of their pre-tax salary subject to statutory limitations. The Company does not currently offer a match and has not provided a match as of March 31, 2022.\\n9. NOTES PAYABLE\\nOn February 18, 2021 and January 5, 2021, the Company entered into financing agreement to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million and $ 0.1 million at an interest rate equal to 6.99 % and 7.50 % per annum, with a maturity date of April 1, 2026 and January 19, 2027, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\\nOn February 19, 2018, January 28, 2019, and May 23, 2019, the Company entered into financing agreements to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.3 million, $ 0.4 million, and $ 0.5 million at an interest rate equal to 8.25 % per annum, with a maturity date of March 5, 2023, February 14, 2024, and June 12, 2024, respectively. The Company makes equal monthly installment payments over the term of each financing arrangement which are allocated between interest and principal.\\n26\\nThe Company entered into a financing agreement on August 2, 2016 to finance the purchase of trucks that the Company utilizes for research and development. The financing agreements consisted of a loan of $ 0.1 million at an interest rate equal to 12.5 % per annum, with a maturity date of August 9, 2020. The Company makes equal monthly installment payments over the term of the financing arrangement, which is allocated between interest and principal.\\nNotes payable as of March 31, 2022 and December 31, 2021 are $ 1.0 million and $ 1.1 million, respectively.\\nThe following table presents future payments of principal as of March 31, 2022 (in thousands):\\n| Years Ended December 31, | Amounts |\\n| 2022 (remaining nine months) | $ | 273 |\\n| 2023 | 313 |\\n| 2024 | 176 |\\n| 2025 | 111 |\\n| 2026 and thereafter | 125 |\\n| Total future payments | $ | 998 |\\n\\n10. COMMITMENTS AND CONTINGENCIES\\nLegal Proceedings\\nThe Company is subject to legal and regulatory actions that arise from time to time in the ordinary course of business. The assessment as to whether a loss is probable or reasonably possible, and as to whether such loss or a range of such loss is estimable, often involves significant judgment about future events. In the opinion of management, all such matters are not expected to have a material effect on the financial position, results of operations or cash flows of the Company. However, the outcome of litigation is inherently uncertain. There is no material pending or threatened litigation against the Company that remains outstanding as of March 31, 2022 and December 31, 2021.\\nOperating leases\\nThe Company’s leases primarily include corporate offices. The lease term of operating leases vary from less than a year to seven years . The Company has leases that include one or more options to extend the lease term to a total term of ten years as well as options to terminate the lease within one year. The Company’s lease terms may include options to extend or terminate the lease when it is reasonably certain that it will exercise such options. The Company’s lease agreements generally do not contain any residual value guarantees or restrictive covenants.\\nThe components of lease expense were as follows (in thousands):\\n| Three Months Ended March 31, 2022 |\\n| Lease cost |\\n| Operating lease cost | $ | 600 |\\n| Short-term lease cost (1) | 102 |\\n| Total lease cost | $ | 702 |\\n\\n(1) The Company elected to account for short-term leases in accordance with ASC 842. ASC 842 defines a short-term lease as a lease whose lease term, at commencement, is 12 months or less and that does not include a purchase option whose exercise is reasonable certain. The Company will recognize the lease payments in profit or loss on a straight-line basis over the lease term.\\n27\\nSupplemental cash flow information related to leases was as follows (in thousands):\\n| Three Months Ended March 31, 2022 |\\n| Other Information |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Operating cash flows used in operating leases | $ | 477 |\\n| Right-of-use assets obtained in exchange for lease obligations |\\n| Operating lease liabilities | $ | 6,587 |\\n\\nSupplemental balance sheet information related to leases was as follows (in thousands, except lease term and discount rate):\\n| March 31,2022 |\\n| Assets |\\n| Operating lease right-of-use assets | $ | 6,099 |\\n| Liabilities |\\n| Operating lease liability, current | $ | 1,948 |\\n| Operating lease liability, non-current | $ | 4,438 |\\n| Total operating lease liability | $ | 6,386 |\\n\\n| March 31,2022 |\\n| Weighted Average Lease Term (in years) |\\n| Operating Leases | 3.38 |\\n| Weighted Average Discount Rate |\\n| Operating Leases | 5.69 | % |\\n\\nTotal future minimum lease payments over the term of the lease as of March 31, 2022, are as follows (in thousands):\\n| Years Ended December 31, | Operating leases |\\n| 2022 (remaining nine months) | 1,723 |\\n| 2023 | 2,108 |\\n| 2024 | 1,976 |\\n| 2025 | 548 |\\n| 2026 | 563 |\\n| 2027 and thereafter | 142 |\\n| Total undiscounted lease payments | $ | 7,060 |\\n| Less: imputed interest | ( 674 ) |\\n| Total lease liabilities | $ | 6,386 |\\n\\nAs of March 31, 2022, the Company entered into additional operating leases for an office and a truck transfer point of $ 25.8 million, and $ 0.6 million respectively. These operating leases will commence in fiscal 2022 with lease terms of seven years and five years respectively, and contain options to renew and extend the terms of up to 60 months and 12 for each renewal, respectively.\\n28\\n11. NET LOSS PER SHARE\\nThe following table sets forth the computation of the basic and diluted net loss per share attributable to common stockholders for the three months ended March 31, 2022 and 2021, respectively (in thousands, except share and per share data).\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Numerator: |\\n| Net loss | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Net loss attributable to common stockholders | $ | ( 18,447 ) | $ | ( 8,482 ) |\\n| Denominator: |\\n| Net loss per share attributable to Class A and Class B common stockholders, basic and diluted | $ | ( 0.04 ) | $ | ( 0.18 ) |\\n| Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted | 452,623,022 | 47,538,331 |\\n| Class A | 365,544,041 | n/a* |\\n| Class B | 87,078,981 | n/a* |\\n\\n*Prior to the Merger and prior to effecting the recapitalization in 2021, the Company had one class of common stock. Subsequent to the Merger, the Company has two classes of common stock: Class A and Class B common stock.\\nSince the Company was in a loss position for all periods presented, basic net loss per share is the same as diluted net loss per share for all periods as the inclusion of all potential common shares outstanding would have been anti-dilutive.\\nThe following weighted-average outstanding common stock equivalents were excluded from the computation of diluted net loss per share attributable to common stockholders for the periods presented because including them would have been anti-dilutive.\\n| March 31, |\\n| 2022 | 2021 |\\n| Founders Preferred shares | — | 162,558 |\\n| Series A-1 convertible preferred shares | — | 3,654,873 |\\n| Series A-2 convertible preferred shares | — | 5,372,703 |\\n| Series A-3 convertible preferred shares | — | 2,485,296 |\\n| Series A-4 convertible preferred shares | — | 590,688 |\\n| Series A-5 convertible preferred shares | — | 2,680,236 |\\n| Series A-6 convertible preferred shares | — | 3,647,817 |\\n| Series A-7 convertible preferred shares | — | 15,139,917 |\\n| Series B convertible preferred shares | — | 32,834,601 |\\n| Series C convertible preferred shares | — | 20,949,454 |\\n| Outstanding options | 21,479,632 | 8,975,275 |\\n| Warrants issued and outstanding | 23,153,266 | 857,142 |\\n| Restricted stock units | 9,317,225 | — |\\n| Common stock units | 1,347,848 | — |\\n| Performance stock units | 44,715,756 | — |\\n| Total | 100,013,727 | 97,350,560 |\\n\\n12. SUBSEQUENT EVENTS\\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark\\n29\\nTechnology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly sufferance financial harm as a result.\\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-reference matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonable estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\\n30\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes appearing elsewhere in this Quarterly Report on Form 10-Q and the Annual Report. In addition to the historical financial information, this discussion contains forward-looking statements that involve risk, assumptions and uncertainties, such as statements of our plans, objectives, expectations, intentions, forecasts and projections. Our actual results and the timing of selected events could differ materially from those discussed in these forward-looking statements as a result of several factors. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in the section titled “Forward-Looking Statements” above, and in the section entitled “Risk Factors” in the Annual Report.\\nOverview\\nEmbark develops technologically advanced autonomous driving software for the truck freight industry and offers a carefully constructed business model that is expected to provide the industry with the most attractive path to adopting autonomous driving. Specifically, Embark has developed a Software as a Service (“SaaS”) platform designed to interoperate with a broad range of truck OEM platforms, forgoing complicated and logistically challenging truck building or hardware manufacturing operations in favor of focusing on a superior driving technology. At scale, domestic fleets will be able to access Embark technology via a subscription software license selected as an option at the time they specify the build of new semi-trucks.\\nHeadquartered in San Francisco, California, Embark’s history as the industry’s longest running autonomous truck driving program is replete with technological firsts that include, but are not limited to:\\n•the first coast-to-coast autonomous truck drive,\\n•the first to reach 100,000 autonomous miles on public roads, and\\n•the first to successfully open autonomous transfer points for human- autonomous vehicle (“AV”) handoff.\\nEmbark’s founding team includes roboticists and its broader team includes numerous computer scientists, many with advanced degrees and experience at other leading robotics and autonomous vehicle companies and academic programs. Embark intends to rapidly scale its engineering team to build on its industry-leading technology position.\\nEmbark has also spent considerable time and effort refining its business model. Embark is initially deploying its technology in a very focused manner, targeting freight highway miles between transfer points located next to metropolitan areas in the lower “Sunbelt” region of the U.S., leaving the “last mile” of driving to and from the transfer points to the industry’s highly skilled human drivers. Embark’s strategy is distinct from other industry players which seek to provide more complicated “end to end” autonomous driving that would entirely displace human drivers and potentially place these companies in competition with the industry’s carriers. Unlike those competitors, Embark anticipates working with the industry’s existing players to help them bring autonomous driving technology to market on their own terms. In addition, Embark believes its solution will be the safest and most reliable in the industry because of its disciplined geographic focus and emphasis on software development, which stands in contrast to Embark’s competitors that focus on multiple markets simultaneously, manufacturing autonomous trucks and/or competing directly with semi-truck OEMs or legacy carriers.\\nEmbark currently targets the growing $730 billion U.S. truck freight market, and its initial commercial phase targets 236 billion serviceable miles within this market. The freight industry that Embark serves has had to face significant pressures from the growth of e-commerce and the well-documented shortage of skilled drivers, and therefore has powerful incentives to adopt autonomous driving solutions to both improve capacity and reduce costs. In addition, Embark’s cooperative model has already had traction with many of the industry’s leading fleets.\\nThe Business Combination\\nEmbark entered into the Merger Agreement with NGA, a special purpose acquisition company, on June 22, 2021. On November 10, 2021, pursuant to the Merger Agreement, Merger Sub, a newly formed subsidiary of NGA, merged with and into Embark Trucks (the “Business Combination”). In connection with the consummation of the Business Combination, the separate corporate existence of Merger Sub ceased; Embark Trucks survived and became a wholly owned subsidiary of NGA, which was renamed Embark Technology, Inc.\\n31\\nThe Business Combination was accounted for as a reverse recapitalization, in accordance with GAAP. Under the guidance in ASC 805, Embark was treated as the “acquired” company for financial reporting purposes. Embark Trucks was deemed the accounting predecessor of the combined business, and Embark Technology, Inc., as the parent company of the combined business, was the successor SEC registrant, meaning that our financial statements for previous periods will be disclosed in the registrant’s periodic reports filed with the SEC. The Business Combination had a significant impact on Embark’s reported financial position and results as a consequence of the reverse recapitalization. The most significant changes in Embark’s reported financial position and results are a net increase in cash of $243.9 million, net of transaction costs for the Business Combination of $70.2 million. As of March 31, 2022 and December 31, 2021, the Company had warrant liabilities of $27.3 million and $49.4 million, respectively. The Company recorded the change in fair value in warrant liabilities were recorded in the other income (expense) on the condensed consolidated statement of operations.\\nAs a result of the Business Combination, Embark became an SEC-registered and Nasdaq-listed company, which required Embark to hire additional personnel and implement procedures and processes to address public company regulatory requirements and customary practices. Embark incurs additional annual expenses as a public company for, among other things, directors’ and officers’ liability insurance, director fees, and additional internal and external accounting, legal and administrative resources.\\nRecent Developments Affecting Comparability\\nCOVID-19 Impact and the Conflict in Ukraine\\nIn March 2020, the World Health Organization declared the 2019 novel coronavirus (“COVID-19”) a global pandemic. In the United States, as part of government-imposed restrictions, Embark was forced to temporarily pause fleet testing and operations in 2020. Embark also implemented a work-from-home policy for most of its non-operations team. However, a select group of workers remained on-site to continue advancing testing work for its test fleet. Since then, Embark has resumed its fleet testing and operations and has increased headcount to match its research and development requirements.\\nThe future impact of the COVID-19 pandemic on Embark’s operational and financial performance will depend on certain developments, including the duration and end of the pandemic and the occurrence of future outbreaks from new variants, impact on Embark’s research and development efforts, and effect on Embark’s suppliers, all of which are uncertain and cannot be predicted. Public and private sector policies and initiatives to reduce the transmission of COVID-19 and disruptions to Embark’s operations and the operations of Embark’s third-party suppliers, along with the related global slowdown in economic activity, may result in increased costs. It is possible that the COVID-19 pandemic, the measures that have been taken or that may be taken by the federal, state, local authorities and businesses affected by government-mandated business closures, vaccination mandates and the resulting economic impact may materially and adversely affect Embark’s business, results of operations, cash flows and financial positions.\\nWhile we have limited direct business exposure in Russia, Belarus and Ukraine, the Russian military actions and the resulting sanctions could adversely affect the global economy, as well as further disrupt the supply chain. A major disruption in the global economy and supply chain could have a material adverse effect on our business, partners, prospects, financial condition, results of operations, and cash flows. The extent and duration of the military action, sanctions, and resulting market and/or supply disruptions are impossible to predict, but could be substantial.\\nKey Factors Affecting Embark’s Operating Performance\\nEmbark’s financial condition, results of operations, and future success depend on several factors that present significant opportunities for Embark but also pose risks and challenges, including those set forth the section entitled “Risk Factors” in this quarterly report, the section entitled “Risk Factors” in the Annual Report and in as set forth below:\\nEmbark’s Ability to Achieve Key Technical Milestones and Deliver a Commercial Product\\nEmbark’s growth will depend on the introduction of Embark Driver and Embark Guardian products which will drive demand from potential customers. Embark has developed a platform agnostic interface, Embark Universal Interface, which will serve as the foundation to utilize Embark Driver and Guardian products in trucks manufactured by a broad range of OEMs. Embark’s ability to introduce its products will be driven by a variety of factors including Embark’s research and development fleet size, the number of autonomous miles driven (measured as the number of miles driven by Embark’s research & development fleet as well as partner fleet autonomous miles), and the ability to provide a safe and sustainable\\n32\\nsolution based on information gathered from the operation of Embark’s research and development fleet. Embark develops most key technologies in-house to achieve a rapid pace of innovation and tests it extensively through research and development fleet operations. Embark expects an increase in research and development fleet size in the foreseeable future to allow it to strategically focus on innovations, which it believes will help solidify its overall solution to customers and partners. To date, Embark has not generated any revenue and until its products reach commercialization, autonomous miles driven will be comprised of autonomous miles driven by its research and development fleet and the fleet of its partners. Embark believes that as the number of autonomous miles driven increases, the data will continually feed improvements to the platform, allowing it to innovate and introduce new products to the market and increase adoption of its products in the future.\\nEmbark’s Ability to Expand its Coverage Map Across the United States\\nEmbark’s long-term growth potential will benefit from strategic network expansion across the United States. Network breadth is measured by the number of transfer points on Embark’s coverage map, which are representative of the cities which Embark plans to support. Embark expects to achieve significant network growth by partnering with key real-estate partners which will enable it to quickly bring their properties into its coverage map. Additionally, Embark will partner with carriers and shippers who currently move, or have in the past moved, a significant amount of freight on Embark’s network to add their properties to the network. Embark believes that expanding its network will enable it to create a significant and sustainable competitive advantage. Embark believes that the continued growth of its partnerships will improve user experience and drive more users to its platform, which it believes will allow it to further densify its coverage map and reinforce rapid network growth. Embark will apply a highly scalable model nationally, with a tailored approach to each state, driven by the regulatory environment and local market dynamics. Embark believes that this will allow it to expand rapidly and efficiently across different geographies, while maintaining a high level of control over the specific strategy within each state.\\nEmbark’s Ability to Expand its Partner Network\\nThe growth of Embark’s business model is focused on driving the adoption of its technical products and maximizing their use across Embark’s partners’ operations. This is achieved by working closely with carrier management teams to prepare them to deploy and scale autonomous trucks. In April 2021, Embark formally announced the Embark Partner Development Program (PDP), which serves as the basis of its partnership network. The PDP is comprised of carriers and shippers from across the freight ecosystem working with Embark to refine and scale Embark’s offerings. Most recently, Embark announced the industry-first Truck Transfer Program to place Embark technology in the hands of Knight-Swift drivers.\\nAdoption and Support of Autonomous Technology in the Freight Industry\\nEmbark’s business model is supported by a large addressable market that Embark believes will benefit from the introduction of autonomous trucking technology. The freight industry is currently facing significant challenges, notably driver shortages and utilization limitations, which it believes it will address through its product offerings. Embark has identified participants from across the freight ecosystem who have expressed support for Embark’s offerings and the potential solutions they provide to the challenges they are facing.\\nWhile Embark has confirmed general market support, the long-term success of its business model is dependent on broad scale adoption and support of autonomous trucking technology. Embark has engaged with notable partners in the freight industry who Embark believes will lead the industry in adopting autonomous vehicle technology. As Embark onboards more partners, it will increase miles driven by partners, which Embark believes will serve to validate its product offerings and generate interest and confidence from other partners. Embark believes customers will be motivated to integrate Embark’s technology to be price competitive with other freight participants who have achieved efficiencies with it.\\nKey Components of Embark’s Results of Operations\\nThe following discussion describes certain line items in Embark’s condensed consolidated statements of operations.\\n33\\nOperating Expenses\\nOperating expenses consist of research and development expenses and general and administrative expenses. Personnel-related costs are the most significant component of Embark’s operating expenses and include salaries, benefits, and stock-based compensation expenses.\\nEmbark’s full-time employee headcount in research and development has grown from 172 as of December 31, 2021 to 242 as of March 31, 2022 and in general and administrative functions has grown from 59 as of December 31, 2021 to 62 as of March 31, 2022. Embark expects to continue to hire new employees to support our growth. The timing of these additional hires could materially affect Embark’s operating expenses in any particular period.\\nEmbark expects to continue to invest substantial resources to support its growth and anticipates that each of the following categories of operating expenses will increase in absolute dollar amounts for the foreseeable future.\\nResearch and Development Expenses\\nResearch and development expenses consist primarily of salaries, employee benefits, stock-based compensation expenses and travel expenses related to Embark’s engineers performing research and development activities to originate, develop and enhance Embark’s products. Additional expenses include consulting charges, component purchases, software licenses and other costs for performing research and development on Embark’s software products.\\nGeneral and Administrative Expenses\\nGeneral and administrative expenses consist primarily of salaries, employee benefits, stock-based compensation expenses, and travel expenses related to Embark’s executives, finance team, and the administrative employees. They also consists of legal, accounting, consulting, and professional fees, rent and lease expenses pertaining to Embark’s offices, business insurance costs and other costs. Embark expects its general and administrative expenses to increase for the foreseeable future as it scales headcount with the growth of its business, and as a result of operating as a public company, including as a result of compliance with the rules and regulations of the SEC, legal, audit, tax and other administrative and professional services.\\nResults of Operations\\nThe results of operations presented below should be reviewed in conjunction with the financial statements and notes included elsewhere in this Quarterly Report on Form 10-Q. The following table sets forth Embark’s results of operations data for the periods presented (in thousands):\\nComparisons for the three months ended March 31, 2022 and 2021\\nThe following table sets forth Embark’s condensed consolidated results of operations data for the periods presented (in thousands):\\n| Three Months Ended | $ | % |\\n| 2022 | 2021 | Change | Change |\\n| Operating expenses: |\\n| Research and development | $ | 18,695 | $ | 6,231 | $ | 12,464 | 200.0 | % |\\n| General and administrative | 21,926 | 2,290 | 19,636 | 857.5 | % |\\n| Total operating expenses | 40,621 | 8,521 | 32,100 | 376.7 | % |\\n| Loss from operations | (40,621) | (8,521) | (32,100) | 376.7 | % |\\n| Other income, net | 22,174 | 39 | 22,135 | N.M. |\\n| Loss before provision for income taxes | (18,447) | (8,482) | (9,965) | 117.5 | % |\\n| Provision for income taxes | — | — | — | N.M. |\\n| Net loss | $ | (18,447) | $ | (8,482) | $ | (9,965) | 117.5 | % |\\n\\n_________________________________________________\\nN.M. — Percentage change not meaningful\\n34\\nResearch and Development Expenses\\nResearch and development expense increased by $12.5 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $8.8 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to continued expansion of Embark’s research and development team, a $0.2 million increase in infrastructure expenditure related to increased R&D activities, a $0.3 million increase in prototype truck hardware expenses, a $1.8 million increase in general R&D costs primarily driven by engineering software & subscription costs and a $0.2 million increase in computer and equipment expenditure related to an increase in Embark’s research and development team.\\nGeneral and Administrative Expense\\nGeneral and administrative expense increased by $19.6 million in the three months ended March 31, 2022, compared to the three months ended March 31, 2021. The increase was primarily due to $16.5 million higher headcount expenses including stock-based compensation, salaries and employee benefits, related to growth in the business, a $0.5 million increase in occupancy expenses related to additional leases, a $0.2 million increase in fleet operation expenses due to increased activity, a $0.6 million increase in insurance expenses and a $0.3 million increase in travel and events expenditure.\\nOther income (expense), net\\nOther income increased by $22.1 million in the three months ended March 31, 2022 compared to the three months ended March 31, 2021. The increase was primarily due to the change in the estimated fair value of Public, Private, Working Capital and FPA Warrants of $22.2 million.\\nLiquidity and Capital Resources\\nSince Embark’s inception, it has financed its operations primarily through the sale of shares of common stock and preferred stock.\\nIn connection with the Business Combination, a convertible promissory note (the “Convertible Note”) issued by Embark in April 2021 was converted in exchange for 3,774,951 shares of Embark Class A common stock. As of March 31, 2022, Embark had outstanding debt of $1.0 million from a financing of freight trucks that it utilizes for research and development. Embark makes monthly installment payments on its truck financing arrangements. The truck financings have varying maturities between March 2023 and January 2027. Embark’s principal uses of cash in recent periods have been to fund its operations, invest in research and development, repay borrowings, and make investments in accordance with its investments policy.\\nEmbark believes existing cash and other components of working capital will be sufficient to meet its needs for at least the next 12 months. Embark’s long-term capital requirements will depend on many factors including timing and extent of spending to support research and development efforts as well as general and administrative activities for the business. If, at any time, Embark determines it requires more capital to execute upon its business plan, and /or that market conditions are favorable, Embark may seek additional equity or debt financing. Additionally, in the event Embark may in the future enter into arrangements to acquire or invest in related products, technologies, software and services, and Embark may need to seek additional equity or debt financing to support such growth. As of March 31, 2022, there were future minimum lease payments of $7.1 million.\\nEmbark currently transports shipments using its research and development truck fleet, demonstrating proof of concept and paving the way for commercialization and revenue generating operations in the future. However, Embark has not earned any revenue to date, and had $244.5 million in cash and cash equivalents and an accumulated deficit of $201.4 million as of March 31, 2022. To the extent Embark is unable to commercialize its technology as expected, its liquidity may be negatively impacted.\\nEmbark’s ability to continue as a going concern is dependent on management’s ability to control operating costs and demonstrate progress against its technical roadmap. This involves developing new capabilities for the Embark Driver software and improving the reliability and performance of the software on public roads. Demonstrating ongoing technical progress will enable Embark to obtain funds from outside sources of financing, including financing from equity interest investors and borrow funds to fund its general operations, research and development activities and capital expenditures.\\n35\\nThe following table shows Embark’s cash flows from operating activities, investing activities and financing activities for the stated periods:\\n| Three Months Ended March 31, |\\n| 2022 | 2021 |\\n| Net cash (used in) provided by: | (unaudited) |\\n| Operating activities | $ | (18,225) | $ | (6,791) |\\n| Investing activities | $ | (1,717) | $ | 17,270 |\\n| Financing activities | $ | 287 | $ | 28 |\\n\\nOperating Activities\\nNet cash used in operating activities for the three months ended March 31, 2022 was $18.2 million, an increase of $11.4 million from $6.8 million for the three months ended March 31, 2021. The increase was primarily due to an increase of $10.0 million net loss for the three months ended March 31, 2022 compared to the three months ended March 31, 2021. In addition, the increase was partially attributable to $5.7 million of non-cash adjustments to net loss, including $0.6 million of depreciation and amortization, $22.2 million of change in fair value of warrant liability, as well as $16.0 million of stock-based compensation, and partially offset by $4.2 million net cash increase by changes in Embark’s operating assets and liabilities, which was primarily attributable to accounts payable, accrued expenses and other current liabilities primarily due to overall growth and timing of payables.\\nInvesting Activities\\nNet cash used in investing activities for the three months ended March 31, 2022 was $1.7 million, a decrease of $19.0 million from $17.3 million of net cash provided by investing activities for the three months ended March 31, 2021. The decrease was primarily due to a decrease of $18.2 million in proceeds received from maturities of investments, and an increase in purchase of property, equipment, and software of $0.7 million.\\nFinancing Activities\\nNet cash provided by financing activities for the three months ended March 31, 2022 was $0.3 million compared to $28,000 of net cash used in investing activities for the three months ended March 31, 2021. The increase was primarily due to an increase of $0.3 million in proceeds received from the exercise of employee stock options.\\nFinancing Arrangements\\nThere have been no material changes outside the ordinary course of business in Embark’s financing arrangements as previously disclosed in Embark’s Annual Report.\\nOff-Balance Sheet Arrangements\\nEmbark did not have any off-balance sheet arrangements as of March 31, 2022.\\nCritical Accounting Policies and Significant Management Estimates\\nThe preparation financial statements in conformity with generally accepted accounting principles requires management to make judgments, estimates and assumptions in the preparation of Embark’s financial statements and accompanying notes. Actual results could differ from those estimates. There have been no material changes to Embark’s critical accounting policies or estimates during the three months ended March 31, 2022, from those discussed in Embark’s Annual Report.\\nRecent Accounting Pronouncements\\n36\\nFor information on recently issued accounting pronouncements, refer to Note 2. Summary of Significant Accounting Policies in Embark’s condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.\\nJOBS Act Accounting Election\\nEmbark is an emerging growth company (EGC), as defined in the JOBS Act. Under the JOBS Act, EGCs can delay adopting new or revised accounting standards until such time as those standards apply to private companies. Embark intends to elect to adopt new or revised accounting standards under private company adoption timelines. Accordingly, the timing of Embark’s adoption of new or revised accounting standards will not be the same as other public companies that are not emerging growth companies or that have opted out of using such extended transition period.\\nItem 3. Quantitative and Qualitative Disclosures About Market.\\nEmbark is exposed to certain market risks as part of its ongoing business operations.\\nCredit Risk\\nEmbark is exposed to credit risk on its investment portfolio. Investments that potentially subject us to credit risk consist principally of cash and investments in debt securities. Embark places cash and cash equivalents with financial institutions with high credit standing and excess cash in marketable investment grade debt securities.\\nInterest Rate Risk\\nEmbark is exposed to interest rate risk on its investment portfolio. Investments that potentially subject Embark to interest rate risk consist principally of cash and investments in debt securities. As of March 31, 2022, Embark has cash and cash equivalents of $244.5 million, consisting of U.S. Treasury securities and interest-bearing money market accounts for which the fair market value would be affected by changes in the general level of U.S. interest rates. However, due to the short-term maturities and the low-risk profile of Embark’s investments, an immediate 10% change in interest rates would not have a material effect on the fair market value of its cash, cash equivalents, and investments.\\nInflation Risk\\nEmbark is exposed to impact of wage inflation, and has experienced wage inflation during 2021. Although wages have increased during 2021, and the continuing supply chain crisis and geopolitical conflict in Ukraine may contribute to continuing inflation, Embark does not believe that inflation has had a material effect on its business, results of operations, or financial condition. If Embark’s costs were to become subject to more significant inflationary pressures before we commercialize and sell our technology, we will not be able to offset such higher costs through price increases. Embark’s inability to do so could harm its business, results of operations, and financial condition.\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nOur management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our CEO and CFO concluded that, as of March 31, 2022, due to the material weakness described in the Annual Report, our disclosure controls and procedures were not effective.\\nAs disclosed in Part II, Item 9A, “Controls and Procedures” in our Annual Report, we identified a material weakness in our internal control over financial reporting resulting from a lack of sufficient number of qualified personnel within our accounting function who possessed an appropriate level of expertise to effectively perform the following functions:\\n•identify, select and apply GAAP sufficiently to provide reasonable assurance that transactions were being appropriately recorded; and\\n37\\n•assess risk and design appropriate control activities over information technology systems and financial and reporting processes necessary to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements.\\nStatus of remediation efforts\\nIn response to the material weaknesses identified and described above, our management, with the oversight of the Audit Committee of our Board of Directors, will continue through 2022 to dedicate significant efforts and resources to further improve our control environment and to take steps to remediate these material weaknesses.\\nChanges in Internal Control Over Financial Reporting\\nExcept for changes in connection with our implementation of the remediation measures or as described above, there were no changes in our internal control over financial reporting during the three months ended March 31, 2022, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n38\\nPart II - OTHER INFORMATION\\nItem 1. Legal Proceedings\\nFrom time to time, Embark may be involved in actions, claims, suits, and other proceedings in the ordinary course of its business. In addition, from time to time, third parties may in the future assert intellectual property infringement claims against Embark in the form of letters and other forms of communication. Litigation or any other legal or administrative proceeding, regardless of the outcome, can result in substantial cost and diversion of its resources, including its management’s time and attention. Such matters are subject to uncertainty and there can be no assurance that such legal proceedings will not have a material adverse effect on our business, the results of operations, financial position or cash flows.\\nOn April 1, 2022, Tyler Hardy filed a putative securities class action lawsuit against Embark and certain of our executive officers and the former executive officers of Northern Genesis Acquisition Corp., captioned Hardy v. Embark Technology, Inc., et al., Case No. 3:22-cv-02090-JSC, in the United States District Court for the Northern District of California, purportedly on behalf of a class consisting of those who purchased or otherwise acquired Embark common stock between January 12, 2021 and January 5, 2022. The complaint alleges that defendants made false and/or misleading statements in violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Plaintiff Hardy does not quantify any damages in the complaint, but in addition to attorneys’ fees and costs, seeks to recover damages on behalf of himself and other persons who purchased or otherwise acquired Embark stock during the putative class period at allegedly inflated prices and purportedly suffered financial harm as a result.\\nEmbark disputes the allegations in the above-reference matter, intends to defend the matter vigorously, and believes that the claims are without merit. Legal and regulatory proceedings, including the above-referenced matter, may be based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, it is not possible to determine the probability of loss or estimate damages for the above-referenced matter, and therefore, Embark has not established reserves for this proceeding. When Embark determines that a loss is both probable and reasonably estimable, Embark will record a liability, and, if the liability is material, will disclose the amount of the liability reserved. Given that such proceedings are subject to uncertainty, there can be no assurance that legal proceedings individually or in the aggregate will not have a material adverse effect on our business, results of operations, financial condition or cash flows.\\nItem 1A. Risk Factors\\nThere are no material changes to the risk factors discussed in Embark’s Annual Report under the heading “Risk Factors.” You should carefully consider these risks, together with management’s discussion and analysis of Embark’s financial condition and results of operations in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q. If any of the events contemplated should occur, Embark’s business, results of operations, financial condition and cash flows could suffer significantly.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nNone.\\nItem 3. Defaults Upon Senior Securities\\nNone.\\nItem 4. Mine Safety Disclosures\\nNot Applicable.\\nItem 5. Other Information\\nNone.\\n39\\nItem 6. Exhibits\\n| Incorporated by Reference |\\n| ExhibitNumber | Description | Form | File No. | Date | Exhibit | Filed Herewith |\\n| 2.1+ | Agreement and Plan of Merger, dated as of June 22, 2021, by and among Northern Genesis Acquisition Corp. II, NGAB Merger Sub Inc. and Embark Trucks Inc. | 8-K | 001-39881 | 6/23/2021 | 2.1 |\\n| 3.1 | Second Amended and Restated Certificate of Incorporation of Northern Genesis Acquisition Corp. II. | 8-K | 001-39881 | 11/17/2021 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws of Embark Technology, Inc. | 8-K | 001-39881 | 11/17/2021 | 3.2 |\\n| 4.1 | Specimen Warrant Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.5 |\\n| 4.2 | Specimen Class A Common Stock Certificate of Embark Technology, Inc. | S-4 | 333-257647 | 10/13/2021 | 4.6 |\\n| 4.3 | Warrant Agreement, dated as of January 12, 2021, by and among Northern Genesis Acquisition Corp. II and Continental Stock Transfer & Trust Company, as warrant agent. | 8-K | 001-39881 | 1/19/2021 | 4.1 |\\n| 31.1** | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\\n| 31.2** | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\\n| 32.1** | Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRIL document. | X |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | X |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. | X |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | X |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. | X |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. | X |\\n| 104 | Cover Page Interactive Data File - the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL Document. | X |\\n\\n________________________\\n* Filed herewith.\\n** Furnished herewith. The certifications attached as Exhibit 31.1, Exhibit 31.2 and Exhibit 32.1 that accompanies this Quarterly Report on Form 10-Q is deemed furnished and not filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Embark Technology, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q, irrespective of any general incorporation language contained in such filing.\\n+ Schedules and exhibits have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The Registrant agrees to furnish supplementally a copy of any omitted schedule or exhibit to the SEC upon request.\\n40\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, on May 11, 2022.\\n| EMBARK TECHNOLOGY, INC. |\\n| By: | /s/ Alex Rodrigues |\\n| Name: | Alex Rodrigues |\\n| Title: | Chief Executive Officer |\\n| (Principal Executive Officer) |\\n\\n| EMBARK TECHNOLOGY, INC. |\\n| By: | /s/ Richard Hawwa |\\n| Name: | Richard Hawwa |\\n| Title: | Chief Financial Officer |\\n| (Principal Financial and Principal Accounting) |\\n\\n41\\n</text>\\n\\nWhat is the year on year percentage change in the Accumulated Deficit for the first quarter of 2022 compared to the first quarter of 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -199.75287322098495.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 41,\n \"input_length\": 27711\n}"}}},{"rowIdx":42,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED BALANCE SHEETS\n\n| June 30, | December 31, |\n| 2023 | 2022 |\n| (unaudited) |\n| Assets |\n| Current Assets |\n| Cash | $ | 810,139 | $ | 300,185 |\n| Accounts receivable, net of allowance of $ 14,600 and $ 21,229 at June 30, 2023 and December 31, 2022, respectively | 58,944 | 106,156 |\n| Accounts receivable - related parties, net of allowance of $ 470,516 and $ 339,503 at June 30, 2023 and December 31, 2022, respectively | 1,075,102 | 1,115,816 |\n| Accounts receivable | 1,075,102 | 1,115,816 |\n| Mortgages receivable, net of allowance $ 55,682 and $ 46,424 at June 30, 2023 and December 31, 2022, respectively | 729,833 | 586,631 |\n| Inventory | 1,960,988 | 1,888,962 |\n| Real estate lots held for sale | 445,412 | 559,487 |\n| Prepaid expenses and other current assets | 423,658 | 461,637 |\n| Total Current Assets | 5,504,076 | 5,018,874 |\n| Long Term Assets |\n| Mortgages receivable, non-current portion, net of allowance of $ 178,541 and $ 150,126 at June 30, 2023 and December 31, 2022, respectively | 3,091,222 | 3,278,617 |\n| Advances to employees | 281,783 | 282,055 |\n| Property and equipment, net | 7,857,485 | 7,621,257 |\n| Operating lease right-of-use asset | 1,335,698 | 1,449,442 |\n| Prepaid foreign taxes, net | 985,470 | 916,823 |\n| Intangible assets, net | 108,967 | 69,787 |\n| Deposits, non-current | 54,713 | 56,130 |\n| Total Assets | $ | 19,219,414 | $ | 18,692,985 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 1 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED BALANCE SHEETS, CONTINUED\n\n| June 30, | December 31, |\n| 2023 | 2022 |\n| (unaudited) |\n| Liabilities and Stockholders’ Equity |\n| Current Liabilities |\n| Accounts payable | $ | 691,739 | $ | 917,270 |\n| Accrued expenses, current portion | 1,258,163 | 1,664,816 |\n| Deferred revenue | 1,368,921 | 1,373,906 |\n| Operating lease liabilities, current portion | 220,416 | 202,775 |\n| Loans payable, current portion | 252,014 | 164,656 |\n| Convertible debt obligations, net, current portion | 3,372,291 | - |\n| Derivative liability, current portion | 2,088,617 |\n| Other current liabilities | 80,200 | 100,331 |\n| Total Current Liabilities | 9,332,361 | 4,423,754 |\n| Long Term Liabilities |\n| Accrued expenses, non-current portion | 81,638 | 66,018 |\n| Operating lease liabilities, non-current portion | 1,212,641 | 1,328,408 |\n| Loans payable, non-current portion | 90,468 | 91,665 |\n| Convertible debt obligations, net, non-current portion | 84,674 | 1,991,459 |\n| Derivative liability | 52,500 | - |\n| Total Liabilities | 10,854,282 | 7,901,304 |\n| Commitments and Contingencies (Note 15) | - | - |\n| Stockholders’ Equity |\n| Preferred stock, 902,670 shares authorized | - | - |\n| Common stock, par value $ 0.01 per share; 150,000,000 shares authorized; 6,809,348 and 3,653,401 shares issued and 6,809,067 and 3,653,120 shares outstanding as of June 30, 2023 and December 31, 2022, respectively | 68,091 | 36,534 |\n| Additional paid-in capital | 144,532,185 | 139,123,642 |\n| Accumulated other comprehensive loss | ( 10,920,361 | ) | ( 10,842,569 | ) |\n| Accumulated deficit | ( 125,268,428 | ) | ( 117,479,571 | ) |\n| Treasury stock, at cost, 281 shares at June 30, 2023 and December 31, 2022 | ( 46,355 | ) | ( 46,355 | ) |\n| Total Stockholders’ Equity | 8,365,132 | 10,791,681 |\n| Total Liabilities and Stockholders’ Equity | $ | 19,219,414 | $ | 18,692,985 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 2 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(unaudited)\n\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Sales | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\n| Cost of sales | ( 668,619 | ) | ( 533,466 | ) | ( 961,918 | ) | ( 771,593 | ) |\n| Gross profit (loss) | 42,356 | ( 128,131 | ) | 196,824 | 59,339 |\n| Operating Expenses |\n| Selling and marketing | 213,157 | 333,410 | 447,736 | 505,230 |\n| General and administrative | 1,710,505 | 1,928,892 | 3,467,193 | 3,674,126 |\n| Depreciation and amortization | 104,281 | 49,000 | 213,487 | 95,219 |\n| Total operating expenses | 2,027,943 | 2,311,302 | 4,128,416 | 4,274,575 |\n| Loss from Operations | ( 1,985,587 | ) | ( 2,439,433 | ) | ( 3,931,592 | ) | ( 4,215,236 | ) |\n| Other Expense (Income) |\n| Interest income | ( 64,375 | ) | ( 26,552 | ) | ( 114,719 | ) | ( 30,404 | ) |\n| Interest expense | 1,065,620 | 694,708 | 1,667,912 | 1,452,780 |\n| Other income, related party | ( 75,000 | ) | ( 75,000 | ) | ( 150,000 | ) | ( 150,000 | ) |\n| Loss on extinguishment of debt | 32,094 | 2,105,119 | 416,081 | 2,105,119 |\n| Gains from foreign currency translation | ( 102,916 | ) | ( 43,005 | ) | ( 214,708 | ) | ( 225,927 | ) |\n| Change in fair value of derivative liability | 2,141,117 | - | 2,141,117 | - |\n| Inducement expense | - | 198,096 | - | 198,096 |\n| Total other expense | 2,996,540 | 2,853,366 | 3,745,683 | 3,349,664 |\n| Net Loss | ( 4,982,127 | ) | ( 5,292,799 | ) | ( 7,677,275 | ) | ( 7,564,900 | ) |\n| Net loss attributable to non-controlling interest | - | - | - | 72,261 |\n| Net Loss Attributable to Common Stockholders | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,492,639 | ) |\n| Net Loss per Common Share |\n| Basic and Diluted | $ | ( 0.80 | ) | $ | ( 4.80 | ) | $ | 1.41 | ) | $ | ( 7.59 | ) |\n| Weighted Average Number of Common Shares Outstanding: |\n| Basic and Diluted | 6,236,737 | 1,103,130 | 5,453,539 | 987,109 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 3 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME\n(unaudited)\n\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Net loss | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\n| Other comprehensive (loss) income : |\n| Foreign currency translation adjustments | ( 37,993 | ) | 358,056 | ( 77,792 | ) | 621,462 |\n| Comprehensive loss | $ | ( 5,020,120 | ) | $ | ( 4,934,743 | ) | $ | ( 7,755,067 | ) | $ | ( 6,943,438 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 4 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\n(unaudited)\n\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Equity |\n| Balance - January 1, 2023 | 3,653,401 | $ | 36,534 | 281 | $ | ( 46,355 | ) | $ | 139,123,642 | $ | ( 10,842,569 | ) | $ | ( 117,479,571 | ) | - | - | $ | 10,791,681 |\n| Cumulative effect of change upon adoption of ASU 2016-13 | - | - | - | - | - | - | ( 111,582 | ) | - | - | ( 111,582 | ) |\n| Stock-based compensation: |\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\n| Restricted stock units | 3,890 | 39 | - | - | 79,383 | - | - | 79,422 |\n| Common stock issued for 401(k) employer matching | 24,160 | 242 | - | - | 32,375 | - | - | 32,617 |\n| Shares issued under the New ELOC, net of offering costs [1] | 364,430 | 3,644 | - | - | 437,765 | - | - | 441,409 |\n| Relative fair value of warrants issued with 2023 Note, net of issuance costs [2] | - | - | - | - | 1,506,319 | - | - | 1,506,319 |\n| Warrants issued for modification of GGH Notes | - | - | - | - | 134,779 | - | - | 134,779 |\n| Reduction of warrant exercise price on new debt issuance | - | - | - | - | 63,502 | - | - | 63,502 |\n| Shares issued upon conversion of debt and interest | 833,333 | 8,333 | - | - | 1,563,220 | - | - | 1,571,553 |\n| Common stock issued for cash in private placement | 591,000 | 5,910 | - | - | 585,090 | - | - | 591,000 |\n| Cashless warrant exercise | 51,305 | 513 | - | - | ( 513 | ) | - | - | - |\n| True-up adjustment | 281 | - | - | - | - | - | - | - |\n| Net loss | - | - | - | - | - | - | ( 2,695,148 | ) | - | - | ( 2,695,148 | ) |\n| Other comprehensive loss | - | - | - | - | - | ( 39,799 | ) | - | ( 39,799 | ) |\n| Balance - March 31, 2023 | 5,521,800 | 55,215 | 281 | ( 46,355 | ) | 143,564,396 | ( 10,882,368 | ) | ( 120,286,301 | ) | - | - | 12,404,587 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\n| Restricted stock units | - | - | - | - | 74,978 | - | - | 74,978 |\n| Shares issued under the New ELOC, net of offering costs [3] | 458,768 | 4,588 | - | - | 287,009 | - | - | 291,597 |\n| Shares issued upon conversion of debt and interest | 828,780 | 8,288 | - | - | 566,968 | - | - | 575,256 |\n| Net loss | - | - | - | - | - | - | ( 4,982,127 | ) | - | - | ( 4,982,127 | ) |\n| Other comprehensive loss | - | - | - | - | - | ( 37,993 | ) | - | ( 37,993 | ) |\n| Balance - June 30, 2023 | 6,809,348 | $ | 68,091 | 281 | $ | ( 46,355 | ) | $ | 144,532,185 | $ | ( 10,920,361 | ) | $ | ( 125,268,428 | ) | - | - | $ | 8,365,132 |\n\n\n| [1] | Includes gross proceeds of $ 480,670 , less $ 39,261 offering costs |\n\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 of allocable issuance costs |\n\n| [3] | Includes gross proceeds of $ 316,953 , less $ 25,356 offering costs |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 5 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\n(unaudited)\n\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Gaucho Group Holdings Stockholders’ | Non- controlling | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Deficiency | Interest | Equity |\n| Balance - January 1, 2022 | 823,496 | $ | 8,235 | 281 | $ | ( 46,355 | ) | $ | 121,633,826 | $ | ( 11,607,446 | ) | $ | ( 95,726,534 | ) | $ | 14,261,726 | $ | ( 169,882 | ) | $ | 14,091,844 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 72,700 | - | - | 72,700 | 10,354 | 83,054 |\n| Common stock issued for 401(k) employer matching | 1,040 | 10 | - | - | 27,811 | - | - | 27,821 | - | 27,821 |\n| Common stock issued for purchase of minority interest | 86,899 | 869 | - | - | ( 232,658 | ) | - | - | ( 231,789 | ) | 231,789 | - |\n| Common stock issued for acquisition of GDS | 106,952 | 1,070 | - | - | 2,193,583 | - | - | 2,194,653 | - | 2,194,653 |\n| Common stock issued for purchase of domain name | 1,250 | 13 | - | - | 39,587 | - | - | 39,600 | - | 39,600 |\n| Warrants issued for modification of convertible debt principal | - | - | - | - | 731,856 | - | - | 731,856 | - | 731,856 |\n| Net loss | - | - | - | - | - | - | ( 2,199,840 | ) | ( 2,199,840 | ) | ( 72,261 | ) | ( 2,272,101 | ) |\n| Other comprehensive income | - | - | - | - | - | 263,406 | - | 263,406 | - | 263,406 |\n| Balance - March 31, 2022 | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\n| Balance | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\n| Stock-based compensation: |\n| Options | - | - | - | - | 87,134 | - | - | 87,134 | - | 87,134 |\n| Common stock | 54,214 | 542 | - | - | 524,458 | - | - | 525,000 | - | 525,000 |\n| Shares issued upon conversion of debt and interest | 74,589 | 746 | - | - | 1,521,851 | - | - | 1,522,597 | - | 1,522,597 |\n| Inducement loss on debt conversions | - | - | - | - | 198,096 | - | - | 198,096 | - | 198,096 |\n| Substantial premium on convertible debt | - | - | - | - | 1,683,847 | - | - | 1,683,847 | - | 1,683,847 |\n| Common stock issued for cash, net of offering costs | 50,049 | 500 | - | - | 510,846 | - | - | 511,346 | - | 511,346 |\n| Common stock issued upon exchange of subsidiary stock options | 183,942 | 1,839 | - | - | ( 1,839 | ) | - | - | - | - | - |\n| True up adjustment | 41 | - | - | - | - | - | - | - | - | - |\n| Net loss | - | - | - | - | - | - | ( 5,292,799 | ) | ( 5,292,799 | ) | - | ( 5,292,799 | ) |\n| Other comprehensive income | - | - | - | - | - | 358,056 | - | 358,056 | - | 358,056 |\n| Balance - June 30, 2022 | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\n| Balance | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 6 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(unaudited)\n\n| 2023 | 2022 |\n| For the Six Months Ended |\n| June 30, |\n| 2023 | 2022 |\n| Cash Flows from Operating Activities |\n| Net loss | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Stock-based compensation: |\n| 401(k) stock | 5,908 | 22,384 |\n| Common stock | - | 525,000 |\n| Stock options and warrants | 77,668 | 170,188 |\n| Restricted stock units | 154,400 | - |\n| Noncash lease expense | 113,744 | 107,343 |\n| Gain on foreign currency translation | ( 214,708 | ) | ( 225,927 | ) |\n| Depreciation and amortization | 213,487 | 95,219 |\n| Amortization of debt discount | 1,079,034 | 1,061,936 |\n| Provision for credit losses | 57,104 | 28,848 |\n| Provision for obsolete inventory | 99,323 | - |\n| Change in fair value of derivative liability | 2,141,117 |\n| Loss on extinguishment of debt | 416,081 | 2,105,119 |\n| Inducement expense | - | 198,096 |\n| Decrease (increase) in assets: |\n| Accounts receivable and mortgages receivable | ( 126,017 | ) | ( 137,652 | ) |\n| Employee advances | ( 571 | ) | 4,964 |\n| Inventory | ( 57,274 | ) | ( 84,917 | ) |\n| Deposits | 1,417 | - |\n| Prepaid expenses and other current assets | ( 30,668 | ) | ( 201,778 | ) |\n| Increase (decrease) in liabilities: |\n| Accounts payable and accrued expenses | ( 162,671 | ) | 774,709 |\n| Operating lease liabilities | ( 98,126 | ) | ( 82,296 | ) |\n| Deferred revenue | ( 4,985 | ) | 517,741 |\n| Other liabilities | ( 20,131 | ) | ( 68,633 | ) |\n| Total Adjustments | 3,644,132 | 4,810,344 |\n| Net Cash Used in Operating Activities | ( 4,033,143 | ) | ( 2,754,556 | ) |\n| Cash Flow from Investing Activities |\n| Cash paid to acquire Gaucho Development S.R.L., net of cash acquired | - | ( 7,560 | ) |\n| Purchase of property and equipment | ( 438,895 | ) | ( 1,677,082 | ) |\n| Purchase of intangible asset | ( 50,000 | ) | ( 34,999 | ) |\n| Net Cash Used in Investing Activities | ( 488,895 | ) | ( 1,719,641 | ) |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 7 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED\n(unaudited)\n\n| For the Six Months Ended |\n| June 30, |\n| 2023 | 2022 |\n| Cash Flow from Financing Activities |\n| Proceeds from loans payable | 185,000 | - |\n| Repayments of loans payable | ( 58,718 | ) | ( 53,333 | ) |\n| Proceeds from common stock issued for cash | 591,000 | 511,346 |\n| Proceeds from the issuance of convertible debt | 5,000,000 | - |\n| Financing costs in connection with the issuance of convertible debt | ( 321,803 | ) | - |\n| Repayments of convertible debt obligations | ( 862,541 | ) | - |\n| Redemption premiums paid on convertible debt obligations | ( 156,160 | ) | - |\n| Proceeds from issuance of shares under the New ELOC, net of offering costs [1] | 733,006 | - |\n| Net Cash Provided by Financing Activities | 5,109,784 | 458,013 |\n| Effect of Exchange Rate Changes on Cash | ( 77,792 | ) | 621,462 |\n| Net (Decrease) Increase in Cash | 509,954 | ( 3,394,722 | ) |\n| Cash - Beginning of Period | 300,185 | 3,649,407 |\n| Cash - End of Period | $ | 810,139 | $ | 254,685 |\n| Supplemental Disclosures of Cash Flow Information: |\n| Interest paid | $ | 561,876 | $ | 140,355 |\n| Income taxes paid | $ | - | $ | - |\n| Non-Cash Investing and Financing Activity |\n| Equity issued to satisfy accrued stock-based compensation obligation | $ | 32,617 | $ | 27,821 |\n| Equity issued as consideration for intangible assets | $ | - | $ | 39,600 |\n| Equity issued for purchase of non-controlling interest | $ | - | $ | 231,789 |\n| Equity issued for acquisition of Gaucho Development, S.R.L. | $ | - | $ | 2,194,653 |\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | - | $ | 731,856 |\n| Shares issued upon conversion of debt and interest | $ | 2,146,809 | $ | 1,522,597 |\n| Common stock and restricted stock units in GGH issued upon exchange of GGI options | $ | - | $ | 1,576,648 |\n| Cashless warrant exercise | $ | 513 | $ | - |\n| Relative fair value of warrants issued with 2023 Note, net of allocable issuance costs [2] | $ | 1,506,319 | $ | - |\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | 63,502 | $ | - |\n\n\n| [1] | Gross proceeds of $ 797,623 , less offering costs of $ 64,617 |\n\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 in allocable issuance costs |\n\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\n\n| 8 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n1. BUSINESS ORGANIZATION AND NATURE OF OPERATIONS\nOrganization and Operations\nThrough its subsidiaries, Gaucho Group Holdings, Inc. (“Company”, “GGH”), a Delaware corporation that was incorporated on April 5, 1999, currently invests in, develops, and operates a collection of luxury assets, including real estate development, fine wines, and a boutique hotel in Argentina, as well as an e-commerce platform for the sale of high-end fashion and accessories.\nAs wholly owned subsidiaries of GGH, InvestProperty Group, LLC (“IPG”), Algodon Global Properties, LLC (“AGP”) and Gaucho Ventures I – Las Vegas, LLC (“GVI”) operate as holding companies that invest in, develop and operate global real estate and other lifestyle businesses such as wine production and distribution, golf, tennis, and restaurants. GGH operates its properties through its ALGODON® brand. IPG and AGP have invested in two ALGODON® brand projects located in Argentina. The first project is Algodon Mansion, a Buenos Aires-based luxury boutique hotel property that opened in 2010 and is owned by the Company’s subsidiary, The Algodon – Recoleta, SRL (“TAR”). The second project is the redevelopment, expansion and repositioning of a Mendoza-based winery and golf resort property now called Algodon Wine Estates (“AWE”), the integration of adjoining wine producing properties, and the subdivision of a portion of this property for residential development. (“GDS”). GVI is a party to an agreement with LVH Holdings (“LVH”) to develop a project in Las Vegas, Nevada.\nOn February 3, 2022, the Company acquired additional real estate through the acquisition of 100 % ownership in Hollywood Burger Argentina S.R.L., now Gaucho Development S.R.L.\nGGH also manufactures, distributes, and sells high-end luxury fashion and accessories through its subsidiary, Gaucho Group, Inc. (“GGI”). GGH held a 79 % ownership interest in GGI through March 28, 2022, at which time GGH acquired the remaining 21 % ownership interest in GGI. See Non-Controlling Interest, below.\nNon-Controlling interest\nAs a result of a 2019 conversion of certain convertible debt into shares of Gaucho Group, Inc. (“GGI”) common stock, GGI investors obtained a 21 % ownership interest in GGI, which was recorded as a non-controlling interest. The profits and losses of GGI for the period from January 1, 2022 through March 28, 2022 are allocated between the controlling interest and the non-controlling interest in the same proportions as their membership interest. On March 28, 2022, the Company issued 86,899 shares of its common stock to the minority holders of GGI, in exchange for the remaining 21 % ownership of GGI. Consequently, the Company owns 100 % of the outstanding common stock of GGI.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nThere have been no material changes to the Company’s significant accounting policies as set forth in the Company’s audited consolidated financial statements included in the annual report on Form 10-K for the year ended December 31, 2022, except as disclosed below.\n\n| 9 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for annual financial statements. In the opinion of management, such statements include all adjustments (consisting only of normal recurring items) which are considered necessary for a fair presentation of the unaudited condensed consolidated financial statements of the Company as of June 30, 2023 and for the three and six months ended June 30, 2023 and 2022. The results of operations for the three and six months ended June 30, 2023 are not necessarily indicative of the operating results for the full year. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission (“SEC”) on April 17, 2023.\nOn November 4, 2022, the Company effected a reverse stock split in a ratio of 1 share of common stock for 12 issued shares of common stock. As a result of the reverse stock split, prior period shares and per share amounts appearing in the accompanying condensed consolidated financial statements and all references in this Quarterly Report to our common stock, as well as amounts per share of our common stock, have been retroactively restated as if the reverse stock split occurred at the beginning of the period presented.\nGoing Concern and Management’s Liquidity Plans\nThe accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The condensed financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the classification of liabilities that might be necessary should the company be unable to continue as a going concern.\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $ 810,000 and $ 3.8 million, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $ 7.7 million and $ 7.6 million, respectively, and used cash in operating activities of approximately $ 4.0 million and $ 2.8 million, respectively. Further, as of June 30, 2023, approximately $ 4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024 , and approximately $ 252,000 represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with proceeds from a convertible debt financing of $ 5.0 million, proceeds of $ 733,000 from draws on the Company’s equity line of credit, $ 185,000 of proceeds from a loan payable and $ 591,000 from the sale of common stock.\n\n| 10 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of one year from the issuance of these financial statements.\nHighly Inflationary Status in Argentina\nThe Company recorded gains on foreign currency transactions of approximately $ 103,000 and $ 215,000 during the three and six months ended June 30, 2023, respectively, and approximately $ 43,000 and $ 226,000 during the three and six months ended June 30, 2022, respectively, as a result of the net monetary liability position of its Argentine subsidiaries.\nConcentrations\nThe Company maintains cash with major financial institutions. Cash held in US bank institutions is currently insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $ 250,000 at each institution. No similar insurance or guarantee exists for cash held in Argentina bank accounts. There were aggregate uninsured cash balances of approximately $ 519,000 at June 30, 2023, of which approximately $ 378,000 represents cash held in Argentine bank accounts.\nRevenue Recognition\nThe Company recognizes revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers. ASC Topic 606 provides a single comprehensive model to use in accounting for revenue arising from contracts with customers, and gains and losses arising from transfers of non-financial assets including sales of property and equipment, real estate, and intangible assets.\nThe Company earns revenues from the sale of real estate lots, as well as hospitality, food and beverage, other related services, and from the sale of clothing and accessories. The Company recognizes revenue when goods or services are transferred to customers in an amount that reflects the consideration which it expects to receive in exchange for those goods or services. In determining when and how revenue is recognized from contracts with customers, the Company performs the following five-step analysis: (i) identification of contract with customer; (ii) determination of performance obligations; (iii) measurement of the transaction price; (iv) allocation of the transaction price to the performance obligations; and (v) recognition of revenue when (or as) the Company satisfies each performance obligation.\n\n| 11 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following table summarizes the revenue recognized in the Company’s condensed consolidated statements of operations:\nSCHEDULE OF DISAGGREGATION OF REVENUE\n| 2023 | 2022 | 2023 | 2022 |\n| For the Three Months Ended | For the Six Months Ended |\n| June 30, | June 30, |\n| 2023 | 2022 | 2023 | 2022 |\n| Real estate sales | $ | 154,959 | $ | - | $ | 154,959 | $ | 184,658 |\n| Hotel rooms and events | 218,838 | 144,123 | 464,525 | 283,222 |\n| Restaurants | 56,989 | 40,323 | 136,007 | 57,593 |\n| Winemaking | 45,918 | 32,880 | 75,741 | 59,689 |\n| Agricultural | 162,764 | 153,531 | 162,764 | 181,029 |\n| Golf, tennis and other | 29,126 | 28,366 | 56,983 | 53,467 |\n| Clothes and accessories | 42,381 | 6,112 | 107,763 | 11,274 |\n| Total revenues | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\n\nRevenue from the sale of food, wine, agricultural products, clothes and accessories is recorded when the customer obtains control of the goods purchased. Revenues from hospitality and other services are recognized as earned at the point in time that the related service is rendered, and the performance obligation has been satisfied. Revenues from gift card sales are recognized when the card is redeemed by the customer. The Company does not adjust revenue for the portion of gift card values that is not expected to be redeemed (“breakage”) due to the lack of historical data. Revenue from real estate lot sales is recorded when the lot is deeded, and legal ownership of the lot is transferred to the customer.\nThe timing of the Company’s revenue recognition may differ from the timing of payment by its customers. A receivable is recorded when revenue is recognized prior to payment and the Company has an unconditional right to payment. Alternatively, when payment precedes the provision of the related services, the Company records deferred revenue until the performance obligations are satisfied. Deferred revenues associated with real estate lot sale deposits are recognized as revenues (along with any outstanding balance) when the lot sale closes, and the deed is provided to the purchaser. Other deferred revenues primarily consist of deposits accepted by the Company in connection with agreements to sell barrels of wine, advance deposits received for grapes and other agricultural products, and hotel deposits. Wine barrel and agricultural product advance deposits are recognized as revenues (along with any outstanding balance) when the product is shipped to the purchaser. Hotel deposits are recognized as revenue upon occupancy of rooms, or the provision of services.\nContracts related to the sale of wine, agricultural products and hotel services have an original expected length of less than one year. The Company has elected not to disclose information about remaining performance obligations pertaining to contracts with an original expected length of one year or less, as permitted under the guidance.\n\n| 12 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nAs of June 30, 2023 and December 31, 2022, the Company had deferred revenue of $ 1,368,921 and $ 1,373,906 , respectively, consisting of $ 1,332,695 and $ 1,179,654 , respectively, associated with real estate lot sale deposits, $ 36,225 and $ 44,252 , respectively, related to hotel deposits and $ 0 and $ 150,000 , respectively, related to prepaid management fees received.\nNet Loss per Common Share\nBasic loss per common share is computed by dividing net loss attributable to GGH common stockholders by the weighted average number of common shares outstanding during the period. Diluted loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding, plus the impact of common shares, if dilutive, resulting from the exercise of outstanding stock options and warrants and the conversion of convertible instruments.\nThe following securities are excluded from the calculation of weighted average dilutive common shares because their inclusion would have been anti-dilutive:\nSCHEDULE OF ANTIDILUTIVE SECURITIES EXCLUDED FROM COMPUTATION OF EARNINGS PER SHARE\n| 2023 | 2022 |\n| As of June 30, |\n| 2023 | 2022 |\n| Options | 34,806 | 561,027 |\n| Warrants | 4,839,254 | 2,024,166 |\n| Unvested restricted stock units | 516,277 | - |\n| Convertible debt | 12,516,374 | [1] | 5,479,255 | [2] |\n| Total potentially dilutive shares | 17,906,711 | 8,064,448 |\n\n\n| [1] | Represents shares issuable upon conversion of $ 4,893,983 of convertible debt, $ 734,097 of redemption premium and $ 8,293 of related accrued interest outstanding as of June 30, 2023, at a conversion price of $ 0.4503 per share, which represents the conversion price in effect as of June 30, 2023. The conversion price of such debt is variable and is not subject to a floor price (see Note 10, Convertible Debt Obligations). |\n| [2] | Represents shares issuable upon conversion of principal and interest outstanding in the aggregate amount of $ 5,205,292 at a conversion price of $ 0.95 per share. |\n\nSequencing Policy\nUnder ASC 815, the Company has adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\n\n| 13 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nDerivative Instruments\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\nRecently Adopted Accounting Pronouncements\nIn June 2016, the FASB issued ASU No. 2016-13 “Financial Instruments – Credit Losses (Topic 326)” and also issued subsequent amendments to the initial guidance under ASU 2018-19, ASU 2019-04, ASU 2019-05 and ASU 2020-02 (collectively Topic 326). Topic 326 requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. This replaces the existing incurred loss model with an expected loss model and requires the use of forward-looking information to calculate credit loss estimates. The Company adopted the provisions of this ASU on January 1, 2023 using the modified retrospective method for all financial assets measured at amortized cost. Results for reporting periods beginning after December 31, 2022 are presented under Topic 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded an adjustment to accumulated deficit of $ 111,582 as of January 1, 2023 for the cumulative effect of adopting Topic 326.\nReclassifications\nCertain reclassifications have been made to prior period amounts to conform to the current period financial statement presentation.\n3. MORTGAGES RECEIVABLE\nThe Company offers loans to purchasers in connection with the sale of real estate lots. The loans bear interest at 7.2 % per annum and terms generally range from eight to ten years. Principal and interest for each loan is billed and receivable on a monthly basis. The loans are secured by a first mortgage lien on the property purchased by the borrower. Mortgages receivable include the related interest receivable and are presented at amortized cost, less bad debt allowances, in the condensed consolidated financial statements.\nManagement evaluates each loan individually on a quarterly basis, to assess collectability and estimate a reserve for past due amounts. Management recorded an additional provision for uncollectible accounts in the amount of $ 37,673 for the six months ended June 30, 2023. The total allowance for uncollectable mortgages as of June 30, 2023 and December 31, 2022 was $ 234,223 and $ 196,550 , respectively. Past due principal amounts of $ 346,680 and $ 254,683 are included in mortgages, receivable, current as of June 30, 2023 and December 31, 2022, respectively. In the case of each of the past due loans, the Company believes that the value of the collateral exceeds the outstanding balance on the loan, plus accrued interest.\n\n| 14 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following represents the maturities of mortgages receivable as of June 30, 2023:\nSCHEDULE OF MATURITIES OF MORTGAGES RECEIVABLE\n| July 1 through December 31, 2023 | $ | 776,657 |\n| For the years ended December 31, |\n| 2024 | 381,532 |\n| 2025 | 409,927 |\n| 2026 | 440,436 |\n| 2027 | 473,215 |\n| 2028 | 480,227 |\n| Thereafter | 1,093,286 |\n| Gross Receivable | 4,055,278 |\n| Less: Allowance | ( 234,223 | ) |\n| Net Receivable | $ | 3,821,055 |\n\nAs of June 30, 2023 and December 31, 2022, no single borrower had loans outstanding representing more than 10 % of the total balance of mortgages receivable.\nThe Company recorded interest income from mortgages receivable of $ 109,816 and $ 28,654 for the six months ended June 30, 2023 and 2022, respectively. As of June 30, 2023 and December 31, 2022, there is $ 261,919 and $ 185,197 , respectively, of interest receivable included in mortgages receivable on the accompanying condensed consolidated balance sheets.\n4. INVENTORY\nInventory at June 30, 2023 and December 31, 2022 was comprised of the following:\nSCHEDULE OF INVENTORY\n| June 30, 2023 | December 31, 2022 |\n| Vineyard in process | $ | 240,619 | $ | 516,096 |\n| Wine in process | 1,031,823 | 797,862 |\n| Finished wine | 42,370 | 40,735 |\n| Clothes and accessories | 720,569 | 552,581 |\n| Other | 125,665 | 82,423 |\n| Inventory gross | 2,161,046 | 1,989,697 |\n| Less: Reserve for obsolescence | ( 200,058 | ) | ( 100,735 | ) |\n| Total | $ | 1,960,988 | $ | 1,888,962 |\n\nThe Company recorded a provision for obsolete inventory in the amount of $ 93,389 and $ 99,323 during the three and six months ended June 30, 2023, respectively. There was no provision for obsolete inventory recognized during the three and six months ended June 30, 2022.\n\n| 15 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n5. INTANGIBLE ASSETS\nOn February 3, 2022, the Company purchased the domain name Gaucho.com, in exchange for cash consideration of $ 34,999 and 15,000 shares of common stock valued at $ 39,600 (see Note 14 – Stockholders’ Equity, Common Stock). The domain name is being amortized over its useful life of 15 years.\nOn June 15, 2023, the Company purchased a music video to be used in certain marketing mediums for $ 50,000 in cash. The music video is being amortized over its useful life of 3 years.\nThe Company recognized $ 5,410 and $ 10,819 of amortization expense during the three and six months ended June 30, 2023, respectively, related to the domain name. The Company recognized $ 1,489 and $ 2,072 of amortization expense during the three and six months ended June 30, 2022, respectively, related to the domain name. Future amortization of the Company’s intangible asset is as follows:\nSCHEDULE OF INTANGIBLE ASSETS FUTURE AMORTIZATION\n| July 1 through December 31, 2023 | $ | 10,819 |\n| For the years ended December 31, |\n| 2024 | 21,640 |\n| 2025 | 21,640 |\n| 2026 | 4,973 |\n| 2027 | 4,973 |\n| 2028 | 4,973 |\n| Thereafter | 39,949 |\n| Total | $ | 108,967 |\n\n6. FAIR VALUE OF FINANCIAL INSTRUMENTS\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company often utilizes certain assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or developed by the Company. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:\nLevel 1 - Valued based on quoted prices at the measurement date for identical assets or liabilities trading in active markets. Financial instruments in this category generally include actively traded equity securities.\nLevel 2 - Valued based on (a) quoted prices for similar assets or liabilities in active markets; (b) quoted prices for identical or similar assets or liabilities in markets that are not active; (c) inputs other than quoted prices that are observable for the asset or liability; or (d) from market corroborated inputs. Financial instruments in this category include certain corporate equities that are not actively traded or are otherwise restricted.\nLevel 3 - Valued based on valuation techniques in which one or more significant inputs is not readily observable. Included in this category are certain corporate debt instruments, certain private equity investments, and certain commitments and guarantees.\nThe carrying amounts of the Company’s short-term financial instruments including cash, accounts receivable, advances and loans to employees, prepaid taxes and expenses, accounts payable, accrued expenses and other liabilities approximate fair value due to the short-term nature of these instruments. The carrying value of the Company’s loans payable, debt obligations, convertible debt obligations and derivative liability approximate fair value, as they bear terms and conditions comparable to market for obligations with similar terms and maturities.\n\n| 16 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n7. ACCRUED EXPENSES\nAccrued expenses are comprised of the following:\nSCHEDULE OF ACCRUED EXPENSES\n| June 30, | December 31, |\n| 2023 | 2022 |\n| Accrued compensation and payroll taxes | $ | 542,659 | $ | 652,943 |\n| Accrued taxes payable - Argentina | 189,722 | 270,239 |\n| Accrued interest | 141,303 | 78,368 |\n| Other accrued expenses | 384,479 | 663,266 |\n| Accrued expenses, current | 1,258,163 | 1,664,816 |\n| Accrued payroll tax obligations, non-current | 81,638 | 66,018 |\n| Total accrued expenses | $ | 1,339,801 | $ | 1,730,834 |\n\nOn November 27, 2020, the Company entered into various payment plans, pursuant to which it agreed to pay its Argentine payroll tax obligations over a period of 60 to 120 months. The current portion of payments due under the plan is $ 84,929 and $ 209,938 as of June 30, 2023 and December 31, 2022, respectively, which is included in accrued taxes payable – Argentina, above. The non-current portion of accrued payroll tax obligations represents payments under the plan that are scheduled to be paid after twelve months. The Company incurred interest expense of $ 64,283 and $ 81,587 during the three and six months ended June 30, 2023, respectively, and incurred interest expense of $ 28,690 and $ 33,177 during the three and six months ended June 30, 2022, respectively, related to these payment plans.\n8. DEFERRED REVENUE\nDeferred revenue is comprised of the following:\nSCHEDULE OF DEFERRED REVENUES\n| June 30, 2023 | December 31, 2022 |\n| Real estate lot sales deposits | $ | 1,332,695 | $ | 1,179,654 |\n| Prepaid management fees | - | 150,000 |\n| Other | 36,226 | 44,252 |\n| Total | $ | 1,368,921 | $ | 1,373,906 |\n\n\n| 17 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe Company accepts deposits in conjunction with agreements to sell real estate building lots at Algodon Wine Estates in the Mendoza wine region of Argentina. These lot sale deposits are generally denominated in U.S. dollars. The Company received deposits for eleven additional lots and recorded deferred revenues in the amount of $ 308,000 during the six months ended June 30, 2023. Revenue is recorded when the sale closes, and the deeds are issued. The Company recorded the sale of one lot and recorded revenue in the amount of $ 154,959 during the three and six months ended June 30, 2023.\n9. LOANS PAYABLE\nThe Company’s loans payable are summarized below:\nSCHEDULE OF LOANS PAYABLE\n| June 30, | December 31, |\n| 2023 | 2022 |\n| EIDL | $ | 92,527 | $ | 93,541 |\n| 2018 Loan | 40,678 | 111,137 |\n| 2022 Loan | 24,277 | 51,643 |\n| 2023 Loan | 185,000 | - |\n| Total Loans Payable | 342,482 | 256,321 |\n| Less: current portion | 252,014 | 164,656 |\n| Loans Payable, non-current | $ | 90,468 | $ | 91,665 |\n\nOn January 9, 2023, the Company received $ 185,000 in proceeds on the issuance of a one-year, non-convertible promissory note with a February 20, 2024 maturity date. The note bears interest at a rate of 8 % per annum. In addition, during the six months ended June 30, 2023, the Company made principal payments in the amount of $ 42,066 on the 2018 Loan payable, $ 15,638 on the 2022 Loan payable and $ 1,014 on the EIDL loan.\nThe Company incurred interest expense related to the loans payable in the amount of $ 33,248 and $ 36,514 during the three and six months ended June 30, 2023, respectively, and incurred interest expense related to the loans payable in the amount of $ 2,986 and $ 6,378 during the three and six months ended June 30, 2022. Other decreases in loan balances are the result of changes in exchange rates during the period. As of June 30, 2023 and December 31, 2022, there is accrued interest of $ 15,996 and $ 9,437 , respectively, related to the Company’s loans payable.\n\n| 18 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n10. CONVERTIBLE DEBT OBLIGATIONS\nAmounts owed pursuant to the Company’s convertible debt obligations are as follows:\nSCHEDULE OF CONVERTIBLE NOTES\n| GGH Notes | 2023 Note | Total Principal | Debt Discount | Convertible debt, net of discount |\n| Balance at January 1, 2023 | $ | 1,997,909 | $ | - | $ | 1,997,909 | $ | ( 6,450 | ) | $ | 1,991,459 |\n| Note issued | - | 5,617,978 | 5,617,978 | ( 2,509,601 | ) | 3,108,377 |\n| Debt principal converted to common stock: | ( 1,335,439 | ) | ( 523,925 | ) | ( 1,859,364 | ) | - | ( 1,859,364 | ) |\n| Principal repayments | ( 662,470 | ) | ( 200,071 | ) | ( 862,541 | ) | - | ( 862,541 | ) |\n| Amortization of debt discount | - | - | - | 1,079,034 | 1,079,034 |\n| Balance at June 30, 2023 | $ | - | $ | 4,893,982 | $ | 4,893,982 | $ | ( 1,437,017 | ) | $ | 3,456,965 |\n| Less: current portion | - | 4,773,982 | 4,773,982 | ( 1,401,781 | ) | 3,372,201 |\n| Equals: convertible debt, non-current | $ | - | $ | 120,000 | $ | 120,000 | $ | ( 35,236 | ) | $ | 84,764 |\n\nGGH Convertible Notes\nOn February 2, 2023, the Company and the holders of the remaining GGH Notes entered into a fourth letter agreement (“Letter Agreement #4). Pursuant to Letter Agreement #4, the parties agreed to reduce the conversion price of the GGH Notes to the lower of: (i) the closing sale price on the trading day immediately preceding the conversion date; and (ii) the average closing sale price of the common stock for the five trading days immediately preceding the conversion date. The conversion price is not subject to a floor price. Between February 3 and February 15, 2023, the holders elected to convert $ 1,571,553 in principal and interest, of which $ 1,335,439 , $ 124,049 , and $ 112,065 was principal, interest and premium paid on conversion, into 833,333 shares of common stock at prices ranging from $ 1.45 and $ 2.40 . The premium paid on conversion of the GGH Notes was recorded as a loss on extinguishment.\nOn February 8, 2023, the Company and the holders of the remaining GGH Notes entered into a fifth letter agreement (“Letter Agreement #5). Pursuant to Letter Agreement #5, the parties agreed to extend the maturity date of the notes from February 9, 2023 to February 28, 2023.\nOn February 20, 2023, the Company entered into another exchange agreement (the “Exchange Agreement #4”) with the remaining holders of the GGH Notes, pursuant to which warrants for the purchase up to an aggregate of 150,000 shares of the Company’s common stock at an exercise price of $ 1.00 were issued as consideration for extending the maturity date in connection with Letter Agreement #5. The warrants have a grant date fair value of $ 134,779 and expire on the second anniversary of the date of issuance. Because the value of the new warrants was deemed to be substantial as compared to the $ 662,470 remaining principal of the GGH Notes, the transaction was accounted for as an extinguishment of old notes which were replaced with the new note. The fair value of the warrants was recorded as a loss on extinguishment and is reflected under Other Expense (Income) in the accompanying condensed consolidated statement of operations.\nOn February 21, 2023, the Company redeemed the remaining GGH Notes for $ 905,428 , which includes the $ 662,470 of principal, $ 118,909 of accrued interest and $ 124,049 of redemption premium, the latter of which was charged to extinguishment loss.\n\n| 19 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n2023 Convertible Note\nOn February 21, 2023, the Company entered into a securities purchase agreement (the “SPA”) with an institutional investor, (the “Investor”) pursuant to which the Company received proceeds of $ 5,000,000 in exchange for a senior secured convertible note (the “2023 Note”) of the Company in the aggregate original principal amount of $ 5,617,978 , and a three-year common stock purchase warrant exercisable into an aggregate of 3,377,099 shares of common stock of the Company at an exercise price equal to $ 1.34 (the “2023 Note Warrant”). In addition to other terms, conditions and rights, both the Company and the Investor have the right to initiate additional closings for up to $ 5 million of cash for additional 2023 Notes and warrants.\nPursuant to the SPA, the exercise price of certain warrants for the purchase of 62,500 common shares exercisable at $ 21.00 per share and warrants for the purchase of 43,814 shares exercisable at $ 6.00 per share was reduced to $ 1.00 per share. The increase in the value of the warrants in the aggregate amount of $ 63,502 as a result of the reduction in exercise price was recorded as debt discount on the 2023 Note.\nThe 2023 Note is convertible into shares of common stock of the Company at a conversion price equal to the lower of (i) $ 1.34 (subject to adjustment for standard anti-dilution events, the non-exempt issuance of common stock for less than $ 1.34 per share and the issuance of additional variable price securities); (ii) the trading price on the day immediately prior to conversion or (iii) the average trading price of the Company’s common stock for the 5 days preceding conversion (collectively the “Conversion Price”), subject to a floor price of $0.27. If the Conversion Price in effect on the date of conversion is less than $ 0.27 , the Investor is entitled to a cash true up payment equal to the difference between the conversion dollar amount and the value of shares issued upon conversion (the “Cash True Up Provision”).\nThe 2023 Note matures on the first anniversary of the issuance date (the “Maturity Date”) and bears interest at a rate of 7 % per annum, which is payable either in cash monthly, or by way of inclusion in the accrued interest in the conversion amount on the conversion date. Interest includes a make-whole amount equal to the additional interest that would accrue if the entire 2023 Note principal remained outstanding through the Maturity Date.\nThe 2023 Note is redeemable at the Company’s election, so long as the Company is not in default, at the greater of (a) 115 % of the conversion amount, or (b) the amount equal to the shares issuable times the greatest closing price from the redemption notice date through the date the Company makes the redemption payment. The minimum redemption amount is $ 500,000 and the Company can only deliver one redemption notice in a 20-day period.\nUpon an event of default on the 2023 Note, the Conversion Price is reduced to the lesser of (a) $1.34 (subject to adjustment as described above); (b) 80% of the volume-weighted average price on the day preceding receipt of the conversion notice; or (c) 80% of the average of the three lowest volume-weighted average prices over the fifteen trading days which precede receipt of the conversion notice, subject to a floor price of $ 0.27 (the “Event of Default Conversion Price”). In addition, the Investor may require the Company to redeem the 2023 Note using the same formula that would be used for a Company-initiated redemption, described above.\nThe Event of Default Conversion Price represents a redemption feature, which was bifurcated from the debt host and recorded as a derivative liability. As of the date of issuance of the 2023 Note, management had estimated that the probability of an event of default was negligible; accordingly, the fair value of the derivative liability was de minimis at the date of issuance.\n\n| 20 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nPursuant to the terms of the 2023 Note, the Company must pay, convert or redeem one quarter of the initial principal, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date. As of June 30, 2023, the Company is in default on the 2023 Note as a result of not making the required quarterly payment due on May 21, 2023. Consequently, the Company remeasured the derivative liability and recorded a change in fair value of the derivative liability of $ 2,141,117 during the three and six months ended June 30, 2023.\nThe following table sets forth a summary of the changes in the fair value of the derivative liability that are measured at fair value on a recurring basis:\nSUMMARY OF THE CHANGES IN THE FAIR VALUE OF DERIVATIVE LIABILITIES\n| Balance as of January 1, 2023 | $ | - |\n| Fair value of derivative liability upon issuance of 2023 Note | - |\n| Change in fair value of derivative liability | 2,141,117 |\n| Balance as of June 30, 2023 | 2,141,117 |\n| Less: current portion of derivative liability | 2,088,617 |\n| Equals: derivative liability, non-current portion | $ | 52,500 |\n\nThe Company incurred financing costs of $ 321,803 in connection with the SPA, of which $ 218,187 was allocated to the 2023 Note and recorded as debt discount and $ 103,616 was allocated to the 2023 Note Warrant and charged against additional paid-in capital.\nUpon the issuance of the 2023 Note, the Company recorded a debt discount at issuance in the aggregate amount $ 2,509,601 , consisting of (i) the $ 617,978 difference between the aggregate principal amount of the 2023 Note and the cash proceeds received, (ii) financing costs in the aggregate amount of $ 218,187 , (iii) value of warrant modification of $ 63,502 , and (iv) the $ 1,609,935 relative fair value of the 2023 Note Warrant. The debt discount is being amortized using the effective interest method over the term of the 2023 Note.\nDuring the six months ended June 30, 2023, the Company made redemption payments in the aggregate amount of $ 246,186 related to the 2023 Note, which included principal repayments of $ 200,070 , accrued interest of $ 14,005 and redemption premiums of $ 32,094 . The Company recorded a loss on extinguishment for the amount of redemption premiums paid.\nDuring the three and six months ended June 30, 2023, a total of $ 575,256 , which included principal of $ 523,925 , accrued interest of $ 38,254 and conversion premiums of $ 13,077 , was converted into 828,780 shares at conversion prices between $ 0.46 and $ 0.78 per share.\nInterest Expense on Convertible Debt Obligations\nThe Company incurred total interest expense of $ 987,037 and $ 661,695 related to its convertible debt obligations during the three months ended June 30, 2023 and 2022, respectively. The Company incurred total interest expense of $ 1,553,077 and $ 1,410,926 related to its convertible debt obligations during the six months ended June 30, 2023 and 2022, respectively.\nInterest expense during the three months ended June 30, 2023 and 2022 consists of (i) $ 211,260 and $ 151,200 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 716,867 and $ 510,495 , respectively, during the six months ended June 30, 2023.\nInterest expense during the six months ended June 30, 2023 and 2022 consists of (i) $ 415,135 and $ 348,990 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 1,079,033 and $ 1,061,936 , respectively, during the six months ended June 30, 2023.\nSee Note 17 - Subsequent Events.\n\n| 21 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\n11. SEGMENT DATA\nThe Company’s financial position and results of operations are classified into three reportable segments, consistent with how the CODM makes decisions about resource allocation and assesses the Company’s performance.\n\n| ● | Real Estate Development, through AWE and TAR, including hospitality and winery operations, which support the ALGODON® brand. |\n| ● | Fashion (e-commerce), through GGI, including the manufacture and sale of high-end fashion and accessories sold through an e-commerce platform. |\n| ● | Corporate, consisting of general corporate overhead expenses not directly attributable to any one of the business segments. |\n\nThe following tables present segment information for the three months ended June 30, 2023 and 2022:\nSCHEDULE OF SEGMENT INFORMATION\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| For the Three Months Ended June 30, 2023 | For the Six Months Ended June 30, 2023 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Revenues | $ | 670,594 | $ | 40,381 | $ | - | $ | 710,975 | $ | 1,052,979 | $ | 105,763 | $ | - | $ | 1,158,742 |\n| Revenues from Foreign Operations | $ | 670,594 | $ | - | $ | - | $ | 670,594 | $ | 1,052,979 | $ | - | $ | - | $ | 1,052,979 |\n| Loss from Operations | $ | ( 123,767 | ) | $ | ( 463,126 | ) | $ | ( 1,398,694 | ) | $ | ( 1,985,587 | ) | $ | ( 457,771 | ) | $ | ( 955,325 | ) | $ | ( 2,518,496 | ) | $ | ( 3,931,592 | ) |\n\n\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| For the Three Months Ended June 30, 2022 | For the Six Months Ended June 30, 2022 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Revenues | $ | 399,223 | $ | 6,112 | $ | - | $ | 405,335 | $ | 819,658 | $ | 11,274 | $ | - | $ | 830,932 |\n| Revenues from Foreign Operations | $ | 399,223 | $ | - | $ | - | $ | 399,223 | $ | 819,658 | $ | - | $ | - | $ | 819,658 |\n| Loss from Operations | $ | ( 1,339,272 | ) | $ | ( 341,668 | ) | $ | ( 758,493 | ) | $ | ( 2,439,433 | ) | $ | ( 1,725,125 | ) | $ | ( 700,201 | ) | $ | ( 1,789,910 | ) | $ | ( 4,215,236 | ) |\n\n\n| 22 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nThe following tables present segment information as of June 30, 2023 and December 31, 2022:\n\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| As of June 30, 2023 | As of December 31, 2022 |\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\n| Total Property and Equipment, net | $ | 6,586,322 | $ | 1,271,163 | $ | - | $ | 7,857,485 | $ | 6,234,856 | $ | 1,369,205 | $ | 17,196 | $ | 7,621,257 |\n| Total Property and Equipment, net in Foreign Countries | $ | 6,586,322 | $ | - | $ | - | $ | 6,586,322 | $ | 6,234,856 | $ | - | $ | - | $ | 6,234,856 |\n| Total Assets | $ | 14,282,151 | $ | 3,330,807 | $ | 1,606,456 | $ | 19,219,414 | $ | 13,504,914 | $ | 3,522,415 | $ | 1,665,656 | $ | 18,692,985 |\n\n12. RELATED PARTY TRANSACTIONS\nAccounts Receivable – Related Parties\nAs of June 30, 2023 and December 31, 2022 the Company had accounts receivable – related parties of $ 1,075,102 and $ 1,115,816 net of allowances for expected credit losses of $ 470,516 and $ 339,503 , respectively, representing the net realizable value of advances made to, and expense sharing obligations receivable from, separate entities under common management. During the three and six months ended June 30, 2023, the Company made advances in the amount of $ 0 and $ 85,644 , respectively, to the related entities. During the three and six months ended June 30, 2022, the Company made advances in the amount of $ 0 and $ 36,000 , respectively to the related entities. During the three and six months ended June 30, 2023, the Company received repayments in the amount of $ 237,813 and $ 367,813 , respectively, from the related entities. During the three and six months ended June 30, 2022, the Company received repayments in the amount of $ 583,000 and $ 703,000 , respectively, from the related entities. Receivables recorded in the amount of $ 383,529 and $ 417,413 in connection with an expense sharing agreement during the six months ended June 30, 2023 and 2022 are discussed below.\nThe Company recorded credit losses related to accounts receivable, related parties of $ 0 and $ 19,431 during the three and six months ended June 30, 2023, respectively. The Company recorded credit losses of $ 0 during the three and six months ended June 30, 2022. Credit losses are recorded as bad debt expense which is reflected in the general and administrative expenses on the on the accompanying unaudited consolidated statements of operations.\nExpense Sharing\nOn April 1, 2010, the Company entered into an agreement with a Related Party to share expenses such as office space, support staff, professional services, and other operating expenses (the “Related Party ESA”). During the six months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 383,529 and $ 417,413 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement. During the three months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 208,103 and $ 189,188 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement.\n\n| 23 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nManagement Fee Income\nThe Company earns management fees of $ 75,000 per quarter from LVH. A member of the Company’s board of directors is the managing member of SLVH, LLC, and holds a 20 % membership interest in SLVH. SLVH owns 88 % of the limited liability interest of LVH.\nAmendment to LVH Limited Liability Company Agreement\nOn June 30, 2023, the Company through its wholly owned subsidiary, GVI, executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\n13. BENEFIT CONTRIBUTION PLAN\nThe Company sponsors a 401(k) profit-sharing plan (“401(k) Plan”) that covers substantially all of its employees in the United States. The 401(k) Plan provides for a discretionary annual contribution, which is allocated in proportion to compensation. In addition, each participant may elect to contribute to the 401(k) Plan by way of a salary deduction.\nA participant is always fully vested in their account, including the Company’s contribution. For the six months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 9,208 and $ 22,384 , respectively. For the three months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 3,300 and $ 3,408 , respectively. This charge has been included as a component of general and administrative expenses in the accompanying condensed consolidated statements of operations. The Company issues shares of its common stock to settle these obligations based on the fair value of its common stock on the date the shares are issued. During the six months ended June 30, 2023, the Company issued 24,160 shares at $ 1.35 per share in satisfaction of $ 32,617 of 401(k) contribution liabilities. During the six months ended June 30, 2022, the Company issued 1,040 shares at $ 26.76 per share in satisfaction of $ 27,821 of 401(k) contribution liabilities.\n14. STOCKHOLDERS’ EQUITY\nCommon Stock\nOn February 2, 2023, the Company issued 51,305 shares of common stock upon the cashless exercise of 134,730 warrants at exercise prices ranging from $ 2.40 and $ 3.82 .\nOn February 10, 2023, the Company sold 591,000 shares of common stock and warrants to purchase 147,750 shares at an exercise price of $ 1.00 for aggregate proceeds of $ 591,000 . The warrants are immediately exercisable and expire two years from the date of issuance.\nDuring the six months ended June 30, 2023, the Company sold an aggregate of 823,198 shares of the Company’s common stock for gross proceeds of $ 797,623 less placement agent fees of $ 64,617 pursuant to a Common Stock Purchase Agreement (the “New ELOC”).\nSee Note 10 – Convertible Debt Obligations for additional details regarding common shares issued during the three and six months ended June 30, 2023.\nAccumulated Other Comprehensive Loss\nFor the three and six months ended June 30, 2023, the Company recorded a loss of $ 37,993 and $ 77,792 , respectively, and for the three and six months ended June 30, 2022, the Company recorded a gain of $ 358,056 and $ 621,462 , respectively, related to foreign currency translation adjustments as accumulated other comprehensive income, primarily related to fluctuations in the Argentine peso to United States dollar exchange rates (see Note 2 – Summary of Significant Accounting Policies, Highly Inflationary Status in Argentina).\n\n| 24 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nWarrants\nA summary of warrant activity during the six months ended June 30, 2023 is presented below:\nSUMMARY OF WARRANTS ACTIVITY\n| Number of Warrants | Weighted Average Exercise Price | Weighted Average Remaining Life in Years | Intrinsic Value |\n| Outstanding, January 1, 2023 | 1,299,135 | $ | 5.77 |\n| Issued | 3,674,849 | 1.31 |\n| Exercised | ( 134,730 | ) | 3.36 |\n| Expired | - | - |\n| Canceled | - | - |\n| Outstanding, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\n| Exercisable, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\n\nSee Common Stock, above, and Note 10 – Convertible Debt Obligations for additional details regarding warrants issued during the six months ended June 30, 2023.\nA summary of outstanding and exercisable warrants as of June 30, 2023 is presented below:\nSCHEDULE OF WARRANTS OUTSTANDING AND EXERCISABLE\n| Warrants Outstanding | Warrants Exercisable |\n| Exercise Price | Exercisable Into | Outstanding Number of Warrants | Weighted Average Remaining Life in Years | Exercisable Number of Warrants |\n| $ | 1.00 | Common Stock | 404,064 | 1.6 | 404,064 |\n| $ | 1.34 | Common Stock | 3,377,099 | 2.7 | 3,377,099 |\n| $ | 3.82 | Common Stock | 454,588 | 0.2 | 454,588 |\n| $ | 6.00 | Common Stock | 602,225 | 0.5 | 602,225 |\n| $ | 90.00 | Common Stock | 1,278 | 2.6 | 1,278 |\n| Total | 4,839,254 | 2.1 | 4,839,254 |\n\n\n| 25 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nRestricted Stock Units\nA summary of RSU activity during the six months ended June 30, 2023 is presented below:\nSCHEDULE OF RESTRICTED STOCK UNITS AND WEIGHTED AVERAGE GRANT DATE FAIR VALUES\n| Weighted Average |\n| Number of | Grant Date Value |\n| RSUs | Per Share |\n| RSUs non-vested January 1, 2023 | 511,500 | $ | 1.16 |\n| Granted | 10,000 | 1.31 |\n| Vested | ( 3,890 | ) | 1.31 |\n| Forfeited | ( 1,333 | ) | 1.16 |\n| RSUs non-vested June 30, 2023 | 516,277 | $ | 1.16 |\n\nOn January 23, 2023, the Company granted 10,000 restricted stock units (“RSUs”) to certain employees and advisors for their service, of which 3,890 RSUs vested on the grant date and 3,055 RSUs will vest on each of the next two anniversaries of the date of the grant.\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 74,978 and $ 154,400 respectively, related to the amortization of RSUs. No expense related to the amortization of RSUs was recorded for the three or six months ended June 30, 2022.\nStock Options\nNo stock options were granted during the six months ended June 30, 2023 or the six months ended June 30, 2022. The following table presents information related to GGH stock options outstanding as of June 30, 2023:\nSCHEDULE OF STOCK OPTION ACTIVITY\n| Weighted | Weighted |\n| Average | Average |\n| Number of | Exercise | Remaining | Intrinsic |\n| Options | Price | Term (Years) | Value |\n| Outstanding, January 1, 2023 | 40,612 | 85.35 |\n| Granted | - | - |\n| Exercised | - | - |\n| Expired | ( 5,806 | ) | 138.60 |\n| Forfeited | - | - |\n| Outstanding, June 30, 2023 | 34,806 | $ | 76.47 | 1.1 | $ | - |\n| Exercisable, June 30, 2023 | 29,698 | $ | 75.78 | 1.0 | $ | - |\n\n\n| 26 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 38,834 and $ 77,668 , respectively, and during the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 57,403 and $ 130,103 , respectively, related to the amortization of options for the purchase of GGH common stock.\nThe Company recorded no stock-based compensation expense related to options for the purchase of GGI common stock for the three and six months ended June 30, 2023 as all of the GGI options were exchanged and cancelled as of June 22, 2022. For the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 29,731 and $ 40,085 , respectively, related to the options for the purchase of GGI common stock.\nStock-based compensation expense is reflected in general and administrative expenses (classified in the same manner as the grantees’ wage compensation) in the accompanying condensed consolidated statements of operations. As of June 30, 2023, there was $ 91,921 of unrecognized stock-based compensation expense related to stock option grants that will be amortized over a weighted average period of 1.1 years.\n15. COMMITMENTS AND CONTINGENCIES\nLegal Matters\nThe Company may be involved in litigation and arbitrations from time to time in the ordinary course of business. At the present time, the Company is not involved in any ongoing litigation. The Company records legal costs associated with loss contingencies as incurred. Settlements are accrued when, and if, they become probable and estimable.\n16. LEASES\nOn April 8, 2021, GGI entered into a lease agreement to lease a retail space in Miami, Florida for 7 years, which expires May 1, 2028 . As of June 30, 2023, the lease had a remaining term of approximately 4.8 years. Lease payments begin at $26,758 per month and escalate 3% every year over the duration of the lease. The Company was granted rent abatements of 15% for the first year of the lease term, and 10% for the second and third year of the lease term. The Company was required to pay a $ 56,130 security deposit.\nAs of June 30, 2023, the Company had no leases that were classified as a financing lease.\nTotal operating lease expense was $ 82,965 and $ 165,931 during the three and six months ended June 30, 2023, respectively, and $ 82,965 and $ 165,931 during the three and six months ended June 30, 2022, respectively. Lease expenses are recorded in general and administrative expenses on the accompanying condensed consolidated statements of operations.\n\n| 27 |\n\n\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(unaudited)\nSupplemental cash flow information related to leases was as follows:\nSCHEDULE OF SUPPLEMENTAL CASH FLOWS INFORMATION RELATED TO LEASES\n| For the Six Months Ended June 30, |\n| 2023 | 2022 |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from operating leases | $ | 98,125 | $ | 82,296 |\n| Right-of-use assets obtained in exchange for lease obligations: |\n| Operating leases | $ | - | $ | - |\n| Weighted Average Remaining Lease Term: |\n| Operating leases | 4.8 | 5.8 |\n| Weighted Average Discount Rate: |\n| Operating leases | 7.0 | % | 7.0 | % |\n\nFuture minimum lease commitments are as follows:\nSCHEDULE OF FUTURE MINIMUM LEASE COMMITMENT\n| For the period July 1 through December 31, 2023 | $ | 153,290 |\n| For the years ended December 31, |\n| 2024 | 336,102 |\n| 2025 | 357,881 |\n| 2026 | 368,617 |\n| 2027 | 365,004 |\n| 2028 | 120,463 |\n| Total future minimum lease payments | 1,701,357 |\n| Less: imputed interest | ( 268,300 | ) |\n| Net future minimum lease payments | 1,433,057 |\n| Less: operating lease liabilities, current portion | 220,416 |\n| Operating lease liabilities, non-current portion | $ | 1,212,641 |\n\nThe Company is the lessor of a building and land that it purchased in connection with acquisition of GDS, pursuant to an operating lease which expires on August 31, 2031. At the end of the leases, the lessee may enter into a new lease or return the asset, which would be available to the Company for releasing. The Company recorded lease revenue of $ 10,937 and $ 21,565 during the three and six months ended June 30, 2023, respectively, related to this lease agreement. The Company recorded lease revenue of $ 10,594 and $ 14,339 during the three and six months ended June 30, 2022, respectively, related to this lease agreement.\n17. SUBSEQUENT EVENTS\nThere have been no subsequent events that occurred during the period subsequent to the date of these condensed consolidated financial statements that would require adjustment to our disclosure in the condensed consolidated financial statements as presented, except as described below:\n2023 Convertible Note\nOn July 3, 2023, $ 120,000 of principal, $ 9,979 of interest, and $ 19,467 of premium owed in connection with the 2023 Note were converted into 329,416 shares of common stock of the Company at a conversion price of $ 0.4538 per share.\nOn August 11, 2023, the Company and the Investor entered into a letter agreement pursuant to which, among other things: i) the Investor agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the requirement in the 2023 Note to pay interest monthly in cash is waived for payments due August 1, 2023 through December 31, 2023; (iii) the application of the default interest rate on the 2023 Note is waived for the period from May 21, 2023 through December 31, 2023, (iv) the requirement for the Company to prepay, redeem, or convert one quarter the initial principal owe on the 2023 Note, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date.is waived through December 31, 2023; (v) the Company adjusted the exercise price of the 2023 Note Warrant from $1.34 to $0.45; and (vi) the Investor may continue to convert the 2023 Note at the Alternate Conversion Price or at $0.45.\nBoard Compensation\nOn July 14, 2023, the Company issued a total of 270,272 shares at $ 0.555 per share for a total value of $ 150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\n\n| 28 |\n\n\n\nThe following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included herein. In connection with, and because we desire to take advantage of, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution readers regarding certain forward-looking statements in the following discussion and elsewhere in this report and in any other statement made by, or on our behalf, whether or not in future filings with the Securities and Exchange Commission. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Forward looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on our behalf. Words such as “anticipate,” “estimate,” “plan,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions are used to identify forward-looking statements. We disclaim any obligation to update forward-looking statements.\nUnless the context requires otherwise, references in this document to “GGH”, “we”, “our”, “us” or the “Company” are to Gaucho Group Holdings, Inc. and its subsidiaries.\nPlease note that because we qualify as an emerging growth company and as a smaller reporting company, we have elected to follow the smaller reporting company rules in preparing this Quarterly Report on Form 10-Q.\nOverview\nGaucho Group Holdings, Inc. (“GGH” or the “Company”) positions its e-commerce leather goods, accessories, and fashion brand, Gaucho – Buenos Aires™, as one of luxury, creating a platform for the global consumer to access their piece of Argentine style and high-end products. With a concentration on leather goods, ready-to-wear and accessories, this is the luxury brand in which Argentina finds its contemporary expression. During the first quarter of 2022, the Company launched Gaucho Casa, a Home & Living line of luxury textiles and home accessories, which will be marketed and sold on the Gaucho – Buenos Aires e-commerce platform. Gaucho Casa challenges traditional lifestyle collections with its luxury textiles and home accessories rooted in the singular spirit of the gaucho aesthetic. GGH seeks to grow its direct-to-consumer online products to global markets in the United States, Asia, the United Kingdom, Europe, and Argentina. We intend to focus on e-commerce and scalability of the Gaucho – Buenos Aires and Gaucho Casa brands, as real estate in Argentina is politically sensitive.\nGGH’s goal is to become recognized as the LVMH (“Louis Vuitton Moët Hennessy”) of South America’s leading luxury brands. Through one of its wholly owned subsidiaries, GGH also owns and operates legacy investments in the boutique hotel, hospitality and luxury vineyard property markets. This includes a golf, tennis and wellness resort, as well as an award-winning wine production company concentrating on Malbecs and Malbec blends. Utilizing these wines as its ambassador, GGH seeks to further develop its legacy real estate, which includes developing residential vineyard lots located within its resort.\nAs a result of the COVID-19 pandemic, we terminated the corporate office lease and senior management now works remotely. GGH’s local operations are managed by professional staff with substantial hotel, hospitality and resort experience in Buenos Aires and San Rafael, Argentina.\n\n| 29 |\n\n\nRecent Developments and Trends\nWhile the World Health Organization declared an end to the COVID-19 global health emergency on May 5, 2023, we continue to closely monitor the outbreak of COVID-19 and the related impact on our operations, financial position and cash flows, as well as the impact on our employees. Due to the continued fluidity of this situation, and the magnitude and duration of the pandemic, its impact on our future operations and liquidity remains uncertain as of the date of this report.\nWe have faced, and may continue to face, significant cost inflation, specifically in raw materials and other supply chain costs due to increased demand for raw materials and the broad disruption of the global supply chain associated with the impact of COVID-19. International conflicts or other geopolitical events, including the 2022 Russian invasion of Ukraine, may further contribute to increased supply chain costs due to shortages in raw materials, increased costs for transportation and energy, disruptions in supply chains, and heightened inflation. Further escalation of geopolitical tensions may also lead to changes to foreign exchange rates and financial markets, any of which may adversely affect our business and supply chain, and consequently our results of operation. While there could ultimately be a material impact on the operations and liquidity of the Company, at the time of issuance, the impact could not be determined.\nDuring the three months ended June 30, 2023, the Company and the holder of a senior secured convertible note of the Company (the “2023 Note”) converted an aggregate of $575,256 of principal, interest and conversion premiums, and the Company issued an aggregate of 828,780 shares upon conversion.\nOn June 30, 2023, the Company through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\nOn July 3, 2023, the Company and the holder of the 2023 Note converted an aggregate of $149,446 of principal, interest and conversion premiums and the Company issued an aggregate of 329,416 shares upon conversion.\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share for a total value of $150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\nConsolidated Results of Operations\nThree months ended June 30, 2023 compared to the three months ended June 30, 2022\nOverview\nWe reported a net loss of approximately $5.0 million and $5.3 million for the three months ended June 30, 2023 and 2022, respectively.\nRevenues\nRevenues from operations were approximately $711,000 and $405,000 during the three months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $306,000 or 76%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $443,000, an increase of approximately $143,000 in lot sales, an increase of agricultural sales of approximately $178,000, and an increase in clothes, accessories and other sales of approximately $61,000, resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease of approximately $519,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\n\n| 30 |\n\n\nGross profit\nWe generated a gross profit of approximately $42,000 for the three months ended June 30, 2023 and a gross loss of approximately $128,000 for the three months ended June 30, 2022, representing an increase in gross profit of approximately $170,000 or 133%, primarily resulting from profits earned from the sale of real estate lots during the period.\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $136,000 or 26%, from approximately $533,000 for the three months ended June 30, 2022 to approximately $669,000 for the three months ended June 30, 2023. The increase in cost of sales resulted from the increases in hotel, restaurant and wine costs of approximately $335,000, an increase in clothes, accessories and other costs of approximately $124,000, and an increase of approximately $102,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $199,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $625,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nSelling and marketing expenses\nSelling and marketing expenses were approximately $213,000 and $333,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $120,000 or 36%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nGeneral and administrative expenses\nGeneral and administrative expenses were approximately $1,711,000 and $1,929,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $218,000 or 11%. Decreases of approximately $225,000 in employee compensation, and approximately $759,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $482,000 in professional and consulting fees (primarily business development and investor relations consulting) and approximately $284,000 in other aggregated expenses that are not individually material.\nDepreciation and amortization expense\nDepreciation and amortization expense was approximately $104,000 and $49,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $55,000 or 112%, related to new asset purchases.\nInterest income\nInterest income was approximately $64,000 and $27,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $37,000 or 137%, related to the increase in mortgages receivable.\nInterest expense\nInterest expense was approximately $1,066,000 and $695,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $371,000 or 53%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\n\n| 31 |\n\n\nOther income, related party\nOther income of approximately $75,000 during the three months ended June 30, 2023 and 2022 represents the management fee earned from LVH.\nLoss on extinguishment of debt\nLoss on extinguishment of debt in the aggregate amount of $32,094 during the three months ended June 30, 2023 consists of extinguishment loss recognized related to premiums paid on the cash redemption of convertible debt. Loss on extinguishment of debt in the aggregate amount of $2,105,119 during the three months ended June 30, 2022 consists of extinguishment loss recognized upon the reduction of the conversion price on the GGH Notes during the second quarter of 2022.\nGains from foreign currency translation\nThe Company recorded gains from foreign currency translation of approximately $103,000 and $43,000 during the three months ended June 30, 2023 and 2022, respectively. The increase of approximately $60,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\nChange in fair value of derivative liability\nThe Company recorded a change in fair value of derivative liability of approximately $2,141,000 and $0 during the three months ended June 30, 2023 and 2022, respectively. The change in fair value during the six months ended June 30, 2023 is associated with the default of the 2023 Convertible Note as of June 30, 2023.\nInducement expense\nInducement expense decreased to $0 for the three months ended June 30, 2023 from approximately $198,000 during the three months ended June 30, 2022. Inducement expense during the three months ended June 30, 2022 resulted from a temporary reduction in the conversion price on convertible debt.\nSix months ended June 30, 2023 compared to the six months ended June 30, 2022\nOverview\nWe reported a net loss of approximately $7.7 million and $7.6 million for the six months ended June 30, 2023 and 2022, respectively.\nRevenues\nRevenues from operations were approximately $1,159,000 and $831,000 during the six months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $328,000 or 39%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $863,000, increases in agricultural revenues of $122,000, and increases in clothes, accessories and other sales of approximately $145,000 resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease in lot sales of approximately $42,000 and approximately $760,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\n\n| 32 |\n\n\nGross profit\nWe generated a gross profit of approximately $197,000 and $59,000 for the six months ended June 30, 2023 and 2022, respectively, representing an increase of approximately $138,000 or 234%. The increase in gross profit during the six months ended June 30, 2023 is primarily related to hotel sales during the period. The Company’s hotel was being renovated during the first half of 2022, resulting in limited revenues, with fixed costs related to hotel operations.\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $190,000 or 25%, from approximately $772,000 for the six months ended June 30, 2022 to approximately $962,000 for the six months ended June 30, 2023. The increase in cost of sales includes increases in hotel, restaurant and wine costs of approximately $534,000, an increase in clothes, accessories and other costs of approximately $166,000, and an increase of approximately $75,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $158,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $743,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nSelling and marketing expenses\nSelling and marketing expenses were approximately $448,000 and $505,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of approximately $57,000 or 11%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\nGeneral and administrative expenses\nGeneral and administrative expenses were approximately $3,467,000 and $3,674,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of $207,000 or 6%. A decrease of approximately $739,000 resulting from gains recognized on transactions denominated in foreign currency, as well as a decrease of approximately $460,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $596,000 in professional and consulting fees (primarily business development and investor relations consulting), approximately $85,000 of compensation expense, as well as approximately $307,000 in other aggregated expenses that are not individually material. Gains recognized on transactions denominated in a foreign currency result from the difference between the official exchange rate, and the actual exchange rate applied to the peso.\nDepreciation and amortization expense\nDepreciation and amortization expense was approximately $213,000 and $95,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $118,000 or 124%, related to new asset purchases.\nInterest income\nInterest income was approximately $115,000 and $30,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $85,000 or 283% as the result of increases in mortgages receivable during the period.\nInterest expense\nInterest expense was approximately $1,668,000 and $1,453,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $215,000 or 15%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\nOther income\nOther income of approximately $150,000 during the six months ended June 30, 2023 and 2022 represents the management fee received from LVH.\n\n| 33 |\n\n\nGains from foreign currency translation.\nThe Company recorded gains from foreign currency translation of approximately $215,000 and $226,000 during the six months ended June 30, 2023 and 2022, respectively, as the result of the highly inflationary status of Argentina. The decrease of approximately $11,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\nLoss on extinguishment of debt\nLoss on extinguishment of debt was approximately $416,000 during the six months ended June 30, 2023, as compared to approximately $2.1 million during the six months ended June 30, 2022. Loss on extinguishment of debt during the six months ended June 30, 2023 in the approximate amount of $416,000 is comprised of (i) premium paid on the conversion of GGH Notes of approximately $112,000, (ii) premium paid on the cash redemption of GGH Notes of approximately $124,000, (iii) premium paid on the 2023 Note for cash redemption of principal in the amount of approximately $32,000; (iv) premium in the amount of approximately $13,000 paid on the conversion an aggregate of $87,179 of principal and interest owed on the 2023 Note, and (iv) the fair value of approximately $135,000 in warrants issued in the exchange agreement for the GGH Notes (See Note 10—Convertible Debt Obligations for additional details).\nLiquidity and Capital Resources\nWe measure our liquidity a variety of ways, including the following:\n\n| June 30, 2023 | December 31, 2022 |\n| (unaudited) |\n| Cash | $ | 810,139 | $ | 300,185 |\n| Working capital (deficiency) | $ | (3,828,285 | ) | $ | 595,120 |\n| Convertible debt obligations | $ | 4,893,983 | $ | 1,997,909 |\n| Loans payable | $ | 342,482 | $ | 256,321 |\n\nCash requirements for our current liabilities include approximately $2.0 million for accounts payable and accrued expenses, approximately $220,000 for lease liabilities, and approximately $332,000 for loans payable and other current liabilities. We also have convertible debt obligations in the approximate amount of $4.8 million which, if not converted prior to maturity, are due on February 21, 2024. Cash requirements for our long-term liabilities include approximately $1.2 million for operating lease liabilities, approximately $90,000 in loans payable, and approximately $82,000 of long-term accrued expenses.\nDuring the six months ended June 30, 2023, we financed a portion of our activities from proceeds derived from debt and equity financings. A significant portion of the funds have been used to cover working capital needs and personnel, office expenses and various consulting and professional fees.\nNet cash used in operating activities for the six months ended June 30, 2023 and 2022 amounted to approximately $4,033,000 and $2,755,000, respectively. During the six months ended June 30, 2023, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.7 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.5 million of cash used to fund changes in the levels of operating assets and liabilities. During the six months ended June 30, 2022, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.6 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.7 million of cash used to fund changes in the levels of operating assets and liabilities.\nCash used in investing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $489,000 and $1,720,000, respectively, resulting primarily from the purchase of property and equipment in the approximate amount of $438,000 and $1,677,000 million, respectively, and approximately $50,000 and $35,000 respectively, used to purchase certain intangible assets.\n\n| 34 |\n\n\nNet cash provided by financing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $5.1 million and $0.5 million, respectively. For the six months ended June 30, 2023, the net cash provided by financing activities resulted from approximately $4.7 million in net proceeds from the issuance of debt, $0.6 million in proceeds from the issuance of common stock in a private placement, approximately $0.7 million in proceeds from the issuance of stock under the New ELOC and $0.2 million in proceeds from the issuance of a note payable, partially offset by the repayment of convertible debt obligations and related redemption premiums in the approximate amount of $1.0 million, and repayment of loans payable of approximately $0.1 million. Net cash used in financing activities for the six months ended June 30, 2022 resulted from approximately $0.5 million of cash proceeds from the sale of commons stock, partially offset by approximately $0.1 million in repayments of loans payable.\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $810,000 and $3,109,000, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $7.7 million and $7.6 million, respectively, and used cash in operating activities of approximately $4.0 million and $2.8 million, respectively. Further, as of June 30, 2023, approximately $4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024, and approximately $0.3 million represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with net proceeds from convertible debt financing of approximately $4.7 million, proceeds of approximately $0.7 million from draws on the Company’s equity line of credit, and $0.6 million from the sale of common stock.\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern.\nAvailability of Additional Funds\nAs a result of our financings, we have been able to sustain operations. However, we will need to raise additional capital in order to meet our future liquidity needs for operating expenses and capital expenditures, including GGI inventory production, continued development of the GGI e-commerce platform, expansion of our winery and additional investments in real estate development. If we are unable to obtain adequate funds on reasonable terms, we may be required to significantly curtail or discontinue operations.\nOff-Balance Sheet Arrangements\nNone.\nContractual Obligations\nAs a smaller reporting company, we are not required to provide the information requested by paragraph (a)(5) of this Item.\nCritical Accounting Policies and Estimates\nThere are no material changes from the critical accounting policies, estimates and new accounting pronouncements set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth in our Annual Report on Form 10-K filed with the SEC on April 17, 2023, except as described below. Please refer to that document for disclosures regarding the critical accounting policies related to our business.\n\n| 35 |\n\n\nConvertible Promissory Notes\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\nSequencing Policy\nUnder ASC 815, we have adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide the information required by this Item.\n\nDisclosure Controls and Procedures\nOur management carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer (who is our Principal Executive Officer) and our Chief Financial Officer (who is our Principal Financial Officer and Principal Accounting Officer), of the effectiveness of the design of our disclosure controls and procedures (as defined by Exchange Act Rules 13a-15(e) or 15d-15(e)) as of June 30, 2023, pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were not effective as of June 30, 2023, resulting from a lack of segregation of duties due to our small size, and lack of testing of the operating effectiveness of the controls.\n\n| 36 |\n\n\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in management’s evaluation pursuant to Rules 13a-15(d) or 15d-15(d) of the Exchange Act during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nInherent Limitations of Controls\nManagement does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. Controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or deterioration in the degree of compliance with the policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\n\n| 37 |\n\n\nPART II - OTHER INFORMATION\n\nFrom time to time, the Company and its subsidiaries and affiliates are subject to litigation and arbitration claims incidental to its business. Such claims may not be covered by its insurance coverage, and even if they are, if claims against GGH and its subsidiaries are successful, they may exceed the limits of applicable insurance coverage. We are not involved in any litigation that we believe is likely, individually or in the aggregate, to have a material adverse effect on our condensed consolidated financial condition, results of operations or cash flows.\n\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this Item. However, our current risk factors are set forth in Item 1A of the Company’s Annual Report on Form 10-K as filed with the SEC on April 17, 2023 and in Item 1A of the Company’s Quarterly Report on Form 10-Q as filed with the SEC on May 19, 2023.\nOur stock has been trading below $1.00 and our failure to maintain compliance with Nasdaq’s continued listing requirements could result in the delisting of our common stock.\nOur common stock is currently listed for trading on The Nasdaq Capital Market. We must satisfy the continued listing requirements of The Nasdaq Stock Market LLC (or Nasdaq), to maintain the listing of our common stock on The Nasdaq Capital Market.\nOn June 1, 2023, the Company received a deficiency letter from the Listing Qualifications Department (the “Staff”) of the Nasdaq Stock Market notifying the Company that, for the preceding 30 consecutive business days, the closing bid price for the Company’s common stock was trading below the minimum $1.00 per share requirement for continued inclusion on The Nasdaq Capital Market pursuant to Nasdaq Listing Rule 5450(a)(1) (the “Bid Price Requirement”). The notification has no immediate effect on the Company’s Nasdaq listing and the Company’s common stock will continue to trade on Nasdaq under the ticker symbol “VINO.”\nIn accordance with Nasdaq Rules, the Company was provided with an initial period of 180 calendar days, or until November 28, 2023 (the “Compliance Date”), to regain compliance with the Bid Price Requirement. If at any time before the Compliance Date the closing bid price for the Company’s common stock is at least $1.00 for a minimum of 10 consecutive business days, the Staff will provide the Company written confirmation of compliance with the Bid Price Requirement.\nIf the Company does not regain compliance with the Bid Price Requirement by the Compliance Date, the Company may be eligible for an additional 180 calendar day compliance period. To qualify, the Company would then be required to meet the continued listing requirement for market value of publicly held shares and all other initial listing standards for The Nasdaq Capital Market, with the exception of the Bid Price Requirement, and will need to provide written notice of its intention to cure the deficiency during the additional 180 calendar day compliance period, which compliance could be achieved by effecting a reverse stock split, if necessary. If the Company does not regain compliance with the Bid Price Requirement by the Compliance Date and is not eligible for an additional compliance period at that time, the Staff will provide written notification to the Company that its common stock will be subject to delisting. At that time, the Company may appeal the Staff’s delisting determination to a Nasdaq Hearings Panel.\n\n| 38 |\n\n\nThe Company is holding its Annual General Meeting on August 24, 2023, at which, among other things, the Company has requested stockholder approval to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing. The Company will need shareholders representing a majority of the outstanding shares of the Company to approve this proposal, which is not guaranteed.\nIf our common stock were delisted from Nasdaq, trading of our common stock would most likely take place on an over-the-counter market established for unlisted securities, such as the OTCQB or the Pink Market maintained by OTC Markets Group Inc. An investor would likely find it less convenient to sell, or to obtain accurate quotations in seeking to buy, our common stock on an over-the-counter market, and many investors would likely not buy or sell our common stock due to difficulty in accessing over-the-counter markets, policies preventing them from trading in securities not listed on a national exchange or other reasons. In addition, as a delisted security, our common stock would be subject to SEC rules as a “penny stock”, which impose additional disclosure requirements on broker-dealers. The regulations relating to penny stocks, coupled with the typically higher cost per trade to the investor of penny stocks due to factors such as broker commissions generally representing a higher percentage of the price of a penny stock than of a higher-priced stock, would further limit the ability of investors to trade in our common stock. In addition, delisting would materially and adversely affect our ability to raise capital on terms acceptable to us, or at all, and may result in the potential loss of confidence by investors, suppliers, customers and employees and fewer business development opportunities. For these reasons and others, delisting would adversely affect the liquidity, trading volume and price of our common stock, causing the value of an investment in us to decrease and having an adverse effect on our business, financial condition and results of operations, including our ability to attract and retain qualified employees and to raise capital.\nThe Company is currently in default under one of its convertible promissory notes, which allows the holder to redeem all or a portion of the Note.\nPursuant to the 2023 Purchase Agreement and Notes, as of May 21, 2023, the Company failed to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The holder may require the Company to redeem all or a portion of the Notes by written notice, which would have a material adverse effect on the Company. On August 11, 2023, the Company and the holder of the Notes entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\nIf LVH does not sign a ground lease by December 29, 2023, LVH will be dissolved and we may not receive a complete return of our investment.\nCurrently, the Company, through its wholly-owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), contributed total capital of $7.0 million to LVH Holdings LLC (“LVH”) to develop a project in Las Vegas, Nevada and received 396 limited liability company interests, representing an 11.9% equity interest in LVH. Pursuant to the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH dated June 30, 2023, if a ground lease for the premises within which the luxury hotel, casino, entertainment and retail project will be developed and constructed has not been executed by LVH on or before December 29, 2023, then as promptly as reasonably practicable after such date, LVH will be liquidated and dissolved.\nAs of June 30, 2023, LVH has used our cash contribution to LVH for land improvement expenses, such as architectural, legal, engineering, and accounting fees. Should LVH be liquidated and dissolved on or before December 29, 2023, we most likely will not receive our entire contribution back from LVH and may lose our entire investment.\n\n| 39 |\n\n\n\nEquity Line of Credit\nPursuant to the Purchase Agreement with Tumim Capital dated November 8, 2022, the Company requested draw-downs and issued shares of common stock and received gross proceeds of the following for the three months ended June 30, 2023: (i) April 19, 2023, the Company issued 195,970 shares of common stock to Tumim for gross proceeds of $144,339; and (ii) on May 5, 2023, the Company issued 262,798 shares of common stock to Tumim for gross proceeds of $172,614. No general solicitation was used, and a commission of 8% of the total gross proceeds was paid to Benchmark Investments, Inc. pursuant to the Underwriting Agreement between the Company and Kingswood Capital Markets, a division of Benchmark Investments, Inc., f/k/a EF Hutton, dated February 16, 2021. The Company relied on the exemptions from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D of the Securities Act, in connection with the sales. A Form D was filed with the SEC on November 21, 2022.\n\nPursuant to the 2023 Purchase Agreement and Notes, as of each three-month anniversary of the Notes, the Company was required to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The Company did not meet that requirement as of May 21, 2023, which is the first three-month anniversary. The Company is required to deliver notice of default to the holder within one (1) business day. The holder may require the Company to redeem all or a portion of the Notes by written notice. On August 11, 2023, the Company and the holder of the Notes entered into an agreement pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\n\nNot applicable.\n\nSpecial Meeting of Stockholders\nOn May 8, 2023, the Company held a special stockholder meeting (the “Special Meeting”) at 12:00 p.m. Eastern Time at which a quorum was present. At the Special Meeting, a proposal to approve, for purposes of complying with Nasdaq Listing Rule 5635(d), the full issuance and exercise of shares of our common stock to be issued pursuant to that certain Securities Purchase Agreement, dated February 21, 2023 (the “Purchase Agreement”), that certain senior secured convertible promissory note dated February 21, 2023 (the “Note”), that certain common stock purchase warrant dated February 21, 2023 (the “Warrants”), and that certain Registration Rights Agreement, dated February 21, 2023 (the “Registration Rights Agreement”) by and between the Company and an institutional investor was approved by the stockholders.\nAnnual General Meeting\nOn June 29, 2023, the Company filed a Preliminary Proxy Statement on Form 14-A, a Definitive Proxy Statement on Form 14-A on July 10, 2023, and additional definitive proxy materials on Form 14-A on July 11, 2023, which request stockholder approval of the following proposals: (i) To elect two (2) Class III nominees to the board of directors (Scott L. Mathis and William A. Allen) to hold office for a three-year term; (ii) to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing; (iii) to conduct an advisory vote on executive compensation; (iv) to conduct an advisory vote on the frequency of advisory votes on executive compensation; and (v) to ratify and approve the appointment of Marcum LLP as the Company’s independent registered accounting firm for the year ended December 31, 2023.\n\n| 40 |\n\n\nLVH Holdings LLC\nOn June 30, 2023, the Company, through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\nAs previously disclosed, on June 16, 2021, the Company, through GVI, entered into the Amended and Restated Limited Liability Company Agreement of LVH; on November 16, 2022, entered into the First Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; on June 7, 2022, entered into the Second Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; and on December 12, 2022, entered into the Third Amendment to the Amended and Restated Limited Liability Company Agreement of LVH.\nAs of the date of the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement, GVI and SLVH LLC comprise all of the members of LVH.\nBoard Compensation\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023. For this sale of securities, no general solicitation was used, no commissions were paid, all persons were accredited investors, and the Company relied on the exemption from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D promulgated under the Securities Act with respect to transactions by an issuer not involving any public offering. A Form D was filed with the SEC on July 28, 2023.\nConvertible Promissory Notes\nAs previously reported on our Current Report on Form 8-K filed on February 21, 2023, the Company and an institutional investor (the “Holder”) entered into that certain Securities Purchase Agreement, dated as of February 21, 2023 (the “Securities Purchase Agreement”) and the Company issued to the Holder a senior secured convertible note (the “Note”) and warrant to purchase 3,377,099 shares of common stock of the Company (the “Warrant” and together with the Securities Purchase Agreement and the Note, the “Note Documents”).\nFor the full description of the Note Documents, please refer to our Current Report on Form 8-K and the exhibits attached thereto as filed with the SEC on February 21, 2023.\nAs previously reported on our Current Report on Form 8-K filed on August 11, 2023, an Event of Default occurred with respect to the Note. As a result, on August 11, 2023, the Company and the Holder entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: (i) the Holder agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the Holder waived the requirement in the Note to pay Interest on the Note monthly in cash for a certain period of time; (iii) the Holder agreed to waive application of the Default Rate in Note for a certain period of time; (iv) the Holder agreed to waive the requirement in the Note for the Company to prepay, redeem, or convert one quarter of the initial Principal and Interest on the Note by each three (3) month anniversary of the Issuance Date for a certain period of time; (v) the Company adjusted the exercise price of the Warrant from $1.34 to $0.45; and (vi) the Holder may continue to convert the Note at the Alternate Conversion Price or at $0.45.\nAll terms not defined herein shall refer to the defined terms in the Note Documents.\nSee also Items 1A and 3 above.\n\n| 41 |\n\n\n\nThe following documents are being filed with the Commission as exhibits to this Current Report on Form 10-Q.\n\n| Exhibit | Description |\n| 1.1 | Underwriting Agreement, dated February 16, 2021 (5) |\n| 1.2 | Warrant Agreement, including the form of Warrant, made as of February 19, 2021, between the Company and Continental. (6) |\n| 3.1 | Amended and Restated Certificate of Incorporation filed with the Delaware Secretary of State effective November 4, 2022 (15) |\n| 3.2 | Amended and Restated Bylaws (1) |\n| 3.3 | Amendment to the Company’s Amended and Restated Bylaws as approved on July 8, 2019 (4) |\n| 4.1 | 2016 Stock Option Plan. (2) |\n| 4.2 | First Amendment to 2016 Stock Option Plan as adopted by the Board of Directors on October 20, 2016. (2) |\n| 4.3 | 2018 Equity Incentive Plan. (3) |\n| 4.4 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on May 13, 2019 and the stockholders on July 8, 2019 (4) |\n| 4.5 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 12, 2021 and the stockholders on August 26, 2021 (14) |\n| 4.6 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 1, 2022 and the stockholders on August 30, 2022 (20) |\n| 4.7 | Underwriters’ Warrant (5) |\n| 4.8 | Form of Warrant (11) |\n| 4.9 | Form Amended and Restated Warrant (17) |\n| 4.10 | Form Warrant (18) |\n| 4.11 | Form Warrant (21) |\n| 4.12 | Form Warrant (25) |\n| 4.13 | Form Warrant (26) |\n| 10.1 | Employment Agreement by and between the Company and Scott L. Mathis dated September 28, 2015 (24) |\n| 10.2 | Retention Bonus Agreement by and between the Company and Scott L. Mathis dated March 29, 2020 (7) |\n| 10.3 | Employment Agreement by and between the Company and its Chief Financial Officer dated December 14, 2022 (23) |\n| 10.4 | Commercial Lease Agreement between Gaucho Group, Inc. and Design District Development Partners, LLC, dated April 8, 2021 (8) |\n| 10.5 | Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC, dated June 16, 2021 (9) |\n| 10.6 | First Amendment to Amended and Restated Limited Liability Agreement dated November 16, 2021 (10) |\n| 10.7 | Second Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (13) |\n| 10.8 | Third Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (22) |\n| 10.9 | Common Stock Purchase Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (19) |\n| 10.10 | Registration Rights Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (16) |\n| 10.11 | Securities Purchase Agreement dated February 21, 2023 (26) |\n| 10.12 | Form of Senior Secured Convertible Note Issued by the Company (26) |\n| 10.13 | Form of Security and Pledge Agreement (26) |\n| 10.14 | Form of Stockholder Pledge Agreement (26) |\n| 10.15 | Form of Registration Rights Agreement (26) |\n| 10.16 | Fourth Amendment to Amended and Restated Limited Liability Agreement dated June 30, 2023 (28) |\n| 10.17 | Letter Agreement, dated as of August 11, 2023, by and among the Company and the subscriber listed therein (29) |\n| 22.1 | Subsidiary guarantors and issuers of guaranteed securities and affiliates whose securities collateralize securities of the registrant (12) |\n| 31.1 | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\n| 31.2 | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\n| 32 | Certification of the Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002** |\n| 99.1 | Algodon Wine Estates Property Map (27) |\n| 101.INS | Inline XBRL Instance Document* |\n| 101.SCH | Inline XBRL Schema Document* |\n| 101.CAL | Inline XBRL Calculation Linkbase Document* |\n| 101.DEF | Inline XBRL Definition Linkbase Document* |\n| 101.LAB | Inline XBRL Label Linkbase Document* |\n| 101.PRE | Inline XBRL Presentation Linkbase Document* |\n| 104 | Cover Page Interactive Data File (embedded within the Inline XBRL document) * |\n\n\n| 42 |\n\n\n\n| 1. | Incorporated by reference from the Company’s Registration of Securities Pursuant to Section 12(g) on Form 10 dated May 14, 2014. |\n| 2. | Incorporated by reference from the Company’s Annual Report on Form 10-K, filed on March 31, 2017. |\n| 3. | Incorporated by reference from the Company’s Quarterly Report on Form 10-Q, filed on November 19, 2018. |\n| 4. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on July 9, 2019. |\n| 5. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 18, 2021. |\n| 6. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 22, 2021. |\n| 7. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on April 1, 2020. |\n| 8. | Incorporated by reference to the Company’s Annual Report on Form 10-K filed on April 12, 2021. |\n| 9. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q filed on August 16, 2021. |\n| 10. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on November 17, 2021. |\n| 11. | Incorporated by reference to the Company’s Current Report on Form 8-K as filed on March 1, 2022. |\n| 12. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 14, 2022. |\n| 13. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on June 8, 2022. |\n| 14. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 31, 2021. |\n| 15. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 3, 2022. |\n| 16. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 9, 2022. |\n| 17. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on October 24, 2022. |\n| 18. | Incorporated by reference to the Company’s Amended Current Report on Form 8-K/A, filed on September 8, 2022. |\n| 19. | Incorporated by reference to the Company’s Current Report as amended on Form 8-K/A, filed on November 14, 2022. |\n| 20. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 18, 2022. |\n| 21. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 1, 2022. |\n| 22. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 13, 2022. |\n| 23. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 15, 2022. |\n| 24. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 16, 2015. |\n| 25. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\n| 26. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\n| 27. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 17, 2023. |\n| 28. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on July 5, 2023. |\n| 29. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 11, 2023. |\n| * | Filed herewith. |\n| ** | Furnished, not filed herewith. |\n\n\n| 43 |\n\n\nSIGNATURES\nPursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Date: August 14, 2023 | GAUCHO GROUP HOLDINGS, INC. |\n| By: |\n| Scott L. Mathis |\n| Chief Executive Officer |\n| By: |\n| Maria Echevarria |\n| Chief Financial Officer and Chief Operating Officer |\n\n\n| 44 |\n\n\n</text>\n\nIf the company can maintain its current cash inflows and outflows in the future, how many months can the company continue to operate while paying off its convertible debt obligations, excluding the cash requirements for current liabilities and long-term liabilities?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1. Financial Statements\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n\\n| June 30, | December 31, |\\n| 2023 | 2022 |\\n| (unaudited) |\\n| Assets |\\n| Current Assets |\\n| Cash | $ | 810,139 | $ | 300,185 |\\n| Accounts receivable, net of allowance of $ 14,600 and $ 21,229 at June 30, 2023 and December 31, 2022, respectively | 58,944 | 106,156 |\\n| Accounts receivable - related parties, net of allowance of $ 470,516 and $ 339,503 at June 30, 2023 and December 31, 2022, respectively | 1,075,102 | 1,115,816 |\\n| Accounts receivable | 1,075,102 | 1,115,816 |\\n| Mortgages receivable, net of allowance $ 55,682 and $ 46,424 at June 30, 2023 and December 31, 2022, respectively | 729,833 | 586,631 |\\n| Inventory | 1,960,988 | 1,888,962 |\\n| Real estate lots held for sale | 445,412 | 559,487 |\\n| Prepaid expenses and other current assets | 423,658 | 461,637 |\\n| Total Current Assets | 5,504,076 | 5,018,874 |\\n| Long Term Assets |\\n| Mortgages receivable, non-current portion, net of allowance of $ 178,541 and $ 150,126 at June 30, 2023 and December 31, 2022, respectively | 3,091,222 | 3,278,617 |\\n| Advances to employees | 281,783 | 282,055 |\\n| Property and equipment, net | 7,857,485 | 7,621,257 |\\n| Operating lease right-of-use asset | 1,335,698 | 1,449,442 |\\n| Prepaid foreign taxes, net | 985,470 | 916,823 |\\n| Intangible assets, net | 108,967 | 69,787 |\\n| Deposits, non-current | 54,713 | 56,130 |\\n| Total Assets | $ | 19,219,414 | $ | 18,692,985 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 1 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED BALANCE SHEETS, CONTINUED\\n\\n| June 30, | December 31, |\\n| 2023 | 2022 |\\n| (unaudited) |\\n| Liabilities and Stockholders’ Equity |\\n| Current Liabilities |\\n| Accounts payable | $ | 691,739 | $ | 917,270 |\\n| Accrued expenses, current portion | 1,258,163 | 1,664,816 |\\n| Deferred revenue | 1,368,921 | 1,373,906 |\\n| Operating lease liabilities, current portion | 220,416 | 202,775 |\\n| Loans payable, current portion | 252,014 | 164,656 |\\n| Convertible debt obligations, net, current portion | 3,372,291 | - |\\n| Derivative liability, current portion | 2,088,617 |\\n| Other current liabilities | 80,200 | 100,331 |\\n| Total Current Liabilities | 9,332,361 | 4,423,754 |\\n| Long Term Liabilities |\\n| Accrued expenses, non-current portion | 81,638 | 66,018 |\\n| Operating lease liabilities, non-current portion | 1,212,641 | 1,328,408 |\\n| Loans payable, non-current portion | 90,468 | 91,665 |\\n| Convertible debt obligations, net, non-current portion | 84,674 | 1,991,459 |\\n| Derivative liability | 52,500 | - |\\n| Total Liabilities | 10,854,282 | 7,901,304 |\\n| Commitments and Contingencies (Note 15) | - | - |\\n| Stockholders’ Equity |\\n| Preferred stock, 902,670 shares authorized | - | - |\\n| Common stock, par value $ 0.01 per share; 150,000,000 shares authorized; 6,809,348 and 3,653,401 shares issued and 6,809,067 and 3,653,120 shares outstanding as of June 30, 2023 and December 31, 2022, respectively | 68,091 | 36,534 |\\n| Additional paid-in capital | 144,532,185 | 139,123,642 |\\n| Accumulated other comprehensive loss | ( 10,920,361 | ) | ( 10,842,569 | ) |\\n| Accumulated deficit | ( 125,268,428 | ) | ( 117,479,571 | ) |\\n| Treasury stock, at cost, 281 shares at June 30, 2023 and December 31, 2022 | ( 46,355 | ) | ( 46,355 | ) |\\n| Total Stockholders’ Equity | 8,365,132 | 10,791,681 |\\n| Total Liabilities and Stockholders’ Equity | $ | 19,219,414 | $ | 18,692,985 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 2 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\\n(unaudited)\\n\\n| 2023 | 2022 | 2023 | 2022 |\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, | June 30, |\\n| 2023 | 2022 | 2023 | 2022 |\\n| Sales | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\\n| Cost of sales | ( 668,619 | ) | ( 533,466 | ) | ( 961,918 | ) | ( 771,593 | ) |\\n| Gross profit (loss) | 42,356 | ( 128,131 | ) | 196,824 | 59,339 |\\n| Operating Expenses |\\n| Selling and marketing | 213,157 | 333,410 | 447,736 | 505,230 |\\n| General and administrative | 1,710,505 | 1,928,892 | 3,467,193 | 3,674,126 |\\n| Depreciation and amortization | 104,281 | 49,000 | 213,487 | 95,219 |\\n| Total operating expenses | 2,027,943 | 2,311,302 | 4,128,416 | 4,274,575 |\\n| Loss from Operations | ( 1,985,587 | ) | ( 2,439,433 | ) | ( 3,931,592 | ) | ( 4,215,236 | ) |\\n| Other Expense (Income) |\\n| Interest income | ( 64,375 | ) | ( 26,552 | ) | ( 114,719 | ) | ( 30,404 | ) |\\n| Interest expense | 1,065,620 | 694,708 | 1,667,912 | 1,452,780 |\\n| Other income, related party | ( 75,000 | ) | ( 75,000 | ) | ( 150,000 | ) | ( 150,000 | ) |\\n| Loss on extinguishment of debt | 32,094 | 2,105,119 | 416,081 | 2,105,119 |\\n| Gains from foreign currency translation | ( 102,916 | ) | ( 43,005 | ) | ( 214,708 | ) | ( 225,927 | ) |\\n| Change in fair value of derivative liability | 2,141,117 | - | 2,141,117 | - |\\n| Inducement expense | - | 198,096 | - | 198,096 |\\n| Total other expense | 2,996,540 | 2,853,366 | 3,745,683 | 3,349,664 |\\n| Net Loss | ( 4,982,127 | ) | ( 5,292,799 | ) | ( 7,677,275 | ) | ( 7,564,900 | ) |\\n| Net loss attributable to non-controlling interest | - | - | - | 72,261 |\\n| Net Loss Attributable to Common Stockholders | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,492,639 | ) |\\n| Net Loss per Common Share |\\n| Basic and Diluted | $ | ( 0.80 | ) | $ | ( 4.80 | ) | $ | 1.41 | ) | $ | ( 7.59 | ) |\\n| Weighted Average Number of Common Shares Outstanding: |\\n| Basic and Diluted | 6,236,737 | 1,103,130 | 5,453,539 | 987,109 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 3 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME\\n(unaudited)\\n\\n| 2023 | 2022 | 2023 | 2022 |\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, | June 30, |\\n| 2023 | 2022 | 2023 | 2022 |\\n| Net loss | $ | ( 4,982,127 | ) | $ | ( 5,292,799 | ) | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\\n| Other comprehensive (loss) income : |\\n| Foreign currency translation adjustments | ( 37,993 | ) | 358,056 | ( 77,792 | ) | 621,462 |\\n| Comprehensive loss | $ | ( 5,020,120 | ) | $ | ( 4,934,743 | ) | $ | ( 7,755,067 | ) | $ | ( 6,943,438 | ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 4 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2023\\n(unaudited)\\n\\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Total Stockholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Equity |\\n| Balance - January 1, 2023 | 3,653,401 | $ | 36,534 | 281 | $ | ( 46,355 | ) | $ | 139,123,642 | $ | ( 10,842,569 | ) | $ | ( 117,479,571 | ) | - | - | $ | 10,791,681 |\\n| Cumulative effect of change upon adoption of ASU 2016-13 | - | - | - | - | - | - | ( 111,582 | ) | - | - | ( 111,582 | ) |\\n| Stock-based compensation: |\\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\\n| Restricted stock units | 3,890 | 39 | - | - | 79,383 | - | - | 79,422 |\\n| Common stock issued for 401(k) employer matching | 24,160 | 242 | - | - | 32,375 | - | - | 32,617 |\\n| Shares issued under the New ELOC, net of offering costs [1] | 364,430 | 3,644 | - | - | 437,765 | - | - | 441,409 |\\n| Relative fair value of warrants issued with 2023 Note, net of issuance costs [2] | - | - | - | - | 1,506,319 | - | - | 1,506,319 |\\n| Warrants issued for modification of GGH Notes | - | - | - | - | 134,779 | - | - | 134,779 |\\n| Reduction of warrant exercise price on new debt issuance | - | - | - | - | 63,502 | - | - | 63,502 |\\n| Shares issued upon conversion of debt and interest | 833,333 | 8,333 | - | - | 1,563,220 | - | - | 1,571,553 |\\n| Common stock issued for cash in private placement | 591,000 | 5,910 | - | - | 585,090 | - | - | 591,000 |\\n| Cashless warrant exercise | 51,305 | 513 | - | - | ( 513 | ) | - | - | - |\\n| True-up adjustment | 281 | - | - | - | - | - | - | - |\\n| Net loss | - | - | - | - | - | - | ( 2,695,148 | ) | - | - | ( 2,695,148 | ) |\\n| Other comprehensive loss | - | - | - | - | - | ( 39,799 | ) | - | ( 39,799 | ) |\\n| Balance - March 31, 2023 | 5,521,800 | 55,215 | 281 | ( 46,355 | ) | 143,564,396 | ( 10,882,368 | ) | ( 120,286,301 | ) | - | - | 12,404,587 |\\n| Stock-based compensation: |\\n| Options | - | - | - | - | 38,834 | - | - | 38,834 |\\n| Restricted stock units | - | - | - | - | 74,978 | - | - | 74,978 |\\n| Shares issued under the New ELOC, net of offering costs [3] | 458,768 | 4,588 | - | - | 287,009 | - | - | 291,597 |\\n| Shares issued upon conversion of debt and interest | 828,780 | 8,288 | - | - | 566,968 | - | - | 575,256 |\\n| Net loss | - | - | - | - | - | - | ( 4,982,127 | ) | - | - | ( 4,982,127 | ) |\\n| Other comprehensive loss | - | - | - | - | - | ( 37,993 | ) | - | ( 37,993 | ) |\\n| Balance - June 30, 2023 | 6,809,348 | $ | 68,091 | 281 | $ | ( 46,355 | ) | $ | 144,532,185 | $ | ( 10,920,361 | ) | $ | ( 125,268,428 | ) | - | - | $ | 8,365,132 |\\n\\n\\n| [1] | Includes gross proceeds of $ 480,670 , less $ 39,261 offering costs |\\n\\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 of allocable issuance costs |\\n\\n| [3] | Includes gross proceeds of $ 316,953 , less $ 25,356 offering costs |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 5 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER’S EQUITY\\nFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2022\\n(unaudited)\\n\\n| Common Stock | Treasury Stock | Additional Paid-In | Accumulated Other Comprehensive | Accumulated | Gaucho Group Holdings Stockholders’ | Non- controlling | Total Stockholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Loss | Deficit | Deficiency | Interest | Equity |\\n| Balance - January 1, 2022 | 823,496 | $ | 8,235 | 281 | $ | ( 46,355 | ) | $ | 121,633,826 | $ | ( 11,607,446 | ) | $ | ( 95,726,534 | ) | $ | 14,261,726 | $ | ( 169,882 | ) | $ | 14,091,844 |\\n| Stock-based compensation: |\\n| Options | - | - | - | - | 72,700 | - | - | 72,700 | 10,354 | 83,054 |\\n| Common stock issued for 401(k) employer matching | 1,040 | 10 | - | - | 27,811 | - | - | 27,821 | - | 27,821 |\\n| Common stock issued for purchase of minority interest | 86,899 | 869 | - | - | ( 232,658 | ) | - | - | ( 231,789 | ) | 231,789 | - |\\n| Common stock issued for acquisition of GDS | 106,952 | 1,070 | - | - | 2,193,583 | - | - | 2,194,653 | - | 2,194,653 |\\n| Common stock issued for purchase of domain name | 1,250 | 13 | - | - | 39,587 | - | - | 39,600 | - | 39,600 |\\n| Warrants issued for modification of convertible debt principal | - | - | - | - | 731,856 | - | - | 731,856 | - | 731,856 |\\n| Net loss | - | - | - | - | - | - | ( 2,199,840 | ) | ( 2,199,840 | ) | ( 72,261 | ) | ( 2,272,101 | ) |\\n| Other comprehensive income | - | - | - | - | - | 263,406 | - | 263,406 | - | 263,406 |\\n| Balance - March 31, 2022 | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\\n| Balance | 1,019,637 | 10,197 | 281 | ( 46,355 | ) | 124,466,705 | ( 11,344,040 | ) | ( 97,926,374 | ) | 15,160,133 | - | 15,160,133 |\\n| Stock-based compensation: |\\n| Options | - | - | - | - | 87,134 | - | - | 87,134 | - | 87,134 |\\n| Common stock | 54,214 | 542 | - | - | 524,458 | - | - | 525,000 | - | 525,000 |\\n| Shares issued upon conversion of debt and interest | 74,589 | 746 | - | - | 1,521,851 | - | - | 1,522,597 | - | 1,522,597 |\\n| Inducement loss on debt conversions | - | - | - | - | 198,096 | - | - | 198,096 | - | 198,096 |\\n| Substantial premium on convertible debt | - | - | - | - | 1,683,847 | - | - | 1,683,847 | - | 1,683,847 |\\n| Common stock issued for cash, net of offering costs | 50,049 | 500 | - | - | 510,846 | - | - | 511,346 | - | 511,346 |\\n| Common stock issued upon exchange of subsidiary stock options | 183,942 | 1,839 | - | - | ( 1,839 | ) | - | - | - | - | - |\\n| True up adjustment | 41 | - | - | - | - | - | - | - | - | - |\\n| Net loss | - | - | - | - | - | - | ( 5,292,799 | ) | ( 5,292,799 | ) | - | ( 5,292,799 | ) |\\n| Other comprehensive income | - | - | - | - | - | 358,056 | - | 358,056 | - | 358,056 |\\n| Balance - June 30, 2022 | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\\n| Balance | 1,382,472 | $ | 13,824 | 281 | $ | ( 46,355 | ) | $ | 128,991,098 | $ | ( 10,985,984 | ) | $ | ( 103,219,173 | ) | $ | 14,753,410 | $ | - | $ | 14,753,410 |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 6 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(unaudited)\\n\\n| 2023 | 2022 |\\n| For the Six Months Ended |\\n| June 30, |\\n| 2023 | 2022 |\\n| Cash Flows from Operating Activities |\\n| Net loss | $ | ( 7,677,275 | ) | $ | ( 7,564,900 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Stock-based compensation: |\\n| 401(k) stock | 5,908 | 22,384 |\\n| Common stock | - | 525,000 |\\n| Stock options and warrants | 77,668 | 170,188 |\\n| Restricted stock units | 154,400 | - |\\n| Noncash lease expense | 113,744 | 107,343 |\\n| Gain on foreign currency translation | ( 214,708 | ) | ( 225,927 | ) |\\n| Depreciation and amortization | 213,487 | 95,219 |\\n| Amortization of debt discount | 1,079,034 | 1,061,936 |\\n| Provision for credit losses | 57,104 | 28,848 |\\n| Provision for obsolete inventory | 99,323 | - |\\n| Change in fair value of derivative liability | 2,141,117 |\\n| Loss on extinguishment of debt | 416,081 | 2,105,119 |\\n| Inducement expense | - | 198,096 |\\n| Decrease (increase) in assets: |\\n| Accounts receivable and mortgages receivable | ( 126,017 | ) | ( 137,652 | ) |\\n| Employee advances | ( 571 | ) | 4,964 |\\n| Inventory | ( 57,274 | ) | ( 84,917 | ) |\\n| Deposits | 1,417 | - |\\n| Prepaid expenses and other current assets | ( 30,668 | ) | ( 201,778 | ) |\\n| Increase (decrease) in liabilities: |\\n| Accounts payable and accrued expenses | ( 162,671 | ) | 774,709 |\\n| Operating lease liabilities | ( 98,126 | ) | ( 82,296 | ) |\\n| Deferred revenue | ( 4,985 | ) | 517,741 |\\n| Other liabilities | ( 20,131 | ) | ( 68,633 | ) |\\n| Total Adjustments | 3,644,132 | 4,810,344 |\\n| Net Cash Used in Operating Activities | ( 4,033,143 | ) | ( 2,754,556 | ) |\\n| Cash Flow from Investing Activities |\\n| Cash paid to acquire Gaucho Development S.R.L., net of cash acquired | - | ( 7,560 | ) |\\n| Purchase of property and equipment | ( 438,895 | ) | ( 1,677,082 | ) |\\n| Purchase of intangible asset | ( 50,000 | ) | ( 34,999 | ) |\\n| Net Cash Used in Investing Activities | ( 488,895 | ) | ( 1,719,641 | ) |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 7 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED\\n(unaudited)\\n\\n| For the Six Months Ended |\\n| June 30, |\\n| 2023 | 2022 |\\n| Cash Flow from Financing Activities |\\n| Proceeds from loans payable | 185,000 | - |\\n| Repayments of loans payable | ( 58,718 | ) | ( 53,333 | ) |\\n| Proceeds from common stock issued for cash | 591,000 | 511,346 |\\n| Proceeds from the issuance of convertible debt | 5,000,000 | - |\\n| Financing costs in connection with the issuance of convertible debt | ( 321,803 | ) | - |\\n| Repayments of convertible debt obligations | ( 862,541 | ) | - |\\n| Redemption premiums paid on convertible debt obligations | ( 156,160 | ) | - |\\n| Proceeds from issuance of shares under the New ELOC, net of offering costs [1] | 733,006 | - |\\n| Net Cash Provided by Financing Activities | 5,109,784 | 458,013 |\\n| Effect of Exchange Rate Changes on Cash | ( 77,792 | ) | 621,462 |\\n| Net (Decrease) Increase in Cash | 509,954 | ( 3,394,722 | ) |\\n| Cash - Beginning of Period | 300,185 | 3,649,407 |\\n| Cash - End of Period | $ | 810,139 | $ | 254,685 |\\n| Supplemental Disclosures of Cash Flow Information: |\\n| Interest paid | $ | 561,876 | $ | 140,355 |\\n| Income taxes paid | $ | - | $ | - |\\n| Non-Cash Investing and Financing Activity |\\n| Equity issued to satisfy accrued stock-based compensation obligation | $ | 32,617 | $ | 27,821 |\\n| Equity issued as consideration for intangible assets | $ | - | $ | 39,600 |\\n| Equity issued for purchase of non-controlling interest | $ | - | $ | 231,789 |\\n| Equity issued for acquisition of Gaucho Development, S.R.L. | $ | - | $ | 2,194,653 |\\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | - | $ | 731,856 |\\n| Shares issued upon conversion of debt and interest | $ | 2,146,809 | $ | 1,522,597 |\\n| Common stock and restricted stock units in GGH issued upon exchange of GGI options | $ | - | $ | 1,576,648 |\\n| Cashless warrant exercise | $ | 513 | $ | - |\\n| Relative fair value of warrants issued with 2023 Note, net of allocable issuance costs [2] | $ | 1,506,319 | $ | - |\\n| Warrants issued and debt principal exchanged upon modification of convertible debt | $ | 63,502 | $ | - |\\n\\n\\n| [1] | Gross proceeds of $ 797,623 , less offering costs of $ 64,617 |\\n\\n| [2] | Represents $ 1,609,935 relative fair value of warrants, less $ 103,616 in allocable issuance costs |\\n\\nThe accompanying notes are an integral part of these condensed consolidated financial statements.\\n\\n| 8 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n1. BUSINESS ORGANIZATION AND NATURE OF OPERATIONS\\nOrganization and Operations\\nThrough its subsidiaries, Gaucho Group Holdings, Inc. (“Company”, “GGH”), a Delaware corporation that was incorporated on April 5, 1999, currently invests in, develops, and operates a collection of luxury assets, including real estate development, fine wines, and a boutique hotel in Argentina, as well as an e-commerce platform for the sale of high-end fashion and accessories.\\nAs wholly owned subsidiaries of GGH, InvestProperty Group, LLC (“IPG”), Algodon Global Properties, LLC (“AGP”) and Gaucho Ventures I – Las Vegas, LLC (“GVI”) operate as holding companies that invest in, develop and operate global real estate and other lifestyle businesses such as wine production and distribution, golf, tennis, and restaurants. GGH operates its properties through its ALGODON® brand. IPG and AGP have invested in two ALGODON® brand projects located in Argentina. The first project is Algodon Mansion, a Buenos Aires-based luxury boutique hotel property that opened in 2010 and is owned by the Company’s subsidiary, The Algodon – Recoleta, SRL (“TAR”). The second project is the redevelopment, expansion and repositioning of a Mendoza-based winery and golf resort property now called Algodon Wine Estates (“AWE”), the integration of adjoining wine producing properties, and the subdivision of a portion of this property for residential development. (“GDS”). GVI is a party to an agreement with LVH Holdings (“LVH”) to develop a project in Las Vegas, Nevada.\\nOn February 3, 2022, the Company acquired additional real estate through the acquisition of 100 % ownership in Hollywood Burger Argentina S.R.L., now Gaucho Development S.R.L.\\nGGH also manufactures, distributes, and sells high-end luxury fashion and accessories through its subsidiary, Gaucho Group, Inc. (“GGI”). GGH held a 79 % ownership interest in GGI through March 28, 2022, at which time GGH acquired the remaining 21 % ownership interest in GGI. See Non-Controlling Interest, below.\\nNon-Controlling interest\\nAs a result of a 2019 conversion of certain convertible debt into shares of Gaucho Group, Inc. (“GGI”) common stock, GGI investors obtained a 21 % ownership interest in GGI, which was recorded as a non-controlling interest. The profits and losses of GGI for the period from January 1, 2022 through March 28, 2022 are allocated between the controlling interest and the non-controlling interest in the same proportions as their membership interest. On March 28, 2022, the Company issued 86,899 shares of its common stock to the minority holders of GGI, in exchange for the remaining 21 % ownership of GGI. Consequently, the Company owns 100 % of the outstanding common stock of GGI.\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nThere have been no material changes to the Company’s significant accounting policies as set forth in the Company’s audited consolidated financial statements included in the annual report on Form 10-K for the year ended December 31, 2022, except as disclosed below.\\n\\n| 9 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nBasis of Presentation\\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for annual financial statements. In the opinion of management, such statements include all adjustments (consisting only of normal recurring items) which are considered necessary for a fair presentation of the unaudited condensed consolidated financial statements of the Company as of June 30, 2023 and for the three and six months ended June 30, 2023 and 2022. The results of operations for the three and six months ended June 30, 2023 are not necessarily indicative of the operating results for the full year. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission (“SEC”) on April 17, 2023.\\nOn November 4, 2022, the Company effected a reverse stock split in a ratio of 1 share of common stock for 12 issued shares of common stock. As a result of the reverse stock split, prior period shares and per share amounts appearing in the accompanying condensed consolidated financial statements and all references in this Quarterly Report to our common stock, as well as amounts per share of our common stock, have been retroactively restated as if the reverse stock split occurred at the beginning of the period presented.\\nGoing Concern and Management’s Liquidity Plans\\nThe accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The condensed financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the classification of liabilities that might be necessary should the company be unable to continue as a going concern.\\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $ 810,000 and $ 3.8 million, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $ 7.7 million and $ 7.6 million, respectively, and used cash in operating activities of approximately $ 4.0 million and $ 2.8 million, respectively. Further, as of June 30, 2023, approximately $ 4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024 , and approximately $ 252,000 represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with proceeds from a convertible debt financing of $ 5.0 million, proceeds of $ 733,000 from draws on the Company’s equity line of credit, $ 185,000 of proceeds from a loan payable and $ 591,000 from the sale of common stock.\\n\\n| 10 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of one year from the issuance of these financial statements.\\nHighly Inflationary Status in Argentina\\nThe Company recorded gains on foreign currency transactions of approximately $ 103,000 and $ 215,000 during the three and six months ended June 30, 2023, respectively, and approximately $ 43,000 and $ 226,000 during the three and six months ended June 30, 2022, respectively, as a result of the net monetary liability position of its Argentine subsidiaries.\\nConcentrations\\nThe Company maintains cash with major financial institutions. Cash held in US bank institutions is currently insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $ 250,000 at each institution. No similar insurance or guarantee exists for cash held in Argentina bank accounts. There were aggregate uninsured cash balances of approximately $ 519,000 at June 30, 2023, of which approximately $ 378,000 represents cash held in Argentine bank accounts.\\nRevenue Recognition\\nThe Company recognizes revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers. ASC Topic 606 provides a single comprehensive model to use in accounting for revenue arising from contracts with customers, and gains and losses arising from transfers of non-financial assets including sales of property and equipment, real estate, and intangible assets.\\nThe Company earns revenues from the sale of real estate lots, as well as hospitality, food and beverage, other related services, and from the sale of clothing and accessories. The Company recognizes revenue when goods or services are transferred to customers in an amount that reflects the consideration which it expects to receive in exchange for those goods or services. In determining when and how revenue is recognized from contracts with customers, the Company performs the following five-step analysis: (i) identification of contract with customer; (ii) determination of performance obligations; (iii) measurement of the transaction price; (iv) allocation of the transaction price to the performance obligations; and (v) recognition of revenue when (or as) the Company satisfies each performance obligation.\\n\\n| 11 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe following table summarizes the revenue recognized in the Company’s condensed consolidated statements of operations:\\nSCHEDULE OF DISAGGREGATION OF REVENUE\\n| 2023 | 2022 | 2023 | 2022 |\\n| For the Three Months Ended | For the Six Months Ended |\\n| June 30, | June 30, |\\n| 2023 | 2022 | 2023 | 2022 |\\n| Real estate sales | $ | 154,959 | $ | - | $ | 154,959 | $ | 184,658 |\\n| Hotel rooms and events | 218,838 | 144,123 | 464,525 | 283,222 |\\n| Restaurants | 56,989 | 40,323 | 136,007 | 57,593 |\\n| Winemaking | 45,918 | 32,880 | 75,741 | 59,689 |\\n| Agricultural | 162,764 | 153,531 | 162,764 | 181,029 |\\n| Golf, tennis and other | 29,126 | 28,366 | 56,983 | 53,467 |\\n| Clothes and accessories | 42,381 | 6,112 | 107,763 | 11,274 |\\n| Total revenues | $ | 710,975 | $ | 405,335 | $ | 1,158,742 | $ | 830,932 |\\n\\nRevenue from the sale of food, wine, agricultural products, clothes and accessories is recorded when the customer obtains control of the goods purchased. Revenues from hospitality and other services are recognized as earned at the point in time that the related service is rendered, and the performance obligation has been satisfied. Revenues from gift card sales are recognized when the card is redeemed by the customer. The Company does not adjust revenue for the portion of gift card values that is not expected to be redeemed (“breakage”) due to the lack of historical data. Revenue from real estate lot sales is recorded when the lot is deeded, and legal ownership of the lot is transferred to the customer.\\nThe timing of the Company’s revenue recognition may differ from the timing of payment by its customers. A receivable is recorded when revenue is recognized prior to payment and the Company has an unconditional right to payment. Alternatively, when payment precedes the provision of the related services, the Company records deferred revenue until the performance obligations are satisfied. Deferred revenues associated with real estate lot sale deposits are recognized as revenues (along with any outstanding balance) when the lot sale closes, and the deed is provided to the purchaser. Other deferred revenues primarily consist of deposits accepted by the Company in connection with agreements to sell barrels of wine, advance deposits received for grapes and other agricultural products, and hotel deposits. Wine barrel and agricultural product advance deposits are recognized as revenues (along with any outstanding balance) when the product is shipped to the purchaser. Hotel deposits are recognized as revenue upon occupancy of rooms, or the provision of services.\\nContracts related to the sale of wine, agricultural products and hotel services have an original expected length of less than one year. The Company has elected not to disclose information about remaining performance obligations pertaining to contracts with an original expected length of one year or less, as permitted under the guidance.\\n\\n| 12 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nAs of June 30, 2023 and December 31, 2022, the Company had deferred revenue of $ 1,368,921 and $ 1,373,906 , respectively, consisting of $ 1,332,695 and $ 1,179,654 , respectively, associated with real estate lot sale deposits, $ 36,225 and $ 44,252 , respectively, related to hotel deposits and $ 0 and $ 150,000 , respectively, related to prepaid management fees received.\\nNet Loss per Common Share\\nBasic loss per common share is computed by dividing net loss attributable to GGH common stockholders by the weighted average number of common shares outstanding during the period. Diluted loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding, plus the impact of common shares, if dilutive, resulting from the exercise of outstanding stock options and warrants and the conversion of convertible instruments.\\nThe following securities are excluded from the calculation of weighted average dilutive common shares because their inclusion would have been anti-dilutive:\\nSCHEDULE OF ANTIDILUTIVE SECURITIES EXCLUDED FROM COMPUTATION OF EARNINGS PER SHARE\\n| 2023 | 2022 |\\n| As of June 30, |\\n| 2023 | 2022 |\\n| Options | 34,806 | 561,027 |\\n| Warrants | 4,839,254 | 2,024,166 |\\n| Unvested restricted stock units | 516,277 | - |\\n| Convertible debt | 12,516,374 | [1] | 5,479,255 | [2] |\\n| Total potentially dilutive shares | 17,906,711 | 8,064,448 |\\n\\n\\n| [1] | Represents shares issuable upon conversion of $ 4,893,983 of convertible debt, $ 734,097 of redemption premium and $ 8,293 of related accrued interest outstanding as of June 30, 2023, at a conversion price of $ 0.4503 per share, which represents the conversion price in effect as of June 30, 2023. The conversion price of such debt is variable and is not subject to a floor price (see Note 10, Convertible Debt Obligations). |\\n| [2] | Represents shares issuable upon conversion of principal and interest outstanding in the aggregate amount of $ 5,205,292 at a conversion price of $ 0.95 per share. |\\n\\nSequencing Policy\\nUnder ASC 815, the Company has adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\\n\\n| 13 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nDerivative Instruments\\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\\nRecently Adopted Accounting Pronouncements\\nIn June 2016, the FASB issued ASU No. 2016-13 “Financial Instruments – Credit Losses (Topic 326)” and also issued subsequent amendments to the initial guidance under ASU 2018-19, ASU 2019-04, ASU 2019-05 and ASU 2020-02 (collectively Topic 326). Topic 326 requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. This replaces the existing incurred loss model with an expected loss model and requires the use of forward-looking information to calculate credit loss estimates. The Company adopted the provisions of this ASU on January 1, 2023 using the modified retrospective method for all financial assets measured at amortized cost. Results for reporting periods beginning after December 31, 2022 are presented under Topic 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded an adjustment to accumulated deficit of $ 111,582 as of January 1, 2023 for the cumulative effect of adopting Topic 326.\\nReclassifications\\nCertain reclassifications have been made to prior period amounts to conform to the current period financial statement presentation.\\n3. MORTGAGES RECEIVABLE\\nThe Company offers loans to purchasers in connection with the sale of real estate lots. The loans bear interest at 7.2 % per annum and terms generally range from eight to ten years. Principal and interest for each loan is billed and receivable on a monthly basis. The loans are secured by a first mortgage lien on the property purchased by the borrower. Mortgages receivable include the related interest receivable and are presented at amortized cost, less bad debt allowances, in the condensed consolidated financial statements.\\nManagement evaluates each loan individually on a quarterly basis, to assess collectability and estimate a reserve for past due amounts. Management recorded an additional provision for uncollectible accounts in the amount of $ 37,673 for the six months ended June 30, 2023. The total allowance for uncollectable mortgages as of June 30, 2023 and December 31, 2022 was $ 234,223 and $ 196,550 , respectively. Past due principal amounts of $ 346,680 and $ 254,683 are included in mortgages, receivable, current as of June 30, 2023 and December 31, 2022, respectively. In the case of each of the past due loans, the Company believes that the value of the collateral exceeds the outstanding balance on the loan, plus accrued interest.\\n\\n| 14 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe following represents the maturities of mortgages receivable as of June 30, 2023:\\nSCHEDULE OF MATURITIES OF MORTGAGES RECEIVABLE\\n| July 1 through December 31, 2023 | $ | 776,657 |\\n| For the years ended December 31, |\\n| 2024 | 381,532 |\\n| 2025 | 409,927 |\\n| 2026 | 440,436 |\\n| 2027 | 473,215 |\\n| 2028 | 480,227 |\\n| Thereafter | 1,093,286 |\\n| Gross Receivable | 4,055,278 |\\n| Less: Allowance | ( 234,223 | ) |\\n| Net Receivable | $ | 3,821,055 |\\n\\nAs of June 30, 2023 and December 31, 2022, no single borrower had loans outstanding representing more than 10 % of the total balance of mortgages receivable.\\nThe Company recorded interest income from mortgages receivable of $ 109,816 and $ 28,654 for the six months ended June 30, 2023 and 2022, respectively. As of June 30, 2023 and December 31, 2022, there is $ 261,919 and $ 185,197 , respectively, of interest receivable included in mortgages receivable on the accompanying condensed consolidated balance sheets.\\n4. INVENTORY\\nInventory at June 30, 2023 and December 31, 2022 was comprised of the following:\\nSCHEDULE OF INVENTORY\\n| June 30, 2023 | December 31, 2022 |\\n| Vineyard in process | $ | 240,619 | $ | 516,096 |\\n| Wine in process | 1,031,823 | 797,862 |\\n| Finished wine | 42,370 | 40,735 |\\n| Clothes and accessories | 720,569 | 552,581 |\\n| Other | 125,665 | 82,423 |\\n| Inventory gross | 2,161,046 | 1,989,697 |\\n| Less: Reserve for obsolescence | ( 200,058 | ) | ( 100,735 | ) |\\n| Total | $ | 1,960,988 | $ | 1,888,962 |\\n\\nThe Company recorded a provision for obsolete inventory in the amount of $ 93,389 and $ 99,323 during the three and six months ended June 30, 2023, respectively. There was no provision for obsolete inventory recognized during the three and six months ended June 30, 2022.\\n\\n| 15 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n5. INTANGIBLE ASSETS\\nOn February 3, 2022, the Company purchased the domain name Gaucho.com, in exchange for cash consideration of $ 34,999 and 15,000 shares of common stock valued at $ 39,600 (see Note 14 – Stockholders’ Equity, Common Stock). The domain name is being amortized over its useful life of 15 years.\\nOn June 15, 2023, the Company purchased a music video to be used in certain marketing mediums for $ 50,000 in cash. The music video is being amortized over its useful life of 3 years.\\nThe Company recognized $ 5,410 and $ 10,819 of amortization expense during the three and six months ended June 30, 2023, respectively, related to the domain name. The Company recognized $ 1,489 and $ 2,072 of amortization expense during the three and six months ended June 30, 2022, respectively, related to the domain name. Future amortization of the Company’s intangible asset is as follows:\\nSCHEDULE OF INTANGIBLE ASSETS FUTURE AMORTIZATION\\n| July 1 through December 31, 2023 | $ | 10,819 |\\n| For the years ended December 31, |\\n| 2024 | 21,640 |\\n| 2025 | 21,640 |\\n| 2026 | 4,973 |\\n| 2027 | 4,973 |\\n| 2028 | 4,973 |\\n| Thereafter | 39,949 |\\n| Total | $ | 108,967 |\\n\\n6. FAIR VALUE OF FINANCIAL INSTRUMENTS\\nFair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company often utilizes certain assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or developed by the Company. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:\\nLevel 1 - Valued based on quoted prices at the measurement date for identical assets or liabilities trading in active markets. Financial instruments in this category generally include actively traded equity securities.\\nLevel 2 - Valued based on (a) quoted prices for similar assets or liabilities in active markets; (b) quoted prices for identical or similar assets or liabilities in markets that are not active; (c) inputs other than quoted prices that are observable for the asset or liability; or (d) from market corroborated inputs. Financial instruments in this category include certain corporate equities that are not actively traded or are otherwise restricted.\\nLevel 3 - Valued based on valuation techniques in which one or more significant inputs is not readily observable. Included in this category are certain corporate debt instruments, certain private equity investments, and certain commitments and guarantees.\\nThe carrying amounts of the Company’s short-term financial instruments including cash, accounts receivable, advances and loans to employees, prepaid taxes and expenses, accounts payable, accrued expenses and other liabilities approximate fair value due to the short-term nature of these instruments. The carrying value of the Company’s loans payable, debt obligations, convertible debt obligations and derivative liability approximate fair value, as they bear terms and conditions comparable to market for obligations with similar terms and maturities.\\n\\n| 16 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n7. ACCRUED EXPENSES\\nAccrued expenses are comprised of the following:\\nSCHEDULE OF ACCRUED EXPENSES\\n| June 30, | December 31, |\\n| 2023 | 2022 |\\n| Accrued compensation and payroll taxes | $ | 542,659 | $ | 652,943 |\\n| Accrued taxes payable - Argentina | 189,722 | 270,239 |\\n| Accrued interest | 141,303 | 78,368 |\\n| Other accrued expenses | 384,479 | 663,266 |\\n| Accrued expenses, current | 1,258,163 | 1,664,816 |\\n| Accrued payroll tax obligations, non-current | 81,638 | 66,018 |\\n| Total accrued expenses | $ | 1,339,801 | $ | 1,730,834 |\\n\\nOn November 27, 2020, the Company entered into various payment plans, pursuant to which it agreed to pay its Argentine payroll tax obligations over a period of 60 to 120 months. The current portion of payments due under the plan is $ 84,929 and $ 209,938 as of June 30, 2023 and December 31, 2022, respectively, which is included in accrued taxes payable – Argentina, above. The non-current portion of accrued payroll tax obligations represents payments under the plan that are scheduled to be paid after twelve months. The Company incurred interest expense of $ 64,283 and $ 81,587 during the three and six months ended June 30, 2023, respectively, and incurred interest expense of $ 28,690 and $ 33,177 during the three and six months ended June 30, 2022, respectively, related to these payment plans.\\n8. DEFERRED REVENUE\\nDeferred revenue is comprised of the following:\\nSCHEDULE OF DEFERRED REVENUES\\n| June 30, 2023 | December 31, 2022 |\\n| Real estate lot sales deposits | $ | 1,332,695 | $ | 1,179,654 |\\n| Prepaid management fees | - | 150,000 |\\n| Other | 36,226 | 44,252 |\\n| Total | $ | 1,368,921 | $ | 1,373,906 |\\n\\n\\n| 17 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe Company accepts deposits in conjunction with agreements to sell real estate building lots at Algodon Wine Estates in the Mendoza wine region of Argentina. These lot sale deposits are generally denominated in U.S. dollars. The Company received deposits for eleven additional lots and recorded deferred revenues in the amount of $ 308,000 during the six months ended June 30, 2023. Revenue is recorded when the sale closes, and the deeds are issued. The Company recorded the sale of one lot and recorded revenue in the amount of $ 154,959 during the three and six months ended June 30, 2023.\\n9. LOANS PAYABLE\\nThe Company’s loans payable are summarized below:\\nSCHEDULE OF LOANS PAYABLE\\n| June 30, | December 31, |\\n| 2023 | 2022 |\\n| EIDL | $ | 92,527 | $ | 93,541 |\\n| 2018 Loan | 40,678 | 111,137 |\\n| 2022 Loan | 24,277 | 51,643 |\\n| 2023 Loan | 185,000 | - |\\n| Total Loans Payable | 342,482 | 256,321 |\\n| Less: current portion | 252,014 | 164,656 |\\n| Loans Payable, non-current | $ | 90,468 | $ | 91,665 |\\n\\nOn January 9, 2023, the Company received $ 185,000 in proceeds on the issuance of a one-year, non-convertible promissory note with a February 20, 2024 maturity date. The note bears interest at a rate of 8 % per annum. In addition, during the six months ended June 30, 2023, the Company made principal payments in the amount of $ 42,066 on the 2018 Loan payable, $ 15,638 on the 2022 Loan payable and $ 1,014 on the EIDL loan.\\nThe Company incurred interest expense related to the loans payable in the amount of $ 33,248 and $ 36,514 during the three and six months ended June 30, 2023, respectively, and incurred interest expense related to the loans payable in the amount of $ 2,986 and $ 6,378 during the three and six months ended June 30, 2022. Other decreases in loan balances are the result of changes in exchange rates during the period. As of June 30, 2023 and December 31, 2022, there is accrued interest of $ 15,996 and $ 9,437 , respectively, related to the Company’s loans payable.\\n\\n| 18 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n10. CONVERTIBLE DEBT OBLIGATIONS\\nAmounts owed pursuant to the Company’s convertible debt obligations are as follows:\\nSCHEDULE OF CONVERTIBLE NOTES\\n| GGH Notes | 2023 Note | Total Principal | Debt Discount | Convertible debt, net of discount |\\n| Balance at January 1, 2023 | $ | 1,997,909 | $ | - | $ | 1,997,909 | $ | ( 6,450 | ) | $ | 1,991,459 |\\n| Note issued | - | 5,617,978 | 5,617,978 | ( 2,509,601 | ) | 3,108,377 |\\n| Debt principal converted to common stock: | ( 1,335,439 | ) | ( 523,925 | ) | ( 1,859,364 | ) | - | ( 1,859,364 | ) |\\n| Principal repayments | ( 662,470 | ) | ( 200,071 | ) | ( 862,541 | ) | - | ( 862,541 | ) |\\n| Amortization of debt discount | - | - | - | 1,079,034 | 1,079,034 |\\n| Balance at June 30, 2023 | $ | - | $ | 4,893,982 | $ | 4,893,982 | $ | ( 1,437,017 | ) | $ | 3,456,965 |\\n| Less: current portion | - | 4,773,982 | 4,773,982 | ( 1,401,781 | ) | 3,372,201 |\\n| Equals: convertible debt, non-current | $ | - | $ | 120,000 | $ | 120,000 | $ | ( 35,236 | ) | $ | 84,764 |\\n\\nGGH Convertible Notes\\nOn February 2, 2023, the Company and the holders of the remaining GGH Notes entered into a fourth letter agreement (“Letter Agreement #4). Pursuant to Letter Agreement #4, the parties agreed to reduce the conversion price of the GGH Notes to the lower of: (i) the closing sale price on the trading day immediately preceding the conversion date; and (ii) the average closing sale price of the common stock for the five trading days immediately preceding the conversion date. The conversion price is not subject to a floor price. Between February 3 and February 15, 2023, the holders elected to convert $ 1,571,553 in principal and interest, of which $ 1,335,439 , $ 124,049 , and $ 112,065 was principal, interest and premium paid on conversion, into 833,333 shares of common stock at prices ranging from $ 1.45 and $ 2.40 . The premium paid on conversion of the GGH Notes was recorded as a loss on extinguishment.\\nOn February 8, 2023, the Company and the holders of the remaining GGH Notes entered into a fifth letter agreement (“Letter Agreement #5). Pursuant to Letter Agreement #5, the parties agreed to extend the maturity date of the notes from February 9, 2023 to February 28, 2023.\\nOn February 20, 2023, the Company entered into another exchange agreement (the “Exchange Agreement #4”) with the remaining holders of the GGH Notes, pursuant to which warrants for the purchase up to an aggregate of 150,000 shares of the Company’s common stock at an exercise price of $ 1.00 were issued as consideration for extending the maturity date in connection with Letter Agreement #5. The warrants have a grant date fair value of $ 134,779 and expire on the second anniversary of the date of issuance. Because the value of the new warrants was deemed to be substantial as compared to the $ 662,470 remaining principal of the GGH Notes, the transaction was accounted for as an extinguishment of old notes which were replaced with the new note. The fair value of the warrants was recorded as a loss on extinguishment and is reflected under Other Expense (Income) in the accompanying condensed consolidated statement of operations.\\nOn February 21, 2023, the Company redeemed the remaining GGH Notes for $ 905,428 , which includes the $ 662,470 of principal, $ 118,909 of accrued interest and $ 124,049 of redemption premium, the latter of which was charged to extinguishment loss.\\n\\n| 19 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n2023 Convertible Note\\nOn February 21, 2023, the Company entered into a securities purchase agreement (the “SPA”) with an institutional investor, (the “Investor”) pursuant to which the Company received proceeds of $ 5,000,000 in exchange for a senior secured convertible note (the “2023 Note”) of the Company in the aggregate original principal amount of $ 5,617,978 , and a three-year common stock purchase warrant exercisable into an aggregate of 3,377,099 shares of common stock of the Company at an exercise price equal to $ 1.34 (the “2023 Note Warrant”). In addition to other terms, conditions and rights, both the Company and the Investor have the right to initiate additional closings for up to $ 5 million of cash for additional 2023 Notes and warrants.\\nPursuant to the SPA, the exercise price of certain warrants for the purchase of 62,500 common shares exercisable at $ 21.00 per share and warrants for the purchase of 43,814 shares exercisable at $ 6.00 per share was reduced to $ 1.00 per share. The increase in the value of the warrants in the aggregate amount of $ 63,502 as a result of the reduction in exercise price was recorded as debt discount on the 2023 Note.\\nThe 2023 Note is convertible into shares of common stock of the Company at a conversion price equal to the lower of (i) $ 1.34 (subject to adjustment for standard anti-dilution events, the non-exempt issuance of common stock for less than $ 1.34 per share and the issuance of additional variable price securities); (ii) the trading price on the day immediately prior to conversion or (iii) the average trading price of the Company’s common stock for the 5 days preceding conversion (collectively the “Conversion Price”), subject to a floor price of $0.27. If the Conversion Price in effect on the date of conversion is less than $ 0.27 , the Investor is entitled to a cash true up payment equal to the difference between the conversion dollar amount and the value of shares issued upon conversion (the “Cash True Up Provision”).\\nThe 2023 Note matures on the first anniversary of the issuance date (the “Maturity Date”) and bears interest at a rate of 7 % per annum, which is payable either in cash monthly, or by way of inclusion in the accrued interest in the conversion amount on the conversion date. Interest includes a make-whole amount equal to the additional interest that would accrue if the entire 2023 Note principal remained outstanding through the Maturity Date.\\nThe 2023 Note is redeemable at the Company’s election, so long as the Company is not in default, at the greater of (a) 115 % of the conversion amount, or (b) the amount equal to the shares issuable times the greatest closing price from the redemption notice date through the date the Company makes the redemption payment. The minimum redemption amount is $ 500,000 and the Company can only deliver one redemption notice in a 20-day period.\\nUpon an event of default on the 2023 Note, the Conversion Price is reduced to the lesser of (a) $1.34 (subject to adjustment as described above); (b) 80% of the volume-weighted average price on the day preceding receipt of the conversion notice; or (c) 80% of the average of the three lowest volume-weighted average prices over the fifteen trading days which precede receipt of the conversion notice, subject to a floor price of $ 0.27 (the “Event of Default Conversion Price”). In addition, the Investor may require the Company to redeem the 2023 Note using the same formula that would be used for a Company-initiated redemption, described above.\\nThe Event of Default Conversion Price represents a redemption feature, which was bifurcated from the debt host and recorded as a derivative liability. As of the date of issuance of the 2023 Note, management had estimated that the probability of an event of default was negligible; accordingly, the fair value of the derivative liability was de minimis at the date of issuance.\\n\\n| 20 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nPursuant to the terms of the 2023 Note, the Company must pay, convert or redeem one quarter of the initial principal, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date. As of June 30, 2023, the Company is in default on the 2023 Note as a result of not making the required quarterly payment due on May 21, 2023. Consequently, the Company remeasured the derivative liability and recorded a change in fair value of the derivative liability of $ 2,141,117 during the three and six months ended June 30, 2023.\\nThe following table sets forth a summary of the changes in the fair value of the derivative liability that are measured at fair value on a recurring basis:\\nSUMMARY OF THE CHANGES IN THE FAIR VALUE OF DERIVATIVE LIABILITIES\\n| Balance as of January 1, 2023 | $ | - |\\n| Fair value of derivative liability upon issuance of 2023 Note | - |\\n| Change in fair value of derivative liability | 2,141,117 |\\n| Balance as of June 30, 2023 | 2,141,117 |\\n| Less: current portion of derivative liability | 2,088,617 |\\n| Equals: derivative liability, non-current portion | $ | 52,500 |\\n\\nThe Company incurred financing costs of $ 321,803 in connection with the SPA, of which $ 218,187 was allocated to the 2023 Note and recorded as debt discount and $ 103,616 was allocated to the 2023 Note Warrant and charged against additional paid-in capital.\\nUpon the issuance of the 2023 Note, the Company recorded a debt discount at issuance in the aggregate amount $ 2,509,601 , consisting of (i) the $ 617,978 difference between the aggregate principal amount of the 2023 Note and the cash proceeds received, (ii) financing costs in the aggregate amount of $ 218,187 , (iii) value of warrant modification of $ 63,502 , and (iv) the $ 1,609,935 relative fair value of the 2023 Note Warrant. The debt discount is being amortized using the effective interest method over the term of the 2023 Note.\\nDuring the six months ended June 30, 2023, the Company made redemption payments in the aggregate amount of $ 246,186 related to the 2023 Note, which included principal repayments of $ 200,070 , accrued interest of $ 14,005 and redemption premiums of $ 32,094 . The Company recorded a loss on extinguishment for the amount of redemption premiums paid.\\nDuring the three and six months ended June 30, 2023, a total of $ 575,256 , which included principal of $ 523,925 , accrued interest of $ 38,254 and conversion premiums of $ 13,077 , was converted into 828,780 shares at conversion prices between $ 0.46 and $ 0.78 per share.\\nInterest Expense on Convertible Debt Obligations\\nThe Company incurred total interest expense of $ 987,037 and $ 661,695 related to its convertible debt obligations during the three months ended June 30, 2023 and 2022, respectively. The Company incurred total interest expense of $ 1,553,077 and $ 1,410,926 related to its convertible debt obligations during the six months ended June 30, 2023 and 2022, respectively.\\nInterest expense during the three months ended June 30, 2023 and 2022 consists of (i) $ 211,260 and $ 151,200 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 716,867 and $ 510,495 , respectively, during the six months ended June 30, 2023.\\nInterest expense during the six months ended June 30, 2023 and 2022 consists of (i) $ 415,135 and $ 348,990 , respectively, of make-whole interest accrued at 7 % per annum; (ii) $ 58,907 and $ 0 , respectively, of incremental default interest, respectively, and (iv) amortization of debt discount in the amount of $ 1,079,033 and $ 1,061,936 , respectively, during the six months ended June 30, 2023.\\nSee Note 17 - Subsequent Events.\\n\\n| 21 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\n11. SEGMENT DATA\\nThe Company’s financial position and results of operations are classified into three reportable segments, consistent with how the CODM makes decisions about resource allocation and assesses the Company’s performance.\\n\\n| ● | Real Estate Development, through AWE and TAR, including hospitality and winery operations, which support the ALGODON® brand. |\\n| ● | Fashion (e-commerce), through GGI, including the manufacture and sale of high-end fashion and accessories sold through an e-commerce platform. |\\n| ● | Corporate, consisting of general corporate overhead expenses not directly attributable to any one of the business segments. |\\n\\nThe following tables present segment information for the three months ended June 30, 2023 and 2022:\\nSCHEDULE OF SEGMENT INFORMATION\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| For the Three Months Ended June 30, 2023 | For the Six Months Ended June 30, 2023 |\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| Revenues | $ | 670,594 | $ | 40,381 | $ | - | $ | 710,975 | $ | 1,052,979 | $ | 105,763 | $ | - | $ | 1,158,742 |\\n| Revenues from Foreign Operations | $ | 670,594 | $ | - | $ | - | $ | 670,594 | $ | 1,052,979 | $ | - | $ | - | $ | 1,052,979 |\\n| Loss from Operations | $ | ( 123,767 | ) | $ | ( 463,126 | ) | $ | ( 1,398,694 | ) | $ | ( 1,985,587 | ) | $ | ( 457,771 | ) | $ | ( 955,325 | ) | $ | ( 2,518,496 | ) | $ | ( 3,931,592 | ) |\\n\\n\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| For the Three Months Ended June 30, 2022 | For the Six Months Ended June 30, 2022 |\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| Revenues | $ | 399,223 | $ | 6,112 | $ | - | $ | 405,335 | $ | 819,658 | $ | 11,274 | $ | - | $ | 830,932 |\\n| Revenues from Foreign Operations | $ | 399,223 | $ | - | $ | - | $ | 399,223 | $ | 819,658 | $ | - | $ | - | $ | 819,658 |\\n| Loss from Operations | $ | ( 1,339,272 | ) | $ | ( 341,668 | ) | $ | ( 758,493 | ) | $ | ( 2,439,433 | ) | $ | ( 1,725,125 | ) | $ | ( 700,201 | ) | $ | ( 1,789,910 | ) | $ | ( 4,215,236 | ) |\\n\\n\\n| 22 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nThe following tables present segment information as of June 30, 2023 and December 31, 2022:\\n\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| As of June 30, 2023 | As of December 31, 2022 |\\n| Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL | Real Estate Development | Fashion (e-commerce) | Corporate | TOTAL |\\n| Total Property and Equipment, net | $ | 6,586,322 | $ | 1,271,163 | $ | - | $ | 7,857,485 | $ | 6,234,856 | $ | 1,369,205 | $ | 17,196 | $ | 7,621,257 |\\n| Total Property and Equipment, net in Foreign Countries | $ | 6,586,322 | $ | - | $ | - | $ | 6,586,322 | $ | 6,234,856 | $ | - | $ | - | $ | 6,234,856 |\\n| Total Assets | $ | 14,282,151 | $ | 3,330,807 | $ | 1,606,456 | $ | 19,219,414 | $ | 13,504,914 | $ | 3,522,415 | $ | 1,665,656 | $ | 18,692,985 |\\n\\n12. RELATED PARTY TRANSACTIONS\\nAccounts Receivable – Related Parties\\nAs of June 30, 2023 and December 31, 2022 the Company had accounts receivable – related parties of $ 1,075,102 and $ 1,115,816 net of allowances for expected credit losses of $ 470,516 and $ 339,503 , respectively, representing the net realizable value of advances made to, and expense sharing obligations receivable from, separate entities under common management. During the three and six months ended June 30, 2023, the Company made advances in the amount of $ 0 and $ 85,644 , respectively, to the related entities. During the three and six months ended June 30, 2022, the Company made advances in the amount of $ 0 and $ 36,000 , respectively to the related entities. During the three and six months ended June 30, 2023, the Company received repayments in the amount of $ 237,813 and $ 367,813 , respectively, from the related entities. During the three and six months ended June 30, 2022, the Company received repayments in the amount of $ 583,000 and $ 703,000 , respectively, from the related entities. Receivables recorded in the amount of $ 383,529 and $ 417,413 in connection with an expense sharing agreement during the six months ended June 30, 2023 and 2022 are discussed below.\\nThe Company recorded credit losses related to accounts receivable, related parties of $ 0 and $ 19,431 during the three and six months ended June 30, 2023, respectively. The Company recorded credit losses of $ 0 during the three and six months ended June 30, 2022. Credit losses are recorded as bad debt expense which is reflected in the general and administrative expenses on the on the accompanying unaudited consolidated statements of operations.\\nExpense Sharing\\nOn April 1, 2010, the Company entered into an agreement with a Related Party to share expenses such as office space, support staff, professional services, and other operating expenses (the “Related Party ESA”). During the six months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 383,529 and $ 417,413 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement. During the three months ended June 30, 2023 and 2022, the Company recorded a contra-expense of $ 208,103 and $ 189,188 , respectively, related to the reimbursement of general and administrative expenses as a result of the agreement.\\n\\n| 23 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nManagement Fee Income\\nThe Company earns management fees of $ 75,000 per quarter from LVH. A member of the Company’s board of directors is the managing member of SLVH, LLC, and holds a 20 % membership interest in SLVH. SLVH owns 88 % of the limited liability interest of LVH.\\nAmendment to LVH Limited Liability Company Agreement\\nOn June 30, 2023, the Company through its wholly owned subsidiary, GVI, executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\\n13. BENEFIT CONTRIBUTION PLAN\\nThe Company sponsors a 401(k) profit-sharing plan (“401(k) Plan”) that covers substantially all of its employees in the United States. The 401(k) Plan provides for a discretionary annual contribution, which is allocated in proportion to compensation. In addition, each participant may elect to contribute to the 401(k) Plan by way of a salary deduction.\\nA participant is always fully vested in their account, including the Company’s contribution. For the six months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 9,208 and $ 22,384 , respectively. For the three months ended June 30, 2023 and 2022, the Company recorded a charge associated with its contribution of $ 3,300 and $ 3,408 , respectively. This charge has been included as a component of general and administrative expenses in the accompanying condensed consolidated statements of operations. The Company issues shares of its common stock to settle these obligations based on the fair value of its common stock on the date the shares are issued. During the six months ended June 30, 2023, the Company issued 24,160 shares at $ 1.35 per share in satisfaction of $ 32,617 of 401(k) contribution liabilities. During the six months ended June 30, 2022, the Company issued 1,040 shares at $ 26.76 per share in satisfaction of $ 27,821 of 401(k) contribution liabilities.\\n14. STOCKHOLDERS’ EQUITY\\nCommon Stock\\nOn February 2, 2023, the Company issued 51,305 shares of common stock upon the cashless exercise of 134,730 warrants at exercise prices ranging from $ 2.40 and $ 3.82 .\\nOn February 10, 2023, the Company sold 591,000 shares of common stock and warrants to purchase 147,750 shares at an exercise price of $ 1.00 for aggregate proceeds of $ 591,000 . The warrants are immediately exercisable and expire two years from the date of issuance.\\nDuring the six months ended June 30, 2023, the Company sold an aggregate of 823,198 shares of the Company’s common stock for gross proceeds of $ 797,623 less placement agent fees of $ 64,617 pursuant to a Common Stock Purchase Agreement (the “New ELOC”).\\nSee Note 10 – Convertible Debt Obligations for additional details regarding common shares issued during the three and six months ended June 30, 2023.\\nAccumulated Other Comprehensive Loss\\nFor the three and six months ended June 30, 2023, the Company recorded a loss of $ 37,993 and $ 77,792 , respectively, and for the three and six months ended June 30, 2022, the Company recorded a gain of $ 358,056 and $ 621,462 , respectively, related to foreign currency translation adjustments as accumulated other comprehensive income, primarily related to fluctuations in the Argentine peso to United States dollar exchange rates (see Note 2 – Summary of Significant Accounting Policies, Highly Inflationary Status in Argentina).\\n\\n| 24 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nWarrants\\nA summary of warrant activity during the six months ended June 30, 2023 is presented below:\\nSUMMARY OF WARRANTS ACTIVITY\\n| Number of Warrants | Weighted Average Exercise Price | Weighted Average Remaining Life in Years | Intrinsic Value |\\n| Outstanding, January 1, 2023 | 1,299,135 | $ | 5.77 |\\n| Issued | 3,674,849 | 1.31 |\\n| Exercised | ( 134,730 | ) | 3.36 |\\n| Expired | - | - |\\n| Canceled | - | - |\\n| Outstanding, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\\n| Exercisable, June 30, 2023 | 4,839,254 | $ | 2.15 | 2.1 | $ | - |\\n\\nSee Common Stock, above, and Note 10 – Convertible Debt Obligations for additional details regarding warrants issued during the six months ended June 30, 2023.\\nA summary of outstanding and exercisable warrants as of June 30, 2023 is presented below:\\nSCHEDULE OF WARRANTS OUTSTANDING AND EXERCISABLE\\n| Warrants Outstanding | Warrants Exercisable |\\n| Exercise Price | Exercisable Into | Outstanding Number of Warrants | Weighted Average Remaining Life in Years | Exercisable Number of Warrants |\\n| $ | 1.00 | Common Stock | 404,064 | 1.6 | 404,064 |\\n| $ | 1.34 | Common Stock | 3,377,099 | 2.7 | 3,377,099 |\\n| $ | 3.82 | Common Stock | 454,588 | 0.2 | 454,588 |\\n| $ | 6.00 | Common Stock | 602,225 | 0.5 | 602,225 |\\n| $ | 90.00 | Common Stock | 1,278 | 2.6 | 1,278 |\\n| Total | 4,839,254 | 2.1 | 4,839,254 |\\n\\n\\n| 25 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nRestricted Stock Units\\nA summary of RSU activity during the six months ended June 30, 2023 is presented below:\\nSCHEDULE OF RESTRICTED STOCK UNITS AND WEIGHTED AVERAGE GRANT DATE FAIR VALUES\\n| Weighted Average |\\n| Number of | Grant Date Value |\\n| RSUs | Per Share |\\n| RSUs non-vested January 1, 2023 | 511,500 | $ | 1.16 |\\n| Granted | 10,000 | 1.31 |\\n| Vested | ( 3,890 | ) | 1.31 |\\n| Forfeited | ( 1,333 | ) | 1.16 |\\n| RSUs non-vested June 30, 2023 | 516,277 | $ | 1.16 |\\n\\nOn January 23, 2023, the Company granted 10,000 restricted stock units (“RSUs”) to certain employees and advisors for their service, of which 3,890 RSUs vested on the grant date and 3,055 RSUs will vest on each of the next two anniversaries of the date of the grant.\\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 74,978 and $ 154,400 respectively, related to the amortization of RSUs. No expense related to the amortization of RSUs was recorded for the three or six months ended June 30, 2022.\\nStock Options\\nNo stock options were granted during the six months ended June 30, 2023 or the six months ended June 30, 2022. The following table presents information related to GGH stock options outstanding as of June 30, 2023:\\nSCHEDULE OF STOCK OPTION ACTIVITY\\n| Weighted | Weighted |\\n| Average | Average |\\n| Number of | Exercise | Remaining | Intrinsic |\\n| Options | Price | Term (Years) | Value |\\n| Outstanding, January 1, 2023 | 40,612 | 85.35 |\\n| Granted | - | - |\\n| Exercised | - | - |\\n| Expired | ( 5,806 | ) | 138.60 |\\n| Forfeited | - | - |\\n| Outstanding, June 30, 2023 | 34,806 | $ | 76.47 | 1.1 | $ | - |\\n| Exercisable, June 30, 2023 | 29,698 | $ | 75.78 | 1.0 | $ | - |\\n\\n\\n| 26 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nDuring the three and six months ended June 30, 2023, the Company recorded stock-based compensation expense of $ 38,834 and $ 77,668 , respectively, and during the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 57,403 and $ 130,103 , respectively, related to the amortization of options for the purchase of GGH common stock.\\nThe Company recorded no stock-based compensation expense related to options for the purchase of GGI common stock for the three and six months ended June 30, 2023 as all of the GGI options were exchanged and cancelled as of June 22, 2022. For the three and six months ended June 30, 2022, the Company recorded stock-based compensation expense of $ 29,731 and $ 40,085 , respectively, related to the options for the purchase of GGI common stock.\\nStock-based compensation expense is reflected in general and administrative expenses (classified in the same manner as the grantees’ wage compensation) in the accompanying condensed consolidated statements of operations. As of June 30, 2023, there was $ 91,921 of unrecognized stock-based compensation expense related to stock option grants that will be amortized over a weighted average period of 1.1 years.\\n15. COMMITMENTS AND CONTINGENCIES\\nLegal Matters\\nThe Company may be involved in litigation and arbitrations from time to time in the ordinary course of business. At the present time, the Company is not involved in any ongoing litigation. The Company records legal costs associated with loss contingencies as incurred. Settlements are accrued when, and if, they become probable and estimable.\\n16. LEASES\\nOn April 8, 2021, GGI entered into a lease agreement to lease a retail space in Miami, Florida for 7 years, which expires May 1, 2028 . As of June 30, 2023, the lease had a remaining term of approximately 4.8 years. Lease payments begin at $26,758 per month and escalate 3% every year over the duration of the lease. The Company was granted rent abatements of 15% for the first year of the lease term, and 10% for the second and third year of the lease term. The Company was required to pay a $ 56,130 security deposit.\\nAs of June 30, 2023, the Company had no leases that were classified as a financing lease.\\nTotal operating lease expense was $ 82,965 and $ 165,931 during the three and six months ended June 30, 2023, respectively, and $ 82,965 and $ 165,931 during the three and six months ended June 30, 2022, respectively. Lease expenses are recorded in general and administrative expenses on the accompanying condensed consolidated statements of operations.\\n\\n| 27 |\\n\\n\\nGAUCHO GROUP HOLDINGS, INC. AND SUBSIDIARIES\\nNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(unaudited)\\nSupplemental cash flow information related to leases was as follows:\\nSCHEDULE OF SUPPLEMENTAL CASH FLOWS INFORMATION RELATED TO LEASES\\n| For the Six Months Ended June 30, |\\n| 2023 | 2022 |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Operating cash flows from operating leases | $ | 98,125 | $ | 82,296 |\\n| Right-of-use assets obtained in exchange for lease obligations: |\\n| Operating leases | $ | - | $ | - |\\n| Weighted Average Remaining Lease Term: |\\n| Operating leases | 4.8 | 5.8 |\\n| Weighted Average Discount Rate: |\\n| Operating leases | 7.0 | % | 7.0 | % |\\n\\nFuture minimum lease commitments are as follows:\\nSCHEDULE OF FUTURE MINIMUM LEASE COMMITMENT\\n| For the period July 1 through December 31, 2023 | $ | 153,290 |\\n| For the years ended December 31, |\\n| 2024 | 336,102 |\\n| 2025 | 357,881 |\\n| 2026 | 368,617 |\\n| 2027 | 365,004 |\\n| 2028 | 120,463 |\\n| Total future minimum lease payments | 1,701,357 |\\n| Less: imputed interest | ( 268,300 | ) |\\n| Net future minimum lease payments | 1,433,057 |\\n| Less: operating lease liabilities, current portion | 220,416 |\\n| Operating lease liabilities, non-current portion | $ | 1,212,641 |\\n\\nThe Company is the lessor of a building and land that it purchased in connection with acquisition of GDS, pursuant to an operating lease which expires on August 31, 2031. At the end of the leases, the lessee may enter into a new lease or return the asset, which would be available to the Company for releasing. The Company recorded lease revenue of $ 10,937 and $ 21,565 during the three and six months ended June 30, 2023, respectively, related to this lease agreement. The Company recorded lease revenue of $ 10,594 and $ 14,339 during the three and six months ended June 30, 2022, respectively, related to this lease agreement.\\n17. SUBSEQUENT EVENTS\\nThere have been no subsequent events that occurred during the period subsequent to the date of these condensed consolidated financial statements that would require adjustment to our disclosure in the condensed consolidated financial statements as presented, except as described below:\\n2023 Convertible Note\\nOn July 3, 2023, $ 120,000 of principal, $ 9,979 of interest, and $ 19,467 of premium owed in connection with the 2023 Note were converted into 329,416 shares of common stock of the Company at a conversion price of $ 0.4538 per share.\\nOn August 11, 2023, the Company and the Investor entered into a letter agreement pursuant to which, among other things: i) the Investor agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the requirement in the 2023 Note to pay interest monthly in cash is waived for payments due August 1, 2023 through December 31, 2023; (iii) the application of the default interest rate on the 2023 Note is waived for the period from May 21, 2023 through December 31, 2023, (iv) the requirement for the Company to prepay, redeem, or convert one quarter the initial principal owe on the 2023 Note, plus any outstanding interest and make-whole amount by each three-month anniversary of the issuance date.is waived through December 31, 2023; (v) the Company adjusted the exercise price of the 2023 Note Warrant from $1.34 to $0.45; and (vi) the Investor may continue to convert the 2023 Note at the Alternate Conversion Price or at $0.45.\\nBoard Compensation\\nOn July 14, 2023, the Company issued a total of 270,272 shares at $ 0.555 per share for a total value of $ 150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\\n\\n| 28 |\\n\\n\\n\\nThe following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included herein. In connection with, and because we desire to take advantage of, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution readers regarding certain forward-looking statements in the following discussion and elsewhere in this report and in any other statement made by, or on our behalf, whether or not in future filings with the Securities and Exchange Commission. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Forward looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on our behalf. Words such as “anticipate,” “estimate,” “plan,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions are used to identify forward-looking statements. We disclaim any obligation to update forward-looking statements.\\nUnless the context requires otherwise, references in this document to “GGH”, “we”, “our”, “us” or the “Company” are to Gaucho Group Holdings, Inc. and its subsidiaries.\\nPlease note that because we qualify as an emerging growth company and as a smaller reporting company, we have elected to follow the smaller reporting company rules in preparing this Quarterly Report on Form 10-Q.\\nOverview\\nGaucho Group Holdings, Inc. (“GGH” or the “Company”) positions its e-commerce leather goods, accessories, and fashion brand, Gaucho – Buenos Aires™, as one of luxury, creating a platform for the global consumer to access their piece of Argentine style and high-end products. With a concentration on leather goods, ready-to-wear and accessories, this is the luxury brand in which Argentina finds its contemporary expression. During the first quarter of 2022, the Company launched Gaucho Casa, a Home & Living line of luxury textiles and home accessories, which will be marketed and sold on the Gaucho – Buenos Aires e-commerce platform. Gaucho Casa challenges traditional lifestyle collections with its luxury textiles and home accessories rooted in the singular spirit of the gaucho aesthetic. GGH seeks to grow its direct-to-consumer online products to global markets in the United States, Asia, the United Kingdom, Europe, and Argentina. We intend to focus on e-commerce and scalability of the Gaucho – Buenos Aires and Gaucho Casa brands, as real estate in Argentina is politically sensitive.\\nGGH’s goal is to become recognized as the LVMH (“Louis Vuitton Moët Hennessy”) of South America’s leading luxury brands. Through one of its wholly owned subsidiaries, GGH also owns and operates legacy investments in the boutique hotel, hospitality and luxury vineyard property markets. This includes a golf, tennis and wellness resort, as well as an award-winning wine production company concentrating on Malbecs and Malbec blends. Utilizing these wines as its ambassador, GGH seeks to further develop its legacy real estate, which includes developing residential vineyard lots located within its resort.\\nAs a result of the COVID-19 pandemic, we terminated the corporate office lease and senior management now works remotely. GGH’s local operations are managed by professional staff with substantial hotel, hospitality and resort experience in Buenos Aires and San Rafael, Argentina.\\n\\n| 29 |\\n\\n\\nRecent Developments and Trends\\nWhile the World Health Organization declared an end to the COVID-19 global health emergency on May 5, 2023, we continue to closely monitor the outbreak of COVID-19 and the related impact on our operations, financial position and cash flows, as well as the impact on our employees. Due to the continued fluidity of this situation, and the magnitude and duration of the pandemic, its impact on our future operations and liquidity remains uncertain as of the date of this report.\\nWe have faced, and may continue to face, significant cost inflation, specifically in raw materials and other supply chain costs due to increased demand for raw materials and the broad disruption of the global supply chain associated with the impact of COVID-19. International conflicts or other geopolitical events, including the 2022 Russian invasion of Ukraine, may further contribute to increased supply chain costs due to shortages in raw materials, increased costs for transportation and energy, disruptions in supply chains, and heightened inflation. Further escalation of geopolitical tensions may also lead to changes to foreign exchange rates and financial markets, any of which may adversely affect our business and supply chain, and consequently our results of operation. While there could ultimately be a material impact on the operations and liquidity of the Company, at the time of issuance, the impact could not be determined.\\nDuring the three months ended June 30, 2023, the Company and the holder of a senior secured convertible note of the Company (the “2023 Note”) converted an aggregate of $575,256 of principal, interest and conversion premiums, and the Company issued an aggregate of 828,780 shares upon conversion.\\nOn June 30, 2023, the Company through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\\nOn July 3, 2023, the Company and the holder of the 2023 Note converted an aggregate of $149,446 of principal, interest and conversion premiums and the Company issued an aggregate of 329,416 shares upon conversion.\\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share for a total value of $150,000 to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023.\\nConsolidated Results of Operations\\nThree months ended June 30, 2023 compared to the three months ended June 30, 2022\\nOverview\\nWe reported a net loss of approximately $5.0 million and $5.3 million for the three months ended June 30, 2023 and 2022, respectively.\\nRevenues\\nRevenues from operations were approximately $711,000 and $405,000 during the three months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $306,000 or 76%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $443,000, an increase of approximately $143,000 in lot sales, an increase of agricultural sales of approximately $178,000, and an increase in clothes, accessories and other sales of approximately $61,000, resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease of approximately $519,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\n\\n| 30 |\\n\\n\\nGross profit\\nWe generated a gross profit of approximately $42,000 for the three months ended June 30, 2023 and a gross loss of approximately $128,000 for the three months ended June 30, 2022, representing an increase in gross profit of approximately $170,000 or 133%, primarily resulting from profits earned from the sale of real estate lots during the period.\\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $136,000 or 26%, from approximately $533,000 for the three months ended June 30, 2022 to approximately $669,000 for the three months ended June 30, 2023. The increase in cost of sales resulted from the increases in hotel, restaurant and wine costs of approximately $335,000, an increase in clothes, accessories and other costs of approximately $124,000, and an increase of approximately $102,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $199,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $625,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\nSelling and marketing expenses\\nSelling and marketing expenses were approximately $213,000 and $333,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $120,000 or 36%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\nGeneral and administrative expenses\\nGeneral and administrative expenses were approximately $1,711,000 and $1,929,000 for the three months ended June 30, 2023 and 2022, respectively, representing a decrease of $218,000 or 11%. Decreases of approximately $225,000 in employee compensation, and approximately $759,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $482,000 in professional and consulting fees (primarily business development and investor relations consulting) and approximately $284,000 in other aggregated expenses that are not individually material.\\nDepreciation and amortization expense\\nDepreciation and amortization expense was approximately $104,000 and $49,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $55,000 or 112%, related to new asset purchases.\\nInterest income\\nInterest income was approximately $64,000 and $27,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $37,000 or 137%, related to the increase in mortgages receivable.\\nInterest expense\\nInterest expense was approximately $1,066,000 and $695,000 during the three months ended June 30, 2023 and 2022, respectively, representing an increase of $371,000 or 53%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\\n\\n| 31 |\\n\\n\\nOther income, related party\\nOther income of approximately $75,000 during the three months ended June 30, 2023 and 2022 represents the management fee earned from LVH.\\nLoss on extinguishment of debt\\nLoss on extinguishment of debt in the aggregate amount of $32,094 during the three months ended June 30, 2023 consists of extinguishment loss recognized related to premiums paid on the cash redemption of convertible debt. Loss on extinguishment of debt in the aggregate amount of $2,105,119 during the three months ended June 30, 2022 consists of extinguishment loss recognized upon the reduction of the conversion price on the GGH Notes during the second quarter of 2022.\\nGains from foreign currency translation\\nThe Company recorded gains from foreign currency translation of approximately $103,000 and $43,000 during the three months ended June 30, 2023 and 2022, respectively. The increase of approximately $60,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\\nChange in fair value of derivative liability\\nThe Company recorded a change in fair value of derivative liability of approximately $2,141,000 and $0 during the three months ended June 30, 2023 and 2022, respectively. The change in fair value during the six months ended June 30, 2023 is associated with the default of the 2023 Convertible Note as of June 30, 2023.\\nInducement expense\\nInducement expense decreased to $0 for the three months ended June 30, 2023 from approximately $198,000 during the three months ended June 30, 2022. Inducement expense during the three months ended June 30, 2022 resulted from a temporary reduction in the conversion price on convertible debt.\\nSix months ended June 30, 2023 compared to the six months ended June 30, 2022\\nOverview\\nWe reported a net loss of approximately $7.7 million and $7.6 million for the six months ended June 30, 2023 and 2022, respectively.\\nRevenues\\nRevenues from operations were approximately $1,159,000 and $831,000 during the six months ended June 30, 2023 and 2022, respectively, reflecting an increase of approximately $328,000 or 39%. The overall increase in sales was driven by increases in hotel, restaurant and wine revenues of approximately $863,000, increases in agricultural revenues of $122,000, and increases in clothes, accessories and other sales of approximately $145,000 resulting from the easing of COVID restrictions and the Argentine government’s efforts to promote tourism and revitalize local businesses, and from the opening of our flagship retail store in Miami. These revenue increases were partially offset by a decrease in lot sales of approximately $42,000 and approximately $760,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\n\\n| 32 |\\n\\n\\nGross profit\\nWe generated a gross profit of approximately $197,000 and $59,000 for the six months ended June 30, 2023 and 2022, respectively, representing an increase of approximately $138,000 or 234%. The increase in gross profit during the six months ended June 30, 2023 is primarily related to hotel sales during the period. The Company’s hotel was being renovated during the first half of 2022, resulting in limited revenues, with fixed costs related to hotel operations.\\nCost of sales, which consists of real estate lots, raw materials, direct labor and indirect labor associated with our business activities, increased by approximately $190,000 or 25%, from approximately $772,000 for the six months ended June 30, 2022 to approximately $962,000 for the six months ended June 30, 2023. The increase in cost of sales includes increases in hotel, restaurant and wine costs of approximately $534,000, an increase in clothes, accessories and other costs of approximately $166,000, and an increase of approximately $75,000 in costs associated with lot sales, which correspond to the increases in the related revenues as discussed above. In addition, a higher number of agricultural sales, which are sold at a loss, provided an increase of approximately $158,000 in cost of sales. These increases in cost of sales were partially offset by a decrease of approximately $743,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\nSelling and marketing expenses\\nSelling and marketing expenses were approximately $448,000 and $505,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of approximately $57,000 or 11%, primarily related to lower GGI advertising and marketing expenses for GGI’s new retail space as well as the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar.\\nGeneral and administrative expenses\\nGeneral and administrative expenses were approximately $3,467,000 and $3,674,000 for the six months ended June 30, 2023 and 2022, respectively, representing a decrease of $207,000 or 6%. A decrease of approximately $739,000 resulting from gains recognized on transactions denominated in foreign currency, as well as a decrease of approximately $460,000 resulting from the impact of the decline in the value of the Argentine peso vis-à-vis the U.S. dollar were partially offset by increases of approximately $596,000 in professional and consulting fees (primarily business development and investor relations consulting), approximately $85,000 of compensation expense, as well as approximately $307,000 in other aggregated expenses that are not individually material. Gains recognized on transactions denominated in a foreign currency result from the difference between the official exchange rate, and the actual exchange rate applied to the peso.\\nDepreciation and amortization expense\\nDepreciation and amortization expense was approximately $213,000 and $95,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $118,000 or 124%, related to new asset purchases.\\nInterest income\\nInterest income was approximately $115,000 and $30,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $85,000 or 283% as the result of increases in mortgages receivable during the period.\\nInterest expense\\nInterest expense was approximately $1,668,000 and $1,453,000 during the six months ended June 30, 2023 and 2022, respectively, representing an increase of $215,000 or 15%. The increase is primarily related to a rise in the interest and debt discount related to convertible debt issued during February 2023.\\nOther income\\nOther income of approximately $150,000 during the six months ended June 30, 2023 and 2022 represents the management fee received from LVH.\\n\\n| 33 |\\n\\n\\nGains from foreign currency translation.\\nThe Company recorded gains from foreign currency translation of approximately $215,000 and $226,000 during the six months ended June 30, 2023 and 2022, respectively, as the result of the highly inflationary status of Argentina. The decrease of approximately $11,000 in gains from foreign currency translation is due to the fluctuation in the Argentine peso to United States dollar exchange rates.\\nLoss on extinguishment of debt\\nLoss on extinguishment of debt was approximately $416,000 during the six months ended June 30, 2023, as compared to approximately $2.1 million during the six months ended June 30, 2022. Loss on extinguishment of debt during the six months ended June 30, 2023 in the approximate amount of $416,000 is comprised of (i) premium paid on the conversion of GGH Notes of approximately $112,000, (ii) premium paid on the cash redemption of GGH Notes of approximately $124,000, (iii) premium paid on the 2023 Note for cash redemption of principal in the amount of approximately $32,000; (iv) premium in the amount of approximately $13,000 paid on the conversion an aggregate of $87,179 of principal and interest owed on the 2023 Note, and (iv) the fair value of approximately $135,000 in warrants issued in the exchange agreement for the GGH Notes (See Note 10—Convertible Debt Obligations for additional details).\\nLiquidity and Capital Resources\\nWe measure our liquidity a variety of ways, including the following:\\n\\n| June 30, 2023 | December 31, 2022 |\\n| (unaudited) |\\n| Cash | $ | 810,139 | $ | 300,185 |\\n| Working capital (deficiency) | $ | (3,828,285 | ) | $ | 595,120 |\\n| Convertible debt obligations | $ | 4,893,983 | $ | 1,997,909 |\\n| Loans payable | $ | 342,482 | $ | 256,321 |\\n\\nCash requirements for our current liabilities include approximately $2.0 million for accounts payable and accrued expenses, approximately $220,000 for lease liabilities, and approximately $332,000 for loans payable and other current liabilities. We also have convertible debt obligations in the approximate amount of $4.8 million which, if not converted prior to maturity, are due on February 21, 2024. Cash requirements for our long-term liabilities include approximately $1.2 million for operating lease liabilities, approximately $90,000 in loans payable, and approximately $82,000 of long-term accrued expenses.\\nDuring the six months ended June 30, 2023, we financed a portion of our activities from proceeds derived from debt and equity financings. A significant portion of the funds have been used to cover working capital needs and personnel, office expenses and various consulting and professional fees.\\nNet cash used in operating activities for the six months ended June 30, 2023 and 2022 amounted to approximately $4,033,000 and $2,755,000, respectively. During the six months ended June 30, 2023, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.7 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.5 million of cash used to fund changes in the levels of operating assets and liabilities. During the six months ended June 30, 2022, the net cash used in operating activities was primarily attributable to the net loss of approximately $7.6 million adjusted for approximately $4.1 million of net non-cash expenses, and approximately $0.7 million of cash used to fund changes in the levels of operating assets and liabilities.\\nCash used in investing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $489,000 and $1,720,000, respectively, resulting primarily from the purchase of property and equipment in the approximate amount of $438,000 and $1,677,000 million, respectively, and approximately $50,000 and $35,000 respectively, used to purchase certain intangible assets.\\n\\n| 34 |\\n\\n\\nNet cash provided by financing activities for the six months ended June 30, 2023 and 2022 amounted to approximately $5.1 million and $0.5 million, respectively. For the six months ended June 30, 2023, the net cash provided by financing activities resulted from approximately $4.7 million in net proceeds from the issuance of debt, $0.6 million in proceeds from the issuance of common stock in a private placement, approximately $0.7 million in proceeds from the issuance of stock under the New ELOC and $0.2 million in proceeds from the issuance of a note payable, partially offset by the repayment of convertible debt obligations and related redemption premiums in the approximate amount of $1.0 million, and repayment of loans payable of approximately $0.1 million. Net cash used in financing activities for the six months ended June 30, 2022 resulted from approximately $0.5 million of cash proceeds from the sale of commons stock, partially offset by approximately $0.1 million in repayments of loans payable.\\nAs of June 30, 2023, the Company had cash and a working capital deficit of approximately $810,000 and $3,109,000, respectively. During the six months ended June 30, 2023 and 2022, the Company incurred net losses of approximately $7.7 million and $7.6 million, respectively, and used cash in operating activities of approximately $4.0 million and $2.8 million, respectively. Further, as of June 30, 2023, approximately $4.8 million owed in connection with the Company’s convertible debt matures on February 21, 2024, and approximately $0.3 million represents the current portion of the Company’s loans payable which are payable on demand or for which payments are due within twelve months after June 30, 2023. During the six months ended June 30, 2023, the Company funded its operations with net proceeds from convertible debt financing of approximately $4.7 million, proceeds of approximately $0.7 million from draws on the Company’s equity line of credit, and $0.6 million from the sale of common stock.\\nThe Company’s operating needs include the planned costs to operate its business, including amounts required to fund working capital and capital expenditures. Based upon projected revenues and expenses, the Company believes that it may not have sufficient funds to operate for the next twelve months from the date these financial statements are made available. Since inception, the Company’s operations have primarily been funded through proceeds received from equity and debt financings. The Company believes it has access to capital resources and continues to evaluate additional financing opportunities. There is no assurance that the Company will be able to obtain funds on commercially acceptable terms, if at all. There is also no assurance that the amount of funds the Company might raise will enable the Company to complete its development initiatives or attain profitable operations. The aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern.\\nAvailability of Additional Funds\\nAs a result of our financings, we have been able to sustain operations. However, we will need to raise additional capital in order to meet our future liquidity needs for operating expenses and capital expenditures, including GGI inventory production, continued development of the GGI e-commerce platform, expansion of our winery and additional investments in real estate development. If we are unable to obtain adequate funds on reasonable terms, we may be required to significantly curtail or discontinue operations.\\nOff-Balance Sheet Arrangements\\nNone.\\nContractual Obligations\\nAs a smaller reporting company, we are not required to provide the information requested by paragraph (a)(5) of this Item.\\nCritical Accounting Policies and Estimates\\nThere are no material changes from the critical accounting policies, estimates and new accounting pronouncements set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth in our Annual Report on Form 10-K filed with the SEC on April 17, 2023, except as described below. Please refer to that document for disclosures regarding the critical accounting policies related to our business.\\n\\n| 35 |\\n\\n\\nConvertible Promissory Notes\\nThe Company evaluates its convertible instruments to determine if those contracts or embedded components of those contracts qualify as derivative financial instruments to be separately accounted for in accordance with Topic 815 “Derivatives and Hedging” (“ASC 815”) of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The accounting treatment of derivative financial instruments requires that the Company record any bifurcated embedded features at their fair values as of the inception date of the agreement and at fair value as of each subsequent balance sheet date. Any change in fair value is recorded in earnings each period as non-operating, non-cash income or expense. The Company reassesses the classification of its derivative instruments at each balance sheet date. If the classification changes as a result of events during the period, the contract is reclassified as of the date of the event that caused the reclassification. Bifurcated embedded features are recorded upon note issuance at their initial fair values which create additional debt discount to the host instrument.\\nSequencing Policy\\nUnder ASC 815, we have adopted a sequencing policy, whereby, in the event that reclassification of contracts from equity to assets or liabilities is necessary pursuant to ASC 815 due to the Company’s inability to demonstrate it has sufficient authorized shares as a result of certain securities with a potentially indeterminable number of shares or the Company’s total potentially dilutive shares exceed the Company’s authorized share limit, shares will be allocated on the basis of the earliest issuance date of potentially dilutive instruments, with the earliest grants receiving the first allocation of shares. Pursuant to ASC 815, issuances of securities granted as compensation in a share-based payment arrangement are not subject to the sequencing policy.\\n\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide the information required by this Item.\\n\\nDisclosure Controls and Procedures\\nOur management carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer (who is our Principal Executive Officer) and our Chief Financial Officer (who is our Principal Financial Officer and Principal Accounting Officer), of the effectiveness of the design of our disclosure controls and procedures (as defined by Exchange Act Rules 13a-15(e) or 15d-15(e)) as of June 30, 2023, pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were not effective as of June 30, 2023, resulting from a lack of segregation of duties due to our small size, and lack of testing of the operating effectiveness of the controls.\\n\\n| 36 |\\n\\n\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting identified in management’s evaluation pursuant to Rules 13a-15(d) or 15d-15(d) of the Exchange Act during the quarter ended June 30, 2023 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nInherent Limitations of Controls\\nManagement does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. Controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or deterioration in the degree of compliance with the policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\\n\\n| 37 |\\n\\n\\nPART II - OTHER INFORMATION\\n\\nFrom time to time, the Company and its subsidiaries and affiliates are subject to litigation and arbitration claims incidental to its business. Such claims may not be covered by its insurance coverage, and even if they are, if claims against GGH and its subsidiaries are successful, they may exceed the limits of applicable insurance coverage. We are not involved in any litigation that we believe is likely, individually or in the aggregate, to have a material adverse effect on our condensed consolidated financial condition, results of operations or cash flows.\\n\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this Item. However, our current risk factors are set forth in Item 1A of the Company’s Annual Report on Form 10-K as filed with the SEC on April 17, 2023 and in Item 1A of the Company’s Quarterly Report on Form 10-Q as filed with the SEC on May 19, 2023.\\nOur stock has been trading below $1.00 and our failure to maintain compliance with Nasdaq’s continued listing requirements could result in the delisting of our common stock.\\nOur common stock is currently listed for trading on The Nasdaq Capital Market. We must satisfy the continued listing requirements of The Nasdaq Stock Market LLC (or Nasdaq), to maintain the listing of our common stock on The Nasdaq Capital Market.\\nOn June 1, 2023, the Company received a deficiency letter from the Listing Qualifications Department (the “Staff”) of the Nasdaq Stock Market notifying the Company that, for the preceding 30 consecutive business days, the closing bid price for the Company’s common stock was trading below the minimum $1.00 per share requirement for continued inclusion on The Nasdaq Capital Market pursuant to Nasdaq Listing Rule 5450(a)(1) (the “Bid Price Requirement”). The notification has no immediate effect on the Company’s Nasdaq listing and the Company’s common stock will continue to trade on Nasdaq under the ticker symbol “VINO.”\\nIn accordance with Nasdaq Rules, the Company was provided with an initial period of 180 calendar days, or until November 28, 2023 (the “Compliance Date”), to regain compliance with the Bid Price Requirement. If at any time before the Compliance Date the closing bid price for the Company’s common stock is at least $1.00 for a minimum of 10 consecutive business days, the Staff will provide the Company written confirmation of compliance with the Bid Price Requirement.\\nIf the Company does not regain compliance with the Bid Price Requirement by the Compliance Date, the Company may be eligible for an additional 180 calendar day compliance period. To qualify, the Company would then be required to meet the continued listing requirement for market value of publicly held shares and all other initial listing standards for The Nasdaq Capital Market, with the exception of the Bid Price Requirement, and will need to provide written notice of its intention to cure the deficiency during the additional 180 calendar day compliance period, which compliance could be achieved by effecting a reverse stock split, if necessary. If the Company does not regain compliance with the Bid Price Requirement by the Compliance Date and is not eligible for an additional compliance period at that time, the Staff will provide written notification to the Company that its common stock will be subject to delisting. At that time, the Company may appeal the Staff’s delisting determination to a Nasdaq Hearings Panel.\\n\\n| 38 |\\n\\n\\nThe Company is holding its Annual General Meeting on August 24, 2023, at which, among other things, the Company has requested stockholder approval to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing. The Company will need shareholders representing a majority of the outstanding shares of the Company to approve this proposal, which is not guaranteed.\\nIf our common stock were delisted from Nasdaq, trading of our common stock would most likely take place on an over-the-counter market established for unlisted securities, such as the OTCQB or the Pink Market maintained by OTC Markets Group Inc. An investor would likely find it less convenient to sell, or to obtain accurate quotations in seeking to buy, our common stock on an over-the-counter market, and many investors would likely not buy or sell our common stock due to difficulty in accessing over-the-counter markets, policies preventing them from trading in securities not listed on a national exchange or other reasons. In addition, as a delisted security, our common stock would be subject to SEC rules as a “penny stock”, which impose additional disclosure requirements on broker-dealers. The regulations relating to penny stocks, coupled with the typically higher cost per trade to the investor of penny stocks due to factors such as broker commissions generally representing a higher percentage of the price of a penny stock than of a higher-priced stock, would further limit the ability of investors to trade in our common stock. In addition, delisting would materially and adversely affect our ability to raise capital on terms acceptable to us, or at all, and may result in the potential loss of confidence by investors, suppliers, customers and employees and fewer business development opportunities. For these reasons and others, delisting would adversely affect the liquidity, trading volume and price of our common stock, causing the value of an investment in us to decrease and having an adverse effect on our business, financial condition and results of operations, including our ability to attract and retain qualified employees and to raise capital.\\nThe Company is currently in default under one of its convertible promissory notes, which allows the holder to redeem all or a portion of the Note.\\nPursuant to the 2023 Purchase Agreement and Notes, as of May 21, 2023, the Company failed to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The holder may require the Company to redeem all or a portion of the Notes by written notice, which would have a material adverse effect on the Company. On August 11, 2023, the Company and the holder of the Notes entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\\nIf LVH does not sign a ground lease by December 29, 2023, LVH will be dissolved and we may not receive a complete return of our investment.\\nCurrently, the Company, through its wholly-owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), contributed total capital of $7.0 million to LVH Holdings LLC (“LVH”) to develop a project in Las Vegas, Nevada and received 396 limited liability company interests, representing an 11.9% equity interest in LVH. Pursuant to the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH dated June 30, 2023, if a ground lease for the premises within which the luxury hotel, casino, entertainment and retail project will be developed and constructed has not been executed by LVH on or before December 29, 2023, then as promptly as reasonably practicable after such date, LVH will be liquidated and dissolved.\\nAs of June 30, 2023, LVH has used our cash contribution to LVH for land improvement expenses, such as architectural, legal, engineering, and accounting fees. Should LVH be liquidated and dissolved on or before December 29, 2023, we most likely will not receive our entire contribution back from LVH and may lose our entire investment.\\n\\n| 39 |\\n\\n\\n\\nEquity Line of Credit\\nPursuant to the Purchase Agreement with Tumim Capital dated November 8, 2022, the Company requested draw-downs and issued shares of common stock and received gross proceeds of the following for the three months ended June 30, 2023: (i) April 19, 2023, the Company issued 195,970 shares of common stock to Tumim for gross proceeds of $144,339; and (ii) on May 5, 2023, the Company issued 262,798 shares of common stock to Tumim for gross proceeds of $172,614. No general solicitation was used, and a commission of 8% of the total gross proceeds was paid to Benchmark Investments, Inc. pursuant to the Underwriting Agreement between the Company and Kingswood Capital Markets, a division of Benchmark Investments, Inc., f/k/a EF Hutton, dated February 16, 2021. The Company relied on the exemptions from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D of the Securities Act, in connection with the sales. A Form D was filed with the SEC on November 21, 2022.\\n\\nPursuant to the 2023 Purchase Agreement and Notes, as of each three-month anniversary of the Notes, the Company was required to prepay, redeem or convert one quarter of the initial principal and interest on the Notes. The Company did not meet that requirement as of May 21, 2023, which is the first three-month anniversary. The Company is required to deliver notice of default to the holder within one (1) business day. The holder may require the Company to redeem all or a portion of the Notes by written notice. On August 11, 2023, the Company and the holder of the Notes entered into an agreement pursuant to which, among other things: the holder agreed to forbear from issuing an event of default notice and event of default redemption notice through December 31, 2023. See Item 5 for additional information.\\n\\nNot applicable.\\n\\nSpecial Meeting of Stockholders\\nOn May 8, 2023, the Company held a special stockholder meeting (the “Special Meeting”) at 12:00 p.m. Eastern Time at which a quorum was present. At the Special Meeting, a proposal to approve, for purposes of complying with Nasdaq Listing Rule 5635(d), the full issuance and exercise of shares of our common stock to be issued pursuant to that certain Securities Purchase Agreement, dated February 21, 2023 (the “Purchase Agreement”), that certain senior secured convertible promissory note dated February 21, 2023 (the “Note”), that certain common stock purchase warrant dated February 21, 2023 (the “Warrants”), and that certain Registration Rights Agreement, dated February 21, 2023 (the “Registration Rights Agreement”) by and between the Company and an institutional investor was approved by the stockholders.\\nAnnual General Meeting\\nOn June 29, 2023, the Company filed a Preliminary Proxy Statement on Form 14-A, a Definitive Proxy Statement on Form 14-A on July 10, 2023, and additional definitive proxy materials on Form 14-A on July 11, 2023, which request stockholder approval of the following proposals: (i) To elect two (2) Class III nominees to the board of directors (Scott L. Mathis and William A. Allen) to hold office for a three-year term; (ii) to grant the Board of Directors discretion (if necessary to prevent the delisting of the Company’s common stock on Nasdaq) on or before June 30, 2024, to implement a reverse stock split of the outstanding shares of common stock in a range from one-for-two (1:2) up to one-for-ten (1:10), or anywhere between, while maintaining the number of authorized shares of common stock at 150,000,000 shares, as required for Nasdaq listing; (iii) to conduct an advisory vote on executive compensation; (iv) to conduct an advisory vote on the frequency of advisory votes on executive compensation; and (v) to ratify and approve the appointment of Marcum LLP as the Company’s independent registered accounting firm for the year ended December 31, 2023.\\n\\n| 40 |\\n\\n\\nLVH Holdings LLC\\nOn June 30, 2023, the Company, through its wholly owned subsidiary, Gaucho Ventures I – Las Vegas, LLC (“GVI”), executed a Fourth Amendment to the Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC (“LVH”) to extend the outside date for execution of the ground lease from June 30, 2023 to December 29, 2023.\\nAs previously disclosed, on June 16, 2021, the Company, through GVI, entered into the Amended and Restated Limited Liability Company Agreement of LVH; on November 16, 2022, entered into the First Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; on June 7, 2022, entered into the Second Amendment to the Amended and Restated Limited Liability Company Agreement of LVH; and on December 12, 2022, entered into the Third Amendment to the Amended and Restated Limited Liability Company Agreement of LVH.\\nAs of the date of the Fourth Amendment to the Amended and Restated Limited Liability Company Agreement, GVI and SLVH LLC comprise all of the members of LVH.\\nBoard Compensation\\nOn July 14, 2023, the Company issued a total of 270,272 shares at $0.555 per share to the non-executive directors of the Company as compensation for service as members of the Board of Directors of the Company for the first half of 2023. For this sale of securities, no general solicitation was used, no commissions were paid, all persons were accredited investors, and the Company relied on the exemption from registration available under Section 4(a)(2) and/or Rule 506(b) of Regulation D promulgated under the Securities Act with respect to transactions by an issuer not involving any public offering. A Form D was filed with the SEC on July 28, 2023.\\nConvertible Promissory Notes\\nAs previously reported on our Current Report on Form 8-K filed on February 21, 2023, the Company and an institutional investor (the “Holder”) entered into that certain Securities Purchase Agreement, dated as of February 21, 2023 (the “Securities Purchase Agreement”) and the Company issued to the Holder a senior secured convertible note (the “Note”) and warrant to purchase 3,377,099 shares of common stock of the Company (the “Warrant” and together with the Securities Purchase Agreement and the Note, the “Note Documents”).\\nFor the full description of the Note Documents, please refer to our Current Report on Form 8-K and the exhibits attached thereto as filed with the SEC on February 21, 2023.\\nAs previously reported on our Current Report on Form 8-K filed on August 11, 2023, an Event of Default occurred with respect to the Note. As a result, on August 11, 2023, the Company and the Holder entered into an agreement (the “Letter Agreement”) pursuant to which, among other things: (i) the Holder agreed to forbear from issuing an Event of Default Notice and Event of Default Redemption Notice; (ii) the Holder waived the requirement in the Note to pay Interest on the Note monthly in cash for a certain period of time; (iii) the Holder agreed to waive application of the Default Rate in Note for a certain period of time; (iv) the Holder agreed to waive the requirement in the Note for the Company to prepay, redeem, or convert one quarter of the initial Principal and Interest on the Note by each three (3) month anniversary of the Issuance Date for a certain period of time; (v) the Company adjusted the exercise price of the Warrant from $1.34 to $0.45; and (vi) the Holder may continue to convert the Note at the Alternate Conversion Price or at $0.45.\\nAll terms not defined herein shall refer to the defined terms in the Note Documents.\\nSee also Items 1A and 3 above.\\n\\n| 41 |\\n\\n\\n\\nThe following documents are being filed with the Commission as exhibits to this Current Report on Form 10-Q.\\n\\n| Exhibit | Description |\\n| 1.1 | Underwriting Agreement, dated February 16, 2021 (5) |\\n| 1.2 | Warrant Agreement, including the form of Warrant, made as of February 19, 2021, between the Company and Continental. (6) |\\n| 3.1 | Amended and Restated Certificate of Incorporation filed with the Delaware Secretary of State effective November 4, 2022 (15) |\\n| 3.2 | Amended and Restated Bylaws (1) |\\n| 3.3 | Amendment to the Company’s Amended and Restated Bylaws as approved on July 8, 2019 (4) |\\n| 4.1 | 2016 Stock Option Plan. (2) |\\n| 4.2 | First Amendment to 2016 Stock Option Plan as adopted by the Board of Directors on October 20, 2016. (2) |\\n| 4.3 | 2018 Equity Incentive Plan. (3) |\\n| 4.4 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on May 13, 2019 and the stockholders on July 8, 2019 (4) |\\n| 4.5 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 12, 2021 and the stockholders on August 26, 2021 (14) |\\n| 4.6 | Amendment to the Company’s 2018 Equity Incentive Plan as approved by the Board of Directors on July 1, 2022 and the stockholders on August 30, 2022 (20) |\\n| 4.7 | Underwriters’ Warrant (5) |\\n| 4.8 | Form of Warrant (11) |\\n| 4.9 | Form Amended and Restated Warrant (17) |\\n| 4.10 | Form Warrant (18) |\\n| 4.11 | Form Warrant (21) |\\n| 4.12 | Form Warrant (25) |\\n| 4.13 | Form Warrant (26) |\\n| 10.1 | Employment Agreement by and between the Company and Scott L. Mathis dated September 28, 2015 (24) |\\n| 10.2 | Retention Bonus Agreement by and between the Company and Scott L. Mathis dated March 29, 2020 (7) |\\n| 10.3 | Employment Agreement by and between the Company and its Chief Financial Officer dated December 14, 2022 (23) |\\n| 10.4 | Commercial Lease Agreement between Gaucho Group, Inc. and Design District Development Partners, LLC, dated April 8, 2021 (8) |\\n| 10.5 | Amended and Restated Limited Liability Company Agreement of LVH Holdings LLC, dated June 16, 2021 (9) |\\n| 10.6 | First Amendment to Amended and Restated Limited Liability Agreement dated November 16, 2021 (10) |\\n| 10.7 | Second Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (13) |\\n| 10.8 | Third Amendment to Amended and Restated Limited Liability Agreement dated June 7, 2022 (22) |\\n| 10.9 | Common Stock Purchase Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (19) |\\n| 10.10 | Registration Rights Agreement by and between Gaucho Group Holdings, Inc. and Tumim Stone Capital LLC, dated November 8, 2022 (16) |\\n| 10.11 | Securities Purchase Agreement dated February 21, 2023 (26) |\\n| 10.12 | Form of Senior Secured Convertible Note Issued by the Company (26) |\\n| 10.13 | Form of Security and Pledge Agreement (26) |\\n| 10.14 | Form of Stockholder Pledge Agreement (26) |\\n| 10.15 | Form of Registration Rights Agreement (26) |\\n| 10.16 | Fourth Amendment to Amended and Restated Limited Liability Agreement dated June 30, 2023 (28) |\\n| 10.17 | Letter Agreement, dated as of August 11, 2023, by and among the Company and the subscriber listed therein (29) |\\n| 22.1 | Subsidiary guarantors and issuers of guaranteed securities and affiliates whose securities collateralize securities of the registrant (12) |\\n| 31.1 | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\\n| 31.2 | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* |\\n| 32 | Certification of the Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002** |\\n| 99.1 | Algodon Wine Estates Property Map (27) |\\n| 101.INS | Inline XBRL Instance Document* |\\n| 101.SCH | Inline XBRL Schema Document* |\\n| 101.CAL | Inline XBRL Calculation Linkbase Document* |\\n| 101.DEF | Inline XBRL Definition Linkbase Document* |\\n| 101.LAB | Inline XBRL Label Linkbase Document* |\\n| 101.PRE | Inline XBRL Presentation Linkbase Document* |\\n| 104 | Cover Page Interactive Data File (embedded within the Inline XBRL document) * |\\n\\n\\n| 42 |\\n\\n\\n\\n| 1. | Incorporated by reference from the Company’s Registration of Securities Pursuant to Section 12(g) on Form 10 dated May 14, 2014. |\\n| 2. | Incorporated by reference from the Company’s Annual Report on Form 10-K, filed on March 31, 2017. |\\n| 3. | Incorporated by reference from the Company’s Quarterly Report on Form 10-Q, filed on November 19, 2018. |\\n| 4. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on July 9, 2019. |\\n| 5. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 18, 2021. |\\n| 6. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on February 22, 2021. |\\n| 7. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on April 1, 2020. |\\n| 8. | Incorporated by reference to the Company’s Annual Report on Form 10-K filed on April 12, 2021. |\\n| 9. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q filed on August 16, 2021. |\\n| 10. | Incorporated by reference to the Company’s Current Report on Form 8-K filed on November 17, 2021. |\\n| 11. | Incorporated by reference to the Company’s Current Report on Form 8-K as filed on March 1, 2022. |\\n| 12. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 14, 2022. |\\n| 13. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on June 8, 2022. |\\n| 14. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 31, 2021. |\\n| 15. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 3, 2022. |\\n| 16. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on November 9, 2022. |\\n| 17. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on October 24, 2022. |\\n| 18. | Incorporated by reference to the Company’s Amended Current Report on Form 8-K/A, filed on September 8, 2022. |\\n| 19. | Incorporated by reference to the Company’s Current Report as amended on Form 8-K/A, filed on November 14, 2022. |\\n| 20. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 18, 2022. |\\n| 21. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 1, 2022. |\\n| 22. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 13, 2022. |\\n| 23. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on December 15, 2022. |\\n| 24. | Incorporated by reference to the Company’s Quarterly Report on Form 10-Q, filed on November 16, 2015. |\\n| 25. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\\n| 26. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on February 21, 2023. |\\n| 27. | Incorporated by reference to the Company’s Annual Report on Form 10-K, filed on April 17, 2023. |\\n| 28. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on July 5, 2023. |\\n| 29. | Incorporated by reference to the Company’s Current Report on Form 8-K, filed on August 11, 2023. |\\n| * | Filed herewith. |\\n| ** | Furnished, not filed herewith. |\\n\\n\\n| 43 |\\n\\n\\nSIGNATURES\\nPursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| Date: August 14, 2023 | GAUCHO GROUP HOLDINGS, INC. |\\n| By: |\\n| Scott L. Mathis |\\n| Chief Executive Officer |\\n| By: |\\n| Maria Echevarria |\\n| Chief Financial Officer and Chief Operating Officer |\\n\\n\\n| 44 |\\n\\n\\n</text>\\n\\nIf the company can maintain its current cash inflows and outflows in the future, how many months can the company continue to operate while paying off its convertible debt obligations, excluding the cash requirements for current liabilities and long-term liabilities?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 82.15080622837371.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 42,\n \"input_length\": 38868\n}"}}},{"rowIdx":43,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| March 31, 2021 | December 31, 2020 |\n| ASSETS |\n| Current assets: |\n| Cash | $ | 3,441,841 | $ | 345,982 |\n| Accounts receivable, net allowance for doubtful accounts | 102,020 | 97,073 |\n| Prepaid expenses and other current assets | 408,397 | 207,592 |\n| Assets of discontinued operations | 45,777 | - |\n| Total current assets | 3,998,035 | 650,647 |\n| Lease right of use asset | 3,917,812 | 3,977,988 |\n| Goodwill | 3,431,148 | 3,431,148 |\n| Leasehold improvements, net of accumulated amortization | 2,571,910 | 2,614,391 |\n| Property and equipment, net | 152,376 | 128,475 |\n| Total assets | $ | 14,071,281 | $ | 10,802,649 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities: |\n| Notes payable, net of discounts current | $ | 393,899 | $ | 2,385,010 |\n| Accrued interest, included related party | 95,079 | 48,601 |\n| Accounts payable and accrued expenses | 572,891 | 148,180 |\n| Loan payable – other | 66,851 | 63,907 |\n| Lease liability - current portion | 198,759 | 189,397 |\n| Liability to issue shares of common stock | 2,325,000 | - |\n| Deferred revenue | 25,703 | 25,703 |\n| Liabilities of discontinued operations | 53,929 | - |\n| Total current liabilities | 3,732,111 | 2,860,798 |\n| Lease liability - net of current portion | 3,821,666 | 3,864,321 |\n| Notes payable, net of discounts and current portion | 298,498 | 322,490 |\n| Total liabilities | 7,852,275 | 7,047,609 |\n| Stockholders’ equity: |\n| Common stock, par value $ 0.0001 ; 100,000,000 shares authorized, 35,395,418 and 4,165,418 issued and outstanding at March 31, 2021 and December 31, 2020, respectively | 3,540 | 417 |\n| Additional paid-in capital | 10,500,222 | 7,460,348 |\n| Subscription receivable | - | ( 30 | ) |\n| Accumulated deficit | ( 4,284,756 | ) | ( 3,705,695 | ) |\n| Total stockholders’ equity | 6,219,006 | 3,755,040 |\n| Total liabilities and stockholders’ equity | $ | 14,071,281 | $ | 10,802,649 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-1 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n\n| 2021 | 2020 |\n| For the Three Months Ended March 31, |\n| 2021 | 2020 |\n| Program revenue | $ | 601,115 | $ | - |\n| Rental income | 5,625 | - |\n| Other revenue | 185 | 915 |\n| Net revenue | 606,925 | 915 |\n| Cost of services provided | 232,460 | - |\n| Gross profit | 374,465 | 915 |\n| Operating expenses |\n| Salaries and payroll expense | 293,114 | 245,712 |\n| General and administrative | 298,200 | 99,083 |\n| Lease expense | 141,675 | 24,061 |\n| Professional fees | 95,691 | 62,800 |\n| Marketing and advertising | 5,670 | 12,631 |\n| Depreciation and amortization expense | 50,583 | - |\n| Total operating expenses | 884,933 | 444,287 |\n| Loss from operations | ( 510,468 | ) | ( 443,372 | ) |\n| Other expense |\n| Interest expense | ( 59,516 | ) | ( 3 | ) |\n| Total other expense | ( 59,516 | ) | ( 3 | ) |\n| LOSS FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES AND LOSS FROM DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\n| Income taxes | - | - |\n| LOSS FROM CONTINUING OPERATIONS BEFORE DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\n| LOSS FROM DISCONTINUED OPERATIONS | ( 9,077 | ) | - |\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\n| Loss per share - basic and diluted - Continuing operations | $ | ( 0.08 | ) | $ | ( 0.11 | ) |\n| Loss per share - basic and diluted - Discontinued operations | $ | ( 0.00 | ) | $ | - |\n| Weighted average number of shares outstanding - basic and diluted | 7,288,419 | 4,008,443 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-2 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY\nFOR THE THREE MONTHS ENDED MARCH 31, 2020 AND 2021\n(UNAUDITED)\n\n| Shares | Amount | Capital | Receivable | Deficit | Total |\n| Common Stock | Additional | Total |\n| Number of | paid-in | Subscription | Accumulated | stockholders’ |\n| shares | Amount | Capital | Receivable | deficit | deficit |\n| For the Three Months Ended March 31, 2020 |\n| Balance at December 31, 2019 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,407,760 | ) | 4,210,835 |\n| Collection on subscription receivable |\n| Shares issuable for Banyan Acquisition |\n| Shares issuable for Banyan Acquisition, shares |\n| Net loss for the period | - | - | - | - | ( 443,375 | ) | ( 443,375 | ) |\n| Balance at March 31, 2020 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,851,135 | ) | 3,767,460 |\n| For the Three months ended March 31, 2021 |\n| - | - | - |\n| Balance at December 31, 2020 | 4,165,418 | 417 | 7,460,348 | ( 30 | ) | ( 3,705,695 | ) | 3,755,040 |\n| Collection on subscription receivable | - | - | - | 30 | - | 30 |\n| Shares issued for Acquisition | 31,230,000 | 3,123 | 3,039,874 | - | - | 3,042,997 |\n| Net loss for the period | - | - | - | ( 579,061 | ) | ( 579,061 | ) |\n| Balance at March 31, 2021 | 35,395,418 | 3,540 | 10,500,222 | - | ( 4,284,756 | ) | 6,219,006 |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-3 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| 2021 | 2020 |\n| For the Three Months Ended March 31, |\n| 2021 | 2020 |\n| Cash flows from operating activities |\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\n| Adjustments to reconcile net loss to cash used in operating activities: |\n| Net loss from discontinued operations | ( 9,077 | ) | - |\n| Non-cash operating lease expense | 26,883 | ( 4,070 | ) |\n| Depreciation and amortization | 50,583 | - |\n| (Increase) decrease in assets |\n| Prepaid expenses | ( 200,805 | ) | 4,564 |\n| Accounts receivable | ( 4,947 | ) | - |\n| Increase (decrease) in liabilities |\n| Accounts payable | - | ( 13,420 | ) |\n| Accrued payroll and other expenses | 441,940 | 28,544 |\n| Accrued interest | 46,478 | - |\n| Cash used in operating activities | ( 228,006 | ) | ( 427,757 | ) |\n| Cash flows from investing activities |\n| Cash from acquisition | 3,042,997 | - |\n| Purchase of property and equipment | ( 32,003 | ) | - |\n| Cash provided by investing activities | 3,010,994 | - |\n| Cash flows from financing activities |\n| Repayment of principal on notes payable to individuals and companies | ( 15,103 | ) | - |\n| Proceeds from the sale of common stock issued and issuable | 325,030 | 139 |\n| Proceeds from other notes payable | 2,944 | 11,746 |\n| Cash provided by financing activities | 312,871 | 11,885 |\n| Net increase (decrease) in cash | 3,095,859 | ( 415,872 | ) |\n| Cash, beginning of year | 345,982 | 4,044,700 |\n| Cash, end of period | $ | 3,441,841 | $ | 3,628,828 |\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\n| Interest paid | $ | 13,037 | $ | - |\n| Taxes paid |\n| NON-CASH ITEMS |\n| Recognition of lease liability and right of use asset at inception | $ | - | $ | 1,897,995 |\n| Conversion of notes payable and accrued interest for common stock | $ | 2,000,000 | $ | - |\n\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\n\n| F-4 |\n\nASSISTED 4 LIVING, INC.\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nNOTE 1 – ORGANIZATION AND DESCRIPTION OF BUSINESS\nAssisted 4 Living, Inc. (“the Company,” “we”, “our” or “us”) was incorporated in the state of Nevada on May 24, 2017 and is based in Sarasota, Florida. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”), and the Company’s fiscal year end is December 31.\nAs discussed in NOTE 4, on March 23, 2021, we entered into a Plan of Merger with our wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”) and Banyan Pediatric Care Centers, Inc. (“Banyan”). Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger (the “Surviving Entity”) and becoming a wholly-owned subsidiary of the Company (the “Merger”). Pursuant to the Merger, we succeeded to the business of Banyan. The Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for financial reporting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan before the Merger in this Quarterly Report and future filings with the SEC\nThrough Banyan, we operate three pediatric extended care centers (“PPECs”) is southwest Florida. A PPEC is a nurse-staffed pediatric day care center for medically complex children age birth to 21 years. Our staff includes Registered Nurses (RNs), Licensed Practical Nurses (LPNs), Certified Nursing Assistants (CNAs) and Caregivers, who attend to the children’s medical conditions throughout the day in classroom, dining, play, and clinical settings. Banyan is fully licensed and accepts Florida Medicaid.\nWe are headquartered at 6801 Energy Court, Suite 201 Sarasota, Florida 34240.\nThe corporate website is www.assisted4living.com.\nCOVID-19\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and are taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with GAAP for interim financial statements and with the instructions to Form 10-Q and Regulation S-X of the United States Securities and Exchange Commission (“SEC”). Accordingly, they do not contain all information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements.\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all the adjustments necessary (consisting only of normal recurring accruals) to present the financial position of the Company as of March 31, 2021 and the results of operations and cash flows for the periods presented. The results of operations for the three months ended March 31, 2021 are not necessarily indicative of the operating results for the full fiscal year or any future period. These unaudited condensed consolidated financial statements should be read in conjunction with the condensed consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on March 1, 2021. As of March 23, 2021 we had discontinued operations reflected in the accompanying unaudited condensed consolidated financial statements. As a result of the Plan of Merger completed on March 23, 2021 (see NOTE 4) we have changed our year end reporting period from November to December.\n\n| F-5 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nBasis of Consolidation\nThese condensed consolidated financial statements include the accounts of the Company and the wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St. Petersburg, LLC, Banyan Pediatric Care Centers, - Pasco, LLC and Banyan Pediatric Care Centers – Sarasota, LLC and the discontinued operations of Assisted 2 Live, Inc., the wholly owned subsidiary that was discontinued as of March 23, 2021. All material intercompany balances and transactions have been eliminated.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less to be cash equivalents. The Company had no cash equivalents at March 31, 2021 and December 31, 2020.\nAccounts Receivable\nAccounts receivable primarily consists of amounts due from third-party payers (non-governmental), governmental payers and private pay patients and is recorded net of allowances for doubtful accounts and contractual discounts. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Accordingly, accounts receivable reported in the Company’s condensed consolidated financial statements is recorded at the net amount expected to be received. The Company’s primary collection risks are (i) the risk of overestimation of net revenues at the time of billing that may result in the Company receiving less than the recorded receivable, (ii) the risk of non-payment as a result of commercial insurance companies’ denial of claims, (iii) the risk that patients will fail to remit insurance payments to the Company when the commercial insurance company pays out-of-network claims directly to the patient, (iv) resource and capacity constraints that may prevent the Company from handling the volume of billing and collection issues in a timely manner, (v) the risk that patients do not pay the Company for their self-pay balances (including co-pays, deductibles and any portion of the claim not covered by insurance) and (vi) the risk of non-payment from uninsured patients.\nThe Company’s accounts receivable from third-party payers are recorded net of estimated contractual adjustments and allowances from third-party payers, which are estimated based on the historical trend of the Company’s facilities’ cash collections and contractual write-offs, accounts receivable aging, established fee schedules, relationships with payers and procedure statistics. While changes in estimated reimbursement from third-party payers remain a possibility, the Company expects that any such changes would be minimal and, therefore, would not have a material effect on the Company’s financial condition or results of operations. The Company’s collection policies and procedures are based on the type of payor, size of claim and estimated collection percentage for each patient account. The Company analyzes accounts receivable at each of the facilities to ensure the proper collection and aged category. The operating systems generate reports that assist in the collection efforts by prioritizing patient accounts. Collection efforts include direct contact with insurance carriers or patients and written correspondence.\nAllowance for Doubtful Accounts, Contractual and Other Discounts\nManagement estimates the allowance for contractual and other discounts based on its historical collection experience and contracted relationship with the payers. The services authorized and provided and related reimbursement are often subject to interpretation and negotiation that could result in payments that differ from the Company’s estimates. The Company’s allowance for doubtful accounts is based on historical experience, but management also takes into consideration the age of accounts, creditworthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. An account may be written-off only after the Company has pursued collection efforts or otherwise determines an account to be uncollectible. Uncollectible balances are written-off against the allowance. Recoveries of previously written-off balances are credited to income when the recoveries are made.\nFair Value of Financial Instruments\nThe carrying amount of accounts receivable and accounts payable approximate their respective fair values due to the short- term nature. The carrying amount of the line of credit and note payable approximates fair values due to their market interest rates. Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable.\nProperty and Equipment\nProperty and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Depreciation of owned assets and amortization of leasehold improvements are computed using the straight-line method over the shorter of the estimated useful lives of the related assets or the lease term. The cost of assets sold or retired, and the related accumulated depreciation are removed from the accounts and any resulting gains or losses are reflected in other income (expense) for the year. Expenditures for maintenance and repairs are charged to expense as incurred.\n\n| F-6 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nGoodwill\nOur goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in business combinations. The goodwill generated from the business combinations is primarily related to the value placed on the employee workforce and expected synergies. Judgment is involved in determining if an indicator or change in circumstances relating to impairment has occurred. Such changes may include, among others, a significant decline in expected future cash flows, a significant adverse change in the business climate, and unforeseen competition. There was no goodwill impairment for the years presented.\nThe Company tests goodwill for impairment on an annual basis, and when events or circumstances indicate the fair value of a reporting unit may be below its carrying value.\nLong-Lived Assets\nLong-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. There were no impairments of long-lived assets for the years presented.\nAdvertising and Marketing\nThe Company uses advertising and marketing to promote its services. Advertising and marketing costs are expensed as incurred.\nNet Loss Per Share\nBasic net loss per common share is computed by dividing net loss applicable to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net loss per common share is determined using the weighted-average of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents, consisting of the conversion option embedded in convertible debt. The weighted-average number of common shares outstanding excludes common stock equivalents because their inclusion would have an anti-dilutive effect.\nIncome Taxes\nThe Company uses the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are determined based on differences between financial reporting and the tax basis of assets, liabilities, the carry forward of operating losses and tax credits, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. An allowance against deferred tax assets is recorded when it is more likely than not that such tax benefits will not be realized.\nAny future benefit arising from losses have been offset by a valuation allowance. Accordingly, no provision for income taxes is reflected in the condensed consolidated financial statements. The Company records a liability for uncertain tax positions when it is probable that a loss has been incurred and the amount can be reasonably estimated. Interest and penalties related to income tax matters, if any, would be recognized as a component of income tax expense. At March 31, 2021 and December 31, 2020, the Company had no liabilities for uncertain tax positions. The Company continually evaluates expiring statutes of limitations, audits, proposed settlements, changes in tax law and new authoritative rulings. Currently, the tax years subsequent to 2017 are open and subject to examination by the taxing authorities.\n\n| F-7 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\nUse of Estimates and Assumptions\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. The estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ from these good faith estimates and judgments.\nRevenue Recognition\nWe follow ASC 606, “Revenue from Contracts with Customers.” Revenues are recognized when promised goods or services are transferred to a customer, in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. We derive our revenues from the rendering of services, such as skilled nursing services. The five-step model defined by ASC 606 requires us to: (i) identify our contracts with customers, (ii) identify our performance obligations under those contracts, (iii) determine the transaction prices of those contracts, (iv) allocate the transaction prices to our performance obligations in those contracts and (v) recognize revenue when each performance obligation under those contracts is satisfied.\nReimbursement rates to provide skilled nursing services in our PPEC facilities are determined by the Medicaid program. Fees are billed to the Medicaid program and other payors weekly following the Medicaid billing guidelines.\nReclassification\nCertain amounts from prior periods have been reclassified to conform to the current period presentation.\nNOTE 3 – ACCRUED LIABILITIES\nOur accrued liabilities at March 31, 2021 and December 31, 2020 consisted of the following:\nSCHEDULE OF ACCRUED LIABILITIES\n| March 31, 2021 | December 31, 2020 |\n| Accounts payable | $ | 70,675 | $ | 16,298 |\n| Credit card | - | 1,050 |\n| Accrued expenses | 354,193 | 130,832 |\n| Accrued salary | 139,952 | - |\n| Payroll tax payable | 8,070 | - |\n| Accrued Liabilities | $ | 572,890 | $ | 148,180 |\n\n\n| F-8 |\n\nNOTE 4 – BANYAN MERGER\nOn March 23, 2021, we entered into a Plan of Merger with Merger Sub and Banyan. Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan as the Surviving Entity and wholly-owned subsidiary of the Company. The Merger was effective on March 23, 2021.\nThe Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for accounting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan.\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock. We also issued a warrant to purchase 75,000 shares of our common stock (the “Warrant”) in exchange for a warrant to purchase 900,000 shares of Banyan’s common stock. The Warrant is held by one investor and is exercisable for cash only until May 2, 2030 at an exercise price of $ 0.38 per share. The number of shares of common stock deliverable upon exercise of the Warrant contains provisions for standard anti-dilution adjustments.\nThe Surviving Entity assumed Banyan’s $ 2,300,000 of outstanding debt, and the $ 2,000,000 of such debt that was convertible into 20,000,000 shares of Banyan common stock was converted at $ 0.50 per share into 4,000,000 shares of our common stock, effective as of March 30, 2021. The remaining $ 300,000 of outstanding debt, evidenced by a promissory note dated November 6, 2020 (the “Note”), accrues interest at the annual rate of 12 %. Interest is payable on the sixth day of each month in the amount of $ 3,000 until the maturity date of the Note on November 6, 2021 , at which time, the remaining principal balance, if any, is due and payable.\n\n| F-9 |\n\nNOTE 5 – DISCONTINUED OPERATIONS\nOn April 30, 2021, our Board of Directors (the “Board”) approved the discontinuance of our wholly-owned subsidiary, Assisted 2 Live, Inc. (the “Discontinued Subsidiary”). The operations of the Discontinued Subsidiary are reflected on our condensed consolidated statement of operations from the date of the Merger as a loss from discontinued operations in the amount of $ 9,077 .\nThe April 30, 2021 Board decision was the result of the Purchase and Sale Option Agreement (the “Option Agreement”) with Romulus Barr (“Barr”) which we entered into on November 7, 2020. The Option Agreement provided us with the option to sell all of our interest in Assisted 2 Live, Inc., consisting of 1,000 shares of common stock of the Discontinued Subsidiary, to Barr in exchange for 200,000 shares of our common stock (the “Shares”) held by Barr. The returned Shares were cancelled, and included in authorized but unissued shares of common stock of the Company. The number of issued and outstanding shares of common stock was decreased by 200,000 as of April 30, 2021.\nThe following table presents the aggregate carrying amounts of the classes of assets and liabilities of discontinued operations for the three months ended:\nSUMMARY OF CARRYING AMOUNTS OF ASSETS AND LIABILITIES AND CASH FLOWS OF DISCONTINUED OPERATIONS\n| March 31, 2021 | December 31, 2020 |\n| Current assets of discontinued operations | $ | 15,928 | $ | - |\n| Non-current assets of discontinued operations | 29,849 | - |\n| $ | 45,777 | $ | - |\n| Current liabilities of discontinued operations | $ | 53,929 | $ | - |\n| $ | 53,929 | $ | - |\n\nThe following table presents cash flows of discontinued operations for the three months ended March 31:\n\n| 2021 | 2020 |\n| Net cash used in discontinued operating activities | $ | ( 14,386 | ) | $ | - |\n| Net cash from discontinued investing activities | - | - |\n| Net cash from discontinued financing activities | - | - |\n| $ | ( 14,386 | ) | $ | - |\n\n\n| Three months ended March 31, |\n| 2021 | 2020 |\n| Net revenues | $ | 5,362 | $ | - |\n| Cost of net revenues | - | - |\n| Gross profit | 5,362 | - |\n| Operating expenses: |\n| Salary and tax expense | 12,890 | - |\n| General and administrative | 763 | - |\n| Lease expense | 733 | - |\n| Total operating expenses | 14,386 | - |\n| Income from operations of discontinued operations | ( 9,024 | ) | - |\n| Interest and other, net | ( 53 | ) | - |\n| Income from discontinued operations before income taxes | ( 9,077 | ) | - |\n| Provision for income taxes | - | - |\n| Income from discontinued operations, net of income taxes | $ | ( 9,077 | ) | $ | - |\n\n\n| F-10 |\n\nNOTE 6 – NOTES PAYABLE\nNotes payable at March 31, 2021 and December 31, 2020 consisted of the following:\nSCHEDULE OF NOTES PAYABLE\n| March 31, 2021 | December 31, 2020 |\n| (Unaudited) |\n| a. Excel Family Partners, LLLP / Banyan Pediatric Investment, Inc. (Sep 2020) | $ | - | $ | 2,000,000 |\n| b. NuView Trust Co. (Nov 2020) | 300,000 | 300,000 |\n| c. Grand Trinity Plaza, LLC (Dec 2020) | 392,397 | 407,500 |\n| $ | 692,397 | $ | 2,707,500 |\n\n\n| a) | On September 18, 2020, through Banyan, we entered into a Convertible Note and Securities Purchase Agreement with two investors for the aggregate principal in the amount of $ 2,000,000 . The note had a maturity date of September 18, 2022 and an interest rate of 8 % to be paid quarterly. The principal was funded by two investors (“Purchasers”), both related parties. Excel Family Partners, LLLP invested $ 1,500,000 and Banyan Pediatric Investments, LLC invested $ 500,000 . The proceeds of this note were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. Written consent from shareholders holding a majority of the issued and outstanding shares of common stock of Banyan was obtained, not including such shares currently held by the Purchasers or their affiliates, consenting to the note contemplated hereby, in a form and substance acceptable to the Purchasers, in their respective reasonable discretion. Both Purchasers were permitted to convert their respective portions of the note at a conversion price of $ 0.10 per share. Subsequent to the Merger (see NOTE 4), the Board revised the conversion price of the note to $ 0.50 per share. Effective March 30, 2021 the Purchasers exercised their right to convert all outstanding principal. As of March 31, 2021 and December 31, 2020, there was $ 90,740 and $ 45,589 of accrued interest, respectively and is reflected in accrued interest balances on the condensed consolidated balance sheet at March 31, 2021 and December 31, 2020. |\n\n\n| b) | On November 6, 2020, through Banyan, we entered into a one-year note in the principal amount of $ 300,000 with NuView Trust Company. The note has a 12 % interest rate with interest only payments until date of maturity. The proceeds of this no were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. As of March 31, 2021 and December 31, 2020 there was no accrued interest. (see NOTE 4) |\n\n\n| c) | On December 15, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into a note payable with Grand Trinity Plaza, LLC in the principal amount of $ 407,500 , which is guaranteed by Banyan. The term of the note is 48 months with an interest rate of 6 %. The maturity date of the note is January 1, 2025 . The note is in conjunction with the 84 -month facility lease for the Pasco County location, pursuant to which the landlord also provided the construction of the buildout and financed $ 407,500 of the construction costs. |\n\nNOTE 7 – LEASEHOLD IMPROVEMENTS\nThe Company had the following leasehold improvements as of March 31, 2021 and December 31, 2020:\nSCHEDULE OF LEASESHOLD IMPROVEMENTS\n| March 31, 2021 | December 31, 2020 | Amortization Period |\n| Leasehold improvements | $ | 2,669,047 | $ | 2,669,047 | 15 - 17 years |\n| Less: amortization | ( 97,137 | ) | ( 54,656 | ) |\n| Net | $ | 2,571,910 | $ | 2,614,391 |\n\nDuring the year ended December 31, 2020, we recorded $ 2,669,047 of leasehold improvements. These amounts include costs related to the build out of the Sarasota location in the amount of $ 1,245,950 . These costs will be amortized over the expected term of the lease including extensions that management expects to be 15 years. We also recorded costs in the amount of $ 1,021,793 related to the New Port Richey location buildout. The expected amortization of the improvements for the New Port Richey location is 17 years. Also recorded were $ 401,303 of improvements as part of the St. Petersburg-Kidz Club Acquisition. The expected amortization of the improvements for the St. Petersburg location is 15 years.\nAmortization expense for the three months ended March 31, 2021 and 2020 was $ 42,481 and $ 0 , respectively.\n\n| F-11 |\n\nNOTE 8 – OPERATING LEASES\nOn August 24, 2019, through Banyan Pediatric Care Centers-Sarasota, LLC, we entered into an operating lease with Northeast Plaza Venture I, LLC for the premises located in the Northeast Plaza Shopping Center located on the Northeast corner of 17th Street & Lockwood Ridge Road, in the County of Sarasota, Florida. The initial term of the lease is five years with minimum annual rent of $ 180,000 . The landlord granted rent abatement for this lease until February 24, 2020 . The lease end date, including two successive 5 -year renewal options, is January 31, 2035. A right of use asset and lease liability in the amount of $ 1,899,869 associated with this lease was recognized. This lease is treated as an operating lease for accounting purposes.\nOn October 15, 2019, through Banyan, we entered into an assignment and assumption of lease agreement with The Kidz Club – St. Pete, LLC whereby we assumed approximately 12,137 square feet of space at the southeast corner of 3rd Avenue S. and 9th Street N., Webb’s Plaza, St. Petersburg, FL 33701. The minimum annual rent for the first year of the lease was $ 113,681 . The current lease termination date, with extensions expected to be exercised, is October 31, 2024 . Upon the exercise of each extension the base rent shall increase by 1.5 %. This assignment of lease was subject to the terms of the Asset Purchase Agreement with The Kidz Club-St. Pete, LLC. A right of use asset and lease liability in the amount of $ 875,539 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nEffective April 1, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into an 84 -month facility lease with Grand Trinity Plaza, LLC for the premises located in the shopping center known as the Grand Trinity Plaza located in New Port Richey, Florida. The initial term of the lease had a minimum annual base rent of $ 94,500 . The landlord granted rent abatement until September 2020. The lease end date, including two successive 5 -year renewals is August 31, 2037. A right of use asset and lease liability in the amount of $ 1,143,743 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn June 9, 2020, through Banyan, we entered into a 63 -month copier lease with Dex Imaging. The lease was for one copier and a printer. The minimum annual lease payment is $ 5,376 with annual increases not to exceed 12 % annually. This lease will auto renew in 12 -month increments. The equipment under this lease has a fixed $1 payment buyout option . This equipment was purchased for the St. Petersburg location. A right of use asset and lease liability in the amount of $ 16,066 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn August 25, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for two 2020 Turtletop Terra Transit passenger buses for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 24,859 . At our discretion, we may exercise a purchase option, by giving written notice no later than 30 days but not more than 120 days before the expiration of the initial term. The purchase option price is $ 23,920 for each bus, based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 102,393 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nOn October 20, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for a 2020 Eldorado National Advance 220 p/t 14 passenger bus for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 13,381 . At our discretion, we may exercise a purchase option, by giving written notice no later than 180 days but not more than 360 days before the expiration of the initial term. The purchase option price is $ 12,891 based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 55,345 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\nIn accordance with ASC 842, we recorded the operating lease right of use asset and lease liability as follows:\nSCHEDULE OF OPERATING LEASE RIGHT OF USE ASSET AND LEASE LIABILITY\n| March 31, 2021 | December 31,2020 |\n| Right of Use (ROU) asset | $ | 3,917,812 | $ | 3,977,988 |\n\n\n| March 31, 2021 | December 31, 2020 |\n| Operating lease liability: |\n| Current | $ | 198,759 | $ | 189,397 |\n| Non-Current | 3,821,666 | 3,864,321 |\n| Total | $ | 4,020,425 | $ | 4,053,718 |\n\n\n| F-12 |\n\nNOTE 8 – OPERATING LEASES (CONTINUED)\nMaturity of Operating Lease Liability for fiscal year ended December 31,\nSCHEDULE OF MATURITY OF OPERATING LEASE LIABILITY\n| 2021 |\n| 2021 (nine months) | $ | 156,105 |\n| 2022 | 213,747 |\n| 2023 | 232,829 |\n| 2024 | 251,264 |\n| 2025 | 267,134 |\n| After 2025 | 2,899,346 |\n| Total lease liability | $ | 4,020,425 |\n\nInformation associated with the measurement of our remaining operating lease obligations as of March 31, 2021 is as follows:\nThe operating leases range from a term of 2.48 years to 16.68 years with a weighted average lease term of 13.35 years.\nThe weighted average discount rate is 6.07 %.\nThe lease expense for the three months ended March 31, 2021 and 2020 was $ 141,675 and $ 24,061 , respectively.\nNOTE 9 - EQUITY\nPreferred Stock\nWe have authorized 25,000,000 preferred shares with a par value of 0.0001 per share. The Board is authorized to divide the authorized preferred shares into one or more series, each of which shall be so designated as to distinguish the shares thereof from the shares of all other series and classes. As of March 31, 2021 and December 31, 2020, we had no classes of preferred shares designated.\nCommon Stock\nWe have authorized 100,000,000 common shares with a par value of $ 0.0001 per share. Each common share entitles the holder to one vote, in person or proxy, on any matter on which action of the stockholders of the corporation is sought. As of March 31, 2021, we had 35,395,418 common shares issued and outstanding.\n\n| F-13 |\n\nNOTE 9 – EQUITY (CONTINUED)\nFiscal Year 2021\nOn March 23, 2021, we entered into a Plan of Merger with Banyan (See NOTE 4).\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock.\nIn conjunction with the Merger, the previously issued 31,230,000 shares of common stock of the Company prior to the Merger were deemed issued for the Merger.\nDuring the period of February 11, 2021 through March 31, 2021 we issued shares of common stock at $ 0.50 per share for an aggregate consideration of $ 3,540,000\nOn March 31, 2021, we had recorded a liability to issue shares in the amount of $ 325,000 to record stock purchases of 650,000 common shares at $ 0.50 per share that were to be issued in the following month, April 2021. On March 30, 2021, the Noteholders of the $ 2,000,000 convertible note exercised their right to convert the note (see NOTE 4). The shares were not issued as of March 31,2021. The conversion was recorded as a liability to issue shares in the amount of $ 2,000,000 , as reflected on our condensed consolidated balance sheet.\nFiscal Year 2020\nDuring the year ended December 31, 2020, $ 140 was received against a subscription receivable balance for the 2019 authorization of the issuance of Founders shares. On December 31, 2020, we had a subscription receivable of $ 30 for shares issued where payments were not received.\nOn September 19, 2020, we issued 2,000,000 restricted common shares to a noteholder for the conversion of $ 500,000 of note principal.\nWarrants\nIn association with the September 27, 2019 Asset Purchase Agreement (The Kidz Club St Pete, LLC), we issued 75,000 common stock warrants (post-merger exchange adjusted) having an exercise price of $ 0.38 per share. These warrants have an expiration of September 27, 2029 .\nSCHEDULE OF WARRANTS OUTSTANDING\n| Weighted |\n| Weighted- | Average |\n| Average | Remaining | Aggregate |\n| Exercise | Contractual | Intrinsic |\n| Shares | Price | Term | Value |\n| Outstanding at January 1, 2020 | - | - | - | $ | - |\n| Granted | 75,000 | $ | 0.38 | 10.0 Years | $ | - |\n| Expired | - | - | - |\n| Exercised | - | - | - |\n| Outstanding at December 31, 2020 | 75,000 | $ | 0.38 | 9.74 Years | $ | - |\n| Outstanding at January 1, 2020 | 75,000 | 0.38 | 9.74 Years | - |\n| Granted | - | - | - |\n| Expired | - | - | - |\n| Exercised | - | - | - |\n| Outstanding and exercisable March 31, 2020 | 75,000 | $ | 0.38 | 9.49 Years | $ | - |\n\n\n| F-14 |\n\nNOTE 10 – RELATED PARTY TRANSACTIONS\nOn February 1, 2021 (the “Effective Date”), we signed an employment agreement with our new CEO, Louis Collier (“Collier”). Collier will be paid a base salary of $ 400,000 , which will be reassessed and renegotiated in good faith after we are profitable over a fiscal year. Collier will also receive a signing bonus of $ 150,000 , which will be payable as follows: $ 50,000 within five days of the Effective Date (paid); $ 50,000 within 90 days of the Effective Date; and $ 50,000 within 180 days of the Effective Date. Collier will also be issued 1,250,000 phantom shares within ten days after the approval and adoption a Phantom Equity Plan. The phantom shares will be subject to a phantom unit interest award agreement, which will set forth the vesting of the phantom shares.\nOn March 23, 2021, we entered into a Plan of Merger (See NOTE 4) whereas we assumed debt of $ 2,000,000 that was convertible into 20,000,000 shares of common stock. After the Merger the debt was converted into 4,000,000 restricted common shares of the Company at $ 0.50 per share. One of the debt holders is majority owned by a director of the Company. As of March 31, 2021, these shares were not issued and are reflected as share liability on our condensed consolidated balance sheet.\nDuring the three months ended March 31, 2021 and 2020, we compensated members of the Board $ 20,769 and $ 0 , respectively.\nAs of March 31, 2021, we had accrued payroll of $ 60,000 and accrued interest on that payroll in the amount of $ 4,340 for the President and the Chief Financial Officer of Banyan. These unpaid amounts were the result of 2020 furloughed salaries. Interest is being accrued on these unpaid balances effective May 15, 2020 at a rate of 8 % per annum and is reflected in accrued interest balance as of March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet. Accrued salaries of $ 60,000 is reflected in accrued liabilities at March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet.\nNOTE 11 – SUBSEQUENT EVENTS\nWe have evaluated subsequent events from March 31, 2021 through the date these financial statements were issued and determined the following events require disclosure:\nSubsequent to March 31, 2021, we issued additional shares of restricted common stock as follow: (i) 1,150,000 shares to five (5) investors at a price of $ 0.50 per share for aggregate proceeds of $ 575,000 , including $ 325,000 issuance to satisfy the liability to issue shares; and (ii) 4,000,000 shares for note conversion.\nOn April 30, 2021, pursuant to the Option Agreement, the number of issued and outstanding shares of common stock was decreased by 200,000 (see NOTE 5).\nDiscontinued Operations\nSee NOTE 5 – DISCONTINUED OPERATIONS regarding the discontinuance of the operations in our wholly-owned subsidiary, Assisted 2 Live, Inc.\nTrillium Healthcare Group, LLC\nOn April 29, 2021, we entered into a Third Amendment (the “Third Amendment”) to a Membership Interest Purchase Agreement dated as of January 29, 2021 (the “Purchase Agreement”), by and among the Company, Richard T. Mason (“Mason”), G. Shayne Bench (“Bench”) and Trillium Healthcare Group, LLC, a Florida limited liability company (“Trillium”) to acquire all of the issued and outstanding ownership interests of Fairway Healthcare Properties, LLC and Trillium Healthcare Consulting, LLC from Trillium.\nAmong other things, the Third Amendment extends the date to May 28, 2021, after which either party may terminate the Purchase Agreement if the closing has not yet occurred.\n\n| F-15 |\n\n\nThe following discussion and analysis of our results of operations and financial condition for period ended March 31, 2021, should be read in conjunction with our consolidated financial statements and the related notes and the other financial information that are included elsewhere in this Quarterly Report. This discussion includes forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Forward-looking statements are based upon estimates, forecasts, and assumptions that are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors. We use words such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions to identify forward-looking statements.\nAs used in this quarterly report, the terms “we,” “us,” “our” and the “Company” means, collectively, Assisted 4 Living, Inc. (“A4L””) and its wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St Petersburg, LLC, Banyan Pediatric Care Centers – Sarasota, LLC and Banyan Pediatric Care Centers – Pasco, LLC, unless otherwise indicated.\nGeneral Overview\nA4L was incorporated in Nevada on May 24, 2017, with an objective to operate as a facilitator of assisted living projects and related services. On March 23, 2021, A4L entered into a Plan of Merger (the “Plan of Merger”) with its wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”), and Banyan Pediatric Care Centers, Inc., a Florida corporation (“Banyan”).\nUnder the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger and becoming a wholly-owned subsidiary of A4L (the “Merger”).\nA4L also had a wholly-owned subsidiary, Assisted 2 Live, Inc., a Florida corporation (“A2L”), which was incorporated on June 15, 2017. On April 30, 2021, the Board of Directors of A4L approved the discontinuance of the operations in A2L. The operations of A2L are reflected on our condensed consolidated statement of operations for the last eight days of the three month period ended March 31, 2021 as a loss from discontinued operations.\nOur principal executive office is located at 6801 Energy Court, Suite 201 Sarasota, Florida 34240 and our telephone number is (855) 668-3331. Our office is provided to us at no charge by our largest shareholder and former President. Our corporate website is www.assisted4living.com.\nWe have not been subject to any bankruptcy, receivership or similar proceeding.\n\n| 3 |\n\nOur Current Business\nBanyan was organized under the laws of the State of Florida on January 15, 2019 for the purpose of providing health care services for medically fragile and chronically ill children. Specifically, to open and operate Prescribed Pediatric Extended Care (“PPEC”) centers in the State of Florida. Our PPEC centers provide, among other services, daily medical care for medically fragile and chronically ill children whose current locations are in Florida.\nPPEC centers provide up to 12 hours of daily care for families struggling with the unique and complex medical needs of their children and allow the parents of children with special needs some independence and the opportunity to still pursue their professional goals.\nOn May 1, 2020, we acquired a PPEC facility located in St. Petersburg, FL. The facility is licensed to provide PPEC services for up to 81 children. All State and County accreditations to run the facility through January 2022 are in place.\nOn October 12, 2019, we entered into a lease for commercial real estate in New Port Richey Florida. The lease commenced on September 1, 2020 with an initial term of 7 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\nOn August 24, 2019, we entered into a lease for commercial real estate in Sarasota Florida. The lease commenced on February 1, 2020 with an initial term of 5 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\nRegulatory Matters\nHealth care operations are highly regulated by both state and federal government agencies. Regulation of health care services is an ever-evolving area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws, statutes, regulations and interpretive guidance occur frequently. In addition, government agencies may impose taxes, fees or other assessments upon Banyan at any time.\nBanyan is also subject to certain state laws prohibiting the payment of remuneration for patient or business referrals and the provision of services where a financial relationship exists between a referring person or entity and the entity providing the service. Federal laws governing our activities include regulation under the Medicare and Medicaid programs. Federal fraud and abuse laws prohibit or restrict, among other things, the payment of remuneration to parties in a position to influence or cause the referral of patients or business, as well as the filing of false claims. Government enforcement authorities have become increasingly active in recent years in their review and scrutiny of various sectors of the health care industry.\nChanges in or new interpretations of these laws could have an adverse effect on our methods and costs of doing business. Further, failure by Banyan to comply with such laws could adversely affect the ability to continue to provide, or receive reimbursement for, our services, and could subject Banyan and its officers and employees to civil and criminal penalties. There can be no assurance that Banyan will not encounter regulatory impediments that could adversely affect the ability to open facilities or to expand the services currently planned to provide at the facilities.\n\n| 4 |\n\nHIPAA, HITECH Act, State Privacy Laws and Breach Notification Laws.\nHIPAA and the regulations adopted under HIPAA are intended to improve the portability and continuity of health insurance coverage and simplify the administration of health insurance claims and related transactions.\nThe HITECH Act modified certain provisions of HIPAA by, among other things, extending the privacy and security provisions to business associates, mandating new regulations around electronic health records, expanding enforcement mechanisms, and increasing penalties for violations.\nOn January 25, 2013, the U.S. Department of Health and Human Services (“HHS”), as required by the HITECH Act, issued the Final Omnibus Rules that provide final modifications to HIPAA rules to implement the HITECH Act.\nThe HITECH Act also contains a number of provisions that provide incentives for states to initiate certain programs related to health care and health care technology, such as electronic health records. While provisions such as these will not apply to us directly, states wishing to apply for grants under the HITECH Act, or otherwise participating in such programs, may impose new health care technology requirements on us through our expected contracts with state Medicaid agencies.\nAll health plans are considered covered entities subject to HIPAA. HIPAA generally requires health plans, as well as their providers and vendors, to: (1) protect patient privacy and safeguard individually identifiable health information; and (2) establish the capability to receive and transmit electronically certain administrative health care transactions, such as claims payments, in a standardized format.\nSpecifically, the HIPAA Privacy Rule regulates use and disclosure of individually identifiable health information, known as “protected health information” (“PHI”). The HIPAA Security Rule requires covered entities to implement administrative, physical and technical safeguards to protect the security of electronic PHI. Certain provisions of the security and privacy regulations apply to business associates (entities that handle PHI on behalf of covered entities), and business associates are subject to direct liability for violation of these provisions. Furthermore, a covered entity may be subject to penalties as a result of a business associate violating HIPAA, if the business associate is found to be an agent of the covered entity.\nCovered entities must report breaches of unsecured PHI to affected individuals without unreasonable delay, but not to exceed 60 days of discovery of the breach by a covered entity or its agents. Notification must also be made to HHS and, in certain situations involving large breaches, to the media. HHS is required to publish on its website a list of all covered entities that report a breach involving more than 500 individuals. All non-permitted uses or disclosures of unsecured PHI are presumed to be breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised. Various state laws and regulations may also require us to notify affected individuals in the event of a data breach involving individually identifiable information.\nHIPAA violations by covered entities may result in civil and criminal penalties. Covered entities could face civil monetary penalties up to an annual maximum of $1,500,000 for uncorrected violations based on willful neglect. HHS enforces the regulations and performs audits to confirm compliance. Investigations of violations that indicate willful neglect, for which penalties are mandatory, are statutorily required. HHS may also resolve HIPAA violations through informal means, such as allowing a covered entity to implement a corrective action plan, but HHS has the discretion to move directly to impose monetary penalties and is required to impose penalties for violations resulting from willful neglect. In addition, state attorneys general are authorized to bring civil actions seeking either injunctions or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.\nBanyan enforces a HIPAA compliance plan, which complies with the HIPAA privacy and security regulations. Banyan also has dedicated resources to monitor compliance with our HIPAA compliance program.\n\n| 5 |\n\nBanyan, its providers, and certain of its vendors are also subject to numerous other privacy and security laws and regulations at the federal and state levels. Banyan remains subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These laws vary and violations may result in additional penalties.\nFraud and Abuse Laws. Federal and state enforcement authorities have prioritized the investigation and prosecution of health care fraud, waste and abuse. Fraud, waste and abuse prohibitions encompass a wide range of operating activities, including kickbacks or other inducements for referral of members, billing for unnecessary medical services by a provider and improper marketing and violation of patient privacy rights. Companies involved in public health care programs such as Medicaid and Medicare are required to maintain compliance programs to detect and deter fraud, waste and abuse, and are often the subject of fraud, waste and abuse investigations and audits. The regulations and contractual requirements applicable to participants in these public-sector programs are complex and subject to change. Although Banyan has structured a compliance program with care in an effort to meet all statutory and regulatory requirements, our policies and procedures will be continuously under review and subject to updates and our training and education programs will always be evolving. We intend to invest significant resources towards our compliance efforts.\nFalse Claims Act. We are subject to federal and state laws and regulations that apply to the submission of information and claims to various agencies. For example, the federal False Claims Act provides, in part, that the federal government may bring a lawsuit against any person or entity who it believes has knowingly presented, or caused to be presented, a false or fraudulent request for payment from the federal government, or who has made a false statement or used a false record to get a claim approved. The federal government has taken the position that claims presented in violation of the federal anti-kickback statute may be considered a violation of the federal False Claims Act. Violations of the False Claims Act are punishable by treble damages and penalties of up to a specified dollar amount per false claim. In addition, a special provision under the False Claims Act allows a private person (for example, a “whistleblower” such as a disgruntled former associate, competitor or member) to bring an action under the False Claims Act on behalf of the government alleging that an entity has defrauded the federal government and permits the private person to share in any settlement of, or judgment entered in, the lawsuit. A number of states, including Florida, have adopted false claims acts that are similar to the federal False Claims Act.\nMedicare and Medicaid Regulations. As a provider of services under the Medicare and Medicaid programs (the “Programs”), we are subject to federal and state laws and regulations governing reimbursement procedures and practices. These laws include the Medicare and Medicaid fraud and abuse statutes and regulations which, among other provisions, prohibit the payment or receipt of any form of remuneration in return for referring business or patients to providers for which payments are made by a governmental health care program. Violation of these laws may result in civil and criminal penalties, including substantial fines, loss of the right to participate in the Programs and imprisonment of responsible individuals. In addition, HIPAA expanded the federal government’s fraud and abuse enforcement powers. Among other provisions, HIPAA expands the federal government’s authority to prosecute fraud and abuse beyond Medicare and Medicaid to all payors; makes exclusion from the Programs mandatory for a minimum of five years for any felony conviction relating to fraud; requires that organizations contracting with another organization or individual take steps to be informed as to whether the organization or individual is excluded from Medicare and Medicaid participation; and enhances civil penalties by increasing the amount of fines permitted. These laws also include a prohibition on referrals contained in the Omnibus Budget Reconciliation Act of 1989, which prohibits referrals by physicians to clinical laboratories where the physician has a financial interest, and further prohibitions contained in the Omnibus Budget Reconciliation Act of 1993, which prohibits such referrals for a more extensive range of services, including durable medical equipment. Various federal and state laws impose civil and criminal penalties against participants in the Programs who make false claims for payment for services or otherwise engage in false billing practices.\nMany state laws prohibit the payment or receipt or the offer of anything of value in return for, or to induce, a referral for health care goods or services. In addition, there are several other statutes that, although they do not explicitly address payments for referrals, could be interpreted as prohibiting the practice. While similar in many respects to the federal laws, these state laws vary from state to state, are often vague and have sometimes been interpreted inconsistently by courts and regulatory agencies. Private insurers and various state enforcement agencies have also increased their scrutiny of health care providers’ practices and claims.\n\n| 6 |\n\nThere can be no assurance that Banyan will not become the subject of a regulatory or other investigation or proceeding or that our interpretations of applicable health care laws and regulations will not be challenged. The defense of any such challenge could result in substantial cost to us, diversion of management’s time and attention, and could have a material adverse effect on The Company.\nThe Social Security Act, as amended by HIPAA, provides for the mandatory exclusion of providers and related persons from participation in the Programs if the individual or entity has been convicted of a criminal offense related to the delivery of an item or service under the Programs or relating to neglect or abuse of patients. Further, individuals or entities may be, but are not required to be, excluded from the Programs in circumstances including, but not limited to, convictions relating to fraud; obstruction of an investigation of a controlled substance; license revocation or suspension; filing claims for excessive charges or unnecessary services or failure to furnish medically necessary services; or ownership or control by an individual who has been excluded from the Programs, against whom a civil monetary penalty related to the Programs has been assessed, or who has been convicted of a crime described in this section. The illegal remuneration provisions of the Social Security Act make it a felony to solicit, receive, offer to pay, or pay any kickback, bribe, or rebate in return for referring a patient for any item or service, or in return for purchasing, leasing or ordering any good, service or item, for which payment may be made under the Programs. Other provisions in HIPAA proscribe false statements in billing and in meeting reporting requirements and in representations made with respect to the conditions or operations of providers. A violation of the illegal remuneration statute is a felony and may result in the imposition of criminal penalties, including imprisonment for up to five years and/or a fine of up to $25,000. Further, a civil action to exclude a provider from participation in the Programs could occur. There are also other civil and criminal statutes applicable to the industry, such as those governing false billings and the health care/services offenses contained in HIPAA, including health care/services fraud, theft or embezzlement, false statements and obstruction of criminal investigation of offenses. Criminal sanctions for these health care criminal offenses can be severe, including imprisonment for up to 20 years.\nResults of Operations\nCOVID-19\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\nThe following summary of our operations should be read in conjunction with our unaudited financial statements for the three months ended March 31, 2021 which are included in this quarterly report.\nFor the three months ended March 31, 2021 compared to the three months ended March 31, 2020\n\n| Three Months Ended March 31, |\n| 2021 | 2020 | Change |\n| Revenue | $ | 606,925 | $ | 915 | $ | 606,010 |\n| Cost of services | 232,460 | - | 232,460 |\n| Operating expenses | 884,933 | 444,287 | 440,646 |\n| Other expense | (59,516 | ) | (3 | ) | (59,513 | ) |\n| Net Loss from continuing operations | $ | (569,984 | ) | $ | (443,375 | ) | $ | (126,609 | ) |\n\nWe recognized revenue of $606,925 for the three months ended March 31, 2021 compared to $915 for the three months ended March 31, 2020. The first operating facility began in May of 2020 with the acquisition of the St. Petersburg location and revenues began being reported at that time.\n\n| 7 |\n\nOperating expenses for the three months ended March 31, 2021 increased to $884,933 from $444,287 from the three months ended March 31, 2020. Operating expenses consist of salary expenses, general and administrative and professional fees. The increase in operating expense was primarily due to the acquisition of the St. Petersburg location in May of 2020 increasing general and administrative costs by $199,117 and an increase in lease expense of $117,614 from additional leases entered into during 2020.\nOther expenses consist of an increase in interest expense from notes entered into starting September 2020.\nOur net loss for the three months ended March 31, 2021 increased to 569,984 from $443,375 for the three months ended March 31, 2020 as net result of the factors mentioned above.\nLiquidity and Capital Resources\nThe following table provides selected financial data about us as of March 31, 2021 and December 31, 2020.\n\n| March 31, | December 30, |\n| 2021 | 2020 | Change |\n| Cash | $ | 3,441,841 | $ | 345,982 | $ | 3,095,859 |\n| Current assets | $ | 3,998,035 | $ | 650,647 | $ | 3,347,388 |\n| Current liabilities | 4,030,609 | 3,183,288 | 847,321 |\n| Working capital | $ | (32,574) | $ | (2,532,641) | $ | 2,500,067 |\n\nAs of March 31, 2021, our working capital increased $2,500,067, primarily due to an increase in cash offset by an increase in current liabilities.\nAs of March 31, 2021 and December 31, 2020, current assets consisted of cash, accounts receivable and other current assets. The increase in cash was primarily due to the issuance of 7,080,000 shares of restricted common stock at a purchase price of $0.50 per share for an aggregate amount of $3,540,000.\nAs of March 31, 2021, current liabilities consisted of notes and loans payable in the amount of $759,248, accrued interest of $95,079, accrued expenses of $572,891, lease liability of $198,759, share liability of $2,325,000, deferred revenue of $25,703 and liabilities from discontinued operations of $53,929.\nCash Flows\n\n| March 31, | March 31, |\n| 2021 | 2020 | Change |\n| Cash used in operating activities | $ | (228,006 | ) | $ | (427,757 | ) | $ | 199,751 |\n| Cash provided by investing activities | 3,010,994 | - | 3,010,994 |\n| Cash provided by financing activities | 312,871 | 11,885 | 300,986 |\n| Net change in cash for period | $ | 3,095,859 | $ | (415,872 | ) | $ | 3,511,731 |\n\nCash flow from Operating Activities\nDuring the three months ended March 31, 2021, we used $228,006 for operating activities compared to $427,757 cash used for operating activities during the three months ended March 31, 2020. The change in cash used for operating activities is due to an increase in non-cash lease operating expense, depreciation and amortization, accrued interest, and liabilities as well as $53,929 in liabilities from discontinued operations for the three months ended March 31, 2021.\nCash flow from Financing Activities\nThe cash flow from financing activities in the three months ended March 31, 2021 is $312,871, and $0 for the three months ended March 31, 2020. The increase is primarily due to $325,030 cash received for restricted common stock to be issued.\nCash flow from Investing Activities\nThe cash flow from investing activities for the three months ended March 31, 2021 was $3,010,994, and $0 for the three months ended March 31, 2020. This is primarily due to the cash from the first-time consolidation of the Company as a result of the Merger.\nCritical Accounting Policies\nWe prepare our financial statements in conformity with GAAP, which requires management to make certain estimates and apply judgments. We base our estimates and judgments on historical experience, current trends and other factors that management believes to be important at the time the financial statements are prepared. On a regular basis, we review our accounting policies and how they are applied and disclosed in our financial statements.\nWhile we believe that the historical experience, current trends, and other factors considered support the preparation of our financial statements in conformity with GAAP, actual results could differ from our estimates and such differences could be material.\nSee Note 2 - Significant Accounting Policies and the unaudited condensed consolidated financial statements that are included in this Report.\n\n| 8 |\n\nOff Balance Sheet Arrangements\nWe do not engage in any activities involving variable interest entities or off-balance sheet arrangements.\n\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act of 1934, as amended (the “Exchange Act”) reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\nAs further discussed below, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on that evaluation, our chief executive officer and chief financial officer concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021. The material weaknesses relate to the absence of in-house accounting personnel with the ability to properly account for complex transactions and a lack of separation of duties between accounting and other functions.\nWe hired a consulting firm to advise on technical issues related to U.S. GAAP as related to the maintenance of our accounting books and records and the preparation of our consolidated financial statements. Although we are aware of the risks associated with not having dedicated accounting personnel, we are also at an early stage in the development of our business. We anticipate expanding our accounting functions with dedicated staff and improving our internal accounting procedures and separation of duties when we can absorb the costs of such expansion and improvement with additional capital resources. In the meantime, management will continue to observe and assess our internal accounting function and make necessary improvements whenever they may be required. If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements, and we could be required to restate our financial results. In addition, if we are unable to successfully remediate this material weakness and if we are unable to produce accurate and timely financial statements, our stock price may be adversely affected, and we may be unable to maintain compliance with applicable stock exchange listing requirements.\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Based on our evaluation under the framework in Internal Control—Integrated Framework (2013), our management concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021.\n\n| 9 |\n\nChanges in Internal Control over Financial Reporting\nThere have been no changes in our internal control over financial reporting during the quarter ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II - OTHER INFORMATION\n\nFrom time to time, we may become involved in litigation relating to claims arising out of its operations in the normal course of business. We are not involved in any pending legal proceeding or litigation and, to the best of our knowledge, no governmental authority is contemplating any proceeding to which we area party or to which any of our properties is subject, which would reasonably be likely to have a material adverse effect on us.\n\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\n\nDuring the quarterly period ended March 31, 2021, we sold an aggregate of 7,080,000 shares of our common stock to 35 investors at a price of $0.50 per share for an aggregate purchase price of $3,540,000. The offers, sales and issuances of shares were deemed to be exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), in reliance on Section 4(a)(2) of the Securities Act and Rule 506(b) of Regulation D promulgated thereunder, as transactions by an issuer not involving a public offering. The recipients of shares in each of these transactions acquired the shares for investment only and not with a view to or for sale in connection with any distribution thereof and represented to us that they could bear the risks of the investment and could hold the securities for an indefinite period of time, and appropriate legends were affixed to the shares issued in these transactions. Each of the recipients of shares in these transactions represented to us in connection with their purchase that they were an accredited investor within the meaning of Rule 501 of Regulation D under the Securities Act.\n\n\n| Exhibit No. | Description |\n| 2.1 | Plan of Merger by and among Assisted 4 Living, Inc., BPCC Acquisition, Inc. and Banyan Pediatric Care Centers, Inc. dated March 23, 2021. (Previously filed on March 29, 2021 as Exhibit 2.1 of the Company’s Current Report on Form 8-K) |\n| 31.1 | Certification of Principal Executive Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification of Principal Financial Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n\n| 10 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| ASSISTED 4 LIVING, INC. |\n| (Registrant) |\n| Dated: May 18, 2021 | /s/ Louis Collier |\n| Louis Collier |\n| Chief Executive Officer (principal executive officer) |\n\n\n| 11 |\n\n</text>\n\nWhat is the growth rate of the shareholders' deficit from the period of three months ended March 31, 2020 to the same period in 2021 in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n(UNAUDITED)\\n\\n| March 31, 2021 | December 31, 2020 |\\n| ASSETS |\\n| Current assets: |\\n| Cash | $ | 3,441,841 | $ | 345,982 |\\n| Accounts receivable, net allowance for doubtful accounts | 102,020 | 97,073 |\\n| Prepaid expenses and other current assets | 408,397 | 207,592 |\\n| Assets of discontinued operations | 45,777 | - |\\n| Total current assets | 3,998,035 | 650,647 |\\n| Lease right of use asset | 3,917,812 | 3,977,988 |\\n| Goodwill | 3,431,148 | 3,431,148 |\\n| Leasehold improvements, net of accumulated amortization | 2,571,910 | 2,614,391 |\\n| Property and equipment, net | 152,376 | 128,475 |\\n| Total assets | $ | 14,071,281 | $ | 10,802,649 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\\n| Current liabilities: |\\n| Notes payable, net of discounts current | $ | 393,899 | $ | 2,385,010 |\\n| Accrued interest, included related party | 95,079 | 48,601 |\\n| Accounts payable and accrued expenses | 572,891 | 148,180 |\\n| Loan payable – other | 66,851 | 63,907 |\\n| Lease liability - current portion | 198,759 | 189,397 |\\n| Liability to issue shares of common stock | 2,325,000 | - |\\n| Deferred revenue | 25,703 | 25,703 |\\n| Liabilities of discontinued operations | 53,929 | - |\\n| Total current liabilities | 3,732,111 | 2,860,798 |\\n| Lease liability - net of current portion | 3,821,666 | 3,864,321 |\\n| Notes payable, net of discounts and current portion | 298,498 | 322,490 |\\n| Total liabilities | 7,852,275 | 7,047,609 |\\n| Stockholders’ equity: |\\n| Common stock, par value $ 0.0001 ; 100,000,000 shares authorized, 35,395,418 and 4,165,418 issued and outstanding at March 31, 2021 and December 31, 2020, respectively | 3,540 | 417 |\\n| Additional paid-in capital | 10,500,222 | 7,460,348 |\\n| Subscription receivable | - | ( 30 | ) |\\n| Accumulated deficit | ( 4,284,756 | ) | ( 3,705,695 | ) |\\n| Total stockholders’ equity | 6,219,006 | 3,755,040 |\\n| Total liabilities and stockholders’ equity | $ | 14,071,281 | $ | 10,802,649 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n\\n| F-1 |\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS\\n(UNAUDITED)\\n\\n| 2021 | 2020 |\\n| For the Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Program revenue | $ | 601,115 | $ | - |\\n| Rental income | 5,625 | - |\\n| Other revenue | 185 | 915 |\\n| Net revenue | 606,925 | 915 |\\n| Cost of services provided | 232,460 | - |\\n| Gross profit | 374,465 | 915 |\\n| Operating expenses |\\n| Salaries and payroll expense | 293,114 | 245,712 |\\n| General and administrative | 298,200 | 99,083 |\\n| Lease expense | 141,675 | 24,061 |\\n| Professional fees | 95,691 | 62,800 |\\n| Marketing and advertising | 5,670 | 12,631 |\\n| Depreciation and amortization expense | 50,583 | - |\\n| Total operating expenses | 884,933 | 444,287 |\\n| Loss from operations | ( 510,468 | ) | ( 443,372 | ) |\\n| Other expense |\\n| Interest expense | ( 59,516 | ) | ( 3 | ) |\\n| Total other expense | ( 59,516 | ) | ( 3 | ) |\\n| LOSS FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES AND LOSS FROM DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\\n| Income taxes | - | - |\\n| LOSS FROM CONTINUING OPERATIONS BEFORE DISCONTINUED OPERATIONS | ( 569,984 | ) | ( 443,375 | ) |\\n| LOSS FROM DISCONTINUED OPERATIONS | ( 9,077 | ) | - |\\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\\n| Loss per share - basic and diluted - Continuing operations | $ | ( 0.08 | ) | $ | ( 0.11 | ) |\\n| Loss per share - basic and diluted - Discontinued operations | $ | ( 0.00 | ) | $ | - |\\n| Weighted average number of shares outstanding - basic and diluted | 7,288,419 | 4,008,443 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n\\n| F-2 |\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nCONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY\\nFOR THE THREE MONTHS ENDED MARCH 31, 2020 AND 2021\\n(UNAUDITED)\\n\\n| Shares | Amount | Capital | Receivable | Deficit | Total |\\n| Common Stock | Additional | Total |\\n| Number of | paid-in | Subscription | Accumulated | stockholders’ |\\n| shares | Amount | Capital | Receivable | deficit | deficit |\\n| For the Three Months Ended March 31, 2020 |\\n| Balance at December 31, 2019 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,407,760 | ) | 4,210,835 |\\n| Collection on subscription receivable |\\n| Shares issuable for Banyan Acquisition |\\n| Shares issuable for Banyan Acquisition, shares |\\n| Net loss for the period | - | - | - | - | ( 443,375 | ) | ( 443,375 | ) |\\n| Balance at March 31, 2020 | 4,008,443 | 401 | 6,618,364 | ( 170 | ) | ( 2,851,135 | ) | 3,767,460 |\\n| For the Three months ended March 31, 2021 |\\n| - | - | - |\\n| Balance at December 31, 2020 | 4,165,418 | 417 | 7,460,348 | ( 30 | ) | ( 3,705,695 | ) | 3,755,040 |\\n| Collection on subscription receivable | - | - | - | 30 | - | 30 |\\n| Shares issued for Acquisition | 31,230,000 | 3,123 | 3,039,874 | - | - | 3,042,997 |\\n| Net loss for the period | - | - | - | ( 579,061 | ) | ( 579,061 | ) |\\n| Balance at March 31, 2021 | 35,395,418 | 3,540 | 10,500,222 | - | ( 4,284,756 | ) | 6,219,006 |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n\\n| F-3 |\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n\\n| 2021 | 2020 |\\n| For the Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Cash flows from operating activities |\\n| Net loss | $ | ( 579,061 | ) | $ | ( 443,375 | ) |\\n| Adjustments to reconcile net loss to cash used in operating activities: |\\n| Net loss from discontinued operations | ( 9,077 | ) | - |\\n| Non-cash operating lease expense | 26,883 | ( 4,070 | ) |\\n| Depreciation and amortization | 50,583 | - |\\n| (Increase) decrease in assets |\\n| Prepaid expenses | ( 200,805 | ) | 4,564 |\\n| Accounts receivable | ( 4,947 | ) | - |\\n| Increase (decrease) in liabilities |\\n| Accounts payable | - | ( 13,420 | ) |\\n| Accrued payroll and other expenses | 441,940 | 28,544 |\\n| Accrued interest | 46,478 | - |\\n| Cash used in operating activities | ( 228,006 | ) | ( 427,757 | ) |\\n| Cash flows from investing activities |\\n| Cash from acquisition | 3,042,997 | - |\\n| Purchase of property and equipment | ( 32,003 | ) | - |\\n| Cash provided by investing activities | 3,010,994 | - |\\n| Cash flows from financing activities |\\n| Repayment of principal on notes payable to individuals and companies | ( 15,103 | ) | - |\\n| Proceeds from the sale of common stock issued and issuable | 325,030 | 139 |\\n| Proceeds from other notes payable | 2,944 | 11,746 |\\n| Cash provided by financing activities | 312,871 | 11,885 |\\n| Net increase (decrease) in cash | 3,095,859 | ( 415,872 | ) |\\n| Cash, beginning of year | 345,982 | 4,044,700 |\\n| Cash, end of period | $ | 3,441,841 | $ | 3,628,828 |\\n| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |\\n| Interest paid | $ | 13,037 | $ | - |\\n| Taxes paid |\\n| NON-CASH ITEMS |\\n| Recognition of lease liability and right of use asset at inception | $ | - | $ | 1,897,995 |\\n| Conversion of notes payable and accrued interest for common stock | $ | 2,000,000 | $ | - |\\n\\nThe accompanying notes are an integral part of the condensed consolidated financial statements.\\n\\n| F-4 |\\n\\nASSISTED 4 LIVING, INC.\\n[BANYAN PEDIATRIC CARE CENTERS, INC., A WHOLLY OWNED SUBSIDIARY]\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\nNOTE 1 – ORGANIZATION AND DESCRIPTION OF BUSINESS\\nAssisted 4 Living, Inc. (“the Company,” “we”, “our” or “us”) was incorporated in the state of Nevada on May 24, 2017 and is based in Sarasota, Florida. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”), and the Company’s fiscal year end is December 31.\\nAs discussed in NOTE 4, on March 23, 2021, we entered into a Plan of Merger with our wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”) and Banyan Pediatric Care Centers, Inc. (“Banyan”). Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger (the “Surviving Entity”) and becoming a wholly-owned subsidiary of the Company (the “Merger”). Pursuant to the Merger, we succeeded to the business of Banyan. The Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for financial reporting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan before the Merger in this Quarterly Report and future filings with the SEC\\nThrough Banyan, we operate three pediatric extended care centers (“PPECs”) is southwest Florida. A PPEC is a nurse-staffed pediatric day care center for medically complex children age birth to 21 years. Our staff includes Registered Nurses (RNs), Licensed Practical Nurses (LPNs), Certified Nursing Assistants (CNAs) and Caregivers, who attend to the children’s medical conditions throughout the day in classroom, dining, play, and clinical settings. Banyan is fully licensed and accepts Florida Medicaid.\\nWe are headquartered at 6801 Energy Court, Suite 201 Sarasota, Florida 34240.\\nThe corporate website is www.assisted4living.com.\\nCOVID-19\\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and are taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation\\nThe accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with GAAP for interim financial statements and with the instructions to Form 10-Q and Regulation S-X of the United States Securities and Exchange Commission (“SEC”). Accordingly, they do not contain all information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements.\\nIn the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all the adjustments necessary (consisting only of normal recurring accruals) to present the financial position of the Company as of March 31, 2021 and the results of operations and cash flows for the periods presented. The results of operations for the three months ended March 31, 2021 are not necessarily indicative of the operating results for the full fiscal year or any future period. These unaudited condensed consolidated financial statements should be read in conjunction with the condensed consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on March 1, 2021. As of March 23, 2021 we had discontinued operations reflected in the accompanying unaudited condensed consolidated financial statements. As a result of the Plan of Merger completed on March 23, 2021 (see NOTE 4) we have changed our year end reporting period from November to December.\\n\\n| F-5 |\\n\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\\nBasis of Consolidation\\nThese condensed consolidated financial statements include the accounts of the Company and the wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St. Petersburg, LLC, Banyan Pediatric Care Centers, - Pasco, LLC and Banyan Pediatric Care Centers – Sarasota, LLC and the discontinued operations of Assisted 2 Live, Inc., the wholly owned subsidiary that was discontinued as of March 23, 2021. All material intercompany balances and transactions have been eliminated.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less to be cash equivalents. The Company had no cash equivalents at March 31, 2021 and December 31, 2020.\\nAccounts Receivable\\nAccounts receivable primarily consists of amounts due from third-party payers (non-governmental), governmental payers and private pay patients and is recorded net of allowances for doubtful accounts and contractual discounts. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Accordingly, accounts receivable reported in the Company’s condensed consolidated financial statements is recorded at the net amount expected to be received. The Company’s primary collection risks are (i) the risk of overestimation of net revenues at the time of billing that may result in the Company receiving less than the recorded receivable, (ii) the risk of non-payment as a result of commercial insurance companies’ denial of claims, (iii) the risk that patients will fail to remit insurance payments to the Company when the commercial insurance company pays out-of-network claims directly to the patient, (iv) resource and capacity constraints that may prevent the Company from handling the volume of billing and collection issues in a timely manner, (v) the risk that patients do not pay the Company for their self-pay balances (including co-pays, deductibles and any portion of the claim not covered by insurance) and (vi) the risk of non-payment from uninsured patients.\\nThe Company’s accounts receivable from third-party payers are recorded net of estimated contractual adjustments and allowances from third-party payers, which are estimated based on the historical trend of the Company’s facilities’ cash collections and contractual write-offs, accounts receivable aging, established fee schedules, relationships with payers and procedure statistics. While changes in estimated reimbursement from third-party payers remain a possibility, the Company expects that any such changes would be minimal and, therefore, would not have a material effect on the Company’s financial condition or results of operations. The Company’s collection policies and procedures are based on the type of payor, size of claim and estimated collection percentage for each patient account. The Company analyzes accounts receivable at each of the facilities to ensure the proper collection and aged category. The operating systems generate reports that assist in the collection efforts by prioritizing patient accounts. Collection efforts include direct contact with insurance carriers or patients and written correspondence.\\nAllowance for Doubtful Accounts, Contractual and Other Discounts\\nManagement estimates the allowance for contractual and other discounts based on its historical collection experience and contracted relationship with the payers. The services authorized and provided and related reimbursement are often subject to interpretation and negotiation that could result in payments that differ from the Company’s estimates. The Company’s allowance for doubtful accounts is based on historical experience, but management also takes into consideration the age of accounts, creditworthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. An account may be written-off only after the Company has pursued collection efforts or otherwise determines an account to be uncollectible. Uncollectible balances are written-off against the allowance. Recoveries of previously written-off balances are credited to income when the recoveries are made.\\nFair Value of Financial Instruments\\nThe carrying amount of accounts receivable and accounts payable approximate their respective fair values due to the short- term nature. The carrying amount of the line of credit and note payable approximates fair values due to their market interest rates. Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable.\\nProperty and Equipment\\nProperty and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Depreciation of owned assets and amortization of leasehold improvements are computed using the straight-line method over the shorter of the estimated useful lives of the related assets or the lease term. The cost of assets sold or retired, and the related accumulated depreciation are removed from the accounts and any resulting gains or losses are reflected in other income (expense) for the year. Expenditures for maintenance and repairs are charged to expense as incurred.\\n\\n| F-6 |\\n\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\\nGoodwill\\nOur goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in business combinations. The goodwill generated from the business combinations is primarily related to the value placed on the employee workforce and expected synergies. Judgment is involved in determining if an indicator or change in circumstances relating to impairment has occurred. Such changes may include, among others, a significant decline in expected future cash flows, a significant adverse change in the business climate, and unforeseen competition. There was no goodwill impairment for the years presented.\\nThe Company tests goodwill for impairment on an annual basis, and when events or circumstances indicate the fair value of a reporting unit may be below its carrying value.\\nLong-Lived Assets\\nLong-lived assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. There were no impairments of long-lived assets for the years presented.\\nAdvertising and Marketing\\nThe Company uses advertising and marketing to promote its services. Advertising and marketing costs are expensed as incurred.\\nNet Loss Per Share\\nBasic net loss per common share is computed by dividing net loss applicable to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net loss per common share is determined using the weighted-average of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents, consisting of the conversion option embedded in convertible debt. The weighted-average number of common shares outstanding excludes common stock equivalents because their inclusion would have an anti-dilutive effect.\\nIncome Taxes\\nThe Company uses the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are determined based on differences between financial reporting and the tax basis of assets, liabilities, the carry forward of operating losses and tax credits, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. An allowance against deferred tax assets is recorded when it is more likely than not that such tax benefits will not be realized.\\nAny future benefit arising from losses have been offset by a valuation allowance. Accordingly, no provision for income taxes is reflected in the condensed consolidated financial statements. The Company records a liability for uncertain tax positions when it is probable that a loss has been incurred and the amount can be reasonably estimated. Interest and penalties related to income tax matters, if any, would be recognized as a component of income tax expense. At March 31, 2021 and December 31, 2020, the Company had no liabilities for uncertain tax positions. The Company continually evaluates expiring statutes of limitations, audits, proposed settlements, changes in tax law and new authoritative rulings. Currently, the tax years subsequent to 2017 are open and subject to examination by the taxing authorities.\\n\\n| F-7 |\\n\\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)\\nUse of Estimates and Assumptions\\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. The estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ from these good faith estimates and judgments.\\nRevenue Recognition\\nWe follow ASC 606, “Revenue from Contracts with Customers.” Revenues are recognized when promised goods or services are transferred to a customer, in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. We derive our revenues from the rendering of services, such as skilled nursing services. The five-step model defined by ASC 606 requires us to: (i) identify our contracts with customers, (ii) identify our performance obligations under those contracts, (iii) determine the transaction prices of those contracts, (iv) allocate the transaction prices to our performance obligations in those contracts and (v) recognize revenue when each performance obligation under those contracts is satisfied.\\nReimbursement rates to provide skilled nursing services in our PPEC facilities are determined by the Medicaid program. Fees are billed to the Medicaid program and other payors weekly following the Medicaid billing guidelines.\\nReclassification\\nCertain amounts from prior periods have been reclassified to conform to the current period presentation.\\nNOTE 3 – ACCRUED LIABILITIES\\nOur accrued liabilities at March 31, 2021 and December 31, 2020 consisted of the following:\\nSCHEDULE OF ACCRUED LIABILITIES\\n| March 31, 2021 | December 31, 2020 |\\n| Accounts payable | $ | 70,675 | $ | 16,298 |\\n| Credit card | - | 1,050 |\\n| Accrued expenses | 354,193 | 130,832 |\\n| Accrued salary | 139,952 | - |\\n| Payroll tax payable | 8,070 | - |\\n| Accrued Liabilities | $ | 572,890 | $ | 148,180 |\\n\\n\\n| F-8 |\\n\\nNOTE 4 – BANYAN MERGER\\nOn March 23, 2021, we entered into a Plan of Merger with Merger Sub and Banyan. Under the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan as the Surviving Entity and wholly-owned subsidiary of the Company. The Merger was effective on March 23, 2021.\\nThe Merger has been treated as a recapitalization and reverse acquisition of the Company for financial accounting purposes, and Banyan is considered the acquirer for accounting purposes. This means that the Company’s historical financial statements before the Merger have been replaced with the historical financial statements of Banyan.\\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock. We also issued a warrant to purchase 75,000 shares of our common stock (the “Warrant”) in exchange for a warrant to purchase 900,000 shares of Banyan’s common stock. The Warrant is held by one investor and is exercisable for cash only until May 2, 2030 at an exercise price of $ 0.38 per share. The number of shares of common stock deliverable upon exercise of the Warrant contains provisions for standard anti-dilution adjustments.\\nThe Surviving Entity assumed Banyan’s $ 2,300,000 of outstanding debt, and the $ 2,000,000 of such debt that was convertible into 20,000,000 shares of Banyan common stock was converted at $ 0.50 per share into 4,000,000 shares of our common stock, effective as of March 30, 2021. The remaining $ 300,000 of outstanding debt, evidenced by a promissory note dated November 6, 2020 (the “Note”), accrues interest at the annual rate of 12 %. Interest is payable on the sixth day of each month in the amount of $ 3,000 until the maturity date of the Note on November 6, 2021 , at which time, the remaining principal balance, if any, is due and payable.\\n\\n| F-9 |\\n\\nNOTE 5 – DISCONTINUED OPERATIONS\\nOn April 30, 2021, our Board of Directors (the “Board”) approved the discontinuance of our wholly-owned subsidiary, Assisted 2 Live, Inc. (the “Discontinued Subsidiary”). The operations of the Discontinued Subsidiary are reflected on our condensed consolidated statement of operations from the date of the Merger as a loss from discontinued operations in the amount of $ 9,077 .\\nThe April 30, 2021 Board decision was the result of the Purchase and Sale Option Agreement (the “Option Agreement”) with Romulus Barr (“Barr”) which we entered into on November 7, 2020. The Option Agreement provided us with the option to sell all of our interest in Assisted 2 Live, Inc., consisting of 1,000 shares of common stock of the Discontinued Subsidiary, to Barr in exchange for 200,000 shares of our common stock (the “Shares”) held by Barr. The returned Shares were cancelled, and included in authorized but unissued shares of common stock of the Company. The number of issued and outstanding shares of common stock was decreased by 200,000 as of April 30, 2021.\\nThe following table presents the aggregate carrying amounts of the classes of assets and liabilities of discontinued operations for the three months ended:\\nSUMMARY OF CARRYING AMOUNTS OF ASSETS AND LIABILITIES AND CASH FLOWS OF DISCONTINUED OPERATIONS\\n| March 31, 2021 | December 31, 2020 |\\n| Current assets of discontinued operations | $ | 15,928 | $ | - |\\n| Non-current assets of discontinued operations | 29,849 | - |\\n| $ | 45,777 | $ | - |\\n| Current liabilities of discontinued operations | $ | 53,929 | $ | - |\\n| $ | 53,929 | $ | - |\\n\\nThe following table presents cash flows of discontinued operations for the three months ended March 31:\\n\\n| 2021 | 2020 |\\n| Net cash used in discontinued operating activities | $ | ( 14,386 | ) | $ | - |\\n| Net cash from discontinued investing activities | - | - |\\n| Net cash from discontinued financing activities | - | - |\\n| $ | ( 14,386 | ) | $ | - |\\n\\n\\n| Three months ended March 31, |\\n| 2021 | 2020 |\\n| Net revenues | $ | 5,362 | $ | - |\\n| Cost of net revenues | - | - |\\n| Gross profit | 5,362 | - |\\n| Operating expenses: |\\n| Salary and tax expense | 12,890 | - |\\n| General and administrative | 763 | - |\\n| Lease expense | 733 | - |\\n| Total operating expenses | 14,386 | - |\\n| Income from operations of discontinued operations | ( 9,024 | ) | - |\\n| Interest and other, net | ( 53 | ) | - |\\n| Income from discontinued operations before income taxes | ( 9,077 | ) | - |\\n| Provision for income taxes | - | - |\\n| Income from discontinued operations, net of income taxes | $ | ( 9,077 | ) | $ | - |\\n\\n\\n| F-10 |\\n\\nNOTE 6 – NOTES PAYABLE\\nNotes payable at March 31, 2021 and December 31, 2020 consisted of the following:\\nSCHEDULE OF NOTES PAYABLE\\n| March 31, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| a. Excel Family Partners, LLLP / Banyan Pediatric Investment, Inc. (Sep 2020) | $ | - | $ | 2,000,000 |\\n| b. NuView Trust Co. (Nov 2020) | 300,000 | 300,000 |\\n| c. Grand Trinity Plaza, LLC (Dec 2020) | 392,397 | 407,500 |\\n| $ | 692,397 | $ | 2,707,500 |\\n\\n\\n| a) | On September 18, 2020, through Banyan, we entered into a Convertible Note and Securities Purchase Agreement with two investors for the aggregate principal in the amount of $ 2,000,000 . The note had a maturity date of September 18, 2022 and an interest rate of 8 % to be paid quarterly. The principal was funded by two investors (“Purchasers”), both related parties. Excel Family Partners, LLLP invested $ 1,500,000 and Banyan Pediatric Investments, LLC invested $ 500,000 . The proceeds of this note were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. Written consent from shareholders holding a majority of the issued and outstanding shares of common stock of Banyan was obtained, not including such shares currently held by the Purchasers or their affiliates, consenting to the note contemplated hereby, in a form and substance acceptable to the Purchasers, in their respective reasonable discretion. Both Purchasers were permitted to convert their respective portions of the note at a conversion price of $ 0.10 per share. Subsequent to the Merger (see NOTE 4), the Board revised the conversion price of the note to $ 0.50 per share. Effective March 30, 2021 the Purchasers exercised their right to convert all outstanding principal. As of March 31, 2021 and December 31, 2020, there was $ 90,740 and $ 45,589 of accrued interest, respectively and is reflected in accrued interest balances on the condensed consolidated balance sheet at March 31, 2021 and December 31, 2020. |\\n\\n\\n| b) | On November 6, 2020, through Banyan, we entered into a one-year note in the principal amount of $ 300,000 with NuView Trust Company. The note has a 12 % interest rate with interest only payments until date of maturity. The proceeds of this no were used for operational expenses and for the payment of the remainder of the buildout of the Pasco County and the Sarasota locations. As of March 31, 2021 and December 31, 2020 there was no accrued interest. (see NOTE 4) |\\n\\n\\n| c) | On December 15, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into a note payable with Grand Trinity Plaza, LLC in the principal amount of $ 407,500 , which is guaranteed by Banyan. The term of the note is 48 months with an interest rate of 6 %. The maturity date of the note is January 1, 2025 . The note is in conjunction with the 84 -month facility lease for the Pasco County location, pursuant to which the landlord also provided the construction of the buildout and financed $ 407,500 of the construction costs. |\\n\\nNOTE 7 – LEASEHOLD IMPROVEMENTS\\nThe Company had the following leasehold improvements as of March 31, 2021 and December 31, 2020:\\nSCHEDULE OF LEASESHOLD IMPROVEMENTS\\n| March 31, 2021 | December 31, 2020 | Amortization Period |\\n| Leasehold improvements | $ | 2,669,047 | $ | 2,669,047 | 15 - 17 years |\\n| Less: amortization | ( 97,137 | ) | ( 54,656 | ) |\\n| Net | $ | 2,571,910 | $ | 2,614,391 |\\n\\nDuring the year ended December 31, 2020, we recorded $ 2,669,047 of leasehold improvements. These amounts include costs related to the build out of the Sarasota location in the amount of $ 1,245,950 . These costs will be amortized over the expected term of the lease including extensions that management expects to be 15 years. We also recorded costs in the amount of $ 1,021,793 related to the New Port Richey location buildout. The expected amortization of the improvements for the New Port Richey location is 17 years. Also recorded were $ 401,303 of improvements as part of the St. Petersburg-Kidz Club Acquisition. The expected amortization of the improvements for the St. Petersburg location is 15 years.\\nAmortization expense for the three months ended March 31, 2021 and 2020 was $ 42,481 and $ 0 , respectively.\\n\\n| F-11 |\\n\\nNOTE 8 – OPERATING LEASES\\nOn August 24, 2019, through Banyan Pediatric Care Centers-Sarasota, LLC, we entered into an operating lease with Northeast Plaza Venture I, LLC for the premises located in the Northeast Plaza Shopping Center located on the Northeast corner of 17th Street & Lockwood Ridge Road, in the County of Sarasota, Florida. The initial term of the lease is five years with minimum annual rent of $ 180,000 . The landlord granted rent abatement for this lease until February 24, 2020 . The lease end date, including two successive 5 -year renewal options, is January 31, 2035. A right of use asset and lease liability in the amount of $ 1,899,869 associated with this lease was recognized. This lease is treated as an operating lease for accounting purposes.\\nOn October 15, 2019, through Banyan, we entered into an assignment and assumption of lease agreement with The Kidz Club – St. Pete, LLC whereby we assumed approximately 12,137 square feet of space at the southeast corner of 3rd Avenue S. and 9th Street N., Webb’s Plaza, St. Petersburg, FL 33701. The minimum annual rent for the first year of the lease was $ 113,681 . The current lease termination date, with extensions expected to be exercised, is October 31, 2024 . Upon the exercise of each extension the base rent shall increase by 1.5 %. This assignment of lease was subject to the terms of the Asset Purchase Agreement with The Kidz Club-St. Pete, LLC. A right of use asset and lease liability in the amount of $ 875,539 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nEffective April 1, 2020, through Banyan Pediatric Care Centers – Pasco, LLC, we entered into an 84 -month facility lease with Grand Trinity Plaza, LLC for the premises located in the shopping center known as the Grand Trinity Plaza located in New Port Richey, Florida. The initial term of the lease had a minimum annual base rent of $ 94,500 . The landlord granted rent abatement until September 2020. The lease end date, including two successive 5 -year renewals is August 31, 2037. A right of use asset and lease liability in the amount of $ 1,143,743 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nOn June 9, 2020, through Banyan, we entered into a 63 -month copier lease with Dex Imaging. The lease was for one copier and a printer. The minimum annual lease payment is $ 5,376 with annual increases not to exceed 12 % annually. This lease will auto renew in 12 -month increments. The equipment under this lease has a fixed $1 payment buyout option . This equipment was purchased for the St. Petersburg location. A right of use asset and lease liability in the amount of $ 16,066 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nOn August 25, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for two 2020 Turtletop Terra Transit passenger buses for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 24,859 . At our discretion, we may exercise a purchase option, by giving written notice no later than 30 days but not more than 120 days before the expiration of the initial term. The purchase option price is $ 23,920 for each bus, based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 102,393 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nOn October 20, 2020, through Banyan, we entered into a 60 -month financing agreement with Ascentium Capital LLC for a 2020 Eldorado National Advance 220 p/t 14 passenger bus for the St. Petersburg location. This lease is considered an operating lease for accounting purposes because the lease period is less than the economic life of the asset being leased . Minimum annual rent payments under this lease are $ 13,381 . At our discretion, we may exercise a purchase option, by giving written notice no later than 180 days but not more than 360 days before the expiration of the initial term. The purchase option price is $ 12,891 based on reasonably predicted fair market value. A right of use asset and lease liability in the amount of $ 55,345 was recognized in association with this lease. This lease is treated as an operating lease for accounting purposes.\\nIn accordance with ASC 842, we recorded the operating lease right of use asset and lease liability as follows:\\nSCHEDULE OF OPERATING LEASE RIGHT OF USE ASSET AND LEASE LIABILITY\\n| March 31, 2021 | December 31,2020 |\\n| Right of Use (ROU) asset | $ | 3,917,812 | $ | 3,977,988 |\\n\\n\\n| March 31, 2021 | December 31, 2020 |\\n| Operating lease liability: |\\n| Current | $ | 198,759 | $ | 189,397 |\\n| Non-Current | 3,821,666 | 3,864,321 |\\n| Total | $ | 4,020,425 | $ | 4,053,718 |\\n\\n\\n| F-12 |\\n\\nNOTE 8 – OPERATING LEASES (CONTINUED)\\nMaturity of Operating Lease Liability for fiscal year ended December 31,\\nSCHEDULE OF MATURITY OF OPERATING LEASE LIABILITY\\n| 2021 |\\n| 2021 (nine months) | $ | 156,105 |\\n| 2022 | 213,747 |\\n| 2023 | 232,829 |\\n| 2024 | 251,264 |\\n| 2025 | 267,134 |\\n| After 2025 | 2,899,346 |\\n| Total lease liability | $ | 4,020,425 |\\n\\nInformation associated with the measurement of our remaining operating lease obligations as of March 31, 2021 is as follows:\\nThe operating leases range from a term of 2.48 years to 16.68 years with a weighted average lease term of 13.35 years.\\nThe weighted average discount rate is 6.07 %.\\nThe lease expense for the three months ended March 31, 2021 and 2020 was $ 141,675 and $ 24,061 , respectively.\\nNOTE 9 - EQUITY\\nPreferred Stock\\nWe have authorized 25,000,000 preferred shares with a par value of 0.0001 per share. The Board is authorized to divide the authorized preferred shares into one or more series, each of which shall be so designated as to distinguish the shares thereof from the shares of all other series and classes. As of March 31, 2021 and December 31, 2020, we had no classes of preferred shares designated.\\nCommon Stock\\nWe have authorized 100,000,000 common shares with a par value of $ 0.0001 per share. Each common share entitles the holder to one vote, in person or proxy, on any matter on which action of the stockholders of the corporation is sought. As of March 31, 2021, we had 35,395,418 common shares issued and outstanding.\\n\\n| F-13 |\\n\\nNOTE 9 – EQUITY (CONTINUED)\\nFiscal Year 2021\\nOn March 23, 2021, we entered into a Plan of Merger with Banyan (See NOTE 4).\\nIn connection with the Merger, we issued 4,165,418 shares of our common stock in exchange for 49,984,649 outstanding shares of Banyan’s common stock held by 64 shareholders, based on an exchange ratio of one (1) share of our common stock for every twelve (12) shares of Banyan common stock.\\nIn conjunction with the Merger, the previously issued 31,230,000 shares of common stock of the Company prior to the Merger were deemed issued for the Merger.\\nDuring the period of February 11, 2021 through March 31, 2021 we issued shares of common stock at $ 0.50 per share for an aggregate consideration of $ 3,540,000\\nOn March 31, 2021, we had recorded a liability to issue shares in the amount of $ 325,000 to record stock purchases of 650,000 common shares at $ 0.50 per share that were to be issued in the following month, April 2021. On March 30, 2021, the Noteholders of the $ 2,000,000 convertible note exercised their right to convert the note (see NOTE 4). The shares were not issued as of March 31,2021. The conversion was recorded as a liability to issue shares in the amount of $ 2,000,000 , as reflected on our condensed consolidated balance sheet.\\nFiscal Year 2020\\nDuring the year ended December 31, 2020, $ 140 was received against a subscription receivable balance for the 2019 authorization of the issuance of Founders shares. On December 31, 2020, we had a subscription receivable of $ 30 for shares issued where payments were not received.\\nOn September 19, 2020, we issued 2,000,000 restricted common shares to a noteholder for the conversion of $ 500,000 of note principal.\\nWarrants\\nIn association with the September 27, 2019 Asset Purchase Agreement (The Kidz Club St Pete, LLC), we issued 75,000 common stock warrants (post-merger exchange adjusted) having an exercise price of $ 0.38 per share. These warrants have an expiration of September 27, 2029 .\\nSCHEDULE OF WARRANTS OUTSTANDING\\n| Weighted |\\n| Weighted- | Average |\\n| Average | Remaining | Aggregate |\\n| Exercise | Contractual | Intrinsic |\\n| Shares | Price | Term | Value |\\n| Outstanding at January 1, 2020 | - | - | - | $ | - |\\n| Granted | 75,000 | $ | 0.38 | 10.0 Years | $ | - |\\n| Expired | - | - | - |\\n| Exercised | - | - | - |\\n| Outstanding at December 31, 2020 | 75,000 | $ | 0.38 | 9.74 Years | $ | - |\\n| Outstanding at January 1, 2020 | 75,000 | 0.38 | 9.74 Years | - |\\n| Granted | - | - | - |\\n| Expired | - | - | - |\\n| Exercised | - | - | - |\\n| Outstanding and exercisable March 31, 2020 | 75,000 | $ | 0.38 | 9.49 Years | $ | - |\\n\\n\\n| F-14 |\\n\\nNOTE 10 – RELATED PARTY TRANSACTIONS\\nOn February 1, 2021 (the “Effective Date”), we signed an employment agreement with our new CEO, Louis Collier (“Collier”). Collier will be paid a base salary of $ 400,000 , which will be reassessed and renegotiated in good faith after we are profitable over a fiscal year. Collier will also receive a signing bonus of $ 150,000 , which will be payable as follows: $ 50,000 within five days of the Effective Date (paid); $ 50,000 within 90 days of the Effective Date; and $ 50,000 within 180 days of the Effective Date. Collier will also be issued 1,250,000 phantom shares within ten days after the approval and adoption a Phantom Equity Plan. The phantom shares will be subject to a phantom unit interest award agreement, which will set forth the vesting of the phantom shares.\\nOn March 23, 2021, we entered into a Plan of Merger (See NOTE 4) whereas we assumed debt of $ 2,000,000 that was convertible into 20,000,000 shares of common stock. After the Merger the debt was converted into 4,000,000 restricted common shares of the Company at $ 0.50 per share. One of the debt holders is majority owned by a director of the Company. As of March 31, 2021, these shares were not issued and are reflected as share liability on our condensed consolidated balance sheet.\\nDuring the three months ended March 31, 2021 and 2020, we compensated members of the Board $ 20,769 and $ 0 , respectively.\\nAs of March 31, 2021, we had accrued payroll of $ 60,000 and accrued interest on that payroll in the amount of $ 4,340 for the President and the Chief Financial Officer of Banyan. These unpaid amounts were the result of 2020 furloughed salaries. Interest is being accrued on these unpaid balances effective May 15, 2020 at a rate of 8 % per annum and is reflected in accrued interest balance as of March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet. Accrued salaries of $ 60,000 is reflected in accrued liabilities at March 31, 2021 and December 31, 2020 on the condensed consolidated balance sheet.\\nNOTE 11 – SUBSEQUENT EVENTS\\nWe have evaluated subsequent events from March 31, 2021 through the date these financial statements were issued and determined the following events require disclosure:\\nSubsequent to March 31, 2021, we issued additional shares of restricted common stock as follow: (i) 1,150,000 shares to five (5) investors at a price of $ 0.50 per share for aggregate proceeds of $ 575,000 , including $ 325,000 issuance to satisfy the liability to issue shares; and (ii) 4,000,000 shares for note conversion.\\nOn April 30, 2021, pursuant to the Option Agreement, the number of issued and outstanding shares of common stock was decreased by 200,000 (see NOTE 5).\\nDiscontinued Operations\\nSee NOTE 5 – DISCONTINUED OPERATIONS regarding the discontinuance of the operations in our wholly-owned subsidiary, Assisted 2 Live, Inc.\\nTrillium Healthcare Group, LLC\\nOn April 29, 2021, we entered into a Third Amendment (the “Third Amendment”) to a Membership Interest Purchase Agreement dated as of January 29, 2021 (the “Purchase Agreement”), by and among the Company, Richard T. Mason (“Mason”), G. Shayne Bench (“Bench”) and Trillium Healthcare Group, LLC, a Florida limited liability company (“Trillium”) to acquire all of the issued and outstanding ownership interests of Fairway Healthcare Properties, LLC and Trillium Healthcare Consulting, LLC from Trillium.\\nAmong other things, the Third Amendment extends the date to May 28, 2021, after which either party may terminate the Purchase Agreement if the closing has not yet occurred.\\n\\n| F-15 |\\n\\n\\nThe following discussion and analysis of our results of operations and financial condition for period ended March 31, 2021, should be read in conjunction with our consolidated financial statements and the related notes and the other financial information that are included elsewhere in this Quarterly Report. This discussion includes forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Forward-looking statements are based upon estimates, forecasts, and assumptions that are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors. We use words such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions to identify forward-looking statements.\\nAs used in this quarterly report, the terms “we,” “us,” “our” and the “Company” means, collectively, Assisted 4 Living, Inc. (“A4L””) and its wholly-owned subsidiaries, Banyan Pediatric Care Centers, Inc, Banyan Pediatric Care Centers – OPS, LLC, Banyan Pediatric Care Centers – St Petersburg, LLC, Banyan Pediatric Care Centers – Sarasota, LLC and Banyan Pediatric Care Centers – Pasco, LLC, unless otherwise indicated.\\nGeneral Overview\\nA4L was incorporated in Nevada on May 24, 2017, with an objective to operate as a facilitator of assisted living projects and related services. On March 23, 2021, A4L entered into a Plan of Merger (the “Plan of Merger”) with its wholly-owned subsidiary, BPCC Acquisition, Inc., a Florida corporation (“Merger Sub”), and Banyan Pediatric Care Centers, Inc., a Florida corporation (“Banyan”).\\nUnder the terms of the Plan of Merger, Merger Sub merged with and into Banyan with Banyan surviving the merger and becoming a wholly-owned subsidiary of A4L (the “Merger”).\\nA4L also had a wholly-owned subsidiary, Assisted 2 Live, Inc., a Florida corporation (“A2L”), which was incorporated on June 15, 2017. On April 30, 2021, the Board of Directors of A4L approved the discontinuance of the operations in A2L. The operations of A2L are reflected on our condensed consolidated statement of operations for the last eight days of the three month period ended March 31, 2021 as a loss from discontinued operations.\\nOur principal executive office is located at 6801 Energy Court, Suite 201 Sarasota, Florida 34240 and our telephone number is (855) 668-3331. Our office is provided to us at no charge by our largest shareholder and former President. Our corporate website is www.assisted4living.com.\\nWe have not been subject to any bankruptcy, receivership or similar proceeding.\\n\\n| 3 |\\n\\nOur Current Business\\nBanyan was organized under the laws of the State of Florida on January 15, 2019 for the purpose of providing health care services for medically fragile and chronically ill children. Specifically, to open and operate Prescribed Pediatric Extended Care (“PPEC”) centers in the State of Florida. Our PPEC centers provide, among other services, daily medical care for medically fragile and chronically ill children whose current locations are in Florida.\\nPPEC centers provide up to 12 hours of daily care for families struggling with the unique and complex medical needs of their children and allow the parents of children with special needs some independence and the opportunity to still pursue their professional goals.\\nOn May 1, 2020, we acquired a PPEC facility located in St. Petersburg, FL. The facility is licensed to provide PPEC services for up to 81 children. All State and County accreditations to run the facility through January 2022 are in place.\\nOn October 12, 2019, we entered into a lease for commercial real estate in New Port Richey Florida. The lease commenced on September 1, 2020 with an initial term of 7 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\\nOn August 24, 2019, we entered into a lease for commercial real estate in Sarasota Florida. The lease commenced on February 1, 2020 with an initial term of 5 years. Construction for this location has been completed and we are in the process of applying for the necessary licenses and certifications to provide PPEC services at this location.\\nRegulatory Matters\\nHealth care operations are highly regulated by both state and federal government agencies. Regulation of health care services is an ever-evolving area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws, statutes, regulations and interpretive guidance occur frequently. In addition, government agencies may impose taxes, fees or other assessments upon Banyan at any time.\\nBanyan is also subject to certain state laws prohibiting the payment of remuneration for patient or business referrals and the provision of services where a financial relationship exists between a referring person or entity and the entity providing the service. Federal laws governing our activities include regulation under the Medicare and Medicaid programs. Federal fraud and abuse laws prohibit or restrict, among other things, the payment of remuneration to parties in a position to influence or cause the referral of patients or business, as well as the filing of false claims. Government enforcement authorities have become increasingly active in recent years in their review and scrutiny of various sectors of the health care industry.\\nChanges in or new interpretations of these laws could have an adverse effect on our methods and costs of doing business. Further, failure by Banyan to comply with such laws could adversely affect the ability to continue to provide, or receive reimbursement for, our services, and could subject Banyan and its officers and employees to civil and criminal penalties. There can be no assurance that Banyan will not encounter regulatory impediments that could adversely affect the ability to open facilities or to expand the services currently planned to provide at the facilities.\\n\\n| 4 |\\n\\nHIPAA, HITECH Act, State Privacy Laws and Breach Notification Laws.\\nHIPAA and the regulations adopted under HIPAA are intended to improve the portability and continuity of health insurance coverage and simplify the administration of health insurance claims and related transactions.\\nThe HITECH Act modified certain provisions of HIPAA by, among other things, extending the privacy and security provisions to business associates, mandating new regulations around electronic health records, expanding enforcement mechanisms, and increasing penalties for violations.\\nOn January 25, 2013, the U.S. Department of Health and Human Services (“HHS”), as required by the HITECH Act, issued the Final Omnibus Rules that provide final modifications to HIPAA rules to implement the HITECH Act.\\nThe HITECH Act also contains a number of provisions that provide incentives for states to initiate certain programs related to health care and health care technology, such as electronic health records. While provisions such as these will not apply to us directly, states wishing to apply for grants under the HITECH Act, or otherwise participating in such programs, may impose new health care technology requirements on us through our expected contracts with state Medicaid agencies.\\nAll health plans are considered covered entities subject to HIPAA. HIPAA generally requires health plans, as well as their providers and vendors, to: (1) protect patient privacy and safeguard individually identifiable health information; and (2) establish the capability to receive and transmit electronically certain administrative health care transactions, such as claims payments, in a standardized format.\\nSpecifically, the HIPAA Privacy Rule regulates use and disclosure of individually identifiable health information, known as “protected health information” (“PHI”). The HIPAA Security Rule requires covered entities to implement administrative, physical and technical safeguards to protect the security of electronic PHI. Certain provisions of the security and privacy regulations apply to business associates (entities that handle PHI on behalf of covered entities), and business associates are subject to direct liability for violation of these provisions. Furthermore, a covered entity may be subject to penalties as a result of a business associate violating HIPAA, if the business associate is found to be an agent of the covered entity.\\nCovered entities must report breaches of unsecured PHI to affected individuals without unreasonable delay, but not to exceed 60 days of discovery of the breach by a covered entity or its agents. Notification must also be made to HHS and, in certain situations involving large breaches, to the media. HHS is required to publish on its website a list of all covered entities that report a breach involving more than 500 individuals. All non-permitted uses or disclosures of unsecured PHI are presumed to be breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised. Various state laws and regulations may also require us to notify affected individuals in the event of a data breach involving individually identifiable information.\\nHIPAA violations by covered entities may result in civil and criminal penalties. Covered entities could face civil monetary penalties up to an annual maximum of $1,500,000 for uncorrected violations based on willful neglect. HHS enforces the regulations and performs audits to confirm compliance. Investigations of violations that indicate willful neglect, for which penalties are mandatory, are statutorily required. HHS may also resolve HIPAA violations through informal means, such as allowing a covered entity to implement a corrective action plan, but HHS has the discretion to move directly to impose monetary penalties and is required to impose penalties for violations resulting from willful neglect. In addition, state attorneys general are authorized to bring civil actions seeking either injunctions or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.\\nBanyan enforces a HIPAA compliance plan, which complies with the HIPAA privacy and security regulations. Banyan also has dedicated resources to monitor compliance with our HIPAA compliance program.\\n\\n| 5 |\\n\\nBanyan, its providers, and certain of its vendors are also subject to numerous other privacy and security laws and regulations at the federal and state levels. Banyan remains subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These laws vary and violations may result in additional penalties.\\nFraud and Abuse Laws. Federal and state enforcement authorities have prioritized the investigation and prosecution of health care fraud, waste and abuse. Fraud, waste and abuse prohibitions encompass a wide range of operating activities, including kickbacks or other inducements for referral of members, billing for unnecessary medical services by a provider and improper marketing and violation of patient privacy rights. Companies involved in public health care programs such as Medicaid and Medicare are required to maintain compliance programs to detect and deter fraud, waste and abuse, and are often the subject of fraud, waste and abuse investigations and audits. The regulations and contractual requirements applicable to participants in these public-sector programs are complex and subject to change. Although Banyan has structured a compliance program with care in an effort to meet all statutory and regulatory requirements, our policies and procedures will be continuously under review and subject to updates and our training and education programs will always be evolving. We intend to invest significant resources towards our compliance efforts.\\nFalse Claims Act. We are subject to federal and state laws and regulations that apply to the submission of information and claims to various agencies. For example, the federal False Claims Act provides, in part, that the federal government may bring a lawsuit against any person or entity who it believes has knowingly presented, or caused to be presented, a false or fraudulent request for payment from the federal government, or who has made a false statement or used a false record to get a claim approved. The federal government has taken the position that claims presented in violation of the federal anti-kickback statute may be considered a violation of the federal False Claims Act. Violations of the False Claims Act are punishable by treble damages and penalties of up to a specified dollar amount per false claim. In addition, a special provision under the False Claims Act allows a private person (for example, a “whistleblower” such as a disgruntled former associate, competitor or member) to bring an action under the False Claims Act on behalf of the government alleging that an entity has defrauded the federal government and permits the private person to share in any settlement of, or judgment entered in, the lawsuit. A number of states, including Florida, have adopted false claims acts that are similar to the federal False Claims Act.\\nMedicare and Medicaid Regulations. As a provider of services under the Medicare and Medicaid programs (the “Programs”), we are subject to federal and state laws and regulations governing reimbursement procedures and practices. These laws include the Medicare and Medicaid fraud and abuse statutes and regulations which, among other provisions, prohibit the payment or receipt of any form of remuneration in return for referring business or patients to providers for which payments are made by a governmental health care program. Violation of these laws may result in civil and criminal penalties, including substantial fines, loss of the right to participate in the Programs and imprisonment of responsible individuals. In addition, HIPAA expanded the federal government’s fraud and abuse enforcement powers. Among other provisions, HIPAA expands the federal government’s authority to prosecute fraud and abuse beyond Medicare and Medicaid to all payors; makes exclusion from the Programs mandatory for a minimum of five years for any felony conviction relating to fraud; requires that organizations contracting with another organization or individual take steps to be informed as to whether the organization or individual is excluded from Medicare and Medicaid participation; and enhances civil penalties by increasing the amount of fines permitted. These laws also include a prohibition on referrals contained in the Omnibus Budget Reconciliation Act of 1989, which prohibits referrals by physicians to clinical laboratories where the physician has a financial interest, and further prohibitions contained in the Omnibus Budget Reconciliation Act of 1993, which prohibits such referrals for a more extensive range of services, including durable medical equipment. Various federal and state laws impose civil and criminal penalties against participants in the Programs who make false claims for payment for services or otherwise engage in false billing practices.\\nMany state laws prohibit the payment or receipt or the offer of anything of value in return for, or to induce, a referral for health care goods or services. In addition, there are several other statutes that, although they do not explicitly address payments for referrals, could be interpreted as prohibiting the practice. While similar in many respects to the federal laws, these state laws vary from state to state, are often vague and have sometimes been interpreted inconsistently by courts and regulatory agencies. Private insurers and various state enforcement agencies have also increased their scrutiny of health care providers’ practices and claims.\\n\\n| 6 |\\n\\nThere can be no assurance that Banyan will not become the subject of a regulatory or other investigation or proceeding or that our interpretations of applicable health care laws and regulations will not be challenged. The defense of any such challenge could result in substantial cost to us, diversion of management’s time and attention, and could have a material adverse effect on The Company.\\nThe Social Security Act, as amended by HIPAA, provides for the mandatory exclusion of providers and related persons from participation in the Programs if the individual or entity has been convicted of a criminal offense related to the delivery of an item or service under the Programs or relating to neglect or abuse of patients. Further, individuals or entities may be, but are not required to be, excluded from the Programs in circumstances including, but not limited to, convictions relating to fraud; obstruction of an investigation of a controlled substance; license revocation or suspension; filing claims for excessive charges or unnecessary services or failure to furnish medically necessary services; or ownership or control by an individual who has been excluded from the Programs, against whom a civil monetary penalty related to the Programs has been assessed, or who has been convicted of a crime described in this section. The illegal remuneration provisions of the Social Security Act make it a felony to solicit, receive, offer to pay, or pay any kickback, bribe, or rebate in return for referring a patient for any item or service, or in return for purchasing, leasing or ordering any good, service or item, for which payment may be made under the Programs. Other provisions in HIPAA proscribe false statements in billing and in meeting reporting requirements and in representations made with respect to the conditions or operations of providers. A violation of the illegal remuneration statute is a felony and may result in the imposition of criminal penalties, including imprisonment for up to five years and/or a fine of up to $25,000. Further, a civil action to exclude a provider from participation in the Programs could occur. There are also other civil and criminal statutes applicable to the industry, such as those governing false billings and the health care/services offenses contained in HIPAA, including health care/services fraud, theft or embezzlement, false statements and obstruction of criminal investigation of offenses. Criminal sanctions for these health care criminal offenses can be severe, including imprisonment for up to 20 years.\\nResults of Operations\\nCOVID-19\\nIn March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic based on the rapid increase in global exposure. COVID-19 continues to spread throughout the world. We are closely monitoring developments and taking steps to mitigate the potential risks related to the COVID-19 pandemic to the Company, its employees, as well as its residential and consulting clients.\\nTo date COVID-19 has not substantially negatively impacted our revenues or operations. Our evaluations of our practices, procedures, and operations, related to COVID-19, is ongoing. Additional updates to policies, procedures and operations will occur as best practices are adopted and as we deem necessary or advisable, or as further governmental guidance or regulations are implemented.\\nThe following summary of our operations should be read in conjunction with our unaudited financial statements for the three months ended March 31, 2021 which are included in this quarterly report.\\nFor the three months ended March 31, 2021 compared to the three months ended March 31, 2020\\n\\n| Three Months Ended March 31, |\\n| 2021 | 2020 | Change |\\n| Revenue | $ | 606,925 | $ | 915 | $ | 606,010 |\\n| Cost of services | 232,460 | - | 232,460 |\\n| Operating expenses | 884,933 | 444,287 | 440,646 |\\n| Other expense | (59,516 | ) | (3 | ) | (59,513 | ) |\\n| Net Loss from continuing operations | $ | (569,984 | ) | $ | (443,375 | ) | $ | (126,609 | ) |\\n\\nWe recognized revenue of $606,925 for the three months ended March 31, 2021 compared to $915 for the three months ended March 31, 2020. The first operating facility began in May of 2020 with the acquisition of the St. Petersburg location and revenues began being reported at that time.\\n\\n| 7 |\\n\\nOperating expenses for the three months ended March 31, 2021 increased to $884,933 from $444,287 from the three months ended March 31, 2020. Operating expenses consist of salary expenses, general and administrative and professional fees. The increase in operating expense was primarily due to the acquisition of the St. Petersburg location in May of 2020 increasing general and administrative costs by $199,117 and an increase in lease expense of $117,614 from additional leases entered into during 2020.\\nOther expenses consist of an increase in interest expense from notes entered into starting September 2020.\\nOur net loss for the three months ended March 31, 2021 increased to 569,984 from $443,375 for the three months ended March 31, 2020 as net result of the factors mentioned above.\\nLiquidity and Capital Resources\\nThe following table provides selected financial data about us as of March 31, 2021 and December 31, 2020.\\n\\n| March 31, | December 30, |\\n| 2021 | 2020 | Change |\\n| Cash | $ | 3,441,841 | $ | 345,982 | $ | 3,095,859 |\\n| Current assets | $ | 3,998,035 | $ | 650,647 | $ | 3,347,388 |\\n| Current liabilities | 4,030,609 | 3,183,288 | 847,321 |\\n| Working capital | $ | (32,574) | $ | (2,532,641) | $ | 2,500,067 |\\n\\nAs of March 31, 2021, our working capital increased $2,500,067, primarily due to an increase in cash offset by an increase in current liabilities.\\nAs of March 31, 2021 and December 31, 2020, current assets consisted of cash, accounts receivable and other current assets. The increase in cash was primarily due to the issuance of 7,080,000 shares of restricted common stock at a purchase price of $0.50 per share for an aggregate amount of $3,540,000.\\nAs of March 31, 2021, current liabilities consisted of notes and loans payable in the amount of $759,248, accrued interest of $95,079, accrued expenses of $572,891, lease liability of $198,759, share liability of $2,325,000, deferred revenue of $25,703 and liabilities from discontinued operations of $53,929.\\nCash Flows\\n\\n| March 31, | March 31, |\\n| 2021 | 2020 | Change |\\n| Cash used in operating activities | $ | (228,006 | ) | $ | (427,757 | ) | $ | 199,751 |\\n| Cash provided by investing activities | 3,010,994 | - | 3,010,994 |\\n| Cash provided by financing activities | 312,871 | 11,885 | 300,986 |\\n| Net change in cash for period | $ | 3,095,859 | $ | (415,872 | ) | $ | 3,511,731 |\\n\\nCash flow from Operating Activities\\nDuring the three months ended March 31, 2021, we used $228,006 for operating activities compared to $427,757 cash used for operating activities during the three months ended March 31, 2020. The change in cash used for operating activities is due to an increase in non-cash lease operating expense, depreciation and amortization, accrued interest, and liabilities as well as $53,929 in liabilities from discontinued operations for the three months ended March 31, 2021.\\nCash flow from Financing Activities\\nThe cash flow from financing activities in the three months ended March 31, 2021 is $312,871, and $0 for the three months ended March 31, 2020. The increase is primarily due to $325,030 cash received for restricted common stock to be issued.\\nCash flow from Investing Activities\\nThe cash flow from investing activities for the three months ended March 31, 2021 was $3,010,994, and $0 for the three months ended March 31, 2020. This is primarily due to the cash from the first-time consolidation of the Company as a result of the Merger.\\nCritical Accounting Policies\\nWe prepare our financial statements in conformity with GAAP, which requires management to make certain estimates and apply judgments. We base our estimates and judgments on historical experience, current trends and other factors that management believes to be important at the time the financial statements are prepared. On a regular basis, we review our accounting policies and how they are applied and disclosed in our financial statements.\\nWhile we believe that the historical experience, current trends, and other factors considered support the preparation of our financial statements in conformity with GAAP, actual results could differ from our estimates and such differences could be material.\\nSee Note 2 - Significant Accounting Policies and the unaudited condensed consolidated financial statements that are included in this Report.\\n\\n| 8 |\\n\\nOff Balance Sheet Arrangements\\nWe do not engage in any activities involving variable interest entities or off-balance sheet arrangements.\\n\\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\\n\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act of 1934, as amended (the “Exchange Act”) reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\\nAs further discussed below, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on that evaluation, our chief executive officer and chief financial officer concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021. The material weaknesses relate to the absence of in-house accounting personnel with the ability to properly account for complex transactions and a lack of separation of duties between accounting and other functions.\\nWe hired a consulting firm to advise on technical issues related to U.S. GAAP as related to the maintenance of our accounting books and records and the preparation of our consolidated financial statements. Although we are aware of the risks associated with not having dedicated accounting personnel, we are also at an early stage in the development of our business. We anticipate expanding our accounting functions with dedicated staff and improving our internal accounting procedures and separation of duties when we can absorb the costs of such expansion and improvement with additional capital resources. In the meantime, management will continue to observe and assess our internal accounting function and make necessary improvements whenever they may be required. If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements, and we could be required to restate our financial results. In addition, if we are unable to successfully remediate this material weakness and if we are unable to produce accurate and timely financial statements, our stock price may be adversely affected, and we may be unable to maintain compliance with applicable stock exchange listing requirements.\\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Based on our evaluation under the framework in Internal Control—Integrated Framework (2013), our management concluded that, because of certain material weaknesses in our internal control over financial reporting our disclosure controls and procedures as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act were not effective as of March 31, 2021.\\n\\n| 9 |\\n\\nChanges in Internal Control over Financial Reporting\\nThere have been no changes in our internal control over financial reporting during the quarter ended March 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nPART II - OTHER INFORMATION\\n\\nFrom time to time, we may become involved in litigation relating to claims arising out of its operations in the normal course of business. We are not involved in any pending legal proceeding or litigation and, to the best of our knowledge, no governmental authority is contemplating any proceeding to which we area party or to which any of our properties is subject, which would reasonably be likely to have a material adverse effect on us.\\n\\nAs a “smaller reporting company,” we are not required to provide the information required by this Item.\\n\\nDuring the quarterly period ended March 31, 2021, we sold an aggregate of 7,080,000 shares of our common stock to 35 investors at a price of $0.50 per share for an aggregate purchase price of $3,540,000. The offers, sales and issuances of shares were deemed to be exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), in reliance on Section 4(a)(2) of the Securities Act and Rule 506(b) of Regulation D promulgated thereunder, as transactions by an issuer not involving a public offering. The recipients of shares in each of these transactions acquired the shares for investment only and not with a view to or for sale in connection with any distribution thereof and represented to us that they could bear the risks of the investment and could hold the securities for an indefinite period of time, and appropriate legends were affixed to the shares issued in these transactions. Each of the recipients of shares in these transactions represented to us in connection with their purchase that they were an accredited investor within the meaning of Rule 501 of Regulation D under the Securities Act.\\n\\n\\n| Exhibit No. | Description |\\n| 2.1 | Plan of Merger by and among Assisted 4 Living, Inc., BPCC Acquisition, Inc. and Banyan Pediatric Care Centers, Inc. dated March 23, 2021. (Previously filed on March 29, 2021 as Exhibit 2.1 of the Company’s Current Report on Form 8-K) |\\n| 31.1 | Certification of Principal Executive Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | Certification of Principal Financial Officer filed pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\\n\\n\\n| 10 |\\n\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| ASSISTED 4 LIVING, INC. |\\n| (Registrant) |\\n| Dated: May 18, 2021 | /s/ Louis Collier |\\n| Louis Collier |\\n| Chief Executive Officer (principal executive officer) |\\n\\n\\n| 11 |\\n\\n</text>\\n\\nWhat is the growth rate of the shareholders' deficit from the period of three months ended March 31, 2020 to the same period in 2021 in percentage?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -11.259563739001619.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 43,\n \"input_length\": 19987\n}"}}},{"rowIdx":44,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nTITAN COMPUTER SERVICES, INC.\n(UNAUDITED)\nContents\n\n| Page |\n| Condensed Consolidated Financial Statements (unaudited) |\n| Condensed Consolidated Balance Sheets as of March 31, 2018 (unaudited) and December 31, 2017 | 4 |\n| Condensed Consolidated Statements of Operations for the three months ended March 31, 2018 (unaudited) | 5 |\n| Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2018 (unaudited) | 6 |\n| Notes to Condensed Consolidated Financial Statements (unaudited) | 7-16 |\n\n3\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Balance Sheets |\n\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| (unaudited) |\n| ASSETS |\n| Current assets |\n| Cash | $ | 18,667 | $ | 24,867 |\n| Prepaid expense | 4,166 | 4,167 |\n| Total current assets | 22,833 | 29,034 |\n| Fixed assets, net | 7,842 | 8,713 |\n| Intangible assets, net | 11,824 | 11,977 |\n| Total assets | $ | 42,499 | $ | 49,724 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| Current liabilities |\n| Notes payable - related party | $ | 60,000 | $ | - |\n| Accounts payable - related party | 7,707 | 4,167 |\n| Accrued expenses | 221,993 | 189,198 |\n| Accrued expenses - related party | 9,923 | - |\n| Shareholder’s advance | 26,764 | 26,764 |\n| Total current liabilities | 326,387 | 220,129 |\n| Total liabilities | 326,387 | 220,129 |\n| Commitments and contingencies - Note 6 |\n| Stockholders’ deficit |\n| Preferred stock - no par value, 5,000,000 shares authorized, no shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively | - | - |\n| Common stock - no par value, 70,000,000 shares authorized, 22,803,659 and 21,728,659 shares issued, issuable, and outstanding at March 31, 2018 and December 31, 2017, respectively | 1,717,894 | 269,769 |\n| Additional paid in capital | (149,769 | ) | (149,769 | ) |\n| Accumulated deficit | (1,852,013 | ) | (290,405 | ) |\n| Total stockholders’ deficit | (283,888 | ) | (170,405 | ) |\n| Total liabilities and stockholders’ deficit | $ | 42,499 | $ | 49,724 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n4\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Statement of Operations |\n| For the three months ended March 31, 2018 |\n| (unaudited) |\n\n\n| Revenue | $ | - |\n| Operating expenses |\n| Professional fees | 12,900 |\n| Corporate expenses | 13,559 |\n| Salary expenses | 31,250 |\n| Stock-based compensation | 1,448,125 |\n| Other general and administrative expenses | 39,748 |\n| Total operating expenses | 1,545,582 |\n| Loss from operations | (1,545,582 | ) |\n| Other income (expenses) |\n| Interest expense | (16,026 | ) |\n| Total other income (expenses) | (16,026 | ) |\n| Net loss | $ | (1,561,608 | ) |\n| Earnings per share - basic and fully diluted | $ | (0.07 | ) |\n| Weighted average number of shares of common stock - basic and fully diluted | 22,768,103 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\n5\n\n| TITAN COMPUTER SERVICES, INC. |\n| and Subsidiary |\n| Condensed Consolidated Statement of Cash Flows |\n| For the three months ended March 31, 2018 |\n| (unaudited) |\n\n\n| Cash flows from operating activities: |\n| Net loss | $ | (1,561,608 | ) |\n| Adjustments to reconcile net loss to net cash used in operations: |\n| Depreciation expense | 871 |\n| Amortization expense | 153 |\n| Stock-based compensation | 1,448,125 |\n| Change in assets and liabilities: |\n| Accrued expenses | 30,233 |\n| Accrued expenses - related party | 16,026 |\n| Net cash used in operating activities | (66,200 | ) |\n| Cash flows from financing activities: |\n| Proceeds from notes payable - related party | 60,000 |\n| Net cash provided by financing activities | 60,000 |\n| Net decrease in cash | (6,200 | ) |\n| Cash at beginning of period | 24,867 |\n| Cash at end of period | $ | 18,667 |\n| Supplemental disclosure of cash flow information: |\n| Cash paid for interest | $ | - |\n| Cash paid for taxes | $ | - |\n\n\n| The accompanying notes are an integral part of these consolidated financial statements. |\n| The financial statements only reflect the current year as the Company was established on May 18, 2017. |\n\n6\nTITAN COMPUTER SERVICES, INC.\nAnd Subsidiary\nNotes to the Condensed Consolidated Financial Statements\nMarch 31, 2018\n(unaudited)\nNOTE 1 – NATURE OF OPERATIONS\nCompany Background\nTitan Computer Services, Inc. (the “Company,” “we,” “us,” “our,” or “Altitude - NY”), was incorporated in the State of New York on July 13, 1994.\nOn June 27, 2017, the Company successfully closed a Share Exchange transaction (“Share Exchange”) with the shareholders of Altitude International, Inc, (“Altitude”) a Wisconsin corporation. Altitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin. Altitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\nEffective February 13, 2018, majority of the shareholders of the Company approved the following changes to the Company’s Articles of Incorporation:\nAmend the Bylaws to Permit a Simple Majority Vote and Allow for the Appointment of up to Seven\nArticle II Section 10 of the Company’s Bylaws stated, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if all Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action except as otherwise permitted by the Certificate of Incorporation.”\nThe Bylaws were amended to allow for a simple majority vote as permitted by §615 of the New York Business Corporation Law. The amended section shall read, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if a majority of the Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action.”\nArticle III Section 2 of the Company’s Bylaws provided that the number of Directors constituting the entire Board “shall not be less than one nor more than three, as may be fixed by resolution of the Board of Director.” The Bylaws were amended to allow for additional directors as proposed herein (up to four) and to allow for additional directors as the Company grows (up to seven). The amended section shall include the number “seven” instead of “three” as the maximum number of directors.\nName Change from “Titan Computer Services, Inc.” to “Altitude International, Inc.”\nOn February 13, 2018, the majority of the shareholders of the Company approved the amendment to the Articles of Incorporation to change the Company’s name from “Titan Computer Services, Inc.” to “Altitude International, Inc.” The purpose of the name change will help further our brand identity and will reflect the major focus of our business operations, the manufacturing and distribution of products in the athletic training industry, specifically altitude training. The filing of the name change with the state of New York has not been completed as of the date of this report. Once processed by New York, the Company will apply for a name and symbol change with FINRA.\nNature of Operations\nThe product designs to be licensed from Sporting Edge UK, Ltd (“Sporting Edge UK”) are proven and cover a wide range of room sizes. The only requirement is to change from metric to imperial sizes where necessary.\nThere are three unique elements to the Altitude product:\n\n| · | Sophisticated Touch Screen control systems capable of integrating the control of simulated altitude, temperature and humidity. |\n\n\n| · | A unique design of Air Separation Unit with only a single active part that provides for ultra-reliable operation and a design life of greater than fifteen years. |\n\n\n| · | Proven training protocols that allow the desired training benefits to be achieved. |\n\n7\nAltitude has leased space in the Woodway facility in Waukesha, Wisconsin to undertake the manufacture of systems. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically-capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and provides the perfect environment to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\nRecapitalization of Altitude\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude which resulted in a change of control of the Company. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to all the individual shareholders of Altitude on a pro rata basis (one to one share exchange). In exchange for this stock issuance, the Company received 100% of the outstanding shares of Altitude. Following this Share Exchange, Altitude became a wholly-owned subsidiary of Titan. There was a cancellation of 14,700,000 shares of common stock of the Company that was held by the Company’s former majority stockholder as part of the share exchange agreement, which all had a net effect of a decrease of 8,598,000 shares in the Company’s outstanding shares. The business, assets and liabilities of the Company changed as a result of this reverse acquisition to Altitude’s business plan.\nThis share exchange transaction resulted in those shareholders obtaining a majority voting interest in –the Company and control of the Board of Directors of the Company. Generally accepted accounting principles require that the Company whose shareholders retain the majority interest and control in a combined business be treated as the acquirer for accounting purposes, resulting in a reverse acquisition with Altitude as the accounting acquirer and the Company as the acquired party. Accordingly, the share exchange transaction has been accounted for as a recapitalization of Altitude, whereby is deemed to be the continuing, surviving entity for accounting purposes but through reorganization, has deemed to have adopted the capital structure of Altitude - NY. The equity section of the accompanying condensed consolidated financial statements has been restated to reflect the recapitalization of the Company due to the reverse acquisition.\nAccordingly, all references to common shares of Altitude’s common stock have been restated to reflect the equivalent number of the Company’s common shares. In other words, the 6,102,000 Altitude shares outstanding at the time of the share exchange are restated to 21,228,659 common shares (prior to the 500,000 common share capital raise mentioned below that was conducted after the share exchange agreement), as of June 27, 2017. Each share of Altitude is accordingly restated at a multiple of approximately 3.48 shares of the Company for the weighted average shares outstanding for the loss per share calculations in the accompanying condensed consolidated statement of operations.\nThe book value of the net assets that for accounting purposes, were deemed to have been acquired by Altitude from the Company, as of the date of acquisition (June 27, 2017) were $0, after the waiver of all debts from officers and third parties.\nA condition to the closing of the Share Exchange Agreement was raising $100,000 in the Company. On June 27, 2017, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share which was kept at escrow account. During the recapitalization, the Company incurred legal fees of $12,500 which was paid through the attorney’s escrow account and recorded as transaction costs which were netted against the $100,000 proceeds.\nAltitude International, Inc.\nAltitude International, Inc. (“Altitude”) was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value. On May 18, 2017, 6,102,000 shares of common stock at $0.001 (par) were issued as founder shares, valued at a total of $6,102 to 15 individuals, including Mr. Dave Vincent who is the majority equity interest shareholder and the director of the Company. These shares were issued for future potential services from these various individuals and as of the date of this issuance, no value was placed on these future potential services and were therefore recorded at par value as stock-based compensation to the founders.\nOn June 27, 2017, after the closing of certain Stock Purchase Agreements, in private sale transaction and the Share Exchange Agreement, a change of control of the Company occurred, see recapitalization of Altitude mentioned above. Dave Vincent was the majority shareholder of the Company, owning 51.3 % of the issued and outstanding common shares of –the Company. See Notes 6 and 8.\nAltitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\n8\nChanges in Management and the Board of Directors\nOn June 27, 2017, pursuant to the Closing of the Share Exchange Agreement, Mr. Dave Vincent was appointed as the Company’s new CEO and Abraham Rosenblum resigned as CEO. Additionally, Mr. Vincent and Mr. Robert Kanuth were appointed as directors of the Company and Mr. Robert Klein resigned. On October 20, 2017, Greg Whyte was appointed to fill the vacancy as a director of the Company. On January 8, 2018, Joseph B. Frost was appointed to serve as the Chief Operating Officer and on February 13, 2018 Lesley Visser and Joseph B. Frost were elected to serve on the Board of Directors.\nNOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of presentation\nThe Company follows the accrual basis of accounting in accordance with generally accepted accounting principles in the United States of America and has a year-end of December 31.\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nManagement further acknowledges that it is solely responsible for adopting sound accounting practices, establishing and maintaining a system of internal accounting control and preventing and detecting fraud. The Company’s system of internal accounting control is designed to assure, among other items, that 1) recorded transactions are valid; 2) valid transactions are recorded; and 3) transactions are recorded in the proper period in a timely manner to produce financial statements which present fairly the financial condition, results of operations and cash flows of the Company for the respective periods being presented.\nGoing Concern and Liquidity\nWe have incurred recurring losses since inception and expect to continue to incur losses as a result of legal and professional fees and our corporate general and administrative expenses. At March 31, 2018, we had $18,667 in cash. Our net losses incurred for the three months ended March 31, 2018 amounted to $1,561,608 and working capital deficit was $303,554 at March 31, 2018. As a result, there is substantial doubt about our ability to continue as a going concern. In the event that we are unable to generate sufficient cash from our operating activities or raise additional funds, we may be required to delay, reduce or severely curtail our operations or otherwise impede our on-going business efforts, which could\nhave a material adverse effect on our business, operating results, financial condition and long-term prospects. The Company expects to seek to obtain additional funding through increased revenues and future financings. There can be no assurance as to the availability or terms upon which such financing and capital might be available.\nPrinciples of Consolidation\nThe consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Altitude. All significant intercompany balances and transactions have been eliminated in the consolidation. The consolidated financial statements included herein, presented in accordance with United States generally accepted accounting principles (“GAAP”) and stated in United States dollars, have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\nSignificant Estimates, Risks and Concentrations\nThese accompanying financial statements include some amounts that are based on management’s best estimates and judgments. The most significant estimates relate to the valuation of the software rights and redeemable common stock liability. It is reasonably possible that the above-mentioned estimate and others may be adjusted as more current information becomes available, and any adjustment could be significant in future reporting periods.\n9\nThe Company is dependent on its ability to handle rapidly substantial quantities of data and transactions on computer-based networks and the capacity, reliability and security of the electronic delivery systems and the Internet. Any significant failure or interruption of these systems could cause our systems to operate slowly or interrupt service for periods of time and could have a material adverse effect on our business and results of our operations. The Company may experience shortage of capacity and increased costs associated with such usage. These events may affect our ability to store, handle and deliver data and services to our customers.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.\nProperty, Plant and Equipment\nProperty and equipment are stated at cost, net of accumulated depreciation. Expenditures that extend the life, increase the capacity, or improve the efficiency of property and equipment are capitalized, while expenditures for repairs and maintenance are expensed as incurred. Depreciation is recognized using the straight-line method over the following approximate useful lives:\nMachinery and equipment\n3-5 Years\nIntangible Assets\nCosts incurred to file patent applications and acquired intangibles are capitalized when the Company believes that there is a high likelihood that the patent will be issued and there will be future economic benefit associated with the patent. These costs will be amortized on a straight-line basis over a 20 years life from the date of patent filing. All costs associated with abandoned patent applications are expensed. In addition, the Company will review the carrying value of patents for indicators of impairment on a periodic basis and if it determines that the carrying value is impaired, it values the patent at fair value. As of March 31, 2018, carrying value of patent was $11,824.\nIn accordance with the provisions of the applicable authoritative guidance, the Company’s long-lived assets and amortizable intangible assets are tested for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. The Company assesses the recoverability of such assets by determining whether their carrying value can be recovered through undiscounted future operating cash flows, including its estimates of revenue driven by assumed market segment share and estimated costs. If impairment is indicated, the\nCompany measures the amount of such impairment by comparing the fair value to the carrying value. The amortization of the trademark was not significant for the period ended March 31, 2018.\nImpairment of Long-Lived Assets\nThe Company’s long-lived assets and other assets (consisting of property and equipment) are reviewed for impairment in accordance with the guidance of the FASB ASC Topic 360-10, Property, Plant, and Equipment, and FASB ASC Topic 205, Presentation of Financial Statements. Long lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the undiscounted future net cash flows expected to be generated by that asset. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. For the three months ended March 31, 2018, the Company had not experienced impairment losses on its long-lived assets.\nRevenue Recognition\nThe Company recognizes revenue in accordance with ASC 605 Revenue Recognition (“ASC 605”). Revenue is recognized when all of the following four criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable, and (4) collectability is reasonably assured. Determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report.\nAdvertising Costs\nAdvertising costs are expensed as incurred. Advertising costs for the three months ended March 31, 2018 was $0.\n10\nStock-Based Compensation\nThe Company accounts for stock-based instruments issued to employees in accordance with ASC Topic 718. ASC Topic 718 requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation issued to employees. The value of the portion of an award that is ultimately expected to vest is recognized as an expense over the requisite service periods using the straight-line attribution method. The Company accounts for non-employee share-based awards in accordance with the measurement and recognition provisions ASC Topic 505-50. The Company estimates the fair value of stock options at the grant date by using the Black-Scholes option-pricing model.\nFair Value of Financial Instruments\nThe book values of cash, prepaid expenses, and accounts payable approximate their respective fair values due to the short-term nature of these instruments. The fair value hierarchy under GAAP distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs).\nThe hierarchy consists of three levels\n\n| · | Level one — Quoted market prices in active markets for identical assets or liabilities; |\n| · | Level two — Inputs other than level one inputs that are either directly or indirectly observable; and |\n| · | Level three — Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use. |\n\nDetermining which category an asset or liability falls within the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter.\nEarnings (Loss) Per Share\nBasic earnings (loss) per share are computed by dividing the net income by the weighted-average number of shares of common stock and common stock equivalents (primarily outstanding options and warrants). Common stock equivalents represent the dilutive effect of the assumed exercise of the outstanding stock options and warrants, using the treasury stock method. The calculation of fully diluted earnings per share assumes the dilutive effect of the exercise of outstanding options and warrants at either the beginning of the respective period presented or the date of issuance, whichever is later.\nIncome Taxes\nThe Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes”. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statements carrying amounts of existing assets and liabilities and loss carry-forwards and their respective tax bases.\nDeferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income (loss) in the years in which those temporary differences are expected to be recovered or settled.\nThe effect of a change in tax rules on deferred tax assets and liabilities is recognized in operations in the year of change. A valuation allowance is recorded when it is “more likely-than-not” that a deferred tax asset will not be realized.\nTax benefits of uncertain tax positions are recognized only if it is more likely than not that the Company will be able to sustain a position taken on an income tax return. The Company has no liability for uncertain tax positions as of December 31, 2017. Interest and penalties in any, related to unrecognized tax benefits would be recognized as interest expense. The Company does not have any accrued interest or penalties associated with unrecognized tax benefits, nor was any significant interest expense recognized during the three months ended March 31, 2018.\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\n11\nContingencies\nCertain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company, but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and its legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the nature of the guarantee would be disclosed.\nEffect of Recent Accounting Pronouncements\nGoing Concern\nASU 2014-15 – “Presentation of Financial Statements—Going Concern—Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”).” In August 2014, FASB issued guidance that requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity’s ability to continue as a going concern. The updated accounting guidance was effective for the Company on March 31, 2018. We have implemented this new accounting standard and we will update our liquidity disclosures as necessary.\nRecent Accounting Pronouncements\nRecently-Issued Accounting Standards: Management does not believe that any recently issued, but not yet effective, accounting standards if currently adopted would have a material effect on the accompanying financial statements.\nFinancial Instruments\nIn January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 will be effective for the Company beginning in its first quarter of 2019. The Company does not believe the adoption of ASU 2016-01 will have a material impact on its consolidated financial statements.\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. ASU 2016-13 will be effective for the Company beginning in its first quarter of 2021 and early adoption is permitted. The Company does not believe the adoption of ASU 2016-13 will have a material impact on its consolidated financial statements.\nLeases\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements. ASU 2016-02 will be effective for the Company beginning in its first quarter of 2020, and early adoption is permitted. The Company is currently evaluating the timing of its adoption and the impact of adopting ASU 2016-02 on its financial statements.\nStock Compensation\nIn March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which simplified certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company beginning in its first quarter of 2018. The Company is currently evaluating the impact of adopting ASU 2016-09 on its consolidated financial statements.\n12\nIncome Taxes\nIn October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16, Income Taxes (Topic 740): Intra-Entity Transfer of Assets Other than Inventory (“ASU 2016-16”), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-06 will be effective for the Company in its first quarter of 2019. The Company is currently evaluating the impact of adopting ASU 2016-16 on its consolidated financial statements.\nRevenue Recognition\nIn May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. ASU 2014-09 will be effective for the Company beginning in its first quarter of 2019, and early adoption is permitted.\nSubsequently, the FASB has issued the following standards related to ASU 2014-09: ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (“ASU 2016-08”); ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”); and ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”). The Company must adopt ASU 2016-08, ASU 2016-10 and ASU 2016-12 with ASU 2014-09 (collectively, the “new revenue standards”).\nThe new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company currently expects to adopt the new revenue standards in its first quarter of 2018 utilizing the full retrospective transition method. The Company is evaluating the effect of the adoption of the new revenue recognition standard as to whether it will have a material impact on its consolidated financial statements.\nNOTE 3 – FIXED ASSETS\nThe Company has fixed assets related to office equipment. The depreciation of the equipment is over a three-year period. As of March 31, 2018, and December 31, 2017, the Company had fixed assets, net of accumulated depreciation, of $7,842 and $8,713, respectively. The fixed assets are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Office equipment | $ | 10,455 | $ | 10,455 |\n| Total fixed assets | 10,455 | 10,455 |\n| Less: Accumulated depreciation | 2,613 | 1,742 |\n| Fixed assets, net | $ | 7,842 | $ | 8,713 |\n\nDepreciation of the office equipment for the three months ended March 31, 2018 was $871.\nNOTE 4 – INTANGIBLE ASSETS - TRADEMARK\nThe Company has intangible assets related to a trademark. The amortization of the intangible asset is over a twenty-year period. As of March 31, 2018, and December 31, 2017, the Company had intangible assets, net of accumulated amortization, of $11,824 and $11,977, respectively. The intangible assets are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Trademark | $ | 12,284 | $ | 12,284 |\n| Total intangible assets | 12,284 | 12,284 |\n| Less: Accumulated amortization | 460 | 307 |\n| Intangible assets, net | $ | 11,824 | $ | 11,977 |\n\nAmortization expense of the trademark for the three months ended March 31, 2018 was $153.\n13\nNOTE 5 – NOTES PAYABLE\n\n| Notes payable |\n| March 31, 2018 | December 31, 2017 |\n| Accrued | Accrued |\n| Principal | Interest | Total | Principal | Interest | Total |\n| Dave Vincent | $ | 20,000 | $ | 581 | $ | 20,581 | $ | - | $ | - | $ | - |\n| Joseph B. Frost | 40,000 | 679 | 40,679 | - | - | - |\n| Total | $ | 60,000 | $ | 1,260 | $ | 61,260 | $ | - | $ | - | $ | - |\n\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 7.\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 7.\nNOTE 6 – COMMITMENTS AND CONTINGENCIES\nThe Company is subject, from time to time, to claims by third parties under various legal disputes. The defense of such claims, or any adverse outcome relating to any such claims, could have a material adverse effect on the Company’s liquidity, financial condition and cash flows. As of May 14, 2018, the Company did not have any legal actions pending against it.\nOn June 27, 2017, Altitude entered a license agreement with Sporting Edge UK (see Note 1), Sporting Edge UK is the sole and exclusive owner of and has the right to license to licensee the ability to manufacture and sell rights to the full range of membrane-based systems for the production of reduced oxygen environments and associated services as well as the use of patents and trademarks held by Sporting Edge UK or Mr. David Vincent.\nSporting Edge UK agreed to grant the licensee exclusive right and license to the Manufacturing and Sales Rights in the Territory including the Continent of North America, Central America and the Continent of South America. On the effective date of this agreement and for a period of 5 years thereafter, the Company (“Licensee”) shall pay upfront payment of $10,000 to Licensor annually. In addition, commencing on the sixth anniversary of the effective date the licensee shall pay continuing royalty fees on all sales of product manufactured using the IP. The royalty payable shall be calculated as 0.5% of the Sale Price. The Company recorded the payment due of $4,167 under Prepaid expenses and accounts payable as of December 31, 2017.\nNOTE 7 – RELATED PARTY TRANSACTIONS\nAs of December 31, 2017, the balance due to our current CEO, David Vincent, was recorded under shareholder’s advance of $26,764, which is a verbal agreement, non-interest bearing, unsecured and payable on demand. These advances included $10,455 of acquisition of office equipment and $12,284 of acquisition of trademark which were disclosed at supplemental disclosure of non-cash flow investing activities of the statement of cash flow. On February 9, 2018, the Board of Directors changed the arrangement whereas the advance would begin accruing interest at the rate of 20%.\nAltitude has an oral agreement with its Chairman of the Board, Robert Kanuth, in which it will provide for reimbursement of private airline travel expenses incurred on behalf of the Company, for his use of an aircraft in which he has an interest in. These travel expenses totaled $123,750 for the period ended December 31, 2017 and is included in accrued expenses at March 31, 2018. In January 2018, the Board of Directors issued a one-time bonus to Mr. Kanuth, in the amount of $7,525, to compensate for the significant payable and what would have been interest. Additionally, the open balance will accrue interest at the rate of 20% per annum and, as of March 31, 2018, the accrued interest was $6,103.\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 8.\n14\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 5.\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 5.\nNOTE 8 – STOCKHOLDERS’ EQUITY\nPreferred Stock\nOn February 5, 2015, the Board of Directors of the Company authorized 5,000,000 shares of preferred stock with no par value. Each share of the preferred stock is entitled to one vote and is convertible into one share of common stock.\nAs of March 31, 2018, and December 31, 2017, the Company has no preferred stock issued and outstanding.\nCommon Stock\nAltitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value.\nOn June 12, 2017, Altitude issued 6,102,000 shares of its common stock at par value of $0.001 per share as founder shares for future potential services from 15 individuals, including David Vincent, who is the majority equity interest shareholder and the director of the Company, with a total recorded at par value of $6,102.\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude and the shareholders of Altitude. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to the individual shareholders of Altitude on a pro rata basis in exchange for receive 100% of the shares of Altitude. Following the Share Exchange, Altitude became a wholly-owned subsidiary of the Company. See Note 1.\nPrior to the Share Exchange Agreement, there were 22,828,659 shares of common stock of the Company issued and outstanding, 14,700,000 of which were cancelled on June 27, 2017. As consideration for the Share Exchange Agreement, the shareholders of Altitude received a total of 6,102,000 restricted shares of –the Company, proportionate to their shareholdings in Altitude.\nOn June 27, 2017, the date of closing of the Share Exchange Agreement, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share. Total proceed received was $87,500 after paying transaction costs of $12,500. Immediately following the Share Exchange agreement, there will are 21,728,659 shares of common stock issued and outstanding and no shares of preferred stock outstanding.\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 37,500 shares of common stock for legal work to date. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $50,625.\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for January 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 7.\nOn February 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for February 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\nOn March 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for March 2018. The common stock of the Company is thinly traded and had a value of $1.10 per share, therefore the Company recorded the transaction at $13,750. As of March 31, 2018, these shares had not been issued.\n15\nAs of March 31, 2018, and December 31, 2017, the Company has 22,803,659 and 21,728,659 shares of no par common stock issued, issuable, and outstanding.\nStock Option Plan\nOn February 13, 2018, the Company’s shareholders and Board of Directors approved the 2017 Incentive Stock Plan.\nNOTE 9 – INCOME TAXES\nAs of March 31, 2018, and December 31, 2017, the Company has net operating loss carry forwards of $403,890 and $290,405. The carry forward expires through the year 2038. The Company’s net operating loss carry forwards may be subject to annual limitations, which could reduce or defer the utilization of the losses as a result of an ownership change as defined in Section 382 of the Internal Revenue Code.\nThe Company’s tax expense differs from the “expected” tax expense for Federal income tax purposes (computed by applying the United States Federal tax rate of 21% to loss before taxes for fiscal year 2018 and 34% to loss before taxes for fiscal year 2017), as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Tax expense (benefit) at the statutory rate | $ | (23,832 | ) | $ | (60,985 | ) |\n| State income taxes, net of federal income tax benefit |\n| Change in valuation allowance | 23,832 | 60,985 |\n| Total | $ | - | $ | - |\n\nThe tax effects of the temporary differences between reportable financial statement income and taxable income are recognized as deferred tax assets and liabilities.\nThe tax year 2017 remains to examination by federal agencies and other jurisdictions in which it operates.\nThe tax effect of significant components of the Company’s deferred tax assets and liabilities at March 31, 2018 and December 31, 2017, are as follows:\n\n| March 31, | December 31, |\n| 2018 | 2017 |\n| Deferred tax assets: |\n| Net operating loss carryforward | $ | 84,817 | $ | 60,985 |\n| Timing differences | - | - |\n| Total gross deferred tax assets | 84,817 | 60,985 |\n| Less: Deferred tax asset valuation allowance | (84,817 | ) | (60,985 | ) |\n| Total net deferred taxes | $ | - | $ | - |\n\nIn assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.\nBecause of the historical earnings history of the Company, the net deferred tax assets for 2018 and 2017 were fully offset by a 100% valuation allowance. The valuation allowance for the remaining net deferred tax assets was $84,817 and $60,985 as of March 31, 2018 and December 31, 2017, respectively.\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 34% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\n16\n\nResults of Operations\nFor the three months ended March 31, 2018 Revenue The Company had no revenue for the three months ended March 31, 2018. Operating Expenses The Company had operating expenses of $1,545,582 for the three months ended March 31, 2018, which primarily consisted of stock-based compensation of $1,448,125. Net Loss The Company had a net loss of $1,561,608 for the three months ended March 31, 2018. The net loss was primarily to the abovementioned effect. Liquidity and Capital Resources As of March 31, 2018, the Company had cash and cash equivalents of $18,667. We do not have sufficient resources to effectuate our business. We expect to incur a minimum of $320,000 in expenses during the next twelve months of operations. We estimate that these expenses will be comprised primarily of general expenses including overhead, legal and accounting fees.\nWe used cash in operations of $66,200 for the three months ended March 31, 2018. The negative cash flow from operating activities for the three months ended March 31, 2018 is attributable to the Company’s net loss from operations of $1,561,608 primarily due to the issuance of common stock for services ($1,448,125).\nWe used cash in investing or financing activities of $0 for the three months ended March 31, 2018.\nWe had cash provided by financing activities of $60,000 for the three months ended March 31, 2018, consisting of loans from Dave Vincent and Joseph B. Frost.\nWe will have to raise funds to pay for our expenses. We may have to borrow money from shareholders or issue debt or equity or enter into a strategic arrangement with a third party. There can be no assurance that additional capital will be available to us. We currently have no arrangements or understandings with any person to obtain funds through bank loans, lines of credit or any other sources. Since we have no such arrangements or plans currently in effect, our inability to raise funds for our operations will have a severe negative impact on our ability to remain a viable company.\nPlan of Operation\nThe Company will produce systems under license from Sporting Edge UK Ltd. These systems include the control of simulated altitude as a minimum and often the simultaneous control of temperature and humidity, providing a full environmental capability. Also included in the license are the Training Protocols that Sporting Edge has established to ensure that the optimum results are achieved by athletes using the altitude facilities. The Company will lease space in the Woodway facility in Waukesha to undertake the manufacture of systems. This will consist primarily of manufacturing space, but with a small office content. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and so is a perfect environment in which to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\nThe Company has two approaches to penetrating the market.\n| · | The Company has appointed Woodway as the sole Distributor for North, South and Central America. This provides access to every professional Sports Club, College and University as well as many Hospitals and Military facilities. As a result, the time and cost associated with establishing and operating a sales force is avoided. |\n\n\n| · | The Company also has Board members and Company Ambassadors who are able to access key, top level decision makers via their personal contact networks. |\n\n17\nA demonstration Altitude Room has been installed at the Woodway facility in Waukesha to allow effective demonstration of the physiological changes brought about be reduced oxygen air. Customer support and installation activities will be carried out in association with the existing network of Woodway Service Centers. Once again, the cost and time of establishing such a network is avoided whilst ensuring that the vital support element is in place.\nCommercial operations will center in Florida where a second demonstration facility will be located, working in association with an existing top end Fitness facility.\nOff-balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.\n\nNot required.\n\nEvaluation of Disclosure Controls and Procedures\nThe Securities and Exchange Commission defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures of an issuer that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the issuer’s management, including its chief executive and chief financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Company maintains such a system of controls and procedures in an effort to ensure that all information which it is required to disclose in the reports it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified under the SEC’s rules and forms and that information required to be disclosed is accumulated and communicated to the chief executive and interim chief financial officer to allow timely decisions regarding disclosure.\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are not effective as of such date. The Chief Executive Officer and Chief Financial Officer have determined that the Company continues to have the following deficiencies which represent a material weakness:\n\n| · | The Company does not have independent directors; |\n| · | Lack of in-house personnel with the technical knowledge to identify and address some of the reporting issues surrounding certain complex or non-routine transactions. With material, complex and non-routine transactions, management has and will continue to seek guidance from third-party experts and/or consultants to gain a thorough understanding of these transactions; |\n| · | Insufficient personnel resources within the accounting function to segregate the duties over financial transaction processing and reporting; and |\n| · | Insufficient written policies and procedures over accounting transaction processing and period end financial disclosure and reporting processes. |\n| · | To remediate our internal control weaknesses, management intends to implement the following measures: |\n| · | As funding permits, the Company will add sufficient accounting personnel to properly segregate duties and to effect a timely, accurate preparation of the financial statements. |\n| · | The Company will hire staff technically proficient at applying U.S. GAAP to financial transactions and reporting. |\n| · | Upon the hiring of additional accounting personnel, the Company will develop and maintain adequate written accounting policies and procedures. |\n\n18\nThe additional hiring is contingent upon The Company’s efforts to obtain additional funding through equity or debt and the results of its operations. Management hopes to secure funds in the coming fiscal year but provides no assurances that it will be able to do so.\nLimitations on the Effectiveness of Controls\nThe Company’s officers do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of the control system must reflect that there are resource constraints and that the benefits must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Changes in Internal Control Over Financial Reporting During the fiscal quarter covered by this Quarterly Report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n19\nPART II. OTHER INFORMATION\n\nNone.\n\nNot required.\n\nDuring the quarter ending March 31, 2018, the Company issued the following unregistered securities. These securities were issued in reliance upon the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended, Regulation D promulgated thereunder as there was no general solicitation, and the transactions did not involve a public offering.\nEffective as of January 2, 2018, the Company issued 1,000,000 shares of the Company’s common stock to the Chief Operating Officer of the Company as payment for services rendered pursuant to an employment agreement.\nOn January 1, 2018, the Company issued 50,000 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\nEffective February 1, 2018, the Company issued 12,500 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\nNone.\n\nNot applicable.\n\nNone.\n20\n\n\n| Exhibit |\n| Number | Description |\n| 3.1 | Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 3.1.1 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 3.1.2 | Articles of Incorporation of Altitude International (incorporated by reference to the form 8-K filed by the Company on July 3, 2017). |\n| 3.2 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\n| 10.1 | Share Exchange Agreement (incorporated by reference to exhibit 10.1 to the form 8-K filed by the Company on July 3, 2017). |\n| 10.2 | Licensing Agreement (incorporated by reference to exhibit 10.2 to the form 8-K filed by the Company on July 3, 2017). |\n| 10.3 | Sole Distribution Agreement (incorporated by reference to exhibit 10.3 to the form 8-K filed by the Company on July 3, 2017). |\n| 31.1 | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101 INS | XBRL Instance Document |\n| 101 SCH | XBRL Taxonomy Extension Schema Document |\n| 101 CAL | XBRL Taxonomy Calculation Linkbase Document |\n| 101 DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101 LAB | XBRL Taxonomy Labels Linkbase Document |\n| 101 PRE | XBRL Taxonomy Presentation Linkbase Document |\n\n21\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| SIGNATURE | TITLE | DATE |\n| /s/ Dave Vincent | Principal Executive Officer and Principal Financial and Accounting Officer | May 21, 2018 |\n| Dave Vincent |\n\n22\n</text>\n\nWhat is the total net value of fixed assets and intangible assets at the end of Q2 2018 (June 30, 2018) in dollars if the yearly depreciation rate of both fixed assets and intangible assets stays unchanged?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nTITAN COMPUTER SERVICES, INC.\\n(UNAUDITED)\\nContents\\n\\n| Page |\\n| Condensed Consolidated Financial Statements (unaudited) |\\n| Condensed Consolidated Balance Sheets as of March 31, 2018 (unaudited) and December 31, 2017 | 4 |\\n| Condensed Consolidated Statements of Operations for the three months ended March 31, 2018 (unaudited) | 5 |\\n| Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2018 (unaudited) | 6 |\\n| Notes to Condensed Consolidated Financial Statements (unaudited) | 7-16 |\\n\\n3\\n\\n| TITAN COMPUTER SERVICES, INC. |\\n| and Subsidiary |\\n| Condensed Consolidated Balance Sheets |\\n\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| (unaudited) |\\n| ASSETS |\\n| Current assets |\\n| Cash | $ | 18,667 | $ | 24,867 |\\n| Prepaid expense | 4,166 | 4,167 |\\n| Total current assets | 22,833 | 29,034 |\\n| Fixed assets, net | 7,842 | 8,713 |\\n| Intangible assets, net | 11,824 | 11,977 |\\n| Total assets | $ | 42,499 | $ | 49,724 |\\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\\n| Current liabilities |\\n| Notes payable - related party | $ | 60,000 | $ | - |\\n| Accounts payable - related party | 7,707 | 4,167 |\\n| Accrued expenses | 221,993 | 189,198 |\\n| Accrued expenses - related party | 9,923 | - |\\n| Shareholder’s advance | 26,764 | 26,764 |\\n| Total current liabilities | 326,387 | 220,129 |\\n| Total liabilities | 326,387 | 220,129 |\\n| Commitments and contingencies - Note 6 |\\n| Stockholders’ deficit |\\n| Preferred stock - no par value, 5,000,000 shares authorized, no shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively | - | - |\\n| Common stock - no par value, 70,000,000 shares authorized, 22,803,659 and 21,728,659 shares issued, issuable, and outstanding at March 31, 2018 and December 31, 2017, respectively | 1,717,894 | 269,769 |\\n| Additional paid in capital | (149,769 | ) | (149,769 | ) |\\n| Accumulated deficit | (1,852,013 | ) | (290,405 | ) |\\n| Total stockholders’ deficit | (283,888 | ) | (170,405 | ) |\\n| Total liabilities and stockholders’ deficit | $ | 42,499 | $ | 49,724 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n4\\n\\n| TITAN COMPUTER SERVICES, INC. |\\n| and Subsidiary |\\n| Condensed Consolidated Statement of Operations |\\n| For the three months ended March 31, 2018 |\\n| (unaudited) |\\n\\n\\n| Revenue | $ | - |\\n| Operating expenses |\\n| Professional fees | 12,900 |\\n| Corporate expenses | 13,559 |\\n| Salary expenses | 31,250 |\\n| Stock-based compensation | 1,448,125 |\\n| Other general and administrative expenses | 39,748 |\\n| Total operating expenses | 1,545,582 |\\n| Loss from operations | (1,545,582 | ) |\\n| Other income (expenses) |\\n| Interest expense | (16,026 | ) |\\n| Total other income (expenses) | (16,026 | ) |\\n| Net loss | $ | (1,561,608 | ) |\\n| Earnings per share - basic and fully diluted | $ | (0.07 | ) |\\n| Weighted average number of shares of common stock - basic and fully diluted | 22,768,103 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.\\n5\\n\\n| TITAN COMPUTER SERVICES, INC. |\\n| and Subsidiary |\\n| Condensed Consolidated Statement of Cash Flows |\\n| For the three months ended March 31, 2018 |\\n| (unaudited) |\\n\\n\\n| Cash flows from operating activities: |\\n| Net loss | $ | (1,561,608 | ) |\\n| Adjustments to reconcile net loss to net cash used in operations: |\\n| Depreciation expense | 871 |\\n| Amortization expense | 153 |\\n| Stock-based compensation | 1,448,125 |\\n| Change in assets and liabilities: |\\n| Accrued expenses | 30,233 |\\n| Accrued expenses - related party | 16,026 |\\n| Net cash used in operating activities | (66,200 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds from notes payable - related party | 60,000 |\\n| Net cash provided by financing activities | 60,000 |\\n| Net decrease in cash | (6,200 | ) |\\n| Cash at beginning of period | 24,867 |\\n| Cash at end of period | $ | 18,667 |\\n| Supplemental disclosure of cash flow information: |\\n| Cash paid for interest | $ | - |\\n| Cash paid for taxes | $ | - |\\n\\n\\n| The accompanying notes are an integral part of these consolidated financial statements. |\\n| The financial statements only reflect the current year as the Company was established on May 18, 2017. |\\n\\n6\\nTITAN COMPUTER SERVICES, INC.\\nAnd Subsidiary\\nNotes to the Condensed Consolidated Financial Statements\\nMarch 31, 2018\\n(unaudited)\\nNOTE 1 – NATURE OF OPERATIONS\\nCompany Background\\nTitan Computer Services, Inc. (the “Company,” “we,” “us,” “our,” or “Altitude - NY”), was incorporated in the State of New York on July 13, 1994.\\nOn June 27, 2017, the Company successfully closed a Share Exchange transaction (“Share Exchange”) with the shareholders of Altitude International, Inc, (“Altitude”) a Wisconsin corporation. Altitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin. Altitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\\nEffective February 13, 2018, majority of the shareholders of the Company approved the following changes to the Company’s Articles of Incorporation:\\nAmend the Bylaws to Permit a Simple Majority Vote and Allow for the Appointment of up to Seven\\nArticle II Section 10 of the Company’s Bylaws stated, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if all Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action except as otherwise permitted by the Certificate of Incorporation.”\\nThe Bylaws were amended to allow for a simple majority vote as permitted by §615 of the New York Business Corporation Law. The amended section shall read, “Any action required or permitted to be taken by the Shareholders thereof may be taken without a meeting if a majority of the Shareholders entitled to vote thereon consent in writing to the adoption of a resolution authorizing the action.”\\nArticle III Section 2 of the Company’s Bylaws provided that the number of Directors constituting the entire Board “shall not be less than one nor more than three, as may be fixed by resolution of the Board of Director.” The Bylaws were amended to allow for additional directors as proposed herein (up to four) and to allow for additional directors as the Company grows (up to seven). The amended section shall include the number “seven” instead of “three” as the maximum number of directors.\\nName Change from “Titan Computer Services, Inc.” to “Altitude International, Inc.”\\nOn February 13, 2018, the majority of the shareholders of the Company approved the amendment to the Articles of Incorporation to change the Company’s name from “Titan Computer Services, Inc.” to “Altitude International, Inc.” The purpose of the name change will help further our brand identity and will reflect the major focus of our business operations, the manufacturing and distribution of products in the athletic training industry, specifically altitude training. The filing of the name change with the state of New York has not been completed as of the date of this report. Once processed by New York, the Company will apply for a name and symbol change with FINRA.\\nNature of Operations\\nThe product designs to be licensed from Sporting Edge UK, Ltd (“Sporting Edge UK”) are proven and cover a wide range of room sizes. The only requirement is to change from metric to imperial sizes where necessary.\\nThere are three unique elements to the Altitude product:\\n\\n| · | Sophisticated Touch Screen control systems capable of integrating the control of simulated altitude, temperature and humidity. |\\n\\n\\n| · | A unique design of Air Separation Unit with only a single active part that provides for ultra-reliable operation and a design life of greater than fifteen years. |\\n\\n\\n| · | Proven training protocols that allow the desired training benefits to be achieved. |\\n\\n7\\nAltitude has leased space in the Woodway facility in Waukesha, Wisconsin to undertake the manufacture of systems. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically-capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and provides the perfect environment to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\\nRecapitalization of Altitude\\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude which resulted in a change of control of the Company. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to all the individual shareholders of Altitude on a pro rata basis (one to one share exchange). In exchange for this stock issuance, the Company received 100% of the outstanding shares of Altitude. Following this Share Exchange, Altitude became a wholly-owned subsidiary of Titan. There was a cancellation of 14,700,000 shares of common stock of the Company that was held by the Company’s former majority stockholder as part of the share exchange agreement, which all had a net effect of a decrease of 8,598,000 shares in the Company’s outstanding shares. The business, assets and liabilities of the Company changed as a result of this reverse acquisition to Altitude’s business plan.\\nThis share exchange transaction resulted in those shareholders obtaining a majority voting interest in –the Company and control of the Board of Directors of the Company. Generally accepted accounting principles require that the Company whose shareholders retain the majority interest and control in a combined business be treated as the acquirer for accounting purposes, resulting in a reverse acquisition with Altitude as the accounting acquirer and the Company as the acquired party. Accordingly, the share exchange transaction has been accounted for as a recapitalization of Altitude, whereby is deemed to be the continuing, surviving entity for accounting purposes but through reorganization, has deemed to have adopted the capital structure of Altitude - NY. The equity section of the accompanying condensed consolidated financial statements has been restated to reflect the recapitalization of the Company due to the reverse acquisition.\\nAccordingly, all references to common shares of Altitude’s common stock have been restated to reflect the equivalent number of the Company’s common shares. In other words, the 6,102,000 Altitude shares outstanding at the time of the share exchange are restated to 21,228,659 common shares (prior to the 500,000 common share capital raise mentioned below that was conducted after the share exchange agreement), as of June 27, 2017. Each share of Altitude is accordingly restated at a multiple of approximately 3.48 shares of the Company for the weighted average shares outstanding for the loss per share calculations in the accompanying condensed consolidated statement of operations.\\nThe book value of the net assets that for accounting purposes, were deemed to have been acquired by Altitude from the Company, as of the date of acquisition (June 27, 2017) were $0, after the waiver of all debts from officers and third parties.\\nA condition to the closing of the Share Exchange Agreement was raising $100,000 in the Company. On June 27, 2017, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share which was kept at escrow account. During the recapitalization, the Company incurred legal fees of $12,500 which was paid through the attorney’s escrow account and recorded as transaction costs which were netted against the $100,000 proceeds.\\nAltitude International, Inc.\\nAltitude International, Inc. (“Altitude”) was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value. On May 18, 2017, 6,102,000 shares of common stock at $0.001 (par) were issued as founder shares, valued at a total of $6,102 to 15 individuals, including Mr. Dave Vincent who is the majority equity interest shareholder and the director of the Company. These shares were issued for future potential services from these various individuals and as of the date of this issuance, no value was placed on these future potential services and were therefore recorded at par value as stock-based compensation to the founders.\\nOn June 27, 2017, after the closing of certain Stock Purchase Agreements, in private sale transaction and the Share Exchange Agreement, a change of control of the Company occurred, see recapitalization of Altitude mentioned above. Dave Vincent was the majority shareholder of the Company, owning 51.3 % of the issued and outstanding common shares of –the Company. See Notes 6 and 8.\\nAltitude will operate through Northern, Central, and South America sales by way of its sole distribution agreement with Woodway Inc. to execute the current business plan of athletic training industry, specifically altitude training. Our objective is to be recognized as one of the upper tier specialty altitude training equipment providers.\\n8\\nChanges in Management and the Board of Directors\\nOn June 27, 2017, pursuant to the Closing of the Share Exchange Agreement, Mr. Dave Vincent was appointed as the Company’s new CEO and Abraham Rosenblum resigned as CEO. Additionally, Mr. Vincent and Mr. Robert Kanuth were appointed as directors of the Company and Mr. Robert Klein resigned. On October 20, 2017, Greg Whyte was appointed to fill the vacancy as a director of the Company. On January 8, 2018, Joseph B. Frost was appointed to serve as the Chief Operating Officer and on February 13, 2018 Lesley Visser and Joseph B. Frost were elected to serve on the Board of Directors.\\nNOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of presentation\\nThe Company follows the accrual basis of accounting in accordance with generally accepted accounting principles in the United States of America and has a year-end of December 31.\\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\\nManagement further acknowledges that it is solely responsible for adopting sound accounting practices, establishing and maintaining a system of internal accounting control and preventing and detecting fraud. The Company’s system of internal accounting control is designed to assure, among other items, that 1) recorded transactions are valid; 2) valid transactions are recorded; and 3) transactions are recorded in the proper period in a timely manner to produce financial statements which present fairly the financial condition, results of operations and cash flows of the Company for the respective periods being presented.\\nGoing Concern and Liquidity\\nWe have incurred recurring losses since inception and expect to continue to incur losses as a result of legal and professional fees and our corporate general and administrative expenses. At March 31, 2018, we had $18,667 in cash. Our net losses incurred for the three months ended March 31, 2018 amounted to $1,561,608 and working capital deficit was $303,554 at March 31, 2018. As a result, there is substantial doubt about our ability to continue as a going concern. In the event that we are unable to generate sufficient cash from our operating activities or raise additional funds, we may be required to delay, reduce or severely curtail our operations or otherwise impede our on-going business efforts, which could\\nhave a material adverse effect on our business, operating results, financial condition and long-term prospects. The Company expects to seek to obtain additional funding through increased revenues and future financings. There can be no assurance as to the availability or terms upon which such financing and capital might be available.\\nPrinciples of Consolidation\\nThe consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Altitude. All significant intercompany balances and transactions have been eliminated in the consolidation. The consolidated financial statements included herein, presented in accordance with United States generally accepted accounting principles (“GAAP”) and stated in United States dollars, have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission.\\nUse of Estimates\\nThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.\\nSignificant Estimates, Risks and Concentrations\\nThese accompanying financial statements include some amounts that are based on management’s best estimates and judgments. The most significant estimates relate to the valuation of the software rights and redeemable common stock liability. It is reasonably possible that the above-mentioned estimate and others may be adjusted as more current information becomes available, and any adjustment could be significant in future reporting periods.\\n9\\nThe Company is dependent on its ability to handle rapidly substantial quantities of data and transactions on computer-based networks and the capacity, reliability and security of the electronic delivery systems and the Internet. Any significant failure or interruption of these systems could cause our systems to operate slowly or interrupt service for periods of time and could have a material adverse effect on our business and results of our operations. The Company may experience shortage of capacity and increased costs associated with such usage. These events may affect our ability to store, handle and deliver data and services to our customers.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.\\nProperty, Plant and Equipment\\nProperty and equipment are stated at cost, net of accumulated depreciation. Expenditures that extend the life, increase the capacity, or improve the efficiency of property and equipment are capitalized, while expenditures for repairs and maintenance are expensed as incurred. Depreciation is recognized using the straight-line method over the following approximate useful lives:\\nMachinery and equipment\\n3-5 Years\\nIntangible Assets\\nCosts incurred to file patent applications and acquired intangibles are capitalized when the Company believes that there is a high likelihood that the patent will be issued and there will be future economic benefit associated with the patent. These costs will be amortized on a straight-line basis over a 20 years life from the date of patent filing. All costs associated with abandoned patent applications are expensed. In addition, the Company will review the carrying value of patents for indicators of impairment on a periodic basis and if it determines that the carrying value is impaired, it values the patent at fair value. As of March 31, 2018, carrying value of patent was $11,824.\\nIn accordance with the provisions of the applicable authoritative guidance, the Company’s long-lived assets and amortizable intangible assets are tested for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. The Company assesses the recoverability of such assets by determining whether their carrying value can be recovered through undiscounted future operating cash flows, including its estimates of revenue driven by assumed market segment share and estimated costs. If impairment is indicated, the\\nCompany measures the amount of such impairment by comparing the fair value to the carrying value. The amortization of the trademark was not significant for the period ended March 31, 2018.\\nImpairment of Long-Lived Assets\\nThe Company’s long-lived assets and other assets (consisting of property and equipment) are reviewed for impairment in accordance with the guidance of the FASB ASC Topic 360-10, Property, Plant, and Equipment, and FASB ASC Topic 205, Presentation of Financial Statements. Long lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the undiscounted future net cash flows expected to be generated by that asset. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. For the three months ended March 31, 2018, the Company had not experienced impairment losses on its long-lived assets.\\nRevenue Recognition\\nThe Company recognizes revenue in accordance with ASC 605 Revenue Recognition (“ASC 605”). Revenue is recognized when all of the following four criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable, and (4) collectability is reasonably assured. Determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report.\\nAdvertising Costs\\nAdvertising costs are expensed as incurred. Advertising costs for the three months ended March 31, 2018 was $0.\\n10\\nStock-Based Compensation\\nThe Company accounts for stock-based instruments issued to employees in accordance with ASC Topic 718. ASC Topic 718 requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation issued to employees. The value of the portion of an award that is ultimately expected to vest is recognized as an expense over the requisite service periods using the straight-line attribution method. The Company accounts for non-employee share-based awards in accordance with the measurement and recognition provisions ASC Topic 505-50. The Company estimates the fair value of stock options at the grant date by using the Black-Scholes option-pricing model.\\nFair Value of Financial Instruments\\nThe book values of cash, prepaid expenses, and accounts payable approximate their respective fair values due to the short-term nature of these instruments. The fair value hierarchy under GAAP distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs).\\nThe hierarchy consists of three levels\\n\\n| · | Level one — Quoted market prices in active markets for identical assets or liabilities; |\\n| · | Level two — Inputs other than level one inputs that are either directly or indirectly observable; and |\\n| · | Level three — Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use. |\\n\\nDetermining which category an asset or liability falls within the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter.\\nEarnings (Loss) Per Share\\nBasic earnings (loss) per share are computed by dividing the net income by the weighted-average number of shares of common stock and common stock equivalents (primarily outstanding options and warrants). Common stock equivalents represent the dilutive effect of the assumed exercise of the outstanding stock options and warrants, using the treasury stock method. The calculation of fully diluted earnings per share assumes the dilutive effect of the exercise of outstanding options and warrants at either the beginning of the respective period presented or the date of issuance, whichever is later.\\nIncome Taxes\\nThe Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes”. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statements carrying amounts of existing assets and liabilities and loss carry-forwards and their respective tax bases.\\nDeferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income (loss) in the years in which those temporary differences are expected to be recovered or settled.\\nThe effect of a change in tax rules on deferred tax assets and liabilities is recognized in operations in the year of change. A valuation allowance is recorded when it is “more likely-than-not” that a deferred tax asset will not be realized.\\nTax benefits of uncertain tax positions are recognized only if it is more likely than not that the Company will be able to sustain a position taken on an income tax return. The Company has no liability for uncertain tax positions as of December 31, 2017. Interest and penalties in any, related to unrecognized tax benefits would be recognized as interest expense. The Company does not have any accrued interest or penalties associated with unrecognized tax benefits, nor was any significant interest expense recognized during the three months ended March 31, 2018.\\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 35% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\\n11\\nContingencies\\nCertain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company, but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and its legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed.\\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the nature of the guarantee would be disclosed.\\nEffect of Recent Accounting Pronouncements\\nGoing Concern\\nASU 2014-15 – “Presentation of Financial Statements—Going Concern—Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”).” In August 2014, FASB issued guidance that requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity’s ability to continue as a going concern. The updated accounting guidance was effective for the Company on March 31, 2018. We have implemented this new accounting standard and we will update our liquidity disclosures as necessary.\\nRecent Accounting Pronouncements\\nRecently-Issued Accounting Standards: Management does not believe that any recently issued, but not yet effective, accounting standards if currently adopted would have a material effect on the accompanying financial statements.\\nFinancial Instruments\\nIn January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 will be effective for the Company beginning in its first quarter of 2019. The Company does not believe the adoption of ASU 2016-01 will have a material impact on its consolidated financial statements.\\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. ASU 2016-13 will be effective for the Company beginning in its first quarter of 2021 and early adoption is permitted. The Company does not believe the adoption of ASU 2016-13 will have a material impact on its consolidated financial statements.\\nLeases\\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements. ASU 2016-02 will be effective for the Company beginning in its first quarter of 2020, and early adoption is permitted. The Company is currently evaluating the timing of its adoption and the impact of adopting ASU 2016-02 on its financial statements.\\nStock Compensation\\nIn March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which simplified certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company beginning in its first quarter of 2018. The Company is currently evaluating the impact of adopting ASU 2016-09 on its consolidated financial statements.\\n12\\nIncome Taxes\\nIn October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16, Income Taxes (Topic 740): Intra-Entity Transfer of Assets Other than Inventory (“ASU 2016-16”), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-06 will be effective for the Company in its first quarter of 2019. The Company is currently evaluating the impact of adopting ASU 2016-16 on its consolidated financial statements.\\nRevenue Recognition\\nIn May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. ASU 2014-09 will be effective for the Company beginning in its first quarter of 2019, and early adoption is permitted.\\nSubsequently, the FASB has issued the following standards related to ASU 2014-09: ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (“ASU 2016-08”); ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”); and ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”). The Company must adopt ASU 2016-08, ASU 2016-10 and ASU 2016-12 with ASU 2014-09 (collectively, the “new revenue standards”).\\nThe new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company currently expects to adopt the new revenue standards in its first quarter of 2018 utilizing the full retrospective transition method. The Company is evaluating the effect of the adoption of the new revenue recognition standard as to whether it will have a material impact on its consolidated financial statements.\\nNOTE 3 – FIXED ASSETS\\nThe Company has fixed assets related to office equipment. The depreciation of the equipment is over a three-year period. As of March 31, 2018, and December 31, 2017, the Company had fixed assets, net of accumulated depreciation, of $7,842 and $8,713, respectively. The fixed assets are as follows:\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| Office equipment | $ | 10,455 | $ | 10,455 |\\n| Total fixed assets | 10,455 | 10,455 |\\n| Less: Accumulated depreciation | 2,613 | 1,742 |\\n| Fixed assets, net | $ | 7,842 | $ | 8,713 |\\n\\nDepreciation of the office equipment for the three months ended March 31, 2018 was $871.\\nNOTE 4 – INTANGIBLE ASSETS - TRADEMARK\\nThe Company has intangible assets related to a trademark. The amortization of the intangible asset is over a twenty-year period. As of March 31, 2018, and December 31, 2017, the Company had intangible assets, net of accumulated amortization, of $11,824 and $11,977, respectively. The intangible assets are as follows:\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| Trademark | $ | 12,284 | $ | 12,284 |\\n| Total intangible assets | 12,284 | 12,284 |\\n| Less: Accumulated amortization | 460 | 307 |\\n| Intangible assets, net | $ | 11,824 | $ | 11,977 |\\n\\nAmortization expense of the trademark for the three months ended March 31, 2018 was $153.\\n13\\nNOTE 5 – NOTES PAYABLE\\n\\n| Notes payable |\\n| March 31, 2018 | December 31, 2017 |\\n| Accrued | Accrued |\\n| Principal | Interest | Total | Principal | Interest | Total |\\n| Dave Vincent | $ | 20,000 | $ | 581 | $ | 20,581 | $ | - | $ | - | $ | - |\\n| Joseph B. Frost | 40,000 | 679 | 40,679 | - | - | - |\\n| Total | $ | 60,000 | $ | 1,260 | $ | 61,260 | $ | - | $ | - | $ | - |\\n\\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 7.\\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 7.\\nNOTE 6 – COMMITMENTS AND CONTINGENCIES\\nThe Company is subject, from time to time, to claims by third parties under various legal disputes. The defense of such claims, or any adverse outcome relating to any such claims, could have a material adverse effect on the Company’s liquidity, financial condition and cash flows. As of May 14, 2018, the Company did not have any legal actions pending against it.\\nOn June 27, 2017, Altitude entered a license agreement with Sporting Edge UK (see Note 1), Sporting Edge UK is the sole and exclusive owner of and has the right to license to licensee the ability to manufacture and sell rights to the full range of membrane-based systems for the production of reduced oxygen environments and associated services as well as the use of patents and trademarks held by Sporting Edge UK or Mr. David Vincent.\\nSporting Edge UK agreed to grant the licensee exclusive right and license to the Manufacturing and Sales Rights in the Territory including the Continent of North America, Central America and the Continent of South America. On the effective date of this agreement and for a period of 5 years thereafter, the Company (“Licensee”) shall pay upfront payment of $10,000 to Licensor annually. In addition, commencing on the sixth anniversary of the effective date the licensee shall pay continuing royalty fees on all sales of product manufactured using the IP. The royalty payable shall be calculated as 0.5% of the Sale Price. The Company recorded the payment due of $4,167 under Prepaid expenses and accounts payable as of December 31, 2017.\\nNOTE 7 – RELATED PARTY TRANSACTIONS\\nAs of December 31, 2017, the balance due to our current CEO, David Vincent, was recorded under shareholder’s advance of $26,764, which is a verbal agreement, non-interest bearing, unsecured and payable on demand. These advances included $10,455 of acquisition of office equipment and $12,284 of acquisition of trademark which were disclosed at supplemental disclosure of non-cash flow investing activities of the statement of cash flow. On February 9, 2018, the Board of Directors changed the arrangement whereas the advance would begin accruing interest at the rate of 20%.\\nAltitude has an oral agreement with its Chairman of the Board, Robert Kanuth, in which it will provide for reimbursement of private airline travel expenses incurred on behalf of the Company, for his use of an aircraft in which he has an interest in. These travel expenses totaled $123,750 for the period ended December 31, 2017 and is included in accrued expenses at March 31, 2018. In January 2018, the Board of Directors issued a one-time bonus to Mr. Kanuth, in the amount of $7,525, to compensate for the significant payable and what would have been interest. Additionally, the open balance will accrue interest at the rate of 20% per annum and, as of March 31, 2018, the accrued interest was $6,103.\\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 8.\\n14\\nOn February 7, 2018, Dave Vincent, the Company’s majority shareholder and director, loaned the Company $20,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $581, and the principal balance was $20,000. See Note 5.\\nOn March 2, 2018, Joseph B. Frost, a director, loaned the Company $40,000 in the form of a promissory note. The note bears interest of 20% and has the term of one year, at which time all principal and interest will be paid in a balloon payment. As of March 31, 2018, the accrued interest was $679, and the principal balance was $40,000. See Note 5.\\nNOTE 8 – STOCKHOLDERS’ EQUITY\\nPreferred Stock\\nOn February 5, 2015, the Board of Directors of the Company authorized 5,000,000 shares of preferred stock with no par value. Each share of the preferred stock is entitled to one vote and is convertible into one share of common stock.\\nAs of March 31, 2018, and December 31, 2017, the Company has no preferred stock issued and outstanding.\\nCommon Stock\\nAltitude was incorporated on May 18, 2017 under the laws of the state of Wisconsin with 100,000,000 authorized common stock with $0.001 par value.\\nOn June 12, 2017, Altitude issued 6,102,000 shares of its common stock at par value of $0.001 per share as founder shares for future potential services from 15 individuals, including David Vincent, who is the majority equity interest shareholder and the director of the Company, with a total recorded at par value of $6,102.\\nOn June 27, 2017, the Company entered into a share exchange transaction with Altitude and the shareholders of Altitude. Pursuant to the terms of the Share Exchange, the Company agreed to issue 6,102,000 shares of its common stock to the individual shareholders of Altitude on a pro rata basis in exchange for receive 100% of the shares of Altitude. Following the Share Exchange, Altitude became a wholly-owned subsidiary of the Company. See Note 1.\\nPrior to the Share Exchange Agreement, there were 22,828,659 shares of common stock of the Company issued and outstanding, 14,700,000 of which were cancelled on June 27, 2017. As consideration for the Share Exchange Agreement, the shareholders of Altitude received a total of 6,102,000 restricted shares of –the Company, proportionate to their shareholdings in Altitude.\\nOn June 27, 2017, the date of closing of the Share Exchange Agreement, the Company issued 500,000 shares of its common stock to an accredited investor pursuant to a Subscription Agreement for $100,000, or $0.20 per share. Total proceed received was $87,500 after paying transaction costs of $12,500. Immediately following the Share Exchange agreement, there will are 21,728,659 shares of common stock issued and outstanding and no shares of preferred stock outstanding.\\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 37,500 shares of common stock for legal work to date. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $50,625.\\nOn January 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for January 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\\nOn January 2, 2018, the Company issued 1,000,000 shares of common stock to Joseph B. Frost, the Company’s Chief Operating Officer, under his employment agreement. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $1,350,000. See Note 7.\\nOn February 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for February 2018. The common stock of the Company is thinly traded and had a value of $1.35 per share, therefore the Company recorded the transaction at $16,875.\\nOn March 1, 2018, the Company was contractually obligated to issue its legal counsel 12,500 shares of common stock for legal work for March 2018. The common stock of the Company is thinly traded and had a value of $1.10 per share, therefore the Company recorded the transaction at $13,750. As of March 31, 2018, these shares had not been issued.\\n15\\nAs of March 31, 2018, and December 31, 2017, the Company has 22,803,659 and 21,728,659 shares of no par common stock issued, issuable, and outstanding.\\nStock Option Plan\\nOn February 13, 2018, the Company’s shareholders and Board of Directors approved the 2017 Incentive Stock Plan.\\nNOTE 9 – INCOME TAXES\\nAs of March 31, 2018, and December 31, 2017, the Company has net operating loss carry forwards of $403,890 and $290,405. The carry forward expires through the year 2038. The Company’s net operating loss carry forwards may be subject to annual limitations, which could reduce or defer the utilization of the losses as a result of an ownership change as defined in Section 382 of the Internal Revenue Code.\\nThe Company’s tax expense differs from the “expected” tax expense for Federal income tax purposes (computed by applying the United States Federal tax rate of 21% to loss before taxes for fiscal year 2018 and 34% to loss before taxes for fiscal year 2017), as follows:\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| Tax expense (benefit) at the statutory rate | $ | (23,832 | ) | $ | (60,985 | ) |\\n| State income taxes, net of federal income tax benefit |\\n| Change in valuation allowance | 23,832 | 60,985 |\\n| Total | $ | - | $ | - |\\n\\nThe tax effects of the temporary differences between reportable financial statement income and taxable income are recognized as deferred tax assets and liabilities.\\nThe tax year 2017 remains to examination by federal agencies and other jurisdictions in which it operates.\\nThe tax effect of significant components of the Company’s deferred tax assets and liabilities at March 31, 2018 and December 31, 2017, are as follows:\\n\\n| March 31, | December 31, |\\n| 2018 | 2017 |\\n| Deferred tax assets: |\\n| Net operating loss carryforward | $ | 84,817 | $ | 60,985 |\\n| Timing differences | - | - |\\n| Total gross deferred tax assets | 84,817 | 60,985 |\\n| Less: Deferred tax asset valuation allowance | (84,817 | ) | (60,985 | ) |\\n| Total net deferred taxes | $ | - | $ | - |\\n\\nIn assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.\\nBecause of the historical earnings history of the Company, the net deferred tax assets for 2018 and 2017 were fully offset by a 100% valuation allowance. The valuation allowance for the remaining net deferred tax assets was $84,817 and $60,985 as of March 31, 2018 and December 31, 2017, respectively.\\nOn December 22, 2017, the United States Government passed new tax legislation that, among other provisions, will lower the corporate tax rate from 34% to 21%. In addition to applying the new lower corporate tax rate in 2018 and thereafter to any taxable income we may have, the legislation affects the way we can use and carry forward net operating losses previously accumulated and results in a revaluation of deferred tax assets recorded on our balance sheet. Given that the deferred tax assets are offset by a full valuation allowance, these changes will have no net impact on the Company’s financial position and net loss. However, if and when we become profitable, we will receive a reduced benefit from such deferred tax assets. Had this legislation been effective prior to our December 31, 2017, fiscal year-end, the effect of the legislation would have been a reduction in deferred tax assets and the corresponding valuation allowance.\\n16\\n\\nResults of Operations\\nFor the three months ended March 31, 2018 Revenue The Company had no revenue for the three months ended March 31, 2018. Operating Expenses The Company had operating expenses of $1,545,582 for the three months ended March 31, 2018, which primarily consisted of stock-based compensation of $1,448,125. Net Loss The Company had a net loss of $1,561,608 for the three months ended March 31, 2018. The net loss was primarily to the abovementioned effect. Liquidity and Capital Resources As of March 31, 2018, the Company had cash and cash equivalents of $18,667. We do not have sufficient resources to effectuate our business. We expect to incur a minimum of $320,000 in expenses during the next twelve months of operations. We estimate that these expenses will be comprised primarily of general expenses including overhead, legal and accounting fees.\\nWe used cash in operations of $66,200 for the three months ended March 31, 2018. The negative cash flow from operating activities for the three months ended March 31, 2018 is attributable to the Company’s net loss from operations of $1,561,608 primarily due to the issuance of common stock for services ($1,448,125).\\nWe used cash in investing or financing activities of $0 for the three months ended March 31, 2018.\\nWe had cash provided by financing activities of $60,000 for the three months ended March 31, 2018, consisting of loans from Dave Vincent and Joseph B. Frost.\\nWe will have to raise funds to pay for our expenses. We may have to borrow money from shareholders or issue debt or equity or enter into a strategic arrangement with a third party. There can be no assurance that additional capital will be available to us. We currently have no arrangements or understandings with any person to obtain funds through bank loans, lines of credit or any other sources. Since we have no such arrangements or plans currently in effect, our inability to raise funds for our operations will have a severe negative impact on our ability to remain a viable company.\\nPlan of Operation\\nThe Company will produce systems under license from Sporting Edge UK Ltd. These systems include the control of simulated altitude as a minimum and often the simultaneous control of temperature and humidity, providing a full environmental capability. Also included in the license are the Training Protocols that Sporting Edge has established to ensure that the optimum results are achieved by athletes using the altitude facilities. The Company will lease space in the Woodway facility in Waukesha to undertake the manufacture of systems. This will consist primarily of manufacturing space, but with a small office content. The work will primarily consist of the assembly of components into the unique licensed designs. Initial recruitment of technically capable persons will be necessary, followed by short training blocks to pass on the required skills. At least one person is likely to visit the UK to see systems in operation and obtain hands-on experience of the manufacturing requirement. Woodway is an engineering-based company and so is a perfect environment in which to establish an operation which is in many ways similar to their own. In addition, many aspects of infrastructure – goods handling, welfare facilities, etc. – can be accessed immediately without expense to Altitude.\\nThe Company has two approaches to penetrating the market.\\n| · | The Company has appointed Woodway as the sole Distributor for North, South and Central America. This provides access to every professional Sports Club, College and University as well as many Hospitals and Military facilities. As a result, the time and cost associated with establishing and operating a sales force is avoided. |\\n\\n\\n| · | The Company also has Board members and Company Ambassadors who are able to access key, top level decision makers via their personal contact networks. |\\n\\n17\\nA demonstration Altitude Room has been installed at the Woodway facility in Waukesha to allow effective demonstration of the physiological changes brought about be reduced oxygen air. Customer support and installation activities will be carried out in association with the existing network of Woodway Service Centers. Once again, the cost and time of establishing such a network is avoided whilst ensuring that the vital support element is in place.\\nCommercial operations will center in Florida where a second demonstration facility will be located, working in association with an existing top end Fitness facility.\\nOff-balance Sheet Arrangements\\nWe do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.\\n\\nNot required.\\n\\nEvaluation of Disclosure Controls and Procedures\\nThe Securities and Exchange Commission defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures of an issuer that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the issuer’s management, including its chief executive and chief financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Company maintains such a system of controls and procedures in an effort to ensure that all information which it is required to disclose in the reports it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified under the SEC’s rules and forms and that information required to be disclosed is accumulated and communicated to the chief executive and interim chief financial officer to allow timely decisions regarding disclosure.\\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are not effective as of such date. The Chief Executive Officer and Chief Financial Officer have determined that the Company continues to have the following deficiencies which represent a material weakness:\\n\\n| · | The Company does not have independent directors; |\\n| · | Lack of in-house personnel with the technical knowledge to identify and address some of the reporting issues surrounding certain complex or non-routine transactions. With material, complex and non-routine transactions, management has and will continue to seek guidance from third-party experts and/or consultants to gain a thorough understanding of these transactions; |\\n| · | Insufficient personnel resources within the accounting function to segregate the duties over financial transaction processing and reporting; and |\\n| · | Insufficient written policies and procedures over accounting transaction processing and period end financial disclosure and reporting processes. |\\n| · | To remediate our internal control weaknesses, management intends to implement the following measures: |\\n| · | As funding permits, the Company will add sufficient accounting personnel to properly segregate duties and to effect a timely, accurate preparation of the financial statements. |\\n| · | The Company will hire staff technically proficient at applying U.S. GAAP to financial transactions and reporting. |\\n| · | Upon the hiring of additional accounting personnel, the Company will develop and maintain adequate written accounting policies and procedures. |\\n\\n18\\nThe additional hiring is contingent upon The Company’s efforts to obtain additional funding through equity or debt and the results of its operations. Management hopes to secure funds in the coming fiscal year but provides no assurances that it will be able to do so.\\nLimitations on the Effectiveness of Controls\\nThe Company’s officers do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of the control system must reflect that there are resource constraints and that the benefits must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Changes in Internal Control Over Financial Reporting During the fiscal quarter covered by this Quarterly Report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\n19\\nPART II. OTHER INFORMATION\\n\\nNone.\\n\\nNot required.\\n\\nDuring the quarter ending March 31, 2018, the Company issued the following unregistered securities. These securities were issued in reliance upon the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended, Regulation D promulgated thereunder as there was no general solicitation, and the transactions did not involve a public offering.\\nEffective as of January 2, 2018, the Company issued 1,000,000 shares of the Company’s common stock to the Chief Operating Officer of the Company as payment for services rendered pursuant to an employment agreement.\\nOn January 1, 2018, the Company issued 50,000 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\\nEffective February 1, 2018, the Company issued 12,500 shares of the Company’s common stock to its legal counsel as payment for services rendered pursuant to an engagement agreement.\\nNone.\\n\\nNot applicable.\\n\\nNone.\\n20\\n\\n\\n| Exhibit |\\n| Number | Description |\\n| 3.1 | Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\\n| 3.1.1 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\\n| 3.1.2 | Articles of Incorporation of Altitude International (incorporated by reference to the form 8-K filed by the Company on July 3, 2017). |\\n| 3.2 | Amended Articles of Incorporation (incorporated by reference from the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on January 19, 2016). |\\n| 10.1 | Share Exchange Agreement (incorporated by reference to exhibit 10.1 to the form 8-K filed by the Company on July 3, 2017). |\\n| 10.2 | Licensing Agreement (incorporated by reference to exhibit 10.2 to the form 8-K filed by the Company on July 3, 2017). |\\n| 10.3 | Sole Distribution Agreement (incorporated by reference to exhibit 10.3 to the form 8-K filed by the Company on July 3, 2017). |\\n| 31.1 | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2 | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 101 INS | XBRL Instance Document |\\n| 101 SCH | XBRL Taxonomy Extension Schema Document |\\n| 101 CAL | XBRL Taxonomy Calculation Linkbase Document |\\n| 101 DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101 LAB | XBRL Taxonomy Labels Linkbase Document |\\n| 101 PRE | XBRL Taxonomy Presentation Linkbase Document |\\n\\n21\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| SIGNATURE | TITLE | DATE |\\n| /s/ Dave Vincent | Principal Executive Officer and Principal Financial and Accounting Officer | May 21, 2018 |\\n| Dave Vincent |\\n\\n22\\n</text>\\n\\nWhat is the total net value of fixed assets and intangible assets at the end of Q2 2018 (June 30, 2018) in dollars if the yearly depreciation rate of both fixed assets and intangible assets stays unchanged?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 18642.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 44,\n \"input_length\": 14657\n}"}}},{"rowIdx":45,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\nPOOL CORPORATION\nConsolidated Statements of Income\n(Unaudited)\n(In thousands, except per share data)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net sales | $ | 597,456 | $ | 585,900 |\n| Cost of sales | 422,825 | 419,827 |\n| Gross profit | 174,631 | 166,073 |\n| Selling and administrative expenses | 136,245 | 132,532 |\n| Operating income | 38,386 | 33,541 |\n| Interest and other non-operating expenses, net | 6,616 | 3,527 |\n| Income before income taxes and equity earnings | 31,770 | 30,014 |\n| Income tax benefit | (802 | ) | (1,279 | ) |\n| Equity earnings in unconsolidated investments, net | 65 | 46 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Earnings per share: |\n| Basic | $ | 0.83 | $ | 0.78 |\n| Diluted | $ | 0.80 | $ | 0.75 |\n| Weighted average shares outstanding: |\n| Basic | 39,479 | 40,370 |\n| Diluted | 40,696 | 41,862 |\n| Cash dividends declared per common share | $ | 0.45 | $ | 0.37 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n1\nPOOL CORPORATION\nConsolidated Statements of Comprehensive Income\n(Unaudited)\n(In thousands)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Other comprehensive (loss) income: |\n| Foreign currency translation gains | 214 | 976 |\n| Change in unrealized (losses) gains on interest rate swaps, net of change in taxes of $90 and $(275) | (269 | ) | 824 |\n| Total other comprehensive (loss) income | (55 | ) | 1,800 |\n| Comprehensive income | $ | 32,582 | $ | 33,139 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n2\nPOOL CORPORATION\nConsolidated Balance Sheets\n(In thousands, except share data)\n| March 31, | March 31, | December 31, |\n| 2019 | 2018 | 2018 (1) |\n| (Unaudited) | (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 28,581 | $ | 8,803 | $ | 16,358 |\n| Receivables, net | 72,352 | 75,889 | 69,493 |\n| Receivables pledged under receivables facility | 240,775 | 238,707 | 138,308 |\n| Product inventories, net | 815,742 | 703,793 | 672,579 |\n| Prepaid expenses and other current assets | 16,116 | 23,714 | 18,506 |\n| Total current assets | 1,173,566 | 1,050,906 | 915,244 |\n| Property and equipment, net | 107,690 | 109,310 | 106,964 |\n| Goodwill | 188,478 | 189,759 | 188,472 |\n| Other intangible assets, net | 11,744 | 12,926 | 12,004 |\n| Equity interest investments | 1,200 | 1,150 | 1,213 |\n| Operating lease assets | 177,293 | — | — |\n| Other assets | 18,379 | 15,615 | 16,974 |\n| Total assets | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\n| Liabilities and stockholders’ equity |\n| Current liabilities: |\n| Accounts payable | $ | 472,487 | $ | 467,795 | $ | 237,835 |\n| Accrued expenses and other current liabilities | 47,658 | 45,504 | 58,607 |\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 | 9,168 |\n| Current operating lease liabilities | 55,744 | — | — |\n| Total current liabilities | 597,623 | 534,085 | 305,610 |\n| Deferred income taxes | 29,368 | 24,947 | 29,399 |\n| Long-term debt, net | 677,243 | 547,324 | 657,593 |\n| Other long-term liabilities | 26,469 | 23,525 | 24,679 |\n| Non-current operating lease liabilities | 122,770 | — | — |\n| Total liabilities | 1,453,473 | 1,129,881 | 1,017,281 |\n| Stockholders’ equity: |\n| Common stock, $0.001 par value; 100,000,000 shares authorized;39,679,157, 40,568,775 and 39,506,067 shares issued andoutstanding at March 31, 2019, March 31, 2018 andDecember 31, 2018, respectively | 40 | 41 | 40 |\n| Additional paid-in capital | 463,522 | 437,878 | 453,193 |\n| Retained deficit | (227,633 | ) | (182,580 | ) | (218,646 | ) |\n| Accumulated other comprehensive loss | (11,052 | ) | (5,554 | ) | (10,997 | ) |\n| Total stockholders’ equity | 224,877 | 249,785 | 223,590 |\n| Total liabilities and stockholders’ equity | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\n\n(1) Derived from audited financial statements.\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n3\nPOOL CORPORATION\nCondensed Consolidated Statements of Cash Flows\n(Unaudited)\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Operating activities |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\n| Depreciation | 6,649 | 6,299 |\n| Amortization | 375 | 470 |\n| Share-based compensation | 3,259 | 3,321 |\n| Equity earnings in unconsolidated investments, net | (65 | ) | (46 | ) |\n| Other | 512 | 681 |\n| Changes in operating assets and liabilities, net of effects of acquisitions: |\n| Receivables | (103,122 | ) | (117,377 | ) |\n| Product inventories | (128,206 | ) | (168,518 | ) |\n| Prepaid expenses and other assets | (1,427 | ) | (3,843 | ) |\n| Accounts payable | 230,030 | 222,285 |\n| Accrued expenses and other current liabilities | (11,838 | ) | (18,760 | ) |\n| Net cash provided by (used in) operating activities | 28,804 | (44,149 | ) |\n| Investing activities |\n| Acquisition of businesses, net of cash acquired | (9,370 | ) | (578 | ) |\n| Purchases of property and equipment, net of sale proceeds | (6,739 | ) | (14,639 | ) |\n| Net cash used in investing activities | (16,109 | ) | (15,217 | ) |\n| Financing activities |\n| Proceeds from revolving line of credit | 206,190 | 148,335 |\n| Payments on revolving line of credit | (253,249 | ) | (170,012 | ) |\n| Proceeds from asset-backed financing | 80,100 | 80,000 |\n| Payments on asset-backed financing | (13,500 | ) | (20,000 | ) |\n| Proceeds from short-term borrowings and current portion of long-term debt | 13,713 | 10,798 |\n| Payments on short-term borrowings and current portion of long-term debt | (1,148 | ) | (848 | ) |\n| Payments of deferred and contingent acquisition consideration | (311 | ) | (265 | ) |\n| Payments of deferred financing costs | — | (8 | ) |\n| Proceeds from stock issued under share-based compensation plans | 7,071 | 7,808 |\n| Payments of cash dividends | (17,819 | ) | (15,011 | ) |\n| Purchases of treasury stock | (23,097 | ) | (2,592 | ) |\n| Net cash (used in) provided by financing activities | (2,050 | ) | 38,205 |\n| Effect of exchange rate changes on cash and cash equivalents | 1,578 | 24 |\n| Change in cash and cash equivalents | 12,223 | (21,137 | ) |\n| Cash and cash equivalents at beginning of period | 16,358 | 29,940 |\n| Cash and cash equivalents at end of period | $ | 28,581 | $ | 8,803 |\n\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\n4\nPOOL CORPORATION\nConsolidated Statements of Changes in Stockholders’ Equity\n(Unaudited)\n(In thousands)\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\n| Shares | Amount | Capital | Deficit | Loss | Total |\n| Balance at December 31, 2018 | 39,506 | $ | 40 | $ | 453,193 | $ | (218,646 | ) | $ | (10,997 | ) | $ | 223,590 |\n| Net income | — | — | — | 32,637 | — | 32,637 |\n| Foreign currency translation | — | — | — | — | 214 | 214 |\n| Interest rate swaps, net of the change in taxes of $90 | — | — | — | — | (269 | ) | (269 | ) |\n| Repurchases of common stock, net of retirements | (155 | ) | (1 | ) | — | (23,096 | ) | — | (23,097 | ) |\n| Share-based compensation | — | — | 3,259 | — | — | 3,259 |\n| Adoption of ASU 2016-02 | — | — | — | (709 | ) | — | (709 | ) |\n| Issuance of shares under share-based compensation plans | 328 | 1 | 7,070 | — | — | 7,071 |\n| Declaration of cash dividends | — | — | — | (17,819 | ) | — | (17,819 | ) |\n| Balance at March 31, 2019 | 39,679 | $ | 40 | $ | 463,522 | $ | (227,633 | ) | $ | (11,052 | ) | $ | 224,877 |\n\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\n| Shares | Amount | Capital | Deficit | Loss | Total |\n| Balance at December 31, 2017 | 40,212 | $ | 40 | $ | 426,750 | $ | (196,316 | ) | $ | (7,328 | ) | $ | 223,146 |\n| Net income | — | — | — | 31,339 | — | 31,339 |\n| Foreign currency translation | — | — | — | — | 976 | 976 |\n| Interest rate swaps, net of the change in taxes of $(275) | — | — | — | — | 824 | 824 |\n| Repurchases of common stock, net of retirements | (18 | ) | — | — | (2,592 | ) | — | (2,592 | ) |\n| Share-based compensation | — | — | 3,321 | — | — | 3,321 |\n| Issuance of shares under share-based compensation plans | 375 | 1 | 7,807 | — | — | 7,808 |\n| Declaration of cash dividends | — | — | — | (15,011 | ) | — | (15,011 | ) |\n| Other | — | — | — | — | (26 | ) | (26 | ) |\n| Balance at March 31, 2018 | 40,569 | $ | 41 | $ | 437,878 | $ | (182,580 | ) | $ | (5,554 | ) | $ | 249,785 |\n\n5\nPOOL CORPORATION\nNotes to Consolidated Financial Statements\n(Unaudited)\nNote 1 – Summary of Significant Accounting Policies\nPool Corporation (the Company, which may be referred to as we, us or our) prepared the unaudited interim Consolidated Financial Statements following U.S. generally accepted accounting principles (GAAP) and the requirements of the Securities and Exchange Commission (SEC) for interim financial information. As permitted under those rules, we have condensed or omitted certain footnotes and other financial information required for complete financial statements.\nThe Consolidated Financial Statements include all normal and recurring adjustments that are necessary for a fair presentation of our financial position and operating results. All significant intercompany accounts and intercompany transactions have been eliminated.\nA description of our significant accounting policies is included in our 2018 Annual Report on Form 10-K. You should read the interim Consolidated Financial Statements in conjunction with the Consolidated Financial Statements and accompanying notes in our 2018 Annual Report on Form 10-K. The results for our three month period ended March 31, 2019 are not necessarily indicative of the expected results for our fiscal year ending December 31, 2019.\nNewly Adopted Accounting Pronouncements\nOn January 1, 2019, we adopted Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) and all the related amendments, which are codified into Accounting Standards Codification (ASC) 842. The adoption of ASU 2016-02 significantly increased assets and liabilities on our Consolidated Balance Sheets as we recorded a right-of-use asset and corresponding liability for each of our existing operating leases. We adopted this guidance using the modified retrospective approach by recognizing a cumulative adjustment to retained earnings on the adoption date, which was not material. Additionally, we elected to apply the practical expedient that allows us to exclude comparative presentation; thus, we did not restate our prior period balance sheets to reflect the new guidance.\nWe recorded operating lease assets and operating lease liabilities of approximately $175.7 million and $181.6 million, respectively, as of January 1, 2019. The difference between the operating lease assets and operating lease liabilities primarily represents our straight-line rent liability of $5.1 million recorded under previous accounting guidance. Under ASU 2016-02, this liability is considered a reduction of the operating lease asset. We recorded the remaining difference between our operating lease assets and operating lease liabilities, net of the deferred tax impact, as an adjustment to retained earnings. Additionally, we reclassified prepaid rent of $4.9 million as of January 1, 2019 to our operating lease asset resulting in a balance of $180.6 million as of the adoption date.\nThe adoption of this guidance did not materially impact our results of operations or cash flows. See Commitments and Contingencies within this note below for additional information regarding our adoption of this new guidance.\nOn January 1, 2019, we adopted ASU 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This new standard expands and refines hedge accounting for both financial and non-financial risk components, aligns the recognition and presentation of the effects of hedging instruments and hedge items in the financial statements and includes certain targeted improvements to ease the application of current guidance related to the assessment of hedge effectiveness. The adoption of this guidance did not impact our results of operations, statement of financial position or cash flows.\nCommitments and Contingencies\nWe lease facilities for our corporate and administrative offices, sales centers and centralized shipping locations under operating leases that expire in various years through 2032. Most of our leases contain five-year terms with renewal options that allow us to extend the lease term beyond the initial period, subject to terms agreed upon at lease inception. Based on our leasing practices and contract negotiations, we determined that we are not reasonably certain to exercise the renewal options and, as such, we have not included optional renewal periods in our measurement of operating lease assets, liabilities and expected lease terms.\nWe elected to apply the package of practical expedients available within ASU 2016-02, which is intended to provide some relief to issuers. Electing this option allowed us to retain our existing assessment of whether an arrangement is or contains a lease, is classified as an operating or financing lease and contains initial direct costs. We also elected the practical expedients that allow us to exclude short-term leases from our Consolidated Balance Sheets and to combine lease and non-lease components.\n6\nFor leases with step rent provisions whereby the rental payments increase incrementally over the life of the lease, we recognize expense on a straight-line basis determined by the total lease payments over the lease term. To the extent we determine that future obligations related to real estate taxes, insurance and other lease components are variable, we exclude them from the measurement of our operating lease assets and liabilities.\nSome of our real estate agreements include rental payments adjusted periodically for inflation. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.\nThe table below presents expense associated with facility and vehicle operating leases (in thousands):\n| Three Months Ended |\n| March 31, |\n| Lease Cost | Classification | 2019 | 2018 |\n| Operating lease cost (1) | Selling and administrative expenses | $ | 15,070 | $ | 14,553 |\n| Variable lease cost | Selling and administrative expenses | 3,259 | 3,021 |\n\n(1) Includes short-term lease cost, which is not material\nBased on our lease portfolio as of March 31, 2019, the table below sets forth the approximate future lease payments related to operating leases with initial terms of one year or more (in thousands):\n| 2019 | $ | 38,389 |\n| 2020 | 50,443 |\n| 2021 | 39,184 |\n| 2022 | 29,883 |\n| 2023 | 18,089 |\n| Thereafter | 17,554 |\n| Total lease payments | 193,542 |\n| Less: interest | 15,028 |\n| Present value of lease liabilities | 178,514 |\n\nTo calculate the present value of our lease liabilities, we determined our incremental borrowing rate based on the effective interest rate on our unsecured syndicated senior credit facility (the Credit Facility) adjusted for a collateral feature similar to that of our leased properties. The table below presents the weighted-average remaining lease term (years) of our operating leases and the weighted-average discount rate used in the above calculation:\n| March 31, |\n| Lease Term and Discount Rate | 2019 |\n| Weighted-average remaining lease term (years) |\n| Operating leases | 5.21 |\n| Weighted-average discount rate |\n| Operating leases | 3.5 | % |\n\n7\nThe table below presents the amount of cash paid for amounts included in the measurement of lease liabilities (in thousands):\n| Three Months Ended |\n| March 31, |\n| 2019 |\n| Operating cash flows for lease liabilities | $ | 14,080 |\n\nWe lease corporate and administrative offices from Northpark Corporate Center, LLC (NCC), an entity in which we have held a 50% ownership interest since May 2005. NCC owns and operates an office building in Covington, Louisiana. As of March 31, 2019, we occupy approximately 60,293 square feet of office space and we pay rent of $97,976 per month. Our lease term ends in May 2025. We recorded rent expense of $0.3 million for each of the three month periods ended March 31, 2019 and March 31, 2018.\nIncome Taxes\nWe reduce federal and state income taxes payable by the tax benefits associated with the exercise of nonqualified stock options and the lapse of restrictions on restricted stock awards. To the extent realized tax deductions exceed the amount of previously recognized deferred tax benefits related to share-based compensation, we record an excess tax benefit. We record all excess tax benefits as a component of income tax benefit or expense on the Consolidated Statements of Income in the period in which stock options are exercised or restrictions on awards lapse. We recorded excess tax benefits of $8.8 million in the first three months of 2019 compared to $9.0 million in the same period of 2018.\nRetained Deficit\nWe account for the retirement of treasury shares as a reduction of retained earnings (deficit). As of March 31, 2019, the Retained deficit on our Consolidated Balance Sheets reflects cumulative net income, the cumulative impact of adjustments for changes in accounting pronouncements, treasury share retirements since the inception of our share repurchase programs of $1,449.9 million and cumulative dividends of $512.9 million.\nAccumulated Other Comprehensive Loss\nThe table below presents the components of our Accumulated other comprehensive loss balance (in thousands):\n| March 31, | December 31, |\n| 2019 | 2018 | 2018 |\n| Foreign currency translation adjustments | $ | (12,208 | ) | $ | (6,528 | ) | $ | (12,422 | ) |\n| Unrealized gains on interest rate swaps, net of tax (1) | 1,156 | 974 | 1,425 |\n| Accumulated other comprehensive loss | $ | (11,052 | ) | $ | (5,554 | ) | $ | (10,997 | ) |\n\n| (1) | In February 2018, the Financial Accounting Standards Board (FASB) issued guidance that allows entities the option to reclassify the tax effects related to items in accumulated other comprehensive income (loss) to retained earnings (deficit) if deemed to be stranded in accumulated other comprehensive income (loss) due to U.S. tax reform. We do not have any material amounts stranded in Accumulated other comprehensive loss as a result of U.S. tax reform. |\n\n8\nRecent Accounting Pronouncements Pending Adoption\n| Standard | Description | Effective Date | Effect on Financial Statements and Other Significant Matters |\n| ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments | Changes the way companies evaluate credit losses for most financial assets and certain other instruments. For trade and other receivables, held-to-maturity debt securities, loans and other instruments, entities will be required to use a new forward-looking “expected loss” model to evaluate impairment, potentially resulting in earlier recognition of allowances for losses. The new standard also requires enhanced disclosures, including the requirement to disclose the information used to track credit quality by year of origination for most financing receivables. The guidance must be applied using a cumulative-effect transition method. | Annual periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\n| ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment | Eliminates the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge (commonly referred to as Step 2 under the current guidance). Rather, the measurement of a goodwill impairment charge will be based on the excess of a reporting unit’s carrying value over its fair value (Step 1 under the current guidance). This guidance should be applied prospectively. | Annual and interim impairment tests performed in periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\n\nNote 2 – Earnings Per Share\nWe calculate basic earnings per share (EPS) by dividing Net income by the weighted average number of common shares outstanding. We include outstanding unvested restricted stock awards of our common stock in the basic weighted average share calculation. Diluted EPS reflects the dilutive effects of potentially dilutive securities, which include in-the-money outstanding stock options and shares to be purchased under our employee stock purchase plan. Using the treasury stock method, the effect of dilutive securities includes these additional shares of common stock that would have been outstanding based on the assumption that these potentially dilutive securities had been issued.\nStock options with exercise prices that are higher than the average market prices of our common stock for the periods presented are excluded from the diluted EPS calculation because the effect is anti-dilutive.\n9\nThe table below presents the computation of EPS, including the reconciliation of basic and diluted weighted average shares outstanding (in thousands, except EPS):\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net income | $ | 32,637 | $ | 31,339 |\n| Weighted average shares outstanding: |\n| Basic | 39,479 | 40,370 |\n| Effect of dilutive securities: |\n| Stock options and employee stock purchase plan | 1,217 | 1,492 |\n| Diluted | 40,696 | 41,862 |\n| Earnings per share: |\n| Basic | $ | 0.83 | $ | 0.78 |\n| Diluted | $ | 0.80 | $ | 0.75 |\n| Anti-dilutive stock options excluded from diluted earnings per share computations | 65 | 85 |\n\nNote 3 – Acquisitions\nIn January 2019, we acquired the distribution assets of W.W. Adcock, Inc., a wholesale distributor of swimming pool products, equipment, parts and supplies adding two locations in Pennsylvania, one location in North Carolina and one location in Virginia.\nIn November 2018, we acquired the distribution assets of Turf & Garden, Inc., a wholesale distributor of irrigation products and landscape maintenance equipment, parts and supplies with three locations in Virginia and one location in North Carolina.\nWe have completed our acquisition accounting for these acquisitions, subject to adjustments for standard holdback provisions per the terms of the purchase agreements, which are not material.\nIn January 2018, we acquired the distribution assets of Tore Pty. Ltd. (doing business as Pool Power), a wholesale distributor of pool and spa equipment in South Australia, with one distribution center in Adelaide, Australia. We have completed our acquisition accounting for this acquisition.\nThese acquisitions did not have a material impact on our financial position or results of operations, either individually or in the aggregate.\nNote 4 – Fair Value Measurements and Interest Rate Swaps\nOur assets and liabilities that are measured at fair value on a recurring basis include the unrealized gains or losses on our interest rate swap contracts and contingent consideration related to recent acquisitions. The three levels of the fair value hierarchy under the accounting guidance are described below:\n| Level 1 | Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets. |\n\n| Level 2 | Inputs to the valuation methodology include: |\n\n| • | quoted prices for similar assets or liabilities in active markets; |\n\n| • | quoted prices for identical or similar assets or liabilities in inactive markets; |\n\n| • | inputs other than quoted prices that are observable for the asset or liability; or |\n\n10\n| • | inputs that are derived principally from or corroborated by observable market data by correlation or other means. |\n\n| Level 3 | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\n\nThe table below presents the estimated fair values of our interest rate swap contracts, our forward-starting interest rate swap contract and our contingent consideration liabilities (in thousands):\n| Fair Value at March 31, |\n| 2019 | 2018 |\n| Level 2 |\n| Unrealized gains on interest rate swaps | $ | 1,785 | $ | 2,451 |\n| Level 3 |\n| Contingent consideration liabilities | $ | 833 | $ | 1,617 |\n\nInterest Rate Swaps\nWe utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on our unsecured syndicated senior credit facility (the Credit Facility).\nFor determining the fair value of our interest rate swap and forward-starting interest rate swap contracts, we use significant other observable market data or assumptions (Level 2 inputs) that we believe market participants would use in pricing similar assets or liabilities, including assumptions about counterparty risk. Our fair value estimates reflect an income approach based on the terms of the interest rate swap contracts and inputs corroborated by observable market data including interest rate curves. We include unrealized gains in Prepaid expenses and other current assets and unrealized losses in Accrued expenses and other current liabilities on the Consolidated Balance Sheets.\nWe recognize any differences between the variable interest rate payments and the fixed interest rate settlements from our swap counterparties as an adjustment to interest expense over the life of the swaps. If determined to be effective cash flow hedges, we record the changes in the estimated fair value of the swaps to Accumulated other comprehensive loss on our Consolidated Balance Sheets. To the extent our interest rate swaps are determined to be ineffective, we recognize the changes in the estimated fair value of our swaps in Interest and other non-operating expenses, net on our Consolidated Statements of Income.\nWe currently have three interest rate swap contracts in place, which became effective on October 19, 2016. These swaps were previously forward-starting contracts that were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates at that time and extend the hedged period for future interest payments on our Credit Facility. As amended, these swap contracts terminate on November 20, 2019. In the first three months of 2019, we recognized a loss of $0.2 million as a result of ineffectiveness.\nThe following table provides additional details related to each of these amended swap contracts:\n| Derivative | Amendment Date | NotionalAmount(in millions) | FixedInterestRate |\n| Interest rate swap 1 | October 1, 2015 | $75.0 | 2.273% |\n| Interest rate swap 2 | October 1, 2015 | $25.0 | 2.111% |\n| Interest rate swap 3 | October 1, 2015 | $50.0 | 2.111% |\n\nFor the three interest rate swap contracts in effect at March 31, 2019, a portion of the change in the estimated fair value between periods relates to future interest expense. Recognition of the change in fair value between periods attributable to accrued interest is reclassified from Accumulated other comprehensive loss on the Consolidated Balance Sheets to Interest and other non-operating expenses, net on the Consolidated Statements of Income. These amounts were not material in the three month periods ended March 31, 2019 and March 31, 2018.\n11\nIn July 2016, we entered into an additional forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the variable interest rate to a fixed interest rate on borrowings under the Credit Facility. This contract becomes effective on November 20, 2019 and terminates on November 20, 2020. The following table provides additional details related to this swap contract:\n| Derivative | Inception Date | NotionalAmount(in millions) | FixedInterestRate |\n| Forward-starting interest rate swap | July 6, 2016 | $150.0 | 1.1425% |\n\nFailure of our swap counterparties would result in the loss of any potential benefit to us under our swap agreements. In this case, we would still be obligated to pay the variable interest payments underlying our debt agreements. Additionally, failure of our swap counterparties would not eliminate our obligation to continue to make payments under our existing swap agreements if we continue to be in a net pay position.\nOur interest rate swap and forward-starting interest rate swap contracts are subject to master netting arrangements. According to our accounting policy, we do not offset the fair values of assets with the fair values of liabilities related to these contracts.\nOther\nThe carrying values of cash, receivables, accounts payable and accrued liabilities approximate fair value due to the short maturity of those instruments (Level 1 inputs). The carrying value of long-term debt approximates fair value (Level 3 inputs). Our determination of the estimated fair value reflects a discounted cash flow model using our estimates, including assumptions related to borrowing rates (Level 3 inputs).\nNote 5 – Debt\nThe table below presents the components of our debt (in thousands):\n| March 31, |\n| 2019 | 2018 |\n| Variable rate debt |\n| Short-term borrowings | $ | 13,714 | $ | 12,263 |\n| Current portion of long-term debt: |\n| Australian credit facility | 8,020 | 8,523 |\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 |\n| Long-term portion: |\n| Revolving credit facility | 503,073 | 388,762 |\n| Receivables securitization facility | 175,100 | 160,000 |\n| Less: financing costs, net | 930 | 1,438 |\n| Long-term debt, net | 677,243 | 547,324 |\n| Total debt | $ | 698,977 | $ | 568,110 |\n\nOur accounts receivable securitization facility (the Receivables Facility) provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities.\nWe account for the sale of the receivable interests as a secured borrowing on our Consolidated Balance Sheets. The receivables subject to the agreement collateralize the cash proceeds received from the third-party financial institutions. We classify the entire outstanding balance as Long-term debt on our Consolidated Balance Sheets as we intend and have the ability to refinance the obligations on a long‑term basis. We present the receivables that collateralize the cash proceeds separately as Receivables pledged under receivables facility on our Consolidated Balance Sheets.\n12\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion in conjunction with Management’s Discussion and Analysis included in our 2018 Annual Report on Form 10-K.\nFor a discussion of our base business calculations, see the Results of Operations section below.\nCautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995\nThis report contains forward-looking information that involves risks and uncertainties. Our forward‑looking statements express our current expectations or forecasts of possible future results or events, including projections of earnings and other financial performance measures, statements of management’s expectations regarding our plans and objectives and industry, general economic and other forecasts of trends, future dividend payments and share repurchases, and other matters. Forward-looking statements speak only as of the date of this filing, and we undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur. You can identify these statements by the fact that they do not relate strictly to historic or current facts and often use words such as “anticipate,” “estimate,” “expect,” “intend,” “believe,” “will likely result,” “outlook,” “project,” “may,” “can,” “plan,” “target,” “potential,” “should” and other words and expressions of similar meaning.\nNo assurance can be given that the expected results in any forward-looking statement will be achieved, and actual results may differ materially due to one or more factors, including the sensitivity of our business to weather conditions, changes in the economy and the housing market, our ability to maintain favorable relationships with suppliers and manufacturers, competition from other leisure product alternatives and mass merchants, excess tax benefits or deficiencies recognized under ASU 2016-09 and other risks detailed in our 2018 Annual Report on Form 10-K. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act.\nOVERVIEW\nFinancial Results\nWe produced solid results in the first quarter of 2019 despite wetter and cooler conditions throughout most of the quarter in some of our major markets. Our team’s strong execution, coupled with modest top line growth, delivered favorable results in the quarter.\nNet sales increased 2% to $597.5 million in the first quarter of 2019 compared to $585.9 million in the first quarter of 2018, while base business sales grew 1%. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\nGross profit increased 5% to $174.6 million in the first quarter of 2019 from $166.1 million in the same period in 2018. Base business gross profit improved 4% over the first quarter of 2018, including a negative currency exchange impact of 1%. Gross margin increased 90 basis points to 29.2% in the first quarter of 2019 compared to 28.3% in the first quarter of 2018, reflecting benefits from our strategic inventory purchases in 2018 and lower customer early buys in the first quarter of 2019.\nSelling and administrative expenses (operating expenses) increased 3% to $136.2 million in the first quarter of 2019 compared to the first quarter of 2018. Base business operating expenses were up 1% over the comparable 2018 period including a 1% currency benefit. As a percentage of net sales, base business operating expenses increased to 22.6% in the first quarter of 2019 compared to 22.5% in the first quarter of 2018.\nOperating income for the first quarter of 2019 increased to $38.4 million, up 14% compared to the same period in 2018. Operating margin was 6.4% in the first quarter of 2019 and 5.7% in the same period in 2018, while base business operating margin improved 90 basis points from the prior year to 6.7% in the first quarter of 2019.\nWe recorded an $8.8 million tax benefit from Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting, in the quarter ended March 31, 2019 compared to a tax benefit of $9.0 million realized in the same period of 2018.\n13\nNet income was $32.6 million in the first quarter of 2019 compared to $31.3 million in the first quarter of 2018. Earnings per share increased 7% to $0.80 per diluted share in the three months ended March 31, 2019 compared to $0.75 per diluted share in the same period of 2018. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\nReferences to product line and product category data throughout this report generally reflect data related to the North American swimming pool market, as it is more readily available for analysis and represents the largest component of our operations.\nFinancial Position and Liquidity\nAs of March 31, 2019, total net receivables, including pledged receivables, remained flat compared to March 31, 2018. Our days sales outstanding (DSO), as calculated on a trailing four quarters basis, was 29.8 days at March 31, 2019 and 30.1 days at March 31, 2018. Our allowance for doubtful accounts balance was $5.6 million at March 31, 2019 and $4.0 million at March 31, 2018.\nNet inventory levels grew 16% compared to levels at March 31, 2018. The increase of $111.9 million in inventory reflects strategic inventory purchases we made in the second half of 2018 in advance of greater than normal vendor price increases, inventory from acquired businesses and normal business growth, as well as the slower start to the season. The inventory reserve was $8.5 million at March 31, 2019 and $7.4 million at March 31, 2018. Our inventory turns, as calculated on a trailing four quarters basis, were 3.1 times at March 31, 2019 and 3.5 times at March 31, 2018.\nTotal debt outstanding at March 31, 2019 was $699.0 million, up 23% compared to total debt at March 31, 2018 primarily to fund business driven working capital growth, acquisitions and share repurchases over the past 12 months.\nCurrent Trends and Outlook\nFor a detailed discussion of trends through 2018, see the Current Trends and Outlook section of Management’s Discussion and Analysis included in Part II, Item 7 of our 2018 Annual Report on Form 10-K.\nAs a result of the additional tax benefits realized from ASU 2016-09 in the first quarter of 2019 beyond what was included in our initial earnings guidance range, we are updating our 2019 earnings guidance to a range of $6.09 to $6.39 from $6.05 to $6.35 per diluted share. Other than the additional $0.04 per diluted share tax benefit, our earnings expectation for 2019 remains unchanged.\nConsistent with our original 2019 projections, we expect base business sales growth of approximately 7% to 9% for 2019 and expect gross margin will be similar to 2018. Unfavorable weather impacts, the loss of a selling day and a later Easter holiday in 2019 led to delayed pool openings, lower customer early buys and lower construction and remodeling activity. We believe these factors negatively impacted our first quarter of 2019 sales by an estimated $30.0 to $45.0 million but will lead to increased sales growth later in the year, depending on customer capacity and weather.\nWe expect a slight improvement in our gross margin in the second quarter of 2019 as we sell through the strategic inventory purchases we made in the second half of 2018; we expect margins to decline in the fourth quarter of 2019 in comparison to the same quarter in the prior year due to a difficult comparison.\nWe expect base business operating expenses will grow at a rate of approximately 60% of gross margin growth for the year, which will enable us to achieve operating margin improvement of approximately 20 to 40 basis points for the full year of 2019 compared to 2018.\nAs discussed further in Results of Operations below, our average outstanding debt for the three months ended March 31, 2019 increased 31% over the same period last year, and given the increase in the 30-Day LIBOR, our effective interest rate increased approximately 70 basis points between periods. Based on these trends, we expect Interest and other non-operating expenses, net will increase for the full year of 2019 compared to 2018.\nWe expect our annual effective tax rate (excluding the benefit from ASU 2016-09) for 2019 will approximate 25.5%, which is consistent with 2018 and a reduction compared to our historical rate of approximately 38.5% due to the impact of U.S. tax reform.\nOur effective tax rate is dependent on our results of operations and may change if actual results differ materially from our current expectations, particularly any significant changes in our geographic mix. Due to ASU 2016-09, we expect our effective tax rate will fluctuate from quarter to quarter, particularly in periods when employees elect to exercise their vested stock options or when restrictions on share-based awards lapse. We recorded an $8.8 million tax benefit from ASU 2016-09 for the three months ended\n14\nMarch 31, 2019. Additional tax benefits could be recognized related to stock option exercises in 2019 from grants that expire in years after 2019, for which we have not included any expected benefits in our guidance. The estimated impact related to ASU 2016-09 is subject to several assumptions which can vary significantly, including our estimated share price and the periods in which our employees will exercise vested stock options.\nExcluding the impact of timing differences from our strategic inventory purchases made in the second half of 2018, we expect cash provided by operations will approximate net income for the 2019 fiscal year. We anticipate that we may use approximately $150.0 million to $200.0 million in cash for share repurchases in 2019, subject to additional authorization by our Board of Directors.\nRESULTS OF OPERATIONS\nAs of March 31, 2019, we conducted operations through 369 sales centers in North America, Europe, South America and Australia.\nThe following table presents information derived from the Consolidated Statements of Income expressed as a percentage of net sales:\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Net sales | 100.0 | % | 100.0 | % |\n| Cost of sales | 70.8 | 71.7 |\n| Gross profit | 29.2 | 28.3 |\n| Operating expenses | 22.8 | 22.6 |\n| Operating income | 6.4 | 5.7 |\n| Interest and other non-operating expenses, net | 1.1 | 0.6 |\n| Income before income taxes and equity earnings | 5.3 | % | 5.1 | % |\n\nWe have included the results of operations from the acquisitions in 2019 and 2018 in our consolidated results since the acquisition dates.\nThree Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018\nThe following table breaks out our consolidated results into the base business component and the excluded component (sales centers excluded from base business):\n| (Unaudited) | Base Business | Excluded | Total |\n| (in thousands) | Three Months Ended | Three Months Ended | Three Months Ended |\n| March 31, | March 31, | March 31, |\n| 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\n| Net sales | $ | 587,320 | $ | 582,822 | $ | 10,136 | $ | 3,078 | $ | 597,456 | $ | 585,900 |\n| Gross profit | 171,706 | 165,334 | 2,925 | 739 | 174,631 | 166,073 |\n| Gross margin | 29.2 | % | 28.4 | % | 28.9 | % | 24.0 | % | 29.2 | % | 28.3 | % |\n| Operating expenses | 132,548 | 131,250 | 3,697 | 1,282 | 136,245 | 132,532 |\n| Expenses as a % of net sales | 22.6 | % | 22.5 | % | 36.5 | % | 41.7 | % | 22.8 | % | 22.6 | % |\n| Operating income (loss) | 39,158 | 34,084 | (772 | ) | (543 | ) | 38,386 | 33,541 |\n| Operating margin | 6.7 | % | 5.8 | % | (7.6 | )% | (17.6 | )% | 6.4 | % | 5.7 | % |\n\n15\nIn our calculation of base business results, we have excluded the following acquisitions for the periods identified:\n| Acquired | AcquisitionDate | NetSales CentersAcquired | PeriodsExcluded |\n| W.W. Adcock, Inc. (1) | January 2019 | 4 | January - March 2019 |\n| Turf & Garden, Inc. (1) | November 2018 | 4 | January - March 2019 |\n| Tore Pty. Ltd. (Pool Power) (1) | January 2018 | 1 | January - March 2019 andJanuary - March 2018 |\n| Chem Quip, Inc. (1) | December 2017 | 5 | January - March 2019 and January - March 2018 |\n| Intermark | December 2017 | 1 | January - February 2019 and January - February 2018 |\n\n| (1) | We acquired certain distribution assets of each of these companies. |\n\nWhen calculating our base business results, we exclude sales centers that are acquired, closed, or opened in new markets for a period of 15 months. We also exclude consolidated sales centers when we do not expect to maintain the majority of the existing business and existing sales centers that are consolidated with acquired sales centers.\nWe generally allocate corporate overhead expenses to excluded sales centers on the basis of their net sales as a percentage of total net sales. After 15 months of operations, we include acquired, consolidated and new market sales centers in the base business calculation including the comparative prior year period.\nThe table below summarizes the changes in our sales center count during the first three months of 2019:\n| December 31, 2018 | 364 |\n| Acquired locations | 4 |\n| New locations, existing markets | 2 |\n| Consolidated location | (1 | ) |\n| March 31, 2019 | 369 |\n\nNet Sales\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Net sales | $ | 597.5 | $ | 585.9 | $ | 11.6 | 2% |\n\nNet sales increased 2% in the first quarter of 2019 compared to the first quarter of 2018, with base business sales up 1% for the period. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\nThe following factors benefited our sales (listed in order of estimated magnitude):\n| • | inflationary product cost increases (estimated at approximately 2% above our historical average of 1% to 2%); |\n\n| • | strong demand for discretionary products, as evidenced by improvements in sales growth rates for product offerings such as building materials (see discussion below); |\n\n| • | acquisitions; and |\n\n| • | market share gains, particularly in building materials and commercial products (see discussion below). |\n\n16\nWe believe that sales growth rates for certain product offerings, such as equipment and building materials, evidence increased spending in traditionally discretionary areas, such as pool construction, pool remodeling and equipment upgrades. In the first quarter of 2019, sales for equipment, which includes swimming pool heaters, pumps, lights and filters, remained relatively flat compared to the same period last year. These products collectively represented approximately 30% of net sales for the period. Sales of building materials grew 8% compared to the first quarter of 2018 and represented approximately 13% of net sales in the first quarter of 2019.\nSales to customers who service large commercial swimming pools such as hotels, universities and community recreational facilities are included in the appropriate existing product categories, and growth in this area is reflected in the numbers above. Sales to these customers represented approximately 6% of our consolidated net sales for the first quarter of 2019 and increased 2% compared to the first quarter of 2018.\nGross Profit\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Gross profit | $ | 174.6 | $ | 166.1 | $ | 8.5 | 5% |\n| Gross margin | 29.2 | % | 28.3 | % |\n\nThe increase in gross margin between periods primarily reflects benefits from strategic inventory purchases in the second half of 2018 and lower customer early buys in the first quarter of 2019.\nOperating Expenses\n| Three Months Ended |\n| March 31, |\n| (in millions) | 2019 | 2018 | Change |\n| Operating expenses | $ | 136.2 | $ | 132.5 | $ | 3.7 | 3% |\n| Operating expenses as a % of net sales | 22.8 | % | 22.6 | % |\n\nOperating expenses increased 3% in the first quarter of 2019 compared to the first quarter of 2018, with base business operating expenses up approximately 1% compared to the same period last year. This increase is largely due to growth-driven increases in labor expenses and increased facility costs offset by a 1% benefit from foreign currency exchange rate fluctuations.\nInterest and Other Non-Operating Expenses, Net\nInterest and other non-operating expenses, net for the first quarter of 2019 increased $3.1 million compared to the first quarter of 2018. The increase mostly reflects higher debt levels and higher interest rates between periods. Our weighted average effective interest rate increased to 3.7% for the first quarter of 2019 from 3.0% for the first quarter of 2018 on higher average outstanding debt of $674.6 million versus $515.9 million for the respective periods.\nIncome Taxes\nOur effective income tax rate was a 2.5% benefit for the three months ended March 31, 2019, compared to a 4.3% benefit for the three months ended March 31, 2018. We recorded an $8.8 million tax benefit from ASU 2016-09 in the quarter ended March 31, 2019 compared to a benefit of $9.0 million realized in the same period last year. Excluding the benefits from ASU 2016-09, our effective tax rate was 25.1% and 25.7% for the first quarters of 2019 and 2018, respectively.\nNet Income and Earnings Per Share\nNet income increased 4% to $32.6 million in the first quarter of 2019 compared to the first quarter of 2018. Earnings per diluted share increased to $0.80 in the first quarter of 2019 versus $0.75 per diluted share for the comparable 2018 period. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\n17\nSeasonality and Quarterly Fluctuations\nOur business is highly seasonal. In general, sales and operating income are highest during the second and third quarters, which represent the peak months of both swimming pool use and installation and irrigation and landscape installations and maintenance. Sales are substantially lower during the first and fourth quarters, when we may incur net losses. In 2018, we generated approximately 62% of our net sales and 81% of our operating income in the second and third quarters of the year.\nWe typically experience a build-up of product inventories and accounts payable during the winter months in anticipation of the peak selling season. Excluding borrowings to finance acquisitions and share repurchases, our peak borrowing usually occurs during the second quarter, primarily because extended payment terms offered by our suppliers typically are payable in April, May and June, while our peak accounts receivable collections typically occur in June, July and August.\nThe following table presents certain unaudited quarterly data for the first quarter of 2019, the four quarters of 2018 and the fourth, third and second quarters of 2017. We have included income statement and balance sheet data for the most recent eight quarters to allow for a meaningful comparison of the seasonal fluctuations in these amounts. In our opinion, this information reflects all normal and recurring adjustments considered necessary for a fair presentation of this data. Due to the seasonal nature of our industry, the results of any one or more quarters are not necessarily a good indication of results for an entire fiscal year or of continuing trends.\n| (Unaudited) | QUARTER |\n| (in thousands) | 2019 | 2018 | 2017 |\n| First | Fourth | Third | Second | First | Fourth | Third | Second |\n| Statement of Income Data |\n| Net sales | $ | 597,456 | $ | 543,082 | $ | 811,311 | $ | 1,057,804 | $ | 585,900 | $ | 510,183 | $ | 743,401 | $ | 988,163 |\n| Gross profit | 174,631 | 160,442 | 235,003 | 308,655 | 166,073 | 145,398 | 216,606 | 289,664 |\n| Operating income | 38,386 | 25,970 | 92,337 | 162,042 | 33,541 | 17,259 | 81,928 | 154,186 |\n| Net income | 32,637 | 16,811 | 69,261 | 117,049 | 31,339 | 25,665 | 48,783 | 94,620 |\n| Balance Sheet Data |\n| Total receivables, net | $ | 313,127 | $ | 207,801 | $ | 287,773 | $ | 404,415 | $ | 314,596 | $ | 196,265 | $ | 262,796 | $ | 370,285 |\n| Product inventories, net | 815,742 | 672,579 | 609,983 | 606,583 | 703,793 | 536,474 | 484,287 | 542,805 |\n| Accounts payable | 472,487 | 237,835 | 204,706 | 300,232 | 467,795 | 245,249 | 209,062 | 273,309 |\n| Total debt | 698,977 | 666,761 | 580,703 | 657,120 | 568,110 | 519,650 | 564,573 | 553,480 |\n\nWe expect that our quarterly results of operations will continue to fluctuate depending on the timing and amount of revenue contributed by new and acquired sales centers. Based on our peak summer selling season, we generally open new sales centers and close or consolidate sales centers, when warranted, either in the first quarter before the peak selling season begins or in the fourth quarter after the peak selling season ends.\n18\nWeather is one of the principal external factors affecting our business. The table below presents some of the possible effects resulting from various weather conditions.\n| Weather | Possible Effects |\n| Hot and dry | • | Increased purchases of chemicals and suppliesfor existing swimming pools |\n| • | Increased purchases of above-ground pools andirrigation products |\n| Unseasonably cool weather or extraordinary amounts of rain | • | Fewer pool and irrigation and landscape installations |\n| • | Decreased purchases of chemicals and supplies |\n| • | Decreased purchases of impulse items such asabove-ground pools and accessories |\n| Unseasonably early warming trends in spring/late cooling trends in fall | • | A longer pool and landscape season, thus positively impacting our sales |\n| (primarily in the northern half of the U.S. and Canada) |\n| Unseasonably late warming trends in spring/early cooling trends in fall | • | A shorter pool and landscape season, thus negatively impacting our sales |\n| (primarily in the northern half of the U.S. and Canada) |\n\nWeather Impacts on 2019 and 2018 Results\nWetter and cooler-than-normal temperatures to begin the year hindered our first quarter of 2019 sales growth. Much of the western United States, particularly California and Arizona, experienced cold to record cold temperatures in January and February. The latter half of March benefited from warmer weather throughout most of the country and provided some relief from the slow start earlier in the year. The first quarter of 2018 experienced similar, though less significant, unfavorable weather in certain markets, leading to adverse conditions in 2019 compared to 2018.\n19\nLIQUIDITY AND CAPITAL RESOURCES\nLiquidity is defined as the ability to generate adequate amounts of cash to meet short-term and long-term cash needs. We assess our liquidity in terms of our ability to generate cash to fund our operating activities, taking into consideration the seasonal nature of our business. Significant factors which could affect our liquidity include the following:\n| • | cash flows generated from operating activities; |\n\n| • | the adequacy of available bank lines of credit; |\n\n| • | the quality of our receivables; |\n\n| • | acquisitions; |\n\n| • | dividend payments; |\n\n| • | capital expenditures; |\n\n| • | changes in income tax laws and regulations; |\n\n| • | the timing and extent of share repurchases; and |\n\n| • | the ability to attract long-term capital with satisfactory terms. |\n\nOur primary capital needs are seasonal working capital requirements and other general corporate purposes, including acquisitions, dividend payments and share repurchases. Our primary sources of working capital are cash from operations supplemented by borrowings, which have historically been sufficient to support our growth and finance acquisitions. The same principles apply to funds used for capital expenditures and share repurchases.\nWe prioritize our use of cash based on investing in our business, maintaining a prudent debt structure, including a modest amount of debt, and returning cash to our shareholders through dividends and share repurchases. Our specific priorities for the use of cash are as follows:\n| • | capital expenditures primarily for maintenance and growth of our sales center structure, technology-related investments and fleet vehicles; |\n\n| • | strategic acquisitions executed opportunistically; |\n\n| • | payment of cash dividends as and when declared by our Board of Directors (Board); |\n\n| • | repayment of debt to maintain an average total leverage ratio (as defined below) between 1.5 and 2.0; and |\n\n| • | repurchases of our common stock under our Board-authorized share repurchase program. |\n\nCapital expenditures were 1.1% of net sales in 2018 and 1.4% of net sales in both 2017 and 2016. Our higher capital spending in 2017 and 2016 related to expanding our facilities and purchasing delivery vehicles to address growth. Over the last five years, capital expenditures have averaged roughly 1.0% of net sales. Going forward, we project capital expenditures will continue to approximate this average.\nSources and Uses of Cash\nThe following table summarizes our cash flows (in thousands):\n| Three Months Ended |\n| March 31, |\n| 2019 | 2018 |\n| Operating activities | $ | 28,804 | $ | (44,149 | ) |\n| Investing activities | (16,109 | ) | (15,217 | ) |\n| Financing activities | (2,050 | ) | 38,205 |\n\nCash provided by operating activities increased $73.0 million during the first three months of 2019 compared to the first three months of 2018 primarily due to payments for pre-price increase inventory purchases in 2018 ahead of the 2019 season, which resulted in decreased inventory purchases in the first quarter of 2019.\nCash used in investing activities for the first three months of 2019 increased compared to the first three months of 2018 primarily due to the acquisition of W.W. Adcock, Inc. which we completed in January 2019.\nCash used in financing activities increased for the first three months of 2019 compared to the first three months of 2018, which reflects a $20.5 million increase in share repurchases as well as a $16.2 million decrease in amounts provided by net borrowings.\n20\nFuture Sources and Uses of Cash\nRevolving Credit Facility\nOur Credit Facility provides for $750.0 million in borrowing capacity under a five-year unsecured revolving credit facility and includes sublimits for the issuance of swingline loans and standby letters of credit. Pursuant to an accordion feature, the aggregate maximum principal amount of the commitments under the Credit Facility may be increased at our request and with agreement by the lenders by up to $75.0 million, to a total of $825.0 million. The Credit Facility matures on September 29, 2022. We intend to use the Credit Facility for general corporate purposes, for future share repurchases and to fund future growth initiatives.\nAt March 31, 2019, there was $503.1 million outstanding, a $4.8 million standby letter of credit outstanding and $242.1 million available for borrowing under the Credit Facility. We utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on the Credit Facility. As of March 31, 2019, we had three interest rate swap contracts in place that became effective on October 19, 2016. These swap contracts were previously forward-starting and were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates and extend the hedged period for future interest payments on our Credit Facility. Now effective, these amended swap contracts convert the Credit Facility’s variable interest rate to fixed rates of 2.273% on a notional amount of $75.0 million and 2.111% on two separate notional amounts, one $25.0 million and the other $50.0 million, totaling $75.0 million. Interest expense related to the notional amounts under these swap contracts is based on the fixed rates plus the applicable margin on the Credit Facility. These interest rate swap contracts will terminate on November 20, 2019.\nIn July 2016, we entered into a forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the Credit Facility’s variable interest rate to a fixed rate of 1.1425% on a notional amount of $150.0 million. The contract becomes effective on November 20, 2019 and terminates on November 20, 2020.\nThe weighted average effective interest rate for the Credit Facility as of March 31, 2019 was approximately 3.5%, excluding commitment fees.\nFinancial covenants on the Credit Facility include maintenance of a maximum average total leverage ratio and a minimum fixed charge coverage ratio. As of March 31, 2019, the calculations of these two covenants are detailed below:\n| • | Maximum Average Total Leverage Ratio. On the last day of each fiscal quarter, our average total leverage ratio must be less than 3.25 to 1.00. Average Total Leverage Ratio is the ratio of the trailing twelve months (TTM) Average Total Funded Indebtedness plus the TTM Average Accounts Securitization Proceeds divided by the TTM EBITDA (as those terms are defined in the Credit Facility). As of March 31, 2019, our average total leverage ratio equaled 1.80 (compared to 1.72 as of December 31, 2018) and the TTM average total debt amount used in this calculation was $646.7 million. |\n\n| • | Minimum Fixed Charge Coverage Ratio. On the last day of each fiscal quarter, our fixed charge ratio must be greater than or equal to 2.25 to 1.00. Fixed Charge Ratio is the ratio of the TTM EBITDAR divided by TTM Interest Expense paid or payable in cash plus TTM Rental Expense (as those terms are defined in the Credit Facility). As of March 31, 2019, our fixed charge ratio equaled 5.17 (compared to 5.33 as of December 31, 2018) and TTM Rental Expense was $57.8 million. |\n\nThe Credit Facility also limits the declaration and payment of dividends on our common stock to no more than 50% of the preceding year’s Net Income (as defined in the Credit Facility), provided no default or event of default has occurred and is continuing, or would result from the payment of dividends. Additionally, we may declare and pay quarterly dividends notwithstanding that the aggregate amount of dividends paid would be in excess of the 50% limit described above so long as (i) the amount per share of such dividends does not exceed the amount per share paid during the most recent fiscal year in which we were in compliance with the 50% limit and (ii) our Average Total Leverage Ratio is less than 3.00 to 1.00 both immediately before and after giving pro forma effect to such dividends. Further, dividends must be declared and paid in a manner consistent with our past practice.\nUnder the Credit Facility, we may repurchase shares of our common stock provided no default or event of default has occurred and is continuing, or would result from the repurchase of shares, and our maximum average total leverage ratio (determined on a pro forma basis) is less than 2.50 to 1.00. Other covenants include restrictions on our ability to grant liens, incur indebtedness, make investments, merge or consolidate, and sell or transfer assets. Failure to comply with any of our financial covenants or any other terms of the Credit Facility could result in higher interest rates on our borrowings or the acceleration of the maturities of our outstanding debt.\n21\nReceivables Securitization Facility\nOur two-year accounts receivable securitization facility (the Receivables Facility) offers us a lower cost form of financing, with a peak funding capacity of up to $295.0 million between May 1 and June 30, which includes an additional seasonal funding capacity that is available between March 1 and July 31. Other funding capacities range from $95.0 million to $280.0 million throughout the remaining months of the year.\nThe Receivables Facility provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities. Upon payment of the receivables by customers, rather than remitting to the financial institutions the amounts collected, we retain such collections as proceeds for the sale of new receivables until payments become due.\nThe Receivables Facility contains terms and conditions (including representations, covenants and conditions precedent) customary for transactions of this type. Additionally, an amortization event will occur if we fail to maintain a maximum average total leverage ratio (average total funded debt/EBITDA) of 3.25 to 1.00 and a minimum fixed charge coverage ratio (EBITDAR/cash interest expense plus rental expense) of 2.25 to 1.00.\nAt March 31, 2019, there was $175.1 million outstanding under the Receivables Facility at a weighted average effective interest rate of 3.3%, excluding commitment fees.\nCompliance and Future Availability\nAs of March 31, 2019, we believe we were in compliance with all covenants and financial ratio requirements under our Credit Facility and our Receivables Facility. We believe we will remain in compliance with all covenants and financial ratio requirements throughout the next twelve months. For additional information regarding our debt arrangements, see Note 5 of “Notes to Consolidated Financial Statements,” included in Part II, Item 8 of our 2018 Annual Report on Form 10-K.\nWe believe we have adequate availability of capital to fund present operations and the current capacity to finance any working capital needs that may arise. We continually evaluate potential acquisitions and hold discussions with acquisition candidates. If suitable acquisition opportunities arise that would require financing, we believe that we have the ability to finance any such transactions.\nAs of April 25, 2019, $49.2 million of the current Board-authorized amount under our share repurchase program remained available. We expect to repurchase additional shares on the open market from time to time depending on market conditions. We plan to fund these repurchases with cash provided by operations and borrowings under the Credit and Receivables Facilities.\nCRITICAL ACCOUNTING ESTIMATES\nWe prepare our Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles (GAAP), which require management to make estimates and assumptions that affect reported amounts and related disclosures. Management identifies critical accounting estimates as:\n| • | those that require the use of assumptions about matters that are inherently and highly uncertain at the time the estimates are made; and |\n\n| • | those for which changes in the estimates or assumptions, or the use of different estimates and assumptions, could have a material impact on our consolidated results of operations or financial condition. |\n\nManagement has discussed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board. For a description of our critical accounting estimates that require us to make the most difficult, subjective or complex judgments, please see our 2018 Annual Report on Form 10-K. We have not changed these policies from those previously disclosed.\nRecent Accounting Pronouncements\nSee Note 1 of “Notes to Consolidated Financial Statements,” included in Item 1 of this Form 10-Q for detail.\n22\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nInterest Rate Risk\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our interest rate risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\nCurrency Risk\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our currency risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\nItem 4. Controls and Procedures\nThe term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the Act). The rules refer to the controls and other procedures designed to ensure that information required to be disclosed in reports that we file or submit under the Act is (1) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. As of March 31, 2019, management, including the CEO and CFO, performed an evaluation of the effectiveness of our disclosure controls and procedures. Based on that evaluation, management, including the CEO and CFO, concluded that as of March 31, 2019, our disclosure controls and procedures were effective.\nWe maintain a system of internal control over financial reporting that is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Based on the most recent evaluation, we have concluded that no change in our internal control over financial reporting occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\n23\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time, we are subject to various claims and litigation arising in the ordinary course of business, including product liability, personal injury, commercial, contract and employment matters. While the outcome of any litigation is inherently unpredictable, based on currently available facts we do not believe that the ultimate resolution of any of these matters will have a material adverse impact on our financial condition, results of operations or cash flows.\nItem 1A. Risk Factors\nThere have been no material changes from the risk factors disclosed in Part I, Item 1A “Risk Factors” in our 2018 Annual Report on Form 10-K.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nThe table below summarizes the repurchases of our common stock in the first quarter of 2019:\n| Period | Total Number of Shares Purchased (1) | Average Price Paid per Share | Total Number ofShares Purchasedas Part of Publicly Announced Plan (2) | Maximum ApproximateDollar Value of SharesThat May Yet be Purchased Under the Plan (3) |\n| January 1 - 31, 2019 | 116,946 | $ | 147.77 | 116,946 | $ | 52,498,367 |\n| February 1 - 28, 2019 | 28,513 | $ | 152.25 | 22,019 | $ | 49,200,474 |\n| March 1 - 31, 2019 | 9,401 | $ | 156.98 | — | $ | 49,200,474 |\n| Total | 154,860 | $ | 149.15 | 138,965 |\n\n| (1) | These shares may include shares of our common stock surrendered to us by employees in order to satisfy minimum tax withholding obligations in connection with certain exercises of employee stock options or lapses upon vesting of restrictions on previously restricted share awards, and/or to cover the exercise price of such options granted under our share-based compensation plans. There were 15,895 shares surrendered for this purpose in the first quarter of 2019. |\n\n| (2) | In May 2018, our Board authorized an additional $200.0 million under our share repurchase program for the repurchase of shares of our common stock in the open market at prevailing market prices or in privately negotiated transactions. |\n\n| (3) | As of April 25, 2019, $49.2 million of the authorized amount remained available under our current share repurchase program. |\n\n24\nItem 6. Exhibits\nExhibits filed as part of this report are listed below.\n| Incorporated by Reference |\n| No. | Description | Filed/ Furnished with thisForm 10-Q | Form | File No. | Date Filed |\n| 3.1 | Restated Certificate of Incorporation of the Company. | 10-Q | 000-26640 | 8/9/2006 |\n| 3.2 | Amended and Restated Bylaws of the Company. | 8-K | 000-26640 | 2/8/2019 |\n| 4.1 | Form of certificate representing shares of common stock of the Company. | 8-K | 000-26640 | 5/19/2006 |\n| 31.1 | Certification by Mark W. Joslin pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 31.2 | Certification by Peter D. Arvan pursuant to Rule 13a-14(a) and 15d‑14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\n| 32.1 | Certification by Peter D.Arvan and Mark W. Joslin furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\n| 101.INS | + | XBRL Instance Document | X |\n| 101.SCH | + | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL | + | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF | + | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB | + | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE | + | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n+ Attached as Exhibit 101 to this report are the following items formatted in XBRL (Extensible Business Reporting Language):\n| 1. | Consolidated Statements of Income for the three months ended March 31, 2019 and March 31, 2018; |\n\n| 2. | Consolidated Statements of Comprehensive Income for the three months ended March 31, 2019 and March 31, 2018; |\n\n| 3. | Consolidated Balance Sheets at March 31, 2019, December 31, 2018 and March 31, 2018; |\n\n| 4. | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2019 and |\n\nMarch 31, 2018;\n| 5. | Consolidated Statements of Changes in Stockholders’ Equity for the three months ended March 31, 2019 and |\n\nMarch 31, 2018; and\n| 6. | Notes to Consolidated Financial Statements. |\n\n25\nSIGNATURE\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on April 30, 2019.\n| POOL CORPORATION |\n| By: | /s/ Mark W. Joslin |\n| Mark W. Joslin |\n| Senior Vice President and Chief Financial Officer, and duly authorized signatory on behalf of the registrant |\n\n26\n</text>\n\nHow much should the company anticipate to pay for operating lease liabilities in 2021 if the inflation rate for that year is projected to be 2% (in thousands)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1. Financial Statements\\nPOOL CORPORATION\\nConsolidated Statements of Income\\n(Unaudited)\\n(In thousands, except per share data)\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Net sales | $ | 597,456 | $ | 585,900 |\\n| Cost of sales | 422,825 | 419,827 |\\n| Gross profit | 174,631 | 166,073 |\\n| Selling and administrative expenses | 136,245 | 132,532 |\\n| Operating income | 38,386 | 33,541 |\\n| Interest and other non-operating expenses, net | 6,616 | 3,527 |\\n| Income before income taxes and equity earnings | 31,770 | 30,014 |\\n| Income tax benefit | (802 | ) | (1,279 | ) |\\n| Equity earnings in unconsolidated investments, net | 65 | 46 |\\n| Net income | $ | 32,637 | $ | 31,339 |\\n| Earnings per share: |\\n| Basic | $ | 0.83 | $ | 0.78 |\\n| Diluted | $ | 0.80 | $ | 0.75 |\\n| Weighted average shares outstanding: |\\n| Basic | 39,479 | 40,370 |\\n| Diluted | 40,696 | 41,862 |\\n| Cash dividends declared per common share | $ | 0.45 | $ | 0.37 |\\n\\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\\n1\\nPOOL CORPORATION\\nConsolidated Statements of Comprehensive Income\\n(Unaudited)\\n(In thousands)\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Net income | $ | 32,637 | $ | 31,339 |\\n| Other comprehensive (loss) income: |\\n| Foreign currency translation gains | 214 | 976 |\\n| Change in unrealized (losses) gains on interest rate swaps, net of change in taxes of $90 and $(275) | (269 | ) | 824 |\\n| Total other comprehensive (loss) income | (55 | ) | 1,800 |\\n| Comprehensive income | $ | 32,582 | $ | 33,139 |\\n\\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\\n2\\nPOOL CORPORATION\\nConsolidated Balance Sheets\\n(In thousands, except share data)\\n| March 31, | March 31, | December 31, |\\n| 2019 | 2018 | 2018 (1) |\\n| (Unaudited) | (Unaudited) |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 28,581 | $ | 8,803 | $ | 16,358 |\\n| Receivables, net | 72,352 | 75,889 | 69,493 |\\n| Receivables pledged under receivables facility | 240,775 | 238,707 | 138,308 |\\n| Product inventories, net | 815,742 | 703,793 | 672,579 |\\n| Prepaid expenses and other current assets | 16,116 | 23,714 | 18,506 |\\n| Total current assets | 1,173,566 | 1,050,906 | 915,244 |\\n| Property and equipment, net | 107,690 | 109,310 | 106,964 |\\n| Goodwill | 188,478 | 189,759 | 188,472 |\\n| Other intangible assets, net | 11,744 | 12,926 | 12,004 |\\n| Equity interest investments | 1,200 | 1,150 | 1,213 |\\n| Operating lease assets | 177,293 | — | — |\\n| Other assets | 18,379 | 15,615 | 16,974 |\\n| Total assets | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\\n| Liabilities and stockholders’ equity |\\n| Current liabilities: |\\n| Accounts payable | $ | 472,487 | $ | 467,795 | $ | 237,835 |\\n| Accrued expenses and other current liabilities | 47,658 | 45,504 | 58,607 |\\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 | 9,168 |\\n| Current operating lease liabilities | 55,744 | — | — |\\n| Total current liabilities | 597,623 | 534,085 | 305,610 |\\n| Deferred income taxes | 29,368 | 24,947 | 29,399 |\\n| Long-term debt, net | 677,243 | 547,324 | 657,593 |\\n| Other long-term liabilities | 26,469 | 23,525 | 24,679 |\\n| Non-current operating lease liabilities | 122,770 | — | — |\\n| Total liabilities | 1,453,473 | 1,129,881 | 1,017,281 |\\n| Stockholders’ equity: |\\n| Common stock, $0.001 par value; 100,000,000 shares authorized;39,679,157, 40,568,775 and 39,506,067 shares issued andoutstanding at March 31, 2019, March 31, 2018 andDecember 31, 2018, respectively | 40 | 41 | 40 |\\n| Additional paid-in capital | 463,522 | 437,878 | 453,193 |\\n| Retained deficit | (227,633 | ) | (182,580 | ) | (218,646 | ) |\\n| Accumulated other comprehensive loss | (11,052 | ) | (5,554 | ) | (10,997 | ) |\\n| Total stockholders’ equity | 224,877 | 249,785 | 223,590 |\\n| Total liabilities and stockholders’ equity | $ | 1,678,350 | $ | 1,379,666 | $ | 1,240,871 |\\n\\n(1) Derived from audited financial statements.\\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\\n3\\nPOOL CORPORATION\\nCondensed Consolidated Statements of Cash Flows\\n(Unaudited)\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Operating activities |\\n| Net income | $ | 32,637 | $ | 31,339 |\\n| Adjustments to reconcile net income to net cash provided by (used in) operating activities: |\\n| Depreciation | 6,649 | 6,299 |\\n| Amortization | 375 | 470 |\\n| Share-based compensation | 3,259 | 3,321 |\\n| Equity earnings in unconsolidated investments, net | (65 | ) | (46 | ) |\\n| Other | 512 | 681 |\\n| Changes in operating assets and liabilities, net of effects of acquisitions: |\\n| Receivables | (103,122 | ) | (117,377 | ) |\\n| Product inventories | (128,206 | ) | (168,518 | ) |\\n| Prepaid expenses and other assets | (1,427 | ) | (3,843 | ) |\\n| Accounts payable | 230,030 | 222,285 |\\n| Accrued expenses and other current liabilities | (11,838 | ) | (18,760 | ) |\\n| Net cash provided by (used in) operating activities | 28,804 | (44,149 | ) |\\n| Investing activities |\\n| Acquisition of businesses, net of cash acquired | (9,370 | ) | (578 | ) |\\n| Purchases of property and equipment, net of sale proceeds | (6,739 | ) | (14,639 | ) |\\n| Net cash used in investing activities | (16,109 | ) | (15,217 | ) |\\n| Financing activities |\\n| Proceeds from revolving line of credit | 206,190 | 148,335 |\\n| Payments on revolving line of credit | (253,249 | ) | (170,012 | ) |\\n| Proceeds from asset-backed financing | 80,100 | 80,000 |\\n| Payments on asset-backed financing | (13,500 | ) | (20,000 | ) |\\n| Proceeds from short-term borrowings and current portion of long-term debt | 13,713 | 10,798 |\\n| Payments on short-term borrowings and current portion of long-term debt | (1,148 | ) | (848 | ) |\\n| Payments of deferred and contingent acquisition consideration | (311 | ) | (265 | ) |\\n| Payments of deferred financing costs | — | (8 | ) |\\n| Proceeds from stock issued under share-based compensation plans | 7,071 | 7,808 |\\n| Payments of cash dividends | (17,819 | ) | (15,011 | ) |\\n| Purchases of treasury stock | (23,097 | ) | (2,592 | ) |\\n| Net cash (used in) provided by financing activities | (2,050 | ) | 38,205 |\\n| Effect of exchange rate changes on cash and cash equivalents | 1,578 | 24 |\\n| Change in cash and cash equivalents | 12,223 | (21,137 | ) |\\n| Cash and cash equivalents at beginning of period | 16,358 | 29,940 |\\n| Cash and cash equivalents at end of period | $ | 28,581 | $ | 8,803 |\\n\\nThe accompanying Notes are an integral part of the Consolidated Financial Statements.\\n4\\nPOOL CORPORATION\\nConsolidated Statements of Changes in Stockholders’ Equity\\n(Unaudited)\\n(In thousands)\\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\\n| Shares | Amount | Capital | Deficit | Loss | Total |\\n| Balance at December 31, 2018 | 39,506 | $ | 40 | $ | 453,193 | $ | (218,646 | ) | $ | (10,997 | ) | $ | 223,590 |\\n| Net income | — | — | — | 32,637 | — | 32,637 |\\n| Foreign currency translation | — | — | — | — | 214 | 214 |\\n| Interest rate swaps, net of the change in taxes of $90 | — | — | — | — | (269 | ) | (269 | ) |\\n| Repurchases of common stock, net of retirements | (155 | ) | (1 | ) | — | (23,096 | ) | — | (23,097 | ) |\\n| Share-based compensation | — | — | 3,259 | — | — | 3,259 |\\n| Adoption of ASU 2016-02 | — | — | — | (709 | ) | — | (709 | ) |\\n| Issuance of shares under share-based compensation plans | 328 | 1 | 7,070 | — | — | 7,071 |\\n| Declaration of cash dividends | — | — | — | (17,819 | ) | — | (17,819 | ) |\\n| Balance at March 31, 2019 | 39,679 | $ | 40 | $ | 463,522 | $ | (227,633 | ) | $ | (11,052 | ) | $ | 224,877 |\\n\\n| Common Stock | AdditionalPaid-In | Retained | AccumulatedOtherComprehensive |\\n| Shares | Amount | Capital | Deficit | Loss | Total |\\n| Balance at December 31, 2017 | 40,212 | $ | 40 | $ | 426,750 | $ | (196,316 | ) | $ | (7,328 | ) | $ | 223,146 |\\n| Net income | — | — | — | 31,339 | — | 31,339 |\\n| Foreign currency translation | — | — | — | — | 976 | 976 |\\n| Interest rate swaps, net of the change in taxes of $(275) | — | — | — | — | 824 | 824 |\\n| Repurchases of common stock, net of retirements | (18 | ) | — | — | (2,592 | ) | — | (2,592 | ) |\\n| Share-based compensation | — | — | 3,321 | — | — | 3,321 |\\n| Issuance of shares under share-based compensation plans | 375 | 1 | 7,807 | — | — | 7,808 |\\n| Declaration of cash dividends | — | — | — | (15,011 | ) | — | (15,011 | ) |\\n| Other | — | — | — | — | (26 | ) | (26 | ) |\\n| Balance at March 31, 2018 | 40,569 | $ | 41 | $ | 437,878 | $ | (182,580 | ) | $ | (5,554 | ) | $ | 249,785 |\\n\\n5\\nPOOL CORPORATION\\nNotes to Consolidated Financial Statements\\n(Unaudited)\\nNote 1 – Summary of Significant Accounting Policies\\nPool Corporation (the Company, which may be referred to as we, us or our) prepared the unaudited interim Consolidated Financial Statements following U.S. generally accepted accounting principles (GAAP) and the requirements of the Securities and Exchange Commission (SEC) for interim financial information. As permitted under those rules, we have condensed or omitted certain footnotes and other financial information required for complete financial statements.\\nThe Consolidated Financial Statements include all normal and recurring adjustments that are necessary for a fair presentation of our financial position and operating results. All significant intercompany accounts and intercompany transactions have been eliminated.\\nA description of our significant accounting policies is included in our 2018 Annual Report on Form 10-K. You should read the interim Consolidated Financial Statements in conjunction with the Consolidated Financial Statements and accompanying notes in our 2018 Annual Report on Form 10-K. The results for our three month period ended March 31, 2019 are not necessarily indicative of the expected results for our fiscal year ending December 31, 2019.\\nNewly Adopted Accounting Pronouncements\\nOn January 1, 2019, we adopted Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) and all the related amendments, which are codified into Accounting Standards Codification (ASC) 842. The adoption of ASU 2016-02 significantly increased assets and liabilities on our Consolidated Balance Sheets as we recorded a right-of-use asset and corresponding liability for each of our existing operating leases. We adopted this guidance using the modified retrospective approach by recognizing a cumulative adjustment to retained earnings on the adoption date, which was not material. Additionally, we elected to apply the practical expedient that allows us to exclude comparative presentation; thus, we did not restate our prior period balance sheets to reflect the new guidance.\\nWe recorded operating lease assets and operating lease liabilities of approximately $175.7 million and $181.6 million, respectively, as of January 1, 2019. The difference between the operating lease assets and operating lease liabilities primarily represents our straight-line rent liability of $5.1 million recorded under previous accounting guidance. Under ASU 2016-02, this liability is considered a reduction of the operating lease asset. We recorded the remaining difference between our operating lease assets and operating lease liabilities, net of the deferred tax impact, as an adjustment to retained earnings. Additionally, we reclassified prepaid rent of $4.9 million as of January 1, 2019 to our operating lease asset resulting in a balance of $180.6 million as of the adoption date.\\nThe adoption of this guidance did not materially impact our results of operations or cash flows. See Commitments and Contingencies within this note below for additional information regarding our adoption of this new guidance.\\nOn January 1, 2019, we adopted ASU 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This new standard expands and refines hedge accounting for both financial and non-financial risk components, aligns the recognition and presentation of the effects of hedging instruments and hedge items in the financial statements and includes certain targeted improvements to ease the application of current guidance related to the assessment of hedge effectiveness. The adoption of this guidance did not impact our results of operations, statement of financial position or cash flows.\\nCommitments and Contingencies\\nWe lease facilities for our corporate and administrative offices, sales centers and centralized shipping locations under operating leases that expire in various years through 2032. Most of our leases contain five-year terms with renewal options that allow us to extend the lease term beyond the initial period, subject to terms agreed upon at lease inception. Based on our leasing practices and contract negotiations, we determined that we are not reasonably certain to exercise the renewal options and, as such, we have not included optional renewal periods in our measurement of operating lease assets, liabilities and expected lease terms.\\nWe elected to apply the package of practical expedients available within ASU 2016-02, which is intended to provide some relief to issuers. Electing this option allowed us to retain our existing assessment of whether an arrangement is or contains a lease, is classified as an operating or financing lease and contains initial direct costs. We also elected the practical expedients that allow us to exclude short-term leases from our Consolidated Balance Sheets and to combine lease and non-lease components.\\n6\\nFor leases with step rent provisions whereby the rental payments increase incrementally over the life of the lease, we recognize expense on a straight-line basis determined by the total lease payments over the lease term. To the extent we determine that future obligations related to real estate taxes, insurance and other lease components are variable, we exclude them from the measurement of our operating lease assets and liabilities.\\nSome of our real estate agreements include rental payments adjusted periodically for inflation. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.\\nThe table below presents expense associated with facility and vehicle operating leases (in thousands):\\n| Three Months Ended |\\n| March 31, |\\n| Lease Cost | Classification | 2019 | 2018 |\\n| Operating lease cost (1) | Selling and administrative expenses | $ | 15,070 | $ | 14,553 |\\n| Variable lease cost | Selling and administrative expenses | 3,259 | 3,021 |\\n\\n(1) Includes short-term lease cost, which is not material\\nBased on our lease portfolio as of March 31, 2019, the table below sets forth the approximate future lease payments related to operating leases with initial terms of one year or more (in thousands):\\n| 2019 | $ | 38,389 |\\n| 2020 | 50,443 |\\n| 2021 | 39,184 |\\n| 2022 | 29,883 |\\n| 2023 | 18,089 |\\n| Thereafter | 17,554 |\\n| Total lease payments | 193,542 |\\n| Less: interest | 15,028 |\\n| Present value of lease liabilities | 178,514 |\\n\\nTo calculate the present value of our lease liabilities, we determined our incremental borrowing rate based on the effective interest rate on our unsecured syndicated senior credit facility (the Credit Facility) adjusted for a collateral feature similar to that of our leased properties. The table below presents the weighted-average remaining lease term (years) of our operating leases and the weighted-average discount rate used in the above calculation:\\n| March 31, |\\n| Lease Term and Discount Rate | 2019 |\\n| Weighted-average remaining lease term (years) |\\n| Operating leases | 5.21 |\\n| Weighted-average discount rate |\\n| Operating leases | 3.5 | % |\\n\\n7\\nThe table below presents the amount of cash paid for amounts included in the measurement of lease liabilities (in thousands):\\n| Three Months Ended |\\n| March 31, |\\n| 2019 |\\n| Operating cash flows for lease liabilities | $ | 14,080 |\\n\\nWe lease corporate and administrative offices from Northpark Corporate Center, LLC (NCC), an entity in which we have held a 50% ownership interest since May 2005. NCC owns and operates an office building in Covington, Louisiana. As of March 31, 2019, we occupy approximately 60,293 square feet of office space and we pay rent of $97,976 per month. Our lease term ends in May 2025. We recorded rent expense of $0.3 million for each of the three month periods ended March 31, 2019 and March 31, 2018.\\nIncome Taxes\\nWe reduce federal and state income taxes payable by the tax benefits associated with the exercise of nonqualified stock options and the lapse of restrictions on restricted stock awards. To the extent realized tax deductions exceed the amount of previously recognized deferred tax benefits related to share-based compensation, we record an excess tax benefit. We record all excess tax benefits as a component of income tax benefit or expense on the Consolidated Statements of Income in the period in which stock options are exercised or restrictions on awards lapse. We recorded excess tax benefits of $8.8 million in the first three months of 2019 compared to $9.0 million in the same period of 2018.\\nRetained Deficit\\nWe account for the retirement of treasury shares as a reduction of retained earnings (deficit). As of March 31, 2019, the Retained deficit on our Consolidated Balance Sheets reflects cumulative net income, the cumulative impact of adjustments for changes in accounting pronouncements, treasury share retirements since the inception of our share repurchase programs of $1,449.9 million and cumulative dividends of $512.9 million.\\nAccumulated Other Comprehensive Loss\\nThe table below presents the components of our Accumulated other comprehensive loss balance (in thousands):\\n| March 31, | December 31, |\\n| 2019 | 2018 | 2018 |\\n| Foreign currency translation adjustments | $ | (12,208 | ) | $ | (6,528 | ) | $ | (12,422 | ) |\\n| Unrealized gains on interest rate swaps, net of tax (1) | 1,156 | 974 | 1,425 |\\n| Accumulated other comprehensive loss | $ | (11,052 | ) | $ | (5,554 | ) | $ | (10,997 | ) |\\n\\n| (1) | In February 2018, the Financial Accounting Standards Board (FASB) issued guidance that allows entities the option to reclassify the tax effects related to items in accumulated other comprehensive income (loss) to retained earnings (deficit) if deemed to be stranded in accumulated other comprehensive income (loss) due to U.S. tax reform. We do not have any material amounts stranded in Accumulated other comprehensive loss as a result of U.S. tax reform. |\\n\\n8\\nRecent Accounting Pronouncements Pending Adoption\\n| Standard | Description | Effective Date | Effect on Financial Statements and Other Significant Matters |\\n| ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments | Changes the way companies evaluate credit losses for most financial assets and certain other instruments. For trade and other receivables, held-to-maturity debt securities, loans and other instruments, entities will be required to use a new forward-looking “expected loss” model to evaluate impairment, potentially resulting in earlier recognition of allowances for losses. The new standard also requires enhanced disclosures, including the requirement to disclose the information used to track credit quality by year of origination for most financing receivables. The guidance must be applied using a cumulative-effect transition method. | Annual periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\\n| ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment | Eliminates the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge (commonly referred to as Step 2 under the current guidance). Rather, the measurement of a goodwill impairment charge will be based on the excess of a reporting unit’s carrying value over its fair value (Step 1 under the current guidance). This guidance should be applied prospectively. | Annual and interim impairment tests performed in periods beginning after December 15, 2019 | We are currently evaluating the effect this will have on our financial position, results of operations and related disclosures. |\\n\\nNote 2 – Earnings Per Share\\nWe calculate basic earnings per share (EPS) by dividing Net income by the weighted average number of common shares outstanding. We include outstanding unvested restricted stock awards of our common stock in the basic weighted average share calculation. Diluted EPS reflects the dilutive effects of potentially dilutive securities, which include in-the-money outstanding stock options and shares to be purchased under our employee stock purchase plan. Using the treasury stock method, the effect of dilutive securities includes these additional shares of common stock that would have been outstanding based on the assumption that these potentially dilutive securities had been issued.\\nStock options with exercise prices that are higher than the average market prices of our common stock for the periods presented are excluded from the diluted EPS calculation because the effect is anti-dilutive.\\n9\\nThe table below presents the computation of EPS, including the reconciliation of basic and diluted weighted average shares outstanding (in thousands, except EPS):\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Net income | $ | 32,637 | $ | 31,339 |\\n| Weighted average shares outstanding: |\\n| Basic | 39,479 | 40,370 |\\n| Effect of dilutive securities: |\\n| Stock options and employee stock purchase plan | 1,217 | 1,492 |\\n| Diluted | 40,696 | 41,862 |\\n| Earnings per share: |\\n| Basic | $ | 0.83 | $ | 0.78 |\\n| Diluted | $ | 0.80 | $ | 0.75 |\\n| Anti-dilutive stock options excluded from diluted earnings per share computations | 65 | 85 |\\n\\nNote 3 – Acquisitions\\nIn January 2019, we acquired the distribution assets of W.W. Adcock, Inc., a wholesale distributor of swimming pool products, equipment, parts and supplies adding two locations in Pennsylvania, one location in North Carolina and one location in Virginia.\\nIn November 2018, we acquired the distribution assets of Turf & Garden, Inc., a wholesale distributor of irrigation products and landscape maintenance equipment, parts and supplies with three locations in Virginia and one location in North Carolina.\\nWe have completed our acquisition accounting for these acquisitions, subject to adjustments for standard holdback provisions per the terms of the purchase agreements, which are not material.\\nIn January 2018, we acquired the distribution assets of Tore Pty. Ltd. (doing business as Pool Power), a wholesale distributor of pool and spa equipment in South Australia, with one distribution center in Adelaide, Australia. We have completed our acquisition accounting for this acquisition.\\nThese acquisitions did not have a material impact on our financial position or results of operations, either individually or in the aggregate.\\nNote 4 – Fair Value Measurements and Interest Rate Swaps\\nOur assets and liabilities that are measured at fair value on a recurring basis include the unrealized gains or losses on our interest rate swap contracts and contingent consideration related to recent acquisitions. The three levels of the fair value hierarchy under the accounting guidance are described below:\\n| Level 1 | Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets. |\\n\\n| Level 2 | Inputs to the valuation methodology include: |\\n\\n| • | quoted prices for similar assets or liabilities in active markets; |\\n\\n| • | quoted prices for identical or similar assets or liabilities in inactive markets; |\\n\\n| • | inputs other than quoted prices that are observable for the asset or liability; or |\\n\\n10\\n| • | inputs that are derived principally from or corroborated by observable market data by correlation or other means. |\\n\\n| Level 3 | Inputs to the valuation methodology are unobservable and significant to the fair value measurement. |\\n\\nThe table below presents the estimated fair values of our interest rate swap contracts, our forward-starting interest rate swap contract and our contingent consideration liabilities (in thousands):\\n| Fair Value at March 31, |\\n| 2019 | 2018 |\\n| Level 2 |\\n| Unrealized gains on interest rate swaps | $ | 1,785 | $ | 2,451 |\\n| Level 3 |\\n| Contingent consideration liabilities | $ | 833 | $ | 1,617 |\\n\\nInterest Rate Swaps\\nWe utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on our unsecured syndicated senior credit facility (the Credit Facility).\\nFor determining the fair value of our interest rate swap and forward-starting interest rate swap contracts, we use significant other observable market data or assumptions (Level 2 inputs) that we believe market participants would use in pricing similar assets or liabilities, including assumptions about counterparty risk. Our fair value estimates reflect an income approach based on the terms of the interest rate swap contracts and inputs corroborated by observable market data including interest rate curves. We include unrealized gains in Prepaid expenses and other current assets and unrealized losses in Accrued expenses and other current liabilities on the Consolidated Balance Sheets.\\nWe recognize any differences between the variable interest rate payments and the fixed interest rate settlements from our swap counterparties as an adjustment to interest expense over the life of the swaps. If determined to be effective cash flow hedges, we record the changes in the estimated fair value of the swaps to Accumulated other comprehensive loss on our Consolidated Balance Sheets. To the extent our interest rate swaps are determined to be ineffective, we recognize the changes in the estimated fair value of our swaps in Interest and other non-operating expenses, net on our Consolidated Statements of Income.\\nWe currently have three interest rate swap contracts in place, which became effective on October 19, 2016. These swaps were previously forward-starting contracts that were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates at that time and extend the hedged period for future interest payments on our Credit Facility. As amended, these swap contracts terminate on November 20, 2019. In the first three months of 2019, we recognized a loss of $0.2 million as a result of ineffectiveness.\\nThe following table provides additional details related to each of these amended swap contracts:\\n| Derivative | Amendment Date | NotionalAmount(in millions) | FixedInterestRate |\\n| Interest rate swap 1 | October 1, 2015 | $75.0 | 2.273% |\\n| Interest rate swap 2 | October 1, 2015 | $25.0 | 2.111% |\\n| Interest rate swap 3 | October 1, 2015 | $50.0 | 2.111% |\\n\\nFor the three interest rate swap contracts in effect at March 31, 2019, a portion of the change in the estimated fair value between periods relates to future interest expense. Recognition of the change in fair value between periods attributable to accrued interest is reclassified from Accumulated other comprehensive loss on the Consolidated Balance Sheets to Interest and other non-operating expenses, net on the Consolidated Statements of Income. These amounts were not material in the three month periods ended March 31, 2019 and March 31, 2018.\\n11\\nIn July 2016, we entered into an additional forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the variable interest rate to a fixed interest rate on borrowings under the Credit Facility. This contract becomes effective on November 20, 2019 and terminates on November 20, 2020. The following table provides additional details related to this swap contract:\\n| Derivative | Inception Date | NotionalAmount(in millions) | FixedInterestRate |\\n| Forward-starting interest rate swap | July 6, 2016 | $150.0 | 1.1425% |\\n\\nFailure of our swap counterparties would result in the loss of any potential benefit to us under our swap agreements. In this case, we would still be obligated to pay the variable interest payments underlying our debt agreements. Additionally, failure of our swap counterparties would not eliminate our obligation to continue to make payments under our existing swap agreements if we continue to be in a net pay position.\\nOur interest rate swap and forward-starting interest rate swap contracts are subject to master netting arrangements. According to our accounting policy, we do not offset the fair values of assets with the fair values of liabilities related to these contracts.\\nOther\\nThe carrying values of cash, receivables, accounts payable and accrued liabilities approximate fair value due to the short maturity of those instruments (Level 1 inputs). The carrying value of long-term debt approximates fair value (Level 3 inputs). Our determination of the estimated fair value reflects a discounted cash flow model using our estimates, including assumptions related to borrowing rates (Level 3 inputs).\\nNote 5 – Debt\\nThe table below presents the components of our debt (in thousands):\\n| March 31, |\\n| 2019 | 2018 |\\n| Variable rate debt |\\n| Short-term borrowings | $ | 13,714 | $ | 12,263 |\\n| Current portion of long-term debt: |\\n| Australian credit facility | 8,020 | 8,523 |\\n| Short-term borrowings and current portion of long-term debt | 21,734 | 20,786 |\\n| Long-term portion: |\\n| Revolving credit facility | 503,073 | 388,762 |\\n| Receivables securitization facility | 175,100 | 160,000 |\\n| Less: financing costs, net | 930 | 1,438 |\\n| Long-term debt, net | 677,243 | 547,324 |\\n| Total debt | $ | 698,977 | $ | 568,110 |\\n\\nOur accounts receivable securitization facility (the Receivables Facility) provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities.\\nWe account for the sale of the receivable interests as a secured borrowing on our Consolidated Balance Sheets. The receivables subject to the agreement collateralize the cash proceeds received from the third-party financial institutions. We classify the entire outstanding balance as Long-term debt on our Consolidated Balance Sheets as we intend and have the ability to refinance the obligations on a long‑term basis. We present the receivables that collateralize the cash proceeds separately as Receivables pledged under receivables facility on our Consolidated Balance Sheets.\\n12\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nYou should read the following discussion in conjunction with Management’s Discussion and Analysis included in our 2018 Annual Report on Form 10-K.\\nFor a discussion of our base business calculations, see the Results of Operations section below.\\nCautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995\\nThis report contains forward-looking information that involves risks and uncertainties. Our forward‑looking statements express our current expectations or forecasts of possible future results or events, including projections of earnings and other financial performance measures, statements of management’s expectations regarding our plans and objectives and industry, general economic and other forecasts of trends, future dividend payments and share repurchases, and other matters. Forward-looking statements speak only as of the date of this filing, and we undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur. You can identify these statements by the fact that they do not relate strictly to historic or current facts and often use words such as “anticipate,” “estimate,” “expect,” “intend,” “believe,” “will likely result,” “outlook,” “project,” “may,” “can,” “plan,” “target,” “potential,” “should” and other words and expressions of similar meaning.\\nNo assurance can be given that the expected results in any forward-looking statement will be achieved, and actual results may differ materially due to one or more factors, including the sensitivity of our business to weather conditions, changes in the economy and the housing market, our ability to maintain favorable relationships with suppliers and manufacturers, competition from other leisure product alternatives and mass merchants, excess tax benefits or deficiencies recognized under ASU 2016-09 and other risks detailed in our 2018 Annual Report on Form 10-K. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act.\\nOVERVIEW\\nFinancial Results\\nWe produced solid results in the first quarter of 2019 despite wetter and cooler conditions throughout most of the quarter in some of our major markets. Our team’s strong execution, coupled with modest top line growth, delivered favorable results in the quarter.\\nNet sales increased 2% to $597.5 million in the first quarter of 2019 compared to $585.9 million in the first quarter of 2018, while base business sales grew 1%. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\\nGross profit increased 5% to $174.6 million in the first quarter of 2019 from $166.1 million in the same period in 2018. Base business gross profit improved 4% over the first quarter of 2018, including a negative currency exchange impact of 1%. Gross margin increased 90 basis points to 29.2% in the first quarter of 2019 compared to 28.3% in the first quarter of 2018, reflecting benefits from our strategic inventory purchases in 2018 and lower customer early buys in the first quarter of 2019.\\nSelling and administrative expenses (operating expenses) increased 3% to $136.2 million in the first quarter of 2019 compared to the first quarter of 2018. Base business operating expenses were up 1% over the comparable 2018 period including a 1% currency benefit. As a percentage of net sales, base business operating expenses increased to 22.6% in the first quarter of 2019 compared to 22.5% in the first quarter of 2018.\\nOperating income for the first quarter of 2019 increased to $38.4 million, up 14% compared to the same period in 2018. Operating margin was 6.4% in the first quarter of 2019 and 5.7% in the same period in 2018, while base business operating margin improved 90 basis points from the prior year to 6.7% in the first quarter of 2019.\\nWe recorded an $8.8 million tax benefit from Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting, in the quarter ended March 31, 2019 compared to a tax benefit of $9.0 million realized in the same period of 2018.\\n13\\nNet income was $32.6 million in the first quarter of 2019 compared to $31.3 million in the first quarter of 2018. Earnings per share increased 7% to $0.80 per diluted share in the three months ended March 31, 2019 compared to $0.75 per diluted share in the same period of 2018. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\\nReferences to product line and product category data throughout this report generally reflect data related to the North American swimming pool market, as it is more readily available for analysis and represents the largest component of our operations.\\nFinancial Position and Liquidity\\nAs of March 31, 2019, total net receivables, including pledged receivables, remained flat compared to March 31, 2018. Our days sales outstanding (DSO), as calculated on a trailing four quarters basis, was 29.8 days at March 31, 2019 and 30.1 days at March 31, 2018. Our allowance for doubtful accounts balance was $5.6 million at March 31, 2019 and $4.0 million at March 31, 2018.\\nNet inventory levels grew 16% compared to levels at March 31, 2018. The increase of $111.9 million in inventory reflects strategic inventory purchases we made in the second half of 2018 in advance of greater than normal vendor price increases, inventory from acquired businesses and normal business growth, as well as the slower start to the season. The inventory reserve was $8.5 million at March 31, 2019 and $7.4 million at March 31, 2018. Our inventory turns, as calculated on a trailing four quarters basis, were 3.1 times at March 31, 2019 and 3.5 times at March 31, 2018.\\nTotal debt outstanding at March 31, 2019 was $699.0 million, up 23% compared to total debt at March 31, 2018 primarily to fund business driven working capital growth, acquisitions and share repurchases over the past 12 months.\\nCurrent Trends and Outlook\\nFor a detailed discussion of trends through 2018, see the Current Trends and Outlook section of Management’s Discussion and Analysis included in Part II, Item 7 of our 2018 Annual Report on Form 10-K.\\nAs a result of the additional tax benefits realized from ASU 2016-09 in the first quarter of 2019 beyond what was included in our initial earnings guidance range, we are updating our 2019 earnings guidance to a range of $6.09 to $6.39 from $6.05 to $6.35 per diluted share. Other than the additional $0.04 per diluted share tax benefit, our earnings expectation for 2019 remains unchanged.\\nConsistent with our original 2019 projections, we expect base business sales growth of approximately 7% to 9% for 2019 and expect gross margin will be similar to 2018. Unfavorable weather impacts, the loss of a selling day and a later Easter holiday in 2019 led to delayed pool openings, lower customer early buys and lower construction and remodeling activity. We believe these factors negatively impacted our first quarter of 2019 sales by an estimated $30.0 to $45.0 million but will lead to increased sales growth later in the year, depending on customer capacity and weather.\\nWe expect a slight improvement in our gross margin in the second quarter of 2019 as we sell through the strategic inventory purchases we made in the second half of 2018; we expect margins to decline in the fourth quarter of 2019 in comparison to the same quarter in the prior year due to a difficult comparison.\\nWe expect base business operating expenses will grow at a rate of approximately 60% of gross margin growth for the year, which will enable us to achieve operating margin improvement of approximately 20 to 40 basis points for the full year of 2019 compared to 2018.\\nAs discussed further in Results of Operations below, our average outstanding debt for the three months ended March 31, 2019 increased 31% over the same period last year, and given the increase in the 30-Day LIBOR, our effective interest rate increased approximately 70 basis points between periods. Based on these trends, we expect Interest and other non-operating expenses, net will increase for the full year of 2019 compared to 2018.\\nWe expect our annual effective tax rate (excluding the benefit from ASU 2016-09) for 2019 will approximate 25.5%, which is consistent with 2018 and a reduction compared to our historical rate of approximately 38.5% due to the impact of U.S. tax reform.\\nOur effective tax rate is dependent on our results of operations and may change if actual results differ materially from our current expectations, particularly any significant changes in our geographic mix. Due to ASU 2016-09, we expect our effective tax rate will fluctuate from quarter to quarter, particularly in periods when employees elect to exercise their vested stock options or when restrictions on share-based awards lapse. We recorded an $8.8 million tax benefit from ASU 2016-09 for the three months ended\\n14\\nMarch 31, 2019. Additional tax benefits could be recognized related to stock option exercises in 2019 from grants that expire in years after 2019, for which we have not included any expected benefits in our guidance. The estimated impact related to ASU 2016-09 is subject to several assumptions which can vary significantly, including our estimated share price and the periods in which our employees will exercise vested stock options.\\nExcluding the impact of timing differences from our strategic inventory purchases made in the second half of 2018, we expect cash provided by operations will approximate net income for the 2019 fiscal year. We anticipate that we may use approximately $150.0 million to $200.0 million in cash for share repurchases in 2019, subject to additional authorization by our Board of Directors.\\nRESULTS OF OPERATIONS\\nAs of March 31, 2019, we conducted operations through 369 sales centers in North America, Europe, South America and Australia.\\nThe following table presents information derived from the Consolidated Statements of Income expressed as a percentage of net sales:\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Net sales | 100.0 | % | 100.0 | % |\\n| Cost of sales | 70.8 | 71.7 |\\n| Gross profit | 29.2 | 28.3 |\\n| Operating expenses | 22.8 | 22.6 |\\n| Operating income | 6.4 | 5.7 |\\n| Interest and other non-operating expenses, net | 1.1 | 0.6 |\\n| Income before income taxes and equity earnings | 5.3 | % | 5.1 | % |\\n\\nWe have included the results of operations from the acquisitions in 2019 and 2018 in our consolidated results since the acquisition dates.\\nThree Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018\\nThe following table breaks out our consolidated results into the base business component and the excluded component (sales centers excluded from base business):\\n| (Unaudited) | Base Business | Excluded | Total |\\n| (in thousands) | Three Months Ended | Three Months Ended | Three Months Ended |\\n| March 31, | March 31, | March 31, |\\n| 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\\n| Net sales | $ | 587,320 | $ | 582,822 | $ | 10,136 | $ | 3,078 | $ | 597,456 | $ | 585,900 |\\n| Gross profit | 171,706 | 165,334 | 2,925 | 739 | 174,631 | 166,073 |\\n| Gross margin | 29.2 | % | 28.4 | % | 28.9 | % | 24.0 | % | 29.2 | % | 28.3 | % |\\n| Operating expenses | 132,548 | 131,250 | 3,697 | 1,282 | 136,245 | 132,532 |\\n| Expenses as a % of net sales | 22.6 | % | 22.5 | % | 36.5 | % | 41.7 | % | 22.8 | % | 22.6 | % |\\n| Operating income (loss) | 39,158 | 34,084 | (772 | ) | (543 | ) | 38,386 | 33,541 |\\n| Operating margin | 6.7 | % | 5.8 | % | (7.6 | )% | (17.6 | )% | 6.4 | % | 5.7 | % |\\n\\n15\\nIn our calculation of base business results, we have excluded the following acquisitions for the periods identified:\\n| Acquired | AcquisitionDate | NetSales CentersAcquired | PeriodsExcluded |\\n| W.W. Adcock, Inc. (1) | January 2019 | 4 | January - March 2019 |\\n| Turf & Garden, Inc. (1) | November 2018 | 4 | January - March 2019 |\\n| Tore Pty. Ltd. (Pool Power) (1) | January 2018 | 1 | January - March 2019 andJanuary - March 2018 |\\n| Chem Quip, Inc. (1) | December 2017 | 5 | January - March 2019 and January - March 2018 |\\n| Intermark | December 2017 | 1 | January - February 2019 and January - February 2018 |\\n\\n| (1) | We acquired certain distribution assets of each of these companies. |\\n\\nWhen calculating our base business results, we exclude sales centers that are acquired, closed, or opened in new markets for a period of 15 months. We also exclude consolidated sales centers when we do not expect to maintain the majority of the existing business and existing sales centers that are consolidated with acquired sales centers.\\nWe generally allocate corporate overhead expenses to excluded sales centers on the basis of their net sales as a percentage of total net sales. After 15 months of operations, we include acquired, consolidated and new market sales centers in the base business calculation including the comparative prior year period.\\nThe table below summarizes the changes in our sales center count during the first three months of 2019:\\n| December 31, 2018 | 364 |\\n| Acquired locations | 4 |\\n| New locations, existing markets | 2 |\\n| Consolidated location | (1 | ) |\\n| March 31, 2019 | 369 |\\n\\nNet Sales\\n| Three Months Ended |\\n| March 31, |\\n| (in millions) | 2019 | 2018 | Change |\\n| Net sales | $ | 597.5 | $ | 585.9 | $ | 11.6 | 2% |\\n\\nNet sales increased 2% in the first quarter of 2019 compared to the first quarter of 2018, with base business sales up 1% for the period. Cooler and wetter weather, particularly in the western United States, combined with a later Easter holiday adversely impacted first quarter sales. Pool openings and normal spring early buys from customers in seasonal markets are influenced by the timing of the Easter holiday. In addition, sales were negatively impacted approximately 2% by the loss of a selling day compared to the first quarter of 2018 and 1% from unfavorable foreign currency exchange rate fluctuations.\\nThe following factors benefited our sales (listed in order of estimated magnitude):\\n| • | inflationary product cost increases (estimated at approximately 2% above our historical average of 1% to 2%); |\\n\\n| • | strong demand for discretionary products, as evidenced by improvements in sales growth rates for product offerings such as building materials (see discussion below); |\\n\\n| • | acquisitions; and |\\n\\n| • | market share gains, particularly in building materials and commercial products (see discussion below). |\\n\\n16\\nWe believe that sales growth rates for certain product offerings, such as equipment and building materials, evidence increased spending in traditionally discretionary areas, such as pool construction, pool remodeling and equipment upgrades. In the first quarter of 2019, sales for equipment, which includes swimming pool heaters, pumps, lights and filters, remained relatively flat compared to the same period last year. These products collectively represented approximately 30% of net sales for the period. Sales of building materials grew 8% compared to the first quarter of 2018 and represented approximately 13% of net sales in the first quarter of 2019.\\nSales to customers who service large commercial swimming pools such as hotels, universities and community recreational facilities are included in the appropriate existing product categories, and growth in this area is reflected in the numbers above. Sales to these customers represented approximately 6% of our consolidated net sales for the first quarter of 2019 and increased 2% compared to the first quarter of 2018.\\nGross Profit\\n| Three Months Ended |\\n| March 31, |\\n| (in millions) | 2019 | 2018 | Change |\\n| Gross profit | $ | 174.6 | $ | 166.1 | $ | 8.5 | 5% |\\n| Gross margin | 29.2 | % | 28.3 | % |\\n\\nThe increase in gross margin between periods primarily reflects benefits from strategic inventory purchases in the second half of 2018 and lower customer early buys in the first quarter of 2019.\\nOperating Expenses\\n| Three Months Ended |\\n| March 31, |\\n| (in millions) | 2019 | 2018 | Change |\\n| Operating expenses | $ | 136.2 | $ | 132.5 | $ | 3.7 | 3% |\\n| Operating expenses as a % of net sales | 22.8 | % | 22.6 | % |\\n\\nOperating expenses increased 3% in the first quarter of 2019 compared to the first quarter of 2018, with base business operating expenses up approximately 1% compared to the same period last year. This increase is largely due to growth-driven increases in labor expenses and increased facility costs offset by a 1% benefit from foreign currency exchange rate fluctuations.\\nInterest and Other Non-Operating Expenses, Net\\nInterest and other non-operating expenses, net for the first quarter of 2019 increased $3.1 million compared to the first quarter of 2018. The increase mostly reflects higher debt levels and higher interest rates between periods. Our weighted average effective interest rate increased to 3.7% for the first quarter of 2019 from 3.0% for the first quarter of 2018 on higher average outstanding debt of $674.6 million versus $515.9 million for the respective periods.\\nIncome Taxes\\nOur effective income tax rate was a 2.5% benefit for the three months ended March 31, 2019, compared to a 4.3% benefit for the three months ended March 31, 2018. We recorded an $8.8 million tax benefit from ASU 2016-09 in the quarter ended March 31, 2019 compared to a benefit of $9.0 million realized in the same period last year. Excluding the benefits from ASU 2016-09, our effective tax rate was 25.1% and 25.7% for the first quarters of 2019 and 2018, respectively.\\nNet Income and Earnings Per Share\\nNet income increased 4% to $32.6 million in the first quarter of 2019 compared to the first quarter of 2018. Earnings per diluted share increased to $0.80 in the first quarter of 2019 versus $0.75 per diluted share for the comparable 2018 period. The benefit from ASU 2016-09 increased diluted earnings per share by $0.21 and $0.22 in the first quarters of 2019 and 2018, respectively. Excluding the impact from ASU 2016-09 in both periods, earnings per diluted share increased 11% to $0.59 in the first quarter of 2019 compared to $0.53 in the first quarter of 2018.\\n17\\nSeasonality and Quarterly Fluctuations\\nOur business is highly seasonal. In general, sales and operating income are highest during the second and third quarters, which represent the peak months of both swimming pool use and installation and irrigation and landscape installations and maintenance. Sales are substantially lower during the first and fourth quarters, when we may incur net losses. In 2018, we generated approximately 62% of our net sales and 81% of our operating income in the second and third quarters of the year.\\nWe typically experience a build-up of product inventories and accounts payable during the winter months in anticipation of the peak selling season. Excluding borrowings to finance acquisitions and share repurchases, our peak borrowing usually occurs during the second quarter, primarily because extended payment terms offered by our suppliers typically are payable in April, May and June, while our peak accounts receivable collections typically occur in June, July and August.\\nThe following table presents certain unaudited quarterly data for the first quarter of 2019, the four quarters of 2018 and the fourth, third and second quarters of 2017. We have included income statement and balance sheet data for the most recent eight quarters to allow for a meaningful comparison of the seasonal fluctuations in these amounts. In our opinion, this information reflects all normal and recurring adjustments considered necessary for a fair presentation of this data. Due to the seasonal nature of our industry, the results of any one or more quarters are not necessarily a good indication of results for an entire fiscal year or of continuing trends.\\n| (Unaudited) | QUARTER |\\n| (in thousands) | 2019 | 2018 | 2017 |\\n| First | Fourth | Third | Second | First | Fourth | Third | Second |\\n| Statement of Income Data |\\n| Net sales | $ | 597,456 | $ | 543,082 | $ | 811,311 | $ | 1,057,804 | $ | 585,900 | $ | 510,183 | $ | 743,401 | $ | 988,163 |\\n| Gross profit | 174,631 | 160,442 | 235,003 | 308,655 | 166,073 | 145,398 | 216,606 | 289,664 |\\n| Operating income | 38,386 | 25,970 | 92,337 | 162,042 | 33,541 | 17,259 | 81,928 | 154,186 |\\n| Net income | 32,637 | 16,811 | 69,261 | 117,049 | 31,339 | 25,665 | 48,783 | 94,620 |\\n| Balance Sheet Data |\\n| Total receivables, net | $ | 313,127 | $ | 207,801 | $ | 287,773 | $ | 404,415 | $ | 314,596 | $ | 196,265 | $ | 262,796 | $ | 370,285 |\\n| Product inventories, net | 815,742 | 672,579 | 609,983 | 606,583 | 703,793 | 536,474 | 484,287 | 542,805 |\\n| Accounts payable | 472,487 | 237,835 | 204,706 | 300,232 | 467,795 | 245,249 | 209,062 | 273,309 |\\n| Total debt | 698,977 | 666,761 | 580,703 | 657,120 | 568,110 | 519,650 | 564,573 | 553,480 |\\n\\nWe expect that our quarterly results of operations will continue to fluctuate depending on the timing and amount of revenue contributed by new and acquired sales centers. Based on our peak summer selling season, we generally open new sales centers and close or consolidate sales centers, when warranted, either in the first quarter before the peak selling season begins or in the fourth quarter after the peak selling season ends.\\n18\\nWeather is one of the principal external factors affecting our business. The table below presents some of the possible effects resulting from various weather conditions.\\n| Weather | Possible Effects |\\n| Hot and dry | • | Increased purchases of chemicals and suppliesfor existing swimming pools |\\n| • | Increased purchases of above-ground pools andirrigation products |\\n| Unseasonably cool weather or extraordinary amounts of rain | • | Fewer pool and irrigation and landscape installations |\\n| • | Decreased purchases of chemicals and supplies |\\n| • | Decreased purchases of impulse items such asabove-ground pools and accessories |\\n| Unseasonably early warming trends in spring/late cooling trends in fall | • | A longer pool and landscape season, thus positively impacting our sales |\\n| (primarily in the northern half of the U.S. and Canada) |\\n| Unseasonably late warming trends in spring/early cooling trends in fall | • | A shorter pool and landscape season, thus negatively impacting our sales |\\n| (primarily in the northern half of the U.S. and Canada) |\\n\\nWeather Impacts on 2019 and 2018 Results\\nWetter and cooler-than-normal temperatures to begin the year hindered our first quarter of 2019 sales growth. Much of the western United States, particularly California and Arizona, experienced cold to record cold temperatures in January and February. The latter half of March benefited from warmer weather throughout most of the country and provided some relief from the slow start earlier in the year. The first quarter of 2018 experienced similar, though less significant, unfavorable weather in certain markets, leading to adverse conditions in 2019 compared to 2018.\\n19\\nLIQUIDITY AND CAPITAL RESOURCES\\nLiquidity is defined as the ability to generate adequate amounts of cash to meet short-term and long-term cash needs. We assess our liquidity in terms of our ability to generate cash to fund our operating activities, taking into consideration the seasonal nature of our business. Significant factors which could affect our liquidity include the following:\\n| • | cash flows generated from operating activities; |\\n\\n| • | the adequacy of available bank lines of credit; |\\n\\n| • | the quality of our receivables; |\\n\\n| • | acquisitions; |\\n\\n| • | dividend payments; |\\n\\n| • | capital expenditures; |\\n\\n| • | changes in income tax laws and regulations; |\\n\\n| • | the timing and extent of share repurchases; and |\\n\\n| • | the ability to attract long-term capital with satisfactory terms. |\\n\\nOur primary capital needs are seasonal working capital requirements and other general corporate purposes, including acquisitions, dividend payments and share repurchases. Our primary sources of working capital are cash from operations supplemented by borrowings, which have historically been sufficient to support our growth and finance acquisitions. The same principles apply to funds used for capital expenditures and share repurchases.\\nWe prioritize our use of cash based on investing in our business, maintaining a prudent debt structure, including a modest amount of debt, and returning cash to our shareholders through dividends and share repurchases. Our specific priorities for the use of cash are as follows:\\n| • | capital expenditures primarily for maintenance and growth of our sales center structure, technology-related investments and fleet vehicles; |\\n\\n| • | strategic acquisitions executed opportunistically; |\\n\\n| • | payment of cash dividends as and when declared by our Board of Directors (Board); |\\n\\n| • | repayment of debt to maintain an average total leverage ratio (as defined below) between 1.5 and 2.0; and |\\n\\n| • | repurchases of our common stock under our Board-authorized share repurchase program. |\\n\\nCapital expenditures were 1.1% of net sales in 2018 and 1.4% of net sales in both 2017 and 2016. Our higher capital spending in 2017 and 2016 related to expanding our facilities and purchasing delivery vehicles to address growth. Over the last five years, capital expenditures have averaged roughly 1.0% of net sales. Going forward, we project capital expenditures will continue to approximate this average.\\nSources and Uses of Cash\\nThe following table summarizes our cash flows (in thousands):\\n| Three Months Ended |\\n| March 31, |\\n| 2019 | 2018 |\\n| Operating activities | $ | 28,804 | $ | (44,149 | ) |\\n| Investing activities | (16,109 | ) | (15,217 | ) |\\n| Financing activities | (2,050 | ) | 38,205 |\\n\\nCash provided by operating activities increased $73.0 million during the first three months of 2019 compared to the first three months of 2018 primarily due to payments for pre-price increase inventory purchases in 2018 ahead of the 2019 season, which resulted in decreased inventory purchases in the first quarter of 2019.\\nCash used in investing activities for the first three months of 2019 increased compared to the first three months of 2018 primarily due to the acquisition of W.W. Adcock, Inc. which we completed in January 2019.\\nCash used in financing activities increased for the first three months of 2019 compared to the first three months of 2018, which reflects a $20.5 million increase in share repurchases as well as a $16.2 million decrease in amounts provided by net borrowings.\\n20\\nFuture Sources and Uses of Cash\\nRevolving Credit Facility\\nOur Credit Facility provides for $750.0 million in borrowing capacity under a five-year unsecured revolving credit facility and includes sublimits for the issuance of swingline loans and standby letters of credit. Pursuant to an accordion feature, the aggregate maximum principal amount of the commitments under the Credit Facility may be increased at our request and with agreement by the lenders by up to $75.0 million, to a total of $825.0 million. The Credit Facility matures on September 29, 2022. We intend to use the Credit Facility for general corporate purposes, for future share repurchases and to fund future growth initiatives.\\nAt March 31, 2019, there was $503.1 million outstanding, a $4.8 million standby letter of credit outstanding and $242.1 million available for borrowing under the Credit Facility. We utilize interest rate swap contracts and forward-starting interest rate swap contracts to reduce our exposure to fluctuations in variable interest rates for future interest payments on the Credit Facility. As of March 31, 2019, we had three interest rate swap contracts in place that became effective on October 19, 2016. These swap contracts were previously forward-starting and were amended in October 2015 to bring the fixed rates per our forward-starting contracts in line with current market rates and extend the hedged period for future interest payments on our Credit Facility. Now effective, these amended swap contracts convert the Credit Facility’s variable interest rate to fixed rates of 2.273% on a notional amount of $75.0 million and 2.111% on two separate notional amounts, one $25.0 million and the other $50.0 million, totaling $75.0 million. Interest expense related to the notional amounts under these swap contracts is based on the fixed rates plus the applicable margin on the Credit Facility. These interest rate swap contracts will terminate on November 20, 2019.\\nIn July 2016, we entered into a forward-starting interest rate swap contract to extend the hedged period for future interest payments on our Credit Facility to its maturity date at that time. This swap contract will convert the Credit Facility’s variable interest rate to a fixed rate of 1.1425% on a notional amount of $150.0 million. The contract becomes effective on November 20, 2019 and terminates on November 20, 2020.\\nThe weighted average effective interest rate for the Credit Facility as of March 31, 2019 was approximately 3.5%, excluding commitment fees.\\nFinancial covenants on the Credit Facility include maintenance of a maximum average total leverage ratio and a minimum fixed charge coverage ratio. As of March 31, 2019, the calculations of these two covenants are detailed below:\\n| • | Maximum Average Total Leverage Ratio. On the last day of each fiscal quarter, our average total leverage ratio must be less than 3.25 to 1.00. Average Total Leverage Ratio is the ratio of the trailing twelve months (TTM) Average Total Funded Indebtedness plus the TTM Average Accounts Securitization Proceeds divided by the TTM EBITDA (as those terms are defined in the Credit Facility). As of March 31, 2019, our average total leverage ratio equaled 1.80 (compared to 1.72 as of December 31, 2018) and the TTM average total debt amount used in this calculation was $646.7 million. |\\n\\n| • | Minimum Fixed Charge Coverage Ratio. On the last day of each fiscal quarter, our fixed charge ratio must be greater than or equal to 2.25 to 1.00. Fixed Charge Ratio is the ratio of the TTM EBITDAR divided by TTM Interest Expense paid or payable in cash plus TTM Rental Expense (as those terms are defined in the Credit Facility). As of March 31, 2019, our fixed charge ratio equaled 5.17 (compared to 5.33 as of December 31, 2018) and TTM Rental Expense was $57.8 million. |\\n\\nThe Credit Facility also limits the declaration and payment of dividends on our common stock to no more than 50% of the preceding year’s Net Income (as defined in the Credit Facility), provided no default or event of default has occurred and is continuing, or would result from the payment of dividends. Additionally, we may declare and pay quarterly dividends notwithstanding that the aggregate amount of dividends paid would be in excess of the 50% limit described above so long as (i) the amount per share of such dividends does not exceed the amount per share paid during the most recent fiscal year in which we were in compliance with the 50% limit and (ii) our Average Total Leverage Ratio is less than 3.00 to 1.00 both immediately before and after giving pro forma effect to such dividends. Further, dividends must be declared and paid in a manner consistent with our past practice.\\nUnder the Credit Facility, we may repurchase shares of our common stock provided no default or event of default has occurred and is continuing, or would result from the repurchase of shares, and our maximum average total leverage ratio (determined on a pro forma basis) is less than 2.50 to 1.00. Other covenants include restrictions on our ability to grant liens, incur indebtedness, make investments, merge or consolidate, and sell or transfer assets. Failure to comply with any of our financial covenants or any other terms of the Credit Facility could result in higher interest rates on our borrowings or the acceleration of the maturities of our outstanding debt.\\n21\\nReceivables Securitization Facility\\nOur two-year accounts receivable securitization facility (the Receivables Facility) offers us a lower cost form of financing, with a peak funding capacity of up to $295.0 million between May 1 and June 30, which includes an additional seasonal funding capacity that is available between March 1 and July 31. Other funding capacities range from $95.0 million to $280.0 million throughout the remaining months of the year.\\nThe Receivables Facility provides for the sale of certain of our receivables to a wholly owned subsidiary (the Securitization Subsidiary). The Securitization Subsidiary transfers variable undivided percentage interests in the receivables and related rights to certain third-party financial institutions in exchange for cash proceeds, limited to the applicable funding capacities. Upon payment of the receivables by customers, rather than remitting to the financial institutions the amounts collected, we retain such collections as proceeds for the sale of new receivables until payments become due.\\nThe Receivables Facility contains terms and conditions (including representations, covenants and conditions precedent) customary for transactions of this type. Additionally, an amortization event will occur if we fail to maintain a maximum average total leverage ratio (average total funded debt/EBITDA) of 3.25 to 1.00 and a minimum fixed charge coverage ratio (EBITDAR/cash interest expense plus rental expense) of 2.25 to 1.00.\\nAt March 31, 2019, there was $175.1 million outstanding under the Receivables Facility at a weighted average effective interest rate of 3.3%, excluding commitment fees.\\nCompliance and Future Availability\\nAs of March 31, 2019, we believe we were in compliance with all covenants and financial ratio requirements under our Credit Facility and our Receivables Facility. We believe we will remain in compliance with all covenants and financial ratio requirements throughout the next twelve months. For additional information regarding our debt arrangements, see Note 5 of “Notes to Consolidated Financial Statements,” included in Part II, Item 8 of our 2018 Annual Report on Form 10-K.\\nWe believe we have adequate availability of capital to fund present operations and the current capacity to finance any working capital needs that may arise. We continually evaluate potential acquisitions and hold discussions with acquisition candidates. If suitable acquisition opportunities arise that would require financing, we believe that we have the ability to finance any such transactions.\\nAs of April 25, 2019, $49.2 million of the current Board-authorized amount under our share repurchase program remained available. We expect to repurchase additional shares on the open market from time to time depending on market conditions. We plan to fund these repurchases with cash provided by operations and borrowings under the Credit and Receivables Facilities.\\nCRITICAL ACCOUNTING ESTIMATES\\nWe prepare our Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles (GAAP), which require management to make estimates and assumptions that affect reported amounts and related disclosures. Management identifies critical accounting estimates as:\\n| • | those that require the use of assumptions about matters that are inherently and highly uncertain at the time the estimates are made; and |\\n\\n| • | those for which changes in the estimates or assumptions, or the use of different estimates and assumptions, could have a material impact on our consolidated results of operations or financial condition. |\\n\\nManagement has discussed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board. For a description of our critical accounting estimates that require us to make the most difficult, subjective or complex judgments, please see our 2018 Annual Report on Form 10-K. We have not changed these policies from those previously disclosed.\\nRecent Accounting Pronouncements\\nSee Note 1 of “Notes to Consolidated Financial Statements,” included in Item 1 of this Form 10-Q for detail.\\n22\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nInterest Rate Risk\\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our interest rate risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\\nCurrency Risk\\nThere have been no material changes during the three months ended March 31, 2019 from what we reported in our 2018 Annual Report on Form 10-K. For additional information on our currency risk, refer to “Quantitative and Qualitative Disclosures about Market Risk” included in Part II, Item 7A. in our 2018 Annual Report on Form 10-K.\\nItem 4. Controls and Procedures\\nThe term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the Act). The rules refer to the controls and other procedures designed to ensure that information required to be disclosed in reports that we file or submit under the Act is (1) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. As of March 31, 2019, management, including the CEO and CFO, performed an evaluation of the effectiveness of our disclosure controls and procedures. Based on that evaluation, management, including the CEO and CFO, concluded that as of March 31, 2019, our disclosure controls and procedures were effective.\\nWe maintain a system of internal control over financial reporting that is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Based on the most recent evaluation, we have concluded that no change in our internal control over financial reporting occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\\n23\\nPART II. OTHER INFORMATION\\nItem 1. Legal Proceedings\\nFrom time to time, we are subject to various claims and litigation arising in the ordinary course of business, including product liability, personal injury, commercial, contract and employment matters. While the outcome of any litigation is inherently unpredictable, based on currently available facts we do not believe that the ultimate resolution of any of these matters will have a material adverse impact on our financial condition, results of operations or cash flows.\\nItem 1A. Risk Factors\\nThere have been no material changes from the risk factors disclosed in Part I, Item 1A “Risk Factors” in our 2018 Annual Report on Form 10-K.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nThe table below summarizes the repurchases of our common stock in the first quarter of 2019:\\n| Period | Total Number of Shares Purchased (1) | Average Price Paid per Share | Total Number ofShares Purchasedas Part of Publicly Announced Plan (2) | Maximum ApproximateDollar Value of SharesThat May Yet be Purchased Under the Plan (3) |\\n| January 1 - 31, 2019 | 116,946 | $ | 147.77 | 116,946 | $ | 52,498,367 |\\n| February 1 - 28, 2019 | 28,513 | $ | 152.25 | 22,019 | $ | 49,200,474 |\\n| March 1 - 31, 2019 | 9,401 | $ | 156.98 | — | $ | 49,200,474 |\\n| Total | 154,860 | $ | 149.15 | 138,965 |\\n\\n| (1) | These shares may include shares of our common stock surrendered to us by employees in order to satisfy minimum tax withholding obligations in connection with certain exercises of employee stock options or lapses upon vesting of restrictions on previously restricted share awards, and/or to cover the exercise price of such options granted under our share-based compensation plans. There were 15,895 shares surrendered for this purpose in the first quarter of 2019. |\\n\\n| (2) | In May 2018, our Board authorized an additional $200.0 million under our share repurchase program for the repurchase of shares of our common stock in the open market at prevailing market prices or in privately negotiated transactions. |\\n\\n| (3) | As of April 25, 2019, $49.2 million of the authorized amount remained available under our current share repurchase program. |\\n\\n24\\nItem 6. Exhibits\\nExhibits filed as part of this report are listed below.\\n| Incorporated by Reference |\\n| No. | Description | Filed/ Furnished with thisForm 10-Q | Form | File No. | Date Filed |\\n| 3.1 | Restated Certificate of Incorporation of the Company. | 10-Q | 000-26640 | 8/9/2006 |\\n| 3.2 | Amended and Restated Bylaws of the Company. | 8-K | 000-26640 | 2/8/2019 |\\n| 4.1 | Form of certificate representing shares of common stock of the Company. | 8-K | 000-26640 | 5/19/2006 |\\n| 31.1 | Certification by Mark W. Joslin pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\\n| 31.2 | Certification by Peter D. Arvan pursuant to Rule 13a-14(a) and 15d‑14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | X |\\n| 32.1 | Certification by Peter D.Arvan and Mark W. Joslin furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | X |\\n| 101.INS | + | XBRL Instance Document | X |\\n| 101.SCH | + | XBRL Taxonomy Extension Schema Document | X |\\n| 101.CAL | + | XBRL Taxonomy Extension Calculation Linkbase Document | X |\\n| 101.DEF | + | XBRL Taxonomy Extension Definition Linkbase Document | X |\\n| 101.LAB | + | XBRL Taxonomy Extension Label Linkbase Document | X |\\n| 101.PRE | + | XBRL Taxonomy Extension Presentation Linkbase Document | X |\\n\\n+ Attached as Exhibit 101 to this report are the following items formatted in XBRL (Extensible Business Reporting Language):\\n| 1. | Consolidated Statements of Income for the three months ended March 31, 2019 and March 31, 2018; |\\n\\n| 2. | Consolidated Statements of Comprehensive Income for the three months ended March 31, 2019 and March 31, 2018; |\\n\\n| 3. | Consolidated Balance Sheets at March 31, 2019, December 31, 2018 and March 31, 2018; |\\n\\n| 4. | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2019 and |\\n\\nMarch 31, 2018;\\n| 5. | Consolidated Statements of Changes in Stockholders’ Equity for the three months ended March 31, 2019 and |\\n\\nMarch 31, 2018; and\\n| 6. | Notes to Consolidated Financial Statements. |\\n\\n25\\nSIGNATURE\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on April 30, 2019.\\n| POOL CORPORATION |\\n| By: | /s/ Mark W. Joslin |\\n| Mark W. Joslin |\\n| Senior Vice President and Chief Financial Officer, and duly authorized signatory on behalf of the registrant |\\n\\n26\\n</text>\\n\\nHow much should the company anticipate to pay for operating lease liabilities in 2021 if the inflation rate for that year is projected to be 2% (in thousands)?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 39967.68.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 45,\n \"input_length\": 20071\n}"}}},{"rowIdx":46,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\n\n| Item 1. | Financial Statements. |\n\nDonegal Group Inc. and Subsidiaries\nConsolidated Balance Sheets\n\n| September 30,2016 | December 31,2015 |\n| (Unaudited) |\n| Assets |\n| Investments |\n| Fixed maturities |\n| Held to maturity, at amortized cost | $ | 332,272,969 | $ | 310,258,704 |\n| Available for sale, at fair value | 515,821,393 | 501,393,559 |\n| Equity securities, available for sale, at fair value | 46,311,943 | 37,260,821 |\n| Investment in affiliate | 40,145,067 | 38,476,708 |\n| Short-term investments, at cost, which approximates fair value | 9,251,153 | 13,432,482 |\n| Total investments | 943,802,525 | 900,822,274 |\n| Cash | 32,130,534 | 28,139,144 |\n| Accrued investment income | 6,817,760 | 5,991,197 |\n| Premiums receivable | 165,761,900 | 141,267,411 |\n| Reinsurance receivable | 259,428,626 | 259,728,113 |\n| Deferred policy acquisition costs | 57,404,289 | 52,108,388 |\n| Deferred tax asset, net | 14,721,101 | 19,443,807 |\n| Prepaid reinsurance premiums | 127,431,503 | 113,522,505 |\n| Property and equipment, net | 6,705,671 | 7,027,143 |\n| Federal income taxes receivable | 1,823,273 | 1,487,656 |\n| Goodwill | 5,625,354 | 5,625,354 |\n| Other intangible assets | 958,010 | 958,010 |\n| Other | 1,453,864 | 1,713,413 |\n| Total assets | $ | 1,624,064,410 | $ | 1,537,834,415 |\n| Liabilities and Stockholders Equity |\n| Liabilities |\n| Unpaid losses and loss expenses | $ | 594,267,943 | $ | 578,205,109 |\n| Unearned premiums | 476,432,783 | 429,493,203 |\n| Accrued expenses | 21,067,170 | 22,460,475 |\n| Reinsurance balances payable | 3,058,225 | 3,480,406 |\n| Borrowings under lines of credit | 74,000,000 | 81,000,000 |\n| Cash dividends declared | | 3,511,881 |\n| Subordinated debentures | 5,000,000 | 5,000,000 |\n| Accounts payable - securities | 540,311 | 582,560 |\n| Due to affiliate | 3,978,958 | 3,557,177 |\n| Other | 1,710,209 | 2,155,036 |\n| Total liabilities | 1,180,055,599 | 1,129,445,847 |\n| Stockholders Equity |\n| Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued | | |\n| Class A common stock, $.01 par value, authorized 40,000,000 shares, issued 24,189,133 and 23,501,805 shares and outstanding 21,186,545 and 20,499,217 shares | 241,892 | 235,018 |\n| Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares | 56,492 | 56,492 |\n| Additional paid-in capital | 231,885,764 | 219,525,301 |\n| Accumulated other comprehensive income | 6,340,292 | 773,744 |\n| Retained earnings | 246,710,728 | 229,024,370 |\n| Treasury stock, at cost | (41,226,357 | ) | (41,226,357 | ) |\n| Total stockholders equity | 444,008,811 | 408,388,568 |\n| Total liabilities and stockholders equity | $ | 1,624,064,410 | $ | 1,537,834,415 |\n\nSee accompanying notes to consolidated financial statements.\n1\nDonegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Three Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 166,809,851 $ 153,096,075 Investment income, net of investment expenses 5,581,238 5,399,080 Net realized investment gains (losses) (includes $1,018,415 and ($754,050) accumulated other comprehensive income (loss) reclassifications) 1,018,415 (754,050 ) Lease income 163,779 178,827 Installment payment fees 1,380,024 1,473,447 Equity in earnings of Donegal Financial Services Corporation 357,956 408,405 Total revenues 175,311,263 159,801,784 Expenses: Net losses and loss expenses 111,174,963 102,233,708 Amortization of deferred policy acquisition costs 27,524,000 25,036,000 Other underwriting expenses 28,340,135 24,155,566 Policyholder dividends 1,143,026 886,210 Interest 473,917 188,000 Other expenses 226,183 301,367 Total expenses 168,882,224 152,800,851 Income before income tax expense 6,429,039 7,000,933 Income tax expense (includes $356,446 and ($263,918) income tax expense (benefit) from reclassification items) 1,615,635 1,314,102 Net income $ 4,813,404 $ 5,686,831 Earnings per common share: Class A common stock - basic $ 0.19 $ 0.21 Class A common stock - diluted $ 0.18 $ 0.21 Class B common stock - basic and diluted $ 0.16 $ 0.18 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Three Months Ended September 30, 2016 2015 Net income $ 4,813,404 $ 5,686,831 Other comprehensive (loss) income, net of tax Unrealized (loss) gain on securities: Unrealized holding (loss) gain during the period, net of income tax (benefit) expense of ($595,724) and 463,221 (1,106,346 ) 860,268 Reclassification adjustment for (gains) losses included in net income, net of income tax expense (benefit) of $356,446 and ($263,918) (661,969 ) 490,132 Other comprehensive (loss) income (1,768,315 ) 1,350,400 Comprehensive income $ 3,045,089 $ 7,037,231 See accompanying notes to consolidated financial statements. 2 Donegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Nine Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 487,227,767 $ 450,083,676 Investment income, net of investment expenses 16,471,630 15,505,429 Net realized investment gains (includes $2,204,533 and $682,932 accumulated other comprehensive income reclassifications) 2,204,533 682,932 Lease income 514,768 568,552 Installment payment fees 4,109,550 4,473,905 Equity in earnings of Donegal Financial Services Corporation 698,658 1,276,692 Total revenues 511,226,906 472,591,186 Expenses: Net losses and loss expenses 309,946,943 296,012,311 Amortization of deferred policy acquisition costs 80,034,000 73,872,000 Other underwriting expenses 81,557,159 73,192,072 Policyholder dividends 2,729,595 2,491,919 Interest 1,286,279 908,615 Other expenses 1,179,660 1,704,680 Total expenses 476,733,636 448,181,597 Income before income tax expense 34,493,270 24,409,589 Income tax expense (includes $771,587 and $239,026 income tax expense from reclassification items) 9,246,299 5,403,395 Net income $ 25,246,971 $ 19,006,194 Earnings per common share: Class A common stock - basic $ 0.98 $ 0.71 Class A common stock - diluted $ 0.95 $ 0.69 Class B common stock - basic and diluted $ 0.88 $ 0.63 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Nine Months Ended September 30, 2016 2015 Net income $ 25,246,971 $ 19,006,194 Other comprehensive income (loss), net of tax Unrealized gain (loss) on securities: Unrealized holding gain (loss) during the period, net of income tax expense (benefit) of $3,768,959 and ($1,141,726) 6,999,494 (2,120,347 ) Reclassification adjustment for gains included in net income, net of income tax expense of $771,587 and $239,026 (1,432,946 ) (443,906 ) Other comprehensive income (loss) 5,566,548 (2,564,253 ) Comprehensive income $ 30,813,519 $ 16,441,941 See accompanying notes to consolidated financial statements. 3 Donegal Group Inc. and Subsidiaries Consolidated Statement of Stockholders’ Equity (Unaudited) Nine Months Ended September 30, 2016 Class A Shares Class B Shares Class A Amount Class B Amount Additional Paid-In Capital Accumulated Other Comprehensive Income Retained Earnings Treasury Stock Total Stockholders’ Equity Balance, December 31, 2015 23,501,805 5,649,240 $ 235,018 $ 56,492 $ 219,525,301 $ 773,744 $ 229,024,370 $ (41,226,357 ) $ 408,388,568 Issuance of common stock 104,271 — 1,043 — 1,389,022 — — — 1,390,065 Share-based compensation 583,057 5,831 10,396,351 10,402,182 Net income — — — — — — 25,246,971 — 25,246,971 Cash dividends declared — — — — — — (6,985,523 ) — (6,985,523 ) Grant of stock options — — — — 575,090 — (575,090 ) — — Other comprehensive income — — — — — 5,566,548 — — 5,566,548 Balance, September 30, 2016 24,189,133 5,649,240 $ 241,892 $ 56,492 $ 231,885,764 $ 6,340,292 $ 246,710,728 $ (41,226,357 ) $ 444,008,811 See accompanying notes to consolidated financial statements. 4 Donegal Group Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended September 30, 2016 2015 Cash Flows from Operating Activities: Net income $ 25,246,971 $ 19,006,194 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and other non-cash items 5,365,877 2,890,128 Net realized investment gains (2,204,533 ) (682,932 ) Equity in earnings of Donegal Financial Services Corporation (698,658 ) (1,276,692 ) Changes in assets and liabilities: Losses and loss expenses 16,062,834 30,888,062 Unearned premiums 46,939,580 32,671,922 Premiums receivable (24,494,489 ) (13,301,356 ) Deferred acquisition costs (5,295,901 ) (5,212,051 ) Deferred income taxes 1,725,335 225,409 Reinsurance receivable 299,487 (6,254,559 ) Prepaid reinsurance premiums (13,908,998 ) (1,631,341 ) Accrued investment income (826,563 ) (929,722 ) Due to affiliate 421,781 (1,655,351 ) Reinsurance balances payable (422,181 ) (3,900,348 ) Current income taxes (335,617 ) 242,849 Accrued expenses (1,393,305 ) (601,830 ) Other, net (185,278 ) (1,943,559 ) Net adjustments 21,049,371 29,528,629 Net cash provided by operating activities 46,296,342 48,534,823 Cash Flows from Investing Activities: Purchases of fixed maturities, held to maturity (35,461,529 ) (18,483,546 ) Purchases of fixed maturities, available for sale (127,113,153 ) (132,823,136 ) Purchases of equity securities, available for sale (10,753,187 ) (9,011,957 ) Maturity of fixed maturities: Held to maturity 13,603,700 22,416,840 Available for sale 64,406,512 56,293,130 Sales of fixed maturities, available for sale 52,032,208 23,485,311 Sales of equity securities, available for sale 5,068,287 2,704,425 Net purchases of property and equipment (260,968 ) (78,292 ) Net decrease in investment in affiliate — 675,100 Net sales (purchases) of short-term investments 4,181,329 (4,302,571 ) Net cash used in investing activities (34,296,801 ) (59,124,696 ) Cash Flows from Financing Activities: Cash dividends paid (10,497,404 ) (10,762,609 ) Issuance of common stock 9,489,253 17,106,300 Purchase of treasury stock — (904,675 ) Payments on lines of credit (7,000,000 ) (9,500,000 ) Borrowings under lines of credit — 4,000,000 Net cash used in financing activities (8,008,151 ) (60,984 ) Net increase (decrease) in cash 3,991,390 (10,650,857 ) Cash at beginning of period 28,139,144 35,578,509 Cash at end of period $ 32,130,534 $ 24,927,652 Cash paid during period - Interest $ 1,001,870 $ 757,175 Net cash paid during period - Taxes $ 8,255,000 $ 4,500,000 See accompanying notes to consolidated financial statements. 5 DONEGAL GROUP INC. AND SUBSIDIARIES (Unaudited) Notes to Consolidated Financial Statements 1 - Organization Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. Our insurance subsidiaries, Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, Sheboygan Falls Insurance Company (“Sheboygan”) and Michigan Insurance Company (“MICO”), write personal and commercial lines of property and casualty coverages exclusively through a network of independent insurance agents in certain Mid-Atlantic, Midwestern, New England and Southern states. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company that owns Union Community Bank (“UCB”), a state savings bank. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC. We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies. At September 30, 2016, Donegal Mutual held approximately 47% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 73% of the total voting power of our outstanding common stock. We believe Donegal Mutual’s voting control of us benefits us for the reasons we describe in our Annual Reports on Form 10-K and in our proxy statements. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions. While each company maintains its separate corporate existence, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products. Atlantic States, our largest subsidiary, participates in a pooling agreement with Donegal Mutual. Under the pooling agreement, Donegal Mutual and Atlantic States pool their insurance business and each company receives an allocated percentage of the pooled business. Atlantic States has an 80% share of the results of the pooled business, and Donegal Mutual has a 20% share of the results of the pooled business. The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries. In addition, as the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual market are generally complementary, thereby allowing the Donegal Insurance Group to offer a broader range of products to a given market and to expand the Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products Donegal Mutual and our insurance subsidiaries offer relate generally to specific risk profiles targeted within similar classes of business, such as preferred tier products versus standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, as the risk characteristics of all business Donegal Mutual and Atlantic States write directly are homogenized within the underwriting pool, Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the pool. Pooled business represents the predominant percentage of the net underwriting activity of both Donegal Mutual and Atlantic States. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. 6 2 - Basis of Presentation Our financial information for the interim periods included in this Form 10-Q Report is unaudited; however, our financial information we include in this Form 10-Q Report reflects all adjustments, consisting only of normal recurring adjustments that, in the opinion of our management, are necessary for a fair presentation of our financial position, results of operations and cash flows for those interim periods. Our results of operations for the nine months ended September 30, 2016 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2016. You should read the interim financial statements we include in this Form 10-Q Report in conjunction with the financial statements and the notes to our financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2015. 3 - Earnings Per Share We have two classes of common stock, which we refer to as our Class A common stock and our Class B common stock. Our certificate of incorporation provides that whenever our board of directors declares a dividend on our Class B common stock, our board of directors shall simultaneously declare a dividend on our Class A common stock that is payable to the holders of our Class A common stock at the same time and as of the same record date at a rate that is at least 10% greater than the rate at which our board of directors declared a dividend on our Class B common stock. Accordingly, we use the two-class method to compute our earnings per common share. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on dividends we have declared and an allocation of our remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. The table below presents for the periods indicated a reconciliation of the numerators and denominators we used to compute basic and diluted net income per share for each class of our common stock: Three Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Weighted-average shares outstanding 21,078 5,577 22,442 5,577 Basic net income per share $ 0.19 $ 0.16 $ 0.21 $ 0.18 Diluted net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Number of shares used in basic computation 21,078 5,577 22,442 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 831 — 242 — Number of shares used in diluted computation 21,909 5,577 22,684 5,577 Diluted net income per share $ 0.18 $ 0.16 $ 0.21 $ 0.18 7 Nine Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Weighted-average shares outstanding 20,791 5,577 21,996 5,577 Basic net income per share $ 0.98 $ 0.88 $ 0.71 $ 0.63 Diluted net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Number of shares used in basic computation 20,791 5,577 21,996 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 560 — 400 — Number of shares used in diluted computation 21,351 5,577 22,396 5,577 Diluted net income per share $ 0.95 $ 0.88 $ 0.69 $ 0.63 We did not include outstanding options to purchase the following number of shares of Class A common stock in our computation of diluted earnings per share because the exercise price of the options exceeded the average market price of our Class A common stock during the applicable periods: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Number of options to purchase Class A shares excluded — 4,014,501 — — 4 - Reinsurance Atlantic States and Donegal Mutual have participated in a pooling agreement since 1986 under which each company places all of its direct written premiums into the pool the pooling agreement established, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool. Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also purchase separate third-party reinsurance that provides coverage that we believe is commensurate with their relative size and risk exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with the requirements of our insurance subsidiaries and Donegal Mutual, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating from A.M. Best. The following information describes the external reinsurance our insurance subsidiaries have in place for 2016: • excess of loss reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, losses over a set retention (generally $1.0 million), and • catastrophe reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, 100% of an accumulation of many losses resulting from a single event, including natural 8 disasters, over a set retention (generally $5.0 million) and after exceeding an annual aggregate deductible (generally $1.0 million) up to aggregate losses of $170.0 million per occurrence. Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures in excess of the covered limits of their third-party reinsurance agreements. In addition to the pooling agreement and third-party reinsurance, our insurance subsidiaries have various reinsurance agreements with Donegal Mutual. We have made no significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the nine months ended September 30, 2016. 5 - Investments The amortized cost and estimated fair values of our fixed maturities and equity securities at September 30, 2016 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 59,254 $ 3,130 $ 7 $ 62,377 Obligations of states and political subdivisions 122,203 14,292 4 136,491 Corporate securities 86,582 3,360 598 89,344 Mortgage-backed securities 64,234 2,425 — 66,659 Totals $ 332,273 $ 23,207 $ 609 $ 354,871 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,009 $ 368 $ 2 $ 36,375 Obligations of states and political subdivisions 184,068 10,219 11 194,276 Corporate securities 88,826 2,156 141 90,841 Mortgage-backed securities 190,936 3,444 51 194,329 Fixed maturities 499,839 16,187 205 515,821 Equity securities 41,806 4,917 411 46,312 Totals $ 541,645 $ 21,104 $ 616 $ 562,133 At September 30, 2016, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $229.6 million and an amortized cost of $213.6 million. Our holdings at September 30, 2016 also included special revenue bonds with an aggregate fair value of $101.2 million and an amortized cost of $92.7 million. With respect to both categories of those bonds at September 30, 2016, we held no securities of any issuer that constituted more than 10% of our holdings of either bond category. Education bonds and water and sewer utility bonds represented 62% and 24%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at September 30, 2016. Many of the issuers of the special revenue bonds we held at September 30, 2016 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held at September 30, 2016 were similar to general obligation bonds. 9 The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2015 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 51,194 $ 1,544 $ — $ 52,738 Obligations of states and political subdivisions 119,115 10,828 119 129,824 Corporate securities 65,307 816 1,561 64,562 Mortgage-backed securities 74,643 1,181 149 75,675 Totals $ 310,259 $ 14,369 $ 1,829 $ 322,799 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,080 $ 160 $ 51 $ 37,189 Obligations of states and political subdivisions 223,769 13,151 364 236,556 Corporate securities 73,474 350 1,012 72,812 Mortgage-backed securities 154,687 1,045 896 154,836 Fixed maturities 489,010 14,706 2,323 501,393 Equity securities 35,765 2,269 773 37,261 Totals $ 524,775 $ 16,975 $ 3,096 $ 538,654 At December 31, 2015, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $256.9 million and an amortized cost of $241.1 million. Our holdings also included special revenue bonds with an aggregate fair value of $109.5 million and an amortized cost of $101.8 million. With respect to both categories of bonds, we held no securities of any issuer that comprised more than 10% of that category at December 31, 2015. Education bonds and water and sewer utility bonds represented 57% and 26%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2015. Many of the issuers of the special revenue bonds we held at December 31, 2015 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds. We made reclassifications from available for sale to held to maturity of certain fixed maturities at fair value on November 30, 2013. We segregated within accumulated other comprehensive income the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities we reclassified from available for sale to held to maturity. We are amortizing this balance over the remaining life of the related securities as an adjustment to yield in a manner consistent with the accretion of discount on the same fixed maturities. We recorded amortization of $1.0 million and $905,446 in accumulated other comprehensive income during the nine months ended September 30, 2016 and 2015, respectively. At September 30, 2016 and December 31, 2015, net unrealized losses of $11.3 million and $12.3 million, respectively, remained within accumulated other comprehensive income. 10 We show below the amortized cost and estimated fair value of our fixed maturities at September 30, 2016 by contractual maturity. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Cost Estimated Fair Value (in thousands) Held to maturity Due in one year or less $ 9,643 $ 9,657 Due after one year through five years 42,967 44,275 Due after five years through ten years 86,925 92,926 Due after ten years 128,504 141,354 Mortgage-backed securities 64,234 66,659 Total held to maturity $ 332,273 $ 354,871 Available for sale Due in one year or less $ 36,476 $ 37,158 Due after one year through five years 115,204 119,709 Due after five years through ten years 105,689 109,631 Due after ten years 51,534 54,994 Mortgage-backed securities 190,936 194,329 Total available for sale $ 499,839 $ 515,821 Gross realized gains and losses from investments before applicable income taxes for the three and nine months ended September 30, 2016 and 2015 were as follows: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 (in thousands) Gross realized gains: Fixed maturities $ 289 $ 7 $ 2,129 $ 974 Equity securities 1,170 30 1,226 733 1,459 37 3,355 1,707 Gross realized losses: Fixed maturities 22 27 280 105 Equity securities 419 764 870 919 441 791 1,150 1,024 Net realized gains (losses) $ 1,018 $ (754 ) $ 2,205 $ 683 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at September 30, 2016 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 2,988 $ 9 $ — $ — Obligations of states and political subdivisions 4,248 13 722 2 Corporate securities 21,006 205 2,911 534 Mortgage-backed securities 20,567 49 831 2 Equity securities 4,515 308 163 103 Totals $ 53,324 $ 584 $ 4,627 $ 641 11 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2015 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 10,168 $ 51 $ — $ — Obligations of states and political subdivisions 19,437 483 — — Corporate securities 69,482 1,615 11,324 958 Mortgage-backed securities 105,300 876 7,538 168 Equity securities 9,245 773 — — Totals $ 213,632 $ 3,798 $ 18,862 $ 1,126 We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual equity security investment to be other than temporary. We monitor all investments individually for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, issuer or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We amortize premiums and discounts on debt securities over the life of the security as an adjustment to yield using the effective interest method. We compute realized investment gains and losses using the specific identification method. We amortize premiums and discounts on mortgage-backed debt securities using anticipated prepayments. We account for our investment in affiliate using the equity method of accounting. Under this method, we record our investment at cost, with adjustments for our share of our affiliate’s earnings and losses as well as changes in the equity of our affiliate due to unrealized gains and losses. Our investment in affiliate represents our 48.2% ownership interest in DFSC. We include our share of DFSC’s net income in our results of operations. We have compiled the following summary financial information for DFSC at September 30, 2016 and December 31, 2015 and for the three and nine months ended September 30, 2016 and 2015, respectively, from the financial statements of DFSC. The financial information of DFSC at September 30, 2016 and 2015 and for the three and nine months then ended is unaudited. 12 Balance sheets: September 30, 2016 December 31, 2015 (in thousands) Total assets $ 522,118 $ 507,139 Total liabilities $ 438,942 $ 427,423 Stockholders’ equity 83,176 79,716 Total liabilities and stockholders’ equity $ 522,118 $ 507,139 Three Months Ended September 30, Nine Months Ended September 30, Income statements: 2016 2015 2016 2015 (in thousands) Net income $ 742 $ 847 $ 1,449 $ 2,372 13 6 - Segment Information We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries using statutory accounting principles (“SAP”) that various state insurance departments prescribe or permit. Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). Financial data by segment for the three and nine months ended September 30, 2016 and 2015 is as follows: Three Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 75,571 $ 66,456 Personal lines 91,239 86,640 GAAP premiums earned 166,810 153,096 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 1,544 1,653 Total revenues $ 175,311 $ 159,802 Income before income taxes: Underwriting (loss) income: Commercial lines $ 3,701 $ 4,447 Personal lines (5,861 ) (3,727 ) SAP underwriting (loss) income (2,160 ) 720 GAAP adjustments 788 65 GAAP underwriting (loss) income (1,372 ) 785 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 844 1,163 Income before income taxes $ 6,429 $ 7,001 14 Nine Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 218,405 $ 193,036 Personal lines 268,823 257,048 GAAP premiums earned 487,228 450,084 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 4,623 5,042 Total revenues $ 511,227 $ 472,591 Income before income taxes: Underwriting income (loss): Commercial lines $ 14,118 $ 6,449 Personal lines (6,953 ) (6,499 ) SAP underwriting income (loss) 7,165 (50 ) GAAP adjustments 5,795 4,565 GAAP underwriting income 12,960 4,515 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 2,157 2,430 Income before income taxes $ 34,493 $ 24,410 7 - Borrowings Lines of Credit In July 2016, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit expires in July 2019. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the credit agreement. At September 30, 2016, we had $39.0 million in outstanding borrowings and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings from M&T is adjustable quarterly, and, at September 30, 2016, that interest rate was 2.78%. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We were in compliance with all requirements of the M&T credit agreement during the nine months ended September 30, 2016. MICO is a member of the Federal Home Loan Bank (“FHLB”) of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. MICO had no outstanding borrowings with the FHLB of Indianapolis at September 30, 2016. The table below presents the amount of FHLB of Indianapolis stock MICO purchased, collateral pledged and assets related to MICO’s membership at September 30, 2016. FHLB of Indianapolis stock purchased and owned $ 236,700 Collateral pledged, at par (carrying value $2,180,650) 2,177,558 Borrowing capacity currently available 2,143,057 Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. Atlantic States had $35.0 million in outstanding advances at 15 September 30, 2016. The interest rate on the advances was .59% at September 30, 2016. The table below presents the amount of FHLB of Pittsburgh stock Atlantic States purchased, collateral pledged and assets related to Atlantic States’ membership in the FHLB of Pittsburgh at September 30, 2016. FHLB of Pittsburgh stock purchased and owned $ 1,574,700 Collateral pledged, at par (carrying value $36,058,067) 36,085,816 Borrowing capacity currently available 310,732 Subordinated Debentures Donegal Mutual holds a $5.0 million surplus note that MICO issued to increase MICO’s statutory surplus. The surplus note carries an interest rate of 5.00%, and any repayment of principal or payment of interest on the surplus note requires prior approval of the Michigan Department of Insurance and Financial Services. 8 - Share–Based Compensation We measure all share-based payments to employees, including grants of stock options, and use a fair-value-based method for the recording of related compensation expense in our consolidated statements of income. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, the expected term, the dividend yield and the expected volatility. We charged compensation expense related to our stock compensation plans against income before income taxes of $414,696 and $598,516 for the three months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $145,143 and $209,481, respectively. We charged compensation expense related to our stock compensation plans against income before income taxes of $2.0 million and $1.9 million for the nine months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $710,584 and $671,607, respectively. At September 30, 2016, we had $2.0 million of unrecognized compensation expense related to nonvested share-based compensation granted under our stock compensation plans. We expect to recognize this compensation expense over a weighted average period of approximately 1.3 years. We received cash from option exercises under all stock compensation plans during the three months ended September 30, 2016 and 2015 of $3.7 million and $181,488, respectively. We received cash from option exercises under all stock compensation plans during the nine months ended September 30, 2016 and 2015 of $7.8 million and $13.7 million, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $243,656 and $4,802 for the three months ended September 30, 2016 and 2015, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $521,852 and $424,537 for the nine months ended September 30, 2016 and 2015, respectively. 9 - Fair Value Measurements We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of the inputs, or assumptions, we use in the determination of fair value, and we classify financial assets and liabilities carried at fair value in one of the following three categories: Level 1 – quoted prices in active markets for identical assets and liabilities; Level 2 – directly or indirectly observable inputs other than Level 1 quoted prices; and Level 3 – unobservable inputs not corroborated by market data. For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these investments in Level 1 of the fair value hierarchy. We classify publicly-traded equity securities as Level 1. When quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or price estimates we obtain from independent pricing services and include these investments in Level 2 of the fair value hierarchy. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury 16 securities and obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, corporate securities and mortgage-backed securities. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. These pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon our investment personnel’s general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel regularly monitor the market, current trading ranges for similar securities and the pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. We present our cash and short-term investments at estimated fair value. We classify these items as Level 1. The carrying values we report in our balance sheet for premium receivables and reinsurance receivables and payables for premiums and paid losses and loss expenses approximate their fair values. The carrying amounts we report in our balance sheet for our subordinated debentures and borrowings under lines of credit approximate their fair values. We classify these items as Level 3. We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at September 30, 2016: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,375 $ — $ 36,375 $ — Obligations of states and political subdivisions 194,276 — 194,276 — Corporate securities 90,841 — 90,841 — Mortgage-backed securities 194,329 — 194,329 — Equity securities 35,167 35,167 — — Total investments in the fair value hierarchy 550,988 35,167 515,821 — Investment measured at net asset value 11,145 — — — Totals $ 562,133 $ 35,167 $ 515,821 $ — We did not transfer any investments between Levels 1 and 2 during the nine months ended September 30, 2016. 17 The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2015: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,189 $ — $ 37,189 $ — Obligations of states and political subdivisions 236,556 — 236,556 — Corporate securities 72,812 — 72,812 — Mortgage-backed securities 154,836 — 154,836 — Equity securities 26,727 26,727 — — Total investments in the fair value hierarchy 528,120 26,727 501,393 — Investment measured at net asset value 10,534 — — — Totals $ 538,654 $ 26,727 $ 501,393 $ — 10 - Income Taxes At September 30, 2016 and December 31, 2015, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. Tax years 2013 through 2016 remained open for examination at September 30, 2016. We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of our tax assets. We established a valuation allowance of $440,778 related to a portion of the net operating loss carryforward of Le Mars at January 1, 2004. We have determined that we are not required to establish a valuation allowance for our other deferred tax assets of $43.4 million and $42.7 million at September 30, 2016 and December 31, 2015, respectively, because it is more likely than not that we will realize these deferred tax assets through reversals of existing temporary differences, future taxable income and the implementation of tax planning strategies. Our deferred tax assets include a net operating loss carryforward of $3.6 million related to Le Mars, which will begin to expire in 2020 if not previously utilized. This carryforward is subject to an annual limitation in the amount that we can use in any one year of approximately $376,000. Our deferred tax assets also include an alternative minimum tax credit carryforward of $7.6 million with an indefinite life. 11 - Impact of New Accounting Standards In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. While the guidance will replace most existing GAAP revenue recognition guidance, the scope of the guidance excludes insurance contracts. The new standard is effective on January 1, 2018. The standard permits the use of either the retrospective or the cumulative effect transition method. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In February 2015, the FASB issued a new standard that amends the current consolidation guidance affecting both the variable interest entity (“VIE”) and voting interest entity (“VOE”) consolidation models. The standard does not add or remove any of the characteristics in determining if an entity is a VIE or a VOE, but rather, the standard enhances assessment of some of these characteristics. The new standard was effective on December 15, 2015. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. In May 2015, the FASB issued guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The guidance also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. The guidance instead limits disclosure to investments for which the entity has elected to measure fair value using that practical expedient. The guidance was effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within those annual reporting periods. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. 18 In May 2015, the FASB issued guidance that requires entities to provide additional disclosures about their liability for unpaid claims and claim adjustment expenses to increase the transparency of significant estimates. The guidance also requires entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including the reasons for the changes and the effects on the entities’ financial statements, and the timing, frequency and severity of claims. The guidance also requires entities to disclose a rollforward of the liability for unpaid claims and claim adjustment expenses for annual and interim reporting periods. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within annual reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In January 2016, the FASB issued guidance that generally requires entities to measure equity investments at fair value and recognize changes in fair value in their results of operations. The guidance also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring entities to perform a qualitative assessment to identify impairment. The FASB issued other disclosure and presentation improvements related to financial instruments within the guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. As a result of this guidance, we will reflect changes in the fair value of our equity investments in our results of operations beginning January 1, 2018. In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the lessee’s balance sheet, unless a lease is considered a short-term lease. The guidance also requires entities to make new judgments to identify leases. The guidance is effective for annual and interim reporting periods beginning after December 15, 2018 and permits early adoption. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In March 2016, the FASB issued guidance that simplifies and improves several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. The guidance is effective for annual and interim reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In June 2016, the FASB issued guidance that amends previous guidance on the impairment of financial instruments by adding an impairment model that allows an entity to recognize expected credit losses as an allowance rather than impairments as credit losses are incurred. The new guidance is intended to reduce complexity and result in a more timely recognition of expected credit losses. The guidance is effective for annual and interim reporting periods beginning after December 15, 2019. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments shall be presented and classified in the statement of cash flows. This guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. 19\nWe recommend that you read the following information in conjunction with the historical financial information and the footnotes to that financial information we include in this Quarterly Report on Form 10-Q. We also recommend you read Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2015.\nCritical Accounting Policies and Estimates\nWe combine our financial statements with those of our insurance subsidiaries and present our financial statements on a consolidated basis in accordance with GAAP.\nOur insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures we report in our financial statements. The most significant estimates relate to the reserves of our insurance subsidiaries for property and casualty insurance unpaid losses and loss expenses, the valuation of investments and the determination of other-than-temporary investment impairments and the policy acquisition costs of our insurance subsidiaries. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts of these liabilities may differ from the estimates we provided. We regularly review our methods for making these estimates and we reflect any adjustment we consider necessary in our current consolidated results of operations.\nLiability for Unpaid Losses and Loss Expenses\nLiabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to incurred policyholder claims based on facts and circumstances the insurer knows at that point in time. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends, expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates for these liabilities. We reflect any adjustments to our insurance subsidiaries’ liabilities for losses and loss expenses in our consolidated results of operations in the period in which our insurance subsidiaries make the changes in estimates.\nOur insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss the policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries monitor their liabilities closely and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses and loss expenses.\nReserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions related to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while the severity of these claims has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on workers’ compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries make adjustments in their reserves that they consider appropriate for such changes. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ\n20\nfrom the amount recorded at September 30, 2016. For every 1% change in our insurance subsidiaries’ estimate for loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $3.4 million. The establishment of appropriate liabilities is an inherently uncertain process and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed our insurance subsidiaries’ loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, because the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods and, in other periods, their estimates of future liabilities have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimates of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received since the prior reporting date. Excluding the impact of severe weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and a slight downward trend in the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the United States property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs. We have also experienced a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could have to make further adjustments to their estimates in the future. However, on the basis of our insurance subsidiaries’ internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for losses and loss expenses. Atlantic States’ participation in the pool with Donegal Mutual exposes Atlantic States to adverse loss development on the business of Donegal Mutual that the pool includes. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States share proportionately any adverse risk development of the pooled business. The business in the pool is homogeneous and each company has a pro-rata share of the entire pool. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than either would experience individually and to spread the risk of loss between the companies. 21 Donegal Mutual and our insurance subsidiaries operate together as the Donegal Insurance Group and share a combined business plan designed to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual offer are generally complementary, thereby allowing Donegal Insurance Group to offer a broader range of products to a given market and to expand Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier products compared to standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, because the pool homogenizes the risk characteristics of all business Donegal Mutual and Atlantic States write directly and each company shares the results according to each company’s participation percentage, each company realizes its percentage share of the underwriting results of the pool. Our insurance subsidiaries’ unpaid liability for losses and loss expenses by major line of business at September 30, 2016 and December 31, 2015 consisted of the following: September 30, 2016 December 31, 2015 (in thousands) Commercial lines: Automobile $ 55,079 $ 53,938 Workers’ compensation 105,873 99,212 Commercial multi-peril 59,279 54,395 Other 3,639 3,119 Total commercial lines 223,870 210,664 Personal lines: Automobile 97,102 93,923 Homeowners 16,947 15,816 Other 2,122 1,651 Total personal lines 116,171 111,390 Total commercial and personal lines 340,041 322,054 Plus reinsurance recoverable 254,227 256,151 Total liability for unpaid losses and loss expenses $ 594,268 $ 578,205 We have evaluated the effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we consider in establishing the loss and loss expense reserves of our insurance subsidiaries. We established the range of reasonably likely changes based on a review of changes in accident-year development by line of business and applied those changes to our insurance subsidiaries’ loss reserves as a whole. The selected range does not necessarily indicate what could be the potential best or worst case or the most likely scenario. The following table sets forth the estimated effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing the loss and loss expense reserves of our insurance subsidiaries: Percentage Change in Loss and Loss Expense Reserves Net of Reinsurance Adjusted Loss and Loss Expense Reserves Net of Reinsurance at September 30, 2016 Percentage Change in Stockholders’ Equity at September 30, 2016(1) Adjusted Loss and Loss Expense Reserves Net of Reinsurance at December 31, 2015 Percentage Change in Stockholders’ Equity at December 31, 2015(1) (dollars in thousands) (10.0)% $ 306,037 5.0 % $ 289,849 5.1 % (7.5) 314,538 3.7 297,900 3.8 (5.0) 323,039 2.5 305,951 2.6 (2.5) 331,540 1.2 314,003 1.3 Base 340,041 — 322,054 — 2.5 348,542 (1.2 ) 330,105 (1.3 ) 5.0 357,043 (2.5 ) 338,157 (2.6 ) 7.5 365,544 (3.7 ) 346,208 (3.8 ) 10.0 374,045 (5.0 ) 354,259 (5.1 ) (1) Net of income tax effect. 22 Statutory Combined Ratios We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting income, combined ratio and net premiums written. An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of the ratio of calendar-year incurred losses and loss expenses to premiums earned; the ratio of expenses incurred for commissions, premium taxes and underwriting expenses to net premiums written and the ratio of dividends to policyholders to premiums earned. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A combined ratio of less than 100 percent generally indicates underwriting profitability. The statutory combined ratio differs from the GAAP combined ratio. In calculating the GAAP combined ratio, we do not deduct installment payment fees from incurred expenses, and we base the expense ratio on premiums earned instead of premiums written. Differences between our GAAP loss ratios reported in our financial statements and our insurance subsidiaries’ statutory loss ratios result from anticipating salvage and subrogation recoveries for the GAAP loss ratios but not for the statutory loss ratios. The following table sets forth our insurance subsidiaries’ statutory combined ratios by major line of business for the three and nine months ended September 30, 2016 and 2015: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Commercial lines: Automobile 110.8 % 118.0 % 106.5 % 106.1 % Workers’ compensation 86.8 79.1 85.3 89.0 Commercial multi-peril 94.7 92.2 88.5 93.2 Total commercial lines 94.3 92.0 90.3 93.2 Personal lines: Automobile 105.9 98.8 102.6 100.0 Homeowners 101.5 108.0 97.1 101.7 Total personal lines 103.6 101.4 99.9 99.8 Total commercial and personal lines 99.5 97.4 95.6 96.9 Investments We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down an individual investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of the individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect on the debt security. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security or rating agency 23 downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in our results of operations for the first nine months of 2016 or 2015. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon the general market knowledge of our investment personnel, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. Policy Acquisition Costs Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that relate directly to the successful acquisition of insurance policies. We amortize these costs over the period in which our insurance subsidiaries earn the related premiums. The method we follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This method gives effect to the premiums to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premiums. Results of Operations - Three Months Ended September 30, 2016 Compared to Three Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the three months ended September 30, 2016 were $171.9 million, an increase of $13.0 million, or 8.2%, from the $158.9 million of net premiums written for the third quarter of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $5.2 million, or 5.6%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $7.8 million, or 12.0%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the third quarter of 2016 were $166.8 million, an increase of $13.7 million, or 9.0%, compared to $153.1 million for the third quarter of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $5.6 million for the third quarter of 2016, compared to $5.4 million for the third quarter of 2015. We attribute the increase primarily to an increase in average invested assets. 24 Net Realized Investment Gains (Losses). Net realized investment gains for the third quarter of 2016 were $1.0 million, compared to net realized investment losses of $754,050 for the third quarter of 2015. The net realized investment gains for the third quarter of 2016 resulted primarily from unrealized gains within a limited partnership that invests in equity securities. The net realized investment losses for the third quarter of 2015 resulted primarily from unrealized losses within the limited partnership. We did not recognize any impairment losses in our investment portfolio during the third quarters of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $357,956 for the third quarter of 2016, compared to $408,405 for the third quarter of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the third quarter of 2016 was 66.6%, a slight decrease from our insurance subsidiaries’ loss ratio of 66.8% for the third quarter of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 62.5% for the third quarter of 2016, compared to 62.3% for the third quarter of 2015, primarily due to an increase in the workers’ compensation loss ratio. The personal lines statutory loss ratio of our insurance subsidiaries increased to 70.4% for the third quarter of 2016, compared to 69.9% for the third quarter of 2015, primarily due to an increase in the personal automobile loss ratio. Our insurance subsidiaries experienced favorable loss reserve development of approximately $1.6 million during the third quarter of 2016 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $1.5 million during the third quarter of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ commercial multi-peril and personal automobile reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.5% for the third quarter of 2016, compared to 32.1% for the third quarter of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs in the third quarter of 2016 compared to the third quarter of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 100.8% and 99.5% for the three months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the third quarter of 2016 was $473,917, compared to $188,000 for the third quarter of 2015. We attribute the increase to higher average borrowings during the third quarter of 2016 compared to the third quarter of 2015. Income Taxes. Income tax expense was $1.6 million for the third quarter of 2016, representing an effective tax rate of 25.1%, compared to income tax expense of $1.3 million for the third quarter of 2015, representing an effective tax rate of 18.8% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the third quarter of 2016 was $4.8 million, or $.18 per share of Class A common stock on a diluted basis and $.16 per share of Class B common stock, compared to net income of $5.7 million, or $.21 per share of Class A common stock and $.18 per share of Class B common stock, for the third quarter of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Results of Operations - Nine Months Ended September 30, 2016 Compared to Nine Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the nine months ended September 30, 2016 were $520.3 million, an increase of $39.2 million, or 8.1%, from the $481.1 million of net premiums written for the comparable period of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $13.4 million, or 5.0%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $25.8 million, or 12.1%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the first nine months of 2016 were $487.2 million, an increase of $37.1 million, or 8.3%, compared to $450.1 million for the first nine months of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as 25 revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $16.5 million for the first nine months of 2016, compared to $15.5 million for the first nine months of 2015. We attribute the increase primarily to an increase in average invested assets. Net Realized Investment Gains. Net realized investment gains for the first nine months of 2016 were $2.2 million, compared to $682,932 for the first nine months of 2015. The net realized investment gains for the first nine months of 2016 and 2015 resulted primarily from calls and strategic sales of fixed maturities and equity securities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the first nine months of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $698,658 for the first nine months of 2016, compared to $1.3 million for the first nine months of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the first nine months of 2016 was 63.6%, a decrease from our insurance subsidiaries’ loss ratio of 65.8% for the first nine months of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 59.4% for the first nine months of 2016, compared to 62.7% for the first nine months of 2015, primarily due to decreases in the commercial multi-peril and workers’ compensation loss ratios. The personal lines statutory loss ratio of our insurance subsidiaries decreased to 67.2% for the first nine months of 2016, compared to 68.1% for the first nine months of 2015, primarily due to a decrease in the homeowners loss ratio. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $2.1 million during the first nine months of 2016 in their reserves for prior accident years, compared to approximately $4.8 million during the first nine months of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ workers’ compensation reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.2% for the first nine months of 2016, compared to 32.7% for the first nine months of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs related to the lower loss ratio in the first nine months of 2016 compared to the first nine months of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 97.3% and 99.0% for the nine months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the first nine months of 2016 was $1.3 million, compared to $908,615 for the first nine months of 2015. We attribute the increase to higher average borrowings during the first nine months of 2016 compared to the first nine months of 2015. Income Taxes. Income tax expense was $9.2 million for the first nine months of 2016, representing an effective tax rate of 26.8%, compared to income tax expense of $5.4 million for the first nine months of 2015, representing an effective tax rate of 22.1% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the first nine months of 2016 was $25.2 million, or $.95 per share of Class A common stock on a diluted basis and $.88 per share of Class B common stock, compared to net income of $19.0 million, or $.69 per share of Class A common stock on a diluted basis and $.63 per share of Class B common stock, for the first nine months of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Liquidity and Capital Resources Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs as such obligations and needs arise. Our major sources of funds from operations are the net cash flows we generate from our insurance subsidiaries’ underwriting results, investment income and investment maturities. 26 Our operations have historically generated sufficient net positive cash flow to fund our commitments and add to our investment portfolio, thereby increasing future investment returns and enhancing our liquidity. The impact of the pooling agreement between Donegal Mutual and Atlantic States has historically been cash-flow positive because of the consistent underwriting profitability of the pool. Donegal Mutual and Atlantic States settle their respective obligations to each other under the pool monthly, thereby resulting in cash flows substantially similar to the cash flows that would result from each company writing the business directly. We have not experienced any unusual variations in the timing of claim payments associated with the loss reserves of our insurance subsidiaries. We maintain significant liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. We structure our fixed-maturity investment portfolio following a “laddering” approach, so that projected cash flows from investment income and principal maturities are evenly distributed from a timing perspective, thereby providing an additional measure of liquidity to meet our obligations should an unexpected variation occur in the future. Our operating activities provided net cash flows in the first nine months of 2016 and 2015 of $46.3 million and $48.5 million, respectively. At September 30, 2016, we had $39.0 million in outstanding borrowings under our line of credit with M&T and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on these borrowings was 2.78% at September 30, 2016. At September 30, 2016, Atlantic States had $35.0 million in outstanding advances with the FHLB of Pittsburgh. The interest rate on these advances was .59% at September 30, 2016. The following table shows our expected payments for significant contractual obligations at September 30, 2016: Total Less than 1 year 1-3 years 4-5 years After 5 years (in thousands) Net liability for unpaid losses and loss expenses of our insurance subsidiaries $ 340,041 $ 158,779 $ 155,378 $ 12,372 $ 13,512 Subordinated debentures 5,000 — — — 5,000 Borrowings under lines of credit 74,000 35,000 39,000 — — Total contractual obligations $ 419,041 $ 193,779 $ 194,378 $ 12,372 $ 18,512 We estimate the date of payment for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. We show the liability net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Amounts Atlantic States assumes pursuant to the pooling agreement with Donegal Mutual represent a substantial portion of our insurance subsidiaries’ gross liability for unpaid losses and loss expenses, and amounts Atlantic States cedes pursuant to the pooling agreement represent a substantial portion of our insurance subsidiaries’ reinsurance recoverable on unpaid losses and loss expenses. We include cash settlement of Atlantic States’ assumed liability from the pool in monthly settlements of pooled activity, as we net amounts ceded to and assumed from the pool. Although Donegal Mutual and we do not anticipate any changes in the pool participation levels in the foreseeable future, any such change would be prospective in nature and therefore would not impact the timing of expected payments by Atlantic States for its percentage share of pooled losses occurring in periods prior to the effective date of such change. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the borrowings under our lines of credit based on their contractual maturities. The borrowings under our lines of credit carry interest rates that vary as we discuss in Note 7 – Borrowings. Based upon the interest rates in effect at September 30, 2016, our annual interest cost associated with the borrowings under our lines of credit is approximately $1.3 million. For every 1% change in the interest rate associated with the borrowings under our lines of credit, the effect on our annual interest cost would be approximately $740,000. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the subordinated debentures based on their contractual maturity. The subordinated debentures carry an interest rate of 5%, and any repayment of principal or payment of interest on the subordinated debentures requires prior approval of the Michigan Department of Insurance and Financial Services. Our annual interest cost associated with the subordinated debentures is approximately $250,000. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 27 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. On October 20, 2016, our board of directors declared quarterly cash dividends of 13.75 cents per share of our Class A common stock and 12.00 cents per share of our Class B common stock, payable on November 15, 2016 to our stockholders of record as of the close of business on November 1, 2016. We are not subject to any restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends by our insurance subsidiaries to us. Dividends from our insurance subsidiaries are our principal source of cash for payment of dividends to our stockholders. Our insurance subsidiaries are subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are also subject to risk based capital (“RBC”) requirements that limit their ability to pay dividends to us. Our insurance subsidiaries’ statutory capital and surplus at December 31, 2015 exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements, by a significant margin. Our insurance subsidiaries paid $9.5 million in dividends to us during the first nine months of 2016. Amounts remaining available for distribution to us as dividends from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities in 2016 are $18.8 million from Atlantic States, $1.3 million from Southern, $1.1 million from Le Mars, $4.2 million from Peninsula, $325,412 from Sheboygan and $619,953 from MICO, or a total of approximately $26.3 million. At September 30, 2016, we had no material commitments for capital expenditures. Equity Price Risk Our portfolio of marketable equity securities, which we carry on our consolidated balance sheets at estimated fair value, has exposure to the risk of loss resulting from an adverse change in prices. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of equity securities. Credit Risk Our portfolio of fixed-maturity securities and, to a lesser extent, our portfolio of short-term investments is subject to credit risk, which we define as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay its debt. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of fixed-maturity securities. We also limit the percentage and amount of our total investment portfolio that we invest in the securities of any one issuer. Our insurance subsidiaries provide property and casualty insurance coverages through independent insurance agencies. We bill the majority of this business directly to the insured, although we bill a portion of our commercial business through licensed insurance agents to whom our insurance subsidiaries extend credit in the normal course of business. Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, Atlantic States is subject to a concentration of credit risk arising from the business it cedes to Donegal Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal Mutual and with a number of other major unaffiliated authorized reinsurers. Impact of Inflation We establish property and casualty insurance premium rates before we know the amount of unpaid losses and loss expenses or the extent to which inflation may impact such losses and expenses. Consequently, our insurance subsidiaries attempt, in establishing rates, to anticipate the potential impact of inflation.\nOur market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of the securities we hold in our investment portfolio as a result of fluctuations in prices and interest rates and, to a lesser extent, our debt obligations. We manage our interest rate risk by maintaining an appropriate relationship between the average duration of our investment portfolio and the approximate duration of our liabilities, i.e., policy claims of our insurance subsidiaries and our debt obligations.\n28\nThere have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2015 through September 30, 2016.\nEvaluation of Disclosure Controls and Procedures\nOur management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, at September 30, 2016, our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information we are required to disclose in the reports that we file or submit under the Exchange Act, and our disclosure controls and procedures were also effective to ensure that information we disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.\nChanges in Internal Control Over Financial Reporting\nThere has been no change in our internal control over financial reporting during the quarter covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.\nSafe Harbor Statement Under the Private Securities Litigation Reform Act of 1995\nWe base all statements contained in this Quarterly Report on Form 10-Q that are not historic facts on our current expectations. Such statements are forward-looking in nature (as defined in the Private Securities Litigation Reform Act of 1995) and necessarily involve risks and uncertainties. Forward-looking statements we make may be identified by our use of words such as “will,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “seeks,” “estimates” and similar expressions. Our actual results could vary materially from our forward-looking statements. The factors that could cause our actual results to vary materially from the forward-looking statements we have previously made include, but are not limited to, our ability to maintain profitable operations, the adequacy of the loss and loss expense reserves of our insurance subsidiaries, business and economic conditions in the areas in which we and our insurance subsidiaries operate, interest rates, competition from various insurance and other financial businesses, terrorism, the availability and cost of reinsurance, adverse and catastrophic weather events, legal and judicial developments, changes in regulatory requirements, our ability to integrate and manage successfully the companies we may acquire from time to time and the other risks that we describe from time to time in our filings with the SEC. We disclaim any obligation to update such statements or to announce publicly the results of any revisions that we may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.\n29\nPart II. Other Information\nNone.\nOur business, results of operations and financial condition, and, therefore, the value of our Class A common stock and our Class B common stock, are subject to a number of risks. For a description of certain risks, we refer to “Risk Factors” in our 2015 Annual Report on Form 10-K we filed with the SEC on March 18, 2016. There have been no material changes in the risk factors we disclosed in that Form 10-K Report during the nine months ended September 30, 2016.\nNone.\nNone.\nItem 4. Removed and Reserved.\nNone.\n30\n\n\n| Exhibit No. | Description |\n| Exhibit 31.1 | Certification of Chief Executive Officer |\n| Exhibit 31.2 | Certification of Chief Financial Officer |\n| Exhibit 32.1 | Statement of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\n| Exhibit 32.2 | Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\n| Exhibit 101.INS | XBRL Instance Document |\n| Exhibit 101.SCH | XBRL Taxonomy Extension Schema Document |\n| Exhibit 101.PRE | XBRL Taxonomy Presentation Linkbase Document |\n| Exhibit 101.CAL | XBRL Taxonomy Calculation Linkbase Document |\n| Exhibit 101.LAB | XBRL Taxonomy Label Linkbase Document |\n| Exhibit 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n\n31\nSignatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DONEGAL GROUP INC. November 7, 2016 By: /s/ Kevin G. Burke Kevin G. Burke, President and Chief Executive Officer November 7, 2016 By: /s/ Jeffrey D. Miller Jeffrey D. Miller, Executive Vice President and Chief Financial Officer\n</text>\n\nWhat is the annual growth rate of the company's total investments from December 31, 2015 to September 30, 2016 in percent?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\n\\n| Item 1. | Financial Statements. |\\n\\nDonegal Group Inc. and Subsidiaries\\nConsolidated Balance Sheets\\n\\n| September 30,2016 | December 31,2015 |\\n| (Unaudited) |\\n| Assets |\\n| Investments |\\n| Fixed maturities |\\n| Held to maturity, at amortized cost | $ | 332,272,969 | $ | 310,258,704 |\\n| Available for sale, at fair value | 515,821,393 | 501,393,559 |\\n| Equity securities, available for sale, at fair value | 46,311,943 | 37,260,821 |\\n| Investment in affiliate | 40,145,067 | 38,476,708 |\\n| Short-term investments, at cost, which approximates fair value | 9,251,153 | 13,432,482 |\\n| Total investments | 943,802,525 | 900,822,274 |\\n| Cash | 32,130,534 | 28,139,144 |\\n| Accrued investment income | 6,817,760 | 5,991,197 |\\n| Premiums receivable | 165,761,900 | 141,267,411 |\\n| Reinsurance receivable | 259,428,626 | 259,728,113 |\\n| Deferred policy acquisition costs | 57,404,289 | 52,108,388 |\\n| Deferred tax asset, net | 14,721,101 | 19,443,807 |\\n| Prepaid reinsurance premiums | 127,431,503 | 113,522,505 |\\n| Property and equipment, net | 6,705,671 | 7,027,143 |\\n| Federal income taxes receivable | 1,823,273 | 1,487,656 |\\n| Goodwill | 5,625,354 | 5,625,354 |\\n| Other intangible assets | 958,010 | 958,010 |\\n| Other | 1,453,864 | 1,713,413 |\\n| Total assets | $ | 1,624,064,410 | $ | 1,537,834,415 |\\n| Liabilities and Stockholders Equity |\\n| Liabilities |\\n| Unpaid losses and loss expenses | $ | 594,267,943 | $ | 578,205,109 |\\n| Unearned premiums | 476,432,783 | 429,493,203 |\\n| Accrued expenses | 21,067,170 | 22,460,475 |\\n| Reinsurance balances payable | 3,058,225 | 3,480,406 |\\n| Borrowings under lines of credit | 74,000,000 | 81,000,000 |\\n| Cash dividends declared | | 3,511,881 |\\n| Subordinated debentures | 5,000,000 | 5,000,000 |\\n| Accounts payable - securities | 540,311 | 582,560 |\\n| Due to affiliate | 3,978,958 | 3,557,177 |\\n| Other | 1,710,209 | 2,155,036 |\\n| Total liabilities | 1,180,055,599 | 1,129,445,847 |\\n| Stockholders Equity |\\n| Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued | | |\\n| Class A common stock, $.01 par value, authorized 40,000,000 shares, issued 24,189,133 and 23,501,805 shares and outstanding 21,186,545 and 20,499,217 shares | 241,892 | 235,018 |\\n| Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares | 56,492 | 56,492 |\\n| Additional paid-in capital | 231,885,764 | 219,525,301 |\\n| Accumulated other comprehensive income | 6,340,292 | 773,744 |\\n| Retained earnings | 246,710,728 | 229,024,370 |\\n| Treasury stock, at cost | (41,226,357 | ) | (41,226,357 | ) |\\n| Total stockholders equity | 444,008,811 | 408,388,568 |\\n| Total liabilities and stockholders equity | $ | 1,624,064,410 | $ | 1,537,834,415 |\\n\\nSee accompanying notes to consolidated financial statements.\\n1\\nDonegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Three Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 166,809,851 $ 153,096,075 Investment income, net of investment expenses 5,581,238 5,399,080 Net realized investment gains (losses) (includes $1,018,415 and ($754,050) accumulated other comprehensive income (loss) reclassifications) 1,018,415 (754,050 ) Lease income 163,779 178,827 Installment payment fees 1,380,024 1,473,447 Equity in earnings of Donegal Financial Services Corporation 357,956 408,405 Total revenues 175,311,263 159,801,784 Expenses: Net losses and loss expenses 111,174,963 102,233,708 Amortization of deferred policy acquisition costs 27,524,000 25,036,000 Other underwriting expenses 28,340,135 24,155,566 Policyholder dividends 1,143,026 886,210 Interest 473,917 188,000 Other expenses 226,183 301,367 Total expenses 168,882,224 152,800,851 Income before income tax expense 6,429,039 7,000,933 Income tax expense (includes $356,446 and ($263,918) income tax expense (benefit) from reclassification items) 1,615,635 1,314,102 Net income $ 4,813,404 $ 5,686,831 Earnings per common share: Class A common stock - basic $ 0.19 $ 0.21 Class A common stock - diluted $ 0.18 $ 0.21 Class B common stock - basic and diluted $ 0.16 $ 0.18 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Three Months Ended September 30, 2016 2015 Net income $ 4,813,404 $ 5,686,831 Other comprehensive (loss) income, net of tax Unrealized (loss) gain on securities: Unrealized holding (loss) gain during the period, net of income tax (benefit) expense of ($595,724) and 463,221 (1,106,346 ) 860,268 Reclassification adjustment for (gains) losses included in net income, net of income tax expense (benefit) of $356,446 and ($263,918) (661,969 ) 490,132 Other comprehensive (loss) income (1,768,315 ) 1,350,400 Comprehensive income $ 3,045,089 $ 7,037,231 See accompanying notes to consolidated financial statements. 2 Donegal Group Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) Nine Months Ended September 30, 2016 2015 Revenues: Net premiums earned $ 487,227,767 $ 450,083,676 Investment income, net of investment expenses 16,471,630 15,505,429 Net realized investment gains (includes $2,204,533 and $682,932 accumulated other comprehensive income reclassifications) 2,204,533 682,932 Lease income 514,768 568,552 Installment payment fees 4,109,550 4,473,905 Equity in earnings of Donegal Financial Services Corporation 698,658 1,276,692 Total revenues 511,226,906 472,591,186 Expenses: Net losses and loss expenses 309,946,943 296,012,311 Amortization of deferred policy acquisition costs 80,034,000 73,872,000 Other underwriting expenses 81,557,159 73,192,072 Policyholder dividends 2,729,595 2,491,919 Interest 1,286,279 908,615 Other expenses 1,179,660 1,704,680 Total expenses 476,733,636 448,181,597 Income before income tax expense 34,493,270 24,409,589 Income tax expense (includes $771,587 and $239,026 income tax expense from reclassification items) 9,246,299 5,403,395 Net income $ 25,246,971 $ 19,006,194 Earnings per common share: Class A common stock - basic $ 0.98 $ 0.71 Class A common stock - diluted $ 0.95 $ 0.69 Class B common stock - basic and diluted $ 0.88 $ 0.63 Donegal Group Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Unaudited) Nine Months Ended September 30, 2016 2015 Net income $ 25,246,971 $ 19,006,194 Other comprehensive income (loss), net of tax Unrealized gain (loss) on securities: Unrealized holding gain (loss) during the period, net of income tax expense (benefit) of $3,768,959 and ($1,141,726) 6,999,494 (2,120,347 ) Reclassification adjustment for gains included in net income, net of income tax expense of $771,587 and $239,026 (1,432,946 ) (443,906 ) Other comprehensive income (loss) 5,566,548 (2,564,253 ) Comprehensive income $ 30,813,519 $ 16,441,941 See accompanying notes to consolidated financial statements. 3 Donegal Group Inc. and Subsidiaries Consolidated Statement of Stockholders’ Equity (Unaudited) Nine Months Ended September 30, 2016 Class A Shares Class B Shares Class A Amount Class B Amount Additional Paid-In Capital Accumulated Other Comprehensive Income Retained Earnings Treasury Stock Total Stockholders’ Equity Balance, December 31, 2015 23,501,805 5,649,240 $ 235,018 $ 56,492 $ 219,525,301 $ 773,744 $ 229,024,370 $ (41,226,357 ) $ 408,388,568 Issuance of common stock 104,271 — 1,043 — 1,389,022 — — — 1,390,065 Share-based compensation 583,057 5,831 10,396,351 10,402,182 Net income — — — — — — 25,246,971 — 25,246,971 Cash dividends declared — — — — — — (6,985,523 ) — (6,985,523 ) Grant of stock options — — — — 575,090 — (575,090 ) — — Other comprehensive income — — — — — 5,566,548 — — 5,566,548 Balance, September 30, 2016 24,189,133 5,649,240 $ 241,892 $ 56,492 $ 231,885,764 $ 6,340,292 $ 246,710,728 $ (41,226,357 ) $ 444,008,811 See accompanying notes to consolidated financial statements. 4 Donegal Group Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended September 30, 2016 2015 Cash Flows from Operating Activities: Net income $ 25,246,971 $ 19,006,194 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and other non-cash items 5,365,877 2,890,128 Net realized investment gains (2,204,533 ) (682,932 ) Equity in earnings of Donegal Financial Services Corporation (698,658 ) (1,276,692 ) Changes in assets and liabilities: Losses and loss expenses 16,062,834 30,888,062 Unearned premiums 46,939,580 32,671,922 Premiums receivable (24,494,489 ) (13,301,356 ) Deferred acquisition costs (5,295,901 ) (5,212,051 ) Deferred income taxes 1,725,335 225,409 Reinsurance receivable 299,487 (6,254,559 ) Prepaid reinsurance premiums (13,908,998 ) (1,631,341 ) Accrued investment income (826,563 ) (929,722 ) Due to affiliate 421,781 (1,655,351 ) Reinsurance balances payable (422,181 ) (3,900,348 ) Current income taxes (335,617 ) 242,849 Accrued expenses (1,393,305 ) (601,830 ) Other, net (185,278 ) (1,943,559 ) Net adjustments 21,049,371 29,528,629 Net cash provided by operating activities 46,296,342 48,534,823 Cash Flows from Investing Activities: Purchases of fixed maturities, held to maturity (35,461,529 ) (18,483,546 ) Purchases of fixed maturities, available for sale (127,113,153 ) (132,823,136 ) Purchases of equity securities, available for sale (10,753,187 ) (9,011,957 ) Maturity of fixed maturities: Held to maturity 13,603,700 22,416,840 Available for sale 64,406,512 56,293,130 Sales of fixed maturities, available for sale 52,032,208 23,485,311 Sales of equity securities, available for sale 5,068,287 2,704,425 Net purchases of property and equipment (260,968 ) (78,292 ) Net decrease in investment in affiliate — 675,100 Net sales (purchases) of short-term investments 4,181,329 (4,302,571 ) Net cash used in investing activities (34,296,801 ) (59,124,696 ) Cash Flows from Financing Activities: Cash dividends paid (10,497,404 ) (10,762,609 ) Issuance of common stock 9,489,253 17,106,300 Purchase of treasury stock — (904,675 ) Payments on lines of credit (7,000,000 ) (9,500,000 ) Borrowings under lines of credit — 4,000,000 Net cash used in financing activities (8,008,151 ) (60,984 ) Net increase (decrease) in cash 3,991,390 (10,650,857 ) Cash at beginning of period 28,139,144 35,578,509 Cash at end of period $ 32,130,534 $ 24,927,652 Cash paid during period - Interest $ 1,001,870 $ 757,175 Net cash paid during period - Taxes $ 8,255,000 $ 4,500,000 See accompanying notes to consolidated financial statements. 5 DONEGAL GROUP INC. AND SUBSIDIARIES (Unaudited) Notes to Consolidated Financial Statements 1 - Organization Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. Our insurance subsidiaries, Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, Sheboygan Falls Insurance Company (“Sheboygan”) and Michigan Insurance Company (“MICO”), write personal and commercial lines of property and casualty coverages exclusively through a network of independent insurance agents in certain Mid-Atlantic, Midwestern, New England and Southern states. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company that owns Union Community Bank (“UCB”), a state savings bank. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC. We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies. At September 30, 2016, Donegal Mutual held approximately 47% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 73% of the total voting power of our outstanding common stock. We believe Donegal Mutual’s voting control of us benefits us for the reasons we describe in our Annual Reports on Form 10-K and in our proxy statements. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions. While each company maintains its separate corporate existence, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products. Atlantic States, our largest subsidiary, participates in a pooling agreement with Donegal Mutual. Under the pooling agreement, Donegal Mutual and Atlantic States pool their insurance business and each company receives an allocated percentage of the pooled business. Atlantic States has an 80% share of the results of the pooled business, and Donegal Mutual has a 20% share of the results of the pooled business. The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries. In addition, as the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual market are generally complementary, thereby allowing the Donegal Insurance Group to offer a broader range of products to a given market and to expand the Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products Donegal Mutual and our insurance subsidiaries offer relate generally to specific risk profiles targeted within similar classes of business, such as preferred tier products versus standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, as the risk characteristics of all business Donegal Mutual and Atlantic States write directly are homogenized within the underwriting pool, Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the pool. Pooled business represents the predominant percentage of the net underwriting activity of both Donegal Mutual and Atlantic States. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. 6 2 - Basis of Presentation Our financial information for the interim periods included in this Form 10-Q Report is unaudited; however, our financial information we include in this Form 10-Q Report reflects all adjustments, consisting only of normal recurring adjustments that, in the opinion of our management, are necessary for a fair presentation of our financial position, results of operations and cash flows for those interim periods. Our results of operations for the nine months ended September 30, 2016 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2016. You should read the interim financial statements we include in this Form 10-Q Report in conjunction with the financial statements and the notes to our financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2015. 3 - Earnings Per Share We have two classes of common stock, which we refer to as our Class A common stock and our Class B common stock. Our certificate of incorporation provides that whenever our board of directors declares a dividend on our Class B common stock, our board of directors shall simultaneously declare a dividend on our Class A common stock that is payable to the holders of our Class A common stock at the same time and as of the same record date at a rate that is at least 10% greater than the rate at which our board of directors declared a dividend on our Class B common stock. Accordingly, we use the two-class method to compute our earnings per common share. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on dividends we have declared and an allocation of our remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. The table below presents for the periods indicated a reconciliation of the numerators and denominators we used to compute basic and diluted net income per share for each class of our common stock: Three Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Weighted-average shares outstanding 21,078 5,577 22,442 5,577 Basic net income per share $ 0.19 $ 0.16 $ 0.21 $ 0.18 Diluted net income per share: Numerator: Allocation of net income $ 3,901 $ 912 $ 4,663 $ 1,024 Denominator: Number of shares used in basic computation 21,078 5,577 22,442 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 831 — 242 — Number of shares used in diluted computation 21,909 5,577 22,684 5,577 Diluted net income per share $ 0.18 $ 0.16 $ 0.21 $ 0.18 7 Nine Months Ended September 30, 2016 2015 Class A Class B Class A Class B (in thousands, except per share data) Basic net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Weighted-average shares outstanding 20,791 5,577 21,996 5,577 Basic net income per share $ 0.98 $ 0.88 $ 0.71 $ 0.63 Diluted net income per share: Numerator: Allocation of net income $ 20,329 $ 4,918 $ 15,502 $ 3,504 Denominator: Number of shares used in basic computation 20,791 5,577 21,996 5,577 Weighted-average shares effect of dilutive securities Add: Director and employee stock options 560 — 400 — Number of shares used in diluted computation 21,351 5,577 22,396 5,577 Diluted net income per share $ 0.95 $ 0.88 $ 0.69 $ 0.63 We did not include outstanding options to purchase the following number of shares of Class A common stock in our computation of diluted earnings per share because the exercise price of the options exceeded the average market price of our Class A common stock during the applicable periods: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Number of options to purchase Class A shares excluded — 4,014,501 — — 4 - Reinsurance Atlantic States and Donegal Mutual have participated in a pooling agreement since 1986 under which each company places all of its direct written premiums into the pool the pooling agreement established, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool. Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also purchase separate third-party reinsurance that provides coverage that we believe is commensurate with their relative size and risk exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with the requirements of our insurance subsidiaries and Donegal Mutual, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating from A.M. Best. The following information describes the external reinsurance our insurance subsidiaries have in place for 2016: • excess of loss reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, losses over a set retention (generally $1.0 million), and • catastrophe reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, 100% of an accumulation of many losses resulting from a single event, including natural 8 disasters, over a set retention (generally $5.0 million) and after exceeding an annual aggregate deductible (generally $1.0 million) up to aggregate losses of $170.0 million per occurrence. Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures in excess of the covered limits of their third-party reinsurance agreements. In addition to the pooling agreement and third-party reinsurance, our insurance subsidiaries have various reinsurance agreements with Donegal Mutual. We have made no significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the nine months ended September 30, 2016. 5 - Investments The amortized cost and estimated fair values of our fixed maturities and equity securities at September 30, 2016 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 59,254 $ 3,130 $ 7 $ 62,377 Obligations of states and political subdivisions 122,203 14,292 4 136,491 Corporate securities 86,582 3,360 598 89,344 Mortgage-backed securities 64,234 2,425 — 66,659 Totals $ 332,273 $ 23,207 $ 609 $ 354,871 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,009 $ 368 $ 2 $ 36,375 Obligations of states and political subdivisions 184,068 10,219 11 194,276 Corporate securities 88,826 2,156 141 90,841 Mortgage-backed securities 190,936 3,444 51 194,329 Fixed maturities 499,839 16,187 205 515,821 Equity securities 41,806 4,917 411 46,312 Totals $ 541,645 $ 21,104 $ 616 $ 562,133 At September 30, 2016, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $229.6 million and an amortized cost of $213.6 million. Our holdings at September 30, 2016 also included special revenue bonds with an aggregate fair value of $101.2 million and an amortized cost of $92.7 million. With respect to both categories of those bonds at September 30, 2016, we held no securities of any issuer that constituted more than 10% of our holdings of either bond category. Education bonds and water and sewer utility bonds represented 62% and 24%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at September 30, 2016. Many of the issuers of the special revenue bonds we held at September 30, 2016 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held at September 30, 2016 were similar to general obligation bonds. 9 The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2015 were as follows: Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 51,194 $ 1,544 $ — $ 52,738 Obligations of states and political subdivisions 119,115 10,828 119 129,824 Corporate securities 65,307 816 1,561 64,562 Mortgage-backed securities 74,643 1,181 149 75,675 Totals $ 310,259 $ 14,369 $ 1,829 $ 322,799 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value (in thousands) Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,080 $ 160 $ 51 $ 37,189 Obligations of states and political subdivisions 223,769 13,151 364 236,556 Corporate securities 73,474 350 1,012 72,812 Mortgage-backed securities 154,687 1,045 896 154,836 Fixed maturities 489,010 14,706 2,323 501,393 Equity securities 35,765 2,269 773 37,261 Totals $ 524,775 $ 16,975 $ 3,096 $ 538,654 At December 31, 2015, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $256.9 million and an amortized cost of $241.1 million. Our holdings also included special revenue bonds with an aggregate fair value of $109.5 million and an amortized cost of $101.8 million. With respect to both categories of bonds, we held no securities of any issuer that comprised more than 10% of that category at December 31, 2015. Education bonds and water and sewer utility bonds represented 57% and 26%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2015. Many of the issuers of the special revenue bonds we held at December 31, 2015 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds. We made reclassifications from available for sale to held to maturity of certain fixed maturities at fair value on November 30, 2013. We segregated within accumulated other comprehensive income the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities we reclassified from available for sale to held to maturity. We are amortizing this balance over the remaining life of the related securities as an adjustment to yield in a manner consistent with the accretion of discount on the same fixed maturities. We recorded amortization of $1.0 million and $905,446 in accumulated other comprehensive income during the nine months ended September 30, 2016 and 2015, respectively. At September 30, 2016 and December 31, 2015, net unrealized losses of $11.3 million and $12.3 million, respectively, remained within accumulated other comprehensive income. 10 We show below the amortized cost and estimated fair value of our fixed maturities at September 30, 2016 by contractual maturity. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Cost Estimated Fair Value (in thousands) Held to maturity Due in one year or less $ 9,643 $ 9,657 Due after one year through five years 42,967 44,275 Due after five years through ten years 86,925 92,926 Due after ten years 128,504 141,354 Mortgage-backed securities 64,234 66,659 Total held to maturity $ 332,273 $ 354,871 Available for sale Due in one year or less $ 36,476 $ 37,158 Due after one year through five years 115,204 119,709 Due after five years through ten years 105,689 109,631 Due after ten years 51,534 54,994 Mortgage-backed securities 190,936 194,329 Total available for sale $ 499,839 $ 515,821 Gross realized gains and losses from investments before applicable income taxes for the three and nine months ended September 30, 2016 and 2015 were as follows: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 (in thousands) Gross realized gains: Fixed maturities $ 289 $ 7 $ 2,129 $ 974 Equity securities 1,170 30 1,226 733 1,459 37 3,355 1,707 Gross realized losses: Fixed maturities 22 27 280 105 Equity securities 419 764 870 919 441 791 1,150 1,024 Net realized gains (losses) $ 1,018 $ (754 ) $ 2,205 $ 683 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at September 30, 2016 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 2,988 $ 9 $ — $ — Obligations of states and political subdivisions 4,248 13 722 2 Corporate securities 21,006 205 2,911 534 Mortgage-backed securities 20,567 49 831 2 Equity securities 4,515 308 163 103 Totals $ 53,324 $ 584 $ 4,627 $ 641 11 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2015 as follows: Less Than 12 Months More Than 12 Months Fair Value Unrealized Losses Fair Value Unrealized Losses (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 10,168 $ 51 $ — $ — Obligations of states and political subdivisions 19,437 483 — — Corporate securities 69,482 1,615 11,324 958 Mortgage-backed securities 105,300 876 7,538 168 Equity securities 9,245 773 — — Totals $ 213,632 $ 3,798 $ 18,862 $ 1,126 We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual equity security investment to be other than temporary. We monitor all investments individually for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, issuer or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We amortize premiums and discounts on debt securities over the life of the security as an adjustment to yield using the effective interest method. We compute realized investment gains and losses using the specific identification method. We amortize premiums and discounts on mortgage-backed debt securities using anticipated prepayments. We account for our investment in affiliate using the equity method of accounting. Under this method, we record our investment at cost, with adjustments for our share of our affiliate’s earnings and losses as well as changes in the equity of our affiliate due to unrealized gains and losses. Our investment in affiliate represents our 48.2% ownership interest in DFSC. We include our share of DFSC’s net income in our results of operations. We have compiled the following summary financial information for DFSC at September 30, 2016 and December 31, 2015 and for the three and nine months ended September 30, 2016 and 2015, respectively, from the financial statements of DFSC. The financial information of DFSC at September 30, 2016 and 2015 and for the three and nine months then ended is unaudited. 12 Balance sheets: September 30, 2016 December 31, 2015 (in thousands) Total assets $ 522,118 $ 507,139 Total liabilities $ 438,942 $ 427,423 Stockholders’ equity 83,176 79,716 Total liabilities and stockholders’ equity $ 522,118 $ 507,139 Three Months Ended September 30, Nine Months Ended September 30, Income statements: 2016 2015 2016 2015 (in thousands) Net income $ 742 $ 847 $ 1,449 $ 2,372 13 6 - Segment Information We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries using statutory accounting principles (“SAP”) that various state insurance departments prescribe or permit. Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). Financial data by segment for the three and nine months ended September 30, 2016 and 2015 is as follows: Three Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 75,571 $ 66,456 Personal lines 91,239 86,640 GAAP premiums earned 166,810 153,096 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 1,544 1,653 Total revenues $ 175,311 $ 159,802 Income before income taxes: Underwriting (loss) income: Commercial lines $ 3,701 $ 4,447 Personal lines (5,861 ) (3,727 ) SAP underwriting (loss) income (2,160 ) 720 GAAP adjustments 788 65 GAAP underwriting (loss) income (1,372 ) 785 Net investment income 5,581 5,399 Realized investment gains (losses) 1,018 (754 ) Equity in earnings of DFSC 358 408 Other 844 1,163 Income before income taxes $ 6,429 $ 7,001 14 Nine Months Ended September 30, 2016 2015 (in thousands) Revenues: Premiums earned Commercial lines $ 218,405 $ 193,036 Personal lines 268,823 257,048 GAAP premiums earned 487,228 450,084 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 4,623 5,042 Total revenues $ 511,227 $ 472,591 Income before income taxes: Underwriting income (loss): Commercial lines $ 14,118 $ 6,449 Personal lines (6,953 ) (6,499 ) SAP underwriting income (loss) 7,165 (50 ) GAAP adjustments 5,795 4,565 GAAP underwriting income 12,960 4,515 Net investment income 16,472 15,505 Realized investment gains 2,205 683 Equity in earnings of DFSC 699 1,277 Other 2,157 2,430 Income before income taxes $ 34,493 $ 24,410 7 - Borrowings Lines of Credit In July 2016, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit expires in July 2019. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the credit agreement. At September 30, 2016, we had $39.0 million in outstanding borrowings and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings from M&T is adjustable quarterly, and, at September 30, 2016, that interest rate was 2.78%. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We were in compliance with all requirements of the M&T credit agreement during the nine months ended September 30, 2016. MICO is a member of the Federal Home Loan Bank (“FHLB”) of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. MICO had no outstanding borrowings with the FHLB of Indianapolis at September 30, 2016. The table below presents the amount of FHLB of Indianapolis stock MICO purchased, collateral pledged and assets related to MICO’s membership at September 30, 2016. FHLB of Indianapolis stock purchased and owned $ 236,700 Collateral pledged, at par (carrying value $2,180,650) 2,177,558 Borrowing capacity currently available 2,143,057 Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. Atlantic States had $35.0 million in outstanding advances at 15 September 30, 2016. The interest rate on the advances was .59% at September 30, 2016. The table below presents the amount of FHLB of Pittsburgh stock Atlantic States purchased, collateral pledged and assets related to Atlantic States’ membership in the FHLB of Pittsburgh at September 30, 2016. FHLB of Pittsburgh stock purchased and owned $ 1,574,700 Collateral pledged, at par (carrying value $36,058,067) 36,085,816 Borrowing capacity currently available 310,732 Subordinated Debentures Donegal Mutual holds a $5.0 million surplus note that MICO issued to increase MICO’s statutory surplus. The surplus note carries an interest rate of 5.00%, and any repayment of principal or payment of interest on the surplus note requires prior approval of the Michigan Department of Insurance and Financial Services. 8 - Share–Based Compensation We measure all share-based payments to employees, including grants of stock options, and use a fair-value-based method for the recording of related compensation expense in our consolidated statements of income. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, the expected term, the dividend yield and the expected volatility. We charged compensation expense related to our stock compensation plans against income before income taxes of $414,696 and $598,516 for the three months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $145,143 and $209,481, respectively. We charged compensation expense related to our stock compensation plans against income before income taxes of $2.0 million and $1.9 million for the nine months ended September 30, 2016 and 2015, respectively, with a corresponding income tax benefit of $710,584 and $671,607, respectively. At September 30, 2016, we had $2.0 million of unrecognized compensation expense related to nonvested share-based compensation granted under our stock compensation plans. We expect to recognize this compensation expense over a weighted average period of approximately 1.3 years. We received cash from option exercises under all stock compensation plans during the three months ended September 30, 2016 and 2015 of $3.7 million and $181,488, respectively. We received cash from option exercises under all stock compensation plans during the nine months ended September 30, 2016 and 2015 of $7.8 million and $13.7 million, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $243,656 and $4,802 for the three months ended September 30, 2016 and 2015, respectively. We realized actual tax benefits for the tax deductions related to option exercises of $521,852 and $424,537 for the nine months ended September 30, 2016 and 2015, respectively. 9 - Fair Value Measurements We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of the inputs, or assumptions, we use in the determination of fair value, and we classify financial assets and liabilities carried at fair value in one of the following three categories: Level 1 – quoted prices in active markets for identical assets and liabilities; Level 2 – directly or indirectly observable inputs other than Level 1 quoted prices; and Level 3 – unobservable inputs not corroborated by market data. For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these investments in Level 1 of the fair value hierarchy. We classify publicly-traded equity securities as Level 1. When quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or price estimates we obtain from independent pricing services and include these investments in Level 2 of the fair value hierarchy. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury 16 securities and obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, corporate securities and mortgage-backed securities. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. These pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon our investment personnel’s general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel regularly monitor the market, current trading ranges for similar securities and the pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. We present our cash and short-term investments at estimated fair value. We classify these items as Level 1. The carrying values we report in our balance sheet for premium receivables and reinsurance receivables and payables for premiums and paid losses and loss expenses approximate their fair values. The carrying amounts we report in our balance sheet for our subordinated debentures and borrowings under lines of credit approximate their fair values. We classify these items as Level 3. We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at September 30, 2016: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 36,375 $ — $ 36,375 $ — Obligations of states and political subdivisions 194,276 — 194,276 — Corporate securities 90,841 — 90,841 — Mortgage-backed securities 194,329 — 194,329 — Equity securities 35,167 35,167 — — Total investments in the fair value hierarchy 550,988 35,167 515,821 — Investment measured at net asset value 11,145 — — — Totals $ 562,133 $ 35,167 $ 515,821 $ — We did not transfer any investments between Levels 1 and 2 during the nine months ended September 30, 2016. 17 The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2015: Fair Value Measurements Using Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 37,189 $ — $ 37,189 $ — Obligations of states and political subdivisions 236,556 — 236,556 — Corporate securities 72,812 — 72,812 — Mortgage-backed securities 154,836 — 154,836 — Equity securities 26,727 26,727 — — Total investments in the fair value hierarchy 528,120 26,727 501,393 — Investment measured at net asset value 10,534 — — — Totals $ 538,654 $ 26,727 $ 501,393 $ — 10 - Income Taxes At September 30, 2016 and December 31, 2015, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. Tax years 2013 through 2016 remained open for examination at September 30, 2016. We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of our tax assets. We established a valuation allowance of $440,778 related to a portion of the net operating loss carryforward of Le Mars at January 1, 2004. We have determined that we are not required to establish a valuation allowance for our other deferred tax assets of $43.4 million and $42.7 million at September 30, 2016 and December 31, 2015, respectively, because it is more likely than not that we will realize these deferred tax assets through reversals of existing temporary differences, future taxable income and the implementation of tax planning strategies. Our deferred tax assets include a net operating loss carryforward of $3.6 million related to Le Mars, which will begin to expire in 2020 if not previously utilized. This carryforward is subject to an annual limitation in the amount that we can use in any one year of approximately $376,000. Our deferred tax assets also include an alternative minimum tax credit carryforward of $7.6 million with an indefinite life. 11 - Impact of New Accounting Standards In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. While the guidance will replace most existing GAAP revenue recognition guidance, the scope of the guidance excludes insurance contracts. The new standard is effective on January 1, 2018. The standard permits the use of either the retrospective or the cumulative effect transition method. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In February 2015, the FASB issued a new standard that amends the current consolidation guidance affecting both the variable interest entity (“VIE”) and voting interest entity (“VOE”) consolidation models. The standard does not add or remove any of the characteristics in determining if an entity is a VIE or a VOE, but rather, the standard enhances assessment of some of these characteristics. The new standard was effective on December 15, 2015. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. In May 2015, the FASB issued guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The guidance also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. The guidance instead limits disclosure to investments for which the entity has elected to measure fair value using that practical expedient. The guidance was effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within those annual reporting periods. The adoption of this new guidance did not have a significant impact on our financial position, results of operations or cash flows. 18 In May 2015, the FASB issued guidance that requires entities to provide additional disclosures about their liability for unpaid claims and claim adjustment expenses to increase the transparency of significant estimates. The guidance also requires entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including the reasons for the changes and the effects on the entities’ financial statements, and the timing, frequency and severity of claims. The guidance also requires entities to disclose a rollforward of the liability for unpaid claims and claim adjustment expenses for annual and interim reporting periods. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within annual reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In January 2016, the FASB issued guidance that generally requires entities to measure equity investments at fair value and recognize changes in fair value in their results of operations. The guidance also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring entities to perform a qualitative assessment to identify impairment. The FASB issued other disclosure and presentation improvements related to financial instruments within the guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. As a result of this guidance, we will reflect changes in the fair value of our equity investments in our results of operations beginning January 1, 2018. In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the lessee’s balance sheet, unless a lease is considered a short-term lease. The guidance also requires entities to make new judgments to identify leases. The guidance is effective for annual and interim reporting periods beginning after December 15, 2018 and permits early adoption. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In March 2016, the FASB issued guidance that simplifies and improves several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. The guidance is effective for annual and interim reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In June 2016, the FASB issued guidance that amends previous guidance on the impairment of financial instruments by adding an impairment model that allows an entity to recognize expected credit losses as an allowance rather than impairments as credit losses are incurred. The new guidance is intended to reduce complexity and result in a more timely recognition of expected credit losses. The guidance is effective for annual and interim reporting periods beginning after December 15, 2019. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments shall be presented and classified in the statement of cash flows. This guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. 19\\nWe recommend that you read the following information in conjunction with the historical financial information and the footnotes to that financial information we include in this Quarterly Report on Form 10-Q. We also recommend you read Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2015.\\nCritical Accounting Policies and Estimates\\nWe combine our financial statements with those of our insurance subsidiaries and present our financial statements on a consolidated basis in accordance with GAAP.\\nOur insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures we report in our financial statements. The most significant estimates relate to the reserves of our insurance subsidiaries for property and casualty insurance unpaid losses and loss expenses, the valuation of investments and the determination of other-than-temporary investment impairments and the policy acquisition costs of our insurance subsidiaries. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts of these liabilities may differ from the estimates we provided. We regularly review our methods for making these estimates and we reflect any adjustment we consider necessary in our current consolidated results of operations.\\nLiability for Unpaid Losses and Loss Expenses\\nLiabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to incurred policyholder claims based on facts and circumstances the insurer knows at that point in time. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends, expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates for these liabilities. We reflect any adjustments to our insurance subsidiaries’ liabilities for losses and loss expenses in our consolidated results of operations in the period in which our insurance subsidiaries make the changes in estimates.\\nOur insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss the policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries monitor their liabilities closely and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses and loss expenses.\\nReserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions related to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while the severity of these claims has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on workers’ compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries make adjustments in their reserves that they consider appropriate for such changes. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ\\n20\\nfrom the amount recorded at September 30, 2016. For every 1% change in our insurance subsidiaries’ estimate for loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $3.4 million. The establishment of appropriate liabilities is an inherently uncertain process and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed our insurance subsidiaries’ loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, because the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods and, in other periods, their estimates of future liabilities have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimates of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received since the prior reporting date. Excluding the impact of severe weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and a slight downward trend in the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the United States property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs. We have also experienced a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could have to make further adjustments to their estimates in the future. However, on the basis of our insurance subsidiaries’ internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for losses and loss expenses. Atlantic States’ participation in the pool with Donegal Mutual exposes Atlantic States to adverse loss development on the business of Donegal Mutual that the pool includes. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States share proportionately any adverse risk development of the pooled business. The business in the pool is homogeneous and each company has a pro-rata share of the entire pool. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than either would experience individually and to spread the risk of loss between the companies. 21 Donegal Mutual and our insurance subsidiaries operate together as the Donegal Insurance Group and share a combined business plan designed to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual offer are generally complementary, thereby allowing Donegal Insurance Group to offer a broader range of products to a given market and to expand Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier products compared to standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, because the pool homogenizes the risk characteristics of all business Donegal Mutual and Atlantic States write directly and each company shares the results according to each company’s participation percentage, each company realizes its percentage share of the underwriting results of the pool. Our insurance subsidiaries’ unpaid liability for losses and loss expenses by major line of business at September 30, 2016 and December 31, 2015 consisted of the following: September 30, 2016 December 31, 2015 (in thousands) Commercial lines: Automobile $ 55,079 $ 53,938 Workers’ compensation 105,873 99,212 Commercial multi-peril 59,279 54,395 Other 3,639 3,119 Total commercial lines 223,870 210,664 Personal lines: Automobile 97,102 93,923 Homeowners 16,947 15,816 Other 2,122 1,651 Total personal lines 116,171 111,390 Total commercial and personal lines 340,041 322,054 Plus reinsurance recoverable 254,227 256,151 Total liability for unpaid losses and loss expenses $ 594,268 $ 578,205 We have evaluated the effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we consider in establishing the loss and loss expense reserves of our insurance subsidiaries. We established the range of reasonably likely changes based on a review of changes in accident-year development by line of business and applied those changes to our insurance subsidiaries’ loss reserves as a whole. The selected range does not necessarily indicate what could be the potential best or worst case or the most likely scenario. The following table sets forth the estimated effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing the loss and loss expense reserves of our insurance subsidiaries: Percentage Change in Loss and Loss Expense Reserves Net of Reinsurance Adjusted Loss and Loss Expense Reserves Net of Reinsurance at September 30, 2016 Percentage Change in Stockholders’ Equity at September 30, 2016(1) Adjusted Loss and Loss Expense Reserves Net of Reinsurance at December 31, 2015 Percentage Change in Stockholders’ Equity at December 31, 2015(1) (dollars in thousands) (10.0)% $ 306,037 5.0 % $ 289,849 5.1 % (7.5) 314,538 3.7 297,900 3.8 (5.0) 323,039 2.5 305,951 2.6 (2.5) 331,540 1.2 314,003 1.3 Base 340,041 — 322,054 — 2.5 348,542 (1.2 ) 330,105 (1.3 ) 5.0 357,043 (2.5 ) 338,157 (2.6 ) 7.5 365,544 (3.7 ) 346,208 (3.8 ) 10.0 374,045 (5.0 ) 354,259 (5.1 ) (1) Net of income tax effect. 22 Statutory Combined Ratios We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting income, combined ratio and net premiums written. An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of the ratio of calendar-year incurred losses and loss expenses to premiums earned; the ratio of expenses incurred for commissions, premium taxes and underwriting expenses to net premiums written and the ratio of dividends to policyholders to premiums earned. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A combined ratio of less than 100 percent generally indicates underwriting profitability. The statutory combined ratio differs from the GAAP combined ratio. In calculating the GAAP combined ratio, we do not deduct installment payment fees from incurred expenses, and we base the expense ratio on premiums earned instead of premiums written. Differences between our GAAP loss ratios reported in our financial statements and our insurance subsidiaries’ statutory loss ratios result from anticipating salvage and subrogation recoveries for the GAAP loss ratios but not for the statutory loss ratios. The following table sets forth our insurance subsidiaries’ statutory combined ratios by major line of business for the three and nine months ended September 30, 2016 and 2015: Three Months Ended September 30, Nine Months Ended September 30, 2016 2015 2016 2015 Commercial lines: Automobile 110.8 % 118.0 % 106.5 % 106.1 % Workers’ compensation 86.8 79.1 85.3 89.0 Commercial multi-peril 94.7 92.2 88.5 93.2 Total commercial lines 94.3 92.0 90.3 93.2 Personal lines: Automobile 105.9 98.8 102.6 100.0 Homeowners 101.5 108.0 97.1 101.7 Total personal lines 103.6 101.4 99.9 99.8 Total commercial and personal lines 99.5 97.4 95.6 96.9 Investments We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down an individual investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of the individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of our original cost and has been in such an unrealized loss position for more than six months. We held seven equity securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect on the debt security. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security or rating agency 23 downgrades. We held 55 debt securities that were in an unrealized loss position at September 30, 2016. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in our results of operations for the first nine months of 2016 or 2015. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain from the pricing services are representative of fair values based upon the general market knowledge of our investment personnel, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At September 30, 2016, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at September 30, 2016, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. Policy Acquisition Costs Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that relate directly to the successful acquisition of insurance policies. We amortize these costs over the period in which our insurance subsidiaries earn the related premiums. The method we follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This method gives effect to the premiums to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premiums. Results of Operations - Three Months Ended September 30, 2016 Compared to Three Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the three months ended September 30, 2016 were $171.9 million, an increase of $13.0 million, or 8.2%, from the $158.9 million of net premiums written for the third quarter of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $5.2 million, or 5.6%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $7.8 million, or 12.0%, for the third quarter of 2016 compared to the third quarter of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the third quarter of 2016 were $166.8 million, an increase of $13.7 million, or 9.0%, compared to $153.1 million for the third quarter of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $5.6 million for the third quarter of 2016, compared to $5.4 million for the third quarter of 2015. We attribute the increase primarily to an increase in average invested assets. 24 Net Realized Investment Gains (Losses). Net realized investment gains for the third quarter of 2016 were $1.0 million, compared to net realized investment losses of $754,050 for the third quarter of 2015. The net realized investment gains for the third quarter of 2016 resulted primarily from unrealized gains within a limited partnership that invests in equity securities. The net realized investment losses for the third quarter of 2015 resulted primarily from unrealized losses within the limited partnership. We did not recognize any impairment losses in our investment portfolio during the third quarters of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $357,956 for the third quarter of 2016, compared to $408,405 for the third quarter of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the third quarter of 2016 was 66.6%, a slight decrease from our insurance subsidiaries’ loss ratio of 66.8% for the third quarter of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 62.5% for the third quarter of 2016, compared to 62.3% for the third quarter of 2015, primarily due to an increase in the workers’ compensation loss ratio. The personal lines statutory loss ratio of our insurance subsidiaries increased to 70.4% for the third quarter of 2016, compared to 69.9% for the third quarter of 2015, primarily due to an increase in the personal automobile loss ratio. Our insurance subsidiaries experienced favorable loss reserve development of approximately $1.6 million during the third quarter of 2016 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $1.5 million during the third quarter of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ commercial multi-peril and personal automobile reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.5% for the third quarter of 2016, compared to 32.1% for the third quarter of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs in the third quarter of 2016 compared to the third quarter of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 100.8% and 99.5% for the three months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the third quarter of 2016 was $473,917, compared to $188,000 for the third quarter of 2015. We attribute the increase to higher average borrowings during the third quarter of 2016 compared to the third quarter of 2015. Income Taxes. Income tax expense was $1.6 million for the third quarter of 2016, representing an effective tax rate of 25.1%, compared to income tax expense of $1.3 million for the third quarter of 2015, representing an effective tax rate of 18.8% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the third quarter of 2016 was $4.8 million, or $.18 per share of Class A common stock on a diluted basis and $.16 per share of Class B common stock, compared to net income of $5.7 million, or $.21 per share of Class A common stock and $.18 per share of Class B common stock, for the third quarter of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Results of Operations - Nine Months Ended September 30, 2016 Compared to Nine Months Ended September 30, 2015 Net Premiums Written. Our insurance subsidiaries’ net premiums written for the nine months ended September 30, 2016 were $520.3 million, an increase of $39.2 million, or 8.1%, from the $481.1 million of net premiums written for the comparable period of 2015. We attribute the increase to the impact of premium rate increases and an increase in the writing of commercial lines of business. Personal lines net premiums written increased $13.4 million, or 5.0%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2015 and 2016. Commercial lines net premiums written increased $25.8 million, or 12.1%, for the first nine months of 2016 compared to the first nine months of 2015. The increase was primarily attributable to premium rate increases and increased writings of new commercial accounts. Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the first nine months of 2016 were $487.2 million, an increase of $37.1 million, or 8.3%, compared to $450.1 million for the first nine months of 2015, reflecting increases in net premiums written during 2016 and 2015. Our insurance subsidiaries earn premiums and recognize them as 25 revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12-month period compared to the comparable period one year earlier. Investment Income. Our net investment income increased to $16.5 million for the first nine months of 2016, compared to $15.5 million for the first nine months of 2015. We attribute the increase primarily to an increase in average invested assets. Net Realized Investment Gains. Net realized investment gains for the first nine months of 2016 were $2.2 million, compared to $682,932 for the first nine months of 2015. The net realized investment gains for the first nine months of 2016 and 2015 resulted primarily from calls and strategic sales of fixed maturities and equity securities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the first nine months of 2016 or 2015. Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $698,658 for the first nine months of 2016, compared to $1.3 million for the first nine months of 2015. Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the first nine months of 2016 was 63.6%, a decrease from our insurance subsidiaries’ loss ratio of 65.8% for the first nine months of 2015. On a statutory basis, our insurance subsidiaries’ commercial lines loss ratio was 59.4% for the first nine months of 2016, compared to 62.7% for the first nine months of 2015, primarily due to decreases in the commercial multi-peril and workers’ compensation loss ratios. The personal lines statutory loss ratio of our insurance subsidiaries decreased to 67.2% for the first nine months of 2016, compared to 68.1% for the first nine months of 2015, primarily due to a decrease in the homeowners loss ratio. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $2.1 million during the first nine months of 2016 in their reserves for prior accident years, compared to approximately $4.8 million during the first nine months of 2015. The improvement in loss reserve development patterns occurred primarily within our insurance subsidiaries’ workers’ compensation reserves. Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 33.2% for the first nine months of 2016, compared to 32.7% for the first nine months of 2015. We attribute the 2016 increase primarily to higher underwriting incentive costs related to the lower loss ratio in the first nine months of 2016 compared to the first nine months of 2015. Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of policyholder dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratios were 97.3% and 99.0% for the nine months ended September 30, 2016 and 2015, respectively. Interest Expense. Our interest expense for the first nine months of 2016 was $1.3 million, compared to $908,615 for the first nine months of 2015. We attribute the increase to higher average borrowings during the first nine months of 2016 compared to the first nine months of 2015. Income Taxes. Income tax expense was $9.2 million for the first nine months of 2016, representing an effective tax rate of 26.8%, compared to income tax expense of $5.4 million for the first nine months of 2015, representing an effective tax rate of 22.1% . The effective tax rate in both periods represented an estimate based on our projected annual taxable income. The increase in the effective tax rate reflects our expectation that tax-exempt interest income will represent a lesser proportion of our 2016 taxable income compared to 2015. Net Income and Earnings Per Share. Our net income for the first nine months of 2016 was $25.2 million, or $.95 per share of Class A common stock on a diluted basis and $.88 per share of Class B common stock, compared to net income of $19.0 million, or $.69 per share of Class A common stock on a diluted basis and $.63 per share of Class B common stock, for the first nine months of 2015. We had 21.2 million and 22.4 million Class A shares outstanding at September 30, 2016 and 2015, respectively. We had 5.6 million Class B shares outstanding at the end of both periods. Liquidity and Capital Resources Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs as such obligations and needs arise. Our major sources of funds from operations are the net cash flows we generate from our insurance subsidiaries’ underwriting results, investment income and investment maturities. 26 Our operations have historically generated sufficient net positive cash flow to fund our commitments and add to our investment portfolio, thereby increasing future investment returns and enhancing our liquidity. The impact of the pooling agreement between Donegal Mutual and Atlantic States has historically been cash-flow positive because of the consistent underwriting profitability of the pool. Donegal Mutual and Atlantic States settle their respective obligations to each other under the pool monthly, thereby resulting in cash flows substantially similar to the cash flows that would result from each company writing the business directly. We have not experienced any unusual variations in the timing of claim payments associated with the loss reserves of our insurance subsidiaries. We maintain significant liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. We structure our fixed-maturity investment portfolio following a “laddering” approach, so that projected cash flows from investment income and principal maturities are evenly distributed from a timing perspective, thereby providing an additional measure of liquidity to meet our obligations should an unexpected variation occur in the future. Our operating activities provided net cash flows in the first nine months of 2016 and 2015 of $46.3 million and $48.5 million, respectively. At September 30, 2016, we had $39.0 million in outstanding borrowings under our line of credit with M&T and had the ability to borrow an additional $21.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on these borrowings was 2.78% at September 30, 2016. At September 30, 2016, Atlantic States had $35.0 million in outstanding advances with the FHLB of Pittsburgh. The interest rate on these advances was .59% at September 30, 2016. The following table shows our expected payments for significant contractual obligations at September 30, 2016: Total Less than 1 year 1-3 years 4-5 years After 5 years (in thousands) Net liability for unpaid losses and loss expenses of our insurance subsidiaries $ 340,041 $ 158,779 $ 155,378 $ 12,372 $ 13,512 Subordinated debentures 5,000 — — — 5,000 Borrowings under lines of credit 74,000 35,000 39,000 — — Total contractual obligations $ 419,041 $ 193,779 $ 194,378 $ 12,372 $ 18,512 We estimate the date of payment for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. We show the liability net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Amounts Atlantic States assumes pursuant to the pooling agreement with Donegal Mutual represent a substantial portion of our insurance subsidiaries’ gross liability for unpaid losses and loss expenses, and amounts Atlantic States cedes pursuant to the pooling agreement represent a substantial portion of our insurance subsidiaries’ reinsurance recoverable on unpaid losses and loss expenses. We include cash settlement of Atlantic States’ assumed liability from the pool in monthly settlements of pooled activity, as we net amounts ceded to and assumed from the pool. Although Donegal Mutual and we do not anticipate any changes in the pool participation levels in the foreseeable future, any such change would be prospective in nature and therefore would not impact the timing of expected payments by Atlantic States for its percentage share of pooled losses occurring in periods prior to the effective date of such change. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the borrowings under our lines of credit based on their contractual maturities. The borrowings under our lines of credit carry interest rates that vary as we discuss in Note 7 – Borrowings. Based upon the interest rates in effect at September 30, 2016, our annual interest cost associated with the borrowings under our lines of credit is approximately $1.3 million. For every 1% change in the interest rate associated with the borrowings under our lines of credit, the effect on our annual interest cost would be approximately $740,000. We discuss in Note 7 – Borrowings our estimate of the timing of the amounts for the subordinated debentures based on their contractual maturity. The subordinated debentures carry an interest rate of 5%, and any repayment of principal or payment of interest on the subordinated debentures requires prior approval of the Michigan Department of Insurance and Financial Services. Our annual interest cost associated with the subordinated debentures is approximately $250,000. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2016. We purchased 27 57,658 shares of our Class A common stock under this program during the nine months ended September 30, 2015. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2016. On October 20, 2016, our board of directors declared quarterly cash dividends of 13.75 cents per share of our Class A common stock and 12.00 cents per share of our Class B common stock, payable on November 15, 2016 to our stockholders of record as of the close of business on November 1, 2016. We are not subject to any restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends by our insurance subsidiaries to us. Dividends from our insurance subsidiaries are our principal source of cash for payment of dividends to our stockholders. Our insurance subsidiaries are subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are also subject to risk based capital (“RBC”) requirements that limit their ability to pay dividends to us. Our insurance subsidiaries’ statutory capital and surplus at December 31, 2015 exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements, by a significant margin. Our insurance subsidiaries paid $9.5 million in dividends to us during the first nine months of 2016. Amounts remaining available for distribution to us as dividends from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities in 2016 are $18.8 million from Atlantic States, $1.3 million from Southern, $1.1 million from Le Mars, $4.2 million from Peninsula, $325,412 from Sheboygan and $619,953 from MICO, or a total of approximately $26.3 million. At September 30, 2016, we had no material commitments for capital expenditures. Equity Price Risk Our portfolio of marketable equity securities, which we carry on our consolidated balance sheets at estimated fair value, has exposure to the risk of loss resulting from an adverse change in prices. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of equity securities. Credit Risk Our portfolio of fixed-maturity securities and, to a lesser extent, our portfolio of short-term investments is subject to credit risk, which we define as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay its debt. We manage this risk by having our investment staff perform an analysis of prospective investments and regular reviews of our portfolio of fixed-maturity securities. We also limit the percentage and amount of our total investment portfolio that we invest in the securities of any one issuer. Our insurance subsidiaries provide property and casualty insurance coverages through independent insurance agencies. We bill the majority of this business directly to the insured, although we bill a portion of our commercial business through licensed insurance agents to whom our insurance subsidiaries extend credit in the normal course of business. Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, Atlantic States is subject to a concentration of credit risk arising from the business it cedes to Donegal Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal Mutual and with a number of other major unaffiliated authorized reinsurers. Impact of Inflation We establish property and casualty insurance premium rates before we know the amount of unpaid losses and loss expenses or the extent to which inflation may impact such losses and expenses. Consequently, our insurance subsidiaries attempt, in establishing rates, to anticipate the potential impact of inflation.\\nOur market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of the securities we hold in our investment portfolio as a result of fluctuations in prices and interest rates and, to a lesser extent, our debt obligations. We manage our interest rate risk by maintaining an appropriate relationship between the average duration of our investment portfolio and the approximate duration of our liabilities, i.e., policy claims of our insurance subsidiaries and our debt obligations.\\n28\\nThere have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2015 through September 30, 2016.\\nEvaluation of Disclosure Controls and Procedures\\nOur management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, at September 30, 2016, our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information we are required to disclose in the reports that we file or submit under the Exchange Act, and our disclosure controls and procedures were also effective to ensure that information we disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.\\nChanges in Internal Control Over Financial Reporting\\nThere has been no change in our internal control over financial reporting during the quarter covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.\\nSafe Harbor Statement Under the Private Securities Litigation Reform Act of 1995\\nWe base all statements contained in this Quarterly Report on Form 10-Q that are not historic facts on our current expectations. Such statements are forward-looking in nature (as defined in the Private Securities Litigation Reform Act of 1995) and necessarily involve risks and uncertainties. Forward-looking statements we make may be identified by our use of words such as “will,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “seeks,” “estimates” and similar expressions. Our actual results could vary materially from our forward-looking statements. The factors that could cause our actual results to vary materially from the forward-looking statements we have previously made include, but are not limited to, our ability to maintain profitable operations, the adequacy of the loss and loss expense reserves of our insurance subsidiaries, business and economic conditions in the areas in which we and our insurance subsidiaries operate, interest rates, competition from various insurance and other financial businesses, terrorism, the availability and cost of reinsurance, adverse and catastrophic weather events, legal and judicial developments, changes in regulatory requirements, our ability to integrate and manage successfully the companies we may acquire from time to time and the other risks that we describe from time to time in our filings with the SEC. We disclaim any obligation to update such statements or to announce publicly the results of any revisions that we may make to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.\\n29\\nPart II. Other Information\\nNone.\\nOur business, results of operations and financial condition, and, therefore, the value of our Class A common stock and our Class B common stock, are subject to a number of risks. For a description of certain risks, we refer to “Risk Factors” in our 2015 Annual Report on Form 10-K we filed with the SEC on March 18, 2016. There have been no material changes in the risk factors we disclosed in that Form 10-K Report during the nine months ended September 30, 2016.\\nNone.\\nNone.\\nItem 4. Removed and Reserved.\\nNone.\\n30\\n\\n\\n| Exhibit No. | Description |\\n| Exhibit 31.1 | Certification of Chief Executive Officer |\\n| Exhibit 31.2 | Certification of Chief Financial Officer |\\n| Exhibit 32.1 | Statement of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\\n| Exhibit 32.2 | Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code |\\n| Exhibit 101.INS | XBRL Instance Document |\\n| Exhibit 101.SCH | XBRL Taxonomy Extension Schema Document |\\n| Exhibit 101.PRE | XBRL Taxonomy Presentation Linkbase Document |\\n| Exhibit 101.CAL | XBRL Taxonomy Calculation Linkbase Document |\\n| Exhibit 101.LAB | XBRL Taxonomy Label Linkbase Document |\\n| Exhibit 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n\\n31\\nSignatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DONEGAL GROUP INC. November 7, 2016 By: /s/ Kevin G. Burke Kevin G. Burke, President and Chief Executive Officer November 7, 2016 By: /s/ Jeffrey D. Miller Jeffrey D. Miller, Executive Vice President and Chief Financial Officer\\n</text>\\n\\nWhat is the annual growth rate of the company's total investments from December 31, 2015 to September 30, 2016 in percent?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 6.411694352303821.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 46,\n \"input_length\": 26460\n}"}}},{"rowIdx":47,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1.\nFinancial Statements.\nConsolidated Balance Sheets 4\nConsolidated Statements of Operations 5\nConsolidated Statements of Comprehensive Income (Loss) 7\nConsolidated Statements of Equity 8\nConsolidated Statements of Cash Flows 12\nNotes to the Consolidated Financial Statements 14\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 51\nItem 4. Controls and Procedures 53\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings 54\nItem 1A. Risk Factors 54\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds 54\nItem 3. Defaults Upon Senior Securities 54\nItem 4. Mine Safety Disclosures 54\nItem 5. Other Information 54\nItem 6. Exhibits 55\nSignatures 56\n3\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAS OF JUNE 30, 2021 [UNAUDITED] AND DECEMBER 31, 2020[IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| June 30, 2021 | December 31, 2020 |\n| Assets: |\n| Investment in Hotel Properties, Net of Accumulated Depreciation | $ | 1,699,230 | $ | 1,784,838 |\n| Investment in Unconsolidated Joint Ventures | 5,936 | 6,633 |\n| Cash and Cash Equivalents | 69,083 | 16,637 |\n| Escrow Deposits | 11,067 | 6,970 |\n| Hotel Accounts Receivable | 5,539 | 5,690 |\n| Due from Related Parties | 1,552 | 2,641 |\n| Intangible Assets, Net of Accumulated Amortization of $ 6,827 and $ 6,840 | 1,465 | 1,739 |\n| Right of Use Assets | 43,467 | 44,126 |\n| Other Assets | 20,395 | 15,494 |\n| Hotel Assets Held for Sale | — | 96,220 |\n| Total Assets | $ | 1,857,734 | $ | 1,980,988 |\n| Liabilities and Equity: |\n| Line of Credit | $ | 118,684 | $ | 133,053 |\n| Term Loans, Net of Unamortized Deferred Financing Costs (Note 5) | 495,657 | 681,744 |\n| Unsecured Notes Payable, Net of Unamortized Discount and Unamortized Deferred Financing Costs (Note 5) | 193,725 | 50,789 |\n| Mortgages Payable, Net of Unamortized Premium and Unamortized Deferred Financing Costs | 304,426 | 330,848 |\n| Lease Liabilities | 53,455 | 53,852 |\n| Accounts Payable, Accrued Expenses and Other Liabilities | 49,088 | 58,453 |\n| Dividends and Distributions Payable | 6,044 | — |\n| Total Liabilities | $ | 1,221,079 | $ | 1,308,739 |\n| Redeemable Noncontrolling Interests - Consolidated Joint Venture (Note 1) | $ | 1,968 | $ | — |\n| Equity: |\n| Shareholders' Equity: |\n| Preferred Shares: $ .01 Par Value, 29,000,000 Shares Authorized, 3,000,000 Series C, 7,701,700 Series D and 4,001,514 Series E Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, with Liquidation Preferences of $ 25.00 Per Share (Note 1) | $ | 147 | $ | 147 |\n| Common Shares: Class A, $ .01 Par Value, 104,000,000 Shares Authorized at June 30, 2021 and December 31, 2020; 39,217,475 and 38,843,482 Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, respectively | 392 | 389 |\n| Common Shares: Class B, $ .01 Par Value, 1,000,000 Shares Authorized, None Issued and Outstanding at June 30, 2021 and December 31, 2020 | — | — |\n| Accumulated Other Comprehensive Loss | ( 11,024 ) | ( 19,275 ) |\n| Additional Paid-in Capital | 1,153,657 | 1,150,985 |\n| Distributions in Excess of Net Income | ( 557,157 ) | ( 509,243 ) |\n| Total Shareholders' Equity | 586,015 | 623,003 |\n| Noncontrolling Interests (Note 1) | 48,672 | 49,246 |\n| Total Equity | 634,687 | 672,249 |\n| Total Liabilities and Equity | $ | 1,857,734 | $ | 1,980,988 |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n4\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| Three Months Ended June 30, | Six months ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue: |\n| Hotel Operating Revenues: |\n| Room | $ | 56,539 | $ | 15,139 | $ | 95,889 | $ | 86,222 |\n| Food & Beverage | 7,230 | 136 | 10,304 | 10,211 |\n| Other Operating Revenues | 6,314 | 2,137 | 11,043 | 10,917 |\n| Other Revenues | 13 | 29 | 25 | 228 |\n| Total Revenues | 70,096 | 17,441 | 117,261 | 107,578 |\n| Operating Expenses: |\n| Hotel Operating Expenses: |\n| Room | 12,350 | 3,622 | 21,548 | 22,714 |\n| Food & Beverage | 5,409 | 721 | 8,282 | 11,342 |\n| Other Operating Expenses | 23,551 | 14,035 | 43,660 | 49,841 |\n| Insurance recoveries in excess of property loss | ( 711 ) | — | ( 711 ) | — |\n| Hotel Ground Rent | 1,064 | 1,058 | 2,164 | 2,121 |\n| Real Estate and Personal Property Taxes and Property Insurance | 9,466 | 9,969 | 19,537 | 19,911 |\n| General and Administrative (including Share Based Payments of $ 2,589 and $ 1,799 and $ 4,758 and $ 4,255 for the three and six months ended June 30, 2021 and 2020, respectively) | 5,287 | 4,187 | 10,231 | 10,021 |\n| Terminated Transaction Costs | 36 | — | 390 | — |\n| Loss on Impairment of Assets | 222 | 1,069 | 222 | 1,069 |\n| Depreciation and Amortization | 21,014 | 24,322 | 42,816 | 48,510 |\n| Total Operating Expenses | 77,688 | 58,983 | 148,139 | 165,529 |\n| Operating Loss | ( 7,592 ) | ( 41,542 ) | ( 30,878 ) | ( 57,951 ) |\n| Interest Income | 4 | 2 | 5 | 38 |\n| Interest Expense | ( 14,982 ) | ( 13,481 ) | ( 28,411 ) | ( 26,488 ) |\n| Other Income (Expense) | ( 84 ) | ( 385 ) | 377 | ( 457 ) |\n| Gain on Disposition of Hotel Properties | — | — | 48,352 | — |\n| Loss on Debt Extinguishment | ( 129 ) | — | ( 3,069 ) | — |\n| Loss Before Results from Unconsolidated Joint Venture Investments and Income Taxes | ( 22,783 ) | ( 55,406 ) | ( 13,624 ) | ( 84,858 ) |\n| Loss from Unconsolidated Joint Ventures | ( 589 ) | ( 502 ) | ( 1,247 ) | ( 1,520 ) |\n| Loss Before Income Taxes | ( 23,372 ) | ( 55,908 ) | ( 14,871 ) | ( 86,378 ) |\n| Income Tax Benefit (Expense) | ( 151 ) | ( 15,872 ) | 438 | ( 11,374 ) |\n| Net Loss | ( 23,523 ) | ( 71,780 ) | ( 14,433 ) | ( 97,752 ) |\n| Loss Allocated to Noncontrolling Interests - Common Units | 2,945 | 7,164 | 2,623 | 10,061 |\n| (Income) Loss Allocated to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\n| Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Net Loss Applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n5\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Earnings Per Share: |\n| BASIC |\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\n| DILUTED |\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\n| Weighted Average Common Shares Outstanding: |\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Diluted* | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n\n* Income (Loss) allocated to noncontrolling interest in Hersha Hospitality Limited Partnership (the “Operating Partnership” or “HHLP”) has been excluded from the numerator and the Class A common shares issuable upon any redemption of the Operating Partnership’s common units of limited partnership interest (“Common Units”) and the Operating Partnership’s vested LTIP units (“Vested LTIP Units”) have been omitted from the denominator for the purpose of computing diluted earnings per share because the effect of including these shares and units in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\nThe following table summarizes potentially dilutive securities that have been excluded from the denominator for the purpose of computing diluted earnings per share:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Common Units and Vested LTIP Units | 4,279,355 | 3,943,319 | 4,314,347 | 3,891,032 |\n| Unvested Stock Awards and LTIP Units Outstanding | 939,591 | 547,315 | 581,989 | 267,443 |\n| Contingently Issuable Share Awards | 408,202 | 185,754 | 594,125 | 680,979 |\n| Total Potentially Dilutive Securities Excluded from the Denominator | 5,627,148 | 4,676,388 | 5,490,461 | 4,839,454 |\n\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\n6\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Other Comprehensive Income (Loss) |\n| Change in Fair Value of Derivative Instruments | 2,539 | ( 2,020 ) | 9,004 | ( 33,146 ) |\n| Reclassification Adjustment for Change in Fair Value of Derivative Instruments Included in Net Income (Loss) | ( 141 ) | 1,228 | 159 | 2,205 |\n| Total Other Comprehensive Income (Loss) | $ | 2,398 | $ | ( 792 ) | $ | 9,163 | $ | ( 30,941 ) |\n| Comprehensive Loss | ( 21,125 ) | ( 72,572 ) | ( 5,270 ) | ( 128,693 ) |\n| Less: Comprehensive Loss Attributable to Noncontrolling Interests - Common Units | 2,712 | 7,270 | 1,711 | 12,895 |\n| Less: Comprehensive (Income) Loss Attributable to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\n| Less: Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Comprehensive Loss Attributable to Common Shareholders | $ | ( 26,425 ) | $ | ( 68,150 ) | $ | ( 17,456 ) | $ | ( 124,690 ) |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n7\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at March 31, 2021 | — | 39,132,307 | 391 | — | 14,703,214 | 147 | 1,154,579 | ( 12,509 ) | ( 530,535 ) | 612,073 | 5,943,014 | 49,172 | 661,245 |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 6,044 ) | ( 6,044 ) | — | — | ( 6,044 ) |\n| Share Based Compensation: |\n| Grants | — | 85,168 | 1 | — | — | — | 365 | — | — | 366 | 19,477 | 65 | 431 |\n| Amortization | — | — | — | — | — | — | 681 | — | — | 681 | 1,468 | 2,149 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 1,485 | — | 1,485 | — | 912 | 2,397 |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\n| Net Loss | — | — | — | — | — | — | — | — | ( 20,578 ) | ( 20,578 ) | — | ( 2,945 ) | ( 23,523 ) |\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\n\n8\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at March 31, 2020 | 3,196 | 38,673,242 | 387 | — | 14,703,214 | 147 | 1,145,450 | ( 26,411 ) | ( 362,777 ) | 756,796 | 4,279,946 | 59,162 | 815,958 |\n| Issuance Costs | — | — | — | — | — | — | ( 10 ) | — | — | ( 10 ) | — | — | ( 10 ) |\n| Share Based Compensation: |\n| Grants | — | 116,129 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\n| Amortization | — | — | — | — | — | — | 655 | — | — | 655 | — | 3,823 | 4,478 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 686 ) | — | ( 686 ) | — | ( 106 ) | ( 792 ) |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\n| Net Income | — | — | — | — | — | — | — | — | ( 64,616 ) | ( 64,616 ) | ( 7,164 ) | ( 71,780 ) |\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\n\n9\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at December 31, 2020 | — | 38,843,482 | 389 | — | 14,703,214 | 147 | 1,150,985 | ( 19,275 ) | ( 509,243 ) | 623,003 | 5,392,808 | 49,246 | 672,249 |\n| Unit Conversion | — | 225,000 | 2 | — | — | — | 2,870 | — | — | 2,872 | ( 225,000 ) | ( 2,872 ) | — |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 36,262 ) | ( 36,262 ) | — | — | ( 36,262 ) |\n| Share Based Compensation: |\n| Grants | — | 148,993 | 1 | — | — | — | 356 | — | — | 357 | 794,683 | 1,683 | 2,040 |\n| Amortization | — | — | — | — | — | — | 1,414 | — | — | 1,414 | 2,326 | 3,740 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 8,251 | — | 8,251 | — | 912 | 9,163 |\n| Equity Contribution to Consolidated Joint Venture | 158 | — | — | — | — | — | — | — | — | — | — | — | — |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\n| Net Income | ( 158 ) | — | — | — | — | — | — | — | ( 11,652 ) | ( 11,652 ) | — | ( 2,623 ) | ( 14,275 ) |\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n10\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\n| Balance at December 31, 2019 | 3,196 | 38,652,650 | 387 | — | 14,703,214 | 147 | 1,144,808 | 1,010 | ( 338,695 ) | 807,657 | 4,279,946 | 64,144 | 871,801 |\n| Unit Conversion | — | — | — | — | — | — | ( 30 ) | — | — | ( 30 ) | — | — | ( 30 ) |\n| Dividends and Distributions declared: |\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 1,007 ) | ( 1,007 ) | — | — | ( 1,007 ) |\n| Dividend Reinvestment Plan | — | 1,094 | — | — | — | — | 14 | — | — | 14 | — | — | 14 |\n| Share Based Compensation: |\n| Grants | — | 135,627 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\n| Amortization | — | — | — | — | — | — | 1,303 | — | — | 1,303 | — | 4,466 | 5,769 |\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 28,107 ) | — | ( 28,107 ) | — | ( 2,834 ) | ( 30,941 ) |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\n| Net Loss | — | — | — | — | — | — | — | — | ( 87,691 ) | ( 87,691 ) | ( 10,061 ) | ( 97,752 ) |\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n11\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Operating Activities: |\n| Net Loss | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities: |\n| Gain on Disposition of Hotel Properties | ( 48,352 ) | — |\n| Loss on Impairment of Assets | 222 | 1,069 |\n| Insurance recoveries in excess of property loss | ( 711 ) | — |\n| Junior Note PIK Interest Added to Principal | 2,514 | — |\n| Deferred Taxes | ( 499 ) | 11,390 |\n| Depreciation | 42,642 | 48,273 |\n| Amortization | 2,594 | 1,116 |\n| Loss on Debt Extinguishment | 634 | — |\n| Equity in Loss of Unconsolidated Joint Ventures | 1,247 | 1,520 |\n| Loss Recognized on Change in Fair Value of Derivative Instrument | 159 | 2,205 |\n| Share Based Compensation Expense | 4,758 | 4,255 |\n| Change in Assets and Liabilities: |\n| (Increase) Decrease in: |\n| Hotel Accounts Receivable | 151 | 5,412 |\n| Other Assets | ( 4,055 ) | 4,884 |\n| Due from Related Parties | 1,089 | 3,750 |\n| Increase (Decrease) in: |\n| Accounts Payable, Accrued Expenses and Other Liabilities | 4,933 | ( 2,479 ) |\n| Net Cash Used in Operating Activities | $ | ( 7,107 ) | $ | ( 16,357 ) |\n| Investing Activities: |\n| Capital Expenditures | ( 5,374 ) | ( 15,612 ) |\n| Hotel Development Projects | — | 21 |\n| Proceeds from Disposition of Hotel Properties | 163,583 | — |\n| Contributions to Unconsolidated Joint Ventures | ( 550 ) | ( 600 ) |\n| Net Cash Provided by (Used in) Investing Activities | $ | 157,659 | $ | ( 16,191 ) |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n12\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\n| Six Months Ended June 30, |\n| 2021 | 2020 |\n| Financing Activities: |\n| (Repayments) Borrowings on Line of Credit, Net | $ | ( 14,369 ) | $ | 47,000 |\n| Payments on Term Loans | ( 187,024 ) | — |\n| Proceeds from Notes Payable | 144,750 | — |\n| Principal Repayment of Mortgages | ( 1,353 ) | ( 650 ) |\n| Proceeds of Paycheck Protection Program (\"PPP\") Loans | — | 18,936 |\n| Repayment of PPP Loans | — | ( 18,936 ) |\n| Deferred Financing Costs | ( 5,795 ) | ( 2,104 ) |\n| Dividends Paid on Common Shares | — | ( 10,809 ) |\n| Dividends Paid on Preferred Shares | ( 30,218 ) | ( 6,044 ) |\n| Distributions Paid on Common Units and LTIP Units | — | ( 1,198 ) |\n| Other Financing Activities | — | ( 30 ) |\n| Net Cash (Used in) Provided by Financing Activities | $ | ( 94,009 ) | $ | 26,165 |\n| Net Increase (Decrease) in Cash, Cash Equivalents, and Restricted Cash | $ | 56,543 | $ | ( 6,383 ) |\n| Cash, Cash Equivalents, and Restricted Cash - Beginning of Period | 23,607 | 36,985 |\n| Cash, Cash Equivalents, and Restricted Cash - End of Period | $ | 80,150 | $ | 30,602 |\n\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\n13\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 1 - BASIS OF PRESENTATION\nThe accompanying unaudited consolidated financial statements of Hersha Hospitality Trust (“we,” “us,” “our” or the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“US GAAP”) for interim financial information and with the general instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by US GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals), considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021 or any future period. Accordingly, readers of these consolidated interim financial statements should refer to the Company’s audited financial statements prepared in accordance with US GAAP, and the related notes thereto, for the year ended December 31, 2020, which are included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as certain footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted from this report pursuant to the rules of the Securities and Exchange Commission.\nWe are a self-administered Maryland real estate investment trust that was organized in May 1998 and completed our initial public offering in January 1999. Our common shares are traded on the New York Stock Exchange (the “NYSE”) under the symbol “HT.” We own our hotels and our investments in joint ventures through our operating partnership, Hersha Hospitality Limited Partnership (“HHLP” or “the Partnership”), for which we serve as the sole general partner. As of June 30, 2021, we owned an approximate 86.8 % partnership interest in HHLP, including a 1.0 % general partnership interest.\nPrinciples of Consolidation and Presentation\nThe accompanying consolidated financial statements have been prepared in accordance with US GAAP and include all of our accounts as well as accounts of the Partnership, subsidiary partnerships and our wholly owned Taxable REIT Subsidiary Lessee (“TRS Lessee”), 44 New England Management Company. All significant inter-company amounts have been eliminated.\nConsolidated properties are either wholly owned or owned less than 100% by the Partnership and are controlled by the Company as general partner of the Partnership. Properties owned in joint ventures are also consolidated if the determination is made that we are the primary beneficiary in a variable interest entity (“VIE”) or we maintain control of the asset through our voting interest in the entity.\nVariable Interest Entities\nWe evaluate each of our investments and contractual relationships to determine whether they meet the guidelines for consolidation. To determine if we are the primary beneficiary of a VIE, we evaluate whether we have a controlling financial interest in that VIE. An enterprise is deemed to have a controlling financial interest if it has i) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance, and ii) the obligation to absorb losses of the VIE that could be significant to the VIE or the rights to receive benefits from the VIE that could be significant to the VIE. Control can also be demonstrated by the ability of a member to manage day-to-day operations, refinance debt and sell the assets of the partnerships without the consent of the other member and the inability of the members to replace the managing member. Based on our examination, there have been no changes to the operating structure of our legal entities during the three and six months ended June 30, 2021 and, therefore, there are no changes to our evaluation of VIE's as presented within our annual report presented on Form 10-K for the year ended December 31, 2020.\n14\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nNoncontrolling Interest\nWe classify the noncontrolling interests of our common units of limited partnership interest in HHLP (“Common Units”), and Long Term Incentive Plan Units (“LTIP Units”) as equity. LTIP Units are a separate class of limited partnership interest in the Operating Partnership that are convertible into Common Units under certain circumstances. The noncontrolling interest of Common Units and LTIP Units totaled $ 48,672 as of June 30, 2021 and $ 49,246 as of December 31, 2020. As of June 30, 2021, there were 5,962,491 Common Units and LTIP Units outstanding with a fair market value of $ 64,156 , based on the price per share of our common shares on the NYSE on such date. In accordance with the partnership agreement of HHLP, holders of these Common Units may redeem them for cash unless we, in our sole and absolute discretion, elect to issue common shares on a one -for-one basis in lieu of paying cash.\nNet income or loss attributed to Common Units and LTIP Units is included in net income or loss but excluded from net income or loss applicable to common shareholders in the consolidated statements of operations.\nWe are party to a joint venture that owns the Ritz-Carlton Coconut Grove, FL, in which our joint venture partner has a noncontrolling equity interest of 15 % in the property. Hersha Holding RC Owner, LLC, the owner entity of the Ritz-Carlton Coconut Grove joint venture (\"Ritz Coconut Grove\"), will distribute income based on cash available for distribution which will be distributed as follows: (1) to us until we receive a cumulative return on our contributed senior common equity interest, currently at 8 %, and (2) then to the owner of the noncontrolling interest until they receive a cumulative return on their contributed junior common equity interest, currently at 8 %, and (3) then 75 % to us and 25 % to the owner of the noncontrolling interest until we both receive a cumulative return on our contributed senior common equity interest, currently at 12 %, and (4) finally, any remaining operating profit shall be distributed 70 % to us and 30 % to the owner of the noncontrolling interest. Additionally, the noncontrolling interest in the Ritz Coconut Grove has the right to put their ownership interest to us for cash consideration at any time during the life of the venture. The balance sheets and financial results of the Ritz Coconut Grove are included in our consolidated financial statements and book value of the noncontrolling interest in the Ritz Coconut Grove is classified as temporary equity within our Consolidated Balance Sheets. The noncontrolling interest in the Ritz Coconut Grove is measured at the greater of historical cost or the put option redemption value. For the three and six months ended June 30, 2021, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated losses of $ 0 and $ 158 , respectively. For the three and six months ended June 30, 2020, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated loss of $ 0 . This is recorded as part of the Loss Allocated to Noncontrolling Interests line item within the Consolidated Statements of Operations. On June 30, 2021, we reclassified $ 1,968 from Additional Paid in Capital to Redeemable Noncontrolling Interests - Consolidated Joint Venture to value the noncontrolling interest at the put option redemption value of $ 1,968 .\nShareholders’ Equity\n| Dividend Per Share (1) |\n| Shares Outstanding | Six Months Ended June 30, |\n| Series | June 30, 2021 | December 31, 2020 | Aggregate Liquidation Preference | Distribution Rate | 2021 | 2020 |\n| Series C | 3,000,000 | 3,000,000 | $ | 75,000 | 6.875 | % | $ | 2.5782 | $ | — |\n| Series D | 7,701,700 | 7,701,700 | $ | 192,500 | 6.500 | % | $ | 2.4378 | $ | — |\n| Series E | 4,001,514 | 4,001,514 | $ | 100,000 | 6.500 | % | $ | 2.4378 | $ | — |\n| Total | 14,703,214 | 14,703,214 |\n\n15\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\n(1) During the six months ended June 30, 2020, we suspended the payment of our preferred dividends. During the six months ended June 30, 2021, the Company paid cash dividends on the Company's Series C, Series D and Series E cumulative redeemable preferred stock reflecting accrued and unpaid dividends for the dividend periods ended April 15, 2020, July 15, 2020, October 15, 2020 and January 15, 2021. In addition, the Company paid a cash dividend on all Series of cumulative redeemable preferred stock for the first dividend period ending April 15, 2021 and declared a similar cash dividend for the second dividend period ending July 15, 2021, which is payable July 15, 2021 to holders of record as of July 1, 2021.\nLiquidity and Management's Plan\nDue to the COVID-19 pandemic and the effects of travel restrictions both globally and in the United States, the hospitality industry has experienced drastic drops in demand. The global impact of the pandemic has been rapidly evolving and, in the United States, certain states and cities, including most of the states and cities where we own properties, have reacted by instituting various restrictive measures such as quarantines, restrictions on travel, school closings, \"stay at home\" rules and restrictions on types of business that may continue to operate. We believe the ongoing effects of the COVID-19 pandemic on our operations have had, and will continue to have a material negative impact on our financial results and liquidity, and such negative impact may continue beyond the containment of the pandemic.\nIn February of 2021, we entered into an unsecured notes facility that provided net proceeds of $ 144,750 and access to an incremental $ 50,000 , which can be drawn through September 30, 2021. The initial net proceeds of $ 144,750 provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our senior secured credit facility and our two secured term loans and allowed us to negotiate amendments to this senior facility. The amendments to the senior secured credit facility and two secured term loans eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company's preferred dividends, allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity to be used at the Company's discretion.\nWe cannot assure you that our assumptions used to estimate our liquidity requirements will be correct because the lodging industry has not previously experienced such an abrupt and drastic reduction in hotel demand, and as a consequence, our ability to be predictive is uncertain. In addition, the magnitude, duration, and speed of the pandemic is uncertain and we cannot estimate when travel demand will recover. Based on the amendments, the Company believes that it has sufficient liquidity to meet its obligations for the next twelve months.\nInvestment in Hotel Properties\nInvestments in hotel properties are recorded at cost. Improvements and replacements are capitalized when they extend the useful life of the asset. Costs of repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful life of up to 40 years for buildings and improvements, two to seven years for furniture, fixtures and equipment. We are required to make subjective assessments as to the useful lives of our properties for purposes of determining the amount of depreciation to record on an annual basis with respect to our investments in hotel properties. These assessments have a direct impact on our net income because if we were to shorten the expected useful lives of our investments in hotel properties we would depreciate these investments over fewer years, resulting in more depreciation expense and lower net income on an annual basis.\nIdentifiable assets, liabilities, and noncontrolling interests related to hotel properties acquired are recorded at fair value. Estimating techniques and assumptions used in determining fair values involve significant estimates and judgments. These estimates and judgments have a direct impact on the carrying value of our assets and liabilities which can directly impact the amount of depreciation expense recorded on an annual basis and could have an impact on our assessment of potential impairment of our investment in hotel properties.\nWe consider a hotel to be held for sale when management and our independent trustees commit to a plan to sell the property, the property is available for sale, management engages in an active program to locate a buyer for the property and it is probable the sale will be completed within a year of the initiation of the plan to sell. We evaluate each disposition to determine whether we need to classify the disposition as discontinued operations. We generally include the operations of a hotel that was sold or a hotel that has been classified as held for sale in continuing operations unless the sale represents a strategic shift that will have a major impact on our future operations and financial results. We anticipate that most of our hotel dispositions will not be classified as discontinued operations as most will not fit this definition.\n16\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nBased on the occurrence of certain events or changes in circumstances, we review the recoverability of the property’s carrying value. Such events or changes in circumstances include the following:\n•a significant decrease in the market price of a long-lived asset;\n•a significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition;\n•a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator;\n•an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset;\n•a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset; and\n•a current expectation that, it is more likely than not that, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.\nWe review our portfolio on an ongoing basis to evaluate the existence of any of the aforementioned events or changes in circumstances that would require us to test for recoverability. In general, our review of recoverability is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as expected future operating income, market and other applicable trends and residual value expected, as well as the effects of hotel demand, competition and other factors. Other assumptions used in the review of recoverability include the holding period and expected terminal capitalization rate. If impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property. We are required to make subjective assessments as to whether there are impairments in the values of our investments in hotel properties.\nAs of June 30, 2021, based on our analysis, we have determined that the estimated future cash flow of each of the properties in our portfolio is sufficient to recover its respective carrying value, after recording an impairment charge prior to the disposition of the Duane Street hotel.\n17\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\nNew Accounting Pronouncements\nIn March 2020, the Financial Accounting Standards Board (\"FASB\") issued ASU No. 2020-4, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting and in January 2021, the FASB issued 2021-01, Reference Rate Reform (Topic 848), Scope, which further clarified the scope of the reference rate reform optional practical expedients and exceptions outlined in Topic 848. As a result of identified structural risks of interbank offered rates, in particular, the London Interbank Offered Rate (LIBOR), reference rate reform is underway to identify alternative reference rates that are more observable or transaction based. The update provides guidance in accounting for changes in contracts, hedging relationships, and other transactions as a result of this reference rate reform. The optional expedients and exceptions contained within these updates, in general, only apply to contract amendments and modifications entered into prior to January 1, 2023. The provisions of these updates that will most likely affect our financial reporting process related to modifications of contracts with lenders and the related hedging contracts associated with each respective modified borrowing contract. In general, the provisions of these updates would impact the Company by allowing, among other things, the following:\n•Allowing modifications of debt contracts with lenders that fall under the guidance of ASC Topic 470 to be accounted for as a non-substantial modification and not be considered a debt extinguishment.\n•Allowing a change to contractual terms of a hedging instrument in conjunction with reference rate reform to not require a dedesignation of the hedging relationship.\n•Allowing a change to the interest rate used for margining, discounting, or contract price alignment for a derivative that is a cash flow hedge to not be considered a change to the critical terms of the hedge and will not require a dedesignation of the hedging relationship.\nWe have not entered into any contract modifications yet, as it directly relates to reference rate reform but we anticipate having to undertake such modifications in the future as a majority of our contracts with lenders and hedging counterparties are indexed to LIBOR. While we anticipate the impact of this update to be to the benefit of the Company, we are still evaluating the overall impact to the Company.\n18\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 - INVESTMENT IN HOTEL PROPERTIES\nInvestment in hotel properties consists of the following at June 30, 2021 and December 31, 2020:\n\n| June 30, 2021 | December 31, 2020 |\n| Land | $ | 478,413 | $ | 488,463 |\n| Buildings and Improvements | 1,557,840 | 1,611,144 |\n| Furniture, Fixtures and Equipment | 271,977 | 281,440 |\n| Construction in Progress | 1,489 | 987 |\n| 2,309,719 | 2,382,034 |\n| Less Accumulated Depreciation | ( 610,489 ) | ( 597,196 ) |\n| Total Investment in Hotel Properties * | $ | 1,699,230 | $ | 1,784,838 |\n\n* The net book value of investment in hotel property at Ritz Coconut Grove, which is a variable interest entity, is $ 40,937 and $ 42,487 at June 30, 2021 and December 31, 2020, respectively.\nAcquisitions\nFor the six months ended June 30, 2021 and 2020, we acquired no hotel properties.\nHotel Dispositions\nFor the six months ended June 30, 2020, we had no hotel dispositions. During the six months ended June 30, 2021, we had the following hotel dispositions:\n| Hotel | AcquisitionDate | DispositionDate | Consideration | Gain onDisposition |\n| Courtyard San Diego, CA | 05/30/2013 | 02/19/2021 | $ | 64,500 | $ | 5,037 |\n| The Capitol Hill Hotel Washington, DC | 04/15/2011 | 03/09/2021 | 51,000 | 12,990 |\n| Holiday Inn Express Cambridge, MA | 05/03/2006 | 03/09/2021 | 32,000 | 20,281 |\n| Residence Inn Miami Coconut Grove, FL | 06/12/2013 | 03/10/2021 | 31,000 | 10,005 |\n| Duane Street Hotel (1) | 01/04/2008 | 05/13/2021 | 18,000 | — |\n| 2021 Total | $ | 48,313 |\n\n(1)During the second quarter of 2020, the Company determined that the carrying value of the Duane Street hotel exceeded the anticipated net proceeds from sale, resulting in a $ 1,069 impairment charge recorded during the second quarter of 2020. We recorded an additional impairment charge of $ 147 prior to the disposition of the hotel property during the six months ended June 30, 2021.\n19\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 – INVESTMENT IN HOTEL PROPERTIES (CONTINUED)\nAssets Held For Sale\nWe classified the assets of the Duane Street Hotel, the Residence Inn Coconut Grove and the Courtyard San Diego as held for sale as of December 31, 2020, all of which closed during the six months ended June 30, 2021.\nThe table below shows the balances for the properties that were classified as assets held for sale as of December 31, 2020:\n| December 31, 2020 |\n| Land | $ | 28,015 |\n| Buildings and Improvements | 93,314 |\n| Furniture, Fixtures and Equipment | 15,469 |\n| 136,798 |\n| Less Accumulated Depreciation | ( 40,578 ) |\n| Assets Held for Sale | $ | 96,220 |\n\n20\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES\nAs of June 30, 2021 and December 31, 2020, our investment in unconsolidated joint ventures consisted of the following:\n\n| Joint Venture | Hotel Properties | Percent Owned | June 30, 2021 | December 31, 2020 |\n| Cindat Hersha Owner JV, LLC | Hilton and IHG branded hotels in NYC | 31.2 | % | * | $ | — | $ | — |\n| Hiren Boston, LLC | Courtyard by Marriott, South Boston, MA | 50 | % | 29 | 219 |\n| SB Partners, LLC | Holiday Inn Express, South Boston, MA | 50 | % | — | — |\n| SB Partners Three, LLC | Home2 Suites, South Boston, MA | 50 | % | 5,907 | 6,414 |\n| $ | 5,936 | $ | 6,633 |\n\n*On February 7, 2021, all of the assets of the properties owned by this joint venture were transferred to the mezzanine lender of Cindat Hersha Owner JV, LLC. As a result, upon dissolution of the venture, we will no longer maintain an interest in this venture.\nIncome/Loss Allocation\nPrior to February 7, 2021, based on the income allocation methodology within Cindat Hersha Owner JV, LLC, the Company had absorbed cumulative losses equal to our accounting basis in the joint venture resulting in a $ 0 investment balance in the table above as of December 31, 2020, however, we maintained a positive equity balance within the venture. This difference is due to the difference in our basis inside the venture versus our basis outside of the venture, which is explained later in this note.\nFor SB Partners, LLC, Hiren Boston, LLC, and SB Partners Three, LLC, income or loss is allocated to us and our joint venture partners consistent with the allocation of cash distributions in accordance with the joint venture agreements. This results in an income allocation consistent with our percentage of ownership interests.\nAny difference between the carrying amount of any of our investments noted above and the underlying equity in net assets is amortized over the expected useful lives of the properties and other intangible assets.\n21\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\nLoss recognized during the three and six months ended June 30, 2021 and 2020, for our investments in unconsolidated joint ventures is as follows:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Hiren Boston, LLC | $ | ( 354 ) | $ | ( 477 ) | $ | ( 689 ) | $ | ( 880 ) |\n| SB Partners, LLC | ( 50 ) | — | ( 50 ) | ( 600 ) |\n| SB Partners Three, LLC | ( 185 ) | ( 25 ) | ( 508 ) | ( 40 ) |\n| Loss from Unconsolidated Joint Venture Investments | $ | ( 589 ) | $ | ( 502 ) | $ | ( 1,247 ) | $ | ( 1,520 ) |\n\nThe following tables set forth the total assets, liabilities, equity and components of net income or loss, including the Company’s share, related to the unconsolidated joint ventures discussed above as of June 30, 2021 and December 31, 2020 and for the three and six months ended June 30, 2021 and 2020.\nBalance Sheets\n\n| June 30, 2021 | December 31, 2020 |\n| Assets |\n| Investment in Hotel Properties, Net | $ | 65,956 | $ | 581,452 |\n| Other Assets | 14,126 | 32,048 |\n| Total Assets | $ | 80,082 | $ | 613,500 |\n| Liabilities and Equity |\n| Mortgages and Notes Payable | $ | 65,457 | $ | 452,284 |\n| Other Liabilities | 14,939 | 42,197 |\n| Equity: |\n| Hersha Hospitality Trust | 4,099 | 5,699 |\n| Joint Venture Partner(s) | ( 4,413 ) | 113,452 |\n| Accumulated Other Comprehensive Loss | — | ( 132 ) |\n| Total Equity | ( 314 ) | 119,019 |\n| Total Liabilities and Equity | $ | 80,082 | $ | 613,500 |\n\n22\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\nStatements of Operations\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Room Revenue | $ | 1,888 | $ | 5,588 | $ | 4,143 | $ | 16,932 |\n| Other Revenue | 125 | — | 242 | 787 |\n| Operating Expenses | ( 1,205 ) | ( 3,265 ) | ( 3,015 ) | ( 11,613 ) |\n| Lease Expense | ( 245 ) | ( 170 ) | ( 516 ) | ( 354 ) |\n| Property Taxes and Insurance | ( 382 ) | ( 3,154 ) | ( 1,948 ) | ( 6,438 ) |\n| General and Administrative | ( 26 ) | ( 553 ) | ( 247 ) | ( 1,516 ) |\n| Depreciation and Amortization | ( 1,300 ) | ( 3,925 ) | ( 3,612 ) | ( 7,840 ) |\n| Interest Expense | ( 642 ) | ( 5,582 ) | ( 3,334 ) | ( 11,869 ) |\n| Loss on Dissolution of Joint Venture | — | — | ( 112,429 ) | — |\n| Net Loss | $ | ( 1,787 ) | $ | ( 11,061 ) | $ | ( 120,716 ) | $ | ( 21,911 ) |\n\nThe following table is a reconciliation of our share in the unconsolidated joint ventures’ equity to our investment in the unconsolidated joint ventures as presented on our balance sheets as of June 30, 2021 and December 31, 2020.\n| June 30, 2021 | December 31, 2020 |\n| Our share of equity recorded on the joint ventures' financial statements | $ | 4,099 | $ | 5,699 |\n| Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures(1) | 1,837 | 934 |\n| Investment in Unconsolidated Joint Ventures | $ | 5,936 | $ | 6,633 |\n\n(1) Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures consists of the following:\n•the difference between our basis in the investment in joint ventures and the equity recorded on the joint ventures' financial statements;\n•accumulated amortization of our equity in joint ventures that reflects the difference in our portion of the fair value of joint ventures' assets on the date of our investment when compared to the carrying value of the assets recorded on the joint ventures’ financial statements (this excess or deficit investment is amortized over the life of the properties, and the amortization is included in Income (Loss) from Unconsolidated Joint Venture Investments on our consolidated statement of operations); and\n• cumulative impairment of our investment in joint ventures not reflected on the joint ventures' financial statements, if any.\n23\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 4 - OTHER ASSETS\nOther Assets\nOther Assets consisted of the following at June 30, 2021 and December 31, 2020:\n| June 30, 2021 | December 31, 2020 |\n| Deferred Financing Costs | $ | 1,783 | $ | 2,395 |\n| Prepaid Expenses | 9,540 | 5,692 |\n| Investment in Statutory Trusts | 1,548 | 1,548 |\n| Investment in Non-Hotel Property and Inventories | 2,318 | 2,443 |\n| Deposits with Unaffiliated Third Parties | 2,456 | 2,561 |\n| Deferred Tax Asset, Net of Valuation Allowance of $ 23,438 and $ 23,591 , respectively | 499 | — |\n| Other | 2,251 | 855 |\n| $ | 20,395 | $ | 15,494 |\n\nDeferred Financing Costs – This category represents financing costs paid by the Company to establish our Line of Credit. These costs have been capitalized and will amortize to interest expense over the term of the Line of Credit.\nPrepaid Expenses – Prepaid expenses include amounts paid for property tax, insurance and other expenditures that will be expensed in the next twelve months.\nInvestment in Statutory Trusts – We have an investment in the common stock of Hersha Statutory Trust I and Hersha Statutory Trust II.\nInvestment in Non-Hotel Property and Inventories – This category represents the costs paid and capitalized by the Company for items such as office leasehold improvements, furniture and equipment, and property inventories.\nDeposits with Unaffiliated Third Parties – These deposits represent deposits made by the Company with unaffiliated third parties for items such as lease security deposits, utility deposits, and deposits with unaffiliated third party management companies.\nDeferred Tax Asset – We have recorded a valuation allowance resulting in net deferred tax assets of $ 499 as of June 30, 2021. We have considered various factors, including future reversals of existing taxable temporary differences, future projected taxable income and tax planning strategies in determining a valuation allowance for our deferred tax assets, and we believe that it is more likely than not that we will not be able to realize the net deferred tax assets in the future, and a valuation allowance for the entire deferred tax asset has been recorded, with the exception of a city net operating loss that we believe that we will be able to realize.\n24\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT\nMortgages\nMortgages payable at June 30, 2021 and December 31, 2020 consisted of the following:\n| June 30, 2021 | December 31, 2020 |\n| Mortgage Indebtedness | $ | 305,911 | $ | 332,264 |\n| Net Unamortized Premium | 127 | 354 |\n| Net Unamortized Deferred Financing Costs | ( 1,612 ) | ( 1,770 ) |\n| Mortgages Payable | $ | 304,426 | $ | 330,848 |\n\nNet Unamortized Deferred Financing Costs associated with entering into mortgage indebtedness are deferred and amortized over the life of the mortgages. Net Unamortized Premiums are also amortized over the remaining life of the loans. Mortgage indebtedness balances are subject to fixed and variable interest rates, which ranged from 2.75 % to 6.30 % as of June 30, 2021.\nOur mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, non-recourse financing arrangements. Our mortgage loans typically require that specified debt service coverage ratios be maintained with respect to the financed properties before we can exercise certain rights under the loan agreements relating to such properties. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. We have determined that all debt covenants contained in the loan agreements securing our consolidated hotel properties with the exception of two mortgages were met as of June 30, 2021.\nDuring the six months ended June 30, 2021, we refinanced the outstanding mortgages secured by the Hilton Garden Inn 52nd Street, the Courtyard Los Angeles Westside, the Hilton Garden Inn Tribeca, and the Hyatt Union Square, which resulted in $ 90 of debt modification expense.\nAs of June 30, 2021, the maturity dates for the outstanding mortgage loans ranged from September 2021 to September 2025. One mortgage with a total principal balance of $ 21,663 will mature within the next twelve months. We are in active discussions with lenders to refinance this mortgage with property level debt prior to its maturity.\n25\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nCredit Facilities\nWe maintain three secured credit arrangements which aggregate to $ 747,481 with Citigroup Global Markets Inc., Wells Fargo Bank, Inc. and various other lenders. Our credit agreement (the \"Credit Agreement\") provides for a $ 442,404 senior secured credit facility (“Credit Facility”). The Credit Facility consists of a $ 250,000 senior secured revolving line of credit (“Line of Credit”) and a $ 192,404 senior secured term loan (\"First Term Loan\"), and expires on August 10, 2022.\nWe maintain another credit agreement which provides for a $ 278,846 senior secured term loan agreement (“Second Term Loan”) and expires on September 10, 2024.\nA separate credit agreement provides for a $ 26,231 senior secured term loan agreement (“Third Term Loan” and collectively with the Credit Agreement and the Second Term Loan, the \"Credit Agreements\") and expires on August 10, 2022. Management intends to explore options including, but not limited to, additional asset sales, the refinancing of debt and the offering of equity or equity-linked securities prior to the maturity of the First Term Loan and the Third Term Loan on August 10, 2022.\nOn February 17, 2021, the Company signed amendments to the Credit Agreements which resulted in debt extinguishment expense $2,977. Debt extinguishment expense consists of $ 635 of debt extinguishment losses and $ 2,342 of debt modification losses. The signed amendments to the Credit Agreements, among other things, provide for:\n•an extension of the maturity date of the Third Term Loan to August 10, 2022;\n•a limited waiver of financial covenants through March 31, 2022; and\n•the ability to borrow up to $ 174,729 , inclusive of amounts already outstanding, under the Line of Credit, the proceeds of which may only be used to fund certain costs and expenses.\nCertain conditions, such as minimum liquid assets in an aggregate amount of at least $ 30,000 , and certain negative covenants and restrictions that are considered normal and customary, must be met on a recurring basis as outlined within the amendments.\nThe amendments to the Credit Agreements make certain other amendments to financial covenants in place beginning in the second quarter of 2022:\n•a fixed charge coverage ratio of not less than 1.20 to 1.00 (was 1.50 to 1.00);\n•a maximum leverage ratio of not more than 65 % (was 60 %); and\n•a new financial covenant that requires the borrowing base leverage ratio to not exceed 60 % at any time.\nThe amount that we can borrow at any given time under our Line of Credit, and the individual term loans (each a “Term Loan” and together the “Term Loans”) is governed by certain operating metrics of designated hotel properties known as borrowing base assets. As of June 30, 2021, the following hotel properties secured the amended facilities under the Credit Agreements:\n26\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\n| - Courtyard by Marriott Brookline, Brookline, MA | - Hampton Inn, Washington, DC |\n| - The Envoy Boston Seaport, Boston, MA | - Ritz-Carlton Georgetown, Washington, DC |\n| - The Boxer, Boston, MA | - Hilton Garden Inn, M Street, Washington, DC |\n| - Hampton Inn Seaport, Seaport, New York, NY | - The Winter Haven Hotel Miami Beach, Miami, FL |\n| - Holiday Inn Express Chelsea, 29th Street, New York, NY | - The Blue Moon Hotel Miami Beach, Miami, FL |\n| - Gate Hotel JFK Airport, New York, NY | - Cadillac Hotel & Beach Club, Miami, FL |\n| - Hilton Garden Inn JFK Airport, New York, NY | - The Parrot Key Hotel & Villas, Key West, FL |\n| - NU Hotel, Brooklyn, New York, NY | - TownePlace Suites, Sunnyvale, CA |\n| - Hyatt House White Plains, White Plains, NY | - The Ambrose Hotel, Santa Monica, CA |\n| - Hampton Inn Center City/ Convention Center, Philadelphia, PA | - The Pan Pacific Hotel Seattle, Seattle, WA |\n| - The Rittenhouse, Philadelphia, PA | - Mystic Marriott Hotel & Spa, Groton, CT |\n| - Philadelphia Westin, Philadelphia, PA |\n\nThe interest rate for borrowings under the Line of Credit and Term Loans are based on a pricing grid with a range of one month U.S. LIBOR plus a spread. The following table summarizes the balances outstanding and interest rate spread for each borrowing:\n| Outstanding Balance |\n| Borrowing | Spread | June 30, 2021 | December 31, 2020 |\n| Line of Credit | 1.50 % to 2.25 % | $ | 118,684 | $ | 133,053 |\n| Term Loans: |\n| First Term Loan | 1.45 % to 2.20 % | $ | 192,404 | $ | 202,158 |\n| Second Term Loan | 1.35 % to 2.00 % | 278,846 | 292,983 |\n| Third Term Loan | 1.45 % to 2.20 % | 26,231 | 189,365 |\n| Deferred Loan Costs | ( 1,824 ) | ( 2,762 ) |\n| Total Term Loans | $ | 495,657 | $ | 681,744 |\n\nPrior to the amendments noted above, the Credit Agreements included certain financial covenants and required that we maintain: (1) a minimum tangible net worth (calculated as total assets, plus accumulated depreciation, less total liabilities, intangibles and other defined adjustments) of $ 1,119,500 , plus an amount equal to 75 % of the net cash proceeds of all issuances and primary sales of equity interests of the parent guarantor or any of its subsidiaries consummated following the closing date; (2) annual distributions not to exceed 95 % of adjusted funds from operations; and (3) certain financial ratios, including the following:\n•a fixed charge coverage ratio of not less than 1.50 to 1.00;\n•a maximum leverage ratio of not more than 60 %; and\n•a maximum secured debt leverage ratio of 45 %.\nThe weighted average interest rate, inclusive of the effect of derivative instruments, on the Credit Agreements was 3.92 % and 4.23 %, and 3.73 % and 4.21 %, for the three and six months ended June 30, 2021 and 2020, respectively.\n27\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nNotes Payable\nNotes payable at June 30, 2021 and December 31, 2020 consisted of the following:\n| June 30, 2021 | December 31, 2020 |\n| Notes Payable | $ | 204,062 | $ | 51,548 |\n| Net Unamortized Discount | ( 4,899 ) | — |\n| Net Unamortized Deferred Financing Costs | ( 5,438 ) | ( 759 ) |\n| Notes Payable | $ | 193,725 | $ | 50,789 |\n\nStatutory Trust I and Statutory Trust II Notes Payable\nWe have two junior subordinated notes payable in the aggregate amount of $ 51,548 related to the Hersha Statutory Trusts pursuant to indenture agreements which will mature on July 30, 2035, but may be redeemed at our option, in whole or in part, prior to maturity in accordance with the provisions of the indenture agreements. The $ 25,774 of notes issued to each of Hersha Statutory Trust I and Hersha Statutory Trust II bear interest at a variable rate of LIBOR plus 3 % per annum. This rate resets 2 business days prior to each quarterly payment. The related deferred financing costs are amortized over the life of the notes payable. The weighted average interest rate on our two junior subordinated notes payable was 3.19 % and 4.08 % for the three months ended June 30, 2021 and 2020, respectively, and 3.20 % and 4.45 % for the six months ended June 30, 2021 and 2020, respectively.\nJunior Notes Payable\nOn February 17, 2021, the Company entered into a note purchase agreement (the “Purchase Agreement”) with several purchasers (the “Purchasers”). The Company agreed to issue and sell to the Purchasers an initial $ 150,000 aggregate principal amount (the “Initial Notes”) of the Company’s 9.50 % Unsecured PIK Toggle Notes due 2026 (the “Notes”), and an incremental $ 50,000 aggregate principal amount of the Notes that can be drawn at the Company’s discretion, subject to certain conditions, in minimum installments of $ 25,000 on or prior to September 30, 2021.\nThe Initial Notes were issued on February 23, 2021. The Notes will mature on February 23, 2026. The Notes bear interest at a rate of 9.50 % per year, payable in arrears on June 30, September 30, December 31 and March 31 of each year, beginning on June 30, 2021. For any interest period ending on or prior to March 31, 2022, the Issuer, in its sole discretion may elect to pay interest (a) in cash at a rate per annum equal to 4.75 % per annum, and (b) in kind at a rate per annum equal to 4.75 % per annum (“PIK Interest”). Any PIK Interest will be paid by increasing the principal amount of the Notes at the end of the applicable interest period by the amount of such PIK Interest. We elected the PIK Interest option for the interest period ended June 30, 2021, increasing the principal balance $ 2,514 to $ 152,514 as of June 30, 2021.\nThe Notes may not be redeemed prior to February 23, 2022. The notes may be redeemed during the 12 month period beginning February 23, 2022 and the 12 month period beginning February 23, 2023, at a redemption price equal to 104 % and 102 % of the principal amount of the Notes being redeemed, respectively. After February 23, 2024, the notes may be redeemed at the principal amount.\nThe Notes are subject to representations, warranties, covenants, terms and conditions customary for transactions of this type, including limitations on liens, incurrence of new debt, investments, mergers and asset dispositions, covenants to preserve corporate existence and comply with laws and default provisions.\nThe Company may only use the net proceeds from the issuance of the Notes in accordance with the mandatory prepayment waterfalls, which includes the repayment of outstanding borrowings under the Credit Agreement and use for certain other general corporate purposes.\n28\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\nInterest Expense\nThe table below shows the interest expense incurred by the Company during the three and six months ended June 30, 2021 and 2020:\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Mortgage Loans Payable | $ | 2,680 | $ | 3,031 | $ | 5,415 | $ | 6,516 |\n| Interest Rate Swap Contracts on Mortgages | 627 | 552 | 1,230 | 585 |\n| Unsecured Notes Payable | 4,311 | 532 | 6,248 | 1,160 |\n| Credit Facility and Term Loans | 3,754 | 5,370 | 8,122 | 12,404 |\n| Interest Rate Swap Contracts on Credit Agreements | 2,417 | 3,133 | 4,841 | 4,219 |\n| Deferred Financing Costs Amortization | 1,088 | 702 | 2,380 | 1,267 |\n| Other | 105 | 161 | 175 | 337 |\n| Total Interest Expense | $ | 14,982 | $ | 13,481 | $ | 28,411 | $ | 26,488 |\n\n29\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 6 – LEASES\nWe own five hotels within our consolidated portfolio of hotels where we do not own the land on which the hotels reside, rather we lease the land from an unrelated third-party lessor. All of our land leases are classified as operating leases and have initial terms with extension options that range from May 2062 to October 2103. We also have two additional office space leases with terms ranging from March 2023 to December 2027.\nThe components of lease costs for the three months ended June 30, 2021 and 2020 were as follows:\n| Three Months Ended June 30, 2021 | Three Months Ended June 30, 2020 |\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\n| Operating lease costs | $ | 1,050 | $ | 121 | $ | 1,171 | $ | 1,050 | $ | 121 | $ | 1,171 |\n| Variable lease costs | 14 | 83 | 97 | 8 | 87 | 95 |\n| Total lease costs | $ | 1,064 | $ | 204 | $ | 1,268 | $ | 1,058 | $ | 208 | $ | 1,266 |\n\nThe components of lease costs for the six months ended June 30, 2021 and 2020 were as follows:\n| Six months ended June 30, 2021 | Six months ended June 30, 2020 |\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\n| Operating lease costs | $ | 2,126 | $ | 242 | $ | 2,368 | $ | 2,100 | $ | 242 | $ | 2,342 |\n| Variable lease costs | 38 | 167 | 205 | 21 | 154 | 175 |\n| Total lease costs | $ | 2,164 | $ | 409 | $ | 2,573 | $ | 2,121 | $ | 396 | $ | 2,517 |\n\nOther information related to leases as of and for the six months ended June 30, 2021 and 2020 is as follows:\n| June 30, 2021 | June 30, 2020 |\n| Cash paid from operating cash flow for operating leases | $ | 2,246 | $ | 1,951 |\n| Weighted average remaining lease term | 64.2 | 64.2 |\n| Weighted average discount rate | 7.87 | % | 7.86 | % |\n\n30\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS\nManagement Agreements\nOur wholly-owned TRS, 44 New England Management Company, and certain of our joint venture entities engage eligible independent contractors in accordance with the requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended, including Hersha Hospitality Management Limited Partnership (“HHMLP”), as the property managers for hotels it leases from us pursuant to management agreements. HHMLP is owned, in part, by certain executives and trustees of the Company. Our management agreements with HHMLP provide for a term of five years and are subject to early termination upon the occurrence of defaults and certain other events described therein. As required under the REIT qualification rules, HHMLP must qualify as an “eligible independent contractor” during the term of the management agreements. Under the management agreements, HHMLP generally pays the operating expenses of our hotels. All operating expenses or other expenses incurred by HHMLP in performing its authorized duties are reimbursed or borne by our TRS to the extent the operating expenses or other expenses are incurred within the limits of the applicable approved hotel operating budget. HHMLP is not obligated to advance any of its own funds for operating expenses of a hotel or to incur any liability in connection with operating a hotel. Management agreements with other unaffiliated hotel management companies have similar terms.\nFor its services, HHMLP receives a base management fee and, if a hotel exceeds certain thresholds, an incentive management fee. The base management fee for a hotel is due monthly and is equal to 3 % of gross revenues associated with each hotel managed for the related month. The incentive management fee, if any, for a hotel is due annually in arrears on the ninetieth day following the end of each fiscal year and is based upon the financial performance of the hotels. For the three and six months ended June 30, 2021 and 2020, base management fees incurred to HHMLP totaled $ 1,745 and $ 564 , and $ 2,925 and $ 2,933 , respectively, and are recorded as Hotel Operating Expenses. For the three and six months ended June 30, 2021 and 2020, we did no t incur incentive management fees.\nFranchise Agreements\nOur branded hotel properties are operated under franchise agreements assumed by the hotel property lessee. The franchise agreements have 10 to 20 year terms, but may be terminated by either the franchisee or franchisor on certain anniversary dates specified in the agreements. The franchise agreements require annual payments for franchise royalties, reservation, and advertising services, and such payments are based upon percentages of gross room revenue. These payments are paid by the hotels and charged to expense as incurred. Franchise fee expenses for the three and six months ended June 30, 2021 and 2020 were $ 2,465 and $ 775 , and $ 4,287 and $ 4,603 , respectively, and are recorded in Hotel Operating Expenses. The initial fees incurred to enter into the franchise agreements are amortized over the life of the franchise agreements.\nAccounting and Information Technology Fees\nEach of the wholly-owned hotels and consolidated joint venture hotel properties managed by HHMLP incurs a monthly accounting and information technology fee. Monthly fees for accounting services are between $ 2 and $ 3 per property and monthly information technology fees range from $ 1 to $ 2 per property. For the three and six months ended June 30, 2021 and 2020, the Company incurred accounting fees of $ 277 and $ 319 , and $ 590 and $ 644 , respectively. For the three and six months ended June 30, 2021 and 2020, the Company incurred information technology fees of $ 90 and $ 103 , and $ 191 and $ 208 , respectively. Accounting fees and information technology fees are included in Hotel Operating Expenses.\nCapital Expenditure Fees\nHHMLP charges a 5 % fee on certain capital expenditures and pending renovation projects at the properties as compensation for procurement services related to capital expenditures and for project management of renovation projects. For the three and six months ended June 30, 2021 and 2020, we incurred fees of $ 78 and $ 56 , and $ 197 and $ 956 , respectively, which were capitalized with the cost of capital expenditures.\n31\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS (CONTINUED)\nAcquisitions from Affiliates\nWe have entered into an option agreement with certain of our officers and trustees such that we obtain a right of first refusal to purchase any hotel owned or developed in the future by these individuals or entities controlled by them at fair market value. This right of first refusal would apply to each party until one year after such party ceases to be an officer or trustee of the Company. Our Acquisition Committee of the Board of Trustees is comprised solely of independent trustees, and the purchase prices and all material terms of the purchase of hotels from related parties are approved by the Acquisition Committee.\nHotel Supplies\nFor the three and six months ended June 30, 2021 and 2020, we incurred charges for hotel supplies of $ 0 and $ 11 , and $ 1 and $ 63 , respectively. For the three and six months ended June 30, 2021 and 2020, we incurred charges for capital expenditure purchases of $ 86 and $ 176 , and $ 220 and $ 1,056 , respectively. These purchases were made from Hersha Purchasing and Design, a hotel supply company owned, in part, by certain executives and trustees of the Company. Hotel supplies are expensed and included in Hotel Operating Expenses on our consolidated statements of operations, and capital expenditure purchases are included in investment in hotel properties on our consolidated balance sheets.\nInsurance Services\nPrior to January 1, 2021, the Company utilized the services of the Hersha Group, a risk management business owned, in part, by certain executives and trustees of the Company. The Hersha Group provided consulting and procurement services to the Company related to the placement of property and casualty insurance, placement of general liability insurance, and for claims handling for our hotel properties. Beginning January 1, 2021, these services were provided by a third-party service provider. For the three and six months ended June 30, 2020, the total cost of property insurance that we paid through the Hersha Group were $ 1,388 and $ 2,984 , respectively. This amount paid to the Hersha Group included insurance premiums and brokerage fees as compensation for brokerage services.\nRestaurant Lease Agreements with Independent Restaurant Group\nThe Company enters into lease agreements with a number of restaurant management companies for the lease of restaurants located within our hotels. The Company previously entered into lease agreements with Independent Restaurant Group (\"IRG\") for restaurants at three of its hotel properties. Jay H. Shah and Neil H. Shah, executive officers and/or trustees of the Company, collectively own a 70.0 % interest in IRG. The Company’s restaurant lease agreements with IRG generally provided for a term of five years and the payment of base rents and percentage rents, which were based on IRG’s revenue in excess of defined thresholds. Effective April 1, 2020, each of these lease agreements became a management agreement between the Company and IRG, subject to the supervision of HHMLP, as property manager. At the time of the conversion of the lease agreements to management agreements there was rent due of $ 103 , which was forgiven due to the impact of the COVID-19 pandemic on the operations of our hotels and IRG's restaurants. For the six months ended June 30, 2021 and 2020, we did no t recognize any revenue from IRG.\nDue From Related Parties\nThe due from related parties balance as of June 30, 2021 and December 31, 2020 was approximately $ 1,552 and $ 2,641 , respectively. The balances primarily consisted of working capital deposits made to HHMLP and other entities owned, in part, by certain executives and trustees of the Company.\nDue to Related Parties\nThe balance due to related parties as of June 30, 2021 and December 31, 2020 was $ 0 .\n32\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS\nFair Value Measurements\nOur determination of fair value measurements are based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, we utilize a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).\nLevel 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liabilities, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.\nAs of June 30, 2021, the Company’s derivative instruments represented the only financial instruments measured at fair value. Currently, the Company uses derivative instruments, such as interest rate swaps and caps, to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs.\nWe incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counter-party’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.\nAlthough we have determined that the majority of the inputs used to value our derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by us and the counter-parties. However, as of June 30, 2021 we have assessed the significance of the effect of the credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivatives. As a result, we have determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.\nDerivative Instruments\nThe Company’s objective in using derivatives is to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and interest rate caps as part of its cash flow hedging strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount. Interest rate caps designated as cash flow hedges limit the Company’s exposure to increased cash payments due to increases in variable interest rates. The table on the following page presents our derivative instruments as of June 30, 2021 and December 31, 2020.\n33\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\n| Estimated Fair Value |\n| (Liability) Balance |\n| Hedged Debt | Type | Strike Rate | Effective Date | Derivative Contract Maturity Date | Notional Amount | June 30, 2021 | December 31, 2020 |\n| Term Loan Instruments: |\n| Credit Facility | Swap | 1.341 | % | 1-Month LIBOR + 2.20 % | October 3, 2019 | August 2, 2021 | 150,000 | $ | ( 165 ) | $ | ( 1,070 ) |\n| Credit Facility (1) | Swap | 1.316 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 2, 2021 | 43,900 | ( 47 ) | ( 307 ) |\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\n| Credit Facility | Swap | 1.460 | % | 1-Month LIBOR + 2.00 % | September 10, 2019 | September 10, 2024 | 300,000 | ( 8,790 ) | ( 13,286 ) |\n| Mortgages: |\n| Annapolis Waterfront Hotel, MD | Cap | 3.350 | % | 1-Month LIBOR + 2.65 % | May 1, 2018 | May 1, 2021 | 28,000 | — | — |\n| Hyatt, Union Square, New York, NY | Swap | 1.870 | % | 1-Month LIBOR + 2.30 % | June 7, 2019 | June 7, 2023 | 56,000 | ( 1,743 ) | ( 2,305 ) |\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\n| Hilton Garden Inn 52nd Street, New York, NY | Swap | 1.540 | % | 1-Month LIBOR + 2.30 % | December 4, 2019 | December 4, 2022 | 44,325 | ( 869 ) | ( 1,186 ) |\n| Courtyard, LA Westside, Culver City, CA (2) | Swap | 0.495 | % | 1-Month LIBOR + 3.75 % | June 1, 2020 | August 1, 2021 | 35,000 | ( 12 ) | ( 75 ) |\n| $ | ( 17,252 ) | $ | ( 26,259 ) |\n\n(1) During the six months ended June 30, 2021, we dedesignated this swap as a cash flow hedge and recorded expense of $ 330 accordingly.\n(2) Subsequent to June 30, 2021, we entered into an interest rate cap for this debt, which is effective on August 1, 2021.\nThe fair value of our interest rate swaps is included in accounts payable, accrued expenses and other liabilities at June 30, 2021 and December 31, 2020.\nThe net change related to derivative instruments designated as cash flow hedges recognized as unrealized gains and losses reflected on our consolidated balance sheet in accumulated other comprehensive income was a gain of $ 2,398 and a loss of $ 792 for the three months ended June 30, 2021 and 2020, respectively, and a gain of $ 9,163 and a loss of $ 30,941 for the six months ended June 30, 2021 and 2020, respectively.\n34\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\nAmounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate derivatives. The change in net unrealized gains/losses on cash flow hedges reflects a reclassification of $( 141 ) and $ 1,228 and $ 159 and $ 2,205 of net unrealized gains from accumulated other comprehensive income as an increase/decrease to interest expense for the three and six months ended June 30, 2021 and 2020, respectively. For the next twelve months ending June 30, 2022, we estimate that an additional $ 10,059 will be reclassified as an increase to interest expense.\nFair Value of Debt\nWe estimate the fair value of our fixed rate debt and the credit spreads over variable market rates on our variable rate debt by discounting the future cash flows of each instrument at estimated market rates or credit spreads consistent with the maturity of the debt obligation with similar credit policies. Credit spreads take into consideration general market conditions and maturity. The inputs utilized in estimating the fair value of debt are classified in Level 2 of the fair value hierarchy. As of June 30, 2021, the carrying value and estimated fair value of our debt was $ 1,112,492 and $ 1,141,023 respectively. As of December 31, 2020, the carrying value and estimated fair value of our debt was $ 1,196,434 and $ 1,176,625 , respectively.\n35\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS\nOur shareholders approved the Hersha Hospitality Trust 2012 Equity Incentive Plan, as amended, (the “2012 Plan”) for the purpose of attracting and retaining executive officers, employees, trustees and other persons and entities that provide services to the Company.\nThe Short Term Incentive Program (\"STIP\") and the Long-Term Incentive Program (\"LTIP\") were incentive compensation programs the Compensation Committee of our Board of Trustees established to align executive compensation with the performance of the Company. Prior to 2019, executives participated in our legacy incentive compensation programs, including the Multi-Year Long Term Equity Incentive Program (\"Multi-Year EIP\").\nOn March 17, 2021, based on the achievement of certain metrics established under the 2020 STIP for the performance period ended December 31, 2020, the Compensation Committee awarded 519,732 LTIP Units. The awards issued pursuant to the STIP vest on December 31, 2022, the two year anniversary following the end of the performance period.\nOn March 3, 2021, the Compensation Committee approved the 2021 LTIP in which 50 % of the awards provide for time based vesting and the remaining 50 % are issuable based on the Company's achievement of a certain level of (1) absolute total shareholder return ( 37.5 % of the award), (2) relative total shareholder return as compared to the Company’s peer\ngroup ( 37.5 % of the award), and (3) relative growth in revenue per available room (\"RevPar\") compared to the Company’s peer group ( 25.0 % of the award). On March 17, 2021, the Compensation Committee awarded 247,689 LTIP Units related to the time based portion of the plan. These Units will vest over a three year period from January 1, 2021 to December 31, 2023. The 50 % market-based portion of the 2021 LTIP has a three-year performance period which commenced on January 1, 2021 and ends December 31, 2023. As of June 30, 2021, no shares or LTIP Units have been issued to the executive officers in settlement of 2021 LTIP market-based awards.\nThe LTIP Units awarded under both the 2020 STIP and the 2021 LTIP were determined by dividing the dollar amount of award earned by $ 8.43 , the per share volume weighted average trading price of the Company’s common shares on the NYSE for the 20 trading days prior to December 31, 2020.\n| LTIP Unit Awards | Restricted Share Awards | Share Awards |\n| Number of Units | Weighted Average Grant Date Fair Value | Number of Restricted Shares | Weighted Average Grant Date Fair Value | Number of Shares | Weighted Average Grant Date Fair Value |\n| Unvested Balance as of December 31, 2020 | 898,126 | $ | 6.15 | 202,878 | $ | 7.87 | — |\n| Granted | 794,683 | 12.86 | 116,743 | 10.18 | 32,460 | 11.31 |\n| Vested | ( 13,512 ) | 12.23 | ( 239,736 ) | 7.73 | ( 32,460 ) | 11.31 |\n| Forfeited | — | N/A | ( 150 ) | 11.31 | — | N/A |\n| Unvested Balance as of June 30, 2021 | 1,679,297 | $ | 9.28 | 79,735 | $ | 11.68 | — |\n\n36\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS (CONTINUED)\n| Share BasedCompensation Expense | UnearnedCompensation |\n| For the Three Months Ended | For the Six Months Ended | As of |\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 | June 30, 2021 | December 31, 2020 |\n| Issued Awards |\n| LTIP Unit Awards | $ | 1,534 | $ | 1,142 | $ | 3,258 | $ | 2,951 | $ | 8,049 | $ | 1,842 |\n| Restricted Share Awards | 254 | 342 | 422 | 674 | 762 | 276 |\n| Share Awards | 367 | — | 367 | — | — | — |\n| Unissued Awards |\n| Market Based | 434 | 315 | 711 | 630 | 3,019 | 1,933 |\n| Performance Based | — | — | — | — | — | — |\n| Total | $ | 2,589 | $ | 1,799 | $ | 4,758 | $ | 4,255 | $ | 11,830 | $ | 4,051 |\n\nThe weighted-average period of which the unrecognized compensation expense will be recorded is approximately 2.0 years for LTIP Unit Awards and 1.1 years for Restricted Share Awards.\n| 2021 | 2022 | 2023 | 2024 |\n| LTIP Unit Awards | 960,046 | 595,406 | 61,921 | 61,924 |\n| Restricted Share Awards | — | 66,202 | 10,533 | 3,000 |\n| 960,046 | 661,608 | 72,454 | 64,924 |\n\n37\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 10 – EARNINGS PER SHARE\nThe following table is a reconciliation of the income or loss (numerator) and the weighted average shares (denominator) used in the calculation of basic and diluted earnings per common share. The computation of basic and diluted earnings per share is presented below.\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| NUMERATOR: |\n| Basic and Diluted* |\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\n| Loss allocated to Noncontrolling Interests | 977 | 10,360 | 813 | 13,257 |\n| Distributions to Preferred Shareholders | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\n| Net loss applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\n| DENOMINATOR: |\n| Weighted average number of common shares - basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Effect of dilutive securities: |\n| Restricted Stock Awards and LTIP Units (unvested) | — | — | — | — |\n| Contingently Issued Shares and Units | — | — | — | — |\n| Weighted average number of common shares - diluted | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n\n*Income (loss) allocated to noncontrolling interest in HHLP has been excluded from the numerator and Common Units and Vested LTIP Units have been omitted from the denominator for the purpose of computing diluted earnings per share since including these amounts in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\n38\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 11 – CASH FLOW DISCLOSURES AND NON CASH INVESTING AND FINANCING ACTIVITIES\nInterest paid during the six months ended June 30, 2021 and 2020 totaled $ 20,052 and $ 21,488 , respectively. Net Cash paid on Interest Rate Derivative contracts during the six months ended June 30, 2021 and 2020 totaled $ 6,259 and $ 1,505 , respectively. Cash paid for income taxes during the six months ended June 30, 2021 and 2020 totaled $ 60 and $ 233 , respectively. The following non-cash investing and financing activities occurred during the six months ended June 30, 2021 and 2020:\n| 2021 | 2020 |\n| Common Shares issued as part of the Dividend Reinvestment Plan | $ | — | $ | 14 |\n| Issuance of share based payments | 13,103 | 6,404 |\n| Accrued payables for capital expenditures placed into service | 230 | 1,398 |\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | ( 3,196 ) |\n\nThe following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the consolidated balance sheets that sum to the total of the same such amounts shown in the consolidated statements of cash flows for the six months ended June 30, 2021 and 2020:\n| 2021 | 2020 |\n| Cash and cash equivalents | $ | 69,083 | $ | 23,228 |\n| Escrowed cash | 11,067 | 7,374 |\n| Total cash, cash equivalents, and restricted cash shown in the consolidated statements of cash flows | $ | 80,150 | $ | 30,602 |\n\nAmounts included in restricted cash represent those required to be set aside in escrow by contractual agreement with various lenders for the payment of specific items such as property insurance, property tax, and capital expenditures.\n39\nItem 2.\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\nCautionary Statement Regarding Forward Looking Statements\nThis report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements containing the words, “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” and words of similar import. Such forward-looking statements relate to future events, our plans, strategies, prospects and future financial performance, and involve known and unknown risks that are difficult to predict, uncertainties and other factors which may cause our actual results, performance or achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Readers should specifically consider the various factors identified in this report and other reports filed by us with the U.S. Securities and Exchange Commission (the \"SEC\"), including, but not limited to those discussed in the sections entitled “Risk Factors” and \"Management's Discussion and Analysis of Financial Conditions and Results of Operations\" of our Annual Report on Form 10-K for the year ended December 31, 2020 and in this Quarterly Report on Form 10-Q, that could cause actual results to differ. Statements regarding the following subjects are forward-looking by their nature:\n● our business or investment strategy;\n● our projected operating results;\n● our ability to generate positive cash flow from operations;\n● our distribution policy;\n● our liquidity and management's plans with respect thereto;\n● completion of any pending transactions;\n● our ability to maintain existing financing arrangements, including compliance with covenants and our ability to obtain future financing arrangements or refinance or extend the maturity of existing financing arrangements as they come due;\n● our ability to negotiate with lenders;\n● our understanding of our competition;\n● market trends;\n● projected capital expenditures;\n● the impact of and changes to various government programs, including in response to the novel coronavirus, or COVID-19, including those specifically affecting New York City;\n● the efficacy of any treatment for COVID-19;\n● our access to capital on the terms and timing we expect;\n● the restoration of public confidence in domestic and international travel;\n● permanent structural changes in demand for conference centers by business and leisure clientele; and\n● our ability to dispose of selected hotel properties on the terms and timing we expect, if at all.\nForward-looking statements are based on our beliefs, assumptions and expectations, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Readers should not place undue reliance on forward-looking statements.\nImportant factors that we think could cause our actual results to differ materially from expected results are summarized below. One of the most significant factors, however, is the ongoing impact of the current outbreak of the novel coronavirus on the United States, regional and global economies, the broader financial markets, our customers and employees, governmental responses thereto and the operation changes we have and may implement in response thereto. The current outbreak of COVID-19 has also impacted, and is likely to continue to impact, directly or indirectly, many other important factors below.\nNew factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. In particular, it is difficult to fully assess the impact of COVID-19 at this time due to, among other factors, uncertainty regarding the severity and duration of the outbreak domestically and internationally, and the possibility of additional subsequent widespread outbreaks and variant strains and the impacts of actions taken in response, and the effectiveness of federal, state and local governments’ efforts to contain the spread of COVID-19 and respond to its direct and indirect impact on the U.S. economy and economic activity.\n40\nThe following non-exclusive list of factors could also cause actual results to vary from our forward-looking statements:\n● general volatility of the capital markets and the market price of our common shares;\n● changes in our business or investment strategy;\n● availability, terms and deployment of capital;\n● changes in our industry and the market in which we operate, interest rates, or the general economy;\n● decreased international travel because of geopolitical events, including terrorism and current U.S. government policies such as immigration policies, border closings, and travel bans related to COVID-19;\n● the degree and nature of our competition;\n● financing risks, including (i) the risk of leverage and the corresponding risk of default on our mortgage loans and other debt, including default with respect to applicable covenants, (ii) potential inability to obtain waivers of covenants or refinance or extend the maturity of existing indebtedness and (iii) our ability to negotiate with lenders;\n● levels of spending in the business, travel and leisure industries, as well as consumer confidence;\n● declines in occupancy, average daily rate and RevPAR and other hotel operating metrics;\n● hostilities, including future terrorist attacks, or fear of hostilities that affect travel;\n● financial condition of, and our relationships with, our joint venture partners, third-party property managers, and franchisors;\n● increased interest rates and operating costs;\n● ability to complete development and redevelopment projects;\n● risks associated with potential dispositions of hotel properties;\n● availability of and our ability to retain qualified personnel;\n● decreases in tourism due to pandemics, geopolitical instability or changes in foreign exchange rates;\n● our failure to maintain our qualification as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the \"Code\";\n● environmental uncertainties and risks related to natural disasters and increases in costs to insure against those risks;\n● changes in real estate and zoning laws and increases in real property tax rates;\n● the uncertainty and economic impact of pandemics, epidemics, or other public health emergencies or fear of such events, such as the recent outbreak of COVID-19, including with respect to New York City;\n● the current COVID-19 pandemic had, and will continue to have, adverse effects on our financial conditions, results of operations, cash flows, and performance for an indefinite period of time. Future pandemics may also have adverse effects on our financial condition, results of operations, cash flows, and performance;\n● world events impacting the ability or desire of people to travel may lead to a decline in demand for hotels; and\n● the factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 under the headings “Risk Factors” and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" and in other reports we file with the SEC from time to time.\nThese factors are not necessarily all of the important factors that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by any of our forward-looking statements. Other unknown or unpredictable factors, many of which are beyond our control, also could harm our results, performance or achievements.\nAll forward-looking statements contained in this report are expressly qualified in their entirety by the cautionary statements set forth above. Forward-looking statements speak only as of the date they are made, and we do not undertake or assume any obligation to update publicly any of these statements to reflect actual results, new information or future events, changes in assumptions or changes in other factors affecting forward-looking statements, except to the extent required by applicable laws. If we update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.\nBACKGROUND\nAs of June 30, 2021, we owned interests in 36 hotels in major urban gateway markets including New York, Washington DC, Boston, Philadelphia, San Diego, Los Angeles, Seattle, and Miami, including 32 wholly-owned hotels, 1 hotel through our interest in a consolidated joint venture, and interests in 3 hotels owned through unconsolidated joint ventures. We have elected to be taxed as a REIT for federal income tax purposes, beginning with the taxable year ended December 31, 1999. For purposes of the REIT qualification rules, we cannot directly operate any of our hotels. Instead, we must lease our hotels to a third party lessee or to a TRS, provided that the TRS engages an eligible independent contractor to manage the\n41\nhotels. As of June 30, 2021, we have leased all of our hotels to a wholly-owned TRS, a joint venture owned TRS, or an entity owned by our wholly-owned TRS. Each of these TRS entities will pay qualifying rent, and the TRS entities have entered into management contracts with qualified independent managers, including HHMLP, with respect to our hotels. We intend to lease all newly acquired hotels to a TRS. The TRS structure enables us to participate more directly in the operating performance of our hotels. The TRS directly receives all revenue from, and funds all expenses relating to, hotel operations. The TRS is also subject to income tax on its earnings.\nOVERVIEW\nWe started to realize the effects from the global economic slowdown caused by the COVID-19 pandemic in March of 2020. As a result of the COVID-19 pandemic and subsequent government mandates and health official recommendations, hotel demand has been substantially reduced across the United States.\nFollowing the government mandates and health official recommendations, and after evaluating the cost of running our respective properties at low occupancy levels versus closing the properties, we originally closed 21 hotel properties and dramatically reduced staffing at the hotels that remained open and at the corporate level; however, we have subsequently reopened all of our consolidated hotels. The reopening of our consolidated hotels provided us the opportunity to capture incremental demand through the end of 2020 and we believe we are prepared to capture market share during the early stages of an economic recovery in 2021.\nIn addition to our focus on strategically reopening hotels and driving occupancy at these hotels, we have remained focused on executing expense mitigation measures and shoring up our liquidity position as we continue to face a challenging operating environment. We suspended our common and preferred dividends in 2020 and during the six months ended June 30, 2021, we paid approximately $24.2 million in preferred dividend arrearage that was not paid in 2020. We also deferred certain planned capital expenditures for 2020 and we will continue to reduce capital expenditures in 2021 with planned allocations estimated between $15.0 and $18.0 million. In February 2021, the Company entered into an unsecured notes facility that provided net proceeds of $144.75 million at closing. An incremental $50 million may be drawn, at the Company’s discretion, in minimum installments of $25.0 million, at any point on or prior to September 30, 2021. The initial net proceeds of $144.75 million provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our Credit Facility, allowing us to amend our Credit Facility on February 17, 2021, eliminating maturities under the Credit Facility until August of 2022. The Credit Facility amendment also waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, and provided additional liquidity at the Company’s discretion.\nThe manner in which the ongoing COVID-19 pandemic will be resolved or the manner that the hospitality and tourism industries will return to historical performance norms, and whether the economy will contract or grow are not reasonably predictable. As a result, there can be no assurances that we will be able to achieve the hotel operating metrics or the results at our properties we have forecasted. Factors that might contribute to less-than-anticipated performance include those described under the headings “Risk Factors” and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our Annual Report on Form 10-K for the year ended December 31, 2020 and other documents that we may file with the SEC in the future. We will continue to cautiously monitor lodging demand and rates, our third-party hotel managers, and our performance generally.\n42\nSUMMARY OF OPERATING RESULTS\nCOMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2021 AND 2020\n(dollars in thousands, except ADR, RevPAR, and per share data)\nRevenue\nOur total revenues for the three months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the three months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $52,671, or 302.5%, to $70,083 for the three months ended June 30, 2021 compared to $17,412 for the same period in 2020. This increase is primarily attributable to an increase in demand across our portfolio in 2021 as the comparable period in 2020 was at the nadir of the reduction in operations across our portfolio due to the decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the three months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\nExpenses\nTotal hotel operating expenses increased 124.8% to approximately $41,310 for the three months ended June 30, 2021 from $18,378 for the three months ended June 30, 2020. The increase in hotel operating expenses is due to increased operations at our hotels for the three months ended June 30, 2021 as we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic during the comparable period in 2020. This increase in hotel operating expense is partially offset by the sale of hotels noted above.\nDepreciation and amortization decreased by 13.6%, or $3,308, to $21,014 for the three months ended June 30, 2021 from $24,322 for the three months ended June 30, 2020. The decrease is primarily attributable to the disposition of the Sheraton Wilmington in December 2020, and the Courtyard San Diego, the Residence Inn Coconut Grove, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, and the Duane Street Hotel in the first half of 2021.\nReal estate and personal property tax and property insurance decreased $503, or 5.0%, for the three months ended June 30, 2021 when compared to the same period in 2020. This decrease is primarily driven by reductions in real estate tax expense due to the sale of hotels noted above. The decrease is partially offset by increased real estate tax that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense for the quarter as we cumulatively catch up, in certain instances, our estimated tax accruals at the time the new assessment is received. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. The Company regularly appeals property taxes but cannot predict property tax reductions from real estate tax appeals.\nGeneral and administrative expense increased by 26.3%, or approximately $1,100, from $4,187 for the three months ended June 30, 2020 to $5,287 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $790 when comparing the three months ended June 30, 2021 to the same period in 2020. This increase resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of share based compensation recognition. In addition, during the three months ended June 30, 2020, we executed cost containment strategies in our payroll and other administrative costs. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\nOperating Loss\nOperating loss for the three months ended June 30, 2021 was $7,592 compared to operating loss of $41,542 during the same period in 2020. The decrease in our operating loss of $33,950 is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020 when we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic.\n43\nInterest Expense\nInterest expense increased $1,501 from $13,481 for the three months ended June 30, 2020 to $14,982 for the three months ended June 30, 2021. The primary driver of the increased interest expense is due to the issuance of the Junior Notes, which is partially offset by a decrease in interest expense on our term loans and decreases in the amortization of our interest rate hedges. Resulting primarily from the proceeds of the sales of assets, the balance of our borrowings, excluding discounts and deferred costs, have decreased by $57,256 in total between June 30, 2020 and June 30, 2021.\nIncome Tax Benefit\nDuring the three months ended June 30, 2021, the Company recorded an income tax expense of $151 compared to an income tax expense of $15,872 for the three months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\nNet Loss Applicable to Common Shareholders\nNet loss applicable to common shareholders for the three months ended June 30, 2021 was $28,590 compared to net loss of $67,464 during the same period in 2020. This decrease is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020, as discussed above, partially offset by increased interest expense during the three months ended June 30, 2021, as discussed above.\nCOMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020\n(dollars in thousands, except ADR, RevPAR, and per share data)\nRevenue\nOur total revenues for the six months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the six months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $9,886, or 9.2%, to $117,236 for the six months ended June 30, 2021 compared to $107,350 for the same period in 2020. This increase is attributable to an increase in RevPAR across our portfolio during the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, when beginning in March 2020, we experienced a significant decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the six months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\nExpenses\nTotal hotel operating expenses decreased 12.4% to approximately $73,490 for the six months ended June 30, 2021 from $83,897 for the six months ended June 30, 2020. The decrease in hotel operating expenses is attributable to the cost saving measures implemented to mitigate the impact of the decrease in demand in 2020, as well the sale of hotels noted above.\nDepreciation and amortization decreased by 11.7%, or $5,694, to $42,816 for the six months ended June 30, 2021 from $48,510 for the six months ended June 30, 2020 due to the dispositions noted above.\nReal estate and personal property tax and property insurance decreased $374, or 1.9%, for the six months ended June 30, 2021 when compared to the same period in 2020, which is primarily due to the sale of hotels noted above. This decrease is partially offset by an increase in real estate taxes at our remaining hotels as a result of properties that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. In general, our property insurance costs continue to rise annually.\n44\nGeneral and administrative expense increased by 2.1%, or $210 from $10,021 for the six months ended June 30, 2020 to $10,231 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $503 when comparing the six months ended June 30, 2021 to 2020, which was partially offset by the execution of our cost containment strategies in other administrative costs. The increase in shared based compensation resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of shared based compensation recognition. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\nOperating Loss\nOperating loss for the six months ended June 30, 2021 was $30,878 compared to operating loss of $57,951 during the same period in 2020. Our decrease in operating loss was largely the result of a decrease in hotel operating expenses for the six months ended June 30, 2021 and an increase in hotel operating revenues, which is the result of an increase in demand across our portfolio, while maintaining certain cost containment strategies in place due to the COVID-19 pandemic. Additionally, we had a decrease in depreciation and amortization expense during the first half of 2021 compared to 2020 as a result of the disposals noted above.\nInterest Expense\nInterest expense increased $1,923 from $26,488 for the six months ended June 30, 2020 to $28,411 for the six months ended June 30, 2021. The balance of our borrowings, excluding discounts and deferred costs, has decreased by $57,256 in total between June 30, 2020 and June 30, 2021. However, we experienced an increase in our weighted average interest rate, driven by the unsecured junior notes payable facility we entered into in February 2021, and increased interest expense related to the amortization of additional deferred costs incurred during the six months ended June 30, 2021. Proceeds from the junior notes payable were used to reduce borrowings under our secured credit facility and term loans.\nIncome Tax Expense\nDuring the six months ended June 30, 2021, the Company recorded an income tax benefit of $438 compared to an income tax expense of $11,374 for the six months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\nNet Loss Applicable to Common Shareholders\nNet loss applicable to common shareholders for the six months ended June 30, 2021 was $25,707 compared to net loss of $96,583 during the same period in 2020, resulting in a decreased loss of $70,876. This decrease in loss is primarily related to gain on hotel dispositions of $48,352, as well as a decrease in operating loss.\n45\nLIQUIDITY, CAPITAL RESOURCES, AND EQUITY OFFERINGS\n(dollars in thousands, except per share data)\nPotential Sources of Capital\nOur organizational documents do not limit the amount of indebtedness that we may incur. Our ability to incur additional debt is dependent upon a number of factors, including the current state of the overall credit markets, our degree of leverage and borrowing restrictions imposed by existing lenders. Our ability to raise funds through the issuance of debt and equity securities is dependent upon, among other things, capital market volatility, risk tolerance of investors, general market conditions for REITs and market perceptions related to the Company’s ability to generate cash flow and positive returns on its investments.\nIn addition, our mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, nonrecourse financing arrangements. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. At June 30, 2021, we failed our debt service coverage ratio (\"DSCR\") requirement related to two of our mortgage borrowings. After considering the effect of the COVID-19 pandemic on our consolidated operations, it is possible that we could fail certain financial covenants within certain property-level mortgage borrowings. For mortgages with financial covenants, the lenders' remedy of a covenant failure would be a requirement to escrow funds for the purpose of meeting our future debt payment obligations.\nIn February 2021, the Company entered into a junior unsecured notes facility (“Junior Notes”) that provided net proceeds of $144,750 at closing. An incremental $50,000 may be drawn, at the Company’s discretion, in minimum installments of $25,000 at any point on or prior to September 30, 2021. The Junior Notes bear interest at a rate of 9.50%, of which half, or 4.75%, will be paid in cash with the remaining half added to the principal of the note through March 31, 2022 at our discretion. The Junior Notes mature in February of 2026 and are non-callable through February 2022. The Junior Notes are callable at 104% beginning February of 2022, 102% beginning in February 2023, and at par any time beginning in February 2024.\nThe net proceeds of $144,750 provided by the Junior Notes, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under the Credit Facility, the Second Term Loan, and the Third Term Loan. The Junior Notes and asset sales that closed in the first quarter of 2021 allowed the Company to execute amendments to Credit Agreements governing the Credit Facility, the Second Term Loan, and the Third Term Loan. These amendments eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company’s preferred dividends and allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity at the Company’s discretion.\nOur secured debt facilities aggregate to $747,481 which is comprised of a $442,404 senior credit facility and two term loans totaling $305,077. The credit facility (“Credit Facility”) contains a $192,404 term loan (“First Term Loan”) and a $250,000 revolving line of credit (“Line of Credit”), and expires on August 10, 2022. As of June 30, 2021, we had $118,684 outstanding under the Line of Credit. Our two additional term loans are $278,846 (“Second Term Loan”) and $26,231 (“Third Term Loan”), which mature on September 10, 2024 and August 10, 2022, respectively.\nWe will continue to monitor our debt maturities to manage our liquidity needs. However, no assurances can be given that we will be successful in refinancing all or a portion of our future debt obligations due to factors beyond our control or that, if refinanced, the terms of such debt will not vary from the existing terms. As of June 30, 2021, we have $23,431 of indebtedness due on or before June 30, 2022. We currently expect that cash requirements for all debt that is not refinanced by our existing lenders for which the maturity date is not extended will be met through a combination of cash on hand, refinancing the existing debt with new lenders, draws on the Line of Credit or Junior Notes and the issuance of our securities.\nIn addition to the incurrence of debt and the offering of equity securities, dispositions of property may serve as additional capital resources and sources of liquidity. We may recycle capital from stabilized assets or from sales of non-core hotels in secondary and tertiary markets. Capital from these types of transactions is intended to be redeployed into high growth acquisitions, share buybacks, or to pay down existing debt.\n46\nAcquisitions\nDuring the six months ended June 30, 2021, we acquired no hotel properties. We intend to invest in additional hotels only as suitable opportunities arise and adequate sources of capital are available. We expect that future investments in hotels will depend upon and will be financed by, in whole or in part, our existing cash, the proceeds from additional issuances of common or preferred shares, proceeds from the sale of assets, issuances of Common Units, issuances of preferred units or other securities or borrowings secured by hotel assets and under our Line of Credit.\nDispositions\nDuring the six months ended June 30, 2021, we disposed of five hotel properties for an aggregate sales price of $196,500 resulting in a gain on disposition of $48,313. The net proceeds were used to repay existing debt.\nOperating Liquidity and Capital Expenditures\nWe expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under the Line of Credit. We believe that the net cash provided by operations in the coming year and borrowings drawn on the Line of Credit will be adequate to fund the Company’s operating requirements, monthly recurring debt service and the payment of dividends in accordance with REIT requirements of the Code.\nTo qualify as a REIT, we must distribute annually at least 90% of our taxable income. This distribution requirement limits our ability to retain earnings and requires us to raise additional capital in order to grow our business and acquire additional hotel properties. However, there is no assurance that we will be able to borrow funds or raise additional equity capital on terms acceptable to us, if at all. In addition, we cannot guarantee that we will be able to make distributions to our shareholders.\nWe will seek to satisfy long-term liquidity requirements through various sources of capital, including borrowings under the Line of Credit and through secured, non-recourse mortgage financings with respect to our unencumbered hotel properties. In addition, we may seek to raise capital through public or private offerings of our securities. Certain factors may have a material adverse effect on our ability to access these capital sources, including our degree of leverage, the value of our unencumbered hotel properties and borrowing restrictions imposed by lenders or franchisors. We will continue to analyze which source of capital is most advantageous to us at any particular point in time, but financing may not be consistently available to us on terms that are attractive, or at all.\nSpending on capital improvements during the six months ended June 30, 2021 decreased when compared to spending on capital improvements during the six months ended June 30, 2020. During the six months ended June 30, 2021, we spent $5,374 on capital expenditures to renovate, improve or replace assets at our hotels. This compares to $15,612 during the same period in 2020. These capital expenditures were undertaken to comply with brand mandated improvements and to initiate projects that we believe will generate a return on investment. We may spend additional amounts, if necessary, to comply with the requirements of any franchise license under which any of our hotels operate and otherwise to the extent we deem such expenditures to be prudent. We are also obligated to fund the cost of certain capital improvements to our hotels.\nWe expect to use operating cash flow, borrowings under the Line of Credit, and proceeds from issuances of our securities and hotel dispositions to pay for the cost of capital improvements and any furniture, fixture and equipment requirements.\n47\nCASH FLOW ANALYSIS\n(dollars in thousands, except per share data)\nComparison of the Six Months Ended June 30, 2021 and 2020\nNet cash used in operating activities decreased $9,250 from $16,357 for the six months ended June 30, 2020 to $7,107 for the comparable period in 2021. The increase in cash flow is primarily attributable to an increase in hotel property cash flow as a result of an increase in demand since the onset of the COVID-19 pandemic.\nNet cash provided by investing activities for the six months ended June 30, 2021 was $157,659 compared to net cash used in investing activities of $16,191 for the six months ended June 30, 2020. The following items are the major contributing factors for the change in investing cash flows:\n•Proceeds of $163,583 received related to the disposition of the Courtyard San Diego, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, the Residence Inn Coconut Grove, and the Duane Street Hotel during the six months ended June 30, 2021.\n•An increase in comparative cash flows of $10,217 related to a decrease in spending on capital expenditures and hotel development projects for the six months ended June 30, 2021 compared to 2020.\n•An increase in comparative cash flows of $50 related to contributions of $600 to unconsolidated joint ventures for the six months ended June 30, 2020 compared to contributions of $550 for the six months ended June 30, 2021.\nNet cash used in financing activities for the six months ended June 30, 2021 was $94,009 compared to net cash provided by financing activities for the six months ended June 30, 2020 of $26,165. The following items are the major contributing factors for the change in financing cash flows:\n•The primary use of cash was the payment of $187,024 of outstanding borrowings under the Term Loan agreements. We received proceeds of $144,750 from the issuance of the Junior Notes, a portion of which, in addition to the proceeds received from the hotel dispositions noted above, were used to pay down the Term Loans.\n•An increase in mortgage payments of $703 for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020.\n•Payment of $5,795 of deferred financing costs for the six months ended June 30, 2021 which primarily relate to the Junior Notes issuance noted above, as compared to the payment of $2,104 during the six months ended June 30, 2020.\n•A decrease in comparative cash flows as we drew $47,000 on our Line of Credit during the six months ended June 30, 2020 when compared to $14,369 in net repayments during the same period in 2021.\n•An increase in cash payments of $12,167 related to dividends paid. During the six months ended June 30, 2021, our executed amendments to the Credit Agreements allowed for the payment of the total arrearage of unpaid cash dividends due on each of our 6.875% Series C Cumulative Redeemable Preferred Shares, 6.50% Series D Cumulative Redeemable Preferred Shares and 6.50% Series E Cumulative Redeemable Preferred Shares of approximately $24,174, which was paid on March 26, 2021, as well as dividends of $6,044 on these preferred shares in April 2021. During the six months ended June 30, 2020 we paid dividends of $6,044 on these preferred shares and $12,007 on our Common Shares, Common Units and LTIP Units.\nOFF BALANCE SHEET ARRANGEMENTS\nThe Company does not have off balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.\n48\nFUNDS FROM OPERATIONS\n(in thousands, except share data)\nThe National Association of Real Estate Investment Trusts (“NAREIT”) developed Funds from Operations (“FFO”) as a non-GAAP financial measure of performance of an equity REIT in order to recognize that income-producing real estate historically has not depreciated on the basis determined under GAAP. We calculate FFO applicable to common shares and Common Units in accordance with the December 2018 Financial Standards White Paper of NAREIT, which we refer to as the White Paper. The White Paper defines FFO as net income (loss) (computed in accordance with GAAP) excluding depreciation and amortization related to real estate, gains and losses from the sale of certain real estate assets, gains and losses from change in control, and impairment write-downs of certain real estate assets and investments in entities when the impairment is directly attributable to decreases in the value of depreciable real estate held by an entity. Our interpretation of the NAREIT definition is that noncontrolling interest in net income (loss) should be added back to (deducted from) net income (loss) as part of reconciling net income (loss) to FFO. Our FFO computation may not be comparable to FFO reported by other REITs that do not compute FFO in accordance with the NAREIT definition, or that interpret the NAREIT definition differently than we do.\nThe GAAP measure that we believe to be most directly comparable to FFO, net income (loss) applicable to common shareholders, includes loss from the impairment of certain depreciable assets, our investment in unconsolidated joint ventures and land, depreciation and amortization expenses, gains or losses on property sales, noncontrolling interest and preferred dividends. In computing FFO, we eliminate these items because, in our view, they are not indicative of the results from our property operations. We determined that the loss from the impairment of certain depreciable assets including investments in unconsolidated joint ventures and land, was driven by a measurable decrease in the fair value of certain hotel properties and other assets as determined by our analysis of those assets in accordance with applicable GAAP. As such, these impairments have been eliminated from net loss to determine FFO.\nFFO does not represent cash flows from operating activities in accordance with GAAP and should not be considered an alternative to net income as an indication of the Company’s performance or to cash flow as a measure of liquidity or ability to make distributions. We consider FFO to be a meaningful, additional measure of operating performance because it excludes the effects of the assumption that the value of real estate assets diminishes predictably over time, and because it is widely used by industry analysts as a performance measure. We show both FFO from consolidated hotel operations and FFO from unconsolidated joint ventures because we believe it is meaningful for the investor to understand the relative contributions from our consolidated and unconsolidated hotels. The display of both FFO from consolidated hotels and FFO from unconsolidated joint ventures allows for a detailed analysis of the operating performance of our hotel portfolio by management and investors. We present FFO applicable to common shares and Common Units because our Common Units are redeemable for common shares. We believe it is meaningful for the investor to understand FFO applicable to all common shares and Common Units.\n49\nThe following table reconciles FFO for the periods presented to the most directly comparable GAAP measure, net income, for the same periods (dollars in thousands):\n| Three Months Ended | Six Months Ended |\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 |\n| Net loss applicable to common shareholders | $ | (28,590) | $ | (67,464) | $ | (25,707) | $ | (96,583) |\n| Loss allocated to noncontrolling interest | (977) | (10,360) | (813) | (13,257) |\n| Loss from unconsolidated joint ventures | 589 | 502 | 1,247 | 1,520 |\n| Gain on disposition of hotel properties | — | — | (48,352) | — |\n| Loss from impairment of depreciable assets | 222 | 1,069 | 222 | 1,069 |\n| Depreciation and amortization | 21,014 | 24,322 | 42,816 | 48,510 |\n| Funds from consolidated hotel operations applicable to common shareholders and Partnership Units | (7,742) | (51,931) | (30,587) | (58,741) |\n| Loss from unconsolidated joint ventures | (589) | (502) | (1,247) | (1,520) |\n| Unrecognized pro rata interest in loss (1) | (318) | (511) | (814) | (361) |\n| Depreciation and amortization of difference between purchase price and historical cost (2) | 21 | 21 | 42 | 42 |\n| Interest in depreciation and amortization of unconsolidated joint ventures (3) | 652 | 393 | 1,282 | 796 |\n| Funds from unconsolidated joint ventures operations applicable to common shareholders and Partnership Units | (234) | (599) | (737) | (1,043) |\n| Funds from Operations applicable to common shareholders and Partnership Units | $ | (7,976) | $ | (52,530) | $ | (31,324) | $ | (59,784) |\n| Weighted Average Common Shares and Common Units |\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\n| Diluted | 44,724,968 | 43,286,310 | 44,525,168 | 43,426,465 |\n\n(1) For U.S. GAAP reporting purposes, our interest in the joint venture's loss is not recognized since our U.S. GAAP basis in the joint venture has been reduced to $0. Our interest in FFO from the joint venture equals our percentage ownership in the venture's FFO, including loss we have not recognized for U.S. GAAP reporting.\n(2) Adjustment made to add depreciation of purchase price in excess of historical cost of the assets in the unconsolidated joint venture at the time of our investment.\n(3) Adjustment made to add our interest in real estate related depreciation and amortization of our unconsolidated joint ventures.\nINFLATION\nOperators of hotel properties, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of our management companies to raise room rates. Additionally, our management companies will face challenges to raise room rates to reflect the impact of inflation until there is a substantial economic recovery from the COVID-19 pandemic.\nCRITICAL ACCOUNTING POLICIES AND ESTIMATES\nRefer to Note 1 – Basis of Presentation of the notes to our consolidated financial statements included herein for information regarding critical accounting policies and estimates.\n50\nItem 3. Quantitative and Qualitative Disclosures About Market Risk (in thousands, except per share data)\nOur primary market risk exposure is to changes in interest rates on our variable rate debt. As of June 30, 2021, we are exposed to interest rate risk with respect to variable rate borrowings under our Line of Credit, certain variable rate mortgages, and notes payable. As of June 30, 2021, we had total variable rate debt outstanding of $233,077 with a weighted average interest rate of 2.94%. The effect of a 100 basis point increase or decrease in the interest rate on our variable rate debt outstanding as of June 30, 2021 would be an increase or decrease in our interest expense for the three and six months ended June 30, 2021 of $577 and $1,198, respectively.\nOur interest rate risk objectives are to limit the impact of interest rate fluctuations on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, we manage our exposure to fluctuations in market interest rates for a portion of our borrowings through the use of fixed rate debt instruments to the extent that reasonably favorable rates are obtainable with such arrangements. We have also entered into derivative financial instruments such as interest rate swaps or caps, and in the future may enter into treasury options or locks, to mitigate our interest rate risk on a related financial instrument or to effectively lock the interest rate on a portion of our variable rate debt. As of June 30, 2021, we have ten interest rate swaps related to debt on Hilton Garden Inn, 52nd Street, New York, NY; Courtyard, LA Westside, Culver City, CA; Hyatt Union Square, New York, NY; Hilton Garden Inn Tribeca, New York, NY; and our Credit Facility. We do not intend to enter into derivative or interest rate transactions for speculative purposes.\nAs of June 30, 2021, approximately 79.3% of our outstanding consolidated long-term indebtedness was subject to fixed rates or effectively capped, while 20.7% of our outstanding long term indebtedness is subject to floating rates, including borrowings under our Line of Credit. The majority of our floating rate debt and any corresponding derivative instruments are indexed to various tenors of LIBOR.\nOn March 5, 2021, the Financial Conduct Authority (“FCA”) announced that USD LIBOR will no longer be published after June 30, 2023. This announcement has several implications, including setting the spread that may be used to automatically convert contracts from LIBOR to the Secured Overnight Financing Rate (\"SOFR\"). Additionally, banking regulators are encouraging banks to discontinue new LIBOR debt issuances by December 31, 2021.\nThe Company anticipates that LIBOR will continue to be available at least until June 30, 2023. Any changes adopted by the FCA or other governing bodies in the method used for determining LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR. If that were to occur, our interest payments could change. In addition, uncertainty about the extent and manner of future changes may result in interest rates and/or payments that are higher or lower than if LIBOR were to remain available in its current form.\nThe Company is monitoring and evaluating the related risks that arise in connection with transitioning contracts to an alternative rate, including any resulting value transfer that may occur, and are likely to vary by contract. The value of loans, securities, or derivative instruments tied to LIBOR, as well as interest rates on our current or future indebtedness, may also be impacted if LIBOR is limited or discontinued. For some instruments the method of transitioning to an alternative reference rate may be challenging, especially if we cannot agree with the respective counterparty about how to make the transition.\nWhile we expect LIBOR to be available in substantially its current form until at least June 30, 2023, it is possible that LIBOR will become unavailable prior to that point. This could result, for example, if sufficient banks decline to make submissions to the LIBOR administrator. In that case, the risks associated with the transition to an alternative reference rate will be accelerated and magnified.\nAlternative rates and other market changes related to the replacement of LIBOR, including the introduction of financial products and changes in market practices, may lead to risk modeling and valuation challenges, such as adjusting interest rate accrual calculations and building a term structure for an alternative rate.\nThe introduction of an alternative rate also may create additional basis risk and increased volatility as alternative rates are phased in and utilized in parallel with LIBOR.\nAdjustments to systems and mathematical models to properly process and account for alternative rates will be required, which may strain the model risk management and information technology functions and result in substantial incremental costs for the company.\nChanges in market interest rates on our fixed-rate debt impact the fair value of the debt, but such changes have no impact on interest expense incurred. If interest rates rise 100 basis points and our fixed rate debt balance remains constant, we expect the fair value of our debt to decrease. The sensitivity analysis related to our fixed-rate debt assumes an immediate 100 basis point move in interest rates from their June 30, 2021 levels, with all other variables held constant. A 100 basis point increase in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be\n51\napproximately $1,114,810 and a 100 basis point decrease in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be approximately $1,168,182.\nWe regularly review interest rate exposure on our outstanding borrowings in an effort to minimize the risk of interest rate fluctuations. For debt obligations outstanding as of June 30, 2021, the following table presents expected principal repayments and related weighted average interest rates by expected maturity dates:\n| 2021 | 2022 - 2023 | 2024 - 2025 | Thereafter | Total |\n| Fixed Rate Debt | $ | 23,431 | $ | 346,889 | $ | 381,977 | $ | 140,764 | $ | 893,061 |\n| Weighted Average Interest Rate | 4.84 | % | 5.27 | % | 8.94 | % | 9.50 | % | 7.14 | % |\n| Floating Rate Debt | $ | 298 | $ | 1,240 | $ | 61,306 | $ | 51,548 | $ | 114,392 |\n| Weighted Average Interest Rate | 3.29 | % | 3.30 | % | 3.10 | % | 3.10 | % | 3.20 | % |\n| $ | 23,729 | $ | 348,129 | $ | 443,283 | $ | 192,312 | $ | 1,007,453 |\n| Line of Credit | $ | — | $ | 118,684 | $ | — | $ | — | $ | 118,684 |\n| Weighted Average Interest Rate | — | 2.50 | % | — | — | 2.50 | % |\n| $ | 23,729 | $ | 466,813 | $ | 443,283 | $ | 192,312 | $ | 1,126,137 |\n\n52\nItem 4. Controls and Procedures\nBased on the most recent evaluation, the Company’s Chief Executive Officer and Chief Financial Officer believe the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of June 30, 2021.\nThere were no changes to the Company’s internal controls over financial reporting during the three months ended June 30, 2021, that materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.\n53\nPART II. OTHER INFORMATION\nItem 1. Legal Proceedings.\nNone.\nItem 1A. Risk Factors.\nThere have been no material changes from our risk factors as previously reported in our Annual Report on Form 10-K for the year ended December 31, 2020.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\n\nItem 3. Defaults Upon Senior Securities.\nNone.\nItem 4. Mine Safety Disclosures.\nNot Applicable.\nItem 5. Other Information.\nNone.\n54\nItem 6. Exhibits.\n| Exhibit No. |\n| 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\n| 32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\n| 32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\n| 101.INS | The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document* |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document* |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document* |\n| 101.LAB | Inline XBRL Taxonomy Extension Labels Linkbase Document* |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document* |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n| * | Filed herewith |\n| + | Compensatory plan or arrangement |\n\n55\nSIGNATURES\n\n| HERSHA HOSPITALITY TRUST |\n| July 28, 2021 | /s/ Ashish R. Parikh |\n| Ashish R. Parikh |\n| Chief Financial Officer(Principal Financial Officer) |\n\n56\n</text>\n\nWhat is the percentage change in Total Shareholders' Equity from December 31, 2020, to June 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1.\\nFinancial Statements.\\nConsolidated Balance Sheets 4\\nConsolidated Statements of Operations 5\\nConsolidated Statements of Comprehensive Income (Loss) 7\\nConsolidated Statements of Equity 8\\nConsolidated Statements of Cash Flows 12\\nNotes to the Consolidated Financial Statements 14\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk 51\\nItem 4. Controls and Procedures 53\\nPART II. OTHER INFORMATION\\nItem 1. Legal Proceedings 54\\nItem 1A. Risk Factors 54\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds 54\\nItem 3. Defaults Upon Senior Securities 54\\nItem 4. Mine Safety Disclosures 54\\nItem 5. Other Information 54\\nItem 6. Exhibits 55\\nSignatures 56\\n3\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAS OF JUNE 30, 2021 [UNAUDITED] AND DECEMBER 31, 2020[IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\n| June 30, 2021 | December 31, 2020 |\\n| Assets: |\\n| Investment in Hotel Properties, Net of Accumulated Depreciation | $ | 1,699,230 | $ | 1,784,838 |\\n| Investment in Unconsolidated Joint Ventures | 5,936 | 6,633 |\\n| Cash and Cash Equivalents | 69,083 | 16,637 |\\n| Escrow Deposits | 11,067 | 6,970 |\\n| Hotel Accounts Receivable | 5,539 | 5,690 |\\n| Due from Related Parties | 1,552 | 2,641 |\\n| Intangible Assets, Net of Accumulated Amortization of $ 6,827 and $ 6,840 | 1,465 | 1,739 |\\n| Right of Use Assets | 43,467 | 44,126 |\\n| Other Assets | 20,395 | 15,494 |\\n| Hotel Assets Held for Sale | — | 96,220 |\\n| Total Assets | $ | 1,857,734 | $ | 1,980,988 |\\n| Liabilities and Equity: |\\n| Line of Credit | $ | 118,684 | $ | 133,053 |\\n| Term Loans, Net of Unamortized Deferred Financing Costs (Note 5) | 495,657 | 681,744 |\\n| Unsecured Notes Payable, Net of Unamortized Discount and Unamortized Deferred Financing Costs (Note 5) | 193,725 | 50,789 |\\n| Mortgages Payable, Net of Unamortized Premium and Unamortized Deferred Financing Costs | 304,426 | 330,848 |\\n| Lease Liabilities | 53,455 | 53,852 |\\n| Accounts Payable, Accrued Expenses and Other Liabilities | 49,088 | 58,453 |\\n| Dividends and Distributions Payable | 6,044 | — |\\n| Total Liabilities | $ | 1,221,079 | $ | 1,308,739 |\\n| Redeemable Noncontrolling Interests - Consolidated Joint Venture (Note 1) | $ | 1,968 | $ | — |\\n| Equity: |\\n| Shareholders' Equity: |\\n| Preferred Shares: $ .01 Par Value, 29,000,000 Shares Authorized, 3,000,000 Series C, 7,701,700 Series D and 4,001,514 Series E Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, with Liquidation Preferences of $ 25.00 Per Share (Note 1) | $ | 147 | $ | 147 |\\n| Common Shares: Class A, $ .01 Par Value, 104,000,000 Shares Authorized at June 30, 2021 and December 31, 2020; 39,217,475 and 38,843,482 Shares Issued and Outstanding at June 30, 2021 and December 31, 2020, respectively | 392 | 389 |\\n| Common Shares: Class B, $ .01 Par Value, 1,000,000 Shares Authorized, None Issued and Outstanding at June 30, 2021 and December 31, 2020 | — | — |\\n| Accumulated Other Comprehensive Loss | ( 11,024 ) | ( 19,275 ) |\\n| Additional Paid-in Capital | 1,153,657 | 1,150,985 |\\n| Distributions in Excess of Net Income | ( 557,157 ) | ( 509,243 ) |\\n| Total Shareholders' Equity | 586,015 | 623,003 |\\n| Noncontrolling Interests (Note 1) | 48,672 | 49,246 |\\n| Total Equity | 634,687 | 672,249 |\\n| Total Liabilities and Equity | $ | 1,857,734 | $ | 1,980,988 |\\n\\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\\n4\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\n| Three Months Ended June 30, | Six months ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Revenue: |\\n| Hotel Operating Revenues: |\\n| Room | $ | 56,539 | $ | 15,139 | $ | 95,889 | $ | 86,222 |\\n| Food & Beverage | 7,230 | 136 | 10,304 | 10,211 |\\n| Other Operating Revenues | 6,314 | 2,137 | 11,043 | 10,917 |\\n| Other Revenues | 13 | 29 | 25 | 228 |\\n| Total Revenues | 70,096 | 17,441 | 117,261 | 107,578 |\\n| Operating Expenses: |\\n| Hotel Operating Expenses: |\\n| Room | 12,350 | 3,622 | 21,548 | 22,714 |\\n| Food & Beverage | 5,409 | 721 | 8,282 | 11,342 |\\n| Other Operating Expenses | 23,551 | 14,035 | 43,660 | 49,841 |\\n| Insurance recoveries in excess of property loss | ( 711 ) | — | ( 711 ) | — |\\n| Hotel Ground Rent | 1,064 | 1,058 | 2,164 | 2,121 |\\n| Real Estate and Personal Property Taxes and Property Insurance | 9,466 | 9,969 | 19,537 | 19,911 |\\n| General and Administrative (including Share Based Payments of $ 2,589 and $ 1,799 and $ 4,758 and $ 4,255 for the three and six months ended June 30, 2021 and 2020, respectively) | 5,287 | 4,187 | 10,231 | 10,021 |\\n| Terminated Transaction Costs | 36 | — | 390 | — |\\n| Loss on Impairment of Assets | 222 | 1,069 | 222 | 1,069 |\\n| Depreciation and Amortization | 21,014 | 24,322 | 42,816 | 48,510 |\\n| Total Operating Expenses | 77,688 | 58,983 | 148,139 | 165,529 |\\n| Operating Loss | ( 7,592 ) | ( 41,542 ) | ( 30,878 ) | ( 57,951 ) |\\n| Interest Income | 4 | 2 | 5 | 38 |\\n| Interest Expense | ( 14,982 ) | ( 13,481 ) | ( 28,411 ) | ( 26,488 ) |\\n| Other Income (Expense) | ( 84 ) | ( 385 ) | 377 | ( 457 ) |\\n| Gain on Disposition of Hotel Properties | — | — | 48,352 | — |\\n| Loss on Debt Extinguishment | ( 129 ) | — | ( 3,069 ) | — |\\n| Loss Before Results from Unconsolidated Joint Venture Investments and Income Taxes | ( 22,783 ) | ( 55,406 ) | ( 13,624 ) | ( 84,858 ) |\\n| Loss from Unconsolidated Joint Ventures | ( 589 ) | ( 502 ) | ( 1,247 ) | ( 1,520 ) |\\n| Loss Before Income Taxes | ( 23,372 ) | ( 55,908 ) | ( 14,871 ) | ( 86,378 ) |\\n| Income Tax Benefit (Expense) | ( 151 ) | ( 15,872 ) | 438 | ( 11,374 ) |\\n| Net Loss | ( 23,523 ) | ( 71,780 ) | ( 14,433 ) | ( 97,752 ) |\\n| Loss Allocated to Noncontrolling Interests - Common Units | 2,945 | 7,164 | 2,623 | 10,061 |\\n| (Income) Loss Allocated to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\\n| Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\\n| Net Loss Applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\\n\\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\\n5\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Earnings Per Share: |\\n| BASIC |\\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\\n| DILUTED |\\n| Loss from Continuing Operations Applicable to Common Shareholders | $ | ( 0.73 ) | $ | ( 1.75 ) | $ | ( 0.66 ) | $ | ( 2.50 ) |\\n| Weighted Average Common Shares Outstanding: |\\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n| Diluted* | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n\\n* Income (Loss) allocated to noncontrolling interest in Hersha Hospitality Limited Partnership (the “Operating Partnership” or “HHLP”) has been excluded from the numerator and the Class A common shares issuable upon any redemption of the Operating Partnership’s common units of limited partnership interest (“Common Units”) and the Operating Partnership’s vested LTIP units (“Vested LTIP Units”) have been omitted from the denominator for the purpose of computing diluted earnings per share because the effect of including these shares and units in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\\nThe following table summarizes potentially dilutive securities that have been excluded from the denominator for the purpose of computing diluted earnings per share:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Common Units and Vested LTIP Units | 4,279,355 | 3,943,319 | 4,314,347 | 3,891,032 |\\n| Unvested Stock Awards and LTIP Units Outstanding | 939,591 | 547,315 | 581,989 | 267,443 |\\n| Contingently Issuable Share Awards | 408,202 | 185,754 | 594,125 | 680,979 |\\n| Total Potentially Dilutive Securities Excluded from the Denominator | 5,627,148 | 4,676,388 | 5,490,461 | 4,839,454 |\\n\\nThe Accompanying Notes Are an Integral Part of These Consolidated Financial Statements.\\n6\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\\n| Other Comprehensive Income (Loss) |\\n| Change in Fair Value of Derivative Instruments | 2,539 | ( 2,020 ) | 9,004 | ( 33,146 ) |\\n| Reclassification Adjustment for Change in Fair Value of Derivative Instruments Included in Net Income (Loss) | ( 141 ) | 1,228 | 159 | 2,205 |\\n| Total Other Comprehensive Income (Loss) | $ | 2,398 | $ | ( 792 ) | $ | 9,163 | $ | ( 30,941 ) |\\n| Comprehensive Loss | ( 21,125 ) | ( 72,572 ) | ( 5,270 ) | ( 128,693 ) |\\n| Less: Comprehensive Loss Attributable to Noncontrolling Interests - Common Units | 2,712 | 7,270 | 1,711 | 12,895 |\\n| Less: Comprehensive (Income) Loss Attributable to Noncontrolling Interests - Consolidated Joint Venture | ( 1,968 ) | 3,196 | ( 1,810 ) | 3,196 |\\n| Less: Preferred Distributions | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\\n| Comprehensive Loss Attributable to Common Shareholders | $ | ( 26,425 ) | $ | ( 68,150 ) | $ | ( 17,456 ) | $ | ( 124,690 ) |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n7\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\\n| Balance at March 31, 2021 | — | 39,132,307 | 391 | — | 14,703,214 | 147 | 1,154,579 | ( 12,509 ) | ( 530,535 ) | 612,073 | 5,943,014 | 49,172 | 661,245 |\\n| Dividends and Distributions declared: |\\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 6,044 ) | ( 6,044 ) | — | — | ( 6,044 ) |\\n| Share Based Compensation: |\\n| Grants | — | 85,168 | 1 | — | — | — | 365 | — | — | 366 | 19,477 | 65 | 431 |\\n| Amortization | — | — | — | — | — | — | 681 | — | — | 681 | 1,468 | 2,149 |\\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 1,485 | — | 1,485 | — | 912 | 2,397 |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\\n| Net Loss | — | — | — | — | — | — | — | — | ( 20,578 ) | ( 20,578 ) | — | ( 2,945 ) | ( 23,523 ) |\\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\\n\\n8\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\\n| Balance at March 31, 2020 | 3,196 | 38,673,242 | 387 | — | 14,703,214 | 147 | 1,145,450 | ( 26,411 ) | ( 362,777 ) | 756,796 | 4,279,946 | 59,162 | 815,958 |\\n| Issuance Costs | — | — | — | — | — | — | ( 10 ) | — | — | ( 10 ) | — | — | ( 10 ) |\\n| Share Based Compensation: |\\n| Grants | — | 116,129 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\\n| Amortization | — | — | — | — | — | — | 655 | — | — | 655 | — | 3,823 | 4,478 |\\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 686 ) | — | ( 686 ) | — | ( 106 ) | ( 792 ) |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\\n| Net Income | — | — | — | — | — | — | — | — | ( 64,616 ) | ( 64,616 ) | ( 7,164 ) | ( 71,780 ) |\\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\\n\\n9\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\\n| Balance at December 31, 2020 | — | 38,843,482 | 389 | — | 14,703,214 | 147 | 1,150,985 | ( 19,275 ) | ( 509,243 ) | 623,003 | 5,392,808 | 49,246 | 672,249 |\\n| Unit Conversion | — | 225,000 | 2 | — | — | — | 2,870 | — | — | 2,872 | ( 225,000 ) | ( 2,872 ) | — |\\n| Dividends and Distributions declared: |\\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 36,262 ) | ( 36,262 ) | — | — | ( 36,262 ) |\\n| Share Based Compensation: |\\n| Grants | — | 148,993 | 1 | — | — | — | 356 | — | — | 357 | 794,683 | 1,683 | 2,040 |\\n| Amortization | — | — | — | — | — | — | 1,414 | — | — | 1,414 | 2,326 | 3,740 |\\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | 8,251 | — | 8,251 | — | 912 | 9,163 |\\n| Equity Contribution to Consolidated Joint Venture | 158 | — | — | — | — | — | — | — | — | — | — | — | — |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | — | — | — | — | — | ( 1,968 ) | — | — | ( 1,968 ) | — | — | ( 1,968 ) |\\n| Net Income | ( 158 ) | — | — | — | — | — | — | — | ( 11,652 ) | ( 11,652 ) | — | ( 2,623 ) | ( 14,275 ) |\\n| Balance at June 30, 2021 | 1,968 | 39,217,475 | 392 | — | 14,703,214 | 147 | 1,153,657 | ( 11,024 ) | ( 557,157 ) | 586,015 | 5,962,491 | 48,672 | 634,687 |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n10\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF EQUITYFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARES]\\n| Redeemable Noncontrolling Interests | Shareholders' Equity | Noncontrolling Interests |\\n| Consolidated Joint Venture ($) | Common Shares | Class A Common Shares ($) | Class B Common Shares ($) | Preferred Shares | Preferred Shares ($) | Additional Paid-In Capital ($) | Accumulated Other Comprehensive Loss ($) | Distributions in Excess of Net Income ($) | Total Shareholders' Equity ($) | Common Units and LTIP Units | Common Units and LTIP Units ($) | Total Equity ($) |\\n| Balance at December 31, 2019 | 3,196 | 38,652,650 | 387 | — | 14,703,214 | 147 | 1,144,808 | 1,010 | ( 338,695 ) | 807,657 | 4,279,946 | 64,144 | 871,801 |\\n| Unit Conversion | — | — | — | — | — | — | ( 30 ) | — | — | ( 30 ) | — | — | ( 30 ) |\\n| Dividends and Distributions declared: |\\n| Preferred Shares | — | — | — | — | — | — | — | — | ( 1,007 ) | ( 1,007 ) | — | — | ( 1,007 ) |\\n| Dividend Reinvestment Plan | — | 1,094 | — | — | — | — | 14 | — | — | 14 | — | — | 14 |\\n| Share Based Compensation: |\\n| Grants | — | 135,627 | 1 | — | — | — | — | — | — | 1 | 1,101,924 | — | 1 |\\n| Amortization | — | — | — | — | — | — | 1,303 | — | — | 1,303 | — | 4,466 | 5,769 |\\n| Change in Fair Value of Derivative Instruments | — | — | — | — | — | — | — | ( 28,107 ) | — | ( 28,107 ) | — | ( 2,834 ) | ( 30,941 ) |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | ( 3,196 ) | — | — | — | — | — | 3,196 | — | — | 3,196 | — | — | 3,196 |\\n| Net Loss | — | — | — | — | — | — | — | — | ( 87,691 ) | ( 87,691 ) | ( 10,061 ) | ( 97,752 ) |\\n| Balance at June 30, 2020 | — | 38,789,371 | 388 | — | 14,703,214 | 147 | 1,149,291 | ( 27,097 ) | ( 427,393 ) | 695,336 | 5,381,870 | 55,715 | 751,051 |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n11\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\\n| Six Months Ended June 30, |\\n| 2021 | 2020 |\\n| Operating Activities: |\\n| Net Loss | $ | ( 14,433 ) | $ | ( 97,752 ) |\\n| Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities: |\\n| Gain on Disposition of Hotel Properties | ( 48,352 ) | — |\\n| Loss on Impairment of Assets | 222 | 1,069 |\\n| Insurance recoveries in excess of property loss | ( 711 ) | — |\\n| Junior Note PIK Interest Added to Principal | 2,514 | — |\\n| Deferred Taxes | ( 499 ) | 11,390 |\\n| Depreciation | 42,642 | 48,273 |\\n| Amortization | 2,594 | 1,116 |\\n| Loss on Debt Extinguishment | 634 | — |\\n| Equity in Loss of Unconsolidated Joint Ventures | 1,247 | 1,520 |\\n| Loss Recognized on Change in Fair Value of Derivative Instrument | 159 | 2,205 |\\n| Share Based Compensation Expense | 4,758 | 4,255 |\\n| Change in Assets and Liabilities: |\\n| (Increase) Decrease in: |\\n| Hotel Accounts Receivable | 151 | 5,412 |\\n| Other Assets | ( 4,055 ) | 4,884 |\\n| Due from Related Parties | 1,089 | 3,750 |\\n| Increase (Decrease) in: |\\n| Accounts Payable, Accrued Expenses and Other Liabilities | 4,933 | ( 2,479 ) |\\n| Net Cash Used in Operating Activities | $ | ( 7,107 ) | $ | ( 16,357 ) |\\n| Investing Activities: |\\n| Capital Expenditures | ( 5,374 ) | ( 15,612 ) |\\n| Hotel Development Projects | — | 21 |\\n| Proceeds from Disposition of Hotel Properties | 163,583 | — |\\n| Contributions to Unconsolidated Joint Ventures | ( 550 ) | ( 600 ) |\\n| Net Cash Provided by (Used in) Investing Activities | $ | 157,659 | $ | ( 16,191 ) |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n12\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS]\\n| Six Months Ended June 30, |\\n| 2021 | 2020 |\\n| Financing Activities: |\\n| (Repayments) Borrowings on Line of Credit, Net | $ | ( 14,369 ) | $ | 47,000 |\\n| Payments on Term Loans | ( 187,024 ) | — |\\n| Proceeds from Notes Payable | 144,750 | — |\\n| Principal Repayment of Mortgages | ( 1,353 ) | ( 650 ) |\\n| Proceeds of Paycheck Protection Program (\\\"PPP\\\") Loans | — | 18,936 |\\n| Repayment of PPP Loans | — | ( 18,936 ) |\\n| Deferred Financing Costs | ( 5,795 ) | ( 2,104 ) |\\n| Dividends Paid on Common Shares | — | ( 10,809 ) |\\n| Dividends Paid on Preferred Shares | ( 30,218 ) | ( 6,044 ) |\\n| Distributions Paid on Common Units and LTIP Units | — | ( 1,198 ) |\\n| Other Financing Activities | — | ( 30 ) |\\n| Net Cash (Used in) Provided by Financing Activities | $ | ( 94,009 ) | $ | 26,165 |\\n| Net Increase (Decrease) in Cash, Cash Equivalents, and Restricted Cash | $ | 56,543 | $ | ( 6,383 ) |\\n| Cash, Cash Equivalents, and Restricted Cash - Beginning of Period | 23,607 | 36,985 |\\n| Cash, Cash Equivalents, and Restricted Cash - End of Period | $ | 80,150 | $ | 30,602 |\\n\\nThe Accompanying Notes are an Integral Part of These Consolidated Financial Statements.\\n13\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 1 - BASIS OF PRESENTATION\\nThe accompanying unaudited consolidated financial statements of Hersha Hospitality Trust (“we,” “us,” “our” or the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“US GAAP”) for interim financial information and with the general instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by US GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals), considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021 or any future period. Accordingly, readers of these consolidated interim financial statements should refer to the Company’s audited financial statements prepared in accordance with US GAAP, and the related notes thereto, for the year ended December 31, 2020, which are included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as certain footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted from this report pursuant to the rules of the Securities and Exchange Commission.\\nWe are a self-administered Maryland real estate investment trust that was organized in May 1998 and completed our initial public offering in January 1999. Our common shares are traded on the New York Stock Exchange (the “NYSE”) under the symbol “HT.” We own our hotels and our investments in joint ventures through our operating partnership, Hersha Hospitality Limited Partnership (“HHLP” or “the Partnership”), for which we serve as the sole general partner. As of June 30, 2021, we owned an approximate 86.8 % partnership interest in HHLP, including a 1.0 % general partnership interest.\\nPrinciples of Consolidation and Presentation\\nThe accompanying consolidated financial statements have been prepared in accordance with US GAAP and include all of our accounts as well as accounts of the Partnership, subsidiary partnerships and our wholly owned Taxable REIT Subsidiary Lessee (“TRS Lessee”), 44 New England Management Company. All significant inter-company amounts have been eliminated.\\nConsolidated properties are either wholly owned or owned less than 100% by the Partnership and are controlled by the Company as general partner of the Partnership. Properties owned in joint ventures are also consolidated if the determination is made that we are the primary beneficiary in a variable interest entity (“VIE”) or we maintain control of the asset through our voting interest in the entity.\\nVariable Interest Entities\\nWe evaluate each of our investments and contractual relationships to determine whether they meet the guidelines for consolidation. To determine if we are the primary beneficiary of a VIE, we evaluate whether we have a controlling financial interest in that VIE. An enterprise is deemed to have a controlling financial interest if it has i) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance, and ii) the obligation to absorb losses of the VIE that could be significant to the VIE or the rights to receive benefits from the VIE that could be significant to the VIE. Control can also be demonstrated by the ability of a member to manage day-to-day operations, refinance debt and sell the assets of the partnerships without the consent of the other member and the inability of the members to replace the managing member. Based on our examination, there have been no changes to the operating structure of our legal entities during the three and six months ended June 30, 2021 and, therefore, there are no changes to our evaluation of VIE's as presented within our annual report presented on Form 10-K for the year ended December 31, 2020.\\n14\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\\nNoncontrolling Interest\\nWe classify the noncontrolling interests of our common units of limited partnership interest in HHLP (“Common Units”), and Long Term Incentive Plan Units (“LTIP Units”) as equity. LTIP Units are a separate class of limited partnership interest in the Operating Partnership that are convertible into Common Units under certain circumstances. The noncontrolling interest of Common Units and LTIP Units totaled $ 48,672 as of June 30, 2021 and $ 49,246 as of December 31, 2020. As of June 30, 2021, there were 5,962,491 Common Units and LTIP Units outstanding with a fair market value of $ 64,156 , based on the price per share of our common shares on the NYSE on such date. In accordance with the partnership agreement of HHLP, holders of these Common Units may redeem them for cash unless we, in our sole and absolute discretion, elect to issue common shares on a one -for-one basis in lieu of paying cash.\\nNet income or loss attributed to Common Units and LTIP Units is included in net income or loss but excluded from net income or loss applicable to common shareholders in the consolidated statements of operations.\\nWe are party to a joint venture that owns the Ritz-Carlton Coconut Grove, FL, in which our joint venture partner has a noncontrolling equity interest of 15 % in the property. Hersha Holding RC Owner, LLC, the owner entity of the Ritz-Carlton Coconut Grove joint venture (\\\"Ritz Coconut Grove\\\"), will distribute income based on cash available for distribution which will be distributed as follows: (1) to us until we receive a cumulative return on our contributed senior common equity interest, currently at 8 %, and (2) then to the owner of the noncontrolling interest until they receive a cumulative return on their contributed junior common equity interest, currently at 8 %, and (3) then 75 % to us and 25 % to the owner of the noncontrolling interest until we both receive a cumulative return on our contributed senior common equity interest, currently at 12 %, and (4) finally, any remaining operating profit shall be distributed 70 % to us and 30 % to the owner of the noncontrolling interest. Additionally, the noncontrolling interest in the Ritz Coconut Grove has the right to put their ownership interest to us for cash consideration at any time during the life of the venture. The balance sheets and financial results of the Ritz Coconut Grove are included in our consolidated financial statements and book value of the noncontrolling interest in the Ritz Coconut Grove is classified as temporary equity within our Consolidated Balance Sheets. The noncontrolling interest in the Ritz Coconut Grove is measured at the greater of historical cost or the put option redemption value. For the three and six months ended June 30, 2021, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated losses of $ 0 and $ 158 , respectively. For the three and six months ended June 30, 2020, based on the income allocation methodology described above, the noncontrolling interest in this joint venture was allocated loss of $ 0 . This is recorded as part of the Loss Allocated to Noncontrolling Interests line item within the Consolidated Statements of Operations. On June 30, 2021, we reclassified $ 1,968 from Additional Paid in Capital to Redeemable Noncontrolling Interests - Consolidated Joint Venture to value the noncontrolling interest at the put option redemption value of $ 1,968 .\\nShareholders’ Equity\\n| Dividend Per Share (1) |\\n| Shares Outstanding | Six Months Ended June 30, |\\n| Series | June 30, 2021 | December 31, 2020 | Aggregate Liquidation Preference | Distribution Rate | 2021 | 2020 |\\n| Series C | 3,000,000 | 3,000,000 | $ | 75,000 | 6.875 | % | $ | 2.5782 | $ | — |\\n| Series D | 7,701,700 | 7,701,700 | $ | 192,500 | 6.500 | % | $ | 2.4378 | $ | — |\\n| Series E | 4,001,514 | 4,001,514 | $ | 100,000 | 6.500 | % | $ | 2.4378 | $ | — |\\n| Total | 14,703,214 | 14,703,214 |\\n\\n15\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\\n(1) During the six months ended June 30, 2020, we suspended the payment of our preferred dividends. During the six months ended June 30, 2021, the Company paid cash dividends on the Company's Series C, Series D and Series E cumulative redeemable preferred stock reflecting accrued and unpaid dividends for the dividend periods ended April 15, 2020, July 15, 2020, October 15, 2020 and January 15, 2021. In addition, the Company paid a cash dividend on all Series of cumulative redeemable preferred stock for the first dividend period ending April 15, 2021 and declared a similar cash dividend for the second dividend period ending July 15, 2021, which is payable July 15, 2021 to holders of record as of July 1, 2021.\\nLiquidity and Management's Plan\\nDue to the COVID-19 pandemic and the effects of travel restrictions both globally and in the United States, the hospitality industry has experienced drastic drops in demand. The global impact of the pandemic has been rapidly evolving and, in the United States, certain states and cities, including most of the states and cities where we own properties, have reacted by instituting various restrictive measures such as quarantines, restrictions on travel, school closings, \\\"stay at home\\\" rules and restrictions on types of business that may continue to operate. We believe the ongoing effects of the COVID-19 pandemic on our operations have had, and will continue to have a material negative impact on our financial results and liquidity, and such negative impact may continue beyond the containment of the pandemic.\\nIn February of 2021, we entered into an unsecured notes facility that provided net proceeds of $ 144,750 and access to an incremental $ 50,000 , which can be drawn through September 30, 2021. The initial net proceeds of $ 144,750 provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our senior secured credit facility and our two secured term loans and allowed us to negotiate amendments to this senior facility. The amendments to the senior secured credit facility and two secured term loans eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company's preferred dividends, allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity to be used at the Company's discretion.\\nWe cannot assure you that our assumptions used to estimate our liquidity requirements will be correct because the lodging industry has not previously experienced such an abrupt and drastic reduction in hotel demand, and as a consequence, our ability to be predictive is uncertain. In addition, the magnitude, duration, and speed of the pandemic is uncertain and we cannot estimate when travel demand will recover. Based on the amendments, the Company believes that it has sufficient liquidity to meet its obligations for the next twelve months.\\nInvestment in Hotel Properties\\nInvestments in hotel properties are recorded at cost. Improvements and replacements are capitalized when they extend the useful life of the asset. Costs of repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful life of up to 40 years for buildings and improvements, two to seven years for furniture, fixtures and equipment. We are required to make subjective assessments as to the useful lives of our properties for purposes of determining the amount of depreciation to record on an annual basis with respect to our investments in hotel properties. These assessments have a direct impact on our net income because if we were to shorten the expected useful lives of our investments in hotel properties we would depreciate these investments over fewer years, resulting in more depreciation expense and lower net income on an annual basis.\\nIdentifiable assets, liabilities, and noncontrolling interests related to hotel properties acquired are recorded at fair value. Estimating techniques and assumptions used in determining fair values involve significant estimates and judgments. These estimates and judgments have a direct impact on the carrying value of our assets and liabilities which can directly impact the amount of depreciation expense recorded on an annual basis and could have an impact on our assessment of potential impairment of our investment in hotel properties.\\nWe consider a hotel to be held for sale when management and our independent trustees commit to a plan to sell the property, the property is available for sale, management engages in an active program to locate a buyer for the property and it is probable the sale will be completed within a year of the initiation of the plan to sell. We evaluate each disposition to determine whether we need to classify the disposition as discontinued operations. We generally include the operations of a hotel that was sold or a hotel that has been classified as held for sale in continuing operations unless the sale represents a strategic shift that will have a major impact on our future operations and financial results. We anticipate that most of our hotel dispositions will not be classified as discontinued operations as most will not fit this definition.\\n16\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\\nBased on the occurrence of certain events or changes in circumstances, we review the recoverability of the property’s carrying value. Such events or changes in circumstances include the following:\\n•a significant decrease in the market price of a long-lived asset;\\n•a significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition;\\n•a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator;\\n•an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset;\\n•a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset; and\\n•a current expectation that, it is more likely than not that, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.\\nWe review our portfolio on an ongoing basis to evaluate the existence of any of the aforementioned events or changes in circumstances that would require us to test for recoverability. In general, our review of recoverability is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property’s use and eventual disposition. These estimates consider factors such as expected future operating income, market and other applicable trends and residual value expected, as well as the effects of hotel demand, competition and other factors. Other assumptions used in the review of recoverability include the holding period and expected terminal capitalization rate. If impairment exists due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property. We are required to make subjective assessments as to whether there are impairments in the values of our investments in hotel properties.\\nAs of June 30, 2021, based on our analysis, we have determined that the estimated future cash flow of each of the properties in our portfolio is sufficient to recover its respective carrying value, after recording an impairment charge prior to the disposition of the Duane Street hotel.\\n17\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]\\nNOTE 1 - BASIS OF PRESENTATION (CONTINUED)\\nNew Accounting Pronouncements\\nIn March 2020, the Financial Accounting Standards Board (\\\"FASB\\\") issued ASU No. 2020-4, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting and in January 2021, the FASB issued 2021-01, Reference Rate Reform (Topic 848), Scope, which further clarified the scope of the reference rate reform optional practical expedients and exceptions outlined in Topic 848. As a result of identified structural risks of interbank offered rates, in particular, the London Interbank Offered Rate (LIBOR), reference rate reform is underway to identify alternative reference rates that are more observable or transaction based. The update provides guidance in accounting for changes in contracts, hedging relationships, and other transactions as a result of this reference rate reform. The optional expedients and exceptions contained within these updates, in general, only apply to contract amendments and modifications entered into prior to January 1, 2023. The provisions of these updates that will most likely affect our financial reporting process related to modifications of contracts with lenders and the related hedging contracts associated with each respective modified borrowing contract. In general, the provisions of these updates would impact the Company by allowing, among other things, the following:\\n•Allowing modifications of debt contracts with lenders that fall under the guidance of ASC Topic 470 to be accounted for as a non-substantial modification and not be considered a debt extinguishment.\\n•Allowing a change to contractual terms of a hedging instrument in conjunction with reference rate reform to not require a dedesignation of the hedging relationship.\\n•Allowing a change to the interest rate used for margining, discounting, or contract price alignment for a derivative that is a cash flow hedge to not be considered a change to the critical terms of the hedge and will not require a dedesignation of the hedging relationship.\\nWe have not entered into any contract modifications yet, as it directly relates to reference rate reform but we anticipate having to undertake such modifications in the future as a majority of our contracts with lenders and hedging counterparties are indexed to LIBOR. While we anticipate the impact of this update to be to the benefit of the Company, we are still evaluating the overall impact to the Company.\\n18\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 - INVESTMENT IN HOTEL PROPERTIES\\nInvestment in hotel properties consists of the following at June 30, 2021 and December 31, 2020:\\n\\n| June 30, 2021 | December 31, 2020 |\\n| Land | $ | 478,413 | $ | 488,463 |\\n| Buildings and Improvements | 1,557,840 | 1,611,144 |\\n| Furniture, Fixtures and Equipment | 271,977 | 281,440 |\\n| Construction in Progress | 1,489 | 987 |\\n| 2,309,719 | 2,382,034 |\\n| Less Accumulated Depreciation | ( 610,489 ) | ( 597,196 ) |\\n| Total Investment in Hotel Properties * | $ | 1,699,230 | $ | 1,784,838 |\\n\\n* The net book value of investment in hotel property at Ritz Coconut Grove, which is a variable interest entity, is $ 40,937 and $ 42,487 at June 30, 2021 and December 31, 2020, respectively.\\nAcquisitions\\nFor the six months ended June 30, 2021 and 2020, we acquired no hotel properties.\\nHotel Dispositions\\nFor the six months ended June 30, 2020, we had no hotel dispositions. During the six months ended June 30, 2021, we had the following hotel dispositions:\\n| Hotel | AcquisitionDate | DispositionDate | Consideration | Gain onDisposition |\\n| Courtyard San Diego, CA | 05/30/2013 | 02/19/2021 | $ | 64,500 | $ | 5,037 |\\n| The Capitol Hill Hotel Washington, DC | 04/15/2011 | 03/09/2021 | 51,000 | 12,990 |\\n| Holiday Inn Express Cambridge, MA | 05/03/2006 | 03/09/2021 | 32,000 | 20,281 |\\n| Residence Inn Miami Coconut Grove, FL | 06/12/2013 | 03/10/2021 | 31,000 | 10,005 |\\n| Duane Street Hotel (1) | 01/04/2008 | 05/13/2021 | 18,000 | — |\\n| 2021 Total | $ | 48,313 |\\n\\n(1)During the second quarter of 2020, the Company determined that the carrying value of the Duane Street hotel exceeded the anticipated net proceeds from sale, resulting in a $ 1,069 impairment charge recorded during the second quarter of 2020. We recorded an additional impairment charge of $ 147 prior to the disposition of the hotel property during the six months ended June 30, 2021.\\n19\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 2 – INVESTMENT IN HOTEL PROPERTIES (CONTINUED)\\nAssets Held For Sale\\nWe classified the assets of the Duane Street Hotel, the Residence Inn Coconut Grove and the Courtyard San Diego as held for sale as of December 31, 2020, all of which closed during the six months ended June 30, 2021.\\nThe table below shows the balances for the properties that were classified as assets held for sale as of December 31, 2020:\\n| December 31, 2020 |\\n| Land | $ | 28,015 |\\n| Buildings and Improvements | 93,314 |\\n| Furniture, Fixtures and Equipment | 15,469 |\\n| 136,798 |\\n| Less Accumulated Depreciation | ( 40,578 ) |\\n| Assets Held for Sale | $ | 96,220 |\\n\\n20\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES\\nAs of June 30, 2021 and December 31, 2020, our investment in unconsolidated joint ventures consisted of the following:\\n\\n| Joint Venture | Hotel Properties | Percent Owned | June 30, 2021 | December 31, 2020 |\\n| Cindat Hersha Owner JV, LLC | Hilton and IHG branded hotels in NYC | 31.2 | % | * | $ | — | $ | — |\\n| Hiren Boston, LLC | Courtyard by Marriott, South Boston, MA | 50 | % | 29 | 219 |\\n| SB Partners, LLC | Holiday Inn Express, South Boston, MA | 50 | % | — | — |\\n| SB Partners Three, LLC | Home2 Suites, South Boston, MA | 50 | % | 5,907 | 6,414 |\\n| $ | 5,936 | $ | 6,633 |\\n\\n*On February 7, 2021, all of the assets of the properties owned by this joint venture were transferred to the mezzanine lender of Cindat Hersha Owner JV, LLC. As a result, upon dissolution of the venture, we will no longer maintain an interest in this venture.\\nIncome/Loss Allocation\\nPrior to February 7, 2021, based on the income allocation methodology within Cindat Hersha Owner JV, LLC, the Company had absorbed cumulative losses equal to our accounting basis in the joint venture resulting in a $ 0 investment balance in the table above as of December 31, 2020, however, we maintained a positive equity balance within the venture. This difference is due to the difference in our basis inside the venture versus our basis outside of the venture, which is explained later in this note.\\nFor SB Partners, LLC, Hiren Boston, LLC, and SB Partners Three, LLC, income or loss is allocated to us and our joint venture partners consistent with the allocation of cash distributions in accordance with the joint venture agreements. This results in an income allocation consistent with our percentage of ownership interests.\\nAny difference between the carrying amount of any of our investments noted above and the underlying equity in net assets is amortized over the expected useful lives of the properties and other intangible assets.\\n21\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\\nLoss recognized during the three and six months ended June 30, 2021 and 2020, for our investments in unconsolidated joint ventures is as follows:\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Hiren Boston, LLC | $ | ( 354 ) | $ | ( 477 ) | $ | ( 689 ) | $ | ( 880 ) |\\n| SB Partners, LLC | ( 50 ) | — | ( 50 ) | ( 600 ) |\\n| SB Partners Three, LLC | ( 185 ) | ( 25 ) | ( 508 ) | ( 40 ) |\\n| Loss from Unconsolidated Joint Venture Investments | $ | ( 589 ) | $ | ( 502 ) | $ | ( 1,247 ) | $ | ( 1,520 ) |\\n\\nThe following tables set forth the total assets, liabilities, equity and components of net income or loss, including the Company’s share, related to the unconsolidated joint ventures discussed above as of June 30, 2021 and December 31, 2020 and for the three and six months ended June 30, 2021 and 2020.\\nBalance Sheets\\n\\n| June 30, 2021 | December 31, 2020 |\\n| Assets |\\n| Investment in Hotel Properties, Net | $ | 65,956 | $ | 581,452 |\\n| Other Assets | 14,126 | 32,048 |\\n| Total Assets | $ | 80,082 | $ | 613,500 |\\n| Liabilities and Equity |\\n| Mortgages and Notes Payable | $ | 65,457 | $ | 452,284 |\\n| Other Liabilities | 14,939 | 42,197 |\\n| Equity: |\\n| Hersha Hospitality Trust | 4,099 | 5,699 |\\n| Joint Venture Partner(s) | ( 4,413 ) | 113,452 |\\n| Accumulated Other Comprehensive Loss | — | ( 132 ) |\\n| Total Equity | ( 314 ) | 119,019 |\\n| Total Liabilities and Equity | $ | 80,082 | $ | 613,500 |\\n\\n22\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 3 – INVESTMENT IN UNCONSOLIDATED JOINT VENTURES (CONTINUED)\\nStatements of Operations\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Room Revenue | $ | 1,888 | $ | 5,588 | $ | 4,143 | $ | 16,932 |\\n| Other Revenue | 125 | — | 242 | 787 |\\n| Operating Expenses | ( 1,205 ) | ( 3,265 ) | ( 3,015 ) | ( 11,613 ) |\\n| Lease Expense | ( 245 ) | ( 170 ) | ( 516 ) | ( 354 ) |\\n| Property Taxes and Insurance | ( 382 ) | ( 3,154 ) | ( 1,948 ) | ( 6,438 ) |\\n| General and Administrative | ( 26 ) | ( 553 ) | ( 247 ) | ( 1,516 ) |\\n| Depreciation and Amortization | ( 1,300 ) | ( 3,925 ) | ( 3,612 ) | ( 7,840 ) |\\n| Interest Expense | ( 642 ) | ( 5,582 ) | ( 3,334 ) | ( 11,869 ) |\\n| Loss on Dissolution of Joint Venture | — | — | ( 112,429 ) | — |\\n| Net Loss | $ | ( 1,787 ) | $ | ( 11,061 ) | $ | ( 120,716 ) | $ | ( 21,911 ) |\\n\\nThe following table is a reconciliation of our share in the unconsolidated joint ventures’ equity to our investment in the unconsolidated joint ventures as presented on our balance sheets as of June 30, 2021 and December 31, 2020.\\n| June 30, 2021 | December 31, 2020 |\\n| Our share of equity recorded on the joint ventures' financial statements | $ | 4,099 | $ | 5,699 |\\n| Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures(1) | 1,837 | 934 |\\n| Investment in Unconsolidated Joint Ventures | $ | 5,936 | $ | 6,633 |\\n\\n(1) Adjustment to reconcile our share of equity recorded on the joint ventures' financial statements to our investment in unconsolidated joint ventures consists of the following:\\n•the difference between our basis in the investment in joint ventures and the equity recorded on the joint ventures' financial statements;\\n•accumulated amortization of our equity in joint ventures that reflects the difference in our portion of the fair value of joint ventures' assets on the date of our investment when compared to the carrying value of the assets recorded on the joint ventures’ financial statements (this excess or deficit investment is amortized over the life of the properties, and the amortization is included in Income (Loss) from Unconsolidated Joint Venture Investments on our consolidated statement of operations); and\\n• cumulative impairment of our investment in joint ventures not reflected on the joint ventures' financial statements, if any.\\n23\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 4 - OTHER ASSETS\\nOther Assets\\nOther Assets consisted of the following at June 30, 2021 and December 31, 2020:\\n| June 30, 2021 | December 31, 2020 |\\n| Deferred Financing Costs | $ | 1,783 | $ | 2,395 |\\n| Prepaid Expenses | 9,540 | 5,692 |\\n| Investment in Statutory Trusts | 1,548 | 1,548 |\\n| Investment in Non-Hotel Property and Inventories | 2,318 | 2,443 |\\n| Deposits with Unaffiliated Third Parties | 2,456 | 2,561 |\\n| Deferred Tax Asset, Net of Valuation Allowance of $ 23,438 and $ 23,591 , respectively | 499 | — |\\n| Other | 2,251 | 855 |\\n| $ | 20,395 | $ | 15,494 |\\n\\nDeferred Financing Costs – This category represents financing costs paid by the Company to establish our Line of Credit. These costs have been capitalized and will amortize to interest expense over the term of the Line of Credit.\\nPrepaid Expenses – Prepaid expenses include amounts paid for property tax, insurance and other expenditures that will be expensed in the next twelve months.\\nInvestment in Statutory Trusts – We have an investment in the common stock of Hersha Statutory Trust I and Hersha Statutory Trust II.\\nInvestment in Non-Hotel Property and Inventories – This category represents the costs paid and capitalized by the Company for items such as office leasehold improvements, furniture and equipment, and property inventories.\\nDeposits with Unaffiliated Third Parties – These deposits represent deposits made by the Company with unaffiliated third parties for items such as lease security deposits, utility deposits, and deposits with unaffiliated third party management companies.\\nDeferred Tax Asset – We have recorded a valuation allowance resulting in net deferred tax assets of $ 499 as of June 30, 2021. We have considered various factors, including future reversals of existing taxable temporary differences, future projected taxable income and tax planning strategies in determining a valuation allowance for our deferred tax assets, and we believe that it is more likely than not that we will not be able to realize the net deferred tax assets in the future, and a valuation allowance for the entire deferred tax asset has been recorded, with the exception of a city net operating loss that we believe that we will be able to realize.\\n24\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT\\nMortgages\\nMortgages payable at June 30, 2021 and December 31, 2020 consisted of the following:\\n| June 30, 2021 | December 31, 2020 |\\n| Mortgage Indebtedness | $ | 305,911 | $ | 332,264 |\\n| Net Unamortized Premium | 127 | 354 |\\n| Net Unamortized Deferred Financing Costs | ( 1,612 ) | ( 1,770 ) |\\n| Mortgages Payable | $ | 304,426 | $ | 330,848 |\\n\\nNet Unamortized Deferred Financing Costs associated with entering into mortgage indebtedness are deferred and amortized over the life of the mortgages. Net Unamortized Premiums are also amortized over the remaining life of the loans. Mortgage indebtedness balances are subject to fixed and variable interest rates, which ranged from 2.75 % to 6.30 % as of June 30, 2021.\\nOur mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, non-recourse financing arrangements. Our mortgage loans typically require that specified debt service coverage ratios be maintained with respect to the financed properties before we can exercise certain rights under the loan agreements relating to such properties. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. We have determined that all debt covenants contained in the loan agreements securing our consolidated hotel properties with the exception of two mortgages were met as of June 30, 2021.\\nDuring the six months ended June 30, 2021, we refinanced the outstanding mortgages secured by the Hilton Garden Inn 52nd Street, the Courtyard Los Angeles Westside, the Hilton Garden Inn Tribeca, and the Hyatt Union Square, which resulted in $ 90 of debt modification expense.\\nAs of June 30, 2021, the maturity dates for the outstanding mortgage loans ranged from September 2021 to September 2025. One mortgage with a total principal balance of $ 21,663 will mature within the next twelve months. We are in active discussions with lenders to refinance this mortgage with property level debt prior to its maturity.\\n25\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\\nCredit Facilities\\nWe maintain three secured credit arrangements which aggregate to $ 747,481 with Citigroup Global Markets Inc., Wells Fargo Bank, Inc. and various other lenders. Our credit agreement (the \\\"Credit Agreement\\\") provides for a $ 442,404 senior secured credit facility (“Credit Facility”). The Credit Facility consists of a $ 250,000 senior secured revolving line of credit (“Line of Credit”) and a $ 192,404 senior secured term loan (\\\"First Term Loan\\\"), and expires on August 10, 2022.\\nWe maintain another credit agreement which provides for a $ 278,846 senior secured term loan agreement (“Second Term Loan”) and expires on September 10, 2024.\\nA separate credit agreement provides for a $ 26,231 senior secured term loan agreement (“Third Term Loan” and collectively with the Credit Agreement and the Second Term Loan, the \\\"Credit Agreements\\\") and expires on August 10, 2022. Management intends to explore options including, but not limited to, additional asset sales, the refinancing of debt and the offering of equity or equity-linked securities prior to the maturity of the First Term Loan and the Third Term Loan on August 10, 2022.\\nOn February 17, 2021, the Company signed amendments to the Credit Agreements which resulted in debt extinguishment expense $2,977. Debt extinguishment expense consists of $ 635 of debt extinguishment losses and $ 2,342 of debt modification losses. The signed amendments to the Credit Agreements, among other things, provide for:\\n•an extension of the maturity date of the Third Term Loan to August 10, 2022;\\n•a limited waiver of financial covenants through March 31, 2022; and\\n•the ability to borrow up to $ 174,729 , inclusive of amounts already outstanding, under the Line of Credit, the proceeds of which may only be used to fund certain costs and expenses.\\nCertain conditions, such as minimum liquid assets in an aggregate amount of at least $ 30,000 , and certain negative covenants and restrictions that are considered normal and customary, must be met on a recurring basis as outlined within the amendments.\\nThe amendments to the Credit Agreements make certain other amendments to financial covenants in place beginning in the second quarter of 2022:\\n•a fixed charge coverage ratio of not less than 1.20 to 1.00 (was 1.50 to 1.00);\\n•a maximum leverage ratio of not more than 65 % (was 60 %); and\\n•a new financial covenant that requires the borrowing base leverage ratio to not exceed 60 % at any time.\\nThe amount that we can borrow at any given time under our Line of Credit, and the individual term loans (each a “Term Loan” and together the “Term Loans”) is governed by certain operating metrics of designated hotel properties known as borrowing base assets. As of June 30, 2021, the following hotel properties secured the amended facilities under the Credit Agreements:\\n26\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\\n| - Courtyard by Marriott Brookline, Brookline, MA | - Hampton Inn, Washington, DC |\\n| - The Envoy Boston Seaport, Boston, MA | - Ritz-Carlton Georgetown, Washington, DC |\\n| - The Boxer, Boston, MA | - Hilton Garden Inn, M Street, Washington, DC |\\n| - Hampton Inn Seaport, Seaport, New York, NY | - The Winter Haven Hotel Miami Beach, Miami, FL |\\n| - Holiday Inn Express Chelsea, 29th Street, New York, NY | - The Blue Moon Hotel Miami Beach, Miami, FL |\\n| - Gate Hotel JFK Airport, New York, NY | - Cadillac Hotel & Beach Club, Miami, FL |\\n| - Hilton Garden Inn JFK Airport, New York, NY | - The Parrot Key Hotel & Villas, Key West, FL |\\n| - NU Hotel, Brooklyn, New York, NY | - TownePlace Suites, Sunnyvale, CA |\\n| - Hyatt House White Plains, White Plains, NY | - The Ambrose Hotel, Santa Monica, CA |\\n| - Hampton Inn Center City/ Convention Center, Philadelphia, PA | - The Pan Pacific Hotel Seattle, Seattle, WA |\\n| - The Rittenhouse, Philadelphia, PA | - Mystic Marriott Hotel & Spa, Groton, CT |\\n| - Philadelphia Westin, Philadelphia, PA |\\n\\nThe interest rate for borrowings under the Line of Credit and Term Loans are based on a pricing grid with a range of one month U.S. LIBOR plus a spread. The following table summarizes the balances outstanding and interest rate spread for each borrowing:\\n| Outstanding Balance |\\n| Borrowing | Spread | June 30, 2021 | December 31, 2020 |\\n| Line of Credit | 1.50 % to 2.25 % | $ | 118,684 | $ | 133,053 |\\n| Term Loans: |\\n| First Term Loan | 1.45 % to 2.20 % | $ | 192,404 | $ | 202,158 |\\n| Second Term Loan | 1.35 % to 2.00 % | 278,846 | 292,983 |\\n| Third Term Loan | 1.45 % to 2.20 % | 26,231 | 189,365 |\\n| Deferred Loan Costs | ( 1,824 ) | ( 2,762 ) |\\n| Total Term Loans | $ | 495,657 | $ | 681,744 |\\n\\nPrior to the amendments noted above, the Credit Agreements included certain financial covenants and required that we maintain: (1) a minimum tangible net worth (calculated as total assets, plus accumulated depreciation, less total liabilities, intangibles and other defined adjustments) of $ 1,119,500 , plus an amount equal to 75 % of the net cash proceeds of all issuances and primary sales of equity interests of the parent guarantor or any of its subsidiaries consummated following the closing date; (2) annual distributions not to exceed 95 % of adjusted funds from operations; and (3) certain financial ratios, including the following:\\n•a fixed charge coverage ratio of not less than 1.50 to 1.00;\\n•a maximum leverage ratio of not more than 60 %; and\\n•a maximum secured debt leverage ratio of 45 %.\\nThe weighted average interest rate, inclusive of the effect of derivative instruments, on the Credit Agreements was 3.92 % and 4.23 %, and 3.73 % and 4.21 %, for the three and six months ended June 30, 2021 and 2020, respectively.\\n27\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\\nNotes Payable\\nNotes payable at June 30, 2021 and December 31, 2020 consisted of the following:\\n| June 30, 2021 | December 31, 2020 |\\n| Notes Payable | $ | 204,062 | $ | 51,548 |\\n| Net Unamortized Discount | ( 4,899 ) | — |\\n| Net Unamortized Deferred Financing Costs | ( 5,438 ) | ( 759 ) |\\n| Notes Payable | $ | 193,725 | $ | 50,789 |\\n\\nStatutory Trust I and Statutory Trust II Notes Payable\\nWe have two junior subordinated notes payable in the aggregate amount of $ 51,548 related to the Hersha Statutory Trusts pursuant to indenture agreements which will mature on July 30, 2035, but may be redeemed at our option, in whole or in part, prior to maturity in accordance with the provisions of the indenture agreements. The $ 25,774 of notes issued to each of Hersha Statutory Trust I and Hersha Statutory Trust II bear interest at a variable rate of LIBOR plus 3 % per annum. This rate resets 2 business days prior to each quarterly payment. The related deferred financing costs are amortized over the life of the notes payable. The weighted average interest rate on our two junior subordinated notes payable was 3.19 % and 4.08 % for the three months ended June 30, 2021 and 2020, respectively, and 3.20 % and 4.45 % for the six months ended June 30, 2021 and 2020, respectively.\\nJunior Notes Payable\\nOn February 17, 2021, the Company entered into a note purchase agreement (the “Purchase Agreement”) with several purchasers (the “Purchasers”). The Company agreed to issue and sell to the Purchasers an initial $ 150,000 aggregate principal amount (the “Initial Notes”) of the Company’s 9.50 % Unsecured PIK Toggle Notes due 2026 (the “Notes”), and an incremental $ 50,000 aggregate principal amount of the Notes that can be drawn at the Company’s discretion, subject to certain conditions, in minimum installments of $ 25,000 on or prior to September 30, 2021.\\nThe Initial Notes were issued on February 23, 2021. The Notes will mature on February 23, 2026. The Notes bear interest at a rate of 9.50 % per year, payable in arrears on June 30, September 30, December 31 and March 31 of each year, beginning on June 30, 2021. For any interest period ending on or prior to March 31, 2022, the Issuer, in its sole discretion may elect to pay interest (a) in cash at a rate per annum equal to 4.75 % per annum, and (b) in kind at a rate per annum equal to 4.75 % per annum (“PIK Interest”). Any PIK Interest will be paid by increasing the principal amount of the Notes at the end of the applicable interest period by the amount of such PIK Interest. We elected the PIK Interest option for the interest period ended June 30, 2021, increasing the principal balance $ 2,514 to $ 152,514 as of June 30, 2021.\\nThe Notes may not be redeemed prior to February 23, 2022. The notes may be redeemed during the 12 month period beginning February 23, 2022 and the 12 month period beginning February 23, 2023, at a redemption price equal to 104 % and 102 % of the principal amount of the Notes being redeemed, respectively. After February 23, 2024, the notes may be redeemed at the principal amount.\\nThe Notes are subject to representations, warranties, covenants, terms and conditions customary for transactions of this type, including limitations on liens, incurrence of new debt, investments, mergers and asset dispositions, covenants to preserve corporate existence and comply with laws and default provisions.\\nThe Company may only use the net proceeds from the issuance of the Notes in accordance with the mandatory prepayment waterfalls, which includes the repayment of outstanding borrowings under the Credit Agreement and use for certain other general corporate purposes.\\n28\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 5 - DEBT (CONTINUED)\\nInterest Expense\\nThe table below shows the interest expense incurred by the Company during the three and six months ended June 30, 2021 and 2020:\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Mortgage Loans Payable | $ | 2,680 | $ | 3,031 | $ | 5,415 | $ | 6,516 |\\n| Interest Rate Swap Contracts on Mortgages | 627 | 552 | 1,230 | 585 |\\n| Unsecured Notes Payable | 4,311 | 532 | 6,248 | 1,160 |\\n| Credit Facility and Term Loans | 3,754 | 5,370 | 8,122 | 12,404 |\\n| Interest Rate Swap Contracts on Credit Agreements | 2,417 | 3,133 | 4,841 | 4,219 |\\n| Deferred Financing Costs Amortization | 1,088 | 702 | 2,380 | 1,267 |\\n| Other | 105 | 161 | 175 | 337 |\\n| Total Interest Expense | $ | 14,982 | $ | 13,481 | $ | 28,411 | $ | 26,488 |\\n\\n29\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 6 – LEASES\\nWe own five hotels within our consolidated portfolio of hotels where we do not own the land on which the hotels reside, rather we lease the land from an unrelated third-party lessor. All of our land leases are classified as operating leases and have initial terms with extension options that range from May 2062 to October 2103. We also have two additional office space leases with terms ranging from March 2023 to December 2027.\\nThe components of lease costs for the three months ended June 30, 2021 and 2020 were as follows:\\n| Three Months Ended June 30, 2021 | Three Months Ended June 30, 2020 |\\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\\n| Operating lease costs | $ | 1,050 | $ | 121 | $ | 1,171 | $ | 1,050 | $ | 121 | $ | 1,171 |\\n| Variable lease costs | 14 | 83 | 97 | 8 | 87 | 95 |\\n| Total lease costs | $ | 1,064 | $ | 204 | $ | 1,268 | $ | 1,058 | $ | 208 | $ | 1,266 |\\n\\nThe components of lease costs for the six months ended June 30, 2021 and 2020 were as follows:\\n| Six months ended June 30, 2021 | Six months ended June 30, 2020 |\\n| Ground Lease | Office Lease | Total | Ground Lease | Office Lease | Total |\\n| Operating lease costs | $ | 2,126 | $ | 242 | $ | 2,368 | $ | 2,100 | $ | 242 | $ | 2,342 |\\n| Variable lease costs | 38 | 167 | 205 | 21 | 154 | 175 |\\n| Total lease costs | $ | 2,164 | $ | 409 | $ | 2,573 | $ | 2,121 | $ | 396 | $ | 2,517 |\\n\\nOther information related to leases as of and for the six months ended June 30, 2021 and 2020 is as follows:\\n| June 30, 2021 | June 30, 2020 |\\n| Cash paid from operating cash flow for operating leases | $ | 2,246 | $ | 1,951 |\\n| Weighted average remaining lease term | 64.2 | 64.2 |\\n| Weighted average discount rate | 7.87 | % | 7.86 | % |\\n\\n30\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS\\nManagement Agreements\\nOur wholly-owned TRS, 44 New England Management Company, and certain of our joint venture entities engage eligible independent contractors in accordance with the requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended, including Hersha Hospitality Management Limited Partnership (“HHMLP”), as the property managers for hotels it leases from us pursuant to management agreements. HHMLP is owned, in part, by certain executives and trustees of the Company. Our management agreements with HHMLP provide for a term of five years and are subject to early termination upon the occurrence of defaults and certain other events described therein. As required under the REIT qualification rules, HHMLP must qualify as an “eligible independent contractor” during the term of the management agreements. Under the management agreements, HHMLP generally pays the operating expenses of our hotels. All operating expenses or other expenses incurred by HHMLP in performing its authorized duties are reimbursed or borne by our TRS to the extent the operating expenses or other expenses are incurred within the limits of the applicable approved hotel operating budget. HHMLP is not obligated to advance any of its own funds for operating expenses of a hotel or to incur any liability in connection with operating a hotel. Management agreements with other unaffiliated hotel management companies have similar terms.\\nFor its services, HHMLP receives a base management fee and, if a hotel exceeds certain thresholds, an incentive management fee. The base management fee for a hotel is due monthly and is equal to 3 % of gross revenues associated with each hotel managed for the related month. The incentive management fee, if any, for a hotel is due annually in arrears on the ninetieth day following the end of each fiscal year and is based upon the financial performance of the hotels. For the three and six months ended June 30, 2021 and 2020, base management fees incurred to HHMLP totaled $ 1,745 and $ 564 , and $ 2,925 and $ 2,933 , respectively, and are recorded as Hotel Operating Expenses. For the three and six months ended June 30, 2021 and 2020, we did no t incur incentive management fees.\\nFranchise Agreements\\nOur branded hotel properties are operated under franchise agreements assumed by the hotel property lessee. The franchise agreements have 10 to 20 year terms, but may be terminated by either the franchisee or franchisor on certain anniversary dates specified in the agreements. The franchise agreements require annual payments for franchise royalties, reservation, and advertising services, and such payments are based upon percentages of gross room revenue. These payments are paid by the hotels and charged to expense as incurred. Franchise fee expenses for the three and six months ended June 30, 2021 and 2020 were $ 2,465 and $ 775 , and $ 4,287 and $ 4,603 , respectively, and are recorded in Hotel Operating Expenses. The initial fees incurred to enter into the franchise agreements are amortized over the life of the franchise agreements.\\nAccounting and Information Technology Fees\\nEach of the wholly-owned hotels and consolidated joint venture hotel properties managed by HHMLP incurs a monthly accounting and information technology fee. Monthly fees for accounting services are between $ 2 and $ 3 per property and monthly information technology fees range from $ 1 to $ 2 per property. For the three and six months ended June 30, 2021 and 2020, the Company incurred accounting fees of $ 277 and $ 319 , and $ 590 and $ 644 , respectively. For the three and six months ended June 30, 2021 and 2020, the Company incurred information technology fees of $ 90 and $ 103 , and $ 191 and $ 208 , respectively. Accounting fees and information technology fees are included in Hotel Operating Expenses.\\nCapital Expenditure Fees\\nHHMLP charges a 5 % fee on certain capital expenditures and pending renovation projects at the properties as compensation for procurement services related to capital expenditures and for project management of renovation projects. For the three and six months ended June 30, 2021 and 2020, we incurred fees of $ 78 and $ 56 , and $ 197 and $ 956 , respectively, which were capitalized with the cost of capital expenditures.\\n31\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 7 – COMMITMENTS AND CONTINGENCIES AND RELATED PARTY TRANSACTIONS (CONTINUED)\\nAcquisitions from Affiliates\\nWe have entered into an option agreement with certain of our officers and trustees such that we obtain a right of first refusal to purchase any hotel owned or developed in the future by these individuals or entities controlled by them at fair market value. This right of first refusal would apply to each party until one year after such party ceases to be an officer or trustee of the Company. Our Acquisition Committee of the Board of Trustees is comprised solely of independent trustees, and the purchase prices and all material terms of the purchase of hotels from related parties are approved by the Acquisition Committee.\\nHotel Supplies\\nFor the three and six months ended June 30, 2021 and 2020, we incurred charges for hotel supplies of $ 0 and $ 11 , and $ 1 and $ 63 , respectively. For the three and six months ended June 30, 2021 and 2020, we incurred charges for capital expenditure purchases of $ 86 and $ 176 , and $ 220 and $ 1,056 , respectively. These purchases were made from Hersha Purchasing and Design, a hotel supply company owned, in part, by certain executives and trustees of the Company. Hotel supplies are expensed and included in Hotel Operating Expenses on our consolidated statements of operations, and capital expenditure purchases are included in investment in hotel properties on our consolidated balance sheets.\\nInsurance Services\\nPrior to January 1, 2021, the Company utilized the services of the Hersha Group, a risk management business owned, in part, by certain executives and trustees of the Company. The Hersha Group provided consulting and procurement services to the Company related to the placement of property and casualty insurance, placement of general liability insurance, and for claims handling for our hotel properties. Beginning January 1, 2021, these services were provided by a third-party service provider. For the three and six months ended June 30, 2020, the total cost of property insurance that we paid through the Hersha Group were $ 1,388 and $ 2,984 , respectively. This amount paid to the Hersha Group included insurance premiums and brokerage fees as compensation for brokerage services.\\nRestaurant Lease Agreements with Independent Restaurant Group\\nThe Company enters into lease agreements with a number of restaurant management companies for the lease of restaurants located within our hotels. The Company previously entered into lease agreements with Independent Restaurant Group (\\\"IRG\\\") for restaurants at three of its hotel properties. Jay H. Shah and Neil H. Shah, executive officers and/or trustees of the Company, collectively own a 70.0 % interest in IRG. The Company’s restaurant lease agreements with IRG generally provided for a term of five years and the payment of base rents and percentage rents, which were based on IRG’s revenue in excess of defined thresholds. Effective April 1, 2020, each of these lease agreements became a management agreement between the Company and IRG, subject to the supervision of HHMLP, as property manager. At the time of the conversion of the lease agreements to management agreements there was rent due of $ 103 , which was forgiven due to the impact of the COVID-19 pandemic on the operations of our hotels and IRG's restaurants. For the six months ended June 30, 2021 and 2020, we did no t recognize any revenue from IRG.\\nDue From Related Parties\\nThe due from related parties balance as of June 30, 2021 and December 31, 2020 was approximately $ 1,552 and $ 2,641 , respectively. The balances primarily consisted of working capital deposits made to HHMLP and other entities owned, in part, by certain executives and trustees of the Company.\\nDue to Related Parties\\nThe balance due to related parties as of June 30, 2021 and December 31, 2020 was $ 0 .\\n32\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS\\nFair Value Measurements\\nOur determination of fair value measurements are based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, we utilize a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).\\nLevel 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liabilities, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.\\nAs of June 30, 2021, the Company’s derivative instruments represented the only financial instruments measured at fair value. Currently, the Company uses derivative instruments, such as interest rate swaps and caps, to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs.\\nWe incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counter-party’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.\\nAlthough we have determined that the majority of the inputs used to value our derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by us and the counter-parties. However, as of June 30, 2021 we have assessed the significance of the effect of the credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivatives. As a result, we have determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.\\nDerivative Instruments\\nThe Company’s objective in using derivatives is to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and interest rate caps as part of its cash flow hedging strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount. Interest rate caps designated as cash flow hedges limit the Company’s exposure to increased cash payments due to increases in variable interest rates. The table on the following page presents our derivative instruments as of June 30, 2021 and December 31, 2020.\\n33\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\\n| Estimated Fair Value |\\n| (Liability) Balance |\\n| Hedged Debt | Type | Strike Rate | Effective Date | Derivative Contract Maturity Date | Notional Amount | June 30, 2021 | December 31, 2020 |\\n| Term Loan Instruments: |\\n| Credit Facility | Swap | 1.341 | % | 1-Month LIBOR + 2.20 % | October 3, 2019 | August 2, 2021 | 150,000 | $ | ( 165 ) | $ | ( 1,070 ) |\\n| Credit Facility (1) | Swap | 1.316 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 2, 2021 | 43,900 | ( 47 ) | ( 307 ) |\\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\\n| Credit Facility | Swap | 1.824 | % | 1-Month LIBOR + 2.20 % | September 3, 2019 | August 10, 2022 | 103,500 | ( 1,944 ) | ( 2,793 ) |\\n| Credit Facility | Swap | 1.460 | % | 1-Month LIBOR + 2.00 % | September 10, 2019 | September 10, 2024 | 300,000 | ( 8,790 ) | ( 13,286 ) |\\n| Mortgages: |\\n| Annapolis Waterfront Hotel, MD | Cap | 3.350 | % | 1-Month LIBOR + 2.65 % | May 1, 2018 | May 1, 2021 | 28,000 | — | — |\\n| Hyatt, Union Square, New York, NY | Swap | 1.870 | % | 1-Month LIBOR + 2.30 % | June 7, 2019 | June 7, 2023 | 56,000 | ( 1,743 ) | ( 2,305 ) |\\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\\n| Hilton Garden Inn Tribeca, New York, NY | Swap | 1.768 | % | 1-Month LIBOR + 2.25 % | July 25, 2019 | July 25, 2024 | 22,725 | ( 869 ) | ( 1,222 ) |\\n| Hilton Garden Inn 52nd Street, New York, NY | Swap | 1.540 | % | 1-Month LIBOR + 2.30 % | December 4, 2019 | December 4, 2022 | 44,325 | ( 869 ) | ( 1,186 ) |\\n| Courtyard, LA Westside, Culver City, CA (2) | Swap | 0.495 | % | 1-Month LIBOR + 3.75 % | June 1, 2020 | August 1, 2021 | 35,000 | ( 12 ) | ( 75 ) |\\n| $ | ( 17,252 ) | $ | ( 26,259 ) |\\n\\n(1) During the six months ended June 30, 2021, we dedesignated this swap as a cash flow hedge and recorded expense of $ 330 accordingly.\\n(2) Subsequent to June 30, 2021, we entered into an interest rate cap for this debt, which is effective on August 1, 2021.\\nThe fair value of our interest rate swaps is included in accounts payable, accrued expenses and other liabilities at June 30, 2021 and December 31, 2020.\\nThe net change related to derivative instruments designated as cash flow hedges recognized as unrealized gains and losses reflected on our consolidated balance sheet in accumulated other comprehensive income was a gain of $ 2,398 and a loss of $ 792 for the three months ended June 30, 2021 and 2020, respectively, and a gain of $ 9,163 and a loss of $ 30,941 for the six months ended June 30, 2021 and 2020, respectively.\\n34\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 8 – FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS (CONTINUED)\\nAmounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate derivatives. The change in net unrealized gains/losses on cash flow hedges reflects a reclassification of $( 141 ) and $ 1,228 and $ 159 and $ 2,205 of net unrealized gains from accumulated other comprehensive income as an increase/decrease to interest expense for the three and six months ended June 30, 2021 and 2020, respectively. For the next twelve months ending June 30, 2022, we estimate that an additional $ 10,059 will be reclassified as an increase to interest expense.\\nFair Value of Debt\\nWe estimate the fair value of our fixed rate debt and the credit spreads over variable market rates on our variable rate debt by discounting the future cash flows of each instrument at estimated market rates or credit spreads consistent with the maturity of the debt obligation with similar credit policies. Credit spreads take into consideration general market conditions and maturity. The inputs utilized in estimating the fair value of debt are classified in Level 2 of the fair value hierarchy. As of June 30, 2021, the carrying value and estimated fair value of our debt was $ 1,112,492 and $ 1,141,023 respectively. As of December 31, 2020, the carrying value and estimated fair value of our debt was $ 1,196,434 and $ 1,176,625 , respectively.\\n35\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS\\nOur shareholders approved the Hersha Hospitality Trust 2012 Equity Incentive Plan, as amended, (the “2012 Plan”) for the purpose of attracting and retaining executive officers, employees, trustees and other persons and entities that provide services to the Company.\\nThe Short Term Incentive Program (\\\"STIP\\\") and the Long-Term Incentive Program (\\\"LTIP\\\") were incentive compensation programs the Compensation Committee of our Board of Trustees established to align executive compensation with the performance of the Company. Prior to 2019, executives participated in our legacy incentive compensation programs, including the Multi-Year Long Term Equity Incentive Program (\\\"Multi-Year EIP\\\").\\nOn March 17, 2021, based on the achievement of certain metrics established under the 2020 STIP for the performance period ended December 31, 2020, the Compensation Committee awarded 519,732 LTIP Units. The awards issued pursuant to the STIP vest on December 31, 2022, the two year anniversary following the end of the performance period.\\nOn March 3, 2021, the Compensation Committee approved the 2021 LTIP in which 50 % of the awards provide for time based vesting and the remaining 50 % are issuable based on the Company's achievement of a certain level of (1) absolute total shareholder return ( 37.5 % of the award), (2) relative total shareholder return as compared to the Company’s peer\\ngroup ( 37.5 % of the award), and (3) relative growth in revenue per available room (\\\"RevPar\\\") compared to the Company’s peer group ( 25.0 % of the award). On March 17, 2021, the Compensation Committee awarded 247,689 LTIP Units related to the time based portion of the plan. These Units will vest over a three year period from January 1, 2021 to December 31, 2023. The 50 % market-based portion of the 2021 LTIP has a three-year performance period which commenced on January 1, 2021 and ends December 31, 2023. As of June 30, 2021, no shares or LTIP Units have been issued to the executive officers in settlement of 2021 LTIP market-based awards.\\nThe LTIP Units awarded under both the 2020 STIP and the 2021 LTIP were determined by dividing the dollar amount of award earned by $ 8.43 , the per share volume weighted average trading price of the Company’s common shares on the NYSE for the 20 trading days prior to December 31, 2020.\\n| LTIP Unit Awards | Restricted Share Awards | Share Awards |\\n| Number of Units | Weighted Average Grant Date Fair Value | Number of Restricted Shares | Weighted Average Grant Date Fair Value | Number of Shares | Weighted Average Grant Date Fair Value |\\n| Unvested Balance as of December 31, 2020 | 898,126 | $ | 6.15 | 202,878 | $ | 7.87 | — |\\n| Granted | 794,683 | 12.86 | 116,743 | 10.18 | 32,460 | 11.31 |\\n| Vested | ( 13,512 ) | 12.23 | ( 239,736 ) | 7.73 | ( 32,460 ) | 11.31 |\\n| Forfeited | — | N/A | ( 150 ) | 11.31 | — | N/A |\\n| Unvested Balance as of June 30, 2021 | 1,679,297 | $ | 9.28 | 79,735 | $ | 11.68 | — |\\n\\n36\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 9 – SHARE BASED PAYMENTS (CONTINUED)\\n| Share BasedCompensation Expense | UnearnedCompensation |\\n| For the Three Months Ended | For the Six Months Ended | As of |\\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 | June 30, 2021 | December 31, 2020 |\\n| Issued Awards |\\n| LTIP Unit Awards | $ | 1,534 | $ | 1,142 | $ | 3,258 | $ | 2,951 | $ | 8,049 | $ | 1,842 |\\n| Restricted Share Awards | 254 | 342 | 422 | 674 | 762 | 276 |\\n| Share Awards | 367 | — | 367 | — | — | — |\\n| Unissued Awards |\\n| Market Based | 434 | 315 | 711 | 630 | 3,019 | 1,933 |\\n| Performance Based | — | — | — | — | — | — |\\n| Total | $ | 2,589 | $ | 1,799 | $ | 4,758 | $ | 4,255 | $ | 11,830 | $ | 4,051 |\\n\\nThe weighted-average period of which the unrecognized compensation expense will be recorded is approximately 2.0 years for LTIP Unit Awards and 1.1 years for Restricted Share Awards.\\n| 2021 | 2022 | 2023 | 2024 |\\n| LTIP Unit Awards | 960,046 | 595,406 | 61,921 | 61,924 |\\n| Restricted Share Awards | — | 66,202 | 10,533 | 3,000 |\\n| 960,046 | 661,608 | 72,454 | 64,924 |\\n\\n37\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 10 – EARNINGS PER SHARE\\nThe following table is a reconciliation of the income or loss (numerator) and the weighted average shares (denominator) used in the calculation of basic and diluted earnings per common share. The computation of basic and diluted earnings per share is presented below.\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| NUMERATOR: |\\n| Basic and Diluted* |\\n| Net Loss | $ | ( 23,523 ) | $ | ( 71,780 ) | $ | ( 14,433 ) | $ | ( 97,752 ) |\\n| Loss allocated to Noncontrolling Interests | 977 | 10,360 | 813 | 13,257 |\\n| Distributions to Preferred Shareholders | ( 6,044 ) | ( 6,044 ) | ( 12,087 ) | ( 12,088 ) |\\n| Net loss applicable to Common Shareholders | $ | ( 28,590 ) | $ | ( 67,464 ) | $ | ( 25,707 ) | $ | ( 96,583 ) |\\n| DENOMINATOR: |\\n| Weighted average number of common shares - basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n| Effect of dilutive securities: |\\n| Restricted Stock Awards and LTIP Units (unvested) | — | — | — | — |\\n| Contingently Issued Shares and Units | — | — | — | — |\\n| Weighted average number of common shares - diluted | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n\\n*Income (loss) allocated to noncontrolling interest in HHLP has been excluded from the numerator and Common Units and Vested LTIP Units have been omitted from the denominator for the purpose of computing diluted earnings per share since including these amounts in the numerator and denominator would have no impact. In addition, potentially dilutive common shares, if any, have been excluded from the denominator if they are anti-dilutive to income (loss) applicable to common shareholders.\\n38\\nHERSHA HOSPITALITY TRUST AND SUBSIDIARIESNOTES TO THE CONSOLIDATED FINANCIAL STATEMENTSFOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2021 AND 2020 [UNAUDITED][IN THOUSANDS, EXCEPT SHARE/UNIT AND PER SHARE AMOUNTS]NOTE 11 – CASH FLOW DISCLOSURES AND NON CASH INVESTING AND FINANCING ACTIVITIES\\nInterest paid during the six months ended June 30, 2021 and 2020 totaled $ 20,052 and $ 21,488 , respectively. Net Cash paid on Interest Rate Derivative contracts during the six months ended June 30, 2021 and 2020 totaled $ 6,259 and $ 1,505 , respectively. Cash paid for income taxes during the six months ended June 30, 2021 and 2020 totaled $ 60 and $ 233 , respectively. The following non-cash investing and financing activities occurred during the six months ended June 30, 2021 and 2020:\\n| 2021 | 2020 |\\n| Common Shares issued as part of the Dividend Reinvestment Plan | $ | — | $ | 14 |\\n| Issuance of share based payments | 13,103 | 6,404 |\\n| Accrued payables for capital expenditures placed into service | 230 | 1,398 |\\n| Adjustment to Record Noncontrolling Interest at Redemption Value | 1,968 | ( 3,196 ) |\\n\\nThe following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the consolidated balance sheets that sum to the total of the same such amounts shown in the consolidated statements of cash flows for the six months ended June 30, 2021 and 2020:\\n| 2021 | 2020 |\\n| Cash and cash equivalents | $ | 69,083 | $ | 23,228 |\\n| Escrowed cash | 11,067 | 7,374 |\\n| Total cash, cash equivalents, and restricted cash shown in the consolidated statements of cash flows | $ | 80,150 | $ | 30,602 |\\n\\nAmounts included in restricted cash represent those required to be set aside in escrow by contractual agreement with various lenders for the payment of specific items such as property insurance, property tax, and capital expenditures.\\n39\\nItem 2.\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\\nCautionary Statement Regarding Forward Looking Statements\\nThis report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements containing the words, “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” and words of similar import. Such forward-looking statements relate to future events, our plans, strategies, prospects and future financial performance, and involve known and unknown risks that are difficult to predict, uncertainties and other factors which may cause our actual results, performance or achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Readers should specifically consider the various factors identified in this report and other reports filed by us with the U.S. Securities and Exchange Commission (the \\\"SEC\\\"), including, but not limited to those discussed in the sections entitled “Risk Factors” and \\\"Management's Discussion and Analysis of Financial Conditions and Results of Operations\\\" of our Annual Report on Form 10-K for the year ended December 31, 2020 and in this Quarterly Report on Form 10-Q, that could cause actual results to differ. Statements regarding the following subjects are forward-looking by their nature:\\n● our business or investment strategy;\\n● our projected operating results;\\n● our ability to generate positive cash flow from operations;\\n● our distribution policy;\\n● our liquidity and management's plans with respect thereto;\\n● completion of any pending transactions;\\n● our ability to maintain existing financing arrangements, including compliance with covenants and our ability to obtain future financing arrangements or refinance or extend the maturity of existing financing arrangements as they come due;\\n● our ability to negotiate with lenders;\\n● our understanding of our competition;\\n● market trends;\\n● projected capital expenditures;\\n● the impact of and changes to various government programs, including in response to the novel coronavirus, or COVID-19, including those specifically affecting New York City;\\n● the efficacy of any treatment for COVID-19;\\n● our access to capital on the terms and timing we expect;\\n● the restoration of public confidence in domestic and international travel;\\n● permanent structural changes in demand for conference centers by business and leisure clientele; and\\n● our ability to dispose of selected hotel properties on the terms and timing we expect, if at all.\\nForward-looking statements are based on our beliefs, assumptions and expectations, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Readers should not place undue reliance on forward-looking statements.\\nImportant factors that we think could cause our actual results to differ materially from expected results are summarized below. One of the most significant factors, however, is the ongoing impact of the current outbreak of the novel coronavirus on the United States, regional and global economies, the broader financial markets, our customers and employees, governmental responses thereto and the operation changes we have and may implement in response thereto. The current outbreak of COVID-19 has also impacted, and is likely to continue to impact, directly or indirectly, many other important factors below.\\nNew factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. In particular, it is difficult to fully assess the impact of COVID-19 at this time due to, among other factors, uncertainty regarding the severity and duration of the outbreak domestically and internationally, and the possibility of additional subsequent widespread outbreaks and variant strains and the impacts of actions taken in response, and the effectiveness of federal, state and local governments’ efforts to contain the spread of COVID-19 and respond to its direct and indirect impact on the U.S. economy and economic activity.\\n40\\nThe following non-exclusive list of factors could also cause actual results to vary from our forward-looking statements:\\n● general volatility of the capital markets and the market price of our common shares;\\n● changes in our business or investment strategy;\\n● availability, terms and deployment of capital;\\n● changes in our industry and the market in which we operate, interest rates, or the general economy;\\n● decreased international travel because of geopolitical events, including terrorism and current U.S. government policies such as immigration policies, border closings, and travel bans related to COVID-19;\\n● the degree and nature of our competition;\\n● financing risks, including (i) the risk of leverage and the corresponding risk of default on our mortgage loans and other debt, including default with respect to applicable covenants, (ii) potential inability to obtain waivers of covenants or refinance or extend the maturity of existing indebtedness and (iii) our ability to negotiate with lenders;\\n● levels of spending in the business, travel and leisure industries, as well as consumer confidence;\\n● declines in occupancy, average daily rate and RevPAR and other hotel operating metrics;\\n● hostilities, including future terrorist attacks, or fear of hostilities that affect travel;\\n● financial condition of, and our relationships with, our joint venture partners, third-party property managers, and franchisors;\\n● increased interest rates and operating costs;\\n● ability to complete development and redevelopment projects;\\n● risks associated with potential dispositions of hotel properties;\\n● availability of and our ability to retain qualified personnel;\\n● decreases in tourism due to pandemics, geopolitical instability or changes in foreign exchange rates;\\n● our failure to maintain our qualification as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the \\\"Code\\\";\\n● environmental uncertainties and risks related to natural disasters and increases in costs to insure against those risks;\\n● changes in real estate and zoning laws and increases in real property tax rates;\\n● the uncertainty and economic impact of pandemics, epidemics, or other public health emergencies or fear of such events, such as the recent outbreak of COVID-19, including with respect to New York City;\\n● the current COVID-19 pandemic had, and will continue to have, adverse effects on our financial conditions, results of operations, cash flows, and performance for an indefinite period of time. Future pandemics may also have adverse effects on our financial condition, results of operations, cash flows, and performance;\\n● world events impacting the ability or desire of people to travel may lead to a decline in demand for hotels; and\\n● the factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2020 under the headings “Risk Factors” and \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" and in other reports we file with the SEC from time to time.\\nThese factors are not necessarily all of the important factors that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by any of our forward-looking statements. Other unknown or unpredictable factors, many of which are beyond our control, also could harm our results, performance or achievements.\\nAll forward-looking statements contained in this report are expressly qualified in their entirety by the cautionary statements set forth above. Forward-looking statements speak only as of the date they are made, and we do not undertake or assume any obligation to update publicly any of these statements to reflect actual results, new information or future events, changes in assumptions or changes in other factors affecting forward-looking statements, except to the extent required by applicable laws. If we update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.\\nBACKGROUND\\nAs of June 30, 2021, we owned interests in 36 hotels in major urban gateway markets including New York, Washington DC, Boston, Philadelphia, San Diego, Los Angeles, Seattle, and Miami, including 32 wholly-owned hotels, 1 hotel through our interest in a consolidated joint venture, and interests in 3 hotels owned through unconsolidated joint ventures. We have elected to be taxed as a REIT for federal income tax purposes, beginning with the taxable year ended December 31, 1999. For purposes of the REIT qualification rules, we cannot directly operate any of our hotels. Instead, we must lease our hotels to a third party lessee or to a TRS, provided that the TRS engages an eligible independent contractor to manage the\\n41\\nhotels. As of June 30, 2021, we have leased all of our hotels to a wholly-owned TRS, a joint venture owned TRS, or an entity owned by our wholly-owned TRS. Each of these TRS entities will pay qualifying rent, and the TRS entities have entered into management contracts with qualified independent managers, including HHMLP, with respect to our hotels. We intend to lease all newly acquired hotels to a TRS. The TRS structure enables us to participate more directly in the operating performance of our hotels. The TRS directly receives all revenue from, and funds all expenses relating to, hotel operations. The TRS is also subject to income tax on its earnings.\\nOVERVIEW\\nWe started to realize the effects from the global economic slowdown caused by the COVID-19 pandemic in March of 2020. As a result of the COVID-19 pandemic and subsequent government mandates and health official recommendations, hotel demand has been substantially reduced across the United States.\\nFollowing the government mandates and health official recommendations, and after evaluating the cost of running our respective properties at low occupancy levels versus closing the properties, we originally closed 21 hotel properties and dramatically reduced staffing at the hotels that remained open and at the corporate level; however, we have subsequently reopened all of our consolidated hotels. The reopening of our consolidated hotels provided us the opportunity to capture incremental demand through the end of 2020 and we believe we are prepared to capture market share during the early stages of an economic recovery in 2021.\\nIn addition to our focus on strategically reopening hotels and driving occupancy at these hotels, we have remained focused on executing expense mitigation measures and shoring up our liquidity position as we continue to face a challenging operating environment. We suspended our common and preferred dividends in 2020 and during the six months ended June 30, 2021, we paid approximately $24.2 million in preferred dividend arrearage that was not paid in 2020. We also deferred certain planned capital expenditures for 2020 and we will continue to reduce capital expenditures in 2021 with planned allocations estimated between $15.0 and $18.0 million. In February 2021, the Company entered into an unsecured notes facility that provided net proceeds of $144.75 million at closing. An incremental $50 million may be drawn, at the Company’s discretion, in minimum installments of $25.0 million, at any point on or prior to September 30, 2021. The initial net proceeds of $144.75 million provided by this facility, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under our Credit Facility, allowing us to amend our Credit Facility on February 17, 2021, eliminating maturities under the Credit Facility until August of 2022. The Credit Facility amendment also waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, and provided additional liquidity at the Company’s discretion.\\nThe manner in which the ongoing COVID-19 pandemic will be resolved or the manner that the hospitality and tourism industries will return to historical performance norms, and whether the economy will contract or grow are not reasonably predictable. As a result, there can be no assurances that we will be able to achieve the hotel operating metrics or the results at our properties we have forecasted. Factors that might contribute to less-than-anticipated performance include those described under the headings “Risk Factors” and \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our Annual Report on Form 10-K for the year ended December 31, 2020 and other documents that we may file with the SEC in the future. We will continue to cautiously monitor lodging demand and rates, our third-party hotel managers, and our performance generally.\\n42\\nSUMMARY OF OPERATING RESULTS\\nCOMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2021 AND 2020\\n(dollars in thousands, except ADR, RevPAR, and per share data)\\nRevenue\\nOur total revenues for the three months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the three months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $52,671, or 302.5%, to $70,083 for the three months ended June 30, 2021 compared to $17,412 for the same period in 2020. This increase is primarily attributable to an increase in demand across our portfolio in 2021 as the comparable period in 2020 was at the nadir of the reduction in operations across our portfolio due to the decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the three months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\\nExpenses\\nTotal hotel operating expenses increased 124.8% to approximately $41,310 for the three months ended June 30, 2021 from $18,378 for the three months ended June 30, 2020. The increase in hotel operating expenses is due to increased operations at our hotels for the three months ended June 30, 2021 as we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic during the comparable period in 2020. This increase in hotel operating expense is partially offset by the sale of hotels noted above.\\nDepreciation and amortization decreased by 13.6%, or $3,308, to $21,014 for the three months ended June 30, 2021 from $24,322 for the three months ended June 30, 2020. The decrease is primarily attributable to the disposition of the Sheraton Wilmington in December 2020, and the Courtyard San Diego, the Residence Inn Coconut Grove, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, and the Duane Street Hotel in the first half of 2021.\\nReal estate and personal property tax and property insurance decreased $503, or 5.0%, for the three months ended June 30, 2021 when compared to the same period in 2020. This decrease is primarily driven by reductions in real estate tax expense due to the sale of hotels noted above. The decrease is partially offset by increased real estate tax that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense for the quarter as we cumulatively catch up, in certain instances, our estimated tax accruals at the time the new assessment is received. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. The Company regularly appeals property taxes but cannot predict property tax reductions from real estate tax appeals.\\nGeneral and administrative expense increased by 26.3%, or approximately $1,100, from $4,187 for the three months ended June 30, 2020 to $5,287 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $790 when comparing the three months ended June 30, 2021 to the same period in 2020. This increase resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of share based compensation recognition. In addition, during the three months ended June 30, 2020, we executed cost containment strategies in our payroll and other administrative costs. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\\nOperating Loss\\nOperating loss for the three months ended June 30, 2021 was $7,592 compared to operating loss of $41,542 during the same period in 2020. The decrease in our operating loss of $33,950 is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020 when we had temporary closed certain of our hotels and reduced operations at the remaining hotels as a result of the decrease in demand caused by the COVID-19 pandemic.\\n43\\nInterest Expense\\nInterest expense increased $1,501 from $13,481 for the three months ended June 30, 2020 to $14,982 for the three months ended June 30, 2021. The primary driver of the increased interest expense is due to the issuance of the Junior Notes, which is partially offset by a decrease in interest expense on our term loans and decreases in the amortization of our interest rate hedges. Resulting primarily from the proceeds of the sales of assets, the balance of our borrowings, excluding discounts and deferred costs, have decreased by $57,256 in total between June 30, 2020 and June 30, 2021.\\nIncome Tax Benefit\\nDuring the three months ended June 30, 2021, the Company recorded an income tax expense of $151 compared to an income tax expense of $15,872 for the three months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\\nNet Loss Applicable to Common Shareholders\\nNet loss applicable to common shareholders for the three months ended June 30, 2021 was $28,590 compared to net loss of $67,464 during the same period in 2020. This decrease is primarily due to an increase in demand during the three months ended June 30, 2021 as compared to the same period in 2020, as discussed above, partially offset by increased interest expense during the three months ended June 30, 2021, as discussed above.\\nCOMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2021 AND 2020\\n(dollars in thousands, except ADR, RevPAR, and per share data)\\nRevenue\\nOur total revenues for the six months ended June 30, 2021 consisted of hotel operating revenues and other revenue. Hotel operating revenues were approximately 99% of total revenues for the six months ended June 30, 2021 and 2020. Hotel operating revenues are recorded for wholly-owned hotels that are leased to our wholly owned TRS and hotels owned through joint venture or other interests that are consolidated in our financial statements. Hotel operating revenues increased $9,886, or 9.2%, to $117,236 for the six months ended June 30, 2021 compared to $107,350 for the same period in 2020. This increase is attributable to an increase in RevPAR across our portfolio during the six months ended June 30, 2021 as compared to the six months ended June 30, 2020, when beginning in March 2020, we experienced a significant decrease in demand caused by the COVID-19 pandemic. The increase in demand is partially offset by the sale of five hotels during the six months ended June 30, 2021 and the sale of one hotel in December of 2020. Total revenues for the six months ended June 30, 2020 includes hotel operating revenue for these six hotels for the entire period.\\nExpenses\\nTotal hotel operating expenses decreased 12.4% to approximately $73,490 for the six months ended June 30, 2021 from $83,897 for the six months ended June 30, 2020. The decrease in hotel operating expenses is attributable to the cost saving measures implemented to mitigate the impact of the decrease in demand in 2020, as well the sale of hotels noted above.\\nDepreciation and amortization decreased by 11.7%, or $5,694, to $42,816 for the six months ended June 30, 2021 from $48,510 for the six months ended June 30, 2020 due to the dispositions noted above.\\nReal estate and personal property tax and property insurance decreased $374, or 1.9%, for the six months ended June 30, 2021 when compared to the same period in 2020, which is primarily due to the sale of hotels noted above. This decrease is partially offset by an increase in real estate taxes at our remaining hotels as a result of properties that had been re-assessed by the applicable taxing authority, resulting in increases in real estate tax expense. We typically experience increases in tax assessments and tax rates as the economy improves which could be offset by reductions resulting from successful real estate tax appeals. In general, our property insurance costs continue to rise annually.\\n44\\nGeneral and administrative expense increased by 2.1%, or $210 from $10,021 for the six months ended June 30, 2020 to $10,231 for the same period in 2021. General and administrative expense includes expenses related to payroll, rents, and other corporate level administrative costs as well as non-cash share based payments issued as incentive compensation to the Company’s trustees, executives, and employees. Expenses related to non-cash share based compensation increased $503 when comparing the six months ended June 30, 2021 to 2020, which was partially offset by the execution of our cost containment strategies in other administrative costs. The increase in shared based compensation resulted primarily from an increase in the valuation of certain market based award programs and a difference in the timing of shared based compensation recognition. Please refer to “Note 9 – Share Based Payments” of the notes to the consolidated financial statements for more information about our share based compensation.\\nOperating Loss\\nOperating loss for the six months ended June 30, 2021 was $30,878 compared to operating loss of $57,951 during the same period in 2020. Our decrease in operating loss was largely the result of a decrease in hotel operating expenses for the six months ended June 30, 2021 and an increase in hotel operating revenues, which is the result of an increase in demand across our portfolio, while maintaining certain cost containment strategies in place due to the COVID-19 pandemic. Additionally, we had a decrease in depreciation and amortization expense during the first half of 2021 compared to 2020 as a result of the disposals noted above.\\nInterest Expense\\nInterest expense increased $1,923 from $26,488 for the six months ended June 30, 2020 to $28,411 for the six months ended June 30, 2021. The balance of our borrowings, excluding discounts and deferred costs, has decreased by $57,256 in total between June 30, 2020 and June 30, 2021. However, we experienced an increase in our weighted average interest rate, driven by the unsecured junior notes payable facility we entered into in February 2021, and increased interest expense related to the amortization of additional deferred costs incurred during the six months ended June 30, 2021. Proceeds from the junior notes payable were used to reduce borrowings under our secured credit facility and term loans.\\nIncome Tax Expense\\nDuring the six months ended June 30, 2021, the Company recorded an income tax benefit of $438 compared to an income tax expense of $11,374 for the six months ended June 30, 2020. After considering various factors, including future reversals of existing taxable temporary differences, future taxable income and tax planning strategies, we believe that as of June 30, 2021, it is not more likely than not that we will be able to realize our net deferred tax asset and therefore, maintained the full valuation allowance that was established during the second quarter of 2020, with the exception of a city net operating loss that we believe that we will be able to realize. As a result, the balance of our net deferred tax asset at June 30, 2021 is $499. Absent the valuation allowance, the amount of income tax expense or benefit that the Company typically records depends mostly on the amount of taxable income or loss that is generated by our consolidated taxable REIT subsidiaries (“TRS”).\\nNet Loss Applicable to Common Shareholders\\nNet loss applicable to common shareholders for the six months ended June 30, 2021 was $25,707 compared to net loss of $96,583 during the same period in 2020, resulting in a decreased loss of $70,876. This decrease in loss is primarily related to gain on hotel dispositions of $48,352, as well as a decrease in operating loss.\\n45\\nLIQUIDITY, CAPITAL RESOURCES, AND EQUITY OFFERINGS\\n(dollars in thousands, except per share data)\\nPotential Sources of Capital\\nOur organizational documents do not limit the amount of indebtedness that we may incur. Our ability to incur additional debt is dependent upon a number of factors, including the current state of the overall credit markets, our degree of leverage and borrowing restrictions imposed by existing lenders. Our ability to raise funds through the issuance of debt and equity securities is dependent upon, among other things, capital market volatility, risk tolerance of investors, general market conditions for REITs and market perceptions related to the Company’s ability to generate cash flow and positive returns on its investments.\\nIn addition, our mortgage indebtedness contains various financial and non-financial covenants customarily found in secured, nonrecourse financing arrangements. If the specified criteria are not satisfied, the lender may be able to escrow cash flow generated by the property securing the applicable mortgage loan. At June 30, 2021, we failed our debt service coverage ratio (\\\"DSCR\\\") requirement related to two of our mortgage borrowings. After considering the effect of the COVID-19 pandemic on our consolidated operations, it is possible that we could fail certain financial covenants within certain property-level mortgage borrowings. For mortgages with financial covenants, the lenders' remedy of a covenant failure would be a requirement to escrow funds for the purpose of meeting our future debt payment obligations.\\nIn February 2021, the Company entered into a junior unsecured notes facility (“Junior Notes”) that provided net proceeds of $144,750 at closing. An incremental $50,000 may be drawn, at the Company’s discretion, in minimum installments of $25,000 at any point on or prior to September 30, 2021. The Junior Notes bear interest at a rate of 9.50%, of which half, or 4.75%, will be paid in cash with the remaining half added to the principal of the note through March 31, 2022 at our discretion. The Junior Notes mature in February of 2026 and are non-callable through February 2022. The Junior Notes are callable at 104% beginning February of 2022, 102% beginning in February 2023, and at par any time beginning in February 2024.\\nThe net proceeds of $144,750 provided by the Junior Notes, along with a portion of the proceeds from asset sales, were used to repay amounts outstanding under the Credit Facility, the Second Term Loan, and the Third Term Loan. The Junior Notes and asset sales that closed in the first quarter of 2021 allowed the Company to execute amendments to Credit Agreements governing the Credit Facility, the Second Term Loan, and the Third Term Loan. These amendments eliminated term loan maturities until August of 2022, waived all financial covenants through March 31, 2022, established accommodative covenant testing methodology through December 31, 2022, enabled the Company to pay down the accrual of the Company’s preferred dividends and allow the ongoing preferred dividend accrual to be kept current, and provided additional liquidity at the Company’s discretion.\\nOur secured debt facilities aggregate to $747,481 which is comprised of a $442,404 senior credit facility and two term loans totaling $305,077. The credit facility (“Credit Facility”) contains a $192,404 term loan (“First Term Loan”) and a $250,000 revolving line of credit (“Line of Credit”), and expires on August 10, 2022. As of June 30, 2021, we had $118,684 outstanding under the Line of Credit. Our two additional term loans are $278,846 (“Second Term Loan”) and $26,231 (“Third Term Loan”), which mature on September 10, 2024 and August 10, 2022, respectively.\\nWe will continue to monitor our debt maturities to manage our liquidity needs. However, no assurances can be given that we will be successful in refinancing all or a portion of our future debt obligations due to factors beyond our control or that, if refinanced, the terms of such debt will not vary from the existing terms. As of June 30, 2021, we have $23,431 of indebtedness due on or before June 30, 2022. We currently expect that cash requirements for all debt that is not refinanced by our existing lenders for which the maturity date is not extended will be met through a combination of cash on hand, refinancing the existing debt with new lenders, draws on the Line of Credit or Junior Notes and the issuance of our securities.\\nIn addition to the incurrence of debt and the offering of equity securities, dispositions of property may serve as additional capital resources and sources of liquidity. We may recycle capital from stabilized assets or from sales of non-core hotels in secondary and tertiary markets. Capital from these types of transactions is intended to be redeployed into high growth acquisitions, share buybacks, or to pay down existing debt.\\n46\\nAcquisitions\\nDuring the six months ended June 30, 2021, we acquired no hotel properties. We intend to invest in additional hotels only as suitable opportunities arise and adequate sources of capital are available. We expect that future investments in hotels will depend upon and will be financed by, in whole or in part, our existing cash, the proceeds from additional issuances of common or preferred shares, proceeds from the sale of assets, issuances of Common Units, issuances of preferred units or other securities or borrowings secured by hotel assets and under our Line of Credit.\\nDispositions\\nDuring the six months ended June 30, 2021, we disposed of five hotel properties for an aggregate sales price of $196,500 resulting in a gain on disposition of $48,313. The net proceeds were used to repay existing debt.\\nOperating Liquidity and Capital Expenditures\\nWe expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under the Line of Credit. We believe that the net cash provided by operations in the coming year and borrowings drawn on the Line of Credit will be adequate to fund the Company’s operating requirements, monthly recurring debt service and the payment of dividends in accordance with REIT requirements of the Code.\\nTo qualify as a REIT, we must distribute annually at least 90% of our taxable income. This distribution requirement limits our ability to retain earnings and requires us to raise additional capital in order to grow our business and acquire additional hotel properties. However, there is no assurance that we will be able to borrow funds or raise additional equity capital on terms acceptable to us, if at all. In addition, we cannot guarantee that we will be able to make distributions to our shareholders.\\nWe will seek to satisfy long-term liquidity requirements through various sources of capital, including borrowings under the Line of Credit and through secured, non-recourse mortgage financings with respect to our unencumbered hotel properties. In addition, we may seek to raise capital through public or private offerings of our securities. Certain factors may have a material adverse effect on our ability to access these capital sources, including our degree of leverage, the value of our unencumbered hotel properties and borrowing restrictions imposed by lenders or franchisors. We will continue to analyze which source of capital is most advantageous to us at any particular point in time, but financing may not be consistently available to us on terms that are attractive, or at all.\\nSpending on capital improvements during the six months ended June 30, 2021 decreased when compared to spending on capital improvements during the six months ended June 30, 2020. During the six months ended June 30, 2021, we spent $5,374 on capital expenditures to renovate, improve or replace assets at our hotels. This compares to $15,612 during the same period in 2020. These capital expenditures were undertaken to comply with brand mandated improvements and to initiate projects that we believe will generate a return on investment. We may spend additional amounts, if necessary, to comply with the requirements of any franchise license under which any of our hotels operate and otherwise to the extent we deem such expenditures to be prudent. We are also obligated to fund the cost of certain capital improvements to our hotels.\\nWe expect to use operating cash flow, borrowings under the Line of Credit, and proceeds from issuances of our securities and hotel dispositions to pay for the cost of capital improvements and any furniture, fixture and equipment requirements.\\n47\\nCASH FLOW ANALYSIS\\n(dollars in thousands, except per share data)\\nComparison of the Six Months Ended June 30, 2021 and 2020\\nNet cash used in operating activities decreased $9,250 from $16,357 for the six months ended June 30, 2020 to $7,107 for the comparable period in 2021. The increase in cash flow is primarily attributable to an increase in hotel property cash flow as a result of an increase in demand since the onset of the COVID-19 pandemic.\\nNet cash provided by investing activities for the six months ended June 30, 2021 was $157,659 compared to net cash used in investing activities of $16,191 for the six months ended June 30, 2020. The following items are the major contributing factors for the change in investing cash flows:\\n•Proceeds of $163,583 received related to the disposition of the Courtyard San Diego, the Capitol Hill Hotel, the Holiday Inn Express Cambridge, the Residence Inn Coconut Grove, and the Duane Street Hotel during the six months ended June 30, 2021.\\n•An increase in comparative cash flows of $10,217 related to a decrease in spending on capital expenditures and hotel development projects for the six months ended June 30, 2021 compared to 2020.\\n•An increase in comparative cash flows of $50 related to contributions of $600 to unconsolidated joint ventures for the six months ended June 30, 2020 compared to contributions of $550 for the six months ended June 30, 2021.\\nNet cash used in financing activities for the six months ended June 30, 2021 was $94,009 compared to net cash provided by financing activities for the six months ended June 30, 2020 of $26,165. The following items are the major contributing factors for the change in financing cash flows:\\n•The primary use of cash was the payment of $187,024 of outstanding borrowings under the Term Loan agreements. We received proceeds of $144,750 from the issuance of the Junior Notes, a portion of which, in addition to the proceeds received from the hotel dispositions noted above, were used to pay down the Term Loans.\\n•An increase in mortgage payments of $703 for the six months ended June 30, 2021 as compared to the six months ended June 30, 2020.\\n•Payment of $5,795 of deferred financing costs for the six months ended June 30, 2021 which primarily relate to the Junior Notes issuance noted above, as compared to the payment of $2,104 during the six months ended June 30, 2020.\\n•A decrease in comparative cash flows as we drew $47,000 on our Line of Credit during the six months ended June 30, 2020 when compared to $14,369 in net repayments during the same period in 2021.\\n•An increase in cash payments of $12,167 related to dividends paid. During the six months ended June 30, 2021, our executed amendments to the Credit Agreements allowed for the payment of the total arrearage of unpaid cash dividends due on each of our 6.875% Series C Cumulative Redeemable Preferred Shares, 6.50% Series D Cumulative Redeemable Preferred Shares and 6.50% Series E Cumulative Redeemable Preferred Shares of approximately $24,174, which was paid on March 26, 2021, as well as dividends of $6,044 on these preferred shares in April 2021. During the six months ended June 30, 2020 we paid dividends of $6,044 on these preferred shares and $12,007 on our Common Shares, Common Units and LTIP Units.\\nOFF BALANCE SHEET ARRANGEMENTS\\nThe Company does not have off balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.\\n48\\nFUNDS FROM OPERATIONS\\n(in thousands, except share data)\\nThe National Association of Real Estate Investment Trusts (“NAREIT”) developed Funds from Operations (“FFO”) as a non-GAAP financial measure of performance of an equity REIT in order to recognize that income-producing real estate historically has not depreciated on the basis determined under GAAP. We calculate FFO applicable to common shares and Common Units in accordance with the December 2018 Financial Standards White Paper of NAREIT, which we refer to as the White Paper. The White Paper defines FFO as net income (loss) (computed in accordance with GAAP) excluding depreciation and amortization related to real estate, gains and losses from the sale of certain real estate assets, gains and losses from change in control, and impairment write-downs of certain real estate assets and investments in entities when the impairment is directly attributable to decreases in the value of depreciable real estate held by an entity. Our interpretation of the NAREIT definition is that noncontrolling interest in net income (loss) should be added back to (deducted from) net income (loss) as part of reconciling net income (loss) to FFO. Our FFO computation may not be comparable to FFO reported by other REITs that do not compute FFO in accordance with the NAREIT definition, or that interpret the NAREIT definition differently than we do.\\nThe GAAP measure that we believe to be most directly comparable to FFO, net income (loss) applicable to common shareholders, includes loss from the impairment of certain depreciable assets, our investment in unconsolidated joint ventures and land, depreciation and amortization expenses, gains or losses on property sales, noncontrolling interest and preferred dividends. In computing FFO, we eliminate these items because, in our view, they are not indicative of the results from our property operations. We determined that the loss from the impairment of certain depreciable assets including investments in unconsolidated joint ventures and land, was driven by a measurable decrease in the fair value of certain hotel properties and other assets as determined by our analysis of those assets in accordance with applicable GAAP. As such, these impairments have been eliminated from net loss to determine FFO.\\nFFO does not represent cash flows from operating activities in accordance with GAAP and should not be considered an alternative to net income as an indication of the Company’s performance or to cash flow as a measure of liquidity or ability to make distributions. We consider FFO to be a meaningful, additional measure of operating performance because it excludes the effects of the assumption that the value of real estate assets diminishes predictably over time, and because it is widely used by industry analysts as a performance measure. We show both FFO from consolidated hotel operations and FFO from unconsolidated joint ventures because we believe it is meaningful for the investor to understand the relative contributions from our consolidated and unconsolidated hotels. The display of both FFO from consolidated hotels and FFO from unconsolidated joint ventures allows for a detailed analysis of the operating performance of our hotel portfolio by management and investors. We present FFO applicable to common shares and Common Units because our Common Units are redeemable for common shares. We believe it is meaningful for the investor to understand FFO applicable to all common shares and Common Units.\\n49\\nThe following table reconciles FFO for the periods presented to the most directly comparable GAAP measure, net income, for the same periods (dollars in thousands):\\n| Three Months Ended | Six Months Ended |\\n| June 30, 2021 | June 30, 2020 | June 30, 2021 | June 30, 2020 |\\n| Net loss applicable to common shareholders | $ | (28,590) | $ | (67,464) | $ | (25,707) | $ | (96,583) |\\n| Loss allocated to noncontrolling interest | (977) | (10,360) | (813) | (13,257) |\\n| Loss from unconsolidated joint ventures | 589 | 502 | 1,247 | 1,520 |\\n| Gain on disposition of hotel properties | — | — | (48,352) | — |\\n| Loss from impairment of depreciable assets | 222 | 1,069 | 222 | 1,069 |\\n| Depreciation and amortization | 21,014 | 24,322 | 42,816 | 48,510 |\\n| Funds from consolidated hotel operations applicable to common shareholders and Partnership Units | (7,742) | (51,931) | (30,587) | (58,741) |\\n| Loss from unconsolidated joint ventures | (589) | (502) | (1,247) | (1,520) |\\n| Unrecognized pro rata interest in loss (1) | (318) | (511) | (814) | (361) |\\n| Depreciation and amortization of difference between purchase price and historical cost (2) | 21 | 21 | 42 | 42 |\\n| Interest in depreciation and amortization of unconsolidated joint ventures (3) | 652 | 393 | 1,282 | 796 |\\n| Funds from unconsolidated joint ventures operations applicable to common shareholders and Partnership Units | (234) | (599) | (737) | (1,043) |\\n| Funds from Operations applicable to common shareholders and Partnership Units | $ | (7,976) | $ | (52,530) | $ | (31,324) | $ | (59,784) |\\n| Weighted Average Common Shares and Common Units |\\n| Basic | 39,097,820 | 38,609,922 | 39,034,707 | 38,587,011 |\\n| Diluted | 44,724,968 | 43,286,310 | 44,525,168 | 43,426,465 |\\n\\n(1) For U.S. GAAP reporting purposes, our interest in the joint venture's loss is not recognized since our U.S. GAAP basis in the joint venture has been reduced to $0. Our interest in FFO from the joint venture equals our percentage ownership in the venture's FFO, including loss we have not recognized for U.S. GAAP reporting.\\n(2) Adjustment made to add depreciation of purchase price in excess of historical cost of the assets in the unconsolidated joint venture at the time of our investment.\\n(3) Adjustment made to add our interest in real estate related depreciation and amortization of our unconsolidated joint ventures.\\nINFLATION\\nOperators of hotel properties, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of our management companies to raise room rates. Additionally, our management companies will face challenges to raise room rates to reflect the impact of inflation until there is a substantial economic recovery from the COVID-19 pandemic.\\nCRITICAL ACCOUNTING POLICIES AND ESTIMATES\\nRefer to Note 1 – Basis of Presentation of the notes to our consolidated financial statements included herein for information regarding critical accounting policies and estimates.\\n50\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk (in thousands, except per share data)\\nOur primary market risk exposure is to changes in interest rates on our variable rate debt. As of June 30, 2021, we are exposed to interest rate risk with respect to variable rate borrowings under our Line of Credit, certain variable rate mortgages, and notes payable. As of June 30, 2021, we had total variable rate debt outstanding of $233,077 with a weighted average interest rate of 2.94%. The effect of a 100 basis point increase or decrease in the interest rate on our variable rate debt outstanding as of June 30, 2021 would be an increase or decrease in our interest expense for the three and six months ended June 30, 2021 of $577 and $1,198, respectively.\\nOur interest rate risk objectives are to limit the impact of interest rate fluctuations on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, we manage our exposure to fluctuations in market interest rates for a portion of our borrowings through the use of fixed rate debt instruments to the extent that reasonably favorable rates are obtainable with such arrangements. We have also entered into derivative financial instruments such as interest rate swaps or caps, and in the future may enter into treasury options or locks, to mitigate our interest rate risk on a related financial instrument or to effectively lock the interest rate on a portion of our variable rate debt. As of June 30, 2021, we have ten interest rate swaps related to debt on Hilton Garden Inn, 52nd Street, New York, NY; Courtyard, LA Westside, Culver City, CA; Hyatt Union Square, New York, NY; Hilton Garden Inn Tribeca, New York, NY; and our Credit Facility. We do not intend to enter into derivative or interest rate transactions for speculative purposes.\\nAs of June 30, 2021, approximately 79.3% of our outstanding consolidated long-term indebtedness was subject to fixed rates or effectively capped, while 20.7% of our outstanding long term indebtedness is subject to floating rates, including borrowings under our Line of Credit. The majority of our floating rate debt and any corresponding derivative instruments are indexed to various tenors of LIBOR.\\nOn March 5, 2021, the Financial Conduct Authority (“FCA”) announced that USD LIBOR will no longer be published after June 30, 2023. This announcement has several implications, including setting the spread that may be used to automatically convert contracts from LIBOR to the Secured Overnight Financing Rate (\\\"SOFR\\\"). Additionally, banking regulators are encouraging banks to discontinue new LIBOR debt issuances by December 31, 2021.\\nThe Company anticipates that LIBOR will continue to be available at least until June 30, 2023. Any changes adopted by the FCA or other governing bodies in the method used for determining LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR. If that were to occur, our interest payments could change. In addition, uncertainty about the extent and manner of future changes may result in interest rates and/or payments that are higher or lower than if LIBOR were to remain available in its current form.\\nThe Company is monitoring and evaluating the related risks that arise in connection with transitioning contracts to an alternative rate, including any resulting value transfer that may occur, and are likely to vary by contract. The value of loans, securities, or derivative instruments tied to LIBOR, as well as interest rates on our current or future indebtedness, may also be impacted if LIBOR is limited or discontinued. For some instruments the method of transitioning to an alternative reference rate may be challenging, especially if we cannot agree with the respective counterparty about how to make the transition.\\nWhile we expect LIBOR to be available in substantially its current form until at least June 30, 2023, it is possible that LIBOR will become unavailable prior to that point. This could result, for example, if sufficient banks decline to make submissions to the LIBOR administrator. In that case, the risks associated with the transition to an alternative reference rate will be accelerated and magnified.\\nAlternative rates and other market changes related to the replacement of LIBOR, including the introduction of financial products and changes in market practices, may lead to risk modeling and valuation challenges, such as adjusting interest rate accrual calculations and building a term structure for an alternative rate.\\nThe introduction of an alternative rate also may create additional basis risk and increased volatility as alternative rates are phased in and utilized in parallel with LIBOR.\\nAdjustments to systems and mathematical models to properly process and account for alternative rates will be required, which may strain the model risk management and information technology functions and result in substantial incremental costs for the company.\\nChanges in market interest rates on our fixed-rate debt impact the fair value of the debt, but such changes have no impact on interest expense incurred. If interest rates rise 100 basis points and our fixed rate debt balance remains constant, we expect the fair value of our debt to decrease. The sensitivity analysis related to our fixed-rate debt assumes an immediate 100 basis point move in interest rates from their June 30, 2021 levels, with all other variables held constant. A 100 basis point increase in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be\\n51\\napproximately $1,114,810 and a 100 basis point decrease in market interest rates would cause the fair value of our fixed-rate debt outstanding at June 30, 2021 to be approximately $1,168,182.\\nWe regularly review interest rate exposure on our outstanding borrowings in an effort to minimize the risk of interest rate fluctuations. For debt obligations outstanding as of June 30, 2021, the following table presents expected principal repayments and related weighted average interest rates by expected maturity dates:\\n| 2021 | 2022 - 2023 | 2024 - 2025 | Thereafter | Total |\\n| Fixed Rate Debt | $ | 23,431 | $ | 346,889 | $ | 381,977 | $ | 140,764 | $ | 893,061 |\\n| Weighted Average Interest Rate | 4.84 | % | 5.27 | % | 8.94 | % | 9.50 | % | 7.14 | % |\\n| Floating Rate Debt | $ | 298 | $ | 1,240 | $ | 61,306 | $ | 51,548 | $ | 114,392 |\\n| Weighted Average Interest Rate | 3.29 | % | 3.30 | % | 3.10 | % | 3.10 | % | 3.20 | % |\\n| $ | 23,729 | $ | 348,129 | $ | 443,283 | $ | 192,312 | $ | 1,007,453 |\\n| Line of Credit | $ | — | $ | 118,684 | $ | — | $ | — | $ | 118,684 |\\n| Weighted Average Interest Rate | — | 2.50 | % | — | — | 2.50 | % |\\n| $ | 23,729 | $ | 466,813 | $ | 443,283 | $ | 192,312 | $ | 1,126,137 |\\n\\n52\\nItem 4. Controls and Procedures\\nBased on the most recent evaluation, the Company’s Chief Executive Officer and Chief Financial Officer believe the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of June 30, 2021.\\nThere were no changes to the Company’s internal controls over financial reporting during the three months ended June 30, 2021, that materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.\\n53\\nPART II. OTHER INFORMATION\\nItem 1. Legal Proceedings.\\nNone.\\nItem 1A. Risk Factors.\\nThere have been no material changes from our risk factors as previously reported in our Annual Report on Form 10-K for the year ended December 31, 2020.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNone.\\n\\nItem 3. Defaults Upon Senior Securities.\\nNone.\\nItem 4. Mine Safety Disclosures.\\nNot Applicable.\\nItem 5. Other Information.\\nNone.\\n54\\nItem 6. Exhibits.\\n| Exhibit No. |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |\\n| 32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\\n| 32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |\\n| 101.INS | The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document* |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document* |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document* |\\n| 101.LAB | Inline XBRL Taxonomy Extension Labels Linkbase Document* |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document* |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n| * | Filed herewith |\\n| + | Compensatory plan or arrangement |\\n\\n55\\nSIGNATURES\\n\\n| HERSHA HOSPITALITY TRUST |\\n| July 28, 2021 | /s/ Ashish R. Parikh |\\n| Ashish R. Parikh |\\n| Chief Financial Officer(Principal Financial Officer) |\\n\\n56\\n</text>\\n\\nWhat is the percentage change in Total Shareholders' Equity from December 31, 2020, to June 30, 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -5.93705006235925.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 47,\n \"input_length\": 41981\n}"}}},{"rowIdx":48,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nPART I\nFINANCIAL INFORMATION\nThis quarterly report contains forward-looking statements within the meaning of the U.S. federal securities laws. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the United States securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report may include information regarding our estimates of losses related to catastrophes and other large losses, measurements of potential losses in the fair value of our investment portfolio and derivative contracts, our expectations regarding pricing and other market conditions, our growth prospects, and valuations of the potential impact of movements in interest rates, equity prices, credit spreads and foreign currency rates. Forward-looking statements only reflect our expectations and are not guarantees of performance.\nThese statements involve risks, uncertainties and assumptions. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. We believe that these factors include, but are not limited to, the following:\n| • | the occurrence and magnitude of natural and man-made disasters, |\n\n| • | actual claims exceeding our loss reserves, |\n\n| • | general economic, capital and credit market conditions, |\n\n| • | the failure of any of the loss limitation methods we employ, |\n\n| • | the effects of emerging claims, coverage and regulatory issues, including uncertainty related to coverage definitions, limits, terms and conditions, |\n\n| • | the failure of our cedants to adequately evaluate risks, |\n\n| • | inability to obtain additional capital on favorable terms, or at all, |\n\n| • | the loss of one or more key executives, |\n\n| • | a decline in our ratings with rating agencies, |\n\n| • | loss of business provided to us by our major brokers, |\n\n| • | changes in accounting policies or practices, |\n\n| • | the use of industry catastrophe models and changes to these models, |\n\n| • | changes in governmental regulations, |\n\n| • | increased competition, |\n\n| • | changes in the political environment of certain countries in which we operate or underwrite business including the United Kingdom’s expected withdrawal from the European Union, |\n\n| • | fluctuations in interest rates, credit spreads, equity prices and/or currency values, and |\n\n| • | the other matters set forth under Item 1A, ‘Risk Factors’ and Item 7, ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ included in our Annual Report on Form 10-K for the year ended December 31, 2015. |\n\nWe undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.\n3\nITEM 1. CONSOLIDATED FINANCIAL STATEMENTS\n\n| Page |\n| Consolidated Balance Sheets at September 30, 2016 (Unaudited) and December 31, 2015 | 5 |\n| Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 6 |\n| Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 7 |\n| Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015 (Unaudited) | 8 |\n| Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015 (Unaudited) | 9 |\n| Notes to Consolidated Financial Statements (Unaudited) | 10 |\n| Note 1 - Basis of Presentation and Accounting Policies | 10 |\n| Note 2 - Segment Information | 12 |\n| Note 3 - Investments | 14 |\n| Note 4 - Fair Value Measurements | 22 |\n| Note 5 - Derivative Instruments | 32 |\n| Note 6 - Reserve for Losses and Loss Expenses | 35 |\n| Note 7 - Share-Based Compensation | 36 |\n| Note 8 - Earnings Per Common Share | 38 |\n| Note 9 - Shareholders' Equity | 39 |\n| Note 10 - Commitments and Contingencies | 40 |\n| Note 11 - Other Comprehensive Income (Loss) | 41 |\n| Note 12 - Subsequent Event | 42 |\n\n4\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED BALANCE SHEETS\nSEPTEMBER 30, 2016 (UNAUDITED) AND DECEMBER 31, 2015\n\n| 2016 | 2015 |\n| (in thousands) |\n| Assets |\n| Investments: |\n| Fixed maturities, available for sale, at fair value(Amortized cost 2016: $11,462,399; 2015: $11,897,639) | $ | 11,566,860 | $ | 11,719,749 |\n| Equity securities, available for sale, at fair value(Cost 2016: $600,604; 2015: $575,776) | 644,344 | 597,998 |\n| Mortgage loans, held for investment, at amortized cost and fair value | 332,753 | 206,277 |\n| Other investments, at fair value | 847,262 | 816,756 |\n| Equity method investments | 111,295 | 10,932 |\n| Short-term investments, at amortized cost and fair value | 39,877 | 34,406 |\n| Total investments | 13,542,391 | 13,386,118 |\n| Cash and cash equivalents | 848,200 | 988,133 |\n| Restricted cash and cash equivalents | 229,063 | 186,618 |\n| Accrued interest receivable | 71,096 | 73,729 |\n| Insurance and reinsurance premium balances receivable | 2,694,976 | 1,967,535 |\n| Reinsurance recoverable on unpaid and paid losses | 2,336,741 | 2,096,104 |\n| Deferred acquisition costs | 545,618 | 471,782 |\n| Prepaid reinsurance premiums | 582,551 | 396,201 |\n| Receivable for investments sold | 2,285 | 26,478 |\n| Goodwill and intangible assets | 85,501 | 86,858 |\n| Other assets | 283,969 | 302,335 |\n| Total assets | $ | 21,222,391 | $ | 19,981,891 |\n| Liabilities |\n| Reserve for losses and loss expenses | $ | 9,874,807 | $ | 9,646,285 |\n| Unearned premiums | 3,453,655 | 2,760,889 |\n| Insurance and reinsurance balances payable | 461,519 | 356,417 |\n| Senior notes | 992,633 | 991,825 |\n| Payable for investments purchased | 141,245 | 9,356 |\n| Other liabilities | 272,874 | 350,237 |\n| Total liabilities | 15,196,733 | 14,115,009 |\n| Shareholders’ equity |\n| Preferred shares | 625,000 | 627,843 |\n| Common shares (2016: 176,575; 2015: 176,240 shares issued and2016: 88,439; 2015: 96,066 shares outstanding) | 2,206 | 2,202 |\n| Additional paid-in capital | 2,307,866 | 2,241,388 |\n| Accumulated other comprehensive income (loss) | 98,505 | (188,465 | ) |\n| Retained earnings | 6,430,573 | 6,194,353 |\n| Treasury shares, at cost (2016: 88,136; 2015: 80,174 shares) | (3,438,492 | ) | (3,010,439 | ) |\n| Total shareholders’ equity | 6,025,658 | 5,866,882 |\n| Total liabilities and shareholders’ equity | $ | 21,222,391 | $ | 19,981,891 |\n\nSee accompanying notes to Consolidated Financial Statements.5\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| Three months ended | Nine months ended |\n| 2016 | 2015 | 2016 | 2015 |\n| (in thousands, except for per share amounts) |\n| Revenues |\n| Net premiums earned | $ | 934,415 | $ | 919,341 | $ | 2,783,746 | $ | 2,764,605 |\n| Net investment income | 116,923 | 45,685 | 257,818 | 226,336 |\n| Other insurance related income | 5,944 | 1,158 | 4,850 | 12,319 |\n| Termination fee received | — | 280,000 | — | 280,000 |\n| Net realized investment gains (losses): |\n| Other-than-temporary impairment (\"OTTI\") losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Other realized investment gains (losses) | 9,452 | (37,656 | ) | (19,949 | ) | (60,856 | ) |\n| Total net realized investment gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\n| Total revenues | 1,062,487 | 1,176,227 | 3,006,119 | 3,159,642 |\n| Expenses |\n| Net losses and loss expenses | 532,328 | 560,387 | 1,663,584 | 1,652,868 |\n| Acquisition costs | 189,810 | 182,744 | 559,570 | 537,549 |\n| General and administrative expenses | 142,906 | 144,727 | 439,554 | 456,451 |\n| Foreign exchange gains | (13,795 | ) | (28,088 | ) | (69,781 | ) | (69,200 | ) |\n| Interest expense and financing costs | 12,839 | 12,918 | 38,586 | 38,114 |\n| Reorganization and related expenses | — | 45,867 | — | 45,867 |\n| Total expenses | 864,088 | 918,555 | 2,631,513 | 2,661,649 |\n| Income before income taxes and interest in income (loss) of equity method investments | 198,399 | 257,672 | 374,606 | 497,993 |\n| Income tax expense | 9,352 | 30 | 7,712 | 1,155 |\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\n| Net income | 186,613 | 257,642 | 364,460 | 496,838 |\n| Preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Per share data |\n| Net income per common share: |\n| Basic net income | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\n| Diluted net income | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Weighted average number of common shares outstanding - basic | 89,621 | 98,226 | 91,852 | 99,464 |\n| Weighted average number of common shares outstanding - diluted | 90,351 | 99,124 | 92,579 | 100,468 |\n| Cash dividends declared per common share | $ | 0.35 | $ | 0.29 | $ | 1.05 | $ | 0.87 |\n\nSee accompanying notes to Consolidated Financial Statements.6\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| Three months ended | Nine months ended |\n| 2016 | 2015 | 2016 | 2015 |\n| (in thousands) |\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\n| Other comprehensive income (loss), net of tax: |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | 36,336 | (99,711 | ) | 238,656 | (176,938 | ) |\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (2,642 | ) | 74,810 | 42,620 | 128,770 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 33,694 | (24,901 | ) | 281,276 | (48,168 | ) |\n| Foreign currency translation adjustment | 1,722 | (14,626 | ) | 5,694 | (23,851 | ) |\n| Total other comprehensive income (loss), net of tax | 35,416 | (39,527 | ) | 286,970 | (72,019 | ) |\n| Comprehensive income | $ | 222,029 | $ | 218,115 | $ | 651,430 | $ | 424,819 |\n\nSee accompanying notes to Consolidated Financial Statements.7\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| 2016 | 2015 |\n| (in thousands) |\n| Preferred shares |\n| Balance at beginning of period | $ | 627,843 | $ | 627,843 |\n| Shares repurchased | (2,843 | ) | — |\n| Balance at end of period | 625,000 | 627,843 |\n| Common shares (par value) |\n| Balance at beginning of period | 2,202 | 2,191 |\n| Shares issued | 4 | 11 |\n| Balance at end of period | 2,206 | 2,202 |\n| Additional paid-in capital |\n| Balance at beginning of period | 2,241,388 | 2,285,016 |\n| Shares issued - common shares | (4 | ) | 2,472 |\n| Cost of treasury shares reissued | (19,647 | ) | (17,674 | ) |\n| Settlement of accelerated share repurchase | 60,000 | (60,000 | ) |\n| Stock options exercised | — | 558 |\n| Share-based compensation expense | 26,129 | 19,906 |\n| Balance at end of period | 2,307,866 | 2,230,278 |\n| Accumulated other comprehensive income (loss) |\n| Balance at beginning of period | (188,465 | ) | (45,574 | ) |\n| Unrealized gains (losses) on available for sale investments, net of tax: |\n| Balance at beginning of period | (149,585 | ) | (28,192 | ) |\n| Unrealized gains (losses) arising during the period, net of reclassification adjustment | 281,276 | (48,168 | ) |\n| Non-credit portion of OTTI losses | — | — |\n| Balance at end of period | 131,691 | (76,360 | ) |\n| Cumulative foreign currency translation adjustments, net of tax: |\n| Balance at beginning of period | (38,880 | ) | (17,382 | ) |\n| Foreign currency translation adjustments | 5,694 | (23,851 | ) |\n| Balance at end of period | (33,186 | ) | (41,233 | ) |\n| Balance at end of period | 98,505 | (117,593 | ) |\n| Retained earnings |\n| Balance at beginning of period | 6,194,353 | 5,715,504 |\n| Net income | 364,460 | 496,838 |\n| Preferred share dividends | (29,906 | ) | (30,066 | ) |\n| Common share dividends | (98,334 | ) | (88,379 | ) |\n| Balance at end of period | 6,430,573 | 6,093,897 |\n| Treasury shares, at cost |\n| Balance at beginning of period | (3,010,439 | ) | (2,763,859 | ) |\n| Shares repurchased for treasury | (449,086 | ) | (264,076 | ) |\n| Cost of treasury shares reissued | 21,033 | 17,674 |\n| Balance at end of period | (3,438,492 | ) | (3,010,261 | ) |\n| Total shareholders’ equity | $ | 6,025,658 | $ | 5,826,366 |\n\nSee accompanying notes to Consolidated Financial Statements.8\nAXIS CAPITAL HOLDINGS LIMITED\nCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\n| 2016 | 2015 |\n| (in thousands) |\n| Cash flows from operating activities: |\n| Net income | $ | 364,460 | $ | 496,838 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Net realized investment losses | 40,295 | 123,618 |\n| Net realized and unrealized gains on other investments | (23,117 | ) | (17,616 | ) |\n| Amortization of fixed maturities | 51,660 | 75,645 |\n| Interest in loss of equity method investments | 2,434 | — |\n| Other amortization and depreciation | 17,370 | 26,219 |\n| Share-based compensation expense, net of cash payments | 28,580 | 25,435 |\n| Changes in: |\n| Accrued interest receivable | 3,286 | 7,128 |\n| Reinsurance recoverable balances | (163,212 | ) | (158,362 | ) |\n| Deferred acquisition costs | (73,759 | ) | (77,348 | ) |\n| Prepaid reinsurance premiums | (184,648 | ) | (69,016 | ) |\n| Reserve for loss and loss expenses | 216,828 | 212,066 |\n| Unearned premiums | 682,686 | 380,610 |\n| Insurance and reinsurance balances, net | (623,170 | ) | (330,128 | ) |\n| Other items | (74,383 | ) | 7,841 |\n| Net cash provided by operating activities | 265,310 | 702,930 |\n| Cash flows from investing activities: |\n| Purchases of: |\n| Fixed maturities | (6,624,573 | ) | (8,110,841 | ) |\n| Equity securities | (295,827 | ) | (240,415 | ) |\n| Mortgage loans | (131,087 | ) | (129,431 | ) |\n| Other investments | (177,500 | ) | (61,591 | ) |\n| Equity method investments | (103,548 | ) | — |\n| Short-term investments | (81,479 | ) | (34,147 | ) |\n| Proceeds from the sale of: |\n| Fixed maturities | 6,067,663 | 6,797,585 |\n| Equity securities | 296,182 | 112,794 |\n| Other investments | 170,111 | 244,353 |\n| Short-term investments | 67,408 | 112,694 |\n| Proceeds from redemption of fixed maturities | 977,852 | 1,107,175 |\n| Proceeds from redemption of short-term investments | 8,185 | 22,337 |\n| Proceeds from the repayment of mortgage loans | 4,808 | — |\n| Purchase of other assets | (19,055 | ) | (18,401 | ) |\n| Change in restricted cash and cash equivalents | (42,445 | ) | 27,996 |\n| Net cash provided by (used in) investing activities | 116,695 | (169,892 | ) |\n| Cash flows from financing activities: |\n| Repurchase of common shares | (389,086 | ) | (332,097 | ) |\n| Dividends paid - common shares | (100,670 | ) | (89,611 | ) |\n| Dividends paid - preferred shares | (29,940 | ) | (30,066 | ) |\n| Repurchase of preferred shares | (2,843 | ) | — |\n| Proceeds from issuance of common shares | 8 | 3,042 |\n| Net cash used in financing activities | (522,531 | ) | (448,732 | ) |\n| Effect of exchange rate changes on foreign currency cash and cash equivalents | 593 | (13,883 | ) |\n| Increase (decrease) in cash and cash equivalents | (139,933 | ) | 70,423 |\n| Cash and cash equivalents - beginning of period | 988,133 | 921,830 |\n| Cash and cash equivalents - end of period | $ | 848,200 | $ | 992,253 |\n\nSupplemental disclosures of cash flow information: Total consideration paid for a quota share and adverse development reinsurance cover was $170 million of which $92 million was settled by transfer of securities and was treated as a non cash activity on the Consolidated Statement of Cash Flows.\nSee accompanying notes to Consolidated Financial Statements.9\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES |\n\nBasis of Presentation\nThese interim consolidated financial statements include the accounts of AXIS Capital Holdings Limited (“AXIS Capital”) and its subsidiaries (herein referred to as “we,” “us,” “our,” or the “Company”).\nThe consolidated balance sheet at September 30, 2016 and the consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for the periods ended September 30, 2016 and 2015 have not been audited. The balance sheet at December 31, 2015 is derived from our audited financial statements.\nThese financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) for interim financial information and with the Securities and Exchange Commission's (“SEC”) instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of our financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All inter-company accounts and transactions have been eliminated.\nThe following information should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollar and share amounts are in thousands, except per share amounts. All amounts are reported in U.S. dollars. To facilitate comparison of information across periods, certain reclassifications have been made to prior year amounts to conform to the current year's presentation. These reclassifications did not impact our results of operations, financial condition or liquidity.\nSignificant Accounting Policies\nThere were no notable changes in our significant accounting policies subsequent to our Annual Report on Form 10-K for the year ended December 31, 2015, with the exception of the addition of accounting policies for equity method investments and retroactive accounting noted below.\nEquity Method Investments\nInvestments in which the Company has significant influence over the operating and financial policies of the investee are classified as equity method investments and are accounted for using the equity method of accounting. In applying the equity method of accounting, investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of net income or loss of the investee. Adjustments are based on the most recently available financial information from the investee.Changes in the carrying value of such investments are recorded in net income as interest in income (loss) of equity method investments.\nRetroactive Reinsurance\nRetroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered under contracts subject to the reinsurance. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and where practical the Company bifurcates the prospective and retrospective elements of these reinsurance contracts and accounts for each element separately. Initial gains in connection with retroactive reinsurance contracts are deferred and amortized into income over the settlement period while losses are recognized immediately. When changes in the estimated amount recoverable from the reinsurer or in the timing of receipts related to that amount occur, a cumulative amortization adjustment is recognized in earnings in the period of the change so that the deferred gain reflects the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction.\nNew Accounting Standards Adopted in 2016\nShare-Based Compensation\nEffective January 1, 2016, the Company adopted the Accounting Standards Update (\"ASU\") 2014-12, \"Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved after the Requisite Service Period\" issued by the Financial Accounting Standards Board (the \"FASB\"). This guidance requires that compensation costs be recognized in the period in which it becomes probable that the performance target will be achieved and to represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. This guidance was issued to clarify treatment where there was a divergence in accounting practice and its adoption did not impact our results of operations, financial condition or liquidity.\nDebt Issuance Costs\nEffective January 1, 2016, the Company adopted ASU 2015-03, \"Simplifying the Presentation of Debt Issuance Costs\" issued by the FASB. This guidance requires the debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the debt liability rather than as an asset. This guidance was issued to simplify the presentation of debt issuance costs and to resolve conflicting guidance. This guidance did not impact our results of operations, financial condition or liquidity.\nInvestments Measured Using The Net Asset Value Per Share (\"NAV\") Practical Expedient\nEffective January 1, 2016, the Company adopted ASU 2015-07, \"Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or its Equivalent)\" issued by the FASB. This guidance eliminated the requirement to categorize investments measured using the net asset value (\"NAV\") practical expedient in the fair value hierarchy table. As this new guidance related solely to disclosures, the adoption did not impact our results of operations, financial condition or liquidity. The updated disclosures have been provided in Note 4 'Fair Value Measurements'.\nRecently Issued Accounting Standards Not Yet Adopted\nLeases\nIn February 2016, the FASB issued guidance that provides a new comprehensive model for lease accounting. The guidance will require most leases to be recognized on the balance sheet by recording a right-of-use asset and a corresponding lease liability. This guidance is effective for reporting periods beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nTransition To Equity Method Of Accounting\nIn March 2016, the FASB issued new guidance eliminating the requirement that an investor retrospectively apply equity method accounting when an existing investment qualifies for equity method accounting. The guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The guidance will be adopted on a prospective basis. The adoption of this guidance is not expected to materially impact our results of operations, financial condition or liquidity.\nShare-Based Compensation Accounting\nIn March 2016, the FASB issued new guidance that will change the accounting for certain aspects of share-based compensation payments to employees. The guidance will require all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. The guidance will also allow employers to increase the amounts withheld to cover income taxes on\n10\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED) |\n\nshare-based compensation awards without requiring liability classification. Additionally, companies will be required to elect whether they will account for award forfeitures by recognizing forfeitures only as they occur or by estimating the number of awards expected to be forfeited. This guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nCredit Losses\nIn June 2016, the FASB issued a new credit loss standard that changes the impairment model for most financial assets and certain other instruments. The guidance will replace the current \"incurred loss\" approach with a more forward looking \"expected loss\" model for instruments measured at amortized cost and will require entities to record allowances for available-for-sale debt securities rather than reduce the carrying amount. This guidance is effective for annual periods beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted for annual periods beginning after December 15, 2018, and interim periods within those fiscal years. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\nCash Flows\nIn August 2016, the FASB issued new guidance to clarify how certain cash receipts and cash payments should be classified on the statement of cash flows. This guidance is effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years with early adoption permitted. The adoption of this guidance is not expected to impact our results of operations, financial condition or liquidity.\n11\n| 2. | SEGMENT INFORMATION |\n\nOur underwriting operations are organized around our global underwriting platforms, AXIS Insurance and AXIS Re. Therefore we have determined that we have two reportable segments, insurance and reinsurance. We do not allocate our assets by segment, with the exception of goodwill and intangible assets, as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.\nThe following tables summarize the underwriting results of our reportable segments, as well as the carrying values of allocated goodwill and intangible assets:\n| 2016 | 2015 |\n| Three months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\n| Gross premiums written | $ | 675,430 | $ | 284,532 | $ | 959,962 | $ | 606,704 | $ | 329,879 | $ | 936,583 |\n| Net premiums written | 433,131 | 162,300 | 595,431 | 381,118 | 296,099 | 677,217 |\n| Net premiums earned | 444,691 | 489,724 | 934,415 | 444,550 | 474,791 | 919,341 |\n| Other insurance related income | 39 | 5,905 | 5,944 | 542 | 616 | 1,158 |\n| Net losses and loss expenses | (273,226 | ) | (259,102 | ) | (532,328 | ) | (283,272 | ) | (277,115 | ) | (560,387 | ) |\n| Acquisition costs | (61,755 | ) | (128,055 | ) | (189,810 | ) | (69,118 | ) | (113,626 | ) | (182,744 | ) |\n| General and administrative expenses | (84,588 | ) | (29,635 | ) | (114,223 | ) | (85,814 | ) | (35,309 | ) | (121,123 | ) |\n| Underwriting income | $ | 25,161 | $ | 78,837 | 103,998 | $ | 6,888 | $ | 49,357 | 56,245 |\n| Corporate expenses | (28,683 | ) | (23,604 | ) |\n| Net investment income | 116,923 | 45,685 |\n| Net realized investment gains (losses) | 5,205 | (69,957 | ) |\n| Foreign exchange gains | 13,795 | 28,088 |\n| Interest expense and financing costs | (12,839 | ) | (12,918 | ) |\n| Termination fee received | — | 280,000 |\n| Reorganization and related expenses | — | (45,867 | ) |\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 198,399 | $ | 257,672 |\n| Net loss and loss expense ratio | 61.4 | % | 52.9 | % | 57.0 | % | 63.7 | % | 58.4 | % | 61.0 | % |\n| Acquisition cost ratio | 13.9 | % | 26.1 | % | 20.3 | % | 15.5 | % | 23.9 | % | 19.9 | % |\n| General and administrative expense ratio | 19.1 | % | 6.1 | % | 15.3 | % | 19.4 | % | 7.4 | % | 15.7 | % |\n| Combined ratio | 94.4 | % | 85.1 | % | 92.6 | % | 98.6 | % | 89.7 | % | 96.6 | % |\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\n\n12\n| 2. | SEGMENT INFORMATION (CONTINUED) |\n\n| 2016 | 2015 |\n| Nine months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\n| Gross premiums written | $ | 2,112,796 | $ | 2,126,762 | $ | 4,239,558 | $ | 1,970,554 | $ | 1,833,374 | $ | 3,803,928 |\n| Net premiums written | 1,433,058 | 1,855,529 | 3,288,587 | 1,352,122 | 1,727,185 | 3,079,307 |\n| Net premiums earned | 1,322,649 | 1,461,097 | 2,783,746 | 1,344,339 | 1,420,266 | 2,764,605 |\n| Other insurance related income (loss) | (57 | ) | 4,907 | 4,850 | 811 | 11,508 | 12,319 |\n| Net losses and loss expenses | (853,771 | ) | (809,813 | ) | (1,663,584 | ) | (866,580 | ) | (786,288 | ) | (1,652,868 | ) |\n| Acquisition costs | (184,982 | ) | (374,588 | ) | (559,570 | ) | (200,493 | ) | (337,056 | ) | (537,549 | ) |\n| General and administrative expenses | (252,652 | ) | (99,980 | ) | (352,632 | ) | (261,924 | ) | (110,701 | ) | (372,625 | ) |\n| Underwriting income | $ | 31,187 | $ | 181,623 | 212,810 | $ | 16,153 | $ | 197,729 | 213,882 |\n| Corporate expenses | (86,922 | ) | (83,826 | ) |\n| Net investment income | 257,818 | 226,336 |\n| Net realized investment losses | (40,295 | ) | (123,618 | ) |\n| Foreign exchange gains | 69,781 | 69,200 |\n| Interest expense and financing costs | (38,586 | ) | (38,114 | ) |\n| Termination fee received | — | 280,000 |\n| Reorganization and related expenses | — | (45,867 | ) |\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 374,606 | $ | 497,993 |\n| Net loss and loss expense ratio | 64.6 | % | 55.4 | % | 59.8 | % | 64.5 | % | 55.4 | % | 59.8 | % |\n| Acquisition cost ratio | 14.0 | % | 25.6 | % | 20.1 | % | 14.9 | % | 23.7 | % | 19.4 | % |\n| General and administrative expense ratio | 19.0 | % | 6.9 | % | 15.8 | % | 19.5 | % | 7.8 | % | 16.5 | % |\n| Combined ratio | 97.6 | % | 87.9 | % | 95.7 | % | 98.9 | % | 86.9 | % | 95.7 | % |\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\n\n13\n| 3. | INVESTMENTS |\n\na) Fixed Maturities and Equities\nThe amortized cost or cost and fair values of our fixed maturities and equities were as follows:\n| AmortizedCost orCost | GrossUnrealizedGains | GrossUnrealizedLosses | FairValue | Non-creditOTTIin AOCI(5) |\n| At September 30, 2016 |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,542,943 | $ | 22,349 | $ | (2,415 | ) | $ | 1,562,877 | $ | — |\n| Non-U.S. government | 620,601 | 4,799 | (43,344 | ) | 582,056 | — |\n| Corporate debt | 4,516,290 | 87,184 | (34,974 | ) | 4,568,500 | — |\n| Agency RMBS(1) | 2,473,832 | 49,661 | (762 | ) | 2,522,731 | — |\n| CMBS(2) | 877,732 | 18,546 | (2,003 | ) | 894,275 | — |\n| Non-Agency RMBS | 71,842 | 1,636 | (1,648 | ) | 71,830 | (870 | ) |\n| ABS(3) | 1,234,292 | 4,028 | (2,724 | ) | 1,235,596 | — |\n| Municipals(4) | 124,867 | 4,215 | (87 | ) | 128,995 | — |\n| Total fixed maturities | $ | 11,462,399 | $ | 192,418 | $ | (87,957 | ) | $ | 11,566,860 | $ | (870 | ) |\n| Equity securities |\n| Common stocks | $ | 379 | $ | 38 | $ | (348 | ) | $ | 69 |\n| Exchange-traded funds | 463,655 | 41,611 | (1,060 | ) | 504,206 |\n| Bond mutual funds | 136,570 | 3,499 | — | 140,069 |\n| Total equity securities | $ | 600,604 | $ | 45,148 | $ | (1,408 | ) | $ | 644,344 |\n| At December 31, 2015 |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,673,617 | $ | 1,545 | $ | (23,213 | ) | $ | 1,651,949 | $ | — |\n| Non-U.S. government | 809,025 | 2,312 | (72,332 | ) | 739,005 | — |\n| Corporate debt | 4,442,315 | 16,740 | (96,286 | ) | 4,362,769 | — |\n| Agency RMBS(1) | 2,236,138 | 22,773 | (9,675 | ) | 2,249,236 | — |\n| CMBS(2) | 1,088,595 | 3,885 | (9,182 | ) | 1,083,298 | — |\n| Non-Agency RMBS | 99,989 | 1,992 | (973 | ) | 101,008 | (875 | ) |\n| ABS(3) | 1,387,919 | 952 | (17,601 | ) | 1,371,270 | — |\n| Municipals(4) | 160,041 | 2,319 | (1,146 | ) | 161,214 | — |\n| Total fixed maturities | $ | 11,897,639 | $ | 52,518 | $ | (230,408 | ) | $ | 11,719,749 | $ | (875 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | — | $ | — |\n| Exchange-traded funds | 447,524 | 31,211 | (4,762 | ) | 473,973 |\n| Bond mutual funds | 128,252 | — | (4,227 | ) | 124,025 |\n| Total equity securities | $ | 575,776 | $ | 31,211 | $ | (8,989 | ) | $ | 597,998 |\n\n| (1) | Residential mortgage-backed securities (RMBS) originated by U.S. agencies. |\n\n| (2) | Commercial mortgage-backed securities (CMBS). |\n\n| (3) | Asset-backed securities (ABS) include debt tranched securities collateralized primarily by auto loans, student loans, credit cards, and other asset types. This asset class also includes collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). |\n\n| (4) | Municipals include bonds issued by states, municipalities and political subdivisions. |\n\n| (5) | Represents the non-credit component of the other-than-temporary impairment (OTTI) losses, adjusted for subsequent sales, maturities and redemptions. It does not include the change in fair value subsequent to the impairment measurement date. |\n\n14\n| 3. | INVESTMENTS (CONTINUED) |\n\nIn the normal course of investing activities, we actively manage allocations to non-controlling tranches of structured securities (variable interests) issued by VIEs. These structured securities include RMBS, CMBS and ABS and are included in the above table. Additionally, within our other investments portfolio, we also invest in limited partnerships (hedge funds, direct lending funds, real estate funds and private equity funds) and CLO equity tranched securities, which are all variable interests issued by VIEs (see Note 3(c)). For these variable interests, we do not have the power to direct the activities that are most significant to the economic performance of the VIEs therefore we are not the primary beneficiary of any of these VIEs. Our maximum exposure to loss on these interests is limited to the amount of our investment. We have not provided financial or other support with respect to these structured securities other than our original investment.\nContractual Maturities\nThe contractual maturities of fixed maturities are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.\n| AmortizedCost | FairValue | % of TotalFair Value |\n| At September 30, 2016 |\n| Maturity |\n| Due in one year or less | $ | 363,821 | $ | 356,706 | 3.0 | % |\n| Due after one year through five years | 3,809,515 | 3,801,104 | 32.9 | % |\n| Due after five years through ten years | 2,286,970 | 2,330,895 | 20.2 | % |\n| Due after ten years | 344,395 | 353,723 | 3.1 | % |\n| 6,804,701 | 6,842,428 | 59.2 | % |\n| Agency RMBS | 2,473,832 | 2,522,731 | 21.8 | % |\n| CMBS | 877,732 | 894,275 | 7.7 | % |\n| Non-Agency RMBS | 71,842 | 71,830 | 0.6 | % |\n| ABS | 1,234,292 | 1,235,596 | 10.7 | % |\n| Total | $ | 11,462,399 | $ | 11,566,860 | 100.0 | % |\n| At December 31, 2015 |\n| Maturity |\n| Due in one year or less | $ | 291,368 | $ | 289,571 | 2.5 | % |\n| Due after one year through five years | 4,217,515 | 4,142,802 | 35.3 | % |\n| Due after five years through ten years | 2,263,684 | 2,181,525 | 18.6 | % |\n| Due after ten years | 312,431 | 301,039 | 2.6 | % |\n| 7,084,998 | 6,914,937 | 59.0 | % |\n| Agency RMBS | 2,236,138 | 2,249,236 | 19.2 | % |\n| CMBS | 1,088,595 | 1,083,298 | 9.2 | % |\n| Non-Agency RMBS | 99,989 | 101,008 | 0.9 | % |\n| ABS | 1,387,919 | 1,371,270 | 11.7 | % |\n| Total | $ | 11,897,639 | $ | 11,719,749 | 100.0 | % |\n\n15\n| 3. | INVESTMENTS (CONTINUED) |\n\nGross Unrealized Losses\nThe following table summarizes fixed maturities and equities in an unrealized loss position and the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position:\n| 12 months or greater | Less than 12 months | Total |\n| FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\n| At September 30, 2016 |\n| Fixed maturities |\n| U.S. government and agency | $ | 55,000 | $ | (1,635 | ) | $ | 422,681 | $ | (780 | ) | $ | 477,681 | $ | (2,415 | ) |\n| Non-U.S. government | 104,441 | (24,061 | ) | 254,694 | (19,283 | ) | 359,135 | (43,344 | ) |\n| Corporate debt | 285,848 | (26,202 | ) | 639,722 | (8,772 | ) | 925,570 | (34,974 | ) |\n| Agency RMBS | 80,375 | (556 | ) | 121,203 | (206 | ) | 201,578 | (762 | ) |\n| CMBS | 99,004 | (1,260 | ) | 173,795 | (743 | ) | 272,799 | (2,003 | ) |\n| Non-Agency RMBS | 10,184 | (1,306 | ) | 5,187 | (342 | ) | 15,371 | (1,648 | ) |\n| ABS | 518,647 | (2,253 | ) | 50,402 | (471 | ) | 569,049 | (2,724 | ) |\n| Municipals | 2,384 | (18 | ) | 15,567 | (69 | ) | 17,951 | (87 | ) |\n| Total fixed maturities | $ | 1,155,883 | $ | (57,291 | ) | $ | 1,683,251 | $ | (30,666 | ) | $ | 2,839,134 | $ | (87,957 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | 31 | $ | (348 | ) | $ | 31 | $ | (348 | ) |\n| Exchange-traded funds | 6,153 | (425 | ) | 39,097 | (635 | ) | 45,250 | (1,060 | ) |\n| Bond mutual funds | — | — | — | — | — | — |\n| Total equity securities | $ | 6,153 | $ | (425 | ) | $ | 39,128 | $ | (983 | ) | $ | 45,281 | $ | (1,408 | ) |\n| At December 31, 2015 |\n| Fixed maturities |\n| U.S. government and agency | $ | 84,179 | $ | (7,622 | ) | $ | 1,474,202 | $ | (15,591 | ) | $ | 1,558,381 | $ | (23,213 | ) |\n| Non-U.S. government | 170,269 | (50,841 | ) | 317,693 | (21,491 | ) | 487,962 | (72,332 | ) |\n| Corporate debt | 340,831 | (33,441 | ) | 2,845,375 | (62,845 | ) | 3,186,206 | (96,286 | ) |\n| Agency RMBS | 64,792 | (1,609 | ) | 1,073,566 | (8,066 | ) | 1,138,358 | (9,675 | ) |\n| CMBS | 75,627 | (1,579 | ) | 659,480 | (7,603 | ) | 735,107 | (9,182 | ) |\n| Non-Agency RMBS | 5,283 | (210 | ) | 43,199 | (763 | ) | 48,482 | (973 | ) |\n| ABS | 562,599 | (11,158 | ) | 667,448 | (6,443 | ) | 1,230,047 | (17,601 | ) |\n| Municipals | 14,214 | (310 | ) | 64,104 | (836 | ) | 78,318 | (1,146 | ) |\n| Total fixed maturities | $ | 1,317,794 | $ | (106,770 | ) | $ | 7,145,067 | $ | (123,638 | ) | $ | 8,462,861 | $ | (230,408 | ) |\n| Equity securities |\n| Common stocks | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — |\n| Exchange-traded funds | 2,331 | (313 | ) | 110,972 | (4,449 | ) | 113,303 | (4,762 | ) |\n| Bond mutual funds | — | — | 124,025 | (4,227 | ) | 124,025 | (4,227 | ) |\n| Total equity securities | $ | 2,331 | $ | (313 | ) | $ | 234,997 | $ | (8,676 | ) | $ | 237,328 | $ | (8,989 | ) |\n\n16\n| 3. | INVESTMENTS (CONTINUED) |\n\nFixed Maturities\nAt September 30, 2016, 935 fixed maturities (2015: 2,314) were in an unrealized loss position of $88 million (2015: $230 million), of which $13 million (2015: $39 million) was related to securities below investment grade or not rated.\nAt September 30, 2016, 399 (2015: 383) securities had been in a continuous unrealized loss position for 12 months or greater and had a fair value of $1,156 million (2015: $1,318 million). Following our credit impairment review, we concluded that these securities as well as the remaining securities in an unrealized loss position in the above table were temporarily impaired at September 30, 2016, and were expected to recover in value as the securities approach maturity. Further, at September 30, 2016, we did not intend to sell these securities in an unrealized loss position and it is more likely than not that we will not be required to sell these securities before the anticipated recovery of their amortized costs.\nEquity Securities\nAt September 30, 2016, 20 securities (2015: 35) were in an unrealized loss position of $1 million (2015: $9 million).\nAt September 30, 2016, 5 securities (2015: 1) were in a continuous unrealized loss position for 12 months or greater. Based on our impairment review process and our ability and intent to hold these securities for a reasonable period of time sufficient for a full recovery, we concluded that the above equities in an unrealized loss position were temporarily impaired at September 30, 2016.\nb) Mortgage Loans\n| September 30, 2016 | December 31, 2015 |\n| Carrying Value | % of Total | Carrying Value | % of Total |\n| Mortgage Loans held-for-investment: |\n| Commercial | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\n| 332,753 | 100 | % | 206,277 | 100 | % |\n| Valuation allowances | — | — | % | — | — | % |\n| Total Mortgage Loans held-for-investment | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\n\nFor commercial mortgage loans, the primary credit quality indicator is the debt service coverage ratio (which compares a property’s net operating income to amounts needed to service the principal and interest due under the loan, generally, the lower the debt service coverage ratio, the higher the risk of experiencing a credit loss) and the loan-to-value ratio (loan-to-value ratios compare the unpaid principal balance of the loan to the estimated fair value of the underlying collateral, generally, the higher the loan-to-value ratio, the higher the risk of experiencing a credit loss). The debt service coverage ratio and loan-to-value ratio, as well as the values utilized in calculating these ratios, are updated annually, on a rolling basis.\nWe have a high quality mortgage portfolio with debt service coverage ratios in excess of 1.1x and loan-to-value ratios of less than 70%; there are no credit losses associated with the commercial mortgage loans that we hold at September 30, 2016.\nThere are no past due amounts at September 30, 2016.\n17\n| 3. | INVESTMENTS (CONTINUED) |\n\nc) Other Investments\nThe following table provides a breakdown of our investments in hedge funds, direct lending funds, private equity funds, real estate funds, CLO Equities and other privately held investments, together with additional information relating to the liquidity of each category:\n| Fair Value | Redemption Frequency(if currently eligible) | Redemption Notice Period |\n| At September 30, 2016 |\n| Long/short equity funds | $ | 139,460 | 16 | % | Quarterly, Semi-annually, Annually | 45-60 days |\n| Multi-strategy funds | 281,153 | 33 | % | Quarterly, Semi-annually | 60-95 days |\n| Event-driven funds | 94,012 | 11 | % | Quarterly, Annually | 45-60 days |\n| Leveraged bank loan funds | — | — | % | n/a | n/a |\n| Direct lending funds | 125,002 | 15 | % | n/a | n/a |\n| Private equity funds | 89,170 | 11 | % | n/a | n/a |\n| Real estate funds | 11,782 | 1 | % | n/a | n/a |\n| CLO - Equities | 63,783 | 8 | % | n/a | n/a |\n| Other privately held investments | 42,900 | 5 | % | n/a | n/a |\n| Total other investments | $ | 847,262 | 100 | % |\n| At December 31, 2015 |\n| Long/short equity funds | $ | 154,348 | 19 | % | Quarterly, Semi-annually, Annually | 45-60 days |\n| Multi-strategy funds | 355,073 | 43 | % | Quarterly, Semi-annually | 60-95 days |\n| Event-driven funds | 147,287 | 18 | % | Quarterly, Annually | 45-60 days |\n| Leveraged bank loan funds | 65 | — | % | n/a | n/a |\n| Direct lending funds | 90,120 | 11 | % | n/a | n/a |\n| Private equity funds | — | — | % | n/a | n/a |\n| Real estate funds | 4,929 | 1 | % | n/a | n/a |\n| CLO - Equities | 64,934 | 8 | % | n/a | n/a |\n| Other privately held investments | — | — | % | n/a | n/a |\n| Total other investments | $ | 816,756 | 100 | % |\n\nn/a - not applicable\nThe investment strategies for the above funds are as follows:\n| • | Long/short equity funds: Seek to achieve attractive returns primarily by executing an equity trading strategy involving both long and short investments in publicly-traded equities. |\n\n| • | Multi-strategy funds: Seek to achieve above-market returns by pursuing multiple investment strategies to diversify risks and reduce volatility. This category includes funds of hedge funds which invest in a large pool of hedge funds across a diversified range of hedge fund strategies. |\n\n| • | Event-driven funds: Seek to achieve attractive returns by exploiting situations where announced or anticipated events create opportunities. |\n\n| • | Leveraged bank loan funds: Seek to achieve attractive returns by investing primarily in bank loan collateral that has limited interest rate risk exposure. |\n\n18\n| 3. | INVESTMENTS (CONTINUED) |\n\n| • | Direct lending funds: Seek to achieve attractive risk-adjusted returns, including current income generation, by investing in funds which provide financing directly to borrowers. |\n\n| • | Real estate funds: Seek to achieve attractive risk-adjusted returns by making and managing investments in real estate and real estate securities and businesses. |\n\n| • | Private equity funds: Seek to achieve attractive risk-adjusted returns by investing in private transactions over the course of several years. |\n\nTwo common redemption restrictions which may impact our ability to redeem our hedge funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the fund's net assets which may otherwise hinder the general partner or investment manager's ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. During 2016 and 2015, neither of these restrictions impacted our redemption requests. At September 30, 2016, $87 million (2015: $66 million), representing 17% (2015: 10%) of our total hedge funds, relate to holdings where we are still within the lockup period. The expiration of these lockup periods range from September 2016 to March 2019.\nAt September 30, 2016, we have $189 million (2015: $222 million) of unfunded commitments within our other investments portfolio relating to our future investments in direct lending funds. Once the full amount of committed capital has been called by the General Partner of each of these funds, the assets will not be fully returned until the completion of the fund's investment term. These funds have investment terms ranging from 5-10 years and the General Partners of certain funds have the option to extend the term by up to three years.\nAt September 30, 2016, we have $12 million (2015: $12 million) of unfunded commitments as a limited partner in a multi-strategy hedge fund. Once the full amount of committed capital has been called by the General Partner, the assets will not be fully returned until the completion of the fund's investment term which ends in March, 2019. The General Partner then has the option to extend the term by up to three years.\nAt September 30, 2016, we have $90 million (2015: $95 million) of unfunded commitments as a limited partner in a fund which invests in real estate and real estate securities and businesses. The fund is subject to a three year commitment period and a total fund life of eight years during which time we are not eligible to redeem our investment.\nDuring 2016, we made a $135 million commitment as a limited partner in a private equity fund. At September 30, 2016, $40 million of our commitment remains unfunded and the current fair value of the funds called to date are included in the private equity funds line of the table above. The fund invests in underlying private equity funds and the life of the fund is subject to the dissolution of the underlying funds. We expect the overall holding period to be over ten years.\nDuring 2015, we made a $50 million commitment as a limited partner of a bank revolver opportunity fund. The fund is subject to an investment term of seven years and the General Partners have the option to extend the term by up to two years. At September 30, 2016, this commitment remains unfunded. It is not anticipated that the full amount of this fund will be drawn.\n19\n| 3. | INVESTMENTS (CONTINUED) |\n\nd) Equity Method Investments\nDuring 2016, we paid $104 million including direct transaction costs to acquire 18% of the common equity of Harrington Reinsurance Holdings Limited (\"Harrington\"), the parent company of Harrington Re Ltd. (\"Harrington Re\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\"Blackstone\"). Through long-term service agreements, AXIS Capital will serve as Harrington Re's reinsurance underwriting manager and Blackstone will serve as exclusive investment management service provider. As an investor, we expect to benefit from underwriting profit generated by Harrington Re and the income and capital appreciation Blackstone seeks to deliver through its investment management services. In addition, we have entered into an arrangement with Blackstone under which underwriting and investment related fees will be shared equally. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting. The Company's proportionate share of the underlying equity in net assets resulted in a basis difference of $5 million which represents initial transactions costs.\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\ne) Net Investment Income\nNet investment income was derived from the following sources:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Fixed maturities | $ | 75,827 | $ | 75,980 | $ | 229,423 | $ | 220,066 |\n| Other investments | 38,248 | (27,421 | ) | 25,770 | 17,616 |\n| Equity securities | 4,633 | 3,445 | 12,843 | 7,795 |\n| Mortgage loans | 2,191 | 482 | 5,683 | 776 |\n| Cash and cash equivalents | 3,768 | 993 | 7,071 | 3,770 |\n| Short-term investments | 337 | 83 | 708 | 277 |\n| Gross investment income | 125,004 | 53,562 | 281,498 | 250,300 |\n| Investment expenses | (8,081 | ) | (7,877 | ) | (23,680 | ) | (23,964 | ) |\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\n\n20\n| 3. | INVESTMENTS (CONTINUED) |\n\nf) Net Realized Investment Gains (Losses)\nThe following table provides an analysis of net realized investment gains (losses):\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Gross realized gains |\n| Fixed maturities and short-term investments | $ | 26,211 | $ | 12,126 | $ | 67,833 | $ | 44,853 |\n| Equities | 5,570 | 232 | 18,804 | 447 |\n| Gross realized gains | 31,781 | 12,358 | 86,637 | 45,300 |\n| Gross realized losses |\n| Fixed maturities and short-term investments | (21,908 | ) | (54,867 | ) | (90,702 | ) | (111,432 | ) |\n| Equities | (576 | ) | (1,559 | ) | (15,923 | ) | (1,952 | ) |\n| Gross realized losses | (22,484 | ) | (56,426 | ) | (106,625 | ) | (113,384 | ) |\n| Net OTTI recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Change in fair value of investment derivatives(1) | 155 | 6,412 | 39 | 7,228 |\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\n\n(1) Refer to Note 5 – Derivative Instruments\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Fixed maturities: |\n| Non-U.S. government | $ | 2,456 | $ | 1,295 | $ | 2,953 | $ | 2,717 |\n| Corporate debt | 1,791 | 20,587 | 14,833 | 38,396 |\n| Non-Agency RMBS | — | — | — | 4 |\n| ABS | — | 84 | — | 124 |\n| 4,247 | 21,966 | 17,786 | 41,241 |\n| Equity Securities |\n| Exchange-traded funds | — | 10,335 | 2,560 | 10,335 |\n| Bond mutual funds | — | — | — | 11,186 |\n| — | 10,335 | 2,560 | 21,521 |\n| Total OTTI recognized in earnings | $ | 4,247 | $ | 32,301 | $ | 20,346 | $ | 62,762 |\n\n21\n| 3. | INVESTMENTS (CONTINUED) |\n\nThe following table provides a roll forward of the credit losses, before income taxes, for which a portion of the OTTI was recognized in AOCI:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Balance at beginning of period | $ | 1,513 | $ | 1,564 | $ | 1,506 | $ | 1,531 |\n| Credit impairments recognized on securities not previously impaired | — | — | — | — |\n| Additional credit impairments recognized on securities previously impaired | — | — | 7 | 33 |\n| Change in timing of future cash flows on securities previously impaired | — | — | — | — |\n| Intent to sell of securities previously impaired | — | — | — | — |\n| Securities sold/redeemed/matured | (33 | ) | (43 | ) | (33 | ) | (43 | ) |\n| Balance at end of period | $ | 1,480 | $ | 1,521 | $ | 1,480 | $ | 1,521 |\n\ng) Reverse Repurchase Agreements\nAt September 30, 2016, we held $160 million (December 31, 2015: $30 million) of reverse repurchase agreements. These loans are fully collateralized, are generally outstanding for a short period of time and are presented on a gross basis as part of cash and cash equivalents on our consolidated balance sheet. The required collateral for these loans is either cash or U.S. Treasuries at a minimum rate of 102% of the loan principal. Upon maturity, we receive principal and interest income. We monitor the estimated fair value of the securities loaned and borrowed on a daily basis with additional collateral obtained as necessary throughout the duration of the transaction.\nFair Value Hierarchy\nFair value is defined as the price to sell an asset or transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants. We use a fair value hierarchy that gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement. The hierarchy is broken down into three levels as follows:\n| • | Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. |\n\n| • | Level 2 - Valuations based on quoted prices in active markets for similar assets or liabilities, quoted prices for identical assets or liabilities in inactive markets, or for which significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data. |\n\n| • | Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own judgments about assumptions that market participants might use. |\n\nThe availability of observable inputs can vary from financial instrument to financial instrument and is affected by a wide variety of factors including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment.\nAccordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This may lead us to change the selection of our valuation technique (from market to cash flow approach) or may cause us to use multiple valuation techniques to estimate the fair value of a financial instrument. This circumstance could cause an instrument to be reclassified between levels within the fair value hierarchy.\nWe used the following valuation techniques including significant inputs and assumptions in estimating the fair value of our financial instruments as well as the general classification of such financial instruments pursuant to the above fair value hierarchy.\nFixed Maturities\nAt each valuation date, we use the market approach valuation technique to estimate the fair value of our fixed maturities portfolio, when possible. This market approach includes, but is not limited to, prices obtained from third party pricing services for identical or comparable securities and the use of “pricing matrix models” using observable market inputs such as yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. Pricing from third party pricing services is sourced from multiple vendors, when available, and we maintain a vendor hierarchy by asset type based on historical pricing experience and vendor expertise. When prices are unavailable from pricing services, we obtain non-binding quotes from broker-dealers who are active in the corresponding markets.\nThe valuation techniques including significant inputs generally used to determine the fair value of our fixed maturities by asset class as well as the classification in the fair value hierarchy are described in detail below.\nU.S. government and agency\nU.S. government and agency securities consist primarily of bonds issued by the U.S. Treasury and mortgage pass-through agencies such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. As the fair values of U.S. Treasury securities are based on unadjusted market prices in active markets, these securities are classified within Level 1. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.\n22\n| 4. | FAIR VALUE MEASUREMENTS |\n\nNon-U.S. government\nNon-U.S. government securities comprise bonds issued by non-U.S. governments and their agencies along with supranational organizations (collectively also known as sovereign debt securities). The fair values of these securities are based on prices obtained from international indices or a valuation model which uses inputs including interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the sovereign bond in terms of issuer, maturity and seniority. As the significant inputs are observable market inputs, the fair value of non-U.S. government securities are classified within Level 2.\nCorporate debt\nCorporate debt securities consist primarily of investment-grade debt of a wide variety of corporate issuers and industries. The fair values of these securities are generally determined using the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of corporate debt securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\nAgency RMBS\nAgency RMBS securities consist of bonds issued by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. The fair values of these securities are priced using a mortgage pool specific model which uses daily inputs from the active to be announced market and the spread associated with each mortgage pool based on vintage. As the significant inputs are observable market inputs, the fair values of Agency RMBS securities are classified within Level 2.\nCMBS\nCMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using a pricing model which uses dealer quotes and other available trade information along with security level characteristics to determine deal specific spreads. As the significant inputs are observable market inputs, the fair values of CMBS securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\nNon-Agency RMBS\nNon-Agency RMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using an option adjusted spread model or other relevant models, which use inputs including available trade information or broker quotes, prepayment and default projections based on historical statistics of the underlying collateral and current market data. As the significant inputs are observable market inputs, the fair values of Non-Agency RMBS securities are classified within Level 2.\nABS\nABS include mostly investment-grade bonds backed by pools of loans with a variety of underlying collateral, including automobile loan receivables, student loans, credit card receivables, and CLO Debt originated by a variety of financial institutions. The fair values of ABS are priced using a model which uses prepayment speeds and spreads sourced primarily from the new issue market. As the significant inputs used to price ABS are observable market inputs, the fair values of ABS are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\n23\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nMunicipals\nMunicipals comprise revenue and general obligation bonds issued by U.S. domiciled state and municipal entities. The fair values of these securities are determined using spreads obtained from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the municipals are observable market inputs, municipals are classified within Level 2.\nEquity Securities\nEquity securities include common stocks, exchange-traded funds and bond mutual funds. As the fair values of common stocks and exchange-traded funds are based on unadjusted quoted market prices in active markets, these securities are classified within Level 1.\nAs bond mutual funds have daily liquidity with redemption based on the NAV of the funds, the fair values of these securities are classified within Level 2.\nOther Investments\nAt September 30, 2016, our investments in CLO - Equities were classified within Level 3 as we estimated the fair value for these securities using an income approach valuation technique (discounted cash flow model) due to the lack of observable and relevant trades in the secondary markets.\nOther privately held securities include convertible preferred shares, convertible notes and notes payable. In the reporting period of investment, the cost of these investments approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These securities are classified within Level 3.\nShort-Term Investments\nShort-term investments primarily comprise highly liquid securities with maturities greater than three months but less than one year from the date of purchase. These securities are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their amortized cost approximates fair value.\nDerivative Instruments\nOur foreign currency forward contracts, interest rate swaps and commodity contracts are customized to our economic hedging strategies and trade in the over-the-counter derivative market. We use the market approach valuation technique to estimate the fair value for these derivatives based on significant observable market inputs from third party pricing vendors, non-binding broker-dealer quotes and/or recent trading activity. Accordingly, we classified these derivatives within Level 2.\nWe also participate in non-exchange traded derivative-based risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. We classify these instruments within Level 3.\nInsurance-linked Securities\nInsurance-linked securities comprise an investment in a catastrophe bond. We obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. These securities are classified within Level 3.\nCash Settled Awards\nCash settled awards comprise restricted stock units that form part of our compensation program. Although the fair value of these awards is determined using observable quoted market prices in active markets, the stock units themselves are not actively traded. Accordingly, we have classified these liabilities within Level 2.\n24\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nThe tables below present the financial instruments measured at fair value on a recurring basis for the periods indicated:\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\n| At September 30, 2016 |\n| Assets |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,522,246 | $ | 40,631 | $ | — | $ | — | $ | 1,562,877 |\n| Non-U.S. government | — | 582,056 | — | — | 582,056 |\n| Corporate debt | — | 4,499,408 | 69,092 | — | 4,568,500 |\n| Agency RMBS | — | 2,522,731 | — | — | 2,522,731 |\n| CMBS | — | 885,355 | 8,920 | — | 894,275 |\n| Non-Agency RMBS | — | 71,830 | — | — | 71,830 |\n| ABS | — | 1,235,596 | — | — | 1,235,596 |\n| Municipals | — | 128,995 | — | — | 128,995 |\n| 1,522,246 | 9,966,602 | 78,012 | — | 11,566,860 |\n| Equity securities |\n| Common stocks | 69 | — | — | — | 69 |\n| Exchange-traded funds | 504,206 | — | — | — | 504,206 |\n| Bond mutual funds | — | 140,069 | — | — | 140,069 |\n| 504,275 | 140,069 | — | — | 644,344 |\n| Other investments |\n| Hedge funds | — | — | — | 514,625 | 514,625 |\n| Direct lending funds | — | — | — | 125,002 | 125,002 |\n| Private equity funds | — | — | — | 89,170 | 89,170 |\n| Real estate funds | — | — | — | 11,782 | 11,782 |\n| Other privately held investments | — | — | 42,900 | — | 42,900 |\n| CLO - Equities | — | — | 63,783 | — | 63,783 |\n| — | — | 106,683 | 740,579 | 847,262 |\n| Short-term investments | — | 39,877 | — | — | 39,877 |\n| Other assets |\n| Derivative instruments (see Note 5) | — | 4,469 | 2,488 | — | 6,957 |\n| Insurance-linked securities | — | — | 25,283 | — | 25,283 |\n| Total Assets | $ | 2,026,521 | $ | 10,151,017 | $ | 212,466 | $ | 740,579 | $ | 13,130,583 |\n| Liabilities |\n| Derivative instruments (see Note 5) | $ | — | $ | 4,411 | $ | 8,184 | $ | — | $ | 12,595 |\n| Cash settled awards (see Note 7) | — | 34,288 | — | — | 34,288 |\n| Total Liabilities | $ | — | $ | 38,699 | $ | 8,184 | $ | — | $ | 46,883 |\n\n25\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\n| At December 31, 2015 |\n| Assets |\n| Fixed maturities |\n| U.S. government and agency | $ | 1,632,355 | $ | 19,594 | $ | — | $ | — | $ | 1,651,949 |\n| Non-U.S. government | — | 739,005 | — | — | 739,005 |\n| Corporate debt | — | 4,324,251 | 38,518 | — | 4,362,769 |\n| Agency RMBS | — | 2,249,236 | — | — | 2,249,236 |\n| CMBS | — | 1,072,376 | 10,922 | — | 1,083,298 |\n| Non-Agency RMBS | — | 101,008 | — | — | 101,008 |\n| ABS | — | 1,371,270 | — | — | 1,371,270 |\n| Municipals | — | 161,214 | — | — | 161,214 |\n| 1,632,355 | 10,037,954 | 49,440 | — | 11,719,749 |\n| Equity securities |\n| Common stocks | — | — | — | — | — |\n| Exchange-traded funds | 473,973 | — | — | — | 473,973 |\n| Bond mutual funds | — | 124,025 | — | — | 124,025 |\n| 473,973 | 124,025 | — | — | 597,998 |\n| Other investments |\n| Hedge funds | — | — | — | 656,773 | 656,773 |\n| Direct lending funds | — | — | — | 90,120 | 90,120 |\n| Private equity funds | — | — | — | — | — |\n| Real estate funds | — | — | — | 4,929 | 4,929 |\n| Other privately held investments | — | — | — | — | — |\n| CLO - Equities | — | — | 27,257 | 37,677 | 64,934 |\n| — | — | 27,257 | 789,499 | 816,756 |\n| Short-term investments | — | 34,406 | — | — | 34,406 |\n| Other assets |\n| Derivative instruments (see Note 5) | — | 2,072 | 4,395 | — | 6,467 |\n| Insurance-linked securities | — | — | 24,925 | — | 24,925 |\n| Total Assets | $ | 2,106,328 | $ | 10,198,457 | $ | 106,017 | $ | 789,499 | $ | 13,200,301 |\n| Liabilities |\n| Derivative instruments (see Note 5) | $ | — | $ | 7,692 | $ | 10,937 | $ | — | $ | 18,629 |\n| Cash settled awards (see Note 7) | — | 33,215 | — | — | 33,215 |\n| Total Liabilities | $ | — | $ | 40,907 | $ | 10,937 | $ | — | $ | 51,844 |\n\nDuring 2016 and 2015, there were no transfers between Levels 1 and 2.\n26\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nExcept certain fixed maturities and insurance-linked securities priced using broker-dealer quotes (underlying inputs are not available), the following table quantifies the significant unobservable inputs we have used in estimating fair value at September 30, 2016 for our investments classified as Level 3 in the fair value hierarchy.\n| Fair Value | Valuation Technique | Unobservable Input | Range | Weighted Average |\n| Other investments - CLO - Equities | $ | 35,594 | Discounted cash flow | Default rates | 4.0% | 4.0% |\n| Loss severity rate | 35.0% - 53.5% | 35.4% |\n| Collateral spreads | 3.6% - 4.0% | 4.0% |\n| Estimated maturity dates | 2 - 6 years | 6 years |\n| 28,189 | Liquidation value | Fair value of collateral | 100% | 100% |\n| Discount margin | 0.1% - 19.1% | 2.4% |\n| Other investments - Other privately held investments | 42,900 | Discounted cash flow | Discount rate | 5.0% - 8.0% | 7.2% |\n| Derivatives - Weather derivatives, net | $ | (5,696 | ) | Simulation model | Weather curve | 1 - 2294(1) | n/a (2) |\n| Weather standard deviation | 1 - 1029(1) | n/a (2) |\n\n(1) Measured in Heating Degree Days (\"HDD\") which is the number of degrees the daily temperature is below a reference temperature. The cumulative HDD for the duration of the derivatives contract is compared to the strike value to determine the necessary settlement.\n| (2) | Due to the diversity of the portfolio, the range of unobservable inputs can be widespread; therefore, presentation of a weighted average is not useful. Weather parameters may include various temperature and/or precipitation measures that will naturally vary by geographic location of each counterparty's operations. |\n\nThe CLO - Equities market continues to be mostly inactive with only a small number of transactions being observed and fewer still involving transactions in our CLO - Equities. Accordingly, we use models to estimate the fair value of our investments in CLO - Equities. Given that all of our direct investments in CLO - Equities are past their reinvestment period, there is uncertainty over the remaining time to maturity. As such our direct investments in CLO - Equities are valued at the lower of the liquidation value and fair value based on an internally developed discounted cash flow model.\nThe liquidation valuation is based on the fair value of the net underlying collateral which is determined by applying market discount margins by credit quality bucket. An increase (decrease) in the market discount margin would result in a decrease (increase) in value of our CLO - Equities. Regarding the discounted cash flow model, the default and loss severity rates are the most judgmental unobservable market inputs to which the valuation of CLO - Equities is most sensitive. A significant increase (decrease) in either of these significant inputs in isolation would result in lower (higher) fair value estimates for direct investments in our CLO - Equities and, in general, a change in default rate assumptions will be accompanied by a directionally similar change in loss severity rate assumptions. Collateral spreads and estimated maturity dates are less judgmental inputs as they are based on the historical average of actual spreads and the weighted average life of the current underlying portfolios, respectively. A significant increase (decrease) in either of these significant inputs in isolation would result in higher (lower) fair value estimates for direct investments in our CLO - Equities. In general, these inputs have no significant interrelationship with each other or with default and loss severity rates.\nOn a quarterly basis, our valuation process for CLO - Equities includes a review of the underlying collateral along with related discount margins by credit quality bucket used in the liquidation valuation and a review of the underlying cash flows and key assumptions used in the discounted cash flow model. We review and update the above significant unobservable inputs based on information obtained from secondary markets, including information received from the managers of our CLO - Equities portfolio.\nIn order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as emerging trends that may impact future cash flows. In addition,we update the assumptions we use in our models through regular communication with industry participants and ongoing monitoring of the deals in which we participate (e.g. default and loss severity rate trends).\n27\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nOther privately held securities are initially valued at cost which approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These models include inputs specific to each investment. The inputs used in the fair value measurement include dividend or interest rates and a discount rate. The discount rate is judgmental and the most significant unobservable input used in the valuation of the other privately held securities. Significant increases (decreases) in this input in isolation could result in a significantly higher (lower) fair value measurement. In order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as investee specific information that may impact future cash flows.\nWeather derivatives relate to non-exchange traded risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. The models may reference market price information for similar instruments. The pricing models are internally reviewed by Risk Management personnel prior to implementation and are reviewed periodically thereafter.\nObservable and unobservable inputs to these models vary by contract type but would typically include the following:\n| • | Observable inputs: market prices for similar instruments, notional price, option strike price, term to expiry, contractual limits; |\n\n| • | Unobservable inputs: correlation; and |\n\n| • | Both observable and unobservable inputs: weather curves, weather standard deviation. |\n\nIn general, weather curves are the most significant contributing input to fair value determination. Changes in this variable can result in higher or lower fair value depending on the underlying position. In addition, changes in any or all of the unobservable inputs identified above may contribute positively or negatively to overall portfolio value. The correlation input will quantify the interrelationship, if any, amongst the other variables.\n28\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\n| Three months ended September 30, 2016 |\n| Fixed maturities |\n| Corporate debt | $ | 62,022 | $ | — | $ | — | $ | (9 | ) | $ | 100 | $ | 7,563 | $ | — | $ | (584 | ) | $ | 69,092 | $ | — |\n| CMBS | 10,210 | — | — | — | (48 | ) | — | — | (1,242 | ) | 8,920 | — |\n| ABS | — | — | — | — | — | — | — | — | — | — |\n| 72,232 | — | — | (9 | ) | 52 | 7,563 | — | (1,826 | ) | 78,012 | — |\n| Other investments |\n| Other privately held investments | 41,755 | — | — | (355 | ) | — | 1,500 | — | — | 42,900 | (355 | ) |\n| CLO - Equities | 65,883 | — | — | 8,419 | — | — | — | (10,519 | ) | 63,783 | 8,419 |\n| 107,638 | — | — | 8,064 | — | 1,500 | — | (10,519 | ) | 106,683 | 8,064 |\n| Other assets |\n| Derivative instruments | 5 | — | — | 665 | — | 1,818 | — | — | 2,488 | 665 |\n| Insurance-linked securities | 25,025 | — | — | 258 | — | — | — | — | 25,283 | 258 |\n| 25,030 | — | — | 923 | — | 1,818 | — | — | 27,771 | 923 |\n| Total assets | $ | 204,900 | $ | — | $ | — | $ | 8,978 | $ | 52 | $ | 10,881 | $ | — | $ | (12,345 | ) | $ | 212,466 | $ | 8,987 |\n| Other liabilities |\n| Derivative instruments | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\n| Total liabilities | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\n| Nine months ended September 30, 2016 |\n| Fixed maturities |\n| Corporate debt | $ | 38,518 | $ | 20,412 | $ | (1,955 | ) | $ | (988 | ) | $ | 1,188 | $ | 17,107 | $ | (4,015 | ) | $ | (1,175 | ) | $ | 69,092 | $ | — |\n| CMBS | 10,922 | — | — | — | (134 | ) | — | — | (1,868 | ) | 8,920 | — |\n| ABS | — | — | — | — | — | — | — | — | — | — |\n| 49,440 | 20,412 | (1,955 | ) | (988 | ) | 1,054 | 17,107 | (4,015 | ) | (3,043 | ) | 78,012 | — |\n| Other investments |\n| Other privately held investments | — | — | — | (1,505 | ) | — | 44,405 | — | — | 42,900 | (1,505 | ) |\n| CLO - Equities | 27,257 | 36,378 | — | 17,431 | — | — | — | (17,283 | ) | 63,783 | 17,431 |\n| 27,257 | 36,378 | — | 15,926 | — | 44,405 | — | (17,283 | ) | 106,683 | 15,926 |\n| Other assets |\n| Derivative instruments | 4,395 | — | — | 3,255 | — | 3,623 | — | (8,785 | ) | 2,488 | 669 |\n| Insurance-linked securities | 24,925 | — | — | 358 | — | — | — | — | 25,283 | 358 |\n| 29,320 | — | — | 3,613 | — | 3,623 | — | (8,785 | ) | 27,771 | 1,027 |\n| Total assets | $ | 106,017 | $ | 56,790 | $ | (1,955 | ) | $ | 18,551 | $ | 1,054 | $ | 65,135 | $ | (4,015 | ) | $ | (29,111 | ) | $ | 212,466 | $ | 16,953 |\n| Other liabilities |\n| Derivative instruments | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\n| Total liabilities | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\n\n29\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\n| Three months ended September 30, 2015 |\n| Fixed maturities |\n| Corporate debt | $ | 43,008 | $ | — | $ | — | $ | (2 | ) | $ | 300 | $ | 22,821 | $ | — | $ | (4,403 | ) | $ | 61,724 | $ | — |\n| CMBS | 21,900 | — | (9,902 | ) | — | (219 | ) | — | — | (461 | ) | 11,318 | — |\n| ABS | 110 | — | — | — | — | — | — | (3 | ) | 107 | — |\n| 65,018 | — | (9,902 | ) | (2 | ) | 81 | 22,821 | — | (4,867 | ) | 73,149 | — |\n| Other investments |\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\n| CLO - Equities | 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\n| 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\n| Other assets |\n| Derivative instruments | 240 | — | — | 35 | — | — | — | (240 | ) | 35 | 35 |\n| Insurance-linked securities | 24,837 | — | — | 175 | — | — | — | — | 25,012 | 175 |\n| 25,077 | — | — | 210 | — | — | — | (240 | ) | 25,047 | 210 |\n| Total assets | $ | 127,016 | $ | — | $ | (9,902 | ) | $ | 1,400 | $ | 81 | $ | 22,821 | $ | — | $ | (8,225 | ) | $ | 133,191 | $ | 1,402 |\n| Other liabilities |\n| Derivative instruments | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\n| Total liabilities | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\n| Nine months ended September 30, 2015 |\n| Fixed maturities |\n| Corporate debt | $ | 15,837 | $ | — | $ | — | $ | (2 | ) | $ | 724 | $ | 54,445 | $ | — | $ | (9,280 | ) | $ | 61,724 | $ | — |\n| CMBS | 17,763 | 5,072 | (9,902 | ) | — | (543 | ) | — | — | (1,072 | ) | 11,318 | — |\n| ABS | 40,031 | — | (39,851 | ) | — | 105 | — | — | (178 | ) | 107 | — |\n| 73,631 | 5,072 | (49,753 | ) | (2 | ) | 286 | 54,445 | — | (10,530 | ) | 73,149 | — |\n| Other investments |\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\n| CLO - Equities | 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\n| 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\n| Other assets |\n| Derivative instruments | 111 | — | — | (792 | ) | — | — | — | 716 | 35 | 35 |\n| Insurance-linked securities | — | — | — | 12 | — | 25,000 | — | — | 25,012 | 12 |\n| 111 | — | — | (780 | ) | — | 25,000 | — | 716 | 25,047 | 47 |\n| Total assets | $ | 110,788 | $ | 5,072 | $ | (49,753 | ) | $ | 7,148 | $ | 286 | $ | 79,445 | $ | — | $ | (19,795 | ) | $ | 133,191 | $ | 7,977 |\n| Other liabilities |\n| Derivative instruments | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\n| Total liabilities | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\n\n| (1) | Gains and losses included in earnings on fixed maturities are included in net realized investment gains (losses). Gains and (losses) included in earnings on other investments are included in net investment income. Gains (losses) on weather derivatives included in earnings are included in other insurance-related income. |\n\n| (2) | Gains and losses included in other comprehensive income (“OCI”) on fixed maturities are included in unrealized gains (losses) arising during the period. |\n\n| (3) | Change in unrealized investment gain (loss) relating to assets held at the reporting date. |\n\nThe transfers into and out of fair value hierarchy levels reflect the fair value of the securities at the end of the reporting period.\n30\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nTransfers into Level 3 from Level 2\nThere were no transfers to Level 3 from Level 2 made during the three months ended September 30, 2016 and 2015.\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2016 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities and as the result of a change in valuation methodology relating to our CLO equity fund. An income approach valuation technique (discounted cash flow model) is used to estimate fair value at September 30, 2016. As the NAV practical expedient is no longer used the CLO equity fund is now categorized within the fair value hierarchy.\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2015 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities.\nTransfers out of Level 3 into Level 2\nThere were no transfers to Level 2 from Level 3 made during the three months ended September 30, 2016. The transfers to Level 2 from Level 3 made during the nine months ended September 30, 2016 were primarily due to the availability of observable market\ninputs and quotes from pricing vendors on certain fixed maturities.\nThe transfers to Level 2 from Level 3 made during the three and nine months ended September 30, 2015 were primarily due to the availability of observable market inputs and quotes from pricing vendors on certain fixed maturities and CLO Debt securities.\nMeasuring the Fair Value of Other Investments Using Net Asset Valuations\nAs a practical expedient, we estimate fair values for hedge funds, direct lending funds, private equity funds and real estate funds using NAVs as advised by external fund managers or third party administrators. For each of these funds, the NAV is based on the manager's or administrator's valuation of the underlying holdings in accordance with the fund's governing documents and in accordance with U.S. GAAP.\nIf there is a reporting lag between the current period end and reporting date of the latest available fund valuation for any hedge fund, we estimate the change in fair value by starting with the most recently available fund valuation and adjusting for return estimates as well as any subscriptions, redemptions and distributions that took place during the current period. Return estimates are obtained from the relevant fund managers. Accordingly, we do not typically have a reporting lag in our fair value measurements for these funds. Historically, our valuation estimates incorporating these return estimates have not significantly diverged from the subsequently received NAVs.\nFor private equity funds, direct lending funds and the real estate fund, valuation statements are typically released on a three month reporting lag therefore the Company estimates fair value of these funds by starting with the prior quarter-end fund valuations and adjusting for capital calls, redemptions, drawdowns and distributions. Return estimates are not available from the relevant fund managers for these funds. Accordingly, we typically have a reporting lag in our fair value measurements for these funds.\nThe Company often does not have access to financial information relating to the underlying securities held within the funds, therefore management is unable to corroborate the fair values placed on the securities underlying the asset valuations provided by the fund manager or fund administrator. To address this, on a quarterly basis, we perform a number of monitoring procedures to assess the quality of the information provided by managers and administrators. These procedures include, but are not limited to, regular review and discussion of each fund's performance with its manager, regular evaluation of fund performance against applicable benchmarks and the backtesting of our fair value estimates against subsequently received NAVs. Backtesting involves comparing our previously reported values for each individual fund against NAVs per audited financial statements (for year-end values) and final NAVs from fund managers and fund administrators (for interim values).\nThe fair value of our hedge funds, direct lending funds, private equity funds and real estate funds are measured using the NAV practical expedient and therefore have not been categorized with the fair value hierarchy.\n31\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\n\nFinancial Instruments Not Carried at Fair Value\nU.S. GAAP guidance over disclosures about the fair value of financial instruments are also applicable to financial instruments not carried at fair value, except for certain financial instruments, including insurance contracts.\nThe carrying values of cash equivalents (including restricted amounts), accrued investment income, receivable for investments sold, certain other assets, payable for investments purchased and certain other liabilities approximated their fair values at September 30, 2016, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.\nThe carrying value of mortgage loans held-for-investment approximated their fair value at September 30, 2016, as the loans are within their first two years of issue. The estimated fair value of mortgage loans is primarily determined by estimating expected future cash flows and discounting them using current interest rates for similar mortgage loans with similar credit risk, or is determined from pricing for similar loans. As mortgage loans are not actively traded, their respective fair values are classified within Level 3.\nAt September 30, 2016, our senior notes are recorded at amortized cost with a carrying value of $993 million (2015: $992 million) and have a fair value of $1,083 million (2015: $1,058 million). The fair values of these securities were obtained from a third party pricing service and pricing was based on the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of our senior notes are classified within Level 2.\n| 5. | DERIVATIVE INSTRUMENTS |\n\nThe following table summarizes the balance sheet classification of derivatives recorded at fair values. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and is presented in the table to quantify the volume of our derivative activities. Notional amounts are not reflective of credit risk.\nNone of our derivative instruments are designated as hedges under current accounting guidance.\n| September 30, 2016 | December 31, 2015 |\n| DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) | DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) |\n| Relating to investment portfolio: |\n| Foreign exchange forward contracts | $ | 40,367 | $ | 279 | $ | 17 | $ | 198,406 | $ | 490 | $ | 837 |\n| Interest rate swaps | — | — | — | — | — | — |\n| Relating to underwriting portfolio: |\n| Foreign exchange forward contracts | 560,477 | 25 | 4,394 | 692,023 | 1,582 | 6,855 |\n| Weather-related contracts | 59,436 | 2,488 | 8,184 | 51,395 | 4,395 | 10,937 |\n| Commodity contracts | 181,000 | 4,165 | — | — | — | — |\n| Total derivatives | $ | 6,957 | $ | 12,595 | $ | 6,467 | $ | 18,629 |\n\n| (1) | Asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\n\n32\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\n\nOffsetting Assets and Liabilities\nOur derivative instruments are generally traded under International Swaps and Derivatives Association master netting agreements, which establish terms that apply to all transactions. In the event of a bankruptcy or other stipulated event, master netting agreements provide that individual positions be replaced with a new amount, usually referred to as the termination amount, determined by taking into account market prices and converting into a single currency. Effectively, this contractual close-out netting reduces credit exposure from gross to net exposure. The table below presents a reconciliation of our gross derivative assets and liabilities to the net amounts presented in our Consolidated Balance Sheets, with the difference being attributable to the impact of master netting agreements.\n| September 30, 2016 | December 31, 2015 |\n| Gross Amounts | Gross Amounts Offset | NetAmounts(1) | Gross Amounts | Gross Amounts Offset | NetAmounts(1) |\n| Derivative assets | $ | 9,370 | $ | (2,413 | ) | $ | 6,957 | $ | 14,336 | $ | (7,869 | ) | $ | 6,467 |\n| Derivative liabilities | $ | 15,008 | $ | (2,413 | ) | $ | 12,595 | $ | 26,498 | $ | (7,869 | ) | $ | 18,629 |\n\n| (1) | Net asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\n\nRefer to Note 3 - Investments for information on reverse repurchase agreements.\nDerivative Instruments not Designated as Hedging Instruments\na) Relating to Investment Portfolio\nForeign Currency Risk\nWithin our investment portfolio we are exposed to foreign currency risk. Accordingly, the fair values for our investment portfolio are partially influenced by the change in foreign exchange rates. We may enter into foreign exchange forward contracts to manage the effect of this foreign currency risk. These foreign currency hedging activities are not designated as specific hedges for financial reporting purposes.\nInterest Rate Risk\nOur investment portfolio contains a large percentage of fixed maturities which exposes us to significant interest rate risk. As part of our overall management of this risk, we may use interest rate swaps.\nb) Relating to Underwriting Portfolio\nForeign Currency Risk\nOur (re)insurance subsidiaries and branches operate in various foreign countries. Consequently, some of our business is written in currencies other than the U.S. dollar and, therefore, our underwriting portfolio is exposed to significant foreign currency risk. We manage foreign currency risk by seeking to match our foreign-denominated net liabilities under (re)insurance contracts with cash and investments that are denominated in such currencies. We may also use derivative instruments, specifically forward contracts and currency options, to economically hedge foreign currency exposures.\n33\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\n\nWeather Risk\nWe write derivative-based risk management products designed to address weather risks with the objective of generating profits on a portfolio basis. The majority of this business consists of receiving a payment at contract inception in exchange for bearing the risk of variations in a quantifiable weather-related phenomenon, such as temperature. Where a client wishes to minimize the upfront payment, these transactions may be structured as swaps or collars. In general, our portfolio of such derivative contracts is of short duration, with contracts being predominantly seasonal in nature. In order to economically hedge a portion of this portfolio, we may also purchase weather derivatives.\nCommodity Risk\nWithin our (re)insurance portfolio we are exposed to commodity price risk. We may hedge a portion of this price risk by entering into commodity derivative contracts.\nThe total unrealized and realized gains (losses) recognized in earnings for derivatives not designated as hedges were as follows:\n| Location of Gain (Loss) Recognized in Income on Derivative | Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Derivatives not designated as hedging instruments |\n| Relating to investment portfolio: |\n| Foreign exchange forward contracts | Net realized investment gains (losses) | $ | 155 | $ | 6,412 | $ | 39 | $ | 11,234 |\n| Interest rate swaps | Net realized investment gains (losses) | — | — | — | (4,006 | ) |\n| Relating to underwriting portfolio: |\n| Foreign exchange forward contracts | Foreign exchange losses (gains) | (182 | ) | (5,210 | ) | (2,958 | ) | (21,494 | ) |\n| Weather-related contracts | Other insurance related income (losses) | 833 | 307 | 809 | 11,274 |\n| Commodity contracts | Other insurance related income (losses) | 1,799 | (33 | ) | 1,499 | (923 | ) |\n| Total | $ | 2,605 | $ | 1,476 | $ | (611 | ) | $ | (3,915 | ) |\n\n34\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)6. RESERVE FOR LOSSES AND LOSS EXPENSES\nThe following table presents a reconciliation of our beginning and ending gross reserve for losses and loss expenses and net reserve for unpaid losses and loss expenses for the periods indicated:\n| Nine months ended September 30, | 2016 | 2015 |\n| Gross reserve for losses and loss expenses, beginning of period | $ | 9,646,285 | $ | 9,596,797 |\n| Less reinsurance recoverable on unpaid losses, beginning of period | (2,031,309 | ) | (1,890,280 | ) |\n| Net reserve for unpaid losses and loss expenses, beginning of period | 7,614,976 | 7,706,517 |\n| Net incurred losses and loss expenses related to: |\n| Current year | 1,887,715 | 1,818,672 |\n| Prior years | (224,131 | ) | (165,804 | ) |\n| 1,663,584 | 1,652,868 |\n| Net paid losses and loss expenses related to: |\n| Current year | (233,124 | ) | (185,953 | ) |\n| Prior years | (1,334,772 | ) | (1,293,776 | ) |\n| (1,567,896 | ) | (1,479,729 | ) |\n| Foreign exchange and other | (112,649 | ) | (183,360 | ) |\n| Net reserve for unpaid losses and loss expenses, end of period | 7,598,015 | 7,696,296 |\n| Reinsurance recoverable on unpaid losses, end of period | 2,276,792 | 2,007,287 |\n| Gross reserve for losses and loss expenses, end of period | $ | 9,874,807 | $ | 9,703,583 |\n\nWe write business with loss experience generally characterized as low frequency and high severity in nature, which can result\nin volatility in our financial results. During the nine months ended September 30, 2016 and 2015, we recognized aggregate net losses and loss expenses, net of reinstatement premiums of $145 million and $90 million, respectively, in relation to catastrophe and weather-related events.\nDuring April 2016, the Company entered into a quota share and adverse development cover reinsurance agreement, a retroactive contract which was deemed to have met the established criteria for retroactive reinsurance accounting. Foreign exchange and other includes reinsurance recoverables of $159 million related to this reinsurance agreement.\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\n\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\n35\n| 6. | RESERVE FOR LOSSES AND LOSS EXPENSES (CONTINUED) |\n\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment. Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\n| 7. | SHARE-BASED COMPENSATION |\n\nFor the three months ended September 30, 2016, we incurred share-based compensation costs of $14 million (2015: $11 million) and recorded associated tax benefits of $3 million (2015: $3 million). For the nine months ended September 30, 2016, we incurred share-based compensation costs of $50 million (2015: $41 million) and recorded associated tax benefits of $11 million (2015: $11 million).\nThe total fair value of restricted stock, restricted stock units and cash settled awards vested during the nine months ended September 30, 2016 was $66 million (2015: $73 million). At September 30, 2016 there were $104 million of unrecognized compensation costs, which are expected to be recognized over the weighted average period of 2.4 years.\n36\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)7. SHARE-BASED COMPENSATION (CONTINUED)\nAwards to settle in shares\nThe following table provides a reconciliation of the beginning and ending balance of nonvested restricted stock (including restricted stock units) for the nine months ended September 30, 2016:\n| Performance-based Stock Awards | Service-based Stock Awards |\n| Number ofRestrictedStock | Weighted AverageGrant DateFair Value | Number ofRestrictedStock | Weighted AverageGrant DateFair Value(1) |\n| Nonvested restricted stock - beginning of period | 201 | $ | 49.24 | 1,954 | $ | 43.34 |\n| Granted | 104 | 53.80 | 586 | 53.81 |\n| Vested | (48 | ) | 45.38 | (779 | ) | 39.26 |\n| Forfeited | — | — | (94 | ) | 47.03 |\n| Nonvested restricted stock - end of period | 257 | $ | 52.04 | 1,667 | $ | 48.77 |\n\n(1) Fair value is based on the closing price of our common shares on the New York Stock Exchange on the day of the grant.\nCash-settled awards\nThe following table provides a reconciliation of the beginning and ending balance of nonvested cash settled restricted stock units for the nine months ended September 30, 2016:\n| Performance-based Cash Settled RSUs | Service-based Cash Settled RSUs |\n| Number ofRestrictedStock Units | Number ofRestrictedStock Units |\n| Nonvested restricted stock units - beginning of period | 70 | 1,433 |\n| Granted | 18 | 494 |\n| Vested | (32 | ) | (371 | ) |\n| Forfeited | — | (94 | ) |\n| Nonvested restricted stock units - end of period | 56 | 1,462 |\n\nAt September 30, 2016, the corresponding liability for cash-settled units, included in other liabilities on the Consolidated Balance Sheets, was $34 million (2015: $23 million).\n37\n| 8. | EARNINGS PER COMMON SHARE |\n\nThe following table sets forth the comparison of basic and diluted earnings per common share:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Basic earnings per common share |\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\n| Less: preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\n| Net income available to common shareholders | 176,644 | 247,620 | 334,554 | 466,772 |\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\n| Basic earnings per common share | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\n| Diluted earnings per common share |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\n| Share based compensation plans | 730 | 898 | 727 | 1,004 |\n| Weighted average common shares outstanding - diluted(1) | 90,351 | 99,124 | 92,579 | 100,468 |\n| Diluted earnings per common share | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Anti-dilutive shares excluded from the dilutive computation | — | — | 226 | 219 |\n\n| (1) | On August 17, 2015, the Company entered into an Accelerated Share Repurchase (“ASR”) agreement (see 'Note 9 - Shareholders' Equity' for additional detail). The weighted-average number of shares outstanding used in the computation of basic and diluted earnings per share reflects the Company’s receipt of 4,149,378 common shares delivered to the Company on August 20, 2015, and 1,358,380 common shares delivered to the company on January 15, 2016 under the Company's ASR agreement. |\n\n38\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)9. SHAREHOLDERS' EQUITY\nThe following table presents our common shares issued and outstanding:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Shares issued, balance at beginning of period | 176,575 | 176,206 | 176,240 | 175,478 |\n| Shares issued | — | 16 | 335 | 744 |\n| Total shares issued at end of period | 176,575 | 176,222 | 176,575 | 176,222 |\n| Treasury shares, balance at beginning of period | (85,921 | ) | (75,922 | ) | (80,174 | ) | (76,052 | ) |\n| Shares repurchased | (2,252 | ) | (4,257 | ) | (8,499 | ) | (4,607 | ) |\n| Shares reissued from treasury | 37 | 6 | 537 | 486 |\n| Total treasury shares at end of period | (88,136 | ) | (80,173 | ) | (88,136 | ) | (80,173 | ) |\n| Total shares outstanding | 88,439 | 96,049 | 88,439 | 96,049 |\n\nTreasury Shares\nThe following table presents our share repurchases:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| In the open market: |\n| Total shares(1) | 2,232 | 4,248 | 8,236 | 4,264 |\n| Total cost | $ | 124,948 | $ | 245,658 | $ | 434,948 | $ | 246,490 |\n| Average price per share(2) | $ | 56.00 | $ | 57.83 | $ | 52.81 | $ | 57.80 |\n| From employees: |\n| Total shares | 20 | 9 | 263 | 343 |\n| Total cost | $ | 1,088 | $ | 489 | $ | 14,137 | $ | 17,586 |\n| Average price per share(2) | $ | 54.13 | $ | 55.59 | $ | 53.68 | $ | 51.28 |\n| Total shares repurchased: |\n| Total shares | 2,252 | 4,257 | 8,499 | 4,607 |\n| Total cost | $ | 126,036 | $ | 246,147 | $ | 449,085 | $ | 264,076 |\n| Average price per share(2) | $ | 55.98 | $ | 57.83 | $ | 52.84 | $ | 57.32 |\n\n(1) The nine months ended September 30, 2016 includes 1,358,380 common shares acquired under the accelerated share repurchase program (see below for more detail).\n(2) Calculated using whole figures.\n39\n| 9. | SHAREHOLDERS' EQUITY (CONTINUED) |\n\nAccelerated Share Repurchase Program\nOn August 17, 2015, the Company entered into an Accelerated Share Repurchase agreement with Goldman, Sachs & Co. (“Goldman Sachs”) to repurchase an aggregate of $300 million of the Company’s ordinary shares under an accelerated share repurchase program.\nDuring August, 2015, under the terms of this agreement, the Company paid $300 million to Goldman Sachs and initially repurchased 4,149,378 ordinary shares. The initial shares acquired represented 80% of the $300 million total paid to Goldman Sachs and were calculated using the Company’s stock price at activation of the program. The ASR program is accounted for as an equity transaction. Accordingly, as at December 31, 2015, $240 million of common shares repurchased were included as treasury shares in the Consolidated Balance Sheet with the remaining $60 million included as a reduction to additional paid-in capital.\nOn January 15, 2016, Goldman Sachs early terminated the ASR agreement and delivered 1,358,380 additional common shares to the Company, resulting in the reduction from additional paid-in capital of $60 million being reclassified to treasury shares. In total, the Company repurchased 5,507,758 common shares under the ASR agreement at an average price of $54.47.\nSeries B Preferred Shares\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of $3 million.\n| 10. | COMMITMENTS AND CONTINGENCIES |\n\nReinsurance Agreements\nWe purchase reinsurance coverage for various lines of our business. The minimum reinsurance premiums are contractually due in advance on a quarterly basis. Accordingly at September 30, 2016, we have unrecorded outstanding reinsurance purchase commitments of $33 million, of which $3 million is due in 2016 while the remaining $30 million is due in 2017. Actual payments under the reinsurance contracts will depend on the underlying subject premium and may exceed the minimum premium.\nInvestments\nRefer 'Note 3 - Investments' for information on commitments related to our other investments.\n40\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)11. OTHER COMPREHENSIVE INCOME (LOSS)\n| 2016 | 2015 |\n| Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount | Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount |\n| Three months ended September 30, |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | $ | 40,125 | $ | (3,789 | ) | $ | 36,336 | $ | (102,810 | ) | $ | 3,099 | $ | (99,711 | ) |\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (5,050 | ) | 2,408 | (2,642 | ) | 76,368 | (1,558 | ) | 74,810 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 35,075 | (1,381 | ) | 33,694 | (26,442 | ) | 1,541 | (24,901 | ) |\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\n| Foreign currency translation adjustment | 1,722 | — | 1,722 | (14,626 | ) | — | (14,626 | ) |\n| Total other comprehensive income (loss), net of tax | $ | 36,797 | $ | (1,381 | ) | $ | 35,416 | $ | (41,068 | ) | $ | 1,541 | $ | (39,527 | ) |\n| Nine months ended September 30, |\n| Available for sale investments: |\n| Unrealized investment gains (losses) arising during the period | $ | 263,235 | $ | (24,579 | ) | $ | 238,656 | $ | (183,822 | ) | $ | 6,884 | $ | (176,938 | ) |\n| Adjustment for reclassification of net realized investment gains and OTTI losses recognized in net income | 40,338 | 2,282 | 42,620 | 130,858 | (2,088 | ) | 128,770 |\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 303,573 | (22,297 | ) | 281,276 | (52,964 | ) | 4,796 | (48,168 | ) |\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\n| Foreign currency translation adjustment | 5,694 | — | 5,694 | (23,851 | ) | — | (23,851 | ) |\n| Total other comprehensive income (loss), net of tax | $ | 309,267 | $ | (22,297 | ) | $ | 286,970 | $ | (76,815 | ) | $ | 4,796 | $ | (72,019 | ) |\n\nReclassifications out of AOCI into net income available to common shareholders were as follows:\n| Amount Reclassified from AOCI(1) |\n| Details About AOCI Components | Consolidated Statement of Operations Line Item That Includes Reclassification | Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Unrealized investment gains (losses) on available for sale investments |\n| Other realized investment gains (losses) | $ | 9,297 | $ | (44,067 | ) | $ | (19,992 | ) | $ | (68,096 | ) |\n| OTTI losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Total before tax | 5,050 | (76,368 | ) | (40,338 | ) | (130,858 | ) |\n| Income tax (expense) benefit | (2,408 | ) | 1,558 | (2,282 | ) | 2,088 |\n| Net of tax | $ | 2,642 | $ | (74,810 | ) | $ | (42,620 | ) | $ | (128,770 | ) |\n\n| (1) | Amounts in parentheses are debits to net income available to common shareholders. |\n\n41\n| 12. | SUBSEQUENT EVENT |\n\nIn October 2016, the landfall of Hurricane Matthew impacted the Caribbean, southeastern United States and Canada, causing catastrophic loss of life, property damage and flooding.\nOur preliminary after-tax net loss estimate for this event is in the range of $45 million to $60 million. The Company's loss estimate is primarily based on a ground-up assessment of losses from individual contracts and treaties exposed to the affected regions, including preliminary information from clients, brokers and loss adjusters. Industry insured loss estimates, market share analyses and catastrophe modeling analyses were also taken into account where appropriate.\nDue to the nature of this event, including the complexity of loss assessment, factors contributing to the losses and the preliminary nature of the information available to prepare these estimates, the actual net ultimate amount of losses for this event may be materially different from this current estimate.\nITEM 2.\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nThe following is a discussion and analysis of our financial condition and results of operations. This should be read in conjunction with the consolidated financial statements and related notes included in Item 1 of this report and also our Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.\n\n| Page |\n| Third Quarter 2016 Financial Highlights | 43 |\n| Executive Summary | 44 |\n| Underwriting Results – Group | 49 |\n| Results by Segment: For the three and nine months ended September 30, 2016 and 2015 | 57 |\n| i) Insurance Segment | 57 |\n| ii) Reinsurance Segment | 61 |\n| Other Expenses (Revenues), Net | 64 |\n| Net Investment Income and Net Realized Investment Gains (Losses) | 65 |\n| Cash and Investments | 67 |\n| Liquidity and Capital Resources | 70 |\n| Critical Accounting Estimates | 72 |\n| New Accounting Standards | 72 |\n| Off-Balance Sheet and Special Purpose Entity Arrangements | 72 |\n| Non-GAAP Financial Measures | 72 |\n\n42\nTHIRD QUARTER 2016 FINANCIAL HIGHLIGHTS\nThird Quarter 2016 Consolidated Results of Operations\n\n| • | Net income available to common shareholders of $177 million, or $1.97 per common share and $1.96 per diluted common share |\n\n| • | Operating income of $161 million, or $1.78 per diluted common share(1) |\n\n| • | Gross premiums written of $1.0 billion |\n\n| • | Net premiums written of $595 million, impacted by a large new retrocessional cover entered into with Harrington Re Ltd. |\n\n| • | Net premiums earned of $934 million |\n\n| • | Net favorable prior year reserve development of $76 million |\n\n| • | Estimated catastrophe and weather-related pre-tax net losses, net of reinstatement premiums, of $22 million compared to $43 million during the third quarter of 2015 |\n\n| • | Underwriting income of $104 million and combined ratio of 92.6% |\n\n| • | Net investment income of $117 million |\n\n| • | Net realized investment gains of $5 million |\n\n| • | Foreign exchange gains of $14 million |\n\nThird Quarter 2016 Consolidated Financial Condition\n| • | Total cash and investments of $14.6 billion; fixed maturities, cash and short-term securities comprise 87% of total cash and investments and have an average credit rating of AA- |\n\n| • | Total assets of $21.2 billion |\n\n| • | Reserve for losses and loss expenses of $9.9 billion and reinsurance recoverable of $2.3 billion |\n\n| • | Total debt of $1.0 billion and the debt to total capital ratio of 14.1% |\n\n| • | Repurchased 2.3 million common shares. At October 27, 2016 the remaining authorization under the repurchase program approved by our Board of Directors was $375 million |\n\n| • | Common shareholders’ equity of $5.4 billion and diluted book value per common share of $59.77 |\n\n| (1) | Operating income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to ‘Non-GAAP Financial Measures’ for reconciliation to nearest GAAP financial measure (net income available to common shareholders). |\n\n43\nEXECUTIVE SUMMARY\nBusiness Overview\nWe are a Bermuda-based global provider of specialty lines insurance and treaty reinsurance products with operations in Bermuda, the United States, Europe, Singapore, Canada, Latin America and the Middle East. Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Re.\nOur mission is to provide our clients and distribution partners with a broad range of risk transfer products and services and meaningful capacity, backed by significant financial strength. We manage our portfolio holistically, aiming to construct the optimum consolidated portfolio of funded and unfunded risks, consistent with our risk appetite and development of our franchise. We nurture an ethical, entrepreneurial and disciplined culture that promotes outstanding client service, intelligent risk taking and the achievement of superior risk-adjusted returns for our shareholders. We believe that the achievement of our objectives will position us as a global leader in specialty risks. Our execution on this strategy in the first nine months of 2016 included:\n| • | continued growth of our accident and health lines, which is focused on specialty accident and health products; |\n\n| • | growth of our Weather and Commodity Markets business unit which offers parametric risk management solutions to clients |\n\nwhose profit margins are exposed to adverse weather and commodity price risks;\n| • | growth of our syndicate at Lloyd's which provides us with access to Lloyd's worldwide licenses and an extensive distribution network. During the first quarter of 2016 we commenced writing business through our underwriting division at Lloyd's in China; |\n\n| • | continued rebalancing of our portfolio towards less-volatile lines of business that carry attractive rates; and |\n\n| • | continued expansion of our broad range of third-party capital capabilities through: |\n\n| • | Our investment in Harrington Reinsurance Holdings Limited (\"Harrington\"), the parent company of Harrington Re Ltd. (\"Harrington Re\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\"Blackstone\"). Harrington Re’s strategy is to combine a multi-line reinsurance portfolio with a diversified allocation to alternative investment strategies to earn attractive risk-adjusted returns. Harrington plans to develop a portfolio that optimizes the risk-reward characteristics of both assets and liabilities, leveraging the respective strengths of AXIS Capital and Blackstone while deploying a disciplined and fully integrated approach to both underwriting and investing; |\n\n| • | AXIS Ventures Reinsurance Limited, which manages capital for investors interested in deploying funds directly into the property-catastrophe and other short-tail business; and |\n\n| • | increased use of available reinsurance and retrocessional protection to optimize the risk-adjusted returns on our portfolio. |\n\n44\nResults of Operations\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Underwriting income: |\n| Insurance | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\n| Reinsurance | 78,837 | 60% | 49,357 | 181,623 | (8%) | 197,729 |\n| Net investment income | 116,923 | 156% | 45,685 | 257,818 | 14% | 226,336 |\n| Net realized investment gains (losses) | 5,205 | nm | (69,957 | ) | (40,295 | ) | (67%) | (123,618 | ) |\n| Other expenses, net | (37,079 | ) | nm | (8,464 | ) | (63,439 | ) | 18% | (53,895 | ) |\n| Termination fee received | — | nm | 280,000 | — | nm | 280,000 |\n| Reorganization and related fees | — | nm | (45,867 | ) | — | nm | (45,867 | ) |\n| Interest in loss of equity method investments | (2,434 | ) | nm | — | (2,434 | ) | nm | — |\n| Net income | 186,613 | (28%) | 257,642 | 364,460 | (27%) | 496,838 |\n| Preferred share dividends | (9,969 | ) | (1%) | (10,022 | ) | (29,906 | ) | (1%) | (30,066 | ) |\n| Net income available to common shareholders | $ | 176,644 | (29%) | $ | 247,620 | $ | 334,554 | (28%) | $ | 466,772 |\n| Operating income | $ | 160,689 | 215% | $ | 51,031 | $ | 309,450 | 10% | $ | 280,682 |\n\nnm – not meaningful\nUnderwriting Results\nTotal underwriting income in the three months ended September 30, 2016 was $104 million, an increase of $48 million compared to $56 million in the three months ended September 30, 2015. The increase in underwriting income was primarily driven by an increase in net favorable prior year development, decreased catastrophe and weather-related losses, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\nThe reinsurance segment underwriting income increased by $29 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily driven by decreased catastrophe and weather-related losses, an increase in net favorable prior year development, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the acquisition cost ratio.\nThe insurance segment underwriting income increased by $18 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development and a decrease in the acquisition cost ratio, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\nTotal underwriting income in the nine months ended September 30, 2016 was $213 million, a decrease of $1 million compared to $214 million in the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by increased catastrophe and weather-related losses, an increase in the acquisition cost ratio and a decrease in other insurance income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\nThe reinsurance segment underwriting income decreased by $16 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by an increase in the acquisition cost ratio, increased catastrophe and weather-related losses and a decrease in other insurance related income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\nThe insurance segment underwriting income increased by $15 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development, a decrease in the acquisition cost ratio and lower general and administrative expenses, partially offset by increased catastrophe and weather-related losses.\n45\nNet Investment Income\nNet investment income in the three months ended September 30, 2016 was $117 million, an increase of $71 million compared to $46 million in the three months ended September 30, 2015. The increase was primarily driven by our other investments. These investments generated a gain of $38 million in the three months ended September 30, 2016, compared to a loss of $27 million in three months ended September 30, 2015. Net investment income for the nine months ended September 30, 2016 was $258 million, an increase of $31 million compared to the same period in 2015. The increase was mainly attributable to income from fixed maturities and other investments. Income from fixed maturities increased as a result of an emphasis on longer duration assets and income from other investments increased as a result of improved valuations on our CLO - Equity holdings.\nNet Realized Investment Gains (Losses)\nRealized gains were $5 million in the three months ended September 30, 2016 compared to realized losses of $70 million for the same period of 2015. The gains were mainly attributable to corporates, agency MBS, CMBS and ETFs which benefited from improvements in pricing in 2016. The realized losses in the three months ended September 30, 2015 were attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and other-than-temporary impairment (\"OTTI\") charges. Realized losses were $40 million in the nine months ended September 30, 2016, compared to realized losses of $124 million for the same period of 2015. The losses for the three and nine months ended September 30, 2016 and 2015 were primarily attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and OTTI charges.\nOther Revenues (Expenses), Net\nCorporate expenses increased to $29 million for the three months ended September 30, 2016, from $24 million for the three months ended September 30, 2015. The increase is primarily attributable to the net reimbursement of PartnerRe Ltd. (\"PartnerRe\") merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. For the nine months ended September 30, 2016, corporate expenses increased to $87 million compared to $84 million in the same period in 2015. The slight increase is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016, and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\nThe foreign exchange gains for the three and nine months ended September 30, 2016 of $14 million and $70 million, respectively, were primarily driven by the depreciation of the pound sterling against the U.S dollar. The foreign exchange gains of $28 million for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar, while the foreign exchange gains for the nine months ended September 30, 2015 of $69 million were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\nThe financial results for the three months ended September 30, 2016 resulted in a tax expense of $9 million, compared to an expense of nil for the three months ended September 30, 2015. Operations in the nine months ended September 30, 2016 resulted in a tax expense of $8 million compared to a tax expense of $1 million in the nine months ended September 30, 2015. The effective tax rate, which drives the tax expense, can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the increase in both periods is the generation of consolidated pre-tax net income in our operations in Europe compared to net losses in 2015.\nTermination Fee Received\nDuring the third quarter of 2015, the Company announced that we had accepted a request from PartnerRe to terminate the Agreement and Plan of Amalgamation (the \"Amalgamation Agreement\") with the Company. PartnerRe paid the Company $315 million to immediately terminate the Amalgamation Agreement, the amount was comprised of a termination fee of $280 million and a reimbursement of merger related expenses of $35 million.\n46\nReorganization and Related Expenses\nDuring the third quarter of 2015, the Company implemented a number of profitability enhancement initiatives which resulted in a recognition of reorganization and related expenses of $46 million and additional corporate expenses of $5 million in the Consolidated Statement of Operations in the three months ended September 30, 2015.\nInterest in Loss of Equity Method Investments\nInterest in losses of equity method investments represents the Company’s aggregate share of losses related to investments in which the Company has significant influence over the operating and financial policies of the investee.\nOutlook\nManagement expects to achieve an increase in gross premiums written in 2016, with variances between our lines of business within the operating segments driven by market conditions and available opportunities, as we maintain our focus on diversification and pursuit of those opportunities that will expand our reach in areas where we believe the returns to be most attractive. We also expect the increase in gross premiums written to be substantially offset by greater cessions of risk to reinsurers and third party capital partners.\nCompetitive conditions continue to impact worldwide insurance markets with greatest pressures impacting catastrophe exposed property and certain global specialty lines of business. We also observed greater competitiveness for large accounts compared to smaller risks. These competitive pressures have led to price reductions across most lines of business, with decreases in international markets generally more severe than those observed in the United States. We expect this trend to continue in the short-term but believe that there are still attractive risks in the market. In this challenging market environment, we are focusing on lines and markets that remain adequately priced or continue to deliver price increases and those that provide opportunities for profitable growth. Where necessary we also continue to shift our business mix toward smaller, less volatile risk accounts which we believe will enable us to achieve a better, more stable attritional loss experience with lower severity.\nThe reinsurance markets' trading environment remains challenging in the majority of lines of business and geographical regions. The market continues to be influenced by excess capacity, strong balance sheets of established market participants and a consolidation of reinsurance purchasing. Despite these conditions we observed recent favorable trends which we expect to impact our business including many cedants reducing the size of their reinsurer panels, some moderation of pricing pressures, increased resistance to demands for greater commission rates as well as more generous terms and conditions, an increase in the number of cedants looking to buy more reinsurance protection and Solvency II-driven opportunities. These factors, combined with AXIS customer-centric approach and opportunities in specific lines of business and geographies allow us to execute on our targeted growth strategy. We continue to address the difficult market conditions by taking actions to protect the quality and profitability of our existing book, targeting larger shares of the more attractive treaties, managing the overall volatility of our reinsurance book, and expanding our already strong group of third party capital partners with whom to share our risks and earn fee income.\n47\nFinancial Measures\nWe believe the following financial indicators are important in evaluating our performance and measuring the overall growth in value generated for our common shareholders:\n| Three months ended and at September 30, | Nine months ended and at September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| ROACE (annualized)(1) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\n| Operating ROACE (annualized)(2) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\n| DBV per common share(3) | $ | 59.77 | $ | 53.68 | $ | 59.77 | $ | 53.68 |\n| Cash dividends declared per common share | 0.35 | 0.29 | 1.05 | 0.87 |\n| Increase in diluted book value per common share adjusted for dividends | $ | 2.50 | $ | 2.16 | $ | 6.74 | $ | 4.67 |\n\n| (1) | Return on average common equity (“ROACE”) is calculated by dividing annualized net income available to common shareholders for the period by the average shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. |\n\n| (2) | Operating ROACE is calculated by dividing annualized operating income for the period by the average common shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. Annualized operating ROACE is a non-GAAP financial measure as defined in SEC Regulation G. Refer to‘Non-GAAP Financial Measures’ for additional information and reconciliation to the nearest GAAP financial measure (ROACE). |\n\n| (3) | Diluted book value (“DBV”) per common share represents total common shareholders’ equity divided by the number of common shares and diluted common share equivalents outstanding, determined using the treasury stock method. Cash settled awards are excluded from the denominator. |\n\nReturn on Equity\nThe decrease in ROACE in the three months ended September 30, 2016, compared to the three months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by net realized gains in the current quarter compared to net realized losses in the same period in 2015, an increase in net investment income and underwriting income in the current quarter compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\nThe increase in operating ROACE for the three months ended September 30, 2016, compared to the three months ended September 30, 2015 was primarily driven by an increase in net investment income and underwriting income in the three months ended September 30, 2016 compared to the same period in 2015.\nThe decrease in ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by a decrease in net realized losses and an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\nThe increase in operating ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015.\nDiluted Book Value per Common Share\nOur diluted book value per common share increase of 11% from $53.68 at September 30, 2015, to $59.77 at September 30, 2016, primarily reflected the generation of $469 million in net income available to common shareholders over the past twelve months and the increase over the last twelve months in unrealized gains on investments which are included in accumulated other comprehensive income, which was partially offset by common share dividends declared.\n48\nDiluted Book Value per Common Share Adjusted for Dividends\nOur diluted book value per common share adjusted for dividends increased by $2.50, or 4%, per common share for the three month period ended September 30, 2016 and $7.49, or 14%, per common share over the past twelve months.\nTaken together, we believe that growth in diluted book value per common share and common share dividends declared represent the total value created for our common shareholders. As companies in the insurance industry have differing dividend payout policies, we believe investors use the diluted book value per common share adjusted for dividends metric to measure comparable performance across the industry.\nDuring the three and nine months ended September 30, 2016, total value created consisted primarily of our net income and an increase in unrealized gains on investments, reported in accumulated other comprehensive income.\nDuring the three and nine months ended September 30, 2015, total value created consisted primarily of our net income, partially offset by an increase in unrealized losses on investments and foreign exchange translation adjustment losses included in accumulated other comprehensive income.\nUNDERWRITING RESULTS – GROUP\nThe following table provides our group underwriting results for the periods indicated. Underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses.\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\n| Net premiums written | 595,431 | (12%) | 677,217 | 3,288,587 | 7% | 3,079,307 |\n| Net premiums earned | 934,415 | 2% | 919,341 | 2,783,746 | 1% | 2,764,605 |\n| Other insurance related income | 5,944 | 413% | 1,158 | 4,850 | (61%) | 12,319 |\n| Expenses: |\n| Current year net losses and loss expenses | (608,347 | ) | (605,512 | ) | (1,887,715 | ) | (1,818,672 | ) |\n| Prior year reserve development | 76,019 | 45,125 | 224,131 | 165,804 |\n| Acquisition costs | (189,810 | ) | (182,744 | ) | (559,570 | ) | (537,549 | ) |\n| Underwriting-related general and administrative |\n| expenses(1) | (114,223 | ) | (121,123 | ) | (352,632 | ) | (372,625 | ) |\n| Underwriting income(2) | $ | 103,998 | 85% | $ | 56,245 | $ | 212,810 | (1%) | $ | 213,882 |\n| General and administrative expenses(1) | $ | 142,906 | $ | 144,727 | $ | 439,554 | $ | 456,451 |\n| Income before income taxes and interest in income (loss) of equity method investments(2) | $ | 198,399 | $ | 257,672 | $ | 374,606 | $ | 497,993 |\n\n| (1) | Underwriting-related general and administrative expenses is a non-GAAP measure as defined in SEC Regulation G. Our total general and administrative expenses also included corporate expenses of $28,683 and $23,604 for the three months ended September 30, 2016 and 2015, respectively, and $86,922 and $83,826 for the nine months ended September 30, 2016 and 2015, respectively. Refer to 'Other Expenses (Revenues), Net' for additional information related to these corporate expenses. Also, refer to 'Non-GAAP Financial Measures' for further information. |\n\n| (2) | Underwriting income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to Item 1, Note 2 to the Consolidated Financial Statements for a reconciliation of underwriting income to the nearest GAAP financial measure (income before income taxes and interest in income (loss) of equity method investments) for the periods indicated above. Also, refer to 'Non-GAAP Financial Measures' for additional information related to the presentation of underwriting income. |\n\n49\nUNDERWRITING REVENUES\nPremiums Written:\n| Gross Premiums Written |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Insurance | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\n| Reinsurance | 284,532 | (14%) | 329,879 | 2,126,762 | 16% | 1,833,374 |\n| Total | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\n| % ceded |\n| Insurance | 36% | (1) pts | 37% | 32% | 1 pts | 31% |\n| Reinsurance | 43% | 33 pts | 10% | 13% | 7 pts | 6% |\n| Total | 38% | 10 pts | 28% | 22% | 3 pts | 19% |\n| Net Premiums Written |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Insurance | $ | 433,131 | 14% | $ | 381,118 | $ | 1,433,058 | 6% | $ | 1,352,122 |\n| Reinsurance | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\n| Total | $ | 595,431 | (12%) | $ | 677,217 | $ | 3,288,587 | 7% | $ | 3,079,307 |\n\nGross premiums written in the three and nine months ended September 30, 2016, increased by $23 million or 2% (3% on a constant currency basis(1)) and $436 million or 11% (13% on a constant currency basis) compared to the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the same period in 2015 was due to an increase in the insurance segment, partially offset by a decrease in the reinsurance segment. The increase for the nine months ended September 30, 2016 compared to the same period in 2015 was due to increases in both our reinsurance and insurance segments.\nOur reinsurance segment's gross premiums written decreased by $45 million or 14% (13% on a constant currency basis) and increased by $293 million, or 16% (19% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The decrease in the reinsurance segment gross written premiums in the three months ended September 30, 2016, compared to the same period of 2015 was primarily driven by timing differences impacting our professional and liability lines. The increase in the reinsurance segment gross written premiums in the nine months ended September 30, 2016, compared to the same period of 2015 was impacted by an increase in the level of premiums written on a multi-year basis. This increase in multi-year contracts increased the amount of premium recorded in the current period relating to future years compared to the same period in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was partially offset by foreign exchange movements as the strength of the U.S. dollar drove comparative premium decreases in treaties denominated in foreign currencies. After adjusting for the impact of the multi-year contracts and foreign exchange movements, our reinsurance segment gross premiums written increased by $204 million in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by new business in our liability, marine and other, catastrophe, professional as well as our credit and surety lines, with favorable treaty restructurings and timing differences also contributing to increased premium written in our liability and professional lines. These increases were partially offset by a decrease in our property lines primarily driven by non-renewals and decreases in the line sizes on several treaties.\n| (1) | Amounts presented on a constant currency basis are “non-GAAP financial measures” as defined in Regulation G. The constant currency basis is calculated by applying the average foreign exchange rate from the current year to the prior year balance. |\n\n50\nOur insurance segment's gross written premiums increased by $69 million or 11% (12% on a constant currency basis) and $142 million or 7% (8% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods of 2015. Increased premiums written were reported in both periods in our accident and health and property lines primarily related to new business. The increase in the nine months ended September 30, 2016, compared to the same period in 2015 was partially offset by decreased premiums written in our marine lines and the impact of our exit from retail insurance operations in Australia.\nIn the three and nine months ended September 30, 2016, the ceded ratio increased by 10% and 3%, compared to the three and nine months ended September 30, 2015, respectively, with the increases primarily attributable to the reinsurance segment. The reinsurance segment ceded ratio increased in the three and nine months ended September 30, 2016 compared to the same periods in 2015, largely due to a new retrocessional cover entered into with Harrington Re.\nNet Premiums Earned:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | %Change | 2016 | 2015 | %Change |\n| Insurance | $ | 444,691 | 48 | % | $ | 444,550 | 48 | % | —% | $ | 1,322,649 | 48 | % | $ | 1,344,339 | 49 | % | (2%) |\n| Reinsurance | 489,724 | 52 | % | 474,791 | 52 | % | 3% | 1,461,097 | 52 | % | 1,420,266 | 51 | % | 3% |\n| Total | $ | 934,415 | 100 | % | $ | 919,341 | 100 | % | 2% | $ | 2,783,746 | 100 | % | $ | 2,764,605 | 100 | % | 1% |\n\nChanges in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in premium earning patterns.\nNet premiums earned increased by 2% (4% on a constant currency basis) and 1% (4% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The increases were driven by the reinsurance segment in both periods, with a reduction in the insurance segment for the nine months ended September 30, 2016 compared to the same period in 2015, partially offsetting the increase in the reinsurance segment.\nThe increase in the reinsurance segment for both periods was primarily driven by strong premium growth in our liability, marine and other as well as our catastrophe lines in recent periods together with favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\nThe decrease in the insurance segment for the nine months ended September 30, 2016, compared to the same period in 2015, was primarily driven by an increase in our professional lines' ceded reinsurance programs, decreased business written in our marine lines and the impact of our exit from retail insurance operations in Australia, partially offset by growth in premiums written in recent periods in our accident and health lines.\nOther Insurance Related Income (Loss):\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by third party capital fees and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\n51\nUNDERWRITING EXPENSES\nThe following table provides a breakdown of our combined ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year loss ratio | 65.1 | % | (0.8) | 65.9 | % | 67.8 | % | 2.0 | 65.8 | % |\n| Prior year reserve development | (8.1 | %) | (3.2) | (4.9 | %) | (8.0 | %) | (2.0) | (6.0 | %) |\n| Acquisition cost ratio | 20.3 | % | 0.4 | 19.9 | % | 20.1 | % | 0.7 | 19.4 | % |\n| General and administrative expense ratio(1) | 15.3 | % | (0.4) | 15.7 | % | 15.8 | % | (0.7) | 16.5 | % |\n| Combined ratio | 92.6 | % | (4.0) | 96.6 | % | 95.7 | % | — | 95.7 | % |\n\n| (1) | The general and administrative expense ratio includes corporate expenses not allocated to reportable segments of 3.1% and 2.6% for the three months ended September 30, 2016 and 2015, respectively, and 3.1% and 3.0% for the nine months ended September 30, 2016 and 2015, respectively. These costs are further discussed in the ‘Other Expenses (Revenues), Net’ section. |\n\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratio decreased to 65.1% in the three months ended September 30, 2016 from 65.9% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.8% in the same period in 2015.\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $22 million, or 2.3 points, and $145 million, or 5.3 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $43 million, or 4.7 points, and $90 million, or 3.3 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.5%, respectively, compared to 61.2% and 62.5% in the three and nine months ended September 30, 2015, respectively. The increase in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three months ended September 30, 2016, compared to the same period in 2015, was mainly due to business mix changes as well as the ongoing adverse impact of rate and trend, partially offset by a decrease in the mid-size loss experience in our insurance marine and property lines. The current accident year loss ratio after adjusting for the impact of the catastrophe and weather-related losses for the nine months ended September 30, 2016 was comparable to the same periods in 2015. The adverse impact of rate and trend together with business mix changes were offset by a decrease in the mid-size loss experience in our insurance marine and property lines.\nPrior Year Reserve Development:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\n\n52\nOverview\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment . Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\nWe caution that conditions and trends that impacted the development of our liabilities in the past may not necessarily occur in the future.\nEstimates of Significant Catastrophe Events\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\n53\nOur estimated net losses in relation to the catastrophe events described above were derived from ground-up assessments of our in-force contracts and treaties providing coverage in the affected regions. These assessments take into account the latest information available from clients, brokers and loss adjusters. In addition, we consider industry insured loss estimates, market share analyses and catastrophe modeling analyses, when appropriate. Our estimates remain subject to change, as additional loss data becomes available.\nThe following sections provide further details on prior year reserve development by segment, reserving class and accident year.\nInsurance Segment:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Property and other | $ | 10,061 | $ | 20,518 | $ | 24,048 | $ | 49,705 |\n| Marine | 4,682 | 2,831 | 8,382 | 23,156 |\n| Aviation | 517 | 667 | 437 | 2,884 |\n| Credit and political risk | (25 | ) | (28 | ) | (232 | ) | (15,427 | ) |\n| Professional lines | 3,378 | (15,279 | ) | 8,956 | (15,887 | ) |\n| Liability | 2,075 | (6,265 | ) | 1,590 | (23,206 | ) |\n| Total | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\n\nIn the three months ended September 30, 2016, we recognized $21 million of net favorable prior year reserve development, the principal components of which were:\n| • | $10 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015 and favorable loss experience in our accident and health lines impacting accident year 2014. |\n\n| • | $5 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\n\nIn the three months ended September 30, 2015, we recognized $2 million of net favorable prior year reserve development, the principal components of which were:\n| • | $21 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence including reserve reductions related to Storm Sandy of $15 million. |\n\n| • | $6 million of net adverse prior year reserve development on liability business, primarily related to a higher frequency of large auto liability claims in accident year 2014. |\n\n| • | $15 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\n\nIn the nine months ended September 30, 2016, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\n| • | $24 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence primarily related to accident year 2014. |\n\n| • | $9 million of net favorable prior year reserve development on professional lines business, driven by better than expected development related to various accident years, partially offset by reserve strengthening relating to updated information on one specific claim impacting accident year 2010. |\n\n54\n| • | $8 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\n\nIn the nine months ended September 30, 2015, we recognized $21 million of net favorable prior year development, the principal components of which were:\n| • | $50 million of net favorable prior year reserve development on property and other business, related to the 2012 and 2013 accident years and driven by better than expected loss emergence, including reserve reductions related to Storm Sandy of $16 million. |\n\n| • | $23 million of net favorable prior year reserve development on marine business, largely related to better than expected loss emergence in our energy offshore business spanning multiple years, particularly accident year 2014. |\n\n| • | $15 million of net adverse prior year reserve development on credit and political risk business, related to updated information on one specific claim impacting accident year 2014. |\n\n| • | $16 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\n\n| • | $23 million of net adverse prior year reserve development on liability business, related to strengthening of specific individual claim reserves and a higher frequency of large auto liability claims in accident year 2014. |\n\nReinsurance Segment:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Property and other | $ | 25,831 | $ | 14,115 | $ | 83,522 | $ | 36,120 |\n| Credit and surety | 3,900 | 7,051 | 6,761 | 18,851 |\n| Professional lines | 8,761 | 1,250 | 18,918 | 25,331 |\n| Motor | 6,653 | 8,997 | 39,794 | 27,321 |\n| Liability | 10,186 | 11,268 | 31,955 | 36,956 |\n| Total | $ | 55,331 | $ | 42,681 | $ | 180,950 | $ | 144,579 |\n\nIn the three months ended September 30, 2016, we recognized $55 million of net favorable prior year reserve development, the principal components of which were:\n| • | $26 million of net favorable prior year reserve development on property and other business, related to the 2011 through 2015 accident years driven by better than expected loss emergence including a reserve reduction of $7 million related to Storm Sandy. |\n\n| • | $10 million of net favorable prior year reserve development on liability business, primarily related to the 2007 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $9 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $7 million of net favorable prior year reserve development on motor business, related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\n\nIn the three months ended September 30, 2015, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\n55\n| • | $14 million of net favorable prior year reserve development on property and other business, related to multiple prior accident years and driven by better than expected loss emergence. |\n\n| • | $11 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $9 million of net favorable prior year reserve development on motor business, largely related to favorable loss emergence trends on several classes spanning multiple accident years. |\n\n| • | $7 million of net favorable prior year reserve development on credit and surety business, related to the 2012 accident year and driven by additional information obtained about a specific claim. |\n\nIn the nine months ended September 30, 2016, we recognized $181 million of net favorable prior year reserve development, the principal components of which were:\n| • | $84 million of net favorable prior year development on property and other business, primarily related to the 2010 through 2015 accident years driven by better than expected loss emergence. |\n\n| • | $40 million of net favorable prior year reserve development on motor business, primarily related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\n\n| • | $32 million of net favorable prior year reserve development on liability business, primarily related to the 2006 through 2011 accident years, for reasons discussed in the overview. |\n\n| • | $19 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\n\nIn the nine months ended September 30, 2015, we recognized $145 million of net favorable prior year reserve development, the principal components of which were:\n| • | $37 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\n\n| • | $36 million of net favorable prior year reserve development on property and other business, spanning a number of accident years and driven by better than expected loss emergence. Included in this net development is $20 million of adverse development on agriculture reserves relating to loss developments on the 2014 accident year driven by lower than expected crop yields reported for two specific treaties. |\n\n| • | $27 million of net favorable prior year reserve development on motor business, predominantly related to non-proportional business in accident years 2011 and prior, driven by better than expected loss emergence. |\n\n| • | $25 million of net favorable prior year reserve development on professional lines business, primarily related to the 2009 through 2010 accident years, for reasons discussed in the overview. |\n\n\n| • | $19 million of net favorable prior year reserve development on credit and surety business, spanning multiple accident years and driven by better than expected loss emergence, as well as additional information obtained about a specific claim. |\n\nAcquisition Cost Ratio: The increase in the acquisition cost ratio in the three and nine months ended September 30, 2016 to 20.3% and 20.1%, respectively, compared to 19.9% and 19.4% in the three and nine months ended September 30, 2015, respectively, was driven by increases in our reinsurance segment. The reinsurance segment's increase in the three months ended September 30, 2016 compared to the same period in 2015 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The reinsurance segment's increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\n56\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio in the three and nine months ended September 30, 2016, decreased to 15.3% and 15.8%, respectively, compared to 15.7% and 16.5% in the three and nine months ended September 30, 2015, respectively. The decrease in the expense ratio in the three months ended September 30, 2016 compared to the same period in 2015 was primarily attributable to growth in net premiums earned, reorganization related expenses adverse to 2015 and increased fees from strategic capital partners, partially offset by the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016. The decrease in the expense ratio in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by growth in net earned premiums, increased fees from strategic capital partners, decreased personnel costs and expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015, partially offset by adjustments to senior leadership executive stock-compensation awards benefiting 2015 and senior executive transition costs in 2016.\nRESULTS BY SEGMENT\nINSURANCE SEGMENT\nResults from our insurance segment were as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\n| Net premiums written | 433,131 | 14% | 381,118 | 1,433,058 | 6% | 1,352,122 |\n| Net premiums earned | 444,691 | —% | 444,550 | 1,322,649 | (2%) | 1,344,339 |\n| Other insurance related income (loss) | 39 | (93%) | 542 | (57 | ) | nm | 811 |\n| Expenses: |\n| Current year net losses and loss expenses | (293,914 | ) | (285,716 | ) | (896,952 | ) | (887,805 | ) |\n| Prior year reserve development | 20,688 | 2,444 | 43,181 | 21,225 |\n| Acquisition costs | (61,755 | ) | (69,118 | ) | (184,982 | ) | (200,493 | ) |\n| General and administrative expenses | (84,588 | ) | (85,814 | ) | (252,652 | ) | (261,924 | ) |\n| Underwriting income | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\n| Ratios: | % PointChange | % PointChange |\n| Current year loss ratio | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\n| Acquisition cost ratio | 13.9 | % | (1.6) | 15.5 | % | 14.0 | % | (0.9) | 14.9 | % |\n| General and administrative expense ratio | 19.1 | % | (0.3) | 19.4 | % | 19.0 | % | (0.5) | 19.5 | % |\n| Combined ratio | 94.4 | % | (4.2) | 98.6 | % | 97.6 | % | (1.3) | 98.9 | % |\n\nnm – not meaningful\n57\nGross Premiums Written:\nThe following table provides gross premiums written by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Property | $ | 164,605 | 25 | % | $ | 139,488 | 24 | % | 18% | $ | 522,380 | 24 | % | $ | 465,929 | 24 | % | 12% |\n| Marine | 33,677 | 5 | % | 38,817 | 6 | % | (13%) | 191,298 | 9 | % | 215,885 | 11 | % | (11%) |\n| Terrorism | 9,394 | 1 | % | 11,192 | 2 | % | (16%) | 28,090 | 1 | % | 25,737 | 1 | % | 9% |\n| Aviation | 9,684 | 1 | % | 10,222 | 2 | % | (5%) | 37,111 | 2 | % | 29,755 | 2 | % | 25% |\n| Credit and Political Risk | 5,423 | 1 | % | 8,542 | 1 | % | (37%) | 34,299 | 2 | % | 29,640 | 2 | % | 16% |\n| Professional Lines | 204,926 | 30 | % | 196,218 | 32 | % | 4% | 590,417 | 28 | % | 598,370 | 30 | % | (1%) |\n| Liability | 108,447 | 16 | % | 104,666 | 17 | % | 4% | 310,797 | 15 | % | 300,204 | 15 | % | 4% |\n| Accident and Health | 139,274 | 21 | % | 97,559 | 16 | % | 43% | 398,404 | 19 | % | 305,034 | 15 | % | 31% |\n| Total | $ | 675,430 | 100 | % | $ | 606,704 | 100 | % | 11% | $ | 2,112,796 | 100 | % | $ | 1,970,554 | 100 | % | 7% |\n\nGross premiums written in the three months ended September 30, 2016, increased by $69 million or 11% (12% on a constant currency basis) compared to the three months ended September 30, 2015. The increase was primarily attributable to growth in our accident and health and property lines related to new business opportunities.\nGross premiums written in the nine months ended September 30, 2016 increased by $142 million or 7% (8% on a constant currency basis) compared to the nine months ended September 30, 2015. The increase was primarily attributable to increases in our accident and health and property lines driven by new business. These increases were partially offset by a decrease in our marine and professional lines. Our marine lines decreased primarily due to reduced new business opportunities, lower rates and timing differences. The professional lines' decrease was due to the impact of our exit from retail insurance operations in Australia, as mentioned above in the quarterly results.\nPremiums Ceded: In the three and nine months ended September 30, 2016, premiums ceded were $242 million, or 36% of gross premiums written and $680 million, or 32% of gross premiums written, respectively, compared to $226 million, or 37% of gross premiums written and $618 million or 31% of gross premiums written, in the three and nine months ended September 30, 2015, respectively. The decrease in the ceded ratio for the three months ended September 30, 2016 compared to the same period in 2015 was primarily driven by changes in our accident and health line, partially offset by increased premiums ceded in our liability and professional lines. The increase in the ceded ratio for the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by increased ceded premiums in our professional lines, partially offset by changes in our accident and health line.\n58\nNet Premiums Earned:\nThe following table provides net premiums earned by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Property | $ | 106,578 | 25 | % | $ | 112,017 | 27 | % | (5%) | $ | 312,804 | 23 | % | $ | 324,720 | 24 | % | (4%) |\n| Marine | 36,218 | 8 | % | 36,837 | 8 | % | (2%) | 113,693 | 9 | % | 143,878 | 11 | % | (21%) |\n| Terrorism | 8,276 | 2 | % | 7,985 | 2 | % | 4% | 26,011 | 2 | % | 26,565 | 2 | % | (2%) |\n| Aviation | 9,015 | 2 | % | 9,982 | 2 | % | (10%) | 33,528 | 3 | % | 32,097 | 2 | % | 4% |\n| Credit and Political Risk | 12,274 | 3 | % | 14,671 | 3 | % | (16%) | 42,661 | 3 | % | 45,993 | 3 | % | (7%) |\n| Professional Lines | 126,574 | 28 | % | 148,110 | 33 | % | (15%) | 386,241 | 29 | % | 451,944 | 34 | % | (15%) |\n| Liability | 42,205 | 9 | % | 41,817 | 9 | % | 1% | 126,429 | 10 | % | 120,181 | 9 | % | 5% |\n| Accident and Health | 103,551 | 23 | % | 73,131 | 16 | % | 42% | 281,282 | 21 | % | 198,961 | 15 | % | 41% |\n| Total | $ | 444,691 | 100 | % | $ | 444,550 | 100 | % | —% | $ | 1,322,649 | 100 | % | $ | 1,344,339 | 100 | % | (2%) |\n\nNet premiums earned in the three months ended September 30, 2016, were comparable (up 2% on a constant currency basis) to the three months ended September 30, 2015, driven by growth in premiums written in recent periods, primarily in our accident and health lines, offset by an increase in our professional lines' ceded reinsurance programs. Net premiums earned in the nine months ended September 30, 2015 decreased by $22 million or 2% (comparable on a constant currency basis) compared to the nine months ended September 30, 2015. The decrease in net premiums earned in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by an increase in our professional lines' ceded reinsurance programs, a reduction in business written in our marine lines and the impact of our exit from retail insurance operations in Australia partially offset by growth in our accident and health lines.\nLoss Ratio:\nThe table below shows the components of our loss ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\n| Loss ratio | 61.4 | % | (2.3) | 63.7 | % | 64.6 | % | 0.1 | 64.5 | % |\n\n59\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratios increased to 66.1% and 67.8% in the three and nine months ended September 30, 2016, respectively, from 64.3% and 66.0% in the three and nine months ended September 30, 2015, respectively.\nDuring the three and nine months ended September 30, 2016, we incurred $15 million, or 3.3 points, and $73 million, or 5.5 points, respectively, in pre-tax catastrophe and weather-related losses related to the U.S. weather events, Japanese earthquake and Fort McMurray wildfires. Comparatively, during the three and nine months ended September 30, 2015 we incurred $19 million, or 4.3 points, and $45 million, or 3.4 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.3%, respectively, compared to 60.0% and 62.7% in the three and nine months ended September 30, 2015, respectively. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was driven by the adverse impact of rate and trend on most lines of business and changes in business mix, partially offset by a decrease in the mid-size loss experience particularly in our marine and property lines.\nRefer to the ‘Prior Year Reserve Development’ section for further details.\nAcquisition Cost Ratio: The decrease in the acquisition cost ratio in the three and nine months ended September 30, 2016 compared to the three and nine months ended September 30, 2015, was driven by an increase in ceding commissions following the expansion of our professional lines' ceded reinsurance programs and a lower acquisition cost ratio in our accident and health line resulting from a change in business mix.\nGeneral and Administrative Expense Ratio: The decrease in the general and administrative expense ratio in the nine months ended September 30, 2016 compared nine months ended September 30, 2015 primarily reflected a decrease in personnel expenses and a reduction in the allocation of certain corporate expenses.\n60\nREINSURANCE SEGMENT\nResults from our reinsurance segment were as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Revenues: |\n| Gross premiums written | $ | 284,532 | (14%) | $ | 329,879 | $ | 2,126,762 | 16% | $ | 1,833,374 |\n| Net premiums written | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\n| Net premiums earned | 489,724 | 3% | 474,791 | 1,461,097 | 3% | 1,420,266 |\n| Other insurance related income | 5,905 | nm | 616 | 4,907 | (57%) | 11,508 |\n| Expenses: |\n| Current year net losses and loss expenses | (314,433 | ) | (319,796 | ) | (990,763 | ) | (930,867 | ) |\n| Prior year reserve development | 55,331 | 42,681 | 180,950 | 144,579 |\n| Acquisition costs | (128,055 | ) | (113,626 | ) | (374,588 | ) | (337,056 | ) |\n| General and administrative expenses | (29,635 | ) | (35,309 | ) | (99,980 | ) | (110,701 | ) |\n| Underwriting income | $ | 78,837 | 60% | $ | 49,357 | $ | 181,623 | (8%) | $ | 197,729 |\n| Ratios: | % PointChange | % PointChange |\n| Current year loss ratio | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\n| Acquisition cost ratio | 26.1 | % | 2.2 | 23.9 | % | 25.6 | % | 1.9 | 23.7 | % |\n| General and administrative expense ratio | 6.1 | % | (1.3) | 7.4 | % | 6.9 | % | (0.9) | 7.8 | % |\n| Combined ratio | 85.1 | % | (4.6) | 89.7 | % | 87.9 | % | 1.0 | 86.9 | % |\n\nnm – not meaningful\nGross Premiums Written:\nThe following table provides gross premiums written by line of business for the periods indicated:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Catastrophe | $ | 46,338 | 16 | % | $ | 56,693 | 18 | % | (18%) | $ | 316,692 | 15 | % | $ | 283,562 | 15 | % | 12% |\n| Property | 61,957 | 22 | % | 67,539 | 20 | % | (8%) | 283,555 | 13 | % | 307,809 | 17 | % | (8%) |\n| Professional Lines | 19,479 | 7 | % | 45,509 | 14 | % | (57%) | 235,094 | 11 | % | 204,685 | 11 | % | 15% |\n| Credit and Surety | 36,174 | 13 | % | 23,390 | 7 | % | 55% | 315,102 | 15 | % | 230,958 | 13 | % | 36% |\n| Motor | 13,344 | 5 | % | 21,359 | 6 | % | (38%) | 338,403 | 16 | % | 333,245 | 18 | % | 2% |\n| Liability | 91,387 | 32 | % | 111,361 | 34 | % | (18%) | 365,380 | 17 | % | 258,862 | 14 | % | 41% |\n| Agriculture | 1,286 | — | % | (3,303 | ) | (1 | %) | nm | 151,315 | 7 | % | 139,135 | 8 | % | 9% |\n| Engineering | 13,588 | 5 | % | 4,397 | 1 | % | 209% | 56,719 | 3 | % | 58,163 | 3 | % | (2%) |\n| Marine and Other | 979 | — | % | 2,934 | 1 | % | (67%) | 64,502 | 3 | % | 16,955 | 1 | % | 280% |\n| Total | $ | 284,532 | 100 | % | $ | 329,879 | 100 | % | (14%) | $ | 2,126,762 | 100 | % | $ | 1,833,374 | 100 | % | 16% |\n\nGross premiums written decreased by $45 million and increased by $293 million in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\n61\nThe decrease in gross premiums written in the three months ended September 30, 2016 compared to the same period in 2015, was primarily driven by our professional and liability lines, largely due to timing differences.\nThe increase in gross premiums written in the nine months ended September 30, 2016 compared to the same period in 2015, was impacted by treaties written on a multi-year basis. In the nine months ended September 30, 2016, the reinsurance segment reported an increase in the level of multi-year contracts written compared to the same period in 2015. This increase in multi-year contracts increased the amount of premium recorded in the current periods relating to future years compared to the same periods in 2015, most notably in the credit & surety and liability lines. On a comparative basis the impact of the multi-year premiums resulted in an increase in gross premiums written of $141 million in the nine months ended September 30, 2016, compared to the same period in 2015. The increase in written premiums was partially offset by the impact of foreign exchange movements in the nine months ended September 30, 2016, compared to the same period in 2015, as the strength of the U.S. dollar drove comparative premium decreases in the treaties denominated in foreign currencies. Foreign exchange movements resulted in a relative decrease of $52 million in gross premiums written in the nine months ended September 30, 2016, compared to the same period in 2015.\nAfter adjusting for the impact of multi-year contracts and on a constant currency basis, our gross premiums written increased by $204 million, or 11% in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by increases in our liability, marine and other, catastrophe, professional as well as our credit and surety lines primarily driven by new business. Favorable treaty restructurings and timing differences also contributed to the increases in liability and professional lines. These increases were partially offset by a decrease in our property lines, primarily relating to non-renewals and decreases in line sizes on several treaties.\nPremiums Ceded: In the three and nine months ended September 30, 2016, the ratio of ceded premium to gross written premium increased to 43% and 13%, respectively, from 10% and 6% in the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the prior period, was due to the impact of a new retrocessional cover entered into with Harrington Re which increased premiums ceded in our liability and professional lines. The increase for the nine months ended September 30, 2016 compared to the prior period was largely due to the new retrocessions to Harrington Re and increased premiums ceded in our catastrophe and property business.\nNet Premiums Earned:\nThe following table provides net premiums earned by line of business:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\n| Catastrophe | $ | 48,799 | 10 | % | $ | 51,116 | 11 | % | (5%) | $ | 151,416 | 12 | % | $ | 165,840 | 12 | % | (9%) |\n| Property | 71,649 | 15 | % | 78,343 | 17 | % | (9%) | 208,179 | 14 | % | 235,828 | 17 | % | (12%) |\n| Professional Lines | 73,109 | 15 | % | 81,986 | 17 | % | (11%) | 225,813 | 15 | % | 231,024 | 16 | % | (2%) |\n| Credit and Surety | 67,430 | 14 | % | 59,601 | 13 | % | 13% | 192,135 | 13 | % | 182,508 | 13 | % | 5% |\n| Motor | 77,786 | 16 | % | 72,893 | 15 | % | 7% | 232,383 | 16 | % | 228,433 | 16 | % | 2% |\n| Liability | 80,137 | 16 | % | 77,441 | 16 | % | 3% | 247,103 | 17 | % | 218,829 | 15 | % | 13% |\n| Agriculture | 36,704 | 7 | % | 33,684 | 7 | % | 9% | 106,251 | 7 | % | 101,335 | 7 | % | 5% |\n| Engineering | 18,573 | 4 | % | 15,128 | 3 | % | 23% | 51,024 | 3 | % | 43,133 | 3 | % | 18% |\n| Marine and Other | 15,537 | 3 | % | 4,599 | 1 | % | 238% | 46,793 | 3 | % | 13,336 | 1 | % | 251% |\n| Total | $ | 489,724 | 100 | % | $ | 474,791 | 100 | % | 3% | $ | 1,461,097 | 100 | % | $ | 1,420,266 | 100 | % | 3% |\n\nNet premiums earned increased by $15 million or 3% (7% on a constant currency basis) and $41 million or 3% (7% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\nThe increase for both periods was primarily driven by the growth in the business written in our liability, marine and other as well as our catastrophe lines in recent periods together with a favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\n62\nOther Insurance Related Income (Losses):\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\nLoss Ratio:\nThe table below shows the components of our loss ratio:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\n| Current accident year | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\n| Loss ratio | 52.9 | % | (5.5) | 58.4 | % | 55.4 | % | — | 55.4 | % |\n\nCurrent Accident Year Loss Ratio:\nThe current accident year loss ratio decreased to 64.2% in the three months ended September 30, 2016 from 67.4% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.5% in the same period in 2015.\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $7 million, or 1.5 points, and $72 million, or 5.0 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $24 million, or 5.1 points, and $45 million, or 3.2 points, respectively.\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.7% and 62.8%, respectively, compared to 62.3% in both the three and nine months ended September 30, 2015. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was mainly due to the ongoing adverse impact of rate and trend, partially offset by the recognition of better than expected recent attritional loss experience across our long tail lines of business.\nRefer ‘Prior Year Reserve Development’ for further details.\nAcquisition Cost Ratio: The acquisition cost ratio increased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The increase in the three months ended September 30, 2016 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis together with higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\n63\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio decreased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The decrease in the general and administrative expense ratio primarily reflects lower personnel expense, benefits of arrangements with our strategic capital partners and the impact of increased net earned premiums.\nOTHER EXPENSES (REVENUES), NET\nThe following table provides a breakdown of our other expenses (revenues), net:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Corporate expenses | $ | 28,683 | 22% | $ | 23,604 | $ | 86,922 | 4% | $ | 83,826 |\n| Foreign exchange gains | (13,795 | ) | (51%) | (28,088 | ) | (69,781 | ) | 1% | (69,200 | ) |\n| Interest expense and financing costs | 12,839 | (1%) | 12,918 | 38,586 | 1% | 38,114 |\n| Income tax expense | 9,352 | nm | 30 | 7,712 | nm | 1,155 |\n| Total | $ | 37,079 | nm | $ | 8,464 | $ | 63,439 | 18% | $ | 53,895 |\n\nnm – not meaningful\nCorporate Expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned, corporate expenses were 3.1% for the three and nine months ended September 30, 2016, compared to 2.6% and 3.0%, respectively, for the same periods of 2015. The increase in corporate expenses in the three month period ended September 30, 2016 is primarily attributable to the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. The slight increase in corporate expenses in the nine month period ended September 30, 2016 is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016 and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\nForeign Exchange Gains: Some of our business is written in currencies other than the U.S. dollar. The foreign exchange gains for the periods presented were largely driven by the re-measurement of our net insurance related liabilities. The foreign exchange gains for the three and nine months ended September 30, 2016 were primarily driven by the depreciation of pound sterling against the U.S dollar. Comparatively, the foreign exchange gains for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar. The foreign exchange gains for the nine months ended September 30, 2015 were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\nIncome Tax Expense: Income tax expense primarily results from income generated by our foreign operations in the United States and Europe. Our effective tax rate, which is calculated as income tax expense divided by net income before tax including interest in loss of equity method investments, was 4.8% and 2.1% in the three and nine months ended September 30, 2016, and was insignificant and 0.2% in the three and nine months ended September 30, 2015. This effective rate can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the current quarter and year-to-date increase is the generation of consolidated pre-tax net income in our operations in Europe compared to a net loss in each of these periods in 2015.\n64\nNET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS (LOSSES)\nNet Investment Income\nThe following table provides a breakdown of income earned from our cash and investment portfolio by major asset class:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\n| Fixed maturities | $ | 75,827 | —% | $ | 75,980 | $ | 229,423 | 4% | $ | 220,066 |\n| Other investments | 38,248 | nm | (27,421 | ) | 25,770 | 46% | 17,616 |\n| Equity securities | 4,633 | 34% | 3,445 | 12,843 | 65% | 7,795 |\n| Mortgage loans | 2,191 | nm | 482 | 5,683 | nm | 776 |\n| Cash and cash equivalents | 3,768 | nm | 993 | 7,071 | 88% | 3,770 |\n| Short-term investments | 337 | nm | 83 | 708 | 156% | 277 |\n| Gross investment income | 125,004 | 133% | 53,562 | 281,498 | 12% | 250,300 |\n| Investment expense | (8,081 | ) | 3% | (7,877 | ) | (23,680 | ) | (1%) | (23,964 | ) |\n| Net investment income | $ | 116,923 | 156% | $ | 45,685 | $ | 257,818 | 14% | $ | 226,336 |\n| Pre-tax yield:(1) |\n| Fixed maturities | 2.7% | 2.5% | 2.6% | 2.4% |\n\nnm - not meaningful\n| (1) | Pre-tax yield is annualized and calculated as net investment income divided by the average month-end amortized cost balances for the periods indicated. |\n\nFixed Maturities\nThe net investment income increase for the nine months ended September 30, 2016 attributable to fixed maturities was due to an emphasis on longer duration assets and an improvement in CPI adjustments following a reduction in our exposure to treasury inflation-protected securities.\nOther Investments\nThe following table provides a breakdown of total net investment income from other investments:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Hedge, direct lending, private equity and real estate funds | $ | 29,459 | $ | (23,483 | ) | $ | 6,127 | $ | 10,357 |\n| Other privately held investments | 370 | — | 177 | — |\n| CLO - Equities | 8,419 | (3,938 | ) | 19,466 | 7,259 |\n| Total net investment income from other investments | $ | 38,248 | $ | (27,421 | ) | $ | 25,770 | $ | 17,616 |\n| Pre-tax return on other investments(1) | 4.5 | % | (3.3 | %) | 3.1 | % | 2.0 | % |\n\n| (1) | The pre-tax return on other investments is non-annualized and calculated by dividing total net investment income from other investments by the average month-end fair value balances held for the periods indicated. |\n\nThe total net investment income from other investments increased for the three and nine months ended September 30, 2016 compared to the same periods in 2015 due to an improvement in the performance of the global equity markets which translated into higher valuations on our hedge funds. CLO - Equities also benefited from an increase in the valuation of the underlying collateral balances.\n65\nNet Realized Investment Gains (Losses)\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| On sale of investments: |\n| Fixed maturities and short-term investments | $ | 4,303 | $ | (42,741 | ) | $ | (22,869 | ) | $ | (66,579 | ) |\n| Equity securities | 4,994 | (1,327 | ) | 2,881 | (1,505 | ) |\n| 9,297 | (44,068 | ) | (19,988 | ) | (68,084 | ) |\n| OTTI charges recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\n| Change in fair value of investment derivatives | 155 | 6,412 | 39 | 7,228 |\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\n\nOn sale of investments\nGenerally, sales of individual securities occur when there are changes in the relative value, credit quality or duration of a particular issue. We may also sell to rebalance our investment portfolio in order to change exposure to particular asset classes or sectors. Net realized investment gains in the three months ended September 30, 2016 are reflective of the improvement in pricing of our fixed maturities and equities. Net realized investment losses in the nine months ended September 30, 2016 are primarily due to foreign exchange losses on non-U.S. denominated securities, as a result of the strengthening of the U.S. dollar.\nOTTI charges\nFor the three months ended September 30, 2016, OTTI charges were driven by impairments on corporate debt securities and losses on non-U.S. denominated securities as a result of the decline in foreign exchange rates against the U.S. dollar. The nine months ended September 30, 2016 also included impairments on high yield corporate debt securities which are exposed to the energy sector and exchange-traded funds (ETFs) which are unlikely to recover in the near term.\nChange in fair value of investment derivatives\nFrom time to time, we may economically hedge the foreign exchange exposure of non-U.S. denominated securities by entering into foreign exchange forward contracts.\n66\nTotal Return\nThe following table provides a breakdown of the total return on cash and investments for the period indicated:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\n| Net realized investments gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\n| Change in net unrealized gains (losses) | 35,075 | (26,441 | ) | 303,573 | (52,965 | ) |\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\n| Total | $ | 154,769 | $ | (50,713 | ) | $ | 518,662 | $ | 49,753 |\n| Average cash and investments(1) | $ | 14,470,231 | $ | 14,893,376 | $ | 14,457,978 | $ | 14,919,752 |\n| Total return on average cash and investments, pre-tax: |\n| Inclusive of investment related foreign exchange movements | 1.1 | % | (0.3 | %) | 3.6 | % | 0.3 | % |\n| Exclusive of investment related foreign exchange movements | 1.1 | % | (0.1 | %) | 3.9 | % | 0.9 | % |\n\n| (1) | The average cash and investments balance is calculated by taking the average of the month-end fair value balances held for the periods indicated. |\n\nCASH AND INVESTMENTS\nThe table below provides a breakdown of our cash and investments:\n| September 30, 2016 | December 31, 2015 |\n| Fair Value | Fair Value |\n| Fixed maturities | $ | 11,566,860 | $ | 11,719,749 |\n| Equities | 644,344 | 597,998 |\n| Mortgage loans | 332,753 | 206,277 |\n| Other investments | 847,262 | 816,756 |\n| Equity method investments | 111,295 | 10,932 |\n| Short-term investments | 39,877 | 34,406 |\n| Total investments | $ | 13,542,391 | $ | 13,386,118 |\n| Cash and cash equivalents(1) | $ | 1,077,263 | $ | 1,174,751 |\n\n| (1) | Includes restricted cash and cash equivalents of $229 million and $187 million at September 30, 2016 and at December 31, 2015, respectively. |\n\nThe $156m increase in the fair value of our total investments was driven by the downward shift in sovereign yield curves and the tightening of credit spreads on both investment grade and high-yield corporate debt. This was partially offset by the funding of financing and operating activities.\n67\nThe following provides a further analysis on our investment portfolio by asset classes:\nFixed Maturities\nThe following provides a breakdown of our investment in fixed maturities:\n| September 30, 2016 | December 31, 2015 |\n| Fair Value | % of Total | Fair Value | % of Total |\n| Fixed maturities: |\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\n| Non-U.S. government | 582,056 | 5 | % | 739,005 | 6 | % |\n| Corporate debt | 4,568,500 | 39 | % | 4,362,769 | 37 | % |\n| Agency RMBS | 2,522,731 | 22 | % | 2,249,236 | 19 | % |\n| CMBS | 894,275 | 8 | % | 1,083,298 | 9 | % |\n| Non-Agency RMBS | 71,830 | — | % | 101,008 | 1 | % |\n| ABS | 1,235,596 | 11 | % | 1,371,270 | 12 | % |\n| Municipals(1) | 128,995 | 1 | % | 161,214 | 2 | % |\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\n| Credit ratings: |\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\n| AAA(2) | 4,359,640 | 38 | % | 4,266,673 | 36 | % |\n| AA | 1,165,958 | 10 | % | 1,273,941 | 11 | % |\n| A | 1,770,161 | 15 | % | 2,065,192 | 18 | % |\n| BBB | 1,607,798 | 14 | % | 1,442,938 | 12 | % |\n| Below BBB(3) | 1,100,426 | 9 | % | 1,019,056 | 9 | % |\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\n\n| (1) | Includes bonds issued by states, municipalities, and political subdivisions. |\n\n| (2) | Includes U.S. government-sponsored agency RMBS and CMBS. |\n\n| (3) | Non-investment grade and non-rated securities. |\n\nAt September 30, 2016, our fixed maturities had a weighted average credit rating of AA- (2015: AA-) and an average duration of 3.2 years (2015: 3.3 years). When incorporating short-term investments and cash and cash equivalents into the calculation (bringing the total to $12.5 billion), the average credit rating would be AA- (2015: AA-) and duration would be 2.9 years (2015: 3.0 years).\nDuring the year, net unrealized investment gains (losses) on fixed maturities moved from a net unrealized investment loss of $178 million at December 31, 2015 to a net unrealized gain of $104 million at September 30, 2016.\nEquities\nNet unrealized investment gains on equities increased from $22 million at December 31, 2015 to $44 million at September 30, 2016, an increase of $22 million due to an improvement in valuations reflective of performance of the global equity markets.\nMortgage Loans\nDuring the year, we increased our investment in commercial mortgage loans from $206 million to $333 million, an increase of $127m. The commercial mortgage loans are high quality and collateralized by a variety of commercial properties and are diversified both geographically throughout the United States and by property type to reduce the risk of concentration.\n68\nOther Investments\nThe composition of our other investments portfolio is summarized as follows:\n| September 30, 2016 | December 31, 2015 |\n| Hedge funds |\n| Long/short equity funds | $ | 139,460 | 16 | % | $ | 154,348 | 19 | % |\n| Multi-strategy funds | 281,153 | 33 | % | 355,073 | 43 | % |\n| Event-driven funds | 94,012 | 11 | % | 147,287 | 18 | % |\n| Leveraged bank loan funds | — | — | % | 65 | — | % |\n| Total hedge funds | 514,625 | 60 | % | 656,773 | 80 | % |\n| Direct lending funds | 125,002 | 15 | % | 90,120 | 11 | % |\n| Private equity funds | 89,170 | 11 | % | — | — | % |\n| Real estate funds | 11,782 | 1 | % | 4,929 | 1 | % |\n| Total hedge, direct lending and real estate funds | 740,579 | 87 | % | 751,822 | 92 | % |\n| Other privately held investments | 42,900 | 5 | % | — | — | % |\n| CLO - Equities | 63,783 | 8 | % | 64,934 | 8 | % |\n| Total other investments | $ | 847,262 | 100 | % | $ | 816,756 | 100 | % |\n\nThe $142 million decrease in the fair value of our total hedge funds in 2016 was driven by $138 million of net redemptions and $4 million of price depreciation.\nWe have made total commitments of $310 million to managers of direct lending funds, of which $121 million of our total commitment has been called to date.\nWe have also made a total commitment of $60 million as a limited partner in a multi-strategy hedge fund, of which $48 million has been called to date.\nWe have made a total commitment of $100 million to a real estate fund, of which $10 million has been called to date.\nDuring 2016, we made a total commitment of $135 million to a private equity fund, of which $95 million has been called to date.\nEquity Method Investments\nDuring 2016, we paid $104 million including direct transactions costs to acquire 18% of the common equity of Harrington, the parent company of Harrington Re, an independent reinsurance company jointly sponsored by AXIS Capital and Blackstone. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting.\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\n69\nLIQUIDITY AND CAPITAL RESOURCES\nRefer to the ‘Liquidity and Capital Resources’ section included under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015 for a general discussion of our liquidity and capital resources.\nThe following table summarizes our consolidated capital as at:\n| September 30, 2016 | December 31, 2015 |\n| Senior notes | $ | 992,633 | $ | 991,825 |\n| Preferred shares | 625,000 | 627,843 |\n| Common equity | 5,400,658 | 5,239,039 |\n| Shareholders’ equity | 6,025,658 | 5,866,882 |\n| Total capital | $ | 7,018,291 | $ | 6,858,707 |\n| Ratio of debt to total capital | 14.1 | % | 14.5 | % |\n| Ratio of debt and preferred equity to total capital | 23.0 | % | 23.6 | % |\n\nWe finance our operations with a combination of debt and equity capital. Our debt to total capital and debt and preferred equity to total capital ratios provide an indication of our capital structure, along with some insight into our financial strength. A company with higher ratios in comparison to industry average may show weak financial strength because the cost of its debts may adversely affect results of operations and/or increase its default risk. We believe that our financial flexibility remains strong.\nPreferred Shares\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of\n$3 million.\n70\nCommon Equity\n| Nine months ended September 30, | 2016 |\n| Common equity - opening | $ | 5,239,039 |\n| Net income | 364,460 |\n| Shares repurchased for treasury | (449,086 | ) |\n| Change in unrealized appreciation on available for sale investments, net of tax | 281,276 |\n| Settlement of accelerated share repurchase | 60,000 |\n| Common share dividends | (98,334 | ) |\n| Preferred share dividends | (29,906 | ) |\n| Share-based compensation expense recognized in equity | 26,129 |\n| Foreign currency translation adjustment | 5,694 |\n| Cost of treasury shares reissued | 1,386 |\n| Common equity - closing | $ | 5,400,658 |\n\nDuring the nine months ended September 30, 2016, we repurchased 8.5 million common shares, including 7.1 million of common shares repurchased for a total of $389 million (including $375 million pursuant to our Board-authorized share repurchase program and $14 million relating to shares purchased in connection with the vesting of restricted stock awards granted under our 2007 Long-Term Equity Compensation Plan), and 1.4 million common shares acquired under the ASR which terminated on January 15, 2016. At October 27, 2016, the remaining authorization under the common share repurchase program approved by our Board of Directors was $375 million (refer to Part II, Item 2 'Unregistered Sales of Equity Securities and Use of Proceeds' for additional information).\nWe continue to expect that cash flows generated from our operations, combined with the liquidity provided by our investment portfolio, will be sufficient to cover our required cash outflows and other contractual commitments through the foreseeable future.\n71\nCRITICAL ACCOUNTING ESTIMATES\nOur Consolidated Financial Statements include certain amounts that are inherently uncertain and judgmental in nature. As a result, we are required to make assumptions and best estimates in order to determine the reported values. We consider an accounting estimate to be critical if: (1) it requires that significant assumptions be made in order to deal with uncertainties and (2) changes in the estimate could have a material impact on our results of operations, financial condition or liquidity.\nAs disclosed in our 2015 Annual Report on Form 10-K, we believe that the material items requiring such subjective and complex estimates are our:\n| • | reserves for losses and loss expenses; |\n\n| • | reinsurance recoverable balances; |\n\n| • | premiums; |\n\n| • | fair value measurements for our financial assets and liabilities; and |\n\n| • | assessments of other-than-temporary impairments. |\n\nWe believe that the critical accounting estimates discussion in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015, continues to describe the significant estimates and judgments included in the preparation of our Consolidated Financial Statements.\nNEW ACCOUNTING STANDARDS\nRefer to Item 1, Note 1 'Basis of Presentation and Accounting policies' to the Consolidated Financial Statements and Item 8, Note 2 'Significant Accounting Policies' to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2015, for a discussion of recently issued accounting pronouncements that we have not yet adopted.\nOFF-BALANCE SHEET AND SPECIAL PURPOSE ENTITY ARRANGEMENTS\nAt September 30, 2016, we have not entered into any off-balance sheet arrangements, as defined by Item 303(a)(4) of Regulation S-K.\nNON-GAAP FINANCIAL MEASURES\nIn this report, we present operating income, consolidated underwriting income, underwriting-related general and administrative expenses and amounts presented on a constant currency basis, which are “non-GAAP financial measures” as defined in Regulation G.\nOperating income represents after-tax operational results without consideration of after-tax net realized investment gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses. We also present diluted operating income per common share and operating return on average common equity (“operating ROACE”), which are derived from the non-GAAP operating income measure.\nConsolidated underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses. Underwriting-related general and administrative expenses include those general and administrative expenses that are incremental and/or directly attributable to our individual underwriting operations. While these measures are presented in Item 1, Note 2 to our Consolidated Financial Statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis.\nAmounts presented on a constant currency basis are calculated by applying the average foreign exchange rate from the current year to prior year amounts.\n72\nOperating income, diluted operating income per common share and operating ROACE can be reconciled to the nearest GAAP financial measures as follows:\n| Three months ended September 30, | Nine months ended September 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\n| Net realized investment (gains) losses, net of tax(1) | (2,726 | ) | 67,897 | 42,667 | 119,442 |\n| Foreign exchange gains, net of tax(2) | (13,229 | ) | (27,410 | ) | (67,771 | ) | (68,456 | ) |\n| Termination fee received(3) | — | (280,000 | ) | — | (280,000 | ) |\n| Reorganization and related expenses, net of tax(4) | — | 42,924 | — | 42,924 |\n| Operating income | $ | 160,689 | $ | 51,031 | $ | 309,450 | $ | 280,682 |\n| Earnings per common share - diluted | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\n| Net realized investment (gains) losses, net of tax | (0.03 | ) | 0.68 | 0.46 | 1.19 |\n| Foreign exchange gains, net of tax | (0.15 | ) | (0.28 | ) | (0.73 | ) | (0.69 | ) |\n| Termination fee received | — | (2.82 | ) | — | (2.79 | ) |\n| Reorganization and related expenses, net of tax | — | 0.43 | — | 0.43 |\n| Operating income per common share - diluted | $ | 1.78 | $ | 0.51 | $ | 3.34 | $ | 2.79 |\n| Weighted average common shares and common share equivalents - diluted(5) | 90,351 | 99,124 | 92,579 | 100,468 |\n| Average common shareholders’ equity | $ | 5,369,921 | $ | 5,259,619 | $ | 5,319,849 | $ | 5,195,901 |\n| ROACE (annualized) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\n| Operating ROACE (annualized) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\n\n| (1) | Tax cost (benefit) of $2,479 and ($2,060) for the three months ended September 30, 2016 and 2015, respectively, and $2,372 and ($4,176) for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the ability to utilize capital losses. |\n\n| (2) | Tax cost of $566 and $678 for the three months ended September 30, 2016 and 2015, respectively, and $2,010 and $744 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the tax status of specific foreign exchange transactions. |\n\n| (3) | Tax impact is nil. |\n\n| (4) | Tax benefit of nil and $2,943 for the three months ended September 30, 2016 and 2015, respectively, and nil and $2,943 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, reflecting the jurisdictional apportionment and related tax treatment of the individual components of the reorganization and related expenses. |\n\n| (5) | Refer to Item 1, Note 8 to our Consolidated Financial Statements for further details on the dilution calculation. |\n\nA reconciliation of consolidated underwriting income to income before income taxes (the nearest GAAP financial measure) can be found in Item 1, Note 2 to the Consolidated Financial Statements. Underwriting-related general and administrative expenses are reconciled to general and administrative expenses (the nearest GAAP financial measure) within 'Underwriting Results - Group'.\nWe present our results of operations in the way we believe will be most meaningful and useful to investors, analysts, rating agencies and others who use our financial information to evaluate our performance. This includes the presentation of “operating income”, (in total and on a per share basis), “annualized operating ROACE” (which is based on the “operating income” measure) and “consolidated underwriting income”, which incorporates “underwriting-related general and administrative expenses”.\nOperating Income\nAlthough the investment of premiums to generate income and realized investment gains (losses) is an integral part of our operations, the determination to realize investment gains (losses) is independent of the underwriting process and is heavily influenced by the availability of market opportunities. Furthermore, many users believe that the timing of the realization of investment gains (losses) is somewhat opportunistic for many companies.\n73\nForeign exchange losses (gains) in our Consolidated Statements of Operations are primarily driven by the impact of foreign exchange rate movements on net insurance related-liabilities. However, this movement is only one element of the overall impact of foreign exchange rate fluctuations on our financial position. In addition, we recognize unrealized foreign exchange losses (gains) on our available-for-sale investments in other comprehensive income and foreign exchange losses (gains) realized upon the sale of these investments in net realized investments gains (losses). These unrealized and realized foreign exchange rate movements generally offset a large portion of the foreign exchange losses (gains) reported separately in earnings, thereby minimizing the impact of foreign exchange rate movements on total shareholders' equity. As such, the Statement of Operations foreign exchange losses (gains) in isolation are not a fair representation of the performance of our business.\nThe termination fee received represents the break-up fee paid by PartnerRe Ltd. following the cancellation of the amalgamation agreement with AXIS Capital and is not indicative of future revenues of the Company.\nReorganization and related expenses are primarily driven by business decisions, the nature and timing of which is unrelated to the underwriting process and which are not representative of underlying business performance.\nIn this regard, certain users of our financial statements evaluate earnings excluding after-tax net realized investment gains (losses) and foreign exchange losses (gains) to understand the profitability of recurring sources of income.\nWe believe that showing net income available to common shareholders exclusive of net realized gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses reflects the underlying fundamentals of our business. In addition, we believe that this presentation enables investors and other users of our financial information to analyze performance in a manner similar to how our management analyzes the underlying business performance. We also believe this measure follows industry practice and, therefore, facilitates comparison of our performance with our peer group. We believe that equity analysts and certain rating agencies that follow us, and the insurance industry as a whole, generally exclude these items from their analyses for the same reasons.\nConsolidated Underwriting Income/Underwriting-Related General and Administrative Expenses\nCorporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As these costs are not incremental and/or directly attributable to our individual underwriting operations, we exclude them from underwriting-related general and administrative expenses and, therefore, consolidated underwriting income. Interest expense and financing costs primarily relate to interest payable on our senior notes and are excluded from consolidated underwriting income for the same reason.\nWe evaluate our underwriting results separately from the performance of our investment portfolio. As such, we believe it appropriate to exclude net investment income and net realized investment gains (losses) from our underwriting profitability measure.\nAs noted above, foreign exchange losses (gains) in our Consolidated Statements of Operations primarily relate to our net insurance-related liabilities. However, we manage our investment portfolio in such a way that unrealized and realized foreign exchange rate losses (gains) on our investment portfolio generally offset a large portion of the foreign exchange losses (gains) arising from our underwriting portfolio. As a result, we believe that foreign exchange losses (gains) are not a meaningful contributor to our underwriting performance and, therefore, exclude them from consolidated underwriting income.\nThe termination fee received represents the break-up fee received on the cancellation of the amalgamation agreement between PartnerRe Ltd. and AXIS Capital and should be excluded from consolidated underwriting income since it is not related to underwriting operations.\nReorganization and related expenses are driven by business decisions, the nature and timing of which are unrelated to the underwriting process and for this reason they are excluded from consolidated underwriting income.\nWe believe that presentation of underwriting-related general and administrative expenses and consolidated underwriting income provides investors with an enhanced understanding of our results of operations, by highlighting the underlying pre-tax profitability of our underwriting activities.\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nRefer to Item 7A included in our 2015 Form 10-K. With the exception of the changes in exposure to foreign currency risk presented below, there have been no material changes to this item since December 31, 2015.\nForeign Currency Risk\nThe table below provides a sensitivity analysis of our total net foreign currency exposures.\n| AUD | NZD | CAD | EUR | GBP | JPY | Other | Total |\n| At September 30, 2016 |\n| Net managed assets (liabilities), excluding derivatives | $ | 85,933 | $ | (6,574 | ) | $ | 74,859 | $ | (159,487 | ) | $ | (59,745 | ) | $ | 21,593 | $ | 132,185 | $ | 88,764 |\n| Foreign currency derivatives, net | (79,700 | ) | 7,287 | (80,621 | ) | 204,334 | 5,836 | (26,126 | ) | 11,790 | 42,800 |\n| Net managed foreign currency exposure | 6,233 | 713 | (5,762 | ) | 44,847 | (53,909 | ) | (4,533 | ) | 143,975 | 131,564 |\n| Other net foreign currency exposure | 2,060 | — | — | 22,881 | 1,011 | — | 68,969 | 94,921 |\n| Total net foreign currency exposure | $ | 8,293 | $ | 713 | $ | (5,762 | ) | $ | 67,728 | $ | (52,898 | ) | $ | (4,533 | ) | $ | 212,944 | $ | 226,485 |\n| Net foreign currency exposure as a percentage of total shareholders’ equity | 0.1 | % | — | % | (0.1 | %) | 1.1 | % | (0.9 | %) | (0.1 | %) | 3.5 | % | 3.8 | % |\n| Pre-tax impact of net foreign currency exposure on shareholders’ equity given a hypothetical 10% rate movement(1) | $ | 829 | $ | 71 | $ | (576 | ) | $ | 6,773 | $ | (5,290 | ) | $ | (453 | ) | $ | 21,294 | $ | 22,648 |\n\n| (1) | Assumes 10% change in underlying currencies relative to the U.S. dollar. |\n\nTotal Net Foreign Currency Exposure\nAt September 30, 2016, our total net foreign currency exposure was $226 million net long, driven by increases in our exposures to the euro and other non-core currencies primarily due to new business written during the first nine months of 2016.\nITEM 4. CONTROLS AND PROCEDURES\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of September 30, 2016. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2016, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and is accumulated and communicated to\n74\nmanagement, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of changes in the Company’s internal control over financial reporting that occurred during the three months ended September 30, 2016. Based upon that evaluation, there were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nFrom time to time, we are subject to routine legal proceedings, including arbitrations, arising in the ordinary course of business. These legal proceedings generally relate to claims asserted by or against us in the ordinary course of insurance or reinsurance operations; estimated amounts payable under such proceedings are included in the reserve for losses and loss expenses in our Consolidated Balance Sheets.\nWe are not a party to any material legal proceedings arising outside the ordinary course of business.\nITEM 1A. RISK FACTORS\nThere were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.\n75\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nThe following table presents information regarding the number of shares we repurchased during the three months ended September 30, 2016:\nISSUER PURCHASES OF EQUITY SECURITIES\nCommon Shares\n| Period | Total Numberof SharesPurchased | AveragePrice PaidPer Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(1) | Maximum Number (or ApproximateDollar Value) of Shares That May Yet BePurchased Under the Announced Plansor Programs(2) |\n| July 1-31, 2016 | 127 | $55.45 | 108 | $494.0 million |\n| August 1-31, 2016 | 1,552 | $55.88 | 1,552 | $407.3 million |\n| September 1-30, 2016 | 572 | $56.36 | 571 | $375.1 million |\n| Total | 2,251 | 2,231 | $375.1 million |\n\n| (1) | From time to time, we purchase shares in connection with the vesting of restricted stock awards granted to our employees under our 2007 Long-Term Equity Compensation Plan. The purchase of these shares is separately authorized and is not part of our Board-authorized share repurchase program, described below. |\n\n| (2) | On December 7, 2015, our Board of Directors authorized a share repurchase plan to repurchase up to $750 million of our common shares through to December 31, 2016. The share repurchase authorization which became effective on December 31, 2015, replaced the previous plan which had $444 million available through the end of 2016. Share repurchases may be effected from time to time in the open market or privately negotiated transactions, depending on market conditions. |\n\nITEM 5. OTHER INFORMATION\nDisclosure of Certain Activities Under Section 13(r) of the Securities Exchange Act of 1934\nSection 13(r) of the Securities Exchange Act of 1934, as amended, requires issuers to disclose in their annual and quarterly reports whether they or any of their affiliates knowingly engaged in certain activities with Iran or with individuals or entities that are subject to certain sanctions under U.S. law. Issuers are required to provide this disclosure even where the activities, transactions or dealings are conducted outside of the United States in compliance with applicable law.\nAs and when allowed by the applicable law and regulations, certain of our non-U.S. subsidiaries provide treaty reinsurance coverage to non-U.S. insurers of marine, aviation and energy risks on a worldwide basis, and as a result, these underlying reinsurance portfolios may have some exposure to Iran. In addition, we underwrite insurance and facultative reinsurance on a global basis to non-U.S. insureds and reinsureds for marine, aviation and energy risks. Coverage provided to non-Iranian business may indirectly cover an exposure in Iran. For example, certain of our operations underwrite global marine hull and cargo policies that provide coverage for vessels navigating into and out of ports worldwide, including Iran. For the quarter ended September 30, 2016, no premium has been allocated or apportioned to activities relating to Iran. As we believe these activities are permitted under applicable laws and regulations, we intend for our non-U.S. subsidiaries to continue to provide such coverage to the extent permitted by applicable law.\n76\nITEM 6. EXHIBITS\n| 3.1 | Certificate of Incorporation and Memorandum of Association (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1(Amendment No. 1) (No. 333-103620) filed on April 16, 2003). |\n| 3.2 | Amended and Restated Bye-Laws (incorporated by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 filed on May 15, 2009). |\n| 4.1 | Specimen Common Share Certificate (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Amendment No. 3) (No. 333-103620) filed on June 10, 2003). |\n| 4.2 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series C Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on March 19, 2012). |\n| 4.3 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series D Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 20, 2013). |\n| 10.1 | Amendment No. 1 to Employment Agreement dated June 23, 2014 by and between Peter W. Wilson and AXIS Specialty U.S. Services, Inc. effective September 21, 2016 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on September 27, 2016). |\n| †31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| †31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| †32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| †32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| †101 | The following financial information from AXIS Capital Holdings Limited’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2016 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2016 and December 31, 2015; (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015; (iv) Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015; (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015; and (vi) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail. |\n\n| † | Filed herewith. |\n\nThe agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time.\n77\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDated: October 27, 2016\n\n| AXIS CAPITAL HOLDINGS LIMITED |\n| By: | /S/ ALBERT BENCHIMOL |\n| Albert Benchimol |\n| President and Chief Executive Officer |\n| /S/ JOSEPH HENRY |\n| Joseph Henry |\n| Executive Vice President and Chief Financial Officer |\n| (Principal Financial Officer) |\n\n78\n</text>\n\nWhat would the return on investment be if the net investment income from the third quarter was invested in acquiring new common shares (in percent)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nPART I\\nFINANCIAL INFORMATION\\nThis quarterly report contains forward-looking statements within the meaning of the U.S. federal securities laws. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the United States securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report may include information regarding our estimates of losses related to catastrophes and other large losses, measurements of potential losses in the fair value of our investment portfolio and derivative contracts, our expectations regarding pricing and other market conditions, our growth prospects, and valuations of the potential impact of movements in interest rates, equity prices, credit spreads and foreign currency rates. Forward-looking statements only reflect our expectations and are not guarantees of performance.\\nThese statements involve risks, uncertainties and assumptions. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. We believe that these factors include, but are not limited to, the following:\\n| • | the occurrence and magnitude of natural and man-made disasters, |\\n\\n| • | actual claims exceeding our loss reserves, |\\n\\n| • | general economic, capital and credit market conditions, |\\n\\n| • | the failure of any of the loss limitation methods we employ, |\\n\\n| • | the effects of emerging claims, coverage and regulatory issues, including uncertainty related to coverage definitions, limits, terms and conditions, |\\n\\n| • | the failure of our cedants to adequately evaluate risks, |\\n\\n| • | inability to obtain additional capital on favorable terms, or at all, |\\n\\n| • | the loss of one or more key executives, |\\n\\n| • | a decline in our ratings with rating agencies, |\\n\\n| • | loss of business provided to us by our major brokers, |\\n\\n| • | changes in accounting policies or practices, |\\n\\n| • | the use of industry catastrophe models and changes to these models, |\\n\\n| • | changes in governmental regulations, |\\n\\n| • | increased competition, |\\n\\n| • | changes in the political environment of certain countries in which we operate or underwrite business including the United Kingdom’s expected withdrawal from the European Union, |\\n\\n| • | fluctuations in interest rates, credit spreads, equity prices and/or currency values, and |\\n\\n| • | the other matters set forth under Item 1A, ‘Risk Factors’ and Item 7, ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ included in our Annual Report on Form 10-K for the year ended December 31, 2015. |\\n\\nWe undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.\\n3\\nITEM 1. CONSOLIDATED FINANCIAL STATEMENTS\\n\\n| Page |\\n| Consolidated Balance Sheets at September 30, 2016 (Unaudited) and December 31, 2015 | 5 |\\n| Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 6 |\\n| Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015 (Unaudited) | 7 |\\n| Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015 (Unaudited) | 8 |\\n| Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015 (Unaudited) | 9 |\\n| Notes to Consolidated Financial Statements (Unaudited) | 10 |\\n| Note 1 - Basis of Presentation and Accounting Policies | 10 |\\n| Note 2 - Segment Information | 12 |\\n| Note 3 - Investments | 14 |\\n| Note 4 - Fair Value Measurements | 22 |\\n| Note 5 - Derivative Instruments | 32 |\\n| Note 6 - Reserve for Losses and Loss Expenses | 35 |\\n| Note 7 - Share-Based Compensation | 36 |\\n| Note 8 - Earnings Per Common Share | 38 |\\n| Note 9 - Shareholders' Equity | 39 |\\n| Note 10 - Commitments and Contingencies | 40 |\\n| Note 11 - Other Comprehensive Income (Loss) | 41 |\\n| Note 12 - Subsequent Event | 42 |\\n\\n4\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED BALANCE SHEETS\\nSEPTEMBER 30, 2016 (UNAUDITED) AND DECEMBER 31, 2015\\n\\n| 2016 | 2015 |\\n| (in thousands) |\\n| Assets |\\n| Investments: |\\n| Fixed maturities, available for sale, at fair value(Amortized cost 2016: $11,462,399; 2015: $11,897,639) | $ | 11,566,860 | $ | 11,719,749 |\\n| Equity securities, available for sale, at fair value(Cost 2016: $600,604; 2015: $575,776) | 644,344 | 597,998 |\\n| Mortgage loans, held for investment, at amortized cost and fair value | 332,753 | 206,277 |\\n| Other investments, at fair value | 847,262 | 816,756 |\\n| Equity method investments | 111,295 | 10,932 |\\n| Short-term investments, at amortized cost and fair value | 39,877 | 34,406 |\\n| Total investments | 13,542,391 | 13,386,118 |\\n| Cash and cash equivalents | 848,200 | 988,133 |\\n| Restricted cash and cash equivalents | 229,063 | 186,618 |\\n| Accrued interest receivable | 71,096 | 73,729 |\\n| Insurance and reinsurance premium balances receivable | 2,694,976 | 1,967,535 |\\n| Reinsurance recoverable on unpaid and paid losses | 2,336,741 | 2,096,104 |\\n| Deferred acquisition costs | 545,618 | 471,782 |\\n| Prepaid reinsurance premiums | 582,551 | 396,201 |\\n| Receivable for investments sold | 2,285 | 26,478 |\\n| Goodwill and intangible assets | 85,501 | 86,858 |\\n| Other assets | 283,969 | 302,335 |\\n| Total assets | $ | 21,222,391 | $ | 19,981,891 |\\n| Liabilities |\\n| Reserve for losses and loss expenses | $ | 9,874,807 | $ | 9,646,285 |\\n| Unearned premiums | 3,453,655 | 2,760,889 |\\n| Insurance and reinsurance balances payable | 461,519 | 356,417 |\\n| Senior notes | 992,633 | 991,825 |\\n| Payable for investments purchased | 141,245 | 9,356 |\\n| Other liabilities | 272,874 | 350,237 |\\n| Total liabilities | 15,196,733 | 14,115,009 |\\n| Shareholders’ equity |\\n| Preferred shares | 625,000 | 627,843 |\\n| Common shares (2016: 176,575; 2015: 176,240 shares issued and2016: 88,439; 2015: 96,066 shares outstanding) | 2,206 | 2,202 |\\n| Additional paid-in capital | 2,307,866 | 2,241,388 |\\n| Accumulated other comprehensive income (loss) | 98,505 | (188,465 | ) |\\n| Retained earnings | 6,430,573 | 6,194,353 |\\n| Treasury shares, at cost (2016: 88,136; 2015: 80,174 shares) | (3,438,492 | ) | (3,010,439 | ) |\\n| Total shareholders’ equity | 6,025,658 | 5,866,882 |\\n| Total liabilities and shareholders’ equity | $ | 21,222,391 | $ | 19,981,891 |\\n\\nSee accompanying notes to Consolidated Financial Statements.5\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\\n| Three months ended | Nine months ended |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (in thousands, except for per share amounts) |\\n| Revenues |\\n| Net premiums earned | $ | 934,415 | $ | 919,341 | $ | 2,783,746 | $ | 2,764,605 |\\n| Net investment income | 116,923 | 45,685 | 257,818 | 226,336 |\\n| Other insurance related income | 5,944 | 1,158 | 4,850 | 12,319 |\\n| Termination fee received | — | 280,000 | — | 280,000 |\\n| Net realized investment gains (losses): |\\n| Other-than-temporary impairment (\\\"OTTI\\\") losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\\n| Other realized investment gains (losses) | 9,452 | (37,656 | ) | (19,949 | ) | (60,856 | ) |\\n| Total net realized investment gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\\n| Total revenues | 1,062,487 | 1,176,227 | 3,006,119 | 3,159,642 |\\n| Expenses |\\n| Net losses and loss expenses | 532,328 | 560,387 | 1,663,584 | 1,652,868 |\\n| Acquisition costs | 189,810 | 182,744 | 559,570 | 537,549 |\\n| General and administrative expenses | 142,906 | 144,727 | 439,554 | 456,451 |\\n| Foreign exchange gains | (13,795 | ) | (28,088 | ) | (69,781 | ) | (69,200 | ) |\\n| Interest expense and financing costs | 12,839 | 12,918 | 38,586 | 38,114 |\\n| Reorganization and related expenses | — | 45,867 | — | 45,867 |\\n| Total expenses | 864,088 | 918,555 | 2,631,513 | 2,661,649 |\\n| Income before income taxes and interest in income (loss) of equity method investments | 198,399 | 257,672 | 374,606 | 497,993 |\\n| Income tax expense | 9,352 | 30 | 7,712 | 1,155 |\\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\\n| Net income | 186,613 | 257,642 | 364,460 | 496,838 |\\n| Preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\\n| Per share data |\\n| Net income per common share: |\\n| Basic net income | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\\n| Diluted net income | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\\n| Weighted average number of common shares outstanding - basic | 89,621 | 98,226 | 91,852 | 99,464 |\\n| Weighted average number of common shares outstanding - diluted | 90,351 | 99,124 | 92,579 | 100,468 |\\n| Cash dividends declared per common share | $ | 0.35 | $ | 0.29 | $ | 1.05 | $ | 0.87 |\\n\\nSee accompanying notes to Consolidated Financial Statements.6\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\\n| Three months ended | Nine months ended |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (in thousands) |\\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\\n| Other comprehensive income (loss), net of tax: |\\n| Available for sale investments: |\\n| Unrealized investment gains (losses) arising during the period | 36,336 | (99,711 | ) | 238,656 | (176,938 | ) |\\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (2,642 | ) | 74,810 | 42,620 | 128,770 |\\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 33,694 | (24,901 | ) | 281,276 | (48,168 | ) |\\n| Foreign currency translation adjustment | 1,722 | (14,626 | ) | 5,694 | (23,851 | ) |\\n| Total other comprehensive income (loss), net of tax | 35,416 | (39,527 | ) | 286,970 | (72,019 | ) |\\n| Comprehensive income | $ | 222,029 | $ | 218,115 | $ | 651,430 | $ | 424,819 |\\n\\nSee accompanying notes to Consolidated Financial Statements.7\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)\\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\\n| 2016 | 2015 |\\n| (in thousands) |\\n| Preferred shares |\\n| Balance at beginning of period | $ | 627,843 | $ | 627,843 |\\n| Shares repurchased | (2,843 | ) | — |\\n| Balance at end of period | 625,000 | 627,843 |\\n| Common shares (par value) |\\n| Balance at beginning of period | 2,202 | 2,191 |\\n| Shares issued | 4 | 11 |\\n| Balance at end of period | 2,206 | 2,202 |\\n| Additional paid-in capital |\\n| Balance at beginning of period | 2,241,388 | 2,285,016 |\\n| Shares issued - common shares | (4 | ) | 2,472 |\\n| Cost of treasury shares reissued | (19,647 | ) | (17,674 | ) |\\n| Settlement of accelerated share repurchase | 60,000 | (60,000 | ) |\\n| Stock options exercised | — | 558 |\\n| Share-based compensation expense | 26,129 | 19,906 |\\n| Balance at end of period | 2,307,866 | 2,230,278 |\\n| Accumulated other comprehensive income (loss) |\\n| Balance at beginning of period | (188,465 | ) | (45,574 | ) |\\n| Unrealized gains (losses) on available for sale investments, net of tax: |\\n| Balance at beginning of period | (149,585 | ) | (28,192 | ) |\\n| Unrealized gains (losses) arising during the period, net of reclassification adjustment | 281,276 | (48,168 | ) |\\n| Non-credit portion of OTTI losses | — | — |\\n| Balance at end of period | 131,691 | (76,360 | ) |\\n| Cumulative foreign currency translation adjustments, net of tax: |\\n| Balance at beginning of period | (38,880 | ) | (17,382 | ) |\\n| Foreign currency translation adjustments | 5,694 | (23,851 | ) |\\n| Balance at end of period | (33,186 | ) | (41,233 | ) |\\n| Balance at end of period | 98,505 | (117,593 | ) |\\n| Retained earnings |\\n| Balance at beginning of period | 6,194,353 | 5,715,504 |\\n| Net income | 364,460 | 496,838 |\\n| Preferred share dividends | (29,906 | ) | (30,066 | ) |\\n| Common share dividends | (98,334 | ) | (88,379 | ) |\\n| Balance at end of period | 6,430,573 | 6,093,897 |\\n| Treasury shares, at cost |\\n| Balance at beginning of period | (3,010,439 | ) | (2,763,859 | ) |\\n| Shares repurchased for treasury | (449,086 | ) | (264,076 | ) |\\n| Cost of treasury shares reissued | 21,033 | 17,674 |\\n| Balance at end of period | (3,438,492 | ) | (3,010,261 | ) |\\n| Total shareholders’ equity | $ | 6,025,658 | $ | 5,826,366 |\\n\\nSee accompanying notes to Consolidated Financial Statements.8\\nAXIS CAPITAL HOLDINGS LIMITED\\nCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)\\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016 AND 2015\\n| 2016 | 2015 |\\n| (in thousands) |\\n| Cash flows from operating activities: |\\n| Net income | $ | 364,460 | $ | 496,838 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Net realized investment losses | 40,295 | 123,618 |\\n| Net realized and unrealized gains on other investments | (23,117 | ) | (17,616 | ) |\\n| Amortization of fixed maturities | 51,660 | 75,645 |\\n| Interest in loss of equity method investments | 2,434 | — |\\n| Other amortization and depreciation | 17,370 | 26,219 |\\n| Share-based compensation expense, net of cash payments | 28,580 | 25,435 |\\n| Changes in: |\\n| Accrued interest receivable | 3,286 | 7,128 |\\n| Reinsurance recoverable balances | (163,212 | ) | (158,362 | ) |\\n| Deferred acquisition costs | (73,759 | ) | (77,348 | ) |\\n| Prepaid reinsurance premiums | (184,648 | ) | (69,016 | ) |\\n| Reserve for loss and loss expenses | 216,828 | 212,066 |\\n| Unearned premiums | 682,686 | 380,610 |\\n| Insurance and reinsurance balances, net | (623,170 | ) | (330,128 | ) |\\n| Other items | (74,383 | ) | 7,841 |\\n| Net cash provided by operating activities | 265,310 | 702,930 |\\n| Cash flows from investing activities: |\\n| Purchases of: |\\n| Fixed maturities | (6,624,573 | ) | (8,110,841 | ) |\\n| Equity securities | (295,827 | ) | (240,415 | ) |\\n| Mortgage loans | (131,087 | ) | (129,431 | ) |\\n| Other investments | (177,500 | ) | (61,591 | ) |\\n| Equity method investments | (103,548 | ) | — |\\n| Short-term investments | (81,479 | ) | (34,147 | ) |\\n| Proceeds from the sale of: |\\n| Fixed maturities | 6,067,663 | 6,797,585 |\\n| Equity securities | 296,182 | 112,794 |\\n| Other investments | 170,111 | 244,353 |\\n| Short-term investments | 67,408 | 112,694 |\\n| Proceeds from redemption of fixed maturities | 977,852 | 1,107,175 |\\n| Proceeds from redemption of short-term investments | 8,185 | 22,337 |\\n| Proceeds from the repayment of mortgage loans | 4,808 | — |\\n| Purchase of other assets | (19,055 | ) | (18,401 | ) |\\n| Change in restricted cash and cash equivalents | (42,445 | ) | 27,996 |\\n| Net cash provided by (used in) investing activities | 116,695 | (169,892 | ) |\\n| Cash flows from financing activities: |\\n| Repurchase of common shares | (389,086 | ) | (332,097 | ) |\\n| Dividends paid - common shares | (100,670 | ) | (89,611 | ) |\\n| Dividends paid - preferred shares | (29,940 | ) | (30,066 | ) |\\n| Repurchase of preferred shares | (2,843 | ) | — |\\n| Proceeds from issuance of common shares | 8 | 3,042 |\\n| Net cash used in financing activities | (522,531 | ) | (448,732 | ) |\\n| Effect of exchange rate changes on foreign currency cash and cash equivalents | 593 | (13,883 | ) |\\n| Increase (decrease) in cash and cash equivalents | (139,933 | ) | 70,423 |\\n| Cash and cash equivalents - beginning of period | 988,133 | 921,830 |\\n| Cash and cash equivalents - end of period | $ | 848,200 | $ | 992,253 |\\n\\nSupplemental disclosures of cash flow information: Total consideration paid for a quota share and adverse development reinsurance cover was $170 million of which $92 million was settled by transfer of securities and was treated as a non cash activity on the Consolidated Statement of Cash Flows.\\nSee accompanying notes to Consolidated Financial Statements.9\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)\\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES |\\n\\nBasis of Presentation\\nThese interim consolidated financial statements include the accounts of AXIS Capital Holdings Limited (“AXIS Capital”) and its subsidiaries (herein referred to as “we,” “us,” “our,” or the “Company”).\\nThe consolidated balance sheet at September 30, 2016 and the consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for the periods ended September 30, 2016 and 2015 have not been audited. The balance sheet at December 31, 2015 is derived from our audited financial statements.\\nThese financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) for interim financial information and with the Securities and Exchange Commission's (“SEC”) instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of our financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All inter-company accounts and transactions have been eliminated.\\nThe following information should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollar and share amounts are in thousands, except per share amounts. All amounts are reported in U.S. dollars. To facilitate comparison of information across periods, certain reclassifications have been made to prior year amounts to conform to the current year's presentation. These reclassifications did not impact our results of operations, financial condition or liquidity.\\nSignificant Accounting Policies\\nThere were no notable changes in our significant accounting policies subsequent to our Annual Report on Form 10-K for the year ended December 31, 2015, with the exception of the addition of accounting policies for equity method investments and retroactive accounting noted below.\\nEquity Method Investments\\nInvestments in which the Company has significant influence over the operating and financial policies of the investee are classified as equity method investments and are accounted for using the equity method of accounting. In applying the equity method of accounting, investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of net income or loss of the investee. Adjustments are based on the most recently available financial information from the investee.Changes in the carrying value of such investments are recorded in net income as interest in income (loss) of equity method investments.\\nRetroactive Reinsurance\\nRetroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered under contracts subject to the reinsurance. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and where practical the Company bifurcates the prospective and retrospective elements of these reinsurance contracts and accounts for each element separately. Initial gains in connection with retroactive reinsurance contracts are deferred and amortized into income over the settlement period while losses are recognized immediately. When changes in the estimated amount recoverable from the reinsurer or in the timing of receipts related to that amount occur, a cumulative amortization adjustment is recognized in earnings in the period of the change so that the deferred gain reflects the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction.\\nNew Accounting Standards Adopted in 2016\\nShare-Based Compensation\\nEffective January 1, 2016, the Company adopted the Accounting Standards Update (\\\"ASU\\\") 2014-12, \\\"Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved after the Requisite Service Period\\\" issued by the Financial Accounting Standards Board (the \\\"FASB\\\"). This guidance requires that compensation costs be recognized in the period in which it becomes probable that the performance target will be achieved and to represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. This guidance was issued to clarify treatment where there was a divergence in accounting practice and its adoption did not impact our results of operations, financial condition or liquidity.\\nDebt Issuance Costs\\nEffective January 1, 2016, the Company adopted ASU 2015-03, \\\"Simplifying the Presentation of Debt Issuance Costs\\\" issued by the FASB. This guidance requires the debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the debt liability rather than as an asset. This guidance was issued to simplify the presentation of debt issuance costs and to resolve conflicting guidance. This guidance did not impact our results of operations, financial condition or liquidity.\\nInvestments Measured Using The Net Asset Value Per Share (\\\"NAV\\\") Practical Expedient\\nEffective January 1, 2016, the Company adopted ASU 2015-07, \\\"Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or its Equivalent)\\\" issued by the FASB. This guidance eliminated the requirement to categorize investments measured using the net asset value (\\\"NAV\\\") practical expedient in the fair value hierarchy table. As this new guidance related solely to disclosures, the adoption did not impact our results of operations, financial condition or liquidity. The updated disclosures have been provided in Note 4 'Fair Value Measurements'.\\nRecently Issued Accounting Standards Not Yet Adopted\\nLeases\\nIn February 2016, the FASB issued guidance that provides a new comprehensive model for lease accounting. The guidance will require most leases to be recognized on the balance sheet by recording a right-of-use asset and a corresponding lease liability. This guidance is effective for reporting periods beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\\nTransition To Equity Method Of Accounting\\nIn March 2016, the FASB issued new guidance eliminating the requirement that an investor retrospectively apply equity method accounting when an existing investment qualifies for equity method accounting. The guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The guidance will be adopted on a prospective basis. The adoption of this guidance is not expected to materially impact our results of operations, financial condition or liquidity.\\nShare-Based Compensation Accounting\\nIn March 2016, the FASB issued new guidance that will change the accounting for certain aspects of share-based compensation payments to employees. The guidance will require all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. The guidance will also allow employers to increase the amounts withheld to cover income taxes on\\n10\\n| 1. | BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED) |\\n\\nshare-based compensation awards without requiring liability classification. Additionally, companies will be required to elect whether they will account for award forfeitures by recognizing forfeitures only as they occur or by estimating the number of awards expected to be forfeited. This guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years with early adoption permitted. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\\nCredit Losses\\nIn June 2016, the FASB issued a new credit loss standard that changes the impairment model for most financial assets and certain other instruments. The guidance will replace the current \\\"incurred loss\\\" approach with a more forward looking \\\"expected loss\\\" model for instruments measured at amortized cost and will require entities to record allowances for available-for-sale debt securities rather than reduce the carrying amount. This guidance is effective for annual periods beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted for annual periods beginning after December 15, 2018, and interim periods within those fiscal years. The Company is currently evaluating the impact of this guidance on our results of operations, financial condition and liquidity.\\nCash Flows\\nIn August 2016, the FASB issued new guidance to clarify how certain cash receipts and cash payments should be classified on the statement of cash flows. This guidance is effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years with early adoption permitted. The adoption of this guidance is not expected to impact our results of operations, financial condition or liquidity.\\n11\\n| 2. | SEGMENT INFORMATION |\\n\\nOur underwriting operations are organized around our global underwriting platforms, AXIS Insurance and AXIS Re. Therefore we have determined that we have two reportable segments, insurance and reinsurance. We do not allocate our assets by segment, with the exception of goodwill and intangible assets, as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.\\nThe following tables summarize the underwriting results of our reportable segments, as well as the carrying values of allocated goodwill and intangible assets:\\n| 2016 | 2015 |\\n| Three months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\\n| Gross premiums written | $ | 675,430 | $ | 284,532 | $ | 959,962 | $ | 606,704 | $ | 329,879 | $ | 936,583 |\\n| Net premiums written | 433,131 | 162,300 | 595,431 | 381,118 | 296,099 | 677,217 |\\n| Net premiums earned | 444,691 | 489,724 | 934,415 | 444,550 | 474,791 | 919,341 |\\n| Other insurance related income | 39 | 5,905 | 5,944 | 542 | 616 | 1,158 |\\n| Net losses and loss expenses | (273,226 | ) | (259,102 | ) | (532,328 | ) | (283,272 | ) | (277,115 | ) | (560,387 | ) |\\n| Acquisition costs | (61,755 | ) | (128,055 | ) | (189,810 | ) | (69,118 | ) | (113,626 | ) | (182,744 | ) |\\n| General and administrative expenses | (84,588 | ) | (29,635 | ) | (114,223 | ) | (85,814 | ) | (35,309 | ) | (121,123 | ) |\\n| Underwriting income | $ | 25,161 | $ | 78,837 | 103,998 | $ | 6,888 | $ | 49,357 | 56,245 |\\n| Corporate expenses | (28,683 | ) | (23,604 | ) |\\n| Net investment income | 116,923 | 45,685 |\\n| Net realized investment gains (losses) | 5,205 | (69,957 | ) |\\n| Foreign exchange gains | 13,795 | 28,088 |\\n| Interest expense and financing costs | (12,839 | ) | (12,918 | ) |\\n| Termination fee received | — | 280,000 |\\n| Reorganization and related expenses | — | (45,867 | ) |\\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 198,399 | $ | 257,672 |\\n| Net loss and loss expense ratio | 61.4 | % | 52.9 | % | 57.0 | % | 63.7 | % | 58.4 | % | 61.0 | % |\\n| Acquisition cost ratio | 13.9 | % | 26.1 | % | 20.3 | % | 15.5 | % | 23.9 | % | 19.9 | % |\\n| General and administrative expense ratio | 19.1 | % | 6.1 | % | 15.3 | % | 19.4 | % | 7.4 | % | 15.7 | % |\\n| Combined ratio | 94.4 | % | 85.1 | % | 92.6 | % | 98.6 | % | 89.7 | % | 96.6 | % |\\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\\n\\n12\\n| 2. | SEGMENT INFORMATION (CONTINUED) |\\n\\n| 2016 | 2015 |\\n| Nine months ended and at September 30, | Insurance | Reinsurance | Total | Insurance | Reinsurance | Total |\\n| Gross premiums written | $ | 2,112,796 | $ | 2,126,762 | $ | 4,239,558 | $ | 1,970,554 | $ | 1,833,374 | $ | 3,803,928 |\\n| Net premiums written | 1,433,058 | 1,855,529 | 3,288,587 | 1,352,122 | 1,727,185 | 3,079,307 |\\n| Net premiums earned | 1,322,649 | 1,461,097 | 2,783,746 | 1,344,339 | 1,420,266 | 2,764,605 |\\n| Other insurance related income (loss) | (57 | ) | 4,907 | 4,850 | 811 | 11,508 | 12,319 |\\n| Net losses and loss expenses | (853,771 | ) | (809,813 | ) | (1,663,584 | ) | (866,580 | ) | (786,288 | ) | (1,652,868 | ) |\\n| Acquisition costs | (184,982 | ) | (374,588 | ) | (559,570 | ) | (200,493 | ) | (337,056 | ) | (537,549 | ) |\\n| General and administrative expenses | (252,652 | ) | (99,980 | ) | (352,632 | ) | (261,924 | ) | (110,701 | ) | (372,625 | ) |\\n| Underwriting income | $ | 31,187 | $ | 181,623 | 212,810 | $ | 16,153 | $ | 197,729 | 213,882 |\\n| Corporate expenses | (86,922 | ) | (83,826 | ) |\\n| Net investment income | 257,818 | 226,336 |\\n| Net realized investment losses | (40,295 | ) | (123,618 | ) |\\n| Foreign exchange gains | 69,781 | 69,200 |\\n| Interest expense and financing costs | (38,586 | ) | (38,114 | ) |\\n| Termination fee received | — | 280,000 |\\n| Reorganization and related expenses | — | (45,867 | ) |\\n| Income before income taxes and interest in income (loss) of equity method investments | $ | 374,606 | $ | 497,993 |\\n| Net loss and loss expense ratio | 64.6 | % | 55.4 | % | 59.8 | % | 64.5 | % | 55.4 | % | 59.8 | % |\\n| Acquisition cost ratio | 14.0 | % | 25.6 | % | 20.1 | % | 14.9 | % | 23.7 | % | 19.4 | % |\\n| General and administrative expense ratio | 19.0 | % | 6.9 | % | 15.8 | % | 19.5 | % | 7.8 | % | 16.5 | % |\\n| Combined ratio | 97.6 | % | 87.9 | % | 95.7 | % | 98.9 | % | 86.9 | % | 95.7 | % |\\n| Goodwill and intangible assets | $ | 85,501 | $ | — | $ | 85,501 | $ | 87,329 | $ | — | $ | 87,329 |\\n\\n13\\n| 3. | INVESTMENTS |\\n\\na) Fixed Maturities and Equities\\nThe amortized cost or cost and fair values of our fixed maturities and equities were as follows:\\n| AmortizedCost orCost | GrossUnrealizedGains | GrossUnrealizedLosses | FairValue | Non-creditOTTIin AOCI(5) |\\n| At September 30, 2016 |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 1,542,943 | $ | 22,349 | $ | (2,415 | ) | $ | 1,562,877 | $ | — |\\n| Non-U.S. government | 620,601 | 4,799 | (43,344 | ) | 582,056 | — |\\n| Corporate debt | 4,516,290 | 87,184 | (34,974 | ) | 4,568,500 | — |\\n| Agency RMBS(1) | 2,473,832 | 49,661 | (762 | ) | 2,522,731 | — |\\n| CMBS(2) | 877,732 | 18,546 | (2,003 | ) | 894,275 | — |\\n| Non-Agency RMBS | 71,842 | 1,636 | (1,648 | ) | 71,830 | (870 | ) |\\n| ABS(3) | 1,234,292 | 4,028 | (2,724 | ) | 1,235,596 | — |\\n| Municipals(4) | 124,867 | 4,215 | (87 | ) | 128,995 | — |\\n| Total fixed maturities | $ | 11,462,399 | $ | 192,418 | $ | (87,957 | ) | $ | 11,566,860 | $ | (870 | ) |\\n| Equity securities |\\n| Common stocks | $ | 379 | $ | 38 | $ | (348 | ) | $ | 69 |\\n| Exchange-traded funds | 463,655 | 41,611 | (1,060 | ) | 504,206 |\\n| Bond mutual funds | 136,570 | 3,499 | — | 140,069 |\\n| Total equity securities | $ | 600,604 | $ | 45,148 | $ | (1,408 | ) | $ | 644,344 |\\n| At December 31, 2015 |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 1,673,617 | $ | 1,545 | $ | (23,213 | ) | $ | 1,651,949 | $ | — |\\n| Non-U.S. government | 809,025 | 2,312 | (72,332 | ) | 739,005 | — |\\n| Corporate debt | 4,442,315 | 16,740 | (96,286 | ) | 4,362,769 | — |\\n| Agency RMBS(1) | 2,236,138 | 22,773 | (9,675 | ) | 2,249,236 | — |\\n| CMBS(2) | 1,088,595 | 3,885 | (9,182 | ) | 1,083,298 | — |\\n| Non-Agency RMBS | 99,989 | 1,992 | (973 | ) | 101,008 | (875 | ) |\\n| ABS(3) | 1,387,919 | 952 | (17,601 | ) | 1,371,270 | — |\\n| Municipals(4) | 160,041 | 2,319 | (1,146 | ) | 161,214 | — |\\n| Total fixed maturities | $ | 11,897,639 | $ | 52,518 | $ | (230,408 | ) | $ | 11,719,749 | $ | (875 | ) |\\n| Equity securities |\\n| Common stocks | $ | — | $ | — | $ | — | $ | — |\\n| Exchange-traded funds | 447,524 | 31,211 | (4,762 | ) | 473,973 |\\n| Bond mutual funds | 128,252 | — | (4,227 | ) | 124,025 |\\n| Total equity securities | $ | 575,776 | $ | 31,211 | $ | (8,989 | ) | $ | 597,998 |\\n\\n| (1) | Residential mortgage-backed securities (RMBS) originated by U.S. agencies. |\\n\\n| (2) | Commercial mortgage-backed securities (CMBS). |\\n\\n| (3) | Asset-backed securities (ABS) include debt tranched securities collateralized primarily by auto loans, student loans, credit cards, and other asset types. This asset class also includes collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). |\\n\\n| (4) | Municipals include bonds issued by states, municipalities and political subdivisions. |\\n\\n| (5) | Represents the non-credit component of the other-than-temporary impairment (OTTI) losses, adjusted for subsequent sales, maturities and redemptions. It does not include the change in fair value subsequent to the impairment measurement date. |\\n\\n14\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nIn the normal course of investing activities, we actively manage allocations to non-controlling tranches of structured securities (variable interests) issued by VIEs. These structured securities include RMBS, CMBS and ABS and are included in the above table. Additionally, within our other investments portfolio, we also invest in limited partnerships (hedge funds, direct lending funds, real estate funds and private equity funds) and CLO equity tranched securities, which are all variable interests issued by VIEs (see Note 3(c)). For these variable interests, we do not have the power to direct the activities that are most significant to the economic performance of the VIEs therefore we are not the primary beneficiary of any of these VIEs. Our maximum exposure to loss on these interests is limited to the amount of our investment. We have not provided financial or other support with respect to these structured securities other than our original investment.\\nContractual Maturities\\nThe contractual maturities of fixed maturities are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.\\n| AmortizedCost | FairValue | % of TotalFair Value |\\n| At September 30, 2016 |\\n| Maturity |\\n| Due in one year or less | $ | 363,821 | $ | 356,706 | 3.0 | % |\\n| Due after one year through five years | 3,809,515 | 3,801,104 | 32.9 | % |\\n| Due after five years through ten years | 2,286,970 | 2,330,895 | 20.2 | % |\\n| Due after ten years | 344,395 | 353,723 | 3.1 | % |\\n| 6,804,701 | 6,842,428 | 59.2 | % |\\n| Agency RMBS | 2,473,832 | 2,522,731 | 21.8 | % |\\n| CMBS | 877,732 | 894,275 | 7.7 | % |\\n| Non-Agency RMBS | 71,842 | 71,830 | 0.6 | % |\\n| ABS | 1,234,292 | 1,235,596 | 10.7 | % |\\n| Total | $ | 11,462,399 | $ | 11,566,860 | 100.0 | % |\\n| At December 31, 2015 |\\n| Maturity |\\n| Due in one year or less | $ | 291,368 | $ | 289,571 | 2.5 | % |\\n| Due after one year through five years | 4,217,515 | 4,142,802 | 35.3 | % |\\n| Due after five years through ten years | 2,263,684 | 2,181,525 | 18.6 | % |\\n| Due after ten years | 312,431 | 301,039 | 2.6 | % |\\n| 7,084,998 | 6,914,937 | 59.0 | % |\\n| Agency RMBS | 2,236,138 | 2,249,236 | 19.2 | % |\\n| CMBS | 1,088,595 | 1,083,298 | 9.2 | % |\\n| Non-Agency RMBS | 99,989 | 101,008 | 0.9 | % |\\n| ABS | 1,387,919 | 1,371,270 | 11.7 | % |\\n| Total | $ | 11,897,639 | $ | 11,719,749 | 100.0 | % |\\n\\n15\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nGross Unrealized Losses\\nThe following table summarizes fixed maturities and equities in an unrealized loss position and the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position:\\n| 12 months or greater | Less than 12 months | Total |\\n| FairValue | UnrealizedLosses | FairValue | UnrealizedLosses | FairValue | UnrealizedLosses |\\n| At September 30, 2016 |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 55,000 | $ | (1,635 | ) | $ | 422,681 | $ | (780 | ) | $ | 477,681 | $ | (2,415 | ) |\\n| Non-U.S. government | 104,441 | (24,061 | ) | 254,694 | (19,283 | ) | 359,135 | (43,344 | ) |\\n| Corporate debt | 285,848 | (26,202 | ) | 639,722 | (8,772 | ) | 925,570 | (34,974 | ) |\\n| Agency RMBS | 80,375 | (556 | ) | 121,203 | (206 | ) | 201,578 | (762 | ) |\\n| CMBS | 99,004 | (1,260 | ) | 173,795 | (743 | ) | 272,799 | (2,003 | ) |\\n| Non-Agency RMBS | 10,184 | (1,306 | ) | 5,187 | (342 | ) | 15,371 | (1,648 | ) |\\n| ABS | 518,647 | (2,253 | ) | 50,402 | (471 | ) | 569,049 | (2,724 | ) |\\n| Municipals | 2,384 | (18 | ) | 15,567 | (69 | ) | 17,951 | (87 | ) |\\n| Total fixed maturities | $ | 1,155,883 | $ | (57,291 | ) | $ | 1,683,251 | $ | (30,666 | ) | $ | 2,839,134 | $ | (87,957 | ) |\\n| Equity securities |\\n| Common stocks | $ | — | $ | — | $ | 31 | $ | (348 | ) | $ | 31 | $ | (348 | ) |\\n| Exchange-traded funds | 6,153 | (425 | ) | 39,097 | (635 | ) | 45,250 | (1,060 | ) |\\n| Bond mutual funds | — | — | — | — | — | — |\\n| Total equity securities | $ | 6,153 | $ | (425 | ) | $ | 39,128 | $ | (983 | ) | $ | 45,281 | $ | (1,408 | ) |\\n| At December 31, 2015 |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 84,179 | $ | (7,622 | ) | $ | 1,474,202 | $ | (15,591 | ) | $ | 1,558,381 | $ | (23,213 | ) |\\n| Non-U.S. government | 170,269 | (50,841 | ) | 317,693 | (21,491 | ) | 487,962 | (72,332 | ) |\\n| Corporate debt | 340,831 | (33,441 | ) | 2,845,375 | (62,845 | ) | 3,186,206 | (96,286 | ) |\\n| Agency RMBS | 64,792 | (1,609 | ) | 1,073,566 | (8,066 | ) | 1,138,358 | (9,675 | ) |\\n| CMBS | 75,627 | (1,579 | ) | 659,480 | (7,603 | ) | 735,107 | (9,182 | ) |\\n| Non-Agency RMBS | 5,283 | (210 | ) | 43,199 | (763 | ) | 48,482 | (973 | ) |\\n| ABS | 562,599 | (11,158 | ) | 667,448 | (6,443 | ) | 1,230,047 | (17,601 | ) |\\n| Municipals | 14,214 | (310 | ) | 64,104 | (836 | ) | 78,318 | (1,146 | ) |\\n| Total fixed maturities | $ | 1,317,794 | $ | (106,770 | ) | $ | 7,145,067 | $ | (123,638 | ) | $ | 8,462,861 | $ | (230,408 | ) |\\n| Equity securities |\\n| Common stocks | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — |\\n| Exchange-traded funds | 2,331 | (313 | ) | 110,972 | (4,449 | ) | 113,303 | (4,762 | ) |\\n| Bond mutual funds | — | — | 124,025 | (4,227 | ) | 124,025 | (4,227 | ) |\\n| Total equity securities | $ | 2,331 | $ | (313 | ) | $ | 234,997 | $ | (8,676 | ) | $ | 237,328 | $ | (8,989 | ) |\\n\\n16\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nFixed Maturities\\nAt September 30, 2016, 935 fixed maturities (2015: 2,314) were in an unrealized loss position of $88 million (2015: $230 million), of which $13 million (2015: $39 million) was related to securities below investment grade or not rated.\\nAt September 30, 2016, 399 (2015: 383) securities had been in a continuous unrealized loss position for 12 months or greater and had a fair value of $1,156 million (2015: $1,318 million). Following our credit impairment review, we concluded that these securities as well as the remaining securities in an unrealized loss position in the above table were temporarily impaired at September 30, 2016, and were expected to recover in value as the securities approach maturity. Further, at September 30, 2016, we did not intend to sell these securities in an unrealized loss position and it is more likely than not that we will not be required to sell these securities before the anticipated recovery of their amortized costs.\\nEquity Securities\\nAt September 30, 2016, 20 securities (2015: 35) were in an unrealized loss position of $1 million (2015: $9 million).\\nAt September 30, 2016, 5 securities (2015: 1) were in a continuous unrealized loss position for 12 months or greater. Based on our impairment review process and our ability and intent to hold these securities for a reasonable period of time sufficient for a full recovery, we concluded that the above equities in an unrealized loss position were temporarily impaired at September 30, 2016.\\nb) Mortgage Loans\\n| September 30, 2016 | December 31, 2015 |\\n| Carrying Value | % of Total | Carrying Value | % of Total |\\n| Mortgage Loans held-for-investment: |\\n| Commercial | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\\n| 332,753 | 100 | % | 206,277 | 100 | % |\\n| Valuation allowances | — | — | % | — | — | % |\\n| Total Mortgage Loans held-for-investment | $ | 332,753 | 100 | % | $ | 206,277 | 100 | % |\\n\\nFor commercial mortgage loans, the primary credit quality indicator is the debt service coverage ratio (which compares a property’s net operating income to amounts needed to service the principal and interest due under the loan, generally, the lower the debt service coverage ratio, the higher the risk of experiencing a credit loss) and the loan-to-value ratio (loan-to-value ratios compare the unpaid principal balance of the loan to the estimated fair value of the underlying collateral, generally, the higher the loan-to-value ratio, the higher the risk of experiencing a credit loss). The debt service coverage ratio and loan-to-value ratio, as well as the values utilized in calculating these ratios, are updated annually, on a rolling basis.\\nWe have a high quality mortgage portfolio with debt service coverage ratios in excess of 1.1x and loan-to-value ratios of less than 70%; there are no credit losses associated with the commercial mortgage loans that we hold at September 30, 2016.\\nThere are no past due amounts at September 30, 2016.\\n17\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nc) Other Investments\\nThe following table provides a breakdown of our investments in hedge funds, direct lending funds, private equity funds, real estate funds, CLO Equities and other privately held investments, together with additional information relating to the liquidity of each category:\\n| Fair Value | Redemption Frequency(if currently eligible) | Redemption Notice Period |\\n| At September 30, 2016 |\\n| Long/short equity funds | $ | 139,460 | 16 | % | Quarterly, Semi-annually, Annually | 45-60 days |\\n| Multi-strategy funds | 281,153 | 33 | % | Quarterly, Semi-annually | 60-95 days |\\n| Event-driven funds | 94,012 | 11 | % | Quarterly, Annually | 45-60 days |\\n| Leveraged bank loan funds | — | — | % | n/a | n/a |\\n| Direct lending funds | 125,002 | 15 | % | n/a | n/a |\\n| Private equity funds | 89,170 | 11 | % | n/a | n/a |\\n| Real estate funds | 11,782 | 1 | % | n/a | n/a |\\n| CLO - Equities | 63,783 | 8 | % | n/a | n/a |\\n| Other privately held investments | 42,900 | 5 | % | n/a | n/a |\\n| Total other investments | $ | 847,262 | 100 | % |\\n| At December 31, 2015 |\\n| Long/short equity funds | $ | 154,348 | 19 | % | Quarterly, Semi-annually, Annually | 45-60 days |\\n| Multi-strategy funds | 355,073 | 43 | % | Quarterly, Semi-annually | 60-95 days |\\n| Event-driven funds | 147,287 | 18 | % | Quarterly, Annually | 45-60 days |\\n| Leveraged bank loan funds | 65 | — | % | n/a | n/a |\\n| Direct lending funds | 90,120 | 11 | % | n/a | n/a |\\n| Private equity funds | — | — | % | n/a | n/a |\\n| Real estate funds | 4,929 | 1 | % | n/a | n/a |\\n| CLO - Equities | 64,934 | 8 | % | n/a | n/a |\\n| Other privately held investments | — | — | % | n/a | n/a |\\n| Total other investments | $ | 816,756 | 100 | % |\\n\\nn/a - not applicable\\nThe investment strategies for the above funds are as follows:\\n| • | Long/short equity funds: Seek to achieve attractive returns primarily by executing an equity trading strategy involving both long and short investments in publicly-traded equities. |\\n\\n| • | Multi-strategy funds: Seek to achieve above-market returns by pursuing multiple investment strategies to diversify risks and reduce volatility. This category includes funds of hedge funds which invest in a large pool of hedge funds across a diversified range of hedge fund strategies. |\\n\\n| • | Event-driven funds: Seek to achieve attractive returns by exploiting situations where announced or anticipated events create opportunities. |\\n\\n| • | Leveraged bank loan funds: Seek to achieve attractive returns by investing primarily in bank loan collateral that has limited interest rate risk exposure. |\\n\\n18\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\n| • | Direct lending funds: Seek to achieve attractive risk-adjusted returns, including current income generation, by investing in funds which provide financing directly to borrowers. |\\n\\n| • | Real estate funds: Seek to achieve attractive risk-adjusted returns by making and managing investments in real estate and real estate securities and businesses. |\\n\\n| • | Private equity funds: Seek to achieve attractive risk-adjusted returns by investing in private transactions over the course of several years. |\\n\\nTwo common redemption restrictions which may impact our ability to redeem our hedge funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the fund's net assets which may otherwise hinder the general partner or investment manager's ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. During 2016 and 2015, neither of these restrictions impacted our redemption requests. At September 30, 2016, $87 million (2015: $66 million), representing 17% (2015: 10%) of our total hedge funds, relate to holdings where we are still within the lockup period. The expiration of these lockup periods range from September 2016 to March 2019.\\nAt September 30, 2016, we have $189 million (2015: $222 million) of unfunded commitments within our other investments portfolio relating to our future investments in direct lending funds. Once the full amount of committed capital has been called by the General Partner of each of these funds, the assets will not be fully returned until the completion of the fund's investment term. These funds have investment terms ranging from 5-10 years and the General Partners of certain funds have the option to extend the term by up to three years.\\nAt September 30, 2016, we have $12 million (2015: $12 million) of unfunded commitments as a limited partner in a multi-strategy hedge fund. Once the full amount of committed capital has been called by the General Partner, the assets will not be fully returned until the completion of the fund's investment term which ends in March, 2019. The General Partner then has the option to extend the term by up to three years.\\nAt September 30, 2016, we have $90 million (2015: $95 million) of unfunded commitments as a limited partner in a fund which invests in real estate and real estate securities and businesses. The fund is subject to a three year commitment period and a total fund life of eight years during which time we are not eligible to redeem our investment.\\nDuring 2016, we made a $135 million commitment as a limited partner in a private equity fund. At September 30, 2016, $40 million of our commitment remains unfunded and the current fair value of the funds called to date are included in the private equity funds line of the table above. The fund invests in underlying private equity funds and the life of the fund is subject to the dissolution of the underlying funds. We expect the overall holding period to be over ten years.\\nDuring 2015, we made a $50 million commitment as a limited partner of a bank revolver opportunity fund. The fund is subject to an investment term of seven years and the General Partners have the option to extend the term by up to two years. At September 30, 2016, this commitment remains unfunded. It is not anticipated that the full amount of this fund will be drawn.\\n19\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nd) Equity Method Investments\\nDuring 2016, we paid $104 million including direct transaction costs to acquire 18% of the common equity of Harrington Reinsurance Holdings Limited (\\\"Harrington\\\"), the parent company of Harrington Re Ltd. (\\\"Harrington Re\\\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\\\"Blackstone\\\"). Through long-term service agreements, AXIS Capital will serve as Harrington Re's reinsurance underwriting manager and Blackstone will serve as exclusive investment management service provider. As an investor, we expect to benefit from underwriting profit generated by Harrington Re and the income and capital appreciation Blackstone seeks to deliver through its investment management services. In addition, we have entered into an arrangement with Blackstone under which underwriting and investment related fees will be shared equally. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting. The Company's proportionate share of the underlying equity in net assets resulted in a basis difference of $5 million which represents initial transactions costs.\\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\\ne) Net Investment Income\\nNet investment income was derived from the following sources:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Fixed maturities | $ | 75,827 | $ | 75,980 | $ | 229,423 | $ | 220,066 |\\n| Other investments | 38,248 | (27,421 | ) | 25,770 | 17,616 |\\n| Equity securities | 4,633 | 3,445 | 12,843 | 7,795 |\\n| Mortgage loans | 2,191 | 482 | 5,683 | 776 |\\n| Cash and cash equivalents | 3,768 | 993 | 7,071 | 3,770 |\\n| Short-term investments | 337 | 83 | 708 | 277 |\\n| Gross investment income | 125,004 | 53,562 | 281,498 | 250,300 |\\n| Investment expenses | (8,081 | ) | (7,877 | ) | (23,680 | ) | (23,964 | ) |\\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\\n\\n20\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nf) Net Realized Investment Gains (Losses)\\nThe following table provides an analysis of net realized investment gains (losses):\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Gross realized gains |\\n| Fixed maturities and short-term investments | $ | 26,211 | $ | 12,126 | $ | 67,833 | $ | 44,853 |\\n| Equities | 5,570 | 232 | 18,804 | 447 |\\n| Gross realized gains | 31,781 | 12,358 | 86,637 | 45,300 |\\n| Gross realized losses |\\n| Fixed maturities and short-term investments | (21,908 | ) | (54,867 | ) | (90,702 | ) | (111,432 | ) |\\n| Equities | (576 | ) | (1,559 | ) | (15,923 | ) | (1,952 | ) |\\n| Gross realized losses | (22,484 | ) | (56,426 | ) | (106,625 | ) | (113,384 | ) |\\n| Net OTTI recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\\n| Change in fair value of investment derivatives(1) | 155 | 6,412 | 39 | 7,228 |\\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\\n\\n(1) Refer to Note 5 – Derivative Instruments\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Fixed maturities: |\\n| Non-U.S. government | $ | 2,456 | $ | 1,295 | $ | 2,953 | $ | 2,717 |\\n| Corporate debt | 1,791 | 20,587 | 14,833 | 38,396 |\\n| Non-Agency RMBS | — | — | — | 4 |\\n| ABS | — | 84 | — | 124 |\\n| 4,247 | 21,966 | 17,786 | 41,241 |\\n| Equity Securities |\\n| Exchange-traded funds | — | 10,335 | 2,560 | 10,335 |\\n| Bond mutual funds | — | — | — | 11,186 |\\n| — | 10,335 | 2,560 | 21,521 |\\n| Total OTTI recognized in earnings | $ | 4,247 | $ | 32,301 | $ | 20,346 | $ | 62,762 |\\n\\n21\\n| 3. | INVESTMENTS (CONTINUED) |\\n\\nThe following table provides a roll forward of the credit losses, before income taxes, for which a portion of the OTTI was recognized in AOCI:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Balance at beginning of period | $ | 1,513 | $ | 1,564 | $ | 1,506 | $ | 1,531 |\\n| Credit impairments recognized on securities not previously impaired | — | — | — | — |\\n| Additional credit impairments recognized on securities previously impaired | — | — | 7 | 33 |\\n| Change in timing of future cash flows on securities previously impaired | — | — | — | — |\\n| Intent to sell of securities previously impaired | — | — | — | — |\\n| Securities sold/redeemed/matured | (33 | ) | (43 | ) | (33 | ) | (43 | ) |\\n| Balance at end of period | $ | 1,480 | $ | 1,521 | $ | 1,480 | $ | 1,521 |\\n\\ng) Reverse Repurchase Agreements\\nAt September 30, 2016, we held $160 million (December 31, 2015: $30 million) of reverse repurchase agreements. These loans are fully collateralized, are generally outstanding for a short period of time and are presented on a gross basis as part of cash and cash equivalents on our consolidated balance sheet. The required collateral for these loans is either cash or U.S. Treasuries at a minimum rate of 102% of the loan principal. Upon maturity, we receive principal and interest income. We monitor the estimated fair value of the securities loaned and borrowed on a daily basis with additional collateral obtained as necessary throughout the duration of the transaction.\\nFair Value Hierarchy\\nFair value is defined as the price to sell an asset or transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants. We use a fair value hierarchy that gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement. The hierarchy is broken down into three levels as follows:\\n| • | Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. |\\n\\n| • | Level 2 - Valuations based on quoted prices in active markets for similar assets or liabilities, quoted prices for identical assets or liabilities in inactive markets, or for which significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data. |\\n\\n| • | Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own judgments about assumptions that market participants might use. |\\n\\nThe availability of observable inputs can vary from financial instrument to financial instrument and is affected by a wide variety of factors including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment.\\nAccordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This may lead us to change the selection of our valuation technique (from market to cash flow approach) or may cause us to use multiple valuation techniques to estimate the fair value of a financial instrument. This circumstance could cause an instrument to be reclassified between levels within the fair value hierarchy.\\nWe used the following valuation techniques including significant inputs and assumptions in estimating the fair value of our financial instruments as well as the general classification of such financial instruments pursuant to the above fair value hierarchy.\\nFixed Maturities\\nAt each valuation date, we use the market approach valuation technique to estimate the fair value of our fixed maturities portfolio, when possible. This market approach includes, but is not limited to, prices obtained from third party pricing services for identical or comparable securities and the use of “pricing matrix models” using observable market inputs such as yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. Pricing from third party pricing services is sourced from multiple vendors, when available, and we maintain a vendor hierarchy by asset type based on historical pricing experience and vendor expertise. When prices are unavailable from pricing services, we obtain non-binding quotes from broker-dealers who are active in the corresponding markets.\\nThe valuation techniques including significant inputs generally used to determine the fair value of our fixed maturities by asset class as well as the classification in the fair value hierarchy are described in detail below.\\nU.S. government and agency\\nU.S. government and agency securities consist primarily of bonds issued by the U.S. Treasury and mortgage pass-through agencies such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. As the fair values of U.S. Treasury securities are based on unadjusted market prices in active markets, these securities are classified within Level 1. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.\\n22\\n| 4. | FAIR VALUE MEASUREMENTS |\\n\\nNon-U.S. government\\nNon-U.S. government securities comprise bonds issued by non-U.S. governments and their agencies along with supranational organizations (collectively also known as sovereign debt securities). The fair values of these securities are based on prices obtained from international indices or a valuation model which uses inputs including interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the sovereign bond in terms of issuer, maturity and seniority. As the significant inputs are observable market inputs, the fair value of non-U.S. government securities are classified within Level 2.\\nCorporate debt\\nCorporate debt securities consist primarily of investment-grade debt of a wide variety of corporate issuers and industries. The fair values of these securities are generally determined using the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of corporate debt securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\\nAgency RMBS\\nAgency RMBS securities consist of bonds issued by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. The fair values of these securities are priced using a mortgage pool specific model which uses daily inputs from the active to be announced market and the spread associated with each mortgage pool based on vintage. As the significant inputs are observable market inputs, the fair values of Agency RMBS securities are classified within Level 2.\\nCMBS\\nCMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using a pricing model which uses dealer quotes and other available trade information along with security level characteristics to determine deal specific spreads. As the significant inputs are observable market inputs, the fair values of CMBS securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\\nNon-Agency RMBS\\nNon-Agency RMBS include mostly investment-grade bonds originated by non-agencies. The fair values of these securities are determined using an option adjusted spread model or other relevant models, which use inputs including available trade information or broker quotes, prepayment and default projections based on historical statistics of the underlying collateral and current market data. As the significant inputs are observable market inputs, the fair values of Non-Agency RMBS securities are classified within Level 2.\\nABS\\nABS include mostly investment-grade bonds backed by pools of loans with a variety of underlying collateral, including automobile loan receivables, student loans, credit card receivables, and CLO Debt originated by a variety of financial institutions. The fair values of ABS are priced using a model which uses prepayment speeds and spreads sourced primarily from the new issue market. As the significant inputs used to price ABS are observable market inputs, the fair values of ABS are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3.\\n23\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nMunicipals\\nMunicipals comprise revenue and general obligation bonds issued by U.S. domiciled state and municipal entities. The fair values of these securities are determined using spreads obtained from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the municipals are observable market inputs, municipals are classified within Level 2.\\nEquity Securities\\nEquity securities include common stocks, exchange-traded funds and bond mutual funds. As the fair values of common stocks and exchange-traded funds are based on unadjusted quoted market prices in active markets, these securities are classified within Level 1.\\nAs bond mutual funds have daily liquidity with redemption based on the NAV of the funds, the fair values of these securities are classified within Level 2.\\nOther Investments\\nAt September 30, 2016, our investments in CLO - Equities were classified within Level 3 as we estimated the fair value for these securities using an income approach valuation technique (discounted cash flow model) due to the lack of observable and relevant trades in the secondary markets.\\nOther privately held securities include convertible preferred shares, convertible notes and notes payable. In the reporting period of investment, the cost of these investments approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These securities are classified within Level 3.\\nShort-Term Investments\\nShort-term investments primarily comprise highly liquid securities with maturities greater than three months but less than one year from the date of purchase. These securities are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their amortized cost approximates fair value.\\nDerivative Instruments\\nOur foreign currency forward contracts, interest rate swaps and commodity contracts are customized to our economic hedging strategies and trade in the over-the-counter derivative market. We use the market approach valuation technique to estimate the fair value for these derivatives based on significant observable market inputs from third party pricing vendors, non-binding broker-dealer quotes and/or recent trading activity. Accordingly, we classified these derivatives within Level 2.\\nWe also participate in non-exchange traded derivative-based risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. We classify these instruments within Level 3.\\nInsurance-linked Securities\\nInsurance-linked securities comprise an investment in a catastrophe bond. We obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. These securities are classified within Level 3.\\nCash Settled Awards\\nCash settled awards comprise restricted stock units that form part of our compensation program. Although the fair value of these awards is determined using observable quoted market prices in active markets, the stock units themselves are not actively traded. Accordingly, we have classified these liabilities within Level 2.\\n24\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nThe tables below present the financial instruments measured at fair value on a recurring basis for the periods indicated:\\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\\n| At September 30, 2016 |\\n| Assets |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 1,522,246 | $ | 40,631 | $ | — | $ | — | $ | 1,562,877 |\\n| Non-U.S. government | — | 582,056 | — | — | 582,056 |\\n| Corporate debt | — | 4,499,408 | 69,092 | — | 4,568,500 |\\n| Agency RMBS | — | 2,522,731 | — | — | 2,522,731 |\\n| CMBS | — | 885,355 | 8,920 | — | 894,275 |\\n| Non-Agency RMBS | — | 71,830 | — | — | 71,830 |\\n| ABS | — | 1,235,596 | — | — | 1,235,596 |\\n| Municipals | — | 128,995 | — | — | 128,995 |\\n| 1,522,246 | 9,966,602 | 78,012 | — | 11,566,860 |\\n| Equity securities |\\n| Common stocks | 69 | — | — | — | 69 |\\n| Exchange-traded funds | 504,206 | — | — | — | 504,206 |\\n| Bond mutual funds | — | 140,069 | — | — | 140,069 |\\n| 504,275 | 140,069 | — | — | 644,344 |\\n| Other investments |\\n| Hedge funds | — | — | — | 514,625 | 514,625 |\\n| Direct lending funds | — | — | — | 125,002 | 125,002 |\\n| Private equity funds | — | — | — | 89,170 | 89,170 |\\n| Real estate funds | — | — | — | 11,782 | 11,782 |\\n| Other privately held investments | — | — | 42,900 | — | 42,900 |\\n| CLO - Equities | — | — | 63,783 | — | 63,783 |\\n| — | — | 106,683 | 740,579 | 847,262 |\\n| Short-term investments | — | 39,877 | — | — | 39,877 |\\n| Other assets |\\n| Derivative instruments (see Note 5) | — | 4,469 | 2,488 | — | 6,957 |\\n| Insurance-linked securities | — | — | 25,283 | — | 25,283 |\\n| Total Assets | $ | 2,026,521 | $ | 10,151,017 | $ | 212,466 | $ | 740,579 | $ | 13,130,583 |\\n| Liabilities |\\n| Derivative instruments (see Note 5) | $ | — | $ | 4,411 | $ | 8,184 | $ | — | $ | 12,595 |\\n| Cash settled awards (see Note 7) | — | 34,288 | — | — | 34,288 |\\n| Total Liabilities | $ | — | $ | 38,699 | $ | 8,184 | $ | — | $ | 46,883 |\\n\\n25\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\n| Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Fair value based on NAV practical expedient | Total Fair Value |\\n| At December 31, 2015 |\\n| Assets |\\n| Fixed maturities |\\n| U.S. government and agency | $ | 1,632,355 | $ | 19,594 | $ | — | $ | — | $ | 1,651,949 |\\n| Non-U.S. government | — | 739,005 | — | — | 739,005 |\\n| Corporate debt | — | 4,324,251 | 38,518 | — | 4,362,769 |\\n| Agency RMBS | — | 2,249,236 | — | — | 2,249,236 |\\n| CMBS | — | 1,072,376 | 10,922 | — | 1,083,298 |\\n| Non-Agency RMBS | — | 101,008 | — | — | 101,008 |\\n| ABS | — | 1,371,270 | — | — | 1,371,270 |\\n| Municipals | — | 161,214 | — | — | 161,214 |\\n| 1,632,355 | 10,037,954 | 49,440 | — | 11,719,749 |\\n| Equity securities |\\n| Common stocks | — | — | — | — | — |\\n| Exchange-traded funds | 473,973 | — | — | — | 473,973 |\\n| Bond mutual funds | — | 124,025 | — | — | 124,025 |\\n| 473,973 | 124,025 | — | — | 597,998 |\\n| Other investments |\\n| Hedge funds | — | — | — | 656,773 | 656,773 |\\n| Direct lending funds | — | — | — | 90,120 | 90,120 |\\n| Private equity funds | — | — | — | — | — |\\n| Real estate funds | — | — | — | 4,929 | 4,929 |\\n| Other privately held investments | — | — | — | — | — |\\n| CLO - Equities | — | — | 27,257 | 37,677 | 64,934 |\\n| — | — | 27,257 | 789,499 | 816,756 |\\n| Short-term investments | — | 34,406 | — | — | 34,406 |\\n| Other assets |\\n| Derivative instruments (see Note 5) | — | 2,072 | 4,395 | — | 6,467 |\\n| Insurance-linked securities | — | — | 24,925 | — | 24,925 |\\n| Total Assets | $ | 2,106,328 | $ | 10,198,457 | $ | 106,017 | $ | 789,499 | $ | 13,200,301 |\\n| Liabilities |\\n| Derivative instruments (see Note 5) | $ | — | $ | 7,692 | $ | 10,937 | $ | — | $ | 18,629 |\\n| Cash settled awards (see Note 7) | — | 33,215 | — | — | 33,215 |\\n| Total Liabilities | $ | — | $ | 40,907 | $ | 10,937 | $ | — | $ | 51,844 |\\n\\nDuring 2016 and 2015, there were no transfers between Levels 1 and 2.\\n26\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nExcept certain fixed maturities and insurance-linked securities priced using broker-dealer quotes (underlying inputs are not available), the following table quantifies the significant unobservable inputs we have used in estimating fair value at September 30, 2016 for our investments classified as Level 3 in the fair value hierarchy.\\n| Fair Value | Valuation Technique | Unobservable Input | Range | Weighted Average |\\n| Other investments - CLO - Equities | $ | 35,594 | Discounted cash flow | Default rates | 4.0% | 4.0% |\\n| Loss severity rate | 35.0% - 53.5% | 35.4% |\\n| Collateral spreads | 3.6% - 4.0% | 4.0% |\\n| Estimated maturity dates | 2 - 6 years | 6 years |\\n| 28,189 | Liquidation value | Fair value of collateral | 100% | 100% |\\n| Discount margin | 0.1% - 19.1% | 2.4% |\\n| Other investments - Other privately held investments | 42,900 | Discounted cash flow | Discount rate | 5.0% - 8.0% | 7.2% |\\n| Derivatives - Weather derivatives, net | $ | (5,696 | ) | Simulation model | Weather curve | 1 - 2294(1) | n/a (2) |\\n| Weather standard deviation | 1 - 1029(1) | n/a (2) |\\n\\n(1) Measured in Heating Degree Days (\\\"HDD\\\") which is the number of degrees the daily temperature is below a reference temperature. The cumulative HDD for the duration of the derivatives contract is compared to the strike value to determine the necessary settlement.\\n| (2) | Due to the diversity of the portfolio, the range of unobservable inputs can be widespread; therefore, presentation of a weighted average is not useful. Weather parameters may include various temperature and/or precipitation measures that will naturally vary by geographic location of each counterparty's operations. |\\n\\nThe CLO - Equities market continues to be mostly inactive with only a small number of transactions being observed and fewer still involving transactions in our CLO - Equities. Accordingly, we use models to estimate the fair value of our investments in CLO - Equities. Given that all of our direct investments in CLO - Equities are past their reinvestment period, there is uncertainty over the remaining time to maturity. As such our direct investments in CLO - Equities are valued at the lower of the liquidation value and fair value based on an internally developed discounted cash flow model.\\nThe liquidation valuation is based on the fair value of the net underlying collateral which is determined by applying market discount margins by credit quality bucket. An increase (decrease) in the market discount margin would result in a decrease (increase) in value of our CLO - Equities. Regarding the discounted cash flow model, the default and loss severity rates are the most judgmental unobservable market inputs to which the valuation of CLO - Equities is most sensitive. A significant increase (decrease) in either of these significant inputs in isolation would result in lower (higher) fair value estimates for direct investments in our CLO - Equities and, in general, a change in default rate assumptions will be accompanied by a directionally similar change in loss severity rate assumptions. Collateral spreads and estimated maturity dates are less judgmental inputs as they are based on the historical average of actual spreads and the weighted average life of the current underlying portfolios, respectively. A significant increase (decrease) in either of these significant inputs in isolation would result in higher (lower) fair value estimates for direct investments in our CLO - Equities. In general, these inputs have no significant interrelationship with each other or with default and loss severity rates.\\nOn a quarterly basis, our valuation process for CLO - Equities includes a review of the underlying collateral along with related discount margins by credit quality bucket used in the liquidation valuation and a review of the underlying cash flows and key assumptions used in the discounted cash flow model. We review and update the above significant unobservable inputs based on information obtained from secondary markets, including information received from the managers of our CLO - Equities portfolio.\\nIn order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as emerging trends that may impact future cash flows. In addition,we update the assumptions we use in our models through regular communication with industry participants and ongoing monitoring of the deals in which we participate (e.g. default and loss severity rate trends).\\n27\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nOther privately held securities are initially valued at cost which approximates fair value. In subsequent measurement periods, a discounted cash flow model is used to determine the fair value of these securities. These models include inputs specific to each investment. The inputs used in the fair value measurement include dividend or interest rates and a discount rate. The discount rate is judgmental and the most significant unobservable input used in the valuation of the other privately held securities. Significant increases (decreases) in this input in isolation could result in a significantly higher (lower) fair value measurement. In order to assess the reasonableness of the inputs we use in our models, we maintain an understanding of current market conditions, historical results, as well as investee specific information that may impact future cash flows.\\nWeather derivatives relate to non-exchange traded risk management products addressing weather risks. We use observable market inputs and unobservable inputs in combination with industry or internally-developed valuation and forecasting techniques to determine fair value. The models may reference market price information for similar instruments. The pricing models are internally reviewed by Risk Management personnel prior to implementation and are reviewed periodically thereafter.\\nObservable and unobservable inputs to these models vary by contract type but would typically include the following:\\n| • | Observable inputs: market prices for similar instruments, notional price, option strike price, term to expiry, contractual limits; |\\n\\n| • | Unobservable inputs: correlation; and |\\n\\n| • | Both observable and unobservable inputs: weather curves, weather standard deviation. |\\n\\nIn general, weather curves are the most significant contributing input to fair value determination. Changes in this variable can result in higher or lower fair value depending on the underlying position. In addition, changes in any or all of the unobservable inputs identified above may contribute positively or negatively to overall portfolio value. The correlation input will quantify the interrelationship, if any, amongst the other variables.\\n28\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\\n| Three months ended September 30, 2016 |\\n| Fixed maturities |\\n| Corporate debt | $ | 62,022 | $ | — | $ | — | $ | (9 | ) | $ | 100 | $ | 7,563 | $ | — | $ | (584 | ) | $ | 69,092 | $ | — |\\n| CMBS | 10,210 | — | — | — | (48 | ) | — | — | (1,242 | ) | 8,920 | — |\\n| ABS | — | — | — | — | — | — | — | — | — | — |\\n| 72,232 | — | — | (9 | ) | 52 | 7,563 | — | (1,826 | ) | 78,012 | — |\\n| Other investments |\\n| Other privately held investments | 41,755 | — | — | (355 | ) | — | 1,500 | — | — | 42,900 | (355 | ) |\\n| CLO - Equities | 65,883 | — | — | 8,419 | — | — | — | (10,519 | ) | 63,783 | 8,419 |\\n| 107,638 | — | — | 8,064 | — | 1,500 | — | (10,519 | ) | 106,683 | 8,064 |\\n| Other assets |\\n| Derivative instruments | 5 | — | — | 665 | — | 1,818 | — | — | 2,488 | 665 |\\n| Insurance-linked securities | 25,025 | — | — | 258 | — | — | — | — | 25,283 | 258 |\\n| 25,030 | — | — | 923 | — | 1,818 | — | — | 27,771 | 923 |\\n| Total assets | $ | 204,900 | $ | — | $ | — | $ | 8,978 | $ | 52 | $ | 10,881 | $ | — | $ | (12,345 | ) | $ | 212,466 | $ | 8,987 |\\n| Other liabilities |\\n| Derivative instruments | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\\n| Total liabilities | $ | 1,978 | $ | — | $ | — | $ | (169 | ) | $ | — | $ | 6,384 | $ | — | $ | (9 | ) | $ | 8,184 | $ | 335 |\\n| Nine months ended September 30, 2016 |\\n| Fixed maturities |\\n| Corporate debt | $ | 38,518 | $ | 20,412 | $ | (1,955 | ) | $ | (988 | ) | $ | 1,188 | $ | 17,107 | $ | (4,015 | ) | $ | (1,175 | ) | $ | 69,092 | $ | — |\\n| CMBS | 10,922 | — | — | — | (134 | ) | — | — | (1,868 | ) | 8,920 | — |\\n| ABS | — | — | — | — | — | — | — | — | — | — |\\n| 49,440 | 20,412 | (1,955 | ) | (988 | ) | 1,054 | 17,107 | (4,015 | ) | (3,043 | ) | 78,012 | — |\\n| Other investments |\\n| Other privately held investments | — | — | — | (1,505 | ) | — | 44,405 | — | — | 42,900 | (1,505 | ) |\\n| CLO - Equities | 27,257 | 36,378 | — | 17,431 | — | — | — | (17,283 | ) | 63,783 | 17,431 |\\n| 27,257 | 36,378 | — | 15,926 | — | 44,405 | — | (17,283 | ) | 106,683 | 15,926 |\\n| Other assets |\\n| Derivative instruments | 4,395 | — | — | 3,255 | — | 3,623 | — | (8,785 | ) | 2,488 | 669 |\\n| Insurance-linked securities | 24,925 | — | — | 358 | — | — | — | — | 25,283 | 358 |\\n| 29,320 | — | — | 3,613 | — | 3,623 | — | (8,785 | ) | 27,771 | 1,027 |\\n| Total assets | $ | 106,017 | $ | 56,790 | $ | (1,955 | ) | $ | 18,551 | $ | 1,054 | $ | 65,135 | $ | (4,015 | ) | $ | (29,111 | ) | $ | 212,466 | $ | 16,953 |\\n| Other liabilities |\\n| Derivative instruments | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\\n| Total liabilities | $ | 10,937 | $ | — | $ | — | $ | 2,445 | $ | — | $ | 7,189 | $ | — | $ | (12,387 | ) | $ | 8,184 | $ | 457 |\\n\\n29\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\n| OpeningBalance | TransfersintoLevel 3 | Transfersout ofLevel 3 | Included inearnings (1) | Includedin OCI (2) | Purchases | Sales | Settlements/Distributions | ClosingBalance | Change inunrealizedinvestmentgain/(loss) (3) |\\n| Three months ended September 30, 2015 |\\n| Fixed maturities |\\n| Corporate debt | $ | 43,008 | $ | — | $ | — | $ | (2 | ) | $ | 300 | $ | 22,821 | $ | — | $ | (4,403 | ) | $ | 61,724 | $ | — |\\n| CMBS | 21,900 | — | (9,902 | ) | — | (219 | ) | — | — | (461 | ) | 11,318 | — |\\n| ABS | 110 | — | — | — | — | — | — | (3 | ) | 107 | — |\\n| 65,018 | — | (9,902 | ) | (2 | ) | 81 | 22,821 | — | (4,867 | ) | 73,149 | — |\\n| Other investments |\\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\\n| CLO - Equities | 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\\n| 36,921 | — | — | 1,192 | — | — | — | (3,118 | ) | 34,995 | 1,192 |\\n| Other assets |\\n| Derivative instruments | 240 | — | — | 35 | — | — | — | (240 | ) | 35 | 35 |\\n| Insurance-linked securities | 24,837 | — | — | 175 | — | — | — | — | 25,012 | 175 |\\n| 25,077 | — | — | 210 | — | — | — | (240 | ) | 25,047 | 210 |\\n| Total assets | $ | 127,016 | $ | — | $ | (9,902 | ) | $ | 1,400 | $ | 81 | $ | 22,821 | $ | — | $ | (8,225 | ) | $ | 133,191 | $ | 1,402 |\\n| Other liabilities |\\n| Derivative instruments | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\\n| Total liabilities | $ | 818 | $ | — | $ | — | $ | (331 | ) | $ | — | $ | 6,475 | $ | — | $ | — | $ | 6,962 | $ | (331 | ) |\\n| Nine months ended September 30, 2015 |\\n| Fixed maturities |\\n| Corporate debt | $ | 15,837 | $ | — | $ | — | $ | (2 | ) | $ | 724 | $ | 54,445 | $ | — | $ | (9,280 | ) | $ | 61,724 | $ | — |\\n| CMBS | 17,763 | 5,072 | (9,902 | ) | — | (543 | ) | — | — | (1,072 | ) | 11,318 | — |\\n| ABS | 40,031 | — | (39,851 | ) | — | 105 | — | — | (178 | ) | 107 | — |\\n| 73,631 | 5,072 | (49,753 | ) | (2 | ) | 286 | 54,445 | — | (10,530 | ) | 73,149 | — |\\n| Other investments |\\n| Other privately held investments | — | — | — | — | — | — | — | — | — | — |\\n| CLO - Equities | 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\\n| 37,046 | — | — | 7,930 | — | — | — | (9,981 | ) | 34,995 | 7,930 |\\n| Other assets |\\n| Derivative instruments | 111 | — | — | (792 | ) | — | — | — | 716 | 35 | 35 |\\n| Insurance-linked securities | — | — | — | 12 | — | 25,000 | — | — | 25,012 | 12 |\\n| 111 | — | — | (780 | ) | — | 25,000 | — | 716 | 25,047 | 47 |\\n| Total assets | $ | 110,788 | $ | 5,072 | $ | (49,753 | ) | $ | 7,148 | $ | 286 | $ | 79,445 | $ | — | $ | (19,795 | ) | $ | 133,191 | $ | 7,977 |\\n| Other liabilities |\\n| Derivative instruments | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\\n| Total liabilities | $ | 15,288 | $ | — | $ | — | $ | (12,053 | ) | $ | — | $ | 8,698 | $ | — | $ | (4,971 | ) | $ | 6,962 | $ | (318 | ) |\\n\\n| (1) | Gains and losses included in earnings on fixed maturities are included in net realized investment gains (losses). Gains and (losses) included in earnings on other investments are included in net investment income. Gains (losses) on weather derivatives included in earnings are included in other insurance-related income. |\\n\\n| (2) | Gains and losses included in other comprehensive income (“OCI”) on fixed maturities are included in unrealized gains (losses) arising during the period. |\\n\\n| (3) | Change in unrealized investment gain (loss) relating to assets held at the reporting date. |\\n\\nThe transfers into and out of fair value hierarchy levels reflect the fair value of the securities at the end of the reporting period.\\n30\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nTransfers into Level 3 from Level 2\\nThere were no transfers to Level 3 from Level 2 made during the three months ended September 30, 2016 and 2015.\\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2016 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities and as the result of a change in valuation methodology relating to our CLO equity fund. An income approach valuation technique (discounted cash flow model) is used to estimate fair value at September 30, 2016. As the NAV practical expedient is no longer used the CLO equity fund is now categorized within the fair value hierarchy.\\nThe transfers to Level 3 from Level 2 made during the nine months ended September 30, 2015 were primarily due to the lack of observable market inputs and multiple quotes from pricing vendors and broker-dealers for certain fixed maturities.\\nTransfers out of Level 3 into Level 2\\nThere were no transfers to Level 2 from Level 3 made during the three months ended September 30, 2016. The transfers to Level 2 from Level 3 made during the nine months ended September 30, 2016 were primarily due to the availability of observable market\\ninputs and quotes from pricing vendors on certain fixed maturities.\\nThe transfers to Level 2 from Level 3 made during the three and nine months ended September 30, 2015 were primarily due to the availability of observable market inputs and quotes from pricing vendors on certain fixed maturities and CLO Debt securities.\\nMeasuring the Fair Value of Other Investments Using Net Asset Valuations\\nAs a practical expedient, we estimate fair values for hedge funds, direct lending funds, private equity funds and real estate funds using NAVs as advised by external fund managers or third party administrators. For each of these funds, the NAV is based on the manager's or administrator's valuation of the underlying holdings in accordance with the fund's governing documents and in accordance with U.S. GAAP.\\nIf there is a reporting lag between the current period end and reporting date of the latest available fund valuation for any hedge fund, we estimate the change in fair value by starting with the most recently available fund valuation and adjusting for return estimates as well as any subscriptions, redemptions and distributions that took place during the current period. Return estimates are obtained from the relevant fund managers. Accordingly, we do not typically have a reporting lag in our fair value measurements for these funds. Historically, our valuation estimates incorporating these return estimates have not significantly diverged from the subsequently received NAVs.\\nFor private equity funds, direct lending funds and the real estate fund, valuation statements are typically released on a three month reporting lag therefore the Company estimates fair value of these funds by starting with the prior quarter-end fund valuations and adjusting for capital calls, redemptions, drawdowns and distributions. Return estimates are not available from the relevant fund managers for these funds. Accordingly, we typically have a reporting lag in our fair value measurements for these funds.\\nThe Company often does not have access to financial information relating to the underlying securities held within the funds, therefore management is unable to corroborate the fair values placed on the securities underlying the asset valuations provided by the fund manager or fund administrator. To address this, on a quarterly basis, we perform a number of monitoring procedures to assess the quality of the information provided by managers and administrators. These procedures include, but are not limited to, regular review and discussion of each fund's performance with its manager, regular evaluation of fund performance against applicable benchmarks and the backtesting of our fair value estimates against subsequently received NAVs. Backtesting involves comparing our previously reported values for each individual fund against NAVs per audited financial statements (for year-end values) and final NAVs from fund managers and fund administrators (for interim values).\\nThe fair value of our hedge funds, direct lending funds, private equity funds and real estate funds are measured using the NAV practical expedient and therefore have not been categorized with the fair value hierarchy.\\n31\\n| 4. | FAIR VALUE MEASUREMENTS (CONTINUED) |\\n\\nFinancial Instruments Not Carried at Fair Value\\nU.S. GAAP guidance over disclosures about the fair value of financial instruments are also applicable to financial instruments not carried at fair value, except for certain financial instruments, including insurance contracts.\\nThe carrying values of cash equivalents (including restricted amounts), accrued investment income, receivable for investments sold, certain other assets, payable for investments purchased and certain other liabilities approximated their fair values at September 30, 2016, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.\\nThe carrying value of mortgage loans held-for-investment approximated their fair value at September 30, 2016, as the loans are within their first two years of issue. The estimated fair value of mortgage loans is primarily determined by estimating expected future cash flows and discounting them using current interest rates for similar mortgage loans with similar credit risk, or is determined from pricing for similar loans. As mortgage loans are not actively traded, their respective fair values are classified within Level 3.\\nAt September 30, 2016, our senior notes are recorded at amortized cost with a carrying value of $993 million (2015: $992 million) and have a fair value of $1,083 million (2015: $1,058 million). The fair values of these securities were obtained from a third party pricing service and pricing was based on the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of our senior notes are classified within Level 2.\\n| 5. | DERIVATIVE INSTRUMENTS |\\n\\nThe following table summarizes the balance sheet classification of derivatives recorded at fair values. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated and is presented in the table to quantify the volume of our derivative activities. Notional amounts are not reflective of credit risk.\\nNone of our derivative instruments are designated as hedges under current accounting guidance.\\n| September 30, 2016 | December 31, 2015 |\\n| DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) | DerivativeNotionalAmount | DerivativeAssetFairValue(1) | DerivativeLiabilityFairValue(1) |\\n| Relating to investment portfolio: |\\n| Foreign exchange forward contracts | $ | 40,367 | $ | 279 | $ | 17 | $ | 198,406 | $ | 490 | $ | 837 |\\n| Interest rate swaps | — | — | — | — | — | — |\\n| Relating to underwriting portfolio: |\\n| Foreign exchange forward contracts | 560,477 | 25 | 4,394 | 692,023 | 1,582 | 6,855 |\\n| Weather-related contracts | 59,436 | 2,488 | 8,184 | 51,395 | 4,395 | 10,937 |\\n| Commodity contracts | 181,000 | 4,165 | — | — | — | — |\\n| Total derivatives | $ | 6,957 | $ | 12,595 | $ | 6,467 | $ | 18,629 |\\n\\n| (1) | Asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\\n\\n32\\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\\n\\nOffsetting Assets and Liabilities\\nOur derivative instruments are generally traded under International Swaps and Derivatives Association master netting agreements, which establish terms that apply to all transactions. In the event of a bankruptcy or other stipulated event, master netting agreements provide that individual positions be replaced with a new amount, usually referred to as the termination amount, determined by taking into account market prices and converting into a single currency. Effectively, this contractual close-out netting reduces credit exposure from gross to net exposure. The table below presents a reconciliation of our gross derivative assets and liabilities to the net amounts presented in our Consolidated Balance Sheets, with the difference being attributable to the impact of master netting agreements.\\n| September 30, 2016 | December 31, 2015 |\\n| Gross Amounts | Gross Amounts Offset | NetAmounts(1) | Gross Amounts | Gross Amounts Offset | NetAmounts(1) |\\n| Derivative assets | $ | 9,370 | $ | (2,413 | ) | $ | 6,957 | $ | 14,336 | $ | (7,869 | ) | $ | 6,467 |\\n| Derivative liabilities | $ | 15,008 | $ | (2,413 | ) | $ | 12,595 | $ | 26,498 | $ | (7,869 | ) | $ | 18,629 |\\n\\n| (1) | Net asset and liability derivatives are classified within other assets and other liabilities in the Consolidated Balance Sheets. |\\n\\nRefer to Note 3 - Investments for information on reverse repurchase agreements.\\nDerivative Instruments not Designated as Hedging Instruments\\na) Relating to Investment Portfolio\\nForeign Currency Risk\\nWithin our investment portfolio we are exposed to foreign currency risk. Accordingly, the fair values for our investment portfolio are partially influenced by the change in foreign exchange rates. We may enter into foreign exchange forward contracts to manage the effect of this foreign currency risk. These foreign currency hedging activities are not designated as specific hedges for financial reporting purposes.\\nInterest Rate Risk\\nOur investment portfolio contains a large percentage of fixed maturities which exposes us to significant interest rate risk. As part of our overall management of this risk, we may use interest rate swaps.\\nb) Relating to Underwriting Portfolio\\nForeign Currency Risk\\nOur (re)insurance subsidiaries and branches operate in various foreign countries. Consequently, some of our business is written in currencies other than the U.S. dollar and, therefore, our underwriting portfolio is exposed to significant foreign currency risk. We manage foreign currency risk by seeking to match our foreign-denominated net liabilities under (re)insurance contracts with cash and investments that are denominated in such currencies. We may also use derivative instruments, specifically forward contracts and currency options, to economically hedge foreign currency exposures.\\n33\\n| 5. | DERIVATIVE INSTRUMENTS (CONTINUED) |\\n\\nWeather Risk\\nWe write derivative-based risk management products designed to address weather risks with the objective of generating profits on a portfolio basis. The majority of this business consists of receiving a payment at contract inception in exchange for bearing the risk of variations in a quantifiable weather-related phenomenon, such as temperature. Where a client wishes to minimize the upfront payment, these transactions may be structured as swaps or collars. In general, our portfolio of such derivative contracts is of short duration, with contracts being predominantly seasonal in nature. In order to economically hedge a portion of this portfolio, we may also purchase weather derivatives.\\nCommodity Risk\\nWithin our (re)insurance portfolio we are exposed to commodity price risk. We may hedge a portion of this price risk by entering into commodity derivative contracts.\\nThe total unrealized and realized gains (losses) recognized in earnings for derivatives not designated as hedges were as follows:\\n| Location of Gain (Loss) Recognized in Income on Derivative | Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Derivatives not designated as hedging instruments |\\n| Relating to investment portfolio: |\\n| Foreign exchange forward contracts | Net realized investment gains (losses) | $ | 155 | $ | 6,412 | $ | 39 | $ | 11,234 |\\n| Interest rate swaps | Net realized investment gains (losses) | — | — | — | (4,006 | ) |\\n| Relating to underwriting portfolio: |\\n| Foreign exchange forward contracts | Foreign exchange losses (gains) | (182 | ) | (5,210 | ) | (2,958 | ) | (21,494 | ) |\\n| Weather-related contracts | Other insurance related income (losses) | 833 | 307 | 809 | 11,274 |\\n| Commodity contracts | Other insurance related income (losses) | 1,799 | (33 | ) | 1,499 | (923 | ) |\\n| Total | $ | 2,605 | $ | 1,476 | $ | (611 | ) | $ | (3,915 | ) |\\n\\n34\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)6. RESERVE FOR LOSSES AND LOSS EXPENSES\\nThe following table presents a reconciliation of our beginning and ending gross reserve for losses and loss expenses and net reserve for unpaid losses and loss expenses for the periods indicated:\\n| Nine months ended September 30, | 2016 | 2015 |\\n| Gross reserve for losses and loss expenses, beginning of period | $ | 9,646,285 | $ | 9,596,797 |\\n| Less reinsurance recoverable on unpaid losses, beginning of period | (2,031,309 | ) | (1,890,280 | ) |\\n| Net reserve for unpaid losses and loss expenses, beginning of period | 7,614,976 | 7,706,517 |\\n| Net incurred losses and loss expenses related to: |\\n| Current year | 1,887,715 | 1,818,672 |\\n| Prior years | (224,131 | ) | (165,804 | ) |\\n| 1,663,584 | 1,652,868 |\\n| Net paid losses and loss expenses related to: |\\n| Current year | (233,124 | ) | (185,953 | ) |\\n| Prior years | (1,334,772 | ) | (1,293,776 | ) |\\n| (1,567,896 | ) | (1,479,729 | ) |\\n| Foreign exchange and other | (112,649 | ) | (183,360 | ) |\\n| Net reserve for unpaid losses and loss expenses, end of period | 7,598,015 | 7,696,296 |\\n| Reinsurance recoverable on unpaid losses, end of period | 2,276,792 | 2,007,287 |\\n| Gross reserve for losses and loss expenses, end of period | $ | 9,874,807 | $ | 9,703,583 |\\n\\nWe write business with loss experience generally characterized as low frequency and high severity in nature, which can result\\nin volatility in our financial results. During the nine months ended September 30, 2016 and 2015, we recognized aggregate net losses and loss expenses, net of reinstatement premiums of $145 million and $90 million, respectively, in relation to catastrophe and weather-related events.\\nDuring April 2016, the Company entered into a quota share and adverse development cover reinsurance agreement, a retroactive contract which was deemed to have met the established criteria for retroactive reinsurance accounting. Foreign exchange and other includes reinsurance recoverables of $159 million related to this reinsurance agreement.\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\\n\\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\\n35\\n| 6. | RESERVE FOR LOSSES AND LOSS EXPENSES (CONTINUED) |\\n\\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment. Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\\n| 7. | SHARE-BASED COMPENSATION |\\n\\nFor the three months ended September 30, 2016, we incurred share-based compensation costs of $14 million (2015: $11 million) and recorded associated tax benefits of $3 million (2015: $3 million). For the nine months ended September 30, 2016, we incurred share-based compensation costs of $50 million (2015: $41 million) and recorded associated tax benefits of $11 million (2015: $11 million).\\nThe total fair value of restricted stock, restricted stock units and cash settled awards vested during the nine months ended September 30, 2016 was $66 million (2015: $73 million). At September 30, 2016 there were $104 million of unrecognized compensation costs, which are expected to be recognized over the weighted average period of 2.4 years.\\n36\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)7. SHARE-BASED COMPENSATION (CONTINUED)\\nAwards to settle in shares\\nThe following table provides a reconciliation of the beginning and ending balance of nonvested restricted stock (including restricted stock units) for the nine months ended September 30, 2016:\\n| Performance-based Stock Awards | Service-based Stock Awards |\\n| Number ofRestrictedStock | Weighted AverageGrant DateFair Value | Number ofRestrictedStock | Weighted AverageGrant DateFair Value(1) |\\n| Nonvested restricted stock - beginning of period | 201 | $ | 49.24 | 1,954 | $ | 43.34 |\\n| Granted | 104 | 53.80 | 586 | 53.81 |\\n| Vested | (48 | ) | 45.38 | (779 | ) | 39.26 |\\n| Forfeited | — | — | (94 | ) | 47.03 |\\n| Nonvested restricted stock - end of period | 257 | $ | 52.04 | 1,667 | $ | 48.77 |\\n\\n(1) Fair value is based on the closing price of our common shares on the New York Stock Exchange on the day of the grant.\\nCash-settled awards\\nThe following table provides a reconciliation of the beginning and ending balance of nonvested cash settled restricted stock units for the nine months ended September 30, 2016:\\n| Performance-based Cash Settled RSUs | Service-based Cash Settled RSUs |\\n| Number ofRestrictedStock Units | Number ofRestrictedStock Units |\\n| Nonvested restricted stock units - beginning of period | 70 | 1,433 |\\n| Granted | 18 | 494 |\\n| Vested | (32 | ) | (371 | ) |\\n| Forfeited | — | (94 | ) |\\n| Nonvested restricted stock units - end of period | 56 | 1,462 |\\n\\nAt September 30, 2016, the corresponding liability for cash-settled units, included in other liabilities on the Consolidated Balance Sheets, was $34 million (2015: $23 million).\\n37\\n| 8. | EARNINGS PER COMMON SHARE |\\n\\nThe following table sets forth the comparison of basic and diluted earnings per common share:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Basic earnings per common share |\\n| Net income | $ | 186,613 | $ | 257,642 | $ | 364,460 | $ | 496,838 |\\n| Less: preferred share dividends | 9,969 | 10,022 | 29,906 | 30,066 |\\n| Net income available to common shareholders | 176,644 | 247,620 | 334,554 | 466,772 |\\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\\n| Basic earnings per common share | $ | 1.97 | $ | 2.52 | $ | 3.64 | $ | 4.69 |\\n| Diluted earnings per common share |\\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\\n| Weighted average common shares outstanding - basic(1) | 89,621 | 98,226 | 91,852 | 99,464 |\\n| Share based compensation plans | 730 | 898 | 727 | 1,004 |\\n| Weighted average common shares outstanding - diluted(1) | 90,351 | 99,124 | 92,579 | 100,468 |\\n| Diluted earnings per common share | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\\n| Anti-dilutive shares excluded from the dilutive computation | — | — | 226 | 219 |\\n\\n| (1) | On August 17, 2015, the Company entered into an Accelerated Share Repurchase (“ASR”) agreement (see 'Note 9 - Shareholders' Equity' for additional detail). The weighted-average number of shares outstanding used in the computation of basic and diluted earnings per share reflects the Company’s receipt of 4,149,378 common shares delivered to the Company on August 20, 2015, and 1,358,380 common shares delivered to the company on January 15, 2016 under the Company's ASR agreement. |\\n\\n38\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)9. SHAREHOLDERS' EQUITY\\nThe following table presents our common shares issued and outstanding:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Shares issued, balance at beginning of period | 176,575 | 176,206 | 176,240 | 175,478 |\\n| Shares issued | — | 16 | 335 | 744 |\\n| Total shares issued at end of period | 176,575 | 176,222 | 176,575 | 176,222 |\\n| Treasury shares, balance at beginning of period | (85,921 | ) | (75,922 | ) | (80,174 | ) | (76,052 | ) |\\n| Shares repurchased | (2,252 | ) | (4,257 | ) | (8,499 | ) | (4,607 | ) |\\n| Shares reissued from treasury | 37 | 6 | 537 | 486 |\\n| Total treasury shares at end of period | (88,136 | ) | (80,173 | ) | (88,136 | ) | (80,173 | ) |\\n| Total shares outstanding | 88,439 | 96,049 | 88,439 | 96,049 |\\n\\nTreasury Shares\\nThe following table presents our share repurchases:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| In the open market: |\\n| Total shares(1) | 2,232 | 4,248 | 8,236 | 4,264 |\\n| Total cost | $ | 124,948 | $ | 245,658 | $ | 434,948 | $ | 246,490 |\\n| Average price per share(2) | $ | 56.00 | $ | 57.83 | $ | 52.81 | $ | 57.80 |\\n| From employees: |\\n| Total shares | 20 | 9 | 263 | 343 |\\n| Total cost | $ | 1,088 | $ | 489 | $ | 14,137 | $ | 17,586 |\\n| Average price per share(2) | $ | 54.13 | $ | 55.59 | $ | 53.68 | $ | 51.28 |\\n| Total shares repurchased: |\\n| Total shares | 2,252 | 4,257 | 8,499 | 4,607 |\\n| Total cost | $ | 126,036 | $ | 246,147 | $ | 449,085 | $ | 264,076 |\\n| Average price per share(2) | $ | 55.98 | $ | 57.83 | $ | 52.84 | $ | 57.32 |\\n\\n(1) The nine months ended September 30, 2016 includes 1,358,380 common shares acquired under the accelerated share repurchase program (see below for more detail).\\n(2) Calculated using whole figures.\\n39\\n| 9. | SHAREHOLDERS' EQUITY (CONTINUED) |\\n\\nAccelerated Share Repurchase Program\\nOn August 17, 2015, the Company entered into an Accelerated Share Repurchase agreement with Goldman, Sachs & Co. (“Goldman Sachs”) to repurchase an aggregate of $300 million of the Company’s ordinary shares under an accelerated share repurchase program.\\nDuring August, 2015, under the terms of this agreement, the Company paid $300 million to Goldman Sachs and initially repurchased 4,149,378 ordinary shares. The initial shares acquired represented 80% of the $300 million total paid to Goldman Sachs and were calculated using the Company’s stock price at activation of the program. The ASR program is accounted for as an equity transaction. Accordingly, as at December 31, 2015, $240 million of common shares repurchased were included as treasury shares in the Consolidated Balance Sheet with the remaining $60 million included as a reduction to additional paid-in capital.\\nOn January 15, 2016, Goldman Sachs early terminated the ASR agreement and delivered 1,358,380 additional common shares to the Company, resulting in the reduction from additional paid-in capital of $60 million being reclassified to treasury shares. In total, the Company repurchased 5,507,758 common shares under the ASR agreement at an average price of $54.47.\\nSeries B Preferred Shares\\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of $3 million.\\n| 10. | COMMITMENTS AND CONTINGENCIES |\\n\\nReinsurance Agreements\\nWe purchase reinsurance coverage for various lines of our business. The minimum reinsurance premiums are contractually due in advance on a quarterly basis. Accordingly at September 30, 2016, we have unrecorded outstanding reinsurance purchase commitments of $33 million, of which $3 million is due in 2016 while the remaining $30 million is due in 2017. Actual payments under the reinsurance contracts will depend on the underlying subject premium and may exceed the minimum premium.\\nInvestments\\nRefer 'Note 3 - Investments' for information on commitments related to our other investments.\\n40\\nAXIS CAPITAL HOLDINGS LIMITEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)11. OTHER COMPREHENSIVE INCOME (LOSS)\\n| 2016 | 2015 |\\n| Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount | Before Tax Amount | Tax (Expense) Benefit | Net of Tax Amount |\\n| Three months ended September 30, |\\n| Available for sale investments: |\\n| Unrealized investment gains (losses) arising during the period | $ | 40,125 | $ | (3,789 | ) | $ | 36,336 | $ | (102,810 | ) | $ | 3,099 | $ | (99,711 | ) |\\n| Adjustment for reclassification of net realized investment gains (losses) and OTTI losses recognized in net income | (5,050 | ) | 2,408 | (2,642 | ) | 76,368 | (1,558 | ) | 74,810 |\\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 35,075 | (1,381 | ) | 33,694 | (26,442 | ) | 1,541 | (24,901 | ) |\\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\\n| Foreign currency translation adjustment | 1,722 | — | 1,722 | (14,626 | ) | — | (14,626 | ) |\\n| Total other comprehensive income (loss), net of tax | $ | 36,797 | $ | (1,381 | ) | $ | 35,416 | $ | (41,068 | ) | $ | 1,541 | $ | (39,527 | ) |\\n| Nine months ended September 30, |\\n| Available for sale investments: |\\n| Unrealized investment gains (losses) arising during the period | $ | 263,235 | $ | (24,579 | ) | $ | 238,656 | $ | (183,822 | ) | $ | 6,884 | $ | (176,938 | ) |\\n| Adjustment for reclassification of net realized investment gains and OTTI losses recognized in net income | 40,338 | 2,282 | 42,620 | 130,858 | (2,088 | ) | 128,770 |\\n| Unrealized investment gains (losses) arising during the period, net of reclassification adjustment | 303,573 | (22,297 | ) | 281,276 | (52,964 | ) | 4,796 | (48,168 | ) |\\n| Non-credit portion of OTTI losses | — | — | — | — | — | — |\\n| Foreign currency translation adjustment | 5,694 | — | 5,694 | (23,851 | ) | — | (23,851 | ) |\\n| Total other comprehensive income (loss), net of tax | $ | 309,267 | $ | (22,297 | ) | $ | 286,970 | $ | (76,815 | ) | $ | 4,796 | $ | (72,019 | ) |\\n\\nReclassifications out of AOCI into net income available to common shareholders were as follows:\\n| Amount Reclassified from AOCI(1) |\\n| Details About AOCI Components | Consolidated Statement of Operations Line Item That Includes Reclassification | Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Unrealized investment gains (losses) on available for sale investments |\\n| Other realized investment gains (losses) | $ | 9,297 | $ | (44,067 | ) | $ | (19,992 | ) | $ | (68,096 | ) |\\n| OTTI losses | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\\n| Total before tax | 5,050 | (76,368 | ) | (40,338 | ) | (130,858 | ) |\\n| Income tax (expense) benefit | (2,408 | ) | 1,558 | (2,282 | ) | 2,088 |\\n| Net of tax | $ | 2,642 | $ | (74,810 | ) | $ | (42,620 | ) | $ | (128,770 | ) |\\n\\n| (1) | Amounts in parentheses are debits to net income available to common shareholders. |\\n\\n41\\n| 12. | SUBSEQUENT EVENT |\\n\\nIn October 2016, the landfall of Hurricane Matthew impacted the Caribbean, southeastern United States and Canada, causing catastrophic loss of life, property damage and flooding.\\nOur preliminary after-tax net loss estimate for this event is in the range of $45 million to $60 million. The Company's loss estimate is primarily based on a ground-up assessment of losses from individual contracts and treaties exposed to the affected regions, including preliminary information from clients, brokers and loss adjusters. Industry insured loss estimates, market share analyses and catastrophe modeling analyses were also taken into account where appropriate.\\nDue to the nature of this event, including the complexity of loss assessment, factors contributing to the losses and the preliminary nature of the information available to prepare these estimates, the actual net ultimate amount of losses for this event may be materially different from this current estimate.\\nITEM 2.\\nMANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nThe following is a discussion and analysis of our financial condition and results of operations. This should be read in conjunction with the consolidated financial statements and related notes included in Item 1 of this report and also our Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2015. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.\\n\\n| Page |\\n| Third Quarter 2016 Financial Highlights | 43 |\\n| Executive Summary | 44 |\\n| Underwriting Results – Group | 49 |\\n| Results by Segment: For the three and nine months ended September 30, 2016 and 2015 | 57 |\\n| i) Insurance Segment | 57 |\\n| ii) Reinsurance Segment | 61 |\\n| Other Expenses (Revenues), Net | 64 |\\n| Net Investment Income and Net Realized Investment Gains (Losses) | 65 |\\n| Cash and Investments | 67 |\\n| Liquidity and Capital Resources | 70 |\\n| Critical Accounting Estimates | 72 |\\n| New Accounting Standards | 72 |\\n| Off-Balance Sheet and Special Purpose Entity Arrangements | 72 |\\n| Non-GAAP Financial Measures | 72 |\\n\\n42\\nTHIRD QUARTER 2016 FINANCIAL HIGHLIGHTS\\nThird Quarter 2016 Consolidated Results of Operations\\n\\n| • | Net income available to common shareholders of $177 million, or $1.97 per common share and $1.96 per diluted common share |\\n\\n| • | Operating income of $161 million, or $1.78 per diluted common share(1) |\\n\\n| • | Gross premiums written of $1.0 billion |\\n\\n| • | Net premiums written of $595 million, impacted by a large new retrocessional cover entered into with Harrington Re Ltd. |\\n\\n| • | Net premiums earned of $934 million |\\n\\n| • | Net favorable prior year reserve development of $76 million |\\n\\n| • | Estimated catastrophe and weather-related pre-tax net losses, net of reinstatement premiums, of $22 million compared to $43 million during the third quarter of 2015 |\\n\\n| • | Underwriting income of $104 million and combined ratio of 92.6% |\\n\\n| • | Net investment income of $117 million |\\n\\n| • | Net realized investment gains of $5 million |\\n\\n| • | Foreign exchange gains of $14 million |\\n\\nThird Quarter 2016 Consolidated Financial Condition\\n| • | Total cash and investments of $14.6 billion; fixed maturities, cash and short-term securities comprise 87% of total cash and investments and have an average credit rating of AA- |\\n\\n| • | Total assets of $21.2 billion |\\n\\n| • | Reserve for losses and loss expenses of $9.9 billion and reinsurance recoverable of $2.3 billion |\\n\\n| • | Total debt of $1.0 billion and the debt to total capital ratio of 14.1% |\\n\\n| • | Repurchased 2.3 million common shares. At October 27, 2016 the remaining authorization under the repurchase program approved by our Board of Directors was $375 million |\\n\\n| • | Common shareholders’ equity of $5.4 billion and diluted book value per common share of $59.77 |\\n\\n| (1) | Operating income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to ‘Non-GAAP Financial Measures’ for reconciliation to nearest GAAP financial measure (net income available to common shareholders). |\\n\\n43\\nEXECUTIVE SUMMARY\\nBusiness Overview\\nWe are a Bermuda-based global provider of specialty lines insurance and treaty reinsurance products with operations in Bermuda, the United States, Europe, Singapore, Canada, Latin America and the Middle East. Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Re.\\nOur mission is to provide our clients and distribution partners with a broad range of risk transfer products and services and meaningful capacity, backed by significant financial strength. We manage our portfolio holistically, aiming to construct the optimum consolidated portfolio of funded and unfunded risks, consistent with our risk appetite and development of our franchise. We nurture an ethical, entrepreneurial and disciplined culture that promotes outstanding client service, intelligent risk taking and the achievement of superior risk-adjusted returns for our shareholders. We believe that the achievement of our objectives will position us as a global leader in specialty risks. Our execution on this strategy in the first nine months of 2016 included:\\n| • | continued growth of our accident and health lines, which is focused on specialty accident and health products; |\\n\\n| • | growth of our Weather and Commodity Markets business unit which offers parametric risk management solutions to clients |\\n\\nwhose profit margins are exposed to adverse weather and commodity price risks;\\n| • | growth of our syndicate at Lloyd's which provides us with access to Lloyd's worldwide licenses and an extensive distribution network. During the first quarter of 2016 we commenced writing business through our underwriting division at Lloyd's in China; |\\n\\n| • | continued rebalancing of our portfolio towards less-volatile lines of business that carry attractive rates; and |\\n\\n| • | continued expansion of our broad range of third-party capital capabilities through: |\\n\\n| • | Our investment in Harrington Reinsurance Holdings Limited (\\\"Harrington\\\"), the parent company of Harrington Re Ltd. (\\\"Harrington Re\\\"), an independent reinsurance company jointly sponsored by AXIS Capital and The Blackstone Group L.P. (\\\"Blackstone\\\"). Harrington Re’s strategy is to combine a multi-line reinsurance portfolio with a diversified allocation to alternative investment strategies to earn attractive risk-adjusted returns. Harrington plans to develop a portfolio that optimizes the risk-reward characteristics of both assets and liabilities, leveraging the respective strengths of AXIS Capital and Blackstone while deploying a disciplined and fully integrated approach to both underwriting and investing; |\\n\\n| • | AXIS Ventures Reinsurance Limited, which manages capital for investors interested in deploying funds directly into the property-catastrophe and other short-tail business; and |\\n\\n| • | increased use of available reinsurance and retrocessional protection to optimize the risk-adjusted returns on our portfolio. |\\n\\n44\\nResults of Operations\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Underwriting income: |\\n| Insurance | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\\n| Reinsurance | 78,837 | 60% | 49,357 | 181,623 | (8%) | 197,729 |\\n| Net investment income | 116,923 | 156% | 45,685 | 257,818 | 14% | 226,336 |\\n| Net realized investment gains (losses) | 5,205 | nm | (69,957 | ) | (40,295 | ) | (67%) | (123,618 | ) |\\n| Other expenses, net | (37,079 | ) | nm | (8,464 | ) | (63,439 | ) | 18% | (53,895 | ) |\\n| Termination fee received | — | nm | 280,000 | — | nm | 280,000 |\\n| Reorganization and related fees | — | nm | (45,867 | ) | — | nm | (45,867 | ) |\\n| Interest in loss of equity method investments | (2,434 | ) | nm | — | (2,434 | ) | nm | — |\\n| Net income | 186,613 | (28%) | 257,642 | 364,460 | (27%) | 496,838 |\\n| Preferred share dividends | (9,969 | ) | (1%) | (10,022 | ) | (29,906 | ) | (1%) | (30,066 | ) |\\n| Net income available to common shareholders | $ | 176,644 | (29%) | $ | 247,620 | $ | 334,554 | (28%) | $ | 466,772 |\\n| Operating income | $ | 160,689 | 215% | $ | 51,031 | $ | 309,450 | 10% | $ | 280,682 |\\n\\nnm – not meaningful\\nUnderwriting Results\\nTotal underwriting income in the three months ended September 30, 2016 was $104 million, an increase of $48 million compared to $56 million in the three months ended September 30, 2015. The increase in underwriting income was primarily driven by an increase in net favorable prior year development, decreased catastrophe and weather-related losses, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\\nThe reinsurance segment underwriting income increased by $29 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily driven by decreased catastrophe and weather-related losses, an increase in net favorable prior year development, lower general and administrative expenses and an increase in other insurance related income, partially offset by an increase in the acquisition cost ratio.\\nThe insurance segment underwriting income increased by $18 million in the three months ended September 30, 2016, compared to the three months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development and a decrease in the acquisition cost ratio, partially offset by an increase in the current accident year loss ratio excluding catastrophe and weather-related losses.\\nTotal underwriting income in the nine months ended September 30, 2016 was $213 million, a decrease of $1 million compared to $214 million in the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by increased catastrophe and weather-related losses, an increase in the acquisition cost ratio and a decrease in other insurance income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\\nThe reinsurance segment underwriting income decreased by $16 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The decrease in underwriting income was primarily driven by an increase in the acquisition cost ratio, increased catastrophe and weather-related losses and a decrease in other insurance related income, partially offset by an increase in net favorable prior year development and lower general and administrative expenses.\\nThe insurance segment underwriting income increased by $15 million in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015. The increase in underwriting income was primarily due to an increase in net favorable prior year development, a decrease in the acquisition cost ratio and lower general and administrative expenses, partially offset by increased catastrophe and weather-related losses.\\n45\\nNet Investment Income\\nNet investment income in the three months ended September 30, 2016 was $117 million, an increase of $71 million compared to $46 million in the three months ended September 30, 2015. The increase was primarily driven by our other investments. These investments generated a gain of $38 million in the three months ended September 30, 2016, compared to a loss of $27 million in three months ended September 30, 2015. Net investment income for the nine months ended September 30, 2016 was $258 million, an increase of $31 million compared to the same period in 2015. The increase was mainly attributable to income from fixed maturities and other investments. Income from fixed maturities increased as a result of an emphasis on longer duration assets and income from other investments increased as a result of improved valuations on our CLO - Equity holdings.\\nNet Realized Investment Gains (Losses)\\nRealized gains were $5 million in the three months ended September 30, 2016 compared to realized losses of $70 million for the same period of 2015. The gains were mainly attributable to corporates, agency MBS, CMBS and ETFs which benefited from improvements in pricing in 2016. The realized losses in the three months ended September 30, 2015 were attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and other-than-temporary impairment (\\\"OTTI\\\") charges. Realized losses were $40 million in the nine months ended September 30, 2016, compared to realized losses of $124 million for the same period of 2015. The losses for the three and nine months ended September 30, 2016 and 2015 were primarily attributable to foreign currency losses on non-U.S. denominated securities as a result of the strengthening of the U.S. dollar and OTTI charges.\\nOther Revenues (Expenses), Net\\nCorporate expenses increased to $29 million for the three months ended September 30, 2016, from $24 million for the three months ended September 30, 2015. The increase is primarily attributable to the net reimbursement of PartnerRe Ltd. (\\\"PartnerRe\\\") merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. For the nine months ended September 30, 2016, corporate expenses increased to $87 million compared to $84 million in the same period in 2015. The slight increase is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016, and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\\nThe foreign exchange gains for the three and nine months ended September 30, 2016 of $14 million and $70 million, respectively, were primarily driven by the depreciation of the pound sterling against the U.S dollar. The foreign exchange gains of $28 million for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar, while the foreign exchange gains for the nine months ended September 30, 2015 of $69 million were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\\nThe financial results for the three months ended September 30, 2016 resulted in a tax expense of $9 million, compared to an expense of nil for the three months ended September 30, 2015. Operations in the nine months ended September 30, 2016 resulted in a tax expense of $8 million compared to a tax expense of $1 million in the nine months ended September 30, 2015. The effective tax rate, which drives the tax expense, can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the increase in both periods is the generation of consolidated pre-tax net income in our operations in Europe compared to net losses in 2015.\\nTermination Fee Received\\nDuring the third quarter of 2015, the Company announced that we had accepted a request from PartnerRe to terminate the Agreement and Plan of Amalgamation (the \\\"Amalgamation Agreement\\\") with the Company. PartnerRe paid the Company $315 million to immediately terminate the Amalgamation Agreement, the amount was comprised of a termination fee of $280 million and a reimbursement of merger related expenses of $35 million.\\n46\\nReorganization and Related Expenses\\nDuring the third quarter of 2015, the Company implemented a number of profitability enhancement initiatives which resulted in a recognition of reorganization and related expenses of $46 million and additional corporate expenses of $5 million in the Consolidated Statement of Operations in the three months ended September 30, 2015.\\nInterest in Loss of Equity Method Investments\\nInterest in losses of equity method investments represents the Company’s aggregate share of losses related to investments in which the Company has significant influence over the operating and financial policies of the investee.\\nOutlook\\nManagement expects to achieve an increase in gross premiums written in 2016, with variances between our lines of business within the operating segments driven by market conditions and available opportunities, as we maintain our focus on diversification and pursuit of those opportunities that will expand our reach in areas where we believe the returns to be most attractive. We also expect the increase in gross premiums written to be substantially offset by greater cessions of risk to reinsurers and third party capital partners.\\nCompetitive conditions continue to impact worldwide insurance markets with greatest pressures impacting catastrophe exposed property and certain global specialty lines of business. We also observed greater competitiveness for large accounts compared to smaller risks. These competitive pressures have led to price reductions across most lines of business, with decreases in international markets generally more severe than those observed in the United States. We expect this trend to continue in the short-term but believe that there are still attractive risks in the market. In this challenging market environment, we are focusing on lines and markets that remain adequately priced or continue to deliver price increases and those that provide opportunities for profitable growth. Where necessary we also continue to shift our business mix toward smaller, less volatile risk accounts which we believe will enable us to achieve a better, more stable attritional loss experience with lower severity.\\nThe reinsurance markets' trading environment remains challenging in the majority of lines of business and geographical regions. The market continues to be influenced by excess capacity, strong balance sheets of established market participants and a consolidation of reinsurance purchasing. Despite these conditions we observed recent favorable trends which we expect to impact our business including many cedants reducing the size of their reinsurer panels, some moderation of pricing pressures, increased resistance to demands for greater commission rates as well as more generous terms and conditions, an increase in the number of cedants looking to buy more reinsurance protection and Solvency II-driven opportunities. These factors, combined with AXIS customer-centric approach and opportunities in specific lines of business and geographies allow us to execute on our targeted growth strategy. We continue to address the difficult market conditions by taking actions to protect the quality and profitability of our existing book, targeting larger shares of the more attractive treaties, managing the overall volatility of our reinsurance book, and expanding our already strong group of third party capital partners with whom to share our risks and earn fee income.\\n47\\nFinancial Measures\\nWe believe the following financial indicators are important in evaluating our performance and measuring the overall growth in value generated for our common shareholders:\\n| Three months ended and at September 30, | Nine months ended and at September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| ROACE (annualized)(1) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\\n| Operating ROACE (annualized)(2) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\\n| DBV per common share(3) | $ | 59.77 | $ | 53.68 | $ | 59.77 | $ | 53.68 |\\n| Cash dividends declared per common share | 0.35 | 0.29 | 1.05 | 0.87 |\\n| Increase in diluted book value per common share adjusted for dividends | $ | 2.50 | $ | 2.16 | $ | 6.74 | $ | 4.67 |\\n\\n| (1) | Return on average common equity (“ROACE”) is calculated by dividing annualized net income available to common shareholders for the period by the average shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. |\\n\\n| (2) | Operating ROACE is calculated by dividing annualized operating income for the period by the average common shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. Annualized operating ROACE is a non-GAAP financial measure as defined in SEC Regulation G. Refer to‘Non-GAAP Financial Measures’ for additional information and reconciliation to the nearest GAAP financial measure (ROACE). |\\n\\n| (3) | Diluted book value (“DBV”) per common share represents total common shareholders’ equity divided by the number of common shares and diluted common share equivalents outstanding, determined using the treasury stock method. Cash settled awards are excluded from the denominator. |\\n\\nReturn on Equity\\nThe decrease in ROACE in the three months ended September 30, 2016, compared to the three months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by net realized gains in the current quarter compared to net realized losses in the same period in 2015, an increase in net investment income and underwriting income in the current quarter compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\\nThe increase in operating ROACE for the three months ended September 30, 2016, compared to the three months ended September 30, 2015 was primarily driven by an increase in net investment income and underwriting income in the three months ended September 30, 2016 compared to the same period in 2015.\\nThe decrease in ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by the termination fee received from PartnerRe in the third quarter of 2015, partially offset by a decrease in net realized losses and an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015 and reorganization and related expenses incurred in the third quarter of 2015.\\nThe increase in operating ROACE in the nine months ended September 30, 2016, compared to the nine months ended September 30, 2015, was primarily driven by an increase in net investment income in the nine months ended September 30, 2016 compared to the same period in 2015.\\nDiluted Book Value per Common Share\\nOur diluted book value per common share increase of 11% from $53.68 at September 30, 2015, to $59.77 at September 30, 2016, primarily reflected the generation of $469 million in net income available to common shareholders over the past twelve months and the increase over the last twelve months in unrealized gains on investments which are included in accumulated other comprehensive income, which was partially offset by common share dividends declared.\\n48\\nDiluted Book Value per Common Share Adjusted for Dividends\\nOur diluted book value per common share adjusted for dividends increased by $2.50, or 4%, per common share for the three month period ended September 30, 2016 and $7.49, or 14%, per common share over the past twelve months.\\nTaken together, we believe that growth in diluted book value per common share and common share dividends declared represent the total value created for our common shareholders. As companies in the insurance industry have differing dividend payout policies, we believe investors use the diluted book value per common share adjusted for dividends metric to measure comparable performance across the industry.\\nDuring the three and nine months ended September 30, 2016, total value created consisted primarily of our net income and an increase in unrealized gains on investments, reported in accumulated other comprehensive income.\\nDuring the three and nine months ended September 30, 2015, total value created consisted primarily of our net income, partially offset by an increase in unrealized losses on investments and foreign exchange translation adjustment losses included in accumulated other comprehensive income.\\nUNDERWRITING RESULTS – GROUP\\nThe following table provides our group underwriting results for the periods indicated. Underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses.\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Revenues: |\\n| Gross premiums written | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\\n| Net premiums written | 595,431 | (12%) | 677,217 | 3,288,587 | 7% | 3,079,307 |\\n| Net premiums earned | 934,415 | 2% | 919,341 | 2,783,746 | 1% | 2,764,605 |\\n| Other insurance related income | 5,944 | 413% | 1,158 | 4,850 | (61%) | 12,319 |\\n| Expenses: |\\n| Current year net losses and loss expenses | (608,347 | ) | (605,512 | ) | (1,887,715 | ) | (1,818,672 | ) |\\n| Prior year reserve development | 76,019 | 45,125 | 224,131 | 165,804 |\\n| Acquisition costs | (189,810 | ) | (182,744 | ) | (559,570 | ) | (537,549 | ) |\\n| Underwriting-related general and administrative |\\n| expenses(1) | (114,223 | ) | (121,123 | ) | (352,632 | ) | (372,625 | ) |\\n| Underwriting income(2) | $ | 103,998 | 85% | $ | 56,245 | $ | 212,810 | (1%) | $ | 213,882 |\\n| General and administrative expenses(1) | $ | 142,906 | $ | 144,727 | $ | 439,554 | $ | 456,451 |\\n| Income before income taxes and interest in income (loss) of equity method investments(2) | $ | 198,399 | $ | 257,672 | $ | 374,606 | $ | 497,993 |\\n\\n| (1) | Underwriting-related general and administrative expenses is a non-GAAP measure as defined in SEC Regulation G. Our total general and administrative expenses also included corporate expenses of $28,683 and $23,604 for the three months ended September 30, 2016 and 2015, respectively, and $86,922 and $83,826 for the nine months ended September 30, 2016 and 2015, respectively. Refer to 'Other Expenses (Revenues), Net' for additional information related to these corporate expenses. Also, refer to 'Non-GAAP Financial Measures' for further information. |\\n\\n| (2) | Underwriting income is a non-GAAP financial measure as defined in SEC Regulation G. Refer to Item 1, Note 2 to the Consolidated Financial Statements for a reconciliation of underwriting income to the nearest GAAP financial measure (income before income taxes and interest in income (loss) of equity method investments) for the periods indicated above. Also, refer to 'Non-GAAP Financial Measures' for additional information related to the presentation of underwriting income. |\\n\\n49\\nUNDERWRITING REVENUES\\nPremiums Written:\\n| Gross Premiums Written |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Insurance | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\\n| Reinsurance | 284,532 | (14%) | 329,879 | 2,126,762 | 16% | 1,833,374 |\\n| Total | $ | 959,962 | 2% | $ | 936,583 | $ | 4,239,558 | 11% | $ | 3,803,928 |\\n| % ceded |\\n| Insurance | 36% | (1) pts | 37% | 32% | 1 pts | 31% |\\n| Reinsurance | 43% | 33 pts | 10% | 13% | 7 pts | 6% |\\n| Total | 38% | 10 pts | 28% | 22% | 3 pts | 19% |\\n| Net Premiums Written |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Insurance | $ | 433,131 | 14% | $ | 381,118 | $ | 1,433,058 | 6% | $ | 1,352,122 |\\n| Reinsurance | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\\n| Total | $ | 595,431 | (12%) | $ | 677,217 | $ | 3,288,587 | 7% | $ | 3,079,307 |\\n\\nGross premiums written in the three and nine months ended September 30, 2016, increased by $23 million or 2% (3% on a constant currency basis(1)) and $436 million or 11% (13% on a constant currency basis) compared to the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the same period in 2015 was due to an increase in the insurance segment, partially offset by a decrease in the reinsurance segment. The increase for the nine months ended September 30, 2016 compared to the same period in 2015 was due to increases in both our reinsurance and insurance segments.\\nOur reinsurance segment's gross premiums written decreased by $45 million or 14% (13% on a constant currency basis) and increased by $293 million, or 16% (19% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The decrease in the reinsurance segment gross written premiums in the three months ended September 30, 2016, compared to the same period of 2015 was primarily driven by timing differences impacting our professional and liability lines. The increase in the reinsurance segment gross written premiums in the nine months ended September 30, 2016, compared to the same period of 2015 was impacted by an increase in the level of premiums written on a multi-year basis. This increase in multi-year contracts increased the amount of premium recorded in the current period relating to future years compared to the same period in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was partially offset by foreign exchange movements as the strength of the U.S. dollar drove comparative premium decreases in treaties denominated in foreign currencies. After adjusting for the impact of the multi-year contracts and foreign exchange movements, our reinsurance segment gross premiums written increased by $204 million in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by new business in our liability, marine and other, catastrophe, professional as well as our credit and surety lines, with favorable treaty restructurings and timing differences also contributing to increased premium written in our liability and professional lines. These increases were partially offset by a decrease in our property lines primarily driven by non-renewals and decreases in the line sizes on several treaties.\\n| (1) | Amounts presented on a constant currency basis are “non-GAAP financial measures” as defined in Regulation G. The constant currency basis is calculated by applying the average foreign exchange rate from the current year to the prior year balance. |\\n\\n50\\nOur insurance segment's gross written premiums increased by $69 million or 11% (12% on a constant currency basis) and $142 million or 7% (8% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods of 2015. Increased premiums written were reported in both periods in our accident and health and property lines primarily related to new business. The increase in the nine months ended September 30, 2016, compared to the same period in 2015 was partially offset by decreased premiums written in our marine lines and the impact of our exit from retail insurance operations in Australia.\\nIn the three and nine months ended September 30, 2016, the ceded ratio increased by 10% and 3%, compared to the three and nine months ended September 30, 2015, respectively, with the increases primarily attributable to the reinsurance segment. The reinsurance segment ceded ratio increased in the three and nine months ended September 30, 2016 compared to the same periods in 2015, largely due to a new retrocessional cover entered into with Harrington Re.\\nNet Premiums Earned:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | %Change | 2016 | 2015 | %Change |\\n| Insurance | $ | 444,691 | 48 | % | $ | 444,550 | 48 | % | —% | $ | 1,322,649 | 48 | % | $ | 1,344,339 | 49 | % | (2%) |\\n| Reinsurance | 489,724 | 52 | % | 474,791 | 52 | % | 3% | 1,461,097 | 52 | % | 1,420,266 | 51 | % | 3% |\\n| Total | $ | 934,415 | 100 | % | $ | 919,341 | 100 | % | 2% | $ | 2,783,746 | 100 | % | $ | 2,764,605 | 100 | % | 1% |\\n\\nChanges in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in premium earning patterns.\\nNet premiums earned increased by 2% (4% on a constant currency basis) and 1% (4% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively. The increases were driven by the reinsurance segment in both periods, with a reduction in the insurance segment for the nine months ended September 30, 2016 compared to the same period in 2015, partially offsetting the increase in the reinsurance segment.\\nThe increase in the reinsurance segment for both periods was primarily driven by strong premium growth in our liability, marine and other as well as our catastrophe lines in recent periods together with favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\\nThe decrease in the insurance segment for the nine months ended September 30, 2016, compared to the same period in 2015, was primarily driven by an increase in our professional lines' ceded reinsurance programs, decreased business written in our marine lines and the impact of our exit from retail insurance operations in Australia, partially offset by growth in premiums written in recent periods in our accident and health lines.\\nOther Insurance Related Income (Loss):\\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by third party capital fees and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\\n51\\nUNDERWRITING EXPENSES\\nThe following table provides a breakdown of our combined ratio:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\\n| Current accident year loss ratio | 65.1 | % | (0.8) | 65.9 | % | 67.8 | % | 2.0 | 65.8 | % |\\n| Prior year reserve development | (8.1 | %) | (3.2) | (4.9 | %) | (8.0 | %) | (2.0) | (6.0 | %) |\\n| Acquisition cost ratio | 20.3 | % | 0.4 | 19.9 | % | 20.1 | % | 0.7 | 19.4 | % |\\n| General and administrative expense ratio(1) | 15.3 | % | (0.4) | 15.7 | % | 15.8 | % | (0.7) | 16.5 | % |\\n| Combined ratio | 92.6 | % | (4.0) | 96.6 | % | 95.7 | % | — | 95.7 | % |\\n\\n| (1) | The general and administrative expense ratio includes corporate expenses not allocated to reportable segments of 3.1% and 2.6% for the three months ended September 30, 2016 and 2015, respectively, and 3.1% and 3.0% for the nine months ended September 30, 2016 and 2015, respectively. These costs are further discussed in the ‘Other Expenses (Revenues), Net’ section. |\\n\\nCurrent Accident Year Loss Ratio:\\nThe current accident year loss ratio decreased to 65.1% in the three months ended September 30, 2016 from 65.9% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.8% in the same period in 2015.\\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $22 million, or 2.3 points, and $145 million, or 5.3 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $43 million, or 4.7 points, and $90 million, or 3.3 points, respectively.\\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.5%, respectively, compared to 61.2% and 62.5% in the three and nine months ended September 30, 2015, respectively. The increase in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three months ended September 30, 2016, compared to the same period in 2015, was mainly due to business mix changes as well as the ongoing adverse impact of rate and trend, partially offset by a decrease in the mid-size loss experience in our insurance marine and property lines. The current accident year loss ratio after adjusting for the impact of the catastrophe and weather-related losses for the nine months ended September 30, 2016 was comparable to the same periods in 2015. The adverse impact of rate and trend together with business mix changes were offset by a decrease in the mid-size loss experience in our insurance marine and property lines.\\nPrior Year Reserve Development:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Insurance | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\\n| Reinsurance | 55,331 | 42,681 | 180,950 | 144,579 |\\n| Total | $ | 76,019 | $ | 45,125 | $ | 224,131 | $ | 165,804 |\\n\\n52\\nOverview\\nThe majority of the net favorable prior year reserve development in each period related to short-tail reserve classes. Net favorable prior year reserve development for professional, reinsurance liability and motor reserve classes also contributed in the three and nine months ended September 30, 2016.\\nOur short tail business includes the underlying exposures in the property and other, marine and aviation reserving classes within our insurance segment and the property and other reserving class within our reinsurance segment . Development from these classes contributed $41 million and $38 million of the total net favorable prior year reserve development for the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these short-tail lines contributed $116 million and $112 million, respectively, of net favorable prior year reserve development. The net favorable prior year reserve development for these classes primarily reflected the recognition of better than expected loss emergence.\\nOur medium-tail business consists primarily of professional insurance and reinsurance reserve classes, credit and political risk insurance reserve class and the credit and surety reinsurance reserve class. In the three and nine months ended September 30, 2016, the professional reserve classes contributed net favorable prior year reserve development of $12 million and $28 million, respectively. In the nine months ended September 30, 2015, the reinsurance professional reserve class contributed $25 million of net favorable development. The net favorable prior year development on these reserve classes continued to reflect the generally favorable experience on earlier accident years as we continued to transition to more experience based methods on these years. As our loss experience has generally been better than expected, this resulted in the recognition of net favorable prior year reserve development. In the three and nine months ended September 30, 2015, the insurance professional reserve class recorded net adverse prior year reserve development of $15 million and $16 million, respectively. This adverse development was primarily the result of strengthening in our Australian book of business during the third quarter of 2015.\\nIn the three and nine months ended September 30, 2015, the credit and surety reserve class recorded net favorable prior year reserve development of $7 million and $19 million, respectively. This net favorable prior year reserve development reflected the recognition of generally better than expected loss emergence.\\nIn the nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $15 million in our credit and political risk reserve class relating to an increase in our loss portfolio estimates.\\nOur long-tail business consists primarily of liability and motor reserve classes. Our motor and liability reinsurance reserve classes contributed additional net favorable prior year reserve development of $17 million and $20 million in the three months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, these long-tail reserve classes contributed $72 million and $64 million, respectively. The net favorable prior year reserve development for the motor reserve class related to favorable loss emergence trends on several classes of business spanning multiple accident years. The net favorable prior year reserve development for the liability reinsurance reserve class primarily reflected the progressively increased weight given by management to experience based indications on older accident years, which has generally been favorable. In the three and nine months ended September 30, 2015, we recorded net adverse prior year reserve development of $6 million and $23 million, respectively, in our insurance liability reserve class related primarily to an increase in loss estimates for specific individual claim reserves, as well as a higher frequency of large auto liability claims.\\nWe caution that conditions and trends that impacted the development of our liabilities in the past may not necessarily occur in the future.\\nEstimates of Significant Catastrophe Events\\nOur September 30, 2016 net reserves for losses and loss expenses includes estimated amounts for numerous catastrophe events. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular the Fort McMurray wildfires, Storm Sandy, the 2011 Japanese earthquake and tsunami, the three New Zealand earthquakes and the Tianjin port explosion, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.\\n53\\nOur estimated net losses in relation to the catastrophe events described above were derived from ground-up assessments of our in-force contracts and treaties providing coverage in the affected regions. These assessments take into account the latest information available from clients, brokers and loss adjusters. In addition, we consider industry insured loss estimates, market share analyses and catastrophe modeling analyses, when appropriate. Our estimates remain subject to change, as additional loss data becomes available.\\nThe following sections provide further details on prior year reserve development by segment, reserving class and accident year.\\nInsurance Segment:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Property and other | $ | 10,061 | $ | 20,518 | $ | 24,048 | $ | 49,705 |\\n| Marine | 4,682 | 2,831 | 8,382 | 23,156 |\\n| Aviation | 517 | 667 | 437 | 2,884 |\\n| Credit and political risk | (25 | ) | (28 | ) | (232 | ) | (15,427 | ) |\\n| Professional lines | 3,378 | (15,279 | ) | 8,956 | (15,887 | ) |\\n| Liability | 2,075 | (6,265 | ) | 1,590 | (23,206 | ) |\\n| Total | $ | 20,688 | $ | 2,444 | $ | 43,181 | $ | 21,225 |\\n\\nIn the three months ended September 30, 2016, we recognized $21 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $10 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015 and favorable loss experience in our accident and health lines impacting accident year 2014. |\\n\\n| • | $5 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\\n\\nIn the three months ended September 30, 2015, we recognized $2 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $21 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence including reserve reductions related to Storm Sandy of $15 million. |\\n\\n| • | $6 million of net adverse prior year reserve development on liability business, primarily related to a higher frequency of large auto liability claims in accident year 2014. |\\n\\n| • | $15 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\\n\\nIn the nine months ended September 30, 2016, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $24 million of net favorable prior year reserve development on property and other business, driven by better than expected loss emergence primarily related to accident year 2014. |\\n\\n| • | $9 million of net favorable prior year reserve development on professional lines business, driven by better than expected development related to various accident years, partially offset by reserve strengthening relating to updated information on one specific claim impacting accident year 2010. |\\n\\n54\\n| • | $8 million of net favorable prior year reserve development on marine business, driven by better than expected loss emergence, primarily driven by reductions in mid-size loss estimates impacting accident year 2015. |\\n\\nIn the nine months ended September 30, 2015, we recognized $21 million of net favorable prior year development, the principal components of which were:\\n| • | $50 million of net favorable prior year reserve development on property and other business, related to the 2012 and 2013 accident years and driven by better than expected loss emergence, including reserve reductions related to Storm Sandy of $16 million. |\\n\\n| • | $23 million of net favorable prior year reserve development on marine business, largely related to better than expected loss emergence in our energy offshore business spanning multiple years, particularly accident year 2014. |\\n\\n| • | $15 million of net adverse prior year reserve development on credit and political risk business, related to updated information on one specific claim impacting accident year 2014. |\\n\\n| • | $16 million of net adverse prior year reserve development on professional lines business, predominately reflecting reserve strengthening resulting from updated actuarial assumptions for our Australian professional lines and impacting accident years 2010 to 2014, partially offset by favorable development in certain US professional lines. |\\n\\n| • | $23 million of net adverse prior year reserve development on liability business, related to strengthening of specific individual claim reserves and a higher frequency of large auto liability claims in accident year 2014. |\\n\\nReinsurance Segment:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Property and other | $ | 25,831 | $ | 14,115 | $ | 83,522 | $ | 36,120 |\\n| Credit and surety | 3,900 | 7,051 | 6,761 | 18,851 |\\n| Professional lines | 8,761 | 1,250 | 18,918 | 25,331 |\\n| Motor | 6,653 | 8,997 | 39,794 | 27,321 |\\n| Liability | 10,186 | 11,268 | 31,955 | 36,956 |\\n| Total | $ | 55,331 | $ | 42,681 | $ | 180,950 | $ | 144,579 |\\n\\nIn the three months ended September 30, 2016, we recognized $55 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $26 million of net favorable prior year reserve development on property and other business, related to the 2011 through 2015 accident years driven by better than expected loss emergence including a reserve reduction of $7 million related to Storm Sandy. |\\n\\n| • | $10 million of net favorable prior year reserve development on liability business, primarily related to the 2007 through 2010 accident years, for reasons discussed in the overview. |\\n\\n| • | $9 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\\n\\n| • | $7 million of net favorable prior year reserve development on motor business, related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\\n\\nIn the three months ended September 30, 2015, we recognized $43 million of net favorable prior year reserve development, the principal components of which were:\\n55\\n| • | $14 million of net favorable prior year reserve development on property and other business, related to multiple prior accident years and driven by better than expected loss emergence. |\\n\\n| • | $11 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\\n\\n| • | $9 million of net favorable prior year reserve development on motor business, largely related to favorable loss emergence trends on several classes spanning multiple accident years. |\\n\\n| • | $7 million of net favorable prior year reserve development on credit and surety business, related to the 2012 accident year and driven by additional information obtained about a specific claim. |\\n\\nIn the nine months ended September 30, 2016, we recognized $181 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $84 million of net favorable prior year development on property and other business, primarily related to the 2010 through 2015 accident years driven by better than expected loss emergence. |\\n\\n| • | $40 million of net favorable prior year reserve development on motor business, primarily related to non-proportional business spanning multiple accident years, driven by better than expected loss emergence. |\\n\\n| • | $32 million of net favorable prior year reserve development on liability business, primarily related to the 2006 through 2011 accident years, for reasons discussed in the overview. |\\n\\n| • | $19 million of net favorable prior year reserve development on professional lines business, primarily related to the 2005 through 2010 accident years, for reasons discussed in the overview. |\\n\\nIn the nine months ended September 30, 2015, we recognized $145 million of net favorable prior year reserve development, the principal components of which were:\\n| • | $37 million of net favorable prior year reserve development on liability business, primarily related to the 2003 through 2010 accident years, for reasons discussed in the overview. |\\n\\n| • | $36 million of net favorable prior year reserve development on property and other business, spanning a number of accident years and driven by better than expected loss emergence. Included in this net development is $20 million of adverse development on agriculture reserves relating to loss developments on the 2014 accident year driven by lower than expected crop yields reported for two specific treaties. |\\n\\n| • | $27 million of net favorable prior year reserve development on motor business, predominantly related to non-proportional business in accident years 2011 and prior, driven by better than expected loss emergence. |\\n\\n| • | $25 million of net favorable prior year reserve development on professional lines business, primarily related to the 2009 through 2010 accident years, for reasons discussed in the overview. |\\n\\n\\n| • | $19 million of net favorable prior year reserve development on credit and surety business, spanning multiple accident years and driven by better than expected loss emergence, as well as additional information obtained about a specific claim. |\\n\\nAcquisition Cost Ratio: The increase in the acquisition cost ratio in the three and nine months ended September 30, 2016 to 20.3% and 20.1%, respectively, compared to 19.9% and 19.4% in the three and nine months ended September 30, 2015, respectively, was driven by increases in our reinsurance segment. The reinsurance segment's increase in the three months ended September 30, 2016 compared to the same period in 2015 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The reinsurance segment's increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\\n56\\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio in the three and nine months ended September 30, 2016, decreased to 15.3% and 15.8%, respectively, compared to 15.7% and 16.5% in the three and nine months ended September 30, 2015, respectively. The decrease in the expense ratio in the three months ended September 30, 2016 compared to the same period in 2015 was primarily attributable to growth in net premiums earned, reorganization related expenses adverse to 2015 and increased fees from strategic capital partners, partially offset by the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016. The decrease in the expense ratio in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by growth in net earned premiums, increased fees from strategic capital partners, decreased personnel costs and expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015, partially offset by adjustments to senior leadership executive stock-compensation awards benefiting 2015 and senior executive transition costs in 2016.\\nRESULTS BY SEGMENT\\nINSURANCE SEGMENT\\nResults from our insurance segment were as follows:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Revenues: |\\n| Gross premiums written | $ | 675,430 | 11% | $ | 606,704 | $ | 2,112,796 | 7% | $ | 1,970,554 |\\n| Net premiums written | 433,131 | 14% | 381,118 | 1,433,058 | 6% | 1,352,122 |\\n| Net premiums earned | 444,691 | —% | 444,550 | 1,322,649 | (2%) | 1,344,339 |\\n| Other insurance related income (loss) | 39 | (93%) | 542 | (57 | ) | nm | 811 |\\n| Expenses: |\\n| Current year net losses and loss expenses | (293,914 | ) | (285,716 | ) | (896,952 | ) | (887,805 | ) |\\n| Prior year reserve development | 20,688 | 2,444 | 43,181 | 21,225 |\\n| Acquisition costs | (61,755 | ) | (69,118 | ) | (184,982 | ) | (200,493 | ) |\\n| General and administrative expenses | (84,588 | ) | (85,814 | ) | (252,652 | ) | (261,924 | ) |\\n| Underwriting income | $ | 25,161 | 265% | $ | 6,888 | $ | 31,187 | 93% | $ | 16,153 |\\n| Ratios: | % PointChange | % PointChange |\\n| Current year loss ratio | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\\n| Acquisition cost ratio | 13.9 | % | (1.6) | 15.5 | % | 14.0 | % | (0.9) | 14.9 | % |\\n| General and administrative expense ratio | 19.1 | % | (0.3) | 19.4 | % | 19.0 | % | (0.5) | 19.5 | % |\\n| Combined ratio | 94.4 | % | (4.2) | 98.6 | % | 97.6 | % | (1.3) | 98.9 | % |\\n\\nnm – not meaningful\\n57\\nGross Premiums Written:\\nThe following table provides gross premiums written by line of business:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\\n| Property | $ | 164,605 | 25 | % | $ | 139,488 | 24 | % | 18% | $ | 522,380 | 24 | % | $ | 465,929 | 24 | % | 12% |\\n| Marine | 33,677 | 5 | % | 38,817 | 6 | % | (13%) | 191,298 | 9 | % | 215,885 | 11 | % | (11%) |\\n| Terrorism | 9,394 | 1 | % | 11,192 | 2 | % | (16%) | 28,090 | 1 | % | 25,737 | 1 | % | 9% |\\n| Aviation | 9,684 | 1 | % | 10,222 | 2 | % | (5%) | 37,111 | 2 | % | 29,755 | 2 | % | 25% |\\n| Credit and Political Risk | 5,423 | 1 | % | 8,542 | 1 | % | (37%) | 34,299 | 2 | % | 29,640 | 2 | % | 16% |\\n| Professional Lines | 204,926 | 30 | % | 196,218 | 32 | % | 4% | 590,417 | 28 | % | 598,370 | 30 | % | (1%) |\\n| Liability | 108,447 | 16 | % | 104,666 | 17 | % | 4% | 310,797 | 15 | % | 300,204 | 15 | % | 4% |\\n| Accident and Health | 139,274 | 21 | % | 97,559 | 16 | % | 43% | 398,404 | 19 | % | 305,034 | 15 | % | 31% |\\n| Total | $ | 675,430 | 100 | % | $ | 606,704 | 100 | % | 11% | $ | 2,112,796 | 100 | % | $ | 1,970,554 | 100 | % | 7% |\\n\\nGross premiums written in the three months ended September 30, 2016, increased by $69 million or 11% (12% on a constant currency basis) compared to the three months ended September 30, 2015. The increase was primarily attributable to growth in our accident and health and property lines related to new business opportunities.\\nGross premiums written in the nine months ended September 30, 2016 increased by $142 million or 7% (8% on a constant currency basis) compared to the nine months ended September 30, 2015. The increase was primarily attributable to increases in our accident and health and property lines driven by new business. These increases were partially offset by a decrease in our marine and professional lines. Our marine lines decreased primarily due to reduced new business opportunities, lower rates and timing differences. The professional lines' decrease was due to the impact of our exit from retail insurance operations in Australia, as mentioned above in the quarterly results.\\nPremiums Ceded: In the three and nine months ended September 30, 2016, premiums ceded were $242 million, or 36% of gross premiums written and $680 million, or 32% of gross premiums written, respectively, compared to $226 million, or 37% of gross premiums written and $618 million or 31% of gross premiums written, in the three and nine months ended September 30, 2015, respectively. The decrease in the ceded ratio for the three months ended September 30, 2016 compared to the same period in 2015 was primarily driven by changes in our accident and health line, partially offset by increased premiums ceded in our liability and professional lines. The increase in the ceded ratio for the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by increased ceded premiums in our professional lines, partially offset by changes in our accident and health line.\\n58\\nNet Premiums Earned:\\nThe following table provides net premiums earned by line of business:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\\n| Property | $ | 106,578 | 25 | % | $ | 112,017 | 27 | % | (5%) | $ | 312,804 | 23 | % | $ | 324,720 | 24 | % | (4%) |\\n| Marine | 36,218 | 8 | % | 36,837 | 8 | % | (2%) | 113,693 | 9 | % | 143,878 | 11 | % | (21%) |\\n| Terrorism | 8,276 | 2 | % | 7,985 | 2 | % | 4% | 26,011 | 2 | % | 26,565 | 2 | % | (2%) |\\n| Aviation | 9,015 | 2 | % | 9,982 | 2 | % | (10%) | 33,528 | 3 | % | 32,097 | 2 | % | 4% |\\n| Credit and Political Risk | 12,274 | 3 | % | 14,671 | 3 | % | (16%) | 42,661 | 3 | % | 45,993 | 3 | % | (7%) |\\n| Professional Lines | 126,574 | 28 | % | 148,110 | 33 | % | (15%) | 386,241 | 29 | % | 451,944 | 34 | % | (15%) |\\n| Liability | 42,205 | 9 | % | 41,817 | 9 | % | 1% | 126,429 | 10 | % | 120,181 | 9 | % | 5% |\\n| Accident and Health | 103,551 | 23 | % | 73,131 | 16 | % | 42% | 281,282 | 21 | % | 198,961 | 15 | % | 41% |\\n| Total | $ | 444,691 | 100 | % | $ | 444,550 | 100 | % | —% | $ | 1,322,649 | 100 | % | $ | 1,344,339 | 100 | % | (2%) |\\n\\nNet premiums earned in the three months ended September 30, 2016, were comparable (up 2% on a constant currency basis) to the three months ended September 30, 2015, driven by growth in premiums written in recent periods, primarily in our accident and health lines, offset by an increase in our professional lines' ceded reinsurance programs. Net premiums earned in the nine months ended September 30, 2015 decreased by $22 million or 2% (comparable on a constant currency basis) compared to the nine months ended September 30, 2015. The decrease in net premiums earned in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily driven by an increase in our professional lines' ceded reinsurance programs, a reduction in business written in our marine lines and the impact of our exit from retail insurance operations in Australia partially offset by growth in our accident and health lines.\\nLoss Ratio:\\nThe table below shows the components of our loss ratio:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\\n| Current accident year | 66.1 | % | 1.8 | 64.3 | % | 67.8 | % | 1.8 | 66.0 | % |\\n| Prior year reserve development | (4.7 | %) | (4.1) | (0.6 | %) | (3.2 | %) | (1.7) | (1.5 | %) |\\n| Loss ratio | 61.4 | % | (2.3) | 63.7 | % | 64.6 | % | 0.1 | 64.5 | % |\\n\\n59\\nCurrent Accident Year Loss Ratio:\\nThe current accident year loss ratios increased to 66.1% and 67.8% in the three and nine months ended September 30, 2016, respectively, from 64.3% and 66.0% in the three and nine months ended September 30, 2015, respectively.\\nDuring the three and nine months ended September 30, 2016, we incurred $15 million, or 3.3 points, and $73 million, or 5.5 points, respectively, in pre-tax catastrophe and weather-related losses related to the U.S. weather events, Japanese earthquake and Fort McMurray wildfires. Comparatively, during the three and nine months ended September 30, 2015 we incurred $19 million, or 4.3 points, and $45 million, or 3.4 points, respectively.\\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.8% and 62.3%, respectively, compared to 60.0% and 62.7% in the three and nine months ended September 30, 2015, respectively. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was driven by the adverse impact of rate and trend on most lines of business and changes in business mix, partially offset by a decrease in the mid-size loss experience particularly in our marine and property lines.\\nRefer to the ‘Prior Year Reserve Development’ section for further details.\\nAcquisition Cost Ratio: The decrease in the acquisition cost ratio in the three and nine months ended September 30, 2016 compared to the three and nine months ended September 30, 2015, was driven by an increase in ceding commissions following the expansion of our professional lines' ceded reinsurance programs and a lower acquisition cost ratio in our accident and health line resulting from a change in business mix.\\nGeneral and Administrative Expense Ratio: The decrease in the general and administrative expense ratio in the nine months ended September 30, 2016 compared nine months ended September 30, 2015 primarily reflected a decrease in personnel expenses and a reduction in the allocation of certain corporate expenses.\\n60\\nREINSURANCE SEGMENT\\nResults from our reinsurance segment were as follows:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Revenues: |\\n| Gross premiums written | $ | 284,532 | (14%) | $ | 329,879 | $ | 2,126,762 | 16% | $ | 1,833,374 |\\n| Net premiums written | 162,300 | (45%) | 296,099 | 1,855,529 | 7% | 1,727,185 |\\n| Net premiums earned | 489,724 | 3% | 474,791 | 1,461,097 | 3% | 1,420,266 |\\n| Other insurance related income | 5,905 | nm | 616 | 4,907 | (57%) | 11,508 |\\n| Expenses: |\\n| Current year net losses and loss expenses | (314,433 | ) | (319,796 | ) | (990,763 | ) | (930,867 | ) |\\n| Prior year reserve development | 55,331 | 42,681 | 180,950 | 144,579 |\\n| Acquisition costs | (128,055 | ) | (113,626 | ) | (374,588 | ) | (337,056 | ) |\\n| General and administrative expenses | (29,635 | ) | (35,309 | ) | (99,980 | ) | (110,701 | ) |\\n| Underwriting income | $ | 78,837 | 60% | $ | 49,357 | $ | 181,623 | (8%) | $ | 197,729 |\\n| Ratios: | % PointChange | % PointChange |\\n| Current year loss ratio | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\\n| Acquisition cost ratio | 26.1 | % | 2.2 | 23.9 | % | 25.6 | % | 1.9 | 23.7 | % |\\n| General and administrative expense ratio | 6.1 | % | (1.3) | 7.4 | % | 6.9 | % | (0.9) | 7.8 | % |\\n| Combined ratio | 85.1 | % | (4.6) | 89.7 | % | 87.9 | % | 1.0 | 86.9 | % |\\n\\nnm – not meaningful\\nGross Premiums Written:\\nThe following table provides gross premiums written by line of business for the periods indicated:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\\n| Catastrophe | $ | 46,338 | 16 | % | $ | 56,693 | 18 | % | (18%) | $ | 316,692 | 15 | % | $ | 283,562 | 15 | % | 12% |\\n| Property | 61,957 | 22 | % | 67,539 | 20 | % | (8%) | 283,555 | 13 | % | 307,809 | 17 | % | (8%) |\\n| Professional Lines | 19,479 | 7 | % | 45,509 | 14 | % | (57%) | 235,094 | 11 | % | 204,685 | 11 | % | 15% |\\n| Credit and Surety | 36,174 | 13 | % | 23,390 | 7 | % | 55% | 315,102 | 15 | % | 230,958 | 13 | % | 36% |\\n| Motor | 13,344 | 5 | % | 21,359 | 6 | % | (38%) | 338,403 | 16 | % | 333,245 | 18 | % | 2% |\\n| Liability | 91,387 | 32 | % | 111,361 | 34 | % | (18%) | 365,380 | 17 | % | 258,862 | 14 | % | 41% |\\n| Agriculture | 1,286 | — | % | (3,303 | ) | (1 | %) | nm | 151,315 | 7 | % | 139,135 | 8 | % | 9% |\\n| Engineering | 13,588 | 5 | % | 4,397 | 1 | % | 209% | 56,719 | 3 | % | 58,163 | 3 | % | (2%) |\\n| Marine and Other | 979 | — | % | 2,934 | 1 | % | (67%) | 64,502 | 3 | % | 16,955 | 1 | % | 280% |\\n| Total | $ | 284,532 | 100 | % | $ | 329,879 | 100 | % | (14%) | $ | 2,126,762 | 100 | % | $ | 1,833,374 | 100 | % | 16% |\\n\\nGross premiums written decreased by $45 million and increased by $293 million in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\\n61\\nThe decrease in gross premiums written in the three months ended September 30, 2016 compared to the same period in 2015, was primarily driven by our professional and liability lines, largely due to timing differences.\\nThe increase in gross premiums written in the nine months ended September 30, 2016 compared to the same period in 2015, was impacted by treaties written on a multi-year basis. In the nine months ended September 30, 2016, the reinsurance segment reported an increase in the level of multi-year contracts written compared to the same period in 2015. This increase in multi-year contracts increased the amount of premium recorded in the current periods relating to future years compared to the same periods in 2015, most notably in the credit & surety and liability lines. On a comparative basis the impact of the multi-year premiums resulted in an increase in gross premiums written of $141 million in the nine months ended September 30, 2016, compared to the same period in 2015. The increase in written premiums was partially offset by the impact of foreign exchange movements in the nine months ended September 30, 2016, compared to the same period in 2015, as the strength of the U.S. dollar drove comparative premium decreases in the treaties denominated in foreign currencies. Foreign exchange movements resulted in a relative decrease of $52 million in gross premiums written in the nine months ended September 30, 2016, compared to the same period in 2015.\\nAfter adjusting for the impact of multi-year contracts and on a constant currency basis, our gross premiums written increased by $204 million, or 11% in the nine months ended September 30, 2016, compared to the same period in 2015. The growth was driven by increases in our liability, marine and other, catastrophe, professional as well as our credit and surety lines primarily driven by new business. Favorable treaty restructurings and timing differences also contributed to the increases in liability and professional lines. These increases were partially offset by a decrease in our property lines, primarily relating to non-renewals and decreases in line sizes on several treaties.\\nPremiums Ceded: In the three and nine months ended September 30, 2016, the ratio of ceded premium to gross written premium increased to 43% and 13%, respectively, from 10% and 6% in the three and nine months ended September 30, 2015, respectively. The increase for the three months ended September 30, 2016 compared to the prior period, was due to the impact of a new retrocessional cover entered into with Harrington Re which increased premiums ceded in our liability and professional lines. The increase for the nine months ended September 30, 2016 compared to the prior period was largely due to the new retrocessions to Harrington Re and increased premiums ceded in our catastrophe and property business.\\nNet Premiums Earned:\\nThe following table provides net premiums earned by line of business:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | % Change | 2016 | 2015 | % Change |\\n| Catastrophe | $ | 48,799 | 10 | % | $ | 51,116 | 11 | % | (5%) | $ | 151,416 | 12 | % | $ | 165,840 | 12 | % | (9%) |\\n| Property | 71,649 | 15 | % | 78,343 | 17 | % | (9%) | 208,179 | 14 | % | 235,828 | 17 | % | (12%) |\\n| Professional Lines | 73,109 | 15 | % | 81,986 | 17 | % | (11%) | 225,813 | 15 | % | 231,024 | 16 | % | (2%) |\\n| Credit and Surety | 67,430 | 14 | % | 59,601 | 13 | % | 13% | 192,135 | 13 | % | 182,508 | 13 | % | 5% |\\n| Motor | 77,786 | 16 | % | 72,893 | 15 | % | 7% | 232,383 | 16 | % | 228,433 | 16 | % | 2% |\\n| Liability | 80,137 | 16 | % | 77,441 | 16 | % | 3% | 247,103 | 17 | % | 218,829 | 15 | % | 13% |\\n| Agriculture | 36,704 | 7 | % | 33,684 | 7 | % | 9% | 106,251 | 7 | % | 101,335 | 7 | % | 5% |\\n| Engineering | 18,573 | 4 | % | 15,128 | 3 | % | 23% | 51,024 | 3 | % | 43,133 | 3 | % | 18% |\\n| Marine and Other | 15,537 | 3 | % | 4,599 | 1 | % | 238% | 46,793 | 3 | % | 13,336 | 1 | % | 251% |\\n| Total | $ | 489,724 | 100 | % | $ | 474,791 | 100 | % | 3% | $ | 1,461,097 | 100 | % | $ | 1,420,266 | 100 | % | 3% |\\n\\nNet premiums earned increased by $15 million or 3% (7% on a constant currency basis) and $41 million or 3% (7% on a constant currency basis) in the three and nine months ended September 30, 2016, compared to the same periods in 2015, respectively.\\nThe increase for both periods was primarily driven by the growth in the business written in our liability, marine and other as well as our catastrophe lines in recent periods together with a favorable premium adjustments impacting our credit and surety lines. The growth for both periods was partially offset by increased premiums ceded in our catastrophe and property lines, as well as the impact on our liability and professional lines of the new retrocession to Harrington Re.\\n62\\nOther Insurance Related Income (Losses):\\nThe increase in other insurance related income of $5 million in the three months ended September 30, 2016, compared to the same period in 2015, reflected fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices. The decrease in other insurance related income of $7 million in the nine months ended September 30, 2016, compared to the same period in 2015, reflected the impact of the realized gains on our weather and commodities derivative portfolio in the nine months ended September 30, 2015 compared to an immaterial impact in the nine months ended September 30, 2016, partially offset by fees from strategic capital partners and favorable fair value adjustments to economic hedges purchased to protect our agriculture line of business against fluctuations in commodity prices.\\nLoss Ratio:\\nThe table below shows the components of our loss ratio:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % PointChange | 2015 | 2016 | % PointChange | 2015 |\\n| Current accident year | 64.2 | % | (3.2) | 67.4 | % | 67.8 | % | 2.3 | 65.5 | % |\\n| Prior year reserve development | (11.3 | %) | (2.3) | (9.0 | %) | (12.4 | %) | (2.3) | (10.1 | %) |\\n| Loss ratio | 52.9 | % | (5.5) | 58.4 | % | 55.4 | % | — | 55.4 | % |\\n\\nCurrent Accident Year Loss Ratio:\\nThe current accident year loss ratio decreased to 64.2% in the three months ended September 30, 2016 from 67.4% in the same period in 2015, while the current accident year loss ratio increased to 67.8% in the nine months ended September 30, 2016 from 65.5% in the same period in 2015.\\nThe decrease for the three months ended September 30, 2016 compared to the same period in 2015 was impacted by a lower level of catastrophe and weather-related losses and the increase for the nine months ended September 30, 2016 compared to the same period in 2015 was impacted by an increased level of catastrophe and weather-related losses. During the three and nine months ended September 30, 2016, we incurred $7 million, or 1.5 points, and $72 million, or 5.0 points, respectively, in pre-tax catastrophe and weather-related losses, net of reinstatement premiums, attributable to the weather-related events, Fort McMurray wildfires, the Japanese and Ecuadorian earthquakes, North Calgary hailstorm and European floods. Comparatively, during the three and nine months ended September 30, 2015 we incurred $24 million, or 5.1 points, and $45 million, or 3.2 points, respectively.\\nAfter adjusting for the impact of the catastrophe and weather-related losses, our current accident year loss ratios in the three and nine months ended September 30, 2016, were 62.7% and 62.8%, respectively, compared to 62.3% in both the three and nine months ended September 30, 2015. The increases in the current accident year loss ratios after adjusting for the impact of the catastrophe and weather-related losses for the three and nine months ended September 30, 2016 compared to the same periods in 2015 was mainly due to the ongoing adverse impact of rate and trend, partially offset by the recognition of better than expected recent attritional loss experience across our long tail lines of business.\\nRefer ‘Prior Year Reserve Development’ for further details.\\nAcquisition Cost Ratio: The acquisition cost ratio increased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The increase in the three months ended September 30, 2016 was primarily due to the impact of retrocessional contracts, an increase in the amount of business being written on a proportional basis together with higher acquisition costs in certain lines of business and fees from strategic capital partners which were a benefit in 2015. The increase in the nine months ended September 30, 2016 compared to the same period in 2015 was primarily due to an increase in the amount of business being written on a proportional basis, higher acquisition costs in certain lines of business and the impact of retrocessional contracts.\\n63\\nGeneral and Administrative Expense Ratio: The general and administrative expense ratio decreased in both the three and nine months ended September 30, 2016 compared to the same periods in 2015. The decrease in the general and administrative expense ratio primarily reflects lower personnel expense, benefits of arrangements with our strategic capital partners and the impact of increased net earned premiums.\\nOTHER EXPENSES (REVENUES), NET\\nThe following table provides a breakdown of our other expenses (revenues), net:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Corporate expenses | $ | 28,683 | 22% | $ | 23,604 | $ | 86,922 | 4% | $ | 83,826 |\\n| Foreign exchange gains | (13,795 | ) | (51%) | (28,088 | ) | (69,781 | ) | 1% | (69,200 | ) |\\n| Interest expense and financing costs | 12,839 | (1%) | 12,918 | 38,586 | 1% | 38,114 |\\n| Income tax expense | 9,352 | nm | 30 | 7,712 | nm | 1,155 |\\n| Total | $ | 37,079 | nm | $ | 8,464 | $ | 63,439 | 18% | $ | 53,895 |\\n\\nnm – not meaningful\\nCorporate Expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned, corporate expenses were 3.1% for the three and nine months ended September 30, 2016, compared to 2.6% and 3.0%, respectively, for the same periods of 2015. The increase in corporate expenses in the three month period ended September 30, 2016 is primarily attributable to the net reimbursement of PartnerRe merger-related expenses benefiting 2015 and senior executive transition costs in 2016, partially offset by reorganization related expenses adverse to 2015. The slight increase in corporate expenses in the nine month period ended September 30, 2016 is attributable to adjustments to senior leadership executive stock-compensation awards benefiting 2015, senior executive transition costs in 2016 and an increase in personnel costs in 2016, partially offset by expenses attributable to the proposed merger with PartnerRe and reorganization related expenses adverse to 2015.\\nForeign Exchange Gains: Some of our business is written in currencies other than the U.S. dollar. The foreign exchange gains for the periods presented were largely driven by the re-measurement of our net insurance related liabilities. The foreign exchange gains for the three and nine months ended September 30, 2016 were primarily driven by the depreciation of pound sterling against the U.S dollar. Comparatively, the foreign exchange gains for the three months ended September 30, 2015 were primarily driven by depreciation of the pound sterling and the Australian dollar against the U.S. dollar. The foreign exchange gains for the nine months ended September 30, 2015 were primarily driven by the depreciation of the euro, pound sterling and Australian dollar.\\nIncome Tax Expense: Income tax expense primarily results from income generated by our foreign operations in the United States and Europe. Our effective tax rate, which is calculated as income tax expense divided by net income before tax including interest in loss of equity method investments, was 4.8% and 2.1% in the three and nine months ended September 30, 2016, and was insignificant and 0.2% in the three and nine months ended September 30, 2015. This effective rate can vary between periods depending on the distribution of net income amongst tax jurisdictions, as well as other factors. The primary driver of the current quarter and year-to-date increase is the generation of consolidated pre-tax net income in our operations in Europe compared to a net loss in each of these periods in 2015.\\n64\\nNET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS (LOSSES)\\nNet Investment Income\\nThe following table provides a breakdown of income earned from our cash and investment portfolio by major asset class:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | % Change | 2015 | 2016 | % Change | 2015 |\\n| Fixed maturities | $ | 75,827 | —% | $ | 75,980 | $ | 229,423 | 4% | $ | 220,066 |\\n| Other investments | 38,248 | nm | (27,421 | ) | 25,770 | 46% | 17,616 |\\n| Equity securities | 4,633 | 34% | 3,445 | 12,843 | 65% | 7,795 |\\n| Mortgage loans | 2,191 | nm | 482 | 5,683 | nm | 776 |\\n| Cash and cash equivalents | 3,768 | nm | 993 | 7,071 | 88% | 3,770 |\\n| Short-term investments | 337 | nm | 83 | 708 | 156% | 277 |\\n| Gross investment income | 125,004 | 133% | 53,562 | 281,498 | 12% | 250,300 |\\n| Investment expense | (8,081 | ) | 3% | (7,877 | ) | (23,680 | ) | (1%) | (23,964 | ) |\\n| Net investment income | $ | 116,923 | 156% | $ | 45,685 | $ | 257,818 | 14% | $ | 226,336 |\\n| Pre-tax yield:(1) |\\n| Fixed maturities | 2.7% | 2.5% | 2.6% | 2.4% |\\n\\nnm - not meaningful\\n| (1) | Pre-tax yield is annualized and calculated as net investment income divided by the average month-end amortized cost balances for the periods indicated. |\\n\\nFixed Maturities\\nThe net investment income increase for the nine months ended September 30, 2016 attributable to fixed maturities was due to an emphasis on longer duration assets and an improvement in CPI adjustments following a reduction in our exposure to treasury inflation-protected securities.\\nOther Investments\\nThe following table provides a breakdown of total net investment income from other investments:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Hedge, direct lending, private equity and real estate funds | $ | 29,459 | $ | (23,483 | ) | $ | 6,127 | $ | 10,357 |\\n| Other privately held investments | 370 | — | 177 | — |\\n| CLO - Equities | 8,419 | (3,938 | ) | 19,466 | 7,259 |\\n| Total net investment income from other investments | $ | 38,248 | $ | (27,421 | ) | $ | 25,770 | $ | 17,616 |\\n| Pre-tax return on other investments(1) | 4.5 | % | (3.3 | %) | 3.1 | % | 2.0 | % |\\n\\n| (1) | The pre-tax return on other investments is non-annualized and calculated by dividing total net investment income from other investments by the average month-end fair value balances held for the periods indicated. |\\n\\nThe total net investment income from other investments increased for the three and nine months ended September 30, 2016 compared to the same periods in 2015 due to an improvement in the performance of the global equity markets which translated into higher valuations on our hedge funds. CLO - Equities also benefited from an increase in the valuation of the underlying collateral balances.\\n65\\nNet Realized Investment Gains (Losses)\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| On sale of investments: |\\n| Fixed maturities and short-term investments | $ | 4,303 | $ | (42,741 | ) | $ | (22,869 | ) | $ | (66,579 | ) |\\n| Equity securities | 4,994 | (1,327 | ) | 2,881 | (1,505 | ) |\\n| 9,297 | (44,068 | ) | (19,988 | ) | (68,084 | ) |\\n| OTTI charges recognized in earnings | (4,247 | ) | (32,301 | ) | (20,346 | ) | (62,762 | ) |\\n| Change in fair value of investment derivatives | 155 | 6,412 | 39 | 7,228 |\\n| Net realized investment gains (losses) | $ | 5,205 | $ | (69,957 | ) | $ | (40,295 | ) | $ | (123,618 | ) |\\n\\nOn sale of investments\\nGenerally, sales of individual securities occur when there are changes in the relative value, credit quality or duration of a particular issue. We may also sell to rebalance our investment portfolio in order to change exposure to particular asset classes or sectors. Net realized investment gains in the three months ended September 30, 2016 are reflective of the improvement in pricing of our fixed maturities and equities. Net realized investment losses in the nine months ended September 30, 2016 are primarily due to foreign exchange losses on non-U.S. denominated securities, as a result of the strengthening of the U.S. dollar.\\nOTTI charges\\nFor the three months ended September 30, 2016, OTTI charges were driven by impairments on corporate debt securities and losses on non-U.S. denominated securities as a result of the decline in foreign exchange rates against the U.S. dollar. The nine months ended September 30, 2016 also included impairments on high yield corporate debt securities which are exposed to the energy sector and exchange-traded funds (ETFs) which are unlikely to recover in the near term.\\nChange in fair value of investment derivatives\\nFrom time to time, we may economically hedge the foreign exchange exposure of non-U.S. denominated securities by entering into foreign exchange forward contracts.\\n66\\nTotal Return\\nThe following table provides a breakdown of the total return on cash and investments for the period indicated:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Net investment income | $ | 116,923 | $ | 45,685 | $ | 257,818 | $ | 226,336 |\\n| Net realized investments gains (losses) | 5,205 | (69,957 | ) | (40,295 | ) | (123,618 | ) |\\n| Change in net unrealized gains (losses) | 35,075 | (26,441 | ) | 303,573 | (52,965 | ) |\\n| Interest in loss of equity method investments | (2,434 | ) | — | (2,434 | ) | — |\\n| Total | $ | 154,769 | $ | (50,713 | ) | $ | 518,662 | $ | 49,753 |\\n| Average cash and investments(1) | $ | 14,470,231 | $ | 14,893,376 | $ | 14,457,978 | $ | 14,919,752 |\\n| Total return on average cash and investments, pre-tax: |\\n| Inclusive of investment related foreign exchange movements | 1.1 | % | (0.3 | %) | 3.6 | % | 0.3 | % |\\n| Exclusive of investment related foreign exchange movements | 1.1 | % | (0.1 | %) | 3.9 | % | 0.9 | % |\\n\\n| (1) | The average cash and investments balance is calculated by taking the average of the month-end fair value balances held for the periods indicated. |\\n\\nCASH AND INVESTMENTS\\nThe table below provides a breakdown of our cash and investments:\\n| September 30, 2016 | December 31, 2015 |\\n| Fair Value | Fair Value |\\n| Fixed maturities | $ | 11,566,860 | $ | 11,719,749 |\\n| Equities | 644,344 | 597,998 |\\n| Mortgage loans | 332,753 | 206,277 |\\n| Other investments | 847,262 | 816,756 |\\n| Equity method investments | 111,295 | 10,932 |\\n| Short-term investments | 39,877 | 34,406 |\\n| Total investments | $ | 13,542,391 | $ | 13,386,118 |\\n| Cash and cash equivalents(1) | $ | 1,077,263 | $ | 1,174,751 |\\n\\n| (1) | Includes restricted cash and cash equivalents of $229 million and $187 million at September 30, 2016 and at December 31, 2015, respectively. |\\n\\nThe $156m increase in the fair value of our total investments was driven by the downward shift in sovereign yield curves and the tightening of credit spreads on both investment grade and high-yield corporate debt. This was partially offset by the funding of financing and operating activities.\\n67\\nThe following provides a further analysis on our investment portfolio by asset classes:\\nFixed Maturities\\nThe following provides a breakdown of our investment in fixed maturities:\\n| September 30, 2016 | December 31, 2015 |\\n| Fair Value | % of Total | Fair Value | % of Total |\\n| Fixed maturities: |\\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\\n| Non-U.S. government | 582,056 | 5 | % | 739,005 | 6 | % |\\n| Corporate debt | 4,568,500 | 39 | % | 4,362,769 | 37 | % |\\n| Agency RMBS | 2,522,731 | 22 | % | 2,249,236 | 19 | % |\\n| CMBS | 894,275 | 8 | % | 1,083,298 | 9 | % |\\n| Non-Agency RMBS | 71,830 | — | % | 101,008 | 1 | % |\\n| ABS | 1,235,596 | 11 | % | 1,371,270 | 12 | % |\\n| Municipals(1) | 128,995 | 1 | % | 161,214 | 2 | % |\\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\\n| Credit ratings: |\\n| U.S. government and agency | $ | 1,562,877 | 14 | % | $ | 1,651,949 | 14 | % |\\n| AAA(2) | 4,359,640 | 38 | % | 4,266,673 | 36 | % |\\n| AA | 1,165,958 | 10 | % | 1,273,941 | 11 | % |\\n| A | 1,770,161 | 15 | % | 2,065,192 | 18 | % |\\n| BBB | 1,607,798 | 14 | % | 1,442,938 | 12 | % |\\n| Below BBB(3) | 1,100,426 | 9 | % | 1,019,056 | 9 | % |\\n| Total | $ | 11,566,860 | 100 | % | $ | 11,719,749 | 100 | % |\\n\\n| (1) | Includes bonds issued by states, municipalities, and political subdivisions. |\\n\\n| (2) | Includes U.S. government-sponsored agency RMBS and CMBS. |\\n\\n| (3) | Non-investment grade and non-rated securities. |\\n\\nAt September 30, 2016, our fixed maturities had a weighted average credit rating of AA- (2015: AA-) and an average duration of 3.2 years (2015: 3.3 years). When incorporating short-term investments and cash and cash equivalents into the calculation (bringing the total to $12.5 billion), the average credit rating would be AA- (2015: AA-) and duration would be 2.9 years (2015: 3.0 years).\\nDuring the year, net unrealized investment gains (losses) on fixed maturities moved from a net unrealized investment loss of $178 million at December 31, 2015 to a net unrealized gain of $104 million at September 30, 2016.\\nEquities\\nNet unrealized investment gains on equities increased from $22 million at December 31, 2015 to $44 million at September 30, 2016, an increase of $22 million due to an improvement in valuations reflective of performance of the global equity markets.\\nMortgage Loans\\nDuring the year, we increased our investment in commercial mortgage loans from $206 million to $333 million, an increase of $127m. The commercial mortgage loans are high quality and collateralized by a variety of commercial properties and are diversified both geographically throughout the United States and by property type to reduce the risk of concentration.\\n68\\nOther Investments\\nThe composition of our other investments portfolio is summarized as follows:\\n| September 30, 2016 | December 31, 2015 |\\n| Hedge funds |\\n| Long/short equity funds | $ | 139,460 | 16 | % | $ | 154,348 | 19 | % |\\n| Multi-strategy funds | 281,153 | 33 | % | 355,073 | 43 | % |\\n| Event-driven funds | 94,012 | 11 | % | 147,287 | 18 | % |\\n| Leveraged bank loan funds | — | — | % | 65 | — | % |\\n| Total hedge funds | 514,625 | 60 | % | 656,773 | 80 | % |\\n| Direct lending funds | 125,002 | 15 | % | 90,120 | 11 | % |\\n| Private equity funds | 89,170 | 11 | % | — | — | % |\\n| Real estate funds | 11,782 | 1 | % | 4,929 | 1 | % |\\n| Total hedge, direct lending and real estate funds | 740,579 | 87 | % | 751,822 | 92 | % |\\n| Other privately held investments | 42,900 | 5 | % | — | — | % |\\n| CLO - Equities | 63,783 | 8 | % | 64,934 | 8 | % |\\n| Total other investments | $ | 847,262 | 100 | % | $ | 816,756 | 100 | % |\\n\\nThe $142 million decrease in the fair value of our total hedge funds in 2016 was driven by $138 million of net redemptions and $4 million of price depreciation.\\nWe have made total commitments of $310 million to managers of direct lending funds, of which $121 million of our total commitment has been called to date.\\nWe have also made a total commitment of $60 million as a limited partner in a multi-strategy hedge fund, of which $48 million has been called to date.\\nWe have made a total commitment of $100 million to a real estate fund, of which $10 million has been called to date.\\nDuring 2016, we made a total commitment of $135 million to a private equity fund, of which $95 million has been called to date.\\nEquity Method Investments\\nDuring 2016, we paid $104 million including direct transactions costs to acquire 18% of the common equity of Harrington, the parent company of Harrington Re, an independent reinsurance company jointly sponsored by AXIS Capital and Blackstone. Harrington is not a variable interest entity and given that we exercise significant influence over this investee we account for our ownership in Harrington under the equity method of accounting.\\nThe Company also has investments in other equity method investments with a carrying value of $9 million.\\n69\\nLIQUIDITY AND CAPITAL RESOURCES\\nRefer to the ‘Liquidity and Capital Resources’ section included under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015 for a general discussion of our liquidity and capital resources.\\nThe following table summarizes our consolidated capital as at:\\n| September 30, 2016 | December 31, 2015 |\\n| Senior notes | $ | 992,633 | $ | 991,825 |\\n| Preferred shares | 625,000 | 627,843 |\\n| Common equity | 5,400,658 | 5,239,039 |\\n| Shareholders’ equity | 6,025,658 | 5,866,882 |\\n| Total capital | $ | 7,018,291 | $ | 6,858,707 |\\n| Ratio of debt to total capital | 14.1 | % | 14.5 | % |\\n| Ratio of debt and preferred equity to total capital | 23.0 | % | 23.6 | % |\\n\\nWe finance our operations with a combination of debt and equity capital. Our debt to total capital and debt and preferred equity to total capital ratios provide an indication of our capital structure, along with some insight into our financial strength. A company with higher ratios in comparison to industry average may show weak financial strength because the cost of its debts may adversely affect results of operations and/or increase its default risk. We believe that our financial flexibility remains strong.\\nPreferred Shares\\nOn January 27, 2016 we redeemed the remaining 28,430 Series B preferred shares, for an aggregate liquidation preference of\\n$3 million.\\n70\\nCommon Equity\\n| Nine months ended September 30, | 2016 |\\n| Common equity - opening | $ | 5,239,039 |\\n| Net income | 364,460 |\\n| Shares repurchased for treasury | (449,086 | ) |\\n| Change in unrealized appreciation on available for sale investments, net of tax | 281,276 |\\n| Settlement of accelerated share repurchase | 60,000 |\\n| Common share dividends | (98,334 | ) |\\n| Preferred share dividends | (29,906 | ) |\\n| Share-based compensation expense recognized in equity | 26,129 |\\n| Foreign currency translation adjustment | 5,694 |\\n| Cost of treasury shares reissued | 1,386 |\\n| Common equity - closing | $ | 5,400,658 |\\n\\nDuring the nine months ended September 30, 2016, we repurchased 8.5 million common shares, including 7.1 million of common shares repurchased for a total of $389 million (including $375 million pursuant to our Board-authorized share repurchase program and $14 million relating to shares purchased in connection with the vesting of restricted stock awards granted under our 2007 Long-Term Equity Compensation Plan), and 1.4 million common shares acquired under the ASR which terminated on January 15, 2016. At October 27, 2016, the remaining authorization under the common share repurchase program approved by our Board of Directors was $375 million (refer to Part II, Item 2 'Unregistered Sales of Equity Securities and Use of Proceeds' for additional information).\\nWe continue to expect that cash flows generated from our operations, combined with the liquidity provided by our investment portfolio, will be sufficient to cover our required cash outflows and other contractual commitments through the foreseeable future.\\n71\\nCRITICAL ACCOUNTING ESTIMATES\\nOur Consolidated Financial Statements include certain amounts that are inherently uncertain and judgmental in nature. As a result, we are required to make assumptions and best estimates in order to determine the reported values. We consider an accounting estimate to be critical if: (1) it requires that significant assumptions be made in order to deal with uncertainties and (2) changes in the estimate could have a material impact on our results of operations, financial condition or liquidity.\\nAs disclosed in our 2015 Annual Report on Form 10-K, we believe that the material items requiring such subjective and complex estimates are our:\\n| • | reserves for losses and loss expenses; |\\n\\n| • | reinsurance recoverable balances; |\\n\\n| • | premiums; |\\n\\n| • | fair value measurements for our financial assets and liabilities; and |\\n\\n| • | assessments of other-than-temporary impairments. |\\n\\nWe believe that the critical accounting estimates discussion in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2015, continues to describe the significant estimates and judgments included in the preparation of our Consolidated Financial Statements.\\nNEW ACCOUNTING STANDARDS\\nRefer to Item 1, Note 1 'Basis of Presentation and Accounting policies' to the Consolidated Financial Statements and Item 8, Note 2 'Significant Accounting Policies' to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2015, for a discussion of recently issued accounting pronouncements that we have not yet adopted.\\nOFF-BALANCE SHEET AND SPECIAL PURPOSE ENTITY ARRANGEMENTS\\nAt September 30, 2016, we have not entered into any off-balance sheet arrangements, as defined by Item 303(a)(4) of Regulation S-K.\\nNON-GAAP FINANCIAL MEASURES\\nIn this report, we present operating income, consolidated underwriting income, underwriting-related general and administrative expenses and amounts presented on a constant currency basis, which are “non-GAAP financial measures” as defined in Regulation G.\\nOperating income represents after-tax operational results without consideration of after-tax net realized investment gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses. We also present diluted operating income per common share and operating return on average common equity (“operating ROACE”), which are derived from the non-GAAP operating income measure.\\nConsolidated underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative costs as expenses. Underwriting-related general and administrative expenses include those general and administrative expenses that are incremental and/or directly attributable to our individual underwriting operations. While these measures are presented in Item 1, Note 2 to our Consolidated Financial Statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis.\\nAmounts presented on a constant currency basis are calculated by applying the average foreign exchange rate from the current year to prior year amounts.\\n72\\nOperating income, diluted operating income per common share and operating ROACE can be reconciled to the nearest GAAP financial measures as follows:\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| Net income available to common shareholders | $ | 176,644 | $ | 247,620 | $ | 334,554 | $ | 466,772 |\\n| Net realized investment (gains) losses, net of tax(1) | (2,726 | ) | 67,897 | 42,667 | 119,442 |\\n| Foreign exchange gains, net of tax(2) | (13,229 | ) | (27,410 | ) | (67,771 | ) | (68,456 | ) |\\n| Termination fee received(3) | — | (280,000 | ) | — | (280,000 | ) |\\n| Reorganization and related expenses, net of tax(4) | — | 42,924 | — | 42,924 |\\n| Operating income | $ | 160,689 | $ | 51,031 | $ | 309,450 | $ | 280,682 |\\n| Earnings per common share - diluted | $ | 1.96 | $ | 2.50 | $ | 3.61 | $ | 4.65 |\\n| Net realized investment (gains) losses, net of tax | (0.03 | ) | 0.68 | 0.46 | 1.19 |\\n| Foreign exchange gains, net of tax | (0.15 | ) | (0.28 | ) | (0.73 | ) | (0.69 | ) |\\n| Termination fee received | — | (2.82 | ) | — | (2.79 | ) |\\n| Reorganization and related expenses, net of tax | — | 0.43 | — | 0.43 |\\n| Operating income per common share - diluted | $ | 1.78 | $ | 0.51 | $ | 3.34 | $ | 2.79 |\\n| Weighted average common shares and common share equivalents - diluted(5) | 90,351 | 99,124 | 92,579 | 100,468 |\\n| Average common shareholders’ equity | $ | 5,369,921 | $ | 5,259,619 | $ | 5,319,849 | $ | 5,195,901 |\\n| ROACE (annualized) | 13.2 | % | 18.8 | % | 8.4 | % | 12.0 | % |\\n| Operating ROACE (annualized) | 12.0 | % | 3.9 | % | 7.8 | % | 7.2 | % |\\n\\n| (1) | Tax cost (benefit) of $2,479 and ($2,060) for the three months ended September 30, 2016 and 2015, respectively, and $2,372 and ($4,176) for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the ability to utilize capital losses. |\\n\\n| (2) | Tax cost of $566 and $678 for the three months ended September 30, 2016 and 2015, respectively, and $2,010 and $744 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the tax status of specific foreign exchange transactions. |\\n\\n| (3) | Tax impact is nil. |\\n\\n| (4) | Tax benefit of nil and $2,943 for the three months ended September 30, 2016 and 2015, respectively, and nil and $2,943 for the nine months ended September 30, 2016 and 2015, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, reflecting the jurisdictional apportionment and related tax treatment of the individual components of the reorganization and related expenses. |\\n\\n| (5) | Refer to Item 1, Note 8 to our Consolidated Financial Statements for further details on the dilution calculation. |\\n\\nA reconciliation of consolidated underwriting income to income before income taxes (the nearest GAAP financial measure) can be found in Item 1, Note 2 to the Consolidated Financial Statements. Underwriting-related general and administrative expenses are reconciled to general and administrative expenses (the nearest GAAP financial measure) within 'Underwriting Results - Group'.\\nWe present our results of operations in the way we believe will be most meaningful and useful to investors, analysts, rating agencies and others who use our financial information to evaluate our performance. This includes the presentation of “operating income”, (in total and on a per share basis), “annualized operating ROACE” (which is based on the “operating income” measure) and “consolidated underwriting income”, which incorporates “underwriting-related general and administrative expenses”.\\nOperating Income\\nAlthough the investment of premiums to generate income and realized investment gains (losses) is an integral part of our operations, the determination to realize investment gains (losses) is independent of the underwriting process and is heavily influenced by the availability of market opportunities. Furthermore, many users believe that the timing of the realization of investment gains (losses) is somewhat opportunistic for many companies.\\n73\\nForeign exchange losses (gains) in our Consolidated Statements of Operations are primarily driven by the impact of foreign exchange rate movements on net insurance related-liabilities. However, this movement is only one element of the overall impact of foreign exchange rate fluctuations on our financial position. In addition, we recognize unrealized foreign exchange losses (gains) on our available-for-sale investments in other comprehensive income and foreign exchange losses (gains) realized upon the sale of these investments in net realized investments gains (losses). These unrealized and realized foreign exchange rate movements generally offset a large portion of the foreign exchange losses (gains) reported separately in earnings, thereby minimizing the impact of foreign exchange rate movements on total shareholders' equity. As such, the Statement of Operations foreign exchange losses (gains) in isolation are not a fair representation of the performance of our business.\\nThe termination fee received represents the break-up fee paid by PartnerRe Ltd. following the cancellation of the amalgamation agreement with AXIS Capital and is not indicative of future revenues of the Company.\\nReorganization and related expenses are primarily driven by business decisions, the nature and timing of which is unrelated to the underwriting process and which are not representative of underlying business performance.\\nIn this regard, certain users of our financial statements evaluate earnings excluding after-tax net realized investment gains (losses) and foreign exchange losses (gains) to understand the profitability of recurring sources of income.\\nWe believe that showing net income available to common shareholders exclusive of net realized gains (losses), foreign exchange losses (gains), termination fee received and reorganization and related expenses reflects the underlying fundamentals of our business. In addition, we believe that this presentation enables investors and other users of our financial information to analyze performance in a manner similar to how our management analyzes the underlying business performance. We also believe this measure follows industry practice and, therefore, facilitates comparison of our performance with our peer group. We believe that equity analysts and certain rating agencies that follow us, and the insurance industry as a whole, generally exclude these items from their analyses for the same reasons.\\nConsolidated Underwriting Income/Underwriting-Related General and Administrative Expenses\\nCorporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As these costs are not incremental and/or directly attributable to our individual underwriting operations, we exclude them from underwriting-related general and administrative expenses and, therefore, consolidated underwriting income. Interest expense and financing costs primarily relate to interest payable on our senior notes and are excluded from consolidated underwriting income for the same reason.\\nWe evaluate our underwriting results separately from the performance of our investment portfolio. As such, we believe it appropriate to exclude net investment income and net realized investment gains (losses) from our underwriting profitability measure.\\nAs noted above, foreign exchange losses (gains) in our Consolidated Statements of Operations primarily relate to our net insurance-related liabilities. However, we manage our investment portfolio in such a way that unrealized and realized foreign exchange rate losses (gains) on our investment portfolio generally offset a large portion of the foreign exchange losses (gains) arising from our underwriting portfolio. As a result, we believe that foreign exchange losses (gains) are not a meaningful contributor to our underwriting performance and, therefore, exclude them from consolidated underwriting income.\\nThe termination fee received represents the break-up fee received on the cancellation of the amalgamation agreement between PartnerRe Ltd. and AXIS Capital and should be excluded from consolidated underwriting income since it is not related to underwriting operations.\\nReorganization and related expenses are driven by business decisions, the nature and timing of which are unrelated to the underwriting process and for this reason they are excluded from consolidated underwriting income.\\nWe believe that presentation of underwriting-related general and administrative expenses and consolidated underwriting income provides investors with an enhanced understanding of our results of operations, by highlighting the underlying pre-tax profitability of our underwriting activities.\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nRefer to Item 7A included in our 2015 Form 10-K. With the exception of the changes in exposure to foreign currency risk presented below, there have been no material changes to this item since December 31, 2015.\\nForeign Currency Risk\\nThe table below provides a sensitivity analysis of our total net foreign currency exposures.\\n| AUD | NZD | CAD | EUR | GBP | JPY | Other | Total |\\n| At September 30, 2016 |\\n| Net managed assets (liabilities), excluding derivatives | $ | 85,933 | $ | (6,574 | ) | $ | 74,859 | $ | (159,487 | ) | $ | (59,745 | ) | $ | 21,593 | $ | 132,185 | $ | 88,764 |\\n| Foreign currency derivatives, net | (79,700 | ) | 7,287 | (80,621 | ) | 204,334 | 5,836 | (26,126 | ) | 11,790 | 42,800 |\\n| Net managed foreign currency exposure | 6,233 | 713 | (5,762 | ) | 44,847 | (53,909 | ) | (4,533 | ) | 143,975 | 131,564 |\\n| Other net foreign currency exposure | 2,060 | — | — | 22,881 | 1,011 | — | 68,969 | 94,921 |\\n| Total net foreign currency exposure | $ | 8,293 | $ | 713 | $ | (5,762 | ) | $ | 67,728 | $ | (52,898 | ) | $ | (4,533 | ) | $ | 212,944 | $ | 226,485 |\\n| Net foreign currency exposure as a percentage of total shareholders’ equity | 0.1 | % | — | % | (0.1 | %) | 1.1 | % | (0.9 | %) | (0.1 | %) | 3.5 | % | 3.8 | % |\\n| Pre-tax impact of net foreign currency exposure on shareholders’ equity given a hypothetical 10% rate movement(1) | $ | 829 | $ | 71 | $ | (576 | ) | $ | 6,773 | $ | (5,290 | ) | $ | (453 | ) | $ | 21,294 | $ | 22,648 |\\n\\n| (1) | Assumes 10% change in underlying currencies relative to the U.S. dollar. |\\n\\nTotal Net Foreign Currency Exposure\\nAt September 30, 2016, our total net foreign currency exposure was $226 million net long, driven by increases in our exposures to the euro and other non-core currencies primarily due to new business written during the first nine months of 2016.\\nITEM 4. CONTROLS AND PROCEDURES\\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of September 30, 2016. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2016, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and is accumulated and communicated to\\n74\\nmanagement, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.\\nThe Company’s management has performed an evaluation, with the participation of the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of changes in the Company’s internal control over financial reporting that occurred during the three months ended September 30, 2016. Based upon that evaluation, there were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nPART II OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nFrom time to time, we are subject to routine legal proceedings, including arbitrations, arising in the ordinary course of business. These legal proceedings generally relate to claims asserted by or against us in the ordinary course of insurance or reinsurance operations; estimated amounts payable under such proceedings are included in the reserve for losses and loss expenses in our Consolidated Balance Sheets.\\nWe are not a party to any material legal proceedings arising outside the ordinary course of business.\\nITEM 1A. RISK FACTORS\\nThere were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.\\n75\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nThe following table presents information regarding the number of shares we repurchased during the three months ended September 30, 2016:\\nISSUER PURCHASES OF EQUITY SECURITIES\\nCommon Shares\\n| Period | Total Numberof SharesPurchased | AveragePrice PaidPer Share | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs(1) | Maximum Number (or ApproximateDollar Value) of Shares That May Yet BePurchased Under the Announced Plansor Programs(2) |\\n| July 1-31, 2016 | 127 | $55.45 | 108 | $494.0 million |\\n| August 1-31, 2016 | 1,552 | $55.88 | 1,552 | $407.3 million |\\n| September 1-30, 2016 | 572 | $56.36 | 571 | $375.1 million |\\n| Total | 2,251 | 2,231 | $375.1 million |\\n\\n| (1) | From time to time, we purchase shares in connection with the vesting of restricted stock awards granted to our employees under our 2007 Long-Term Equity Compensation Plan. The purchase of these shares is separately authorized and is not part of our Board-authorized share repurchase program, described below. |\\n\\n| (2) | On December 7, 2015, our Board of Directors authorized a share repurchase plan to repurchase up to $750 million of our common shares through to December 31, 2016. The share repurchase authorization which became effective on December 31, 2015, replaced the previous plan which had $444 million available through the end of 2016. Share repurchases may be effected from time to time in the open market or privately negotiated transactions, depending on market conditions. |\\n\\nITEM 5. OTHER INFORMATION\\nDisclosure of Certain Activities Under Section 13(r) of the Securities Exchange Act of 1934\\nSection 13(r) of the Securities Exchange Act of 1934, as amended, requires issuers to disclose in their annual and quarterly reports whether they or any of their affiliates knowingly engaged in certain activities with Iran or with individuals or entities that are subject to certain sanctions under U.S. law. Issuers are required to provide this disclosure even where the activities, transactions or dealings are conducted outside of the United States in compliance with applicable law.\\nAs and when allowed by the applicable law and regulations, certain of our non-U.S. subsidiaries provide treaty reinsurance coverage to non-U.S. insurers of marine, aviation and energy risks on a worldwide basis, and as a result, these underlying reinsurance portfolios may have some exposure to Iran. In addition, we underwrite insurance and facultative reinsurance on a global basis to non-U.S. insureds and reinsureds for marine, aviation and energy risks. Coverage provided to non-Iranian business may indirectly cover an exposure in Iran. For example, certain of our operations underwrite global marine hull and cargo policies that provide coverage for vessels navigating into and out of ports worldwide, including Iran. For the quarter ended September 30, 2016, no premium has been allocated or apportioned to activities relating to Iran. As we believe these activities are permitted under applicable laws and regulations, we intend for our non-U.S. subsidiaries to continue to provide such coverage to the extent permitted by applicable law.\\n76\\nITEM 6. EXHIBITS\\n| 3.1 | Certificate of Incorporation and Memorandum of Association (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1(Amendment No. 1) (No. 333-103620) filed on April 16, 2003). |\\n| 3.2 | Amended and Restated Bye-Laws (incorporated by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 filed on May 15, 2009). |\\n| 4.1 | Specimen Common Share Certificate (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Amendment No. 3) (No. 333-103620) filed on June 10, 2003). |\\n| 4.2 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series C Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on March 19, 2012). |\\n| 4.3 | Certificate of Designations establishing the specific rights, preferences, limitations and other terms of the Series D Preferred Shares (incorporated by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed on May 20, 2013). |\\n| 10.1 | Amendment No. 1 to Employment Agreement dated June 23, 2014 by and between Peter W. Wilson and AXIS Specialty U.S. Services, Inc. effective September 21, 2016 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on September 27, 2016). |\\n| †31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| †31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| †32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| †32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| †101 | The following financial information from AXIS Capital Holdings Limited’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2016 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2016 and December 31, 2015; (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015; (iv) Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2016 and 2015; (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015; and (vi) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail. |\\n\\n| † | Filed herewith. |\\n\\nThe agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time.\\n77\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\nDated: October 27, 2016\\n\\n| AXIS CAPITAL HOLDINGS LIMITED |\\n| By: | /S/ ALBERT BENCHIMOL |\\n| Albert Benchimol |\\n| President and Chief Executive Officer |\\n| /S/ JOSEPH HENRY |\\n| Joseph Henry |\\n| Executive Vice President and Chief Financial Officer |\\n| (Principal Financial Officer) |\\n\\n78\\n</text>\\n\\nWhat would the return on investment be if the net investment income from the third quarter was invested in acquiring new common shares (in percent)?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 31.2.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 48,\n \"input_length\": 70675\n}"}}},{"rowIdx":49,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nPART I—FINANCIAL INFORMATION\nItem 1. Condensed Consolidated Financial Statements.\nUnaudited Condensed Consolidated Balance Sheets\n\n| As of | June 30, 2022 | December 31, 2021 |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 149,824 | $ | 905,051 |\n| Accounts receivable, net of allowance for doubtful accounts of $ 0 and $ 0 , respectively | 1,293 | - |\n| Inventories, net | 102,981 | 88,877 |\n| Prepaid expense and other current assets | 220,113 | 191,838 |\n| Total current assets | 474,211 | 1,185,766 |\n| Property and equipment, net | 1,181,365 | 1,110,890 |\n| Operating lease right-of-use asset | 2,937,437 | 2,466,873 |\n| Total assets | $ | 4,593,013 | $ | 4,763,529 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) |\n| Current liabilities: |\n| Accounts payable | $ | 158 | $ | 45,748 |\n| Accrued expenses and current liabilities | 171,070 | 124,535 |\n| Line of credit | 594,529 | - |\n| Loans payable to financial institutions – current portion | - | 98,475 |\n| Loans payable to shareholders | 150,000 | - |\n| Loan payable, emergency injury disaster loan (EIDL) – current portion | 10,760 | 7,957 |\n| Loan payable, payroll protection program (PPP) – current portion | 39,169 | 42,345 |\n| Equipment loan payable – current portion | 6,312 | 15,989 |\n| Operating lease liabilities – current portion | 655,603 | 578,419 |\n| Total current liabilities | 1,627,601 | 913,468 |\n| Loans payable to financial institutions – net of current portion | - | 23,228 |\n| Loan payable, emergency injury disaster loan (EIDL), net of current portion | 489,240 | 492,043 |\n| Loan payable, payroll protection program (PPP), net of current portion | 127,969 | 124,793 |\n| Operating lease liabilities, net of current portion | 2,427,168 | 2,011,702 |\n| Total liabilities | 4,671,978 | 3,565,234 |\n| Commitments and Contingencies |\n| Stockholders’ equity (deficit) |\n| Common Stock, $ 0.0001 par value, 40,000,000 shares authorized; 11,679,523 and 11,634,523 shares issued and outstanding at June 30, 2022 and December 31, 2021 | 1,168 | 1,163 |\n| Preferred Stock, $ 0.0001 par value, 1,000,000 shares authorized; no shares issued and outstanding at June 30, 2022 and December 31, 2021 | - | - |\n| Additional paid-in capital | 9,899,031 | 9,674,036 |\n| Accumulated deficit | ( 9,979,164 | ) | ( 8,476,904 | ) |\n| Total stockholders’ equity (deficit) | ( 78,965 | ) | 1,198,295 |\n| Total liabilities and stockholders’ equity | $ | 4,593,013 | $ | 4,763,529 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n1\nUnaudited Condensed Consolidated Statements of Operations\n\n| Six Months Ended June 30, | Three Months Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net revenues: |\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 775,956 | $ | 475,824 |\n| Wholesale and online | 29,674 | 28,336 | 12,520 | 15,368 |\n| Total net revenues | 1,541,626 | 880,121 | 788,476 | 491,192 |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 563,906 | 270,148 | 278,952 | 135,452 |\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 5,484 | 6,732 |\n| General and administrative | 2,468,447 | 1,226,951 | 1,432,432 | 656,310 |\n| Total operating costs and expenses | 3,045,350 | 1,509,511 | 1,716,868 | 798,494 |\n| Loss from operations | ( 1,503,724 | ) | ( 629,390 | ) | ( 928,392 | ) | ( 307,302 | ) |\n| Other income (expense): |\n| Other income | 16,440 | - | 1,440 | - |\n| Interest expense | ( 14,976 | ) | ( 5,773 | ) | ( 10,196 | ) | ( 382 | ) |\n| Total other income (expense), net | 1,464 | ( 5,773 | ) | ( 8,756 | ) | ( 382 | ) |\n| Loss before income taxes | ( 1,502,260 | ) | ( 635,163 | ) | ( 937,148 | ) | ( 307,684 | ) |\n| Provision for income taxes | - | - | - | - |\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\n| Loss per share: |\n| Basic and diluted | $ | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n| Weighted average number of common shares outstanding: |\n| Basic and diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n2\nUnaudited Condensed Consolidated Stockholders’ Equity (Deficit)\n\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\n| Balance as of December 31, 2021 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 8,476,904 | ) | $ | 1,198,295 |\n| Net loss | - | - | - | - | - | - | ( 565,112 | ) | ( 565,112 | ) |\n| Balance as of March 31, 2022 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 9,042,016 | ) | $ | 633,183 |\n| Stock compensation | 45,000 | 5 | - | - | 224,995 | - | - | 225,000 |\n| Net loss | - | - | - | - | - | - | ( 937,148 | ) | ( 937,148 | ) |\n| Balance as of June 30, 2022 | 11,679,523 | $ | 1,168 | - | $ | - | $ | 9,899,031 | $ | - | $ | ( 9,979,164 | ) | $ | ( 78,965 | ) |\n\n\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\n| Balance as of December 31, 2020 | 10,443,721 | $ | 1,045 | - | $ | - | $ | 4,733,063 | $ | ( 450,000 | ) | $ | ( 5,036,504 | ) | $ | ( 752,396 | ) |\n| Net loss | - | - | - | - | - | - | ( 327,479 | ) | ( 327,479 | ) |\n| Payments received for prior year subscription | - | - | - | - | - | 450,000 | - | 450,000 |\n| Stock issued for store acquisition | 232,558 | 23 | - | - | 149,977 | - | - | 150,000 |\n| Balance as of March 31, 2021 | 10,676,279 | $ | 1,068 | - | $ | - | $ | 4,883,040 | $ | - | $ | ( 5,363,983 | ) | $ | ( 479,875 | ) |\n| Net loss | - | - | - | - | - | - | ( 307,684 | ) | ( 307,684 | ) |\n| Stock subscription | 30,950 | 3 | - | - | 154,747 | ( 154,750 | ) | - | - |\n| Payments received for prior year subscription | - | - | - | - | - | 103,500 | - | 103,500 |\n| Balance as of June 30, 2021 | 10,707,229 | $ | 1,071 | - | $ | - | $ | 5,037,787 | $ | ( 51,250 | ) | $ | ( 5,671,667 | ) | $ | ( 684,059 | ) |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n3\nUnaudited Condensed Consolidated Statements of Cash Flows\n\n| For the Six Months Ended June 30, | 2022 | 2021 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Stock compensation | 225,000 | - |\n| Operating lease | 22,086 | 20,559 |\n| Depreciation | 97,922 | 81,926 |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | ( 1,293 | ) | ( 269 | ) |\n| Inventories | ( 14,104 | ) | ( 7,245 | ) |\n| Prepaid expense and other current assets | ( 28,275 | ) | ( 65,083 | ) |\n| Accounts payable | ( 45,590 | ) | 49,508 |\n| Accrued expenses and current liabilities | 46,535 | 17,415 |\n| Net cash used in operating activities | ( 1,199,979 | ) | ( 538,352 | ) |\n| Cash flows from investing activities: |\n| Purchases of property and equipment | ( 168,397 | ) | ( 167,152 | ) |\n| Reacquisition of store | - | ( 150,000 | ) |\n| Net cash used in investing activities | ( 168,397 | ) | ( 317,152 | ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of common stock | - | 553,499 |\n| Proceeds from line of credit | 594,529 | - |\n| Proceeds from loan payable to shareholders | 150,000 | 533,127 |\n| Repayment of loans | ( 121,703 | ) | ( 210,453 | ) |\n| Repayment of equipment loan payable | ( 9,677 | ) | ( 9,594 | ) |\n| Net cash provided by financing activities | 613,149 | 866,579 |\n| Net (decrease) increase in cash | ( 755,227 | ) | 11,075 |\n| Cash at beginning of period | 905,051 | 128,568 |\n| Cash at end of period | $ | 149,824 | $ | 139,643 |\n| Supplemental disclosures of non-cash financing activities: |\n| Issuance of common shares for repurchase of store | $ | - | $ | 150,000 |\n| Issuance of common shares for compensation | $ | 225,000 | $ | - |\n| Supplemental disclosure of cash flow information: |\n| Cash paid during the years for: |\n| Lease liabilities | $ | 435,635 | $ | 224,988 |\n| Interest | $ | 367 | $ | 5,773 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n4\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n1. NATURE OF OPERATIONS\nReborn Coffee, Inc. (“Reborn”) was incorporated in the State of Florida in January 2018. In July 2022, Reborn was migrated from Florida to Delaware, and filed a certificate of incorporation with the Secretary of State of the State of Delaware having the same capitalization structure as the Florida predecessor entity. Reborn has the following wholly owned subsidiaries:\n\n| ● | Reborn Global Holdings, Inc. (“Reborn Holdings”), a California Corporation incorporated in November 2014. Reborn Holdings is engaged in the operation of wholesale distribution and retail coffee stores in California to sell a variety of coffee, tea, Reborn brand name water and other beverages along with bakery and dessert products. |\n\n\n| ● | Reborn Coffee Franchise, LLC (the “Reborn Coffee Franchise”), a California limited liability corporation formed in December 2020, is a franchisor providing premier roaster specialty coffee to franchisees or customers. Reborn Coffee Franchise continues to develop the Reborn Coffee system for the establishment and operation of Reborn Coffee stores using one or more Reborn Coffee marks. The franchisee obtains a license to develop and operate a store under the strict compliance with terms of the agreement. The specific rights the franchisee is granted is to develop, own, and/or operate franchisee’s Reborn Coffee stores. The non-refundable initial franchise fee is $ 20,000 . In addition, the franchisee is required to pay the company a royalty fee equal to 5 % of the weekly gross sales of their respective store. |\n\nReborn Coffee, Inc., Reborn Global Holdings, Inc., and Reborn Coffee Franchise, LLC will be collectively referred as the “Company”.\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nReporting\nThe unaudited condensed consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries as of June 30, 2022 and December 31, 2021 and for the three and six month periods ended June 30, 2022 and 2021.\nBasis of Presentation and Consolidation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) as promulgated in the United States of America. The consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries. All intercompany accounts, transactions, and profits have been eliminated upon consolidation.\nReverse Stock Split\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse stock split , and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\nGoing Concern\nThe accompanying unaudited condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. The Company had an accumulated deficit of $ 9,979,164 at June 30, 2022, had a net loss of $ 1,502,260 for the six-month period ended June 30, 2022 and net cash used in operating activities of $ 1,199,979 for the six-month period ended June 30, 2022. These matters raise substantial doubt about the Company’s ability to continue as a going concern.\n5\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nWhile the Company is attempting to expand operations and increase revenues, the Company’s cash position may not be significant enough to support the Company’s daily operations. Management intends to raise additional funds by way of public or private offerings. Management believes that the actions presently being taken to further implement its business plan and generate revenues provide the opportunity for the Company to continue as a going concern. While management believes in the viability of its strategy to generate revenues and in its ability to raise additional funds, there can be no assurances to that effect or if available, on terms acceptable to the Company. The ability of the Company to continue as a going concern is dependent upon the Company’s ability to further implement its business plan and generate additional profit. Compared to the revenue for the six-month period ended June 30, 2021, however, net revenue for the six-month period ended June 30, 2022 has increased from $ 880,121 to $ 1,541,626 , and the Company expects consistent increase in sales with the opening of more stores. In August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $ 5.00 per share, generating gross proceeds of $ 7,200,000 . The initial public offering is summarized in Note 12 to the unaudited condensed consolidated financial statements.\nThe unaudited condensed consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires the Company to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and the accompanying notes. Such estimates include accounts receivables, accrued liabilities, income taxes, long-lived assets, and deferred tax valuation allowances. These estimates generally involve complex issues and require management to make judgments, involve analysis of historical and future trends that can require extended periods of time to resolve, and are subject to change from period to period. In all cases, actual results could differ materially from estimates.\nRevenue Recognition\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail stores and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\n\n| ● | Retail Store Revenue |\n\nRetail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 98 % of the Company’s total revenue.\n\n| ● | Wholesale and Online Revenue |\n\nWholesale and online revenues are recognized when the products are delivered, and title passes to the customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 2 % of the Company’s total revenue.\n\n| ● | Royalties and Other Fees |\n\nFranchise revenues consists of royalties and other franchise fees. Royalties are based on a percentage of franchisee’s weekly gross sales revenue at 5 %. The Company recognizes the royalties as the underlying sales occur. The Company recorded revenue from royalties of $ 0 for the six-month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the six-month periods ended June 30, 2022 and 2021.\nShipping and Handling Costs\nThe Company incurred freight out cost and is included in the Company’s cost of sales - wholesale and online.\n6\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nGeneral and Administrative Expense\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\nAdvertising Expense\nAdvertising costs are expensed as incurred. Advertising expenses amounted to $ 20,513 and $ 50,160 for the six-month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying consolidated statements of operations.\nPre-opening Costs\nPre-opening costs for new stores, consist primarily of store and leasehold improvements, and are capitalized and depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\nAccounts Receivable\nAccounts receivables are stated net of allowance for doubtful accounts. The allowance for doubtful accounts is determined primarily on the basis of past collection experience and general economic conditions. The Company determines terms and conditions for its customers based on volume transacted by the customer, customer creditworthiness and past transaction history. At June 30, 2022 and December 31, 2021, allowance for doubtful accounts was $ 0 and $ 0 , respectively. The Company does not have any off-balance sheet exposure related to its customers.\nInventories\nInventories consisted primarily of coffee beans, drink products, and supplies which are recorded at cost or at net realizable value.\nProperty and Equipment\nProperty and equipment are recorded at cost. Maintenance and repairs are charged to expense as incurred. Depreciation and amortization are provided using both the straight-line and declining balance methods over the following estimated useful lives:\n\n| Furniture and fixtures | 5 - 7 Years |\n| Store construction | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\n| Leasehold improvement | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\n\nWhen assets are retired or disposed of, the cost and accumulated depreciation thereon are removed, and any resulting gains or losses are included in the consolidated statements of operations. Leasehold improvements are amortized using the straight-line method over the estimated life of the asset, not to exceed the length of the lease. Repair and maintenance costs are expensed as incurred.\nOperating Leases\nThe Company adopted FASB Accounting Standards Codification, or ASC, Topic 842, Leases (“ASC 842”) which requires the recognition of the right-of-use assets and relating operating and finance lease liabilities on the balance sheet. Under ASC 842, all leases are required to be recorded on the balance sheet and are classified as either operating leases or finance leases. The lease classification affects the expense recognition in the income statement. Operating lease charges are recorded entirely in operating expenses. Finance lease charges are split, where amortization of the right-of-use asset is recorded in operating expenses and an implied interest component is recorded in interest expense.\nEarnings Per Share\nFinancial Accounting Standard Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 260, Earnings Per Share, requires a reconciliation of the numerator and denominator of the basic and diluted earnings (loss) per share (EPS) computations.\n7\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nBasic earnings (loss) per share are computed by dividing net earnings available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. In periods where losses are reported, the weighted-average number of common stock outstanding excludes common stock equivalents, because their inclusion would be anti-dilutive.\nThe Company did not have any dilutive shares for the three and six month periods ended June 30, 2022 and 2021.\nSegment Reporting\nFASB ASC Topic 280, Segment Reporting, requires public companies to report financial and descriptive information about their reportable operating segments. The Company’s management identifies operating segments based on how the Company’s management internally evaluate separate financial information, business activities and management responsibility. At the current time, the Company has only one reportable segment, consisting of both the wholesale and retail sales of coffee, water, and other beverages. The Company’s franchisor subsidiary was not material as of and for the three and six month periods ended June 30, 2022 and 2021.\nLong-lived Assets\nIn accordance with FASB ASC Topic 360, Property, Plant, and Equipment, the Company reviews for impairment of long-lived assets and certain identifiable intangibles whenever events or circumstances indicate that the carrying amount of assets may not be recoverable. The Company considers the carrying value of assets may not be recoverable based upon our review of the following events or changes in circumstances: the asset’s ability to continue to generate income from operations and positive cash flow in future periods; loss of legal ownership or title to the assets; significant changes in our strategic business objectives and utilization of the asset; or significant negative industry or economic trends. An impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset are less than its carrying amount. As of June 30, 2022 and December 31, 2021, the Company was not aware of any events or changes in circumstances that would indicate that the long-lived assets are impaired.\nFair Value of Financial Instruments\nThe Company records its financial assets and liabilities at fair value, which is defined under the applicable accounting standards as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measure date. The Company uses valuation techniques to measure fair value, maximizing the use of observable outputs and minimizing the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:\nLevel 1 – Quoted prices in active markets for identical assets or liabilities.\nLevel 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.\nLevel 3 – Inputs include management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument’s valuation.\nAs of June 30, 2022 and December 31, 2021, the Company believes that the carrying value of accounts receivable, accounts payable, accrued expenses, and other current assets and liabilities approximate fair value due to the short maturity of theses financial instruments. The financial statements do not include any financial instruments at fair value on a recurring or non-recurring basis.\n8\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nIncome Taxes\nIncome taxes are provided for the tax effects of transactions reported in the financial statements and consisted of taxes currently due and deferred taxes. Deferred taxes are recognized for the differences between the basis of assets and liabilities for financial statement and income tax purposes.\nThe Company follows FASB ASC Topic 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. ASC 740-10-25 provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax position. The Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The Company did not recognize additional liabilities for uncertain tax positions pursuant to ASC 740-10-25 for the three and six month periods ended June 30, 2022 and 2021.\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk are accounts receivable arising from its normal business activities. The Company performs ongoing credit evaluations to its customers and establishes allowances when appropriate.\nCompany purchases from various vendors for its operations. For the three and six month periods ended June 30, 2022 and 2021, no purchases from any vendors accounted for a significant amount of the Company’s bean coffee purchases.\nRelated Parties\nRelated parties are any entities or individuals that, through employment, ownership, or other means, possess the ability to direct or cause the direction of management and policies of the Company.\nSignificant Recent Developments Regarding COVID-19\nThe novel coronavirus, known as the global pandemic COVID-19, was first identified in December 2019. During March 2020, a global pandemic was declared by the World Health Organization related to the rapidly spreading outbreak of a novel strain of coronavirus designated COVID-19. The pandemic has significantly impacted economic conditions in the United States. The outbreak of the virus impacted our company-owned retail locations in Southern California.\nThe Company first began to experience impacts from COVID-19 around the middle of March 2020 as federal, state and local governments began to react to the public health crisis by encouraging or requiring social distancing, instituting stay-at-home orders, and requiring, in varying degrees, restaurant dine-in limitations, capacity limitations or other restrictions that largely limited restaurants to take-out, drive-thru and delivery sales. Although we have experienced some recovery from the initial impact of COVID-19, the long-term impact of COVID-19 on the economy and on our business remains uncertain, the duration and scope of which cannot currently be predicted.\n9\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\nRecent Accounting Pronouncement\nIn June 2016, the FASB issued Accounting Standards Update No. 2016-13, “Financial Instruments - Credit Losses (Topic 326)” (“ASU 2016-13”). ASU 2016-13 revises the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. Originally, ASU 2016-13 was effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2019, with early adoption permitted. In November 2019, FASB issued ASU 2019-10, “Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842).” This ASU defers the effective date of ASU 2016-13 for public companies that are considered smaller reporting companies as defined by the SEC to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is planning to adopt this standard in the first quarter of fiscal 2023.The Company is currently evaluating the potential effects of adopting the provisions of ASU No. 2016-13 on its consolidated financial statements, particularly its recognition of allowances for accounts receivable.\nOther recently issued accounting updates are not expected to have a material impact on the Company’s consolidated financial statements.\n3. PROPERTY AND EQUIPMENT\nProperty and equipment consisted of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| Furniture and equipment | $ | 849,809 | $ | 779,649 |\n| Leasehold improvement | 639,602 | 639,602 |\n| Store construction | 150,399 | 52,161 |\n| Store | 300,000 | 300,000 |\n| Total property and equipment | 1,939,810 | 1,771,412 |\n| Less accumulated depreciation | ( 758,445 | ) | ( 660,522 | ) |\n| Total property and equipment, net | $ | 1,181,365 | $ | 1,110,890 |\n\nIn February 2021, the Company repurchased its retail location in Corona Del Mar. The purchase price was $ 300,000 , comprised of $ 150,000 in cash and 232,558 shares of the Company’s common stock. The Company recorded the assumption of the ongoing lease for the store, which included a right of use asset of $ 183,442 and a lease liability of $ 193,463 .\nDepreciation expense on property and equipment amounted to approximately $ 97,922 and $ 81,926 for the six-month periods ended and $ 48,479 and $ 45,797 for the three-month periods ended June 30, 2022 and 2021, respectively.\n10\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n4. LOANS PAYABLE TO FINANCIAL INSTITUTIONS\nLoans payable to financial institutions consist of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| July 2021 - Loan agreement with principal amount of $ 90,000 and repayment rate of 19 % for a total of $ 101,700 . The loan payable matures on January 31, 2023 . | $ | - | $ | 52,819 |\n| August 2021 - Loan agreement with principal amount of $72,500 and repayment rate of 18.5 % for a total of $ 81,925 . The loan payable matures on February 10, 2023 . | - | 36,502 |\n| August 2021 - Loan agreement with principal amount of $ 67,500 and repayment rate of 18.5 % for a total of $ 76,275 . The loan payable matures on February 11, 2023 . | - | 32,382 |\n| Total loan payable | $ | - | $ | 121,703 |\n| Less: current portion | - | ( 98,475 | ) |\n| Total loan payable, net of current | $ | - | $ | 23,228 |\n\nJuly 2021 - $ 101,700 loan payable\nIn July 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 90,000 with loan cost $ 11,700 . The loan payable has a maturity date on January 31, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 52,819 , respectively.\nAugust 2021 - $ 81,925 loan payable\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 72,500 with loan cost $ 9,425 . The loan payable has a maturity date on February 10, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 36,502 , respectively.\nAugust 2021 - $ 76,275 loan payable\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 67,500 with loan cost $ 8,775 . The loan payable has a maturity date on February 11, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 32,382 , respectively.\n11\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL)\n\n| June 30, 2022 | December 31, 2021 |\n| May 16, 2020 ($ 150,000 ) - Loan agreement with principal amount of $150,000 with an interest rate of 3.75 % and maturity date on May 16, 2050 | $ | 150,000 | $ | 150,000 |\n| June 28, 2021 ($ 350,000 ) – Loan agreement with principal amount of $350,000 with an interest rate of 3.75 % and maturity date on May 18, 2050 | 350,000 | 350,000 |\n| Total long-term loan payable, emergency injury disaster loan (EIDL) | 500,000 | 500,000 |\n| Less - current portion | ( 10,760 | ) | ( 7,957 | ) |\n| Total loan payable, emergency injury disaster loan (EIDL), less current portion | $ | 489,240 | $ | 492,043 |\n\nThe following table provides future minimum payments:\n\n| For the years ended December 31, | Amount |\n| 2022 (remaining six months) | 5,330 |\n| 2023 | 10,964 |\n| 2024 | 11,382 |\n| 2025 | 11,816 |\n| 2026 | 12,267 |\n| Thereafter | 448,241 |\n| Total | $ | 500,000 |\n\nMay 16, 2020 – $ 150,000\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 150,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $ 731 . The balance of principal and interest is payable thirty years from the date of the SBA Loan.\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\n12\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL) (continued)\nJune 28, 2021 – $ 350,000\nOn June 28, 2021, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Amended Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 500,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning October 16, 2022 (thirty months from the original date of the SBA Loan) in the amount of $ 2,505 . The balance of principal and interest is payable thirty years from the original date of the SBA Loan.\n6. LOAN PAYABLE, PAYROLL PROTECTION LOAN PROGRAM (PPP)\n\n| June 30, 2022 | December 31, 2021 |\n| Loan payable, payroll protection program (PPP) – February 10, 2021 | $ | 167,138 | $ | 167,138 |\n| Total long-term loan payable, payroll protection program (PPP) | 167,138 | 167,138 |\n| Less - current portion | ( 39,169 | ) | ( 42,345 | ) |\n| Total loan payable, payroll protection program (PPP), less current portion | $ | 127,969 | $ | 124,793 |\n\nThe Paycheck Protection Program Loan (the “PPP Loan”) is administered by the U.S. Small Business Administration (the “SBA”). The interest rate of the loan is 1.00 % per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of the PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the PPP Loan (the “Maturity Date”). The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan.\n13\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n7. EQUIPMENT LOAN PAYABLE\nEquipment loan payable consist of the following:\n\n| June 30, 2022 | December 31, 2021 |\n| October 2017 - Loan agreement with principal amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 | $ | 6,312 | $ | 15,989 |\n| Total long-term equipment loan payable | 6,312 | 15,989 |\n| Less – current portion | ( 6,312 | ) | ( 15,989 | ) |\n| Total long-term debt, net of current portion | $ | - | $ | - |\n\n\n| For the year ended December 31, | Amount |\n| 2022 (remaining six months) | $ | 6,312 |\n| Total long-term equipment loan payable | $ | 6,312 |\n\nOctober 2017 - $ 82,011 equipment loan payable\nIn October 2017, the Company entered into equipment finance loan agreement with US Bank Equipment Finance in the amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 , payable in 60 payments. All principal, together with interest cost is due and payable on October 1, 2022. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 6,312 and $ 15,989 , respectively.\n8. INCOME TAX\nTotal income tax (benefit) expense consists of the following:\n\n| For the Six-Month Periods Ended June 30, | 2022 | 2021 |\n| Current provision (benefit): |\n| Federal | $ | - | $ | - |\n| State | - | - |\n| Total current provision (benefit) | - | - |\n| Deferred provision (benefit): |\n| Federal | - | - |\n| State | - | - |\n| Total deferred provision (benefit) | - | - |\n| Total tax provision (benefit) | $ | - | $ | - |\n\nA reconciliation of the Company’s effective tax rate to the statutory federal rate is as follows:\n\n| Description | Rate |\n| Statutory federal rate | 21.00 | % |\n| State income taxes net of federal income tax benefit and others | 8.84 | % |\n| Permanent differences for tax purposes and others | 0.00 | % |\n| Change in valuation allowance | - 29.84 | % |\n| Effective tax rate | 0 | % |\n\n14\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n8. INCOME TAX (continued)\nThe income tax benefit differs from the amount computed by applying the U.S. federal statutory tax rate of 21 % and California state income taxes of 8.84 % due to the change in the valuation allowance.\nDeferred income taxes reflect the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The components of deferred tax assets and liabilities are as follows:\n\n| Deferred tax assets | June 30, 2022 | December 31, 2021 |\n| Deferred tax assets: |\n| Net operating loss | $ | 2,961,949 | $ | 2,513,674 |\n| Other temporary differences | - | - |\n| Total deferred tax assets | 2,961,949 | 2,513,674 |\n| Less - valuation allowance | ( 2,961,949 | ) | ( 2,513,674 | ) |\n| Total deferred tax assets, net of valuation allowance | $ | - | $ | - |\n\nAs of December 31, 2021, the Company had available net operating loss carryovers of approximately $ 8,423,841 . Per the Tax Cuts and Jobs Act (TCJA) implemented in 2018, the two-year carryback provision was removed and now allows for an indefinite carryforward period. The carryforwards are limited to 80 % of each subsequent year’s net income. As a result, net operating loss may be applied against future taxable income and expires at various dates subject to certain limitations. The Company has a deferred tax asset arising substantially from the benefits of such net operating loss deduction and has recorded a valuation allowance for the full amount of this deferred tax asset since it is more likely than not that some or all of the deferred tax asset may not be realized.\nThe Company files income tax returns in the U.S. federal jurisdiction and California and is subject to income tax examinations by federal tax authorities for tax year ended 2017 and later and subject to California authorities for tax year ended 2016 and later. The Company currently is not under examination by any tax authority. The Company’s policy is to record interest and penalties on uncertain tax positions as income tax expense. As of June 30, 2022 and December 31, 2021, the Company has no accrued interest or penalties related to uncertain tax positions.\nAs of June 30, 2022, the Company had cumulative net operating loss carryforwards for federal tax purposes of approximately $ 9,926,101 . In addition, the Company had state tax net operating loss carryforwards of approximately $ 9,926,101 . The carryforwards may be applied against future taxable income and expires at various dates subject to certain limitations.\n15\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n9. COMMITMENTS AND CONTINGENCIES\nOperating Leases\nThe Company entered into the following operating facility leases\n\n| ● | La Floresta - On July 25, 2016, the Company entered into an operating facility lease for its store located at La Floresta Shopping Village in Brea, California with 60 months term with option to extend. The lease started on July 2016 and expires on November 2024. |\n\n\n| ● | La Crescenta - On May 2017, the Company entered into an operating facility lease for its store located in La Crescenta, California with 120 months term with option to extend. The lease started on May 2017 and expires in May 2027. The Company entered into non-cancellable lease agreement for a coffee shop approximately 1,607 square feet located in La Crescenta, California commencing in May 2017 and expiring in April 2027. The monthly lease payment under the lease agreement approximately $ 6,026 . |\n\n\n| ● | Brea - On September 1, 2018, the Company entered into an operating facility lease for its corporate office located in Brea, California with 72 months term with option to extend. The lease starts on September 2018 and expires on August 2024. |\n\n\n| ● | Glendale – On October 27, 2020, The Company entered a 7-year operating facility lease for its store located at the Glendale Galleria in Glendale, California. The lease starts on November 2020 and expires in October 2027. |\n| ● | San Francisco - On December 22, 2020, the Company entered into an operating facility lease for its store located at Stonestown Galleria in San Francisco, California with 84 months term with option to extend. The lease starts in June 2021 and expires in April 2028. |\n\n\n| ● | Santa Anita - On December 22, 2020, the Company entered into an operating facility lease for its store located at Arcadia, California with 36 months term with option to extend. The lease starts in February 2021 and expires in January 2024. |\n| ● | Riverside - On February 4, 2021, the Company entered into an operating facility lease for its store located at Galleria at Tyler in Riverside, California with 84 months term with option to extend. The lease starts in April 2021 and expires in March 2028. |\n\n\n| ● | Corona Del Mar - On February 5, 2021, the Company repurchased its retail store in Corona Del Mar, California. As part of that repurchase, the Company assumed the original operating lease on the facility, with 66 months term with an option to extend. The lease expires in December 2022. |\n\n\n| ● | Laguna Woods - On February 12, 2021, the Company entered into an operating facility lease for its store located at Home Depot Center in Laguna Woods, California with 60 months term with option to extend. The lease starts in June 2021 and expires in May 2026. |\n\n\n| ● | Huntington Beach - On November 1 2021, the Company entered into an operating facility lease for its store located at Huntington Beach, California with 124 months term with option to extend. The lease starts in November 2021 and expires in February 2032. |\n\n\n| ● | Manhattan Village - On March 1 2022, the Company entered into an operating facility lease for its store located at Manhattan Beach, California with 60 months term with option to extend. The lease starts in March 2022 and expires in February 2027. |\n\nThe Company adopted ASC 842 as of January 2018 (date of formation). The Company has operating leases for the Company’s corporate office and stores and accounts for these leases in accordance with ASC 842, which resulted in the recognition of ROU assets and operating lease liabilities of $ 2,937,437 and $ 3,082,771 , respectively, as of June 30, 2022. Certain of the leases for the Company’s retail store facilities provide for variable payments for property taxes, insurance and common area maintenance payments related to rental payments based on future sales volumes at the leased location, which are not measurable at the inception of the lease, or rental payments that are adjusted periodically for inflation.\nFor the new lease and adjustments, the Company recorded an additional non-cash increase of $470,564 to ROU assets and $492,650 to operational lease liabilities for the six-month period ended June 30, 2022.\n16\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n9. COMMITMENTS AND CONTINGENCIES (continued)\nIn accordance with ASC 842, the components of lease expense were as follows:\n\n| Six-month period ended June 30, | 2022 | 2021 |\n| Operating lease expense | $ | 452,155 | $ | 279,888 |\n| Total lease expense | $ | 452,155 | $ | 279,888 |\n\nIn accordance with ASC 842, other information related to leases was as follows:\n\n| Six-month period ended June 30, | 2022 | 2021 |\n| Operating cash flows from operating leases | $ | 435,635 | $ | 224,988 |\n| Cash paid for amounts included in the measurement of lease liabilities | $ | 435,635 | $ | 224,988 |\n| Weighted-average remaining lease term—operating leases | 4.1 Years |\n| Weighted-average discount rate—operating leases | 8.9 | % |\n\nIn accordance with ASC 842, maturities of operating lease liabilities as of June 30, 2022 were as follows:\n\n| Operating |\n| For the years ended December 31, | Lease |\n| 2022 (remaining six months) | $ | 467,758 |\n| 2023 | 864,887 |\n| 2024 | 785,267 |\n| 2025 | 642,387 |\n| 2026 | 574,150 |\n| Thereafter | 456,435 |\n| Total undiscounted cash flows | $ | 3,790,884 |\n| Reconciliation of lease liabilities: |\n| Weighted-average remaining lease terms | 4.1 Years |\n| Weighted-average discount rate | 8.9 | % |\n| Present values | $ | 3,082,771 |\n| Lease liabilities—current | 655,603 |\n| Lease liabilities—long-term | 2,427,168 |\n| Lease liabilities—total | $ | 3,082,771 |\n| Difference between undiscounted and discounted cash flows | $ | 708,113 |\n\nContingencies\nThe Company is subject to various legal proceedings from time to time as part of its business. As of June 30, 2022, the Company was not currently party to any legal proceedings or threatened legal proceedings, the adverse outcome of which, individually or in the aggregate, it believes would have a material adverse effect on its business, financial condition, and results of operations.\n17\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n10. SHAREHOLDERS’ EQUITY\nCommon Stock\nThe Company has authorization to issue and have outstanding at any one time 40,000,000 share of common stock with a par value of $ 0.0001 per share. The shareholders of common stock shall be entitled to one vote per share and dividends declared by the Company’s Board of Directors.\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse split, and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\nPreferred Stock\nThe Company has authorization to issue and have outstanding at any one time 1,000,000 share of preferred stock with a par value of $ 0.0001 per share, in one or more classes or series within a class as may be determined by our board of directors, who establish, from time to time, the number of shares to be included in each class or series, fix the designation, powers, preferences and rights of the shares of each such class or series and any qualifications, limitations or restrictions thereof. Any preferred stock so issued is senior to other existing classes of common stock with respect to the payment of dividends or amounts upon liquidation or dissolution. As of June 30, 2022 and December 31, 2021, no shares of our preferred stock had been designated any rights and we had no shares of preferred stock issued and outstanding.\nSubscription of Common Stock Receivables\nThe Company issued 1,569,768 shares of common stock to several individuals in March 2020 and in December 2020 for total proceeds of $ 1,350,000 , of which $ 553,500 was received in January, February, and June 2021.\nIssuance of Common Stock in Settlement of Antidilution Provisions\nIn May 2018, the Company had entered into a share exchange agreement wherein Capax, Inc., the predecessor entity of Reborn Coffee, Inc. (“Capax”) effectively merged with Reborn Global Holdings, Inc. to form the Company. In this share exchange agreement, the preexisting shareholder of Capax were provided covenants that for a period of one year following the date upon which the Company is approved for quotation or trading on a public exchange (“IPO”), the percentage of ownership of the prior shareholders of Capax would not be less than the 5% of the total number of shares of voting common stock outstanding of the Company that they owned following the share exchange. In the event the ownership of the pre-merger shareholders of Capax fell below 5%, the Company was obligated to issue that number of shares of common stock to those shareholders which would increase the ownership of all of the Pre-Merger Shareholders to five percent (5%) of the total outstanding voting common shares of the Company. During the year ended December 31, 2021, the Company issued 325,495 shares of common stock under these provisions.\nOn January 25, 2022, the Company modified this agreement with the preexisting shareholders to effectively end the antidilution protection at the time of a successful IPO, eliminating the one-year period following an IPO as provided under the original agreement. The shareholders would be entitled to additional protection through the IPO date should the Company issue any additional shares between December 31, 2021 and the IPO date. The Company has not issued any additional shares subsequent to December 31, 2021.\nDividend policy\nDividends are paid at the discretion of the Board of Directors. There were no dividends declared for the six-month periods ended June 30, 2022 and 2021.\n18\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n11. EARNINGS PER SHARE\nThe Company calculates earnings per share in accordance with FASB ASC 260, Earnings Per Share, which requires a dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of shares outstanding during the fiscal year. Potentially dilutive common shares consist of stock options outstanding (using the treasury method).\nThe following table sets forth the computation of basic and diluted net income per common share:\n\n| Six-Month Period | Three-Month Period |\n| Ended June 30, | Ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net Loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\n| Weighted Average Shares of Common Stock Outstanding |\n| Basic | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n| Diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\n| Earnings Per Share - Basic |\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n| Earnings Per Share - Diluted |\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\n\n12. SUBSEQUENT EVENTS\nThe Company evaluated all events or transactions that occurred after June 30, 2022 up through the date the unaudited condensed consolidated financial statements were available to be issued. During this period, the Company did not have any material recognizable subsequent events required to be disclosed as of and for the six-month period ended June 30, 2022, except for the following:\nInitial Public Offering\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $ 7,200,000 . Net proceeds from the IPO was approximately $ 6.2 million after deducting underwriting discounts and commissions and other offering expenses of approximately $ 998,000 .\nThe Company had granted the underwriters a 45-day option to purchase up to 216,000 additional shares (equal to 15 % of the shares of common stock sold in the offering) to cover over-allotments. In addition, the Company had agreed to issue to the representative of the several underwriters warrants to purchase the number of shares of common stock in the aggregate equal to five percent ( 5 %) of the shares of common stock to be issued and sold in the IPO. The warrants are exercisable for a price per share equal to 125 % of the public offering price. No over-allotment option or representative’s warrants have been exercised.\n19\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Prospectus on Form S-1. As discussed in the section titled “Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” in our Prospectus filed on Form S-1 (File No: 333-261937).\nBusiness\nReborn Coffee is focused on serving high quality, specialty-roasted coffee at retail locations, kiosks and cafes. We are an innovative company that strives for constant improvement in the coffee experience through exploration of new technology and premier service, guided by traditional brewing techniques. We believe Reborn differentiates itself from other coffee roasters through its innovative techniques, including sourcing, washing, roasting, and brewing our coffee beans with a balance of precision and craft.\nFounded in 2015 by Jay Kim, our Chief Executive Officer, Mr. Kim and his team launched Reborn Coffee with the vision of using the finest pure ingredients and pristine water. We currently serve customers through our retail store locations in California: Brea, La Crescenta, Glendale, Corona Del Mar, Arcadia, Laguna Woods, Riverside, San Francisco and Manhattan Beach, with four other locations in development. Additionally, we expect to begin franchising in 2022 and expect to continue to develop additional retail locations as we expand outside of California. We estimate that the average development cost of a company-owned retail location is approximately $150,000. Therefore, taking into account the proceeds from this offering and within a year from its completion, we expect to open up to 20 company-owned retail locations (using approximately $3,000,000 of the proceeds of this offering) and 20 franchise locations (all costs and expenses associated with a franchise store location development are borne by the franchisees). We acknowledge that we have not yet signed any franchise agreements and that such number of franchise locations is purely speculative. Reborn Coffee continues to elevate the high-end coffee experience and we received 1st place traditional still in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles.\nThe Experience, Reborn\nAs leading pioneers of the emerging “Fourth Wave” movement, Reborn Coffee is redefining specialty coffee as an experience that demands much more than premium quality. We consider ourselves leaders of the “fourth wave” coffee movement because we are constantly developing our bean processing methods, researching design concepts, and reinventing new ways of drinking coffee. For instance, the current transition from the K-Cup trend to the pour over drip concept allowed us to reinvent the way people consume coffee, by merging convenience and quality. We took the pour over drip concept and made it available and affordable to the public through our Reborn Coffee Pour Over packs. Our Pour Over Packs allow our consumers to consume our specialty coffee outdoors and on-the-go.\nOur success in innovating within the “fourth wave” coffee movement is measured by our success in B2B sales with our introduction of Reborn Coffee Pour Over Packs to hotels. With the introduction of our Pour Over Packs to major hotels (including one hotel company with 7 locations), our B2B sales increased as these companies recognized the convenience and functionality our Pour Over Packs serve to their customers.\nReborn Coffee’s continuous Research and Development is essential to developing new parameters in the production of new blends. Our 1st place position in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles is a testament to the way we believe we lead the “fourth wave” movement by example.\nCentered around its core values of service, trust, and well-being, Reborn Coffee delivers an appreciation of coffee as both a science and an art. Developing innovative processes such as washing green coffee beans with magnetized water, we challenge traditional preparation methods by focusing on the relationship between water chemistry, health, and flavor profile. Leading research studies, testing brewing equipment, and refining roasting/brewing methods to a specific, Reborn Coffee proactively distinguishes exceptional quality from good quality by starting at the foundation and paying attention to the details. Our mission places an equal emphasis on humanizing the coffee experience, delivering a fresh take on “farm-to-table” by sourcing internationally. In this way, Reborn Coffee creates opportunities to develop transparency by paying homage to origin stories and spark new conversations by building cross-cultural communities united by a passion for the finest coffee.\nThrough a broad product offering, Reborn Coffee provides customers with a wide variety of beverages and coffee options. As a result, we believe we can capture share of any experience where customers seek to consume great beverages whether in our inviting store atmospheres which are designed for comfort, or on the go through our pour over packs, or at home with our whole bean ground coffee bags. We believe that the retail coffee market in the US is large and growing. According to IBIS, in 2021, the retail market for coffee in the United States is expected to be $46.2 billion. This is expected to grow due to a shift in consumer preferences to premium coffee, including specialized blends, espresso-based beverages, and cold brew options. Reborn aims to capture a growing portion of the market as we expand and increase consumer awareness of our brand.\n20\nPlan of Operation\nWe have a production and distribution center at our headquarters that we use to process and roast coffee for wholesale and retail distribution.\nCurrently, we have the following nine retail coffee locations, and four locations in development (i.e., Cabazon, Huntington Beach, Irvine and Mission Viejo, California):\n\n| ● | La Floresta Shopping Village in Brea, California; |\n| ● | La Crescenta, California; |\n\n\n| ● | Glendale Galleria in Glendale, California; |\n| ● | Galleria at Tyler in Riverside, California; |\n| ● | Home Depot Center in Laguna Woods, California; |\n| ● | Stonestown Galleria in San Francisco, California (opened in first quarter of 2022); |\n| ● | Corona Del Mar, California; |\n| ● | Santa Anita Westfield Mall in Arcadia, California; and |\n| ● | Manhattan Village at Manhattan Beach, California. |\n\nImpact of COVID-19\nThe COVID-19 pandemic and resulting disruptions including, without limitation, governmental lockdown mandates and restrictions, made 2020 a challenging year for businesses, particularly in the foodservice and restaurant industries. Reborn Coffee took immediate action to protect the health and safety of our employees and customers including the implementation of all operating protocols dictated by state and local guidelines and instituting strict health and safety practices. Fortunately, we did not experience any significant disruptions in our supply chain operations.\nDespite efforts to ensure a safe consumer experience, we did experience repressed customer flow through periods when malls and shopping centers were restricted or closed entirely due to governmental lockdown mandates and restrictions. Our current retail locations are within popular shopping areas with anticipated regular customer traffic. Such closures or limitations and restrictions were at times mandated the government, and at other times due to natural customer uncertainties regarding the status of COVID-19. Such restrictions and uncertainties not only impacted anticipated revenues from current locations, but added additional risk to us related to the opening of new locations. Thus, the uncertainty regarding the scope and longevity of such restrictions modified our plans as to how quickly we could enact our expansion plans.\nMore specifically, COVID-19 has challenged our performance at our kiosk locations, though our cafe locations have improved in performance. Shopping mall restrictions and mandates during the pandemic made it difficult for our kiosks to operate at maximum performance, as indoor restrictions of shopping malls affected the way we had to operate business. For instance, we had to offer only to-go/pickup operations to operate while meeting regulations. We have learned how to move forward aggressively despite such regulations and mandates, doing what we can to serve the coffee we are so proud to serve, whether this means offering to-go orders only or working with delivery services.\nIn May 2020, the Company availed itself of a loan under the Paycheck Protection Program (PPP) administered by the U.S. Small Business Administration (SBA) in the amount of $115,000, and $500,000 under the SBA’s Economic Injury Disaster Loan assistance program, all of which is currently outstanding as of December 31, 2021, provided however that repayment was deferred to commence in May 2022. In February 2021, the Company secured a second PPP loan under this program in the amount of approximately $167,000. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\n21\nIn January 2022 we announced a price increase of our whole roasted beans by 15% on our website which we attribute to increases due to inflation in the cost of raw green coffee beans, the cost of shipping and supplies, and nationwide increases in labor costs-- factors that may or may not be attributable to the pandemic and/or the governmental policies and mandates that were implemented during and in the wake of COVID-19. As of the date hereof and in January 2022 at the time of our price increase, inflation has not had a material effect on our results of operations since we have been able to offset such increased costs by increasing the price of our whole roasted beans by 15% in January 2022, through increased sales and growth in opening 2 new company-owned retail locations, better lease terms on such new company-owned retail locations, more efficient purchasing practices (e.g., volume purchase discounts), productivity improvements and greater economies of scale. Severe increases in inflation, however, could affect the global and U.S. economies and could have a materially adverse impact on our business, financial condition or results of operations.\nWe do not expect COVID-19 to affect our future operating results significantly, as we are confident that coffee is an essential product that people rely on and will always drink. We intend to meet all governmental business operation regulations and improve sales by whatever means necessary, utilizing resources such as food delivery services and to-go/pickup orders. However, the impact of COVID-19 continues to evolve, and we cannot easily predict the future potential impacts of the pandemic on our business or operations or on the United States or global economy in general. This may include any recurrence of the disease, actions taken in response to the evolving pandemic, any ongoing effects on consumer demand and spending patterns or other impacts of the pandemic. Whether these or other currently unanticipated consequences of the pandemic are reasonably likely to materially affect our results of operations, cash flows or financial condition is yet to be determined. For additional details regarding the impact of COVID-19 on our business, see “Risk Factors-Risks Related to Our Business-Pandemics or disease outbreaks such as the COVID-19 have had, and may continue to have, an effect on our business and results of operations.”\nComponents of Our Results of Operations\nRevenue\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail locations and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\n\n| ● | Retail Store Revenue |\n| Retail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 97% of the Company’s total revenue. |\n| ● | Wholesale and Online Revenue |\n| Wholesale and online revenues are recognized when the products are delivered, and title passes to customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 3% of the Company’s total revenue. |\n\n\n| ● | Royalties and Other Fees |\n| Franchise revenues consist of royalty fee and other franchise fees. Royalty fee is based on a percentage of franchisee’s weekly gross sales revenue at 5%. The Company recognizes the fee as the underlying sales occur. The Company recorded revenue from royalty of $0 for the three and six month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the three and six month periods ended June 30, 2022 and 2021. |\n\nCost of Sales\nCost of sales includes costs associated with generating revenue within our company-owned retail locations, and franchising operations (of which, as of the date of this prospectus, we had none).\nShipping and Handling Costs\nThe Company incurred freight out cost and is included in the Company’s cost of sale.\nGeneral and Administrative Expense\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\nAdvertising Expense\nAdvertising expense are expensed as incurred. Advertising expenses amounted to $20,513 and $50,160 for the six month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations.\n22\nPre-opening Costs\nPre-opening costs for new stores, which are not material, consist primarily of payroll and recruiting expense, training, marketing, rent, travel, and supplies, and are expensed as incurred depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\nResults of Operations\nThree and six months ended June 30, 2022 Compared to three and six months ended June 30, 2021\nThe following table presents selected comparative results of operations from our unaudited financial statements for the three and six months ended June 30, 2022 compared to three and six months ended June 30, 2021. Our financial results for these periods are not necessarily indicative of the financial results that we will achieve in future periods. Certain totals for the table below may not sum to 100% due to rounding.\n\n| Six Months Ended June 30, | Increase / (Decrease) |\n| 2022 | 2021 | Dollars | Percentage |\n| Net revenues: |\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 660,167 | 77.5 | % |\n| Wholesale and online | 29,674 | 28,336 | 1,338 | 4.7 | % |\n| Total net revenues | 1,541,626 | 880,121 | 661,505 | 75.2 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 563,906 | 270,148 | 293,758 | 108.7 | % |\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 585 | 4.7 | % |\n| General and administrative | 2,468,447 | 1,226,951 | 1,241,496 | 101.2 | % |\n| Loss from operations | (1,503,724 | ) | (629,390 | ) | (874,334 | ) | 138.9 | % |\n| Other income | 16,440 | - | 16,440 | N/A | % |\n| Interest expense | (14,976 | ) | (5,773 | ) | (9,203 | ) | 159.4 | % |\n| Loss before income taxes | (1,502,260 | ) | (635,163 | ) | (867,097 | ) | 136.5 | % |\n| Provision for income taxes | - | - | - | 0.0 | % |\n| Net loss | $ | (1,502,260 | ) | $ | (635,163 | ) | $ | (867,097 | ) | 136.5 | % |\n\n\n| Three Months Ended June 30, | Increase / (Decrease) |\n| 2022 | 2021 | Dollars | Percentage |\n| Net revenues: |\n| Stores | $ | 775,956 | $ | 475,824 | $ | 300,132 | 63.1 | % |\n| Wholesale and online | 12,520 | 15,368 | (2,848 | ) | -18.5 | % |\n| Total net revenues | 788,476 | 491,192 | 297,284 | 60.5 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 278,952 | 135,452 | 143,500 | 105.9 | % |\n| Cost of sales—wholesale and online | 5,484 | 6,732 | (1,248 | ) | -18.5 | % |\n| General and administrative | 1,432,432 | 656,310 | 776,122 | 118.3 | % |\n| Loss from operations | (928,392 | ) | (307,302 | ) | (621,090 | ) | 202.1 | % |\n| Other income | 1,440 | - | 1,440 | N/A | % |\n| Interest expense | (10,196 | ) | (382 | ) | (9,814 | ) | 2569.1 | % |\n| Loss before income taxes | (937,148 | ) | (307,684 | ) | (629,464 | ) | 204.6 | % |\n| Provision for income taxes | - | - | - | 0.0 | % |\n| Net loss | $ | (937,148 | ) | $ | (307,684 | ) | $ | (629,464 | ) | 204.6 | % |\n\n23\n\n| Six months ended June 30, | Three months ended June 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Net revenues: |\n| Stores | 98.1 | % | 96.8 | % | 98.4 | % | 96.9 | % |\n| Wholesale and online | 1.9 | % | 3.2 | % | 1.6 | % | 3.1 | % |\n| Total net revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |\n| Operating costs and expenses: |\n| Product, food and drink costs—stores | 36.6 | % | 30.7 | % | 35.4 | % | 27.6 | % |\n| Cost of sales—wholesale and online | 0.8 | % | 1.4 | % | 0.7 | % | 1.4 | % |\n| General and administrative | 160.1 | % | 139.4 | % | 181.7 | % | 133.6 | % |\n| Loss from operations | -97.5 | % | -71.5 | % | -117.7 | % | -62.6 | % |\n| Other income | 1.1 | % | 0.0 | % | 0.2 | % | 0.0 | % |\n| Interest expense | -1.0 | % | -0.7 | % | -1.3 | % | -0.1 | % |\n| Loss before income taxes | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\n| Provision for income taxes | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % |\n| Net loss | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\n\nRevenues. Revenues were approximately $1.5 million for the six-month period ended June 30, 2022, compared to $880,000 for the comparable period in 2021, representing an increase of $661,000, or 75.2%. Revenues were approximately $788,000 million for the three-month period ended June 30, 2022, compared to $491,000 for the comparable period in 2021, representing an increase of $297,000, or 60.5%. The increase in sales for the periods was primarily driven by the opening of the Corona Del Mar, Laguna Woods and Santa Anita locations during 2021, and to the continued focus on marketing efforts to grow brand recognition.\nProduct, food and drink costs. Product, food and drink costs were approximately $564,000 for the six-month period ended June 30, 2022 compared to $270,000 for the comparable period in 2021, representing an increase of approximately $294,000, or 108.7%, and were approximately $279,000 for the three-month period ended June 30, 2022 compared to $135,000 for the comparable period in the prior year, representing an increase of $144,000 of 105.9%. The increase in costs for the periods was partially driven by the opening of new locations and the overall increase in sales for the period. As a percentage of revenues, product, food and drink costs increased to 36.6% in the six-month period ended June 30, 2022 compared to 30.7% in the comparable period in 2021 and increased to 35.4% in the three-month period ended June 30, 2022 compared to 27.6% in the comparable period in 2021. The increase in costs as a percentage of sales was primarily driven by general inflationary pressures and the seasonal fluctuations in cost of ingredients. We monitor these fluctuations in product costs to analyze whether they are considered to be representative of general economic conditions, such as inflation, or to be related to commodity specific changes. For example, green bean suppliers raised pricing by 15 to 20% throughout 2021, higher than the overall rate of inflation, however it has been more stable recently and even decreasing slightly in the second quarter of 2022.\nGeneral and administrative expenses. General and administrative expenses were approximately $2.5 million for the six-month period ended June 30, 2022 compared to $1.2 million for the comparable period in the prior year, representing an increase of approximately $1.2 million, or 101.2%, and were approximately $1.4 million for the three-month period ended June 30, 2022 compared to $656,000 for the comparable period in 2021, representing an increase of approximately $775,000, or 118.3%. This increase in general and administrative expenses was primarily due to the hiring of additional administrative employees, increases in professional services and corporate-level costs to support growth plans, the opening of new restaurants, as well as costs associated with outside administrative, legal and professional fees and other general corporate expenses associated with preparing to become a public company. As a percentage of sales, general and administrative expenses increased to 160.1% in the six-month period ended June 30, 2022 from 139.4% in the comparable period of 2021, and increased to 181.7% for the three-month period ended June 30, 2022 from 133.6% in the comparable period in 2021, primarily due to the increased administrative expenditures for the reasons mentioned above.\n24\nLiquidity and Capital Resources\n\n| Six Months Ended June 30, |\n| 2022 | 2021 |\n| Statement of Cash Flow Data: |\n| Net cash used in operating activities | (1,199,979 | ) | (538,352 | ) |\n| Net cash used in investing activities | (168,397 | ) | (317,152 | ) |\n| Net cash provided by financing activities | 613,149 | 866,579 |\n\nCash Flows Provided by Operating Activities\nNet cash used in operating activities during the six-month period ended June 30, 2022 was $1.2 million, which resulted from net loss of $1.5 million, non-cash charges of $225,000 for stock compensation and $98,000 for depreciation and net cash outflows of $43,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventory of $14,000 and prepaid and other assets of $28,000 and a decrease in accounts payable of $46,000, partially offset by increase of $47,000 in accrued liabilities. The increase in accrued liabilities was primarily due to the timing of cash payments for sales tax and payroll.\nNet cash used in operating activities during the six-month period ended June 30, 2021 was $538,000, which resulted from net loss of $635,000, non-cash charges of $82,000 for depreciation, and net cash outflows of $6,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventories of $7,000 and prepaids and other assets of $65,000, partially offset by increases of $50,000 in accounts payable and $17,000 in accrued liabilities.\nCash Flows Used in Investing Activities\nNet cash used in investing activities during the six-month periods ended June 30, 2022 and 2021 was $168,000 and $317,000, respectively, These expenditures in each period are primarily related to purchases of property and equipment in connection with current and future location openings and maintaining our existing locations.\nCash Flows Provided by (Used in) Financing Activities\nNet cash provided by financing activities during the six-month period ended June 30, 2022 was $613,000, primarily due to $595,000 of borrowings under a line of credit, and $150,000 of loans from shareholders. This was partially offset by $131,000 of repayments of borrowings.\nNet cash provided by financing activities during the six-month period ended June 30, 2021 was $867,000, primarily due to approximately $533,000 cash received through borrowings and $553,000 of proceeds from issuance of common stock, offset by approximately $220,000 of repayments of borrowings.\nAs of June 30, 2022, the Company had total assets of $4,593,013. Our cash balance as of June 30, 2022 was approximately $150,000. From inception (of Reborn Global in November 2014) to June 30, 2022, we have not had any positive operating cash flow.\nCredit Facilities\nLoan with Fora Financial\nIn October 2019, the Company entered into a loan agreement with Fora Financial in the principal amount of $138,600 and remaining principal amount of $48,510. The loan payable has a maturity date on October 11, 2019. The loan was due on demand. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $0.\nLoans with Square Capital\nBetween April and August 2021, the Company entered into loan agreements with Square Capital in the aggregate principal amount of approximately $268,000 with loan costs of $34,840. The loans have maturity dates ranging from September 2022 to February 2023. As of June 20, 2022 and December 31, 2021, there was a balance outstanding of approximately $0 and $122,000, respectively.\n25\nEconomic Injury Disaster Loan\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the Company’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $500,000, with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75% per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $731. The balance of principal and interest is payable thirty years from the date of the SBA Loan. In connection therewith, the Company also received a $10,000 grant, which does not have to be repaid. During the year ended December 31, 2020, $10,000 was recorded in Economy injury disaster loan (EIDL) grant income in the Statements of Operations. The schedule of payments on this loan was later deferred to commence 24 months from the date of loan, and therefore, the full amount of the loan is outstanding as of June 30, 2022 and payments shall commence starting in May 2022.\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\nPaycheck Protection Program Loan\nIn May 2020, the Company secured a loan under the Paycheck Protection Program administered by the U.S. Small Business Administration (the “SBA”) in the amount of $115,000. In February 2021, the Company secured a second loan under this program in the amount of approximately $167,000. The interest rate of the loan is 1.00% per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of each PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the loan. The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\nLine of Credit Facility\nDuring the second quarter of 2022, the Company entered into a line of credit agreement with a financial institution that provides a maximum borrowing limit of $2,000,000 with interest at 5% per annum. This line of credit facility matures on December 31, 2022. Total balance as of June 30, 2022 was $594,529.\nLeases\nOperating Leases\nWe currently lease all company-owned retail locations. Operating leases typically contain escalating rentals over the lease term, as well as optional renewal periods. Rent expense for operating leases is recorded on a straight-line basis over the lease term and begins when Reborn has the right to use the property. The difference between rent expense and cash payment is recorded as deferred rent on the accompanying consolidated balance sheets. Pre-opening rent is included in selling, general and administrative expenses on the accompanying consolidated statements of income. Tenant incentives used to fund leasehold improvements are recorded in deferred rent and amortized as reductions to rent expense over the term of the lease.\n26\nIncome Taxes\nReborn files income tax returns in the U.S. federal and California state jurisdictions.\nUpon the closing of this offering, we will be taxed at the prevailing U.S. corporate tax rates. We will be treated as a U.S. corporation and a regarded entity for U.S. federal, state and local income taxes. Accordingly, a provision will be recorded for the anticipated tax consequences of our reported results of operations for U.S. federal, state and foreign income taxes.\nJOBS Act Accounting Election\nWe are an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various public company reporting requirements for up to five years or until we are no longer an emerging growth company, whichever is earlier. The JOBS Act provides that an “emerging growth company” can delay adopting new or revised accounting standards until those standards apply to private companies. We have elected to use this extended transition period under the JOBS Act. Accordingly, our financial statements may not be comparable to the financial statements of public companies that comply with such new or revised accounting standards.\nOff Balance Sheet Arrangements\nWe do not have any off-balance sheet arrangements that we are required to disclose pursuant to these regulations. In the ordinary course of business, we enter into operating lease commitments, purchase commitments and other contractual obligations. These transactions are recognized in our financial statements in accordance with GAAP.\nCritical Accounting Policies\nThe preparation of financial statements requires management to utilize estimates and make judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. These estimates are based on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. The estimates are evaluated by management on an ongoing basis, and the results of these evaluations form a basis for making decisions about the carrying value of assets and liabilities that are not readily apparent from other sources. Although actual results may differ from these estimates under different assumptions or conditions, management believes that the estimates used in the preparation of our financial statements are reasonable. The critical accounting policies affecting our financial reporting are summarized in Note 2 to the financial statements included elsewhere in this prospectus.\nRecent Accounting Pronouncements\nWe have determined that all other issued, but not yet effective accounting pronouncements are inapplicable or insignificant to us and once adopted are not expected to have a material impact on our financial position.\n27\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\nWe are a smaller reporting company as defined by 17 C.F.R. 229 (10)(f)(i) and are not required to provide information under this item.\n\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nOur management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)), as of June 30, 2022. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of June 30, 2022, our disclosure controls and procedures were ineffective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (a) is recorded, processed, summarized and reported within the time periods specified by Securities and Exchange Commission (“SEC”) rules and forms and (b) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding any required disclosure.\nChanges in Internal Control Over Financial Reporting\nDuring the period ended June 30, 2022, our management has evaluated the internal control over financial reporting pursuant to Rules 13a-15(d) or 15d-15(d) under the Exchange Act. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our internal controls over financial reporting were ineffective as of June 30, 2022. Management of the Company believes that the ineffectiveness of internal controls was due to the lack of accounting and financial team.\n28\nPART II—OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nIn the future, the Company may be subject to various legal proceedings from time to time as part of its business. We are currently not involved in litigation that we believe will have a materially adverse effect on our financial condition or results of operations. As of June 30, 2022, there is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self- regulatory organization or body pending or, to the knowledge of the executive officers of our company or any of our subsidiaries threatened against or affecting our company, our common stock, any of our subsidiaries or of our company’s or our company’s subsidiaries’ officers or directors in their capacities as such, in which an adverse decision is expected to have a material adverse effect.\n\nItem 1A. Risk Factors.\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this item.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nWe have not made any sales of unregistered equity securities during the quarterly period ended June 30, 2022.\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $7,200,000 pursuant to our Registration Statement on Form S-1 (as amended) (File No. 333-261937), which was declared effective by the SEC on August 11, 2022. . EF Hutton, division of Benchmark Investments, LLC, acted as the representative of the underwriters of the IPO. After deducting underwriting discounts and commissions and other offering expenses payable by us, we received approximately $6.2 million in net proceeds from our initial public offering.\nThere has been no material change in the planned use of proceeds from our initial public offering as described in our final prospectus, dated August 11, 2022, which was filed with the SEC on August 16, 2021 pursuant to Rule 424(b) under the Securities Act. The primary use of the net proceeds from our initial public offering continues to be, as follows: (i) approximately $8.0 million for the acquisition of property and the development of a manufacturing plant to build, design and manufacture our new line of electric boats; (ii) approximately $2.0 million for ramp up of production and inventory; (iii) approximately $2.6 million for working capital.\nNo payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries. Pending the uses described, we have invested the net proceeds in our operating cash account.\n29\n\nItem 6. Exhibits.\nThe following exhibits are included herein or incorporated herein by reference:\n\n| 3.1 | Certificate of Incorporation (Delaware), dated July 27, 2022 (incorporated by reference to Exhibit 3.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 3.2 | Bylaws of Registrant (Delaware) (incorporated by reference to Exhibit 3.2 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 4.1 | Specimen Common Stock Certificate (Delaware) (incorporated by reference to Exhibit 4.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 4.2 | Form of Representative’s Warrant (incorporated by reference to Exhibit 4.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.1 | Share Exchange Agreement, dated May 7, 2018 by and among Capax, Reborn and each of the RB shareholders (incorporated by reference to Exhibit 10.1 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.2 | Form of Letter Agreement (Lockup) by and among Registrant, officers and directors of the Company and EF Hutton (incorporated by reference to Exhibit 10.2 to Amendment No. 6 to our Registration Statement on Form S-1 filed on August 9, 2022) |\n| 10.3 | Form of Director and Officer Indemnity Agreement (incorporated by reference to Exhibit 10.3 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.4 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and La Floresta Regency, LLC, effective July 25, 2016 (incorporated by reference to Exhibit 10.4 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.5 | Standard Industrial/Commercial Multi-Tenant Lease, as amended, by and between Reborn Global Holdings, Inc. and Foothill Crescenta, LLC, effective December 6, 2016 (incorporated by reference to Exhibit 10.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.6 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and Sibling Associates, LLC, effective July 12, 2017 (incorporated by reference to Exhibit 10.6 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.7 | Standard Lease by and between Reborn Global Holdings, Inc. and El Toro, LP, effective February 12, 2021 (incorporated by reference to Exhibit 10.7 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.8 | Form of Subscription Agreement (Regulation A+ Offering) (incorporated by reference to Exhibit 10.11 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.9 | Consulting Agreement by and between the Company and Kevin Hartley, effective September 15, 2021 (incorporated by reference to Exhibit 10.12 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\n| 10.10 | Amendment to Share Exchange Agreement, dated January 25, 2022, by and among Reborn Coffee Inc., Andrew Weeraratne and each of the former shareholders of Reborn Global Holdings, Inc., a California corporation (incorporated by reference to Exhibit 10.10 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 10.11 | Offer of Employment by and between the Company and Stephan Kim, dated July 27, 2022 (incorporated by reference to Exhibit 10.11 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\n| 31.1* | Certification of Jay Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Stephan Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Jay Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Stephan Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n\n| * | Filed herewith. |\n\n\n| ** | Furnished herewith. |\n\n30\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| Signature | Title | Date |\n| /s/ Jay Kim | Chief Executive Officer (Principal Executive Officer) | September 30, 2022 |\n| Jay Kim |\n| /s/ Stephan Kim | Chief Financial Officer (Principal Financial and Accounting Officer) | September 30, 2022 |\n\n31\n\n</text>\n\nWhat was the percentage change in earnings per share (EPS) year over year?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nPART I—FINANCIAL INFORMATION\\nItem 1. Condensed Consolidated Financial Statements.\\nUnaudited Condensed Consolidated Balance Sheets\\n\\n| As of | June 30, 2022 | December 31, 2021 |\\n| ASSETS |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 149,824 | $ | 905,051 |\\n| Accounts receivable, net of allowance for doubtful accounts of $ 0 and $ 0 , respectively | 1,293 | - |\\n| Inventories, net | 102,981 | 88,877 |\\n| Prepaid expense and other current assets | 220,113 | 191,838 |\\n| Total current assets | 474,211 | 1,185,766 |\\n| Property and equipment, net | 1,181,365 | 1,110,890 |\\n| Operating lease right-of-use asset | 2,937,437 | 2,466,873 |\\n| Total assets | $ | 4,593,013 | $ | 4,763,529 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) |\\n| Current liabilities: |\\n| Accounts payable | $ | 158 | $ | 45,748 |\\n| Accrued expenses and current liabilities | 171,070 | 124,535 |\\n| Line of credit | 594,529 | - |\\n| Loans payable to financial institutions – current portion | - | 98,475 |\\n| Loans payable to shareholders | 150,000 | - |\\n| Loan payable, emergency injury disaster loan (EIDL) – current portion | 10,760 | 7,957 |\\n| Loan payable, payroll protection program (PPP) – current portion | 39,169 | 42,345 |\\n| Equipment loan payable – current portion | 6,312 | 15,989 |\\n| Operating lease liabilities – current portion | 655,603 | 578,419 |\\n| Total current liabilities | 1,627,601 | 913,468 |\\n| Loans payable to financial institutions – net of current portion | - | 23,228 |\\n| Loan payable, emergency injury disaster loan (EIDL), net of current portion | 489,240 | 492,043 |\\n| Loan payable, payroll protection program (PPP), net of current portion | 127,969 | 124,793 |\\n| Operating lease liabilities, net of current portion | 2,427,168 | 2,011,702 |\\n| Total liabilities | 4,671,978 | 3,565,234 |\\n| Commitments and Contingencies |\\n| Stockholders’ equity (deficit) |\\n| Common Stock, $ 0.0001 par value, 40,000,000 shares authorized; 11,679,523 and 11,634,523 shares issued and outstanding at June 30, 2022 and December 31, 2021 | 1,168 | 1,163 |\\n| Preferred Stock, $ 0.0001 par value, 1,000,000 shares authorized; no shares issued and outstanding at June 30, 2022 and December 31, 2021 | - | - |\\n| Additional paid-in capital | 9,899,031 | 9,674,036 |\\n| Accumulated deficit | ( 9,979,164 | ) | ( 8,476,904 | ) |\\n| Total stockholders’ equity (deficit) | ( 78,965 | ) | 1,198,295 |\\n| Total liabilities and stockholders’ equity | $ | 4,593,013 | $ | 4,763,529 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n1\\nUnaudited Condensed Consolidated Statements of Operations\\n\\n| Six Months Ended June 30, | Three Months Ended June 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net revenues: |\\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 775,956 | $ | 475,824 |\\n| Wholesale and online | 29,674 | 28,336 | 12,520 | 15,368 |\\n| Total net revenues | 1,541,626 | 880,121 | 788,476 | 491,192 |\\n| Operating costs and expenses: |\\n| Product, food and drink costs—stores | 563,906 | 270,148 | 278,952 | 135,452 |\\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 5,484 | 6,732 |\\n| General and administrative | 2,468,447 | 1,226,951 | 1,432,432 | 656,310 |\\n| Total operating costs and expenses | 3,045,350 | 1,509,511 | 1,716,868 | 798,494 |\\n| Loss from operations | ( 1,503,724 | ) | ( 629,390 | ) | ( 928,392 | ) | ( 307,302 | ) |\\n| Other income (expense): |\\n| Other income | 16,440 | - | 1,440 | - |\\n| Interest expense | ( 14,976 | ) | ( 5,773 | ) | ( 10,196 | ) | ( 382 | ) |\\n| Total other income (expense), net | 1,464 | ( 5,773 | ) | ( 8,756 | ) | ( 382 | ) |\\n| Loss before income taxes | ( 1,502,260 | ) | ( 635,163 | ) | ( 937,148 | ) | ( 307,684 | ) |\\n| Provision for income taxes | - | - | - | - |\\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\\n| Loss per share: |\\n| Basic and diluted | $ | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\\n| Weighted average number of common shares outstanding: |\\n| Basic and diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n2\\nUnaudited Condensed Consolidated Stockholders’ Equity (Deficit)\\n\\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\\n| Balance as of December 31, 2021 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 8,476,904 | ) | $ | 1,198,295 |\\n| Net loss | - | - | - | - | - | - | ( 565,112 | ) | ( 565,112 | ) |\\n| Balance as of March 31, 2022 | 11,634,523 | $ | 1,163 | - | $ | - | $ | 9,674,036 | $ | - | $ | ( 9,042,016 | ) | $ | 633,183 |\\n| Stock compensation | 45,000 | 5 | - | - | 224,995 | - | - | 225,000 |\\n| Net loss | - | - | - | - | - | - | ( 937,148 | ) | ( 937,148 | ) |\\n| Balance as of June 30, 2022 | 11,679,523 | $ | 1,168 | - | $ | - | $ | 9,899,031 | $ | - | $ | ( 9,979,164 | ) | $ | ( 78,965 | ) |\\n\\n\\n| Common Stock | Preferred Stock | Additional Paid-in | Subscription of Common | Accumulated | Total Shareholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Stock | Deficit | Deficit |\\n| Balance as of December 31, 2020 | 10,443,721 | $ | 1,045 | - | $ | - | $ | 4,733,063 | $ | ( 450,000 | ) | $ | ( 5,036,504 | ) | $ | ( 752,396 | ) |\\n| Net loss | - | - | - | - | - | - | ( 327,479 | ) | ( 327,479 | ) |\\n| Payments received for prior year subscription | - | - | - | - | - | 450,000 | - | 450,000 |\\n| Stock issued for store acquisition | 232,558 | 23 | - | - | 149,977 | - | - | 150,000 |\\n| Balance as of March 31, 2021 | 10,676,279 | $ | 1,068 | - | $ | - | $ | 4,883,040 | $ | - | $ | ( 5,363,983 | ) | $ | ( 479,875 | ) |\\n| Net loss | - | - | - | - | - | - | ( 307,684 | ) | ( 307,684 | ) |\\n| Stock subscription | 30,950 | 3 | - | - | 154,747 | ( 154,750 | ) | - | - |\\n| Payments received for prior year subscription | - | - | - | - | - | 103,500 | - | 103,500 |\\n| Balance as of June 30, 2021 | 10,707,229 | $ | 1,071 | - | $ | - | $ | 5,037,787 | $ | ( 51,250 | ) | $ | ( 5,671,667 | ) | $ | ( 684,059 | ) |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n3\\nUnaudited Condensed Consolidated Statements of Cash Flows\\n\\n| For the Six Months Ended June 30, | 2022 | 2021 |\\n| Cash flows from operating activities: |\\n| Net loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Stock compensation | 225,000 | - |\\n| Operating lease | 22,086 | 20,559 |\\n| Depreciation | 97,922 | 81,926 |\\n| Changes in operating assets and liabilities: |\\n| Accounts receivable | ( 1,293 | ) | ( 269 | ) |\\n| Inventories | ( 14,104 | ) | ( 7,245 | ) |\\n| Prepaid expense and other current assets | ( 28,275 | ) | ( 65,083 | ) |\\n| Accounts payable | ( 45,590 | ) | 49,508 |\\n| Accrued expenses and current liabilities | 46,535 | 17,415 |\\n| Net cash used in operating activities | ( 1,199,979 | ) | ( 538,352 | ) |\\n| Cash flows from investing activities: |\\n| Purchases of property and equipment | ( 168,397 | ) | ( 167,152 | ) |\\n| Reacquisition of store | - | ( 150,000 | ) |\\n| Net cash used in investing activities | ( 168,397 | ) | ( 317,152 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds from issuance of common stock | - | 553,499 |\\n| Proceeds from line of credit | 594,529 | - |\\n| Proceeds from loan payable to shareholders | 150,000 | 533,127 |\\n| Repayment of loans | ( 121,703 | ) | ( 210,453 | ) |\\n| Repayment of equipment loan payable | ( 9,677 | ) | ( 9,594 | ) |\\n| Net cash provided by financing activities | 613,149 | 866,579 |\\n| Net (decrease) increase in cash | ( 755,227 | ) | 11,075 |\\n| Cash at beginning of period | 905,051 | 128,568 |\\n| Cash at end of period | $ | 149,824 | $ | 139,643 |\\n| Supplemental disclosures of non-cash financing activities: |\\n| Issuance of common shares for repurchase of store | $ | - | $ | 150,000 |\\n| Issuance of common shares for compensation | $ | 225,000 | $ | - |\\n| Supplemental disclosure of cash flow information: |\\n| Cash paid during the years for: |\\n| Lease liabilities | $ | 435,635 | $ | 224,988 |\\n| Interest | $ | 367 | $ | 5,773 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n4\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n1. NATURE OF OPERATIONS\\nReborn Coffee, Inc. (“Reborn”) was incorporated in the State of Florida in January 2018. In July 2022, Reborn was migrated from Florida to Delaware, and filed a certificate of incorporation with the Secretary of State of the State of Delaware having the same capitalization structure as the Florida predecessor entity. Reborn has the following wholly owned subsidiaries:\\n\\n| ● | Reborn Global Holdings, Inc. (“Reborn Holdings”), a California Corporation incorporated in November 2014. Reborn Holdings is engaged in the operation of wholesale distribution and retail coffee stores in California to sell a variety of coffee, tea, Reborn brand name water and other beverages along with bakery and dessert products. |\\n\\n\\n| ● | Reborn Coffee Franchise, LLC (the “Reborn Coffee Franchise”), a California limited liability corporation formed in December 2020, is a franchisor providing premier roaster specialty coffee to franchisees or customers. Reborn Coffee Franchise continues to develop the Reborn Coffee system for the establishment and operation of Reborn Coffee stores using one or more Reborn Coffee marks. The franchisee obtains a license to develop and operate a store under the strict compliance with terms of the agreement. The specific rights the franchisee is granted is to develop, own, and/or operate franchisee’s Reborn Coffee stores. The non-refundable initial franchise fee is $ 20,000 . In addition, the franchisee is required to pay the company a royalty fee equal to 5 % of the weekly gross sales of their respective store. |\\n\\nReborn Coffee, Inc., Reborn Global Holdings, Inc., and Reborn Coffee Franchise, LLC will be collectively referred as the “Company”.\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nReporting\\nThe unaudited condensed consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries as of June 30, 2022 and December 31, 2021 and for the three and six month periods ended June 30, 2022 and 2021.\\nBasis of Presentation and Consolidation\\nThe accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) as promulgated in the United States of America. The consolidated financial statements include Reborn Coffee, Inc. and its wholly owned subsidiaries. All intercompany accounts, transactions, and profits have been eliminated upon consolidation.\\nReverse Stock Split\\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse stock split , and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\\nGoing Concern\\nThe accompanying unaudited condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. The Company had an accumulated deficit of $ 9,979,164 at June 30, 2022, had a net loss of $ 1,502,260 for the six-month period ended June 30, 2022 and net cash used in operating activities of $ 1,199,979 for the six-month period ended June 30, 2022. These matters raise substantial doubt about the Company’s ability to continue as a going concern.\\n5\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nWhile the Company is attempting to expand operations and increase revenues, the Company’s cash position may not be significant enough to support the Company’s daily operations. Management intends to raise additional funds by way of public or private offerings. Management believes that the actions presently being taken to further implement its business plan and generate revenues provide the opportunity for the Company to continue as a going concern. While management believes in the viability of its strategy to generate revenues and in its ability to raise additional funds, there can be no assurances to that effect or if available, on terms acceptable to the Company. The ability of the Company to continue as a going concern is dependent upon the Company’s ability to further implement its business plan and generate additional profit. Compared to the revenue for the six-month period ended June 30, 2021, however, net revenue for the six-month period ended June 30, 2022 has increased from $ 880,121 to $ 1,541,626 , and the Company expects consistent increase in sales with the opening of more stores. In August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $ 5.00 per share, generating gross proceeds of $ 7,200,000 . The initial public offering is summarized in Note 12 to the unaudited condensed consolidated financial statements.\\nThe unaudited condensed consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.\\nUse of Estimates\\nThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires the Company to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and the accompanying notes. Such estimates include accounts receivables, accrued liabilities, income taxes, long-lived assets, and deferred tax valuation allowances. These estimates generally involve complex issues and require management to make judgments, involve analysis of historical and future trends that can require extended periods of time to resolve, and are subject to change from period to period. In all cases, actual results could differ materially from estimates.\\nRevenue Recognition\\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail stores and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\\n\\n| ● | Retail Store Revenue |\\n\\nRetail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 98 % of the Company’s total revenue.\\n\\n| ● | Wholesale and Online Revenue |\\n\\nWholesale and online revenues are recognized when the products are delivered, and title passes to the customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 2 % of the Company’s total revenue.\\n\\n| ● | Royalties and Other Fees |\\n\\nFranchise revenues consists of royalties and other franchise fees. Royalties are based on a percentage of franchisee’s weekly gross sales revenue at 5 %. The Company recognizes the royalties as the underlying sales occur. The Company recorded revenue from royalties of $ 0 for the six-month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the six-month periods ended June 30, 2022 and 2021.\\nShipping and Handling Costs\\nThe Company incurred freight out cost and is included in the Company’s cost of sales - wholesale and online.\\n6\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nGeneral and Administrative Expense\\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\\nAdvertising Expense\\nAdvertising costs are expensed as incurred. Advertising expenses amounted to $ 20,513 and $ 50,160 for the six-month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying consolidated statements of operations.\\nPre-opening Costs\\nPre-opening costs for new stores, consist primarily of store and leasehold improvements, and are capitalized and depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\\nAccounts Receivable\\nAccounts receivables are stated net of allowance for doubtful accounts. The allowance for doubtful accounts is determined primarily on the basis of past collection experience and general economic conditions. The Company determines terms and conditions for its customers based on volume transacted by the customer, customer creditworthiness and past transaction history. At June 30, 2022 and December 31, 2021, allowance for doubtful accounts was $ 0 and $ 0 , respectively. The Company does not have any off-balance sheet exposure related to its customers.\\nInventories\\nInventories consisted primarily of coffee beans, drink products, and supplies which are recorded at cost or at net realizable value.\\nProperty and Equipment\\nProperty and equipment are recorded at cost. Maintenance and repairs are charged to expense as incurred. Depreciation and amortization are provided using both the straight-line and declining balance methods over the following estimated useful lives:\\n\\n| Furniture and fixtures | 5 - 7 Years |\\n| Store construction | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\\n| Leasehold improvement | Lesser of the lease term or the estimated useful lives of the improvements, generally 6 years |\\n\\nWhen assets are retired or disposed of, the cost and accumulated depreciation thereon are removed, and any resulting gains or losses are included in the consolidated statements of operations. Leasehold improvements are amortized using the straight-line method over the estimated life of the asset, not to exceed the length of the lease. Repair and maintenance costs are expensed as incurred.\\nOperating Leases\\nThe Company adopted FASB Accounting Standards Codification, or ASC, Topic 842, Leases (“ASC 842”) which requires the recognition of the right-of-use assets and relating operating and finance lease liabilities on the balance sheet. Under ASC 842, all leases are required to be recorded on the balance sheet and are classified as either operating leases or finance leases. The lease classification affects the expense recognition in the income statement. Operating lease charges are recorded entirely in operating expenses. Finance lease charges are split, where amortization of the right-of-use asset is recorded in operating expenses and an implied interest component is recorded in interest expense.\\nEarnings Per Share\\nFinancial Accounting Standard Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 260, Earnings Per Share, requires a reconciliation of the numerator and denominator of the basic and diluted earnings (loss) per share (EPS) computations.\\n7\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nBasic earnings (loss) per share are computed by dividing net earnings available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. In periods where losses are reported, the weighted-average number of common stock outstanding excludes common stock equivalents, because their inclusion would be anti-dilutive.\\nThe Company did not have any dilutive shares for the three and six month periods ended June 30, 2022 and 2021.\\nSegment Reporting\\nFASB ASC Topic 280, Segment Reporting, requires public companies to report financial and descriptive information about their reportable operating segments. The Company’s management identifies operating segments based on how the Company’s management internally evaluate separate financial information, business activities and management responsibility. At the current time, the Company has only one reportable segment, consisting of both the wholesale and retail sales of coffee, water, and other beverages. The Company’s franchisor subsidiary was not material as of and for the three and six month periods ended June 30, 2022 and 2021.\\nLong-lived Assets\\nIn accordance with FASB ASC Topic 360, Property, Plant, and Equipment, the Company reviews for impairment of long-lived assets and certain identifiable intangibles whenever events or circumstances indicate that the carrying amount of assets may not be recoverable. The Company considers the carrying value of assets may not be recoverable based upon our review of the following events or changes in circumstances: the asset’s ability to continue to generate income from operations and positive cash flow in future periods; loss of legal ownership or title to the assets; significant changes in our strategic business objectives and utilization of the asset; or significant negative industry or economic trends. An impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset are less than its carrying amount. As of June 30, 2022 and December 31, 2021, the Company was not aware of any events or changes in circumstances that would indicate that the long-lived assets are impaired.\\nFair Value of Financial Instruments\\nThe Company records its financial assets and liabilities at fair value, which is defined under the applicable accounting standards as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measure date. The Company uses valuation techniques to measure fair value, maximizing the use of observable outputs and minimizing the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:\\nLevel 1 – Quoted prices in active markets for identical assets or liabilities.\\nLevel 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.\\nLevel 3 – Inputs include management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument’s valuation.\\nAs of June 30, 2022 and December 31, 2021, the Company believes that the carrying value of accounts receivable, accounts payable, accrued expenses, and other current assets and liabilities approximate fair value due to the short maturity of theses financial instruments. The financial statements do not include any financial instruments at fair value on a recurring or non-recurring basis.\\n8\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nIncome Taxes\\nIncome taxes are provided for the tax effects of transactions reported in the financial statements and consisted of taxes currently due and deferred taxes. Deferred taxes are recognized for the differences between the basis of assets and liabilities for financial statement and income tax purposes.\\nThe Company follows FASB ASC Topic 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. ASC 740-10-25 provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax position. The Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The Company did not recognize additional liabilities for uncertain tax positions pursuant to ASC 740-10-25 for the three and six month periods ended June 30, 2022 and 2021.\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk are accounts receivable arising from its normal business activities. The Company performs ongoing credit evaluations to its customers and establishes allowances when appropriate.\\nCompany purchases from various vendors for its operations. For the three and six month periods ended June 30, 2022 and 2021, no purchases from any vendors accounted for a significant amount of the Company’s bean coffee purchases.\\nRelated Parties\\nRelated parties are any entities or individuals that, through employment, ownership, or other means, possess the ability to direct or cause the direction of management and policies of the Company.\\nSignificant Recent Developments Regarding COVID-19\\nThe novel coronavirus, known as the global pandemic COVID-19, was first identified in December 2019. During March 2020, a global pandemic was declared by the World Health Organization related to the rapidly spreading outbreak of a novel strain of coronavirus designated COVID-19. The pandemic has significantly impacted economic conditions in the United States. The outbreak of the virus impacted our company-owned retail locations in Southern California.\\nThe Company first began to experience impacts from COVID-19 around the middle of March 2020 as federal, state and local governments began to react to the public health crisis by encouraging or requiring social distancing, instituting stay-at-home orders, and requiring, in varying degrees, restaurant dine-in limitations, capacity limitations or other restrictions that largely limited restaurants to take-out, drive-thru and delivery sales. Although we have experienced some recovery from the initial impact of COVID-19, the long-term impact of COVID-19 on the economy and on our business remains uncertain, the duration and scope of which cannot currently be predicted.\\n9\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)\\nRecent Accounting Pronouncement\\nIn June 2016, the FASB issued Accounting Standards Update No. 2016-13, “Financial Instruments - Credit Losses (Topic 326)” (“ASU 2016-13”). ASU 2016-13 revises the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. Originally, ASU 2016-13 was effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2019, with early adoption permitted. In November 2019, FASB issued ASU 2019-10, “Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842).” This ASU defers the effective date of ASU 2016-13 for public companies that are considered smaller reporting companies as defined by the SEC to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is planning to adopt this standard in the first quarter of fiscal 2023.The Company is currently evaluating the potential effects of adopting the provisions of ASU No. 2016-13 on its consolidated financial statements, particularly its recognition of allowances for accounts receivable.\\nOther recently issued accounting updates are not expected to have a material impact on the Company’s consolidated financial statements.\\n3. PROPERTY AND EQUIPMENT\\nProperty and equipment consisted of the following:\\n\\n| June 30, 2022 | December 31, 2021 |\\n| Furniture and equipment | $ | 849,809 | $ | 779,649 |\\n| Leasehold improvement | 639,602 | 639,602 |\\n| Store construction | 150,399 | 52,161 |\\n| Store | 300,000 | 300,000 |\\n| Total property and equipment | 1,939,810 | 1,771,412 |\\n| Less accumulated depreciation | ( 758,445 | ) | ( 660,522 | ) |\\n| Total property and equipment, net | $ | 1,181,365 | $ | 1,110,890 |\\n\\nIn February 2021, the Company repurchased its retail location in Corona Del Mar. The purchase price was $ 300,000 , comprised of $ 150,000 in cash and 232,558 shares of the Company’s common stock. The Company recorded the assumption of the ongoing lease for the store, which included a right of use asset of $ 183,442 and a lease liability of $ 193,463 .\\nDepreciation expense on property and equipment amounted to approximately $ 97,922 and $ 81,926 for the six-month periods ended and $ 48,479 and $ 45,797 for the three-month periods ended June 30, 2022 and 2021, respectively.\\n10\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n4. LOANS PAYABLE TO FINANCIAL INSTITUTIONS\\nLoans payable to financial institutions consist of the following:\\n\\n| June 30, 2022 | December 31, 2021 |\\n| July 2021 - Loan agreement with principal amount of $ 90,000 and repayment rate of 19 % for a total of $ 101,700 . The loan payable matures on January 31, 2023 . | $ | - | $ | 52,819 |\\n| August 2021 - Loan agreement with principal amount of $72,500 and repayment rate of 18.5 % for a total of $ 81,925 . The loan payable matures on February 10, 2023 . | - | 36,502 |\\n| August 2021 - Loan agreement with principal amount of $ 67,500 and repayment rate of 18.5 % for a total of $ 76,275 . The loan payable matures on February 11, 2023 . | - | 32,382 |\\n| Total loan payable | $ | - | $ | 121,703 |\\n| Less: current portion | - | ( 98,475 | ) |\\n| Total loan payable, net of current | $ | - | $ | 23,228 |\\n\\nJuly 2021 - $ 101,700 loan payable\\nIn July 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 90,000 with loan cost $ 11,700 . The loan payable has a maturity date on January 31, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 52,819 , respectively.\\nAugust 2021 - $ 81,925 loan payable\\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 72,500 with loan cost $ 9,425 . The loan payable has a maturity date on February 10, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 36,502 , respectively.\\nAugust 2021 - $ 76,275 loan payable\\nIn August 2021, the Company entered into a loan agreement with Square Capital in the principal amount of $ 67,500 with loan cost $ 8,775 . The loan payable has a maturity date on February 11, 2023 . As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 0 and $ 32,382 , respectively.\\n11\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL)\\n\\n| June 30, 2022 | December 31, 2021 |\\n| May 16, 2020 ($ 150,000 ) - Loan agreement with principal amount of $150,000 with an interest rate of 3.75 % and maturity date on May 16, 2050 | $ | 150,000 | $ | 150,000 |\\n| June 28, 2021 ($ 350,000 ) – Loan agreement with principal amount of $350,000 with an interest rate of 3.75 % and maturity date on May 18, 2050 | 350,000 | 350,000 |\\n| Total long-term loan payable, emergency injury disaster loan (EIDL) | 500,000 | 500,000 |\\n| Less - current portion | ( 10,760 | ) | ( 7,957 | ) |\\n| Total loan payable, emergency injury disaster loan (EIDL), less current portion | $ | 489,240 | $ | 492,043 |\\n\\nThe following table provides future minimum payments:\\n\\n| For the years ended December 31, | Amount |\\n| 2022 (remaining six months) | 5,330 |\\n| 2023 | 10,964 |\\n| 2024 | 11,382 |\\n| 2025 | 11,816 |\\n| 2026 | 12,267 |\\n| Thereafter | 448,241 |\\n| Total | $ | 500,000 |\\n\\nMay 16, 2020 – $ 150,000\\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 150,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $ 731 . The balance of principal and interest is payable thirty years from the date of the SBA Loan.\\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\\n12\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n5. LOAN PAYABLES, EMERGENCY INJURY DISASTER LOAN (EIDL) (continued)\\nJune 28, 2021 – $ 350,000\\nOn June 28, 2021, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the TNB’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\\nPursuant to that certain Amended Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $ 500,000 , with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75 % per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning October 16, 2022 (thirty months from the original date of the SBA Loan) in the amount of $ 2,505 . The balance of principal and interest is payable thirty years from the original date of the SBA Loan.\\n6. LOAN PAYABLE, PAYROLL PROTECTION LOAN PROGRAM (PPP)\\n\\n| June 30, 2022 | December 31, 2021 |\\n| Loan payable, payroll protection program (PPP) – February 10, 2021 | $ | 167,138 | $ | 167,138 |\\n| Total long-term loan payable, payroll protection program (PPP) | 167,138 | 167,138 |\\n| Less - current portion | ( 39,169 | ) | ( 42,345 | ) |\\n| Total loan payable, payroll protection program (PPP), less current portion | $ | 127,969 | $ | 124,793 |\\n\\nThe Paycheck Protection Program Loan (the “PPP Loan”) is administered by the U.S. Small Business Administration (the “SBA”). The interest rate of the loan is 1.00 % per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of the PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the PPP Loan (the “Maturity Date”). The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan.\\n13\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n7. EQUIPMENT LOAN PAYABLE\\nEquipment loan payable consist of the following:\\n\\n| June 30, 2022 | December 31, 2021 |\\n| October 2017 - Loan agreement with principal amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 | $ | 6,312 | $ | 15,989 |\\n| Total long-term equipment loan payable | 6,312 | 15,989 |\\n| Less – current portion | ( 6,312 | ) | ( 15,989 | ) |\\n| Total long-term debt, net of current portion | $ | - | $ | - |\\n\\n\\n| For the year ended December 31, | Amount |\\n| 2022 (remaining six months) | $ | 6,312 |\\n| Total long-term equipment loan payable | $ | 6,312 |\\n\\nOctober 2017 - $ 82,011 equipment loan payable\\nIn October 2017, the Company entered into equipment finance loan agreement with US Bank Equipment Finance in the amount of $ 82,011 with an interest rate of 6.40 % and maturity date on October 1, 2022 , payable in 60 payments. All principal, together with interest cost is due and payable on October 1, 2022. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $ 6,312 and $ 15,989 , respectively.\\n8. INCOME TAX\\nTotal income tax (benefit) expense consists of the following:\\n\\n| For the Six-Month Periods Ended June 30, | 2022 | 2021 |\\n| Current provision (benefit): |\\n| Federal | $ | - | $ | - |\\n| State | - | - |\\n| Total current provision (benefit) | - | - |\\n| Deferred provision (benefit): |\\n| Federal | - | - |\\n| State | - | - |\\n| Total deferred provision (benefit) | - | - |\\n| Total tax provision (benefit) | $ | - | $ | - |\\n\\nA reconciliation of the Company’s effective tax rate to the statutory federal rate is as follows:\\n\\n| Description | Rate |\\n| Statutory federal rate | 21.00 | % |\\n| State income taxes net of federal income tax benefit and others | 8.84 | % |\\n| Permanent differences for tax purposes and others | 0.00 | % |\\n| Change in valuation allowance | - 29.84 | % |\\n| Effective tax rate | 0 | % |\\n\\n14\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n8. INCOME TAX (continued)\\nThe income tax benefit differs from the amount computed by applying the U.S. federal statutory tax rate of 21 % and California state income taxes of 8.84 % due to the change in the valuation allowance.\\nDeferred income taxes reflect the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The components of deferred tax assets and liabilities are as follows:\\n\\n| Deferred tax assets | June 30, 2022 | December 31, 2021 |\\n| Deferred tax assets: |\\n| Net operating loss | $ | 2,961,949 | $ | 2,513,674 |\\n| Other temporary differences | - | - |\\n| Total deferred tax assets | 2,961,949 | 2,513,674 |\\n| Less - valuation allowance | ( 2,961,949 | ) | ( 2,513,674 | ) |\\n| Total deferred tax assets, net of valuation allowance | $ | - | $ | - |\\n\\nAs of December 31, 2021, the Company had available net operating loss carryovers of approximately $ 8,423,841 . Per the Tax Cuts and Jobs Act (TCJA) implemented in 2018, the two-year carryback provision was removed and now allows for an indefinite carryforward period. The carryforwards are limited to 80 % of each subsequent year’s net income. As a result, net operating loss may be applied against future taxable income and expires at various dates subject to certain limitations. The Company has a deferred tax asset arising substantially from the benefits of such net operating loss deduction and has recorded a valuation allowance for the full amount of this deferred tax asset since it is more likely than not that some or all of the deferred tax asset may not be realized.\\nThe Company files income tax returns in the U.S. federal jurisdiction and California and is subject to income tax examinations by federal tax authorities for tax year ended 2017 and later and subject to California authorities for tax year ended 2016 and later. The Company currently is not under examination by any tax authority. The Company’s policy is to record interest and penalties on uncertain tax positions as income tax expense. As of June 30, 2022 and December 31, 2021, the Company has no accrued interest or penalties related to uncertain tax positions.\\nAs of June 30, 2022, the Company had cumulative net operating loss carryforwards for federal tax purposes of approximately $ 9,926,101 . In addition, the Company had state tax net operating loss carryforwards of approximately $ 9,926,101 . The carryforwards may be applied against future taxable income and expires at various dates subject to certain limitations.\\n15\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n9. COMMITMENTS AND CONTINGENCIES\\nOperating Leases\\nThe Company entered into the following operating facility leases\\n\\n| ● | La Floresta - On July 25, 2016, the Company entered into an operating facility lease for its store located at La Floresta Shopping Village in Brea, California with 60 months term with option to extend. The lease started on July 2016 and expires on November 2024. |\\n\\n\\n| ● | La Crescenta - On May 2017, the Company entered into an operating facility lease for its store located in La Crescenta, California with 120 months term with option to extend. The lease started on May 2017 and expires in May 2027. The Company entered into non-cancellable lease agreement for a coffee shop approximately 1,607 square feet located in La Crescenta, California commencing in May 2017 and expiring in April 2027. The monthly lease payment under the lease agreement approximately $ 6,026 . |\\n\\n\\n| ● | Brea - On September 1, 2018, the Company entered into an operating facility lease for its corporate office located in Brea, California with 72 months term with option to extend. The lease starts on September 2018 and expires on August 2024. |\\n\\n\\n| ● | Glendale – On October 27, 2020, The Company entered a 7-year operating facility lease for its store located at the Glendale Galleria in Glendale, California. The lease starts on November 2020 and expires in October 2027. |\\n| ● | San Francisco - On December 22, 2020, the Company entered into an operating facility lease for its store located at Stonestown Galleria in San Francisco, California with 84 months term with option to extend. The lease starts in June 2021 and expires in April 2028. |\\n\\n\\n| ● | Santa Anita - On December 22, 2020, the Company entered into an operating facility lease for its store located at Arcadia, California with 36 months term with option to extend. The lease starts in February 2021 and expires in January 2024. |\\n| ● | Riverside - On February 4, 2021, the Company entered into an operating facility lease for its store located at Galleria at Tyler in Riverside, California with 84 months term with option to extend. The lease starts in April 2021 and expires in March 2028. |\\n\\n\\n| ● | Corona Del Mar - On February 5, 2021, the Company repurchased its retail store in Corona Del Mar, California. As part of that repurchase, the Company assumed the original operating lease on the facility, with 66 months term with an option to extend. The lease expires in December 2022. |\\n\\n\\n| ● | Laguna Woods - On February 12, 2021, the Company entered into an operating facility lease for its store located at Home Depot Center in Laguna Woods, California with 60 months term with option to extend. The lease starts in June 2021 and expires in May 2026. |\\n\\n\\n| ● | Huntington Beach - On November 1 2021, the Company entered into an operating facility lease for its store located at Huntington Beach, California with 124 months term with option to extend. The lease starts in November 2021 and expires in February 2032. |\\n\\n\\n| ● | Manhattan Village - On March 1 2022, the Company entered into an operating facility lease for its store located at Manhattan Beach, California with 60 months term with option to extend. The lease starts in March 2022 and expires in February 2027. |\\n\\nThe Company adopted ASC 842 as of January 2018 (date of formation). The Company has operating leases for the Company’s corporate office and stores and accounts for these leases in accordance with ASC 842, which resulted in the recognition of ROU assets and operating lease liabilities of $ 2,937,437 and $ 3,082,771 , respectively, as of June 30, 2022. Certain of the leases for the Company’s retail store facilities provide for variable payments for property taxes, insurance and common area maintenance payments related to rental payments based on future sales volumes at the leased location, which are not measurable at the inception of the lease, or rental payments that are adjusted periodically for inflation.\\nFor the new lease and adjustments, the Company recorded an additional non-cash increase of $470,564 to ROU assets and $492,650 to operational lease liabilities for the six-month period ended June 30, 2022.\\n16\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n9. COMMITMENTS AND CONTINGENCIES (continued)\\nIn accordance with ASC 842, the components of lease expense were as follows:\\n\\n| Six-month period ended June 30, | 2022 | 2021 |\\n| Operating lease expense | $ | 452,155 | $ | 279,888 |\\n| Total lease expense | $ | 452,155 | $ | 279,888 |\\n\\nIn accordance with ASC 842, other information related to leases was as follows:\\n\\n| Six-month period ended June 30, | 2022 | 2021 |\\n| Operating cash flows from operating leases | $ | 435,635 | $ | 224,988 |\\n| Cash paid for amounts included in the measurement of lease liabilities | $ | 435,635 | $ | 224,988 |\\n| Weighted-average remaining lease term—operating leases | 4.1 Years |\\n| Weighted-average discount rate—operating leases | 8.9 | % |\\n\\nIn accordance with ASC 842, maturities of operating lease liabilities as of June 30, 2022 were as follows:\\n\\n| Operating |\\n| For the years ended December 31, | Lease |\\n| 2022 (remaining six months) | $ | 467,758 |\\n| 2023 | 864,887 |\\n| 2024 | 785,267 |\\n| 2025 | 642,387 |\\n| 2026 | 574,150 |\\n| Thereafter | 456,435 |\\n| Total undiscounted cash flows | $ | 3,790,884 |\\n| Reconciliation of lease liabilities: |\\n| Weighted-average remaining lease terms | 4.1 Years |\\n| Weighted-average discount rate | 8.9 | % |\\n| Present values | $ | 3,082,771 |\\n| Lease liabilities—current | 655,603 |\\n| Lease liabilities—long-term | 2,427,168 |\\n| Lease liabilities—total | $ | 3,082,771 |\\n| Difference between undiscounted and discounted cash flows | $ | 708,113 |\\n\\nContingencies\\nThe Company is subject to various legal proceedings from time to time as part of its business. As of June 30, 2022, the Company was not currently party to any legal proceedings or threatened legal proceedings, the adverse outcome of which, individually or in the aggregate, it believes would have a material adverse effect on its business, financial condition, and results of operations.\\n17\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n10. SHAREHOLDERS’ EQUITY\\nCommon Stock\\nThe Company has authorization to issue and have outstanding at any one time 40,000,000 share of common stock with a par value of $ 0.0001 per share. The shareholders of common stock shall be entitled to one vote per share and dividends declared by the Company’s Board of Directors.\\nIn June 2022, the Company approved (a) the conversion of all Class B Common Stock into Class A Common Stock, (b) a 1 for 100 reverse split, and (c) an amendment to Articles of Incorporation to eliminate Class B and to change “Class A” to simply “common stock”. All share and earnings per share information have been retroactively adjusted to reflect the stock split and the incremental par value of the newly issued shares was recorded with the offset to additional paid-in capital.\\nPreferred Stock\\nThe Company has authorization to issue and have outstanding at any one time 1,000,000 share of preferred stock with a par value of $ 0.0001 per share, in one or more classes or series within a class as may be determined by our board of directors, who establish, from time to time, the number of shares to be included in each class or series, fix the designation, powers, preferences and rights of the shares of each such class or series and any qualifications, limitations or restrictions thereof. Any preferred stock so issued is senior to other existing classes of common stock with respect to the payment of dividends or amounts upon liquidation or dissolution. As of June 30, 2022 and December 31, 2021, no shares of our preferred stock had been designated any rights and we had no shares of preferred stock issued and outstanding.\\nSubscription of Common Stock Receivables\\nThe Company issued 1,569,768 shares of common stock to several individuals in March 2020 and in December 2020 for total proceeds of $ 1,350,000 , of which $ 553,500 was received in January, February, and June 2021.\\nIssuance of Common Stock in Settlement of Antidilution Provisions\\nIn May 2018, the Company had entered into a share exchange agreement wherein Capax, Inc., the predecessor entity of Reborn Coffee, Inc. (“Capax”) effectively merged with Reborn Global Holdings, Inc. to form the Company. In this share exchange agreement, the preexisting shareholder of Capax were provided covenants that for a period of one year following the date upon which the Company is approved for quotation or trading on a public exchange (“IPO”), the percentage of ownership of the prior shareholders of Capax would not be less than the 5% of the total number of shares of voting common stock outstanding of the Company that they owned following the share exchange. In the event the ownership of the pre-merger shareholders of Capax fell below 5%, the Company was obligated to issue that number of shares of common stock to those shareholders which would increase the ownership of all of the Pre-Merger Shareholders to five percent (5%) of the total outstanding voting common shares of the Company. During the year ended December 31, 2021, the Company issued 325,495 shares of common stock under these provisions.\\nOn January 25, 2022, the Company modified this agreement with the preexisting shareholders to effectively end the antidilution protection at the time of a successful IPO, eliminating the one-year period following an IPO as provided under the original agreement. The shareholders would be entitled to additional protection through the IPO date should the Company issue any additional shares between December 31, 2021 and the IPO date. The Company has not issued any additional shares subsequent to December 31, 2021.\\nDividend policy\\nDividends are paid at the discretion of the Board of Directors. There were no dividends declared for the six-month periods ended June 30, 2022 and 2021.\\n18\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n11. EARNINGS PER SHARE\\nThe Company calculates earnings per share in accordance with FASB ASC 260, Earnings Per Share, which requires a dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of shares outstanding during the fiscal year. Potentially dilutive common shares consist of stock options outstanding (using the treasury method).\\nThe following table sets forth the computation of basic and diluted net income per common share:\\n\\n| Six-Month Period | Three-Month Period |\\n| Ended June 30, | Ended June 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net Loss | $ | ( 1,502,260 | ) | $ | ( 635,163 | ) | $ | ( 937,148 | ) | $ | ( 307,684 | ) |\\n| Weighted Average Shares of Common Stock Outstanding |\\n| Basic | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\\n| Diluted | 11,642,550 | 10,282,669 | 11,667,545 | 10,380,944 |\\n| Earnings Per Share - Basic |\\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\\n| Earnings Per Share - Diluted |\\n| Net Loss Per Share | ( 0.13 | ) | ( 0.06 | ) | ( 0.08 | ) | ( 0.03 | ) |\\n\\n12. SUBSEQUENT EVENTS\\nThe Company evaluated all events or transactions that occurred after June 30, 2022 up through the date the unaudited condensed consolidated financial statements were available to be issued. During this period, the Company did not have any material recognizable subsequent events required to be disclosed as of and for the six-month period ended June 30, 2022, except for the following:\\nInitial Public Offering\\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $ 7,200,000 . Net proceeds from the IPO was approximately $ 6.2 million after deducting underwriting discounts and commissions and other offering expenses of approximately $ 998,000 .\\nThe Company had granted the underwriters a 45-day option to purchase up to 216,000 additional shares (equal to 15 % of the shares of common stock sold in the offering) to cover over-allotments. In addition, the Company had agreed to issue to the representative of the several underwriters warrants to purchase the number of shares of common stock in the aggregate equal to five percent ( 5 %) of the shares of common stock to be issued and sold in the IPO. The warrants are exercisable for a price per share equal to 125 % of the public offering price. No over-allotment option or representative’s warrants have been exercised.\\n19\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.\\nYou should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Prospectus on Form S-1. As discussed in the section titled “Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” in our Prospectus filed on Form S-1 (File No: 333-261937).\\nBusiness\\nReborn Coffee is focused on serving high quality, specialty-roasted coffee at retail locations, kiosks and cafes. We are an innovative company that strives for constant improvement in the coffee experience through exploration of new technology and premier service, guided by traditional brewing techniques. We believe Reborn differentiates itself from other coffee roasters through its innovative techniques, including sourcing, washing, roasting, and brewing our coffee beans with a balance of precision and craft.\\nFounded in 2015 by Jay Kim, our Chief Executive Officer, Mr. Kim and his team launched Reborn Coffee with the vision of using the finest pure ingredients and pristine water. We currently serve customers through our retail store locations in California: Brea, La Crescenta, Glendale, Corona Del Mar, Arcadia, Laguna Woods, Riverside, San Francisco and Manhattan Beach, with four other locations in development. Additionally, we expect to begin franchising in 2022 and expect to continue to develop additional retail locations as we expand outside of California. We estimate that the average development cost of a company-owned retail location is approximately $150,000. Therefore, taking into account the proceeds from this offering and within a year from its completion, we expect to open up to 20 company-owned retail locations (using approximately $3,000,000 of the proceeds of this offering) and 20 franchise locations (all costs and expenses associated with a franchise store location development are borne by the franchisees). We acknowledge that we have not yet signed any franchise agreements and that such number of franchise locations is purely speculative. Reborn Coffee continues to elevate the high-end coffee experience and we received 1st place traditional still in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles.\\nThe Experience, Reborn\\nAs leading pioneers of the emerging “Fourth Wave” movement, Reborn Coffee is redefining specialty coffee as an experience that demands much more than premium quality. We consider ourselves leaders of the “fourth wave” coffee movement because we are constantly developing our bean processing methods, researching design concepts, and reinventing new ways of drinking coffee. For instance, the current transition from the K-Cup trend to the pour over drip concept allowed us to reinvent the way people consume coffee, by merging convenience and quality. We took the pour over drip concept and made it available and affordable to the public through our Reborn Coffee Pour Over packs. Our Pour Over Packs allow our consumers to consume our specialty coffee outdoors and on-the-go.\\nOur success in innovating within the “fourth wave” coffee movement is measured by our success in B2B sales with our introduction of Reborn Coffee Pour Over Packs to hotels. With the introduction of our Pour Over Packs to major hotels (including one hotel company with 7 locations), our B2B sales increased as these companies recognized the convenience and functionality our Pour Over Packs serve to their customers.\\nReborn Coffee’s continuous Research and Development is essential to developing new parameters in the production of new blends. Our 1st place position in “America’s Best Cold Brew” competition by Coffee Fest in 2017 in Portland and 2018 in Los Angeles is a testament to the way we believe we lead the “fourth wave” movement by example.\\nCentered around its core values of service, trust, and well-being, Reborn Coffee delivers an appreciation of coffee as both a science and an art. Developing innovative processes such as washing green coffee beans with magnetized water, we challenge traditional preparation methods by focusing on the relationship between water chemistry, health, and flavor profile. Leading research studies, testing brewing equipment, and refining roasting/brewing methods to a specific, Reborn Coffee proactively distinguishes exceptional quality from good quality by starting at the foundation and paying attention to the details. Our mission places an equal emphasis on humanizing the coffee experience, delivering a fresh take on “farm-to-table” by sourcing internationally. In this way, Reborn Coffee creates opportunities to develop transparency by paying homage to origin stories and spark new conversations by building cross-cultural communities united by a passion for the finest coffee.\\nThrough a broad product offering, Reborn Coffee provides customers with a wide variety of beverages and coffee options. As a result, we believe we can capture share of any experience where customers seek to consume great beverages whether in our inviting store atmospheres which are designed for comfort, or on the go through our pour over packs, or at home with our whole bean ground coffee bags. We believe that the retail coffee market in the US is large and growing. According to IBIS, in 2021, the retail market for coffee in the United States is expected to be $46.2 billion. This is expected to grow due to a shift in consumer preferences to premium coffee, including specialized blends, espresso-based beverages, and cold brew options. Reborn aims to capture a growing portion of the market as we expand and increase consumer awareness of our brand.\\n20\\nPlan of Operation\\nWe have a production and distribution center at our headquarters that we use to process and roast coffee for wholesale and retail distribution.\\nCurrently, we have the following nine retail coffee locations, and four locations in development (i.e., Cabazon, Huntington Beach, Irvine and Mission Viejo, California):\\n\\n| ● | La Floresta Shopping Village in Brea, California; |\\n| ● | La Crescenta, California; |\\n\\n\\n| ● | Glendale Galleria in Glendale, California; |\\n| ● | Galleria at Tyler in Riverside, California; |\\n| ● | Home Depot Center in Laguna Woods, California; |\\n| ● | Stonestown Galleria in San Francisco, California (opened in first quarter of 2022); |\\n| ● | Corona Del Mar, California; |\\n| ● | Santa Anita Westfield Mall in Arcadia, California; and |\\n| ● | Manhattan Village at Manhattan Beach, California. |\\n\\nImpact of COVID-19\\nThe COVID-19 pandemic and resulting disruptions including, without limitation, governmental lockdown mandates and restrictions, made 2020 a challenging year for businesses, particularly in the foodservice and restaurant industries. Reborn Coffee took immediate action to protect the health and safety of our employees and customers including the implementation of all operating protocols dictated by state and local guidelines and instituting strict health and safety practices. Fortunately, we did not experience any significant disruptions in our supply chain operations.\\nDespite efforts to ensure a safe consumer experience, we did experience repressed customer flow through periods when malls and shopping centers were restricted or closed entirely due to governmental lockdown mandates and restrictions. Our current retail locations are within popular shopping areas with anticipated regular customer traffic. Such closures or limitations and restrictions were at times mandated the government, and at other times due to natural customer uncertainties regarding the status of COVID-19. Such restrictions and uncertainties not only impacted anticipated revenues from current locations, but added additional risk to us related to the opening of new locations. Thus, the uncertainty regarding the scope and longevity of such restrictions modified our plans as to how quickly we could enact our expansion plans.\\nMore specifically, COVID-19 has challenged our performance at our kiosk locations, though our cafe locations have improved in performance. Shopping mall restrictions and mandates during the pandemic made it difficult for our kiosks to operate at maximum performance, as indoor restrictions of shopping malls affected the way we had to operate business. For instance, we had to offer only to-go/pickup operations to operate while meeting regulations. We have learned how to move forward aggressively despite such regulations and mandates, doing what we can to serve the coffee we are so proud to serve, whether this means offering to-go orders only or working with delivery services.\\nIn May 2020, the Company availed itself of a loan under the Paycheck Protection Program (PPP) administered by the U.S. Small Business Administration (SBA) in the amount of $115,000, and $500,000 under the SBA’s Economic Injury Disaster Loan assistance program, all of which is currently outstanding as of December 31, 2021, provided however that repayment was deferred to commence in May 2022. In February 2021, the Company secured a second PPP loan under this program in the amount of approximately $167,000. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\\n21\\nIn January 2022 we announced a price increase of our whole roasted beans by 15% on our website which we attribute to increases due to inflation in the cost of raw green coffee beans, the cost of shipping and supplies, and nationwide increases in labor costs-- factors that may or may not be attributable to the pandemic and/or the governmental policies and mandates that were implemented during and in the wake of COVID-19. As of the date hereof and in January 2022 at the time of our price increase, inflation has not had a material effect on our results of operations since we have been able to offset such increased costs by increasing the price of our whole roasted beans by 15% in January 2022, through increased sales and growth in opening 2 new company-owned retail locations, better lease terms on such new company-owned retail locations, more efficient purchasing practices (e.g., volume purchase discounts), productivity improvements and greater economies of scale. Severe increases in inflation, however, could affect the global and U.S. economies and could have a materially adverse impact on our business, financial condition or results of operations.\\nWe do not expect COVID-19 to affect our future operating results significantly, as we are confident that coffee is an essential product that people rely on and will always drink. We intend to meet all governmental business operation regulations and improve sales by whatever means necessary, utilizing resources such as food delivery services and to-go/pickup orders. However, the impact of COVID-19 continues to evolve, and we cannot easily predict the future potential impacts of the pandemic on our business or operations or on the United States or global economy in general. This may include any recurrence of the disease, actions taken in response to the evolving pandemic, any ongoing effects on consumer demand and spending patterns or other impacts of the pandemic. Whether these or other currently unanticipated consequences of the pandemic are reasonably likely to materially affect our results of operations, cash flows or financial condition is yet to be determined. For additional details regarding the impact of COVID-19 on our business, see “Risk Factors-Risks Related to Our Business-Pandemics or disease outbreaks such as the COVID-19 have had, and may continue to have, an effect on our business and results of operations.”\\nComponents of Our Results of Operations\\nRevenue\\nThe Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers. The Company’s net revenue primarily consists of revenues from its retail locations and wholesale and online store. Accordingly, the Company recognizes revenue as follows:\\n\\n| ● | Retail Store Revenue |\\n| Retail store revenues are recognized when payment is tendered at the point of sale. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities. Sales taxes that are payable are recorded as accrued as other current liabilities. Retail store revenue makes up approximately 97% of the Company’s total revenue. |\\n| ● | Wholesale and Online Revenue |\\n| Wholesale and online revenues are recognized when the products are delivered, and title passes to customers or to the wholesale distributors. When customers pick up products at the Company’s warehouse, or distributed to the wholesale distributors, the title passes, and revenue is recognized. Wholesale revenues make up approximately 3% of the Company’s total revenue. |\\n\\n\\n| ● | Royalties and Other Fees |\\n| Franchise revenues consist of royalty fee and other franchise fees. Royalty fee is based on a percentage of franchisee’s weekly gross sales revenue at 5%. The Company recognizes the fee as the underlying sales occur. The Company recorded revenue from royalty of $0 for the three and six month periods ended June 30, 2022 and 2021. Other fees are earned as incurred and the Company did not have any other fee revenue for the three and six month periods ended June 30, 2022 and 2021. |\\n\\nCost of Sales\\nCost of sales includes costs associated with generating revenue within our company-owned retail locations, and franchising operations (of which, as of the date of this prospectus, we had none).\\nShipping and Handling Costs\\nThe Company incurred freight out cost and is included in the Company’s cost of sale.\\nGeneral and Administrative Expense\\nGeneral and administrative expense includes store-related expense as well as the Company’s corporate headquarters’ expenses.\\nAdvertising Expense\\nAdvertising expense are expensed as incurred. Advertising expenses amounted to $20,513 and $50,160 for the six month periods ended June 30, 2022 and 2021, respectively, and is recorded under general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations.\\n22\\nPre-opening Costs\\nPre-opening costs for new stores, which are not material, consist primarily of payroll and recruiting expense, training, marketing, rent, travel, and supplies, and are expensed as incurred depreciated over the shorter of the useful life of the improvement or the lease term, including renewal periods that are reasonably assured.\\nResults of Operations\\nThree and six months ended June 30, 2022 Compared to three and six months ended June 30, 2021\\nThe following table presents selected comparative results of operations from our unaudited financial statements for the three and six months ended June 30, 2022 compared to three and six months ended June 30, 2021. Our financial results for these periods are not necessarily indicative of the financial results that we will achieve in future periods. Certain totals for the table below may not sum to 100% due to rounding.\\n\\n| Six Months Ended June 30, | Increase / (Decrease) |\\n| 2022 | 2021 | Dollars | Percentage |\\n| Net revenues: |\\n| Stores | $ | 1,511,952 | $ | 851,785 | $ | 660,167 | 77.5 | % |\\n| Wholesale and online | 29,674 | 28,336 | 1,338 | 4.7 | % |\\n| Total net revenues | 1,541,626 | 880,121 | 661,505 | 75.2 | % |\\n| Operating costs and expenses: |\\n| Product, food and drink costs—stores | 563,906 | 270,148 | 293,758 | 108.7 | % |\\n| Cost of sales—wholesale and online | 12,997 | 12,412 | 585 | 4.7 | % |\\n| General and administrative | 2,468,447 | 1,226,951 | 1,241,496 | 101.2 | % |\\n| Loss from operations | (1,503,724 | ) | (629,390 | ) | (874,334 | ) | 138.9 | % |\\n| Other income | 16,440 | - | 16,440 | N/A | % |\\n| Interest expense | (14,976 | ) | (5,773 | ) | (9,203 | ) | 159.4 | % |\\n| Loss before income taxes | (1,502,260 | ) | (635,163 | ) | (867,097 | ) | 136.5 | % |\\n| Provision for income taxes | - | - | - | 0.0 | % |\\n| Net loss | $ | (1,502,260 | ) | $ | (635,163 | ) | $ | (867,097 | ) | 136.5 | % |\\n\\n\\n| Three Months Ended June 30, | Increase / (Decrease) |\\n| 2022 | 2021 | Dollars | Percentage |\\n| Net revenues: |\\n| Stores | $ | 775,956 | $ | 475,824 | $ | 300,132 | 63.1 | % |\\n| Wholesale and online | 12,520 | 15,368 | (2,848 | ) | -18.5 | % |\\n| Total net revenues | 788,476 | 491,192 | 297,284 | 60.5 | % |\\n| Operating costs and expenses: |\\n| Product, food and drink costs—stores | 278,952 | 135,452 | 143,500 | 105.9 | % |\\n| Cost of sales—wholesale and online | 5,484 | 6,732 | (1,248 | ) | -18.5 | % |\\n| General and administrative | 1,432,432 | 656,310 | 776,122 | 118.3 | % |\\n| Loss from operations | (928,392 | ) | (307,302 | ) | (621,090 | ) | 202.1 | % |\\n| Other income | 1,440 | - | 1,440 | N/A | % |\\n| Interest expense | (10,196 | ) | (382 | ) | (9,814 | ) | 2569.1 | % |\\n| Loss before income taxes | (937,148 | ) | (307,684 | ) | (629,464 | ) | 204.6 | % |\\n| Provision for income taxes | - | - | - | 0.0 | % |\\n| Net loss | $ | (937,148 | ) | $ | (307,684 | ) | $ | (629,464 | ) | 204.6 | % |\\n\\n23\\n\\n| Six months ended June 30, | Three months ended June 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Net revenues: |\\n| Stores | 98.1 | % | 96.8 | % | 98.4 | % | 96.9 | % |\\n| Wholesale and online | 1.9 | % | 3.2 | % | 1.6 | % | 3.1 | % |\\n| Total net revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |\\n| Operating costs and expenses: |\\n| Product, food and drink costs—stores | 36.6 | % | 30.7 | % | 35.4 | % | 27.6 | % |\\n| Cost of sales—wholesale and online | 0.8 | % | 1.4 | % | 0.7 | % | 1.4 | % |\\n| General and administrative | 160.1 | % | 139.4 | % | 181.7 | % | 133.6 | % |\\n| Loss from operations | -97.5 | % | -71.5 | % | -117.7 | % | -62.6 | % |\\n| Other income | 1.1 | % | 0.0 | % | 0.2 | % | 0.0 | % |\\n| Interest expense | -1.0 | % | -0.7 | % | -1.3 | % | -0.1 | % |\\n| Loss before income taxes | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\\n| Provision for income taxes | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % |\\n| Net loss | -97.4 | % | -72.2 | % | -118.9 | % | -62.6 | % |\\n\\nRevenues. Revenues were approximately $1.5 million for the six-month period ended June 30, 2022, compared to $880,000 for the comparable period in 2021, representing an increase of $661,000, or 75.2%. Revenues were approximately $788,000 million for the three-month period ended June 30, 2022, compared to $491,000 for the comparable period in 2021, representing an increase of $297,000, or 60.5%. The increase in sales for the periods was primarily driven by the opening of the Corona Del Mar, Laguna Woods and Santa Anita locations during 2021, and to the continued focus on marketing efforts to grow brand recognition.\\nProduct, food and drink costs. Product, food and drink costs were approximately $564,000 for the six-month period ended June 30, 2022 compared to $270,000 for the comparable period in 2021, representing an increase of approximately $294,000, or 108.7%, and were approximately $279,000 for the three-month period ended June 30, 2022 compared to $135,000 for the comparable period in the prior year, representing an increase of $144,000 of 105.9%. The increase in costs for the periods was partially driven by the opening of new locations and the overall increase in sales for the period. As a percentage of revenues, product, food and drink costs increased to 36.6% in the six-month period ended June 30, 2022 compared to 30.7% in the comparable period in 2021 and increased to 35.4% in the three-month period ended June 30, 2022 compared to 27.6% in the comparable period in 2021. The increase in costs as a percentage of sales was primarily driven by general inflationary pressures and the seasonal fluctuations in cost of ingredients. We monitor these fluctuations in product costs to analyze whether they are considered to be representative of general economic conditions, such as inflation, or to be related to commodity specific changes. For example, green bean suppliers raised pricing by 15 to 20% throughout 2021, higher than the overall rate of inflation, however it has been more stable recently and even decreasing slightly in the second quarter of 2022.\\nGeneral and administrative expenses. General and administrative expenses were approximately $2.5 million for the six-month period ended June 30, 2022 compared to $1.2 million for the comparable period in the prior year, representing an increase of approximately $1.2 million, or 101.2%, and were approximately $1.4 million for the three-month period ended June 30, 2022 compared to $656,000 for the comparable period in 2021, representing an increase of approximately $775,000, or 118.3%. This increase in general and administrative expenses was primarily due to the hiring of additional administrative employees, increases in professional services and corporate-level costs to support growth plans, the opening of new restaurants, as well as costs associated with outside administrative, legal and professional fees and other general corporate expenses associated with preparing to become a public company. As a percentage of sales, general and administrative expenses increased to 160.1% in the six-month period ended June 30, 2022 from 139.4% in the comparable period of 2021, and increased to 181.7% for the three-month period ended June 30, 2022 from 133.6% in the comparable period in 2021, primarily due to the increased administrative expenditures for the reasons mentioned above.\\n24\\nLiquidity and Capital Resources\\n\\n| Six Months Ended June 30, |\\n| 2022 | 2021 |\\n| Statement of Cash Flow Data: |\\n| Net cash used in operating activities | (1,199,979 | ) | (538,352 | ) |\\n| Net cash used in investing activities | (168,397 | ) | (317,152 | ) |\\n| Net cash provided by financing activities | 613,149 | 866,579 |\\n\\nCash Flows Provided by Operating Activities\\nNet cash used in operating activities during the six-month period ended June 30, 2022 was $1.2 million, which resulted from net loss of $1.5 million, non-cash charges of $225,000 for stock compensation and $98,000 for depreciation and net cash outflows of $43,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventory of $14,000 and prepaid and other assets of $28,000 and a decrease in accounts payable of $46,000, partially offset by increase of $47,000 in accrued liabilities. The increase in accrued liabilities was primarily due to the timing of cash payments for sales tax and payroll.\\nNet cash used in operating activities during the six-month period ended June 30, 2021 was $538,000, which resulted from net loss of $635,000, non-cash charges of $82,000 for depreciation, and net cash outflows of $6,000 from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were primarily the result of increases in inventories of $7,000 and prepaids and other assets of $65,000, partially offset by increases of $50,000 in accounts payable and $17,000 in accrued liabilities.\\nCash Flows Used in Investing Activities\\nNet cash used in investing activities during the six-month periods ended June 30, 2022 and 2021 was $168,000 and $317,000, respectively, These expenditures in each period are primarily related to purchases of property and equipment in connection with current and future location openings and maintaining our existing locations.\\nCash Flows Provided by (Used in) Financing Activities\\nNet cash provided by financing activities during the six-month period ended June 30, 2022 was $613,000, primarily due to $595,000 of borrowings under a line of credit, and $150,000 of loans from shareholders. This was partially offset by $131,000 of repayments of borrowings.\\nNet cash provided by financing activities during the six-month period ended June 30, 2021 was $867,000, primarily due to approximately $533,000 cash received through borrowings and $553,000 of proceeds from issuance of common stock, offset by approximately $220,000 of repayments of borrowings.\\nAs of June 30, 2022, the Company had total assets of $4,593,013. Our cash balance as of June 30, 2022 was approximately $150,000. From inception (of Reborn Global in November 2014) to June 30, 2022, we have not had any positive operating cash flow.\\nCredit Facilities\\nLoan with Fora Financial\\nIn October 2019, the Company entered into a loan agreement with Fora Financial in the principal amount of $138,600 and remaining principal amount of $48,510. The loan payable has a maturity date on October 11, 2019. The loan was due on demand. As of June 30, 2022 and December 31, 2021, there was a balance outstanding of $0.\\nLoans with Square Capital\\nBetween April and August 2021, the Company entered into loan agreements with Square Capital in the aggregate principal amount of approximately $268,000 with loan costs of $34,840. The loans have maturity dates ranging from September 2022 to February 2023. As of June 20, 2022 and December 31, 2021, there was a balance outstanding of approximately $0 and $122,000, respectively.\\n25\\nEconomic Injury Disaster Loan\\nOn May 16, 2020, the Company executed the standard loan documents required for securing a loan (the “EIDL Loan”) from the SBA under its Economic Injury Disaster Loan (“EIDL”) assistance program in light of the impact of the COVID-19 pandemic on the Company’s business. As of June 30, 2022, the loan payable, Emergency Injury Disaster Loan noted above is not in default.\\nPursuant to that certain Loan Authorization and Agreement (the “SBA Loan Agreement”), the Company borrowed an aggregate principal amount of the EIDL Loan of $500,000, with proceeds to be used for working capital purposes. Interest accrues at the rate of 3.75% per annum and will accrue only on funds actually advanced from the date of each advance. Installment payments, including principal and interest, are due monthly beginning May 16, 2021 (twelve months from the date of the SBA Loan) in the amount of $731. The balance of principal and interest is payable thirty years from the date of the SBA Loan. In connection therewith, the Company also received a $10,000 grant, which does not have to be repaid. During the year ended December 31, 2020, $10,000 was recorded in Economy injury disaster loan (EIDL) grant income in the Statements of Operations. The schedule of payments on this loan was later deferred to commence 24 months from the date of loan, and therefore, the full amount of the loan is outstanding as of June 30, 2022 and payments shall commence starting in May 2022.\\nIn connection therewith, the Company executed (i) a loan for the benefit of the SBA (the “SBA Loan”), which contains customary events of default and (ii) a Security Agreement, granting the SBA a security interest in all tangible and intangible personal property of the Company, which also contains customary events of default (the “SBA Security Agreement”).\\nPaycheck Protection Program Loan\\nIn May 2020, the Company secured a loan under the Paycheck Protection Program administered by the U.S. Small Business Administration (the “SBA”) in the amount of $115,000. In February 2021, the Company secured a second loan under this program in the amount of approximately $167,000. The interest rate of the loan is 1.00% per annum and accrues on the unpaid principal balance computed on the basis of the actual number of days elapsed in a year of 360 days. Commencing seven months after the effective date of each PPP Loan, the Company is required to pay the Lender equal monthly payments of principal and interest as required to fully amortize any unforgiven principal balance of the loan by the two-year anniversary of the effective date of the loan. The PPP Loan contains customary events of default relating to, among other things, payment defaults, making materially false or misleading representations to the SBA or the Lender, or breaching the terms of the PPP Loan. The occurrence of an event of default may result in the repayment of all amounts outstanding under the PPP Loan, collection of all amounts owing from the Company, or filing suit and obtaining judgment against the Company. Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of the loan granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. Recent modifications to the PPP by the U.S. Treasury and Congress have extended the time period for loan forgiveness beyond the original eight-week period, making it possible for the Company to apply for forgiveness of its PPP loan. The Company was granted forgiveness for the initial PPP Loan prior to December 31, 2021 and expects to be granted forgiveness on the remainder subsequently.\\nLine of Credit Facility\\nDuring the second quarter of 2022, the Company entered into a line of credit agreement with a financial institution that provides a maximum borrowing limit of $2,000,000 with interest at 5% per annum. This line of credit facility matures on December 31, 2022. Total balance as of June 30, 2022 was $594,529.\\nLeases\\nOperating Leases\\nWe currently lease all company-owned retail locations. Operating leases typically contain escalating rentals over the lease term, as well as optional renewal periods. Rent expense for operating leases is recorded on a straight-line basis over the lease term and begins when Reborn has the right to use the property. The difference between rent expense and cash payment is recorded as deferred rent on the accompanying consolidated balance sheets. Pre-opening rent is included in selling, general and administrative expenses on the accompanying consolidated statements of income. Tenant incentives used to fund leasehold improvements are recorded in deferred rent and amortized as reductions to rent expense over the term of the lease.\\n26\\nIncome Taxes\\nReborn files income tax returns in the U.S. federal and California state jurisdictions.\\nUpon the closing of this offering, we will be taxed at the prevailing U.S. corporate tax rates. We will be treated as a U.S. corporation and a regarded entity for U.S. federal, state and local income taxes. Accordingly, a provision will be recorded for the anticipated tax consequences of our reported results of operations for U.S. federal, state and foreign income taxes.\\nJOBS Act Accounting Election\\nWe are an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various public company reporting requirements for up to five years or until we are no longer an emerging growth company, whichever is earlier. The JOBS Act provides that an “emerging growth company” can delay adopting new or revised accounting standards until those standards apply to private companies. We have elected to use this extended transition period under the JOBS Act. Accordingly, our financial statements may not be comparable to the financial statements of public companies that comply with such new or revised accounting standards.\\nOff Balance Sheet Arrangements\\nWe do not have any off-balance sheet arrangements that we are required to disclose pursuant to these regulations. In the ordinary course of business, we enter into operating lease commitments, purchase commitments and other contractual obligations. These transactions are recognized in our financial statements in accordance with GAAP.\\nCritical Accounting Policies\\nThe preparation of financial statements requires management to utilize estimates and make judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. These estimates are based on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. The estimates are evaluated by management on an ongoing basis, and the results of these evaluations form a basis for making decisions about the carrying value of assets and liabilities that are not readily apparent from other sources. Although actual results may differ from these estimates under different assumptions or conditions, management believes that the estimates used in the preparation of our financial statements are reasonable. The critical accounting policies affecting our financial reporting are summarized in Note 2 to the financial statements included elsewhere in this prospectus.\\nRecent Accounting Pronouncements\\nWe have determined that all other issued, but not yet effective accounting pronouncements are inapplicable or insignificant to us and once adopted are not expected to have a material impact on our financial position.\\n27\\n\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk.\\nWe are a smaller reporting company as defined by 17 C.F.R. 229 (10)(f)(i) and are not required to provide information under this item.\\n\\nItem 4. Controls and Procedures.\\nEvaluation of Disclosure Controls and Procedures\\nOur management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)), as of June 30, 2022. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of June 30, 2022, our disclosure controls and procedures were ineffective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (a) is recorded, processed, summarized and reported within the time periods specified by Securities and Exchange Commission (“SEC”) rules and forms and (b) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding any required disclosure.\\nChanges in Internal Control Over Financial Reporting\\nDuring the period ended June 30, 2022, our management has evaluated the internal control over financial reporting pursuant to Rules 13a-15(d) or 15d-15(d) under the Exchange Act. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our internal controls over financial reporting were ineffective as of June 30, 2022. Management of the Company believes that the ineffectiveness of internal controls was due to the lack of accounting and financial team.\\n28\\nPART II—OTHER INFORMATION\\n\\nItem 1. Legal Proceedings.\\nIn the future, the Company may be subject to various legal proceedings from time to time as part of its business. We are currently not involved in litigation that we believe will have a materially adverse effect on our financial condition or results of operations. As of June 30, 2022, there is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self- regulatory organization or body pending or, to the knowledge of the executive officers of our company or any of our subsidiaries threatened against or affecting our company, our common stock, any of our subsidiaries or of our company’s or our company’s subsidiaries’ officers or directors in their capacities as such, in which an adverse decision is expected to have a material adverse effect.\\n\\nItem 1A. Risk Factors.\\nAs a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this item.\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nWe have not made any sales of unregistered equity securities during the quarterly period ended June 30, 2022.\\nIn August 2022, the Company consummated its initial public offering (the “IPO”) of 1,440,000 shares of its common stock at a public offering price of $5.00 per share, generating gross proceeds of $7,200,000 pursuant to our Registration Statement on Form S-1 (as amended) (File No. 333-261937), which was declared effective by the SEC on August 11, 2022. . EF Hutton, division of Benchmark Investments, LLC, acted as the representative of the underwriters of the IPO. After deducting underwriting discounts and commissions and other offering expenses payable by us, we received approximately $6.2 million in net proceeds from our initial public offering.\\nThere has been no material change in the planned use of proceeds from our initial public offering as described in our final prospectus, dated August 11, 2022, which was filed with the SEC on August 16, 2021 pursuant to Rule 424(b) under the Securities Act. The primary use of the net proceeds from our initial public offering continues to be, as follows: (i) approximately $8.0 million for the acquisition of property and the development of a manufacturing plant to build, design and manufacture our new line of electric boats; (ii) approximately $2.0 million for ramp up of production and inventory; (iii) approximately $2.6 million for working capital.\\nNo payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries. Pending the uses described, we have invested the net proceeds in our operating cash account.\\n29\\n\\nItem 6. Exhibits.\\nThe following exhibits are included herein or incorporated herein by reference:\\n\\n| 3.1 | Certificate of Incorporation (Delaware), dated July 27, 2022 (incorporated by reference to Exhibit 3.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 3.2 | Bylaws of Registrant (Delaware) (incorporated by reference to Exhibit 3.2 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 4.1 | Specimen Common Stock Certificate (Delaware) (incorporated by reference to Exhibit 4.1 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 4.2 | Form of Representative’s Warrant (incorporated by reference to Exhibit 4.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.1 | Share Exchange Agreement, dated May 7, 2018 by and among Capax, Reborn and each of the RB shareholders (incorporated by reference to Exhibit 10.1 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.2 | Form of Letter Agreement (Lockup) by and among Registrant, officers and directors of the Company and EF Hutton (incorporated by reference to Exhibit 10.2 to Amendment No. 6 to our Registration Statement on Form S-1 filed on August 9, 2022) |\\n| 10.3 | Form of Director and Officer Indemnity Agreement (incorporated by reference to Exhibit 10.3 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.4 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and La Floresta Regency, LLC, effective July 25, 2016 (incorporated by reference to Exhibit 10.4 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.5 | Standard Industrial/Commercial Multi-Tenant Lease, as amended, by and between Reborn Global Holdings, Inc. and Foothill Crescenta, LLC, effective December 6, 2016 (incorporated by reference to Exhibit 10.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.6 | Shopping Center Lease by and between Reborn Global Holdings, Inc. and Sibling Associates, LLC, effective July 12, 2017 (incorporated by reference to Exhibit 10.6 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.7 | Standard Lease by and between Reborn Global Holdings, Inc. and El Toro, LP, effective February 12, 2021 (incorporated by reference to Exhibit 10.7 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.8 | Form of Subscription Agreement (Regulation A+ Offering) (incorporated by reference to Exhibit 10.11 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.9 | Consulting Agreement by and between the Company and Kevin Hartley, effective September 15, 2021 (incorporated by reference to Exhibit 10.12 to Amendment No. 2 to our Registration Statement on Form S-1 filed on April 18, 2022) |\\n| 10.10 | Amendment to Share Exchange Agreement, dated January 25, 2022, by and among Reborn Coffee Inc., Andrew Weeraratne and each of the former shareholders of Reborn Global Holdings, Inc., a California corporation (incorporated by reference to Exhibit 10.10 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 10.11 | Offer of Employment by and between the Company and Stephan Kim, dated July 27, 2022 (incorporated by reference to Exhibit 10.11 to Amendment No. 5 to our Registration Statement on Form S-1 filed on August 2, 2022) |\\n| 31.1* | Certification of Jay Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2* | Certification of Stephan Kim pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1** | Certification of Jay Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2** | Certification of Stephan Kim pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | Inline XBRL Instance Document. |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document. |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document. |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document. |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\\n\\n\\n| * | Filed herewith. |\\n\\n\\n| ** | Furnished herewith. |\\n\\n30\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| Signature | Title | Date |\\n| /s/ Jay Kim | Chief Executive Officer (Principal Executive Officer) | September 30, 2022 |\\n| Jay Kim |\\n| /s/ Stephan Kim | Chief Financial Officer (Principal Financial and Accounting Officer) | September 30, 2022 |\\n\\n31\\n\\n</text>\\n\\nWhat was the percentage change in earnings per share (EPS) year over year?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 108.89000325379874.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 49,\n \"input_length\": 26349\n}"}}},{"rowIdx":50,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS\n(in thousands, except share and per share data)\n| As of |\n| March 31, 2021 | December 31, 2020 |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 171,867 | $ | 35,531 |\n| Accounts receivable | 2,383 | 1,399 |\n| Deferred contract costs, current portion | 4,817 | 4,049 |\n| Prepaid expenses and other current assets | 3,626 | 2,649 |\n| Total current assets | 182,693 | 43,628 |\n| Property and equipment, net | 3,876 | 2,968 |\n| Intangible assets, net | 2,176 | 2,231 |\n| Goodwill | 1,991 | 1,991 |\n| Deferred contract costs, net of current portion | 2,000 | 1,670 |\n| Other long-term assets | 1,130 | 2,470 |\n| Total assets | $ | 193,866 | $ | 54,958 |\n| Liabilities, redeemable convertible preferred stock and stockholders’ equity (deficit) |\n| Current liabilities |\n| Accounts payable | $ | 10,233 | $ | 8,654 |\n| Accrued expenses | 10,286 | 7,719 |\n| Deferred revenue | 32,078 | 26,537 |\n| Total current liabilities | 52,597 | 42,910 |\n| Long-term liabilities |\n| Deferred revenue, net of current portion | 181 | 123 |\n| Deferred tax liability | 153 | 209 |\n| Other long-term liabilities | 1,024 | 497 |\n| Total liabilities | 53,955 | 43,739 |\n| Commitments and contingencies (Note 11) |\n| Series A redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 3,379,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 8,000 at December 31, 2020) | — | 7,789 |\n| Series A-1 redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 1,837,600 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 5,000 at December 31, 2020) | — | 10,270 |\n| Stockholders' equity (deficit) |\n| Series B convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 4,681,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 24,000 at December 31, 2020) | — | 24,000 |\n| Undesignated preferred stock, $ 0.00001 par value - 100,000,000 shares authorized, and no shares issued or outstanding as of March 31, 2021; no shares authorized, issued, or outstanding as of December 31, 2020 | — | — |\n| Common stock, $ 0.00001 par value - no shares authorized, issued, or outstanding as of March 31, 2021; 300,000,000 shares authorized, and 95,206,893 shares issued and 95,050,041 shares outstanding at December 31, 2020 | — | — |\n| Class A common stock, $ 0.00001 par value - 1,000,000,000 shares authorized, and 10,000,000 shares issued and outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | — | — |\n| Class B common stock, $ 0.00001 par value - 160,000,000 shares authorized, and 124,905,954 shares issued and 124,749,102 outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | 1 | — |\n| Additional paid-in capital | 174,254 | 4,975 |\n| Accumulated deficit | ( 34,344 ) | ( 35,815 ) |\n| Total stockholders’ equity (deficit) | 139,911 | ( 6,840 ) |\n| Total liabilities, redeemable convertible preferred stock, and stockholders' deficit | $ | 193,866 | $ | 54,958 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.1\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)\n(in thousands, except per share data)\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Revenue | $ | 39,998 | $ | 27,787 |\n| Cost of revenue | 8,773 | 6,611 |\n| Gross profit | 31,225 | 21,176 |\n| Operating expenses |\n| Sales and marketing | 16,457 | 12,877 |\n| Research and development | 5,358 | 4,237 |\n| General and administrative | 7,904 | 5,933 |\n| Total operating expenses | 29,719 | 23,047 |\n| Income (loss) from operations | 1,506 | ( 1,871 ) |\n| Other income, net | 51 | 56 |\n| Income (loss) before income taxes | 1,557 | ( 1,815 ) |\n| Provision for income taxes | 86 | 116 |\n| Net income (loss) and comprehensive income (loss) | $ | 1,471 | $ | ( 1,931 ) |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.02 | $ | ( 0.02 ) |\n| Diluted | $ | 0.01 | $ | ( 0.02 ) |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders: |\n| Basic | 96,376 | 94,593 |\n| Diluted | 131,356 | 94,593 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.2\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)\n(in thousands, except share data)\n| Series A | Series A-1 | Series B | Common Stock | Class A Common Stock | Class B Common Stock | AdditionalPaid-inCapital | AccumulatedDeficit | TotalStockholders’Equity(Deficit) |\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\n| Balances at December 31, 2019 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | $ | 3,644 | $ | ( 28,803 ) | $ | ( 1,159 ) |\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 205 | — | 205 |\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 1,931 ) | ( 1,931 ) |\n| Balances at March 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | 3,849 | ( 30,734 ) | ( 2,885 ) |\n| Balances at December 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 95,050,041 | $ | — | — | $ | — | — | $ | — | 4,975 | ( 35,815 ) | $ | ( 6,840 ) |\n| Conversion of Preferred Stock | ( 3,379,400 ) | ( 7,789 ) | ( 1,837,600 ) | ( 10,270 ) | ( 4,681,400 ) | ( 24,000 ) | 29,695,200 | — | — | — | — | — | 42,058 | — | 18,058 |\n| Issuance of Class A Common Stock in connection with the initial public offering, net of $ 13,378 in issuance costs | — | — | — | — | — | — | — | — | 10,000,000 | — | — | — | 126,622 | — | 126,622 |\n| Reclassification of Common Stock to Class B Common Stock in connection with the initial public offering | — | — | — | — | — | — | ( 124,745,241 ) | — | — | — | 124,745,241 | 1 | ( 1 ) | — | — |\n| Exercise of stock options | — | — | — | — | — | — | — | — | — | — | 3,861 | — | 7 | — | 7 |\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 593 | — | 593 |\n| Net Income | — | — | — | — | — | — | — | — | — | — | — | — | — | 1,471 | 1,471 |\n| Balances at March 31, 2021 | — | $ | — | — | $ | — | — | $ | — | — | $ | — | 10,000,000 | $ | — | 124,749,102 | $ | 1 | $ | 174,254 | $ | ( 34,344 ) | $ | 139,911 |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.3\nSEMRUSH HOLDINGS, INC.\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(in thousands)\n| Three Months Ended |\n| March 31, |\n| 2021 | 2020 |\n| Operating Activities |\n| Net income (loss) | $ | 1,471 | $ | ( 1,931 ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities |\n| Depreciation and amortization expense | 460 | 232 |\n| Amortization of deferred contract costs | 1,322 | 1,104 |\n| Stock-based compensation expense | 593 | 205 |\n| Deferred taxes | ( 56 ) | ( 57 ) |\n| Changes in operating assets and liabilities |\n| Accounts receivable | ( 985 ) | 745 |\n| Deferred contract costs | ( 2,420 ) | ( 1,704 ) |\n| Prepaid expenses and other current assets | ( 976 ) | ( 747 ) |\n| Accounts payable | 1,579 | 58 |\n| Accrued expenses | 2,420 | 1,002 |\n| Deferred revenue | 5,599 | 1,654 |\n| Net cash provided by operating activities | 9,007 | 561 |\n| Investing Activities |\n| Purchases of property and equipment | ( 166 ) | ( 1,084 ) |\n| Purchases of convertible debt securities | ( 500 ) | — |\n| Capitalization of internal-use software development costs | ( 123 ) | ( 297 ) |\n| Cash paid for acquisition of business, net of cash acquired | ( 350 ) | — |\n| Net cash used in investing activities | ( 1,139 ) | ( 1,381 ) |\n| Financing Activities |\n| Proceeds from exercise of stock options | 7 | — |\n| Net proceeds from completing initial public offering | 128,461 | — |\n| Payment of deferred offering costs | — | ( 16 ) |\n| Net cash provided by (used in) financing activities | 128,468 | ( 16 ) |\n| Increase in cash, cash equivalents and restricted cash | 136,336 | ( 836 ) |\n| Cash, cash equivalents and restricted cash, at beginning of period | 35,619 | 37,523 |\n| Cash, cash equivalents and restricted cash, at end of period | $ | 171,955 | $ | 36,687 |\n| Supplemental cash flow disclosures |\n| Cash paid for income taxes | $ | 158 | $ | 154 |\n| Deferred offering costs incurred and not paid | $ | 1,839 | $ | — |\n| Acquisition of fixed asset under capital lease | $ | 1,024 | $ | — |\n\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.4\nSEMRUSH HOLDINGS, INC.\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\nThree months ended March 31, 2021 and 2020\n(in thousands, except share and per share data, unless otherwise noted)\n1. Overview and Basis of Presentation\nDescription of Business\nSemrush Holdings, Inc. (“Semrush Holdings”) and its subsidiaries (together the “Group”, the “Company”, or “Semrush”) provide an online visibility management software-as-a-service (“SaaS”) platform. The Company’s platform enables its subscribers to improve their online visibility and drive traffic, including on their websites and social media pages, and distribute highly relevant content to their customers on a targeted basis across various channels to drive high-quality traffic and measure the effectiveness of their digital marketing campaigns. The Company is headquartered in Boston, Massachusetts, and has wholly owned subsidiaries in Cyprus, Russia, the Czech Republic, Poland, and the United States.\nThe Company is subject to a number of risks and uncertainties common to companies in similar industries and stages of development that could affect future operations and financial performance. These risks include, but are not limited to, rapid technological change, competitive pressure from substitute products or larger companies, protection of proprietary technology, management of international activities, the need to obtain additional financing to support growth, and dependence on third parties and key individuals.\n2019 Reorganization\nOn December 19, 2019, Semrush Holdings was incorporated in the state of Delaware and entered into a Contribution and Exchange Agreement with SEMrush CY Ltd (“SEMrush CY”) (a private limited liability company organized under the Cyprus Companies Law, Cap 113), pursuant to which the holders of all outstanding shares of capital stock of SEMrush CY contributed those shares to Semrush Holdings in exchange for identical shares of capital stock of Semrush Holdings (the “2019 Share Exchange”). Upon the 2019 Share Exchange, Semrush Holdings became the holding company of SEMrush CY and its wholly owned subsidiaries and the historical consolidated financial statements of SEMrush CY became the historical consolidated financial statements of Semrush Holdings. The 2019 Share Exchange and related transactions were completed on December 27, 2019.\nInitial Public Offering\nOn March 29, 2021, the Company closed its initial public offering (“IPO”) in which it sold 10,000,000 shares of its Class A common stock at a price to the public of $ 14.00 per share. The Company received $ 126.6 million in net proceeds after deducting approximately $ 13.4 million for underwriting discounts, commissions and offering expenses. Immediately prior to the completion of the IPO, all shares of common stock then outstanding were reclassified as Class B common stock, and all shares of redeemable convertible preferred stock and convertible preferred stock then outstanding were converted into shares of common stock on a one -to-one basis and then reclassified into Class B common stock.\nEffects of COVID-19\nThe Company considered the potential effects of the novel strain of coronavirus (“COVID-19”) pandemic on the Company. In March 2020, the World Health Organization declared the outbreak of COVID–19 a pandemic, and numerous new strains of COVID-19 have subsequently spread throughout\n5\nthe world. COVID–19 has continued to impact market and economic conditions globally. In an attempt to limit the spread of the virus, various governmental restrictions have been implemented, including restrictions with respect to business activities and travel restrictions, and “shelter–at–home” orders, that have had and may continue to have an adverse impact on the Company’s business and operations. In light of the evolving nature of COVID–19 and the uncertainty it has produced around the world, it is not possible to predict the COVID–19 pandemic’s cumulative and ultimate impact on the Company’s future business operations, results of operations, financial position, liquidity, and cash flows. The extent of the impact of the pandemic on the Company’s business and financial results will depend largely on future developments, including the duration of the spread of the outbreak both globally and within the U.S., the impact on capital, foreign currencies exchange and financial markets, and governmental or regulatory orders that impact the Company’s business, all of which are highly uncertain and cannot be predicted.\nThe Company will continue to actively monitor the current international and domestic impacts of and responses to COVID-19 and its related risks.\nBasis of Presentation\nThe accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Any reference in these notes to applicable guidance is meant to refer to the authoritative United States generally accepted accounting principles as found in the Accounting Standards Codification (“ASC”) and Accounting Standards Update (“ASU”) of the Financial Accounting Standards Board (“FASB”).\nThe unaudited condensed consolidated interim financial statements have been prepared on the same basis as the audited annual consolidated financial statements as of and for the year ended December 31, 2020, and, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2021, and the results of its operations and its cash flows for the three months ended March 31, 2021 and 2020. The consolidated balance sheet as of December 31, 2020 included herein was derived from the audited financial statements as of that date.\nThe results for the three months ended March 31, 2021 are not necessarily indicative of the results to be expected for the year ending December 31, 2021, any other interim periods, or any future year or period.\nThe unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s final prospectus dated March 24, 2021 (the “Prospectus”) as filed with the SEC on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”).\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described below and elsewhere in these notes to the unaudited condensed consolidated financial statements. As of March 31, 2021, there have been no material changes in the Company's significant accounting policies from those that were disclosed in the Prospectus except as discussed below.\n2. Summary of Significant Accounting Policies\nPrinciples of Consolidation\n6\nThe unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.\nUse of Estimates\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates relied upon in preparing these financial statements include, but are not limited to, revenue recognition, expected future cash flows used to evaluate the recoverability of long-lived assets, contingent liabilities, expensing and capitalization of research and development costs for internal-use software, the average period of benefit associated with costs capitalized to obtain revenue contracts, the determination of the fair value of stock-based awards issued, stock-based compensation expense, and the recoverability of the Company’s net deferred tax assets and related valuation allowance.\nAlthough the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period in which they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results may differ from management’s estimates if these results differ from historical experience, or other assumptions do not turn out to be substantially accurate, even if such assumptions are reasonable when made.\nSubsequent Events Considerations\nThe Company considers events or transactions that occur after the balance sheet date but prior to the issuance of the financial statements to provide additional evidence for certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated as required. The Company has evaluated all subsequent events and determined that there are no material recognized or unrecognized subsequent events requiring disclosure, other than those disclosed in this Quarterly Report on Form 10-Q.\nEmerging Growth Company Status\nThe Company is an \"emerging growth company,\" as defined in the Jumpstart Our Business Startups Act, or JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not \"emerging growth companies.\" The Company may take advantage of these exemptions until the Company is no longer an \"emerging growth company.\" Section 107 of the JOBS Act provides that an \"emerging growth company\" can take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards. The Company has elected to use the extended transition period for complying with new or revised accounting standards and, as a result of this election, its financial statements may not be comparable to companies that comply with public company effective dates. The Company may take advantage of these exemptions up until the last day of the year following the fifth anniversary of an offering or such earlier time that it is no longer an emerging growth company. The Company would cease to be an emerging growth company if it has more than $1.07 billion in annual revenue, has more than $700.0 million in market value of its stock held by non-affiliates (and it has been a public company for at least 12 months, and has filed one annual report on Form 10-K), or it issues more than $1.0 billion of non-convertible debt securities over a three-year period.\n7\nRevenue Recognition\nThe Company derives revenue from two sources: (1) subscription revenues via the Semrush Online Visibility Management Platform and the Prowly Public Relations Platform, which are comprised of subscription fees from customers accessing the Company’s SaaS services and related customer support; and (2) the Semrush Marketplace, which allows customers to pay a set fee for services or products offered through the marketplace.\nThe Company recognizes revenue in accordance with ASC 606, Revenue from Contracts with Customers (“ASC 606”). Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration it expects to receive in exchange for those products or services. There were no changes to the Company’s revenue recognition policies since the filing of the Prospectus.\nFor the three months ended March 31, 2021 and 2020, subscription revenue accounted for nearly all of the Company’s revenue. Revenue related to the Semrush Marketplace was not material for the three months ended March 31, 2021 and 2020.\nAmounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. The Company primarily invoices and collects payments from customers for its services in advance on a monthly or annual basis.\nDeferred revenue represents amounts billed for which revenue has not yet been recognized. Deferred revenue that will be recognized during the succeeding 12-month period is recorded as current deferred revenue, and the remaining portion is recorded as long-term deferred revenue. Deferred revenue increased by $ 5,599 as of March 31, 2021 compared December 31, 2020. During the three months ended March 31, 2021 and 2020, $ 13,303 and $ 9,583 of revenue was recognized that was included in deferred revenue at the beginning of each respective period.\nThe Company has elected to exclude amounts charged to customers for sales tax from the transaction price. Accordingly, revenue is presented net of any sales tax collected from customers.\nTransaction Price Allocated to Future Performance Obligations\nASC 606 requires that the Company disclose the aggregate amount of the transaction price that is allocated to performance obligations that have not yet been satisfied as of the balance sheet dates reported.\nFor contracts with an original expected duration greater than one year, the aggregate amount of the transaction price allocated to the performance obligations that were unsatisfied as of March 31, 2021 and December 31, 2020 was $ 866 and $ 1,280 , respectively, which the Company expects to recognize over the next 12 months.\nFor contracts with an original expected duration of one year or less, the Company has applied the practical expedient available under ASC 606 to not disclose the amount of transaction price allocated to unsatisfied performance obligations as of March 31, 2021 and December 31, 2020. For performance obligations not satisfied as of March 31, 2021 and December 31, 2020, and to which this expedient applies, the nature of the performance obligations is consistent with performance obligations satisfied as of December 31, 2019. The remaining durations are less than one year.\nCosts to Obtain a Contract\nThe incremental direct costs of obtaining a contract, which primarily consist of sales commissions paid for new subscription contracts, are deferred and recorded as deferred contract costs in the\n8\nconsolidated balance sheet and are amortized over a period of approximately 24 months on a systematic basis, consistent with the pattern of transfer of the goods or services to which the asset relates. The 24-month period represents the estimated benefit period of the customer relationship and has been determined by taking into consideration the type of product sold, the commitment term of the customer contract, the nature of the Company’s technology development life-cycle, and an estimated customer relationship period based on historical experience and future expectations. Sales commissions for renewals and upgrade contracts are deferred and amortized on a straight-line basis over the remaining estimated customer relationship period of the related customer. Deferred contract costs that will be recorded as expense during the succeeding 12-month period are recorded as current deferred contract costs, and the remaining portion is recorded as deferred contract costs, net of current portion. Amortization of deferred contract costs is included in sales and marketing expense in the accompanying consolidated statement of operations and comprehensive loss.\nCash, Cash Equivalents, and Restricted Cash\nThe Company considers all highly liquid instruments purchased with an original maturity date of 90 days or less from the date of purchase to be cash equivalents. Management determines the appropriate classification of investments at the time of purchase and re-evaluates such determination at each balance sheet date.\nCash and cash equivalents consist of cash on deposit with banks and amounts held in interest-bearing money market funds. Cash equivalents are carried at cost, which approximates their fair market value. At both March 31, 2021 and December 31, 2020, restricted cash was $ 88 , and related to cash held at a financial institution in an interest-bearing cash account as collateral for a letter of credit related to the contractual provisions for one of the Company’s building leases.\nThe following table is a reconciliation of cash, cash equivalents and restricted cash included in the accompanying condensed consolidated balance sheets that sum to the total cash, cash equivalents and restricted cash included in the accompanying condensed consolidated statements of cash flows for the three months ended March 31, 2021 and 2020.\n| March 31, 2021 | March 31, 2020 |\n| Cash and cash equivalents | $ | 171,867 | $ | 36,599 |\n| Restricted cash included in “prepaid expenses and other current assets” and “other long-term assets,” respectively | 88 | 88 |\n| $ | 171,955 | $ | 36,687 |\n\nConcentrations of Credit Risk and Significant Customers\nThe Company has no off-balance sheet risk, such as foreign exchange contracts, option contracts, or other hedging arrangements. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\nCredit risk with respect to accounts receivable is dispersed due to the large number of customers of the Company. The Company routinely assesses the creditworthiness of its customers and generally does not require its customers to provide collateral or other security to support accounts receivable. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\n9\nAs of March 31, 2021 and December 31, 2020, no individual customer represented more than 10% of the Company’s accounts receivable. During the three months ended March 31, 2021 and 2020, no individual customer represented more than 10% of the Company’s revenue.\nDisclosure of Fair Value of Financial Instruments\nThe carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, approximated their fair values at March 31, 2021 and December 31, 2020, due to the short-term nature of these instruments.\nThe Company has evaluated the estimated fair value of financial instruments using available market information. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. See below for further discussion.\nFair Value Measurements\nASC 820, Fair Value Measurements and Disclosures (“ASC 820”), establishes a three-level valuation hierarchy for instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and the Company’s own assumptions (unobservable inputs). Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances.\nThis guidance further identifies fair value as the exchange price, or exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants based on the highest and best use of the asset or liability. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. The Company uses valuation techniques to measure fair value that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs are prioritized as follows:\nLevel 1 inputs—Unadjusted observable quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.\nLevel 2 inputs—Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.\nLevel 3 inputs—Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity.\nTo the extent that the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.\nThe Company evaluates assets and liabilities subject to fair value measurements on a recurring and nonrecurring basis to determine the appropriate level to classify them for each reporting period.\nCash equivalents include money market funds with original maturities of 90 days or less from the date of purchase. The fair value measurement of these assets is based on quoted market prices in active markets for identical assets and, therefore, these assets are recorded at fair value on a recurring basis\n10\nand classified as Level 1 in the fair value hierarchy. As of March 31, 2021 and December 31, 2020, cash equivalents held in money market funds totaled $ 35,505 and $ 29,369 , respectively.\nAs of March 31, 2021, the Company measured its investments in convertible notes (see Note 4) and its contingent consideration associated with the acquisition of Prowly.com sp. z o.o (“Prowly”) on a recurring basis using significant unobservable inputs (Level 3) and did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2). Changes in fair value of the convertible notes were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. Changes in fair value of the contingent consideration associated with the Prowly acquisition were not material for the three months ended March 31, 2021. As of December 31, 2020, the Company did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2).\nForeign Currency Translation\nThe Group operates in a multi-currency environment having transactions in such currencies as the U.S. dollar, Russian rubles, Czech koruna, euros, and others. The reporting currency of the Company is the U.S. dollar. The functional currency of the Company’s foreign subsidiaries is the U.S. dollar, with the exception of Prowly, where the functional currency is the local currency, the Zloty. The foreign currency translation adjustment as it relates to Prowly was immaterial for the three months ended March 31, 2021 and 2020. For all other entities, foreign currency transactions are measured initially in the functional currency of the recording entity by use of the exchange rate in effect at that date. At each subsequent balance sheet date, foreign currency denominated assets and liabilities of these international subsidiaries are remeasured into U.S. dollars using the exchange rates in effect at the balance sheet date or historical rates, as appropriate. Any differences resulting from the remeasurement of foreign denominated assets and liabilities of the international subsidiaries to the U.S. dollar functional currency are recorded within other income (expense) in the unaudited condensed consolidated statement of operations and comprehensive loss. The foreign currency exchange gain (loss) included in other income for the three months ended March 31, 2021 and 2020 was $ 44 and $( 107 ), respectively.\nNet Income (Loss) Per Share\nNet income (loss) per share information is determined using the two-class method, which includes the weighted-average number of shares of common stock outstanding during the period and other securities that participate in dividends (a participating security). Prior to the completion of the IPO, the Company considered the shares of Preferred Stock to be participating securities because they include rights to participate in dividends with the common stock. As of March 31, 2021, the Company did not have any participating securities outstanding.\nUnder the two-class method, basic net income (loss) per share attributable to common stockholders is computed by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income (loss) per share attributable to common stockholders is computed using the more dilutive of (1) the two-class method or (2) the if-converted method. The Company allocates net income first to preferred stockholders based on dividend rights under the Company’s certificate of incorporation and then to preferred and common stockholders based on ownership interests. Net losses are not allocated to preferred stockholders as they do not have an obligation to share in the Company’s net losses.\nDuring the three months ended March 31, 2021, the Company amended its certificate of incorporation to create two classes of common stock outstanding: Class A common stock and Class B common stock. As more fully described in Note 9, the rights of the holders of Class A and Class B common stock are identical, except with respect to voting and conversion. Each share of Class A common stock is entitled to one (1) vote per share and each share of Class B common stock is entitled to ten (10) votes per share. Each share of Class B common stock is convertible into one share of Class A common stock at the option\n11\nof the holder at any time. Shares of Class B common stock are automatically converted into Class A common stock upon sale or transfer, subject to certain limited exceptions. Shares of Class A common stock are not convertible. See Note 9 to these unaudited condensed consolidated financial statements for additional information regarding the current conversion and transfer terms of the Company’s common stock. The Company allocates undistributed earnings attributable to common stock between the common stock classes on a one to one basis when computing net income (loss) per share. As a result, basic and diluted net income (loss) per share of Class A common stock and share of Class B common stock are equivalent.\nDiluted net income (loss) per share gives effect to all potentially dilutive securities. Potential dilutive securities consist of shares of common stock issuable upon the exercise of stock options, shares of common stock issuable upon the conversion of the outstanding shares of Preferred Stock, and shares of common stock issuable upon the vesting of restricted stock awards or restricted stock units.\nFor the three months ended March 31, 2021, dilutive net income per share was calculated by dividing net income by the weighted-average number of shares of common stock outstanding during the period, the dilutive impact of stock options, shares of common stock issuable upon the vesting of RSUs, and the dilutive impact of shares issuable upon the conversion of the outstanding shares of Preferred Stock.\nFor the three months ended March 31, 2020, the net loss attributable to common stockholders is divided by the weighted-average number of shares of common stock outstanding during the period to calculate diluted earnings per share. The dilutive effect of common stock equivalents has been excluded from the calculation for the three months ended March 31, 2020 as their effect would have been anti-dilutive due to the net losses incurred for the period.\nThe following table presents a reconciliation of the weighted-average shares outstanding used in the calculation of basic and diluted net income (loss) per share:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Weighted-average shares outstanding: |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—basic | 96,375,531 | 94,592,700 |\n| Dilutive effect of share equivalents resulting from stock options | 6,151,361 | — |\n| Dilutive effect of share equivalents resulting from RSAs | 123,841 | — |\n| Dilutive effect of shares issuable upon conversion of preferred stock | 28,705,360 | — |\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—diluted | 131,356,093 | 94,592,700 |\n\nThe following potentially dilutive common stock equivalents have been excluded from the calculation of diluted weighted-average shares outstanding for the three months ended March 31, 2021 and 2020:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Stock options outstanding | — | 6,286,357 |\n| Shares of Preferred Stock | — | 29,695,200 |\n| Restricted stock units outstanding | 1,733 | — |\n\n12\nComprehensive income (loss)\nComprehensive income (loss) is comprised of two components: net income (loss) and other comprehensive income (loss), which includes other changes in stockholders’ deficit that result from transactions and economic events other than those with stockholders. The Company had no items qualifying as other comprehensive income (loss) with the exception of an immaterial cumulative translation adjustment related to the Prowly entity and an immaterial fair-value adjustment related to the convertible note investments; accordingly, comprehensive income (loss) equaled total net loss for the three months ended March 31, 2021 and 2020.\nRecent Accounting Pronouncements\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). ASU 2016-02 requires a lessee to recognize most leases on the balance sheet but recognize expenses on the income statement in a manner similar to current practice. The update states that a lessee will recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying assets for the lease term. Leases will continue to be classified as either financing or operating, with classification affecting the recognition, measurement, and presentation of expenses and cash flows arising from a lease. For public entities, ASU 2016-02 is effective for years beginning after December 15, 2019. For non-public companies, ASU 2016-02 is effective for fiscal years beginning after December 15, 2021 and interim periods in annual periods beginning after December 15, 2022. Early adoption is permitted. The Company plans to adopt this guidance in the year ended December 31, 2022. The Company is currently assessing the impact that adopting this guidance will have on its consolidated financial statements.\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 requires that credit losses be reported as an allowance using an expected losses model, representing the entity's current estimate of credit losses expected to be incurred. The accounting guidance currently in effect is based on an incurred loss model. ASU 2016-13 affect loans, debt securities, trade receivables, net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. ASU 2016-13 is effective for public entities for annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years. For non-public companies, ASU 2016-13 is effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently evaluating ASU 2016-13 and the potential impact on its condensed consolidated financial statements and financial statement disclosures.\nIn August 2018, the FASB issued ASU No. 2018-15, Intangible-Goodwill and Other Internal-Use Software (Subtopic 350-40). ASU 2018-15 updates guidance regarding accounting for implementation costs associated with a cloud computing arrangement that is a service contract. The amendments under ASU 2018-15 are effective for public entities for years beginning after December 15, 2019, and interim periods within those years. For non-public companies, ASU 2081-15 is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes – Simplifying the Accounting for Income Taxes. The new guidance simplifies the accounting for income taxes by removing several exceptions in the current standard and adding guidance to reduce complexity in certain areas, such as requiring that an entity reflect the effect of an enacted change in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date. For public companies, the ASU is effective for years beginning after December 15, 2020, and interim periods within those years,\n13\nwith early adoption permitted. For non-public companies, the new standard is effective for years beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\n3. Property and Equipment, Net\nProperty and equipment consists of the following (in thousands):\n| As of |\n| March 31,2021 | December 31,2020 |\n| Computer equipment | $ | 3,383 | $ | 3,513 |\n| Furniture and office equipment | 877 | 1,041 |\n| Leasehold improvements | 1,142 | 667 |\n| Capital leases | 1,024 | — |\n| Total property and equipment | 6,426 | 5,221 |\n| Less: accumulated depreciation and amortization | ( 2,550 ) | ( 2,253 ) |\n| Property and equipment, net | $ | 3,876 | $ | 2,968 |\n\nDepreciation and amortization expense related to property and equipment was $ 344 and $ 203 for the three months ended March 31, 2021 and 2020, respectively.\n4. Other Long-Term Assets\nDeferred Offering Costs\nDeferred offering costs, which primarily consist of direct incremental legal and accounting fees relating to the IPO and to a credit facility, are deferred. The deferred issuance costs relating to the IPO were offset against IPO proceeds upon the consummation of the Company’s offering. The deferred costs relating to the credit facility are being amortized to interest expense up through the maturity date of the facility. As of March 31, 2021 and December 31, 2020, the Company had deferred offering costs relating to the IPO of $ 0 and $ 1,839 . As of March 31, 2021 and December 31, 2020, the Company had $ 578 and $ 630 , respectively, in issuance costs relating to the credit facility. The issuance costs for the IPO and credit facility are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets.\nInvestments in Convertible Debt\nIn January 2021, the Company purchased two convertible debt securities for a total aggregate investment of $ 500 . Both investments mature on January 1, 2023 and receive interest at an annual rate of 6 %. Interest accrues and becomes payable upon conversion of the convertible notes, or will be paid in connection with the repayment in full of the principal amount of such convertible notes.\nThese convertible note investments are classified as available-for-sale securities with changes in fair value reported in other comprehensive income (loss). Changes in fair value were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. These investments are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets based on the maturity date.\n14\n5. Acquisitions, Acquired Intangible Assets, and Goodwill\nAcquisitions\nOn August 27, 2020, the Company acquired 100 % of the outstanding capital of Prowly for cash consideration of $ 3,317 . In addition to the purchase consideration, the founders of Prowly are eligible to earn up to a maximum of $ 2,750 in aggregate additional consideration based on the satisfaction of certain earnings targets as defined in the purchase agreement. For the three months ended March 31, 2021, the Company recognized compensation expense of $ 56 as compensation expense related to the additional consideration.\nIntangible Assets\nIntangible assets consisted of intangible assets resulting from the acquisition of Prowly and capitalized internal-use software development costs. Intangible assets consists of the following:\n| As of March 31, 2021 |\n| Gross | Net |\n| Carrying | Accumulated | Carrying |\n| Amount | Amortization | Amount |\n| Developed technology | 1,194 | ( 109 ) | 1,085 |\n| Trade name | 68 | ( 9 ) | 59 |\n| Capitalized internal-use software | 1,684 | ( 652 ) | 1,032 |\n| Total as of March 31, 2021 | $ | 2,946 | $ | ( 770 ) | $ | 2,176 |\n\n| As of December 31, 2020 |\n| Gross | Net |\n| Carrying | Accumulated | Carrying |\n| Amount | Amortization | Amount |\n| Developed technology | 1,194 | ( 66 ) | 1,128 |\n| Trade name | 68 | ( 3 ) | 65 |\n| Capitalized internal-use software | 1,561 | ( 523 ) | 1,038 |\n| Total as of December 31, 2020 | $ | 2,823 | $ | ( 592 ) | $ | 2,231 |\n\nDuring the three months ended March 31, 2021 and 2020, the Company capitalized $ 123 and $ 200 , respectively, of software development costs, which are classified as intangible assets on the accompanying consolidated balance sheets. The Company recorded amortization expense associated with its capitalized development costs of $ 129 and $ 52 for the three months ended March 31, 2021 and 2020, respectively. As of March 31, 2021 and December 31, 2020, the capitalized internal-use software asset balances totaled $ 1,032 and $ 1,038 , respectively.\nAmortization expense for acquired intangible assets was $ 55 for the three months ended March 31, 2021.\n15\nAs of March 31, 2021, future amortization expense is expected to be as follows:\n| Amount |\n| Remainder of 2021 | $ | 519 |\n| 2022 | 559 |\n| 2023 | 428 |\n| 2024 | 199 |\n| 2025 and thereafter | 471 |\n| Total | $ | 2,176 |\n\nGoodwill\nThe was no change in the carrying value of goodwill of $ 1,991 from December 31, 2020 through March 31, 2021.\n6. Accrued expenses\nAccrued expenses consist of the following:\n| As of |\n| March 31,2021 | December 31,2020 |\n| Employee compensation | $ | 4,776 | $ | 4,478 |\n| Vacation reserves | 464 | 465 |\n| Other current liabilities | 5,046 | 2,776 |\n| Total accrued expenses | $ | 10,286 | $ | 7,719 |\n\n7. Revolving Credit Facility\nSenior Secured Revolving Credit Facility\nOn January 12, 2021, the Company executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $ 45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $ 5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400 % multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\nBorrowings under the credit facility bear interest at the Company’s option at (i) LIBOR, subject to a 0.50 % floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25 % floor (or 1.50 % prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75 % (or 3.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00 % (or 2.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). The Company is also required to pay a 0.25 % per annum fee on undrawn amounts under the Company’s revolving credit facility, payable quarterly in arrears.\n16\nAs of March 31, 2021, the Company has not drawn on this revolving credit facility. For the three months ended March 31, 2021, the Company incurred $ 53 in interest expense relating to this credit facility.\n8. Income Taxes\nWe are subject to U.S. federal, state, and foreign income taxes. For the three months ended March 31, 2021 and 2020, we recorded provisions for income taxes of $ 86 and $ 116 , respectively. Our effective tax rate for the three months ended March 31, 2021 and 2020 was lower than the U.S. statutory rate primarily due to the valuation allowance.\nWe recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. These differences are measured using the enacted statutory tax rates that are expected to be in effect for the years in which differences are expected to reverse. On a periodic basis, we reassess any valuation allowances that we maintain on our deferred tax assets, weighing positive and negative evidence to assess the recoverability of the deferred tax assets. We will maintain a valuation allowance on certain federal, state, and foreign tax attributes that we expect will expire prior to the utilization.\nIn March 2020, the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act includes provisions relating to several aspects of corporate income taxes. We do not currently expect the CARES Act to have a significant impact on our provision for income taxes.\n9. Redeemable Convertible Preferred Stock and Stockholders’ Equity\nPrior to the IPO, the authorized capital stock of the Company included 9,898,400 shares of preferred stock, of which 3,379,400 shares have been designated as Series A Redeemable Convertible Preferred Stock, 1,837,600 shares have been designated as Series A-1 Redeemable Convertible Preferred Stock and 4,681,400 shares have been designated as Series B Convertible Preferred Stock (collectively the “Preferred Stock”).\nImmediately prior to the closing of the IPO, the outstanding shares of Preferred Stock were converted on a three -for-one basis into 29,695,200 shares of common stock. The holders of the Company’s Preferred Stock had certain voting, dividend, and redemption rights, as well as liquidation preferences and conversion privileges. All rights, preferences, and privileges associated with the preferred stock were terminated at the time of the Company’s IPO in conjunction with the conversion of all outstanding shares of Preferred Stock into shares of common stock.\nAs of March 31, 2021, the total number of shares of all classes of stock which the Company shall have authority to issue was (i) 1,000,000,000 shares of Class A common stock, par value $ 0.00001 per share, and (ii) 160,000,000 shares of Class B common stock, par value $ 0.00001 per share, and (iii) 100,000,000 undesignated shares of Preferred Stock, par value $ 0.00001 per share.\nEach share of Class A common stock entitles the holder to one vote for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings. Each share of Class B common stock entitles the holder to ten votes for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings.\nHolders of Class A common stock and Class B common stock are entitled to receive dividends, when and if declared by the board of directors (the “Board”).\n17\nEach share of Class B common stock is convertible into one share of Class A common stock at the option of the holder at any time. Automatic conversion shall occur upon the occurrence of (i) a Transfer, as defined in the amended and restated certificate of incorporation, of such share of Class B common stock, (ii) the affirmative vote of at least two-thirds of the outstanding shares of Class B common stock, voting as a single class, or (iii) on or after the earlier to occur of (a) the seventh year anniversary of the effectiveness of the amended and restated certificate of incorporation or (b) the date on which the outstanding shares of Class B common stock represents less than 10 % of the aggregate number of the then outstanding shares of Class A common stock and Class B common stock. Further, upon either the death or incapacitation of a holder of Class B common stock, the shares held by such shareholder shall automatically be converted into one share of Class A common stock.\nStock Split\nOn March 15, 2021, the Board approved a 3 -for-1 stock-split of the Company’s common stock. The stock split was approved by the stockholders on March 15, 2021 and became effective on March 15, 2021. Upon the effectiveness of the stock split, (i) every one share of common stock outstanding was increased to 3 shares of common stock, (ii) the number of shares of common stock into which each outstanding option to purchase common stock is exercisable was proportionally increased on a 3 -for-1 basis, and (iii) the exercise price of each outstanding option to purchase common stock was proportionately decreased on a 3 -for-1 basis. Additionally, shares of common stock reserved for issuance upon the conversion of the Company’s Preferred Stock were proportionately increased on a 3 -for-1 basis and the respective conversion prices of the Preferred Stock were proportionately reduced. All share and per share data shown in the accompanying consolidated financial statements and related notes have been retroactively revised to reflect the stock split.\nCommon Stock Reserved for Future Issuance\nAs of March 31, 2021, the Company had reserved the following shares of common stock for future issuance:\n| Options outstanding | 7,591,554 |\n| Options reserved for future issuance | 13,483,501 |\n| Restricted stock outstanding | 156,852 |\n| Restricted stock units | 19,500 |\n| Total authorized shares of common stock reserved for future issuance | 21,251,407 |\n\nn\n10. Stock-Based Compensation\nIn 2019, the Board adopted the Semrush Holdings, Inc. 2019 Stock Option and Grant Plan (the “2019 Plan”), which provides for the grant of qualified incentive stock options and nonqualified stock options or other awards, including restricted stock unit awards, to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 8,682,600 shares of the Company’s common stock. In July 2020, the Plan was amended to provide for the grant of qualified incentive stock options and nonqualified stock options or other awards to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 10,163,772 shares of the Company’s common stock. Stock options generally vest over a 4 year period and expire 10 years from the date of grant. Certain options provide for accelerated vesting if there is a change in control (as defined in the Plan).\nThe Semrush Holdings, Inc. 2021 Stock Option and Incentive Plan (the “2021 Plan”) was adopted by the Board March 3, 2021 and approved by stockholders on March 15, 2021 and became effective immediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The 2021 Plan replaced the 2019 Plan as the Board determined not to make additional awards under the\n18\n2019 Plan following the pricing of the Company’s IPO. The 2021 Plan allows the compensation committee of the Board to make equity-based and cash-based incentive awards to the Company’s officers, employees, directors and other key persons (including consultants).\nThe Company initially reserved 13,503,001 shares of Class A common stock for the issuance of awards under the 2021 Plan. The 2021 Plan provides that the number of shares reserved and available for issuance under the plan will automatically increase each January 1, beginning on January 1, 2022, by the lesser of 5 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31, or such lesser number of shares as determined by the compensation committee. This number is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization.\nThe Company accounts for stock-based compensation in accordance with the provisions of ASC 718, which requires the recognition of expense related to the fair value of stock-based compensation awards in the statements of operations. For stock-based awards issued under the Company’s stock-based compensation plans to employees and members of the Board for their services on the Board, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model as discussed further below. For service-based awards, the Company recognizes compensation expense on a straight-line basis over the requisite service period of the award with actual forfeitures recognized as they occur.\nGiven the absence of an active market for the Company’s common stock prior to the completion of the IPO, the Board, the members of which the Company believes have extensive business, finance, and venture capital experience, were required to estimate the fair value of the Company’s common stock at the time of each grant of a stock-based award. The Company and the Board utilized various valuation methodologies in accordance with the framework of the American Institute of Certified Public Accountants’ Technical Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation, to estimate the fair value of its common stock. Each valuation methodology included estimates and assumptions that require the Company’s judgment. These estimates and assumptions include a number of objective and subjective factors, in determining the value of the Company’s common stock at each grant date, including the following factors: (1) prices paid for the Company’s Preferred Stock, which the Company had sold to outside investors in arm’s-length transactions, and the rights, preferences, and privileges of the Company’s Preferred Stock and common stock; (2) valuations performed by an independent valuation specialist; (3) the Company’s stage of development and revenue growth; (4) the fact that the grants of stock-based awards involved illiquid securities in a private company; and (5) the likelihood of achieving a liquidity event for the common stock underlying the stock-based awards, such as an IPO or sale of the Company, given prevailing market conditions.\nThe Company believes this methodology to be reasonable based upon the Company’s internal peer company analyses, and further supported by several arm’s-length transactions involving the Company’s Preferred Stock. As the Company’s common stock is not actively traded, the determination of fair value involves assumptions, judgments, and estimates. If different assumptions were made, stock-based compensation expense, consolidated net income (loss) and consolidated net income (loss) per share could have been significantly different.\nThe Company has recorded stock-based compensation expense for stock options of $ 593 and $ 205 during the three months ended March 31, 2021 and 2020, respectively. The following table shows stock-\n19\nbased compensation expense by where the stock-based compensation expense is recorded in the Company’s unaudited condensed consolidated statement of operations:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Cost of revenue | $ | 7 | $ | 5 |\n| Sales and marketing | 190 | 27 |\n| Research and development | 67 | 29 |\n| General and administrative | 329 | 144 |\n| Total stock-based compensation | $ | 593 | $ | 205 |\n\nAs of March 31, 2021, there was $ 5,024 of unrecognized compensation cost related to unvested common stock option arrangements granted under the 2021 Plan, which is expected to be recognized over a weighted-average period of 3.12 years.\nThe fair value of each option award was estimated on the date of grant using the Black-Scholes option-pricing model. As there was no public market for its common stock prior to March 25, 2021, which was the first day of trading, and as the trading history of the Company’s common stock was limited through March 31, 2021, the Company determined the expected volatility for options granted based on an analysis of reported data for a peer group of companies that issued options with substantially similar terms. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies. The expected life of options granted to employees was calculated using the simplified method, which represents the average of the contractual term of the option and the weighted-average vesting period of the option. The Company uses the simplified method because it does not have sufficient historical option exercise data to provide a reasonable basis upon which to estimate expected term. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the share option. The Company has not paid, nor anticipates paying, cash dividends on its ordinary shares; therefore, the expected dividend yield is assumed to be zero .\n20\nThe weighted-average assumptions utilized to determine the fair value of options granted to employees are presented in the following table:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| Expected volatility | 52.0 | % | 46.7 | % |\n| Weighted-average risk-free interest rate | 0.58 | % | 1.46 | % |\n| Expected dividend yield | — | — |\n| Expected life – in years | 6 | 6 |\n\nA summary of the Company’s option activity as of March 31, 2021, which all occurred under the Semrush Holdings, Inc. Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”), and changes during the three months then ended are as follows:\n| Number of Options | Weighted-Average Exercise Price (per share) | Weighted-Average Remaining Contractual Term (in years) |\n| Outstanding at December 31, 2020 | 7,611,258 | $ | 1.37 | 8.40 |\n| Granted | 34,500 | 6.21 |\n| Exercised | ( 3,861 ) | 1.35 |\n| Forfeited | ( 50,343 ) | 2.00 |\n| Outstanding at March 31, 2021 | 7,591,554 | 1.39 | 8.28 |\n| Options exercisable at March 31, 2021 | 3,309,264 | 0.94 | 7.60 |\n\nThe weighted-average grant-date fair value of options granted during the three months ended March 31, 2021 and 2020 was $ 9.09 and $ 1.70 per share, respectively. No tax benefits were realized from options during the three months ended March 31, 2021.\nThe aggregate intrinsic value of options outstanding as of March 31, 2021 and December 31, 2020 was $ 79,858 and $ 36,816 , respectively.\nThe aggregate intrinsic value for options exercised during the three months ended March 31, 2021 was $ 19 . No options were exercised for the three months ended March 31,2020.\nThe aggregate intrinsic value for options exercisable as of March 31, 2021 was $ 36,313 .\nThe aggregate intrinsic value was calculated based on the positive difference, if any, between the estimated fair value of the Company’s common stock on March 31, 2021 and December 31, 2020, respectively, or the date of exercise, as appropriate, and the exercise price of the underlying options.\nOn July 28, 2020, the Company issued 156,852 shares of its restricted common stock (“Restricted Stock Issuance”) to the founders of Prowly for a total fair value of $ 291 under the 2019 Plan. This Restricted Stock Issuance vests over a three-year service period, applicable to both founders. On March 3, 2021, the Company granted, to an employee, a restricted stock unit award for 19,500 shares of Class A common stock under the 2021 Plan.\n2021 Employee Stock Purchase Plan\nThe Semrush Holdings, Inc. 2021 Employee Stock Purchase Plan (the “ESPP”) was adopted by the Board on March 3, 2021 and approved by stockholders on March 15, 2021 and became effective\n21\nimmediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The ESPP initially reserves and authorizes the issuance of up to a total of 3,000,667 shares of Class A common stock to participating employees. The ESPP provides that the number of shares reserved and available for issuance will automatically increase each January 1, beginning on January 1, 2022 and each January 1 thereafter through January 1, 2031, by the least of (i) 1 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31; (ii) 3,000,667 shares or (iii) such lesser number of shares of Class A common stock as determined by the ESPP administrator. The number of shares reserved under the ESPP is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization. The Company expects to offer, sell and issue shares of common stock under the ESPP from time to time based on various factors and conditions, although the Company is under no obligation to sell any shares under the ESPP. The Company has not issued any shares of Class A common stock under the ESPP.\n11. Commitments and Contingencies\nThe Company leases office facilities under noncancelable operating leases that expire at various dates through 2024. In addition, the Company has multi-year commitments with data centers. Some of these lease agreements contain escalating rent payments. Rent expense is recorded on a straight-line basis. Rent expense was $ 928 and $ 1,086 for the three months ended March 31, 2021 and 2020, respectively. The Company also has non-cancelable commitments related to its data centers.\nFuture minimum amounts payable as of March 31, 2021, under the office facilities operating leases and data center agreements are as follows:\n| Operating Leases |\n| Remainder of 2021 | $ | 3,070 |\n| 2022 | 3,109 |\n| 2023 | 1,515 |\n| 2024 | 459 |\n| 2025 and thereafter | — |\n| Total minimum lease payments | $ | 8,153 |\n\nDuring the year ended December 31, 2020, the Company entered into leasing arrangements for certain data center equipment under non-cancelable capital leases. The leasing arrangements have terms of 36 months beginning on the date the Company accepts the installation of the equipment subject to the lease. As of December 31, 2020, the equipment had not been installed and the Company had not accepted the equipment under these leases, and as such the lease commencement date had not begun. During the three months ended March 31, 2021, a portion of the equipment was installed and the related lease commenced. The Company is required to make total payments of $ 6,045 over the term of the leases which is excluded from the table above. The Company recorded $ 1,024 in capital leases to property and equipment, net, as of March 31, 2021 (see Note 3), which is being depreciated over the lease term of 36 months. The $ 1,024 of capital leases represents the total balance of other-long term liabilities on the unaudited condensed consolidated balance sheet as of March 31, 2021.\nIn addition to the lease commitments above, the Company also has multi-year commitments with certain data providers. The Company is committed to spend approximately $ 4,124 , $ 6,776 , and $ 1,933 for the remainder of the year ending December 31, 2021, and for the years ending December 31, 2022, and 2023, respectively, for data services.\n22\nLitigation\nThe Company, from time to time, may be party to litigation arising in the ordinary course of its business. The Company was not subject to any material legal proceedings during the three months ended March 31, 2021, and, to the best of its knowledge, no material legal proceedings are currently pending or threatened.\nIndemnification\nThe Company typically enters into indemnification agreements with customers in the ordinary course of business. Pursuant to these agreements, the Company indemnifies and agrees to reimburse the indemnified party for losses suffered or incurred as a result of claims of intellectual property infringement. These indemnification agreements are provisions of the applicable customer agreement. Based on when clients first sign an agreement for the Company’s service, the maximum potential amount of future payments the Company could be required to make under certain of these indemnification agreements is unlimited. Based on historical experience and information known as of March 31, 2021, the Company has not incurred any costs for the above guarantees and indemnities.\nIn certain circumstances, the Company warrants that its services will perform in all material respects in accordance with its standard published specification documentation in effect at the time of delivery of the services to the customer for the term of the agreement. To date, the Company has not incurred significant expense under its warranties and, as a result, the Company believes the estimated fair value of these agreements is immaterial.\n12. Components of Other Income, Net\nThe components of other income, net, are as follows:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Foreign currency exchange gain (loss) | 44 | ( 107 ) |\n| Other, net | 7 | 163 |\n| Other income, net | $ | 51 | $ | 56 |\n\n13. Employee Benefit Plan\nThe Company maintains a defined contribution savings plan under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”) covering all U.S. employees who satisfy certain eligibility requirements. The 401(k) Plan allows each participant to defer a percentage of their eligible compensation subject to applicable annual limits pursuant to the limits established by the Internal Revenue Service. The Company may, at the discretion of the Board, make contributions in the form of matching contributions or profit-sharing contributions. For the three months ended March 31, 2021 and 2020, the Company made matching contributions of $ 90 and $ 34 , respectively, to the 401(k) Plan.\n14. Segment and Geographic Information\nDisclosure requirements about segments of an enterprise and related information establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information of those segments to be presented in interim financial reports issued to shareholders. Operating segments are defined as components of an enterprise about which separate discrete financial information is available that is evaluated regularly by the chief operating decision maker,\n23\nor decision-making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is the chief executive officer. The Company and the chief executive officer view the Company’s operations and manage its business as one operating segment.\nGeographic Data\nThe Company allocates, for the purpose of geographic data reporting, its revenue based upon the location of the customer. Total revenue by geographic area was as follows:\n| For the Three Months EndedMarch 31, |\n| 2021 | 2020 |\n| Revenue: |\n| United States | $ | 18,132 | $ | 12,886 |\n| United Kingdom | 4,195 | 2,994 |\n| Other | 17,671 | 11,907 |\n| Total revenue | $ | 39,998 | $ | 27,787 |\n\nProperty and equipment, net by geographic location consists of the following:\n| As of |\n| March 31,2021 | December 31,2020 |\n| Property and equipment, net: |\n| United States | $ | 2,020 | $ | 1,023 |\n| Russia | 1,360 | 1,450 |\n| Czech Republic | 440 | 439 |\n| Other | 56 | 56 |\n| Total assets | $ | 3,876 | $ | 2,968 |\n\n15. Subsequent Events\nThe Company has completed an evaluation of all subsequent events after the balance sheet date of March 31, 2021 through the date this Quarterly Report on Form 10-Q was filed with the SEC, to ensure that this filing includes appropriate disclosure of events both recognized in the financial statements as of March 31, 2021, and events which occurred subsequently but were not recognized in the financial statements. The Company has concluded that no subsequent events have occurred that require disclosure, except as disclosed within these financial statements and except as disclosed below.\nExercise of Overallotment Option\nOn April 20, 2021, the underwriters of the Company’s IPO partially exercised their option to purchase additional shares of Class A common stock. In connection with the closing of the partial exercise on April 23, 2021, the underwriters purchased 719,266 shares of the Company’s Class A common stock for net proceeds to the Company of $ 9.4 million.\n24\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nYou should read the following discussion and analysis of our financial condition and results of operations together with the unaudited condensed consolidated financial statements, and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, along with the financial information included in our prospectus dated March 24, 2021 (the “Prospectus”) as filed with the Securities Exchange Commission (the “SEC”) on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”). Some of the information contained in this discussion and analysis, including information with respect to our planned investments in our research and development, sales and marketing, and general and administrative functions, contains forward-looking statements based upon current plans, beliefs, and expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the sections titled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q.\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\nThis Quarterly Report on Form 10-Q contains forward-looking statements about Semrush Holdings, Inc. (“Semrush Holdings”) and our subsidiaries (collectively, the “Group”, the “Company”, “Semrush”, “we”, “us”, or “our”) and our industry that involve substantial risks and uncertainties. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations, financial condition, business strategy and plans and objectives of management for future operations, are forward-looking statements. In some cases, you can identify forward-looking statements because they contain words such as “anticipate,” “believe,” “contemplate,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “target,” “will,” or “would,” or the negative of these words or other similar terms or expressions. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:\n•our future financial performance, including our revenue, annual recurring revenue (“ARR”), costs of revenue, gross profit or gross margin and operating expenses;\n•the sufficiency of our cash and cash equivalents to meet our liquidity needs;\n•anticipated trends and growth rates in our business and in the markets in which we operate;\n•our ability to maintain the security and availability of our internal networks and platform;\n•our ability to attract new paying customers and convert free customers into paying customers;\n•our ability to retain and expand sales to our existing paying customers, including upgrades to premium subscriptions, purchases of add-on offerings, and increasing the number of authorized users per paying customer;\n•our ability to access, collect, and analyze data;\n•our ability to successfully expand in our existing markets and into new markets;\n•our ability to effectively manage our growth and future expenses;\n•our ability to continue to innovate and develop new products and features, improve our data assets, and enhance our technological capabilities;\n•our estimated total addressable market;\n25\n•our ability to maintain, protect, and enhance our intellectual property;\n•our ability to comply with modified or new laws and regulations applying to our business;\n•the attraction and retention of qualified employees and key personnel;\n•our anticipated investments in sales and marketing, and research and development;\n•our ability to successfully defend litigation brought against us;\n•our ability to successfully acquire and integrate companies and assets;\n•the increased expenses associated with being a public company;\n•our use of the net proceeds from our initial public offering (“IPO”); and\n•the impact of the novel strain of coronavirus (“COVID-19”) on our business and industry.\nYou should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations and prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and other factors described in the section titled “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. The results, events, and circumstances reflected in the forward-looking statements may not be achieved or occur, and actual results, events, or circumstances could differ materially from those described in the forward-looking statements.\nThe forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make.\nIn addition, statements that “we believe” and similar statements reflect our beliefs and opinions on the relevant subject. These statements are based upon information available to us as of the date of this Quarterly Report on Form 10-Q, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and you are cautioned not to unduly rely upon these statements.\nCompany Overview\nWe are a leading online visibility management software-as-a-service (“SaaS”) platform, enabling companies globally to identify and reach the right audience in the right context and through the right channels. Online visibility represents how effectively companies connect with consumers across a variety of digital channels, including search, social and digital media, digital public relations, and review websites.\n26\nOur proprietary SaaS platform enables us to aggregate and enrich trillions of data points collected from hundreds of millions of unique domains, social media platforms, online ads, and web traffic. This allows our customers to understand trends, derive unique and actionable insights to improve their websites and social media pages, and distribute highly relevant content to their targeted customers across channels to drive high-quality traffic.\nOn March 29, 2021, we completed our IPO in which we issued and sold 10,000,000 shares of our Class A common stock at a public offering price of $14.00 per share for aggregate gross proceeds of $140.0 million. We received approximately $126.6 million in net proceeds after deducting $9.8 million of underwriting discounts and commissions and approximately $3.6 million in offering costs. In connection with the closing of the IPO, all of the outstanding shares of our Preferred Stock and Common Stock automatically converted into 124,905,954 shares of Class B common stock.\nWe generate substantially all of our revenue from monthly and annual subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date the product is made available to customers.\nWe have one reportable segment. See Note 14 of our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\nKey Factors Affecting Our Performance\nWe regularly review a number of factors that have impacted, and we believe will continue to impact, our results of operations and growth. These factors include:\nAcquiring New Paying Customers\nWe expect increasing demand for third-party online visibility software to accelerate adoption of our platform. Our recurring subscription model provides significant visibility into our future results and we believe ARR is the best indicator of the scale of our platform, while mitigating fluctuations due to seasonality and contract term. We define ARR as the daily revenue of all paid subscription agreements that are actively generating revenue as of the last day of the reporting period multiplied by 365. We include both monthly recurring paid subscriptions, which renew automatically unless cancelled, as well as the annual recurring paid subscriptions so long as we do not have any indication that a customer has cancelled or intends to cancel its subscription and we continue to generate revenue from them. As of March 31, 2021 and 2020, we had more than 72,000 paying customers and 56,000 paying customers, respectively, accounting for $167.6 million and $109.5 million in ARR, respectively.\nRetaining and Expanding Sales to Our Existing Customers\nWe serve a diverse customer base across a variety of sizes and industries that is focused on maximizing their online visibility. We believe there is a significant opportunity to expand within our existing customer base as customers often initially purchase our entry-level subscription, which offers lower usage limits and limited user licenses, as well as fewer features. We have demonstrated the ability to expand contract values with our existing customers as they use our products and recognize the critical nature of our platform and often seek premium offerings through incremental usage, features, add-ons, and additional user licenses.\nWe have successfully increased ARR per paying customer over time and believe this metric is an indicator of our ability to grow the long-term value of our platform. We expect ARR per paying customer to continue to increase as customers adopt our premium offerings and we continue to introduce new products and functionality. Our ARR per paying customer as of March 31, 2021 and 2020 was $2,274 and $1,942, respectively. We define ARR per paying customer during a given period as ARR from our paying customers at the end of the period divided by the number of paying customers as of the end of the same\n27\nperiod. We define the number of paying customers as the number of unique business and individual customers at the end of a particular period. We define a business customer as all accounts that contain a common non-individual business email domain (e.g., all subscriptions with an email domain of @XYZ.com will be considered to be one customer), and an individual customer as an account that uses an individual non-business email domain.\nSustaining Product and Technology Innovation\nWe have a strong track record of developing new products that have high adoption rates among our paying customers. Our product development organization plays a critical role in continuing to enhance the effectiveness and differentiation of our technology in an evolving landscape and maximizing retention of our existing customers. We intend to continue investing in product development to improve our data assets, expand our products and enhance our technological capabilities.\nNon-GAAP Financial Measures\nIn addition to our financial results determined in accordance with U.S. generally accepted accounting principles (“GAAP”), we believe that free cash flow and free cash flow margin, each a non-GAAP financial measure, are useful in evaluating the performance of our business.\nFree cash flow and free cash flow margin\nWe define free cash flow, a non-GAAP financial measure, as net cash provided by operating activities less purchases of property and equipment and capitalized software development costs. We define free cash flow margin as free cash flow divided by total revenue. We monitor free cash flow and free cash flow margin as two measures of our overall business performance, which enables us to analyze our future performance without the effects of non-cash items and allow us to better understand the cash needs of our business. While we believe that free cash flow and free cash flow margin are useful in evaluating our business, free cash flow and free cash flow margin are each a non-GAAP financial measure that have limitations as an analytical tool, and free cash flow and free cash flow margin should not be considered as an alternative to, or substitute for, net cash used in operating activities in accordance with GAAP. The utility of each of free cash flow and free cash flow margin as a measure of our liquidity is further limited as each measure does not represent the total increase or decrease in our cash balance for any given period. In addition, other companies, including companies in our industry, may calculate free cash flow and free cash flow margin differently or not at all, which reduces the usefulness of free cash flow and free cash flow margin as tool for comparison. A summary of our cash flows from operating, investing and financing activities is provided below. We recommend that you review the reconciliation of free cash flow to net cash used in operating activities, the most directly comparable GAAP financial measure, and the reconciliation of free cash flow margin to net cash used in operating activities (as a percentage of revenue), the most directly comparable GAAP financial measure, provided below, and that you not rely on free cash flow, free cash flow margin or any single financial measure to evaluate our business.\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\n| Net cash used in investing activities | (1,139) | (1,381) |\n| Net cash provided by (used in) financing activities | 128,468 | (16) |\n| Net increase (decrease) in cash, cash equivalents and restricted cash | $ | 136,336 | (836) |\n\n28\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\n| Purchases of property and equipment | (166) | (1,084) |\n| Capitalization of internal-use software costs | (123) | (297) |\n| Free cash flow | $ | 8,718 | $ | (820) |\n\n| Three Months Ended March 31,(in thousands) |\n| 2021 | 2020 |\n| Net cash provided by operating activities (as a percentage of revenue) | 22.5 | % | 2.0 | % |\n| Purchases of property and equipment (as a percentage of revenue) | (0.4) | % | (3.9) | % |\n| Capitalization of internal-use software costs (as a percentage of revenue) | (0.3) | % | (1.1) | % |\n| Free cash flow margin | 21.8 | % | (3.0) | % |\n\nComponents of our Results of Operations\nRevenue\nWe generate nearly all of our revenue from subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date on which we provide the customer access to our platform. Our customers do not have the right to take possession of our software. Our subscriptions are generally non-cancellable during the contractual subscription term, however our subscription contracts contain a right to a refund if requested within seven days of purchase.\nWe offer our paid products to customers via monthly or annual subscription plans, as well as one-time and ongoing add-ons. As of March 31, 2021 and 2020, approximately 77% and 76%, respectively, of our paying customers purchased monthly subscription plans. Our subscription-based model enables customers to select a plan based on their needs and license our platform on a per user per month basis.\nAs of March 31, 2021, we served approximately 72,000 paying customers in various industries, and our revenue is not concentrated with any single customer or industry. For the three months ended March 31, 2021 and 2020, no single customer accounted for more than 1% of our revenue.\nCost of Revenue\nCost of revenue primarily consists of expenses related to hosting our platform, acquiring data, and providing support to our customers. These expenses are comprised of personnel and related costs, including salaries, benefits, incentive compensation, and stock-based compensation expense related to the management of our data centers, our customer support team and our customer success team, and data acquisition costs. In addition to these expenses, we incur third-party service provider costs, such as data center and networking expenses, allocated overhead costs, depreciation expense and amortization associated with the Company’s property and equipment, and amortization of capitalized software development costs and other intangible assets. We allocate overhead costs, such as rent and facility costs, information technology costs, and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of revenue and each operating expense category.\n29\nWe expect our cost of revenue to increase in absolute dollars due to expenditures related to the purchase of hardware, data, expansion, and support of our data center operations and customer support teams. We also expect that cost of revenue as a percentage of revenue will decrease over time as we are able to achieve economies of scale in our business, although it may fluctuate from period to period depending on the timing of significant expenditures. To the extent that our customer base grows, we intend to continue to invest additional resources in expanding the delivery capability of our products and other services. The timing of these additional expenses could affect our cost of revenue, both in terms of absolute dollars and as a percentage of revenue in any particular quarterly or annual period.\nOperating Expenses\nResearch and Development\nResearch and development expenses primarily consist of personnel and related costs, including salaries, benefits, incentive compensation, stock-based compensation, and allocated overhead costs. Research and development expenses also include depreciation expense and other expenses associated with product development. Other than internal-use software costs that qualify for capitalization, research and development costs are expensed as incurred. We plan to increase the dollar amount of our investment in research and development for the foreseeable future as we focus on developing new products, features, and enhancements to our platform. We believe that investing in the development of new products, features, and enhancements improves customer experience, makes our platform more attractive to new paying customers and provides us with opportunities to expand sales to existing paying customers and convert free customers to paying customers. However, we expect our research and development expenses to decrease as a percentage of our revenue over time.\nSales and Marketing\nSales and marketing expenses primarily consist of personnel and related costs directly associated with our sales and marketing department, including salaries, benefits, incentive compensation, and stock-based compensation, online advertising expenses, and marketing and promotional expenses, as well as allocated overhead costs. We expense all costs as they are incurred, excluding sales commissions identified as incremental costs to obtain a contract, which are capitalized and amortized on a straight-line basis over the average period of benefit, which we estimate to be two years. We expect that our sales and marketing expenses will continue to increase in absolute dollars in the year ending December 31, 2021. New sales personnel require training and may take several months or more to achieve productivity; as such, the costs we incur in connection with the hiring of new sales personnel in a given period are not typically offset by increased revenue in that period and may not result in new revenue if these sales personnel fail to become productive. We expect to increase our investment in sales and marketing as we add new services, which will increase these expenses in absolute dollars. Over the long term, we believe that sales and marketing expenses as a percentage of revenue will vary depending upon the mix of revenue from new and existing customers, as well as changes in the productivity of our sales and marketing programs.\nGeneral and Administrative\nGeneral and administrative expenses primarily consist of personnel and related expenses, including salaries, benefits, incentive compensation, and stock-based compensation, associated with our finance, legal, human resources, and other administrative employees. Our general and administrative expenses also include professional fees for external legal, accounting, and other consulting services, insurance, depreciation and amortization expense, as well as allocated overhead. We expect to increase the size of our general and administrative functions to support the growth of our business. We expect to continue to incur additional expenses as a result of operating as a public company, including costs to comply with rules and regulations applicable to companies listed on a U.S. securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, increases in\n30\ninsurance premiums, investor relations and professional services. We expect the dollar amount of our general and administrative expenses to increase for the foreseeable future. However, we expect our general and administrative expenses to decrease as a percentage of revenue over time.\nOther Income, Net\nIncluded in other income, net are foreign currency transaction gains and losses. The functional currency of our international operations is the U.S. dollar except for Prowly, which is Polish Zloty. Any differences resulting from the re-measurement of assets and liabilities denominated in a currency other than the functional currency are recorded within other income, net. We expect our foreign currency exchange gains and losses to continue to fluctuate in the future as foreign currency exchange rates change.\nOther income, net also includes amounts for other miscellaneous income and expense unrelated to our core operations.\nIncome Tax Provision\nWe operate in several tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. We account for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. In addition, this method requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. To date, we have incurred cumulative net losses and maintain a full valuation allowance on our net deferred tax assets. We expect this trend to continue for the foreseeable future. Our tax expense for the three months ended March 31, 2021 and 2020 primarily relates to income earned in certain foreign jurisdictions.\nResults of Operations\nThe following tables set forth information comparing our results of operations in dollars and as a percentage of total revenue for the periods presented. The period-to-period comparison of results is not necessarily indicative of results for future periods.\n31\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Revenue | $ | 39,998 | $ | 27,787 |\n| Cost of revenue (1) | 8,773 | 6,611 |\n| Gross profit | 31,225 | 21,176 |\n| Operating expenses |\n| Sales and marketing (1) | 16,457 | 12,877 |\n| Research and development (1) | 5,358 | 4,237 |\n| General and administrative (1) | 7,904 | 5,933 |\n| Total operating expenses | 29,719 | 23,047 |\n| Income (loss) from operations | 1,506 | (1,871) |\n| Other income, net | 51 | 56 |\n| Income (loss) before income taxes | 1,557 | (1,815) |\n| Provision for income taxes | 86 | 116 |\n| Net income (loss) | $ | 1,471 | $ | (1,931) |\n\n__________________\n(1)Includes stock-based compensation expense as follows:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Cost of revenue | $ | 7 | $ | 5 |\n| Sales and marketing | 190 | 27 |\n| Research and development | 67 | 29 |\n| General and administrative | 329 | 144 |\n| Total stock-based compensation | $ | 593 | $ | 205 |\n\n32\nThe following table sets forth our unaudited condensed consolidated statements of operations data expressed as a percentage of revenue for the periods indicated:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (as a percentage of total revenue) |\n| Revenue | 100 | % | 100 | % |\n| Cost of revenue | 22 | % | 24 | % |\n| Gross profit | 78 | % | 76 | % |\n| Operating expenses |\n| Sales and marketing | 41 | % | 46 | % |\n| Research and development | 13 | % | 15 | % |\n| General and administrative | 20 | % | 22 | % |\n| Total operating expenses | 74 | % | 83 | % |\n| Income (loss) from operations | 4 | % | (6) | % |\n| Other income, net | — | % | — | % |\n| Income (loss) before income taxes | 4 | % | (6) | % |\n| Provision for income taxes | — | % | — | % |\n| Net income (loss) | 4 | % | (6) | % |\n\nComparison of the Three Months Ended March 31, 2021 and 2020\nRevenue\nOur revenue during the three months ended March 31, 2021 and 2020 was as follows:\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Revenue | $ | 39,998 | 27,787 | $ | 12,211 | 44 | % |\n\nRevenue increased in all regions and was most pronounced in the United States. The majority of this increase was driven by an increase in the number of paying customers from 56,000 as of March 31, 2020 to 72,000 as of March 31, 2021. The net income for the three months ended March 31, 2021 was partially driven by an increase in the subscription price of our core product.\n33\nThe locations of our paying customers during the three months ended March 31, 2021 and 2020 were as follows:\n| Three Months Ended March 31, |\n| 2021 | 2020 |\n| (in thousands) |\n| Revenue: |\n| United States | $ | 18,132 | $ | 12,886 |\n| United Kingdom | 4,195 | 2,994 |\n| Other | 17,671 | 11,907 |\n| Total revenue | $ | 39,998 | $ | 27,787 |\n\nCost of Revenue, Gross Profit and Gross Margin\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Cost of revenue | $ | 8,773 | $ | 6,611 | $ | 2,162 | 33 | % |\n| Gross profit | $ | 31,225 | $ | 21,176 | $ | 10,049 | 47 | % |\n| Gross margin | 78.1 | % | 76.2 | % |\n\nThe increase in cost of revenue for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following changes:\n| Change |\n| (in thousands) |\n| Hosting fees | $ | 446 |\n| Integration and data costs | 787 |\n| Merchant fees | 309 |\n| Other | 620 |\n| Cost of revenue | $ | 2,162 |\n\nHosting fees increased, driven by the additional costs associated with our growth in subscription revenue and the additional costs associated with expanding our relationships with our current paying subscribers. Integration and data costs increased primarily as a result of increasing costs incurred related to new products and customer growth. Merchant fees increased commensurate with sales growth. Other costs increased primarily as a result of a 95% increase in headcount as we continue to grow our customer support and customer success teams to support our customer growth.\n34\nOperating Expenses\nSales and Marketing\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Sales and marketing | $ | 16,457 | $ | 12,877 | $ | 3,580 | 28 | % |\n| Percentage of total revenue | 41 | % | 46 | % |\n\nThe increase in sales and marketing expense for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following:\n| Change |\n| (in thousands) |\n| Personnel costs | $ | 2,156 |\n| Advertising expense | 1,503 |\n| Other | (79) |\n| Sales and marketing | $ | 3,580 |\n\nPersonnel costs increased primarily as a result of a 24% increase in headcount as we continue to expand our sales teams to grow our customer base. Personnel costs include the amortization of capitalized commission costs, which increased quarter over quarter partially due to the amortization of commissions paid in prior periods, as well as expense associated with the amortization of commissions paid and capitalized during the three months ended March 31, 2021, which increased compared to the three months ended March 31, 2020 due to the overall growth in sales. Advertising expense increased primarily as a result of increasing expenses to acquire new paying customers.\nResearch and Development\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Research and development | $ | 5,358 | $ | 4,237 | $ | 1,121 | 26 | % |\n| Percentage of total revenue | 13 | % | 15 | % |\n\nResearch and development costs increased primarily as a result of a 31% increase in headcount as we continue to expand our product development teams.\nGeneral and administrative\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| General and administrative | $ | 7,904 | $ | 5,933 | $ | 1,971 | 33 | % |\n| Percentage of total revenue | 20 | % | 21 | % |\n\n35\nThe increase in general and administrative expense was primarily driven by a 47% increase in headcount as we continue to expand our accounting and reporting, legal and compliance, and internal support teams. It was also driven by a 167% increase in stock-based compensation applicable to these teams.\nOther Income, Net\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Other income, net | $ | 51 | $ | 56 | $ | (5) | (9) | % |\n| Percentage of total revenue | — | % | — | % |\n\nThe relatively small decrease in other income was partially driven by changes in the foreign exchange gains or losses from foreign currency translation adjustments associated with our international activities.\nProvision for Income Taxes\n| Three Months Ended March 31, | Change |\n| 2021 | 2020 | Amount | % |\n| (dollars in thousands) |\n| Provision for income taxes | $ | 86 | $ | 116 | $ | (30) | (26) | % |\n| Percentage of total revenue | — | % | — | % |\n\nThe provision for income taxes is primarily attributable to estimated taxes related to our foreign jurisdictions.\nLiquidity and Capital Resources\nTo date, our principal sources of liquidity have been the net proceeds of $126.6 million, after deducting underwriting discounts and offering expenses paid or payable by us, from our IPO in March 2021, the net proceeds we received through private sales of equity securities, as well as sales of premium subscriptions to our platform.\nAs of March 31, 2021, our principal sources of liquidity were cash and cash equivalents of $171.9 million and accounts receivable of $2.4 million. With the exception of this three month period ended March 31, 2021, we have generated losses from operations since inception. With the exception of this three month period ended March 31, 2021, we expect to continue to incur operating losses and negative cash flows for the foreseeable future due to the investments in our business we intend to make as described above.\nOur principal uses of cash in recent periods have been to fund operations and invest in capital expenditures, and are held in cash deposits and money market funds.\nWe believe our existing cash will be sufficient to meet our operating and capital needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our subscription growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced product offerings, and the continuing market acceptance of our platform and products. In the future, we may enter into arrangements to acquire or invest in complementary companies,\n36\nproducts, and technologies, including intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us, or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations, our business, results of operations, and financial condition could be adversely affected.\nOur Credit Facility\nPursuant to the Credit Agreement among us and Semrush Inc., a Delaware corporation (“Semrush US Sub”), each as a borrower, the lenders party thereto from time to time and JPMorgan Chase Bank, N.A., as the administrative agent, as amended from time to time, we have a senior secured credit facility that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\nBorrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25% floor (or 1.50% prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\nOperating Activities\nOur largest source of operating cash is cash collections from our customers for subscription services. Our primary uses of cash from operating activities are for online advertising, personnel costs across the sales and marketing and product and development departments, and hosting costs.\nNet cash provided by operating activities during the three months ended March 31, 2021 was $9.0 million, which resulted from a net income of $1.5 million adjusted for non-cash charges of $2.3 million and a net cash inflow of $5.2 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $0.5 million of depreciation and amortization expense, $1.3 million for amortization of deferred contract acquisition costs related to capitalized commissions, and $0.6 million of stock-based compensation expense. The changes in operating assets and liabilities was primarily the result of a $5.6 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $2.4 million increase in accrued expenses, and a $1.6 million increase in accounts payable. These inflows were partially offset by a $2.4 million increase in deferred contract costs, a $1.0 million increase in prepaid expenses and other current assets, and a $1.0 million increase in accounts receivable.\nNet cash provided by operating activities during the three months ended March 31, 2020 was $0.6 million, which resulted from a net loss of $1.9 million adjusted for non-cash charges of $1.5 million and net cash inflow of $1.0 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $1.1 million for amortization of deferred contract acquisition costs related to capitalized commissions, $0.2 million of stock-based compensation expense, and $0.2 million of depreciation and amortization expense. The changes in operating assets and liabilities was primarily the result of a $1.7 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $1.0 million increase in accrued expenses, a $0.7 million decrease in accounts receivable, and a $0.1 million increase in accounts payable. These inflows were partially offset by\n37\na $1.7 million increase in deferred contract costs and a $0.7 million increase in prepaid expenses and other current assets.\nInvesting Activities\nNet cash used in investing activities for the three months ended March 31, 2021 and 2020 was $1.1 million and $1.4 million, respectively. The decrease of $0.2 million of cash used in investing activities was primarily due to the reduced purchases of computer equipment and hardware, as well as a decrease in capitalized costs associated with internal use software. During the three months ended March 31, 2021, cash used in investing activities also included $500 paid for two convertible debt securities.\nFinancing Activities\nNet cash provided by financing activities for the three months ended March 31, 2021 was $128.5 million, primarily consisting of the net proceeds from the IPO. Net cash used in financing activities for the three months ended March 31, 2020 was insignificant and consisted entirely of payments of deferred offering costs.\nContractual Obligations\nAs of March 31, 2021, there were no material changes in our contractual obligations and commitments from those disclosed in the Prospectus, other than those appearing in the notes to the Unaudited Condensed Consolidated Financial Statements appearing elsewhere in this Quarterly Report on Form 10-Q.\nOff-Balance Sheet Arrangements\nAs of March 31, 2021, we did not have any relationships with any entities or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other purposes. As a result, we are not exposed to related financing, liquidity, market or credit risks that could arise if we had engaged in those types of arrangements.\nRecent Accounting Pronouncements\nRefer to the section titled “Recent Accounting Pronouncements” in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\nCritical Accounting Policies and Estimates\nOur Unaudited Condensed Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Unaudited Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates.\nOur critical accounting policies are described under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Critical Accounting Policies and Estimates” in the Prospectus and in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.\n38\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nWe are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and inflation. We do not hold or issue financial instruments for trading purposes.\nInterest Rate Risk\nWe had cash and cash equivalents of $171.9 million and $35.5 million as of March 31, 2021 and December 31, 2020, respectively. Our cash and cash equivalents are held in cash deposits and money market funds. Due to the short-term nature of these instruments, we do not believe that we have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates.\nAs of March 31, 2021, we had $45.0 million available under the revolving credit facility, with $5.0 million of such revolving commitments available under the letter of credit sub-facility. Borrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the base rate, subject to a 3.25% floor (or 1.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\nWe did not have any current investments in marketable securities as of March 31, 2021 and 2020.\nForeign Currency Exchange Risk\nWe are not currently subject to significant foreign currency exchange risk with respect to revenue as our U.S. and international sales are predominantly denominated in U.S. dollars. However, we have some foreign currency risk related to a small amount of sales denominated in euros, and expenses denominated in euros, rubles, korunas, and zloty. Sales denominated in euros reflect the prevailing U.S. dollar exchange rate on the date of invoice for such sales. Increases in the relative value of the U.S. dollar to the euro may negatively affect revenue and other operating results as expressed in U.S. dollars. We incur significant expenses outside the United States denominated in these foreign currencies, primarily the ruble. If the average exchange rates of any of these foreign currencies strengthen against the dollar, the dollar value of our expenses outside the United States will increase. For example, an immediate 10% decrease or increase in the relative value of the U.S. dollar to the ruble would result in a $3.4 million loss or gain on our unaudited condensed consolidated statements of operations and cash flows.\nWe have not engaged in the hedging of foreign currency transactions to date. However, as our international operations expand, our foreign currency exchange risk may increase. If our foreign currency exchange risk increases in the future, we may evaluate the costs and benefits of initiating a foreign currency hedge program in connection with non-U.S. dollar denominated transactions.\n39\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nOur management, including our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on management’s review, with participation of our Chief Executive Officer and Chief Financial Officer, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the quarter ended March 31, 2021, the Company’s disclosure controls and procedures were not effective.\nAs previously disclosed under the section titled “Risk Factors” of the Prospectus, in connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operation of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\nNotwithstanding the identified material weakness, our management believes the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows as of and for the periods presented in accordance with U.S. generally accepted accounting principles.\nRemediation Plan for Material Weakness\nRemediation generally requires making changes to how controls are designed and implemented and then adhering to those changes for a sufficient period of time such that the effectiveness of those changes is demonstrated with an appropriate amount of consistency. In response to the material weakness, we implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting. Further, changes and improvements in our internal control over financial reporting environment will be implemented based on ongoing management reviews and the continued implementation of the remediation plan.\nChanges in Internal Control Over Financial Reporting\nExcept for the remediation measures in connection with the material weakness described above, there were no other changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2021, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nInherent Limitations on Effectiveness of Controls\nOur management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitation in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of\n40\nfraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Due to inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\n41\nPART II — OTHER INFORMATION\nItem 1. Legal Proceedings\nFrom time to time we may become in involved in legal proceedings or be subject to claims arising in the ordinary course of our business. We are not presently a party to any legal proceedings that, if determined adversely to us, would individually or taken together have a material adverse effect on our business, operating results, financial condition or cash flows. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors.\nItem 1A. Risk Factors\nInvesting in our Class A common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, before making a decision to invest in our Class A common stock. If any of the risks actually occur, our business, results of operations, financial condition, and prospects could be harmed. In that event, the trading price of our Class A common stock could decline, and you could lose part or all of your investment.\nSummary of the Material Risks Associated with Our Business\nOur business is subject to numerous risks and uncertainties that you should be aware of in evaluating our business. These risks and uncertainties include, but are not limited to, the following:\n• We derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\n• Our business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\n• If we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\n• The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\n• Our products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\n• Our ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\n• If we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\n42\n• We depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\n• An inability to attract and retain other highly skilled employees could harm our business.\n• Changes by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\n• If the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\n• The effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\n• If the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\n• We may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\nMost Material Risks to Us\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions. Our business and financial results depend on our paying customers renewing their subscriptions for our products when existing contract terms expire. Although our customer agreements provide for auto-renewal of subscriptions, our paying customers have no obligation to renew their premium subscriptions if they provide proper notice of their desire not to renew, and we cannot guarantee that they will renew their premium subscriptions for the same or longer terms, the same or a greater number of user licenses or products and add-ons, or at all. We offer premium subscriptions on a monthly or annual basis with our annual subscriptions receiving a discount for the longer-term commitment. Our paying customers predominantly choose monthly subscription terms, which allow them to terminate or adjust their premium subscriptions with us on a monthly basis as external factors change and could cause our results of operations to fluctuate significantly from quarter to quarter. Our renewal rates, including our dollar-based net revenue retention rate, may decline or fluctuate as a result of a number of factors, including customer satisfaction with our platform and products, reliability of our products, our customer success and support experience, the price and functionality of our platform, products, and add-ons relative to those of our competitors, mergers and acquisitions affecting our customer base, the effects of global economic conditions and other external factors, or reductions in our customers’ spending levels. Our business and operating results will be adversely affected if our paying customers do not renew their premium subscriptions.\n43\nOur business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\nOur future financial performance also depends in part on our ability to continue to upgrade paying customers to higher-price point subscriptions and sell additional user licenses, and products and add-ons such as Prowly, Sellerly, and Competitive Intelligence. Conversely, our paying customers may convert to lower-cost or free subscriptions if they do not perceive value in paying for our higher-price point subscriptions, thereby impacting our ability to increase revenue. For example, a paying customer subscribing to our core product through a “Business” subscription may downgrade to the “Guru” subscription if they do not deem the additional features and functionality worth the incremental costs. To expand our relationships with our customers, we must demonstrate to existing paying and free customers that the additional functionality associated with an upgraded subscription outweighs the incremental costs. Our customers’ decisions as to whether to upgrade their subscriptions or not is driven by a number of factors, including customer satisfaction with the security, performance, and reliability of our platform and products, general economic conditions, the price and functionality of our platform and products relative to those of our competitors, and customer reaction to the price for additional products. If our efforts to expand our relationships with our existing paying and free customers are not successful, our revenue growth rate may decline and our business and operating results will be adversely affected.\nIf we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\nThe number of new customers we attract, whether as free or paying customers, is a key factor in growing our customer and premium subscription base which drive our revenues and collections. We utilize various unpaid content marketing strategies, including blogs, webinars, thought leadership, and social media engagement, as well as paid advertising, to attract visitors to our websites. We cannot guarantee that these unpaid or paid marketing efforts will continue to attract the same volume and quality of traffic to our websites or will continue to result in the same level of registrations for premium subscriptions as they have in the past. In the future, we may be required to increase our marketing spend to maintain the same volume and quality of traffic. Moreover, we cannot be certain that increased sales and marketing spend will generate more paying customers without increasing our customer acquisition costs on a per paying customer basis. We offer potential customers several tiered subscription options for our online visibility management platform, including free subscriptions of a limited-functionality product and premium subscriptions of our “Pro”, “Guru” or “Business” offerings for our core product, depending on the level of functionality they seek. We have materially grown our number of paying customers through the provision of free subscriptions and through trials of a premium version of our online visibility and marketing insight products. Trial subscriptions automatically become premium subscriptions if the customer does not opt out of the trial subscription after the trial period is over, and such trial subscriptions can be upgraded to obtain additional features, functionality, and varying levels of access and report generating capabilities. In the future, we may be required to provide additional functionality to our free subscriptions to attract visitors to our websites and incent visitors to sign up for free subscriptions. In addition, we encourage our free customers to upgrade to premium subscriptions through in-product prompts and notifications, by recommending additional features and functionality, and by providing customer support to explain such additional features and functionality. Our failure to attract new free customers and convert them into paying customers could have a material adverse effect on our operating results as our business may be adversely affected by the costs of, and sales lost from, making certain of our products available on a free basis. While we do not receive any revenue from our customers who use our platform on a free basis, we bear incremental expenses as a result of their continuing free access to our platform and certain of our products.\n44\nThe market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\nThe market for our products is fragmented, rapidly evolving, and highly competitive, with relatively low barriers to entry. Our all-in-one SaaS platform competes with software products and solutions that are focused on a particular customer need, or point solutions. For example, we compete with point solutions for search advertising and search engine optimization, marketing analytics and social media management, market intelligence, and web analytics services. Our ability to attract and retain free and paying customers depends in part on the actual and perceived quality and design of our platform, products, and add-ons compared to competitive point solutions and continued market acceptance of our platform, products, and add-ons for existing and new use-cases. To remain competitive and to acquire new customers, we must deliver features and functionality that enhance the utility and perceived value of our platform, products, and add-ons to our prospective and existing customers. Our platform, products, and add-ons must (i) operate without the presence of material software defects, whether actual or perceived, (ii) maintain deep and rich data sources, (iii) adapt to the changing needs of our current and prospective customers including by developing new technology, (iv) adapt to changing functionality and provide interoperability with third-party application programming interfaces (“APIs”), (v) maintain and develop integrations with complementary third-party services that provide value to our customers, (vi) be easy to use and visually pleasing, (vii) deliver rapid return on investment to our customers across multiple functions within their organizations, and (viii) be delivered with a superior customer support experience. We may not be successful in delivering on some or all of the foregoing or in doing so while maintaining competitive pricing, which could result in customer dissatisfaction leading to termination or downgrades of premium subscriptions, fewer new free customers, fewer subscription upgrades or lower dollar-based net revenue retention rates, prospective customers’ selection of our competitors’ products over our own, and other adverse effects on our business.\nMany of our current and future competitors benefit from competitive advantages over us, such as greater name recognition, longer operating histories, more targeted products for specific use cases, larger sales and more established relationships or integrations with third-party data providers, search engines, online retail platforms, and social media networking sites, and more established relationships with customers in the market. Additionally, many of our competitors may expend a considerably greater amount of funds on their research and development efforts, and those that do not, may be acquired by larger companies that would allocate greater resources to our competitors’ research and development programs. Specifically, our competitors focusing on point solutions may have the ability to expend greater funds in a more targeted manner to develop superior solutions that address a specific need, as compared to our research and development expenditures which are allocated across our platform. In addition, some of our competitors may enter into strategic relationships or consummate strategic acquisitions to offer a broader range of functionality than we do, a more competitive multi-point solution, or to address needs that our platform does not. These types of business combinations may make it more difficult for us to acquire new free customers or maintain or upgrade our free and paying customers, any of which could ultimately impact our ability to compete effectively. We expect these competitive pressures to continue as competitors attempt to strengthen or preserve their market positions and as new competitors enter the market.\nDemand for our platform is also price sensitive. Many factors, including our marketing, sales and technology costs, and the pricing and marketing strategies of our competitors, can significantly affect our pricing strategies. Certain competitors offer, or may in the future offer, lower-priced or free products that compete with our platform, products, and/or add-ons, or may bundle their solutions with other companies’ offerings to provide a broader range of functionality at reduced volume pricing. Similarly, certain competitors may use marketing strategies that enable them to acquire customers at a lower cost than we do. Even if such competitive products do not include all the features and functionality that our platform provides, we could face pricing pressure to the extent that customers find such alternative products to be sufficient to meet their needs or do not perceive a material return on investment from the additional\n45\nfeatures and functionality they would obtain by purchasing our platform relative to the competitive point solutions. Additionally, our competitors may further drive down the price through strategic business combinations. We may be forced to engage in price-cutting initiatives, offer other discounts, or increase our sales and marketing and other expenses to attract and retain free and paying customers in response to competitive pressures, any of which would harm our business and operating results.\nWe have incurred losses in the past and may not consistently achieve profitability in the future.\nWe have a history of incurring net losses and although we have achieved profitability in certain periods we expect to continue to incur net losses in the future. We incurred net losses of $10.2 million and $7.0 million for the years ended December 31, 2019 and 2020, respectively. As of March 31, 2021, we had an accumulated deficit of $34.3 million. We do not know if we will be able to achieve or sustain profitability in the future. We plan to continue to invest in our research and development, and sales and marketing efforts, and we anticipate that our operating expenses will continue to increase as we scale our business and expand our operations. We also expect our general and administrative expenses to increase as a result of our growth and operating as a public company. Our ability to achieve and sustain profitability is based on numerous factors, many of which are beyond our control.\nOur products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\nWe have developed our platform, products, and add-ons to rely in part on access to data from third-party sources. The primary sources of third-party data include data collected from third-party websites algorithmically through our proprietary data collection techniques, including web crawling of third-party websites, data purchased from independent third-party data providers, which includes clickstream data, search engine data, online advertising data, and data from social media sources, and reference data that our customers grant us access to, which includes our customers’ website and social media data. We obtain social media data through APIs that connect to social media platform operators, including Facebook, Twitter, Instagram, Pinterest, and LinkedIn. We also collect data from our customers in connection with their use of our platform.\nTo date, our relationships with most data providers (including social media platforms) are governed by such data providers’ respective standard terms and conditions, which govern the availability and access to, and permitted uses of such data (including via APIs), and which are subject to change by such providers from time to time, with little or no notice and with little or no right of redress. Similarly, our access to publicly available data may depend on restrictions that website owners may impose through technical measures or otherwise, including restrictions on automated data collection. We cannot accurately predict the impact of changes in the terms of data providers that may impede our access to the data. If these data providers or websites choose not to make their data available on the same terms, or at all, we would have to seek alternative sources, which could prove expensive and time-consuming, and may be less efficient or effective. Such changes could impact our ability to provide our services in a timely manner, if at all, and could negatively impact the perceived value of our platform and our business. There can be no assurance that following any such modification of terms or termination we would be able to maintain the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nWe also rely on negotiated agreements with other data providers from whom we purchase independently sourced data, including clickstream data, search engine data, online advertising data, data from social media, and other sources. These negotiated agreements provide access to additional data that allow us to provide a more comprehensive solution for our customers. These agreements are subject to termination in certain circumstances, and there can be no assurance that we will be able to renew those agreements or that the terms of any such renewal, including pricing and levels of service, will be favorable. In addition, there can be no assurance that we will not be required to enter into new negotiated\n46\nagreements with data providers in the future to maintain or enhance the level of functionality of our platform, or that the terms and conditions of such agreements, including pricing and levels of service, will not be less favorable, which could adversely affect our results of operations. Further, third-party data providers have previously, and may again, cease operations or a specific business line or cease providing products or data to their customers, including us. If we are not able to obtain third-party data on commercially reasonable terms, if these data providers stop making their data available to us, or if our competitors are able to purchase such data on better terms, the functionality of our platform and our ability to compete could be harmed.\nTo the extent that we license or obtain data from third parties, we may be subject to contractual obligations to satisfy certain requirements under applicable laws including, but not limited to, providing public notice of our data processing activities and obtaining appropriate consents where required. If one or more of those third-party data providers considers that we have failed to satisfy these requirements, such third-party data provider may bring claims against us seeking damages, and/or seeking to prevent our future use of any data already provided. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nOur business may be harmed if any of our data sources:\n•changes, limits or discontinues our access to their data;\n•modifies its terms of service or other policies, including imposing prohibitive fees or restrictions on our use of their data or our ability to access it;\n•changes or limits how customer information is accessed by us or our customers and their users;\n•changes or limits how we can use such data;\n•establishes more favorable relationships with one or more of our competitors; or\n•experiences disruptions of its technology, services or business generally.\nRisks Related to our Business\nOur ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\nTo remain competitive, we must continue to develop new product offerings, as well as features and enhancements to our existing platform and products. Maintaining adequate research and development personnel and resources to meet the demands of the market is essential. If we experience high turnover of our product and development personnel, a lack of management ability to guide our research and development, or a lack of other research and development resources, we may miss or fail to execute on new product development and strategic opportunities and consequently lose potential and actual market share. The success of our business is dependent on our product and development teams developing and executing on a product roadmap that allows us to retain and increase the spending of our existing customers, attract new customers and upgrade our free customers to premium subscriptions. Our failure to maintain adequate research and development resources, to use our research and development resources efficiently, and to address the demands of our prospective and actual customers could materially adversely affect our business.\n47\nIf we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\nMaintaining, promoting, and enhancing our brand is critical to maintaining and expanding our customer base. We seek to build our brand through a mix of free and paid initiatives. We market our platform and products through free information resources on our website, including our blog and online digital marketing courses (including through our Semrush Academy), pay-per-click advertisements on search engines and social networking sites, participation in social networking sites, and free and paid banner advertisements on other websites. The strength of our brand further drives free traffic sources, including customer referrals, word-of-mouth, and direct searches for our “Semrush” name, or web presence solutions, in search engines. In addition, we maintain relationships with agencies and affiliates to further increase brand awareness and generate customer demand. To the extent that new customers are increasingly derived from paid as opposed to free marketing initiatives, our customer acquisition cost will increase.\nBeyond direct sales and marketing efforts, maintaining and enhancing our brand will depend largely on our ability to continue to provide a well-designed, useful, reliable, and innovative platform, efficient sales process, and high-quality customer service, which we may not do successfully. For a discussion of other factors that will impact our brand recognition see the risk factors described elsewhere in this section, including without limitation, those risk factors entitled “The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free customers and paying customers could be harmed, which would negatively impact our business and operating results.”; “If we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers and increase the number of user licenses per paying customer, especially from large enterprises.”; “If third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.”; “We rely on search engines and social networking sites to attract a meaningful portion of our customers, and if those search engines or social networking sites change their listings or policies regarding advertising, or increase their pricing or suffer problems, it may limit our ability to attract new customers.”; and “If we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.”\nWe depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\nOur success depends largely upon the continued services of our executive officers and other key employees. We rely on our leadership team in the areas of research and development, operations, security, marketing, sales, customer service, and general and administrative functions, and on individual contributors and team leaders in our research and development and operations. From time to time, there may be changes in our executive management team resulting from the hiring or departure of executives, which could disrupt our business. The loss of one or more of our executive officers or key employees could harm our business. Changes in our executive management team may also cause disruptions in, and harm to, our business.\nWe are led by our CEO and co-founder, Oleg Shchegolev, our COO and co-founder, Dmitry Melnikov, and our Chief Product Officer, Vitalii Obishchenko, each of whom plays an important role in driving our culture, determining our strategy, and executing against that strategy companywide. If the services of Mr. Shchegolev, Mr. Melnikov, and/or Mr. Obishchenko become unavailable to us for any reason, it may be difficult or impossible for us to find an adequate and timely replacement, which could cause us to be less successful in maintaining our culture, and developing and effectively executing on our strategies and initiatives.\n48\nAn inability to attract and retain other highly skilled employees could harm our business.\nTo execute our growth plan, we must attract and retain highly qualified personnel. Competition for highly qualified personnel in Boston, Massachusetts, where our headquarters is located, and Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, St. Petersburg, Russia, and Warsaw, Poland where we have offices. Competition in these locations is intense, especially for software engineers experienced in designing and developing software and SaaS applications, and experienced sales professionals who understand our products and the market in which we operate. We have from time to time experienced, and we expect to continue to experience, difficulty in hiring and retaining employees with appropriate qualifications. In addition, immigration laws in the locations in which we have offices and operations restrict or limit our ability to recruit internationally. Any changes to the immigration policies applicable to locations in which we have offices and operations that restrain the flow of technical and professional talent may inhibit our ability to recruit and retain highly qualified employees. Many of the companies with which we compete for experienced personnel may be able to offer more attractive terms of employment to potential candidates. If we hire employees from competitors or other companies, their former employers may attempt to assert that these employees have breached their legal obligations to such former employers, resulting in a diversion of our time and resources.\nIn addition, job candidates and existing employees often consider the value of the equity awards they receive in connection with their employment as part of their overall compensation package. If the perceived value of our equity awards declines or does not compare favorably to the value of equity offered by other companies competing for the same personnel resources, it may harm our ability to recruit and retain highly skilled employees. In addition, we invest significant time and expense in training our employees, which increases their value to competitors who may seek to recruit them. For example, our software developers gain deep and direct experience in data analytics, machine learning, and search optimization, making them increasingly attractive to our competitors and other similar businesses. If we fail to attract new personnel or fail to retain and motivate our current personnel, our business and future growth prospects could be harmed.\nChanges by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\nOur online visibility platform is designed to help our customers connect with consumers across a variety of digital channels, search engines, social networking sites, and other third-party services. These services may adapt and change their strategies and policies over time. Search engines typically provide two types of search results, organic (i.e., non-paid) and purchased listings. Organic search results are determined and organized solely by automated criteria set by the search engine, and a ranking level cannot be purchased. Search engines revise their algorithms from time to time in an attempt to optimize their search result listings. Changes to search engine algorithms may diminish the efficacy of certain of our products, tools, and add-ons, and potentially render them obsolete. For example, if a given search engine stopped using backlinks in its ranking algorithm, our customers’ perception of our backlink analytics tool, which enables customers to analyze and monitor the backlink profile of their own and other websites, may be adversely impacted. Similarly, if a search engine ceases to manually penalize or take action against web pages for unnatural backlinks, then our customers may determine that auditing their backlinks is unnecessary which could cause them to devalue our backlink audit tool, which enables companies to check whether malicious websites have links to their sites, or cease using it altogether. In response to these types of changes we may be required to recalibrate our product offerings by reducing prices, discontinuing the affected product, or otherwise. These responses may be costly, may not be effective, and our business may suffer.\nAdditionally, search engines, social networking sites, and other third-party services typically have terms of service, guidelines, and other policies to which its users are contractually obligated to adhere.\n49\nFor example, Google’s Gmail offering has a spam and abuse policy that prohibits sending spam, distributing viruses, or otherwise abusing the service. Prowly and our link building tool enable our customers to send emails to their desired recipients, such as marketing and affiliate partners, social media influencers, journalists, and bloggers. Our link building tool relies on a direct Gmail integration through which our customers are able to send emails using our platform as if they were sending emails directly from their Gmail account, and our Prowly product involves emails initiated by customers over Prowly servers. Our customers’ actions using either the link building tool or Prowly could be flagged under Google’s spam and abuse policy or in the future such actions may be prohibited by subsequent changes to Google’s policies. Any change to the policies of the third-party services with which our products, tools, and add-ons integrate or interact, or with which our products are intended to be used, including any anti-spam policies, or any actions taken by these third-party service providers under their policies could adversely impact the efficacy and perceived value of our products, tools, and add-ons, and as a result, our business may be harmed.\nIf third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.\nThe attractiveness of our platform depends, in part, on our ability to integrate via APIs with third-party applications that our customers desire to use with our products, such as Google, Facebook, Instagram, Twitter, YouTube, LinkedIn, Pinterest, Majestic, and others. Third-party application providers may change the features of their applications and platforms, including their APIs, or alter the terms governing use of their applications and platforms in an adverse manner. Further, third-party application providers may refuse to partner with us, or limit or restrict our access to their applications and platforms. Such changes could functionally limit or terminate our ability to use these third-party applications with our platform, which could negatively impact our offerings and the customer experience, and ultimately harm our business. If we fail to integrate our platform with new third-party applications that our customers desire, or to adapt to the data transfer requirements of such third-party applications and platforms, we may not be able to offer the functionality that our customers expect, which would negatively impact our offerings and, as a result, harm our business. Additionally, our business could be harmed if our customers have negative experiences in using the third-party integrations that we offer.\nIf we fail to maintain and improve our methods and technologies, or fail to anticipate new methods or technologies for data collection and analysis, hardware, software, and software related technologies, competing products and services could surpass ours in depth, breadth, or accuracy of our data, the insights that we offer or in other respects.\nWe expect continuous development in the market with respect to data matching, data filtering, data predicting, algorithms, machine learning, and other related technologies and methods for gathering, cataloging, updating, processing, analyzing, and communicating data and other information about how consumers find, interact with, and digest digital content. Similarly, we expect continuous changes in computer hardware, network operating systems, programming tools, programming languages, operating systems, the use of the internet, and the variety of network, hardware, browser, mobile, and browser-side platforms, and related technologies with which our platform and products must integrate. Further, changes in customer preferences or regulatory requirements may require changes in the technology used to gather and process the data necessary to deliver our customers the insights that they expect. Any of these developments and changes could create opportunities for a competitor to create products or a platform comparable or superior to ours, or that takes material market share from us in one or more product categories, and create challenges and risks for us if we are unable to successfully modify and enhance our products to adapt accordingly.\n50\nIf we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.\nThe use of social media throughout the world is pervasive and growing. According to a survey by GlobalWebIndex of individuals ages 16 to 64, 97% of digital consumers have used social media during the first quarter of 2020, with digital consumers spending an average of 2 hours and 22 minutes per day on social networks and messaging apps between January and March 2020. The social media industry has experienced, and is likely to continue to experience, rapid change due to the evolving trends, tastes and preferences of users. If consumers widely adopt new social media networks and platforms, we will need to develop integrations and functionality related to these new networks and platforms. This development effort may require significant research and development and sales and marketing resources, as well as licensing fees, all of which could adversely affect our business and operating results. In addition, new social media networks and platforms may not provide us with sufficient access to data from their platforms, preventing us from building effective integrations with our platform and products. Changing consumer tastes may also render our current integrations or functionality obsolete and the financial terms, if any, under which we would obtain integrations or functionality, unfavorable. Any failure of our products to operate effectively with the social media networks used most frequently by consumers could reduce the demand for our products. If we are unable to respond to these changes in a cost-effective manner, our products and aspects of our platform may become less marketable and less competitive or obsolete, and our operating results may be negatively affected.\nIf we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers, secure upgrades, sell add-ons, and increase the number of user licenses per paying customer.\nOur ability to add and retain paying customers, secure subscription upgrades, and sell add-ons depends in part on our customer service. Our sales and customer success team engages with customers to onboard them onto our platform, responds to support requests and other general inquiries, and assists with other account management matters. The perceived quality of customer service is one of the key facets potential customers evaluate when deciding between competing products and if our customer service is not viewed favorably, potential customers may choose our competitors’ products over our own. Additionally, our large enterprise customers from time to time demand custom solutions, such as custom APIs and custom reporting, and customer support that do not fit within one of our pre-packaged premium subscriptions, and addressing such demands often requires additional one-on-one engagement with our sales and customer success team members in order to finalize and service the commercial relationship. As we add more large enterprise customers and increase the number of user licenses per paying customer, we may need to devote more resources to customer service, and we may find it difficult and costly to effectively scale. If we do not adequately scale our customer success teams to meet the demands of new and existing customers, or if we otherwise fail to provide high-quality customer service during onboarding or at any other stage of the customer relationship, or a positive customer experience, we may lose such customers to our competition and fewer customers could renew or upgrade their subscriptions and purchase add-ons, which would harm our business, results of operations, and financial condition.\nFailures or loss of, or material changes with respect to, the third-party hardware, software, and infrastructure on which we rely, including third-party data center hosting facilities and third-party distribution channels to support our operations, could adversely affect our business.\nWe rely on leased and third-party owned hardware, software and infrastructure, including third-party data center hosting facilities and third-party distribution channels to support our operations. We primarily use three data centers in the United States, two located in Virginia and one in Georgia, as well as two Google Cloud locations in Virginia and South Carolina. We host each of our products and the data processed through such products in a combination of two of the foregoing locations for redundancy. If any\n51\nof our data center suppliers experience disruptions or failures, it would take time for the applicable backup data center to become fully functioning, and we would likely experience delays in delivering the affected products and segments of our platform, which may involve incurring significant additional expenses.\nFurthermore, the owners and operators of our data center facilities do not guarantee that access to our platform will be uninterrupted or error-free. We do not control the operation of these third-party providers’ facilities, which could be subject to break-ins, computer viruses, sabotage, intentional acts of vandalism and other misconduct. Further, our leased servers and data centers are vulnerable to damage or interruption from natural disasters, terrorist attacks, power loss, telecommunications failures or similar catastrophic events. The COVID-19 pandemic could cause our third-party data center hosting facilities and cloud computing platform providers, which are critical to our infrastructure, to shut down their operations, experience technical or security incidents that delay or disrupt performance or delivery of services to us, or experience interference with the supply chain of hardware required by their systems and services, any of which could materially adversely affect our business. For example, we have experienced delays in migrating to our new data center in Virginia, due to the limited availability of certain required hardware components resulting from supply chain delays caused by the COVID-19 pandemic. If there were to be a significant outage or disaster that rendered one of our servers or data centers inoperable for any length of time, we would have to undertake recovery operations for the impacted products, which could interrupt the availability of our platform. If we were unable to restore the availability of our platform and products within a reasonable period of time, our customer satisfaction could suffer, damaging our reputation as a result, and we could lose customers to our competition, which would materially and adversely affect our business and results of operations.\nIn addition, third-party data hosting and transmission services comprise a significant portion of our operating costs. If the costs for such services increase due to vendor consolidation, regulation, contract renegotiation, or otherwise, we may not be able to increase the fees for our platform or products to cover the changes, which would have a negative impact on our results of operations.\nIf the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\nWith consent from our customers, we obtain confidential and other customer data from our customers’ websites, social media accounts, and Google Analytics’ accounts to operate certain functionality on our platform. We rely on credit card purchases as the primary means of collecting our premium subscription fees. In addition, with consent from our customers, we collect and store certain personally identifiable information (“personal data”), credit card information, and other data needed to create, support, and administer the customer account, conduct our business, and comply with legal obligations, including rules imposed by the Payment Card Industry networks.\nWe believe that we take reasonable steps to protect the security, integrity, availability, and confidentiality of the information we and our third-party service providers hold, but there is no guarantee that despite our efforts, inadvertent disclosure (such as may arise from software bugs or other technical malfunctions, employee error or malfeasance, or other factors) or unauthorized disclosure or loss of personal or other confidential information will not occur or that third parties will not gain unauthorized access to this information. We have experienced, and may experience in the future, breaches of our security due to human error, malfeasance, system errors or vulnerabilities, or other irregularities. For example, we have been the target of attempts to identify and exploit system vulnerabilities and/or penetrate or bypass our security measures to gain unauthorized access to our systems, including a brute force attack that resulted in access to our affiliate program partner contact information. Since techniques used to obtain unauthorized access change frequently, we and our third-party service providers may be unable to anticipate these techniques or to implement adequate preventative measures. If our security measures or the security measures of our third-party service providers are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in our software are exposed\n52\nand exploited, and, as a result, a third-party obtains unauthorized access to any customers’ data, our relationships with our customers may be damaged, and we could incur liability. Further, our customers with annual subscription terms may have the right to terminate their subscriptions before the end of the subscription term due to our uncured material breach of agreement, including with respect to our data security obligations. It is also possible that unauthorized access to customer data may be obtained through inadequate use of security controls by customers, suppliers or other vendors. While we are not currently aware of any impact that the SolarWinds supply chain attack had on our business, this is a recent event, and the scope of the attack is yet unknown. Therefore, there is residual risk that we may experience a security breach arising from the SolarWinds supply chain attack. We may also be subject to additional liability risks for failing to disclose data breaches or other security incidents under state data breach notification laws or under the private right of action granted to individuals under certain data privacy laws for actions arising from certain data security incidents, such as the California Consumer Privacy Act (“CCPA”) (which is further discussed below in this “Risk Factors” section). In addition, some regions, such as the EU, the United Kingdom (“UK”), and the United States, have enacted mandatory data breach notification requirements for companies to notify data protection authorities, state and federal agencies, or individuals of data security incidents or personal data breaches. We may also be contractually required to notify certain customers in the event of a security incident pursuant to the applicable customer agreement. These mandatory disclosures regarding a security breach may lead to negative publicity and may cause our customers to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, may harm our reputation, and we could lose customers or fail to acquire new customers.\nFederal, state, and provincial regulators and industry groups may also consider and implement from time to time new privacy and security requirements that apply to our business, such as the long established Massachusetts data security law and the recently enacted New York Stop Hacks and Improve Electronic Data Act, both of which establish prescriptive administrative, technical, and physical data security requirements on companies, and permits civil penalties for each violation. Compliance with evolving privacy and security laws, requirements, and regulations may result in cost increases due to necessary systems changes, new limitations or constraints on our business models and the development of new administrative processes. They also may impose further restrictions on our collection, disclosure, and use of personally identifiable information kept in our databases or those of our vendors. If our security measures fail to protect credit card information adequately, we could be liable to both our customers and their users for their losses, as well as the vendors under our agreements with them such that we could be subject to fines and higher transaction fees, we could face regulatory action, and our customers and vendors could end their relationships with us, any of which could harm our business, results of operations or financial condition. Any willful or accidental security breaches or other unauthorized access to or disclosure of personal data could expose us to enforcement actions, regulatory or governmental audits, investigations, litigation, fines, penalties, adverse publicity, downtime of our systems, and other possible liabilities. There can be no assurance that the limitations of liability in our contracts would be enforceable or adequate or would otherwise protect us from any such liabilities or damages with respect to any particular claim. In addition, our cybersecurity insurance coverage may be inadequate to cover all costs and expenses associated with a security breach that may occur in the future.\nIn recent periods, we have experienced, and expect to continue to experience, rapid growth and organizational change. If we fail to manage our growth effectively, we may be unable to execute our business plan, maintain high levels of service and customer satisfaction or attract new employees and customers.\nWe have experienced, and expect to continue to experience, rapid growth in our number of customers, sales, revenues, locations, and headcount, which has placed, and may continue to place, significant demands on our management, and our operational and financial resources. We have paying customers in over 142 countries, and the number of our paying customers has grown from over 56,000 as of March 31, 2020 to over 72,000 as of March 31, 2021. We have seven offices across the globe with salespeople dispersed in various other locations, and the continued domestic and international growth\n53\nthat we anticipate will require us to continue to expand our global employee headcount. It may be difficult for us to identify, recruit, train, and manage enough personnel to efficiently scale our operations, manage our product development effectively and to match the growth of our customer base. As we continue to grow, we face challenges of integrating, developing, training, and motivating a rapidly growing and dispersed employee base. We are facing novel challenges with respect to integrating new employees and managing multi-geographic teams as COVID-19 prevents certain of our onboarding personnel from travelling between our offices to assist with such integration and training. Certain members of our executive management team have not previously worked together for an extended period of time, which may affect how they manage our growth. If we fail to manage our anticipated growth effectively, our brand and reputation could be negatively affected, which could harm our ability to attract employees and customers.\nTo manage growth in our operations and personnel, we will need to continue to scale and improve our operational, financial, and management controls, and our reporting systems and procedures, which will require significant capital expenditures increasing our cost of operations and the reallocation of valuable management resources. As we scale, it may become more difficult and will require additional capital expenditures to maintain and increase the productivity of our employees, to address the needs of our actual and prospective customers, and provide high-quality customer service, to further develop and enhance our products, and remain competitive against our competitors’ products. Additionally, our expansion has placed, and our expected future growth will continue to place, a significant strain on our management, customer service teams, product and development, sales and marketing, administrative, financial, and other resources.\nTechnical problems or disruptions that affect either our customers’ (and their users’) ability to access our platform and products, or the software, internal applications, database, and network systems underlying our platform and products, could damage our reputation and brands, lead to reduced demand for our platform and products, lower revenues, and increased costs.\nOur business, brands, reputation, and ability to attract and retain customers depend upon the satisfactory performance, reliability, and availability of our platform, which in turn depend upon the availability of the internet and our third-party service providers. Interruptions in these systems, whether due to system failures, computer viruses, software errors, physical or electronic break-ins, malicious hacks or attacks on our systems (such as denial of service attacks), or force majeure events, could affect the security and availability of our products and prevent or inhibit the ability of customers to access our platform. In addition, the software, internal applications, and systems underlying our products and platform are complex and may not be error-free. We may encounter technical problems when we attempt to perform routine maintenance or enhance our software, internal applications, and systems. In addition, our platform may be negatively impacted by technical issues experienced by our third-party service providers. Any inefficiencies, errors, or technical problems with our software, internal applications, and systems could reduce the quality of our platform and products or interfere with our customers’ (and their users’) use of our platform and products, which could negatively impact our brand, reduce demand, lower our revenues, and increase our costs.\nWe are exposed to risks associated with premium subscription and payment processing and any disruption to such processing systems could adversely affect our business and results of operations.\nWe primarily rely on our own billing systems to manage our subscriptions and billing frequencies, and we use third-party subscription management and payment processing platforms for some of our products. If we or any of our third-party vendors were to experience an interruption, delay, or outage in service and availability, we may be unable to process new and renewals of subscriptions and our ability to process such subscription and credit card payments would be delayed while we activate an alternative billing platform. Although alternative third-party providers may be available to us, we may incur significant expenses and research and development efforts to deploy any alternative providers. To the extent there\n54\nare disruptions in our billing systems or third-party subscription and payment processing systems, we could experience revenue loss, accounting issues, and harm to our reputation and customer relationships, which would adversely affect our business and results of operations.\nWe are subject to a number of risks related to credit and debit card payments, including:\n•we pay interchange and other fees, which may increase over time and could require us to either increase the prices we charge for our products or experience an increase in our operating expenses;\n•if our billing systems fail to work properly and the failure has an adverse effect on our customer satisfaction, causes credit and debit card issuers to disallow our continued use of their payment products, or, does not permit us to automatically charge our paying customers’ credit and debit cards on a timely basis or at all, we could lose or experience a delay in collection of customer payments;\n•if we are unable to maintain our chargeback rate at acceptable levels, we may face civil liability, diminished public perception of our security measures and our credit card fees for chargeback transactions, or our fees for other credit and debit card transactions or issuers, may increase, or issuers may terminate their relationship with us; and\n•we could be significantly impaired in our ability to operate our business if we lose our ability to process payments on any major credit or debit card.\nA significant portion of our operations is located outside of the United States, which subjects us to additional risks, including increased complexity, the costs of managing international operations, geopolitical instability, and fluctuations in currency exchange rates.\nThe design and development of our products is primarily conducted by our subsidiaries in Russia, the Czech Republic, Cyprus, and Poland. We also have marketing and administrative operations in the same jurisdictions. In addition, members of our sales force are located in Russia, Europe, the United Kingdom and Australia. Approximately 55% of our revenue for the three months ended March 31, 2021 was generated from sales to paying customers located outside the United States, including indirect sales through our resellers outside of the United States. As a result of our international operations and sales efforts, we face numerous challenges and risks that could harm our international operations, delay new product releases, increase our operating costs, and hinder our ability to grow and detect underlying trends in our operations and business, and consequently adversely impact our business, financial condition, and results of operations. Such risks include but are not limited to the following:\n•geopolitical and economic instability in and impacting the localities where we have foreign operations, such as Russia;\n•military conflicts impacting the localities where we have foreign operations;\n•limited protection for, and vulnerability to theft of, our intellectual property rights, including our trade secrets;\n•compliance with local laws and regulations, and unanticipated changes in local laws and regulations, including tax laws and regulations;\n•trade and foreign exchange restrictions and higher tariffs;\n•the complexity of managing international trade sanctions and export restrictions from the jurisdictions in which we have foreign operations;\n55\n•fluctuations in foreign currency exchange rates which may make our premium subscriptions more expensive for international paying customers and which may increase our expenses for employee compensation and other operating expenses that are paid in currencies other than U.S. dollars;\n•restrictions imposed by the United States government against other countries, or foreign governments restrictions imposed on the United States, impacting our ability to do business with certain companies or in certain countries and the complexity of complying with those restrictions;\n•power outages, natural disasters, and other local events that could affect the availability of the internet and the consequences of disruptions, such as large-scale outages or interruptions of service from utilities or telecommunications providers;\n•difficulties in staffing international operations;\n•changes in immigration policies which may impact our ability to hire personnel;\n•differing employment practices, laws, and labor relations;\n•regional health issues and the impact of public health epidemics and pandemics on employees and the global economy, such as the COVID-19 pandemic; and\n•travel, work-from-home or other restrictions or work stoppages, like those currently imposed by governments around the world as a result of the COVID-19 pandemic.\nFurther, it is possible that governments of one or more foreign countries may seek to limit access to the internet or our platform, products or certain features in their countries, or impose other restrictions that may affect the availability of our platform, products, or certain features in their countries for an extended period of time or indefinitely. For example, Russia and China are among a number of countries that have recently blocked certain online services, including Amazon Web Services, making it difficult for such services to access those markets. In addition, governments in certain countries may seek to restrict or prohibit access to our platform if they consider us to be in violation of their laws (including privacy laws) and may require us to disclose or provide access to information in our possession. If we fail to anticipate developments in the law or fail for any reason to comply with relevant laws, our platforms could be further blocked or restricted and we could be exposed to significant liability that could harm our business. In the event that access to our platform is restricted, in whole or in part, in one or more countries or our competitors are able to successfully penetrate geographic markets that we cannot access, our ability to acquire new customers or renew or grow the premium subscriptions of existing paying customers may be adversely affected, we may not be able to maintain or grow our revenue as anticipated and our business, results of operations, and financial condition could be adversely affected.\nThe effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\nThe global COVID-19 pandemic has disrupted the economy and put unprecedented strains on governments, health care systems, educational institutions, companies, and individuals around the world. The impact and duration of the COVID-19 pandemic are difficult to assess or predict and will depend in part upon the actions taken by governments, companies, and other enterprises in response to the pandemic. The pandemic has already caused, and is likely to result in further, significant disruption of global financial markets and economic uncertainty. Adverse market conditions resulting from the COVID-19 pandemic could materially adversely affect our revenues, business and the value of our Class A common stock.\n56\nOur customers, particularly small-to-medium sized businesses (“SMBs”) and marketing agencies focused on SMBs, which have been particularly impacted by the COVID-19 pandemic, have reduced and may further reduce their technology or sales and marketing spending or delay purchasing decisions, which could result in slowed growth, reduced demand from new and existing SMB customers, and/or lower dollar-based net revenue retention rates, which could materially and adversely impact our business. In March 2020, our paying customer growth rate was relatively flat compared to our paying customer growth rate in February 2020. However, in April 2020 our paying customer growth rate declined, which we believe was primarily a result of the COVID-19 pandemic and the related socioeconomic impacts. In response, we offered free or discounted pricing to certain paying customers contemplating canceling their premium subscriptions as a remedial measure to retain them. Our paying customer growth rate started to increase again by May 2020. Depending on the duration of the COVID-19 pandemic, we may in the future be required to take further remedial measures, including changing our terms or offering further discounts, which may materially adversely impact our revenues and business in future periods.\nIn response to the COVID-19 pandemic, we temporarily closed all of our offices (including our headquarters in Boston, Massachusetts, and offices in Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, and St. Petersburg, Russia), subsequently reopened certain offices at reduced capacity, enabled our employees to work remotely, implemented temporary travel restrictions for all non-essential business, and shifted company events to virtual-only experiences. We may deem it advisable to similarly alter, postpone, or cancel additional events in the future. If the COVID-19 pandemic worsens, especially in regions where we have offices, our business activities conducted from those offices could be adversely affected and we may have to invest additional capital into improving our technology and remote working capabilities and in relocating those activities to alternate locations from which we operate. We may take further actions that alter our business operations as may be required by local, state, or federal authorities or that we determine are in the best interests of our employees. Such measures could negatively affect our sales and marketing efforts, sales cycles, employee productivity, or customer retention, any of which could harm our financial condition and business operations.\nFurther, the COVID-19 pandemic has resulted in our employees and the employees of many of our customers and vendors working remotely. If the network and infrastructure of internet providers becomes overburdened by increased usage or is otherwise unreliable or unavailable, our employees’, and our customers’ and vendors’ employees’ access to the internet and ability to conduct business could be negatively impacted. We and our vendors may experience an increase in attempted cyber-attacks, targeted intrusion, ransomware, and phishing campaigns seeking to take advantage of shifts to employees working remotely using their household or personal internet networks. Any of these factors could interrupt our ability to provide our platform, decrease the productivity of our workforce, and significantly harm our business operations, financial condition, and results of operations.\nTo the extent the COVID-19 pandemic adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in this ‘‘Risk Factors’’ section.\nAdverse or weakened general economic and market conditions may reduce spending on sales and marketing technology and information, which could harm our revenue, results of operations, and cash flows.\nOur revenue, results of operations, and cash flows depend on the overall demand for and use of technology and information for sales and marketing, which depends in part on the amount of spending allocated by our paying customers or potential paying customers on sales and marketing technology and information. In addition to the internal strategy of our paying customers, which is not predictable and is subject to change, this spending depends on worldwide economic and geopolitical conditions. The United States, EU, and other key international economies have experienced cyclical downturns from time to time in which economic activity was impacted by falling demand for a variety of goods and services, restricted credit, poor liquidity, reduced corporate profitability, volatility in credit, equity, and foreign exchange markets, bankruptcies, public health crises, and pandemics such as COVID-19, and overall economic\n57\nuncertainty. These economic conditions can arise suddenly, may disproportionately impact SMBs that make up an important segment of our paying customer base, and the full impact of such conditions often remains uncertain for extended periods of time. Further actions or inactions of the United States or other major national governments, including the UK’s 2016 vote in favor of the UK’s exit from the EU, may also impact economic conditions, which could result in financial market disruptions or an economic downturn.\nConcerns about the systemic impact of an economic recession, energy costs, geopolitical issues, or the availability and cost of credit could lead to increased market volatility, decreased consumer confidence, and diminished growth expectations in the U.S. economy and abroad, which could affect the rate of information technology spending and adversely affect our paying customers’ ability or willingness to purchase our products, delay prospective paying customers’ purchasing decisions, reduce the value or duration of their premium subscription contracts, or affect retention rates. Any of these conditions or occurrences could adversely affect our future sales and operating results because most of our paying customers are on month-to-month premium subscriptions that can be cancelled at any time. Further, some of our paying customers may view a premium subscription to our platform as a discretionary purchase, and our paying customers may reduce their discretionary spending on our platform during an economic downturn and consequently reduce or terminate their premium subscription or decide not to upgrade another premium subscription. In particular, spending patterns of the SMBs that make up a large portion of our paying customer base are difficult to predict and are sensitive to the general economic climate, the economic outlook specific to small businesses, the then-current level of profitability experienced by SMBs and overall consumer confidence. In addition, weak economic conditions can result in paying customers seeking to utilize free or lower-cost solutions from alternative sources. Prolonged economic slowdowns may result in requests to renegotiate existing contracts on less advantageous terms to us than those currently in place, payment defaults on existing contracts, or non-renewal at the end of a contract term.\nFailure of our commercial liability insurance policy to cover claims and any changes to the availability or coverage amounts in our existing policy could have a material adverse effect on our business, financial condition, and results of operations.\nWe cannot assure you that our existing general liability insurance coverage and coverage for errors and omissions in our products will be fully covered by our existing policies and will continue to be available on acceptable terms, or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceeds available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on our business, financial condition, and results of operations.\nAs we acquire and invest in companies or technologies, we may not realize expected business or financial benefits and the acquisitions or investments could prove difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our business, results of operations, and financial condition.\nAs part of our business strategy, we evaluate and may make investments in, or acquisitions of, complementary companies, services, databases, and technologies, and we expect that we will continue to evaluate and pursue such investments and acquisitions in the future to further grow and augment our business, our platform, and product offerings. For example, in August 2020, we acquired Prowly, an advertising and public relations technology company based in Poland. We have incurred and will continue to incur costs to integrate Prowly’s business and selling process into our business and to integrate Prowly’s products into our platform, such as software integration expenses and costs related to the renegotiation of redundant vendor agreements, and we expect to incur similar costs to integrate future acquisitions. We may have difficulty effectively integrating the personnel, businesses, and technologies of these acquisitions into our company and platform, and achieving the strategic goals of those acquisitions.\n58\nOur strategy to make selective acquisitions to complement our platform depends in part on the availability of, our ability to identify, and our ability to engage and pursue suitable acquisition candidates. We may not be able to find suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. Acquired assets, data, or companies may not be successfully integrated into our operations, costs in connection with acquisitions and integrations may be higher than expected, and we may also incur unanticipated acquisition-related costs. These costs could adversely affect our financial condition, results of operations, or prospects. Any acquisition we complete could be viewed negatively by customers, users, developers, and other employees, partners, or investors, and could have adverse effects on our existing business relationships and company culture.\nAcquisitions and other transactions, arrangements, and investments involve numerous risks and could create unforeseen operating difficulties and expenditures, including:\n•difficulties in, and the cost of, integrating personnel and cultures, operations, technologies, products, services, and platforms which may lead to failure to achieve the expected benefits on a timely basis or at all;\n•diversion of financial and managerial resources from existing operations;\n•the potential entry into new markets in which we have little or no experience or where competitors may have stronger market positions;\n•potential write-offs of acquired assets or investments, and potential financial and credit risks associated with acquired customers;\n•additional stock-based compensation and difficulties in, and financial costs of, addressing acquired compensation structures inconsistent with our compensation structure;\n•inability to generate sufficient revenue to offset acquisition and/or investment costs;\n•inability to maintain, or changes in, relationships with customers and partners of the acquired business;\n•challenges converting the revenue recognition policies of companies we may acquire and forecasting the recognition of their revenue, including subscription-based revenue and revenue based on the transfer of control, as well as appropriate allocation of the customer consideration to the individual deliverables;\n•difficulty with, and costs related to, transitioning the acquired technology onto our existing platform, augmenting the acquired technologies and platforms to the levels that are consistent with our brand and reputation, augmenting or maintaining the security standards for acquired technology consistent with our platform and other products, and customer acceptance of multiple platforms on a temporary or permanent basis;\n•potential unknown liabilities associated with the acquired companies, including risks associated with acquired intellectual property and/or technologies;\n•challenges relating to the structure of an investment, such as governance, accountability, and decision-making conflicts;\n•negative impact to our results of operations because of the depreciation and amortization of amounts related to acquired intangible assets, fixed assets, and deferred compensation;\n•the loss of acquired unearned revenue and unbilled unearned revenue;\n59\n•delays in customer purchases due to uncertainty related to any acquisition;\n•ineffective or inadequate controls, procedures, and policies at the acquired company;\n•challenges caused by integrating operations over distance, and across different languages, cultures, and political environments;\n•currency and regulatory risks associated with conducting operations in foreign countries and potential additional cybersecurity and compliance risks resulting from entry into new markets;\n•tax effects and costs of any such acquisitions, including the related integration into our tax structure and assessment of the impact on the realizability of our future tax assets or liabilities; and\n•potential challenges by governmental authorities for anti-competitive or other reasons.\nAny of these risks could harm our business. In addition, to facilitate these acquisitions or investments, we may seek additional equity or debt financing, which may not be available on terms favorable to us or at all, may affect our ability to complete subsequent acquisitions or investments and may affect the risks of owning our Class A common stock. For example, if we finance acquisitions by issuing equity or convertible debt securities or loans, our existing stockholders may be diluted, or we could face constraints related to the terms of, and repayment obligations related to, the incurrence of indebtedness that could affect the market price of our Class A common stock.\nOur debt obligations contain restrictions that impact our business and expose us to risks that could adversely affect our liquidity and financial condition.\nOn January 12, 2021, we executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The amount of borrowings permitted at any one time under the revolving credit facility is subject to a borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. As a result, our access to the revolving credit facility is potentially subject to significant fluctuations depending on the value of the borrowing base as of any measurement date.\nThe credit agreement (as amended, restated, amended and restated, supplemented or otherwise modified from time to time, the “Credit Agreement”) governing our revolving credit facility (collectively, our “credit facility”) contains various covenants that are operative so long as our credit facility remains outstanding. The covenants, among other things, limit our and certain of our subsidiaries’ abilities to:\n•incur additional indebtedness or guarantee indebtedness of others;\n•create additional liens on our assets;\n•pay dividends and make other distributions on our capital stock, and redeem and repurchase our capital stock;\n•make investments, including acquisitions;\n•make capital expenditures;\n•enter into mergers or consolidations or sell assets;\n•sell our subsidiaries; or\n60\n•enter into transactions with affiliates.\nOur credit facility also contains numerous affirmative covenants and a financial covenant of either minimum liquidity or a maximum leverage ratio.\nIf we experience a decline in cash flow due to any of the factors described in this “Risk Factors” section or otherwise, we could have difficulty paying interest due on our indebtedness and meeting the financial covenants set forth in our credit facility. If we fail to comply with the various requirements of our indebtedness, we could default under our credit facility. Any such default that is not cured or waived could result in an acceleration of indebtedness then outstanding under our credit facility, an increase in the applicable interest rates under our credit facility, and a requirement that Semrush US Sub, which is a co-borrower under the facility, pay the obligations in full, and would permit the lenders to exercise remedies with respect to all of the collateral that is securing our credit facility, including substantially all of our and Semrush US Sub’s assets. Thus, any such default could have a material adverse effect on our liquidity and financial condition.\nIf we cannot maintain our company culture as we grow, we could lose the innovation, teamwork, passion, and focus on execution that we believe contribute to our success and our business may be harmed.\nWe believe that a critical component to our success has been our company culture, which is based on transparency, innovation, creativity, and personal autonomy to take on challenges and initiatives. We have invested substantial time and resources in building our team within this company culture across our offices. Any failure to preserve our culture could negatively affect our ability to retain and recruit personnel and to effectively focus on and pursue our corporate objectives. As we grow and develop the infrastructure of a public company, we may find it difficult to maintain these foundational aspects of our company culture. If we fail to maintain our company culture, we may fail to recruit qualified employees, our existing employees may terminate their employment, our ability to execute on marketing, sales, product and development, and other initiatives may suffer, and our business may be adversely impacted in other ways.\nChanges in the sizes or types of paying customers that purchase premium subscriptions to our platform or products could affect our business, and our financial results may fluctuate due to increasing variability in our sales cycles.\nOur strategy is to sell premium subscriptions of our platform to paying customers of all sizes, from sole proprietors, to SMBs, to large enterprise customers. Selling monthly premium subscriptions to SMBs generally involves lower or plateauing premium subscription upgrade potential, lower retention rates (especially in times of economic uncertainty where marketing and sales budgets are subject to increased scrutiny and reduction), and more limited interaction with our sales and other personnel than sales to large enterprises. Conversely, sales to large enterprises generally entail longer sales cycles, more significant and costly selling and support efforts, and greater uncertainty of completing the sale than sales to SMBs. We plan our expenses based on certain assumptions about the length and variability of our sales cycle based upon historical trends for sales and conversion rates associated with our existing paying customers. If and as our paying customer base expands to include more large enterprise customers, our sales expenses may increase, sales cycles may lengthen and become less predictable, and we may see a greater number of paying customers with longer terms and extended payment terms which, in turn, may increase our paying customer acquisition costs, increase our credit risk, and may in other ways adversely affect our financial results. Additional factors that may influence the length and variability of our sales cycle include:\n•the need to educate prospective customers about the different products available on our platform, and their uses and benefits;\n61\n•the discretionary nature of purchase and budget cycles and decisions;\n•the competitive nature of evaluation and purchasing processes;\n•economic and political stability and other external factors;\n•evolving functionality demands;\n•announcements of planned introductions of new products, features or functionality by us or our competitors; and\n•lengthy and multi-faceted purchasing approval processes required by our customers, especially large enterprise customers.\nIf there are changes in, or we fail to adequately predict, the mix of paying customers that purchase premium subscriptions to our platform, our gross margins and operating results could be adversely affected, and fluctuations increasing the variability in our sales cycles could negatively affect our financial results.\nForecasts of our market and market growth may prove to be inaccurate, and even if the markets in which we compete achieve the forecasted growth, there can be no assurance that our business will grow at similar rates, or at all.\nGrowth forecasts that we have provided and may provide, including those in the Prospectus and in this Quarterly Report on Form 10-Q, relating to our market opportunities and the expected growth thereof are subject to significant uncertainty and are based on assumptions and estimates which may prove to be inaccurate. Even if these markets grow at the forecasted rates, we may not grow our business at a similar rate, or at all. Our growth is subject to many factors, including our success in implementing our business strategy, which is subject to many risks and uncertainties. Accordingly, the forecasts of market growth that we have provided and may in the future provide should not be taken as indicative of our future growth.\nOur management has broad discretion over the use of the proceeds from the IPO, and might not use the net proceeds effectively.\nOur management has broad discretion to use the net proceeds from the IPO, including for any of the purposes described in the section titled “Use of Proceeds” included in the Prospectus, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management might not apply the net proceeds in ways that increase the value of your investment. Until we use the net proceeds from the IPO, we plan to invest them, and these investments may not yield a favorable rate of return. If we do not invest or apply the net proceeds from the IPO in ways that enhance stockholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.\nWe may be subject to litigation for any of a variety of claims, which could harm our reputation and adversely affect our business, results of operations, and financial condition.\nIn the ordinary course of business, we may be involved in and subject to litigation for a variety of claims or disputes and receive regulatory inquiries. These claims, lawsuits, and proceedings could include labor and employment, wage and hour, income tax, commercial, data privacy, antitrust, alleged securities law violations or other investor claims, and other matters. The number and significance of these potential claims and disputes may increase as our business expands. Any claim against us, regardless of its merit, could be costly, divert management’s attention and operational resources, and harm our reputation. As litigation is inherently unpredictable, we cannot assure you that any potential claims or disputes will not\n62\nhave a material adverse effect on our business, results of operations, and financial condition. Any claims or litigation, even if fully indemnified or insured, could make it more difficult to compete effectively or to obtain adequate insurance in the future.\nIn addition, we may be required to spend significant resources to monitor and protect our contractual, intellectual property, and other rights, including collection of payments and fees. Litigation has been and may be necessary in the future to enforce such rights. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of our rights. Furthermore, our efforts to enforce our rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of such rights. Our inability to protect our rights, as well as any costly litigation or diversion of our management’s attention and resources, could have an adverse effect on our business, results of operations, and financial condition or harm our reputation.\nOur failure to raise additional capital or generate cash flows necessary to expand our operations and invest in new technologies in the future could reduce our ability to compete successfully and harm our results of operations.\nWe may require additional financing, and we may not be able to obtain debt or equity financing on favorable terms, if at all. Any debt financing obtained by us could involve restrictive covenants relating to financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could experience significant dilution, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our Class A common stock. The terms of any debt financing may include liquidity requirements, restrict our ability to pay dividends, and require us to comply with other covenants restrictions. If we need additional capital and cannot raise it on acceptable terms, or at all, we may not be able to, among other things:\n•develop new features, integrations, capabilities, and enhancements;\n•continue to expand our product and development, and sales and marketing teams;\n•hire, train, and retain employees;\n•respond to competitive pressures or unanticipated working capital requirements; or\n•pursue acquisition opportunities.\nOur referral partners and resellers provide revenue to our business, and we benefit from our association with them. Our failure to maintain successful relationships with these partners could adversely affect our business.\nOur referral partners and resellers drive revenue to our business and our agreements with these partners and resellers are non-exclusive, with the exception of one exclusive reseller agreement in Japan. While most of these partners and resellers offer products or services that are complementary to our platform and products, some offer point solutions that compete with certain functionalities of our platform. These referral partners and resellers may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own products or services rather than ours, which could cause our revenue to decline. Our competitors may in some cases be effective in causing our referral partners and resellers, or potential referrals and resellers, to favor their products and services or to prevent or reduce sales of our platform and products. Also, we derive tangible and intangible benefits from our association with some of our referral partners and members of our affiliate networking programs, particularly high-profile partners that reach a large number of companies through the internet. If a\n63\nsubstantial number of these partners or networking affiliates reduce or cease their relationships with us, our business, financial condition, and results of operations could be adversely affected.\nWe expect that we will need to continue to expand and maintain a network of referral partners and resellers in order to expand into certain international markets. A loss of or reduction in sales through these third parties could reduce our revenue. Recruiting and retaining qualified resellers in our network and training them in our technology and product offerings requires significant time and resources. If we decide to further develop and expand our indirect sales channels, we must continue to scale and improve our processes and procedures to support these channels, including investment in systems and training. Many resellers may not be willing to invest the time and resources required to train their staff to effectively sell our platform. If we fail to maintain relationships with our referral partners and resellers, fail to develop relationships with new referral partners and resellers in new markets or expand the same in existing markets, or fail to manage, train, or provide appropriate incentives to our existing referral partners and resellers, our ability to increase the number of new paying customers and increase sales to existing paying customers could be adversely impacted, which would harm our business.\nOur ability to utilize our net operating loss carryforwards may be limited.\nAs of December 31, 2020, we had U.S. federal and state net operating loss carryforwards of approximately $28.0 million and $14.1 million, respectively. Our ability to utilize our federal net operating loss carryforwards may be limited under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). The limitations apply if we experience an “ownership change,” which is generally defined as a greater than 50 percentage point change (by value) in the ownership of our equity by certain stockholders over a rolling three-year period. Similar provisions of state tax law may also apply to limit the use of our state net operating loss carryforwards. Future changes in our stock ownership, which may be outside of our control, may trigger an ownership change and, consequently, the limitations under Section 382 of the Code. As a result, if or when we earn net taxable income, our ability to use our pre-change net operating loss carryforwards to offset such taxable income may be subject to limitations, which could adversely affect our future cash flows.\nWe could be required to collect additional sales and other similar taxes or be subject to other tax liabilities that may increase the costs our customers would have to pay for our subscriptions and adversely affect our operating results.\nSales and use, value-added, goods and services, and similar tax laws and rates are complicated and vary greatly by jurisdiction. There is significant uncertainty as to what constitutes sufficient nexus for a national, state or local jurisdiction to levy taxes, fees, and surcharges for sales made over the internet, as well as whether our subscriptions are subject to tax in various jurisdictions. Certain countries and the vast majority of states have considered or adopted laws that impose tax collection obligations on out-of-state companies. Additionally, in the United States, the Supreme Court of the United States recently ruled in South Dakota v. Wayfair, Inc. et. al. (“Wayfair”) that online sellers can be required to collect sales and use tax despite not having a physical presence in the buyer’s state. In response to the Wayfair case, or otherwise, national, states or local governments may enforce laws requiring us to calculate, collect, and remit taxes on sales in their jurisdictions. We have not always collected sales and other similar taxes in all jurisdictions in which we are required to. We may be obligated to collect and remit sales tax in jurisdictions in which we have not previously collected and remitted sales tax. We could also be subject to audits in states and non-U.S. jurisdictions for which we have not accrued tax liabilities. A successful assertion by one or more countries or states requiring us to collect taxes where we historically have not or presently do not do so could result in substantial tax liabilities, including taxes on past sales, as well as penalties and interest. The imposition by national, state or local governments of sales tax collection obligations on out-of-state sellers could also create additional administrative burdens for us and decrease our future sales, which could adversely affect our business and operating results.\nRisks Related to the Regulatory Framework that Governs Us\n64\nIf the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\nWe rely on small text files and other technologies, such as web beacons (collectively, “cookies”) which are placed on internet browsers to gather data regarding the content of a user’s web browsing activity. We use cookies to store users’ settings between sessions and to enable visitors to our website to use certain features, such as gaining access to secure areas of the website. We also use cookies, including cookies placed by third-party services with which we integrate, to enable us to gather statistics about our visitors’ use of our website and to allow our website visitors to connect our platform to their social networking sites, which enables us to advertise our products to them using retargeting methods. The availability of this data may be limited by numerous potential factors, including government legislation or regulation restricting the use of cookies for certain purposes, such as retargeting, browser limitations on the collection or use of cookies, or internet users deleting or blocking cookies on their web browsers or on our website.\nOur ability, like those of other technology companies, to collect, augment, analyze, use, and share information collected through the use of third-party cookies for online behavioral advertising is governed by U.S. and foreign laws and regulations which change from time to time, such as those regulating the level of consumer notice and consent required before a company can employ cookies to collect data about interactions with users online. In the United States, both state and federal legislation govern activities such as the collection and use of data, and privacy in the advertising technology industry has frequently been subject to review, and occasional enforcement, by the Federal Trade Commission, or the FTC, U.S. Congress, and individual states.\nAs our business is global, our activities are also subject to foreign legislation and regulation. In the EU, the EU Directive 2002/58/EC (as amended by Directive 2009/136/EC), commonly referred to as the e-Privacy Directive, and related implementing legislation in the EU and the UK requires that accessing or storing information on an internet user’s device, such as through a cookie, is allowed only if the internet user has been informed thereof, and provided prior unambiguous, specific, and informed consent for the placement of a cookie on a user’s device. A new e-Privacy Regulation is currently under discussion by EU member states to replace the e-Privacy Directive. Although it remains under debate, the proposed e-Privacy Regulation would amend rules on third-party cookies and significantly increase penalties for non-compliance. We cannot yet determine the impact such future laws, regulations, and standards may have on our use of third-party cookies. Additionally, the use of third-party cookies in the digital advertising ecosystem, particularly in the context of real-time bidding advertising auctions, is subject to increased regulatory scrutiny in the EU. Several European data protection authorities (including in Belgium, Ireland, UK, Poland, Spain, Luxembourg, and the Netherlands) have launched investigations or inquiries over Google’s and other AdTech companies’ practices concerning the collection and sharing of consumer data through cookies, the outcome of which is still uncertain. These investigations or inquiries could result in the imposition of more stringent standards around consent to place cookies or otherwise restrict the use of third-party cookies for online behavioral advertising. We have also received inquiries from, and engaged in correspondence with, European data protection authorities regarding our practices regarding cookies used on our websites, and the outcome of these inquiries is still uncertain.\nAdditionally, new and expanding “Do Not Track” regulations have recently been enacted or proposed that protect users’ right to choose whether or not to be tracked online. These regulations seek, among other things, to allow end users to have greater control over the use of private information collected online, to forbid the collection or use of online information, to demand a business to comply with their choice to opt out of such collection or use, and to place limits upon the disclosure of information to third-party websites.\n65\nContinued regulation of cookies, and changes in the interpretation and enforcement of existing laws, regulations, standards, and other obligations, as well as increased enforcement by industry groups or data protection authorities, could restrict our activities, such as efforts to understand users’ internet usage and engage in marketing activities, or require changes to our practices. Any inability to obtain information through cookies or to obtain it on the terms we anticipate, could cause a significant impact on the operation of our platform, impair our ability to target and attract new customers, and reduce our ability to predict our customers’ interests in or need for one or more of our products, any of which may cause a reduction in revenue or a reduction in revenue growth, negatively impact our ability to obtain new subscriptions and retain or grow the subscriptions of existing customers.\nAdditionally, cookies may easily be deleted or blocked by internet users. All of the most commonly used internet browsers (including Chrome, Firefox, Internet Explorer, and Safari) allow internet users to prevent cookies from being accepted by their browsers. Internet users can also delete cookies from their computers at any time. Some internet users also download “ad blocking” software that prevents cookies from being stored on a user’s device. If more internet users adopt these settings or delete their cookies more frequently than they currently do, our business could be harmed. In addition, the Safari and Firefox browsers block third-party cookies by default, and other browsers may do so in the future. Unless such default settings in browsers were altered by internet users to permit the placement of third-party cookies, fewer cookies would be available, which could adversely affect our business. In addition, companies such as Google LLC have publicly disclosed their intention to move away from cookies to another form of persistent unique identifier, or ID, to identify individual internet users or internet-connected devices in the bidding process on advertising exchanges. If companies do not use shared IDs across the entire ecosystem, this could have a negative impact on our ability obtain content consumption data.\nChanges in laws, regulations, and public perception concerning data protection and privacy, or changes in the interpretation or patterns of enforcement of existing laws and regulations, could impair our efforts to maintain and expand our customer base or the ability of our customers and users to use our platform and some or all of our products. Breaches of laws and regulations concerning data protection and privacy could expose us to significant fines and other penalties.\nWe hold personal data about a variety of individuals, such as our customers, users, employees, contractors, and business partners, and we use such personal data as needed to collect payment from our customers, communicate with and recommend products to our customers and prospective customers through our marketing and advertising efforts, and comply with legal obligations. Processing of personal data is increasingly subject to legislation and regulation in numerous jurisdictions around the world.\nFor example, relevant applicable laws and regulations governing the collection, use, disclosure or other processing of personal information include, in the United States, rules and regulations promulgated under the authority of the Federal Trade Commission, the California Consumer Privacy Act of 2018 (the “CCPA”), and state breach notification laws. In particular, in California, the CCPA was enacted in June 2018, became effective back on January 1, 2020 and became subject to enforcement by the California Attorney General’s office on July 1, 2020. The CCPA broadly defines personal information and provides an expansive meaning to activity considered to be a sale of personal information, and gives California residents expanded privacy rights and protections, including the right to opt out of the sale of personal information. The CCPA also provides for civil penalties for violations and a private right of action for data breaches. Moreover, a new privacy law that amends and expands the CCPA, the California Privacy Rights Act, or CPRA, was passed on November 3, 2020. The CPRA creates additional obligations relating to personal information that take effect on January 1, 2023 (with certain provisions having retroactive effect to January 1, 2022). The CPRA also establishes a new enforcement agency dedicated to consumer privacy. The CPRA’s implementing regulations are expected on or before July 1, 2022, and enforcement is scheduled to begin July 1, 2023. We will continue to monitor developments related to the CPRA and anticipate additional costs and expenses associated with CPRA compliance. In addition, since the enactment of CCPA, new privacy and data security laws have been proposed in more than half of the states in the United States and in the U.S. Congress, reflecting a trend toward more stringent privacy\n66\nlegislation in the United States, which trend may accelerate depending on the results of the 2020 U.S. presidential election. The effects of the CCPA, CPRA, and other similar state or federal laws, are potentially significant and may require us to modify our data processing practices and policies, and to incur substantial costs and potential liability in an effort to comply with such legislation.\nWe maintain offices in the EU (including Poland, the Czech Republic, and Cyprus) and we have customers in the EU and the UK. Accordingly, we are subject to the General Data Protection Regulation (EU) 2016/679 (the “GDPR”), and related member state implementing legislation, and to the UK’s Data Protection Act 2018 (collectively, “European Data Protection Law”). European Data Protection Law places obligations on controllers and processors of personal data, while establishing rights for individuals with respect to their personal data, including rights of access and deletion in certain circumstances. European Data Protection Law is also explicitly extraterritorial in its application, and could affect our business activities in jurisdictions outside the EU and the UK.\nWe have implemented measures designed to comply with the requirements of European Data Protection Law. In respect of these measures, we rely on positions and interpretations of the law (including European Data Protection Law) that have yet to be fully tested before the relevant courts and regulators. If a regulator or court of competent jurisdiction determined that one or more of our compliance efforts does not satisfy the applicable requirements of the law (including European Data Protection Law), or if any party brought a claim in this regard, we could be subject to governmental or regulatory investigations, enforcement actions, regulatory fines, compliance orders, litigation or public statements against us by consumer advocacy groups or others, any of which could cause customers to lose trust in us or otherwise damage our reputation. Likewise, a change in guidance could be costly and have an adverse effect on our business.\nThe requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nEuropean Data Protection Law also imposes strict rules on the transfer of personal data out of the EU/UK to third countries deemed to lack adequate privacy protections (including the United States), unless an appropriate safeguard specified by the GDPR is implemented, such as the Standard Contractual Clauses (“SCCs”), approved by the European Commission, or a derogation applies. The Court of Justice of the EU (the “CJEU”), recently deemed that the SCCs are valid. However, the CJEU ruled that transfers made pursuant to the SCCs and other alternative transfer mechanisms need to be analyzed on a case-by-case basis to ensure EU standards of data protection are met in the jurisdiction where the data importer is based, and there continue to be concerns about whether the SCCs and other mechanisms will face additional challenges. EU regulators have announced that there will be further guidance issued on these topics, but such guidance has yet to be finalized. We rely on SCCs and certain derogations to transfer personal data from the EU and the UK to the United States and Russia. Until the remaining legal uncertainties regarding how to legally continue transfers pursuant to the SCCs and other mechanisms are settled, we will continue to face uncertainty as to whether our efforts to comply with our obligations under European Data Protection Law are sufficient. European or multi-national customers may refuse or be reluctant to use or continue to use our platform or products as a result of such developments until law makers and regulators in the EU and the United States have resolved the issues that instigated the decision of the CJEU noted above. This and other future developments regarding the flow of data across borders could increase the cost and complexity of delivering our platform and products in some markets and may lead to governmental enforcement actions, litigation, fines, and penalties or adverse publicity, which could have an adverse effect on our reputation and business.\n67\nThe relationship between the UK and the EU in relation to certain aspects of data protection law remains unclear. In addition, it is likely that documentation will need to be put in place between UK entities and entities in EU member states to ensure adequate safeguards are in place for data transfers, which may result in us incurring additional costs with respect to transfers of personal data between the EU and the UK. We may find it necessary or advantageous to join industry bodies, or self-regulatory organizations, that impose stricter compliance requirements than those set out in applicable laws, including European Data Protection Laws. We may also be bound by contractual restrictions that prevent us from participating in data processing activities that would otherwise be permissible under applicable laws, including European Data Protection Laws. Such strategic choices may impact our ability to exploit data and may have an adverse impact on our business.\nAs we maintain offices in Russia, we face particular privacy, data security, and data protection risks in connection with requirements of Russia’s data protection and security laws, including Federal Law of 21 July 2014 No. 242-FZ, which entered into effect September 1, 2015, Federal Law of 27 July 2006 No. 152-FZ (as amended) and Federal Law of 27 July 2006 No. 149-FZ (as amended). Among other stringent requirements, these laws require ensuring that certain operations on personal data of Russian citizens are conducted in database(s) located in Russia.\nWe expect that there will continue to be new proposed laws, regulations, and industry standards concerning privacy, data protection, and information security in the United States, the EU, and other jurisdictions, and we cannot yet determine the impact such future laws, regulations, and standards may have on our business.\nThese and other legal requirements could require us to make additional changes to our platform or products in order for us or our customers to comply with such legal requirements or reduce our ability to lawfully collect personal data used in our platform and products. These changes could reduce demand for our platform or products, require us to take on more onerous obligations in our contracts, restrict our ability to store, transfer, and process personal data or, in some cases, impact our ability or our customers’ ability to offer our products in certain locations, to deploy our solutions, to reach current and prospective customers, or to derive insights from data globally.\nThe costs of complying with existing or new data privacy or data protection laws and regulations, regulatory guidance, our privacy policies and contractual obligations to customers, users, or other third parties, may limit the use and adoption of our platform and products, reduce overall demand for our products, make it more difficult for us to meet expectations from or commitments to customers and users, lead to significant fines, penalties, or liabilities for noncompliance, impact our reputation, or slow the pace at which we close sales transactions, any of which could harm our business.\nFurthermore, the uncertain and shifting regulatory environment and trust climate may cause concerns regarding data privacy and may cause our vendors, customers and users to resist providing the data necessary to allow us to offer our platform and products to our customers and users effectively, or could prompt individuals to opt out of our collection of their personal data. Even the perception that the privacy of personal data is not satisfactorily protected or does not meet regulatory requirements could discourage prospective customers from subscribing to our products or discourage current customers from renewing their subscriptions.\nCompliance with any of the foregoing laws and regulations can be costly and can delay or impede the development of new products. We may incur substantial fines if we violate any laws or regulations relating to the collection or use of personal data. For example, the GDPR imposes sanctions for violations up to the greater of €20 million and 4% of worldwide gross annual revenue, enables individuals to claim damages resulting from infringement of the GDPR and introduces the right for non-profit organizations to bring claims on behalf of data subjects. CCPA allows for fines of up to $7,500 for each violation (affected individual) that a business does not cure within 30 days of receiving notice of the violation. Non-compliance with Russian data localization rules may result in imposition of an administrative fine of up to\n68\nRUB 18 million, or approximately $240,000, for each violation. Our actual or alleged failure to comply with applicable privacy or data security laws, regulations, and policies, or to protect personal data, could result in enforcement actions and significant penalties against us, which could result in negative publicity or costs, subject us to claims or other remedies, and have a material adverse effect on our business, financial condition, and results of operations.\nMany aspects of data protection and privacy laws are relatively new and their scope has not been tested in the courts. As a result, these laws and regulations are subject to differing interpretations and may be inconsistent among jurisdictions. It is possible that these laws and regulations may be interpreted and applied in a manner that is inconsistent with our interpretations and existing data management practices or the features of our products. Certain of our activities could be found by a court, government or regulatory authority to be noncompliant or become noncompliant in the future with one or more data protection or data privacy laws, even if we have implemented and maintained a strategy that we believe to be compliant. Further, we may be subject to additional risks associated with data security breaches or other incidents, in particular because certain data privacy laws, including the GDPR and CCPA, grant individuals a private right of action arising from certain data security incidents. If so, in addition to the possibility of fines, lawsuits, and other claims and penalties, we could be required to fundamentally change our business activities and practices or modify our products, which could harm our business.\nWe also receive personal data from third-party vendors (e.g., data brokers). We may not be able to verify with complete certainty the source of such data, how it was collected, and that such data was collected and is being shared with us in compliance with all applicable data protection and privacy laws. Our use of personal data obtained from third-party vendors could result in potential regulatory investigations, fines, penalties, compliance orders, liability, litigation, and remediation costs, as well as reputational harm, any of which could materially adversely affect our business and financial results. The requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\nChanges in legislation or requirements related to automatically renewing subscription plans, or our failure to comply with existing or future regulations, may adversely impact our business.\nOur business relies heavily on the fact that customers enter subscription contracts where they agree that the subscription will automatically renew for a new term, and their credit or debit cards will automatically be charged on an ongoing basis, unless the subscription is canceled by the customer. Some states have passed or considered legislation limiting the duration for which subscriptions can automatically renew, if at all.\nAlthough this enacted and proposed legislation generally would not affect companies that sell subscriptions to other companies, like ours does, there could be variances and inconsistencies in these rules or requirements among jurisdictions that expose us to compliance risks that would have a material adverse effect on our business operations and financial condition, and could result in fines, penalties, damages, civil liability, and higher transaction fees. In addition, any costs that result from future legislation and regulations, or from changes in the interpretation of existing legislation and regulations, could individually or in the aggregate cause us to change or limit our business practices, which may make our subscription business model less attractive.\nChanges in laws and regulations related to the internet or changes in the internet infrastructure itself may diminish the demand for our platform and could harm our business.\n69\nThe future success of our business depends upon the continued use of the internet as a primary medium for commerce, communication, and business applications. Federal, state, or foreign governmental bodies or agencies have in the past adopted, and may in the future adopt, laws or regulations affecting the use of the internet as a commercial medium. The adoption of any laws or regulations that could reduce the growth or use of the internet, including laws or practices limiting internet neutrality, could decrease the demand for, or the usage of, our platform and products, increase our cost of doing business, require us to modify our platform or financial systems, and may harm our results of operations. In addition, government agencies or private organizations have imposed and may impose additional taxes, fees, or other charges for accessing the internet or commerce conducted via the internet, which could limit the growth of internet-related commerce or communications generally, result in higher prices for our products and platform, or result in reduced demand for internet-based products such as ours.\nAs the internet continues to experience growth in the number of users, frequency of use, and amount of data transmitted, the internet infrastructure that we and our customers rely on may be unable to support the demands placed upon it. In addition, there could be adverse effects from delays in the development or adoption of new standards and protocols to handle increased demands of internet activity, security, reliability, cost, ease-of-use, accessibility, and quality of service. Further, our platform depends on the quality of our customers’ access to the internet. The failure of the internet infrastructure that we or our customers rely on, even for a short period of time, could undermine our operations and harm our results of operations.\nInternet access is frequently provided by companies that have significant market power that could take actions that degrade, disrupt, or increase the cost of customer access to our platform, any of which would negatively impact our business. On June 11, 2018, the repeal of the Federal Communications Commission’s, or the FCC, “net neutrality” rules took effect and returned to a “light-touch” regulatory framework. The prior rules were designed to ensure that all online content is treated the same by internet service providers and other companies that provide broadband services. Additionally, on September 30, 2018, California enacted the California internet Consumer Protection and Net Neutrality Act of 2018, making California the fourth state to enact a state-level net neutrality law since the FCC repealed its nationwide regulations, mandating that all broadband services in California must be provided in accordance with state net neutrality requirements. The U.S. Department of Justice has sued to block the law going into effect, and California has agreed to delay enforcement until the resolution of the FCC’s repeal of the federal rules. A number of other states are considering legislation or executive actions that would regulate the conduct of broadband providers. We cannot predict whether the FCC order or state initiatives will be modified, overturned, or vacated by legal action of the court, federal legislation or the FCC. With the repeal of net neutrality rules, network operators may choose to implement usage-based pricing, discount pricing charged to providers of competitive products, otherwise materially change their pricing rates or schemes, charge us to deliver our traffic or throttle its delivery, implement bandwidth caps or other usage restrictions or otherwise try to monetize or control access to their networks, any of which could increase our costs, or those of our customers in accessing our platform, and negatively impact our business and results of operations.\nFederal, state, and foreign laws regulate internet tracking software, the sending of commercial emails and text messages, and other activities, which could impact the use of our platform and products, and potentially subject us to regulatory enforcement or private litigation.\nWe are subject to laws and regulations that govern sending marketing and advertising by electronic means, such email and telephone. For example, in the United States, the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003, or the CAN-SPAM Act, among other things, obligates the sender of commercial emails to provide recipients with the ability to opt out of receiving future commercial emails from the sender. In addition, the Telephone Consumer Protection Act imposes certain notice, consent, and opt-out obligations on companies that send telephone or text communications using auto dialers to consumers, and provides consumers with private rights of action for violations. Further,\n70\ncertain states and foreign jurisdictions, such as Australia, Canada, and the EU, have enacted laws that prohibit sending unsolicited marketing emails unless the recipient has provided its prior consent to receipt of such email, or in other words has “opted-in” to receiving it. A requirement that recipients opt into, or the ability of recipients to opt out of, receiving commercial emails may minimize the effectiveness of our marketing, which could adversely affect our ability to attract new customers or entice existing customers to upgrade their subscriptions.\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that could impair our ability to compete in international markets or subject us to liability if we violate such laws and regulations.\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that prohibit the provision of certain products and services to certain countries, governments, and persons targeted by U.S. sanctions. We are in the process of implementing certain precautions to prevent our platform and products from being exported or accessed in violation of U.S. export controls or U.S. sanctions laws and regulations. However, we cannot be certain that the precautions we take will prevent all violations of these laws.\nWe have previously identified, and may continue to identify, customer accounts for our platform and products that may originate from, or are intended to benefit, persons in countries that are subject to U.S. embargoes, including transactions or events in or relating to Cuba, Iran, North Korea, Syria, and the Crimea region of Ukraine. We have recently submitted a voluntary self-disclosure to the U.S. Department of the Treasury’s Office of Foreign Assets Control, or OFAC, regarding potential violations of OFAC regulations that may have involved the provision of services to customers in sanctioned countries. We have not yet obtained a determination from OFAC.\nIf we are found to be in violation of U.S. sanctions or export control laws, we may be fined or other penalties could be imposed. Furthermore, changes in export control or economic sanctions laws and enforcement could also result in increased compliance requirements and related costs, which could materially adversely affect our business, results of operations, financial condition and/or cash flows.\nWe are also subject to various U.S. and international anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act and the UK Bribery Act, as well as other similar anti-bribery and anti-kickback laws and regulations. These laws and regulations generally prohibit companies and their employees and intermediaries from authorizing, offering, or providing improper payments or benefits to government officials and other recipients for improper purposes. Our exposure for violating these laws may increase as we continue to expand our international presence, and any failure to comply with such laws could harm our business.\nOur internal controls over financial reporting currently do not meet all of the standards contemplated by Section 404 of the Sarbanes-Oxley Act of 2002, as amended (“SOX”), and failure to achieve and maintain effective internal controls over financial reporting in accordance with Section 404 of SOX could impair our ability to produce timely and accurate financial statements or comply with applicable regulations and have a material adverse effect on our business. In the future, our disclosure controls and procedures may not prevent or detect all errors or acts of fraud.\nAs a public company, we are subject to certain reporting requirements of the Exchange Act and have significant requirements for enhanced financial reporting and internal controls. Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC. The process of designing and implementing effective internal controls is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments, and to expend significant resources to maintain a system of internal controls that is\n71\nadequate to satisfy our reporting obligations as a public company. If we are unable to establish or maintain appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations on a timely basis, result in material misstatements in our consolidated financial statements, and harm our operating results. We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements or insufficient disclosures due to error or fraud may occur and not be detected.\nIn addition, we are required pursuant to Section 404 of SOX, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting in the Annual Report on Form 10-K for the year ended December 31, 2022. This assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting. The rules governing the standards that must be met for our management to assess our internal control over financial reporting are complex and require significant documentation, testing, and possible remediation. Testing and maintaining internal controls may divert management’s attention from other matters that are important to our business. Beginning with our Annual Report on Form 10-K for the year ended December 31, 2022, our independent registered public accounting firm may be required to attest to the effectiveness of our internal control over financial reporting on an annual basis. However, while we remain an emerging growth company, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting. If we are not able to complete our initial assessment of our internal controls and otherwise implement the requirements of Section 404 of SOX in a timely manner or with adequate compliance, our independent registered public accounting firm may not be able to certify as to the adequacy of our internal controls over financial reporting. Additionally, when required, an independent assessment of the effectiveness of our internal controls over financial reporting could detect problems that our management’s assessment might not. Undetected material weaknesses in our internal controls over financial reporting could lead to financial statement restatements and require us to incur the expense of remediation.\nMatters impacting our internal controls may cause us to be unable to report our financial information on a timely basis and thereby subject us to adverse regulatory consequences, including sanctions by the SEC or violations of applicable stock exchange listing rules, which may result in a breach of the covenants under existing or future financing arrangements. There also could be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements. Confidence in the reliability of our financial statements also could suffer if we or our independent registered public accounting firm report a material weakness in our internal controls over financial reporting. This could materially adversely affect us and lead to a decline in the market price of our Class A common stock.\nIn connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operations of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\nWe have implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting to remediate this material weakness. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting.\n72\nWe expect to incur additional costs to remediate the control deficiencies identified, though there can be no assurance that our efforts will be successful or avoid potential future material weaknesses. If we are unable to successfully remediate our existing or any future material weaknesses in our internal control over financial reporting, or if we identify any additional material weaknesses, the accuracy and timing of our financial reporting may be adversely affected, we may be unable to maintain compliance with securities law requirements regarding timely filing of periodic reports in addition to applicable stock exchange listing requirements, investors may lose confidence in our financial reporting, and our stock price may decline as a result. We also could become subject to investigations by the New York Stock Exchange (“NYSE”), the SEC or other regulatory authorities.\nOur internal resources and personnel may in the future be insufficient to avoid accounting errors and there can be no assurance that we will not have additional material weaknesses in the future. Any failure to develop or maintain effective controls or any difficulties encountered implementing required new or improved controls could harm our operating results or cause us to fail to meet our reporting obligations and may result in a restatement of our financial statements for prior periods. Any failure to implement and maintain effective internal control over financial reporting also could adversely affect the results of periodic management evaluations and annual independent registered public accounting firm attestation reports regarding the effectiveness of our internal control over financial reporting that we will eventually be required to include in our periodic reports that will be filed with the SEC. Ineffective disclosure controls, procedures, and internal control over financial reporting could also cause investors to lose confidence in our reported financial and other information, which would likely have a negative effect on the trading price of our common stock. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on the NYSE.\nUnanticipated changes in our effective tax rate and additional tax liabilities may impact our financial results.\nWe are subject to income taxes in the United States and various jurisdictions outside of the United States. Our income tax obligations are generally determined based on our business operations in these jurisdictions. Significant judgment is often required in the determination of our worldwide provision for income taxes. Our effective tax rate could be impacted by changes in the earnings and losses in countries with differing statutory tax rates, changes in non-deductible expenses, changes in excess tax benefits of stock-based compensation, changes in the valuation of deferred tax assets and liabilities and our ability to utilize them, the applicability of withholding taxes, effects from acquisitions, changes in accounting principles and tax laws in jurisdictions where we operate. Any changes, ambiguity, or uncertainty in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions could also materially impact our income tax liabilities.\nAs our business continues to grow and if we become more profitable, we anticipate that our income tax obligations could significantly increase. If our existing tax credits and net operating loss carry-forwards become fully utilized, we may be unable to offset or otherwise mitigate our tax obligations to the same extent as in prior years. This could have a material impact to our future cash flows or operating results.\nIn addition, recent global tax developments applicable to multinational companies, including certain approaches of addressing taxation of digital economy recently proposed or enacted by the Organisation for Economic Co-operation and Development, the European Commission or certain major jurisdictions where we operate or might in the future operate, might have a material impact to our business and future cash flow from operating activities, or future financial results. We are also subject to tax examinations in multiple jurisdictions. While we regularly evaluate new information that may change our judgment resulting in recognition, derecognition, or changes in measurement of a tax position taken, there can be no assurance that the final determination of any examinations will not have an adverse effect on our operating results and financial position. In addition, our operations may change, which may impact our tax liabilities. As our brand becomes increasingly recognizable both domestically and internationally, our tax\n73\nplanning structure and corresponding profile may be subject to increased scrutiny, and if we are perceived negatively, we may experience brand or reputational harm.\nWe may also be subject to additional tax liabilities and penalties due to changes in non-income based taxes resulting from changes in federal, state, or international tax laws, changes in taxing jurisdictions’ administrative interpretations, decisions, policies and positions, results of tax examinations, settlements or judicial decisions, changes in accounting principles, and changes to the business operations, including acquisitions, as well as the evaluation of new information that results in a change to a tax position taken in a prior period. Any resulting increase in our tax obligation or cash taxes paid could adversely affect our cash flows and financial results.\nOur international operations may subject us to greater than anticipated tax liabilities.\nWe are expanding our international operations to better support our growth into international markets. Our corporate structure and associated transfer pricing policies contemplate future growth in international markets, and consider the functions, risks, and assets of the various entities involved in intercompany transactions. The amount of taxes we pay in different jurisdictions may depend on the application of the tax laws of various jurisdictions, including the United States, to our international business activities, changes in tax rates, new or revised tax laws or interpretations of existing tax laws and policies, and our ability to operate our business in a manner consistent with our corporate structure and intercompany arrangements. The taxing authorities of the jurisdictions in which we operate may challenge our methodologies for pricing intercompany transactions pursuant to our intercompany arrangements or disagree with our determinations as to the income and expenses attributable to specific jurisdictions. If such a challenge or disagreement were to occur, and our position was not sustained, we could be required to pay additional taxes, interest, and penalties, which could result in one-time tax charges, higher effective tax rates, reduced cash flows, and lower overall profitability of our operations and we may be required to revise our intercompany agreements. Our financial statements could fail to reflect adequate reserves to cover such a contingency.\nRisks Related to Our Intellectual Property\nWe may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\nOur success is dependent, in part, upon protecting our proprietary information and technology. Our intellectual property portfolio primarily consists of registered and unregistered trademarks, unregistered copyrights, domain names, know-how, and trade secrets. We may be unsuccessful in adequately protecting our intellectual property. No assurance can be given that confidentiality, non-disclosure, or invention or copyright assignment agreements with employees, consultants, partners or other parties have been entered into, will not be breached, or will otherwise be effective in establishing our rights in intellectual property and in controlling access to and distribution of our platform, or certain aspects of our platform, and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our platform. Additionally, certain unauthorized use of our intellectual property may go undetected, or we may face legal or practical barriers to enforcing our legal rights even where unauthorized use is detected.\nCurrent laws may not provide for adequate protection of our platform or data, especially in foreign jurisdictions which may have laws that provide insufficient protections to companies. In addition, legal standards relating to the validity, enforceability, and scope of protection of proprietary rights in internet-related businesses are uncertain and evolving, and changes in these standards may adversely impact the viability or value of our proprietary rights. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our products, or certain aspects of our platform, or our data may be unenforceable under the laws of certain jurisdictions. Further, the laws of some countries do not protect\n74\nproprietary rights to the same extent as the laws of the United States, and the laws and mechanisms for protection and enforcement of intellectual property rights in some foreign countries may be inadequate. As we continue to operate in foreign countries and expand our international activities, we have encountered and may in the future encounter challenges in navigating the laws of foreign countries, which may adversely affect our ability to protect our proprietary rights and subject us to claims from current or former personnel and other third parties. Moreover, our exposure to unauthorized copying of certain aspects of our platform, or our data may increase. Further, competitors, foreign governments, foreign government-backed actors, criminals, or other third parties may gain unauthorized access to our proprietary information and technology. Accordingly, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our technology and intellectual property or claiming that we infringe upon or misappropriate their technology and intellectual property.\nTo protect our intellectual property rights, we may be required to spend significant resources to monitor, protect, and defend these rights, and we may or may not be able to detect infringement by our customers or third parties. Litigation has been and may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of portions of our intellectual property. Furthermore, our efforts to enforce our intellectual property rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of our intellectual property rights. Our inability to protect our proprietary technology against unauthorized copying or use, as well as any costly litigation or diversion of our management’s attention and resources, could delay further sales or the implementation of our platform, impair the functionality of our platform, delay introductions of new features, integrations, and capabilities, result in our substituting inferior or more costly technologies into our platform, or injure our reputation. In addition, we may be required to license additional technology from third parties to develop and market new features, integrations, and capabilities, and we cannot be certain that we could license that technology on commercially reasonable terms or at all, and our inability to license this technology could harm our ability to compete.\nIf third parties claim that we infringe upon or otherwise violate their intellectual property rights, our business could be adversely affected.\nWe have in the past and may in the future be subject to claims that we have infringed or otherwise violated third parties’ intellectual property rights. There is patent, copyright, and other intellectual property development and enforcement activity in our industry and relating to the technology we use in our business. Our future success depends in part on not infringing upon or otherwise violating the intellectual property rights of others. From time to time, our competitors or other third parties (including non-practicing entities and patent holding companies) may claim that we are infringing upon or otherwise violating their intellectual property rights, and we may be found to be infringing upon or otherwise violating such rights. In addition, we do not own any issued, nor do we have any pending patents, which limits our ability to deter patent infringement claims by competitors and other third parties who hold patents. We may be unaware of the intellectual property rights of others that may cover some or all of our current or future technology or conflict with our rights, and the patent, copyright, and other intellectual property rights of others may limit our ability to improve our technology and compete effectively. Any claims of intellectual property infringement or other intellectual property violations, even those without merit, could:\n•be expensive and time consuming to defend;\n•cause us to cease making, licensing or using our platform or products that incorporate the challenged intellectual property;\n•require us to modify, redesign, reengineer or rebrand our platform or products, if feasible;\n•divert management’s attention and resources; or\n75\n•require us to enter into royalty or licensing agreements to obtain the right to use a third-party’s intellectual property.\nAny royalty or licensing agreements, if required, may not be available to us on acceptable terms or at all. A successful claim of infringement against us could result in our being required to pay significant damages, enter into costly settlement agreements, or prevent us from offering our platform or products, any of which could have a negative impact on our operating profits and harm our future prospects. We may also be obligated to indemnify our customers or business partners in connection with any such litigation and to obtain licenses, modify our platform or products, or refund premium subscription fees, which could further exhaust our resources. Such disputes could also disrupt our platform or products, adversely affecting our customer satisfaction and ability to attract customers.\nOur use of “open source” software could negatively affect our ability to offer and sell access to our platform and products, and subject us to possible litigation.\nWe use open source software in our platform and products, and expect to continue to use open source software in the future. There are uncertainties regarding the proper interpretation of and compliance with open source licenses, and there is a risk that such licenses could be construed in a manner that imposes unanticipated conditions or restrictions on our ability to use such open source software, and consequently to provide or distribute our platform and products. Although use of open source software has historically been free, recently several open source providers have begun to charge license fees for use of their software. If our current open source providers were to begin to charge for these licenses or increase their license fees significantly, we would have to choose between paying such license fees or incurring the expense to replace the open source software with other software or with our own software, which would increase our research and development costs, and have a negative impact on our results of operations and financial condition.\nAdditionally, we may from time to time face claims from third parties claiming ownership of, or seeking to enforce the terms of, an open source license, including by demanding release of source code for the open source software, derivative works or our proprietary source code that was developed using or that is distributed with such open source software. These claims could also result in litigation and could require us to make our proprietary software source code freely available, require us to devote additional research and development resources to change our platform or incur additional costs and expenses, any of which could result in reputational harm and would have a negative effect on our business and operating results. In addition, if the license terms for the open source software we utilize change, we may be forced to reengineer our platform or incur additional costs to comply with the changed license terms or to replace the affected open source software. Further, use of certain open source software can lead to greater risks than use of third-party commercial software, as open source licensors generally do not provide warranties or controls on the origin of software or indemnification for third-party infringement claims. Although we have implemented policies to regulate the use and incorporation of open source software into our platform and products, we cannot be certain that we have not incorporated open source software in our platform and products in a manner that is inconsistent with such policies.\nIndemnity provisions in various agreements potentially expose us to substantial liability for intellectual property infringement and other losses.\nOur agreements with resellers and other third parties may include indemnification or other provisions under which we agree to indemnify or otherwise be liable to them for losses suffered or incurred as a result of claims of intellectual property infringement, damages caused by us to property or persons, or other liabilities relating to or arising from our platform, products or other acts or omissions. For some of our larger customers, we sometimes negotiate similar indemnification provisions or indemnification for breaches of our obligations, representations or warranties in the subscription agreement, gross negligence or willful misconduct, breaches of confidentiality, losses related to security incidents, breach of the data processing addendum or violations of applicable law. In some instances, the term of these\n76\ncontractual provisions survives the termination or expiration of the applicable agreement. Large indemnity payments or damage claims from contractual breach could harm our business, operating results, and financial condition.\nFrom time to time, third parties may assert infringement claims against our customers or resellers. These claims may require us to initiate or defend protracted and costly litigation on behalf of customers and resellers, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of our customers and resellers or may be required to obtain licenses for the platform or products they use or resell or modify our platform or products. We may not be able to obtain all necessary licenses on commercially reasonable terms, or at all, or to make such modifications to avoid a claim, in which case our customers and resellers may be required to stop using or reselling our platform or products. Further, customers may require us to indemnify or otherwise be liable to them for breach of confidentiality or failure to implement adequate security measures with respect to their data stored, transmitted or processed by our employees or platform. Although we normally contractually limit our liability with respect to such obligations, we may still incur substantial liability related to them. Any dispute with a customer with respect to such obligations could have adverse effects on our relationship with that customer and other current and prospective customers, reduce demand for our platform or products, and harm our revenue, business, and operating results.\nRisks Related to Ownership of Our Class A Common Stock\nWe are an emerging growth company and we cannot be certain that the reduced disclosure requirements applicable to emerging growth companies will not make our Class A common stock less attractive to investors.\nWe are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\nFor as long as we continue to be an emerging growth company, we also intend to take advantage of certain other exemptions from various reporting requirements that are applicable to other public companies including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports, proxy statements, and registration statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We cannot predict if investors will find our Class A common stock less attractive because we will rely on these exemptions. If some investors find our Class A common stock less attractive as a result, there may be a less active trading market for our Class A common stock and our stock price may be more volatile.\nWe will remain an emerging growth company until the earliest of (i) the last day of the year in which we have total annual gross revenue of $1.07 billion or more, (ii) December 31, 2026, (iii) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous three years, or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.\n77\nWe are subject to costs, regulations and requirements as a result of being a public company, which could impair our profitability, make it more difficult to run our business, or divert management’s attention from our business.\nAs a public company, and particularly after we are no longer an emerging growth company, we are required to commit significant resources, management time, and attention to the requirements of being a public company, which causes us to incur significant legal, accounting, and other expenses, including costs associated with public company reporting requirements, and recruiting and retaining independent directors. We also have incurred and will continue to incur costs associated with SOX and the Dodd-Frank Wall Street Reform and Consumer Protection Act and related rules implemented by the SEC and the NYSE, and compliance with these requirements will place significant demands on our legal, accounting, and finance staff and on our accounting, financial, and information systems. The expenses incurred by public companies generally for reporting and corporate governance purposes have been increasing. These rules and regulations may increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In addition, we might not be successful in implementing these requirements. These laws and regulations also could make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors (the “Board”) or Board committees or as our executive officers. Furthermore, if we are unable to continue to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nAn active public market for our Class A common stock may not be sustained and could be highly volatile, and you may not be able to resell your shares at or above your original purchase price, if at all.\nWe have a limited trading history. The market price of our Class A common stock could be highly volatile and may fluctuate substantially as a result of many factors, including:\n•actual or anticipated fluctuations in our results of operations;\n•variance in our results of operation from the expectations of market analysts;\n•announcements by us or our competitors of significant business developments, changes in service provider relationships, acquisitions or expansion plans;\n•changes in the prices of our products;\n•our involvement in litigation;\n•our sale of Class A common stock or other securities in the future;\n•market conditions in our industry;\n•changes in key personnel;\n•the trading volume of our Class A common stock;\n•changes in the estimation of the future size and growth rate of our markets; and\n•general economic and market conditions.\n78\nIn addition, the stock markets have experienced extreme price and volume fluctuations. Broad market and industry factors may materially harm the market price of our Class A common stock, regardless of our results of operation. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. If we were involved in any similar litigation we could incur substantial costs, and our management’s attention and resources could be diverted.\nIf you purchase shares of our Class A common stock, you may not be able to resell those shares at or above the price you originally paid. An active or liquid market in our Class A common stock may not be sustainable, which could adversely affect your ability to sell your shares and could depress the market price of our Class A common stock.\nThe issuance of additional stock in connection with financings, acquisitions, investments, our stock incentive plans or otherwise will dilute all other stockholders.\nOur amended and restated certificate of incorporation authorizes us to issue up to 1,000,000,000 shares of Class A common stock and up to 100,000,000 shares of preferred stock with such rights and preferences as may be determined by our Board. Subject to compliance with applicable rules and regulations, we may issue our shares of Class A common stock or securities convertible into our Class A common stock from time to time in connection with a financing, acquisition, investment, our stock incentive plans or otherwise. Any such issuance could result in substantial dilution to our existing stockholders and cause the trading price of our Class A common stock to decline.\nA total of 124,905,954, or approximately 93%, of the outstanding shares of our Class A and Class B common stock are restricted from immediate resale, but may be sold on a stock exchange in the near future. The large number of shares eligible for public sale or subject to rights requiring us to register them for public sale could depress the market price of our Class A common stock.\nThe market price of our Class A common stock could decline as a result of sales of a large number of shares of our Class A common stock in the market, and the perception that these sales could occur may also depress the market price of our Class A common stock. We, our executive officers, directors, and the holders of substantially all of our capital stock and securities convertible into or exchangeable for our capital stock outstanding prior to our IPO have entered into lock-up agreements with the underwriters under which they have agreed, subject to specific exceptions and early release triggers, not to sell any of our stock for 180 days following March 24, 2021. Following the expiration of this period and subject to applicable securities laws, such shares may be sold on the public market.\nStockholders owning an aggregate of up to 36,750,000 shares of our Class B common stock are entitled, under contracts providing for registration rights, to require us to register shares owned by them for public sale in the United States. In addition, we filed a registration statement on Form S-8 on March 25, 2021, to register 24,114,926 shares of our Class A common stock under our equity compensation plans.\nSales of our shares as restrictions end or pursuant to registration rights may make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. These sales also could cause the trading price of our Class A common stock to fall and make it more difficult for you to sell shares of our Class A common stock.\nIf we do not meet the expectations of equity research analysts, if they do not publish research or reports about our business or if they issue unfavorable commentary or downgrade our Class A common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will depend in part on the research and reports that equity research analysts publish about us and our business. The analysts’ estimates are based upon their\n79\nown opinions and are often different from our estimates or expectations. If our results of operations are below the estimates or expectations of public market analysts and investors, our stock price could decline. Moreover, the price of our Class A common stock could decline if one or more securities analysts downgrade our Class A common stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.\nWe cannot predict the impact our dual structure may have on the market price of our Class A common stock.\nWe cannot predict whether our dual class structure, combined with the concentrated control of our stockholders who held our capital stock prior to the completion of our IPO, including our executive officers, employees, and directors and their affiliates, will result in a lower or more volatile market price of our Class A common stock or in adverse publicity or other adverse consequences. For example, certain index providers have announced restrictions on including companies with multiple class share structures in certain of their indices. In July 2017, FTSE Russell and Standard & Poor’s announced that they would cease to allow most newly public companies utilizing dual or multi-class capital structures to be included in their indices. Under the announced policies, our dual class capital structure would make us ineligible for inclusion in any of these indices. Given the sustained flow of investment funds into passive strategies that seek to track certain indexes, exclusion from stock indexes would likely preclude investment by many of these funds and could make our Class A common stock less attractive to other investors. As a result, the market price of our Class A common stock could be adversely affected.\nThe dual class structure of our common stock has the effect of concentrating voting control with those stockholders who held our capital stock prior to the completion of our IPO, including our directors, executive officers, and their affiliates, who as of March 31, 2021 held in aggregate 93% of the voting power of our capital stock, which will limit or preclude your ability to influence corporate matters.\nOur Class B common stock has ten votes per share, and our Class A common stock has one vote per share. As of March 31, 2021, our directors, executive officers, and their affiliates, held in the aggregate 93% of the voting power of our capital stock. Because of the ten-to-one voting ratio between our Class B common stock and Class A common stock, the holders of our Class B common stock collectively will continue to control a majority of the combined voting power of our common stock and therefore will be able to control all matters submitted to our stockholders for approval until the earlier of (a) the seven year anniversary of the closing of our IPO (b) such time as the outstanding shares of Class B common stock represent less than ten percent of the aggregate number of shares of our outstanding common stock and (c) the date the holders of two-thirds of our Class B common stock elect to convert the Class B common stock to Class A common stock. This concentrated control may limit or preclude your ability to influence corporate matters for the foreseeable future, including the election of directors, amendments of our organizational documents, and any merger, consolidation, sale of all or substantially all of our assets, or other major corporate transaction requiring stockholder approval. In addition, this may prevent or discourage unsolicited acquisition proposals or offers for our capital stock that you may feel are in your best interest as one of our stockholders.\nFuture transfers by holders of Class B common stock will generally result in those shares converting to Class A common stock, subject to limited exceptions, such as certain transfers effected for estate planning purposes. The conversion of Class B common stock to Class A common stock will have the effect, over time, of increasing the relative voting power of those holders of Class B common stock who retain their shares in the long term.\nWe do not expect to declare any dividends in the foreseeable future.\nWe do not anticipate declaring any cash dividends to holders of our common stock in the foreseeable future. In addition, our credit facility places restrictions on our ability to pay cash dividends. Consequently,\n80\ninvestors may need to rely on sales of their Class A common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment. Investors seeking cash dividends should not purchase our Class A common stock.\nProvisions in our charter documents and under Delaware law could make an acquisition of our company more difficult, limit attempts by our stockholders to replace or remove our current Board, and limit the market price of our Class A common stock.\nProvisions in our amended and restated certificate of incorporation and amended and restated bylaws may have the effect of delaying or preventing a change of control or changes in our management. Our amended and restated certificate of incorporation and amended and restated bylaws, include provisions that:\n•provide that the authorized but unissued shares of our common stock and our preferred stock are available for future issuance without stockholder approval;\n•provide that our Board is classified into three classes of directors with staggered three-year terms;\n•permit the Board to establish the number of directors and fill any vacancies and newly created directorships;\n•require super-majority voting to amend some provisions in our amended and restated certificate of incorporation and amended and restated bylaws;\n•authorize the issuance of “blank check” preferred stock that our Board could use to implement a stockholder rights plan;\n•provide that only the Chairperson of our Board, our Chief Executive Officer, or a majority of our Board will be authorized to call a special meeting of stockholders;\n•provide for a dual class common stock structure in which holders of our Class B common stock have the ability to control the outcome of matters requiring stockholder approval, even if they own significantly less than a majority of the outstanding shares of our Class A and Class B common stock, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets;\n•prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders;\n•provide that the Board is expressly authorized to make, alter or repeal our bylaws; and\n•advance notice requirements for nominations for election to our Board or for proposing matters that can be acted upon by stockholders at annual stockholder meetings.\nMoreover, Section 203 of the Delaware General Corporation Law may discourage, delay, or prevent a change in control of our company. Section 203 imposes certain restrictions on mergers, business combinations, and other transactions between us and holders of 15% or more of our common stock.\nOur bylaws designate certain courts as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’\n81\nability to obtain a favorable judicial forum for disputes with us or our directors, officers, or employees.\nOur bylaws provide that, unless we consent in writing to an alternative forum, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for any state law claim for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of or based on a fiduciary duty owed by any of our current or former directors, officers, or employees to us or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, our amended and restated certificate of incorporation or our amended and restated bylaws (including the interpretation, validity or enforceability thereof) or (iv) any action asserting a claim that is governed by the internal affairs doctrine, in each case subject to the Court of Chancery having personal jurisdiction over the indispensable parties named as defendants therein, or the Delaware Forum Provision. The Delaware Forum Provision will not apply to any causes of action arising under the Securities Act or the Exchange Act. Our amended and restated bylaws further provide that, unless we consent in writing to the selection of an alternative forum, the federal district courts of the United States shall be the sole and exclusive forum for resolving any complaint asserting a cause of action arising under the Securities Act, or the Federal Forum Provision. In addition, our amended and restated bylaws provide that any person or entity purchasing or otherwise acquiring any interest in shares of our common stock is deemed to have notice of and consented to the foregoing provisions; provided, however, that stockholders cannot and will not be deemed to have waived our compliance with the federal securities laws and the rules and regulations thereunder.\nThe Delaware Forum Provision and the Federal Forum Provision in our amended and restated bylaws may impose additional litigation costs on stockholders in pursuing any such claims, particularly if the stockholders do not reside in or near the State of Delaware. Additionally, the forum selection clauses in our amended and restated bylaws may limit our stockholders’ ability to bring a claim in a forum that they find favorable for disputes with us or our directors, officers or employees, which may discourage such lawsuits against us and our directors, officers and employees even though an action, if successful, might benefit our stockholders. In addition, while the Delaware Supreme Court ruled in March 2020 that federal forum selection provisions purporting to require claims under the Securities Act be brought in federal court were “facially valid” under Delaware law, there is uncertainty as to whether other courts will enforce our Federal Forum Provision. If the Federal Forum Provision is found to be unenforceable, we may incur additional costs associated with resolving such matters. The Federal Forum Provision may also impose additional litigation costs on stockholders who assert that the provision is not enforceable or invalid. The Court of Chancery of the State of Delaware and the federal district courts of the United States may also reach different judgments or results than would other courts, including courts where a stockholder considering an action may be located or would otherwise choose to bring the action, and such judgments may be more or less favorable to us than our stockholders.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nUnregistered Sales of Equity Securities\nFrom January 1, 2021 through March 31, 2021, pursuant to our Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”) we issued and sold to our employees, consultants and other service providers an aggregate of 3,861 shares of common stock upon the exercise of options under our 2019 Plan at exercise prices ranging from $1.23 to $1.68 per share, for an aggregate exercise price of $5,207. These 3,861 shares of common stock were exchanged for an equal number of shares of our Class B common stock in connection with our IPO.\nFrom January 1, 2021 through March 31, 2021, pursuant to our 2021 Stock Option and Grant Plan we granted one employee an aggregate of 19,500 restricted stock units, with a grant date fair value $14 per restricted stock unit.\n82\nNone of the foregoing transactions involved any underwriters, underwriting discounts or commissions, or any public offering. The sales of the above securities were deemed to be exempt from registration under the Securities Act in reliance on Section 4(a)(2) of the Securities Act or Rule 701 promulgated under Section 3(b) of the Securities Act as transactions by an issuer not involving any public offering or pursuant to benefit plans and contracts relating to compensation as provided under Rule 701. The recipients of the securities in each of these transactions represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the securities issued in these transactions. All recipients had adequate access, through their relationships with us, to information about us. The sales of these securities were made without any general solicitation or advertising.\nUse of Proceeds From the IPO\nOn March 29, 2021, we closed the IPO, in which we issued 10,000,000 shares of Class A common stock, and on April 23, 2021 we closed the partial exercise of the underwriter’s option to purchase additional shares of our Class A common stock, in which we issued an additional 719,266 shares of Class A common stock, at a price to the public of $14.00 for aggregate net proceeds of $135,987 after deducting underwriting discounts and commissions of $10,505 and expenses payable by us of $3,578. The offer and sale of all of the shares in the IPO were registered under the Securities Act pursuant to the Prospectus. No payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries and to non-employee directors pursuant to our director compensation policy. There has been no material change in the planned use of proceeds from the IPO as described in the Prospectus. We invested the funds received in accordance with our Board approved investment policy, which provides for investments in obligations of the U.S. and foreign governments, money market instruments, registered money market funds, corporate and municipal bonds. Goldman, Sachs & Co. LLC, J.P. Morgan Securities LLC and Jefferies LLC acted as joint lead bookrunning managers of the IPO.\nItem 3. Defaults Upon Senior Securities\nNone.\nItem 4. Mine Safety Disclosures\nNot applicable.\nItem 5. Other Information\nNone.\nItem 6. Exhibits\nThe exhibits listed below are filed or incorporated by reference in this Quarterly Report on Form 10-Q.\n| Exhibit Number | Exhibit Title |\n| 3.1(1) | Amended and Restated Certificate of Incorporation of the Registrant |\n| 3.2(2) | Amended and Restated Bylaws of the Registrant |\n| 4.1(3) | Form of Common Stock certificate of the Registrant |\n\n83\n| 31.1* | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\n| 31.2* | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\n| 32.1+ | Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act |\n| 101.INS* | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page with Interactive Data File (formatted as Inline XBRL with applicable taxonomy extension information contained in Exhibits 101) |\n\n(1) File as Exhibit 3.2 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n(2) Filed as Exhibit 3.4 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n(3) Filed as Exhibit 4.1 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\n* Filed herewith.\n+ The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Quarterly Report on Form 10-Q and will not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference.\n84\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| SEMRUSH HOLDINGS, INC. |\n| May 11, 2021 | By: | /s/ Oleg Shchegolev |\n| Oleg Shchegolev |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n| May 11, 2021 | By: | /s/ Evgeny Fetisov |\n| Evgeny Fetisov |\n| Chief Financial Officer |\n| (Principal Financial Officer and Principal Accounting Officer) |\n\n85\n</text>\n\nIf the company plans to maintain an equal distribution of total assets and total liabilities and stockholders' equity by the end of 2021, along with a 10% increase in \"Deferred contract costs, net of current portion\" and \"Other long-term assets\" from March 2021 levels, what should be the new total of current assets in dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1. Financial Statements\\nSEMRUSH HOLDINGS, INC.\\nUNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS\\n(in thousands, except share and per share data)\\n| As of |\\n| March 31, 2021 | December 31, 2020 |\\n| Assets |\\n| Current assets |\\n| Cash and cash equivalents | $ | 171,867 | $ | 35,531 |\\n| Accounts receivable | 2,383 | 1,399 |\\n| Deferred contract costs, current portion | 4,817 | 4,049 |\\n| Prepaid expenses and other current assets | 3,626 | 2,649 |\\n| Total current assets | 182,693 | 43,628 |\\n| Property and equipment, net | 3,876 | 2,968 |\\n| Intangible assets, net | 2,176 | 2,231 |\\n| Goodwill | 1,991 | 1,991 |\\n| Deferred contract costs, net of current portion | 2,000 | 1,670 |\\n| Other long-term assets | 1,130 | 2,470 |\\n| Total assets | $ | 193,866 | $ | 54,958 |\\n| Liabilities, redeemable convertible preferred stock and stockholders’ equity (deficit) |\\n| Current liabilities |\\n| Accounts payable | $ | 10,233 | $ | 8,654 |\\n| Accrued expenses | 10,286 | 7,719 |\\n| Deferred revenue | 32,078 | 26,537 |\\n| Total current liabilities | 52,597 | 42,910 |\\n| Long-term liabilities |\\n| Deferred revenue, net of current portion | 181 | 123 |\\n| Deferred tax liability | 153 | 209 |\\n| Other long-term liabilities | 1,024 | 497 |\\n| Total liabilities | 53,955 | 43,739 |\\n| Commitments and contingencies (Note 11) |\\n| Series A redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 3,379,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 8,000 at December 31, 2020) | — | 7,789 |\\n| Series A-1 redeemable convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 1,837,600 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 5,000 at December 31, 2020) | — | 10,270 |\\n| Stockholders' equity (deficit) |\\n| Series B convertible preferred stock, $ 0.00001 par value - no shares authorized, issued or outstanding as of March 31, 2021; 4,681,400 shares authorized, issued and outstanding as of December 31, 2020 (liquidation value of $ 24,000 at December 31, 2020) | — | 24,000 |\\n| Undesignated preferred stock, $ 0.00001 par value - 100,000,000 shares authorized, and no shares issued or outstanding as of March 31, 2021; no shares authorized, issued, or outstanding as of December 31, 2020 | — | — |\\n| Common stock, $ 0.00001 par value - no shares authorized, issued, or outstanding as of March 31, 2021; 300,000,000 shares authorized, and 95,206,893 shares issued and 95,050,041 shares outstanding at December 31, 2020 | — | — |\\n| Class A common stock, $ 0.00001 par value - 1,000,000,000 shares authorized, and 10,000,000 shares issued and outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | — | — |\\n| Class B common stock, $ 0.00001 par value - 160,000,000 shares authorized, and 124,905,954 shares issued and 124,749,102 outstanding as of March 31, 2021; no shares authorized, issued or outstanding as of December 31, 2020 | 1 | — |\\n| Additional paid-in capital | 174,254 | 4,975 |\\n| Accumulated deficit | ( 34,344 ) | ( 35,815 ) |\\n| Total stockholders’ equity (deficit) | 139,911 | ( 6,840 ) |\\n| Total liabilities, redeemable convertible preferred stock, and stockholders' deficit | $ | 193,866 | $ | 54,958 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.1\\nSEMRUSH HOLDINGS, INC.\\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)\\n(in thousands, except per share data)\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Revenue | $ | 39,998 | $ | 27,787 |\\n| Cost of revenue | 8,773 | 6,611 |\\n| Gross profit | 31,225 | 21,176 |\\n| Operating expenses |\\n| Sales and marketing | 16,457 | 12,877 |\\n| Research and development | 5,358 | 4,237 |\\n| General and administrative | 7,904 | 5,933 |\\n| Total operating expenses | 29,719 | 23,047 |\\n| Income (loss) from operations | 1,506 | ( 1,871 ) |\\n| Other income, net | 51 | 56 |\\n| Income (loss) before income taxes | 1,557 | ( 1,815 ) |\\n| Provision for income taxes | 86 | 116 |\\n| Net income (loss) and comprehensive income (loss) | $ | 1,471 | $ | ( 1,931 ) |\\n| Net income (loss) per share attributable to common stockholders: |\\n| Basic | $ | 0.02 | $ | ( 0.02 ) |\\n| Diluted | $ | 0.01 | $ | ( 0.02 ) |\\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders: |\\n| Basic | 96,376 | 94,593 |\\n| Diluted | 131,356 | 94,593 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.2\\nSEMRUSH HOLDINGS, INC.\\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)\\n(in thousands, except share data)\\n| Series A | Series A-1 | Series B | Common Stock | Class A Common Stock | Class B Common Stock | AdditionalPaid-inCapital | AccumulatedDeficit | TotalStockholders’Equity(Deficit) |\\n| Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount | Shares | Amount |\\n| Balances at December 31, 2019 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | $ | 3,644 | $ | ( 28,803 ) | $ | ( 1,159 ) |\\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 205 | — | 205 |\\n| Net loss | — | — | — | — | — | — | — | — | — | — | — | — | — | ( 1,931 ) | ( 1,931 ) |\\n| Balances at March 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 94,592,700 | $ | — | — | $ | — | — | $ | — | 3,849 | ( 30,734 ) | ( 2,885 ) |\\n| Balances at December 31, 2020 | 3,379,400 | $ | 7,789 | 1,837,600 | $ | 10,270 | 4,681,400 | $ | 24,000 | 95,050,041 | $ | — | — | $ | — | — | $ | — | 4,975 | ( 35,815 ) | $ | ( 6,840 ) |\\n| Conversion of Preferred Stock | ( 3,379,400 ) | ( 7,789 ) | ( 1,837,600 ) | ( 10,270 ) | ( 4,681,400 ) | ( 24,000 ) | 29,695,200 | — | — | — | — | — | 42,058 | — | 18,058 |\\n| Issuance of Class A Common Stock in connection with the initial public offering, net of $ 13,378 in issuance costs | — | — | — | — | — | — | — | — | 10,000,000 | — | — | — | 126,622 | — | 126,622 |\\n| Reclassification of Common Stock to Class B Common Stock in connection with the initial public offering | — | — | — | — | — | — | ( 124,745,241 ) | — | — | — | 124,745,241 | 1 | ( 1 ) | — | — |\\n| Exercise of stock options | — | — | — | — | — | — | — | — | — | — | 3,861 | — | 7 | — | 7 |\\n| Stock-based compensation expense | — | — | — | — | — | — | — | — | — | — | — | — | 593 | — | 593 |\\n| Net Income | — | — | — | — | — | — | — | — | — | — | — | — | — | 1,471 | 1,471 |\\n| Balances at March 31, 2021 | — | $ | — | — | $ | — | — | $ | — | — | $ | — | 10,000,000 | $ | — | 124,749,102 | $ | 1 | $ | 174,254 | $ | ( 34,344 ) | $ | 139,911 |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.3\\nSEMRUSH HOLDINGS, INC.\\nUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(in thousands)\\n| Three Months Ended |\\n| March 31, |\\n| 2021 | 2020 |\\n| Operating Activities |\\n| Net income (loss) | $ | 1,471 | $ | ( 1,931 ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities |\\n| Depreciation and amortization expense | 460 | 232 |\\n| Amortization of deferred contract costs | 1,322 | 1,104 |\\n| Stock-based compensation expense | 593 | 205 |\\n| Deferred taxes | ( 56 ) | ( 57 ) |\\n| Changes in operating assets and liabilities |\\n| Accounts receivable | ( 985 ) | 745 |\\n| Deferred contract costs | ( 2,420 ) | ( 1,704 ) |\\n| Prepaid expenses and other current assets | ( 976 ) | ( 747 ) |\\n| Accounts payable | 1,579 | 58 |\\n| Accrued expenses | 2,420 | 1,002 |\\n| Deferred revenue | 5,599 | 1,654 |\\n| Net cash provided by operating activities | 9,007 | 561 |\\n| Investing Activities |\\n| Purchases of property and equipment | ( 166 ) | ( 1,084 ) |\\n| Purchases of convertible debt securities | ( 500 ) | — |\\n| Capitalization of internal-use software development costs | ( 123 ) | ( 297 ) |\\n| Cash paid for acquisition of business, net of cash acquired | ( 350 ) | — |\\n| Net cash used in investing activities | ( 1,139 ) | ( 1,381 ) |\\n| Financing Activities |\\n| Proceeds from exercise of stock options | 7 | — |\\n| Net proceeds from completing initial public offering | 128,461 | — |\\n| Payment of deferred offering costs | — | ( 16 ) |\\n| Net cash provided by (used in) financing activities | 128,468 | ( 16 ) |\\n| Increase in cash, cash equivalents and restricted cash | 136,336 | ( 836 ) |\\n| Cash, cash equivalents and restricted cash, at beginning of period | 35,619 | 37,523 |\\n| Cash, cash equivalents and restricted cash, at end of period | $ | 171,955 | $ | 36,687 |\\n| Supplemental cash flow disclosures |\\n| Cash paid for income taxes | $ | 158 | $ | 154 |\\n| Deferred offering costs incurred and not paid | $ | 1,839 | $ | — |\\n| Acquisition of fixed asset under capital lease | $ | 1,024 | $ | — |\\n\\nThe accompanying notes are an integral part of these unaudited condensed consolidated financial statements.4\\nSEMRUSH HOLDINGS, INC.\\nNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\nThree months ended March 31, 2021 and 2020\\n(in thousands, except share and per share data, unless otherwise noted)\\n1. Overview and Basis of Presentation\\nDescription of Business\\nSemrush Holdings, Inc. (“Semrush Holdings”) and its subsidiaries (together the “Group”, the “Company”, or “Semrush”) provide an online visibility management software-as-a-service (“SaaS”) platform. The Company’s platform enables its subscribers to improve their online visibility and drive traffic, including on their websites and social media pages, and distribute highly relevant content to their customers on a targeted basis across various channels to drive high-quality traffic and measure the effectiveness of their digital marketing campaigns. The Company is headquartered in Boston, Massachusetts, and has wholly owned subsidiaries in Cyprus, Russia, the Czech Republic, Poland, and the United States.\\nThe Company is subject to a number of risks and uncertainties common to companies in similar industries and stages of development that could affect future operations and financial performance. These risks include, but are not limited to, rapid technological change, competitive pressure from substitute products or larger companies, protection of proprietary technology, management of international activities, the need to obtain additional financing to support growth, and dependence on third parties and key individuals.\\n2019 Reorganization\\nOn December 19, 2019, Semrush Holdings was incorporated in the state of Delaware and entered into a Contribution and Exchange Agreement with SEMrush CY Ltd (“SEMrush CY”) (a private limited liability company organized under the Cyprus Companies Law, Cap 113), pursuant to which the holders of all outstanding shares of capital stock of SEMrush CY contributed those shares to Semrush Holdings in exchange for identical shares of capital stock of Semrush Holdings (the “2019 Share Exchange”). Upon the 2019 Share Exchange, Semrush Holdings became the holding company of SEMrush CY and its wholly owned subsidiaries and the historical consolidated financial statements of SEMrush CY became the historical consolidated financial statements of Semrush Holdings. The 2019 Share Exchange and related transactions were completed on December 27, 2019.\\nInitial Public Offering\\nOn March 29, 2021, the Company closed its initial public offering (“IPO”) in which it sold 10,000,000 shares of its Class A common stock at a price to the public of $ 14.00 per share. The Company received $ 126.6 million in net proceeds after deducting approximately $ 13.4 million for underwriting discounts, commissions and offering expenses. Immediately prior to the completion of the IPO, all shares of common stock then outstanding were reclassified as Class B common stock, and all shares of redeemable convertible preferred stock and convertible preferred stock then outstanding were converted into shares of common stock on a one -to-one basis and then reclassified into Class B common stock.\\nEffects of COVID-19\\nThe Company considered the potential effects of the novel strain of coronavirus (“COVID-19”) pandemic on the Company. In March 2020, the World Health Organization declared the outbreak of COVID–19 a pandemic, and numerous new strains of COVID-19 have subsequently spread throughout\\n5\\nthe world. COVID–19 has continued to impact market and economic conditions globally. In an attempt to limit the spread of the virus, various governmental restrictions have been implemented, including restrictions with respect to business activities and travel restrictions, and “shelter–at–home” orders, that have had and may continue to have an adverse impact on the Company’s business and operations. In light of the evolving nature of COVID–19 and the uncertainty it has produced around the world, it is not possible to predict the COVID–19 pandemic’s cumulative and ultimate impact on the Company’s future business operations, results of operations, financial position, liquidity, and cash flows. The extent of the impact of the pandemic on the Company’s business and financial results will depend largely on future developments, including the duration of the spread of the outbreak both globally and within the U.S., the impact on capital, foreign currencies exchange and financial markets, and governmental or regulatory orders that impact the Company’s business, all of which are highly uncertain and cannot be predicted.\\nThe Company will continue to actively monitor the current international and domestic impacts of and responses to COVID-19 and its related risks.\\nBasis of Presentation\\nThe accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Any reference in these notes to applicable guidance is meant to refer to the authoritative United States generally accepted accounting principles as found in the Accounting Standards Codification (“ASC”) and Accounting Standards Update (“ASU”) of the Financial Accounting Standards Board (“FASB”).\\nThe unaudited condensed consolidated interim financial statements have been prepared on the same basis as the audited annual consolidated financial statements as of and for the year ended December 31, 2020, and, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, necessary for the fair presentation of the Company’s financial position as of March 31, 2021, and the results of its operations and its cash flows for the three months ended March 31, 2021 and 2020. The consolidated balance sheet as of December 31, 2020 included herein was derived from the audited financial statements as of that date.\\nThe results for the three months ended March 31, 2021 are not necessarily indicative of the results to be expected for the year ending December 31, 2021, any other interim periods, or any future year or period.\\nThe unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s final prospectus dated March 24, 2021 (the “Prospectus”) as filed with the SEC on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”).\\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described below and elsewhere in these notes to the unaudited condensed consolidated financial statements. As of March 31, 2021, there have been no material changes in the Company's significant accounting policies from those that were disclosed in the Prospectus except as discussed below.\\n2. Summary of Significant Accounting Policies\\nPrinciples of Consolidation\\n6\\nThe unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.\\nUse of Estimates\\nThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates relied upon in preparing these financial statements include, but are not limited to, revenue recognition, expected future cash flows used to evaluate the recoverability of long-lived assets, contingent liabilities, expensing and capitalization of research and development costs for internal-use software, the average period of benefit associated with costs capitalized to obtain revenue contracts, the determination of the fair value of stock-based awards issued, stock-based compensation expense, and the recoverability of the Company’s net deferred tax assets and related valuation allowance.\\nAlthough the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period in which they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results may differ from management’s estimates if these results differ from historical experience, or other assumptions do not turn out to be substantially accurate, even if such assumptions are reasonable when made.\\nSubsequent Events Considerations\\nThe Company considers events or transactions that occur after the balance sheet date but prior to the issuance of the financial statements to provide additional evidence for certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated as required. The Company has evaluated all subsequent events and determined that there are no material recognized or unrecognized subsequent events requiring disclosure, other than those disclosed in this Quarterly Report on Form 10-Q.\\nEmerging Growth Company Status\\nThe Company is an \\\"emerging growth company,\\\" as defined in the Jumpstart Our Business Startups Act, or JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not \\\"emerging growth companies.\\\" The Company may take advantage of these exemptions until the Company is no longer an \\\"emerging growth company.\\\" Section 107 of the JOBS Act provides that an \\\"emerging growth company\\\" can take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards. The Company has elected to use the extended transition period for complying with new or revised accounting standards and, as a result of this election, its financial statements may not be comparable to companies that comply with public company effective dates. The Company may take advantage of these exemptions up until the last day of the year following the fifth anniversary of an offering or such earlier time that it is no longer an emerging growth company. The Company would cease to be an emerging growth company if it has more than $1.07 billion in annual revenue, has more than $700.0 million in market value of its stock held by non-affiliates (and it has been a public company for at least 12 months, and has filed one annual report on Form 10-K), or it issues more than $1.0 billion of non-convertible debt securities over a three-year period.\\n7\\nRevenue Recognition\\nThe Company derives revenue from two sources: (1) subscription revenues via the Semrush Online Visibility Management Platform and the Prowly Public Relations Platform, which are comprised of subscription fees from customers accessing the Company’s SaaS services and related customer support; and (2) the Semrush Marketplace, which allows customers to pay a set fee for services or products offered through the marketplace.\\nThe Company recognizes revenue in accordance with ASC 606, Revenue from Contracts with Customers (“ASC 606”). Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration it expects to receive in exchange for those products or services. There were no changes to the Company’s revenue recognition policies since the filing of the Prospectus.\\nFor the three months ended March 31, 2021 and 2020, subscription revenue accounted for nearly all of the Company’s revenue. Revenue related to the Semrush Marketplace was not material for the three months ended March 31, 2021 and 2020.\\nAmounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. The Company primarily invoices and collects payments from customers for its services in advance on a monthly or annual basis.\\nDeferred revenue represents amounts billed for which revenue has not yet been recognized. Deferred revenue that will be recognized during the succeeding 12-month period is recorded as current deferred revenue, and the remaining portion is recorded as long-term deferred revenue. Deferred revenue increased by $ 5,599 as of March 31, 2021 compared December 31, 2020. During the three months ended March 31, 2021 and 2020, $ 13,303 and $ 9,583 of revenue was recognized that was included in deferred revenue at the beginning of each respective period.\\nThe Company has elected to exclude amounts charged to customers for sales tax from the transaction price. Accordingly, revenue is presented net of any sales tax collected from customers.\\nTransaction Price Allocated to Future Performance Obligations\\nASC 606 requires that the Company disclose the aggregate amount of the transaction price that is allocated to performance obligations that have not yet been satisfied as of the balance sheet dates reported.\\nFor contracts with an original expected duration greater than one year, the aggregate amount of the transaction price allocated to the performance obligations that were unsatisfied as of March 31, 2021 and December 31, 2020 was $ 866 and $ 1,280 , respectively, which the Company expects to recognize over the next 12 months.\\nFor contracts with an original expected duration of one year or less, the Company has applied the practical expedient available under ASC 606 to not disclose the amount of transaction price allocated to unsatisfied performance obligations as of March 31, 2021 and December 31, 2020. For performance obligations not satisfied as of March 31, 2021 and December 31, 2020, and to which this expedient applies, the nature of the performance obligations is consistent with performance obligations satisfied as of December 31, 2019. The remaining durations are less than one year.\\nCosts to Obtain a Contract\\nThe incremental direct costs of obtaining a contract, which primarily consist of sales commissions paid for new subscription contracts, are deferred and recorded as deferred contract costs in the\\n8\\nconsolidated balance sheet and are amortized over a period of approximately 24 months on a systematic basis, consistent with the pattern of transfer of the goods or services to which the asset relates. The 24-month period represents the estimated benefit period of the customer relationship and has been determined by taking into consideration the type of product sold, the commitment term of the customer contract, the nature of the Company’s technology development life-cycle, and an estimated customer relationship period based on historical experience and future expectations. Sales commissions for renewals and upgrade contracts are deferred and amortized on a straight-line basis over the remaining estimated customer relationship period of the related customer. Deferred contract costs that will be recorded as expense during the succeeding 12-month period are recorded as current deferred contract costs, and the remaining portion is recorded as deferred contract costs, net of current portion. Amortization of deferred contract costs is included in sales and marketing expense in the accompanying consolidated statement of operations and comprehensive loss.\\nCash, Cash Equivalents, and Restricted Cash\\nThe Company considers all highly liquid instruments purchased with an original maturity date of 90 days or less from the date of purchase to be cash equivalents. Management determines the appropriate classification of investments at the time of purchase and re-evaluates such determination at each balance sheet date.\\nCash and cash equivalents consist of cash on deposit with banks and amounts held in interest-bearing money market funds. Cash equivalents are carried at cost, which approximates their fair market value. At both March 31, 2021 and December 31, 2020, restricted cash was $ 88 , and related to cash held at a financial institution in an interest-bearing cash account as collateral for a letter of credit related to the contractual provisions for one of the Company’s building leases.\\nThe following table is a reconciliation of cash, cash equivalents and restricted cash included in the accompanying condensed consolidated balance sheets that sum to the total cash, cash equivalents and restricted cash included in the accompanying condensed consolidated statements of cash flows for the three months ended March 31, 2021 and 2020.\\n| March 31, 2021 | March 31, 2020 |\\n| Cash and cash equivalents | $ | 171,867 | $ | 36,599 |\\n| Restricted cash included in “prepaid expenses and other current assets” and “other long-term assets,” respectively | 88 | 88 |\\n| $ | 171,955 | $ | 36,687 |\\n\\nConcentrations of Credit Risk and Significant Customers\\nThe Company has no off-balance sheet risk, such as foreign exchange contracts, option contracts, or other hedging arrangements. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\\nCredit risk with respect to accounts receivable is dispersed due to the large number of customers of the Company. The Company routinely assesses the creditworthiness of its customers and generally does not require its customers to provide collateral or other security to support accounts receivable. Credit losses historically have not been significant and the Company generally has not experienced any material losses related to receivables from individual customers, or groups of customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company's accounts receivable.\\n9\\nAs of March 31, 2021 and December 31, 2020, no individual customer represented more than 10% of the Company’s accounts receivable. During the three months ended March 31, 2021 and 2020, no individual customer represented more than 10% of the Company’s revenue.\\nDisclosure of Fair Value of Financial Instruments\\nThe carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, approximated their fair values at March 31, 2021 and December 31, 2020, due to the short-term nature of these instruments.\\nThe Company has evaluated the estimated fair value of financial instruments using available market information. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. See below for further discussion.\\nFair Value Measurements\\nASC 820, Fair Value Measurements and Disclosures (“ASC 820”), establishes a three-level valuation hierarchy for instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and the Company’s own assumptions (unobservable inputs). Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances.\\nThis guidance further identifies fair value as the exchange price, or exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants based on the highest and best use of the asset or liability. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. The Company uses valuation techniques to measure fair value that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs are prioritized as follows:\\nLevel 1 inputs—Unadjusted observable quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.\\nLevel 2 inputs—Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.\\nLevel 3 inputs—Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity.\\nTo the extent that the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.\\nThe Company evaluates assets and liabilities subject to fair value measurements on a recurring and nonrecurring basis to determine the appropriate level to classify them for each reporting period.\\nCash equivalents include money market funds with original maturities of 90 days or less from the date of purchase. The fair value measurement of these assets is based on quoted market prices in active markets for identical assets and, therefore, these assets are recorded at fair value on a recurring basis\\n10\\nand classified as Level 1 in the fair value hierarchy. As of March 31, 2021 and December 31, 2020, cash equivalents held in money market funds totaled $ 35,505 and $ 29,369 , respectively.\\nAs of March 31, 2021, the Company measured its investments in convertible notes (see Note 4) and its contingent consideration associated with the acquisition of Prowly.com sp. z o.o (“Prowly”) on a recurring basis using significant unobservable inputs (Level 3) and did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2). Changes in fair value of the convertible notes were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. Changes in fair value of the contingent consideration associated with the Prowly acquisition were not material for the three months ended March 31, 2021. As of December 31, 2020, the Company did not have any assets or liabilities measured at fair value on a recurring basis using significant other observable inputs (Level 2).\\nForeign Currency Translation\\nThe Group operates in a multi-currency environment having transactions in such currencies as the U.S. dollar, Russian rubles, Czech koruna, euros, and others. The reporting currency of the Company is the U.S. dollar. The functional currency of the Company’s foreign subsidiaries is the U.S. dollar, with the exception of Prowly, where the functional currency is the local currency, the Zloty. The foreign currency translation adjustment as it relates to Prowly was immaterial for the three months ended March 31, 2021 and 2020. For all other entities, foreign currency transactions are measured initially in the functional currency of the recording entity by use of the exchange rate in effect at that date. At each subsequent balance sheet date, foreign currency denominated assets and liabilities of these international subsidiaries are remeasured into U.S. dollars using the exchange rates in effect at the balance sheet date or historical rates, as appropriate. Any differences resulting from the remeasurement of foreign denominated assets and liabilities of the international subsidiaries to the U.S. dollar functional currency are recorded within other income (expense) in the unaudited condensed consolidated statement of operations and comprehensive loss. The foreign currency exchange gain (loss) included in other income for the three months ended March 31, 2021 and 2020 was $ 44 and $( 107 ), respectively.\\nNet Income (Loss) Per Share\\nNet income (loss) per share information is determined using the two-class method, which includes the weighted-average number of shares of common stock outstanding during the period and other securities that participate in dividends (a participating security). Prior to the completion of the IPO, the Company considered the shares of Preferred Stock to be participating securities because they include rights to participate in dividends with the common stock. As of March 31, 2021, the Company did not have any participating securities outstanding.\\nUnder the two-class method, basic net income (loss) per share attributable to common stockholders is computed by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income (loss) per share attributable to common stockholders is computed using the more dilutive of (1) the two-class method or (2) the if-converted method. The Company allocates net income first to preferred stockholders based on dividend rights under the Company’s certificate of incorporation and then to preferred and common stockholders based on ownership interests. Net losses are not allocated to preferred stockholders as they do not have an obligation to share in the Company’s net losses.\\nDuring the three months ended March 31, 2021, the Company amended its certificate of incorporation to create two classes of common stock outstanding: Class A common stock and Class B common stock. As more fully described in Note 9, the rights of the holders of Class A and Class B common stock are identical, except with respect to voting and conversion. Each share of Class A common stock is entitled to one (1) vote per share and each share of Class B common stock is entitled to ten (10) votes per share. Each share of Class B common stock is convertible into one share of Class A common stock at the option\\n11\\nof the holder at any time. Shares of Class B common stock are automatically converted into Class A common stock upon sale or transfer, subject to certain limited exceptions. Shares of Class A common stock are not convertible. See Note 9 to these unaudited condensed consolidated financial statements for additional information regarding the current conversion and transfer terms of the Company’s common stock. The Company allocates undistributed earnings attributable to common stock between the common stock classes on a one to one basis when computing net income (loss) per share. As a result, basic and diluted net income (loss) per share of Class A common stock and share of Class B common stock are equivalent.\\nDiluted net income (loss) per share gives effect to all potentially dilutive securities. Potential dilutive securities consist of shares of common stock issuable upon the exercise of stock options, shares of common stock issuable upon the conversion of the outstanding shares of Preferred Stock, and shares of common stock issuable upon the vesting of restricted stock awards or restricted stock units.\\nFor the three months ended March 31, 2021, dilutive net income per share was calculated by dividing net income by the weighted-average number of shares of common stock outstanding during the period, the dilutive impact of stock options, shares of common stock issuable upon the vesting of RSUs, and the dilutive impact of shares issuable upon the conversion of the outstanding shares of Preferred Stock.\\nFor the three months ended March 31, 2020, the net loss attributable to common stockholders is divided by the weighted-average number of shares of common stock outstanding during the period to calculate diluted earnings per share. The dilutive effect of common stock equivalents has been excluded from the calculation for the three months ended March 31, 2020 as their effect would have been anti-dilutive due to the net losses incurred for the period.\\nThe following table presents a reconciliation of the weighted-average shares outstanding used in the calculation of basic and diluted net income (loss) per share:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Weighted-average shares outstanding: |\\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—basic | 96,375,531 | 94,592,700 |\\n| Dilutive effect of share equivalents resulting from stock options | 6,151,361 | — |\\n| Dilutive effect of share equivalents resulting from RSAs | 123,841 | — |\\n| Dilutive effect of shares issuable upon conversion of preferred stock | 28,705,360 | — |\\n| Weighted-average number of shares of common stock used in computing net income (loss) per share attributable to common stockholders—diluted | 131,356,093 | 94,592,700 |\\n\\nThe following potentially dilutive common stock equivalents have been excluded from the calculation of diluted weighted-average shares outstanding for the three months ended March 31, 2021 and 2020:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Stock options outstanding | — | 6,286,357 |\\n| Shares of Preferred Stock | — | 29,695,200 |\\n| Restricted stock units outstanding | 1,733 | — |\\n\\n12\\nComprehensive income (loss)\\nComprehensive income (loss) is comprised of two components: net income (loss) and other comprehensive income (loss), which includes other changes in stockholders’ deficit that result from transactions and economic events other than those with stockholders. The Company had no items qualifying as other comprehensive income (loss) with the exception of an immaterial cumulative translation adjustment related to the Prowly entity and an immaterial fair-value adjustment related to the convertible note investments; accordingly, comprehensive income (loss) equaled total net loss for the three months ended March 31, 2021 and 2020.\\nRecent Accounting Pronouncements\\nIn February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). ASU 2016-02 requires a lessee to recognize most leases on the balance sheet but recognize expenses on the income statement in a manner similar to current practice. The update states that a lessee will recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying assets for the lease term. Leases will continue to be classified as either financing or operating, with classification affecting the recognition, measurement, and presentation of expenses and cash flows arising from a lease. For public entities, ASU 2016-02 is effective for years beginning after December 15, 2019. For non-public companies, ASU 2016-02 is effective for fiscal years beginning after December 15, 2021 and interim periods in annual periods beginning after December 15, 2022. Early adoption is permitted. The Company plans to adopt this guidance in the year ended December 31, 2022. The Company is currently assessing the impact that adopting this guidance will have on its consolidated financial statements.\\nIn June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 requires that credit losses be reported as an allowance using an expected losses model, representing the entity's current estimate of credit losses expected to be incurred. The accounting guidance currently in effect is based on an incurred loss model. ASU 2016-13 affect loans, debt securities, trade receivables, net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. ASU 2016-13 is effective for public entities for annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years. For non-public companies, ASU 2016-13 is effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently evaluating ASU 2016-13 and the potential impact on its condensed consolidated financial statements and financial statement disclosures.\\nIn August 2018, the FASB issued ASU No. 2018-15, Intangible-Goodwill and Other Internal-Use Software (Subtopic 350-40). ASU 2018-15 updates guidance regarding accounting for implementation costs associated with a cloud computing arrangement that is a service contract. The amendments under ASU 2018-15 are effective for public entities for years beginning after December 15, 2019, and interim periods within those years. For non-public companies, ASU 2081-15 is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\\nIn December 2019, the FASB issued ASU 2019-12, Income Taxes – Simplifying the Accounting for Income Taxes. The new guidance simplifies the accounting for income taxes by removing several exceptions in the current standard and adding guidance to reduce complexity in certain areas, such as requiring that an entity reflect the effect of an enacted change in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date. For public companies, the ASU is effective for years beginning after December 15, 2020, and interim periods within those years,\\n13\\nwith early adoption permitted. For non-public companies, the new standard is effective for years beginning after December 15, 2021, with early adoption permitted. The Company plans to adopt this guidance in the year ended December 31, 2021. The Company is currently assessing the impact that adopting this guidance will have on its condensed consolidated financial statements.\\n3. Property and Equipment, Net\\nProperty and equipment consists of the following (in thousands):\\n| As of |\\n| March 31,2021 | December 31,2020 |\\n| Computer equipment | $ | 3,383 | $ | 3,513 |\\n| Furniture and office equipment | 877 | 1,041 |\\n| Leasehold improvements | 1,142 | 667 |\\n| Capital leases | 1,024 | — |\\n| Total property and equipment | 6,426 | 5,221 |\\n| Less: accumulated depreciation and amortization | ( 2,550 ) | ( 2,253 ) |\\n| Property and equipment, net | $ | 3,876 | $ | 2,968 |\\n\\nDepreciation and amortization expense related to property and equipment was $ 344 and $ 203 for the three months ended March 31, 2021 and 2020, respectively.\\n4. Other Long-Term Assets\\nDeferred Offering Costs\\nDeferred offering costs, which primarily consist of direct incremental legal and accounting fees relating to the IPO and to a credit facility, are deferred. The deferred issuance costs relating to the IPO were offset against IPO proceeds upon the consummation of the Company’s offering. The deferred costs relating to the credit facility are being amortized to interest expense up through the maturity date of the facility. As of March 31, 2021 and December 31, 2020, the Company had deferred offering costs relating to the IPO of $ 0 and $ 1,839 . As of March 31, 2021 and December 31, 2020, the Company had $ 578 and $ 630 , respectively, in issuance costs relating to the credit facility. The issuance costs for the IPO and credit facility are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets.\\nInvestments in Convertible Debt\\nIn January 2021, the Company purchased two convertible debt securities for a total aggregate investment of $ 500 . Both investments mature on January 1, 2023 and receive interest at an annual rate of 6 %. Interest accrues and becomes payable upon conversion of the convertible notes, or will be paid in connection with the repayment in full of the principal amount of such convertible notes.\\nThese convertible note investments are classified as available-for-sale securities with changes in fair value reported in other comprehensive income (loss). Changes in fair value were not material for the three months ended March 31, 2021 due to the short time period between when the investment was made and the balance sheet date. These investments are classified in other long-term assets in the accompanying unaudited condensed consolidated balance sheets based on the maturity date.\\n14\\n5. Acquisitions, Acquired Intangible Assets, and Goodwill\\nAcquisitions\\nOn August 27, 2020, the Company acquired 100 % of the outstanding capital of Prowly for cash consideration of $ 3,317 . In addition to the purchase consideration, the founders of Prowly are eligible to earn up to a maximum of $ 2,750 in aggregate additional consideration based on the satisfaction of certain earnings targets as defined in the purchase agreement. For the three months ended March 31, 2021, the Company recognized compensation expense of $ 56 as compensation expense related to the additional consideration.\\nIntangible Assets\\nIntangible assets consisted of intangible assets resulting from the acquisition of Prowly and capitalized internal-use software development costs. Intangible assets consists of the following:\\n| As of March 31, 2021 |\\n| Gross | Net |\\n| Carrying | Accumulated | Carrying |\\n| Amount | Amortization | Amount |\\n| Developed technology | 1,194 | ( 109 ) | 1,085 |\\n| Trade name | 68 | ( 9 ) | 59 |\\n| Capitalized internal-use software | 1,684 | ( 652 ) | 1,032 |\\n| Total as of March 31, 2021 | $ | 2,946 | $ | ( 770 ) | $ | 2,176 |\\n\\n| As of December 31, 2020 |\\n| Gross | Net |\\n| Carrying | Accumulated | Carrying |\\n| Amount | Amortization | Amount |\\n| Developed technology | 1,194 | ( 66 ) | 1,128 |\\n| Trade name | 68 | ( 3 ) | 65 |\\n| Capitalized internal-use software | 1,561 | ( 523 ) | 1,038 |\\n| Total as of December 31, 2020 | $ | 2,823 | $ | ( 592 ) | $ | 2,231 |\\n\\nDuring the three months ended March 31, 2021 and 2020, the Company capitalized $ 123 and $ 200 , respectively, of software development costs, which are classified as intangible assets on the accompanying consolidated balance sheets. The Company recorded amortization expense associated with its capitalized development costs of $ 129 and $ 52 for the three months ended March 31, 2021 and 2020, respectively. As of March 31, 2021 and December 31, 2020, the capitalized internal-use software asset balances totaled $ 1,032 and $ 1,038 , respectively.\\nAmortization expense for acquired intangible assets was $ 55 for the three months ended March 31, 2021.\\n15\\nAs of March 31, 2021, future amortization expense is expected to be as follows:\\n| Amount |\\n| Remainder of 2021 | $ | 519 |\\n| 2022 | 559 |\\n| 2023 | 428 |\\n| 2024 | 199 |\\n| 2025 and thereafter | 471 |\\n| Total | $ | 2,176 |\\n\\nGoodwill\\nThe was no change in the carrying value of goodwill of $ 1,991 from December 31, 2020 through March 31, 2021.\\n6. Accrued expenses\\nAccrued expenses consist of the following:\\n| As of |\\n| March 31,2021 | December 31,2020 |\\n| Employee compensation | $ | 4,776 | $ | 4,478 |\\n| Vacation reserves | 464 | 465 |\\n| Other current liabilities | 5,046 | 2,776 |\\n| Total accrued expenses | $ | 10,286 | $ | 7,719 |\\n\\n7. Revolving Credit Facility\\nSenior Secured Revolving Credit Facility\\nOn January 12, 2021, the Company executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $ 45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $ 5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400 % multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\\nBorrowings under the credit facility bear interest at the Company’s option at (i) LIBOR, subject to a 0.50 % floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25 % floor (or 1.50 % prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75 % (or 3.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00 % (or 2.50 % prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). The Company is also required to pay a 0.25 % per annum fee on undrawn amounts under the Company’s revolving credit facility, payable quarterly in arrears.\\n16\\nAs of March 31, 2021, the Company has not drawn on this revolving credit facility. For the three months ended March 31, 2021, the Company incurred $ 53 in interest expense relating to this credit facility.\\n8. Income Taxes\\nWe are subject to U.S. federal, state, and foreign income taxes. For the three months ended March 31, 2021 and 2020, we recorded provisions for income taxes of $ 86 and $ 116 , respectively. Our effective tax rate for the three months ended March 31, 2021 and 2020 was lower than the U.S. statutory rate primarily due to the valuation allowance.\\nWe recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. These differences are measured using the enacted statutory tax rates that are expected to be in effect for the years in which differences are expected to reverse. On a periodic basis, we reassess any valuation allowances that we maintain on our deferred tax assets, weighing positive and negative evidence to assess the recoverability of the deferred tax assets. We will maintain a valuation allowance on certain federal, state, and foreign tax attributes that we expect will expire prior to the utilization.\\nIn March 2020, the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act includes provisions relating to several aspects of corporate income taxes. We do not currently expect the CARES Act to have a significant impact on our provision for income taxes.\\n9. Redeemable Convertible Preferred Stock and Stockholders’ Equity\\nPrior to the IPO, the authorized capital stock of the Company included 9,898,400 shares of preferred stock, of which 3,379,400 shares have been designated as Series A Redeemable Convertible Preferred Stock, 1,837,600 shares have been designated as Series A-1 Redeemable Convertible Preferred Stock and 4,681,400 shares have been designated as Series B Convertible Preferred Stock (collectively the “Preferred Stock”).\\nImmediately prior to the closing of the IPO, the outstanding shares of Preferred Stock were converted on a three -for-one basis into 29,695,200 shares of common stock. The holders of the Company’s Preferred Stock had certain voting, dividend, and redemption rights, as well as liquidation preferences and conversion privileges. All rights, preferences, and privileges associated with the preferred stock were terminated at the time of the Company’s IPO in conjunction with the conversion of all outstanding shares of Preferred Stock into shares of common stock.\\nAs of March 31, 2021, the total number of shares of all classes of stock which the Company shall have authority to issue was (i) 1,000,000,000 shares of Class A common stock, par value $ 0.00001 per share, and (ii) 160,000,000 shares of Class B common stock, par value $ 0.00001 per share, and (iii) 100,000,000 undesignated shares of Preferred Stock, par value $ 0.00001 per share.\\nEach share of Class A common stock entitles the holder to one vote for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings. Each share of Class B common stock entitles the holder to ten votes for each share on all matters submitted to a vote of the Company's stockholders at all meetings of stockholders and written actions in lieu of meetings.\\nHolders of Class A common stock and Class B common stock are entitled to receive dividends, when and if declared by the board of directors (the “Board”).\\n17\\nEach share of Class B common stock is convertible into one share of Class A common stock at the option of the holder at any time. Automatic conversion shall occur upon the occurrence of (i) a Transfer, as defined in the amended and restated certificate of incorporation, of such share of Class B common stock, (ii) the affirmative vote of at least two-thirds of the outstanding shares of Class B common stock, voting as a single class, or (iii) on or after the earlier to occur of (a) the seventh year anniversary of the effectiveness of the amended and restated certificate of incorporation or (b) the date on which the outstanding shares of Class B common stock represents less than 10 % of the aggregate number of the then outstanding shares of Class A common stock and Class B common stock. Further, upon either the death or incapacitation of a holder of Class B common stock, the shares held by such shareholder shall automatically be converted into one share of Class A common stock.\\nStock Split\\nOn March 15, 2021, the Board approved a 3 -for-1 stock-split of the Company’s common stock. The stock split was approved by the stockholders on March 15, 2021 and became effective on March 15, 2021. Upon the effectiveness of the stock split, (i) every one share of common stock outstanding was increased to 3 shares of common stock, (ii) the number of shares of common stock into which each outstanding option to purchase common stock is exercisable was proportionally increased on a 3 -for-1 basis, and (iii) the exercise price of each outstanding option to purchase common stock was proportionately decreased on a 3 -for-1 basis. Additionally, shares of common stock reserved for issuance upon the conversion of the Company’s Preferred Stock were proportionately increased on a 3 -for-1 basis and the respective conversion prices of the Preferred Stock were proportionately reduced. All share and per share data shown in the accompanying consolidated financial statements and related notes have been retroactively revised to reflect the stock split.\\nCommon Stock Reserved for Future Issuance\\nAs of March 31, 2021, the Company had reserved the following shares of common stock for future issuance:\\n| Options outstanding | 7,591,554 |\\n| Options reserved for future issuance | 13,483,501 |\\n| Restricted stock outstanding | 156,852 |\\n| Restricted stock units | 19,500 |\\n| Total authorized shares of common stock reserved for future issuance | 21,251,407 |\\n\\nn\\n10. Stock-Based Compensation\\nIn 2019, the Board adopted the Semrush Holdings, Inc. 2019 Stock Option and Grant Plan (the “2019 Plan”), which provides for the grant of qualified incentive stock options and nonqualified stock options or other awards, including restricted stock unit awards, to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 8,682,600 shares of the Company’s common stock. In July 2020, the Plan was amended to provide for the grant of qualified incentive stock options and nonqualified stock options or other awards to the Company’s employees, officers, directors, advisors, and outside consultants for the purchase of up to 10,163,772 shares of the Company’s common stock. Stock options generally vest over a 4 year period and expire 10 years from the date of grant. Certain options provide for accelerated vesting if there is a change in control (as defined in the Plan).\\nThe Semrush Holdings, Inc. 2021 Stock Option and Incentive Plan (the “2021 Plan”) was adopted by the Board March 3, 2021 and approved by stockholders on March 15, 2021 and became effective immediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The 2021 Plan replaced the 2019 Plan as the Board determined not to make additional awards under the\\n18\\n2019 Plan following the pricing of the Company’s IPO. The 2021 Plan allows the compensation committee of the Board to make equity-based and cash-based incentive awards to the Company’s officers, employees, directors and other key persons (including consultants).\\nThe Company initially reserved 13,503,001 shares of Class A common stock for the issuance of awards under the 2021 Plan. The 2021 Plan provides that the number of shares reserved and available for issuance under the plan will automatically increase each January 1, beginning on January 1, 2022, by the lesser of 5 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31, or such lesser number of shares as determined by the compensation committee. This number is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization.\\nThe Company accounts for stock-based compensation in accordance with the provisions of ASC 718, which requires the recognition of expense related to the fair value of stock-based compensation awards in the statements of operations. For stock-based awards issued under the Company’s stock-based compensation plans to employees and members of the Board for their services on the Board, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model as discussed further below. For service-based awards, the Company recognizes compensation expense on a straight-line basis over the requisite service period of the award with actual forfeitures recognized as they occur.\\nGiven the absence of an active market for the Company’s common stock prior to the completion of the IPO, the Board, the members of which the Company believes have extensive business, finance, and venture capital experience, were required to estimate the fair value of the Company’s common stock at the time of each grant of a stock-based award. The Company and the Board utilized various valuation methodologies in accordance with the framework of the American Institute of Certified Public Accountants’ Technical Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation, to estimate the fair value of its common stock. Each valuation methodology included estimates and assumptions that require the Company’s judgment. These estimates and assumptions include a number of objective and subjective factors, in determining the value of the Company’s common stock at each grant date, including the following factors: (1) prices paid for the Company’s Preferred Stock, which the Company had sold to outside investors in arm’s-length transactions, and the rights, preferences, and privileges of the Company’s Preferred Stock and common stock; (2) valuations performed by an independent valuation specialist; (3) the Company’s stage of development and revenue growth; (4) the fact that the grants of stock-based awards involved illiquid securities in a private company; and (5) the likelihood of achieving a liquidity event for the common stock underlying the stock-based awards, such as an IPO or sale of the Company, given prevailing market conditions.\\nThe Company believes this methodology to be reasonable based upon the Company’s internal peer company analyses, and further supported by several arm’s-length transactions involving the Company’s Preferred Stock. As the Company’s common stock is not actively traded, the determination of fair value involves assumptions, judgments, and estimates. If different assumptions were made, stock-based compensation expense, consolidated net income (loss) and consolidated net income (loss) per share could have been significantly different.\\nThe Company has recorded stock-based compensation expense for stock options of $ 593 and $ 205 during the three months ended March 31, 2021 and 2020, respectively. The following table shows stock-\\n19\\nbased compensation expense by where the stock-based compensation expense is recorded in the Company’s unaudited condensed consolidated statement of operations:\\n| For the Three Months EndedMarch 31, |\\n| 2021 | 2020 |\\n| Cost of revenue | $ | 7 | $ | 5 |\\n| Sales and marketing | 190 | 27 |\\n| Research and development | 67 | 29 |\\n| General and administrative | 329 | 144 |\\n| Total stock-based compensation | $ | 593 | $ | 205 |\\n\\nAs of March 31, 2021, there was $ 5,024 of unrecognized compensation cost related to unvested common stock option arrangements granted under the 2021 Plan, which is expected to be recognized over a weighted-average period of 3.12 years.\\nThe fair value of each option award was estimated on the date of grant using the Black-Scholes option-pricing model. As there was no public market for its common stock prior to March 25, 2021, which was the first day of trading, and as the trading history of the Company’s common stock was limited through March 31, 2021, the Company determined the expected volatility for options granted based on an analysis of reported data for a peer group of companies that issued options with substantially similar terms. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies. The expected life of options granted to employees was calculated using the simplified method, which represents the average of the contractual term of the option and the weighted-average vesting period of the option. The Company uses the simplified method because it does not have sufficient historical option exercise data to provide a reasonable basis upon which to estimate expected term. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the share option. The Company has not paid, nor anticipates paying, cash dividends on its ordinary shares; therefore, the expected dividend yield is assumed to be zero .\\n20\\nThe weighted-average assumptions utilized to determine the fair value of options granted to employees are presented in the following table:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| Expected volatility | 52.0 | % | 46.7 | % |\\n| Weighted-average risk-free interest rate | 0.58 | % | 1.46 | % |\\n| Expected dividend yield | — | — |\\n| Expected life – in years | 6 | 6 |\\n\\nA summary of the Company’s option activity as of March 31, 2021, which all occurred under the Semrush Holdings, Inc. Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”), and changes during the three months then ended are as follows:\\n| Number of Options | Weighted-Average Exercise Price (per share) | Weighted-Average Remaining Contractual Term (in years) |\\n| Outstanding at December 31, 2020 | 7,611,258 | $ | 1.37 | 8.40 |\\n| Granted | 34,500 | 6.21 |\\n| Exercised | ( 3,861 ) | 1.35 |\\n| Forfeited | ( 50,343 ) | 2.00 |\\n| Outstanding at March 31, 2021 | 7,591,554 | 1.39 | 8.28 |\\n| Options exercisable at March 31, 2021 | 3,309,264 | 0.94 | 7.60 |\\n\\nThe weighted-average grant-date fair value of options granted during the three months ended March 31, 2021 and 2020 was $ 9.09 and $ 1.70 per share, respectively. No tax benefits were realized from options during the three months ended March 31, 2021.\\nThe aggregate intrinsic value of options outstanding as of March 31, 2021 and December 31, 2020 was $ 79,858 and $ 36,816 , respectively.\\nThe aggregate intrinsic value for options exercised during the three months ended March 31, 2021 was $ 19 . No options were exercised for the three months ended March 31,2020.\\nThe aggregate intrinsic value for options exercisable as of March 31, 2021 was $ 36,313 .\\nThe aggregate intrinsic value was calculated based on the positive difference, if any, between the estimated fair value of the Company’s common stock on March 31, 2021 and December 31, 2020, respectively, or the date of exercise, as appropriate, and the exercise price of the underlying options.\\nOn July 28, 2020, the Company issued 156,852 shares of its restricted common stock (“Restricted Stock Issuance”) to the founders of Prowly for a total fair value of $ 291 under the 2019 Plan. This Restricted Stock Issuance vests over a three-year service period, applicable to both founders. On March 3, 2021, the Company granted, to an employee, a restricted stock unit award for 19,500 shares of Class A common stock under the 2021 Plan.\\n2021 Employee Stock Purchase Plan\\nThe Semrush Holdings, Inc. 2021 Employee Stock Purchase Plan (the “ESPP”) was adopted by the Board on March 3, 2021 and approved by stockholders on March 15, 2021 and became effective\\n21\\nimmediately prior to the effectiveness of the Company’s registration statement in connection with its IPO. The ESPP initially reserves and authorizes the issuance of up to a total of 3,000,667 shares of Class A common stock to participating employees. The ESPP provides that the number of shares reserved and available for issuance will automatically increase each January 1, beginning on January 1, 2022 and each January 1 thereafter through January 1, 2031, by the least of (i) 1 % of the outstanding number of shares of Class A and Class B common stock on the immediately preceding December 31; (ii) 3,000,667 shares or (iii) such lesser number of shares of Class A common stock as determined by the ESPP administrator. The number of shares reserved under the ESPP is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization. The Company expects to offer, sell and issue shares of common stock under the ESPP from time to time based on various factors and conditions, although the Company is under no obligation to sell any shares under the ESPP. The Company has not issued any shares of Class A common stock under the ESPP.\\n11. Commitments and Contingencies\\nThe Company leases office facilities under noncancelable operating leases that expire at various dates through 2024. In addition, the Company has multi-year commitments with data centers. Some of these lease agreements contain escalating rent payments. Rent expense is recorded on a straight-line basis. Rent expense was $ 928 and $ 1,086 for the three months ended March 31, 2021 and 2020, respectively. The Company also has non-cancelable commitments related to its data centers.\\nFuture minimum amounts payable as of March 31, 2021, under the office facilities operating leases and data center agreements are as follows:\\n| Operating Leases |\\n| Remainder of 2021 | $ | 3,070 |\\n| 2022 | 3,109 |\\n| 2023 | 1,515 |\\n| 2024 | 459 |\\n| 2025 and thereafter | — |\\n| Total minimum lease payments | $ | 8,153 |\\n\\nDuring the year ended December 31, 2020, the Company entered into leasing arrangements for certain data center equipment under non-cancelable capital leases. The leasing arrangements have terms of 36 months beginning on the date the Company accepts the installation of the equipment subject to the lease. As of December 31, 2020, the equipment had not been installed and the Company had not accepted the equipment under these leases, and as such the lease commencement date had not begun. During the three months ended March 31, 2021, a portion of the equipment was installed and the related lease commenced. The Company is required to make total payments of $ 6,045 over the term of the leases which is excluded from the table above. The Company recorded $ 1,024 in capital leases to property and equipment, net, as of March 31, 2021 (see Note 3), which is being depreciated over the lease term of 36 months. The $ 1,024 of capital leases represents the total balance of other-long term liabilities on the unaudited condensed consolidated balance sheet as of March 31, 2021.\\nIn addition to the lease commitments above, the Company also has multi-year commitments with certain data providers. The Company is committed to spend approximately $ 4,124 , $ 6,776 , and $ 1,933 for the remainder of the year ending December 31, 2021, and for the years ending December 31, 2022, and 2023, respectively, for data services.\\n22\\nLitigation\\nThe Company, from time to time, may be party to litigation arising in the ordinary course of its business. The Company was not subject to any material legal proceedings during the three months ended March 31, 2021, and, to the best of its knowledge, no material legal proceedings are currently pending or threatened.\\nIndemnification\\nThe Company typically enters into indemnification agreements with customers in the ordinary course of business. Pursuant to these agreements, the Company indemnifies and agrees to reimburse the indemnified party for losses suffered or incurred as a result of claims of intellectual property infringement. These indemnification agreements are provisions of the applicable customer agreement. Based on when clients first sign an agreement for the Company’s service, the maximum potential amount of future payments the Company could be required to make under certain of these indemnification agreements is unlimited. Based on historical experience and information known as of March 31, 2021, the Company has not incurred any costs for the above guarantees and indemnities.\\nIn certain circumstances, the Company warrants that its services will perform in all material respects in accordance with its standard published specification documentation in effect at the time of delivery of the services to the customer for the term of the agreement. To date, the Company has not incurred significant expense under its warranties and, as a result, the Company believes the estimated fair value of these agreements is immaterial.\\n12. Components of Other Income, Net\\nThe components of other income, net, are as follows:\\n| For the Three Months EndedMarch 31, |\\n| 2021 | 2020 |\\n| Foreign currency exchange gain (loss) | 44 | ( 107 ) |\\n| Other, net | 7 | 163 |\\n| Other income, net | $ | 51 | $ | 56 |\\n\\n13. Employee Benefit Plan\\nThe Company maintains a defined contribution savings plan under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”) covering all U.S. employees who satisfy certain eligibility requirements. The 401(k) Plan allows each participant to defer a percentage of their eligible compensation subject to applicable annual limits pursuant to the limits established by the Internal Revenue Service. The Company may, at the discretion of the Board, make contributions in the form of matching contributions or profit-sharing contributions. For the three months ended March 31, 2021 and 2020, the Company made matching contributions of $ 90 and $ 34 , respectively, to the 401(k) Plan.\\n14. Segment and Geographic Information\\nDisclosure requirements about segments of an enterprise and related information establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information of those segments to be presented in interim financial reports issued to shareholders. Operating segments are defined as components of an enterprise about which separate discrete financial information is available that is evaluated regularly by the chief operating decision maker,\\n23\\nor decision-making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is the chief executive officer. The Company and the chief executive officer view the Company’s operations and manage its business as one operating segment.\\nGeographic Data\\nThe Company allocates, for the purpose of geographic data reporting, its revenue based upon the location of the customer. Total revenue by geographic area was as follows:\\n| For the Three Months EndedMarch 31, |\\n| 2021 | 2020 |\\n| Revenue: |\\n| United States | $ | 18,132 | $ | 12,886 |\\n| United Kingdom | 4,195 | 2,994 |\\n| Other | 17,671 | 11,907 |\\n| Total revenue | $ | 39,998 | $ | 27,787 |\\n\\nProperty and equipment, net by geographic location consists of the following:\\n| As of |\\n| March 31,2021 | December 31,2020 |\\n| Property and equipment, net: |\\n| United States | $ | 2,020 | $ | 1,023 |\\n| Russia | 1,360 | 1,450 |\\n| Czech Republic | 440 | 439 |\\n| Other | 56 | 56 |\\n| Total assets | $ | 3,876 | $ | 2,968 |\\n\\n15. Subsequent Events\\nThe Company has completed an evaluation of all subsequent events after the balance sheet date of March 31, 2021 through the date this Quarterly Report on Form 10-Q was filed with the SEC, to ensure that this filing includes appropriate disclosure of events both recognized in the financial statements as of March 31, 2021, and events which occurred subsequently but were not recognized in the financial statements. The Company has concluded that no subsequent events have occurred that require disclosure, except as disclosed within these financial statements and except as disclosed below.\\nExercise of Overallotment Option\\nOn April 20, 2021, the underwriters of the Company’s IPO partially exercised their option to purchase additional shares of Class A common stock. In connection with the closing of the partial exercise on April 23, 2021, the underwriters purchased 719,266 shares of the Company’s Class A common stock for net proceeds to the Company of $ 9.4 million.\\n24\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nYou should read the following discussion and analysis of our financial condition and results of operations together with the unaudited condensed consolidated financial statements, and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, along with the financial information included in our prospectus dated March 24, 2021 (the “Prospectus”) as filed with the Securities Exchange Commission (the “SEC”) on March 25, 2021 pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”). Some of the information contained in this discussion and analysis, including information with respect to our planned investments in our research and development, sales and marketing, and general and administrative functions, contains forward-looking statements based upon current plans, beliefs, and expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the sections titled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q.\\nSPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS\\nThis Quarterly Report on Form 10-Q contains forward-looking statements about Semrush Holdings, Inc. (“Semrush Holdings”) and our subsidiaries (collectively, the “Group”, the “Company”, “Semrush”, “we”, “us”, or “our”) and our industry that involve substantial risks and uncertainties. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations, financial condition, business strategy and plans and objectives of management for future operations, are forward-looking statements. In some cases, you can identify forward-looking statements because they contain words such as “anticipate,” “believe,” “contemplate,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “target,” “will,” or “would,” or the negative of these words or other similar terms or expressions. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:\\n•our future financial performance, including our revenue, annual recurring revenue (“ARR”), costs of revenue, gross profit or gross margin and operating expenses;\\n•the sufficiency of our cash and cash equivalents to meet our liquidity needs;\\n•anticipated trends and growth rates in our business and in the markets in which we operate;\\n•our ability to maintain the security and availability of our internal networks and platform;\\n•our ability to attract new paying customers and convert free customers into paying customers;\\n•our ability to retain and expand sales to our existing paying customers, including upgrades to premium subscriptions, purchases of add-on offerings, and increasing the number of authorized users per paying customer;\\n•our ability to access, collect, and analyze data;\\n•our ability to successfully expand in our existing markets and into new markets;\\n•our ability to effectively manage our growth and future expenses;\\n•our ability to continue to innovate and develop new products and features, improve our data assets, and enhance our technological capabilities;\\n•our estimated total addressable market;\\n25\\n•our ability to maintain, protect, and enhance our intellectual property;\\n•our ability to comply with modified or new laws and regulations applying to our business;\\n•the attraction and retention of qualified employees and key personnel;\\n•our anticipated investments in sales and marketing, and research and development;\\n•our ability to successfully defend litigation brought against us;\\n•our ability to successfully acquire and integrate companies and assets;\\n•the increased expenses associated with being a public company;\\n•our use of the net proceeds from our initial public offering (“IPO”); and\\n•the impact of the novel strain of coronavirus (“COVID-19”) on our business and industry.\\nYou should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations and prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and other factors described in the section titled “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. The results, events, and circumstances reflected in the forward-looking statements may not be achieved or occur, and actual results, events, or circumstances could differ materially from those described in the forward-looking statements.\\nThe forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make.\\nIn addition, statements that “we believe” and similar statements reflect our beliefs and opinions on the relevant subject. These statements are based upon information available to us as of the date of this Quarterly Report on Form 10-Q, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain and you are cautioned not to unduly rely upon these statements.\\nCompany Overview\\nWe are a leading online visibility management software-as-a-service (“SaaS”) platform, enabling companies globally to identify and reach the right audience in the right context and through the right channels. Online visibility represents how effectively companies connect with consumers across a variety of digital channels, including search, social and digital media, digital public relations, and review websites.\\n26\\nOur proprietary SaaS platform enables us to aggregate and enrich trillions of data points collected from hundreds of millions of unique domains, social media platforms, online ads, and web traffic. This allows our customers to understand trends, derive unique and actionable insights to improve their websites and social media pages, and distribute highly relevant content to their targeted customers across channels to drive high-quality traffic.\\nOn March 29, 2021, we completed our IPO in which we issued and sold 10,000,000 shares of our Class A common stock at a public offering price of $14.00 per share for aggregate gross proceeds of $140.0 million. We received approximately $126.6 million in net proceeds after deducting $9.8 million of underwriting discounts and commissions and approximately $3.6 million in offering costs. In connection with the closing of the IPO, all of the outstanding shares of our Preferred Stock and Common Stock automatically converted into 124,905,954 shares of Class B common stock.\\nWe generate substantially all of our revenue from monthly and annual subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date the product is made available to customers.\\nWe have one reportable segment. See Note 14 of our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\\nKey Factors Affecting Our Performance\\nWe regularly review a number of factors that have impacted, and we believe will continue to impact, our results of operations and growth. These factors include:\\nAcquiring New Paying Customers\\nWe expect increasing demand for third-party online visibility software to accelerate adoption of our platform. Our recurring subscription model provides significant visibility into our future results and we believe ARR is the best indicator of the scale of our platform, while mitigating fluctuations due to seasonality and contract term. We define ARR as the daily revenue of all paid subscription agreements that are actively generating revenue as of the last day of the reporting period multiplied by 365. We include both monthly recurring paid subscriptions, which renew automatically unless cancelled, as well as the annual recurring paid subscriptions so long as we do not have any indication that a customer has cancelled or intends to cancel its subscription and we continue to generate revenue from them. As of March 31, 2021 and 2020, we had more than 72,000 paying customers and 56,000 paying customers, respectively, accounting for $167.6 million and $109.5 million in ARR, respectively.\\nRetaining and Expanding Sales to Our Existing Customers\\nWe serve a diverse customer base across a variety of sizes and industries that is focused on maximizing their online visibility. We believe there is a significant opportunity to expand within our existing customer base as customers often initially purchase our entry-level subscription, which offers lower usage limits and limited user licenses, as well as fewer features. We have demonstrated the ability to expand contract values with our existing customers as they use our products and recognize the critical nature of our platform and often seek premium offerings through incremental usage, features, add-ons, and additional user licenses.\\nWe have successfully increased ARR per paying customer over time and believe this metric is an indicator of our ability to grow the long-term value of our platform. We expect ARR per paying customer to continue to increase as customers adopt our premium offerings and we continue to introduce new products and functionality. Our ARR per paying customer as of March 31, 2021 and 2020 was $2,274 and $1,942, respectively. We define ARR per paying customer during a given period as ARR from our paying customers at the end of the period divided by the number of paying customers as of the end of the same\\n27\\nperiod. We define the number of paying customers as the number of unique business and individual customers at the end of a particular period. We define a business customer as all accounts that contain a common non-individual business email domain (e.g., all subscriptions with an email domain of @XYZ.com will be considered to be one customer), and an individual customer as an account that uses an individual non-business email domain.\\nSustaining Product and Technology Innovation\\nWe have a strong track record of developing new products that have high adoption rates among our paying customers. Our product development organization plays a critical role in continuing to enhance the effectiveness and differentiation of our technology in an evolving landscape and maximizing retention of our existing customers. We intend to continue investing in product development to improve our data assets, expand our products and enhance our technological capabilities.\\nNon-GAAP Financial Measures\\nIn addition to our financial results determined in accordance with U.S. generally accepted accounting principles (“GAAP”), we believe that free cash flow and free cash flow margin, each a non-GAAP financial measure, are useful in evaluating the performance of our business.\\nFree cash flow and free cash flow margin\\nWe define free cash flow, a non-GAAP financial measure, as net cash provided by operating activities less purchases of property and equipment and capitalized software development costs. We define free cash flow margin as free cash flow divided by total revenue. We monitor free cash flow and free cash flow margin as two measures of our overall business performance, which enables us to analyze our future performance without the effects of non-cash items and allow us to better understand the cash needs of our business. While we believe that free cash flow and free cash flow margin are useful in evaluating our business, free cash flow and free cash flow margin are each a non-GAAP financial measure that have limitations as an analytical tool, and free cash flow and free cash flow margin should not be considered as an alternative to, or substitute for, net cash used in operating activities in accordance with GAAP. The utility of each of free cash flow and free cash flow margin as a measure of our liquidity is further limited as each measure does not represent the total increase or decrease in our cash balance for any given period. In addition, other companies, including companies in our industry, may calculate free cash flow and free cash flow margin differently or not at all, which reduces the usefulness of free cash flow and free cash flow margin as tool for comparison. A summary of our cash flows from operating, investing and financing activities is provided below. We recommend that you review the reconciliation of free cash flow to net cash used in operating activities, the most directly comparable GAAP financial measure, and the reconciliation of free cash flow margin to net cash used in operating activities (as a percentage of revenue), the most directly comparable GAAP financial measure, provided below, and that you not rely on free cash flow, free cash flow margin or any single financial measure to evaluate our business.\\n| Three Months Ended March 31,(in thousands) |\\n| 2021 | 2020 |\\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\\n| Net cash used in investing activities | (1,139) | (1,381) |\\n| Net cash provided by (used in) financing activities | 128,468 | (16) |\\n| Net increase (decrease) in cash, cash equivalents and restricted cash | $ | 136,336 | (836) |\\n\\n28\\n| Three Months Ended March 31,(in thousands) |\\n| 2021 | 2020 |\\n| Net cash provided by operating activities | $ | 9,007 | $ | 561 |\\n| Purchases of property and equipment | (166) | (1,084) |\\n| Capitalization of internal-use software costs | (123) | (297) |\\n| Free cash flow | $ | 8,718 | $ | (820) |\\n\\n| Three Months Ended March 31,(in thousands) |\\n| 2021 | 2020 |\\n| Net cash provided by operating activities (as a percentage of revenue) | 22.5 | % | 2.0 | % |\\n| Purchases of property and equipment (as a percentage of revenue) | (0.4) | % | (3.9) | % |\\n| Capitalization of internal-use software costs (as a percentage of revenue) | (0.3) | % | (1.1) | % |\\n| Free cash flow margin | 21.8 | % | (3.0) | % |\\n\\nComponents of our Results of Operations\\nRevenue\\nWe generate nearly all of our revenue from subscriptions to our online visibility management platform under a SaaS model. Subscription revenue is recognized ratably over the contract term beginning on the date on which we provide the customer access to our platform. Our customers do not have the right to take possession of our software. Our subscriptions are generally non-cancellable during the contractual subscription term, however our subscription contracts contain a right to a refund if requested within seven days of purchase.\\nWe offer our paid products to customers via monthly or annual subscription plans, as well as one-time and ongoing add-ons. As of March 31, 2021 and 2020, approximately 77% and 76%, respectively, of our paying customers purchased monthly subscription plans. Our subscription-based model enables customers to select a plan based on their needs and license our platform on a per user per month basis.\\nAs of March 31, 2021, we served approximately 72,000 paying customers in various industries, and our revenue is not concentrated with any single customer or industry. For the three months ended March 31, 2021 and 2020, no single customer accounted for more than 1% of our revenue.\\nCost of Revenue\\nCost of revenue primarily consists of expenses related to hosting our platform, acquiring data, and providing support to our customers. These expenses are comprised of personnel and related costs, including salaries, benefits, incentive compensation, and stock-based compensation expense related to the management of our data centers, our customer support team and our customer success team, and data acquisition costs. In addition to these expenses, we incur third-party service provider costs, such as data center and networking expenses, allocated overhead costs, depreciation expense and amortization associated with the Company’s property and equipment, and amortization of capitalized software development costs and other intangible assets. We allocate overhead costs, such as rent and facility costs, information technology costs, and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of revenue and each operating expense category.\\n29\\nWe expect our cost of revenue to increase in absolute dollars due to expenditures related to the purchase of hardware, data, expansion, and support of our data center operations and customer support teams. We also expect that cost of revenue as a percentage of revenue will decrease over time as we are able to achieve economies of scale in our business, although it may fluctuate from period to period depending on the timing of significant expenditures. To the extent that our customer base grows, we intend to continue to invest additional resources in expanding the delivery capability of our products and other services. The timing of these additional expenses could affect our cost of revenue, both in terms of absolute dollars and as a percentage of revenue in any particular quarterly or annual period.\\nOperating Expenses\\nResearch and Development\\nResearch and development expenses primarily consist of personnel and related costs, including salaries, benefits, incentive compensation, stock-based compensation, and allocated overhead costs. Research and development expenses also include depreciation expense and other expenses associated with product development. Other than internal-use software costs that qualify for capitalization, research and development costs are expensed as incurred. We plan to increase the dollar amount of our investment in research and development for the foreseeable future as we focus on developing new products, features, and enhancements to our platform. We believe that investing in the development of new products, features, and enhancements improves customer experience, makes our platform more attractive to new paying customers and provides us with opportunities to expand sales to existing paying customers and convert free customers to paying customers. However, we expect our research and development expenses to decrease as a percentage of our revenue over time.\\nSales and Marketing\\nSales and marketing expenses primarily consist of personnel and related costs directly associated with our sales and marketing department, including salaries, benefits, incentive compensation, and stock-based compensation, online advertising expenses, and marketing and promotional expenses, as well as allocated overhead costs. We expense all costs as they are incurred, excluding sales commissions identified as incremental costs to obtain a contract, which are capitalized and amortized on a straight-line basis over the average period of benefit, which we estimate to be two years. We expect that our sales and marketing expenses will continue to increase in absolute dollars in the year ending December 31, 2021. New sales personnel require training and may take several months or more to achieve productivity; as such, the costs we incur in connection with the hiring of new sales personnel in a given period are not typically offset by increased revenue in that period and may not result in new revenue if these sales personnel fail to become productive. We expect to increase our investment in sales and marketing as we add new services, which will increase these expenses in absolute dollars. Over the long term, we believe that sales and marketing expenses as a percentage of revenue will vary depending upon the mix of revenue from new and existing customers, as well as changes in the productivity of our sales and marketing programs.\\nGeneral and Administrative\\nGeneral and administrative expenses primarily consist of personnel and related expenses, including salaries, benefits, incentive compensation, and stock-based compensation, associated with our finance, legal, human resources, and other administrative employees. Our general and administrative expenses also include professional fees for external legal, accounting, and other consulting services, insurance, depreciation and amortization expense, as well as allocated overhead. We expect to increase the size of our general and administrative functions to support the growth of our business. We expect to continue to incur additional expenses as a result of operating as a public company, including costs to comply with rules and regulations applicable to companies listed on a U.S. securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, increases in\\n30\\ninsurance premiums, investor relations and professional services. We expect the dollar amount of our general and administrative expenses to increase for the foreseeable future. However, we expect our general and administrative expenses to decrease as a percentage of revenue over time.\\nOther Income, Net\\nIncluded in other income, net are foreign currency transaction gains and losses. The functional currency of our international operations is the U.S. dollar except for Prowly, which is Polish Zloty. Any differences resulting from the re-measurement of assets and liabilities denominated in a currency other than the functional currency are recorded within other income, net. We expect our foreign currency exchange gains and losses to continue to fluctuate in the future as foreign currency exchange rates change.\\nOther income, net also includes amounts for other miscellaneous income and expense unrelated to our core operations.\\nIncome Tax Provision\\nWe operate in several tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. We account for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. In addition, this method requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. To date, we have incurred cumulative net losses and maintain a full valuation allowance on our net deferred tax assets. We expect this trend to continue for the foreseeable future. Our tax expense for the three months ended March 31, 2021 and 2020 primarily relates to income earned in certain foreign jurisdictions.\\nResults of Operations\\nThe following tables set forth information comparing our results of operations in dollars and as a percentage of total revenue for the periods presented. The period-to-period comparison of results is not necessarily indicative of results for future periods.\\n31\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in thousands) |\\n| Revenue | $ | 39,998 | $ | 27,787 |\\n| Cost of revenue (1) | 8,773 | 6,611 |\\n| Gross profit | 31,225 | 21,176 |\\n| Operating expenses |\\n| Sales and marketing (1) | 16,457 | 12,877 |\\n| Research and development (1) | 5,358 | 4,237 |\\n| General and administrative (1) | 7,904 | 5,933 |\\n| Total operating expenses | 29,719 | 23,047 |\\n| Income (loss) from operations | 1,506 | (1,871) |\\n| Other income, net | 51 | 56 |\\n| Income (loss) before income taxes | 1,557 | (1,815) |\\n| Provision for income taxes | 86 | 116 |\\n| Net income (loss) | $ | 1,471 | $ | (1,931) |\\n\\n__________________\\n(1)Includes stock-based compensation expense as follows:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in thousands) |\\n| Cost of revenue | $ | 7 | $ | 5 |\\n| Sales and marketing | 190 | 27 |\\n| Research and development | 67 | 29 |\\n| General and administrative | 329 | 144 |\\n| Total stock-based compensation | $ | 593 | $ | 205 |\\n\\n32\\nThe following table sets forth our unaudited condensed consolidated statements of operations data expressed as a percentage of revenue for the periods indicated:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (as a percentage of total revenue) |\\n| Revenue | 100 | % | 100 | % |\\n| Cost of revenue | 22 | % | 24 | % |\\n| Gross profit | 78 | % | 76 | % |\\n| Operating expenses |\\n| Sales and marketing | 41 | % | 46 | % |\\n| Research and development | 13 | % | 15 | % |\\n| General and administrative | 20 | % | 22 | % |\\n| Total operating expenses | 74 | % | 83 | % |\\n| Income (loss) from operations | 4 | % | (6) | % |\\n| Other income, net | — | % | — | % |\\n| Income (loss) before income taxes | 4 | % | (6) | % |\\n| Provision for income taxes | — | % | — | % |\\n| Net income (loss) | 4 | % | (6) | % |\\n\\nComparison of the Three Months Ended March 31, 2021 and 2020\\nRevenue\\nOur revenue during the three months ended March 31, 2021 and 2020 was as follows:\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Revenue | $ | 39,998 | 27,787 | $ | 12,211 | 44 | % |\\n\\nRevenue increased in all regions and was most pronounced in the United States. The majority of this increase was driven by an increase in the number of paying customers from 56,000 as of March 31, 2020 to 72,000 as of March 31, 2021. The net income for the three months ended March 31, 2021 was partially driven by an increase in the subscription price of our core product.\\n33\\nThe locations of our paying customers during the three months ended March 31, 2021 and 2020 were as follows:\\n| Three Months Ended March 31, |\\n| 2021 | 2020 |\\n| (in thousands) |\\n| Revenue: |\\n| United States | $ | 18,132 | $ | 12,886 |\\n| United Kingdom | 4,195 | 2,994 |\\n| Other | 17,671 | 11,907 |\\n| Total revenue | $ | 39,998 | $ | 27,787 |\\n\\nCost of Revenue, Gross Profit and Gross Margin\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Cost of revenue | $ | 8,773 | $ | 6,611 | $ | 2,162 | 33 | % |\\n| Gross profit | $ | 31,225 | $ | 21,176 | $ | 10,049 | 47 | % |\\n| Gross margin | 78.1 | % | 76.2 | % |\\n\\nThe increase in cost of revenue for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following changes:\\n| Change |\\n| (in thousands) |\\n| Hosting fees | $ | 446 |\\n| Integration and data costs | 787 |\\n| Merchant fees | 309 |\\n| Other | 620 |\\n| Cost of revenue | $ | 2,162 |\\n\\nHosting fees increased, driven by the additional costs associated with our growth in subscription revenue and the additional costs associated with expanding our relationships with our current paying subscribers. Integration and data costs increased primarily as a result of increasing costs incurred related to new products and customer growth. Merchant fees increased commensurate with sales growth. Other costs increased primarily as a result of a 95% increase in headcount as we continue to grow our customer support and customer success teams to support our customer growth.\\n34\\nOperating Expenses\\nSales and Marketing\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Sales and marketing | $ | 16,457 | $ | 12,877 | $ | 3,580 | 28 | % |\\n| Percentage of total revenue | 41 | % | 46 | % |\\n\\nThe increase in sales and marketing expense for the three months ended March 31, 2021 compared to the three months ended March 31, 2020 was primarily due to the following:\\n| Change |\\n| (in thousands) |\\n| Personnel costs | $ | 2,156 |\\n| Advertising expense | 1,503 |\\n| Other | (79) |\\n| Sales and marketing | $ | 3,580 |\\n\\nPersonnel costs increased primarily as a result of a 24% increase in headcount as we continue to expand our sales teams to grow our customer base. Personnel costs include the amortization of capitalized commission costs, which increased quarter over quarter partially due to the amortization of commissions paid in prior periods, as well as expense associated with the amortization of commissions paid and capitalized during the three months ended March 31, 2021, which increased compared to the three months ended March 31, 2020 due to the overall growth in sales. Advertising expense increased primarily as a result of increasing expenses to acquire new paying customers.\\nResearch and Development\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Research and development | $ | 5,358 | $ | 4,237 | $ | 1,121 | 26 | % |\\n| Percentage of total revenue | 13 | % | 15 | % |\\n\\nResearch and development costs increased primarily as a result of a 31% increase in headcount as we continue to expand our product development teams.\\nGeneral and administrative\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| General and administrative | $ | 7,904 | $ | 5,933 | $ | 1,971 | 33 | % |\\n| Percentage of total revenue | 20 | % | 21 | % |\\n\\n35\\nThe increase in general and administrative expense was primarily driven by a 47% increase in headcount as we continue to expand our accounting and reporting, legal and compliance, and internal support teams. It was also driven by a 167% increase in stock-based compensation applicable to these teams.\\nOther Income, Net\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Other income, net | $ | 51 | $ | 56 | $ | (5) | (9) | % |\\n| Percentage of total revenue | — | % | — | % |\\n\\nThe relatively small decrease in other income was partially driven by changes in the foreign exchange gains or losses from foreign currency translation adjustments associated with our international activities.\\nProvision for Income Taxes\\n| Three Months Ended March 31, | Change |\\n| 2021 | 2020 | Amount | % |\\n| (dollars in thousands) |\\n| Provision for income taxes | $ | 86 | $ | 116 | $ | (30) | (26) | % |\\n| Percentage of total revenue | — | % | — | % |\\n\\nThe provision for income taxes is primarily attributable to estimated taxes related to our foreign jurisdictions.\\nLiquidity and Capital Resources\\nTo date, our principal sources of liquidity have been the net proceeds of $126.6 million, after deducting underwriting discounts and offering expenses paid or payable by us, from our IPO in March 2021, the net proceeds we received through private sales of equity securities, as well as sales of premium subscriptions to our platform.\\nAs of March 31, 2021, our principal sources of liquidity were cash and cash equivalents of $171.9 million and accounts receivable of $2.4 million. With the exception of this three month period ended March 31, 2021, we have generated losses from operations since inception. With the exception of this three month period ended March 31, 2021, we expect to continue to incur operating losses and negative cash flows for the foreseeable future due to the investments in our business we intend to make as described above.\\nOur principal uses of cash in recent periods have been to fund operations and invest in capital expenditures, and are held in cash deposits and money market funds.\\nWe believe our existing cash will be sufficient to meet our operating and capital needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our subscription growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced product offerings, and the continuing market acceptance of our platform and products. In the future, we may enter into arrangements to acquire or invest in complementary companies,\\n36\\nproducts, and technologies, including intellectual property rights. We may be required to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us, or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations, our business, results of operations, and financial condition could be adversely affected.\\nOur Credit Facility\\nPursuant to the Credit Agreement among us and Semrush Inc., a Delaware corporation (“Semrush US Sub”), each as a borrower, the lenders party thereto from time to time and JPMorgan Chase Bank, N.A., as the administrative agent, as amended from time to time, we have a senior secured credit facility that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The availability of the credit facility is subject to the borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. The credit facility has a maturity of three years and will mature on January 12, 2024.\\nBorrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the alternate base rate, subject to a 3.25% floor (or 1.50% prior to positive consolidated adjusted earnings before interest, taxes, depreciation, and amortization (“adjusted EBITDA”) for the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\\nOperating Activities\\nOur largest source of operating cash is cash collections from our customers for subscription services. Our primary uses of cash from operating activities are for online advertising, personnel costs across the sales and marketing and product and development departments, and hosting costs.\\nNet cash provided by operating activities during the three months ended March 31, 2021 was $9.0 million, which resulted from a net income of $1.5 million adjusted for non-cash charges of $2.3 million and a net cash inflow of $5.2 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $0.5 million of depreciation and amortization expense, $1.3 million for amortization of deferred contract acquisition costs related to capitalized commissions, and $0.6 million of stock-based compensation expense. The changes in operating assets and liabilities was primarily the result of a $5.6 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $2.4 million increase in accrued expenses, and a $1.6 million increase in accounts payable. These inflows were partially offset by a $2.4 million increase in deferred contract costs, a $1.0 million increase in prepaid expenses and other current assets, and a $1.0 million increase in accounts receivable.\\nNet cash provided by operating activities during the three months ended March 31, 2020 was $0.6 million, which resulted from a net loss of $1.9 million adjusted for non-cash charges of $1.5 million and net cash inflow of $1.0 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $1.1 million for amortization of deferred contract acquisition costs related to capitalized commissions, $0.2 million of stock-based compensation expense, and $0.2 million of depreciation and amortization expense. The changes in operating assets and liabilities was primarily the result of a $1.7 million increase in deferred revenue due to the addition of new customers and expansion of the business, a $1.0 million increase in accrued expenses, a $0.7 million decrease in accounts receivable, and a $0.1 million increase in accounts payable. These inflows were partially offset by\\n37\\na $1.7 million increase in deferred contract costs and a $0.7 million increase in prepaid expenses and other current assets.\\nInvesting Activities\\nNet cash used in investing activities for the three months ended March 31, 2021 and 2020 was $1.1 million and $1.4 million, respectively. The decrease of $0.2 million of cash used in investing activities was primarily due to the reduced purchases of computer equipment and hardware, as well as a decrease in capitalized costs associated with internal use software. During the three months ended March 31, 2021, cash used in investing activities also included $500 paid for two convertible debt securities.\\nFinancing Activities\\nNet cash provided by financing activities for the three months ended March 31, 2021 was $128.5 million, primarily consisting of the net proceeds from the IPO. Net cash used in financing activities for the three months ended March 31, 2020 was insignificant and consisted entirely of payments of deferred offering costs.\\nContractual Obligations\\nAs of March 31, 2021, there were no material changes in our contractual obligations and commitments from those disclosed in the Prospectus, other than those appearing in the notes to the Unaudited Condensed Consolidated Financial Statements appearing elsewhere in this Quarterly Report on Form 10-Q.\\nOff-Balance Sheet Arrangements\\nAs of March 31, 2021, we did not have any relationships with any entities or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other purposes. As a result, we are not exposed to related financing, liquidity, market or credit risks that could arise if we had engaged in those types of arrangements.\\nRecent Accounting Pronouncements\\nRefer to the section titled “Recent Accounting Pronouncements” in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for more information.\\nCritical Accounting Policies and Estimates\\nOur Unaudited Condensed Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Unaudited Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates.\\nOur critical accounting policies are described under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Critical Accounting Policies and Estimates” in the Prospectus and in Note 2 of the notes to our Unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.\\n38\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nWe are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and inflation. We do not hold or issue financial instruments for trading purposes.\\nInterest Rate Risk\\nWe had cash and cash equivalents of $171.9 million and $35.5 million as of March 31, 2021 and December 31, 2020, respectively. Our cash and cash equivalents are held in cash deposits and money market funds. Due to the short-term nature of these instruments, we do not believe that we have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates.\\nAs of March 31, 2021, we had $45.0 million available under the revolving credit facility, with $5.0 million of such revolving commitments available under the letter of credit sub-facility. Borrowings under our credit facility bear interest at our option at (i) LIBOR, subject to a 0.50% floor, plus a margin, or (ii) the base rate, subject to a 3.25% floor (or 1.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended), plus a margin. For LIBOR borrowings, the applicable rate margin is 2.75% (or 3.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). For base rate borrowings, the applicable margin is 0.00% (or 2.50% prior to an IPO or positive consolidated adjusted EBITDA as of the twelve months most recently ended). We are also required to pay a 0.25% per annum fee on undrawn amounts under our revolving credit facility, payable quarterly in arrears.\\nWe did not have any current investments in marketable securities as of March 31, 2021 and 2020.\\nForeign Currency Exchange Risk\\nWe are not currently subject to significant foreign currency exchange risk with respect to revenue as our U.S. and international sales are predominantly denominated in U.S. dollars. However, we have some foreign currency risk related to a small amount of sales denominated in euros, and expenses denominated in euros, rubles, korunas, and zloty. Sales denominated in euros reflect the prevailing U.S. dollar exchange rate on the date of invoice for such sales. Increases in the relative value of the U.S. dollar to the euro may negatively affect revenue and other operating results as expressed in U.S. dollars. We incur significant expenses outside the United States denominated in these foreign currencies, primarily the ruble. If the average exchange rates of any of these foreign currencies strengthen against the dollar, the dollar value of our expenses outside the United States will increase. For example, an immediate 10% decrease or increase in the relative value of the U.S. dollar to the ruble would result in a $3.4 million loss or gain on our unaudited condensed consolidated statements of operations and cash flows.\\nWe have not engaged in the hedging of foreign currency transactions to date. However, as our international operations expand, our foreign currency exchange risk may increase. If our foreign currency exchange risk increases in the future, we may evaluate the costs and benefits of initiating a foreign currency hedge program in connection with non-U.S. dollar denominated transactions.\\n39\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nOur management, including our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on management’s review, with participation of our Chief Executive Officer and Chief Financial Officer, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the quarter ended March 31, 2021, the Company’s disclosure controls and procedures were not effective.\\nAs previously disclosed under the section titled “Risk Factors” of the Prospectus, in connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operation of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\\nNotwithstanding the identified material weakness, our management believes the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows as of and for the periods presented in accordance with U.S. generally accepted accounting principles.\\nRemediation Plan for Material Weakness\\nRemediation generally requires making changes to how controls are designed and implemented and then adhering to those changes for a sufficient period of time such that the effectiveness of those changes is demonstrated with an appropriate amount of consistency. In response to the material weakness, we implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting. Further, changes and improvements in our internal control over financial reporting environment will be implemented based on ongoing management reviews and the continued implementation of the remediation plan.\\nChanges in Internal Control Over Financial Reporting\\nExcept for the remediation measures in connection with the material weakness described above, there were no other changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2021, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nInherent Limitations on Effectiveness of Controls\\nOur management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitation in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of\\n40\\nfraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Due to inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.\\n41\\nPART II — OTHER INFORMATION\\nItem 1. Legal Proceedings\\nFrom time to time we may become in involved in legal proceedings or be subject to claims arising in the ordinary course of our business. We are not presently a party to any legal proceedings that, if determined adversely to us, would individually or taken together have a material adverse effect on our business, operating results, financial condition or cash flows. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors.\\nItem 1A. Risk Factors\\nInvesting in our Class A common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, before making a decision to invest in our Class A common stock. If any of the risks actually occur, our business, results of operations, financial condition, and prospects could be harmed. In that event, the trading price of our Class A common stock could decline, and you could lose part or all of your investment.\\nSummary of the Material Risks Associated with Our Business\\nOur business is subject to numerous risks and uncertainties that you should be aware of in evaluating our business. These risks and uncertainties include, but are not limited to, the following:\\n• We derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\\n• Our business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\\n• If we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\\n• The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\\n• Our products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\\n• Our ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\\n• If we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\\n42\\n• We depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\\n• An inability to attract and retain other highly skilled employees could harm our business.\\n• Changes by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\\n• If the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\\n• The effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\\n• If the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\\n• We may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\\nMost Material Risks to Us\\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions, and our business and operating results will be harmed if our paying customers do not renew their premium subscriptions.\\nWe derive, and expect to continue to derive, substantially all of our revenue and cash flows from our paying customers with premium subscriptions. Our business and financial results depend on our paying customers renewing their subscriptions for our products when existing contract terms expire. Although our customer agreements provide for auto-renewal of subscriptions, our paying customers have no obligation to renew their premium subscriptions if they provide proper notice of their desire not to renew, and we cannot guarantee that they will renew their premium subscriptions for the same or longer terms, the same or a greater number of user licenses or products and add-ons, or at all. We offer premium subscriptions on a monthly or annual basis with our annual subscriptions receiving a discount for the longer-term commitment. Our paying customers predominantly choose monthly subscription terms, which allow them to terminate or adjust their premium subscriptions with us on a monthly basis as external factors change and could cause our results of operations to fluctuate significantly from quarter to quarter. Our renewal rates, including our dollar-based net revenue retention rate, may decline or fluctuate as a result of a number of factors, including customer satisfaction with our platform and products, reliability of our products, our customer success and support experience, the price and functionality of our platform, products, and add-ons relative to those of our competitors, mergers and acquisitions affecting our customer base, the effects of global economic conditions and other external factors, or reductions in our customers’ spending levels. Our business and operating results will be adversely affected if our paying customers do not renew their premium subscriptions.\\n43\\nOur business and operating results will be harmed if our paying customers do not upgrade their premium subscriptions or if they fail to purchase additional products.\\nOur future financial performance also depends in part on our ability to continue to upgrade paying customers to higher-price point subscriptions and sell additional user licenses, and products and add-ons such as Prowly, Sellerly, and Competitive Intelligence. Conversely, our paying customers may convert to lower-cost or free subscriptions if they do not perceive value in paying for our higher-price point subscriptions, thereby impacting our ability to increase revenue. For example, a paying customer subscribing to our core product through a “Business” subscription may downgrade to the “Guru” subscription if they do not deem the additional features and functionality worth the incremental costs. To expand our relationships with our customers, we must demonstrate to existing paying and free customers that the additional functionality associated with an upgraded subscription outweighs the incremental costs. Our customers’ decisions as to whether to upgrade their subscriptions or not is driven by a number of factors, including customer satisfaction with the security, performance, and reliability of our platform and products, general economic conditions, the price and functionality of our platform and products relative to those of our competitors, and customer reaction to the price for additional products. If our efforts to expand our relationships with our existing paying and free customers are not successful, our revenue growth rate may decline and our business and operating results will be adversely affected.\\nIf we fail to attract new potential customers through unpaid and paid marketing efforts, register them for trials, and convert them into paying customers, our operating results would be harmed.\\nThe number of new customers we attract, whether as free or paying customers, is a key factor in growing our customer and premium subscription base which drive our revenues and collections. We utilize various unpaid content marketing strategies, including blogs, webinars, thought leadership, and social media engagement, as well as paid advertising, to attract visitors to our websites. We cannot guarantee that these unpaid or paid marketing efforts will continue to attract the same volume and quality of traffic to our websites or will continue to result in the same level of registrations for premium subscriptions as they have in the past. In the future, we may be required to increase our marketing spend to maintain the same volume and quality of traffic. Moreover, we cannot be certain that increased sales and marketing spend will generate more paying customers without increasing our customer acquisition costs on a per paying customer basis. We offer potential customers several tiered subscription options for our online visibility management platform, including free subscriptions of a limited-functionality product and premium subscriptions of our “Pro”, “Guru” or “Business” offerings for our core product, depending on the level of functionality they seek. We have materially grown our number of paying customers through the provision of free subscriptions and through trials of a premium version of our online visibility and marketing insight products. Trial subscriptions automatically become premium subscriptions if the customer does not opt out of the trial subscription after the trial period is over, and such trial subscriptions can be upgraded to obtain additional features, functionality, and varying levels of access and report generating capabilities. In the future, we may be required to provide additional functionality to our free subscriptions to attract visitors to our websites and incent visitors to sign up for free subscriptions. In addition, we encourage our free customers to upgrade to premium subscriptions through in-product prompts and notifications, by recommending additional features and functionality, and by providing customer support to explain such additional features and functionality. Our failure to attract new free customers and convert them into paying customers could have a material adverse effect on our operating results as our business may be adversely affected by the costs of, and sales lost from, making certain of our products available on a free basis. While we do not receive any revenue from our customers who use our platform on a free basis, we bear incremental expenses as a result of their continuing free access to our platform and certain of our products.\\n44\\nThe market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free and paying customers could be harmed, which would negatively impact our business and operating results.\\nThe market for our products is fragmented, rapidly evolving, and highly competitive, with relatively low barriers to entry. Our all-in-one SaaS platform competes with software products and solutions that are focused on a particular customer need, or point solutions. For example, we compete with point solutions for search advertising and search engine optimization, marketing analytics and social media management, market intelligence, and web analytics services. Our ability to attract and retain free and paying customers depends in part on the actual and perceived quality and design of our platform, products, and add-ons compared to competitive point solutions and continued market acceptance of our platform, products, and add-ons for existing and new use-cases. To remain competitive and to acquire new customers, we must deliver features and functionality that enhance the utility and perceived value of our platform, products, and add-ons to our prospective and existing customers. Our platform, products, and add-ons must (i) operate without the presence of material software defects, whether actual or perceived, (ii) maintain deep and rich data sources, (iii) adapt to the changing needs of our current and prospective customers including by developing new technology, (iv) adapt to changing functionality and provide interoperability with third-party application programming interfaces (“APIs”), (v) maintain and develop integrations with complementary third-party services that provide value to our customers, (vi) be easy to use and visually pleasing, (vii) deliver rapid return on investment to our customers across multiple functions within their organizations, and (viii) be delivered with a superior customer support experience. We may not be successful in delivering on some or all of the foregoing or in doing so while maintaining competitive pricing, which could result in customer dissatisfaction leading to termination or downgrades of premium subscriptions, fewer new free customers, fewer subscription upgrades or lower dollar-based net revenue retention rates, prospective customers’ selection of our competitors’ products over our own, and other adverse effects on our business.\\nMany of our current and future competitors benefit from competitive advantages over us, such as greater name recognition, longer operating histories, more targeted products for specific use cases, larger sales and more established relationships or integrations with third-party data providers, search engines, online retail platforms, and social media networking sites, and more established relationships with customers in the market. Additionally, many of our competitors may expend a considerably greater amount of funds on their research and development efforts, and those that do not, may be acquired by larger companies that would allocate greater resources to our competitors’ research and development programs. Specifically, our competitors focusing on point solutions may have the ability to expend greater funds in a more targeted manner to develop superior solutions that address a specific need, as compared to our research and development expenditures which are allocated across our platform. In addition, some of our competitors may enter into strategic relationships or consummate strategic acquisitions to offer a broader range of functionality than we do, a more competitive multi-point solution, or to address needs that our platform does not. These types of business combinations may make it more difficult for us to acquire new free customers or maintain or upgrade our free and paying customers, any of which could ultimately impact our ability to compete effectively. We expect these competitive pressures to continue as competitors attempt to strengthen or preserve their market positions and as new competitors enter the market.\\nDemand for our platform is also price sensitive. Many factors, including our marketing, sales and technology costs, and the pricing and marketing strategies of our competitors, can significantly affect our pricing strategies. Certain competitors offer, or may in the future offer, lower-priced or free products that compete with our platform, products, and/or add-ons, or may bundle their solutions with other companies’ offerings to provide a broader range of functionality at reduced volume pricing. Similarly, certain competitors may use marketing strategies that enable them to acquire customers at a lower cost than we do. Even if such competitive products do not include all the features and functionality that our platform provides, we could face pricing pressure to the extent that customers find such alternative products to be sufficient to meet their needs or do not perceive a material return on investment from the additional\\n45\\nfeatures and functionality they would obtain by purchasing our platform relative to the competitive point solutions. Additionally, our competitors may further drive down the price through strategic business combinations. We may be forced to engage in price-cutting initiatives, offer other discounts, or increase our sales and marketing and other expenses to attract and retain free and paying customers in response to competitive pressures, any of which would harm our business and operating results.\\nWe have incurred losses in the past and may not consistently achieve profitability in the future.\\nWe have a history of incurring net losses and although we have achieved profitability in certain periods we expect to continue to incur net losses in the future. We incurred net losses of $10.2 million and $7.0 million for the years ended December 31, 2019 and 2020, respectively. As of March 31, 2021, we had an accumulated deficit of $34.3 million. We do not know if we will be able to achieve or sustain profitability in the future. We plan to continue to invest in our research and development, and sales and marketing efforts, and we anticipate that our operating expenses will continue to increase as we scale our business and expand our operations. We also expect our general and administrative expenses to increase as a result of our growth and operating as a public company. Our ability to achieve and sustain profitability is based on numerous factors, many of which are beyond our control.\\nOur products depend on publicly available and paid third-party data sources, and, if we lose access to data provided by such data sources or the terms and conditions on which we obtain such access become less favorable, our business could suffer.\\nWe have developed our platform, products, and add-ons to rely in part on access to data from third-party sources. The primary sources of third-party data include data collected from third-party websites algorithmically through our proprietary data collection techniques, including web crawling of third-party websites, data purchased from independent third-party data providers, which includes clickstream data, search engine data, online advertising data, and data from social media sources, and reference data that our customers grant us access to, which includes our customers’ website and social media data. We obtain social media data through APIs that connect to social media platform operators, including Facebook, Twitter, Instagram, Pinterest, and LinkedIn. We also collect data from our customers in connection with their use of our platform.\\nTo date, our relationships with most data providers (including social media platforms) are governed by such data providers’ respective standard terms and conditions, which govern the availability and access to, and permitted uses of such data (including via APIs), and which are subject to change by such providers from time to time, with little or no notice and with little or no right of redress. Similarly, our access to publicly available data may depend on restrictions that website owners may impose through technical measures or otherwise, including restrictions on automated data collection. We cannot accurately predict the impact of changes in the terms of data providers that may impede our access to the data. If these data providers or websites choose not to make their data available on the same terms, or at all, we would have to seek alternative sources, which could prove expensive and time-consuming, and may be less efficient or effective. Such changes could impact our ability to provide our services in a timely manner, if at all, and could negatively impact the perceived value of our platform and our business. There can be no assurance that following any such modification of terms or termination we would be able to maintain the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\\nWe also rely on negotiated agreements with other data providers from whom we purchase independently sourced data, including clickstream data, search engine data, online advertising data, data from social media, and other sources. These negotiated agreements provide access to additional data that allow us to provide a more comprehensive solution for our customers. These agreements are subject to termination in certain circumstances, and there can be no assurance that we will be able to renew those agreements or that the terms of any such renewal, including pricing and levels of service, will be favorable. In addition, there can be no assurance that we will not be required to enter into new negotiated\\n46\\nagreements with data providers in the future to maintain or enhance the level of functionality of our platform, or that the terms and conditions of such agreements, including pricing and levels of service, will not be less favorable, which could adversely affect our results of operations. Further, third-party data providers have previously, and may again, cease operations or a specific business line or cease providing products or data to their customers, including us. If we are not able to obtain third-party data on commercially reasonable terms, if these data providers stop making their data available to us, or if our competitors are able to purchase such data on better terms, the functionality of our platform and our ability to compete could be harmed.\\nTo the extent that we license or obtain data from third parties, we may be subject to contractual obligations to satisfy certain requirements under applicable laws including, but not limited to, providing public notice of our data processing activities and obtaining appropriate consents where required. If one or more of those third-party data providers considers that we have failed to satisfy these requirements, such third-party data provider may bring claims against us seeking damages, and/or seeking to prevent our future use of any data already provided. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\\nOur business may be harmed if any of our data sources:\\n•changes, limits or discontinues our access to their data;\\n•modifies its terms of service or other policies, including imposing prohibitive fees or restrictions on our use of their data or our ability to access it;\\n•changes or limits how customer information is accessed by us or our customers and their users;\\n•changes or limits how we can use such data;\\n•establishes more favorable relationships with one or more of our competitors; or\\n•experiences disruptions of its technology, services or business generally.\\nRisks Related to our Business\\nOur ability to introduce new products and add-ons is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts or use product and development teams effectively, our business and operating results may be harmed.\\nTo remain competitive, we must continue to develop new product offerings, as well as features and enhancements to our existing platform and products. Maintaining adequate research and development personnel and resources to meet the demands of the market is essential. If we experience high turnover of our product and development personnel, a lack of management ability to guide our research and development, or a lack of other research and development resources, we may miss or fail to execute on new product development and strategic opportunities and consequently lose potential and actual market share. The success of our business is dependent on our product and development teams developing and executing on a product roadmap that allows us to retain and increase the spending of our existing customers, attract new customers and upgrade our free customers to premium subscriptions. Our failure to maintain adequate research and development resources, to use our research and development resources efficiently, and to address the demands of our prospective and actual customers could materially adversely affect our business.\\n47\\nIf we are unable to maintain and enhance our brand, or if events occur that damage our reputation and brand, our ability to maintain and expand our customer base may be impaired, and our business and financial results may be harmed.\\nMaintaining, promoting, and enhancing our brand is critical to maintaining and expanding our customer base. We seek to build our brand through a mix of free and paid initiatives. We market our platform and products through free information resources on our website, including our blog and online digital marketing courses (including through our Semrush Academy), pay-per-click advertisements on search engines and social networking sites, participation in social networking sites, and free and paid banner advertisements on other websites. The strength of our brand further drives free traffic sources, including customer referrals, word-of-mouth, and direct searches for our “Semrush” name, or web presence solutions, in search engines. In addition, we maintain relationships with agencies and affiliates to further increase brand awareness and generate customer demand. To the extent that new customers are increasingly derived from paid as opposed to free marketing initiatives, our customer acquisition cost will increase.\\nBeyond direct sales and marketing efforts, maintaining and enhancing our brand will depend largely on our ability to continue to provide a well-designed, useful, reliable, and innovative platform, efficient sales process, and high-quality customer service, which we may not do successfully. For a discussion of other factors that will impact our brand recognition see the risk factors described elsewhere in this section, including without limitation, those risk factors entitled “The market in which we operate is intensely competitive, and if we do not compete effectively, our ability to attract and retain free customers and paying customers could be harmed, which would negatively impact our business and operating results.”; “If we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers and increase the number of user licenses per paying customer, especially from large enterprises.”; “If third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.”; “We rely on search engines and social networking sites to attract a meaningful portion of our customers, and if those search engines or social networking sites change their listings or policies regarding advertising, or increase their pricing or suffer problems, it may limit our ability to attract new customers.”; and “If we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.”\\nWe depend on our executive officers and other key employees, and the loss of one or more of these employees could harm our business.\\nOur success depends largely upon the continued services of our executive officers and other key employees. We rely on our leadership team in the areas of research and development, operations, security, marketing, sales, customer service, and general and administrative functions, and on individual contributors and team leaders in our research and development and operations. From time to time, there may be changes in our executive management team resulting from the hiring or departure of executives, which could disrupt our business. The loss of one or more of our executive officers or key employees could harm our business. Changes in our executive management team may also cause disruptions in, and harm to, our business.\\nWe are led by our CEO and co-founder, Oleg Shchegolev, our COO and co-founder, Dmitry Melnikov, and our Chief Product Officer, Vitalii Obishchenko, each of whom plays an important role in driving our culture, determining our strategy, and executing against that strategy companywide. If the services of Mr. Shchegolev, Mr. Melnikov, and/or Mr. Obishchenko become unavailable to us for any reason, it may be difficult or impossible for us to find an adequate and timely replacement, which could cause us to be less successful in maintaining our culture, and developing and effectively executing on our strategies and initiatives.\\n48\\nAn inability to attract and retain other highly skilled employees could harm our business.\\nTo execute our growth plan, we must attract and retain highly qualified personnel. Competition for highly qualified personnel in Boston, Massachusetts, where our headquarters is located, and Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, St. Petersburg, Russia, and Warsaw, Poland where we have offices. Competition in these locations is intense, especially for software engineers experienced in designing and developing software and SaaS applications, and experienced sales professionals who understand our products and the market in which we operate. We have from time to time experienced, and we expect to continue to experience, difficulty in hiring and retaining employees with appropriate qualifications. In addition, immigration laws in the locations in which we have offices and operations restrict or limit our ability to recruit internationally. Any changes to the immigration policies applicable to locations in which we have offices and operations that restrain the flow of technical and professional talent may inhibit our ability to recruit and retain highly qualified employees. Many of the companies with which we compete for experienced personnel may be able to offer more attractive terms of employment to potential candidates. If we hire employees from competitors or other companies, their former employers may attempt to assert that these employees have breached their legal obligations to such former employers, resulting in a diversion of our time and resources.\\nIn addition, job candidates and existing employees often consider the value of the equity awards they receive in connection with their employment as part of their overall compensation package. If the perceived value of our equity awards declines or does not compare favorably to the value of equity offered by other companies competing for the same personnel resources, it may harm our ability to recruit and retain highly skilled employees. In addition, we invest significant time and expense in training our employees, which increases their value to competitors who may seek to recruit them. For example, our software developers gain deep and direct experience in data analytics, machine learning, and search optimization, making them increasingly attractive to our competitors and other similar businesses. If we fail to attract new personnel or fail to retain and motivate our current personnel, our business and future growth prospects could be harmed.\\nChanges by search engines, social networking sites, and other third-party services to their underlying technology configurations or policies regarding the use of their platforms and/or technologies for commercial purposes, including anti-spam policies, may limit the efficacy of certain of our products, tools, and add-ons and as a result, our business may suffer.\\nOur online visibility platform is designed to help our customers connect with consumers across a variety of digital channels, search engines, social networking sites, and other third-party services. These services may adapt and change their strategies and policies over time. Search engines typically provide two types of search results, organic (i.e., non-paid) and purchased listings. Organic search results are determined and organized solely by automated criteria set by the search engine, and a ranking level cannot be purchased. Search engines revise their algorithms from time to time in an attempt to optimize their search result listings. Changes to search engine algorithms may diminish the efficacy of certain of our products, tools, and add-ons, and potentially render them obsolete. For example, if a given search engine stopped using backlinks in its ranking algorithm, our customers’ perception of our backlink analytics tool, which enables customers to analyze and monitor the backlink profile of their own and other websites, may be adversely impacted. Similarly, if a search engine ceases to manually penalize or take action against web pages for unnatural backlinks, then our customers may determine that auditing their backlinks is unnecessary which could cause them to devalue our backlink audit tool, which enables companies to check whether malicious websites have links to their sites, or cease using it altogether. In response to these types of changes we may be required to recalibrate our product offerings by reducing prices, discontinuing the affected product, or otherwise. These responses may be costly, may not be effective, and our business may suffer.\\nAdditionally, search engines, social networking sites, and other third-party services typically have terms of service, guidelines, and other policies to which its users are contractually obligated to adhere.\\n49\\nFor example, Google’s Gmail offering has a spam and abuse policy that prohibits sending spam, distributing viruses, or otherwise abusing the service. Prowly and our link building tool enable our customers to send emails to their desired recipients, such as marketing and affiliate partners, social media influencers, journalists, and bloggers. Our link building tool relies on a direct Gmail integration through which our customers are able to send emails using our platform as if they were sending emails directly from their Gmail account, and our Prowly product involves emails initiated by customers over Prowly servers. Our customers’ actions using either the link building tool or Prowly could be flagged under Google’s spam and abuse policy or in the future such actions may be prohibited by subsequent changes to Google’s policies. Any change to the policies of the third-party services with which our products, tools, and add-ons integrate or interact, or with which our products are intended to be used, including any anti-spam policies, or any actions taken by these third-party service providers under their policies could adversely impact the efficacy and perceived value of our products, tools, and add-ons, and as a result, our business may be harmed.\\nIf third-party applications change such that we do not or cannot maintain the compatibility of our platform with these applications or if we fail to integrate with or provide third-party applications that our customers desire to use with our products, demand for our solutions and platform could decline.\\nThe attractiveness of our platform depends, in part, on our ability to integrate via APIs with third-party applications that our customers desire to use with our products, such as Google, Facebook, Instagram, Twitter, YouTube, LinkedIn, Pinterest, Majestic, and others. Third-party application providers may change the features of their applications and platforms, including their APIs, or alter the terms governing use of their applications and platforms in an adverse manner. Further, third-party application providers may refuse to partner with us, or limit or restrict our access to their applications and platforms. Such changes could functionally limit or terminate our ability to use these third-party applications with our platform, which could negatively impact our offerings and the customer experience, and ultimately harm our business. If we fail to integrate our platform with new third-party applications that our customers desire, or to adapt to the data transfer requirements of such third-party applications and platforms, we may not be able to offer the functionality that our customers expect, which would negatively impact our offerings and, as a result, harm our business. Additionally, our business could be harmed if our customers have negative experiences in using the third-party integrations that we offer.\\nIf we fail to maintain and improve our methods and technologies, or fail to anticipate new methods or technologies for data collection and analysis, hardware, software, and software related technologies, competing products and services could surpass ours in depth, breadth, or accuracy of our data, the insights that we offer or in other respects.\\nWe expect continuous development in the market with respect to data matching, data filtering, data predicting, algorithms, machine learning, and other related technologies and methods for gathering, cataloging, updating, processing, analyzing, and communicating data and other information about how consumers find, interact with, and digest digital content. Similarly, we expect continuous changes in computer hardware, network operating systems, programming tools, programming languages, operating systems, the use of the internet, and the variety of network, hardware, browser, mobile, and browser-side platforms, and related technologies with which our platform and products must integrate. Further, changes in customer preferences or regulatory requirements may require changes in the technology used to gather and process the data necessary to deliver our customers the insights that they expect. Any of these developments and changes could create opportunities for a competitor to create products or a platform comparable or superior to ours, or that takes material market share from us in one or more product categories, and create challenges and risks for us if we are unable to successfully modify and enhance our products to adapt accordingly.\\n50\\nIf we fail to anticipate and adapt to new and increasingly prevalent social media platforms, other competing products and services that do so more effectively could surpass us and lead to decreased demand for our platform and products.\\nThe use of social media throughout the world is pervasive and growing. According to a survey by GlobalWebIndex of individuals ages 16 to 64, 97% of digital consumers have used social media during the first quarter of 2020, with digital consumers spending an average of 2 hours and 22 minutes per day on social networks and messaging apps between January and March 2020. The social media industry has experienced, and is likely to continue to experience, rapid change due to the evolving trends, tastes and preferences of users. If consumers widely adopt new social media networks and platforms, we will need to develop integrations and functionality related to these new networks and platforms. This development effort may require significant research and development and sales and marketing resources, as well as licensing fees, all of which could adversely affect our business and operating results. In addition, new social media networks and platforms may not provide us with sufficient access to data from their platforms, preventing us from building effective integrations with our platform and products. Changing consumer tastes may also render our current integrations or functionality obsolete and the financial terms, if any, under which we would obtain integrations or functionality, unfavorable. Any failure of our products to operate effectively with the social media networks used most frequently by consumers could reduce the demand for our products. If we are unable to respond to these changes in a cost-effective manner, our products and aspects of our platform may become less marketable and less competitive or obsolete, and our operating results may be negatively affected.\\nIf we fail to offer high-quality customer service and provide a positive customer experience, it may be more difficult to add and retain paying customers, secure upgrades, sell add-ons, and increase the number of user licenses per paying customer.\\nOur ability to add and retain paying customers, secure subscription upgrades, and sell add-ons depends in part on our customer service. Our sales and customer success team engages with customers to onboard them onto our platform, responds to support requests and other general inquiries, and assists with other account management matters. The perceived quality of customer service is one of the key facets potential customers evaluate when deciding between competing products and if our customer service is not viewed favorably, potential customers may choose our competitors’ products over our own. Additionally, our large enterprise customers from time to time demand custom solutions, such as custom APIs and custom reporting, and customer support that do not fit within one of our pre-packaged premium subscriptions, and addressing such demands often requires additional one-on-one engagement with our sales and customer success team members in order to finalize and service the commercial relationship. As we add more large enterprise customers and increase the number of user licenses per paying customer, we may need to devote more resources to customer service, and we may find it difficult and costly to effectively scale. If we do not adequately scale our customer success teams to meet the demands of new and existing customers, or if we otherwise fail to provide high-quality customer service during onboarding or at any other stage of the customer relationship, or a positive customer experience, we may lose such customers to our competition and fewer customers could renew or upgrade their subscriptions and purchase add-ons, which would harm our business, results of operations, and financial condition.\\nFailures or loss of, or material changes with respect to, the third-party hardware, software, and infrastructure on which we rely, including third-party data center hosting facilities and third-party distribution channels to support our operations, could adversely affect our business.\\nWe rely on leased and third-party owned hardware, software and infrastructure, including third-party data center hosting facilities and third-party distribution channels to support our operations. We primarily use three data centers in the United States, two located in Virginia and one in Georgia, as well as two Google Cloud locations in Virginia and South Carolina. We host each of our products and the data processed through such products in a combination of two of the foregoing locations for redundancy. If any\\n51\\nof our data center suppliers experience disruptions or failures, it would take time for the applicable backup data center to become fully functioning, and we would likely experience delays in delivering the affected products and segments of our platform, which may involve incurring significant additional expenses.\\nFurthermore, the owners and operators of our data center facilities do not guarantee that access to our platform will be uninterrupted or error-free. We do not control the operation of these third-party providers’ facilities, which could be subject to break-ins, computer viruses, sabotage, intentional acts of vandalism and other misconduct. Further, our leased servers and data centers are vulnerable to damage or interruption from natural disasters, terrorist attacks, power loss, telecommunications failures or similar catastrophic events. The COVID-19 pandemic could cause our third-party data center hosting facilities and cloud computing platform providers, which are critical to our infrastructure, to shut down their operations, experience technical or security incidents that delay or disrupt performance or delivery of services to us, or experience interference with the supply chain of hardware required by their systems and services, any of which could materially adversely affect our business. For example, we have experienced delays in migrating to our new data center in Virginia, due to the limited availability of certain required hardware components resulting from supply chain delays caused by the COVID-19 pandemic. If there were to be a significant outage or disaster that rendered one of our servers or data centers inoperable for any length of time, we would have to undertake recovery operations for the impacted products, which could interrupt the availability of our platform. If we were unable to restore the availability of our platform and products within a reasonable period of time, our customer satisfaction could suffer, damaging our reputation as a result, and we could lose customers to our competition, which would materially and adversely affect our business and results of operations.\\nIn addition, third-party data hosting and transmission services comprise a significant portion of our operating costs. If the costs for such services increase due to vendor consolidation, regulation, contract renegotiation, or otherwise, we may not be able to increase the fees for our platform or products to cover the changes, which would have a negative impact on our results of operations.\\nIf the security of the confidential information or personal information of any customers of our platform is breached or otherwise subjected to unauthorized access or disclosure, our reputation may be harmed and we may be exposed to liability.\\nWith consent from our customers, we obtain confidential and other customer data from our customers’ websites, social media accounts, and Google Analytics’ accounts to operate certain functionality on our platform. We rely on credit card purchases as the primary means of collecting our premium subscription fees. In addition, with consent from our customers, we collect and store certain personally identifiable information (“personal data”), credit card information, and other data needed to create, support, and administer the customer account, conduct our business, and comply with legal obligations, including rules imposed by the Payment Card Industry networks.\\nWe believe that we take reasonable steps to protect the security, integrity, availability, and confidentiality of the information we and our third-party service providers hold, but there is no guarantee that despite our efforts, inadvertent disclosure (such as may arise from software bugs or other technical malfunctions, employee error or malfeasance, or other factors) or unauthorized disclosure or loss of personal or other confidential information will not occur or that third parties will not gain unauthorized access to this information. We have experienced, and may experience in the future, breaches of our security due to human error, malfeasance, system errors or vulnerabilities, or other irregularities. For example, we have been the target of attempts to identify and exploit system vulnerabilities and/or penetrate or bypass our security measures to gain unauthorized access to our systems, including a brute force attack that resulted in access to our affiliate program partner contact information. Since techniques used to obtain unauthorized access change frequently, we and our third-party service providers may be unable to anticipate these techniques or to implement adequate preventative measures. If our security measures or the security measures of our third-party service providers are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in our software are exposed\\n52\\nand exploited, and, as a result, a third-party obtains unauthorized access to any customers’ data, our relationships with our customers may be damaged, and we could incur liability. Further, our customers with annual subscription terms may have the right to terminate their subscriptions before the end of the subscription term due to our uncured material breach of agreement, including with respect to our data security obligations. It is also possible that unauthorized access to customer data may be obtained through inadequate use of security controls by customers, suppliers or other vendors. While we are not currently aware of any impact that the SolarWinds supply chain attack had on our business, this is a recent event, and the scope of the attack is yet unknown. Therefore, there is residual risk that we may experience a security breach arising from the SolarWinds supply chain attack. We may also be subject to additional liability risks for failing to disclose data breaches or other security incidents under state data breach notification laws or under the private right of action granted to individuals under certain data privacy laws for actions arising from certain data security incidents, such as the California Consumer Privacy Act (“CCPA”) (which is further discussed below in this “Risk Factors” section). In addition, some regions, such as the EU, the United Kingdom (“UK”), and the United States, have enacted mandatory data breach notification requirements for companies to notify data protection authorities, state and federal agencies, or individuals of data security incidents or personal data breaches. We may also be contractually required to notify certain customers in the event of a security incident pursuant to the applicable customer agreement. These mandatory disclosures regarding a security breach may lead to negative publicity and may cause our customers to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, may harm our reputation, and we could lose customers or fail to acquire new customers.\\nFederal, state, and provincial regulators and industry groups may also consider and implement from time to time new privacy and security requirements that apply to our business, such as the long established Massachusetts data security law and the recently enacted New York Stop Hacks and Improve Electronic Data Act, both of which establish prescriptive administrative, technical, and physical data security requirements on companies, and permits civil penalties for each violation. Compliance with evolving privacy and security laws, requirements, and regulations may result in cost increases due to necessary systems changes, new limitations or constraints on our business models and the development of new administrative processes. They also may impose further restrictions on our collection, disclosure, and use of personally identifiable information kept in our databases or those of our vendors. If our security measures fail to protect credit card information adequately, we could be liable to both our customers and their users for their losses, as well as the vendors under our agreements with them such that we could be subject to fines and higher transaction fees, we could face regulatory action, and our customers and vendors could end their relationships with us, any of which could harm our business, results of operations or financial condition. Any willful or accidental security breaches or other unauthorized access to or disclosure of personal data could expose us to enforcement actions, regulatory or governmental audits, investigations, litigation, fines, penalties, adverse publicity, downtime of our systems, and other possible liabilities. There can be no assurance that the limitations of liability in our contracts would be enforceable or adequate or would otherwise protect us from any such liabilities or damages with respect to any particular claim. In addition, our cybersecurity insurance coverage may be inadequate to cover all costs and expenses associated with a security breach that may occur in the future.\\nIn recent periods, we have experienced, and expect to continue to experience, rapid growth and organizational change. If we fail to manage our growth effectively, we may be unable to execute our business plan, maintain high levels of service and customer satisfaction or attract new employees and customers.\\nWe have experienced, and expect to continue to experience, rapid growth in our number of customers, sales, revenues, locations, and headcount, which has placed, and may continue to place, significant demands on our management, and our operational and financial resources. We have paying customers in over 142 countries, and the number of our paying customers has grown from over 56,000 as of March 31, 2020 to over 72,000 as of March 31, 2021. We have seven offices across the globe with salespeople dispersed in various other locations, and the continued domestic and international growth\\n53\\nthat we anticipate will require us to continue to expand our global employee headcount. It may be difficult for us to identify, recruit, train, and manage enough personnel to efficiently scale our operations, manage our product development effectively and to match the growth of our customer base. As we continue to grow, we face challenges of integrating, developing, training, and motivating a rapidly growing and dispersed employee base. We are facing novel challenges with respect to integrating new employees and managing multi-geographic teams as COVID-19 prevents certain of our onboarding personnel from travelling between our offices to assist with such integration and training. Certain members of our executive management team have not previously worked together for an extended period of time, which may affect how they manage our growth. If we fail to manage our anticipated growth effectively, our brand and reputation could be negatively affected, which could harm our ability to attract employees and customers.\\nTo manage growth in our operations and personnel, we will need to continue to scale and improve our operational, financial, and management controls, and our reporting systems and procedures, which will require significant capital expenditures increasing our cost of operations and the reallocation of valuable management resources. As we scale, it may become more difficult and will require additional capital expenditures to maintain and increase the productivity of our employees, to address the needs of our actual and prospective customers, and provide high-quality customer service, to further develop and enhance our products, and remain competitive against our competitors’ products. Additionally, our expansion has placed, and our expected future growth will continue to place, a significant strain on our management, customer service teams, product and development, sales and marketing, administrative, financial, and other resources.\\nTechnical problems or disruptions that affect either our customers’ (and their users’) ability to access our platform and products, or the software, internal applications, database, and network systems underlying our platform and products, could damage our reputation and brands, lead to reduced demand for our platform and products, lower revenues, and increased costs.\\nOur business, brands, reputation, and ability to attract and retain customers depend upon the satisfactory performance, reliability, and availability of our platform, which in turn depend upon the availability of the internet and our third-party service providers. Interruptions in these systems, whether due to system failures, computer viruses, software errors, physical or electronic break-ins, malicious hacks or attacks on our systems (such as denial of service attacks), or force majeure events, could affect the security and availability of our products and prevent or inhibit the ability of customers to access our platform. In addition, the software, internal applications, and systems underlying our products and platform are complex and may not be error-free. We may encounter technical problems when we attempt to perform routine maintenance or enhance our software, internal applications, and systems. In addition, our platform may be negatively impacted by technical issues experienced by our third-party service providers. Any inefficiencies, errors, or technical problems with our software, internal applications, and systems could reduce the quality of our platform and products or interfere with our customers’ (and their users’) use of our platform and products, which could negatively impact our brand, reduce demand, lower our revenues, and increase our costs.\\nWe are exposed to risks associated with premium subscription and payment processing and any disruption to such processing systems could adversely affect our business and results of operations.\\nWe primarily rely on our own billing systems to manage our subscriptions and billing frequencies, and we use third-party subscription management and payment processing platforms for some of our products. If we or any of our third-party vendors were to experience an interruption, delay, or outage in service and availability, we may be unable to process new and renewals of subscriptions and our ability to process such subscription and credit card payments would be delayed while we activate an alternative billing platform. Although alternative third-party providers may be available to us, we may incur significant expenses and research and development efforts to deploy any alternative providers. To the extent there\\n54\\nare disruptions in our billing systems or third-party subscription and payment processing systems, we could experience revenue loss, accounting issues, and harm to our reputation and customer relationships, which would adversely affect our business and results of operations.\\nWe are subject to a number of risks related to credit and debit card payments, including:\\n•we pay interchange and other fees, which may increase over time and could require us to either increase the prices we charge for our products or experience an increase in our operating expenses;\\n•if our billing systems fail to work properly and the failure has an adverse effect on our customer satisfaction, causes credit and debit card issuers to disallow our continued use of their payment products, or, does not permit us to automatically charge our paying customers’ credit and debit cards on a timely basis or at all, we could lose or experience a delay in collection of customer payments;\\n•if we are unable to maintain our chargeback rate at acceptable levels, we may face civil liability, diminished public perception of our security measures and our credit card fees for chargeback transactions, or our fees for other credit and debit card transactions or issuers, may increase, or issuers may terminate their relationship with us; and\\n•we could be significantly impaired in our ability to operate our business if we lose our ability to process payments on any major credit or debit card.\\nA significant portion of our operations is located outside of the United States, which subjects us to additional risks, including increased complexity, the costs of managing international operations, geopolitical instability, and fluctuations in currency exchange rates.\\nThe design and development of our products is primarily conducted by our subsidiaries in Russia, the Czech Republic, Cyprus, and Poland. We also have marketing and administrative operations in the same jurisdictions. In addition, members of our sales force are located in Russia, Europe, the United Kingdom and Australia. Approximately 55% of our revenue for the three months ended March 31, 2021 was generated from sales to paying customers located outside the United States, including indirect sales through our resellers outside of the United States. As a result of our international operations and sales efforts, we face numerous challenges and risks that could harm our international operations, delay new product releases, increase our operating costs, and hinder our ability to grow and detect underlying trends in our operations and business, and consequently adversely impact our business, financial condition, and results of operations. Such risks include but are not limited to the following:\\n•geopolitical and economic instability in and impacting the localities where we have foreign operations, such as Russia;\\n•military conflicts impacting the localities where we have foreign operations;\\n•limited protection for, and vulnerability to theft of, our intellectual property rights, including our trade secrets;\\n•compliance with local laws and regulations, and unanticipated changes in local laws and regulations, including tax laws and regulations;\\n•trade and foreign exchange restrictions and higher tariffs;\\n•the complexity of managing international trade sanctions and export restrictions from the jurisdictions in which we have foreign operations;\\n55\\n•fluctuations in foreign currency exchange rates which may make our premium subscriptions more expensive for international paying customers and which may increase our expenses for employee compensation and other operating expenses that are paid in currencies other than U.S. dollars;\\n•restrictions imposed by the United States government against other countries, or foreign governments restrictions imposed on the United States, impacting our ability to do business with certain companies or in certain countries and the complexity of complying with those restrictions;\\n•power outages, natural disasters, and other local events that could affect the availability of the internet and the consequences of disruptions, such as large-scale outages or interruptions of service from utilities or telecommunications providers;\\n•difficulties in staffing international operations;\\n•changes in immigration policies which may impact our ability to hire personnel;\\n•differing employment practices, laws, and labor relations;\\n•regional health issues and the impact of public health epidemics and pandemics on employees and the global economy, such as the COVID-19 pandemic; and\\n•travel, work-from-home or other restrictions or work stoppages, like those currently imposed by governments around the world as a result of the COVID-19 pandemic.\\nFurther, it is possible that governments of one or more foreign countries may seek to limit access to the internet or our platform, products or certain features in their countries, or impose other restrictions that may affect the availability of our platform, products, or certain features in their countries for an extended period of time or indefinitely. For example, Russia and China are among a number of countries that have recently blocked certain online services, including Amazon Web Services, making it difficult for such services to access those markets. In addition, governments in certain countries may seek to restrict or prohibit access to our platform if they consider us to be in violation of their laws (including privacy laws) and may require us to disclose or provide access to information in our possession. If we fail to anticipate developments in the law or fail for any reason to comply with relevant laws, our platforms could be further blocked or restricted and we could be exposed to significant liability that could harm our business. In the event that access to our platform is restricted, in whole or in part, in one or more countries or our competitors are able to successfully penetrate geographic markets that we cannot access, our ability to acquire new customers or renew or grow the premium subscriptions of existing paying customers may be adversely affected, we may not be able to maintain or grow our revenue as anticipated and our business, results of operations, and financial condition could be adversely affected.\\nThe effects of the COVID-19 pandemic are uncertain and may materially affect our customers or potential customers and how we operate our business, and the duration and extent to which the pandemic continues to threaten our future operating results remains uncertain.\\nThe global COVID-19 pandemic has disrupted the economy and put unprecedented strains on governments, health care systems, educational institutions, companies, and individuals around the world. The impact and duration of the COVID-19 pandemic are difficult to assess or predict and will depend in part upon the actions taken by governments, companies, and other enterprises in response to the pandemic. The pandemic has already caused, and is likely to result in further, significant disruption of global financial markets and economic uncertainty. Adverse market conditions resulting from the COVID-19 pandemic could materially adversely affect our revenues, business and the value of our Class A common stock.\\n56\\nOur customers, particularly small-to-medium sized businesses (“SMBs”) and marketing agencies focused on SMBs, which have been particularly impacted by the COVID-19 pandemic, have reduced and may further reduce their technology or sales and marketing spending or delay purchasing decisions, which could result in slowed growth, reduced demand from new and existing SMB customers, and/or lower dollar-based net revenue retention rates, which could materially and adversely impact our business. In March 2020, our paying customer growth rate was relatively flat compared to our paying customer growth rate in February 2020. However, in April 2020 our paying customer growth rate declined, which we believe was primarily a result of the COVID-19 pandemic and the related socioeconomic impacts. In response, we offered free or discounted pricing to certain paying customers contemplating canceling their premium subscriptions as a remedial measure to retain them. Our paying customer growth rate started to increase again by May 2020. Depending on the duration of the COVID-19 pandemic, we may in the future be required to take further remedial measures, including changing our terms or offering further discounts, which may materially adversely impact our revenues and business in future periods.\\nIn response to the COVID-19 pandemic, we temporarily closed all of our offices (including our headquarters in Boston, Massachusetts, and offices in Trevose, Pennsylvania, Dallas, Texas, Prague, Czech Republic, Limassol, Cyprus, and St. Petersburg, Russia), subsequently reopened certain offices at reduced capacity, enabled our employees to work remotely, implemented temporary travel restrictions for all non-essential business, and shifted company events to virtual-only experiences. We may deem it advisable to similarly alter, postpone, or cancel additional events in the future. If the COVID-19 pandemic worsens, especially in regions where we have offices, our business activities conducted from those offices could be adversely affected and we may have to invest additional capital into improving our technology and remote working capabilities and in relocating those activities to alternate locations from which we operate. We may take further actions that alter our business operations as may be required by local, state, or federal authorities or that we determine are in the best interests of our employees. Such measures could negatively affect our sales and marketing efforts, sales cycles, employee productivity, or customer retention, any of which could harm our financial condition and business operations.\\nFurther, the COVID-19 pandemic has resulted in our employees and the employees of many of our customers and vendors working remotely. If the network and infrastructure of internet providers becomes overburdened by increased usage or is otherwise unreliable or unavailable, our employees’, and our customers’ and vendors’ employees’ access to the internet and ability to conduct business could be negatively impacted. We and our vendors may experience an increase in attempted cyber-attacks, targeted intrusion, ransomware, and phishing campaigns seeking to take advantage of shifts to employees working remotely using their household or personal internet networks. Any of these factors could interrupt our ability to provide our platform, decrease the productivity of our workforce, and significantly harm our business operations, financial condition, and results of operations.\\nTo the extent the COVID-19 pandemic adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in this ‘‘Risk Factors’’ section.\\nAdverse or weakened general economic and market conditions may reduce spending on sales and marketing technology and information, which could harm our revenue, results of operations, and cash flows.\\nOur revenue, results of operations, and cash flows depend on the overall demand for and use of technology and information for sales and marketing, which depends in part on the amount of spending allocated by our paying customers or potential paying customers on sales and marketing technology and information. In addition to the internal strategy of our paying customers, which is not predictable and is subject to change, this spending depends on worldwide economic and geopolitical conditions. The United States, EU, and other key international economies have experienced cyclical downturns from time to time in which economic activity was impacted by falling demand for a variety of goods and services, restricted credit, poor liquidity, reduced corporate profitability, volatility in credit, equity, and foreign exchange markets, bankruptcies, public health crises, and pandemics such as COVID-19, and overall economic\\n57\\nuncertainty. These economic conditions can arise suddenly, may disproportionately impact SMBs that make up an important segment of our paying customer base, and the full impact of such conditions often remains uncertain for extended periods of time. Further actions or inactions of the United States or other major national governments, including the UK’s 2016 vote in favor of the UK’s exit from the EU, may also impact economic conditions, which could result in financial market disruptions or an economic downturn.\\nConcerns about the systemic impact of an economic recession, energy costs, geopolitical issues, or the availability and cost of credit could lead to increased market volatility, decreased consumer confidence, and diminished growth expectations in the U.S. economy and abroad, which could affect the rate of information technology spending and adversely affect our paying customers’ ability or willingness to purchase our products, delay prospective paying customers’ purchasing decisions, reduce the value or duration of their premium subscription contracts, or affect retention rates. Any of these conditions or occurrences could adversely affect our future sales and operating results because most of our paying customers are on month-to-month premium subscriptions that can be cancelled at any time. Further, some of our paying customers may view a premium subscription to our platform as a discretionary purchase, and our paying customers may reduce their discretionary spending on our platform during an economic downturn and consequently reduce or terminate their premium subscription or decide not to upgrade another premium subscription. In particular, spending patterns of the SMBs that make up a large portion of our paying customer base are difficult to predict and are sensitive to the general economic climate, the economic outlook specific to small businesses, the then-current level of profitability experienced by SMBs and overall consumer confidence. In addition, weak economic conditions can result in paying customers seeking to utilize free or lower-cost solutions from alternative sources. Prolonged economic slowdowns may result in requests to renegotiate existing contracts on less advantageous terms to us than those currently in place, payment defaults on existing contracts, or non-renewal at the end of a contract term.\\nFailure of our commercial liability insurance policy to cover claims and any changes to the availability or coverage amounts in our existing policy could have a material adverse effect on our business, financial condition, and results of operations.\\nWe cannot assure you that our existing general liability insurance coverage and coverage for errors and omissions in our products will be fully covered by our existing policies and will continue to be available on acceptable terms, or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceeds available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on our business, financial condition, and results of operations.\\nAs we acquire and invest in companies or technologies, we may not realize expected business or financial benefits and the acquisitions or investments could prove difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our business, results of operations, and financial condition.\\nAs part of our business strategy, we evaluate and may make investments in, or acquisitions of, complementary companies, services, databases, and technologies, and we expect that we will continue to evaluate and pursue such investments and acquisitions in the future to further grow and augment our business, our platform, and product offerings. For example, in August 2020, we acquired Prowly, an advertising and public relations technology company based in Poland. We have incurred and will continue to incur costs to integrate Prowly’s business and selling process into our business and to integrate Prowly’s products into our platform, such as software integration expenses and costs related to the renegotiation of redundant vendor agreements, and we expect to incur similar costs to integrate future acquisitions. We may have difficulty effectively integrating the personnel, businesses, and technologies of these acquisitions into our company and platform, and achieving the strategic goals of those acquisitions.\\n58\\nOur strategy to make selective acquisitions to complement our platform depends in part on the availability of, our ability to identify, and our ability to engage and pursue suitable acquisition candidates. We may not be able to find suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. Acquired assets, data, or companies may not be successfully integrated into our operations, costs in connection with acquisitions and integrations may be higher than expected, and we may also incur unanticipated acquisition-related costs. These costs could adversely affect our financial condition, results of operations, or prospects. Any acquisition we complete could be viewed negatively by customers, users, developers, and other employees, partners, or investors, and could have adverse effects on our existing business relationships and company culture.\\nAcquisitions and other transactions, arrangements, and investments involve numerous risks and could create unforeseen operating difficulties and expenditures, including:\\n•difficulties in, and the cost of, integrating personnel and cultures, operations, technologies, products, services, and platforms which may lead to failure to achieve the expected benefits on a timely basis or at all;\\n•diversion of financial and managerial resources from existing operations;\\n•the potential entry into new markets in which we have little or no experience or where competitors may have stronger market positions;\\n•potential write-offs of acquired assets or investments, and potential financial and credit risks associated with acquired customers;\\n•additional stock-based compensation and difficulties in, and financial costs of, addressing acquired compensation structures inconsistent with our compensation structure;\\n•inability to generate sufficient revenue to offset acquisition and/or investment costs;\\n•inability to maintain, or changes in, relationships with customers and partners of the acquired business;\\n•challenges converting the revenue recognition policies of companies we may acquire and forecasting the recognition of their revenue, including subscription-based revenue and revenue based on the transfer of control, as well as appropriate allocation of the customer consideration to the individual deliverables;\\n•difficulty with, and costs related to, transitioning the acquired technology onto our existing platform, augmenting the acquired technologies and platforms to the levels that are consistent with our brand and reputation, augmenting or maintaining the security standards for acquired technology consistent with our platform and other products, and customer acceptance of multiple platforms on a temporary or permanent basis;\\n•potential unknown liabilities associated with the acquired companies, including risks associated with acquired intellectual property and/or technologies;\\n•challenges relating to the structure of an investment, such as governance, accountability, and decision-making conflicts;\\n•negative impact to our results of operations because of the depreciation and amortization of amounts related to acquired intangible assets, fixed assets, and deferred compensation;\\n•the loss of acquired unearned revenue and unbilled unearned revenue;\\n59\\n•delays in customer purchases due to uncertainty related to any acquisition;\\n•ineffective or inadequate controls, procedures, and policies at the acquired company;\\n•challenges caused by integrating operations over distance, and across different languages, cultures, and political environments;\\n•currency and regulatory risks associated with conducting operations in foreign countries and potential additional cybersecurity and compliance risks resulting from entry into new markets;\\n•tax effects and costs of any such acquisitions, including the related integration into our tax structure and assessment of the impact on the realizability of our future tax assets or liabilities; and\\n•potential challenges by governmental authorities for anti-competitive or other reasons.\\nAny of these risks could harm our business. In addition, to facilitate these acquisitions or investments, we may seek additional equity or debt financing, which may not be available on terms favorable to us or at all, may affect our ability to complete subsequent acquisitions or investments and may affect the risks of owning our Class A common stock. For example, if we finance acquisitions by issuing equity or convertible debt securities or loans, our existing stockholders may be diluted, or we could face constraints related to the terms of, and repayment obligations related to, the incurrence of indebtedness that could affect the market price of our Class A common stock.\\nOur debt obligations contain restrictions that impact our business and expose us to risks that could adversely affect our liquidity and financial condition.\\nOn January 12, 2021, we executed a credit agreement with JPMorgan Chase Bank, N.A., in the form of a revolving credit facility, that consists of a $45.0 million revolving credit facility and a letter of credit sub-facility with an aggregate limit equal to the lesser of $5.0 million and the aggregate unused amount of the revolving commitments then in effect. The amount of borrowings permitted at any one time under the revolving credit facility is subject to a borrowing base based on an advance rate of 400% multiplied by annualized retention applied to monthly recurring revenue. As a result, our access to the revolving credit facility is potentially subject to significant fluctuations depending on the value of the borrowing base as of any measurement date.\\nThe credit agreement (as amended, restated, amended and restated, supplemented or otherwise modified from time to time, the “Credit Agreement”) governing our revolving credit facility (collectively, our “credit facility”) contains various covenants that are operative so long as our credit facility remains outstanding. The covenants, among other things, limit our and certain of our subsidiaries’ abilities to:\\n•incur additional indebtedness or guarantee indebtedness of others;\\n•create additional liens on our assets;\\n•pay dividends and make other distributions on our capital stock, and redeem and repurchase our capital stock;\\n•make investments, including acquisitions;\\n•make capital expenditures;\\n•enter into mergers or consolidations or sell assets;\\n•sell our subsidiaries; or\\n60\\n•enter into transactions with affiliates.\\nOur credit facility also contains numerous affirmative covenants and a financial covenant of either minimum liquidity or a maximum leverage ratio.\\nIf we experience a decline in cash flow due to any of the factors described in this “Risk Factors” section or otherwise, we could have difficulty paying interest due on our indebtedness and meeting the financial covenants set forth in our credit facility. If we fail to comply with the various requirements of our indebtedness, we could default under our credit facility. Any such default that is not cured or waived could result in an acceleration of indebtedness then outstanding under our credit facility, an increase in the applicable interest rates under our credit facility, and a requirement that Semrush US Sub, which is a co-borrower under the facility, pay the obligations in full, and would permit the lenders to exercise remedies with respect to all of the collateral that is securing our credit facility, including substantially all of our and Semrush US Sub’s assets. Thus, any such default could have a material adverse effect on our liquidity and financial condition.\\nIf we cannot maintain our company culture as we grow, we could lose the innovation, teamwork, passion, and focus on execution that we believe contribute to our success and our business may be harmed.\\nWe believe that a critical component to our success has been our company culture, which is based on transparency, innovation, creativity, and personal autonomy to take on challenges and initiatives. We have invested substantial time and resources in building our team within this company culture across our offices. Any failure to preserve our culture could negatively affect our ability to retain and recruit personnel and to effectively focus on and pursue our corporate objectives. As we grow and develop the infrastructure of a public company, we may find it difficult to maintain these foundational aspects of our company culture. If we fail to maintain our company culture, we may fail to recruit qualified employees, our existing employees may terminate their employment, our ability to execute on marketing, sales, product and development, and other initiatives may suffer, and our business may be adversely impacted in other ways.\\nChanges in the sizes or types of paying customers that purchase premium subscriptions to our platform or products could affect our business, and our financial results may fluctuate due to increasing variability in our sales cycles.\\nOur strategy is to sell premium subscriptions of our platform to paying customers of all sizes, from sole proprietors, to SMBs, to large enterprise customers. Selling monthly premium subscriptions to SMBs generally involves lower or plateauing premium subscription upgrade potential, lower retention rates (especially in times of economic uncertainty where marketing and sales budgets are subject to increased scrutiny and reduction), and more limited interaction with our sales and other personnel than sales to large enterprises. Conversely, sales to large enterprises generally entail longer sales cycles, more significant and costly selling and support efforts, and greater uncertainty of completing the sale than sales to SMBs. We plan our expenses based on certain assumptions about the length and variability of our sales cycle based upon historical trends for sales and conversion rates associated with our existing paying customers. If and as our paying customer base expands to include more large enterprise customers, our sales expenses may increase, sales cycles may lengthen and become less predictable, and we may see a greater number of paying customers with longer terms and extended payment terms which, in turn, may increase our paying customer acquisition costs, increase our credit risk, and may in other ways adversely affect our financial results. Additional factors that may influence the length and variability of our sales cycle include:\\n•the need to educate prospective customers about the different products available on our platform, and their uses and benefits;\\n61\\n•the discretionary nature of purchase and budget cycles and decisions;\\n•the competitive nature of evaluation and purchasing processes;\\n•economic and political stability and other external factors;\\n•evolving functionality demands;\\n•announcements of planned introductions of new products, features or functionality by us or our competitors; and\\n•lengthy and multi-faceted purchasing approval processes required by our customers, especially large enterprise customers.\\nIf there are changes in, or we fail to adequately predict, the mix of paying customers that purchase premium subscriptions to our platform, our gross margins and operating results could be adversely affected, and fluctuations increasing the variability in our sales cycles could negatively affect our financial results.\\nForecasts of our market and market growth may prove to be inaccurate, and even if the markets in which we compete achieve the forecasted growth, there can be no assurance that our business will grow at similar rates, or at all.\\nGrowth forecasts that we have provided and may provide, including those in the Prospectus and in this Quarterly Report on Form 10-Q, relating to our market opportunities and the expected growth thereof are subject to significant uncertainty and are based on assumptions and estimates which may prove to be inaccurate. Even if these markets grow at the forecasted rates, we may not grow our business at a similar rate, or at all. Our growth is subject to many factors, including our success in implementing our business strategy, which is subject to many risks and uncertainties. Accordingly, the forecasts of market growth that we have provided and may in the future provide should not be taken as indicative of our future growth.\\nOur management has broad discretion over the use of the proceeds from the IPO, and might not use the net proceeds effectively.\\nOur management has broad discretion to use the net proceeds from the IPO, including for any of the purposes described in the section titled “Use of Proceeds” included in the Prospectus, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management might not apply the net proceeds in ways that increase the value of your investment. Until we use the net proceeds from the IPO, we plan to invest them, and these investments may not yield a favorable rate of return. If we do not invest or apply the net proceeds from the IPO in ways that enhance stockholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.\\nWe may be subject to litigation for any of a variety of claims, which could harm our reputation and adversely affect our business, results of operations, and financial condition.\\nIn the ordinary course of business, we may be involved in and subject to litigation for a variety of claims or disputes and receive regulatory inquiries. These claims, lawsuits, and proceedings could include labor and employment, wage and hour, income tax, commercial, data privacy, antitrust, alleged securities law violations or other investor claims, and other matters. The number and significance of these potential claims and disputes may increase as our business expands. Any claim against us, regardless of its merit, could be costly, divert management’s attention and operational resources, and harm our reputation. As litigation is inherently unpredictable, we cannot assure you that any potential claims or disputes will not\\n62\\nhave a material adverse effect on our business, results of operations, and financial condition. Any claims or litigation, even if fully indemnified or insured, could make it more difficult to compete effectively or to obtain adequate insurance in the future.\\nIn addition, we may be required to spend significant resources to monitor and protect our contractual, intellectual property, and other rights, including collection of payments and fees. Litigation has been and may be necessary in the future to enforce such rights. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of our rights. Furthermore, our efforts to enforce our rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of such rights. Our inability to protect our rights, as well as any costly litigation or diversion of our management’s attention and resources, could have an adverse effect on our business, results of operations, and financial condition or harm our reputation.\\nOur failure to raise additional capital or generate cash flows necessary to expand our operations and invest in new technologies in the future could reduce our ability to compete successfully and harm our results of operations.\\nWe may require additional financing, and we may not be able to obtain debt or equity financing on favorable terms, if at all. Any debt financing obtained by us could involve restrictive covenants relating to financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could experience significant dilution, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our Class A common stock. The terms of any debt financing may include liquidity requirements, restrict our ability to pay dividends, and require us to comply with other covenants restrictions. If we need additional capital and cannot raise it on acceptable terms, or at all, we may not be able to, among other things:\\n•develop new features, integrations, capabilities, and enhancements;\\n•continue to expand our product and development, and sales and marketing teams;\\n•hire, train, and retain employees;\\n•respond to competitive pressures or unanticipated working capital requirements; or\\n•pursue acquisition opportunities.\\nOur referral partners and resellers provide revenue to our business, and we benefit from our association with them. Our failure to maintain successful relationships with these partners could adversely affect our business.\\nOur referral partners and resellers drive revenue to our business and our agreements with these partners and resellers are non-exclusive, with the exception of one exclusive reseller agreement in Japan. While most of these partners and resellers offer products or services that are complementary to our platform and products, some offer point solutions that compete with certain functionalities of our platform. These referral partners and resellers may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own products or services rather than ours, which could cause our revenue to decline. Our competitors may in some cases be effective in causing our referral partners and resellers, or potential referrals and resellers, to favor their products and services or to prevent or reduce sales of our platform and products. Also, we derive tangible and intangible benefits from our association with some of our referral partners and members of our affiliate networking programs, particularly high-profile partners that reach a large number of companies through the internet. If a\\n63\\nsubstantial number of these partners or networking affiliates reduce or cease their relationships with us, our business, financial condition, and results of operations could be adversely affected.\\nWe expect that we will need to continue to expand and maintain a network of referral partners and resellers in order to expand into certain international markets. A loss of or reduction in sales through these third parties could reduce our revenue. Recruiting and retaining qualified resellers in our network and training them in our technology and product offerings requires significant time and resources. If we decide to further develop and expand our indirect sales channels, we must continue to scale and improve our processes and procedures to support these channels, including investment in systems and training. Many resellers may not be willing to invest the time and resources required to train their staff to effectively sell our platform. If we fail to maintain relationships with our referral partners and resellers, fail to develop relationships with new referral partners and resellers in new markets or expand the same in existing markets, or fail to manage, train, or provide appropriate incentives to our existing referral partners and resellers, our ability to increase the number of new paying customers and increase sales to existing paying customers could be adversely impacted, which would harm our business.\\nOur ability to utilize our net operating loss carryforwards may be limited.\\nAs of December 31, 2020, we had U.S. federal and state net operating loss carryforwards of approximately $28.0 million and $14.1 million, respectively. Our ability to utilize our federal net operating loss carryforwards may be limited under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). The limitations apply if we experience an “ownership change,” which is generally defined as a greater than 50 percentage point change (by value) in the ownership of our equity by certain stockholders over a rolling three-year period. Similar provisions of state tax law may also apply to limit the use of our state net operating loss carryforwards. Future changes in our stock ownership, which may be outside of our control, may trigger an ownership change and, consequently, the limitations under Section 382 of the Code. As a result, if or when we earn net taxable income, our ability to use our pre-change net operating loss carryforwards to offset such taxable income may be subject to limitations, which could adversely affect our future cash flows.\\nWe could be required to collect additional sales and other similar taxes or be subject to other tax liabilities that may increase the costs our customers would have to pay for our subscriptions and adversely affect our operating results.\\nSales and use, value-added, goods and services, and similar tax laws and rates are complicated and vary greatly by jurisdiction. There is significant uncertainty as to what constitutes sufficient nexus for a national, state or local jurisdiction to levy taxes, fees, and surcharges for sales made over the internet, as well as whether our subscriptions are subject to tax in various jurisdictions. Certain countries and the vast majority of states have considered or adopted laws that impose tax collection obligations on out-of-state companies. Additionally, in the United States, the Supreme Court of the United States recently ruled in South Dakota v. Wayfair, Inc. et. al. (“Wayfair”) that online sellers can be required to collect sales and use tax despite not having a physical presence in the buyer’s state. In response to the Wayfair case, or otherwise, national, states or local governments may enforce laws requiring us to calculate, collect, and remit taxes on sales in their jurisdictions. We have not always collected sales and other similar taxes in all jurisdictions in which we are required to. We may be obligated to collect and remit sales tax in jurisdictions in which we have not previously collected and remitted sales tax. We could also be subject to audits in states and non-U.S. jurisdictions for which we have not accrued tax liabilities. A successful assertion by one or more countries or states requiring us to collect taxes where we historically have not or presently do not do so could result in substantial tax liabilities, including taxes on past sales, as well as penalties and interest. The imposition by national, state or local governments of sales tax collection obligations on out-of-state sellers could also create additional administrative burdens for us and decrease our future sales, which could adversely affect our business and operating results.\\nRisks Related to the Regulatory Framework that Governs Us\\n64\\nIf the use of cookies or other tracking technologies becomes subject to unfavorable legislation or regulation, is restricted by internet users or other third parties or is blocked or limited by users or by technical changes on end users’ devices, our ability to attract new customers and to develop and provide certain products could be diminished or eliminated.\\nWe rely on small text files and other technologies, such as web beacons (collectively, “cookies”) which are placed on internet browsers to gather data regarding the content of a user’s web browsing activity. We use cookies to store users’ settings between sessions and to enable visitors to our website to use certain features, such as gaining access to secure areas of the website. We also use cookies, including cookies placed by third-party services with which we integrate, to enable us to gather statistics about our visitors’ use of our website and to allow our website visitors to connect our platform to their social networking sites, which enables us to advertise our products to them using retargeting methods. The availability of this data may be limited by numerous potential factors, including government legislation or regulation restricting the use of cookies for certain purposes, such as retargeting, browser limitations on the collection or use of cookies, or internet users deleting or blocking cookies on their web browsers or on our website.\\nOur ability, like those of other technology companies, to collect, augment, analyze, use, and share information collected through the use of third-party cookies for online behavioral advertising is governed by U.S. and foreign laws and regulations which change from time to time, such as those regulating the level of consumer notice and consent required before a company can employ cookies to collect data about interactions with users online. In the United States, both state and federal legislation govern activities such as the collection and use of data, and privacy in the advertising technology industry has frequently been subject to review, and occasional enforcement, by the Federal Trade Commission, or the FTC, U.S. Congress, and individual states.\\nAs our business is global, our activities are also subject to foreign legislation and regulation. In the EU, the EU Directive 2002/58/EC (as amended by Directive 2009/136/EC), commonly referred to as the e-Privacy Directive, and related implementing legislation in the EU and the UK requires that accessing or storing information on an internet user’s device, such as through a cookie, is allowed only if the internet user has been informed thereof, and provided prior unambiguous, specific, and informed consent for the placement of a cookie on a user’s device. A new e-Privacy Regulation is currently under discussion by EU member states to replace the e-Privacy Directive. Although it remains under debate, the proposed e-Privacy Regulation would amend rules on third-party cookies and significantly increase penalties for non-compliance. We cannot yet determine the impact such future laws, regulations, and standards may have on our use of third-party cookies. Additionally, the use of third-party cookies in the digital advertising ecosystem, particularly in the context of real-time bidding advertising auctions, is subject to increased regulatory scrutiny in the EU. Several European data protection authorities (including in Belgium, Ireland, UK, Poland, Spain, Luxembourg, and the Netherlands) have launched investigations or inquiries over Google’s and other AdTech companies’ practices concerning the collection and sharing of consumer data through cookies, the outcome of which is still uncertain. These investigations or inquiries could result in the imposition of more stringent standards around consent to place cookies or otherwise restrict the use of third-party cookies for online behavioral advertising. We have also received inquiries from, and engaged in correspondence with, European data protection authorities regarding our practices regarding cookies used on our websites, and the outcome of these inquiries is still uncertain.\\nAdditionally, new and expanding “Do Not Track” regulations have recently been enacted or proposed that protect users’ right to choose whether or not to be tracked online. These regulations seek, among other things, to allow end users to have greater control over the use of private information collected online, to forbid the collection or use of online information, to demand a business to comply with their choice to opt out of such collection or use, and to place limits upon the disclosure of information to third-party websites.\\n65\\nContinued regulation of cookies, and changes in the interpretation and enforcement of existing laws, regulations, standards, and other obligations, as well as increased enforcement by industry groups or data protection authorities, could restrict our activities, such as efforts to understand users’ internet usage and engage in marketing activities, or require changes to our practices. Any inability to obtain information through cookies or to obtain it on the terms we anticipate, could cause a significant impact on the operation of our platform, impair our ability to target and attract new customers, and reduce our ability to predict our customers’ interests in or need for one or more of our products, any of which may cause a reduction in revenue or a reduction in revenue growth, negatively impact our ability to obtain new subscriptions and retain or grow the subscriptions of existing customers.\\nAdditionally, cookies may easily be deleted or blocked by internet users. All of the most commonly used internet browsers (including Chrome, Firefox, Internet Explorer, and Safari) allow internet users to prevent cookies from being accepted by their browsers. Internet users can also delete cookies from their computers at any time. Some internet users also download “ad blocking” software that prevents cookies from being stored on a user’s device. If more internet users adopt these settings or delete their cookies more frequently than they currently do, our business could be harmed. In addition, the Safari and Firefox browsers block third-party cookies by default, and other browsers may do so in the future. Unless such default settings in browsers were altered by internet users to permit the placement of third-party cookies, fewer cookies would be available, which could adversely affect our business. In addition, companies such as Google LLC have publicly disclosed their intention to move away from cookies to another form of persistent unique identifier, or ID, to identify individual internet users or internet-connected devices in the bidding process on advertising exchanges. If companies do not use shared IDs across the entire ecosystem, this could have a negative impact on our ability obtain content consumption data.\\nChanges in laws, regulations, and public perception concerning data protection and privacy, or changes in the interpretation or patterns of enforcement of existing laws and regulations, could impair our efforts to maintain and expand our customer base or the ability of our customers and users to use our platform and some or all of our products. Breaches of laws and regulations concerning data protection and privacy could expose us to significant fines and other penalties.\\nWe hold personal data about a variety of individuals, such as our customers, users, employees, contractors, and business partners, and we use such personal data as needed to collect payment from our customers, communicate with and recommend products to our customers and prospective customers through our marketing and advertising efforts, and comply with legal obligations. Processing of personal data is increasingly subject to legislation and regulation in numerous jurisdictions around the world.\\nFor example, relevant applicable laws and regulations governing the collection, use, disclosure or other processing of personal information include, in the United States, rules and regulations promulgated under the authority of the Federal Trade Commission, the California Consumer Privacy Act of 2018 (the “CCPA”), and state breach notification laws. In particular, in California, the CCPA was enacted in June 2018, became effective back on January 1, 2020 and became subject to enforcement by the California Attorney General’s office on July 1, 2020. The CCPA broadly defines personal information and provides an expansive meaning to activity considered to be a sale of personal information, and gives California residents expanded privacy rights and protections, including the right to opt out of the sale of personal information. The CCPA also provides for civil penalties for violations and a private right of action for data breaches. Moreover, a new privacy law that amends and expands the CCPA, the California Privacy Rights Act, or CPRA, was passed on November 3, 2020. The CPRA creates additional obligations relating to personal information that take effect on January 1, 2023 (with certain provisions having retroactive effect to January 1, 2022). The CPRA also establishes a new enforcement agency dedicated to consumer privacy. The CPRA’s implementing regulations are expected on or before July 1, 2022, and enforcement is scheduled to begin July 1, 2023. We will continue to monitor developments related to the CPRA and anticipate additional costs and expenses associated with CPRA compliance. In addition, since the enactment of CCPA, new privacy and data security laws have been proposed in more than half of the states in the United States and in the U.S. Congress, reflecting a trend toward more stringent privacy\\n66\\nlegislation in the United States, which trend may accelerate depending on the results of the 2020 U.S. presidential election. The effects of the CCPA, CPRA, and other similar state or federal laws, are potentially significant and may require us to modify our data processing practices and policies, and to incur substantial costs and potential liability in an effort to comply with such legislation.\\nWe maintain offices in the EU (including Poland, the Czech Republic, and Cyprus) and we have customers in the EU and the UK. Accordingly, we are subject to the General Data Protection Regulation (EU) 2016/679 (the “GDPR”), and related member state implementing legislation, and to the UK’s Data Protection Act 2018 (collectively, “European Data Protection Law”). European Data Protection Law places obligations on controllers and processors of personal data, while establishing rights for individuals with respect to their personal data, including rights of access and deletion in certain circumstances. European Data Protection Law is also explicitly extraterritorial in its application, and could affect our business activities in jurisdictions outside the EU and the UK.\\nWe have implemented measures designed to comply with the requirements of European Data Protection Law. In respect of these measures, we rely on positions and interpretations of the law (including European Data Protection Law) that have yet to be fully tested before the relevant courts and regulators. If a regulator or court of competent jurisdiction determined that one or more of our compliance efforts does not satisfy the applicable requirements of the law (including European Data Protection Law), or if any party brought a claim in this regard, we could be subject to governmental or regulatory investigations, enforcement actions, regulatory fines, compliance orders, litigation or public statements against us by consumer advocacy groups or others, any of which could cause customers to lose trust in us or otherwise damage our reputation. Likewise, a change in guidance could be costly and have an adverse effect on our business.\\nThe requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\\nEuropean Data Protection Law also imposes strict rules on the transfer of personal data out of the EU/UK to third countries deemed to lack adequate privacy protections (including the United States), unless an appropriate safeguard specified by the GDPR is implemented, such as the Standard Contractual Clauses (“SCCs”), approved by the European Commission, or a derogation applies. The Court of Justice of the EU (the “CJEU”), recently deemed that the SCCs are valid. However, the CJEU ruled that transfers made pursuant to the SCCs and other alternative transfer mechanisms need to be analyzed on a case-by-case basis to ensure EU standards of data protection are met in the jurisdiction where the data importer is based, and there continue to be concerns about whether the SCCs and other mechanisms will face additional challenges. EU regulators have announced that there will be further guidance issued on these topics, but such guidance has yet to be finalized. We rely on SCCs and certain derogations to transfer personal data from the EU and the UK to the United States and Russia. Until the remaining legal uncertainties regarding how to legally continue transfers pursuant to the SCCs and other mechanisms are settled, we will continue to face uncertainty as to whether our efforts to comply with our obligations under European Data Protection Law are sufficient. European or multi-national customers may refuse or be reluctant to use or continue to use our platform or products as a result of such developments until law makers and regulators in the EU and the United States have resolved the issues that instigated the decision of the CJEU noted above. This and other future developments regarding the flow of data across borders could increase the cost and complexity of delivering our platform and products in some markets and may lead to governmental enforcement actions, litigation, fines, and penalties or adverse publicity, which could have an adverse effect on our reputation and business.\\n67\\nThe relationship between the UK and the EU in relation to certain aspects of data protection law remains unclear. In addition, it is likely that documentation will need to be put in place between UK entities and entities in EU member states to ensure adequate safeguards are in place for data transfers, which may result in us incurring additional costs with respect to transfers of personal data between the EU and the UK. We may find it necessary or advantageous to join industry bodies, or self-regulatory organizations, that impose stricter compliance requirements than those set out in applicable laws, including European Data Protection Laws. We may also be bound by contractual restrictions that prevent us from participating in data processing activities that would otherwise be permissible under applicable laws, including European Data Protection Laws. Such strategic choices may impact our ability to exploit data and may have an adverse impact on our business.\\nAs we maintain offices in Russia, we face particular privacy, data security, and data protection risks in connection with requirements of Russia’s data protection and security laws, including Federal Law of 21 July 2014 No. 242-FZ, which entered into effect September 1, 2015, Federal Law of 27 July 2006 No. 152-FZ (as amended) and Federal Law of 27 July 2006 No. 149-FZ (as amended). Among other stringent requirements, these laws require ensuring that certain operations on personal data of Russian citizens are conducted in database(s) located in Russia.\\nWe expect that there will continue to be new proposed laws, regulations, and industry standards concerning privacy, data protection, and information security in the United States, the EU, and other jurisdictions, and we cannot yet determine the impact such future laws, regulations, and standards may have on our business.\\nThese and other legal requirements could require us to make additional changes to our platform or products in order for us or our customers to comply with such legal requirements or reduce our ability to lawfully collect personal data used in our platform and products. These changes could reduce demand for our platform or products, require us to take on more onerous obligations in our contracts, restrict our ability to store, transfer, and process personal data or, in some cases, impact our ability or our customers’ ability to offer our products in certain locations, to deploy our solutions, to reach current and prospective customers, or to derive insights from data globally.\\nThe costs of complying with existing or new data privacy or data protection laws and regulations, regulatory guidance, our privacy policies and contractual obligations to customers, users, or other third parties, may limit the use and adoption of our platform and products, reduce overall demand for our products, make it more difficult for us to meet expectations from or commitments to customers and users, lead to significant fines, penalties, or liabilities for noncompliance, impact our reputation, or slow the pace at which we close sales transactions, any of which could harm our business.\\nFurthermore, the uncertain and shifting regulatory environment and trust climate may cause concerns regarding data privacy and may cause our vendors, customers and users to resist providing the data necessary to allow us to offer our platform and products to our customers and users effectively, or could prompt individuals to opt out of our collection of their personal data. Even the perception that the privacy of personal data is not satisfactorily protected or does not meet regulatory requirements could discourage prospective customers from subscribing to our products or discourage current customers from renewing their subscriptions.\\nCompliance with any of the foregoing laws and regulations can be costly and can delay or impede the development of new products. We may incur substantial fines if we violate any laws or regulations relating to the collection or use of personal data. For example, the GDPR imposes sanctions for violations up to the greater of €20 million and 4% of worldwide gross annual revenue, enables individuals to claim damages resulting from infringement of the GDPR and introduces the right for non-profit organizations to bring claims on behalf of data subjects. CCPA allows for fines of up to $7,500 for each violation (affected individual) that a business does not cure within 30 days of receiving notice of the violation. Non-compliance with Russian data localization rules may result in imposition of an administrative fine of up to\\n68\\nRUB 18 million, or approximately $240,000, for each violation. Our actual or alleged failure to comply with applicable privacy or data security laws, regulations, and policies, or to protect personal data, could result in enforcement actions and significant penalties against us, which could result in negative publicity or costs, subject us to claims or other remedies, and have a material adverse effect on our business, financial condition, and results of operations.\\nMany aspects of data protection and privacy laws are relatively new and their scope has not been tested in the courts. As a result, these laws and regulations are subject to differing interpretations and may be inconsistent among jurisdictions. It is possible that these laws and regulations may be interpreted and applied in a manner that is inconsistent with our interpretations and existing data management practices or the features of our products. Certain of our activities could be found by a court, government or regulatory authority to be noncompliant or become noncompliant in the future with one or more data protection or data privacy laws, even if we have implemented and maintained a strategy that we believe to be compliant. Further, we may be subject to additional risks associated with data security breaches or other incidents, in particular because certain data privacy laws, including the GDPR and CCPA, grant individuals a private right of action arising from certain data security incidents. If so, in addition to the possibility of fines, lawsuits, and other claims and penalties, we could be required to fundamentally change our business activities and practices or modify our products, which could harm our business.\\nWe also receive personal data from third-party vendors (e.g., data brokers). We may not be able to verify with complete certainty the source of such data, how it was collected, and that such data was collected and is being shared with us in compliance with all applicable data protection and privacy laws. Our use of personal data obtained from third-party vendors could result in potential regulatory investigations, fines, penalties, compliance orders, liability, litigation, and remediation costs, as well as reputational harm, any of which could materially adversely affect our business and financial results. The requirements of European Data Protection Law pertaining to the licensing of data or obtaining such data from third parties are not entirely clear in all cases. It is possible that third parties may bring claims against us, alleging non-compliance with such requirements, and seeking damages, seeking to prevent us from using certain data, or seeking to prevent us from using data in particular ways. Such claims could potentially adversely affect our ability to provide our services and the current level of functionality of our platform in such circumstances, which could adversely affect our results of operations.\\nChanges in legislation or requirements related to automatically renewing subscription plans, or our failure to comply with existing or future regulations, may adversely impact our business.\\nOur business relies heavily on the fact that customers enter subscription contracts where they agree that the subscription will automatically renew for a new term, and their credit or debit cards will automatically be charged on an ongoing basis, unless the subscription is canceled by the customer. Some states have passed or considered legislation limiting the duration for which subscriptions can automatically renew, if at all.\\nAlthough this enacted and proposed legislation generally would not affect companies that sell subscriptions to other companies, like ours does, there could be variances and inconsistencies in these rules or requirements among jurisdictions that expose us to compliance risks that would have a material adverse effect on our business operations and financial condition, and could result in fines, penalties, damages, civil liability, and higher transaction fees. In addition, any costs that result from future legislation and regulations, or from changes in the interpretation of existing legislation and regulations, could individually or in the aggregate cause us to change or limit our business practices, which may make our subscription business model less attractive.\\nChanges in laws and regulations related to the internet or changes in the internet infrastructure itself may diminish the demand for our platform and could harm our business.\\n69\\nThe future success of our business depends upon the continued use of the internet as a primary medium for commerce, communication, and business applications. Federal, state, or foreign governmental bodies or agencies have in the past adopted, and may in the future adopt, laws or regulations affecting the use of the internet as a commercial medium. The adoption of any laws or regulations that could reduce the growth or use of the internet, including laws or practices limiting internet neutrality, could decrease the demand for, or the usage of, our platform and products, increase our cost of doing business, require us to modify our platform or financial systems, and may harm our results of operations. In addition, government agencies or private organizations have imposed and may impose additional taxes, fees, or other charges for accessing the internet or commerce conducted via the internet, which could limit the growth of internet-related commerce or communications generally, result in higher prices for our products and platform, or result in reduced demand for internet-based products such as ours.\\nAs the internet continues to experience growth in the number of users, frequency of use, and amount of data transmitted, the internet infrastructure that we and our customers rely on may be unable to support the demands placed upon it. In addition, there could be adverse effects from delays in the development or adoption of new standards and protocols to handle increased demands of internet activity, security, reliability, cost, ease-of-use, accessibility, and quality of service. Further, our platform depends on the quality of our customers’ access to the internet. The failure of the internet infrastructure that we or our customers rely on, even for a short period of time, could undermine our operations and harm our results of operations.\\nInternet access is frequently provided by companies that have significant market power that could take actions that degrade, disrupt, or increase the cost of customer access to our platform, any of which would negatively impact our business. On June 11, 2018, the repeal of the Federal Communications Commission’s, or the FCC, “net neutrality” rules took effect and returned to a “light-touch” regulatory framework. The prior rules were designed to ensure that all online content is treated the same by internet service providers and other companies that provide broadband services. Additionally, on September 30, 2018, California enacted the California internet Consumer Protection and Net Neutrality Act of 2018, making California the fourth state to enact a state-level net neutrality law since the FCC repealed its nationwide regulations, mandating that all broadband services in California must be provided in accordance with state net neutrality requirements. The U.S. Department of Justice has sued to block the law going into effect, and California has agreed to delay enforcement until the resolution of the FCC’s repeal of the federal rules. A number of other states are considering legislation or executive actions that would regulate the conduct of broadband providers. We cannot predict whether the FCC order or state initiatives will be modified, overturned, or vacated by legal action of the court, federal legislation or the FCC. With the repeal of net neutrality rules, network operators may choose to implement usage-based pricing, discount pricing charged to providers of competitive products, otherwise materially change their pricing rates or schemes, charge us to deliver our traffic or throttle its delivery, implement bandwidth caps or other usage restrictions or otherwise try to monetize or control access to their networks, any of which could increase our costs, or those of our customers in accessing our platform, and negatively impact our business and results of operations.\\nFederal, state, and foreign laws regulate internet tracking software, the sending of commercial emails and text messages, and other activities, which could impact the use of our platform and products, and potentially subject us to regulatory enforcement or private litigation.\\nWe are subject to laws and regulations that govern sending marketing and advertising by electronic means, such email and telephone. For example, in the United States, the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003, or the CAN-SPAM Act, among other things, obligates the sender of commercial emails to provide recipients with the ability to opt out of receiving future commercial emails from the sender. In addition, the Telephone Consumer Protection Act imposes certain notice, consent, and opt-out obligations on companies that send telephone or text communications using auto dialers to consumers, and provides consumers with private rights of action for violations. Further,\\n70\\ncertain states and foreign jurisdictions, such as Australia, Canada, and the EU, have enacted laws that prohibit sending unsolicited marketing emails unless the recipient has provided its prior consent to receipt of such email, or in other words has “opted-in” to receiving it. A requirement that recipients opt into, or the ability of recipients to opt out of, receiving commercial emails may minimize the effectiveness of our marketing, which could adversely affect our ability to attract new customers or entice existing customers to upgrade their subscriptions.\\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that could impair our ability to compete in international markets or subject us to liability if we violate such laws and regulations.\\nWe are subject to U.S. economic sanctions, export control and anti-corruption laws, and regulations that prohibit the provision of certain products and services to certain countries, governments, and persons targeted by U.S. sanctions. We are in the process of implementing certain precautions to prevent our platform and products from being exported or accessed in violation of U.S. export controls or U.S. sanctions laws and regulations. However, we cannot be certain that the precautions we take will prevent all violations of these laws.\\nWe have previously identified, and may continue to identify, customer accounts for our platform and products that may originate from, or are intended to benefit, persons in countries that are subject to U.S. embargoes, including transactions or events in or relating to Cuba, Iran, North Korea, Syria, and the Crimea region of Ukraine. We have recently submitted a voluntary self-disclosure to the U.S. Department of the Treasury’s Office of Foreign Assets Control, or OFAC, regarding potential violations of OFAC regulations that may have involved the provision of services to customers in sanctioned countries. We have not yet obtained a determination from OFAC.\\nIf we are found to be in violation of U.S. sanctions or export control laws, we may be fined or other penalties could be imposed. Furthermore, changes in export control or economic sanctions laws and enforcement could also result in increased compliance requirements and related costs, which could materially adversely affect our business, results of operations, financial condition and/or cash flows.\\nWe are also subject to various U.S. and international anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act and the UK Bribery Act, as well as other similar anti-bribery and anti-kickback laws and regulations. These laws and regulations generally prohibit companies and their employees and intermediaries from authorizing, offering, or providing improper payments or benefits to government officials and other recipients for improper purposes. Our exposure for violating these laws may increase as we continue to expand our international presence, and any failure to comply with such laws could harm our business.\\nOur internal controls over financial reporting currently do not meet all of the standards contemplated by Section 404 of the Sarbanes-Oxley Act of 2002, as amended (“SOX”), and failure to achieve and maintain effective internal controls over financial reporting in accordance with Section 404 of SOX could impair our ability to produce timely and accurate financial statements or comply with applicable regulations and have a material adverse effect on our business. In the future, our disclosure controls and procedures may not prevent or detect all errors or acts of fraud.\\nAs a public company, we are subject to certain reporting requirements of the Exchange Act and have significant requirements for enhanced financial reporting and internal controls. Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC. The process of designing and implementing effective internal controls is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments, and to expend significant resources to maintain a system of internal controls that is\\n71\\nadequate to satisfy our reporting obligations as a public company. If we are unable to establish or maintain appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations on a timely basis, result in material misstatements in our consolidated financial statements, and harm our operating results. We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements or insufficient disclosures due to error or fraud may occur and not be detected.\\nIn addition, we are required pursuant to Section 404 of SOX, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting in the Annual Report on Form 10-K for the year ended December 31, 2022. This assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting. The rules governing the standards that must be met for our management to assess our internal control over financial reporting are complex and require significant documentation, testing, and possible remediation. Testing and maintaining internal controls may divert management’s attention from other matters that are important to our business. Beginning with our Annual Report on Form 10-K for the year ended December 31, 2022, our independent registered public accounting firm may be required to attest to the effectiveness of our internal control over financial reporting on an annual basis. However, while we remain an emerging growth company, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting. If we are not able to complete our initial assessment of our internal controls and otherwise implement the requirements of Section 404 of SOX in a timely manner or with adequate compliance, our independent registered public accounting firm may not be able to certify as to the adequacy of our internal controls over financial reporting. Additionally, when required, an independent assessment of the effectiveness of our internal controls over financial reporting could detect problems that our management’s assessment might not. Undetected material weaknesses in our internal controls over financial reporting could lead to financial statement restatements and require us to incur the expense of remediation.\\nMatters impacting our internal controls may cause us to be unable to report our financial information on a timely basis and thereby subject us to adverse regulatory consequences, including sanctions by the SEC or violations of applicable stock exchange listing rules, which may result in a breach of the covenants under existing or future financing arrangements. There also could be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements. Confidence in the reliability of our financial statements also could suffer if we or our independent registered public accounting firm report a material weakness in our internal controls over financial reporting. This could materially adversely affect us and lead to a decline in the market price of our Class A common stock.\\nIn connection with the audit of our consolidated financial statements for the year ended December 31, 2019, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting related to deficiencies in our controls over the financial statement close process. Specifically, there were deficiencies in the design and operations of internal controls over the identification and review of complex accounting issues involving significant judgment or estimates with respect to certain prior period transactions.\\nWe have implemented, and are continuing to implement, measures designed to improve our internal control over financial reporting to remediate this material weakness. These measures include formalizing our processes and internal control documentation, strengthening supervisory reviews by our financial management, hiring additional qualified accounting and finance personnel, and engaging financial consultants to enable the implementation of internal control over financial reporting.\\n72\\nWe expect to incur additional costs to remediate the control deficiencies identified, though there can be no assurance that our efforts will be successful or avoid potential future material weaknesses. If we are unable to successfully remediate our existing or any future material weaknesses in our internal control over financial reporting, or if we identify any additional material weaknesses, the accuracy and timing of our financial reporting may be adversely affected, we may be unable to maintain compliance with securities law requirements regarding timely filing of periodic reports in addition to applicable stock exchange listing requirements, investors may lose confidence in our financial reporting, and our stock price may decline as a result. We also could become subject to investigations by the New York Stock Exchange (“NYSE”), the SEC or other regulatory authorities.\\nOur internal resources and personnel may in the future be insufficient to avoid accounting errors and there can be no assurance that we will not have additional material weaknesses in the future. Any failure to develop or maintain effective controls or any difficulties encountered implementing required new or improved controls could harm our operating results or cause us to fail to meet our reporting obligations and may result in a restatement of our financial statements for prior periods. Any failure to implement and maintain effective internal control over financial reporting also could adversely affect the results of periodic management evaluations and annual independent registered public accounting firm attestation reports regarding the effectiveness of our internal control over financial reporting that we will eventually be required to include in our periodic reports that will be filed with the SEC. Ineffective disclosure controls, procedures, and internal control over financial reporting could also cause investors to lose confidence in our reported financial and other information, which would likely have a negative effect on the trading price of our common stock. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on the NYSE.\\nUnanticipated changes in our effective tax rate and additional tax liabilities may impact our financial results.\\nWe are subject to income taxes in the United States and various jurisdictions outside of the United States. Our income tax obligations are generally determined based on our business operations in these jurisdictions. Significant judgment is often required in the determination of our worldwide provision for income taxes. Our effective tax rate could be impacted by changes in the earnings and losses in countries with differing statutory tax rates, changes in non-deductible expenses, changes in excess tax benefits of stock-based compensation, changes in the valuation of deferred tax assets and liabilities and our ability to utilize them, the applicability of withholding taxes, effects from acquisitions, changes in accounting principles and tax laws in jurisdictions where we operate. Any changes, ambiguity, or uncertainty in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions could also materially impact our income tax liabilities.\\nAs our business continues to grow and if we become more profitable, we anticipate that our income tax obligations could significantly increase. If our existing tax credits and net operating loss carry-forwards become fully utilized, we may be unable to offset or otherwise mitigate our tax obligations to the same extent as in prior years. This could have a material impact to our future cash flows or operating results.\\nIn addition, recent global tax developments applicable to multinational companies, including certain approaches of addressing taxation of digital economy recently proposed or enacted by the Organisation for Economic Co-operation and Development, the European Commission or certain major jurisdictions where we operate or might in the future operate, might have a material impact to our business and future cash flow from operating activities, or future financial results. We are also subject to tax examinations in multiple jurisdictions. While we regularly evaluate new information that may change our judgment resulting in recognition, derecognition, or changes in measurement of a tax position taken, there can be no assurance that the final determination of any examinations will not have an adverse effect on our operating results and financial position. In addition, our operations may change, which may impact our tax liabilities. As our brand becomes increasingly recognizable both domestically and internationally, our tax\\n73\\nplanning structure and corresponding profile may be subject to increased scrutiny, and if we are perceived negatively, we may experience brand or reputational harm.\\nWe may also be subject to additional tax liabilities and penalties due to changes in non-income based taxes resulting from changes in federal, state, or international tax laws, changes in taxing jurisdictions’ administrative interpretations, decisions, policies and positions, results of tax examinations, settlements or judicial decisions, changes in accounting principles, and changes to the business operations, including acquisitions, as well as the evaluation of new information that results in a change to a tax position taken in a prior period. Any resulting increase in our tax obligation or cash taxes paid could adversely affect our cash flows and financial results.\\nOur international operations may subject us to greater than anticipated tax liabilities.\\nWe are expanding our international operations to better support our growth into international markets. Our corporate structure and associated transfer pricing policies contemplate future growth in international markets, and consider the functions, risks, and assets of the various entities involved in intercompany transactions. The amount of taxes we pay in different jurisdictions may depend on the application of the tax laws of various jurisdictions, including the United States, to our international business activities, changes in tax rates, new or revised tax laws or interpretations of existing tax laws and policies, and our ability to operate our business in a manner consistent with our corporate structure and intercompany arrangements. The taxing authorities of the jurisdictions in which we operate may challenge our methodologies for pricing intercompany transactions pursuant to our intercompany arrangements or disagree with our determinations as to the income and expenses attributable to specific jurisdictions. If such a challenge or disagreement were to occur, and our position was not sustained, we could be required to pay additional taxes, interest, and penalties, which could result in one-time tax charges, higher effective tax rates, reduced cash flows, and lower overall profitability of our operations and we may be required to revise our intercompany agreements. Our financial statements could fail to reflect adequate reserves to cover such a contingency.\\nRisks Related to Our Intellectual Property\\nWe may not be able to adequately protect our proprietary and intellectual property rights in our data or technology.\\nOur success is dependent, in part, upon protecting our proprietary information and technology. Our intellectual property portfolio primarily consists of registered and unregistered trademarks, unregistered copyrights, domain names, know-how, and trade secrets. We may be unsuccessful in adequately protecting our intellectual property. No assurance can be given that confidentiality, non-disclosure, or invention or copyright assignment agreements with employees, consultants, partners or other parties have been entered into, will not be breached, or will otherwise be effective in establishing our rights in intellectual property and in controlling access to and distribution of our platform, or certain aspects of our platform, and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our platform. Additionally, certain unauthorized use of our intellectual property may go undetected, or we may face legal or practical barriers to enforcing our legal rights even where unauthorized use is detected.\\nCurrent laws may not provide for adequate protection of our platform or data, especially in foreign jurisdictions which may have laws that provide insufficient protections to companies. In addition, legal standards relating to the validity, enforceability, and scope of protection of proprietary rights in internet-related businesses are uncertain and evolving, and changes in these standards may adversely impact the viability or value of our proprietary rights. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our products, or certain aspects of our platform, or our data may be unenforceable under the laws of certain jurisdictions. Further, the laws of some countries do not protect\\n74\\nproprietary rights to the same extent as the laws of the United States, and the laws and mechanisms for protection and enforcement of intellectual property rights in some foreign countries may be inadequate. As we continue to operate in foreign countries and expand our international activities, we have encountered and may in the future encounter challenges in navigating the laws of foreign countries, which may adversely affect our ability to protect our proprietary rights and subject us to claims from current or former personnel and other third parties. Moreover, our exposure to unauthorized copying of certain aspects of our platform, or our data may increase. Further, competitors, foreign governments, foreign government-backed actors, criminals, or other third parties may gain unauthorized access to our proprietary information and technology. Accordingly, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our technology and intellectual property or claiming that we infringe upon or misappropriate their technology and intellectual property.\\nTo protect our intellectual property rights, we may be required to spend significant resources to monitor, protect, and defend these rights, and we may or may not be able to detect infringement by our customers or third parties. Litigation has been and may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Such litigation could be costly, time consuming, and distracting to management and could result in the impairment or loss of portions of our intellectual property. Furthermore, our efforts to enforce our intellectual property rights may be met with defenses, counterclaims, and countersuits attacking the validity and enforceability of our intellectual property rights. Our inability to protect our proprietary technology against unauthorized copying or use, as well as any costly litigation or diversion of our management’s attention and resources, could delay further sales or the implementation of our platform, impair the functionality of our platform, delay introductions of new features, integrations, and capabilities, result in our substituting inferior or more costly technologies into our platform, or injure our reputation. In addition, we may be required to license additional technology from third parties to develop and market new features, integrations, and capabilities, and we cannot be certain that we could license that technology on commercially reasonable terms or at all, and our inability to license this technology could harm our ability to compete.\\nIf third parties claim that we infringe upon or otherwise violate their intellectual property rights, our business could be adversely affected.\\nWe have in the past and may in the future be subject to claims that we have infringed or otherwise violated third parties’ intellectual property rights. There is patent, copyright, and other intellectual property development and enforcement activity in our industry and relating to the technology we use in our business. Our future success depends in part on not infringing upon or otherwise violating the intellectual property rights of others. From time to time, our competitors or other third parties (including non-practicing entities and patent holding companies) may claim that we are infringing upon or otherwise violating their intellectual property rights, and we may be found to be infringing upon or otherwise violating such rights. In addition, we do not own any issued, nor do we have any pending patents, which limits our ability to deter patent infringement claims by competitors and other third parties who hold patents. We may be unaware of the intellectual property rights of others that may cover some or all of our current or future technology or conflict with our rights, and the patent, copyright, and other intellectual property rights of others may limit our ability to improve our technology and compete effectively. Any claims of intellectual property infringement or other intellectual property violations, even those without merit, could:\\n•be expensive and time consuming to defend;\\n•cause us to cease making, licensing or using our platform or products that incorporate the challenged intellectual property;\\n•require us to modify, redesign, reengineer or rebrand our platform or products, if feasible;\\n•divert management’s attention and resources; or\\n75\\n•require us to enter into royalty or licensing agreements to obtain the right to use a third-party’s intellectual property.\\nAny royalty or licensing agreements, if required, may not be available to us on acceptable terms or at all. A successful claim of infringement against us could result in our being required to pay significant damages, enter into costly settlement agreements, or prevent us from offering our platform or products, any of which could have a negative impact on our operating profits and harm our future prospects. We may also be obligated to indemnify our customers or business partners in connection with any such litigation and to obtain licenses, modify our platform or products, or refund premium subscription fees, which could further exhaust our resources. Such disputes could also disrupt our platform or products, adversely affecting our customer satisfaction and ability to attract customers.\\nOur use of “open source” software could negatively affect our ability to offer and sell access to our platform and products, and subject us to possible litigation.\\nWe use open source software in our platform and products, and expect to continue to use open source software in the future. There are uncertainties regarding the proper interpretation of and compliance with open source licenses, and there is a risk that such licenses could be construed in a manner that imposes unanticipated conditions or restrictions on our ability to use such open source software, and consequently to provide or distribute our platform and products. Although use of open source software has historically been free, recently several open source providers have begun to charge license fees for use of their software. If our current open source providers were to begin to charge for these licenses or increase their license fees significantly, we would have to choose between paying such license fees or incurring the expense to replace the open source software with other software or with our own software, which would increase our research and development costs, and have a negative impact on our results of operations and financial condition.\\nAdditionally, we may from time to time face claims from third parties claiming ownership of, or seeking to enforce the terms of, an open source license, including by demanding release of source code for the open source software, derivative works or our proprietary source code that was developed using or that is distributed with such open source software. These claims could also result in litigation and could require us to make our proprietary software source code freely available, require us to devote additional research and development resources to change our platform or incur additional costs and expenses, any of which could result in reputational harm and would have a negative effect on our business and operating results. In addition, if the license terms for the open source software we utilize change, we may be forced to reengineer our platform or incur additional costs to comply with the changed license terms or to replace the affected open source software. Further, use of certain open source software can lead to greater risks than use of third-party commercial software, as open source licensors generally do not provide warranties or controls on the origin of software or indemnification for third-party infringement claims. Although we have implemented policies to regulate the use and incorporation of open source software into our platform and products, we cannot be certain that we have not incorporated open source software in our platform and products in a manner that is inconsistent with such policies.\\nIndemnity provisions in various agreements potentially expose us to substantial liability for intellectual property infringement and other losses.\\nOur agreements with resellers and other third parties may include indemnification or other provisions under which we agree to indemnify or otherwise be liable to them for losses suffered or incurred as a result of claims of intellectual property infringement, damages caused by us to property or persons, or other liabilities relating to or arising from our platform, products or other acts or omissions. For some of our larger customers, we sometimes negotiate similar indemnification provisions or indemnification for breaches of our obligations, representations or warranties in the subscription agreement, gross negligence or willful misconduct, breaches of confidentiality, losses related to security incidents, breach of the data processing addendum or violations of applicable law. In some instances, the term of these\\n76\\ncontractual provisions survives the termination or expiration of the applicable agreement. Large indemnity payments or damage claims from contractual breach could harm our business, operating results, and financial condition.\\nFrom time to time, third parties may assert infringement claims against our customers or resellers. These claims may require us to initiate or defend protracted and costly litigation on behalf of customers and resellers, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of our customers and resellers or may be required to obtain licenses for the platform or products they use or resell or modify our platform or products. We may not be able to obtain all necessary licenses on commercially reasonable terms, or at all, or to make such modifications to avoid a claim, in which case our customers and resellers may be required to stop using or reselling our platform or products. Further, customers may require us to indemnify or otherwise be liable to them for breach of confidentiality or failure to implement adequate security measures with respect to their data stored, transmitted or processed by our employees or platform. Although we normally contractually limit our liability with respect to such obligations, we may still incur substantial liability related to them. Any dispute with a customer with respect to such obligations could have adverse effects on our relationship with that customer and other current and prospective customers, reduce demand for our platform or products, and harm our revenue, business, and operating results.\\nRisks Related to Ownership of Our Class A Common Stock\\nWe are an emerging growth company and we cannot be certain that the reduced disclosure requirements applicable to emerging growth companies will not make our Class A common stock less attractive to investors.\\nWe are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.\\nFor as long as we continue to be an emerging growth company, we also intend to take advantage of certain other exemptions from various reporting requirements that are applicable to other public companies including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports, proxy statements, and registration statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We cannot predict if investors will find our Class A common stock less attractive because we will rely on these exemptions. If some investors find our Class A common stock less attractive as a result, there may be a less active trading market for our Class A common stock and our stock price may be more volatile.\\nWe will remain an emerging growth company until the earliest of (i) the last day of the year in which we have total annual gross revenue of $1.07 billion or more, (ii) December 31, 2026, (iii) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous three years, or (iv) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.\\n77\\nWe are subject to costs, regulations and requirements as a result of being a public company, which could impair our profitability, make it more difficult to run our business, or divert management’s attention from our business.\\nAs a public company, and particularly after we are no longer an emerging growth company, we are required to commit significant resources, management time, and attention to the requirements of being a public company, which causes us to incur significant legal, accounting, and other expenses, including costs associated with public company reporting requirements, and recruiting and retaining independent directors. We also have incurred and will continue to incur costs associated with SOX and the Dodd-Frank Wall Street Reform and Consumer Protection Act and related rules implemented by the SEC and the NYSE, and compliance with these requirements will place significant demands on our legal, accounting, and finance staff and on our accounting, financial, and information systems. The expenses incurred by public companies generally for reporting and corporate governance purposes have been increasing. These rules and regulations may increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In addition, we might not be successful in implementing these requirements. These laws and regulations also could make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors (the “Board”) or Board committees or as our executive officers. Furthermore, if we are unable to continue to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\\nAn active public market for our Class A common stock may not be sustained and could be highly volatile, and you may not be able to resell your shares at or above your original purchase price, if at all.\\nWe have a limited trading history. The market price of our Class A common stock could be highly volatile and may fluctuate substantially as a result of many factors, including:\\n•actual or anticipated fluctuations in our results of operations;\\n•variance in our results of operation from the expectations of market analysts;\\n•announcements by us or our competitors of significant business developments, changes in service provider relationships, acquisitions or expansion plans;\\n•changes in the prices of our products;\\n•our involvement in litigation;\\n•our sale of Class A common stock or other securities in the future;\\n•market conditions in our industry;\\n•changes in key personnel;\\n•the trading volume of our Class A common stock;\\n•changes in the estimation of the future size and growth rate of our markets; and\\n•general economic and market conditions.\\n78\\nIn addition, the stock markets have experienced extreme price and volume fluctuations. Broad market and industry factors may materially harm the market price of our Class A common stock, regardless of our results of operation. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. If we were involved in any similar litigation we could incur substantial costs, and our management’s attention and resources could be diverted.\\nIf you purchase shares of our Class A common stock, you may not be able to resell those shares at or above the price you originally paid. An active or liquid market in our Class A common stock may not be sustainable, which could adversely affect your ability to sell your shares and could depress the market price of our Class A common stock.\\nThe issuance of additional stock in connection with financings, acquisitions, investments, our stock incentive plans or otherwise will dilute all other stockholders.\\nOur amended and restated certificate of incorporation authorizes us to issue up to 1,000,000,000 shares of Class A common stock and up to 100,000,000 shares of preferred stock with such rights and preferences as may be determined by our Board. Subject to compliance with applicable rules and regulations, we may issue our shares of Class A common stock or securities convertible into our Class A common stock from time to time in connection with a financing, acquisition, investment, our stock incentive plans or otherwise. Any such issuance could result in substantial dilution to our existing stockholders and cause the trading price of our Class A common stock to decline.\\nA total of 124,905,954, or approximately 93%, of the outstanding shares of our Class A and Class B common stock are restricted from immediate resale, but may be sold on a stock exchange in the near future. The large number of shares eligible for public sale or subject to rights requiring us to register them for public sale could depress the market price of our Class A common stock.\\nThe market price of our Class A common stock could decline as a result of sales of a large number of shares of our Class A common stock in the market, and the perception that these sales could occur may also depress the market price of our Class A common stock. We, our executive officers, directors, and the holders of substantially all of our capital stock and securities convertible into or exchangeable for our capital stock outstanding prior to our IPO have entered into lock-up agreements with the underwriters under which they have agreed, subject to specific exceptions and early release triggers, not to sell any of our stock for 180 days following March 24, 2021. Following the expiration of this period and subject to applicable securities laws, such shares may be sold on the public market.\\nStockholders owning an aggregate of up to 36,750,000 shares of our Class B common stock are entitled, under contracts providing for registration rights, to require us to register shares owned by them for public sale in the United States. In addition, we filed a registration statement on Form S-8 on March 25, 2021, to register 24,114,926 shares of our Class A common stock under our equity compensation plans.\\nSales of our shares as restrictions end or pursuant to registration rights may make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. These sales also could cause the trading price of our Class A common stock to fall and make it more difficult for you to sell shares of our Class A common stock.\\nIf we do not meet the expectations of equity research analysts, if they do not publish research or reports about our business or if they issue unfavorable commentary or downgrade our Class A common stock, the price of our Class A common stock could decline.\\nThe trading market for our Class A common stock will depend in part on the research and reports that equity research analysts publish about us and our business. The analysts’ estimates are based upon their\\n79\\nown opinions and are often different from our estimates or expectations. If our results of operations are below the estimates or expectations of public market analysts and investors, our stock price could decline. Moreover, the price of our Class A common stock could decline if one or more securities analysts downgrade our Class A common stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.\\nWe cannot predict the impact our dual structure may have on the market price of our Class A common stock.\\nWe cannot predict whether our dual class structure, combined with the concentrated control of our stockholders who held our capital stock prior to the completion of our IPO, including our executive officers, employees, and directors and their affiliates, will result in a lower or more volatile market price of our Class A common stock or in adverse publicity or other adverse consequences. For example, certain index providers have announced restrictions on including companies with multiple class share structures in certain of their indices. In July 2017, FTSE Russell and Standard & Poor’s announced that they would cease to allow most newly public companies utilizing dual or multi-class capital structures to be included in their indices. Under the announced policies, our dual class capital structure would make us ineligible for inclusion in any of these indices. Given the sustained flow of investment funds into passive strategies that seek to track certain indexes, exclusion from stock indexes would likely preclude investment by many of these funds and could make our Class A common stock less attractive to other investors. As a result, the market price of our Class A common stock could be adversely affected.\\nThe dual class structure of our common stock has the effect of concentrating voting control with those stockholders who held our capital stock prior to the completion of our IPO, including our directors, executive officers, and their affiliates, who as of March 31, 2021 held in aggregate 93% of the voting power of our capital stock, which will limit or preclude your ability to influence corporate matters.\\nOur Class B common stock has ten votes per share, and our Class A common stock has one vote per share. As of March 31, 2021, our directors, executive officers, and their affiliates, held in the aggregate 93% of the voting power of our capital stock. Because of the ten-to-one voting ratio between our Class B common stock and Class A common stock, the holders of our Class B common stock collectively will continue to control a majority of the combined voting power of our common stock and therefore will be able to control all matters submitted to our stockholders for approval until the earlier of (a) the seven year anniversary of the closing of our IPO (b) such time as the outstanding shares of Class B common stock represent less than ten percent of the aggregate number of shares of our outstanding common stock and (c) the date the holders of two-thirds of our Class B common stock elect to convert the Class B common stock to Class A common stock. This concentrated control may limit or preclude your ability to influence corporate matters for the foreseeable future, including the election of directors, amendments of our organizational documents, and any merger, consolidation, sale of all or substantially all of our assets, or other major corporate transaction requiring stockholder approval. In addition, this may prevent or discourage unsolicited acquisition proposals or offers for our capital stock that you may feel are in your best interest as one of our stockholders.\\nFuture transfers by holders of Class B common stock will generally result in those shares converting to Class A common stock, subject to limited exceptions, such as certain transfers effected for estate planning purposes. The conversion of Class B common stock to Class A common stock will have the effect, over time, of increasing the relative voting power of those holders of Class B common stock who retain their shares in the long term.\\nWe do not expect to declare any dividends in the foreseeable future.\\nWe do not anticipate declaring any cash dividends to holders of our common stock in the foreseeable future. In addition, our credit facility places restrictions on our ability to pay cash dividends. Consequently,\\n80\\ninvestors may need to rely on sales of their Class A common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment. Investors seeking cash dividends should not purchase our Class A common stock.\\nProvisions in our charter documents and under Delaware law could make an acquisition of our company more difficult, limit attempts by our stockholders to replace or remove our current Board, and limit the market price of our Class A common stock.\\nProvisions in our amended and restated certificate of incorporation and amended and restated bylaws may have the effect of delaying or preventing a change of control or changes in our management. Our amended and restated certificate of incorporation and amended and restated bylaws, include provisions that:\\n•provide that the authorized but unissued shares of our common stock and our preferred stock are available for future issuance without stockholder approval;\\n•provide that our Board is classified into three classes of directors with staggered three-year terms;\\n•permit the Board to establish the number of directors and fill any vacancies and newly created directorships;\\n•require super-majority voting to amend some provisions in our amended and restated certificate of incorporation and amended and restated bylaws;\\n•authorize the issuance of “blank check” preferred stock that our Board could use to implement a stockholder rights plan;\\n•provide that only the Chairperson of our Board, our Chief Executive Officer, or a majority of our Board will be authorized to call a special meeting of stockholders;\\n•provide for a dual class common stock structure in which holders of our Class B common stock have the ability to control the outcome of matters requiring stockholder approval, even if they own significantly less than a majority of the outstanding shares of our Class A and Class B common stock, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets;\\n•prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders;\\n•provide that the Board is expressly authorized to make, alter or repeal our bylaws; and\\n•advance notice requirements for nominations for election to our Board or for proposing matters that can be acted upon by stockholders at annual stockholder meetings.\\nMoreover, Section 203 of the Delaware General Corporation Law may discourage, delay, or prevent a change in control of our company. Section 203 imposes certain restrictions on mergers, business combinations, and other transactions between us and holders of 15% or more of our common stock.\\nOur bylaws designate certain courts as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’\\n81\\nability to obtain a favorable judicial forum for disputes with us or our directors, officers, or employees.\\nOur bylaws provide that, unless we consent in writing to an alternative forum, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for any state law claim for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of or based on a fiduciary duty owed by any of our current or former directors, officers, or employees to us or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, our amended and restated certificate of incorporation or our amended and restated bylaws (including the interpretation, validity or enforceability thereof) or (iv) any action asserting a claim that is governed by the internal affairs doctrine, in each case subject to the Court of Chancery having personal jurisdiction over the indispensable parties named as defendants therein, or the Delaware Forum Provision. The Delaware Forum Provision will not apply to any causes of action arising under the Securities Act or the Exchange Act. Our amended and restated bylaws further provide that, unless we consent in writing to the selection of an alternative forum, the federal district courts of the United States shall be the sole and exclusive forum for resolving any complaint asserting a cause of action arising under the Securities Act, or the Federal Forum Provision. In addition, our amended and restated bylaws provide that any person or entity purchasing or otherwise acquiring any interest in shares of our common stock is deemed to have notice of and consented to the foregoing provisions; provided, however, that stockholders cannot and will not be deemed to have waived our compliance with the federal securities laws and the rules and regulations thereunder.\\nThe Delaware Forum Provision and the Federal Forum Provision in our amended and restated bylaws may impose additional litigation costs on stockholders in pursuing any such claims, particularly if the stockholders do not reside in or near the State of Delaware. Additionally, the forum selection clauses in our amended and restated bylaws may limit our stockholders’ ability to bring a claim in a forum that they find favorable for disputes with us or our directors, officers or employees, which may discourage such lawsuits against us and our directors, officers and employees even though an action, if successful, might benefit our stockholders. In addition, while the Delaware Supreme Court ruled in March 2020 that federal forum selection provisions purporting to require claims under the Securities Act be brought in federal court were “facially valid” under Delaware law, there is uncertainty as to whether other courts will enforce our Federal Forum Provision. If the Federal Forum Provision is found to be unenforceable, we may incur additional costs associated with resolving such matters. The Federal Forum Provision may also impose additional litigation costs on stockholders who assert that the provision is not enforceable or invalid. The Court of Chancery of the State of Delaware and the federal district courts of the United States may also reach different judgments or results than would other courts, including courts where a stockholder considering an action may be located or would otherwise choose to bring the action, and such judgments may be more or less favorable to us than our stockholders.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nUnregistered Sales of Equity Securities\\nFrom January 1, 2021 through March 31, 2021, pursuant to our Amended and Restated 2019 Stock Option and Grant Plan (the “2019 Plan”) we issued and sold to our employees, consultants and other service providers an aggregate of 3,861 shares of common stock upon the exercise of options under our 2019 Plan at exercise prices ranging from $1.23 to $1.68 per share, for an aggregate exercise price of $5,207. These 3,861 shares of common stock were exchanged for an equal number of shares of our Class B common stock in connection with our IPO.\\nFrom January 1, 2021 through March 31, 2021, pursuant to our 2021 Stock Option and Grant Plan we granted one employee an aggregate of 19,500 restricted stock units, with a grant date fair value $14 per restricted stock unit.\\n82\\nNone of the foregoing transactions involved any underwriters, underwriting discounts or commissions, or any public offering. The sales of the above securities were deemed to be exempt from registration under the Securities Act in reliance on Section 4(a)(2) of the Securities Act or Rule 701 promulgated under Section 3(b) of the Securities Act as transactions by an issuer not involving any public offering or pursuant to benefit plans and contracts relating to compensation as provided under Rule 701. The recipients of the securities in each of these transactions represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the securities issued in these transactions. All recipients had adequate access, through their relationships with us, to information about us. The sales of these securities were made without any general solicitation or advertising.\\nUse of Proceeds From the IPO\\nOn March 29, 2021, we closed the IPO, in which we issued 10,000,000 shares of Class A common stock, and on April 23, 2021 we closed the partial exercise of the underwriter’s option to purchase additional shares of our Class A common stock, in which we issued an additional 719,266 shares of Class A common stock, at a price to the public of $14.00 for aggregate net proceeds of $135,987 after deducting underwriting discounts and commissions of $10,505 and expenses payable by us of $3,578. The offer and sale of all of the shares in the IPO were registered under the Securities Act pursuant to the Prospectus. No payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries and to non-employee directors pursuant to our director compensation policy. There has been no material change in the planned use of proceeds from the IPO as described in the Prospectus. We invested the funds received in accordance with our Board approved investment policy, which provides for investments in obligations of the U.S. and foreign governments, money market instruments, registered money market funds, corporate and municipal bonds. Goldman, Sachs & Co. LLC, J.P. Morgan Securities LLC and Jefferies LLC acted as joint lead bookrunning managers of the IPO.\\nItem 3. Defaults Upon Senior Securities\\nNone.\\nItem 4. Mine Safety Disclosures\\nNot applicable.\\nItem 5. Other Information\\nNone.\\nItem 6. Exhibits\\nThe exhibits listed below are filed or incorporated by reference in this Quarterly Report on Form 10-Q.\\n| Exhibit Number | Exhibit Title |\\n| 3.1(1) | Amended and Restated Certificate of Incorporation of the Registrant |\\n| 3.2(2) | Amended and Restated Bylaws of the Registrant |\\n| 4.1(3) | Form of Common Stock certificate of the Registrant |\\n\\n83\\n| 31.1* | Certification of Principal Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\\n| 31.2* | Certification of Principal Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended |\\n| 32.1+ | Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act |\\n| 101.INS* | XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\\n| 101.SCH* | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page with Interactive Data File (formatted as Inline XBRL with applicable taxonomy extension information contained in Exhibits 101) |\\n\\n(1) File as Exhibit 3.2 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\\n(2) Filed as Exhibit 3.4 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\\n(3) Filed as Exhibit 4.1 to Registrant’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 16, 2021, and incorporated herein by reference.\\n* Filed herewith.\\n+ The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Quarterly Report on Form 10-Q and will not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference.\\n84\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| SEMRUSH HOLDINGS, INC. |\\n| May 11, 2021 | By: | /s/ Oleg Shchegolev |\\n| Oleg Shchegolev |\\n| Chief Executive Officer |\\n| (Principal Executive Officer) |\\n| May 11, 2021 | By: | /s/ Evgeny Fetisov |\\n| Evgeny Fetisov |\\n| Chief Financial Officer |\\n| (Principal Financial Officer and Principal Accounting Officer) |\\n\\n85\\n</text>\\n\\nIf the company plans to maintain an equal distribution of total assets and total liabilities and stockholders' equity by the end of 2021, along with a 10% increase in \\\"Deferred contract costs, net of current portion\\\" and \\\"Other long-term assets\\\" from March 2021 levels, what should be the new total of current assets in dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 190736.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 50,\n \"input_length\": 62594\n}"}}},{"rowIdx":51,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1 —\nBusiness\nIn this annual report on Form 10-K, “the Company,” “we” or “our” refer to A. M. Castle & Co., a Maryland corporation, and its subsidiaries included in the consolidated financial statements, except as otherwise indicated or as the context otherwise requires.\nBusiness and Markets\nCompany Overview\nThe Company is a specialty metals (90% of net sales) and plastics (10% of net sales) distribution company serving customers on a global basis. The Company provides a broad range of products and value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment manufacturing, marine, office furniture and fixtures, safety products, life sciences applications, transportation and general manufacturing industries.\nThe Company’s corporate headquarters are currently located in Oak Brook, Illinois. The Company operates out of 49 service centers located throughout North America (44), Europe (4) and Asia (1). The Company’s service centers hold inventory and process and distribute products to both local and export markets.\nIndustry and Markets\nService centers act as supply chain intermediaries between primary producers, which deal in bulk quantities in order to achieve economies of scale, and end-users in a variety of industries that require specialized products in significantly smaller quantities and forms. Service centers also manage the differences in lead times that exist in the supply chain. While original equipment manufacturers (“OEM”) and other customers often demand delivery within hours, the lead time required by primary producers can be as long as several months. Service centers also provide value to customers by aggregating purchasing, providing warehousing and distribution services to meet specific customer needs, including demanding delivery times and precise metal specifications.\nThe principal markets served by the Company are highly competitive. Competition is based on service, quality, processing capabilities, inventory availability, timely delivery, ability to provide supply chain solutions and price. The\n3\nCompany competes in a highly fragmented industry. Competition in the various markets in which the Company participates comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources and some of which have more established brand names in the local markets served by the Company.\nThe Company also competes to a lesser extent with primary metals producers who typically sell to larger customers requiring shipments of large volumes of metal.\nIn order to capture scale efficiencies and remain competitive, many primary metal producers are consolidating their operations and focusing on their core production activities. These producers have increasingly outsourced metals distribution and inventory management to metals service centers. This process of outsourcing allows them to work with a relatively small number of intermediaries rather than many end customers. As a result, metals service centers, including the Company, are now providing a range of services for their customers, including metal purchasing, processing and supply chain solutions.\nRecent Acquisitions\nDuring December 2011, the Company completed its acquisition (the “Acquisition”) of Tube Supply, Inc. (“Tube Supply”), which has expanded the Company’s product offerings in the oil and gas industry. Subsequent to the acquisition, Tube Supply operated as a Limited Liability Corporation until it was merged with A. M. Castle & Co. in September of 2012. The results of Tube Supply are included in the Company’s Metals segment.\nProcurement\nThe Company purchases metals and plastics from many producers. Material is purchased in large lots and stocked at its service centers until sold, usually in smaller quantities and typically with some value-added processing services performed. The Company’s ability to provide quick delivery of a wide variety of specialty metals and plastic products, along with its processing capabilities and supply chain management solutions, allows customers to lower their own inventory investment by reducing their need to order the large quantities required by producers and their need to perform additional material processing services. Some of the Company’s purchases are covered by long-term contracts and commitments, which generally have corresponding customer sales agreements.\nOrders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Deliveries are made principally by the Company’s fleet contracted through third party logistics providers. Common carrier delivery is used in areas not serviced directly by the Company’s fleet.\nAt December 31, 2012, the Company had 1,701 full-time employees. Of these, approximately 250 are represented by collective bargaining units, principally the United Steelworkers of America and International Brotherhood of Teamsters.\nBusiness Segments\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly in the Company’s various public filings. Neither of the Company’s reportable segments has any unusual working capital requirements.\nIn the last three years, the percentages of total sales of the two segments were as follows:\n| 2012 | 2011 | 2010 |\n| Metals | 90 | % | 90 | % | 89 | % |\n| Plastics | 10 | % | 10 | % | 11 | % |\n| 100 | % | 100 | % | 100 | % |\n\nMetals Segment\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, nickel, stainless steel, carbon and titanium. Inventories of\n4\nthese products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, a service center is equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting equipment, stress relieving and annealing furnaces, surface grinding equipment, and sheet shearing equipment.\nThe Company’s customer base is well diversified and therefore, the Company does not have dependence upon any single customer, or a few customers. Our customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms.\nThe Company’s broad network of locations provides same or next-day delivery to most of the segment’s markets, and two-day delivery to substantially all of the remaining markets.\nPlastics Segment\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications.\nThe Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\nJoint Venture\nThe Company holds a 50% joint venture interest in Kreher Steel Co. (“Kreher”), a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois. The Company’s equity in the earnings of this joint venture is reported separately in the Company’s consolidated statements of operations. Kreher is considered a significant subsidiary under Rule 3-09 of Regulation S-X. Therefore, its stand-alone financial statements are included in this filing.\nAccess to SEC Filings\nThe Company makes available free of charge on or through its Web site at www.amcastle.com the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the U.S. Securities and Exchange Commission (the “SEC”). Information on our website does not constitute part of this annual report on Form 10-K.\nITEM 1A —\nRisk Factors\nOur business, financial condition, results of operations, and cash flows are subject to various risks, many of which are not exclusively within our control that may cause actual performance to differ materially from historical or projected future performance. The risks described below are not the only risks we face. Any of the following risks, as well as other risks and uncertainties not currently known to us or that we currently consider to be immaterial, could materially and adversely affect our business, financial condition, results of operations, or cash flows.\nWe may not achieve all of the expected benefits from our restructuring and performance enhancement initiatives.\nWe have recently begun implementing restructuring actions in our metals business, including organizational restructuring, warehouse realignments and performance improvement programs. We expect these measures will result in improvements to annualized operating profits of approximately $33.0 million once fully implemented in 2013. In addition, we continue to evaluate additional options to improve efficiency and performance of our operations. We have made certain assumptions in estimating the anticipated impact of our restructuring and performance enhancement initiatives. These assumptions may turn out to be incorrect due to a variety of factors. In addition, our ability to realize the expected benefits from these initiatives is subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control. Some of our cost saving measures may not have the impact on our operating profitability that we currently project. If we are unsuccessful in implementing these initiatives or if we do not achieve our expected results, our results of operations and cash flows could be materially adversely affected.\n5\nOur substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under our debt instruments.\nWe have substantial debt service obligations. As of December 31, 2012, we had approximately $322.5 million of total debt outstanding, excluding capital lease obligations of $1.4 million, of which $264.5 million is secured. As of December 31, 2012, the Company had approximately $50.5 million of availability under our revolving credit facility. Subject to restrictions contained in the debt instruments, we may incur additional indebtedness.\nOur substantial level of indebtedness could have significant effects on our business, including the following:\n\n| • | it may be more difficult for us to satisfy our financial obligations; |\n\n| • | our ability to obtain additional financing for working capital, capital expenditures, strategic acquisitions or general corporate purposes may be impaired; |\n\n| • | we must use a substantial portion of our cash flow from operations to pay interest on our indebtedness, which will reduce the funds available to use for operations and other purposes; |\n\n| • | our ability to fund a change of control offer under our debt instruments may be limited; |\n\n| • | our substantial level of indebtedness could place us at a competitive disadvantage compared to our competitors that may have proportionately less debt; |\n\n| • | our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate may be limited; and |\n\n| • | our substantial level of indebtedness may make us more vulnerable to economic downturns and adverse developments in our business. |\n\nWe expect to obtain the funds to pay our expenses and to repay our indebtedness primarily from our operations and, in the case of our indebtedness, from the refinancing thereof. Our ability to meet our expenses and make these payments therefore depends on our future performance, which will be affected by financial, business, economic and other factors, many of which we cannot control. Our business may not generate sufficient cash flow from operations in the future, and our currently anticipated growth in revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. If we do not have enough funds, we may be required to refinance all or part of our then existing debt, sell assets or borrow more funds, which we may not be able to accomplish on terms acceptable to us, or at all. In addition, the terms of existing or future debt agreements may restrict us from pursuing any of these alternatives.\nOur debt instruments impose significant operating and financial restrictions, which may prevent us from pursuing certain business opportunities and taking certain actions and our failure to comply with the covenants contained in our debt instruments could result in an event of default that could adversely affect our operating results.\nOur debt agreements impose, and future debt agreements may impose, operating and financial restrictions on us. These restrictions limit or prohibit, among other things, our ability to:\n\n| • | incur additional indebtedness unless certain financial tests are satisfied or issue disqualified capital stock; |\n\n| • | pay dividends, redeem subordinated debt or make other restricted payments; |\n\n| • | make certain investments or acquisitions; |\n\n| • | issue stock of subsidiaries; |\n\n| • | grant or permit certain liens on our assets; |\n\n| • | enter into certain transactions with affiliates; |\n\n| • | merge, consolidate or transfer substantially all of our assets; |\n\n| • | incur dividend or other payment restrictions affecting certain of our subsidiaries; |\n\n| • | transfer, sell or acquire assets, including capital stock of our subsidiaries; and |\n\n| • | change the business we conduct. |\n\nThese covenants could adversely affect our ability to finance our future operations or capital needs, withstand a future downturn in our business or the economy in general, engage in business activities, including future opportunities that may be in our interest, and plan for or react to market conditions or otherwise execute our business strategies. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders or holders of such indebtedness could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. If the maturity of our indebtedness is accelerated, we may not have sufficient cash resources to satisfy our debt obligations and may not be able to continue our operations as planned.\n6\nWe may not be able to generate sufficient cash to service all of our existing debt service obligations, and may be forced to take other actions to satisfy our obligations under our debt agreements, which may not be successful.\nOur annual debt service obligations until December 2015, when our revolving credit facility is scheduled to mature, will be primarily limited to interest payments on our outstanding debt securities, with an aggregate principal amount of $282.5 million, and on borrowings under our $100.0 million revolving credit facility of $39.5 million as of December 31, 2012. Our ability to make scheduled payments on or to refinance our debt obligations depends on our future financial condition and operating performance, which are subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. Our business may not generate sufficient cash flow from operations in the future and our currently anticipated levels of revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. Therefore, we may not be able to maintain or realize a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness.\nIf our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness. Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous borrowing covenants, which could further restrict our business operations. The terms of existing or future debt instruments may restrict us from adopting some of these alternatives. In addition, any failure to make payments of principal and interest on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations.\nOur future operating results depend on the volatility of the prices of metals and plastics, which could cause our results to be adversely affected.\nThe prices we pay for raw materials, both metals and plastics, and the prices we charge for products may fluctuate depending on many factors, including general economic conditions (both domestic and international), competition, production levels, import duties and other trade restrictions and currency fluctuations. To the extent metals and plastics prices decline, we would generally expect lower sales and possibly lower net income, depending on the timing of the price changes and the ability to pass price changes on to our customers. To the extent we are not able to pass on to our customers any increases in our raw materials prices, our operating results may be adversely affected. In addition, because we maintain substantial inventories of metals and plastics in order to meet short lead-times and the just-in-time delivery requirements of our customers, a reduction in our selling prices could result in lower profitability or, in some cases, losses, either of which could adversely impact our ability to remain in compliance with certain financial covenants contained in our debt instruments, as well as result in us incurring impairment charges.\nDisruptions or shortages in the supply of raw materials could adversely affect our operating results and our ability to meet our customers’ demands.\nOur business requires materials that are sourced from third party suppliers. If for any reason our primary suppliers of metals should curtail or discontinue their delivery of raw materials to us at competitive prices and in a timely manner, our operating results could suffer. Unforeseen disruptions in our supply bases could materially impact our ability to deliver products to customers. The number of available suppliers could be reduced by factors such as industry consolidation and bankruptcies affecting metals and plastics producers, or suppliers may be unwilling or unable to meet our demand due to industry supply conditions generally. If we are unable to obtain sufficient amounts of raw materials from our traditional suppliers, we may not be able to obtain such raw materials from alternative sources at competitive prices to meet our delivery schedules, which could have an adverse impact on our operating results. To the extent we have quoted prices to customers and accepted orders for products prior to purchasing necessary raw materials, or have existing contracts, we may be unable to raise the price of products to cover all or part of the increased cost of the raw materials to our customers.\nIn some cases the availability of raw materials requires long lead times. As a result, we may experience delays or shortages in the supply of raw materials. If unable to obtain adequate and timely deliveries of required raw materials, we may be unable to timely supply customers with sufficient quantities of products. This could cause us to lose sales, incur additional costs, or suffer harm to our reputation.\n7\nIncreases in freight and energy prices would increase our operating costs and we may be unable to pass these increases on to our customers in the form of higher prices, which may adversely affect our operating results.\nWe use energy to process and transport our products. The prices for and availability of energy resources are subject to volatile market conditions, which are affected by political, economic and regulatory factors beyond our control. Our operating costs increase if energy costs, including electricity, diesel fuel and natural gas, rise. During periods of higher freight and energy costs, we may not be able to recover our operating cost increases through price increases without reducing demand for our products. In addition, we typically do not hedge our exposure to higher freight or energy prices.\nWe service industries that are highly cyclical, and any downturn in our customers’ industries could reduce our revenue and profitability.\nMany of our products are sold to customers in industries that experience significant fluctuations in demand based on economic conditions, energy prices, consumer demand, availability of adequate credit and financing, customer inventory levels, changes in governmental policies and other factors beyond our control. As a result of this volatility in the industries we serve, when one or more of our customers' industries experiences a decline, we may have difficulty increasing or maintaining our level of sales or profitability if we are not able to divert sales of our products to customers in other industries. We have made a strategic decision to focus sales resources on certain industries, specifically the aerospace, oil and gas and heavy equipment, machine tools and general industrial equipment industries. A downturn in these industries has had, and may in the future continue to have, an adverse effect on our operating results. We are also particularly sensitive to market trends in the manufacturing sector of the North American economy.\nA portion of our sales, particularly in the aerospace industry, are related to contracts awarded to our customers under various U.S. Government defense-related programs. Significant changes in defense spending, or in government priorities and requirements could impact the funding, or the timing of funding, of those defense programs, which could negatively impact our results of operations and financial condition.\nOur industry is highly competitive, which may force us to lower our prices and may have an adverse effect on our operating results.\nThe principal markets that we serve are highly competitive. Competition is based principally on price, service, quality, processing capabilities, inventory availability and timely delivery. We compete in a highly fragmented industry. Competition in the various markets in which we participate comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources than we do and some of which have more established brand names in the local markets we serve. We also compete to a lesser extent with primary metals producers who typically sell to very large customers requiring shipments of large volumes of metal. Increased competition could force us to lower our prices or to offer increased services at a higher cost to us, which could have an adverse effect on our operating results.\nOur operating results are subject to the seasonal nature of our customers’ businesses.\nA portion of our customers experience seasonal slowdowns. Historically, our revenues in the months of July, November and December have been lower than in other months because of a reduced number of shipping days and holiday or vacation closures for some customers. Consequently, our sales in the first two quarters of the year are usually higher than in the third and fourth quarters. As a result, analysts and investors may inaccurately estimate the effects of seasonality on our operating results in one or more future quarters and, consequently, our operating results may fall below expectations.\nWe rely upon our suppliers as to the specifications of the metals we purchase from them.\nWe rely on mill certifications that attest to the physical and chemical specifications of the metal received from our suppliers for resale and generally, consistent with industry practice, do not undertake independent testing of such metals. We rely on our customers to notify us of any metal that does not conform to the specifications certified by the supplying mill. Although our primary sources of products have been domestic mills, we have and will continue to purchase product from foreign suppliers when we believe it is appropriate. In the event that metal purchased from domestic suppliers is deemed to not meet quality specifications as set forth in the mill certifications or customer specifications, we generally have recourse against these suppliers for both the cost of the products purchased and possible claims from our customers. However, such recourse will not compensate us for the damage to our reputation that may arise from sub-standard products and possible losses of customers. Moreover, there is a greater level of risk that similar recourse will not be available to us in the event of claims by our customers related to products from foreign\n8\nsuppliers that do not meet the specifications set forth in the mill certifications. In such circumstances, we may be at greater risk of loss for claims for which we do not carry, or do not carry sufficient, insurance.\nWe are vulnerable to interest rate fluctuations on our indebtedness, which could hurt our operating results.\nWe are exposed to various interest rate risks that arise in the normal course of business. We finance our operations with fixed and variable rate borrowings. Market risk arises from changes in variable interest rates. Under our revolving credit facility, our interest rate on borrowings is subject to changes based on fluctuations in the LIBOR and prime rates of interest. If interest rates significantly increase, we could be unable to service our debt which could have an adverse effect on our operating results.\nWe operate in international markets, which expose us to a number of risks.\nAlthough a substantial majority of our business activity takes place in the United States, we serve and operate in certain international markets, which expose us to political, economic and currency related risks, including the following:\n| • | potential for adverse change in the local political or social climate or in government policies, laws and regulations; |\n\n| • | difficulty staffing and managing geographically diverse operations and the application of foreign labor regulations; |\n\n| • | restrictions on imports and exports or sources of supply; |\n\n| • | currency exchange rate risk; and |\n\n| • | change in duties and taxes. |\n\nWe operate in Canada, Mexico, France, and the United Kingdom, with limited operations in Singapore and China. An act of war or terrorism or major pandemic event could disrupt international shipping schedules, cause additional delays in importing our products into the United States or increase the costs required to do so. In addition, acts of crime or violence in these international markets (for example, in Mexico) could adversely affect our operating results. Fluctuations in the value of the U.S. dollar versus foreign currencies could reduce the value of these assets as reported in our financial statements, which could reduce our stockholders' equity. If we do not adequately anticipate and respond to these risks and the other risks inherent in international operations, it could have a material adverse effect on our operating results.\nWe may not be able to realize the benefits we anticipate from our acquisitions, including the Tube Supply acquisition.\nIn December 2011 we acquired Tube Supply, Inc. We intend to continue to seek attractive opportunities to acquire other businesses in the future. Achieving the benefits of these acquisitions depends on the timely, efficient and successful execution of a number of post-acquisition events, including our integration of the acquired businesses. Factors that could affect our ability to achieve the benefits we anticipate from our acquisition include:\n| • | difficulties in integrating and managing personnel, financial reporting and other systems used by the acquired businesses; |\n\n| • | the failure of the acquired businesses to perform in accordance with our expectations; |\n\n| • | failure to achieve anticipated synergies between our business units and the acquired businesses; |\n\n| • | the loss of the acquired businesses' customers; and |\n\n| • | cyclicality of business. |\n\nThe presence of any of the above factors individually or in combination could result in future impairment charges against the assets of the acquired businesses. If the acquired businesses do not operate as we anticipate, it could adversely affect our operating results and financial condition. As a result, there can be no assurance that the acquisitions, including the Tube Supply acquisition, will be successful or will not, in fact, adversely affect our business.\nOur business could be adversely affected by a disruption to our primary distribution hub.\nOur largest facility, in Franklin Park, Illinois, serves as a primary distribution center that ships product to our other facilities as well as external customers. Our business could be adversely impacted by a major disruption at this facility due to unforeseen developments occurring in or around the facility, such as:\n| • | damage to or inoperability of our warehouse or related systems; |\n\n| • | a prolonged power or telecommunication failure; |\n\n| • | a natural disaster, environmental or public health issue; or |\n\n| • | an airplane crash or act of war or terrorism on-site or nearby as the facility is located within seven miles of O'Hare International Airport (a major U.S. airport) and lies below certain take-off and landing flight patterns. |\n\n9\nA prolonged disruption of the services and capabilities of our Franklin Park facility and operation could adversely impact our operating results.\nDamage to or a disruption in our information technology systems could impact our ability to conduct business and/or report our financial performance.\nOver the last several years we have been implementing a new enterprise-wide resources planning (''ERP'') system. While we have completed the conversions of substantially all of our North American and European locations onto the new ERP system, we can provide no assurance that the continued phased-implementation at our remaining facilities, including Tube Supply, will be successful or will occur as planned. Difficulties associated with the design and implementation of the new ERP system could adversely affect our business, our customer service and our operating results.\nWe rely on information technology systems to provide inventory availability to our sales and operating personnel, improve customer service through better order and product reference data and monitor operating results. Difficulties associated with upgrades or integration with new systems could lead to business interruption that could harm our reputation, increase our operating costs and decrease profitability. In addition, any significant disruption relating to our current or new information technology systems, whether due from such things as fire, flood, tornado and other natural disasters, power loss, network failures, loss of data, security breaches and computer viruses, or otherwise, may have an adverse effect on our business, our operating results and our ability to report our financial performance in a timely manner.\nA portion of our workforce is represented by collective bargaining units, which may lead to work stoppages.\nAs of December 31, 2012, approximately 15% of our U.S. employees were represented by unions under collective bargaining agreements, including hourly warehouse employees at our primary distribution center in Franklin Park, Illinois. As these agreements expire, there can be no assurance that we will succeed in concluding collective bargaining agreements with the union to replace those that expire. Although we believe that our labor relations have generally been satisfactory, we cannot predict how stable our relationships with these labor organizations will be or whether we will be able to meet union requirements without impacting our operating results and financial condition. The unions may also limit our flexibility in dealing with our workforce. Work stoppages and instability in our union relationships could negatively impact the timely processing and shipment of our products, which could strain relationships with customers and adversely affect our operating results.\nAn impairment or restructuring charge could have an adverse effect on our operating results.\nWe continue to evaluate opportunities to reduce costs and improve operating performance. These actions could result in restructuring and related charges, including but not limited to asset impairments, employee termination costs, charges for pension benefits, and pension curtailments that could be significant, which could adversely affect our financial condition and results of operations.\nWe have a significant amount of long-lived assets, including goodwill and intangible assets. We review the recoverability of goodwill annually or whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. We review the recoverability of definite lived intangible assets and other long-lived assets whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. The results of these calculations may be affected by the current or further declines in the market conditions for our products, as well as interest rates and general economic conditions. If impairment is determined to exist, we will incur impairment losses, which will have an adverse effect on our operating results and our ability to remain in compliance with certain financial covenants contained in our debt instruments.\nWe could incur substantial costs in order to comply with, or to address any violations under, environmental and employee health and safety laws, which could adversely affect our operating results.\nOur operations are subject to various environmental statutes and regulations, including laws and regulations governing materials we use. In addition, certain of our operations are subject to international, federal, state and local environmental laws and regulations that impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. Our operations are also subject to various employee safety and health laws and regulations, including those concerning occupational injury and illness, employee exposure to hazardous materials and employee complaints. Certain of our facilities are located in industrial areas, have a history of heavy industrial use and have been in operation for many years and, over time, we and other\n10\npredecessor operators of these facilities have generated, used, handled and disposed of hazardous and other regulated wastes. Currently unknown cleanup obligations at these facilities, or at off-site locations at which materials from our operations were disposed, could result in future expenditures that cannot be currently quantified but which could have an adverse effect on our operating results.\nWe may face risks associated with current or future litigation and claims.\nFrom time to time, we are involved in a variety of lawsuits, claims and other proceedings relating to the conduct of our business. These suits concern issues including contract disputes, employment actions, employee benefits, taxes, environmental, health and safety, personal injury and product liability matters. Due to the uncertainties of litigation, we can give no assurance that we will prevail on all claims made against us in the lawsuits that we currently face or that additional claims will not be made against us in the future. While it is not feasible to predict the outcome of all pending lawsuits and claims, we do not believe that the disposition of any such pending matters is likely to have an adverse effect on our financial condition or liquidity, although the resolution in any reporting period of one of more of these matters could have an adverse effect on our operating results for that period. Also, we can give no assurance that any other lawsuits or claims brought in the future will not have an adverse effect on our financial condition, liquidity or operating results.\nPotential environmental legislative and regulatory actions could impose significant costs on the operations of our customers and suppliers, which could have a material adverse impact on our results of operations, financial condition and cash flows.\nClimate change regulation or some form of legislation aimed at reducing greenhouse gas (''GHG'') emissions is currently being considered in the United States as well as globally. As a metals and plastics distributor, our operations do not emit significant amounts of GHG. However, the manufacturing processes of many of our suppliers and customers are energy intensive and generate carbon dioxide and other GHG emissions. Any adopted future climate change and GHG regulations may impose significant costs on the operations of our customers and suppliers and indirectly impact our operations.\nThe Tube Supply acquisition significantly extends our exposure in the oil and gas sector to customers who utilize non-traditional drilling techniques, including hydraulic fracturing. Hydraulic fracturing is an important and commonly used process for the completion of natural gas, and to a lesser extent, oil wells in shale formations. Certain environmental and other groups have asserted that chemicals used in the fracturing process could adversely affect drinking water supplies. The U.S. Congress and various state and local governments are considering increased regulatory oversight of the hydraulic fracturing process, including through additional permit requirements, operational restrictions, reporting obligations and temporary or permanent bans on hydraulic fracturing in certain environmentally sensitive areas such as watersheds. We cannot predict whether such laws or regulations will be enacted and, if so, what actions any such laws or regulations would require or prohibit. Additional levels of regulatory oversight on, or otherwise limiting, the hydraulic fracturing process could subject the business and operations of our oil and gas customers to delays, increased operating costs and process prohibitions, and indirectly impact our oil and gas business through reduced demand for our products.\nUntil the timing, scope and extent of any future regulation becomes known, we cannot predict the effect on our results of operations, financial condition and cash flows.\nCommodity hedging transactions may expose us to loss or limit our potential gains.\nWe have entered into certain fixed price sales contracts with customers which expose us to risks associated with fluctuations in commodity prices. As part of our risk management program, we may use financial instruments from time-to-time to mitigate all or portions of these risks, including commodity futures, forwards or other derivative instruments. While intended to reduce the effects of the commodity price fluctuations, these transactions may limit our potential gains or expose us to losses. Also, should our counterparties to such transactions fail to honor their obligations due to financial distress we would be exposed to potential losses or the inability to recover anticipated gains from these transactions.\nOwnership of our stock is concentrated, which may limit stockholders’ ability to influence corporate matters.\nAs of December 31, 2012, based on filings made with the SEC and other information made available to us as of that date, we believe Patrick J. Herbert, III, one of our directors, may be deemed to beneficially own approximately 22.8% of our common stock. Accordingly, Mr. Herbert and his affiliates may have the voting power to substantially control the outcome of matters requiring a stockholder vote including the election of directors and the approval of significant\n11\ncorporate matters. Such a concentration of control could adversely affect the market price of our common stock or prevent a change in control or other business combinations that might be beneficial to us.\nWe have various mechanisms in place that may prevent a change in control that stockholders may otherwise consider favorable.\nOn August 31, 2012, our Board of Directors adopted a shareholder rights plan pursuant to which one purchase right was distributed as a dividend on each share of our common stock held of record as of the close of business on September 11, 2012. Upon becoming exercisable, each right will entitle its holder to purchase from the Company one one-hundredth of a share of our Series B Junior Preferred Stock for the purchase price of $54.00. Generally, the rights will become exercisable ten days after the date on which any person or group becomes the beneficial owner of 10% or more of our common stock or has commenced a tender or exchange offer which, if consummated, would result in any person or group becoming the beneficial owner of 10% or more of our common stock, subject to the terms and conditions set forth in the shareholder rights plan. The rights are attached to the certificates representing outstanding shares of common stock until the rights become exercisable, at which point separate certificates will be distributed to the record holders of our common stock. If a person or group becomes the beneficial owner of 10% or more of our common stock, which we refer to as an “acquiring person,” each right will entitle its holder, other than the acquiring person, to receive upon exercise a number of shares of our common stock having a market value of two times the purchase price of the right.\nThe shareholder rights plan is designed to deter coercive takeover tactics and to prevent an acquirer from gaining control of the Company without offering a fair price to all of our stockholders. The existence of the shareholder rights plan, however, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding common stock, and thereby adversely affect the market price of our common stock.\nIn addition, our charter and by-laws and the Maryland General Corporation Law, or the MGCL, include provisions that may be deemed to have antitakeover effects and may delay, defer or prevent a takeover attempt that stockholders might consider to be in their best interests. For example, the MGCL, our charter and bylaws require the approval of the holders of two-thirds of the votes entitled to be cast on the matter to amend our charter (unless our Board of Directors has unanimously approved the amendment, in which case the approval of the holders of a majority of such votes is required), contain certain advance notice procedures for nominating candidates for election to our Board of Directors, and permit our Board of Directors to issue up to 9.988 million shares of preferred stock.\nFurthermore, we are subject to the anti-takeover provisions of the MGCL that prohibit us from engaging in a “business combination” with an “interested stockholder” for a period of five years after the date of the transaction in which the person first becomes an “interested stockholder,” unless the business combination or stockholder interest is approved in a prescribed manner. The application of these and certain other provisions of our charter could have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.\nThe provisions of our debt instruments also contain limitations on our ability to enter into change of control transactions. In addition, the repurchase rights in our 7.0% convertible senior notes due 2017 (“Convertible Notes”) triggered by the occurrence of a “fundamental change” (as defined in the indenture for the Convertible Notes), and the additional shares of our common stock by which the conversion rate is increased in connection with certain fundamental change transactions, as described in the indenture for the Convertible Notes, could discourage a potential acquirer.\nWe may not have the cash necessary to satisfy our cash obligations under our Convertible Notes.\nAs of December 31, 2012, we had approximately $57.5 million of aggregate principal amount outstanding under the Convertible Notes. The Convertible Notes bear cash interest semiannually at a rate of 7.0% per year, and mature on December 15, 2017. Upon the occurrence of a fundamental change (as defined in the indenture for the Convertible Notes), we may be required to repurchase some or all of the Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest up to but excluding the relevant fundamental change repurchase date. We may not have sufficient funds to satisfy such cash obligations and, in such circumstances, may not be able to arrange the necessary financing on favorable terms or at all. In addition, our ability to satisfy such cash obligations will be restricted pursuant to covenants contained in the indenture for the Convertible Notes and will be permitted to be paid only in limited circumstances. We may also be limited in our ability to satisfy such cash obligations by applicable law or the terms of other instruments governing our indebtedness. Our inability to make cash payments to satisfy our obligations described above would trigger an event of default under the Convertible Notes, which in turn could constitute an event of default under any of our outstanding indebtedness, thereby resulting in the acceleration of such indebtedness, the prepayment of which could further restrict our ability to satisfy such cash obligations.\n12\nThe conditional conversion features of our Convertible Notes, if triggered, may adversely affect our financial condition and operating results.\nIn the event the conditional conversion features of the Convertible Notes are triggered, holders of the Convertible Notes will be entitled to convert the Convertible Notes at any time during specified periods at their option. If one or more holders elect to convert their Convertible Notes, and we elect or are deemed to have elected cash settlement or combination settlement, we would be required to pay cash to satisfy all or a portion of our conversion obligation for such Convertible Notes, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their Convertible Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Convertible Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.\nITEM 1B —\nUnresolved Staff Comments\nNone.\nITEM 2 —\nProperties\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. All properties and equipment are sufficient for the Company’s current level of activities. Distribution centers and sales offices are maintained at each of the following locations, most of which are leased, except as indicated:\n| Locations | ApproximateFloor Area inSquare Feet |\n| Metals Segment |\n| North America |\n| Bedford Heights, Ohio | 374,400 | (1) |\n| Birmingham, Alabama | 76,000 | (1) |\n| Blaine, Minnesota | 65,200 | (1) |\n| Charlotte, North Carolina | 116,500 | (1) |\n| Edmonton, Alberta | 87,103 |\n| Fairless Hills, Pennsylvania | 71,600 | (1) |\n| Franklin Park, Illinois | 522,600 | (1) |\n| Gardena, California | 117,000 |\n| Grand Prairie, Texas | 78,000 | (1) |\n| Hammond, Indiana (H-A Industries) | 243,000 |\n| Houston, Texas | 383,100 | (3) |\n| Kansas City, Missouri | 118,000 |\n| Kennesaw, Georgia | 87,500 |\n| Kent, Washington | 53,000 |\n| Lafayette, Louisiana | 5,000 |\n| Mississauga, Ontario | 57,000 |\n| Orange, Connecticut | 57,389 |\n| Paramount, California | 155,500 |\n| Point Claire, Quebec | 38,760 |\n| Santa Cantarina, Nuevo Leon, Mexico | 112,000 |\n| Saskatoon, Saskatchewan | 15,000 |\n| Selkirk, Manitoba | 50,000 | (1) |\n| Stockton, California | 60,000 |\n| Twinsburg, Ohio | 120,000 |\n| Wichita, Kansas | 95,000 |\n\n13\n| Locations | ApproximateFloor Area inSquare Feet |\n| Worcester, Massachusetts | 53,500 | (1) |\n| Europe |\n| Blackburn, England | 62,139 |\n| Letchworth, England | 40,000 |\n| Trafford Park, England | 30,000 |\n| Montoir de Bretagne, France | 38,944 |\n| Asia |\n| Shanghai, China | 45,700 |\n| Sales Offices |\n| Bilbao, Spain | (Intentionally left blank) |\n| Fairfield, Ohio |\n| Milwaukee, Wisconsin |\n| Phoenix, Arizona |\n| Singapore |\n| Tulsa, Oklahoma |\n| Total Metals Segment | 3,428,935 |\n| Plastics Segment |\n| Baltimore, Maryland | 24,000 |\n| Cleveland, Ohio | 8,600 |\n| Cranston, Rhode Island | 14,990 |\n| Detroit, Michigan | 22,000 |\n| Elk Grove Village, Illinois | 22,500 |\n| Fort Wayne, Indiana | 17,600 |\n| Grand Rapids, Michigan | 42,500 | (1) |\n| Harrisburg, Pennsylvania | 13,900 |\n| Indianapolis, Indiana | 13,500 |\n| Kalamazoo, Michigan | 81,000 |\n| Knoxville, Tennessee | 16,530 |\n| Maple Shade, New Jersey | 12,480 |\n| Mt. Vernon, New York | 30,000 |\n| New Philadelphia, Ohio | 15,700 |\n| Pittsburgh, Pennsylvania | 12,800 |\n| Rockford, Michigan | 53,600 |\n| Tampa, Florida | 17,700 |\n| Worcester, Massachusetts | 2,500 | (1) |\n| Total Plastics Segment | 421,900 |\n| Headquarters |\n| Oak Brook, Illinois | 39,360 | (2) |\n| GRAND TOTAL | 3,890,195 |\n\n| (1) | Represents owned facility. |\n\n| (2) | The Company’s principal executive offices do not include a distribution or sales office. |\n\n| (3) | Represents two leased facilities (274,000 square feet) and one owned facility (109,100 square feet). |\n\n14\nITEM 3 —\nLegal Proceedings\n(Amounts in thousands)\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\nGovernment Proceeding\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning. While the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\nITEM 4 —\nMine Safety Disclosures\nNot applicable.\nExecutive Officers of The Registrant\nThe following selected information for each of our current executive officers (as defined by regulations of the SEC) was prepared as of March 4, 2013.\n| Name and Title | Age | Business Experience |\n| Patrick R. AndersonVice President, CorporateController and Chief Accounting Officer | 41 | Mr. Anderson began his employment with the registrant in 2007 and was elected to the position of Vice President, Corporate Controller and Chief Accounting Officer. Prior to joining the registrant, he was employed as a Senior Manager with Deloitte & Touche LLP (a global accounting firm) where he was employed from 1994 to 2007. |\n| Scott J. DolanPresident and Chief Executive Officer | 42 | Mr. Dolan most recently served as Senior Vice President, Airport Operations and Cargo, of United Continental Holdings, Inc. (a $37 billion publicly traded provider of passenger and cargo air transportation services), and its principal wholly-owned subsidiaries, United Airlines and Continental Airlines, from 2010 to 2011. From 2004 until 2010, Mr. Dolan served as Senior Vice President, Airport Operations and President, United Cargo (2006-2010) and as Senior Vice President and President, United Cargo (2004-2006) for UAL Corporation and its principal subsidiary, United Airlines. Mr. Dolan worked at Atlas Air Worldwide Holdings, Inc. (a global airfreight company) from 2002 to 2004, where he served as Senior Vice President and Chief Operating Officer from 2003-2004 and as Vice President, Business Integration from 2002 to 2003. Prior to joining Atlas Air, Mr. Dolan spent five years at General Electric Company, where he served in a variety of positions including Vice President, Operational Performance, Polar Air Cargo, a subsidiary of GE Capital Aviation Services. |\n\n15\n| Name and Title | Age | Business Experience |\n| Thomas L. GarrettVice President andPresident, Total Plastics, Inc. | 50 | Mr. Garrett began his employment with Total Plastics, Inc., a wholly owned subsidiary of the registrant, in 1988 and was appointed to the position of Controller. In 1996, he was elected to the position of Vice President and in 2001 was appointed to the position of Vice President of the registrant and President of Total Plastics, Inc. |\n| Kevin H. GlynnVice Presidentand Chief Information Officer | 49 | Mr. Glynn began his employment with the registrant in October 2010 as the Interim Chief Information Officer. In January 2011 he was appointed Vice President and Chief Information Officer. Prior to joining the registrant, he was employed as a Managing Principal at Laminar Group LLC (a management consulting company) from 2009 to 2010, Chief Operating Officer at IRON Solutions, Inc. (an information technology company specializing in data, software and media services for the agriculture equipment market) from 2008 to 2009 and as Senior Vice President and Chief Information Officer at CNH America, LLC (a manufacturer of agricultural and construction equipment) from 2006 to 2007. |\n| Robert J. PernaVice President,General Counsel and Secretary | 49 | Mr. Perna began his employment with the registrant in 2008 and was elected to the position of Vice President-General Counsel and Secretary. Prior to joining the registrant he was General Counsel, North America, CNH America, LLC (a manufacturer of agricultural and construction equipment) since 2007, and he also served as Associate General Counsel and Corporate Secretary for Navistar International Corporation (a manufacturer of commercial trucks and diesel engines) since 2001. |\n| Anne D. ScharmVice President, Human Resources | 36 | Ms. Scharm began her employment with the registrant in 2011 as the Director of Organizational Development. In December 2011, she was appointed as the Interim Vice President, Human Resources. In March 2012, she was appointed Vice President, Human Resources. Prior to joining the registrant, she was employed as Director of Human Resources and Organizational Development with Delnor Health System, (now known as Cadence Health - a healthcare organization) from 2006 to 2011. |\n| Scott F. StephensVice President,Chief Financial Officer and Treasurer | 43 | Mr. Stephens began his employment with the registrant in 2008 and was elected to the position of Vice President, Chief Financial Officer, and Treasurer. From February 2010 to December 2010, he was also appointed to the position of Interim President, Castle Metals Oil & Gas. In May 2012, Mr. Stephens was elected to serve as Interim Chief Executive Officer until October 2012. Formerly, he served as the CFO of Lawson Products, Inc. (a distributor of services, systems and products to the MRO and OEM marketplace) from 2004 to 2008, and CFO of The Wormser Company from 2001 to 2004. |\n| Blain A. TiffanyChief Commercial Officer | 54 | Mr. Tiffany began his employment with the registrant in 2000 and was appointed to the position of District Manager. He was appointed Eastern Region Manager in 2003, Vice President – Regional Manager in 2005 and in 2006 was appointed to the position of Vice President – Sales. In 2007, Mr. Tiffany was appointed to the position of Vice President, President of Castle Metals Plate. In 2009, Mr. Tiffany served as Vice President, President of Castle Metals Aerospace through 2011. In 2012, Mr. Tiffany served as Vice President, Castle Metals and in January 2013 was appointed to the position of Chief Commercial Officer. |\n\n16\nPART II\n\nITEM 5 —\nMarket for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\nThe Company’s common stock trades on the New York Stock Exchange under the ticker symbol “CAS”. As of March 1, 2013 there were approximately 880 shareholders of record. Payment of cash dividends and repurchase of common stock are currently limited due to restrictions contained in the Company’s debt agreements. No cash dividends were paid on the Company’s common stock in 2012 and 2011. We may consider paying cash dividends on the Company common stock at some point in the future, subject to the limitations described above. Any future payment of cash dividends, if any, is at the discretion of the Board of Directors and will depend on the Company’s earnings, capital requirements and financial condition, restrictions under the Company’s debt instruments, and such other factors as the Board of Directors may consider.\nSee Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”, for information regarding common stock authorized for issuance under equity compensation plans.\nThe table below presents shares of the Company’s common stock which were acquired by the Company during the quarter ended December 31, 2012:\n| Period | TotalNumber ofSharesPurchased(1) | AveragePricePaid perShare | Total numberof SharesPurchased asPart ofPubliclyAnnouncedPlans orPrograms | MaximumNumber (orApproximateDollar Value) of Shares that May Yet Be Purchased under the Plans or Programs |\n| October 1 through October 31 | — | — | — | — |\n| November 1 through November 30 | — | — | — | — |\n| December 1 through December 31 | 24,469 | $ | 14.77 | — | — |\n| Total | 24,469 | $ | 14.77 | — | — |\n\n| (1) | The total number of shares purchased represents shares surrendered to the Company by employees to satisfy tax withholding obligations upon vesting of restricted stock units awarded pursuant to the Company’s 2010 - 2012 Long-Term Compensation Plan. |\n\nOn October 15, 2012 the Company granted 78,492 restricted stock units to Scott J. Dolan, President and Chief Executive Officer, as an equity inducement award. The restricted stock units subject to the inducement award will vest in four equal annual installments, subject to Mr. Dolan's continued employment by the Company. At the time of vesting, the Company will issue to Mr. Dolan in cancellation of the restricted stock units, the number of shares of common stock of the Company equal to the number of restricted stock units. The inducement award was granted outside of the Company's 2008 Omnibus Incentive Plan, authorized by the independent members of the Human Resources Committee of the Company's Board of Directors and granted as an inducement material to Mr. Dolan's employment with the Company in accordance with Section 303A.08 of the New York Stock Exchange Listed Company Manual. The issuance of these shares of restricted stock units was made in reliance upon the exemptions form registration provided by Section 4(2) under the Securities Act of 1933, as amended.\nThe following table sets forth the range of the high and low sales prices of shares of the Company’s common stock for the periods indicated:\n| 2012 | 2011 |\n| Low | High | Low | High |\n| First Quarter | $ | 9.59 | $ | 12.90 | $ | 15.14 | $ | 19.29 |\n| Second Quarter | $ | 9.65 | $ | 14.20 | $ | 15.25 | $ | 19.24 |\n| Third Quarter | $ | 6.99 | $ | 13.54 | $ | 10.37 | $ | 18.46 |\n| Fourth Quarter | $ | 10.83 | $ | 14.97 | $ | 7.85 | $ | 14.91 |\n\n17\nThe following graph compares the cumulative total stockholder return on our common stock for the five-year period ended December 31, 2012, with the cumulative total return of the Standard and Poor’s 500 Index and to a peer group index. The comparison in the graph assumes the investment of $100 on December 31, 2007. Cumulative total stockholder return means share price increases or decreases plus dividends paid, with the dividends reinvested, and reflect market capitalization weighting. The graph does not forecast future performance of our common stock. The Company moved to a new peer group index during 2010 in conjunction with the establishment of a relative total shareholder return performance measure under the Company’s long term compensation plan. The Company believes this new peer group provides a more meaningful comparison of our stock performance. The new peer group index is made up of companies in the metals industry or in the industrial products distribution business, although not all of the companies included in the new peer group index participate in all of the lines of business in which the Company is engaged and some of the companies included in the peer group index also engage in lines of business in which the Company does not participate. Additionally, the market capitalizations of many of the companies in the peer group are quite different from that of the Company.\nCOMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*\nAmong A.M. Castle & Co., the S&P 500 Index, and a Peer Group\n*$100 invested on 12/31/07 in stock or index, including reinvestment of dividends.\nFiscal year ending December 31.\nCopyright© 2013 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved.\n| 12/07 | 12/08 | 12/09 | 12/10 | 12/11 | 12/12 |\n| A. M. Castle & Co. | $ | 100.00 | $ | 40.32 | $ | 51.30 | $ | 68.99 | $ | 35.45 | $ | 55.35 |\n| S&P 500 | 100.00 | 63.00 | 79.67 | 91.67 | 93.61 | 108.59 |\n| Peer Group (a) | 100.00 | 51.46 | 69.81 | 84.89 | 76.47 | 78.43 |\n\n\n| (a) | The Peer Group Index consists of the following companies: AEP Industries Inc.; AK Steel Holding Corp.; Allegheny Technologies Inc.; Amcol International Corp.; Applied Industrial Technologies Inc.; Carpenter Technology Corp.; Cliffs Natural Resources Inc.; Commercial Metals Company; Fastenal Company; Gibraltar Industries Inc.; Haynes International Inc.; Kaman Corp.; Lawson Products Inc.; MSC Industrial Direct Company Inc.; Nucor Corp.; Olin Corp.; Olympic Steel, Inc.; Quanex Building Products Corp.; Reliance Steel & Aluminum Co.; RTI International Metals Inc.; Schnitzer Steel Industries Inc.; Steel Dynamics Inc.; Stillwater Mining Company; Texas Industries Inc.; United States Steel Corp.; and Worthington Industries Inc. |\n\n18\nITEM 6 —\nSelected Financial Data\nThe Selected Financial Data in the table below includes the results of the December 2011 and January 2008 acquisitions of Tube Supply and Metals U.K., respectively, from the date of acquisition.\n| (dollars in millions, except per share data) | 2012 | 2011 | 2010 | 2009 | 2008 |\n| For the year ended December 31: |\n| Net sales | $ | 1,270.4 | $ | 1,132.4 | $ | 943.7 | $ | 812.6 | $ | 1,501.0 |\n| Equity in earnings of joint venture | 7.2 | 11.7 | 5.6 | 0.4 | 8.8 |\n| Net loss from continuing operations | (9.7 | ) | (1.8 | ) | (5.6 | ) | (26.9 | ) | (17.1 | ) |\n| Basic (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\n| Diluted (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\n| Cash dividends declared per common share | — | — | — | 0.06 | 0.24 |\n| As of December 31: |\n| Total assets | 788.8 | 822.3 | 529.4 | 558.0 | 679.0 |\n| Long-term debt, less current portion | 296.2 | 314.2 | 61.1 | 67.7 | 75.0 |\n| Total debt | 297.1 | 314.9 | 69.1 | 89.2 | 117.1 |\n| Total stockholders’ equity | 337.3 | 312.3 | 313.5 | 318.2 | 347.3 |\n\nITEM 7 —\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\nAmounts in millions except per share data\nInformation regarding the business and markets of A.M. Castle & Co. and its subsidiaries (the “Company”), including its reportable segments, is included in Item 1 “Business” of this annual report on Form 10-K.\nThe following discussion should be read in conjunction with Item 6 “Selected Financial Data” and the Company’s consolidated financial statements and related notes thereto in Item 8 “Financial Statements and Supplementary Data”.\nEXECUTIVE OVERVIEW\nThe Company’s strategy is to become the foremost global provider of specialty metals products and services and specialized supply chain solutions to targeted global industries.\nDuring 2012, the following significant events occurred which impacted the Company’s operations and/or financial results:\n\n| • | Lower LIFO charges and the inclusion of Tube Supply's activity in 2012 resulted in decreased cost of materials as a percentage of sales to 73.0% in 2012 compared to 74.7% in 2011; |\n\n| • | Increased operating income as a percentage of sales to 3.2%, up from 0.5% in 2011; |\n\n| • | Expanded operations in the United Kingdom to support the continued increase in aerospace defense program business; and |\n\n| • | In the first four months of 2012, the Company recognized $15.6 million of interest expense related to the mark-to-market adjustment on the conversion option associated with the convertible debt. In April, the Company reclassified the cumulative value of the conversion option associated with the convertible debt to additional paid-in capital as a result of the authorization of additional shares of common stock and the conversion option is no longer required to be marked-to-market through earnings. |\n\nRecent Market and Pricing Trends\nThe Company experienced decreased demand from its customer base during the second half of 2012 in the Metals segment as customer buying patterns slowed to reflect a more cautious outlook. Industry data indicates that U.S. service center steel shipments were higher than 2011 levels by approximately 1%, while U.S. service center aluminum shipments were approximately 1% lower in 2012 compared to 2011 levels. Virtually all key end-use\n19\nmarkets experienced decreases in demand in the Company’s Metals segment during 2012. The Plastics segment experienced an increase in demand for its products in 2012 compared to 2011, reflecting continued strength in the automotive sector. Due to the late-cycle nature of the Company’s targeted customers, results typically lag the general economic cycle by twelve months.\nPricing across the majority of the Company’s markets started strong during 2012 and then softened for the majority of the year. The combination of factors above negatively impacted the Company’s operating results during the last three quarters of 2012.\nChanges in pricing can have a more direct impact on the Company’s operating results than changes in volume due to certain factors including but not limited to:\n\n| • | Changes in volume typically result in corresponding changes to the Company’s variable costs. However, as pricing changes occur, variable expenses are not directly impacted. |\n\n| • | If surcharges are not passed through to the customer or are passed through without a mark-up, the Company’s profitability will be adversely impacted. |\n\nCurrent Business Outlook\nManagement uses the Purchasing Managers Index (‘PMI’) provided by the Institute for Supply Management (website is www.ism.ws) as an external indicator for tracking the demand outlook and possible trends in its general manufacturing markets. The table below shows PMI trends from the first quarter of 2010 through the fourth quarter of 2012. Generally speaking, according to the ISM, an index above 50.0 indicates growth in the manufacturing sector of the U.S. economy, while readings under 50.0 indicate contraction.\n| YEAR | Qtr 1 | Qtr 2 | Qtr 3 | Qtr 4 |\n| 2010 | 58.2 | 58.8 | 55.4 | 56.8 |\n| 2011 | 61.1 | 56.4 | 51.0 | 52.4 |\n| 2012 | 53.3 | 52.7 | 50.3 | 50.6 |\n\nMaterial pricing and demand in both the Metals and Plastics segments of the Company’s business have historically proven to be difficult to predict with any degree of accuracy. A favorable PMI trend suggests that demand for some of the Company’s products and services, in particular those that are sold to the general manufacturing customer base in the U.S., could potentially be at a higher level in the near-term. The PMI trended upward from late 2012 levels in the first two months of 2013 to 53.1 in January and 54.2 in February. The Company believes that its revenue trends typically correlate to the changes in PMI on a six to twelve month lag basis.\nRESULTS OF OPERATIONS: YEAR-TO-YEAR COMPARISONS AND COMMENTARY\nOur discussion of comparative period results is based upon the following components of the Company’s consolidated statements of operations.\nNet Sales —The Company derives its sales from the processing and delivery of metals and plastics. Pricing is established with each customer order and includes charges for the material, processing activities and delivery. The pricing varies by product line and type of processing. From time to time the Company may enter into fixed price arrangements with customers while simultaneously obtaining similar agreements with its suppliers.\nCost of Materials — Cost of materials consists of the costs that the Company pays suppliers for metals, plastics and related inbound freight charges, excluding depreciation and amortization which are included in operating costs and expenses discussed below. The Company accounts for inventory primarily on a last-in-first-out (“LIFO”) basis. LIFO adjustments are calculated as of December 31 of each year. The Company may enter into hedges to mitigate the risk associated with commodity price fluctuations. Gains and losses which result from marking the hedge contracts to market are recorded in cost of materials.\nOperating Costs and Expenses — Operating costs and expenses primarily consist of:\n\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\n\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\n\n20\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily related to accounting and legal advisory services, bad debt expense, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\n\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\n\n2012 Results Compared to 2011\nAs a result of the acquisition of Tube Supply in December 2011, the full year results were included in the Company's Metals segment during 2012.\nConsolidated results by business segment are summarized in the following table for years 2012 and 2011.\nOperating Results by Segment\n| Year Ended December 31, | Fav / (Unfav) |\n| 2012 | 2011 | $ Change | % Change |\n| Net Sales |\n| Metals | $ | 1,143.9 | $ | 1,014.2 | $ | 129.7 | 12.8 | % |\n| Plastics | 126.5 | 118.2 | 8.3 | 7.0 | % |\n| Total Net Sales | $ | 1,270.4 | $ | 1,132.4 | $ | 138.0 | 12.2 | % |\n| Cost of Materials |\n| Metals | $ | 836.3 | $ | 763.0 | $ | (73.3 | ) | (9.6 | )% |\n| % of Metals Sales | 73.1 | % | 75.2 | % |\n| Plastics | 91.0 | 82.6 | (8.4 | ) | (10.2 | )% |\n| % of Plastics Sales | 71.9 | % | 69.9 | % |\n| Total Cost of Materials | $ | 927.3 | $ | 845.6 | $ | (81.7 | ) | (9.7 | )% |\n| % of Total Sales | 73.0 | % | 74.7 | % |\n| Operating Costs and Expenses |\n| Metals | $ | 257.8 | $ | 237.7 | $ | (20.1 | ) | (8.5 | )% |\n| Plastics | 32.3 | 32.7 | 0.4 | 1.2 | % |\n| Other | 11.9 | 11.2 | (0.7 | ) | (6.3 | )% |\n| Total Operating Costs & Expenses | $ | 302.0 | $ | 281.6 | $ | (20.4 | ) | (7.2 | )% |\n| % of Total Sales | 23.8 | % | 24.9 | % |\n| Operating Income (Loss) |\n| Metals | $ | 49.8 | $ | 13.5 | $ | 36.3 | 268.9 | % |\n| % of Metals Sales | 4.4 | % | 1.3 | % |\n| Plastics | 3.2 | 2.9 | 0.3 | 10.3 | % |\n| % of Plastics Sales | 2.5 | % | 2.5 | % |\n| Other | (11.9 | ) | (11.2 | ) | (0.7 | ) | (6.3 | )% |\n| Total Operating Income | $ | 41.1 | $ | 5.2 | $ | 35.9 | 690.4 | % |\n| % of Total Sales | 3.2 | % | 0.5 | % |\n\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\nNet Sales:\nConsolidated net sales were $1,270.4 million in 2012, an increase of $138.0 million, or 12.2%, versus 2011. Metals segment net sales during 2012 of $1,143.9 million were $129.7 million, or 12.8%, higher than 2011. Tube Supply contributed net sales of $178.5 million in 2012 compared to $7.6 million for the two-week period ended December 31, 2011. Excluding Tube Supply results, net sales for the Metals segment were $41.2 million lower in\n21\n2012 compared to 2011. Lower net sales were primarily the result of lower shipping volumes. Average tons sold per day, excluding Tube Supply, decreased 3.9% compared to the prior year. The decrease in demand experienced in 2012 was driven primarily by SBQ bar, carbon bar and aluminum products. Excluding Tube Supply, gains in the oil and gas business were offset by weakness in the industrial business in 2012 compared to 2011.\nPlastics segment net sales during 2012 of $126.5 million were $8.3 million, or 7.0%, higher than 2011 primarily due to increased sales volume, reflecting continued strength in the automotive sector.\nCost of Materials:\nCost of materials (exclusive of depreciation and amortization) were $927.3 million, an increase of $81.7 million, or 9.7%, compared to 2011. Material costs for the Metals segment were $836.3 million or 73.1% as a percent of net sales compared to $763.0 million or 75.2% as a percent of net sales in 2011. Tube Supply cost of materials were $118.7 million in 2012 compared to $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2012 results include a $0.4 million charge associated with the realized and unrealized losses for forward contracts related to the commodity hedging program compared to a $2.4 million charge in 2011. Cost of materials for the Metals segment include a LIFO charge of $1.1 million in 2012 compared to $15.1 million in 2011. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\nMaterial costs for the Plastics segment were 71.9% as a percent of net sales in 2012 as compared to 69.9% for the same period last year due to higher costs experienced in the automotive sector of the business.\nOperating Expenses and Operating Income (Loss):\nOperating costs and expenses increased $20.4 million, or 7.2%, compared to last year. Operating costs and expenses for 2012 were $302.0 million, or 23.8% as a percent of net sales, compared to $281.6 million million, or 24.9% as a percent of net sales last year. Operating costs related to Tube Supply were $32.9 million in 2012 compared to $0.9 million in 2011.\nDuring the second quarter of 2012, the Company incurred costs associated with executive employment transition in the amount of $1.6 million. As a result of the transition, share-based awards were forfeited, which resulted in a significant increase in the Company’s forfeiture rate. The increase in the forfeiture rate estimate associated with the active Long-term Compensation Plans resulted in a decrease in sales, general and administrative cost of approximately $1.0 million. The net impact of the employment transition costs on sales, general and administrative expense was approximately $0.6 million.\nThe increase in operating expenses for 2012 compared to 2011 primarily relates to the following:\n\n| • | Warehouse, processing and delivery costs increased by $13.4 million of which a $15.6 million increase is associated with the increase for Tube Supply for the period. The Tube Supply impact was offset by a $2.2 million decrease primarily attributed to a decline in workers’ compensation, overtime wage, temporary employee and utilities costs, partially offset by an increase in compensation and benefits expense as a result of headcount, merit and healthcare cost increases and rent expense due to a full year of expense for the expanded facility in Mexico, which was substantially completed in 2011 and rent expense for the new facility in Trafford Park, United Kingdom during 2012; |\n\n| • | Sales, general and administrative costs increased by $1.6 million of which a $9.8 million increase is associated with the increase for Tube Supply for the period. The net impact of the CEO transition costs of $0.6 million and an increase to bad debt reserves for customer bankruptcies of $0.8 million were included in the 2012 results. The 2011 results include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and $4.3 million for charges related to the acquisition of Tube Supply. The remaining decrease of $4.6 million is primarily attributed to a decline incentive compensation and other compensation and benefits costs, partially offset by an increase in workers' compensation and outside services costs; and |\n\n| • | Depreciation and amortization expense was $5.4 million higher than 2011 primarily due to the depreciation and amortization of Tube Supply’s fixed and intangible assets acquired in December 2011. |\n\nConsolidated operating income for 2012 was $41.1 million compared to $5.2 million in 2011.\n22\nOther Income and Expense, Income Taxes and Net Loss:\nInterest expense was $56.7 million in 2012, an increase of $36.9 million versus 2011 as a result of interest charges on the Company’s new senior secured and convertible notes, as well as the unrealized loss for the mark-to-market adjustment on the conversion option associated with the convertible notes.\nThe increase in interest expense for 2012 compared to the prior year is a result of the following:\n\n| • | Increase for the non-cash interest charge of $11.6 million associated with the mark-to-market adjustment on the conversion option associated with the convertible notes, which is not deductible for federal income tax purposes; |\n\n| • | Increase for interest on senior secured and convertible notes of $31.0 million; and |\n\n| • | Increase for amortization of deferred financing fees and debt discount of $1.1 million. |\n\nIn addition to items above, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million and a charge for underwriting fees associated with the debt financing of $3.4 million recorded in 2011.\nThe Company recorded income tax expense of $1.4 million in 2012 compared to a tax benefit of $1.1 million in 2011. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2012 and 2011 was 9.2% and 7.7%, respectively. The change in the effective tax rate for 2012 compared to 2011 was primarily the result of the non-deductibility of the change in the mark-to-market adjustment on the conversion option associated with the convertible notes in the amount of $11.6 million.\nEquity in earnings of the Company’s joint venture was $7.2 million in 2012 compared to $11.7 million in 2011. The decrease is a result of lower demand in virtually all of the joint venture’s end-use markets compared to last year.\nConsolidated net loss for 2012 was $9.7 million, or $0.42 per diluted share, compared to net loss of $1.8 million, or $0.08 per diluted share, for 2011.\n23\n2011 Results Compared to 2010\nConsolidated results by business segment are summarized in the following table for years 2011 and 2010.\nOperating Results by Segment\n| Year Ended December 31, | Fav / (Unfav) |\n| 2011 | 2010 | $ Change | % Change |\n| Net Sales |\n| Metals | $ | 1,014.2 | $ | 841.1 | $ | 173.1 | 20.6 | % |\n| Plastics | 118.2 | 102.6 | 15.6 | 15.2 | % |\n| Total Net Sales | $ | 1,132.4 | $ | 943.7 | $ | 188.7 | 20.0 | % |\n| Cost of Materials |\n| Metals | $ | 763.0 | $ | 631.1 | $ | (131.9 | ) | (20.9 | )% |\n| % of Metals Sales | 75.2 | % | 75.0 | % |\n| Plastics | 82.6 | 69.8 | (12.8 | ) | (18.3 | )% |\n| % of Plastics Sales | 69.9 | % | 68.0 | % |\n| Total Cost of Materials | $ | 845.6 | $ | 700.9 | $ | (144.7 | ) | (20.6 | )% |\n| % of Total Sales | 74.7 | % | 74.3 | % |\n| Operating Costs and Expenses |\n| Metals | $ | 237.7 | $ | 215.5 | $ | (22.2 | ) | (10.3 | )% |\n| Plastics | 32.7 | 29.3 | (3.4 | ) | (11.6 | )% |\n| Other | 11.2 | 7.4 | (3.8 | ) | (51.4 | )% |\n| Total Operating Costs & Expenses | $ | 281.6 | $ | 252.2 | $ | (29.4 | ) | (11.7 | )% |\n| % of Total Sales | 24.9 | % | 26.7 | % |\n| Operating (Loss) Income |\n| Metals | $ | 13.5 | $ | (5.5 | ) | $ | 19.0 | 345.5 | % |\n| % of Metals Sales | 1.3 | % | (0.7 | )% |\n| Plastics | 2.9 | 3.6 | (0.7 | ) | (19.4 | )% |\n| % of Plastics Sales | 2.5 | % | 3.5 | % |\n| Other | (11.2 | ) | (7.4 | ) | (3.8 | ) | (51.4 | )% |\n| Total Operating (Loss) | $ | 5.2 | $ | (9.3 | ) | $ | 14.5 | 155.9 | % |\n| % of Total Sales | 0.5 | % | (1.0 | )% |\n\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\nNet Sales:\nConsolidated net sales were $1,132.4 million in 2011, an increase of $188.7 million, or 20.0%, versus 2010. Metals segment net sales during 2011 of $1,014.2 million were $173.1 million, or 20.6%, higher than 2010. Tube Supply contributed net sales of $7.6 million for the two-week period ended December 31, 2011. Higher net sales were primarily the result of higher shipping volumes. Average tons sold per day, excluding Tube Supply, increased 18.1% compared to the prior year. The increase in demand experienced in 2011 was driven primarily by SBQ bar, alloy bar, carbon and alloy plate, stainless and tubing products. Key end-use markets that experienced increased demand in 2011 compared to 2010 include oil and gas, mining and heavy equipment and general industrial markets.\nPlastics segment net sales during 2011 of $118.2 million were $15.6 million, or 15.2%, higher than 2010 primarily due to higher overall pricing and, to a lesser extent, increased sales volume. The Plastics business experienced increased sales volume during 2011 reflecting strength in the automotive and office furniture end-use markets compared to 2010.\n24\nCost of Materials:\nCost of materials (exclusive of depreciation and amortization) were $845.6 million, an increase of $144.7 million, or 20.6%, compared to 2010. Material costs for the Metals segment were $763.0 million or 75.2% as a percent of net sales compared to $631.1 million or 75.0% as a percent of net sales in 2010. Tube Supply cost of materials were $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2011 results include a $2.4 million charge associated with the mark-to-market adjustment for forward contracts related to the commodity hedging program compared to no charge in 2010. The Metals segment recorded LIFO expense of $15.1 million in 2011 compared to $7.7 million in 2010. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\nMaterial costs for the Plastics segment were 69.9% as a percent of net sales in 2011 as compared to 68.0% for the same period last year. The Plastics segment recorded LIFO expense of $0.9 million in 2011 compared to $0.3 million in 2010.\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. On a consolidated basis, cost of materials for 2010 were lower by $12.5 million as a result of the liquidations.\nOperating Expenses and Operating Income (Loss):\nOperating costs and expenses increased $29.4 million, or 11.7%, compared to last year. Operating costs and expenses for 2011 were $281.6 million, or 24.9% as a percent of net sales, compared to $252.2 million, or 26.7% as a percent of net sales last year. Operating costs and expenses in 2011 include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011 compared to no charge in 2010. Additionally, there were no facility consolidation charges during 2011 compared to $2.4 million in 2010.\nFull workweeks and 401(k) matching contributions were reinstated in January and April 2010, respectively, resulting in overall increases in payroll related costs in 2011 compared to 2010. Additionally, effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation. Effective July 1, 2011, the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Other factors that contributed to increased payroll related costs in 2011 compared to 2010 included merit increases and headcount increases.\nIn addition to payroll related costs, there were costs associated with the acquisition of Tube Supply in December 2011 of $4.3 million, as well as Tube Supply activity for the two-week period ended December 31, 2011 that contributed $0.9 million to the overall increase.\nThe $29.4 million increase in operating expenses in 2011 compared to 2010 primarily relates to the following:\n\n| • | Warehouse, processing and delivery costs increased by $11.6 million of which $4.1 million is due to increased compensation and benefits expenses as a result of headcount, merit and healthcare cost increases and $7.2 million is the result of increases in charges associated with higher sales volumes, such as warehouse, packing and shipping supplies, repairs and maintenance, utilities, outside services, overtime wages and temporary help. The warehouse, processing and delivery cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million; |\n\n| • | Sales, general and administrative costs increased by $17.9 million. The increase is primarily comprised of $4.3 million of direct acquisition-related costs, $7.1 million as a result of headcount, merit and healthcare cost increases and a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011. The sales, general and administrative cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. The balance of the difference relates other administrative expenses including training, travel and insurance; and |\n\n| • | Depreciation and amortization expense decreased $0.1 million in 2011 compared to 2010. The depreciation and amortization expense for Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. |\n\nConsolidated operating income for 2011 was $5.2 million compared to operating loss of $9.3 million in 2010.\n25\nOther Income and Expense, Income Taxes and Net Loss:\nInterest expense was $13.7 million in 2011, an increase of $8.7 million versus 2010 as a result of charges associated with refinancing the Company’s debt in conjunction with the Tube Supply acquisition. The Company issued $225.0 million of senior secured notes and $57.5 million of convertible senior notes and entered into a $100.0 million senior secured asset based revolving credit facility.\nInterest expense for 2011 includes the following charges:\n\n| • | Non-cash interest charge of $4.0 million associated with the mark-to-market adjustment for the derivative liability component of the convertible notes, which is not deductible for federal income tax purposes; |\n\n| • | Non-cash interest charge of $0.2 million for the amortization of new debt origination fees; |\n\n| • | Interest on new debt of $1.6 million; and |\n\n| • | Underwriting fees of $3.4 million associated with the debt financing. |\n\nIn addition to increased interest expense, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million, which is comprised of a non-cash charge of $0.9 million for the write-off of existing debt issuance costs and $5.2 million for the fees associated with the prepayment of the notes.\nThe Company recorded a tax benefit of $1.1 million in 2011 compared to a tax benefit of $3.1 million in 2010. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2011 and 2010 was 7.7% and 21.7%, respectively. The change in the tax rate was due primarily to the additional income tax on joint venture income compared to 2010 and the non-deductibility of the mark-to-market charge on the derivative liability component of the convertible notes.\nEquity in earnings of the Company’s joint venture was $11.7 million in 2011 compared to $5.6 million in 2010. The increase is a result of higher demand in virtually all of the joint venture’s end-use markets, most notably the oil and gas and automotive sectors, and higher pricing compared to last year.\nConsolidated net loss for 2011 was $1.8 million, or $0.08 per diluted share, compared to net loss of $5.6 million, or $0.25 per diluted share, for 2010.\nLiquidity and Capital Resources\nCash and cash equivalents decreased by $8.9 million and $6.2 million for the years ended December 31, 2012 and 2011, respectively, and increased by $8.4 million for the year ended December 31, 2010.\nThe Company’s principal sources of liquidity are cash provided by operations and available borrowing capacity to fund working capital needs and growth initiatives. Cash provided by operations for the year-ended December 31, 2012 was $5.4 million compared to cash used in operations of $46.3 million for the year-ended December 31, 2011 and cash provided by operations of $34.4 million for the year-ended December 31, 2010. Specific components of the change in working capital are highlighted below:\n\n| • | During 2012, cash receipts from customers exceeded net sales resulting in a $44.6 million cash flow source due to a decrease in accounts receivable compared to a $26.4 million cash flow use due to an increase in accounts receivable for 2011. Net sales increased 12.2% from 2011. Average receivable days outstanding was 49.0 days for 2012 and 50.3 for 2011. |\n\n| • | During 2012, inventory purchases exceeded sales of inventory resulting in a $29.3 million cash flow use due to an increase in inventory compared to a $39.4 million cash flow use due to an increase in inventory in 2011. Average days sales in inventory was 187.0 days for 2012 verses 128.5 days for 2011. |\n\n| • | During 2012, cash paid for inventories and other goods and services exceeded purchases resulting in a $38.0 million cash flow use due to a net decrease in accounts payable and accrued liabilities compared to a $9.7 million cash flow source due to a net increase in accounts payable and accrued liabilities for 2011. |\n\n| • | The Company received its 2010 federal income tax refund of approximately $2.0 million during February 2012 and its 2009 federal income tax refund of approximately $6.3 million during January 2011. |\n\n26\nIn December 2011, in conjunction with the acquisition of Tube Supply, the Company issued $225.0 million aggregate principal amount of 12.75% Senior Secured Notes due 2016, $57.5 million aggregate principal amount of 7.0% Convertible Senior Notes due 2017 and entered into a $100.0 million senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds of $304.6 million were used to complete the Acquisition, pay-off amounts outstanding under our previous credit agreement and for general corporate purposes.\nHistorically, the Company’s primary uses of liquidity and capital resources have been capital expenditures, payments on debt (including interest payments), acquisitions and dividend payments. Management believes the Company will be able to generate sufficient cash from operations and planned working capital improvements to fund its ongoing capital expenditure programs and meet its debt obligations for at least the next twelve months. Furthermore, the Company does have available borrowing capacity under the New Revolving Credit Agreement. The new debt agreements impose significant operating and financial restrictions which may prevent the Company from certain business opportunities such as, making acquisitions or paying dividends among other things. The New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10 million. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12.5 million, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement (“cash dominion”). Based on the Company’s cash projections, it does not anticipate a scenario whereby cash dominion would occur during the next twelve months.\nThe Company is committed to maintaining a strong financial position through maintaining sufficient levels of available liquidity, managing working capital and monitoring the Company’s overall capitalization. Cash and cash equivalents at December 31, 2012 were $21.6 million and the Company had $50.5 million of available borrowing capacity under its New Revolving Credit Facility. Approximately 23% of the Company’s consolidated cash and cash equivalents balance resides in the United States. As foreign earnings are permanently reinvested, availability under the Company’s New Revolving Credit Facility would be used to fund operations in the United States should the need arise in the future.\nWorking capital at December 31, 2012 was $379.3 million compared to $349.0 million at December 31, 2011. The increase in working capital is primarily due to higher inventory of $31.7 million, prepaid expenses and other current assets of $4.7 million and lower accounts payable of $48.9 million, offset by lower accounts receivable of $42.7 million and lower cash of $8.9 million, from December 31, 2011 to 2012.\nThe Company monitors its overall capitalization by evaluating total debt to total capitalization. Total debt to total capitalization is defined as the sum of short- and long-term debt, divided by the sum of total debt and stockholders’ equity. Total debt to total capitalization was 46.8% at December 31, 2012 and 50.2% at December 31, 2011. As of April 26, 2012, the conversion option value of $42.0 million associated with the convertible debt, which was issued in December 2011, was reclassified from long-term debt to additional paid-in capital, resulting in a decrease to the debt to total capitalization at December 31, 2012. The deferred tax benefit of $8.3 million associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital. Over the long-term, the Company plans to continue to improve its total debt to total capitalization by improving operating results, managing working capital and using cash generated from operations to repay outstanding debt. Going forward, as and when permitted by term of agreements noted above, depending on market conditions, the Company may decide in the future to refinance, redeem or repurchase its debt and take other steps to reduce its debt or lease obligations or otherwise improve its overall financial position and balance sheet.\nCapital Expenditures\nCash paid for capital expenditures for 2012 was $11.1 million compared to $11.7 million in 2011. The expenditures during 2012 were comprised of approximately $1.1 million of ERP and other information technology enhancements and $1.3 million related to existing and new facility expansions for additional automotive business in the Plastics segment and for additional aerospace defense business in the United Kingdom. The balance of the capital expenditures in 2012 are the result of normal equipment, building improvement and furniture and fixture upgrades throughout the year. Management believes that capital expenditures will approximate $14 million in 2013.\n27\nContractual Obligations and Other Commitments\nThe following table includes information about the Company’s contractual obligations that impact its short-term and long-term liquidity and capital needs. The table includes information about payments due under specified contractual obligations and is aggregated by type of contractual obligation. It includes the maturity profile of the Company’s consolidated long-term debt, operating leases and other long-term liabilities.\nAt December 31, 2012, the Company’s contractual obligations, including estimated payments by period, were as follows:\n| Payments Due In | Total | Less Than One Year | One toThree Years | Three toFive Years | More Than Five Years |\n| Long-term debt obligations (excluding capital lease obligations) | $ | 322.0 | $ | — | $ | 39.5 | $ | 282.5 | $ | — |\n| Interest payments on debt obligations (a) | 137.4 | 33.6 | 67.1 | 36.7 | — |\n| Capital lease obligations | 1.4 | 0.4 | 0.8 | 0.2 | — |\n| Operating lease obligations | 76.7 | 14.4 | 21.5 | 16.7 | 24.1 |\n| Purchase obligations (b) | 333.5 | 222.6 | 110.9 | — | — |\n| Other (c) | 8.1 | 8.1 | — | — | — |\n| Total | $ | 879.1 | $ | 279.1 | $ | 239.8 | $ | 336.1 | $ | 24.1 |\n\n| a) | Interest payments on debt obligations represent interest on all Company debt outstanding as of December 31, 2012. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2012. Future interest rates may change, and therefore, actual interest payments could differ from those disclosed in the table above. |\n\n| b) | Purchase obligations consist of raw material purchases made in the normal course of business. The Company has contracts to purchase minimum quantities of material with certain suppliers. For each contractual purchase obligation, the Company generally has a purchase agreement from its customer for the same amount of material over the same time period. |\n\n| c) | ‘Other’ is comprised of deferred revenues that represent commitments to deliver products and obligations related to recognizing and measuring tax positions taken or expected to be taken in a tax return that directly or indirectly affect amounts reported in financial statements. The uncertain tax positions included in the Company’s obligations are related to temporary differences and uncertain tax positions where the Company anticipates a high probability of settlement within a given timeframe. The years for which the temporary differences related to the uncertain tax positions will reverse have been estimated in scheduling the obligations within the table. |\n\nThe table and corresponding footnotes above do not include $10.7 million of other non-current liabilities recorded on the consolidated balance sheets. These non-current liabilities consist of liabilities related to the Company’s non-funded supplemental pension plan and postretirement benefit plans for which payment periods cannot be determined. Non-current liabilities also include $37.5 million of deferred income taxes, deferred gain on the sale of certain assets, derivative liability associated with commodity hedges and unfavorable lease liability for a lease entered into in conjunction with the Tube Supply acquisition, which was excluded from the table as the amounts due and timing of payments (or receipts) at future contract settlement dates cannot be determined.\nPension Funding\nThe Company’s funding policy on its defined benefit pension plans is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”). Future funding requirements are dependent upon various factors outside the Company’s control including, but not limited to, fund asset performance and changes in regulatory or accounting requirements. Based upon factors known and considered as of December 31, 2012, the Company does not anticipate making significant cash contributions to the pension plans in 2013.\nThe investment target portfolio allocation for the Company-sponsored pension plans and supplemental pension plan focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. Refer to “Retirement Plans” within Critical Accounting Policies and Note 5 to the consolidated financial statements for additional details regarding other plan assumptions.\nOff-Balance Sheet Arrangements\n28\nWith the exception of letters of credit and operating lease financing on certain equipment used in the operation of the business, it is not the Company’s general practice to use off-balance sheet arrangements, such as third-party special-purpose entities or guarantees of third parties.\nAs of December 31, 2012, the Company had $6.8 million of irrevocable letters of credit outstanding which primarily consisted of $4.0 million for collateral associated with commodity hedges and $2.0 million for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\nThe Company is party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\nObligations of the Company associated with its leased equipment are disclosed under the “Contractual Obligations and Other Commitments” section above.\nCritical Accounting Policies\nThe consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, and include amounts that are based on management’s estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The following is a description of the Company’s accounting policies that management believes require the most significant judgments and estimates when preparing the Company’s consolidated financial statements:\nRevenue Recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at time of shipment represents less than 3% of the Company’s consolidated net sales. Revenue from shipping and handling charges is recorded in net sales. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. Actual results could differ from these estimates. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\nThe Company maintains an allowance for doubtful accounts resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers, which can fluctuate significantly from year to year. The Company cannot be certain that the rate of future credit losses will be similar to past experience.\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month. If actual results differ significantly from historical experience, there could be a negative impact on the Company’s operating results.\nIncome Taxes — The Company’s income tax expense, deferred tax assets and liabilities and reserve for uncertain tax positions reflect management’s best estimate of taxes to be paid. The Company is subject to income taxes in the U.S. and several foreign jurisdictions. The determination of the consolidated income tax expense requires judgment and estimation by management. It is possible that actual results could differ from the estimates that management has used to determine its consolidated income tax expense.\nThe Company accounts for deferred income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\n29\nValuation allowances are recorded against deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83.4 million at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\nThe Company’s investment in the joint venture is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. The joint venture has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of the income of the joint venture and its subsidiaries. The income tax liability of the joint venture itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of the joint venture is treated as deferred income tax expense. The Company can not independently cause a dividend to be declared by one of the subsidiaries of the joint venture, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of the C-Corporation subsidiaries of the joint venture declares a dividend payable to the joint venture, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\nThe Company’s income tax provisions are based on calculations and assumptions that are subject to examination by the IRS and other tax authorities. Although the Company believes that the positions taken on previously filed tax returns are reasonable, it has established tax and interest reserves in recognition that various taxing authorities may challenge the positions taken, which could result in additional liabilities for taxes and interest. The Company regularly reviews its deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies.\nFor uncertain tax positions, the Company applies the provisions of relevant authoritative guidance, which requires application of a “more likely than not” threshold to the recognition and derecognition of tax positions. The Company’s ongoing assessments of the more likely than not outcomes of tax authority examinations and related tax positions require significant judgment and can increase or decrease the Company’s effective tax rate as well as impact operating results.\nRetirement Plans — The Company values retirement plan liabilities based on assumptions and valuations established by management. Future valuations are subject to market changes, which are not in the control of the Company and could differ materially from the amounts currently reported. The Company evaluates the discount rate and expected return on assets at least annually and evaluates other assumptions involving demographic factors, such as retirement age, mortality and turnover periodically, and updates them to reflect actual experience and expectations for the future. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors.\nAccumulated and projected benefit obligations are expressed as the present value of future cash payments which are discounted using the weighted average of market-observed yields for high quality fixed income securities with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent-year pension expense; higher discount rates decrease present values and subsequent-year pension expense. Discount rates used for determining the Company’s projected benefit obligation for retirement plans were 3.50 - 3.75% and 4.25% at December 31, 2012 and 2011, respectively.\nThe Company’s pension plan asset portfolio as of December 31, 2012 is primarily invested in fixed income securities with a duration of approximately 12 years. The assets generally fall within Level 2 of the fair value hierarchy. Assets in the Company’s pension plans have earned approximately 12% since 2008 when the Company changed its target investment allocation to focus primarily on fixed income securities. The target investment asset allocation for the pension plans’ funds focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. As of December 31, 2012 and 2011, the funding surplus was approximately 3% and 6%, respectively. To determine the expected long-term rate of return on the pension plans’ assets, current and expected asset allocations are considered, as well as historical and expected returns on various categories of plan assets.\n30\nThe Company used the following weighted-average discount rates and expected return on plan assets to determine the net periodic pension credit:\n| 2012 | 2011 |\n| Discount rate | 4.25 | % | 5.25 | % |\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % |\n\nHolding all other assumptions constant, the following table illustrates the sensitivity of changes to the discount rate and long-term rate of return assumptions on the Company’s net periodic pension credit (amounts in millions):\n| Impact on 2012Expenses - increase (decrease) |\n| 50 basis point decrease in discount rate | $(1.1) |\n| 50 basis point increase in discount rate | $1.1 |\n| 50 basis point decrease in expected return on assets | $0.9 |\n\nGoodwill and Other Intangible Assets Impairment — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step it to measure the amount of impairment loss, if any.\nThe determination of the fair value of the reporting units requires significant estimates and assumptions to be made by management. The fair value of each reporting unit is estimated using a combination of an income approach, which estimates fair value based on a discounted cash flow analysis using historical data, estimates of future cash flows and discount rates based on the view of a market participant, and a market approach, which estimates fair value using market multiples of various financial measures of comparable public companies. In selecting the appropriate assumptions the Company considers: the selection of appropriate peer group companies; control premiums appropriate for acquisitions in the industry in which the Company competes; discount rates; terminal growth rates; long-term projections of future financial performance; and relative weighting of income and market approaches. The long-term projections used in the valuation are developed as part of the Company’s annual budgeting and strategic planning process. The discount rates used to determine the fair values of the reporting units are those of a hypothetical market participant which are developed based upon an analysis of comparable companies and include adjustments made to account for any individual reporting unit specific attributes such as, size and industry.\nBased on the impairment test performed on January 1, 2012 (the Company's annual measurement date), the Company concluded that the fair values for each reporting unit exceeded the carrying values. Except for Aerospace and Oil & Gas, all other reporting units' fair values exceeded their carrying values by more than 10% as of January 1, 2012.\nThe Company has completed its January 1, 2013 annual goodwill impairment test. As of January 1, 2013, the Aerospace and Oil & Gas reporting units had goodwill balances of approximately $21 million and $20 million, respectively, and $0 of indefinite lived intangible assets. A combination of the income approach and the market approach was utilized to estimate the reporting units' fair values. The Aerospace and Oil & Gas reporting units both had estimated fair values that exceeded carry value by less than 10%. Under the income approach, the following key assumptions were used in the Company's discounted cash flow analysis:\n| Aerospace | Oil & Gas |\n| Discount rate | 15.0 | % | 14.0 | % |\n| 5-year CAGR | 4.2 | % | 1.5 | % |\n| Terminal growth rate | 3.0 | % | 3.0 | % |\n\n31\nUnder the market approach, the Company used a multiple of earnings before interest, taxes, depreciation and amortization (“EBITDA”) of 6.5 and 6.0 for Aerospace and Oil & Gas, respectively. The EBITDA multiple observed in the marketplace for recent transactions ranged from 6.0 to 8.7 with a median of 6.9 as of January 1, 2013. The Company considers several factors in estimating the EBITDA multiple including a reporting unit's market position, gross and operating margins and prospects for growth, among other factors.\nHolding all other assumptions in the model constant, the Company has summarized what the discount rate and EBITDA multiple would have to be (holding the other variable constant) in order for the fair value of Aerospace and Oil & Gas reporting units to fall below their respective carrying value:\n| Aerospace | Oil & Gas |\n| Discount rate | 16.5 | % | 14.8 | % |\n| EBITDA multiple | 5.8 | 5.6 |\n\nIf either reporting unit's carrying value exceeded its fair value, additional valuation procedures would have been required to determine whether the reporting unit's goodwill was impaired, and to the extent goodwill was impaired, the magnitude of the impairment charge.\nAlthough the Company believes its estimates of fair value are reasonable, actual financial results could differ from those estimates due to the inherent uncertainty involved in making such estimates. Changes in assumptions concerning future financial results or other underlying assumptions could have a significant impact on either the fair value of the reporting units, the amount of the goodwill impairment charge, or both. Future declines in the overall market value of the Company’s equity may also result in a conclusion that the fair value of one or more reporting units has declined below its carrying value.\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. The intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets discussed below, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\nSee Note 8 to the consolidated financial statements for detailed information on goodwill and intangible assets.\nLong-Lived Assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans. Measurement of an impairment loss requires a determination of fair value. The Company uses an income approach, which estimates fair value based on estimates of future cash flows discounted at an appropriate interest rate.\nShare-Based Compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the ten trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise.\n32\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\nThe grant date fair value for stock options granted during 2010 was estimated using the Black-Scholes option-pricing model with the following assumptions:\n| 2010 |\n| Expected volatility | 58.5 | % |\n| Risk-free interest rate | 2.3 | % |\n| Expected life (in years) | 5.5 |\n| Expected dividend yield | 1.2 | % |\n\nShare-based compensation expense for non-vested shares and restricted share units in the long-term compensation plans (“LTC Plans”) is established using the market price of the Company’s common stock on the date of grant.\nThe grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans were estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\n| Expected dividend yield | — | — | — |\n\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\n| Expected dividend yield | — | — | — |\n\nManagement estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the LTC Plans. As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate. Final award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met.\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company’s actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”) (as defined in the 2012 and 2011 LTC Plans). Under the 2012 LTC Plan, the non-market based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for\n33\nany one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, or the award will be forfeited.\nFair Value of Financial Instruments — The three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities.\nFair value disclosures for the Senior Secured Notes are determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy. The fair value of the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes. The estimated fair value of the derivative liability for the conversion feature, which falls within level 3 of the fair value hierarchy, is computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature. The estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which fall within level 3 of the fair value hierarchy, assumes the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015.\nFair value of commodity hedges is based on information which is representative of readily observable market data. Derivative liabilities associated with commodity hedges are classified as Level 2 in the fair value hierarchy.\nRecent Accounting Pronouncements\nEffective January 1, 2012, the Company adopted new guidance that applies to the presentation of other comprehensive (loss) income, the testing of goodwill for impairment and the measurement and disclosure of fair value of assets, liabilities and instruments classified in a reporting entity’s shareholders’ equity in the financial statements.\nSee Note 1 to the consolidated financial statements for detailed information on recent accounting pronouncements.\n34\nITEM 7a —\nQuantitative and Qualitative Disclosures about Market Risk\nThe Company is exposed to interest rate, commodity price, and foreign exchange rate risks that arise in the normal course of business.\nInterest Rate Risk — The Company is exposed to market risk related to its fixed rate and variable rate long-term debt. We do not utilize derivative instruments to manage exposure to interest rate changes. The market value of the Company’s $282.5 million of fixed rate long-term debt may be impacted by changes in interest rates. The Company does not expect to repay its fixed rate debt prior to its scheduled maturities.\nThe Company’s interest rates on borrowings under its $100 million four-year revolving credit facility are subject to changes in the LIBOR and prime interest rates. Borrowings under the Company’s revolving credit agreement were approximately $39.5 million as of December 31, 2012. A hypothetical 100 basis point increase on the Company’s variable rate debt would result in $0.4 million of additional interest expense on an annual basis.\nCommodity Price Risk — The Company’s raw material costs are comprised primarily of engineered metals and plastics. Market risk arises from changes in the price of steel, other metals and plastics. Although average selling prices generally increase or decrease as material costs increase or decrease, the impact of a change in the purchase price of materials is more immediately reflected in the Company’s cost of materials than in its selling prices. The ability to pass surcharges on to customers immediately can be limited due to contractual provisions with those customers. Therefore, a lag may exist between when the surcharge impacts net sales and cost of materials, respectively, which could result in a higher or lower operating profit.\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. If the commodity prices hedged were to decrease hypothetically by 100 basis points, the 2012 unrealized loss recorded in cost of materials would have increased by approximately $0.1 million.\nForeign Currency Risk — The Company conducts the majority of its business in the United States but also has operations in Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company’s results of operations historically have not been materially affected by foreign currency transaction gains and losses and, therefore, the Company has no financial instruments in place for managing the exposure to foreign currency exchange rates.\nAs a result of the new debt financing arrangements entered into during December 2011, the Company has certain outstanding intercompany borrowings denominated in the U.S. dollar at its Canadian and United Kingdom subsidiaries. These intercompany borrowings are not hedged and may cause foreign currency exposure, which could be significant, in future periods if they remain unhedged.\n35\nITEM 8 — Financial Statements and Supplementary Data\nAmounts in thousands, except par value and per share data\n| Consolidated Statements of Operations and Comprehensive Loss |\n| Year Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Net sales | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 927,287 | 845,609 | 700,854 |\n| Warehouse, processing and delivery expense | 148,256 | 134,898 | 123,318 |\n| Sales, general and administrative expense | 127,813 | 126,193 | 108,223 |\n| Depreciation and amortization expense | 25,867 | 20,472 | 20,649 |\n| Operating income (loss) | 41,145 | 5,194 | (9,338 | ) |\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\n| Income taxes | (1,430 | ) | 1,126 | 3,101 |\n| Loss before equity in earnings of joint venture | (16,972 | ) | (13,487 | ) | (11,225 | ) |\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Dividends per common share | $ | — | $ | — | $ | — |\n| Comprehensive loss: |\n| Foreign currency translation gains (losses) | $ | 2,369 | $ | (941 | ) | $ | (536 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax benefit of $2,312, $1,965 and $1,116 | (3,616 | ) | (3,071 | ) | (1,748 | ) |\n| Other comprehensive loss | (1,247 | ) | (4,012 | ) | (2,284 | ) |\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\n| Comprehensive loss | $ | (10,995 | ) | $ | (5,772 | ) | $ | (7,924 | ) |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n36\n| Consolidated Balance Sheets |\n| December 31, |\n| 2012 | 2011 |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 21,607 | $ | 30,524 |\n| Accounts receivable, less allowances of $3,529 and $3,584 | 138,311 | 181,036 |\n| Inventories, principally on last-in first-out basis (replacement cost higher by $139,940 and $138,882) | 303,772 | 272,039 |\n| Prepaid expenses and other current assets | 15,092 | 10,382 |\n| Income tax receivable | 7,596 | 8,287 |\n| Total current assets | 486,378 | 502,268 |\n| Investment in joint venture | 38,854 | 36,460 |\n| Goodwill | 70,300 | 69,901 |\n| Intangible assets | 82,477 | 93,813 |\n| Prepaid pension cost | 12,891 | 15,956 |\n| Other assets | 18,266 | 21,784 |\n| Property, plant and equipment, at cost |\n| Land | 5,195 | 5,194 |\n| Building | 52,884 | 52,434 |\n| Machinery and equipment | 178,664 | 172,833 |\n| Property, plant and equipment, at cost | 236,743 | 230,461 |\n| Less—accumulated depreciation | (157,103 | ) | (148,320 | ) |\n| Property, plant and equipment, net | 79,640 | 82,141 |\n| Total assets | $ | 788,806 | $ | 822,323 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 67,990 | $ | 116,874 |\n| Accrued payroll and employee benefits | 11,749 | 14,792 |\n| Accrued liabilities | 24,815 | 19,036 |\n| Income taxes payable | 1,563 | 1,884 |\n| Current portion of long-term debt | 415 | 192 |\n| Short term debt | 500 | 500 |\n| Total current liabilities | 107,032 | 153,278 |\n| Long-term debt, less current portion | 296,154 | 314,240 |\n| Deferred income taxes | 32,350 | 25,650 |\n| Other non-current liabilities | 5,279 | 7,252 |\n| Pension and post retirement benefit obligations | 10,651 | 9,624 |\n| Commitments and contingencies |\n| Stockholders’ equity |\n| Preferred stock, $0.01 par value—9,988 shares authorized (including 400 Series B Junior Preferred $0.00 par value shares); no shares issued and outstanding at December 31, 2012 and December 31, 2011 | — | — |\n| Common stock, $0.01 par value—60,000 shares authorized and 23,211 shares issued and 23,152 outstanding at December 31, 2012; 30,000 shares authorized and 23,159 shares issued and 23,010 outstanding at December 31, 2011 | 232 | 232 |\n| Additional paid-in capital | 219,619 | 184,596 |\n| Retained earnings | 139,239 | 148,987 |\n| Accumulated other comprehensive loss | (21,071 | ) | (19,824 | ) |\n| Treasury stock, at cost—59 shares at December 31, 2012 and 149 shares at December 31, 2011 | (679 | ) | (1,712 | ) |\n| Total stockholders’ equity | 337,340 | 312,279 |\n| Total liabilities and stockholders’ equity | $ | 788,806 | $ | 822,323 |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n37\n| Consolidated Statements of Cash Flows |\n| Years Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Operating activities: |\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\n| Adjustments to reconcile net loss to net cash from (used in) operating activities: |\n| Depreciation and amortization | 25,867 | 20,472 | 20,649 |\n| Amortization of deferred gain | (1,619 | ) | (503 | ) | (890 | ) |\n| Amortization of deferred financing costs and debt discount | 6,232 | 1,662 | 685 |\n| Loss on sale of fixed assets | 354 | 120 | 391 |\n| Unrealized loss on debt conversion option | 15,597 | 3,991 | — |\n| Unrealized losses on commodity hedges | 163 | 2,331 | — |\n| Equity in earnings of joint venture | (7,224 | ) | (11,727 | ) | (5,585 | ) |\n| Dividends from joint venture | 4,729 | 3,117 | 1,260 |\n| Deferred tax (benefit) provision | (1,284 | ) | (3,333 | ) | (11,386 | ) |\n| Share-based compensation expense | 2,277 | 4,349 | 2,411 |\n| Excess tax benefits from share-based payment arrangements | (90 | ) | (301 | ) | (219 | ) |\n| Increase (decrease) from changes in, net of acquisition: |\n| Accounts receivable | 44,570 | (26,446 | ) | (22,521 | ) |\n| Inventories | (29,340 | ) | (39,435 | ) | 39,686 |\n| Prepaid expenses and other current assets | (2,397 | ) | (3,408 | ) | (1,718 | ) |\n| Other assets | (480 | ) | 188 | 399 |\n| Prepaid pension costs | (2,863 | ) | (2,412 | ) | (1,530 | ) |\n| Accounts payable | (42,560 | ) | 9,910 | (1,866 | ) |\n| Accrued payroll and employee benefits | (2,974 | ) | (2,470 | ) | 5,827 |\n| Income taxes payable and receivable | 454 | (820 | ) | 11,536 |\n| Accrued liabilities | 4,514 | (184 | ) | 1,586 |\n| Postretirement benefit obligations and other liabilities | 1,173 | 371 | 1,287 |\n| Net cash from (used in) operating activities | 5,351 | (46,288 | ) | 34,362 |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | (174,244 | ) | — |\n| Capital expenditures | (11,121 | ) | (11,744 | ) | (7,572 | ) |\n| Proceeds from sale of fixed assets | 153 | 226 | 4 |\n| Insurance proceeds | — | 573 | 125 |\n| Net cash used in investing activities | (17,440 | ) | (185,189 | ) | (7,443 | ) |\n| Financing activities: |\n| Short-term (repayments) borrowings, net | (27 | ) | 653 | (13,720 | ) |\n| Net (repayments) borrowings on previously existing revolving lines of credit | — | (26,403 | ) | 2,324 |\n| Proceeds from long-term debt, including new revolving credit facility | 767,090 | 320,476 | — |\n| Repayments of long-term debt, including new revolving credit facility | (762,887 | ) | (53,212 | ) | (7,754 | ) |\n| Payment of debt issue costs | (1,503 | ) | (16,633 | ) | — |\n| Exercise of stock options | 146 | 356 | 566 |\n| Excess tax benefits from share-based payment arrangements | 90 | 301 | 219 |\n| Net cash from (used in) financing activities | 2,909 | 225,538 | (18,365 | ) |\n| Effect of exchange rate changes on cash and cash equivalents | 263 | (253 | ) | (149 | ) |\n| Net (decrease) increase in cash and cash equivalents | (8,917 | ) | (6,192 | ) | 8,405 |\n| Cash and cash equivalents—beginning of year | 30,524 | 36,716 | 28,311 |\n| Cash and cash equivalents—end of year | $ | 21,607 | $ | 30,524 | $ | 36,716 |\n\nSee Note 1 to the consolidated financial statements for supplemental cash flow disclosures.\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n38\n| Consolidated Statements of Stockholders' Equity |\n| CommonShares | TreasuryShares | PreferredStock | CommonStock | TreasuryStock | AdditionalPaid-inCapital | RetainedEarnings | Accumulated OtherComprehensiveIncome | Total |\n| Balance at January 1, 2010 | 23,115 | (209 | ) | $ | — | $ | 230 | $ | (3,010 | ) | $ | 178,129 | $ | 156,387 | $ | (13,528 | ) | $ | 318,208 |\n| Net loss | (5,640 | ) | (5,640 | ) |\n| Foreign currency translation | (536 | ) | (536 | ) |\n| Defined benefit pension liability adjustments, net of tax benefit of $1,116 | (1,748 | ) | (1,748 | ) |\n| Long-term incentive plan | 1,278 | 1,278 |\n| Exercise of stock options and other | 34 | 46 | 1 | 784 | 1,112 | 1,897 |\n| Balance at December 31, 2010 | 23,149 | (163 | ) | $ | — | $ | 231 | $ | (2,226 | ) | $ | 180,519 | $ | 150,747 | $ | (15,812 | ) | $ | 313,459 |\n| Net loss | (1,760 | ) | (1,760 | ) |\n| Foreign currency translation | (941 | ) | (941 | ) |\n| Defined benefit pension liability adjustments, net of tax benefit of $1,965 | (3,071 | ) | (3,071 | ) |\n| Long-term incentive plan | 3,260 | 3,260 |\n| Exercise of stock options and other | 10 | 14 | 1 | 514 | 817 | 1,332 |\n| Balance at December 31, 2011 | 23,159 | (149 | ) | $ | — | $ | 232 | $ | (1,712 | ) | $ | 184,596 | $ | 148,987 | $ | (19,824 | ) | $ | 312,279 |\n| Net loss | (9,748 | ) | — | (9,748 | ) |\n| Foreign currency translation | 2,369 | 2,369 |\n| Defined benefit pension liability adjustments, net of tax benefit of $2,312 | (3,616 | ) | (3,616 | ) |\n| Embedded conversion option, net of tax benefit of $8,285 | 33,752 | 33,752 |\n| Long-term incentive plan | 1,592 | 1,592 |\n| Exercise of stock options and other | 52 | 90 | 1,033 | (321 | ) | 712 |\n| Balance at December 31, 2012 | 23,211 | (59 | ) | $ | — | $ | 232 | $ | (679 | ) | $ | 219,619 | $ | 139,239 | $ | (21,071 | ) | $ | 337,340 |\n\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\n39\nA. M. Castle & Co.\nNotes to Consolidated Financial Statements\nAmounts in thousands except per share data and percentages\n(1) Basis of Presentation and Significant Accounting Policies\nNature of operations — A.M. Castle & Co. and its subsidiaries (the “Company”) is a specialty metals and plastics distribution company serving principally the North American market, but with a growing global presence. The Company has operations in the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company provides a broad range of product inventories as well as value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment, marine, office furniture and fixtures, safety products, life science applications, automotive and general manufacturing industries as well as general engineering applications.\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. The Company has 49 operational service centers located throughout North America (44), Europe (4) and Asia (1).\nThe Company purchases metals and plastics from many producers. Purchases are made in large lots and held in distribution centers until sold, usually in smaller quantities and often with value-added processing services performed. Orders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Thousands of customers from a wide array of industries are serviced primarily through the Company’s own sales organization.\nBasis of presentation — The consolidated financial statements include the accounts of A. M. Castle & Co. and its subsidiaries over which the Company exhibits a controlling interest. The equity method of accounting is used for the Company’s 50% owned joint venture, Kreher Steel Company, LLC (“Kreher”). All inter-company accounts and transactions have been eliminated.\nReclassification — For comparability, certain 2011 amounts have been reclassified to conform to presentation adopted in 2012.\nUse of estimates — The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The principal areas of estimation reflected in the consolidated financial statements are accounts receivable allowances, inventory reserves, goodwill and intangible assets, income taxes, pension and other post-employment benefits and share-based compensation and convertible debt feature mark-to-mark adjustments.\nRevenue recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at the time of shipment represents less than 3% of the Company’s consolidated net sales for the years ended December 31, 2012, 2011 and 2010. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\nThe Company maintains an allowance for doubtful accounts resulting from the inability of customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers.\n40\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month.\nAccounts receivable allowance activity is presented in the table below:\n| 2012 | 2011 | 2010 |\n| Balance, beginning of year | $ | 3,584 | $ | 3,848 | $ | 4,195 |\n| Add Provision charged to expense | 1,420 | 523 | 777 |\n| Recoveries | 90 | 140 | 186 |\n| Other | — | 157 | — |\n| Less Charges against allowance | (1,565 | ) | (1,084 | ) | (1,310 | ) |\n| Balance, end of year | $ | 3,529 | $ | 3,584 | $ | 3,848 |\n\nRevenue from shipping and handling charges is recorded in net sales. Costs incurred in connection with shipping and handling the Company’s products, which are related to third-party carriers or performed by Company personnel are included in warehouse, processing and delivery expenses. For the years ended December 31, 2012, 2011 and 2010, shipping and handling costs included in warehouse, processing and delivery expenses were $36,585, $35,214, and $31,067, respectively.\nCost of materials — Cost of materials consists of the costs the Company pays for metals, plastics and related inbound freight charges. It excludes depreciation and amortization which are discussed below. The Company accounts for the majority of its inventory on a last-in, first-out (“LIFO”) basis and LIFO adjustments are recorded in cost of materials.\nOperating expenses — Operating costs and expenses primarily consist of:\n\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\n\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\n\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily attributable to accounting and legal advisory services, bad debt expenses, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\n\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\n\nCash equivalents — Cash equivalents are highly liquid, short-term investments that have an original maturity of 90 days or less.\nStatement of cash flows — Non-cash investing and financing activities and supplemental disclosures of consolidated cash flow information are as follows:\n| Year Ended December 31, |\n| 2012 | 2011 | 2010 |\n| Non-cash investing and financing activities: |\n| Capital expenditures financed by accounts payable | $ | 479 | $ | 1,123 | $ | 100 |\n| Capital lease obligations | 1,009 | — | — |\n| Deferred debt origination fees | — | 886 | — |\n| Additional purchase price paid in 2012 for Tube Supply acquisition | — | 6,472 | — |\n| Cash paid during the year for: |\n| Interest | 34,051 | 7,234 | 4,392 |\n| Income taxes | 5,557 | 9,555 | 1,631 |\n| Cash received during the year for: |\n| Income tax refunds | 3,184 | 6,724 | 4,430 |\n\n41\nInventories — Inventories consist of finished goods. Approximately eighty percent of the Company’s inventories are valued at the lower of LIFO cost or market at December 31, 2012 and 2011. Final inventory determination under the LIFO costing method is made at the end of each fiscal year based on the actual inventory levels and costs at that time. The Company values its LIFO increments using the cost of its latest purchases during the years reported. Current replacement cost of inventories exceeded book value by $139,940 and $138,882 at December 31, 2012 and 2011, respectively. Income taxes would become payable on any realization of this excess from reductions in the level of inventories.\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. Cost of materials for 2010 were lower by $12,500, as a result of the liquidations.\nThe Company maintains allowances for excess and obsolete inventory and physical inventory losses. The excess and obsolete inventory allowance is determined based on specific identification of material, adjusted for expected scrap value to be received. The allowance for physical inventory losses is determined based on historical physical inventory experience.\nInsurance plans — In August 2009, the Company became a member of a group captive insurance company (the “Captive”) domiciled in Grand Cayman Island. The Captive reinsures losses related to certain of the Company’s workers’ compensation, automobile and general liability risks that occur subsequent to August 2009. Premiums are based on the Company’s loss experience and are accrued as expenses for the period to which the premium relates. Premiums are credited to the Company’s “loss fund” and earn investment income until claims are actually paid. For workers’ compensation, automobile and general liability claims that were incurred prior to August 2009, the Company is self-insured. Self-insurance amounts are capped, for individual claims and in the aggregate, for each policy year by an insurance company. Self-insurance reserves are based on unpaid, known claims (including related administrative fees assessed by the insurance company for claims processing) and a reserve for incurred but not reported claims based on the Company’s historical claims experience and development.\nThe Company is self-insured for medical insurance for its domestic operations. Self-insurance reserves are maintained based on incurred but not paid claims based on a historical lag.\nProperty, plant and equipment — Property, plant and equipment are stated at cost and include assets held under capital leases. Expenditures for major additions and improvements are capitalized, while maintenance and repair costs that do not substantially improve or extend the useful lives of the respective assets are expensed in the period in which they are incurred. When items are disposed, the related costs and accumulated depreciation are removed from the accounts and any gain or loss is reflected in income.\nThe Company provides for depreciation of plant and equipment sufficient to amortize the cost over their estimated useful lives as follows:\n| Buildings and building improvements | 3 – 40 years |\n| Plant equipment | 3 – 25 years |\n| Furniture and fixtures | 2 – 10 years |\n| Vehicles and office equipment | 3 – 7 years |\n\nLeasehold improvements are depreciated over the shorter of their useful lives or the remaining term of the lease. Depreciation is calculated using the straight-line method and depreciation expense for 2012, 2011 and 2010 was $14,024, $13,605 and $13,578, respectively.\nLong-lived assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset or asset group. If future net cash flows are less than the carrying value, the asset or asset group may be impaired. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans.\n42\nGoodwill and intangible assets — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step is to measure the amount of impairment loss, if any.\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply, Inc. (“Tube Supply”) acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. These intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names, and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\nIncome taxes — The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\nThe Company records valuation allowances against its deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83,352 at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\nThe Company's 50% ownership interest in Kreher (see Note 6) is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. Kreher has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of Kreher income. The income tax liability of Kreher itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of Kreher is treated as a deferred income tax expense. The Company can not independently cause a dividend to be declared by one of Kreher's subsidiaries, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of Kreher's C-Corporation subsidiaries declares a dividend payable to Kreher, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\nThe Company recognizes the tax benefits of uncertain tax positions only if those benefits will more likely than not be sustained upon examination by the relevant tax authorities. Unrecognized tax benefits are subsequently recognized at the time the recognition threshold is met, the tax matter is effectively settled or the statute of limitations expires for the return containing the tax position, whichever is earlier. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that differs from the current estimate.\nThe Company recognizes interest and penalties related to unrecognized tax benefits within income tax expense. Accrued interest and penalties are included within other long-term liabilities in the consolidated balance sheets.\nForeign currency — For the majority of the Company’s non-U.S. operations, the functional currency is the local currency. Assets and liabilities of those operations are translated into U.S. dollars using year-end exchange rates, and income and expenses are translated using the average exchange rates for the reporting period. The currency effects of translating financial statements of the Company’s non-U.S. operations which operate in local currency environments are recorded in accumulated other comprehensive income (loss), a separate component of\n43\nstockholders’ equity. Transaction gains or losses resulting from foreign currency transactions were not material for any of the years presented.\nEarnings per share — Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock plus common stock equivalents. Common stock equivalents consist of employee and director stock options, restricted stock awards, other share-based payment awards, and contingently issuable shares related to the Company’s convertible debt which are included in the calculation of weighted average shares outstanding using the treasury stock method, if dilutive.\nThe following table is a reconciliation of the basic and diluted earnings per share calculations:\n| 2012 | 2011 | 2010 |\n| Numerator: |\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\n| Denominator: |\n| Denominator for basic loss per share: |\n| Weighted average common shares outstanding | 22,993 | 22,983 | 22,708 |\n| Effect of dilutive securities: |\n| Outstanding common stock equivalents | — | — | — |\n| Denominator for diluted loss per share | 22,993 | 22,983 | 22,708 |\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\n| Excluded outstanding share-based awards having an anti-dilutive effect | 994 | 757 | 471 |\n\nThe Convertible Notes are dilutive to the extent the Company generates net income and the average stock price during the period is greater than $10.28, the conversion price of the Convertible Notes. The Convertible Notes are only dilutive for the “in the money” portion of the Convertible Notes that could be settled with the Company’s stock. In future periods, absent a fundamental change, (as defined in the Convertible Notes agreement), the outstanding Convertible Notes could increase diluted average shares outstanding by a maximum of approximately 5,600 shares. As of December 31, 2012 and 2011, 1,416 and 1,734 shares, respectively, were excluded from diluted average shares outstanding as there would have been an anti-dilutive effect.\nFor the years ended December 31, 2012, 2011 and 2010, the participating securities, which represent certain non-vested shares granted by the Company, were less than one percent of total securities. These securities do not participate in the Company’s net losses.\nConcentrations — The Company serves a wide range of customers within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the economy from locations throughout the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. Its customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms spread across the entire spectrum of metals and plastics using industries. The Company’s customer base is well diversified and, therefore, the Company does not have dependence upon any single customer or a few customers. No single customer represents more than 3% of the Company’s total net sales. Approximately 78% of the Company’s business is conducted from locations in the United States.\nShare-based compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the 10 trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise. Management estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the long-term compensation plans (\"LTC Plans\"). As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate.\n44\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\nShare-based compensation expense for restricted share units and non-vested shares in the LTC Plans is established using the market price of the Company’s common stock on the date of grant.\nFinal award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\nUnder the 2012, 2011, and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. The grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans was estimated using a Monte Carlo simulation.\nUnder the 2012 and 2011 LTC Plans, the potential award for performance share units containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management's expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited.\nNew Accounting Standards Updates\nStandards Updates Adopted\nEffective January 1, 2012, the Company adopted ASU No. 2011-08, “Intangibles – Goodwill and Other.” The objective of this ASU is to simplify how entities test goodwill for impairment. The amendments allow entities to assess qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test per Topic 350, “Intangibles – Goodwill and Other.” The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. The adoption of this ASU impacts the way the Company tests goodwill for impairment. As allowed by this ASU for its January 1, 2012 annual impairment test, the Company did not elect the option to perform a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. Instead the Company followed the two-step method. Refer to Note 8 for the results of the annual goodwill impairment test.\nEffective January 1, 2012, the Company adopted ASU No. 2011-05, “Presentation of Comprehensive Income.” The amendments in this ASU impact all entities that report items of other comprehensive (loss) income and are effective retrospectively for public entities. The amendments in this ASU eliminate the option to present the components of other comprehensive (loss) income as part of the statement of changes in stockholders’ equity. The amendments provide the entity with the option to present the total of comprehensive (loss) income, the components of net (loss) income and the components of other comprehensive (loss) income either in a single continuous statement of comprehensive (loss) income or in two separate but consecutive statements. Both options require an entity to present each component of net (loss) income along with total net (loss) income, each component of other\n45\ncomprehensive (loss) income along with total other comprehensive (loss) income and a total amount for comprehensive (loss) income. The subsequent issuance of ASU 2011-12, “Comprehensive Income” in December 2011 deferred the changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive (loss) income. All other provisions in ASU 2011-05 were effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The presentation requirements associated with the adoption of ASU 2011-05 are reflected in the consolidated statements of operations and comprehensive loss herein.\nEffective January 1, 2012, the Company adopted ASU No. 2011-04, “Fair Value Measurement.” The amendments in this ASU apply to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s shareholders’ equity in the financial statements. The amendments in this ASU clarify the requirements of the existing standard and include some changes to principles or requirements for measuring or disclosing information about fair value measurements. The adoption of this ASU did not have an impact on the Company's financial condition, liquidity or operating results. The disclosure requirements associated with the adoption of ASU 2011-04 are reflected in Note 10.\nStandards Updates Issued Not Yet Effective\nDuring December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU require an entity to disclose information to enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on its financial position, including the effect or potential effect of rights of set off associated with an entity’s recognized assets and recognized liabilities within the scope of Topic 210. The ASU is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The adoption of this ASU may impact the Company’s disclosures in future interim and annual financial statements issued.\n(2) Acquisition\nOn December 15, 2011, the Company acquired 100 percent of the outstanding common shares of Tube Supply (the “Acquisition”). The Acquisition was accounted for using the acquisition method. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on estimated fair values at date of acquisition. The nonrecurring fair value measurements are classified as Level 3 in the fair value hierarchy (see Note 10 for the definition of Level 3 inputs).\nThe results and the assets of Tube Supply are included in the Company’s Metals segment.\nTube Supply, based in Houston, Texas, is a leading value-added distributor of specialty tubular and bar products for the oil and gas industry. Tube Supply provides high quality products and services primarily to the North American oilfield equipment manufacturing industry. Tube Supply operates two service centers, which are located in Houston, Texas and Edmonton, Alberta. The Acquisition will allow the Company to capitalize on the growing demand and opportunities in the oil and gas sector through new product offerings to an expanded customer base.\nThe aggregate purchase price was $184,385 and represents the aggregate cash purchase price, including a working capital adjustment. The premium paid in excess of the fair value of the net assets acquired was primarily for the ability to expand the Company’s oil and gas product offerings, as well as to obtain Tube Supply’s skilled, established workforce.\nDuring 2011, the Company incurred $4,260 of direct acquisition-related costs, which are recorded in Sales, general and administrative expense.\n46\nAn allocation of the purchase price to the fair value of the assets acquired and liabilities assumed, which was finalized as of December 2012, is as follows:\nPurchase Price Allocation\n| Current assets | $ | 134,817 |\n| Property, plant and equipment, net | 6,767 |\n| Other assets | 346 |\n| Trade name | 7,700 |\n| Customer relationships | 48,800 |\n| Non-compete agreements | 1,000 |\n| Developed technology | 1,400 |\n| Goodwill | 19,637 |\n| Total assets acquired | 220,467 |\n| Current liabilities | 33,211 |\n| Long-term liabilities | 2,871 |\n| Total liabilities assumed | 36,082 |\n| Total purchase price | $ | 184,385 |\n\nThe acquired intangible assets have a weighted average useful life of approximately 11.4 years. Useful lives by intangible asset category are as follows: trade name - 10 years, customer relationships - 12 years, non-compete agreements - 3 years and developed technology - 3 years.\nAt closing, the Company entered into a lease agreement with the former owners of Tube Supply. At December 31, 2012 and 2011, an unfavorable lease liability associated with the lease for a newly constructed distribution center used by Tube Supply of $2,168 and $2,871, respectively, is recorded in other non-current liabilities. The current portion of the unfavorable lease liability in the amount of $645 is included in accrued liabilities in the consolidated balance sheets at December 31, 2012 and 2011. The unfavorable lease liability resulted from the present value of the difference between the estimated fair market value and the executed contract price the Company will pay to lease the property. The unfavorable lease liability will be amortized over the remaining life of the lease.\nThe goodwill and intangible assets are deductible for tax purposes.\nThe results of operations of Tube Supply have been included in the Company's consolidated statements of operations and comprehensive loss since December 15, 2011. The net sales and net income for Tube Supply during the period from December 15, 2011 through December 31, 2011 were $7,648 and $901, respectively.\nThe following unaudited pro forma summary presents the effect of the Acquisition during the years ended December 31, 2011 and 2010 as though the business had been acquired as of January 1, 2010:\n| Year ended December 31,(Unaudited) |\n| 2011 | 2010 |\n| Pro forma net sales | $ | 1,332,176 | $ | 1,069,564 |\n| Pro forma net income (loss) | 7,033 | (24,268 | ) |\n| Pro forma basic net income (loss) per share | $ | 0.31 | $ | (1.06 | ) |\n| Pro forma diluted net income (loss) per share | 0.28 | (1.06 | ) |\n\nUnaudited pro forma supplemental information is based upon management estimates and judgments. The unaudited pro forma supplemental information also includes purchase accounting and interest expense adjustments and the related tax effects. The unaudited pro forma supplemental information for the year ended December 31, 2011 excludes direct acquisition-related costs of $4,260 and includes loss on extinguishment of debt of $6,153 and interest costs of $7,366 associated with the underwriting fee for debt financing and the mark-to-market adjustment for the conversion option on the convertible bonds. The unaudited pro forma supplemental information for the year ended December 31, 2010 includes direct acquisition-related costs of $4,260. These pro forma results are not necessarily indicative of what would have occurred if the acquisition had been in effect for the periods presented or of future results. Pro forma financial information is not provided for the year ended December 31, 2012 as a full\n47\nyear of post-acquisition results of operations for Tube Supply were included in the Company's consolidated statements of operations and comprehensive loss.\nSee Note 9 for detailed discussion on the Company’s debt financing structure used to finance the Acquisition.\n(3) Segment Reporting\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly. Neither of the Company’s reportable segments has any unusual working capital requirements.\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, stainless, nickel, titanium and carbon. Inventories of these products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, service centers are equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting, stress relieving and annealing furnaces, surface grinding equipment and sheet shearing equipment. This segment also performs various specialized fabrications for its customers through pre-qualified subcontractors that thermally process, turn, polish and straighten alloy and carbon bar.\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications. The Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\nThe accounting policies of all segments are the same as described in Note 1. Management evaluates the performance of its business segments based on operating income.\nThe Company operates locations in the United States, Canada, Mexico, France, the United Kingdom, China and Singapore. No activity from any individual country outside the United States is material, and therefore, foreign activity is reported on an aggregate basis. Net sales are attributed to countries based on the location of the Company’s subsidiary that is selling direct to the customer. Company-wide geographic data as of and for the years ended December 31, 2012, 2011 and 2010 are as follows:\n| 2012 | 2011 | 2010 |\n| Net sales |\n| United States | $ | 988,161 | $ | 895,165 | $ | 757,052 |\n| All other countries | 282,207 | 237,201 | 186,654 |\n| Total | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\n| Long-lived assets |\n| United States | $ | 68,253 | $ | 72,138 |\n| All other countries | 11,387 | 10,003 |\n| Total | $ | 79,640 | $ | 82,141 |\n\n48\nSegment information as of and for the years ended December 31, 2012, 2011 and 2010 is as follows:\n| NetSales | OperatingIncome(Loss) | TotalAssets | CapitalExpenditures | Depreciation &Amortization |\n| 2012 |\n| Metals segment (a) | $ | 1,143,884 | $ | 49,822 | $ | 693,803 | $ | 9,819 | $ | 24,480 |\n| Plastics segment | 126,484 | 3,188 | 56,149 | 1,831 | 1,387 |\n| Other (b) | — | (11,865 | ) | 38,854 | — | — |\n| Consolidated | $ | 1,270,368 | $ | 41,145 | $ | 788,806 | $ | 11,650 | $ | 25,867 |\n| 2011 |\n| Metals segment (a) | $ | 1,014,130 | $ | 13,524 | $ | 729,692 | $ | 10,639 | $ | 19,329 |\n| Plastics segment | 118,236 | 2,860 | 56,171 | 2,228 | 1,143 |\n| Other (b) | — | (11,190 | ) | 36,460 | — | — |\n| Consolidated | $ | 1,132,366 | $ | 5,194 | $ | 822,323 | $ | 12,867 | $ | 20,472 |\n| 2010 |\n| Metals segment | $ | 841,067 | $ | (5,478 | ) | $ | 454,345 | $ | 6,815 | $ | 19,392 |\n| Plastics segment | 102,639 | 3,559 | 47,128 | 757 | 1,257 |\n| Other (b) | — | (7,419 | ) | 27,879 | — | — |\n| Consolidated | $ | 943,706 | $ | (9,338 | ) | $ | 529,352 | $ | 7,572 | $ | 20,649 |\n\n(a) The results of Tube Supply, acquired on December 15, 2011, are included in the Company's Metals segment.\n(b) “Other” – Operating loss includes the costs of executive, legal and finance departments, which are shared by both the Metals and Plastics segments. The “Other” category’s total assets consist of the Company’s investment in joint venture.\nBelow are reconciliations of segment data to the consolidated loss before income taxes:\n| 2012 | 2011 | 2010 |\n| Operating income (loss) | $ | 41,145 | $ | 5,194 | $ | (9,338 | ) |\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\n| Consolidated loss before income taxes | $ | (8,318 | ) | $ | (2,886 | ) | $ | (8,741 | ) |\n\n(4) Lease Agreements\nThe Company has operating and capital leases covering certain warehouse facilities, equipment, automobiles and trucks, with the lapse of time as the basis for all rental payments.\nFuture minimum rental payments under operating and capital leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2012, are as follows:\n| Capital | Operating |\n| 2013 | $ | 415 | $ | 14,401 |\n| 2014 | 396 | 11,375 |\n| 2015 | 392 | 10,091 |\n| 2016 | 197 | 8,702 |\n| 2017 | — | 8,007 |\n| Later years | — | 24,130 |\n| Total future minimum rental payments | $ | 1,400 | $ | 76,706 |\n\n49\nTotal rental payments charged to expense were $15,579 in 2012, $12,362 in 2011, and $13,712 in 2010. Lease extrication charges of $1,215 associated with the consolidation of two of the Company’s facilities in the Metals segment were included in total rental payments charged to expense in 2010 within Warehouse, processing and delivery expense in the consolidated statements of operations and comprehensive loss. There were no lease extrication charges in 2012 and 2011. Total gross value of property, plant and equipment under capital leases was $1,895 and $2,698 in 2012 and 2011, respectively.\n(5) Employee Benefit Plans\nPension Plans\nSubstantially all employees who meet certain requirements of age, length of service and hours worked per year are covered by Company-sponsored pension plans and supplemental pension plan (collectively, the “pension plans”). These pension plans are defined benefit, noncontributory plans. Benefits paid to retirees are based upon age at retirement, years of credited service and average earnings. The Company also has a supplemental pension plan, which is a non-qualified, unfunded plan. The Company uses a December 31 measurement date for the pension plans.\nThe Company-sponsored pension plans are frozen for all employees except for employees of certain subsidiaries and employees represented by the United Steelworkers of America. The assets of the Company-sponsored pension plans are maintained in a single trust account.\nThe Company’s funding policy is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act of 1974, commonly called ERISA.\nComponents of net periodic pension credit are as follows:\n| 2012 | 2011 | 2010 |\n| Service cost | $ | 608 | $ | 539 | $ | 623 |\n| Interest cost | 6,832 | 7,393 | 7,456 |\n| Expected return on assets | (9,855 | ) | (10,054 | ) | (9,342 | ) |\n| Amortization of prior service cost | 324 | 324 | 231 |\n| Amortization of actuarial loss | 594 | 229 | 237 |\n| Net periodic pension credit | $ | (1,497 | ) | $ | (1,569 | ) | $ | (795 | ) |\n\nThe expected 2013 amortization of pension prior service cost and actuarial loss is $323 and $1,942, respectively.\n50\nThe status of the plans at December 31, 2012 and 2011 are as follows:\n| 2012 | 2011 |\n| Change in projected benefit obligation: |\n| Projected benefit obligation at beginning of year | $ | 164,407 | $ | 144,235 |\n| Service cost | 608 | 539 |\n| Interest cost | 6,832 | 7,393 |\n| Benefit payments | (6,558 | ) | (6,151 | ) |\n| Actuarial loss | 15,848 | 18,391 |\n| Projected benefit obligation at end of year | $ | 181,137 | $ | 164,407 |\n| Change in plan assets: |\n| Fair value of plan assets at beginning of year | $ | 174,938 | $ | 157,996 |\n| Actual return on assets | 18,463 | 22,867 |\n| Employer contributions | 307 | 226 |\n| Benefit payments | (6,558 | ) | (6,151 | ) |\n| Fair value of plan assets at end of year | $ | 187,150 | $ | 174,938 |\n| Funded status – net prepaid | $ | 6,013 | $ | 10,531 |\n| Amounts recognized in the consolidated balance sheets consist of: |\n| Prepaid pension cost | $ | 12,891 | $ | 15,956 |\n| Accrued liabilities | (309 | ) | (219 | ) |\n| Pension benefit obligations | (6,569 | ) | (5,206 | ) |\n| Net amount recognized | $ | 6,013 | $ | 10,531 |\n| Pre-tax components of accumulated other comprehensive income (loss): |\n| Unrecognized actuarial loss | $ | (29,778 | ) | $ | (23,131 | ) |\n| Unrecognized prior service cost | (1,617 | ) | (1,942 | ) |\n| Total | $ | (31,395 | ) | $ | (25,073 | ) |\n| Accumulated benefit obligation | $ | 180,551 | $ | 163,874 |\n\nFor the plan with an accumulated benefit obligation in excess of plan assets, the projected benefit obligation, accumulated benefit obligation and fair value of plan assets were $5,893, $5,893 and $0, respectively, at December 31, 2012; and $5,425, $5,425 and $0, respectively, at December 31, 2011.\nThe assumptions used to measure the projected benefit obligations for the Company’s defined benefit pension plans are as follows:\n| 2012 | 2011 |\n| Discount rate | 3.50 - 3.75% | 4.25 | % |\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% |\n\nThe assumptions used to determine net periodic pension credit are as follows:\n| 2012 | 2011 | 2010 |\n| Discount rate | 4.25 | % | 5.25 | % | 5.75 | % |\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % | 6.50 | % |\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% | 0 - 3.00% |\n\nThe Company’s expected return on plan assets is derived from reviews of asset allocation strategies and historical and anticipated future long-term performance of individual asset classes. The Company’s analysis gives consideration to historical returns and long-term, prospective rates of return.\n51\nThe Company’s pension plan assets are allocated entirely to fixed income securities at December 31, 2012 and 2011.\nThe Company’s pension plans’ funds are managed in accordance with investment policies recommended by its investment advisor and approved by the Human Resources Committee of the Board of Directors. The overall target portfolio allocation is 100% fixed income securities. These funds’ conformance with style profiles and performance is monitored regularly by management, with the assistance of the Company’s investment advisor. Adjustments are typically made in the subsequent quarters when investment allocations deviate from the target range. The investment advisor provides quarterly reports to management and the Human Resources Committee of the Board of Directors.\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2012:\n| Level 1 | Level 2 | Level 3 | Total |\n| Fixed income securities (1) | $ | 10,562 | $ | 176,610 | $ | — | $ | 187,172 |\n| Accounts payable – pending trades | (22 | ) |\n| Total | $ | 187,150 |\n\n\n| (1) | Fixed income securities are comprised of corporate bonds (75%), government bonds (16%), government agencies securities (6%) and other fixed income securities (3%). |\n\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2011:\n| Level 1 | Level 2 | Level 3 | Total |\n| Fixed income securities (2) | $ | 9,949 | $ | 172,694 | $ | — | $ | 182,643 |\n| Accounts payable – pending trades | (7,705 | ) |\n| Total | $ | 174,938 |\n\n\n| (2) | Fixed income securities are comprised of corporate bonds (74%), government bonds (16%), government agencies securities (7%) and other fixed income securities (3%). |\n\nThe estimated future pension benefit payments are:\n| 2013 | $ | 7,974 |\n| 2014 | 8,213 |\n| 2015 | 8,828 |\n| 2016 | 9,115 |\n| 2017 | 9,607 |\n| 2018 — 2022 | 51,839 |\n\nThe Company is also party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\nPostretirement Plan\nThe Company also provides declining value life insurance to its retirees and a maximum of three years of medical coverage to qualified individuals who retire between the ages of 62 and 65. The Company does not fund these benefits in advance, and uses a December 31 measurement date.\n52\nComponents of net periodic postretirement benefit cost for 2012, 2011 and 2010 were as follows:\n| 2012 | 2011 | 2010 |\n| Service cost | $ | 161 | $ | 164 | $ | 177 |\n| Interest cost | 170 | 222 | 219 |\n| Amortization of prior service cost | — | — | 29 |\n| Amortization of actuarial gain | — | — | (16 | ) |\n| Net periodic postretirement benefit cost | $ | 331 | $ | 386 | $ | 409 |\n\nThe expected 2012, amortization of postretirement prior service cost and actuarial gain are insignificant.\nThe status of the postretirement benefit plans at December 31, 2012 and 2011 were as follows:\n| 2012 | 2011 |\n| Change in accumulated postretirement benefit obligations: |\n| Accumulated postretirement benefit obligation at beginning of year | $ | 4,635 | $ | 4,339 |\n| Service cost | 161 | 164 |\n| Interest cost | 170 | 222 |\n| Benefit payments | (193 | ) | (100 | ) |\n| Actuarial (gain) loss | (394 | ) | 10 |\n| Accumulated postretirement benefit obligation at end of year | $ | 4,379 | $ | 4,635 |\n| Funded status – net liability | $ | 4,379 | $ | 4,635 |\n| Amounts recognized in the consolidated balance sheets consist of: |\n| Accrued liabilities | $ | (296 | ) | $ | (218 | ) |\n| Postretirement benefit obligations | (4,083 | ) | (4,417 | ) |\n| Net amount recognized | $ | (4,379 | ) | $ | (4,635 | ) |\n| Pre-tax components of accumulated other comprehensive income (loss): |\n| Unrecognized actuarial gain | $ | 661 | $ | 266 |\n| Total | $ | 661 | $ | 266 |\n\nThe assumed health care cost trend rates for medical plans at December 31 were as follows:\n| 2012 | 2011 | 2010 |\n| Medical cost trend rate | 8.00 | % | 8.50 | % | 8.00 | % |\n| Ultimate medical cost trend rate | 5.00 | % | 5.00 | % | 5.00 | % |\n| Year ultimate medical cost trend rate will be reached | 2019 | 2018 | 2013 |\n\nA 1% increase in the health care cost trend rate assumptions would have increased the accumulated postretirement benefit obligation at December 31, 2012 by $259 with no significant impact on the annual periodic postretirement benefit cost. A 1% decrease in the health care cost trend rate assumptions would have decreased the accumulated postretirement benefit obligation at December 31, 2012 by $235 with no significant impact on the annual periodic postretirement benefit cost.\n53\nThe weighted average discount rate used to determine the net periodic postretirement benefit costs and the accumulated postretirement benefit obligations were as follows:\n| 2012 | 2011 | 2010 |\n| Net periodic postretirement benefit costs | 3.75 | % | 5.25 | % | 5.75 | % |\n| Accumulated postretirement benefit obligations | 3.50 | % | 3.75 | % | 5.25 | % |\n\nRetirement Savings Plan\nThe Company’s retirement savings plan includes features under Section 401(k) of the Internal Revenue Code. Effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation and the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Company contributions cliff vest after two years of employment.\nEffective July 1, 2012, the Company's 401(k) plan was amended to include the U.S. employees of Tube Supply. Employees were eligible to participate in the Company's 401(k) plan immediately. Tube Supply's existing plan assets were rolled over into the Company's 401(k) plan during 2012 as a result of this amendment.\nThe amounts expensed are summarized below:\n| 2012 | 2011 | 2010 |\n| Supplemental contributions and 401(k) match | $ | 5,260 | $ | 4,414 | $ | 1,634 |\n\n(6) Joint Venture\nKreher Steel Co., LLC is a 50% owned joint venture of the Company. It is a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois.\nThe following information summarizes the Company’s participation in the joint venture as of and for the year ended December 31:\n| 2012 | 2011 | 2010 |\n| Equity in earnings of joint venture | $ | 7,224 | $ | 11,727 | $ | 5,585 |\n| Investment in joint venture | 38,854 | 36,460 | 27,879 |\n| Sales to joint venture | 455 | 362 | 973 |\n| Purchases from joint venture | 695 | 884 | 223 |\n\nThe following information summarizes financial data for this joint venture as of and for the year ended December 31:\n| 2012 | 2011 | 2010 |\n| Revenues | $ | 257,776 | $ | 269,657 | $ | 188,107 |\n| Net income | 14,603 | 23,643 | 11,035 |\n| Current assets | 92,421 | 111,263 | 71,611 |\n| Non-current assets | 26,099 | 22,979 | 17,880 |\n| Current liabilities | 14,315 | 59,952 | 32,828 |\n| Non-current liabilities | 27,845 | 3,089 | 2,872 |\n| Members’ equity | 76,360 | 71,199 | 53,791 |\n| Capital expenditures | 5,259 | 6,736 | 2,271 |\n| Depreciation and amortization | 2,034 | 1,603 | 1,720 |\n\n54\n(7) Income Taxes\n(Loss) Income before income taxes and equity in earnings of joint venture generated by the Company’s U.S. and non-U.S. operations were as follows:\n| 2012 | 2011 | 2010 |\n| U.S | $ | (28,398 | ) | $ | (26,321 | ) | $ | (19,420 | ) |\n| Non-U.S. | 12,856 | 11,708 | 5,094 |\n\nThe Company’s income tax expense (benefit) is comprised of the following:\n| 2012 | 2011 | 2010 |\n| Federal |\n| current | $ | (842 | ) | $ | (1,204 | ) | $ | 6,823 |\n| deferred | (1,542 | ) | (2,041 | ) | (11,270 | ) |\n| State |\n| current | 629 | 461 | 17 |\n| deferred | 401 | (1,218 | ) | (186 | ) |\n| Foreign |\n| current | 2,927 | 2,970 | 1,464 |\n| deferred | (143 | ) | (94 | ) | 51 |\n| $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\n\nThe reconciliation between the Company’s effective tax rate on income or loss and the U.S. federal income tax rate of 35% is as follows:\n| 2012 | 2011 | 2010 |\n| Federal income tax at statutory rates | $ | (5,439 | ) | $ | (5,115 | ) | $ | (5,014 | ) |\n| State income taxes, net of federal income tax benefits | 22 | (1,007 | ) | (313 | ) |\n| Permanent items: |\n| Dividends received deductions | (766 | ) | — | — |\n| Convertible debt mark-to-market - non-deductible | 6,206 | 1,551 |\n| Other permanent differences | 480 | 662 | 326 |\n| Federal and state income tax on joint venture | 2,766 | 4,478 | 2,158 |\n| Rate differential on foreign income | (1,680 | ) | (726 | ) | (755 | ) |\n| Unrecognized tax benefits | (557 | ) | (576 | ) | 424 |\n| Audit settlements | 218 | — | — |\n| State rate changes | (68 | ) | (478 | ) | — |\n| Other | 248 | 85 | 73 |\n| Income tax expense (benefit) | $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\n| Effective income tax expense rate | 9.2 | % | 7.7 | % | 21.7 | % |\n\n55\nSignificant components of the Company’s deferred tax assets and liabilities are as follows:\n| 2012 | 2011 |\n| Deferred tax assets: |\n| Postretirement benefits | $ | 3,830 | $ | 3,675 |\n| Deferred compensation | 1,940 | 1,916 |\n| Deferred gain | — | 271 |\n| Impairments | 1,452 | 1,311 |\n| Alternative minimum tax and net operating loss carryforward | 3,487 | 2,635 |\n| Total deferred tax assets | $ | 10,709 | $ | 9,808 |\n| Deferred tax liabilities: |\n| Depreciation | $ | 8,032 | $ | 8,307 |\n| Inventory | 1,146 | 1,695 |\n| Pension | 4,240 | 5,742 |\n| Intangible assets and goodwill | 24,224 | 16,486 |\n| Other, net | 1,665 | 1,475 |\n| Total deferred tax liabilities | 39,307 | 33,705 |\n| Net deferred tax liabilities | $ | 28,598 | $ | 23,897 |\n\nAs of December 31, 2012, the Company has federal, state and foreign net operating losses (\"NOLs\") as follows:\n| Amount | Expiration Period |\n| Federal | $ | — |\n| State | 19,499 | 2015 to 2032 |\n| Foreign | 2,473 | (a) |\n\n(a) Foreign NOLs of $369 expire in 2014 and $2,104 do not expire.\nBased on all available evidence, including historical and forecasted financial results, the Company determined that it is more likely than not that the federal, state and foreign NOLs that have expiration dates will be realized due to the fact that the Company anticipates it will be able to have sufficient earnings in future years to use the NOL carryforwards prior to expiration. To the extent that the Company does not generate sufficient state or foreign taxable income within the statutory carryforward periods to utilize the NOL carryforwards in the respective jurisdictions, they will expire unused. However, based upon all available evidence, the Company has concluded that it will utilize these NOL carryforwards prior to the expiration period.\nThe following table shows the net change in the Company’s unrecognized tax benefits:\n| 2012 | 2011 | 2010 |\n| Balance as of January 1 | $ | 861 | $ | 1,465 | $ | 726 |\n| Increases (decreases) in unrecognized tax benefits: |\n| Due to tax positions taken in prior years | — | 91 | 729 |\n| Due to tax positions taken during the current year | 45 | 60 | 44 |\n| Due to settlement with tax authorities | (757 | ) | — | (34 | ) |\n| Due to expiration of statute | (44 | ) | (755 | ) | — |\n| Balance as of December 31 | $ | 105 | $ | 861 | $ | 1,465 |\n\nUnrecognized tax benefits of $105, $861 and $950 would impact the effective tax rate if recognized as of December 31, 2012, 2011 and 2010, respectively. The accrued interest and penalties related to unrecognized tax benefits were insignificant at December 31, 2012 and 2011. The interest and penalties recorded by the Company were insignificant for the years ended December 31, 2012, 2011 and 2010.\n56\nDuring 2012 and 2011, statutes expired on certain unrecognized tax benefits of the Company. The reversal of the reserve of these unrecognized tax benefits was recorded as a component of overall income tax benefit for the years ended December 31, 2012 and 2011, respectively.\nThe Company or its subsidiaries files income tax returns in the United States federal jurisdiction, 29 states, and 7 foreign jurisdictions.\nThe following tax years remain open to examination by the major taxing jurisdictions to which the Company is subject:\n| U.S. Federal | 2010 to 2011 |\n| U.S. States | 2008 to 2011 |\n| Foreign | 2007 to 2011 |\n\nDuring the second quarter of 2012, audits of the Company’s 2008 and 2009 U.S. federal income tax returns were concluded with no significant assessment. During 2011, the Company recognized $423 of tax benefits, excluding interest, due to the expiration of the statute of limitations for uncertain tax positions taken in prior years. Due to the potential for resolution of the examination or expiration of statutes of limitations, it is reasonably possible that the Company’s gross unrecognized tax benefits may change within the next 12 months by a range of zero to $60.\nThe Company received its 2010 federal tax refund of $2,025 during February 2012 and its 2009 federal income tax refund of $6,344 during January 2011.\n(8) Goodwill and Intangible Assets\nThe changes in carrying amounts of goodwill during the years ended December 31, 2012 and 2011 were as follows:\n| 2012 | 2011 |\n| MetalsSegment | PlasticsSegment | Total | MetalsSegment | PlasticsSegment | Total |\n| Balance as of January 1 |\n| Goodwill | $ | 117,145 | $ | 12,973 | $ | 130,118 | $ | 97,354 | $ | 12,973 | $ | 110,327 |\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\n| 56,928 | 12,973 | 69,901 | 37,137 | 12,973 | 50,110 |\n| Acquisition of Tube Supply | — | — | — | 19,637 | — | 19,637 |\n| Currency valuation | 399 | — | 399 | 154 | — | 154 |\n| Balance as of December 31 |\n| Goodwill | 117,544 | 12,973 | 130,517 | 117,145 | 12,973 | 130,118 |\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\n| $ | 57,327 | $ | 12,973 | $ | 70,300 | $ | 56,928 | $ | 12,973 | $ | 69,901 |\n\nThe Company’s annual test for goodwill impairment is completed as of January 1st each year. Based on its January 1, 2012 test, the Company determined that there was no impairment of goodwill. The Company's year-to-date operating results, among other factors, are considered in determining whether it is more likely than not that the fair value for any reporting unit has declined below its carrying value, which would require the Company to perform an interim goodwill impairment test. Another recession or economic declines in specific industries could change management's expectations of future financial results and/or key valuation assumptions used in determining the fair-value of its reporting units, which could result in a goodwill impairment.\n57\nThe following summarizes the components of intangible assets at December 31, 2012 and 2011 :\n| 2012 | 2011 |\n| Gross CarryingAmount | AccumulatedAmortization | Gross CarryingAmount | AccumulatedAmortization |\n| Customer relationships | $ | 119,118 | $ | 45,317 | $ | 118,567 | $ | 34,960 |\n| Non-compete agreements | 3,888 | 3,235 | 3,888 | 2,902 |\n| Trade names | 8,297 | 1,188 | 8,249 | 410 |\n| Developed technology | 1,400 | 486 | 1,400 | 19 |\n| Total | $ | 132,703 | $ | 50,226 | $ | 132,104 | $ | 38,291 |\n\nThe weighted-average amortization period for the intangible assets is 10.8 years, 11.3 years for customer relationships, 9.4 years for trade names, 3 years for non-compete agreements and 3 years for developed technology. Substantially all of the Company’s intangible assets were acquired as part of the acquisitions of Transtar on September 5, 2006 and Tube Supply on December 15, 2011.\nFor the years ended December 31, 2012, 2011, and 2010, the aggregate amortization expense was $11,843, $6,867 and $7,071, respectively.\nThe following is a summary of the estimated annual amortization expense for each of the next 5 years:\n| 2013 | $ | 11,775 |\n| 2014 | 11,742 |\n| 2015 | 10,975 |\n| 2016 | 10,975 |\n| 2017 | 8,951 |\n\n(9) Debt\nShort-term and long-term debt consisted of the following at December 31, 2012 and 2011:\n| 2012 | 2011 |\n| SHORT-TERM DEBT |\n| Foreign | $ | 500 | $ | 500 |\n| Total short-term debt | 500 | 500 |\n| LONG-TERM DEBT |\n| 12.75% Senior Secured Notes due December 15, 2016 | 225,000 | 225,000 |\n| 7.0% Convertible Notes due December 15, 2017 | 57,500 | 57,500 |\n| New Revolving Credit Facility due December 15, 2015 | 39,500 | 35,500 |\n| Other, primarily capital leases | 1,400 | 244 |\n| Total long-term debt | 323,400 | 318,244 |\n| Plus: derivative liability for conversion feature associated with convertible debt | — | 26,440 |\n| Less: unamortized discount | (26,831 | ) | (30,252 | ) |\n| Less: current portion | (415 | ) | (192 | ) |\n| Total long-term portion | 296,154 | 314,240 |\n| TOTAL SHORT-TERM AND LONG-TERM DEBT | $ | 297,069 | $ | 314,932 |\n\nDuring December of 2011, in conjunction with the completion of the Acquisition (see Note 2), the Company issued $225,000 aggregate principal amount of 12.75% Senior Secured Notes due 2016 (the “Secured Notes”), $57,500 aggregate principal amount of 7.0% Convertible Senior Notes due 2017 (the “Convertible Notes”) and entered into a $100,000 senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds from these transactions (collectively referred to as the “Debt Transactions”) were used to complete the Acquisition, repay existing debt and for general corporate purposes. The Company incurred debt origination fees of $18,136\n58\nassociated with the Debt Transactions which are primarily being amortized using the effective interest method and recognized interest expense of $3,375 for underwriting fees associated with the debt financing. The Company recognized a loss of $6,153 on the extinguishment of its previously existing debt which included prepayment fees and the write-off of previously existing deferred financing costs.\nSecured Notes\nThe Company filed a registration statement with the Securities and Exchange Commission on Form S-4 on April 11, 2012. The registration statement was declared effective on June 12, 2012.\nOn June 12, 2012, the Company commenced an offer to exchange $225,000 principal amount of 12.75% Secured Notes due 2016, which are registered under the Securities Act of 1933 (the “New Secured Notes”), for $225,000 principal amount of outstanding 12.75% Senior Secured Notes due 2016, which had not been registered under the Securities Act of 1933 (the “Old Secured Notes”). The terms of the New Secured Notes issued are identical in all material respects to the Old Secured Notes, except that the New Secured Notes are registered under the Securities Act of 1933, do not have any of the transfer restrictions, registration rights and additional interest provisions relating to the Old Secured Notes and bear a different CUSIP number from the Old Secured Notes. The Company did not receive any proceeds from the exchange offer.\nThe New Secured Notes will mature on December 15, 2016. The Company will pay interest on the New Secured Notes at a rate of 12.75% per annum in cash semi-annually. During 2012, interest payments totaling $28,688 were made on June 15, 2012 and December 14, 2012. The New Secured Notes are fully and unconditionally guaranteed, jointly and severally, by certain 100% owned domestic subsidiaries of the Company (the “Note Guarantors”). The New Secured Notes and the related guarantees are secured by a lien on substantially all of the Company's and the Note Guarantors' assets, subject to certain exceptions and permitted liens pursuant to a pledge and security agreement. The terms of the New Secured Notes contain numerous covenants imposing financial and operating restrictions on the Company's business. These covenants place restrictions on the Company's ability and the ability of its subsidiaries to, among other things, pay dividends, redeem stock or make other distributions or restricted payments; incur indebtedness or issue common stock; make certain investments; create liens; agree to payment restrictions affecting certain subsidiaries; consolidate or merge; sell or otherwise transfer or dispose of assets, including equity interests of certain subsidiaries; enter into transactions with affiliates, enter into sale and leaseback transactions; and use the proceeds of permitted sales of the Company's assets. Refer to Note 14 for Guarantor Financial Information disclosure.\nOn or after December 15, 2014, the Company may redeem some or all of the New Secured Notes at a redemption premium of 106.375% of the principal amount for the 12-month period beginning December 15, 2014 and 100% thereafter, plus accrued and unpaid interest. Prior to December 15, 2014, the Company may redeem up to 35% of the aggregate principal amount of the New Secured Notes at a redemption price of 112.75% of the principal amount, plus accrued and unpaid interest, with the net cash proceeds of certain equity offerings. In addition, the Company may, at its option, redeem some or all of the New Secured Notes at any time prior to December 15, 2014, by paying a “make-whole” premium, plus accrued and unpaid interest.\nThe New Secured Notes also contain a provision that allows holders of the New Secured Notes to require the Company to repurchase all or any part of the Secured Notes if a change of control triggering event occurs. Under this provision, the repurchase of the New Secured Notes will occur at a purchase price of 101% of the outstanding principal amount, plus accrued and unpaid interest, if any, on such New Secured Notes to the date of repurchase. In addition, upon certain asset sales, the Company may be required to offer to use the net proceeds thereof to purchase some of the New Secured Notes at 100% of the principal amount thereof, plus accrued and unpaid interest.\nSubject to certain conditions, within 95 days after the end of each fiscal year, the Company must make an offer to purchase New Secured Notes with certain of its excess cash flow for such fiscal year (as defined in the indenture) for such fiscal year, commencing with the fiscal year ending December 31, 2012, at 103% of the principal amount thereof, plus accrued and unpaid interest. For the fiscal year ended December 31, 2012, the Company estimated excess cash flow (as defined in the indenture) to be approximately $17,000 and therefore, an offer to purchase New Secured Notes is required to be made within 95 days of year end.\nAlthough redemption of the New Secured Notes is outside of the control of the Company, the New Secured Notes in the amount of $17,000 are reported as long-term debt as availability under the Company's revolving credit facility, which is long-term in nature, would be used if redemption occurred.\n59\nConvertible Notes\nThe $50,000 Convertible Notes were issued pursuant to an indenture, dated as of December 15, 2011, among the Company, the Note Guarantors and U.S. Bank National Association, as trustee. The Convertible Notes were issued by the Company at an initial offering price equal to 100% of the principal amount. The Company granted the initial purchaser in the Convertible Notes offering an option, exercisable within 30 days, to purchase up to an additional $7,500 aggregate principal amount of Convertible Notes. The initial purchaser exercised their option in full and, on December 20, 2011, the Company issued an additional $7,500 aggregate principal amount of Convertible Notes.\nThe Convertible Notes will mature on December 15, 2017. The Company will pay interest on the Convertible Notes at a rate of 7.0% in cash semi-annually. During 2012, interest payments totaling $4,025 were made on June 15, 2012 and December 14, 2012. The Convertible Notes will be fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by the Note Guarantors. The initial conversion rate for the Convertible Notes will be 97.2384 shares of the Company’s common stock per $1 principal amount of Convertible Notes, equivalent to an initial conversion price of approximately $10.28 per share of common stock. The conversion rate will be subject to adjustment, but will not be adjusted for accrued and unpaid interest, if any. In addition, if an event constituting a fundamental change occurs, the Company will in some cases increase the conversion rate for a holder that elects to convert its Convertible Notes in connection with such fundamental change. Upon conversion, the Company will pay and/or deliver, as the case may be, cash, shares of common stock or a combination of cash and shares of common stock, at the Company’s election, together with cash in lieu of fractional shares.\nHolders may convert their Convertible Notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding June 15, 2017 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the trading price per note for each day of that measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the applicable conversion rate on each such day; (2) during any calendar quarter (and only during such calendar quarter) after the calendar quarter ended December 31, 2011, if the last reported sale price of the Company’s common stock for 20 or more trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is equal to or greater than 130% of the applicable conversion price in effect for each applicable trading day; (3) upon the occurrence of specified corporate events, including certain dividends and distributions; or (4) if the Company calls the Convertible Notes for redemption on or after December 20, 2015. The Convertible Notes will be convertible, regardless of the foregoing circumstances, at any time from, and including, June 15, 2017 through the second scheduled trading day immediately preceding the maturity date.\nPrior to April 26, 2012, the Company had the option to elect not to issue shares of common stock upon conversion of the Convertible Notes to the extent such election would result in the issuance of more than 19.99% of the common stock outstanding immediately before the issuance of the Convertible Notes until the Company receives shareholder approval for such issuance and shareholder approval of the increase in the number of shares of common stock authorized and available for issuance upon conversion of the Convertible Notes. Since the Company did not have sufficient authorized shares available to share-settle the conversion option in full, the embedded conversion option did not qualify for equity classification and instead was separately valued and accounted for as a derivative liability as of December 31, 2011. The initial value allocated to the derivative liability was $22,330 of the $57,500 principal amount of the Convertible Notes, which represents a discount to the debt to be amortized through interest expense using the effective interest method through the maturity of the Convertible Notes. Accordingly, the effective interest rate used to amortize the debt discount on the Convertible Notes was determined to be 17.78%. During each reporting period prior to April 26, 2012, the derivative liability was marked to fair value through earnings. As of December 31, 2011, the derivative liability, which is classified in long-term debt, had a fair value of $26,440. There was no derivative liability as of December 31, 2012.\nOn April 26, 2012, at the Company's Annual Meeting of Stockholders, shareholder approval was obtained for the issuance of shares in excess of 20% of the Company's outstanding common stock to satisfy any conversions of the Convertible Notes. Additionally, shareholder approval was obtained to amend the Company's charter to authorize additional shares of common stock from 30,000 to 60,000. With these approvals, the Company now has the ability to share-settle the conversion option in full and therefore, the embedded conversion option is no longer required to be separately valued and accounted for as a derivative liability. As of April 26, 2012, the conversion option's cumulative value of $42,037 was reclassified to additional paid-in capital and will no longer be marked-to-market through earnings. The deferred tax benefit of $8,285 associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital.\n60\nUpon a fundamental change, subject to certain exceptions, holders may require the Company to repurchase some or all of their Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest.\nThe Company may not redeem the Convertible Notes prior to December 20, 2015. On or after December 20, 2015, the Company may redeem all or part of the Convertible Notes (except for the Convertible Notes that we are required to repurchase as described above) if the last reported sale price of the Company’s common stock exceeds 135% of the applicable conversion price for 20 or more trading days in a period of 30 consecutive trading days ending on the trading day immediately prior to the date of the redemption notice. The redemption price will equal the sum of 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest, plus a “make-whole premium” payment. The Company must make the \"make-whole\" premium payments on all Convertible Notes called for redemption including Convertible Notes converted after the date we delivered the notice of redemption. The Company will pay the redemption price in cash except for any non-cash portion of the \"make-whole\" premium.\nNew Revolving Credit Facility\nThe New Revolving Credit Facility consists of a $100,000 senior secured asset-based revolving credit facility (subject to adjustment pursuant to a borrowing base described below), of which (a) up to an aggregate principal amount of $20,000 will be available for a Canadian subfacility, (b) up to an aggregate principal amount of $20,000 will be available for letters of credit and (c) up to an aggregate principal amount of $10,000 will be available for swingline loans. Loans under the New Revolving Credit Facility will be made available to the Company and certain domestic subsidiaries (the “U.S. Borrowers”) in U.S. dollars and the Canadian Borrowers in U.S. dollars and Canadian dollars. The New Revolving Credit Facility will mature on December 15, 2015.\nAll obligations of the U.S. Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by each direct and indirect, existing and future, domestic subsidiary of the U.S. Borrowers (the “U.S. Subsidiary Guarantors” and together with the U.S. Borrowers, the “U.S. Credit Parties”), subject to certain exceptions for immaterial subsidiaries. All obligations of the Canadian Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by (a) each U.S. Credit Party and (b) each direct and indirect, existing and future, Canadian subsidiary of the Company (the “Canadian Subsidiary Guarantors” and together with the Canadian Borrowers, the “Canadian Credit Parties”; and the U.S. Credit Parties together with the Canadian Credit Parties, the “Credit Parties”), subject to certain exceptions.\nAll obligations under the New Revolving Credit Facility are secured on a first-priority basis by a perfected security interest in substantially all assets of the Credit Parties (subject to certain exceptions for permitted liens). The New Revolving Credit Facility will rank pari passu in right of payment with the Secured Notes, but, pursuant to the intercreditor agreement, the Secured Notes will be effectively subordinated to the indebtedness under the New Revolving Credit Facility with respect to the collateral.\nAt the Company’s election, borrowings under the New Revolving Credit Facility will bear interest at variable rates based on (a) a customary base rate plus an applicable margin of between 0.50% and 1.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility) or (b) an adjusted LIBOR rate plus an applicable margin of between 1.50% and 2.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility). The weighted average interest rate on borrowings under the revolving credit facilities were 2.71% and 1.63% for the year ended December 31, 2012 and 2011, respectively. The Company will pay certain customary recurring fees with respect to the New Revolving Credit Facility.\nThe New Revolving Credit Facility permits the Company to increase the aggregate amount of the commitments under the New Revolving Credit Facility from time to time in an aggregate amount for all such increases not to exceed $50,000, subject to certain conditions. The existing lenders under the New Revolving Credit Facility are not obligated to provide the incremental commitments.\nThe New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10,000. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12,500, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement. As of December 31, 2012, the Company’s excess availability of $50,543 was above such thresholds.\n61\nNet interest expense reported on the consolidated statements of operations was reduced by interest income from investment of excess cash balances of $222 in 2012, $254 in 2011 and $201 in 2010.\n(10) Fair Value Measurements\nThe three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities in the are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities. Refer to Note 5 for pension fair value disclosures.\nFair Value Measurements of Debt\nThe fair value of the Company’s Senior Secured Notes as of December 31, 2012 was estimated to be $263,813 compared to a carrying value of $218,335, net of unamortized discount. The fair value for the Senior Secured Notes is determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy.\nThe fair value of the Convertible Notes, as of December 31, 2012 was estimated to be approximately $95,000 compared to a carrying value of $37,334, net of unamortized discount. The fair value for the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes.\nThe main inputs and assumptions into the fair value model for the Convertible Notes at December 31, 2012 were as follows:\n| Company's stock price at the end of the period | $ | 14.77 |\n| Expected volatility | 22.3 | % |\n| Credit spreads | 8.22 | % |\n| Risk-free interest rate | 0.36 | % |\n\nThe estimated fair value of the derivative liability for the conversion feature (refer to table below), which falls within level 3 of the fair value hierarchy, as of December 31, 2011 was computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature.\nAs of December 31, 2012, the estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which falls within level 3 of the fair value hierarchy, is $37,775 compared to its carrying value of $40,000, assuming the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015. Although borrowings could be materially greater or less than the current amount of borrowings outstanding at the end of the year, it is not practical to estimate the amounts that may be outstanding during the future periods since there is no predetermined borrowing or repayment schedule.\n62\nFair Value Measurements of Commodity Hedges\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. At December 31, 2012, the Company had executed forward contracts that extend through 2016. The counterparty to these contracts is not considered a credit risk by the Company. At December 31, 2012 and 2011, the notional value associated with forward contracts was $17,191 and $15,486, respectively. The Company recorded, through cost of materials, realized and unrealized losses of $430 and $2,377 during the years ended December 31, 2012 and 2011, respectively, as a result of the decline in the fair value of the contracts. There were no gains or losses recorded for commodity hedges during 2010. Refer to Note 13 for letters of credit outstanding for collateral associated with commodity hedges.\nThe Company uses information which is representative of readily observable market data when valuing derivative liabilities associated with commodity hedges. The derivative liabilities are classified as Level 2 in the table below.\nThe liabilities measured at fair value on a recurring basis were as follows:\n| Level 1 | Level 2 | Level 3 | Total |\n| As of December 31, 2012: |\n| Derivative liability for commodity hedges | $ | — | $ | 2,494 | $ | — | $ | 2,494 |\n| As of December 31, 2011: |\n| Derivative liability for commodity hedges | $ | — | $ | 2,331 | $ | — | $ | 2,331 |\n| Derivative liability for conversion feature associated with convertible debt | — | — | 26,440 | 26,440 |\n\nThe following reconciliation represents the change in fair value of Level 3 liabilities between January 1, 2012 and December 31, 2012:\n| Derivative liability forconversion featureassociated withconvertible debt |\n| Fair value as of January 1 | $ | 26,440 |\n| Mark-to-market adjustment on conversion feature | 15,597 |\n| Reclassification from long-term debt to additional paid-in capital | (42,037 | ) |\n| Fair value as of December 31 | $ | — |\n\n(11) Share-based Compensation\nThe Company accounts for its share-based compensation arrangements by recognizing compensation expense for the fair value of the share awards ratably over their vesting period or a shorter period, as applicable. The consolidated compensation cost recorded for the Company’s share-based compensation arrangements was $2,277, $4,349 and $2,411 for 2012, 2011 and 2010, respectively. The total income tax benefit recognized in the consolidated statements of operations for share-based compensation arrangements was $872, $1,534 and $831 in 2012, 2011 and 2010, respectively. All compensation expense related to share-based compensation arrangements is recorded in sales, general and administrative expense. The unrecognized compensation cost as of December 31, 2012 associated with all share-based payment arrangements is $4,973 and the weighted average period over which it is to be expensed is 1.4 years.\n| Plan Description | Authorized Shares |\n| 1995 Directors Stock Option Plan | 188 |\n| 1996 Restricted Stock and Stock Option Plan | 938 |\n| 2000 Restricted Stock and Stock Option Plan | 1,200 |\n| 2004 Restricted Stock, Stock Option and Equity Compensation Plan | 1,350 |\n| 2008 A. M. Castle & Co. Omnibus Incentive Plan (amended and restated as of April 28, 2011) | 2,750 |\n\n63\nLong-Term Compensation and Incentive Plans\nOn March 7, 2012, the Human Resources Committee (the “Committee”) of the Board of Directors of the Company approved equity awards under the Company’s 2012 Long-Term Compensation Plan (\"2012 LTC Plan\") for executive officers and other select personnel. The 2012 LTC Plan awards included restricted stock units (\"RSUs\") and performance share units (\"PSUs\"). All 2012 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle & Co. Omnibus Incentive Plan.\nOn March 2, 2011, the Committee approved equity awards under the Company's 2011 Long-Term Compensation Plan (\"2011 LTC Plan\") for executive officers and other select personnel. The 2011 LTC Plan awards included RSUs and PSUs. All 2011 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle Omnibus Incentive Plan.\nOn March 18, 2010, the Committee approved equity awards under the Company’s 2010 Long-Term Compensation Plan (“2010 LTC Plan”) for executive officers and other select personnel. The 2010 LTC Plan awards included RSUs, PSUs, and stock options. All 2010 LTC Plan awards are subject to the terms of the Company’s 2008 Restricted Stock, Stock Option and Equity Compensation Plan, amended and restated as of December 9, 2010.\nUnless covered by a specific change-in-control or severance agreement, participants to whom RSUs, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited. However, for stock option awards, unless a participant is covered by a specific change-in-control or severance agreement, options are forfeited in the event of the termination of employment other than by reason of disability or a retirement.\nCompensation expense is recognized based on management’s estimate of the total number of share-based awards expected to vest at the end of the service period.\nRestricted Share Units and Non-Vested Shares\nThe RSUs granted under the 2012 and 2011 LTC Plans will cliff vest on December 31, 2014 and December 31, 2013, respectively. Approximately 78 RSUs granted under the 2010 LTC Plan cliff vested on December 31, 2012. Each RSU that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\nThe outstanding non-vested share balance consists of shares issued to the Board of Directors during the second quarter of 2012 and shares issued for retention incentive purposes. The Director shares vest during the second quarter of 2015 and the balance of the shares vest on December 31, 2014. The RSU share balance consists of units granted to employees for incentive purposes.\nThe fair value of the RSUs and non-vested shares is established using the market price of the Company’s stock on the date of grant.\nA summary of the non-vested share and RSU activity is as follows:\n| Shares | Units |\n| Shares | Weighted-Average GrantDate Fair Value | Units | Weighted-Average GrantDate Fair Value |\n| Outstanding at January 1, 2012 | 38 | $ | 18.74 | 232 | $ | 14.39 |\n| Granted | 73 | $ | 12.22 | 309 | $ | 10.60 |\n| Forfeited | (5 | ) | $ | 17.02 | (158 | ) | $ | 12.44 |\n| Vested | (33 | ) | $ | 18.95 | (85 | ) | $ | 12.45 |\n| Outstanding at December 31, 2012 | 73 | $ | 12.22 | 298 | $ | 12.05 |\n| Expected to vest at December 31, 2012 | 73 | $ | 12.22 | 256 | $ | 12.36 |\n\nThe unrecognized compensation cost as of December 31, 2012 associated with RSU and non-vested share awards is $2,758. The total fair value of shares vested during the years ended December 31, 2012, 2011 and 2010 was $1,685, $2,166 and $600, respectively.\n64\nPerformance Shares\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition, over a three-year performance period, beginning January 1, 2012, January 1, 2011 and January 1, 2010 and ending December 31, 2014, December 31, 2013 and December 31, 2012, respectively. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry (the “RTSR Peer Group”). The 2012, 2011 and 2010 LTC Plans provide with respect to performance shares for (1) a threshold level up to which the threshold level of performance shares will vest, a target performance level at which the target number of performance shares will vest, a maximum performance level at or above which the maximum number of performance shares will vest, and pro rata vesting between the threshold and maximum performance levels and (2) minimum and maximum vesting opportunities ranging from one-half up to two times the target number. The threshold, target and maximum performance levels for RTSR are the 25th, 50th and 75th percentile, respectively, relative to RTSR Peer Group performance. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. Each performance share that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\nThe grant date fair values of performance shares awarded containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Grant Date Fair Value per Share | $ | 13.78 | $ | 23.89 | $ | 12.26 |\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\n| Expected dividend yield | — | — | — |\n\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\n| 2012 | 2011 | 2010 |\n| Grant Date Fair Value per Share | $ | 16.65 | $ | 10.61 | $ | 5.57 |\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\n| Expected dividend yield | — | — | — |\n\n65\nFinal award vesting and distribution of performance awards granted under the 2010 LTC Plan was determined based on the Company’s actual performance versus the target goals for a three-year consecutive period (as defined in the 2010 Plan). Refer to the table below for the number of shares expected to be issued under 2010 LTC Plan.\n| Plan Year | Grant Date Fair Value | Estimated Number ofPerformance Shares to be Issued | Maximum Number ofPerformance Shares thatcould Potentially be Issued |\n| 2012 LTC Plan |\n| Market-based performance condition | $ | 13.78 | 172 | 244 |\n| Market-based performance condition (1) | $ | 16.65 | 41 | 58 |\n| Non-market-based performance condition | $ | 10.02 | — | 244 |\n| Non-market-based performance condition (1) | $ | 12.74 | — | 58 |\n| 2011 LTC Plan |\n| Market-based performance condition | $ | 23.89 | 39 | 131 |\n| Market-based performance condition (1) | $ | 10.61 | 9 | 32 |\n| Non-market-based performance condition | $ | 17.13 | — | 131 |\n| Non-market-based performance condition (1) | $ | 12.74 | — | 32 |\n| 2010 LTC Plan |\n| Market-based performance condition | $ | 12.26 | 83 | 237 |\n| Market-based performance condition (1) | $ | 5.57 | 2 | 5 |\n\n(1) Represents the status of performance awards granted under the active LTC Plans in October 2012.\nThe unrecognized compensation cost as of December 31, 2012 associated with the 2012 and 2011 LTC Plans performance shares is $2,145.\nStock Options\nThere were no stock options issued under the 2012 or 2011 LTC Plans. The stock options issued under the 2010 LTC Plan vest and become exercisable three years from the date of the grant. The term of the options is eight years. The exercise price of the options is $12.79 per share. The grant date fair value of $5.71 per share was estimated using the Black-Scholes option-pricing model with the following assumptions:\n| 2010 |\n| Expected volatility | 58.5 | % |\n| Risk-free interest rate | 2.3 | % |\n| Expected life (in years) | 5.5 |\n| Expected dividend yield | 1.2 | % |\n\n| Shares | WeightedAverageExercise Price | IntrinsicValue | Weighted AverageRemainingContractual Life |\n| Stock options outstanding at January 1, 2012 | 418 | $ | 12.44 |\n| Exercised | (16 | ) | $ | 9.11 |\n| Forfeited | (113 | ) | $ | 15.56 |\n| Expired | (19 | ) | $ | 12.60 |\n| Stock options outstanding at December 31, 2012 | 270 | $ | 11.34 | $ | 937 | 3.8 |\n| Stock options exercisable at December 31, 2012 | 111 | $ | 9.25 | $ | 621 | 1.5 |\n| Stock options vested or expected to vest as of December 31, 2012 | 259 | $ | 11.28 | $ | 915 | 3.7 |\n\n66\nThe total intrinsic value of options exercised during the years ended December 31, 2012, 2011 and 2010, was $36, $194 and $219, respectively. The unrecognized compensation cost as of December 31, 2012 associated with stock options is $70.\n(12) Stockholders' Equity\nShareholder Rights Plan\nIn August 2012, the Company's Board of Directors adopted a Shareholder Rights Plan (the “Rights Plan”) and declared a dividend of one right for each outstanding share of the Company's common stock outstanding at the close of business on September 11, 2012. Pursuant to the Rights Plan, the Company is issuing one preferred stock purchase right (a “Right”) for each share of common stock outstanding on September 11, 2012. Each Right, once exercisable, represents the right to purchase one one-hundredth of a share (a “Unit”) of Series B Junior Preferred Stock of the Company, without par value, for $54.00, subject to adjustment. The Rights become exercisable in the event any individual person or entity, without Board approval, acquires 10% or more of the Company's common stock, subject to certain exceptions. In these circumstances, each holder of a Right (other than rights held by the acquirer) will be entitled to purchase, at the then-current exercise price of the Right, additional shares of the Company's common stock having a value of twice the exercise price of the Right. Additionally, if the Company is involved in a merger or other business combination transaction with another person after which its common stock does not remain outstanding, each Right will entitle its holder to purchase, at the then-current exercise price of the Right, shares of common stock of the ultimate parent of such other person having a market value of twice the exercise price of the Right. The Rights may be redeemed by the Company for $0.001 per Right at any time until the tenth business day following the first public announcement of an acquisition of beneficial ownership of 10% of the Company's common stock. The Rights Plan will expire on August 30, 2013.\nAccumulated Other Comprehensive Loss\nAccumulated other comprehensive loss as reported in the consolidated balance sheets as of December 31, 2012 and 2011 was comprised of the following:\n| 2012 | 2011 |\n| Foreign currency translation losses | $ | (2,322 | ) | $ | (4,691 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (18,749 | ) | (15,133 | ) |\n| Total accumulated other comprehensive loss | $ | (21,071 | ) | $ | (19,824 | ) |\n\n(13) Commitments and Contingent Liabilities\nAs of December 31, 2012, the Company had $6,794 of irrevocable letters of credit outstanding which primarily consisted of $4,000 for collateral associated with commodity hedges and $1,994 for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. The Company previously disclosed similar incidents to BIS in 2008, which were resolved in September 2011 through the payment of a $775 civil penalty and a commitment to satisfy certain compliance and reporting obligations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning.\n67\nWhile the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\n(14) Guarantor Financial Information\nThe accompanying consolidating financial information has been prepared and presented pursuant to Rule 3-10 of SEC Regulation S-X “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The consolidating financial information presents A. M. Castle & Co. (Parent) and subsidiaries. The consolidating financial information has been prepared on the same basis as the consolidated statements of the Parent. The equity method of accounting is followed within this financial information.\nIn September 2012, the Company merged Tube Supply, LLC, a guarantor, with the Parent. The Company has reflected this change in its accompanying consolidating financial statements of guarantors and non-guarantors.\n68\n| Condensed Consolidating Balance SheetAs of December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\n| Accounts receivable, less allowance for doubtful accounts | 60,293 | 34,037 | 43,981 | — | 138,311 |\n| Receivables from affiliates | 95 | 1,118 | 668 | (1,881 | ) | — |\n| Inventories | 183,189 | 44,874 | 75,777 | (68 | ) | 303,772 |\n| Prepaid expenses and other current assets | 16,141 | (1,490 | ) | 8,239 | (202 | ) | 22,688 |\n| Total current assets | 263,050 | 80,216 | 145,263 | (2,151 | ) | 486,378 |\n| Investment in joint venture | 38,854 | — | — | — | 38,854 |\n| Goodwill | 12,921 | 41,556 | 15,823 | — | 70,300 |\n| Intangible assets | 34,343 | 28,325 | 19,809 | — | 82,477 |\n| Other assets | 28,142 | (98 | ) | 3,113 | — | 31,157 |\n| Investment in subsidiaries | 245,798 | 11,526 | — | (257,324 | ) | — |\n| Receivables from affiliates | 62,696 | 83,891 | 3,280 | (149,867 | ) | — |\n| Property, plant and equipment, net | 52,424 | 15,403 | 11,813 | — | 79,640 |\n| Total assets | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 40,510 | $ | 13,434 | $ | 14,046 | $ | — | $ | 67,990 |\n| Payables due to affiliates | 742 | 95 | 1,044 | (1,881 | ) | — |\n| Other current liabilities | 26,566 | 3,478 | 8,083 | — | 38,127 |\n| Current portion of long-term debt and short-term debt | 386 | 1 | 528 | — | 915 |\n| Total current liabilities | 68,204 | 17,008 | 23,701 | (1,881 | ) | 107,032 |\n| Long-term debt, less current portion | 292,086 | — | 4,068 | — | 296,154 |\n| Payables due to affiliates | 12,114 | 11,994 | 125,759 | (149,867 | ) | — |\n| Deferred income taxes | 14,209 | 18,614 | (473 | ) | — | 32,350 |\n| Other non-current liabilities | 14,275 | 1,339 | 316 | — | 15,930 |\n| Stockholders’ equity | 337,340 | 211,864 | 45,730 | (257,594 | ) | 337,340 |\n| Total liabilities and stockholders’ equity | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\n\n69\n| Condensed Consolidating Balance SheetAs of December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Assets |\n| Current assets |\n| Cash and cash equivalents | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\n| Accounts receivable, less allowance for doubtful accounts | 88,434 | 37,487 | 55,115 | — | 181,036 |\n| Receivables from affiliates | 273 | 3,495 | 146 | (3,914 | ) | — |\n| Inventories | 163,776 | 48,980 | 59,547 | (264 | ) | 272,039 |\n| Prepaid expenses and other current assets | 18,517 | (3,331 | ) | 3,483 | — | 18,669 |\n| Total current assets | 282,534 | 87,213 | 136,699 | (4,178 | ) | 502,268 |\n| Investment in joint venture | 36,460 | — | — | — | 36,460 |\n| Goodwill | 12,921 | 41,556 | 15,424 | — | 69,901 |\n| Intangible assets | 38,238 | 34,395 | 21,180 | — | 93,813 |\n| Other assets | 34,691 | 237 | 2,812 | — | 37,740 |\n| Investment in subsidiaries | 243,823 | 12,151 | — | (255,974 | ) | — |\n| Receivables from affiliates | 66,878 | 71,041 | 7,292 | (145,211 | ) | — |\n| Property, plant and equipment, net | 56,266 | 15,416 | 10,459 | — | 82,141 |\n| Total assets | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\n| Liabilities and Stockholders’ Equity |\n| Current liabilities |\n| Accounts payable | $ | 84,437 | $ | 14,826 | $ | 17,611 | $ | — | $ | 116,874 |\n| Payables due to affiliates | 1,387 | 76 | 2,451 | (3,914 | ) | — |\n| Other current liabilities | 25,895 | 4,459 | 5,358 | — | 35,712 |\n| Current portion of long-term debt and short-term debt | 82 | 50 | 560 | — | 692 |\n| Total current liabilities | 111,801 | 19,411 | 25,980 | (3,914 | ) | 153,278 |\n| Long-term debt, less current portion | 303,739 | 1 | 10,500 | — | 314,240 |\n| Payables due to affiliates | 23,727 | 8,572 | 112,912 | (145,211 | ) | — |\n| Deferred income taxes | 6,280 | 19,647 | (277 | ) | — | 25,650 |\n| Other non-current liabilities | 13,985 | 2,324 | 567 | — | 16,876 |\n| Stockholders’ equity | 312,279 | 212,054 | 44,184 | (256,238 | ) | 312,279 |\n| Total liabilities and stockholders’ equity | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\n\n70\n| Condensed Consolidating Statement of Operations and Comprehensive (Loss) IncomeFor the year ended December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 755,642 | $ | 270,644 | $ | 282,274 | $ | (38,192 | ) | $ | 1,270,368 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 548,659 | 199,004 | 217,749 | (38,125 | ) | 927,287 |\n| Warehouse, processing and delivery expense | 91,628 | 32,459 | 24,169 | — | 148,256 |\n| Sales, general and administrative expense | 75,497 | 30,351 | 21,965 | — | 127,813 |\n| Depreciation and amortization expense | 12,955 | 8,888 | 4,024 | — | 25,867 |\n| Operating income (loss) | 26,903 | (58 | ) | 14,367 | (67 | ) | 41,145 |\n| Interest expense, net | (25,820 | ) | — | (15,270 | ) | — | (41,090 | ) |\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | — | — | — | (15,597 | ) |\n| Loss before income taxes and equity in earnings of subsidiaries and joint venture | (14,514 | ) | (58 | ) | (903 | ) | (67 | ) | (15,542 | ) |\n| Income taxes | (1,805 | ) | 475 | 102 | (202 | ) | (1,430 | ) |\n| Equity in (losses) earnings of subsidiaries | (653 | ) | (1,203 | ) | — | 1,856 | — |\n| Equity in earnings of joint venture | 7,224 | — | — | — | 7,224 |\n| Net (loss) income | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation gains (losses) | 2,369 | 578 | 2,369 | (2,947 | ) | 2,369 |\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,616 | ) | — | — | — | (3,616 | ) |\n| Other comprehensive (loss) income | (1,247 | ) | 578 | 2,369 | (2,947 | ) | (1,247 | ) |\n| Net loss | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\n| Comprehensive (loss) income | $ | (10,995 | ) | $ | (208 | ) | $ | 1,568 | $ | (1,360 | ) | $ | (10,995 | ) |\n\n71\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 621,036 | $ | 283,290 | $ | 237,201 | $ | (9,161 | ) | $ | 1,132,366 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 466,133 | 207,269 | 181,104 | (8,897 | ) | 845,609 |\n| Warehouse, processing and delivery expense | 80,543 | 33,828 | 20,527 | — | 134,898 |\n| Sales, general and administrative expense | 74,154 | 31,807 | 20,232 | — | 126,193 |\n| Depreciation and amortization expense | 8,874 | 8,910 | 2,688 | — | 20,472 |\n| Operating (loss) income | (8,668 | ) | 1,476 | 12,650 | (264 | ) | 5,194 |\n| Interest expense, net | (4,982 | ) | — | (4,681 | ) | — | (9,663 | ) |\n| Interest expense - unrealized loss on debt conversion option | (3,991 | ) | (3,991 | ) |\n| Loss on extinguishment of debt | (6,153 | ) | — | — | — | (6,153 | ) |\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (23,794 | ) | 1,476 | 7,969 | (264 | ) | (14,613 | ) |\n| Income taxes | 3,267 | (433 | ) | (1,708 | ) | — | 1,126 |\n| Equity in earnings of subsidiaries | 7,040 | (209 | ) | — | (6,831 | ) | — |\n| Equity in earnings of joint venture | 11,727 | — | — | — | 11,727 |\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation (losses) gains | (941 | ) | 1,180 | (941 | ) | (239 | ) | (941 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,071 | ) | — | — | — | (3,071 | ) |\n| Other comprehensive (loss) income | (4,012 | ) | 1,180 | (941 | ) | (239 | ) | (4,012 | ) |\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\n| Comprehensive (loss) income | $ | (5,772 | ) | $ | 2,014 | $ | 5,320 | $ | (7,334 | ) | $ | (5,772 | ) |\n\n72\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2010 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Net Sales | $ | 498,848 | $ | 266,491 | $ | 186,654 | $ | (8,287 | ) | $ | 943,706 |\n| Costs and expenses: |\n| Cost of materials (exclusive of depreciation and amortization) | 369,865 | 195,184 | 144,092 | (8,287 | ) | 700,854 |\n| Warehouse, processing and delivery expense | 72,234 | 33,250 | 17,834 | — | 123,318 |\n| Sales, general and administrative expense | 61,751 | 29,684 | 16,788 | — | 108,223 |\n| Depreciation and amortization expense | 8,665 | 9,114 | 2,870 | — | 20,649 |\n| Operating (loss) income | (13,667 | ) | (741 | ) | 5,070 | — | (9,338 | ) |\n| Interest expense, net | (1,008 | ) | — | (3,980 | ) | — | (4,988 | ) |\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (14,675 | ) | (741 | ) | 1,090 | — | (14,326 | ) |\n| Income taxes | 3,106 | 420 | (425 | ) | — | 3,101 |\n| Equity in earnings of subsidiaries | 344 | 110 | — | (454 | ) | — |\n| Equity in earnings of joint venture | 5,585 | — | — | — | 5,585 |\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\n| Comprehensive (loss) income: |\n| Foreign currency translation (losses) gains | (536 | ) | (2,337 | ) | (536 | ) | 2,873 | (536 | ) |\n| Unrecognized pension and postretirement benefit costs, net of tax | (1,748 | ) | — | — | — | (1,748 | ) |\n| Other comprehensive (loss) income | (2,284 | ) | (2,337 | ) | (536 | ) | 2,873 | (2,284 | ) |\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\n| Comprehensive (loss) income | $ | (7,924 | ) | $ | (2,548 | ) | $ | 129 | $ | 2,419 | $ | (7,924 | ) |\n\n73\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2012 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (9,748 | ) | $ | (786 | ) | $ | (801 | ) | $ | 1,587 | $ | (9,748 | ) |\n| Equity in losses of subsidiaries | 653 | 1,203 | — | (1,856 | ) | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,688 | 12,951 | (8,809 | ) | 269 | 15,099 |\n| Net cash from (used in) operating activities | 1,593 | 13,368 | (9,610 | ) | — | 5,351 |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | — | — | — | (6,472 | ) |\n| Capital expenditures | (5,336 | ) | (2,802 | ) | (2,983 | ) | — | (11,121 | ) |\n| Other investing activities, net | — | 6 | 147 | — | 153 |\n| Net cash used in investing activities | (11,808 | ) | (2,796 | ) | (2,836 | ) | — | (17,440 | ) |\n| Financing activities: |\n| Proceeds from long-term debt, including new revolving credit facility | 756,550 | — | 10,540 | — | 767,090 |\n| Repayments of long-term debt, including new revolving credit facility | (745,839 | ) | (49 | ) | (16,999 | ) | — | (762,887 | ) |\n| Payment of debt issue costs | (1,503 | ) | — | — | — | (1,503 | ) |\n| Net intercompany (repayments) borrowings | (7,431 | ) | (9,428 | ) | 16,859 | — | — |\n| Other financing | 236 | — | (27 | ) | — | 209 |\n| Net cash from (used in) financing activities | 2,013 | (9,477 | ) | 10,373 | — | 2,909 |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | 263 | — | 263 |\n| (Decrease) increase in cash and cash equivalents | (8,202 | ) | 1,095 | (1,810 | ) | — | (8,917 | ) |\n| Cash and cash equivalents - beginning of year | 11,534 | 582 | 18,408 | — | 30,524 |\n| Cash and cash equivalents - end of period | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\n\n74\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2011 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (1,760 | ) | $ | 834 | $ | 6,261 | $ | (7,095 | ) | $ | (1,760 | ) |\n| Equity in earnings of subsidiaries | (7,040 | ) | 209 | — | 6,831 | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,232 | 15,095 | (70,119 | ) | 264 | (44,528 | ) |\n| Net cash from (used in) operating activities | 1,432 | 16,138 | (63,858 | ) | — | (46,288 | ) |\n| Investing activities: |\n| Acquisition/Investment of businesses, net of cash acquired | (175,836 | ) | — | 1,592 | (174,244 | ) |\n| Capital expenditures | (6,077 | ) | (2,783 | ) | (2,884 | ) | — | (11,744 | ) |\n| Other investing activities, net | 605 | 136 | 58 | — | 799 |\n| Net cash used in investing activities | (181,308 | ) | (2,647 | ) | (1,234 | ) | — | (185,189 | ) |\n| Financing activities: |\n| Net borrowings (repayments) of debt | 82 | 8 | (25,840 | ) | — | (25,750 | ) |\n| Proceeds from long-term debt, including new revolving credit facility | 309,625 | — | 10,851 | — | 320,476 |\n| Repayments of long-term debt, including new revolving credit facility | (52,896 | ) | (55 | ) | (261 | ) | — | (53,212 | ) |\n| Payment of debt issue costs | (16,380 | ) | — | (253 | ) | — | (16,633 | ) |\n| Net intercompany (repayments) borrowings | (57,307 | ) | (13,930 | ) | 71,237 | — | — |\n| Other financing activities, net | 657 | — | — | — | 657 |\n| Net cash from (used in) financing activities | 183,781 | (13,977 | ) | 55,734 | — | 225,538 |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (253 | ) | — | (253 | ) |\n| Increase (decrease) in cash and cash equivalents | 3,905 | (486 | ) | (9,611 | ) | — | (6,192 | ) |\n| Cash and cash equivalents - beginning of year | 7,629 | 1,068 | 28,019 | — | 36,716 |\n| Cash and cash equivalents - end of period | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\n\n75\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2010 |\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\n| Operating activities: |\n| Net (loss) income | $ | (5,640 | ) | $ | (211 | ) | $ | 665 | $ | (454 | ) | $ | (5,640 | ) |\n| Equity in earnings of subsidiaries | (344 | ) | (110 | ) | — | 454 | — |\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 12,721 | 29,562 | 500 | (2,781 | ) | 40,002 |\n| Net cash from (used in) operating activities | 6,737 | 29,241 | 1,165 | (2,781 | ) | 34,362 |\n| Investing activities: |\n| Capital expenditures | (4,244 | ) | (1,267 | ) | (2,061 | ) | — | (7,572 | ) |\n| Other investing activities, net | 125 | 4 | — | — | 129 |\n| Net cash used in investing activities | (4,119 | ) | (1,263 | ) | (2,061 | ) | — | (7,443 | ) |\n| Financing activities: |\n| Net (repayments) borrowings of debt | (13,720 | ) | — | 2,324 | — | (11,396 | ) |\n| Repayments of long-term debt | (7,007 | ) | (343 | ) | (404 | ) | — | (7,754 | ) |\n| Net intercompany borrowings (repayments) | 15,794 | (27,350 | ) | 8,775 | 2,781 | — |\n| Other financing activities, net | 785 | — | — | — | 785 |\n| Net cash (used in) from financing activities | (4,148 | ) | (27,693 | ) | 10,695 | 2,781 | (18,365 | ) |\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (149 | ) | — | (149 | ) |\n| (Decrease) increase in cash and cash equivalents | (1,530 | ) | 285 | 9,650 | — | 8,405 |\n| Cash and cash equivalents - beginning of year | 9,159 | 783 | 18,369 | — | 28,311 |\n| Cash and cash equivalents - end of period | $ | 7,629 | $ | 1,068 | $ | 28,019 | $ | — | $ | 36,716 |\n\n76\n(15) Selected Quarterly Data (Unaudited)\nThe results of Tube Supply, acquired during December 2011, were included in the 2012 selected quarterly data in the table below.\n| FirstQuarter | SecondQuarter | ThirdQuarter | FourthQuarter |\n| 2012 |\n| Net sales | $ | 362,916 | $ | 329,392 | $ | 304,039 | $ | 274,021 |\n| Gross profit (a) | 53,810 | 43,763 | 42,867 | 28,518 |\n| Net (loss) income (c) | (4,300 | ) | (2,978 | ) | 3,173 | (5,643 | ) |\n| Basic (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.14 | $ | (0.24 | ) |\n| Diluted (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.13 | $ | (0.24 | ) |\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\n| 2011 |\n| Net sales | $ | 272,788 | $ | 282,568 | $ | 294,860 | $ | 282,150 |\n| Gross profit (a) | 33,219 | 35,165 | 33,233 | 29,770 |\n| Net income (loss) (b) | 2,703 | 3,697 | 3,803 | (11,963 | ) |\n| Basic earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.17 | $ | (0.52 | ) |\n| Diluted earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.16 | $ | (0.52 | ) |\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\n\n| (a) | Gross profit equals net sales minus cost of materials, warehouse, processing, and delivery costs and less depreciation and amortization expense. |\n\n| (b) | Fourth quarter results include fees incurred as a result of the acquisition of Tube Supply and the related debt refinancing in December 2011. The results of Tube Supply are included in the fourth quarter results for the two-week period ended December 31, 2011 and for the entire fiscal year ended December 31, 2012. In addition, a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $3,991 was included in interest expense during the fourth quarter. |\n\n| (c) | First and second quarter results include a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $11,340 and $4,257, respectively. Amounts were included in interest expense during the respective quarters. |\n\n(16) Subsequent Events\nOn January 16, 2013, the Company announced restructuring actions, including an organizational restructuring, warehouse realignments and performance improvement programs. The total pre-tax charge associated with these actions is estimated to be approximately $10,000, which is expected to be incurred in the first half of 2013. Of this amount, approximately $3,500 is attributable to employee severance and other employment related benefits, $2,500 is attributable to lease termination costs, $1,600 is attributable to moving costs in conjunction with the warehouse realignments and $2,400 relates to other costs. The Company may identify additional opportunities as it implements the restructuring actions that could impact its overall estimate. In addition, the Company expects to incur capital expenditures of approximately $1,400 in 2013 that are directly associated with the restructuring actions.\n77\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Board of Directors and Stockholders of A.M. Castle & Co.\nOak Brook, Illinois\nWe have audited the accompanying consolidated balance sheets of A.M. Castle & Co. and subsidiaries (the \"Company\") as of December 31, 2012 and 2011, and the related consolidated statements of operations and comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits. We did not audit the financial statements of Kreher Steel Company, LLC, a 50% owned joint venture, the Company's investment in which is accounted for by use of the equity method. The Company's equity of $38,854 and $36,460 in Kreher Steel Company, LLC's net assets at December 31, 2012 and 2011, respectively, and of $7,224 and $11,727 in that company's net income for the years then ended are included in the accompanying financial statements. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Kreher Steel Company, LLC, is based solely on the report of the other auditors.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, based on our audits and the report of other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of A.M. Castle & Co. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2013 expressed an unqualified opinion on the Company's internal control over financial reporting.\n/s/ DELOITTE & TOUCHE LLP\nDELOITTE & TOUCHE LLP\nChicago, Illinois\nMarch 11, 2013\n78\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED BALANCE SHEETSDecember 31, |\n| 2012 | 2011 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 3,373,355 | $ | 8,743,820 |\n| Accounts receivable (net of allowance for doubtful accounts of approximately $1,435,000 in 2012 and $1,335,000 in 2011) | 19,736,301 | 32,461,983 |\n| Inventory, net | 66,958,361 | 69,297,422 |\n| Deferred taxes | 271,553 | 29,699 |\n| Prepaid income taxes | 1,424,064 | 186,889 |\n| Prepaid expenses and other current assets | 657,039 | 542,689 |\n| Total current assets | 92,420,673 | 111,262,502 |\n| Property and equipment |\n| Land and building | 14,485,343 | 14,334,997 |\n| Machinery and equipment | 16,533,990 | 11,923,342 |\n| Furniture, fixtures and office equipment | 2,155,447 | 1,952,447 |\n| Automobiles and trucks | 990,508 | 871,929 |\n| Leasehold improvements | 2,334,855 | 1,872,955 |\n| Construction in progress | 266,129 | 753,234 |\n| 36,766,272 | 31,708,904 |\n| Less accumulated depreciation and amortization | 14,719,685 | 12,856,503 |\n| Property and equipment, net | 22,046,587 | 18,852,401 |\n| Deferred financing costs, net of amortization | 104,616 | 121,263 |\n| Goodwill | 3,525,247 | 3,525,247 |\n| Intangible assets, net of amortization | 275,616 | 398,112 |\n| Other assets | 146,785 | 81,543 |\n| $ | 118,519,524 | $ | 134,241,068 |\n| LIABILITIES AND MEMBER'S CAPITAL |\n| Current liabilities |\n| Revolving line of credit | $ | — | $ | 35,000,000 |\n| Current portion of long-term debt | 211,894 | 215,918 |\n| Accounts payable | 11,536,613 | 21,094,460 |\n| Accrued expenses | 2,565,966 | 3,641,502 |\n| Total current liabilities | 14,314,473 | 59,951,880 |\n| Revolving line of credit | 24,000,000 | — |\n| Deferred taxes, non-current | 1,977,273 | 1,008,748 |\n| Long-term debt, less current portion | 1,867,707 | 2,080,993 |\n| Commitments and contingencies |\n| Member's capital | 76,360,071 | 71,199,447 |\n| $ | 118,519,524 | $ | 134,241,068 |\n\n79\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEYears ended December 31, |\n| 2012 | 2011 | 2010 |\n| Net revenues | $ | 257,776,157 | $ | 269,657,054 | $ | 188,107,237 |\n| Cost of sales | 213,490,152 | 219,478,535 | 156,801,397 |\n| Gross profit | 44,286,005 | 50,178,519 | 31,305,840 |\n| Operating expenses |\n| Selling | 12,970,475 | 12,761,204 | 9,729,856 |\n| General and administrative | 12,657,611 | 9,970,335 | 8,283,347 |\n| Total operating expenses | 25,628,086 | 22,731,539 | 18,013,203 |\n| Earnings from operations | 18,657,919 | 27,446,980 | 13,292,637 |\n| Other expense (income) |\n| Interest expense | 519,416 | 432,990 | 259,558 |\n| Interest income | (3,263 | ) | (1,994 | ) | (5,035 | ) |\n| Other income, net | (169,015 | ) | (180,807 | ) | (152,887 | ) |\n| Net earnings before taxes | 18,310,781 | 27,196,791 | 13,191,001 |\n| Income tax provision (benefit) | 3,708,101 | 3,553,382 | 2,155,950 |\n| NET EARNINGS | 14,602,680 | 23,643,409 | 11,035,051 |\n| Other comprehensive income |\n| Foreign currency translation adjustment | 15,554 | — | — |\n| COMPREHENSIVE INCOME | $ | 14,618,234 | $ | 23,643,409 | $ | 11,035,051 |\n\n80\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF MEMBERS’ CAPITALThree years ended December 31, 2012 |\n| Accumulated |\n| other | Total |\n| Member's | Retained | Accumulated | Treasury | comprehensive | member's |\n| contribution | earnings | distributions | stock | income | capital |\n| Balance at January 1, 2010, 400 units | 7,042,411 | 67,379,821 | (23,906,770 | ) | (5,240,092 | ) | — | 45,275,370 |\n| Net earnings | — | 11,035,051 | — | — | — | 11,035,051 |\n| Distributions | — | — | (2,519,593 | ) | — | — | (2,519,593 | ) |\n| Balance at December 31, 2010, 400 units | 7,042,411 | 78,414,872 | (26,426,363 | ) | (5,240,092 | ) | — | 53,790,828 |\n| Net earnings | — | 23,643,409 | — | — | — | 23,643,409 |\n| Distributions | — | — | (6,234,790 | ) | — | — | (6,234,790 | ) |\n| Balance at December 31, 2011, 400 units | 7,042,411 | 102,058,281 | (32,661,153 | ) | (5,240,092 | ) | — | 71,199,447 |\n| Net earnings | — | 14,602,680 | — | — | — | 14,602,680 |\n| Distributions | — | — | (9,457,600 | ) | — | — | (9,457,600 | ) |\n| Foreign currency translation adjustment | — | — | — | — | 15,544 | 15,544 |\n| Balance at December 31, 2012, 400 units | $ | 7,042,411 | $ | 116,660,961 | $ | (42,118,753 | ) | $ | (5,240,092 | ) | $ | 15,544 | $ | 76,360,071 |\n\n81\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWSYears ended December 31, |\n| 2012 | 2011 | 2010 |\n| Cash flows from operating activities |\n| Net earnings | $ | 14,602,680 | $ | 23,643,409 | $ | 11,035,051 |\n| Adjustments to reconcile net earnings to net cash provided by (used in) operating activities |\n| Depreciation and amortization | 2,033,956 | 1,602,925 | 1,720,133 |\n| Deferred taxes | 726,671 | 390,341 | 84,362 |\n| Bad debt expense | 2,595,710 | 34,779 | 178,911 |\n| (Gain) loss on sale of property and equipment | (4,851 | ) | 9,790 | 59,676 |\n| Changes in assets and liabilities |\n| Accounts receivable | 10,129,971 | (8,508,956 | ) | (8,488,036 | ) |\n| Inventory | 2,339,061 | (27,383,374 | ) | (11,823,574 | ) |\n| Prepaid expenses and other assets | (1,400,121 | ) | (58,839 | ) | 182,962 |\n| Accounts payable | (9,557,992 | ) | 3,900,243 | 1,739,501 |\n| Accrued expenses | (1,075,536 | ) | 1,215,113 | 388,680 |\n| Net cash provided by (used in) operating activities | 20,389,549 | (5,154,569 | ) | (4,922,334 | ) |\n| Cash flows from investing activities |\n| Purchases of property and equipment | (5,258,846 | ) | (6,735,595 | ) | (2,271,435 | ) |\n| Proceeds from sale of property and equipment | 145,605 | 19,843 | 256,132 |\n| Net cash used in investing activities | (5,113,241 | ) | (6,715,752 | ) | (2,015,303 | ) |\n| Cash flows from financing activities |\n| Net (decrease) increase in line of credit | (11,000,000 | ) | 22,163,000 | 10,837,000 |\n| Repayment of long-term debt | (217,310 | ) | (268,089 | ) | (360,000 | ) |\n| Distributions to member | (9,457,600 | ) | (6,234,790 | ) | (2,519,593 | ) |\n| Net cash (used in) provided by financing activities | (20,674,910 | ) | 15,660,121 | 7,957,407 |\n| Effect of exchange rate changes on cash and cash equivalents | 28,137 | — | — |\n| Net (decrease) increase in cash and cash equivalents | (5,370,465 | ) | 3,789,800 | 1,019,770 |\n| Cash and cash equivalents at beginning of year | 8,743,820 | 4,954,020 | 3,934,250 |\n| Cash and cash equivalents at end of year | $ | 3,373,355 | $ | 8,743,820 | $ | 4,954,020 |\n| Supplemental disclosures of cash flow information |\n| Cash paid during the year for |\n| Interest | $ | 422,074 | $ | 350,341 | $ | 171,525 |\n| Income taxes, net of refunds | 4,855,764 | 2,910,000 | 1,097,409 |\n| Supplemental disclosures of non-cash investing and financing activities |\n| Acquisition of machinery and equipment through capital leases | $ | — | $ | — | $ | 150,019 |\n\n82\nNOTE A - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nDescription of Company\nKreher Steel Company, LLC and Subsidiaries (the Company) was formed as a limited liability company (LLC) on January 11, 1996, and commenced business on May 1, 1996. The LLC member's initial contribution consisted of the net assets of Kreher Steel Co., Inc.\nThe Company is a national distributor and processor of carbon and alloy steel bar products. The Company has locations throughout the United States and in Edmonton, Canada, and primarily sells in the vicinity of these locations.\nPrinciples of Consolidation\nThe Company's financial statements are presented on a consolidated basis and include its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., as well as a branch of Kreher Steel Company, LLC located in Edmonton, Canada. All intercompany transactions and balances have been eliminated.\nUse of Estimates\nThe preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with maturities of three months or less to be cash equivalents. The Company maintains cash balances at financial institutions in the United States of America that are insured by the Federal Deposit Insurance Corporation (FDIC). At December 31, 2012 and 2011, the Company had approximately $2,113,000 and $7,975,000, respectively, in excess of FDIC insured limits. The Company has not experienced any losses related to these balances, and management believes its credit risk to be minimal.\nShipping and Handling Fees\nFor the years ended December 31, 2012, 2011 and 2010, shipping and handling costs billed to customers amounted to approximately $1,548,000, $1,431,230 and $899,000, respectively, and were included in selling expenses.\nFinancial Instruments and Risk Management\nConcentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base and their dispersion across different businesses and geographic areas. At December 31, 2012, 2011 and 2010, there were no individual customers that made up more than 10% of consolidated sales.\nThe Company's financial instruments include cash equivalents, accounts receivable, accounts payable and notes payable. The carrying amounts of cash equivalents, accounts receivable, accounts payable and notes payable approximate fair value due to their short-term nature and variable interest rates paid.\nPrices for steel fluctuate based on worldwide production and, as a result, the Company is subject to the risk of future changing market prices. Furthermore, the Company purchased approximately 6%, 9% and 7% of its inventory from foreign suppliers for the years ended December 31, 2012, 2011 and 2010, respectively.\nInventory\nInventory is valued at the lower of cost or market. Cost is determined by the specific identification method. The Company provides a reserve for obsolete and slow-moving inventory. As of December 31, 2012 and 2011, the reserve for obsolete and slow-moving inventory was approximately $810,000 and $583,000, respectively.\n83\nChanges in the Company's inventory reserve are as follows at December 31:\n| 2012 | 2011 |\n| Beginning balance | $ | 583,346 | $ | 1,778,365 |\n| Provision (release of provision) | 307,440 | (1,140,966 | ) |\n| Write-offs | (81,119 | ) | (54,053 | ) |\n| Total inventory reserve | $ | 809,667 | $ | 583,346 |\n\nProperty and Equipment\nProperty and equipment are stated at cost less accumulated depreciation. Depreciation is based on the straight-line method and the estimated useful lives of the property and equipment. Depreciation of leasehold improvements is based on the estimated useful life or the term of the lease, whichever is shorter. The Company uses an accelerated method of depreciation for tax purposes. Depreciation expense for December 31, 2012, 2011 and 2010, was approximately $1,911,000, $1,467,000 and $1,543,000, respectively.\nDepreciable lives by asset classification are as follows:\n| Asset description | Life |\n| Furniture and fixtures | 5 - 7 years |\n| Office equipment | 5 - 7 years |\n| Machinery and equipment | 7 - 10 years |\n| Automobiles and trucks | 3 - 5 years |\n| Building and leasehold improvements | 7 - 40 years |\n\nRepairs and maintenance are charged to expense when incurred. Expenditures for improvements are capitalized. Upon sale or retirement, the related cost and accumulated depreciation or amortization are removed from the respective accounts, and any resulting gain or loss is included in operations.\nLong-Lived Assets\nThe Company reviews the carrying values of its long-lived assets for possible impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be recoverable. Any long-lived assets held for disposal are reported at the lower of their carrying amounts or fair value less cost to sell. No triggering events were identified during each year presented that would require an impairment analysis. Additionally, no assets were held for disposal as of December 31, 2012 or 2011.\nGoodwill and Intangible Assets\nGoodwill represents the excess of purchase price paid over the fair values of net assets acquired and liabilities assumed in the Company's acquisitions.\nIntangible assets include non-competition agreements and non-contractual customer relationships. The fair value of identifiable intangible assets was estimated based on discounted future cash flow projections. Intangible assets are amortized on a straight-line basis over their estimated economic lives. The weighted-average useful life of intangible assets was five years as of December 31, 2012.\nThe Company evaluates the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset's carrying amount may not be recoverable. Such circumstances could include, but are not limited to, a significant decrease in the market value of the asset, a significant adverse change in the extent or manner in which an asset is used, or an accumulation of costs significantly in excess of the amount originally expected for the acquisition of an asset. No events or changes in circumstances were identified during the year that required an impairment analysis.\n84\nManagement is required to evaluate goodwill for impairment on an annual basis. The Company tests for impairment using a two-step process that involves (1) comparing the estimated fair value of the reporting unit to its net book value and (2) comparing the estimated implied fair value of goodwill and intangible assets to its carrying value. Goodwill and intangible assets were valued on the date of the acquisition. As of December 31, 2012 and 2011, there was no impairment of the goodwill or intangible assets acquired based on the analysis performed as of December 31, 2012.\nRevenue Recognition\nRevenue from the sale of goods is recognized at the time of shipment, except for revenue from sales of products to certain customers whose contractual terms specify FOB destination. Revenue from sales of products to these customers is recognized at the time of receipt by the customer when title and risk of loss pass to the customer.\nAccounts Receivable\nCredit is extended based on an evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable are generally due within 30 days of the negotiated terms and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. The Company maintains reserves for potential losses on receivables and credits from its customers, and these losses have not exceeded management's expectations. The Company determines its allowance for doubtful accounts by considering a number of factors, including the length of time trade accounts receivable are past due, the Company's previous loss history, the customer's current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.\nEconomic Dependency - Major Suppliers\nDuring the years ended December 31, 2012, 2011 and 2010, the Company purchased approximately 44%, 45% and 49%, respectively, of its materials from five suppliers.\nDeferred Financing Costs\nDeferred financing costs are amortized over the life of the underlying credit agreement or the expected remaining life of the underlying credit agreement.\nIncome Taxes\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. Accordingly, no liability or provision for federal and state income taxes attributable to the LLC's operations is included in the accompanying financial statements. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes as they are structured as C Corporations. Special Metals Canada, which is structured as a foreign branch of a domestic company, will pay federal and provincial taxes in Canada. The taxes paid will be reported to the member in order to claim foreign tax credits.\nThe Company applies a comprehensive model for the financial statement recognition, measurement, classification and disclosure of uncertain tax positions. In the first step of the two-step process, the Company evaluates the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. In the second step, the Company measures the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. As of December 31, 2012 and 2011, the Company determined that there are no uncertain tax positions with a more than 50% likelihood of being realized upon settlement.\nAdvertising Costs\nAdvertising costs are charged to expense when the advertisement is first run. The Company expensed advertising costs of approximately $102,000, $80,000 and $62,000 in 2012, 2011 and 2010, respectively.\n85\nReclassifications\nCertain reclassifications of prior-year presentations have been made to conform to the 2012 presentation.\nNOTE B - INTANGIBLE ASSETS\nIntangible assets are amortized using the straight-line method, using the remaining useful life, and are as follows at December 31, 2012:\n| Remaining |\n| Asset description | useful life |\n| Non-contractual customer relationships | 2.25 years |\n\nThe following is a summary of intangible assets at December 31:\n| 2012 | 2011 |\n| Intangible assets |\n| Finite life |\n| Non-compete agreements | $ | 220,000 | $ | 220,000 |\n| Non-contractual customer relationships | 980,000 | 980,000 |\n| 1,200,000 | 1,200,000 |\n| Less accumulated amortization | 924,384 | 801,888 |\n| Net intangible assets | $ | 275,616 | $ | 398,112 |\n\nAmortization expense related to identifiable intangible assets was $122,496, $136,245 and $177,492 for the years ended December 31, 2012, 2011 and 2010, respectively. The intangible assets related to the non-compete agreements became fully amortized during 2011. Estimated annual amortization expense as of December 31, 2012, is a follows:\n| Years ending December 31, |\n| 2013 | $ | 122,496 |\n| 2014 | 122,496 |\n| 2015 | 30,624 |\n\nNOTE C - TRANSACTIONS WITH AFFILIATES\nIncluded in accounts receivable at December 31, 2012, was approximately $3,000 due from companies related through common ownership. There was no amount included in accounts receivable at December 31, 2011, due from companies related through common ownership.\nIncluded in accounts payable at December 31, 2012 and 2011, was approximately $21,000 and $79,000, respectively, due to companies related through common ownership.\nSales to and purchases from companies related through common ownership for the year ended December 31, 2012, were approximately $695,000 and $809,000, respectively, for the year ended December 31, 2011, were approximately $851,000 and $2,294,000, respectively, and for the year ended December 31, 2010, were approximately $351,000 and $2,118,000, respectively.\nNOTE D - ALLOWANCE FOR DOUBTFUL ACCOUNTS\nChanges in the Company's allowance for doubtful accounts are as follows at December 31:\n86\n| 2012 | 2011 |\n| Beginning balance | $ | 1,335,000 | $ | 1,340,000 |\n| Bad debt expense | 2,595,710 | 34,779 |\n| Recoveries | 20,125 | 536 |\n| Accounts written off | (2,515,835 | ) | (40,315 | ) |\n| Total allowance for doubtful accounts | $ | 1,435,000 | $ | 1,335,000 |\n\nNOTE E - DEBT\nDebt as of December 31, 2012 and 2011, is as follows:\n| 2012 | 2011 |\n| Revolving lines of credit | $ | 24,000,000 | $ | 35,000,000 |\n| Notes payable |\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2000) | $ | 875,000 | $ | 950,000 |\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2006) | 1,150,000 | 1,245,000 |\n| Capitalized leases | 54,601 | 101,911 |\n| Total notes payable | 2,079,601 | 2,296,911 |\n| Current portion of long-term debt | 211,894 | 215,918 |\n| Long-term debt | $ | 1,867,707 | $ | 2,080,993 |\n\nIn April 2004, the Company entered into a loan agreement. The loan consists of advances on a revolving line of credit, with maximum availability of $25,000,000, with the option of extending the credit to $40,000,000, through April 2009. In May 2007, the Company took that option and refinanced its $25,000,000 secured revolving credit agreement from an asset-based loan to a commercial-based loan, which can be increased to $40,000,000 in $5,000,000 increments. In April 2008, the Company increased the revolving credit to $30,000,000. The Company decreased the revolving credit to $20,000,000 in September 2009. In August 2011, the Company increased the revolving credit to $25,000,000. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $21,000,000 at December 31, 2011. There was a balance of $2,000,000 outstanding on the prime rate portion at a rate of 2.625% (prime minus 0.625%) at December 31, 2011.\nIn May 2007, the Company's subsidiary, Special Metals, Inc., also entered into a commercial-based loan for $5,000,000, which can be increased to $10,000,000 in $1,000,000 increments. In October 2011, the Company amended the loan agreement and increased the revolving credit to $15,000,000 based on the consolidated availability of the Company. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $12,000,000 at December 31, 2011. There was no outstanding balance on the LIBOR portion of the loan at December 31, 2011.\nIn April 2012, the Company entered into a new loan agreement. The loan named both the Company and its subsidiary, Special Metals, Inc., as co-borrowers. The loan is for $50,000,000, which can be increased to $65,000,000 in $5,000,000 increments. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.21% was $22,000,000 at December 31, 2012. The outstanding balance on the prime rate portion at a rate of 2.75% was $2,000,000 at December 31, 2012. The loan is secured by the Company's receivables, inventory and fixed assets, and expires in April 2017.\nThe Company is in compliance with all covenants related to the revolving credit agreements and all other notes payable.\nIn 2000, the Company's subsidiary, Kreher Wire Processing, Inc., obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $4,900,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make annual payments for the letter of credit fee. The bonds mature on May 1, 2016.\n87\nIn 2006, Kreher Wire Processing, Inc. obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $2,695,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make quarterly payments for the letter of credit fee. The bonds mature on October 1, 2021.\nIn 2010, Special Metals, Inc. entered into several lease agreements that met the criteria for capitalization. At December 31, 2012 and 2011, the gross amount of cost related to capital leases included in machinery and equipment was approximately $150,000. Related accumulated amortization at December 31, 2012 and 2011, was approximately $110,000 and $65,000, respectively. The total rental payments incurred for the years ended December 31, 2012, 2011 and 2010, was approximately $73,000, $73,000 and $33,000, respectively.\nThe carrying value of debt approximates fair value given the variable nature of the interest rates. Maturities of debt at December 31, 2012, are as follows:\n| Years ending December 31, |\n| 2013 | $ | 211,894 |\n| 2014 | 205,778 |\n| 2015 | 226,929 |\n| 2016 | 725,000 |\n| 2017 | 24,125,000 |\n| Thereafter | 585,000 |\n| Total | $ | 26,079,601 |\n\nNOTE F - INCOME TAXES\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes. The Company also provides for federal and provincial taxes at Special Metals Canada, which is structured as a foreign branch of a domestic company. The taxes paid will be reported to the member in order to claim foreign tax credits.\nThe tax effect of temporary differences that give rise to deferred tax assets and liabilities as of December 31, 2012 and 2011, are as follows:\n| 2012 | 2011 |\n| Deferred tax assets |\n| Accounts receivable and inventory reserves | $ | 271,553 | $ | 29,699 |\n| Deferred tax liabilities |\n| Amortization of intangibles | (110,246 | ) | (159,245 | ) |\n| Depreciation and other | (1,867,027 | ) | (849,503 | ) |\n| Total deferred tax liabilities | (1,977,273 | ) | (1,008,748 | ) |\n| Net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\n\n88\nThe net current and non-current components of the deferred income taxes recognized in the balance sheets at December 31, 2012 and 2011, are as follows:\n| 2012 | 2011 |\n| Net current assets | $ | 271,553 | $ | 29,699 |\n| Net long-term liabilities | (1,977,273 | ) | (1,008,748 | ) |\n| Total net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\n\nIncome tax expense consists of the following components as of December 31:\n| 2012 | 2011 | 2010 |\n| Current |\n| Federal | $ | 2,673,070 | $ | 2,667,703 | $ | 1,845,850 |\n| State | 398,649 | 495,338 | 225,738 |\n| Foreign | (90,289 | ) | — | — |\n| Deferred | 726,671 | 390,341 | 84,362 |\n| Total income tax expense | $ | 3,708,101 | $ | 3,553,382 | $ | 2,155,950 |\n\nThe differences between the federal statutory rate of 34% and the effective rate are due to state income taxes, permanent deductions, settlement of prior returns related to the acquisition and the fact that no tax provisions are recorded for operations attributable to Kreher Steel Company, LLC in the accompanying financial statements. Tax years dated back to December 31, 2009, are open for federal and state tax audit purposes. The total effective rate of the subsidiaries at December 31, 2012, 2011 and 2010, was 20.2%, 13.1% and 16.3%, respectively.\nA reconciliation of the effective income tax rate to the U.S. statutory tax rate is as follows:\n| 2012 | 2011 | 2010 |\n| U.S. statutory tax rate | 34 | % | 34 | % | 34 | % |\n| Non-taxable LLC income | (16.2 | ) | (21.1 | ) | (20.4 | ) |\n| State and local taxes - net of federal tax expense | 2.2 | 0.5 | 2.1 |\n| Foreign taxes | (0.2 | ) | 0.0 | 0.0 |\n| Other, net | 0.4 | (0.3 | ) | 0.6 |\n| Effective tax rate | 20.2 | % | 13.1 | % | 16.3 | % |\n\n89\nNOTE G - COMMITMENTS\nOperating Lease Commitments\nThe Company leases certain equipment and warehouse space under operating lease obligations with rent escalation clauses for the warehouse space only. Accordingly, the Company has recorded these lease obligations on a straight-line basis and recorded a deferred rent liability of approximately $53,000 and $94,000 for the years ended December 31, 2012 and 2011, respectively. Rent expense, net of sublease income for the years ended December 31, 2012, 2011 and 2010, was approximately $1,339,000, $1,081,000 and $687,000, respectively. The following shows minimum future rental payments for the next five years under these obligations:\n| Years ending December 31, |\n| 2,013 | $ | 1,001,042 |\n| 2,014 | 629,844 |\n| 2,015 | 596,404 |\n| 2,016 | 538,668 |\n| 2017 and thereafter | 421,401 |\n\nHealth Insurance\nThe Company maintains a fully self-insured health insurance plan. Approximately $1,105,000, $1,021,000 and $904,000 were expensed in 2012, 2011 and 2010, respectively, under this plan. The Company also maintains a fully self-insured health insurance plan at one of its wholly owned subsidiaries. Approximately $850,000, $562,000 and $346,000 were expensed for this plan during 2012, 2011 and 2010, respectively.\nNOTE H - EMPLOYEE BENEFIT PLAN\nThe Company maintains a qualified plan under Section 401(k) of the Internal Revenue Code. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of the lesser of 60% of eligible compensation or $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company has a non-discretionary match of 100%, up to 4% of what employees elect. The Company also has a profit-sharing match of $500 per participant, which is discretionary. This discretionary match was paid in 2012, 2011 and 2010. Participants are fully vested at all times in their contributions and become fully vested in the Company's contributions over a defined period. The plan is responsible for costs associated with its administration. Approximately $280,000, $200,000 and $153,000 was charged to expense for the years ended December 31, 2012, 2011 and 2010, respectively.\nThe Company also maintains a qualified plan under Section 401(k) of the Internal Revenue Code at a wholly owned subsidiary. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company also has a discretionary profit-sharing contribution. Participants are fully vested in all contributions. The plan is responsible for costs associated with its administration. During 2012, 2011 and 2010, approximately $320,000, $240,000 and $210,000, respectively, was charged to expense.\nNOTE I - CONTINGENCIES\nThe Company is subject to various legal proceedings that have arisen in the normal course of business. In the opinion of management, these actions, when concluded and determined, will not have a material adverse effect on the financial position or operations of the Company.\nNOTE J - MEMBER'S CAPITAL\nThe Company is a single-member LLC and shall continue until December 31, 2045.\n90\nNOTE K - SUBSEQUENT EVENTS\nThe Company evaluated its December 31, 2012, financial statements for subsequent events through February 18, 2013, the date the financial statements were available to be issued. The Company is not aware of any subsequent events that would require recognition or disclosure in the financial statements.\n91\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nBoard of Directors\nKreher Steel Company, LLC\nWe have audited the accompanying consolidated balance sheets of Kreher Steel Company, LLC (a Delaware limited liability company) and Subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, member's capital and cash flows for each of the three years ended December 31, 2012. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kreher Steel Company, LLC and Subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\n/s/ Grant Thornton LLP\nGrant Thornton LLP\nChicago, Illinois\nFebruary 18, 2013\n92\nITEM 9 —\nChanges In and Disagreements With Accountants on Accounting and Financial Disclosure\nNone.\nITEM 9A —\nControls & Procedures\nDisclosure Controls and Procedures\nA review and evaluation was performed by the Company’s management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Security Exchange Act of 1934). Based upon that review and evaluation, the CEO and CFO have concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2012.\n(a) Management’s Annual Report on Internal Control Over Financial Reporting\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in the Securities Exchange Act of 1934 rule 240.13a-15(f). The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.\nInternal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\nThe Company, under the direction of its Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2012 based upon the framework published by the Committee of Sponsoring Organizations of the Treadway Commission, referred to as the Internal Control—Integrated Framework.\nBased on our evaluation under the framework in Internal Control — Integrated Framework, the Company’s management has concluded that our internal control over financial reporting was effective as of December 31, 2012.\nThe effectiveness of the Company’s internal control over financial reporting as of December 31, 2012 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their attestation report included in Item 9A of this annual report.\n(b) Report of Independent Registered Public Accounting Firm\nTo the Board of Directors and Stockholders of\nA.M. Castle & Co.\nOak Brook, Illinois\nWe have audited the internal control over financial reporting of A.M. Castle & Co. and subsidiaries (the \"Company\") as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.\nWe conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\n93\nA company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.\nBecause of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\nIn our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2012 of the Company and our report dated March 11, 2013 expressed an unqualified opinion on those financial statements.\n/s/ DELOITTE & TOUCHE LLP\nDELOITTE & TOUCHE LLP\nChicago, Illinois\nMarch 11, 2013\n(c) Change in Internal Control Over Financial Reporting\nAn evaluation was performed by the Company’s management, including the CEO and CFO, of any changes in internal controls over financial reporting that occurred during the last fiscal quarter and that materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting. The evaluation did not identify any change in the Company’s internal control over financial reporting that occurred during the latest fiscal quarter and that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.\nItem 9B —\nOther Information\nNone.\n94\nPART III\nITEM 10 —\nDirectors, Executive Officers and Corporate Governance\nInformation regarding our executive officers is included under the heading “Executive Officers of the Registrant” in Part I of this Annual Report on Form 10-K. All additional information required to be filed in Part III, Item 10, Form 10-K, has been included in the sections of the Company's Definitive Proxy Statement for its 2013 annual meeting of shareholders (fiscal 2012 Proxy Statement) dated and to be filed with the Securities and Exchange Commission on or about March 12, 2013 entitled “Proposal 1- Election of Directors,” “Certain Governance Matters,” and “Section 16(A) Beneficial Ownership Reporting Compliance,” and is hereby incorporated by this specific reference.\nITEM 11 —\nExecutive Compensation\nAll information required to be filed in Part III, Item 11, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Compensation Discussion and Analysis,” “Report of the Human Resources Committee,” “Compensation Committee Interlocks and Insider Participation”, “Compensation Risk”, “Non-Employee Director Compensation,” and “Executive Compensation and Other Information” and is hereby incorporated by this specific reference.\nITEM 12 —\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\nThe information required to be filed in Part III, Item 12, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Stock Ownership of Directors, Management and Principal Stockholders” and “Equity Compensation Plan Information” and is hereby incorporated by this specific reference.\nITEM 13 —\nCertain Relationships and Related Transactions, and Director Independence\nAll information required to be filed in Part III, Item 13, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Related Party Transactions” and “Director Independence; Financial Experts” and is hereby incorporated by this specific reference.\nITEM 14 —\nPrincipal Accountant Fees and Services\nAll information required to be filed in Part III, Item 14, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Audit and Non-Audit Fees” and “Pre-Approval Policy for Audit and Non-Audit Services” and is hereby incorporated by this specific reference.\n95\nPART IV\nITEM 15 —\nExhibits\nA. M. Castle & Co.\nIndex To Financial Statements\n\n| Page |\n| Consolidated Statements of Operations and Comprehensive Loss—For the years ended December 31, 2012, 2011 and 2010 | 36 |\n| Consolidated Balance Sheets—December 31, 2012 and 2011 | 37 |\n| Consolidated Statements of Cash Flows—For the years ended December 31, 2012, 2011 and 2010 | 38 |\n| Consolidated Statements of Stockholders’ Equity – For the years ended December 31, 2012, 2011 and 2010 | 39 |\n| Notes to Consolidated Financial Statements | 40 |\n| Report of Independent Registered Public Accounting Firm | 77 |\n| Kreher Steel Co., LLC Financial Statements | 79 |\n| Exhibit Index |\n\n96\nThe following exhibits are filed herewith or incorporated by reference.\n| ExhibitNumber | Description of Exhibit |\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. |\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. |\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. |\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. |\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. |\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. |\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. |\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. |\n\n97\n| ExhibitNumber | Description of Exhibit |\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. |\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. |\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. |\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. |\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. |\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. |\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n\n98\n| ExhibitNumber | Description of Exhibit |\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. |\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. |\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. |\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\n\n99\n| ExhibitNumber | Description of Exhibit |\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. |\n| 21.1 | Subsidiaries of Registrant |\n| 23.1 | Consent of Deloitte & Touche LLP |\n| 23.2 | Consent of Grant Thornton LLP |\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document (1) |\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) |\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) |\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) |\n\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\n| * | These agreements are considered a compensatory plan or arrangement. |\n\n100\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n| A. M. Castle & Co. |\n| (Registrant) |\n\n| By: | /s/ Patrick R. Anderson |\n| Patrick R. Anderson, Vice President—Controller and Chief Accounting Officer |\n| (Principal Accounting Officer) |\n| Date: | March 11, 2013 |\n\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities as shown following their name on this 11th day of March, 2013.\n| /s/ Brian P. Anderson | /s/ Gary A. Masse | /s/ Ann M. Drake |\n| Brian P. Anderson, Chairman of the Board | Gary A. Masse, Director | Ann M. Drake, Director |\n| /s/ Scott J. Dolan | /s/ Scott F. Stephens | /s/ Reuben S. Donnelley |\n| Scott J. Dolan, President, | Scott F. Stephens, Vice President | Reuben S. Donnelley, Director |\n| Chief Executive Officer and | and Chief Financial Officer |\n| Director | (Principal Financial Officer) |\n| (Principal Executive Officer) |\n| /s/ Patrick J. Herbert, III | /s/ Terrence J. Keating | /s/ James D. Kelly |\n| Patrick J. Herbert, III, Director | Terrence J. Keating, Director | James D. Kelly, Director |\n| /s/ Pamela Forbes Lieberman |\n| Pamela Forbes Lieberman, Director | John McCartney, Director |\n\n101\nExhibit Index\nThe following exhibits are filed herewith or incorporated herein by reference:\n\n| Exhibit No. | Description | Page |\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. | — |\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-1 |\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-3 |\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. | — |\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. | — |\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. | — |\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. | — |\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. | — |\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. | — |\n\n102\n| Exhibit No. | Description | Page |\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. | — |\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. | — |\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. | — |\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. | — |\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. | — |\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. | — |\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. | — |\n\n103\n| Exhibit No. | Description | Page |\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. | — |\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. | — |\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. | — |\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n\n104\n| Exhibit No. | Description | Page |\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. | — |\n| 21.1 | Subsidiaries of Registrant | E-5 |\n| 23.1 | Consent of Deloitte & Touche LLP | E-6 |\n| 23.2 | Consent of Grant Thornton LLP | E-7 |\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-8 |\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-9 |\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. | E-10 |\n| 101.INS | XBRL Instance Document (1) | — |\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) | — |\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) | — |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) | — |\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) | — |\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) | — |\n\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\n| * | These agreements are considered a compensatory plan or arrangement. |\n\n105\n</text>\n\nWhat is the total cost incurred by the company for the acquisition of Tube Supply, inclusive of direct acquisition-related costs, CEO transition costs, bad debt reserves for customer bankruptcies, charges for export penalties related to product shipments and underwriting fees associated with debt financing in $ million?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nITEM 1 —\\nBusiness\\nIn this annual report on Form 10-K, “the Company,” “we” or “our” refer to A. M. Castle & Co., a Maryland corporation, and its subsidiaries included in the consolidated financial statements, except as otherwise indicated or as the context otherwise requires.\\nBusiness and Markets\\nCompany Overview\\nThe Company is a specialty metals (90% of net sales) and plastics (10% of net sales) distribution company serving customers on a global basis. The Company provides a broad range of products and value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment manufacturing, marine, office furniture and fixtures, safety products, life sciences applications, transportation and general manufacturing industries.\\nThe Company’s corporate headquarters are currently located in Oak Brook, Illinois. The Company operates out of 49 service centers located throughout North America (44), Europe (4) and Asia (1). The Company’s service centers hold inventory and process and distribute products to both local and export markets.\\nIndustry and Markets\\nService centers act as supply chain intermediaries between primary producers, which deal in bulk quantities in order to achieve economies of scale, and end-users in a variety of industries that require specialized products in significantly smaller quantities and forms. Service centers also manage the differences in lead times that exist in the supply chain. While original equipment manufacturers (“OEM”) and other customers often demand delivery within hours, the lead time required by primary producers can be as long as several months. Service centers also provide value to customers by aggregating purchasing, providing warehousing and distribution services to meet specific customer needs, including demanding delivery times and precise metal specifications.\\nThe principal markets served by the Company are highly competitive. Competition is based on service, quality, processing capabilities, inventory availability, timely delivery, ability to provide supply chain solutions and price. The\\n3\\nCompany competes in a highly fragmented industry. Competition in the various markets in which the Company participates comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources and some of which have more established brand names in the local markets served by the Company.\\nThe Company also competes to a lesser extent with primary metals producers who typically sell to larger customers requiring shipments of large volumes of metal.\\nIn order to capture scale efficiencies and remain competitive, many primary metal producers are consolidating their operations and focusing on their core production activities. These producers have increasingly outsourced metals distribution and inventory management to metals service centers. This process of outsourcing allows them to work with a relatively small number of intermediaries rather than many end customers. As a result, metals service centers, including the Company, are now providing a range of services for their customers, including metal purchasing, processing and supply chain solutions.\\nRecent Acquisitions\\nDuring December 2011, the Company completed its acquisition (the “Acquisition”) of Tube Supply, Inc. (“Tube Supply”), which has expanded the Company’s product offerings in the oil and gas industry. Subsequent to the acquisition, Tube Supply operated as a Limited Liability Corporation until it was merged with A. M. Castle & Co. in September of 2012. The results of Tube Supply are included in the Company’s Metals segment.\\nProcurement\\nThe Company purchases metals and plastics from many producers. Material is purchased in large lots and stocked at its service centers until sold, usually in smaller quantities and typically with some value-added processing services performed. The Company’s ability to provide quick delivery of a wide variety of specialty metals and plastic products, along with its processing capabilities and supply chain management solutions, allows customers to lower their own inventory investment by reducing their need to order the large quantities required by producers and their need to perform additional material processing services. Some of the Company’s purchases are covered by long-term contracts and commitments, which generally have corresponding customer sales agreements.\\nOrders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Deliveries are made principally by the Company’s fleet contracted through third party logistics providers. Common carrier delivery is used in areas not serviced directly by the Company’s fleet.\\nAt December 31, 2012, the Company had 1,701 full-time employees. Of these, approximately 250 are represented by collective bargaining units, principally the United Steelworkers of America and International Brotherhood of Teamsters.\\nBusiness Segments\\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly in the Company’s various public filings. Neither of the Company’s reportable segments has any unusual working capital requirements.\\nIn the last three years, the percentages of total sales of the two segments were as follows:\\n| 2012 | 2011 | 2010 |\\n| Metals | 90 | % | 90 | % | 89 | % |\\n| Plastics | 10 | % | 10 | % | 11 | % |\\n| 100 | % | 100 | % | 100 | % |\\n\\nMetals Segment\\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, nickel, stainless steel, carbon and titanium. Inventories of\\n4\\nthese products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, a service center is equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting equipment, stress relieving and annealing furnaces, surface grinding equipment, and sheet shearing equipment.\\nThe Company’s customer base is well diversified and therefore, the Company does not have dependence upon any single customer, or a few customers. Our customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms.\\nThe Company’s broad network of locations provides same or next-day delivery to most of the segment’s markets, and two-day delivery to substantially all of the remaining markets.\\nPlastics Segment\\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications.\\nThe Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\\nJoint Venture\\nThe Company holds a 50% joint venture interest in Kreher Steel Co. (“Kreher”), a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois. The Company’s equity in the earnings of this joint venture is reported separately in the Company’s consolidated statements of operations. Kreher is considered a significant subsidiary under Rule 3-09 of Regulation S-X. Therefore, its stand-alone financial statements are included in this filing.\\nAccess to SEC Filings\\nThe Company makes available free of charge on or through its Web site at www.amcastle.com the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the U.S. Securities and Exchange Commission (the “SEC”). Information on our website does not constitute part of this annual report on Form 10-K.\\nITEM 1A —\\nRisk Factors\\nOur business, financial condition, results of operations, and cash flows are subject to various risks, many of which are not exclusively within our control that may cause actual performance to differ materially from historical or projected future performance. The risks described below are not the only risks we face. Any of the following risks, as well as other risks and uncertainties not currently known to us or that we currently consider to be immaterial, could materially and adversely affect our business, financial condition, results of operations, or cash flows.\\nWe may not achieve all of the expected benefits from our restructuring and performance enhancement initiatives.\\nWe have recently begun implementing restructuring actions in our metals business, including organizational restructuring, warehouse realignments and performance improvement programs. We expect these measures will result in improvements to annualized operating profits of approximately $33.0 million once fully implemented in 2013. In addition, we continue to evaluate additional options to improve efficiency and performance of our operations. We have made certain assumptions in estimating the anticipated impact of our restructuring and performance enhancement initiatives. These assumptions may turn out to be incorrect due to a variety of factors. In addition, our ability to realize the expected benefits from these initiatives is subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control. Some of our cost saving measures may not have the impact on our operating profitability that we currently project. If we are unsuccessful in implementing these initiatives or if we do not achieve our expected results, our results of operations and cash flows could be materially adversely affected.\\n5\\nOur substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under our debt instruments.\\nWe have substantial debt service obligations. As of December 31, 2012, we had approximately $322.5 million of total debt outstanding, excluding capital lease obligations of $1.4 million, of which $264.5 million is secured. As of December 31, 2012, the Company had approximately $50.5 million of availability under our revolving credit facility. Subject to restrictions contained in the debt instruments, we may incur additional indebtedness.\\nOur substantial level of indebtedness could have significant effects on our business, including the following:\\n\\n| • | it may be more difficult for us to satisfy our financial obligations; |\\n\\n| • | our ability to obtain additional financing for working capital, capital expenditures, strategic acquisitions or general corporate purposes may be impaired; |\\n\\n| • | we must use a substantial portion of our cash flow from operations to pay interest on our indebtedness, which will reduce the funds available to use for operations and other purposes; |\\n\\n| • | our ability to fund a change of control offer under our debt instruments may be limited; |\\n\\n| • | our substantial level of indebtedness could place us at a competitive disadvantage compared to our competitors that may have proportionately less debt; |\\n\\n| • | our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate may be limited; and |\\n\\n| • | our substantial level of indebtedness may make us more vulnerable to economic downturns and adverse developments in our business. |\\n\\nWe expect to obtain the funds to pay our expenses and to repay our indebtedness primarily from our operations and, in the case of our indebtedness, from the refinancing thereof. Our ability to meet our expenses and make these payments therefore depends on our future performance, which will be affected by financial, business, economic and other factors, many of which we cannot control. Our business may not generate sufficient cash flow from operations in the future, and our currently anticipated growth in revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. If we do not have enough funds, we may be required to refinance all or part of our then existing debt, sell assets or borrow more funds, which we may not be able to accomplish on terms acceptable to us, or at all. In addition, the terms of existing or future debt agreements may restrict us from pursuing any of these alternatives.\\nOur debt instruments impose significant operating and financial restrictions, which may prevent us from pursuing certain business opportunities and taking certain actions and our failure to comply with the covenants contained in our debt instruments could result in an event of default that could adversely affect our operating results.\\nOur debt agreements impose, and future debt agreements may impose, operating and financial restrictions on us. These restrictions limit or prohibit, among other things, our ability to:\\n\\n| • | incur additional indebtedness unless certain financial tests are satisfied or issue disqualified capital stock; |\\n\\n| • | pay dividends, redeem subordinated debt or make other restricted payments; |\\n\\n| • | make certain investments or acquisitions; |\\n\\n| • | issue stock of subsidiaries; |\\n\\n| • | grant or permit certain liens on our assets; |\\n\\n| • | enter into certain transactions with affiliates; |\\n\\n| • | merge, consolidate or transfer substantially all of our assets; |\\n\\n| • | incur dividend or other payment restrictions affecting certain of our subsidiaries; |\\n\\n| • | transfer, sell or acquire assets, including capital stock of our subsidiaries; and |\\n\\n| • | change the business we conduct. |\\n\\nThese covenants could adversely affect our ability to finance our future operations or capital needs, withstand a future downturn in our business or the economy in general, engage in business activities, including future opportunities that may be in our interest, and plan for or react to market conditions or otherwise execute our business strategies. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders or holders of such indebtedness could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. If the maturity of our indebtedness is accelerated, we may not have sufficient cash resources to satisfy our debt obligations and may not be able to continue our operations as planned.\\n6\\nWe may not be able to generate sufficient cash to service all of our existing debt service obligations, and may be forced to take other actions to satisfy our obligations under our debt agreements, which may not be successful.\\nOur annual debt service obligations until December 2015, when our revolving credit facility is scheduled to mature, will be primarily limited to interest payments on our outstanding debt securities, with an aggregate principal amount of $282.5 million, and on borrowings under our $100.0 million revolving credit facility of $39.5 million as of December 31, 2012. Our ability to make scheduled payments on or to refinance our debt obligations depends on our future financial condition and operating performance, which are subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. Our business may not generate sufficient cash flow from operations in the future and our currently anticipated levels of revenue and cash flow may not be realized, either or both of which could result in our being unable to repay indebtedness or to fund other liquidity needs. Therefore, we may not be able to maintain or realize a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness.\\nIf our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness. Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous borrowing covenants, which could further restrict our business operations. The terms of existing or future debt instruments may restrict us from adopting some of these alternatives. In addition, any failure to make payments of principal and interest on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations.\\nOur future operating results depend on the volatility of the prices of metals and plastics, which could cause our results to be adversely affected.\\nThe prices we pay for raw materials, both metals and plastics, and the prices we charge for products may fluctuate depending on many factors, including general economic conditions (both domestic and international), competition, production levels, import duties and other trade restrictions and currency fluctuations. To the extent metals and plastics prices decline, we would generally expect lower sales and possibly lower net income, depending on the timing of the price changes and the ability to pass price changes on to our customers. To the extent we are not able to pass on to our customers any increases in our raw materials prices, our operating results may be adversely affected. In addition, because we maintain substantial inventories of metals and plastics in order to meet short lead-times and the just-in-time delivery requirements of our customers, a reduction in our selling prices could result in lower profitability or, in some cases, losses, either of which could adversely impact our ability to remain in compliance with certain financial covenants contained in our debt instruments, as well as result in us incurring impairment charges.\\nDisruptions or shortages in the supply of raw materials could adversely affect our operating results and our ability to meet our customers’ demands.\\nOur business requires materials that are sourced from third party suppliers. If for any reason our primary suppliers of metals should curtail or discontinue their delivery of raw materials to us at competitive prices and in a timely manner, our operating results could suffer. Unforeseen disruptions in our supply bases could materially impact our ability to deliver products to customers. The number of available suppliers could be reduced by factors such as industry consolidation and bankruptcies affecting metals and plastics producers, or suppliers may be unwilling or unable to meet our demand due to industry supply conditions generally. If we are unable to obtain sufficient amounts of raw materials from our traditional suppliers, we may not be able to obtain such raw materials from alternative sources at competitive prices to meet our delivery schedules, which could have an adverse impact on our operating results. To the extent we have quoted prices to customers and accepted orders for products prior to purchasing necessary raw materials, or have existing contracts, we may be unable to raise the price of products to cover all or part of the increased cost of the raw materials to our customers.\\nIn some cases the availability of raw materials requires long lead times. As a result, we may experience delays or shortages in the supply of raw materials. If unable to obtain adequate and timely deliveries of required raw materials, we may be unable to timely supply customers with sufficient quantities of products. This could cause us to lose sales, incur additional costs, or suffer harm to our reputation.\\n7\\nIncreases in freight and energy prices would increase our operating costs and we may be unable to pass these increases on to our customers in the form of higher prices, which may adversely affect our operating results.\\nWe use energy to process and transport our products. The prices for and availability of energy resources are subject to volatile market conditions, which are affected by political, economic and regulatory factors beyond our control. Our operating costs increase if energy costs, including electricity, diesel fuel and natural gas, rise. During periods of higher freight and energy costs, we may not be able to recover our operating cost increases through price increases without reducing demand for our products. In addition, we typically do not hedge our exposure to higher freight or energy prices.\\nWe service industries that are highly cyclical, and any downturn in our customers’ industries could reduce our revenue and profitability.\\nMany of our products are sold to customers in industries that experience significant fluctuations in demand based on economic conditions, energy prices, consumer demand, availability of adequate credit and financing, customer inventory levels, changes in governmental policies and other factors beyond our control. As a result of this volatility in the industries we serve, when one or more of our customers' industries experiences a decline, we may have difficulty increasing or maintaining our level of sales or profitability if we are not able to divert sales of our products to customers in other industries. We have made a strategic decision to focus sales resources on certain industries, specifically the aerospace, oil and gas and heavy equipment, machine tools and general industrial equipment industries. A downturn in these industries has had, and may in the future continue to have, an adverse effect on our operating results. We are also particularly sensitive to market trends in the manufacturing sector of the North American economy.\\nA portion of our sales, particularly in the aerospace industry, are related to contracts awarded to our customers under various U.S. Government defense-related programs. Significant changes in defense spending, or in government priorities and requirements could impact the funding, or the timing of funding, of those defense programs, which could negatively impact our results of operations and financial condition.\\nOur industry is highly competitive, which may force us to lower our prices and may have an adverse effect on our operating results.\\nThe principal markets that we serve are highly competitive. Competition is based principally on price, service, quality, processing capabilities, inventory availability and timely delivery. We compete in a highly fragmented industry. Competition in the various markets in which we participate comes from a large number of value-added metals processors and service centers on a regional and local basis, some of which have greater financial resources than we do and some of which have more established brand names in the local markets we serve. We also compete to a lesser extent with primary metals producers who typically sell to very large customers requiring shipments of large volumes of metal. Increased competition could force us to lower our prices or to offer increased services at a higher cost to us, which could have an adverse effect on our operating results.\\nOur operating results are subject to the seasonal nature of our customers’ businesses.\\nA portion of our customers experience seasonal slowdowns. Historically, our revenues in the months of July, November and December have been lower than in other months because of a reduced number of shipping days and holiday or vacation closures for some customers. Consequently, our sales in the first two quarters of the year are usually higher than in the third and fourth quarters. As a result, analysts and investors may inaccurately estimate the effects of seasonality on our operating results in one or more future quarters and, consequently, our operating results may fall below expectations.\\nWe rely upon our suppliers as to the specifications of the metals we purchase from them.\\nWe rely on mill certifications that attest to the physical and chemical specifications of the metal received from our suppliers for resale and generally, consistent with industry practice, do not undertake independent testing of such metals. We rely on our customers to notify us of any metal that does not conform to the specifications certified by the supplying mill. Although our primary sources of products have been domestic mills, we have and will continue to purchase product from foreign suppliers when we believe it is appropriate. In the event that metal purchased from domestic suppliers is deemed to not meet quality specifications as set forth in the mill certifications or customer specifications, we generally have recourse against these suppliers for both the cost of the products purchased and possible claims from our customers. However, such recourse will not compensate us for the damage to our reputation that may arise from sub-standard products and possible losses of customers. Moreover, there is a greater level of risk that similar recourse will not be available to us in the event of claims by our customers related to products from foreign\\n8\\nsuppliers that do not meet the specifications set forth in the mill certifications. In such circumstances, we may be at greater risk of loss for claims for which we do not carry, or do not carry sufficient, insurance.\\nWe are vulnerable to interest rate fluctuations on our indebtedness, which could hurt our operating results.\\nWe are exposed to various interest rate risks that arise in the normal course of business. We finance our operations with fixed and variable rate borrowings. Market risk arises from changes in variable interest rates. Under our revolving credit facility, our interest rate on borrowings is subject to changes based on fluctuations in the LIBOR and prime rates of interest. If interest rates significantly increase, we could be unable to service our debt which could have an adverse effect on our operating results.\\nWe operate in international markets, which expose us to a number of risks.\\nAlthough a substantial majority of our business activity takes place in the United States, we serve and operate in certain international markets, which expose us to political, economic and currency related risks, including the following:\\n| • | potential for adverse change in the local political or social climate or in government policies, laws and regulations; |\\n\\n| • | difficulty staffing and managing geographically diverse operations and the application of foreign labor regulations; |\\n\\n| • | restrictions on imports and exports or sources of supply; |\\n\\n| • | currency exchange rate risk; and |\\n\\n| • | change in duties and taxes. |\\n\\nWe operate in Canada, Mexico, France, and the United Kingdom, with limited operations in Singapore and China. An act of war or terrorism or major pandemic event could disrupt international shipping schedules, cause additional delays in importing our products into the United States or increase the costs required to do so. In addition, acts of crime or violence in these international markets (for example, in Mexico) could adversely affect our operating results. Fluctuations in the value of the U.S. dollar versus foreign currencies could reduce the value of these assets as reported in our financial statements, which could reduce our stockholders' equity. If we do not adequately anticipate and respond to these risks and the other risks inherent in international operations, it could have a material adverse effect on our operating results.\\nWe may not be able to realize the benefits we anticipate from our acquisitions, including the Tube Supply acquisition.\\nIn December 2011 we acquired Tube Supply, Inc. We intend to continue to seek attractive opportunities to acquire other businesses in the future. Achieving the benefits of these acquisitions depends on the timely, efficient and successful execution of a number of post-acquisition events, including our integration of the acquired businesses. Factors that could affect our ability to achieve the benefits we anticipate from our acquisition include:\\n| • | difficulties in integrating and managing personnel, financial reporting and other systems used by the acquired businesses; |\\n\\n| • | the failure of the acquired businesses to perform in accordance with our expectations; |\\n\\n| • | failure to achieve anticipated synergies between our business units and the acquired businesses; |\\n\\n| • | the loss of the acquired businesses' customers; and |\\n\\n| • | cyclicality of business. |\\n\\nThe presence of any of the above factors individually or in combination could result in future impairment charges against the assets of the acquired businesses. If the acquired businesses do not operate as we anticipate, it could adversely affect our operating results and financial condition. As a result, there can be no assurance that the acquisitions, including the Tube Supply acquisition, will be successful or will not, in fact, adversely affect our business.\\nOur business could be adversely affected by a disruption to our primary distribution hub.\\nOur largest facility, in Franklin Park, Illinois, serves as a primary distribution center that ships product to our other facilities as well as external customers. Our business could be adversely impacted by a major disruption at this facility due to unforeseen developments occurring in or around the facility, such as:\\n| • | damage to or inoperability of our warehouse or related systems; |\\n\\n| • | a prolonged power or telecommunication failure; |\\n\\n| • | a natural disaster, environmental or public health issue; or |\\n\\n| • | an airplane crash or act of war or terrorism on-site or nearby as the facility is located within seven miles of O'Hare International Airport (a major U.S. airport) and lies below certain take-off and landing flight patterns. |\\n\\n9\\nA prolonged disruption of the services and capabilities of our Franklin Park facility and operation could adversely impact our operating results.\\nDamage to or a disruption in our information technology systems could impact our ability to conduct business and/or report our financial performance.\\nOver the last several years we have been implementing a new enterprise-wide resources planning (''ERP'') system. While we have completed the conversions of substantially all of our North American and European locations onto the new ERP system, we can provide no assurance that the continued phased-implementation at our remaining facilities, including Tube Supply, will be successful or will occur as planned. Difficulties associated with the design and implementation of the new ERP system could adversely affect our business, our customer service and our operating results.\\nWe rely on information technology systems to provide inventory availability to our sales and operating personnel, improve customer service through better order and product reference data and monitor operating results. Difficulties associated with upgrades or integration with new systems could lead to business interruption that could harm our reputation, increase our operating costs and decrease profitability. In addition, any significant disruption relating to our current or new information technology systems, whether due from such things as fire, flood, tornado and other natural disasters, power loss, network failures, loss of data, security breaches and computer viruses, or otherwise, may have an adverse effect on our business, our operating results and our ability to report our financial performance in a timely manner.\\nA portion of our workforce is represented by collective bargaining units, which may lead to work stoppages.\\nAs of December 31, 2012, approximately 15% of our U.S. employees were represented by unions under collective bargaining agreements, including hourly warehouse employees at our primary distribution center in Franklin Park, Illinois. As these agreements expire, there can be no assurance that we will succeed in concluding collective bargaining agreements with the union to replace those that expire. Although we believe that our labor relations have generally been satisfactory, we cannot predict how stable our relationships with these labor organizations will be or whether we will be able to meet union requirements without impacting our operating results and financial condition. The unions may also limit our flexibility in dealing with our workforce. Work stoppages and instability in our union relationships could negatively impact the timely processing and shipment of our products, which could strain relationships with customers and adversely affect our operating results.\\nAn impairment or restructuring charge could have an adverse effect on our operating results.\\nWe continue to evaluate opportunities to reduce costs and improve operating performance. These actions could result in restructuring and related charges, including but not limited to asset impairments, employee termination costs, charges for pension benefits, and pension curtailments that could be significant, which could adversely affect our financial condition and results of operations.\\nWe have a significant amount of long-lived assets, including goodwill and intangible assets. We review the recoverability of goodwill annually or whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. We review the recoverability of definite lived intangible assets and other long-lived assets whenever significant events or changes occur which might impair the recovery of recorded costs, making certain assumptions regarding future operating performance. The results of these calculations may be affected by the current or further declines in the market conditions for our products, as well as interest rates and general economic conditions. If impairment is determined to exist, we will incur impairment losses, which will have an adverse effect on our operating results and our ability to remain in compliance with certain financial covenants contained in our debt instruments.\\nWe could incur substantial costs in order to comply with, or to address any violations under, environmental and employee health and safety laws, which could adversely affect our operating results.\\nOur operations are subject to various environmental statutes and regulations, including laws and regulations governing materials we use. In addition, certain of our operations are subject to international, federal, state and local environmental laws and regulations that impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. Our operations are also subject to various employee safety and health laws and regulations, including those concerning occupational injury and illness, employee exposure to hazardous materials and employee complaints. Certain of our facilities are located in industrial areas, have a history of heavy industrial use and have been in operation for many years and, over time, we and other\\n10\\npredecessor operators of these facilities have generated, used, handled and disposed of hazardous and other regulated wastes. Currently unknown cleanup obligations at these facilities, or at off-site locations at which materials from our operations were disposed, could result in future expenditures that cannot be currently quantified but which could have an adverse effect on our operating results.\\nWe may face risks associated with current or future litigation and claims.\\nFrom time to time, we are involved in a variety of lawsuits, claims and other proceedings relating to the conduct of our business. These suits concern issues including contract disputes, employment actions, employee benefits, taxes, environmental, health and safety, personal injury and product liability matters. Due to the uncertainties of litigation, we can give no assurance that we will prevail on all claims made against us in the lawsuits that we currently face or that additional claims will not be made against us in the future. While it is not feasible to predict the outcome of all pending lawsuits and claims, we do not believe that the disposition of any such pending matters is likely to have an adverse effect on our financial condition or liquidity, although the resolution in any reporting period of one of more of these matters could have an adverse effect on our operating results for that period. Also, we can give no assurance that any other lawsuits or claims brought in the future will not have an adverse effect on our financial condition, liquidity or operating results.\\nPotential environmental legislative and regulatory actions could impose significant costs on the operations of our customers and suppliers, which could have a material adverse impact on our results of operations, financial condition and cash flows.\\nClimate change regulation or some form of legislation aimed at reducing greenhouse gas (''GHG'') emissions is currently being considered in the United States as well as globally. As a metals and plastics distributor, our operations do not emit significant amounts of GHG. However, the manufacturing processes of many of our suppliers and customers are energy intensive and generate carbon dioxide and other GHG emissions. Any adopted future climate change and GHG regulations may impose significant costs on the operations of our customers and suppliers and indirectly impact our operations.\\nThe Tube Supply acquisition significantly extends our exposure in the oil and gas sector to customers who utilize non-traditional drilling techniques, including hydraulic fracturing. Hydraulic fracturing is an important and commonly used process for the completion of natural gas, and to a lesser extent, oil wells in shale formations. Certain environmental and other groups have asserted that chemicals used in the fracturing process could adversely affect drinking water supplies. The U.S. Congress and various state and local governments are considering increased regulatory oversight of the hydraulic fracturing process, including through additional permit requirements, operational restrictions, reporting obligations and temporary or permanent bans on hydraulic fracturing in certain environmentally sensitive areas such as watersheds. We cannot predict whether such laws or regulations will be enacted and, if so, what actions any such laws or regulations would require or prohibit. Additional levels of regulatory oversight on, or otherwise limiting, the hydraulic fracturing process could subject the business and operations of our oil and gas customers to delays, increased operating costs and process prohibitions, and indirectly impact our oil and gas business through reduced demand for our products.\\nUntil the timing, scope and extent of any future regulation becomes known, we cannot predict the effect on our results of operations, financial condition and cash flows.\\nCommodity hedging transactions may expose us to loss or limit our potential gains.\\nWe have entered into certain fixed price sales contracts with customers which expose us to risks associated with fluctuations in commodity prices. As part of our risk management program, we may use financial instruments from time-to-time to mitigate all or portions of these risks, including commodity futures, forwards or other derivative instruments. While intended to reduce the effects of the commodity price fluctuations, these transactions may limit our potential gains or expose us to losses. Also, should our counterparties to such transactions fail to honor their obligations due to financial distress we would be exposed to potential losses or the inability to recover anticipated gains from these transactions.\\nOwnership of our stock is concentrated, which may limit stockholders’ ability to influence corporate matters.\\nAs of December 31, 2012, based on filings made with the SEC and other information made available to us as of that date, we believe Patrick J. Herbert, III, one of our directors, may be deemed to beneficially own approximately 22.8% of our common stock. Accordingly, Mr. Herbert and his affiliates may have the voting power to substantially control the outcome of matters requiring a stockholder vote including the election of directors and the approval of significant\\n11\\ncorporate matters. Such a concentration of control could adversely affect the market price of our common stock or prevent a change in control or other business combinations that might be beneficial to us.\\nWe have various mechanisms in place that may prevent a change in control that stockholders may otherwise consider favorable.\\nOn August 31, 2012, our Board of Directors adopted a shareholder rights plan pursuant to which one purchase right was distributed as a dividend on each share of our common stock held of record as of the close of business on September 11, 2012. Upon becoming exercisable, each right will entitle its holder to purchase from the Company one one-hundredth of a share of our Series B Junior Preferred Stock for the purchase price of $54.00. Generally, the rights will become exercisable ten days after the date on which any person or group becomes the beneficial owner of 10% or more of our common stock or has commenced a tender or exchange offer which, if consummated, would result in any person or group becoming the beneficial owner of 10% or more of our common stock, subject to the terms and conditions set forth in the shareholder rights plan. The rights are attached to the certificates representing outstanding shares of common stock until the rights become exercisable, at which point separate certificates will be distributed to the record holders of our common stock. If a person or group becomes the beneficial owner of 10% or more of our common stock, which we refer to as an “acquiring person,” each right will entitle its holder, other than the acquiring person, to receive upon exercise a number of shares of our common stock having a market value of two times the purchase price of the right.\\nThe shareholder rights plan is designed to deter coercive takeover tactics and to prevent an acquirer from gaining control of the Company without offering a fair price to all of our stockholders. The existence of the shareholder rights plan, however, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding common stock, and thereby adversely affect the market price of our common stock.\\nIn addition, our charter and by-laws and the Maryland General Corporation Law, or the MGCL, include provisions that may be deemed to have antitakeover effects and may delay, defer or prevent a takeover attempt that stockholders might consider to be in their best interests. For example, the MGCL, our charter and bylaws require the approval of the holders of two-thirds of the votes entitled to be cast on the matter to amend our charter (unless our Board of Directors has unanimously approved the amendment, in which case the approval of the holders of a majority of such votes is required), contain certain advance notice procedures for nominating candidates for election to our Board of Directors, and permit our Board of Directors to issue up to 9.988 million shares of preferred stock.\\nFurthermore, we are subject to the anti-takeover provisions of the MGCL that prohibit us from engaging in a “business combination” with an “interested stockholder” for a period of five years after the date of the transaction in which the person first becomes an “interested stockholder,” unless the business combination or stockholder interest is approved in a prescribed manner. The application of these and certain other provisions of our charter could have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.\\nThe provisions of our debt instruments also contain limitations on our ability to enter into change of control transactions. In addition, the repurchase rights in our 7.0% convertible senior notes due 2017 (“Convertible Notes”) triggered by the occurrence of a “fundamental change” (as defined in the indenture for the Convertible Notes), and the additional shares of our common stock by which the conversion rate is increased in connection with certain fundamental change transactions, as described in the indenture for the Convertible Notes, could discourage a potential acquirer.\\nWe may not have the cash necessary to satisfy our cash obligations under our Convertible Notes.\\nAs of December 31, 2012, we had approximately $57.5 million of aggregate principal amount outstanding under the Convertible Notes. The Convertible Notes bear cash interest semiannually at a rate of 7.0% per year, and mature on December 15, 2017. Upon the occurrence of a fundamental change (as defined in the indenture for the Convertible Notes), we may be required to repurchase some or all of the Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest up to but excluding the relevant fundamental change repurchase date. We may not have sufficient funds to satisfy such cash obligations and, in such circumstances, may not be able to arrange the necessary financing on favorable terms or at all. In addition, our ability to satisfy such cash obligations will be restricted pursuant to covenants contained in the indenture for the Convertible Notes and will be permitted to be paid only in limited circumstances. We may also be limited in our ability to satisfy such cash obligations by applicable law or the terms of other instruments governing our indebtedness. Our inability to make cash payments to satisfy our obligations described above would trigger an event of default under the Convertible Notes, which in turn could constitute an event of default under any of our outstanding indebtedness, thereby resulting in the acceleration of such indebtedness, the prepayment of which could further restrict our ability to satisfy such cash obligations.\\n12\\nThe conditional conversion features of our Convertible Notes, if triggered, may adversely affect our financial condition and operating results.\\nIn the event the conditional conversion features of the Convertible Notes are triggered, holders of the Convertible Notes will be entitled to convert the Convertible Notes at any time during specified periods at their option. If one or more holders elect to convert their Convertible Notes, and we elect or are deemed to have elected cash settlement or combination settlement, we would be required to pay cash to satisfy all or a portion of our conversion obligation for such Convertible Notes, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their Convertible Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Convertible Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.\\nITEM 1B —\\nUnresolved Staff Comments\\nNone.\\nITEM 2 —\\nProperties\\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. All properties and equipment are sufficient for the Company’s current level of activities. Distribution centers and sales offices are maintained at each of the following locations, most of which are leased, except as indicated:\\n| Locations | ApproximateFloor Area inSquare Feet |\\n| Metals Segment |\\n| North America |\\n| Bedford Heights, Ohio | 374,400 | (1) |\\n| Birmingham, Alabama | 76,000 | (1) |\\n| Blaine, Minnesota | 65,200 | (1) |\\n| Charlotte, North Carolina | 116,500 | (1) |\\n| Edmonton, Alberta | 87,103 |\\n| Fairless Hills, Pennsylvania | 71,600 | (1) |\\n| Franklin Park, Illinois | 522,600 | (1) |\\n| Gardena, California | 117,000 |\\n| Grand Prairie, Texas | 78,000 | (1) |\\n| Hammond, Indiana (H-A Industries) | 243,000 |\\n| Houston, Texas | 383,100 | (3) |\\n| Kansas City, Missouri | 118,000 |\\n| Kennesaw, Georgia | 87,500 |\\n| Kent, Washington | 53,000 |\\n| Lafayette, Louisiana | 5,000 |\\n| Mississauga, Ontario | 57,000 |\\n| Orange, Connecticut | 57,389 |\\n| Paramount, California | 155,500 |\\n| Point Claire, Quebec | 38,760 |\\n| Santa Cantarina, Nuevo Leon, Mexico | 112,000 |\\n| Saskatoon, Saskatchewan | 15,000 |\\n| Selkirk, Manitoba | 50,000 | (1) |\\n| Stockton, California | 60,000 |\\n| Twinsburg, Ohio | 120,000 |\\n| Wichita, Kansas | 95,000 |\\n\\n13\\n| Locations | ApproximateFloor Area inSquare Feet |\\n| Worcester, Massachusetts | 53,500 | (1) |\\n| Europe |\\n| Blackburn, England | 62,139 |\\n| Letchworth, England | 40,000 |\\n| Trafford Park, England | 30,000 |\\n| Montoir de Bretagne, France | 38,944 |\\n| Asia |\\n| Shanghai, China | 45,700 |\\n| Sales Offices |\\n| Bilbao, Spain | (Intentionally left blank) |\\n| Fairfield, Ohio |\\n| Milwaukee, Wisconsin |\\n| Phoenix, Arizona |\\n| Singapore |\\n| Tulsa, Oklahoma |\\n| Total Metals Segment | 3,428,935 |\\n| Plastics Segment |\\n| Baltimore, Maryland | 24,000 |\\n| Cleveland, Ohio | 8,600 |\\n| Cranston, Rhode Island | 14,990 |\\n| Detroit, Michigan | 22,000 |\\n| Elk Grove Village, Illinois | 22,500 |\\n| Fort Wayne, Indiana | 17,600 |\\n| Grand Rapids, Michigan | 42,500 | (1) |\\n| Harrisburg, Pennsylvania | 13,900 |\\n| Indianapolis, Indiana | 13,500 |\\n| Kalamazoo, Michigan | 81,000 |\\n| Knoxville, Tennessee | 16,530 |\\n| Maple Shade, New Jersey | 12,480 |\\n| Mt. Vernon, New York | 30,000 |\\n| New Philadelphia, Ohio | 15,700 |\\n| Pittsburgh, Pennsylvania | 12,800 |\\n| Rockford, Michigan | 53,600 |\\n| Tampa, Florida | 17,700 |\\n| Worcester, Massachusetts | 2,500 | (1) |\\n| Total Plastics Segment | 421,900 |\\n| Headquarters |\\n| Oak Brook, Illinois | 39,360 | (2) |\\n| GRAND TOTAL | 3,890,195 |\\n\\n| (1) | Represents owned facility. |\\n\\n| (2) | The Company’s principal executive offices do not include a distribution or sales office. |\\n\\n| (3) | Represents two leased facilities (274,000 square feet) and one owned facility (109,100 square feet). |\\n\\n14\\nITEM 3 —\\nLegal Proceedings\\n(Amounts in thousands)\\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\\nGovernment Proceeding\\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning. While the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\\nITEM 4 —\\nMine Safety Disclosures\\nNot applicable.\\nExecutive Officers of The Registrant\\nThe following selected information for each of our current executive officers (as defined by regulations of the SEC) was prepared as of March 4, 2013.\\n| Name and Title | Age | Business Experience |\\n| Patrick R. AndersonVice President, CorporateController and Chief Accounting Officer | 41 | Mr. Anderson began his employment with the registrant in 2007 and was elected to the position of Vice President, Corporate Controller and Chief Accounting Officer. Prior to joining the registrant, he was employed as a Senior Manager with Deloitte & Touche LLP (a global accounting firm) where he was employed from 1994 to 2007. |\\n| Scott J. DolanPresident and Chief Executive Officer | 42 | Mr. Dolan most recently served as Senior Vice President, Airport Operations and Cargo, of United Continental Holdings, Inc. (a $37 billion publicly traded provider of passenger and cargo air transportation services), and its principal wholly-owned subsidiaries, United Airlines and Continental Airlines, from 2010 to 2011. From 2004 until 2010, Mr. Dolan served as Senior Vice President, Airport Operations and President, United Cargo (2006-2010) and as Senior Vice President and President, United Cargo (2004-2006) for UAL Corporation and its principal subsidiary, United Airlines. Mr. Dolan worked at Atlas Air Worldwide Holdings, Inc. (a global airfreight company) from 2002 to 2004, where he served as Senior Vice President and Chief Operating Officer from 2003-2004 and as Vice President, Business Integration from 2002 to 2003. Prior to joining Atlas Air, Mr. Dolan spent five years at General Electric Company, where he served in a variety of positions including Vice President, Operational Performance, Polar Air Cargo, a subsidiary of GE Capital Aviation Services. |\\n\\n15\\n| Name and Title | Age | Business Experience |\\n| Thomas L. GarrettVice President andPresident, Total Plastics, Inc. | 50 | Mr. Garrett began his employment with Total Plastics, Inc., a wholly owned subsidiary of the registrant, in 1988 and was appointed to the position of Controller. In 1996, he was elected to the position of Vice President and in 2001 was appointed to the position of Vice President of the registrant and President of Total Plastics, Inc. |\\n| Kevin H. GlynnVice Presidentand Chief Information Officer | 49 | Mr. Glynn began his employment with the registrant in October 2010 as the Interim Chief Information Officer. In January 2011 he was appointed Vice President and Chief Information Officer. Prior to joining the registrant, he was employed as a Managing Principal at Laminar Group LLC (a management consulting company) from 2009 to 2010, Chief Operating Officer at IRON Solutions, Inc. (an information technology company specializing in data, software and media services for the agriculture equipment market) from 2008 to 2009 and as Senior Vice President and Chief Information Officer at CNH America, LLC (a manufacturer of agricultural and construction equipment) from 2006 to 2007. |\\n| Robert J. PernaVice President,General Counsel and Secretary | 49 | Mr. Perna began his employment with the registrant in 2008 and was elected to the position of Vice President-General Counsel and Secretary. Prior to joining the registrant he was General Counsel, North America, CNH America, LLC (a manufacturer of agricultural and construction equipment) since 2007, and he also served as Associate General Counsel and Corporate Secretary for Navistar International Corporation (a manufacturer of commercial trucks and diesel engines) since 2001. |\\n| Anne D. ScharmVice President, Human Resources | 36 | Ms. Scharm began her employment with the registrant in 2011 as the Director of Organizational Development. In December 2011, she was appointed as the Interim Vice President, Human Resources. In March 2012, she was appointed Vice President, Human Resources. Prior to joining the registrant, she was employed as Director of Human Resources and Organizational Development with Delnor Health System, (now known as Cadence Health - a healthcare organization) from 2006 to 2011. |\\n| Scott F. StephensVice President,Chief Financial Officer and Treasurer | 43 | Mr. Stephens began his employment with the registrant in 2008 and was elected to the position of Vice President, Chief Financial Officer, and Treasurer. From February 2010 to December 2010, he was also appointed to the position of Interim President, Castle Metals Oil & Gas. In May 2012, Mr. Stephens was elected to serve as Interim Chief Executive Officer until October 2012. Formerly, he served as the CFO of Lawson Products, Inc. (a distributor of services, systems and products to the MRO and OEM marketplace) from 2004 to 2008, and CFO of The Wormser Company from 2001 to 2004. |\\n| Blain A. TiffanyChief Commercial Officer | 54 | Mr. Tiffany began his employment with the registrant in 2000 and was appointed to the position of District Manager. He was appointed Eastern Region Manager in 2003, Vice President – Regional Manager in 2005 and in 2006 was appointed to the position of Vice President – Sales. In 2007, Mr. Tiffany was appointed to the position of Vice President, President of Castle Metals Plate. In 2009, Mr. Tiffany served as Vice President, President of Castle Metals Aerospace through 2011. In 2012, Mr. Tiffany served as Vice President, Castle Metals and in January 2013 was appointed to the position of Chief Commercial Officer. |\\n\\n16\\nPART II\\n\\nITEM 5 —\\nMarket for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\\nThe Company’s common stock trades on the New York Stock Exchange under the ticker symbol “CAS”. As of March 1, 2013 there were approximately 880 shareholders of record. Payment of cash dividends and repurchase of common stock are currently limited due to restrictions contained in the Company’s debt agreements. No cash dividends were paid on the Company’s common stock in 2012 and 2011. We may consider paying cash dividends on the Company common stock at some point in the future, subject to the limitations described above. Any future payment of cash dividends, if any, is at the discretion of the Board of Directors and will depend on the Company’s earnings, capital requirements and financial condition, restrictions under the Company’s debt instruments, and such other factors as the Board of Directors may consider.\\nSee Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”, for information regarding common stock authorized for issuance under equity compensation plans.\\nThe table below presents shares of the Company’s common stock which were acquired by the Company during the quarter ended December 31, 2012:\\n| Period | TotalNumber ofSharesPurchased(1) | AveragePricePaid perShare | Total numberof SharesPurchased asPart ofPubliclyAnnouncedPlans orPrograms | MaximumNumber (orApproximateDollar Value) of Shares that May Yet Be Purchased under the Plans or Programs |\\n| October 1 through October 31 | — | — | — | — |\\n| November 1 through November 30 | — | — | — | — |\\n| December 1 through December 31 | 24,469 | $ | 14.77 | — | — |\\n| Total | 24,469 | $ | 14.77 | — | — |\\n\\n| (1) | The total number of shares purchased represents shares surrendered to the Company by employees to satisfy tax withholding obligations upon vesting of restricted stock units awarded pursuant to the Company’s 2010 - 2012 Long-Term Compensation Plan. |\\n\\nOn October 15, 2012 the Company granted 78,492 restricted stock units to Scott J. Dolan, President and Chief Executive Officer, as an equity inducement award. The restricted stock units subject to the inducement award will vest in four equal annual installments, subject to Mr. Dolan's continued employment by the Company. At the time of vesting, the Company will issue to Mr. Dolan in cancellation of the restricted stock units, the number of shares of common stock of the Company equal to the number of restricted stock units. The inducement award was granted outside of the Company's 2008 Omnibus Incentive Plan, authorized by the independent members of the Human Resources Committee of the Company's Board of Directors and granted as an inducement material to Mr. Dolan's employment with the Company in accordance with Section 303A.08 of the New York Stock Exchange Listed Company Manual. The issuance of these shares of restricted stock units was made in reliance upon the exemptions form registration provided by Section 4(2) under the Securities Act of 1933, as amended.\\nThe following table sets forth the range of the high and low sales prices of shares of the Company’s common stock for the periods indicated:\\n| 2012 | 2011 |\\n| Low | High | Low | High |\\n| First Quarter | $ | 9.59 | $ | 12.90 | $ | 15.14 | $ | 19.29 |\\n| Second Quarter | $ | 9.65 | $ | 14.20 | $ | 15.25 | $ | 19.24 |\\n| Third Quarter | $ | 6.99 | $ | 13.54 | $ | 10.37 | $ | 18.46 |\\n| Fourth Quarter | $ | 10.83 | $ | 14.97 | $ | 7.85 | $ | 14.91 |\\n\\n17\\nThe following graph compares the cumulative total stockholder return on our common stock for the five-year period ended December 31, 2012, with the cumulative total return of the Standard and Poor’s 500 Index and to a peer group index. The comparison in the graph assumes the investment of $100 on December 31, 2007. Cumulative total stockholder return means share price increases or decreases plus dividends paid, with the dividends reinvested, and reflect market capitalization weighting. The graph does not forecast future performance of our common stock. The Company moved to a new peer group index during 2010 in conjunction with the establishment of a relative total shareholder return performance measure under the Company’s long term compensation plan. The Company believes this new peer group provides a more meaningful comparison of our stock performance. The new peer group index is made up of companies in the metals industry or in the industrial products distribution business, although not all of the companies included in the new peer group index participate in all of the lines of business in which the Company is engaged and some of the companies included in the peer group index also engage in lines of business in which the Company does not participate. Additionally, the market capitalizations of many of the companies in the peer group are quite different from that of the Company.\\nCOMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*\\nAmong A.M. Castle & Co., the S&P 500 Index, and a Peer Group\\n*$100 invested on 12/31/07 in stock or index, including reinvestment of dividends.\\nFiscal year ending December 31.\\nCopyright© 2013 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved.\\n| 12/07 | 12/08 | 12/09 | 12/10 | 12/11 | 12/12 |\\n| A. M. Castle & Co. | $ | 100.00 | $ | 40.32 | $ | 51.30 | $ | 68.99 | $ | 35.45 | $ | 55.35 |\\n| S&P 500 | 100.00 | 63.00 | 79.67 | 91.67 | 93.61 | 108.59 |\\n| Peer Group (a) | 100.00 | 51.46 | 69.81 | 84.89 | 76.47 | 78.43 |\\n\\n\\n| (a) | The Peer Group Index consists of the following companies: AEP Industries Inc.; AK Steel Holding Corp.; Allegheny Technologies Inc.; Amcol International Corp.; Applied Industrial Technologies Inc.; Carpenter Technology Corp.; Cliffs Natural Resources Inc.; Commercial Metals Company; Fastenal Company; Gibraltar Industries Inc.; Haynes International Inc.; Kaman Corp.; Lawson Products Inc.; MSC Industrial Direct Company Inc.; Nucor Corp.; Olin Corp.; Olympic Steel, Inc.; Quanex Building Products Corp.; Reliance Steel & Aluminum Co.; RTI International Metals Inc.; Schnitzer Steel Industries Inc.; Steel Dynamics Inc.; Stillwater Mining Company; Texas Industries Inc.; United States Steel Corp.; and Worthington Industries Inc. |\\n\\n18\\nITEM 6 —\\nSelected Financial Data\\nThe Selected Financial Data in the table below includes the results of the December 2011 and January 2008 acquisitions of Tube Supply and Metals U.K., respectively, from the date of acquisition.\\n| (dollars in millions, except per share data) | 2012 | 2011 | 2010 | 2009 | 2008 |\\n| For the year ended December 31: |\\n| Net sales | $ | 1,270.4 | $ | 1,132.4 | $ | 943.7 | $ | 812.6 | $ | 1,501.0 |\\n| Equity in earnings of joint venture | 7.2 | 11.7 | 5.6 | 0.4 | 8.8 |\\n| Net loss from continuing operations | (9.7 | ) | (1.8 | ) | (5.6 | ) | (26.9 | ) | (17.1 | ) |\\n| Basic (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\\n| Diluted (loss) earnings per common share from continuing operations | (0.42 | ) | (0.08 | ) | (0.25 | ) | (1.18 | ) | (0.76 | ) |\\n| Cash dividends declared per common share | — | — | — | 0.06 | 0.24 |\\n| As of December 31: |\\n| Total assets | 788.8 | 822.3 | 529.4 | 558.0 | 679.0 |\\n| Long-term debt, less current portion | 296.2 | 314.2 | 61.1 | 67.7 | 75.0 |\\n| Total debt | 297.1 | 314.9 | 69.1 | 89.2 | 117.1 |\\n| Total stockholders’ equity | 337.3 | 312.3 | 313.5 | 318.2 | 347.3 |\\n\\nITEM 7 —\\nManagement’s Discussion and Analysis of Financial Condition and Results of Operations\\nAmounts in millions except per share data\\nInformation regarding the business and markets of A.M. Castle & Co. and its subsidiaries (the “Company”), including its reportable segments, is included in Item 1 “Business” of this annual report on Form 10-K.\\nThe following discussion should be read in conjunction with Item 6 “Selected Financial Data” and the Company’s consolidated financial statements and related notes thereto in Item 8 “Financial Statements and Supplementary Data”.\\nEXECUTIVE OVERVIEW\\nThe Company’s strategy is to become the foremost global provider of specialty metals products and services and specialized supply chain solutions to targeted global industries.\\nDuring 2012, the following significant events occurred which impacted the Company’s operations and/or financial results:\\n\\n| • | Lower LIFO charges and the inclusion of Tube Supply's activity in 2012 resulted in decreased cost of materials as a percentage of sales to 73.0% in 2012 compared to 74.7% in 2011; |\\n\\n| • | Increased operating income as a percentage of sales to 3.2%, up from 0.5% in 2011; |\\n\\n| • | Expanded operations in the United Kingdom to support the continued increase in aerospace defense program business; and |\\n\\n| • | In the first four months of 2012, the Company recognized $15.6 million of interest expense related to the mark-to-market adjustment on the conversion option associated with the convertible debt. In April, the Company reclassified the cumulative value of the conversion option associated with the convertible debt to additional paid-in capital as a result of the authorization of additional shares of common stock and the conversion option is no longer required to be marked-to-market through earnings. |\\n\\nRecent Market and Pricing Trends\\nThe Company experienced decreased demand from its customer base during the second half of 2012 in the Metals segment as customer buying patterns slowed to reflect a more cautious outlook. Industry data indicates that U.S. service center steel shipments were higher than 2011 levels by approximately 1%, while U.S. service center aluminum shipments were approximately 1% lower in 2012 compared to 2011 levels. Virtually all key end-use\\n19\\nmarkets experienced decreases in demand in the Company’s Metals segment during 2012. The Plastics segment experienced an increase in demand for its products in 2012 compared to 2011, reflecting continued strength in the automotive sector. Due to the late-cycle nature of the Company’s targeted customers, results typically lag the general economic cycle by twelve months.\\nPricing across the majority of the Company’s markets started strong during 2012 and then softened for the majority of the year. The combination of factors above negatively impacted the Company’s operating results during the last three quarters of 2012.\\nChanges in pricing can have a more direct impact on the Company’s operating results than changes in volume due to certain factors including but not limited to:\\n\\n| • | Changes in volume typically result in corresponding changes to the Company’s variable costs. However, as pricing changes occur, variable expenses are not directly impacted. |\\n\\n| • | If surcharges are not passed through to the customer or are passed through without a mark-up, the Company’s profitability will be adversely impacted. |\\n\\nCurrent Business Outlook\\nManagement uses the Purchasing Managers Index (‘PMI’) provided by the Institute for Supply Management (website is www.ism.ws) as an external indicator for tracking the demand outlook and possible trends in its general manufacturing markets. The table below shows PMI trends from the first quarter of 2010 through the fourth quarter of 2012. Generally speaking, according to the ISM, an index above 50.0 indicates growth in the manufacturing sector of the U.S. economy, while readings under 50.0 indicate contraction.\\n| YEAR | Qtr 1 | Qtr 2 | Qtr 3 | Qtr 4 |\\n| 2010 | 58.2 | 58.8 | 55.4 | 56.8 |\\n| 2011 | 61.1 | 56.4 | 51.0 | 52.4 |\\n| 2012 | 53.3 | 52.7 | 50.3 | 50.6 |\\n\\nMaterial pricing and demand in both the Metals and Plastics segments of the Company’s business have historically proven to be difficult to predict with any degree of accuracy. A favorable PMI trend suggests that demand for some of the Company’s products and services, in particular those that are sold to the general manufacturing customer base in the U.S., could potentially be at a higher level in the near-term. The PMI trended upward from late 2012 levels in the first two months of 2013 to 53.1 in January and 54.2 in February. The Company believes that its revenue trends typically correlate to the changes in PMI on a six to twelve month lag basis.\\nRESULTS OF OPERATIONS: YEAR-TO-YEAR COMPARISONS AND COMMENTARY\\nOur discussion of comparative period results is based upon the following components of the Company’s consolidated statements of operations.\\nNet Sales —The Company derives its sales from the processing and delivery of metals and plastics. Pricing is established with each customer order and includes charges for the material, processing activities and delivery. The pricing varies by product line and type of processing. From time to time the Company may enter into fixed price arrangements with customers while simultaneously obtaining similar agreements with its suppliers.\\nCost of Materials — Cost of materials consists of the costs that the Company pays suppliers for metals, plastics and related inbound freight charges, excluding depreciation and amortization which are included in operating costs and expenses discussed below. The Company accounts for inventory primarily on a last-in-first-out (“LIFO”) basis. LIFO adjustments are calculated as of December 31 of each year. The Company may enter into hedges to mitigate the risk associated with commodity price fluctuations. Gains and losses which result from marking the hedge contracts to market are recorded in cost of materials.\\nOperating Costs and Expenses — Operating costs and expenses primarily consist of:\\n\\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\\n\\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\\n\\n20\\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily related to accounting and legal advisory services, bad debt expense, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\\n\\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\\n\\n2012 Results Compared to 2011\\nAs a result of the acquisition of Tube Supply in December 2011, the full year results were included in the Company's Metals segment during 2012.\\nConsolidated results by business segment are summarized in the following table for years 2012 and 2011.\\nOperating Results by Segment\\n| Year Ended December 31, | Fav / (Unfav) |\\n| 2012 | 2011 | $ Change | % Change |\\n| Net Sales |\\n| Metals | $ | 1,143.9 | $ | 1,014.2 | $ | 129.7 | 12.8 | % |\\n| Plastics | 126.5 | 118.2 | 8.3 | 7.0 | % |\\n| Total Net Sales | $ | 1,270.4 | $ | 1,132.4 | $ | 138.0 | 12.2 | % |\\n| Cost of Materials |\\n| Metals | $ | 836.3 | $ | 763.0 | $ | (73.3 | ) | (9.6 | )% |\\n| % of Metals Sales | 73.1 | % | 75.2 | % |\\n| Plastics | 91.0 | 82.6 | (8.4 | ) | (10.2 | )% |\\n| % of Plastics Sales | 71.9 | % | 69.9 | % |\\n| Total Cost of Materials | $ | 927.3 | $ | 845.6 | $ | (81.7 | ) | (9.7 | )% |\\n| % of Total Sales | 73.0 | % | 74.7 | % |\\n| Operating Costs and Expenses |\\n| Metals | $ | 257.8 | $ | 237.7 | $ | (20.1 | ) | (8.5 | )% |\\n| Plastics | 32.3 | 32.7 | 0.4 | 1.2 | % |\\n| Other | 11.9 | 11.2 | (0.7 | ) | (6.3 | )% |\\n| Total Operating Costs & Expenses | $ | 302.0 | $ | 281.6 | $ | (20.4 | ) | (7.2 | )% |\\n| % of Total Sales | 23.8 | % | 24.9 | % |\\n| Operating Income (Loss) |\\n| Metals | $ | 49.8 | $ | 13.5 | $ | 36.3 | 268.9 | % |\\n| % of Metals Sales | 4.4 | % | 1.3 | % |\\n| Plastics | 3.2 | 2.9 | 0.3 | 10.3 | % |\\n| % of Plastics Sales | 2.5 | % | 2.5 | % |\\n| Other | (11.9 | ) | (11.2 | ) | (0.7 | ) | (6.3 | )% |\\n| Total Operating Income | $ | 41.1 | $ | 5.2 | $ | 35.9 | 690.4 | % |\\n| % of Total Sales | 3.2 | % | 0.5 | % |\\n\\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\\nNet Sales:\\nConsolidated net sales were $1,270.4 million in 2012, an increase of $138.0 million, or 12.2%, versus 2011. Metals segment net sales during 2012 of $1,143.9 million were $129.7 million, or 12.8%, higher than 2011. Tube Supply contributed net sales of $178.5 million in 2012 compared to $7.6 million for the two-week period ended December 31, 2011. Excluding Tube Supply results, net sales for the Metals segment were $41.2 million lower in\\n21\\n2012 compared to 2011. Lower net sales were primarily the result of lower shipping volumes. Average tons sold per day, excluding Tube Supply, decreased 3.9% compared to the prior year. The decrease in demand experienced in 2012 was driven primarily by SBQ bar, carbon bar and aluminum products. Excluding Tube Supply, gains in the oil and gas business were offset by weakness in the industrial business in 2012 compared to 2011.\\nPlastics segment net sales during 2012 of $126.5 million were $8.3 million, or 7.0%, higher than 2011 primarily due to increased sales volume, reflecting continued strength in the automotive sector.\\nCost of Materials:\\nCost of materials (exclusive of depreciation and amortization) were $927.3 million, an increase of $81.7 million, or 9.7%, compared to 2011. Material costs for the Metals segment were $836.3 million or 73.1% as a percent of net sales compared to $763.0 million or 75.2% as a percent of net sales in 2011. Tube Supply cost of materials were $118.7 million in 2012 compared to $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2012 results include a $0.4 million charge associated with the realized and unrealized losses for forward contracts related to the commodity hedging program compared to a $2.4 million charge in 2011. Cost of materials for the Metals segment include a LIFO charge of $1.1 million in 2012 compared to $15.1 million in 2011. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\\nMaterial costs for the Plastics segment were 71.9% as a percent of net sales in 2012 as compared to 69.9% for the same period last year due to higher costs experienced in the automotive sector of the business.\\nOperating Expenses and Operating Income (Loss):\\nOperating costs and expenses increased $20.4 million, or 7.2%, compared to last year. Operating costs and expenses for 2012 were $302.0 million, or 23.8% as a percent of net sales, compared to $281.6 million million, or 24.9% as a percent of net sales last year. Operating costs related to Tube Supply were $32.9 million in 2012 compared to $0.9 million in 2011.\\nDuring the second quarter of 2012, the Company incurred costs associated with executive employment transition in the amount of $1.6 million. As a result of the transition, share-based awards were forfeited, which resulted in a significant increase in the Company’s forfeiture rate. The increase in the forfeiture rate estimate associated with the active Long-term Compensation Plans resulted in a decrease in sales, general and administrative cost of approximately $1.0 million. The net impact of the employment transition costs on sales, general and administrative expense was approximately $0.6 million.\\nThe increase in operating expenses for 2012 compared to 2011 primarily relates to the following:\\n\\n| • | Warehouse, processing and delivery costs increased by $13.4 million of which a $15.6 million increase is associated with the increase for Tube Supply for the period. The Tube Supply impact was offset by a $2.2 million decrease primarily attributed to a decline in workers’ compensation, overtime wage, temporary employee and utilities costs, partially offset by an increase in compensation and benefits expense as a result of headcount, merit and healthcare cost increases and rent expense due to a full year of expense for the expanded facility in Mexico, which was substantially completed in 2011 and rent expense for the new facility in Trafford Park, United Kingdom during 2012; |\\n\\n| • | Sales, general and administrative costs increased by $1.6 million of which a $9.8 million increase is associated with the increase for Tube Supply for the period. The net impact of the CEO transition costs of $0.6 million and an increase to bad debt reserves for customer bankruptcies of $0.8 million were included in the 2012 results. The 2011 results include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and $4.3 million for charges related to the acquisition of Tube Supply. The remaining decrease of $4.6 million is primarily attributed to a decline incentive compensation and other compensation and benefits costs, partially offset by an increase in workers' compensation and outside services costs; and |\\n\\n| • | Depreciation and amortization expense was $5.4 million higher than 2011 primarily due to the depreciation and amortization of Tube Supply’s fixed and intangible assets acquired in December 2011. |\\n\\nConsolidated operating income for 2012 was $41.1 million compared to $5.2 million in 2011.\\n22\\nOther Income and Expense, Income Taxes and Net Loss:\\nInterest expense was $56.7 million in 2012, an increase of $36.9 million versus 2011 as a result of interest charges on the Company’s new senior secured and convertible notes, as well as the unrealized loss for the mark-to-market adjustment on the conversion option associated with the convertible notes.\\nThe increase in interest expense for 2012 compared to the prior year is a result of the following:\\n\\n| • | Increase for the non-cash interest charge of $11.6 million associated with the mark-to-market adjustment on the conversion option associated with the convertible notes, which is not deductible for federal income tax purposes; |\\n\\n| • | Increase for interest on senior secured and convertible notes of $31.0 million; and |\\n\\n| • | Increase for amortization of deferred financing fees and debt discount of $1.1 million. |\\n\\nIn addition to items above, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million and a charge for underwriting fees associated with the debt financing of $3.4 million recorded in 2011.\\nThe Company recorded income tax expense of $1.4 million in 2012 compared to a tax benefit of $1.1 million in 2011. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2012 and 2011 was 9.2% and 7.7%, respectively. The change in the effective tax rate for 2012 compared to 2011 was primarily the result of the non-deductibility of the change in the mark-to-market adjustment on the conversion option associated with the convertible notes in the amount of $11.6 million.\\nEquity in earnings of the Company’s joint venture was $7.2 million in 2012 compared to $11.7 million in 2011. The decrease is a result of lower demand in virtually all of the joint venture’s end-use markets compared to last year.\\nConsolidated net loss for 2012 was $9.7 million, or $0.42 per diluted share, compared to net loss of $1.8 million, or $0.08 per diluted share, for 2011.\\n23\\n2011 Results Compared to 2010\\nConsolidated results by business segment are summarized in the following table for years 2011 and 2010.\\nOperating Results by Segment\\n| Year Ended December 31, | Fav / (Unfav) |\\n| 2011 | 2010 | $ Change | % Change |\\n| Net Sales |\\n| Metals | $ | 1,014.2 | $ | 841.1 | $ | 173.1 | 20.6 | % |\\n| Plastics | 118.2 | 102.6 | 15.6 | 15.2 | % |\\n| Total Net Sales | $ | 1,132.4 | $ | 943.7 | $ | 188.7 | 20.0 | % |\\n| Cost of Materials |\\n| Metals | $ | 763.0 | $ | 631.1 | $ | (131.9 | ) | (20.9 | )% |\\n| % of Metals Sales | 75.2 | % | 75.0 | % |\\n| Plastics | 82.6 | 69.8 | (12.8 | ) | (18.3 | )% |\\n| % of Plastics Sales | 69.9 | % | 68.0 | % |\\n| Total Cost of Materials | $ | 845.6 | $ | 700.9 | $ | (144.7 | ) | (20.6 | )% |\\n| % of Total Sales | 74.7 | % | 74.3 | % |\\n| Operating Costs and Expenses |\\n| Metals | $ | 237.7 | $ | 215.5 | $ | (22.2 | ) | (10.3 | )% |\\n| Plastics | 32.7 | 29.3 | (3.4 | ) | (11.6 | )% |\\n| Other | 11.2 | 7.4 | (3.8 | ) | (51.4 | )% |\\n| Total Operating Costs & Expenses | $ | 281.6 | $ | 252.2 | $ | (29.4 | ) | (11.7 | )% |\\n| % of Total Sales | 24.9 | % | 26.7 | % |\\n| Operating (Loss) Income |\\n| Metals | $ | 13.5 | $ | (5.5 | ) | $ | 19.0 | 345.5 | % |\\n| % of Metals Sales | 1.3 | % | (0.7 | )% |\\n| Plastics | 2.9 | 3.6 | (0.7 | ) | (19.4 | )% |\\n| % of Plastics Sales | 2.5 | % | 3.5 | % |\\n| Other | (11.2 | ) | (7.4 | ) | (3.8 | ) | (51.4 | )% |\\n| Total Operating (Loss) | $ | 5.2 | $ | (9.3 | ) | $ | 14.5 | 155.9 | % |\\n| % of Total Sales | 0.5 | % | (1.0 | )% |\\n\\n“Other” includes costs of executive, legal and finance departments which are shared by both segments of the Company.\\nNet Sales:\\nConsolidated net sales were $1,132.4 million in 2011, an increase of $188.7 million, or 20.0%, versus 2010. Metals segment net sales during 2011 of $1,014.2 million were $173.1 million, or 20.6%, higher than 2010. Tube Supply contributed net sales of $7.6 million for the two-week period ended December 31, 2011. Higher net sales were primarily the result of higher shipping volumes. Average tons sold per day, excluding Tube Supply, increased 18.1% compared to the prior year. The increase in demand experienced in 2011 was driven primarily by SBQ bar, alloy bar, carbon and alloy plate, stainless and tubing products. Key end-use markets that experienced increased demand in 2011 compared to 2010 include oil and gas, mining and heavy equipment and general industrial markets.\\nPlastics segment net sales during 2011 of $118.2 million were $15.6 million, or 15.2%, higher than 2010 primarily due to higher overall pricing and, to a lesser extent, increased sales volume. The Plastics business experienced increased sales volume during 2011 reflecting strength in the automotive and office furniture end-use markets compared to 2010.\\n24\\nCost of Materials:\\nCost of materials (exclusive of depreciation and amortization) were $845.6 million, an increase of $144.7 million, or 20.6%, compared to 2010. Material costs for the Metals segment were $763.0 million or 75.2% as a percent of net sales compared to $631.1 million or 75.0% as a percent of net sales in 2010. Tube Supply cost of materials were $5.3 million for the two-week period ended December 31, 2011. During 2011, the Company implemented a commodity hedging program to mitigate the risks associated with certain commodity price fluctuations. The 2011 results include a $2.4 million charge associated with the mark-to-market adjustment for forward contracts related to the commodity hedging program compared to no charge in 2010. The Metals segment recorded LIFO expense of $15.1 million in 2011 compared to $7.7 million in 2010. The remaining increase in cost of materials for the Metals segment is consistent with the sales volume increase year-over-year.\\nMaterial costs for the Plastics segment were 69.9% as a percent of net sales in 2011 as compared to 68.0% for the same period last year. The Plastics segment recorded LIFO expense of $0.9 million in 2011 compared to $0.3 million in 2010.\\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. On a consolidated basis, cost of materials for 2010 were lower by $12.5 million as a result of the liquidations.\\nOperating Expenses and Operating Income (Loss):\\nOperating costs and expenses increased $29.4 million, or 11.7%, compared to last year. Operating costs and expenses for 2011 were $281.6 million, or 24.9% as a percent of net sales, compared to $252.2 million, or 26.7% as a percent of net sales last year. Operating costs and expenses in 2011 include a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011 compared to no charge in 2010. Additionally, there were no facility consolidation charges during 2011 compared to $2.4 million in 2010.\\nFull workweeks and 401(k) matching contributions were reinstated in January and April 2010, respectively, resulting in overall increases in payroll related costs in 2011 compared to 2010. Additionally, effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation. Effective July 1, 2011, the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Other factors that contributed to increased payroll related costs in 2011 compared to 2010 included merit increases and headcount increases.\\nIn addition to payroll related costs, there were costs associated with the acquisition of Tube Supply in December 2011 of $4.3 million, as well as Tube Supply activity for the two-week period ended December 31, 2011 that contributed $0.9 million to the overall increase.\\nThe $29.4 million increase in operating expenses in 2011 compared to 2010 primarily relates to the following:\\n\\n| • | Warehouse, processing and delivery costs increased by $11.6 million of which $4.1 million is due to increased compensation and benefits expenses as a result of headcount, merit and healthcare cost increases and $7.2 million is the result of increases in charges associated with higher sales volumes, such as warehouse, packing and shipping supplies, repairs and maintenance, utilities, outside services, overtime wages and temporary help. The warehouse, processing and delivery cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million; |\\n\\n| • | Sales, general and administrative costs increased by $17.9 million. The increase is primarily comprised of $4.3 million of direct acquisition-related costs, $7.1 million as a result of headcount, merit and healthcare cost increases and a $0.9 million charge for export penalties related to product shipments that occurred from 2005 to 2008 and in 2011. The sales, general and administrative cost increase associated with Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. The balance of the difference relates other administrative expenses including training, travel and insurance; and |\\n\\n| • | Depreciation and amortization expense decreased $0.1 million in 2011 compared to 2010. The depreciation and amortization expense for Tube Supply for the two-week period ended December 31, 2011 amounted to $0.3 million. |\\n\\nConsolidated operating income for 2011 was $5.2 million compared to operating loss of $9.3 million in 2010.\\n25\\nOther Income and Expense, Income Taxes and Net Loss:\\nInterest expense was $13.7 million in 2011, an increase of $8.7 million versus 2010 as a result of charges associated with refinancing the Company’s debt in conjunction with the Tube Supply acquisition. The Company issued $225.0 million of senior secured notes and $57.5 million of convertible senior notes and entered into a $100.0 million senior secured asset based revolving credit facility.\\nInterest expense for 2011 includes the following charges:\\n\\n| • | Non-cash interest charge of $4.0 million associated with the mark-to-market adjustment for the derivative liability component of the convertible notes, which is not deductible for federal income tax purposes; |\\n\\n| • | Non-cash interest charge of $0.2 million for the amortization of new debt origination fees; |\\n\\n| • | Interest on new debt of $1.6 million; and |\\n\\n| • | Underwriting fees of $3.4 million associated with the debt financing. |\\n\\nIn addition to increased interest expense, there was a loss on extinguishment of the Company’s existing long-term notes of $6.2 million, which is comprised of a non-cash charge of $0.9 million for the write-off of existing debt issuance costs and $5.2 million for the fees associated with the prepayment of the notes.\\nThe Company recorded a tax benefit of $1.1 million in 2011 compared to a tax benefit of $3.1 million in 2010. The Company’s effective tax rate is expressed as ‘Income tax benefit’ (which includes tax expense on the Company’s share of joint venture earnings) as a percentage of ‘Loss before income taxes and equity in earnings of joint venture.’ This calculation includes taxes on the joint venture income but excludes joint venture income. The effective tax rate for 2011 and 2010 was 7.7% and 21.7%, respectively. The change in the tax rate was due primarily to the additional income tax on joint venture income compared to 2010 and the non-deductibility of the mark-to-market charge on the derivative liability component of the convertible notes.\\nEquity in earnings of the Company’s joint venture was $11.7 million in 2011 compared to $5.6 million in 2010. The increase is a result of higher demand in virtually all of the joint venture’s end-use markets, most notably the oil and gas and automotive sectors, and higher pricing compared to last year.\\nConsolidated net loss for 2011 was $1.8 million, or $0.08 per diluted share, compared to net loss of $5.6 million, or $0.25 per diluted share, for 2010.\\nLiquidity and Capital Resources\\nCash and cash equivalents decreased by $8.9 million and $6.2 million for the years ended December 31, 2012 and 2011, respectively, and increased by $8.4 million for the year ended December 31, 2010.\\nThe Company’s principal sources of liquidity are cash provided by operations and available borrowing capacity to fund working capital needs and growth initiatives. Cash provided by operations for the year-ended December 31, 2012 was $5.4 million compared to cash used in operations of $46.3 million for the year-ended December 31, 2011 and cash provided by operations of $34.4 million for the year-ended December 31, 2010. Specific components of the change in working capital are highlighted below:\\n\\n| • | During 2012, cash receipts from customers exceeded net sales resulting in a $44.6 million cash flow source due to a decrease in accounts receivable compared to a $26.4 million cash flow use due to an increase in accounts receivable for 2011. Net sales increased 12.2% from 2011. Average receivable days outstanding was 49.0 days for 2012 and 50.3 for 2011. |\\n\\n| • | During 2012, inventory purchases exceeded sales of inventory resulting in a $29.3 million cash flow use due to an increase in inventory compared to a $39.4 million cash flow use due to an increase in inventory in 2011. Average days sales in inventory was 187.0 days for 2012 verses 128.5 days for 2011. |\\n\\n| • | During 2012, cash paid for inventories and other goods and services exceeded purchases resulting in a $38.0 million cash flow use due to a net decrease in accounts payable and accrued liabilities compared to a $9.7 million cash flow source due to a net increase in accounts payable and accrued liabilities for 2011. |\\n\\n| • | The Company received its 2010 federal income tax refund of approximately $2.0 million during February 2012 and its 2009 federal income tax refund of approximately $6.3 million during January 2011. |\\n\\n26\\nIn December 2011, in conjunction with the acquisition of Tube Supply, the Company issued $225.0 million aggregate principal amount of 12.75% Senior Secured Notes due 2016, $57.5 million aggregate principal amount of 7.0% Convertible Senior Notes due 2017 and entered into a $100.0 million senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds of $304.6 million were used to complete the Acquisition, pay-off amounts outstanding under our previous credit agreement and for general corporate purposes.\\nHistorically, the Company’s primary uses of liquidity and capital resources have been capital expenditures, payments on debt (including interest payments), acquisitions and dividend payments. Management believes the Company will be able to generate sufficient cash from operations and planned working capital improvements to fund its ongoing capital expenditure programs and meet its debt obligations for at least the next twelve months. Furthermore, the Company does have available borrowing capacity under the New Revolving Credit Agreement. The new debt agreements impose significant operating and financial restrictions which may prevent the Company from certain business opportunities such as, making acquisitions or paying dividends among other things. The New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10 million. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12.5 million, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement (“cash dominion”). Based on the Company’s cash projections, it does not anticipate a scenario whereby cash dominion would occur during the next twelve months.\\nThe Company is committed to maintaining a strong financial position through maintaining sufficient levels of available liquidity, managing working capital and monitoring the Company’s overall capitalization. Cash and cash equivalents at December 31, 2012 were $21.6 million and the Company had $50.5 million of available borrowing capacity under its New Revolving Credit Facility. Approximately 23% of the Company’s consolidated cash and cash equivalents balance resides in the United States. As foreign earnings are permanently reinvested, availability under the Company’s New Revolving Credit Facility would be used to fund operations in the United States should the need arise in the future.\\nWorking capital at December 31, 2012 was $379.3 million compared to $349.0 million at December 31, 2011. The increase in working capital is primarily due to higher inventory of $31.7 million, prepaid expenses and other current assets of $4.7 million and lower accounts payable of $48.9 million, offset by lower accounts receivable of $42.7 million and lower cash of $8.9 million, from December 31, 2011 to 2012.\\nThe Company monitors its overall capitalization by evaluating total debt to total capitalization. Total debt to total capitalization is defined as the sum of short- and long-term debt, divided by the sum of total debt and stockholders’ equity. Total debt to total capitalization was 46.8% at December 31, 2012 and 50.2% at December 31, 2011. As of April 26, 2012, the conversion option value of $42.0 million associated with the convertible debt, which was issued in December 2011, was reclassified from long-term debt to additional paid-in capital, resulting in a decrease to the debt to total capitalization at December 31, 2012. The deferred tax benefit of $8.3 million associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital. Over the long-term, the Company plans to continue to improve its total debt to total capitalization by improving operating results, managing working capital and using cash generated from operations to repay outstanding debt. Going forward, as and when permitted by term of agreements noted above, depending on market conditions, the Company may decide in the future to refinance, redeem or repurchase its debt and take other steps to reduce its debt or lease obligations or otherwise improve its overall financial position and balance sheet.\\nCapital Expenditures\\nCash paid for capital expenditures for 2012 was $11.1 million compared to $11.7 million in 2011. The expenditures during 2012 were comprised of approximately $1.1 million of ERP and other information technology enhancements and $1.3 million related to existing and new facility expansions for additional automotive business in the Plastics segment and for additional aerospace defense business in the United Kingdom. The balance of the capital expenditures in 2012 are the result of normal equipment, building improvement and furniture and fixture upgrades throughout the year. Management believes that capital expenditures will approximate $14 million in 2013.\\n27\\nContractual Obligations and Other Commitments\\nThe following table includes information about the Company’s contractual obligations that impact its short-term and long-term liquidity and capital needs. The table includes information about payments due under specified contractual obligations and is aggregated by type of contractual obligation. It includes the maturity profile of the Company’s consolidated long-term debt, operating leases and other long-term liabilities.\\nAt December 31, 2012, the Company’s contractual obligations, including estimated payments by period, were as follows:\\n| Payments Due In | Total | Less Than One Year | One toThree Years | Three toFive Years | More Than Five Years |\\n| Long-term debt obligations (excluding capital lease obligations) | $ | 322.0 | $ | — | $ | 39.5 | $ | 282.5 | $ | — |\\n| Interest payments on debt obligations (a) | 137.4 | 33.6 | 67.1 | 36.7 | — |\\n| Capital lease obligations | 1.4 | 0.4 | 0.8 | 0.2 | — |\\n| Operating lease obligations | 76.7 | 14.4 | 21.5 | 16.7 | 24.1 |\\n| Purchase obligations (b) | 333.5 | 222.6 | 110.9 | — | — |\\n| Other (c) | 8.1 | 8.1 | — | — | — |\\n| Total | $ | 879.1 | $ | 279.1 | $ | 239.8 | $ | 336.1 | $ | 24.1 |\\n\\n| a) | Interest payments on debt obligations represent interest on all Company debt outstanding as of December 31, 2012. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2012. Future interest rates may change, and therefore, actual interest payments could differ from those disclosed in the table above. |\\n\\n| b) | Purchase obligations consist of raw material purchases made in the normal course of business. The Company has contracts to purchase minimum quantities of material with certain suppliers. For each contractual purchase obligation, the Company generally has a purchase agreement from its customer for the same amount of material over the same time period. |\\n\\n| c) | ‘Other’ is comprised of deferred revenues that represent commitments to deliver products and obligations related to recognizing and measuring tax positions taken or expected to be taken in a tax return that directly or indirectly affect amounts reported in financial statements. The uncertain tax positions included in the Company’s obligations are related to temporary differences and uncertain tax positions where the Company anticipates a high probability of settlement within a given timeframe. The years for which the temporary differences related to the uncertain tax positions will reverse have been estimated in scheduling the obligations within the table. |\\n\\nThe table and corresponding footnotes above do not include $10.7 million of other non-current liabilities recorded on the consolidated balance sheets. These non-current liabilities consist of liabilities related to the Company’s non-funded supplemental pension plan and postretirement benefit plans for which payment periods cannot be determined. Non-current liabilities also include $37.5 million of deferred income taxes, deferred gain on the sale of certain assets, derivative liability associated with commodity hedges and unfavorable lease liability for a lease entered into in conjunction with the Tube Supply acquisition, which was excluded from the table as the amounts due and timing of payments (or receipts) at future contract settlement dates cannot be determined.\\nPension Funding\\nThe Company’s funding policy on its defined benefit pension plans is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”). Future funding requirements are dependent upon various factors outside the Company’s control including, but not limited to, fund asset performance and changes in regulatory or accounting requirements. Based upon factors known and considered as of December 31, 2012, the Company does not anticipate making significant cash contributions to the pension plans in 2013.\\nThe investment target portfolio allocation for the Company-sponsored pension plans and supplemental pension plan focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. Refer to “Retirement Plans” within Critical Accounting Policies and Note 5 to the consolidated financial statements for additional details regarding other plan assumptions.\\nOff-Balance Sheet Arrangements\\n28\\nWith the exception of letters of credit and operating lease financing on certain equipment used in the operation of the business, it is not the Company’s general practice to use off-balance sheet arrangements, such as third-party special-purpose entities or guarantees of third parties.\\nAs of December 31, 2012, the Company had $6.8 million of irrevocable letters of credit outstanding which primarily consisted of $4.0 million for collateral associated with commodity hedges and $2.0 million for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\\nThe Company is party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\\nObligations of the Company associated with its leased equipment are disclosed under the “Contractual Obligations and Other Commitments” section above.\\nCritical Accounting Policies\\nThe consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, and include amounts that are based on management’s estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The following is a description of the Company’s accounting policies that management believes require the most significant judgments and estimates when preparing the Company’s consolidated financial statements:\\nRevenue Recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at time of shipment represents less than 3% of the Company’s consolidated net sales. Revenue from shipping and handling charges is recorded in net sales. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. Actual results could differ from these estimates. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\\nThe Company maintains an allowance for doubtful accounts resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers, which can fluctuate significantly from year to year. The Company cannot be certain that the rate of future credit losses will be similar to past experience.\\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month. If actual results differ significantly from historical experience, there could be a negative impact on the Company’s operating results.\\nIncome Taxes — The Company’s income tax expense, deferred tax assets and liabilities and reserve for uncertain tax positions reflect management’s best estimate of taxes to be paid. The Company is subject to income taxes in the U.S. and several foreign jurisdictions. The determination of the consolidated income tax expense requires judgment and estimation by management. It is possible that actual results could differ from the estimates that management has used to determine its consolidated income tax expense.\\nThe Company accounts for deferred income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\\n29\\nValuation allowances are recorded against deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83.4 million at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\\nThe Company’s investment in the joint venture is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. The joint venture has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of the income of the joint venture and its subsidiaries. The income tax liability of the joint venture itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of the joint venture is treated as deferred income tax expense. The Company can not independently cause a dividend to be declared by one of the subsidiaries of the joint venture, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of the C-Corporation subsidiaries of the joint venture declares a dividend payable to the joint venture, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\\nThe Company’s income tax provisions are based on calculations and assumptions that are subject to examination by the IRS and other tax authorities. Although the Company believes that the positions taken on previously filed tax returns are reasonable, it has established tax and interest reserves in recognition that various taxing authorities may challenge the positions taken, which could result in additional liabilities for taxes and interest. The Company regularly reviews its deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies.\\nFor uncertain tax positions, the Company applies the provisions of relevant authoritative guidance, which requires application of a “more likely than not” threshold to the recognition and derecognition of tax positions. The Company’s ongoing assessments of the more likely than not outcomes of tax authority examinations and related tax positions require significant judgment and can increase or decrease the Company’s effective tax rate as well as impact operating results.\\nRetirement Plans — The Company values retirement plan liabilities based on assumptions and valuations established by management. Future valuations are subject to market changes, which are not in the control of the Company and could differ materially from the amounts currently reported. The Company evaluates the discount rate and expected return on assets at least annually and evaluates other assumptions involving demographic factors, such as retirement age, mortality and turnover periodically, and updates them to reflect actual experience and expectations for the future. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors.\\nAccumulated and projected benefit obligations are expressed as the present value of future cash payments which are discounted using the weighted average of market-observed yields for high quality fixed income securities with maturities that correspond to the payment of benefits. Lower discount rates increase present values and subsequent-year pension expense; higher discount rates decrease present values and subsequent-year pension expense. Discount rates used for determining the Company’s projected benefit obligation for retirement plans were 3.50 - 3.75% and 4.25% at December 31, 2012 and 2011, respectively.\\nThe Company’s pension plan asset portfolio as of December 31, 2012 is primarily invested in fixed income securities with a duration of approximately 12 years. The assets generally fall within Level 2 of the fair value hierarchy. Assets in the Company’s pension plans have earned approximately 12% since 2008 when the Company changed its target investment allocation to focus primarily on fixed income securities. The target investment asset allocation for the pension plans’ funds focuses primarily on corporate fixed income securities that match the overall duration and term of the Company’s pension liability structure. As of December 31, 2012 and 2011, the funding surplus was approximately 3% and 6%, respectively. To determine the expected long-term rate of return on the pension plans’ assets, current and expected asset allocations are considered, as well as historical and expected returns on various categories of plan assets.\\n30\\nThe Company used the following weighted-average discount rates and expected return on plan assets to determine the net periodic pension credit:\\n| 2012 | 2011 |\\n| Discount rate | 4.25 | % | 5.25 | % |\\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % |\\n\\nHolding all other assumptions constant, the following table illustrates the sensitivity of changes to the discount rate and long-term rate of return assumptions on the Company’s net periodic pension credit (amounts in millions):\\n| Impact on 2012Expenses - increase (decrease) |\\n| 50 basis point decrease in discount rate | $(1.1) |\\n| 50 basis point increase in discount rate | $1.1 |\\n| 50 basis point decrease in expected return on assets | $0.9 |\\n\\nGoodwill and Other Intangible Assets Impairment — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step it to measure the amount of impairment loss, if any.\\nThe determination of the fair value of the reporting units requires significant estimates and assumptions to be made by management. The fair value of each reporting unit is estimated using a combination of an income approach, which estimates fair value based on a discounted cash flow analysis using historical data, estimates of future cash flows and discount rates based on the view of a market participant, and a market approach, which estimates fair value using market multiples of various financial measures of comparable public companies. In selecting the appropriate assumptions the Company considers: the selection of appropriate peer group companies; control premiums appropriate for acquisitions in the industry in which the Company competes; discount rates; terminal growth rates; long-term projections of future financial performance; and relative weighting of income and market approaches. The long-term projections used in the valuation are developed as part of the Company’s annual budgeting and strategic planning process. The discount rates used to determine the fair values of the reporting units are those of a hypothetical market participant which are developed based upon an analysis of comparable companies and include adjustments made to account for any individual reporting unit specific attributes such as, size and industry.\\nBased on the impairment test performed on January 1, 2012 (the Company's annual measurement date), the Company concluded that the fair values for each reporting unit exceeded the carrying values. Except for Aerospace and Oil & Gas, all other reporting units' fair values exceeded their carrying values by more than 10% as of January 1, 2012.\\nThe Company has completed its January 1, 2013 annual goodwill impairment test. As of January 1, 2013, the Aerospace and Oil & Gas reporting units had goodwill balances of approximately $21 million and $20 million, respectively, and $0 of indefinite lived intangible assets. A combination of the income approach and the market approach was utilized to estimate the reporting units' fair values. The Aerospace and Oil & Gas reporting units both had estimated fair values that exceeded carry value by less than 10%. Under the income approach, the following key assumptions were used in the Company's discounted cash flow analysis:\\n| Aerospace | Oil & Gas |\\n| Discount rate | 15.0 | % | 14.0 | % |\\n| 5-year CAGR | 4.2 | % | 1.5 | % |\\n| Terminal growth rate | 3.0 | % | 3.0 | % |\\n\\n31\\nUnder the market approach, the Company used a multiple of earnings before interest, taxes, depreciation and amortization (“EBITDA”) of 6.5 and 6.0 for Aerospace and Oil & Gas, respectively. The EBITDA multiple observed in the marketplace for recent transactions ranged from 6.0 to 8.7 with a median of 6.9 as of January 1, 2013. The Company considers several factors in estimating the EBITDA multiple including a reporting unit's market position, gross and operating margins and prospects for growth, among other factors.\\nHolding all other assumptions in the model constant, the Company has summarized what the discount rate and EBITDA multiple would have to be (holding the other variable constant) in order for the fair value of Aerospace and Oil & Gas reporting units to fall below their respective carrying value:\\n| Aerospace | Oil & Gas |\\n| Discount rate | 16.5 | % | 14.8 | % |\\n| EBITDA multiple | 5.8 | 5.6 |\\n\\nIf either reporting unit's carrying value exceeded its fair value, additional valuation procedures would have been required to determine whether the reporting unit's goodwill was impaired, and to the extent goodwill was impaired, the magnitude of the impairment charge.\\nAlthough the Company believes its estimates of fair value are reasonable, actual financial results could differ from those estimates due to the inherent uncertainty involved in making such estimates. Changes in assumptions concerning future financial results or other underlying assumptions could have a significant impact on either the fair value of the reporting units, the amount of the goodwill impairment charge, or both. Future declines in the overall market value of the Company’s equity may also result in a conclusion that the fair value of one or more reporting units has declined below its carrying value.\\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. The intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets discussed below, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\\nSee Note 8 to the consolidated financial statements for detailed information on goodwill and intangible assets.\\nLong-Lived Assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans. Measurement of an impairment loss requires a determination of fair value. The Company uses an income approach, which estimates fair value based on estimates of future cash flows discounted at an appropriate interest rate.\\nShare-Based Compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the ten trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise.\\n32\\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\\nThe grant date fair value for stock options granted during 2010 was estimated using the Black-Scholes option-pricing model with the following assumptions:\\n| 2010 |\\n| Expected volatility | 58.5 | % |\\n| Risk-free interest rate | 2.3 | % |\\n| Expected life (in years) | 5.5 |\\n| Expected dividend yield | 1.2 | % |\\n\\nShare-based compensation expense for non-vested shares and restricted share units in the long-term compensation plans (“LTC Plans”) is established using the market price of the Company’s common stock on the date of grant.\\nThe grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans were estimated using a Monte Carlo simulation with the following assumptions:\\n| 2012 | 2011 | 2010 |\\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\\n| Expected dividend yield | — | — | — |\\n\\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\\n| 2012 | 2011 | 2010 |\\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\\n| Expected dividend yield | — | — | — |\\n\\nManagement estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the LTC Plans. As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate. Final award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met.\\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company’s actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”) (as defined in the 2012 and 2011 LTC Plans). Under the 2012 LTC Plan, the non-market based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for\\n33\\nany one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, or the award will be forfeited.\\nFair Value of Financial Instruments — The three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities.\\nFair value disclosures for the Senior Secured Notes are determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy. The fair value of the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes. The estimated fair value of the derivative liability for the conversion feature, which falls within level 3 of the fair value hierarchy, is computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature. The estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which fall within level 3 of the fair value hierarchy, assumes the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015.\\nFair value of commodity hedges is based on information which is representative of readily observable market data. Derivative liabilities associated with commodity hedges are classified as Level 2 in the fair value hierarchy.\\nRecent Accounting Pronouncements\\nEffective January 1, 2012, the Company adopted new guidance that applies to the presentation of other comprehensive (loss) income, the testing of goodwill for impairment and the measurement and disclosure of fair value of assets, liabilities and instruments classified in a reporting entity’s shareholders’ equity in the financial statements.\\nSee Note 1 to the consolidated financial statements for detailed information on recent accounting pronouncements.\\n34\\nITEM 7a —\\nQuantitative and Qualitative Disclosures about Market Risk\\nThe Company is exposed to interest rate, commodity price, and foreign exchange rate risks that arise in the normal course of business.\\nInterest Rate Risk — The Company is exposed to market risk related to its fixed rate and variable rate long-term debt. We do not utilize derivative instruments to manage exposure to interest rate changes. The market value of the Company’s $282.5 million of fixed rate long-term debt may be impacted by changes in interest rates. The Company does not expect to repay its fixed rate debt prior to its scheduled maturities.\\nThe Company’s interest rates on borrowings under its $100 million four-year revolving credit facility are subject to changes in the LIBOR and prime interest rates. Borrowings under the Company’s revolving credit agreement were approximately $39.5 million as of December 31, 2012. A hypothetical 100 basis point increase on the Company’s variable rate debt would result in $0.4 million of additional interest expense on an annual basis.\\nCommodity Price Risk — The Company’s raw material costs are comprised primarily of engineered metals and plastics. Market risk arises from changes in the price of steel, other metals and plastics. Although average selling prices generally increase or decrease as material costs increase or decrease, the impact of a change in the purchase price of materials is more immediately reflected in the Company’s cost of materials than in its selling prices. The ability to pass surcharges on to customers immediately can be limited due to contractual provisions with those customers. Therefore, a lag may exist between when the surcharge impacts net sales and cost of materials, respectively, which could result in a higher or lower operating profit.\\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. If the commodity prices hedged were to decrease hypothetically by 100 basis points, the 2012 unrealized loss recorded in cost of materials would have increased by approximately $0.1 million.\\nForeign Currency Risk — The Company conducts the majority of its business in the United States but also has operations in Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company’s results of operations historically have not been materially affected by foreign currency transaction gains and losses and, therefore, the Company has no financial instruments in place for managing the exposure to foreign currency exchange rates.\\nAs a result of the new debt financing arrangements entered into during December 2011, the Company has certain outstanding intercompany borrowings denominated in the U.S. dollar at its Canadian and United Kingdom subsidiaries. These intercompany borrowings are not hedged and may cause foreign currency exposure, which could be significant, in future periods if they remain unhedged.\\n35\\nITEM 8 — Financial Statements and Supplementary Data\\nAmounts in thousands, except par value and per share data\\n| Consolidated Statements of Operations and Comprehensive Loss |\\n| Year Ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Net sales | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\\n| Costs and expenses: |\\n| Cost of materials (exclusive of depreciation and amortization) | 927,287 | 845,609 | 700,854 |\\n| Warehouse, processing and delivery expense | 148,256 | 134,898 | 123,318 |\\n| Sales, general and administrative expense | 127,813 | 126,193 | 108,223 |\\n| Depreciation and amortization expense | 25,867 | 20,472 | 20,649 |\\n| Operating income (loss) | 41,145 | 5,194 | (9,338 | ) |\\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\\n| Income taxes | (1,430 | ) | 1,126 | 3,101 |\\n| Loss before equity in earnings of joint venture | (16,972 | ) | (13,487 | ) | (11,225 | ) |\\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\\n| Dividends per common share | $ | — | $ | — | $ | — |\\n| Comprehensive loss: |\\n| Foreign currency translation gains (losses) | $ | 2,369 | $ | (941 | ) | $ | (536 | ) |\\n| Unrecognized pension and postretirement benefit costs, net of tax benefit of $2,312, $1,965 and $1,116 | (3,616 | ) | (3,071 | ) | (1,748 | ) |\\n| Other comprehensive loss | (1,247 | ) | (4,012 | ) | (2,284 | ) |\\n| Net loss | (9,748 | ) | (1,760 | ) | (5,640 | ) |\\n| Comprehensive loss | $ | (10,995 | ) | $ | (5,772 | ) | $ | (7,924 | ) |\\n\\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\\n36\\n| Consolidated Balance Sheets |\\n| December 31, |\\n| 2012 | 2011 |\\n| Assets |\\n| Current assets |\\n| Cash and cash equivalents | $ | 21,607 | $ | 30,524 |\\n| Accounts receivable, less allowances of $3,529 and $3,584 | 138,311 | 181,036 |\\n| Inventories, principally on last-in first-out basis (replacement cost higher by $139,940 and $138,882) | 303,772 | 272,039 |\\n| Prepaid expenses and other current assets | 15,092 | 10,382 |\\n| Income tax receivable | 7,596 | 8,287 |\\n| Total current assets | 486,378 | 502,268 |\\n| Investment in joint venture | 38,854 | 36,460 |\\n| Goodwill | 70,300 | 69,901 |\\n| Intangible assets | 82,477 | 93,813 |\\n| Prepaid pension cost | 12,891 | 15,956 |\\n| Other assets | 18,266 | 21,784 |\\n| Property, plant and equipment, at cost |\\n| Land | 5,195 | 5,194 |\\n| Building | 52,884 | 52,434 |\\n| Machinery and equipment | 178,664 | 172,833 |\\n| Property, plant and equipment, at cost | 236,743 | 230,461 |\\n| Less—accumulated depreciation | (157,103 | ) | (148,320 | ) |\\n| Property, plant and equipment, net | 79,640 | 82,141 |\\n| Total assets | $ | 788,806 | $ | 822,323 |\\n| Liabilities and Stockholders’ Equity |\\n| Current liabilities |\\n| Accounts payable | $ | 67,990 | $ | 116,874 |\\n| Accrued payroll and employee benefits | 11,749 | 14,792 |\\n| Accrued liabilities | 24,815 | 19,036 |\\n| Income taxes payable | 1,563 | 1,884 |\\n| Current portion of long-term debt | 415 | 192 |\\n| Short term debt | 500 | 500 |\\n| Total current liabilities | 107,032 | 153,278 |\\n| Long-term debt, less current portion | 296,154 | 314,240 |\\n| Deferred income taxes | 32,350 | 25,650 |\\n| Other non-current liabilities | 5,279 | 7,252 |\\n| Pension and post retirement benefit obligations | 10,651 | 9,624 |\\n| Commitments and contingencies |\\n| Stockholders’ equity |\\n| Preferred stock, $0.01 par value—9,988 shares authorized (including 400 Series B Junior Preferred $0.00 par value shares); no shares issued and outstanding at December 31, 2012 and December 31, 2011 | — | — |\\n| Common stock, $0.01 par value—60,000 shares authorized and 23,211 shares issued and 23,152 outstanding at December 31, 2012; 30,000 shares authorized and 23,159 shares issued and 23,010 outstanding at December 31, 2011 | 232 | 232 |\\n| Additional paid-in capital | 219,619 | 184,596 |\\n| Retained earnings | 139,239 | 148,987 |\\n| Accumulated other comprehensive loss | (21,071 | ) | (19,824 | ) |\\n| Treasury stock, at cost—59 shares at December 31, 2012 and 149 shares at December 31, 2011 | (679 | ) | (1,712 | ) |\\n| Total stockholders’ equity | 337,340 | 312,279 |\\n| Total liabilities and stockholders’ equity | $ | 788,806 | $ | 822,323 |\\n\\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\\n37\\n| Consolidated Statements of Cash Flows |\\n| Years Ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Operating activities: |\\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\\n| Adjustments to reconcile net loss to net cash from (used in) operating activities: |\\n| Depreciation and amortization | 25,867 | 20,472 | 20,649 |\\n| Amortization of deferred gain | (1,619 | ) | (503 | ) | (890 | ) |\\n| Amortization of deferred financing costs and debt discount | 6,232 | 1,662 | 685 |\\n| Loss on sale of fixed assets | 354 | 120 | 391 |\\n| Unrealized loss on debt conversion option | 15,597 | 3,991 | — |\\n| Unrealized losses on commodity hedges | 163 | 2,331 | — |\\n| Equity in earnings of joint venture | (7,224 | ) | (11,727 | ) | (5,585 | ) |\\n| Dividends from joint venture | 4,729 | 3,117 | 1,260 |\\n| Deferred tax (benefit) provision | (1,284 | ) | (3,333 | ) | (11,386 | ) |\\n| Share-based compensation expense | 2,277 | 4,349 | 2,411 |\\n| Excess tax benefits from share-based payment arrangements | (90 | ) | (301 | ) | (219 | ) |\\n| Increase (decrease) from changes in, net of acquisition: |\\n| Accounts receivable | 44,570 | (26,446 | ) | (22,521 | ) |\\n| Inventories | (29,340 | ) | (39,435 | ) | 39,686 |\\n| Prepaid expenses and other current assets | (2,397 | ) | (3,408 | ) | (1,718 | ) |\\n| Other assets | (480 | ) | 188 | 399 |\\n| Prepaid pension costs | (2,863 | ) | (2,412 | ) | (1,530 | ) |\\n| Accounts payable | (42,560 | ) | 9,910 | (1,866 | ) |\\n| Accrued payroll and employee benefits | (2,974 | ) | (2,470 | ) | 5,827 |\\n| Income taxes payable and receivable | 454 | (820 | ) | 11,536 |\\n| Accrued liabilities | 4,514 | (184 | ) | 1,586 |\\n| Postretirement benefit obligations and other liabilities | 1,173 | 371 | 1,287 |\\n| Net cash from (used in) operating activities | 5,351 | (46,288 | ) | 34,362 |\\n| Investing activities: |\\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | (174,244 | ) | — |\\n| Capital expenditures | (11,121 | ) | (11,744 | ) | (7,572 | ) |\\n| Proceeds from sale of fixed assets | 153 | 226 | 4 |\\n| Insurance proceeds | — | 573 | 125 |\\n| Net cash used in investing activities | (17,440 | ) | (185,189 | ) | (7,443 | ) |\\n| Financing activities: |\\n| Short-term (repayments) borrowings, net | (27 | ) | 653 | (13,720 | ) |\\n| Net (repayments) borrowings on previously existing revolving lines of credit | — | (26,403 | ) | 2,324 |\\n| Proceeds from long-term debt, including new revolving credit facility | 767,090 | 320,476 | — |\\n| Repayments of long-term debt, including new revolving credit facility | (762,887 | ) | (53,212 | ) | (7,754 | ) |\\n| Payment of debt issue costs | (1,503 | ) | (16,633 | ) | — |\\n| Exercise of stock options | 146 | 356 | 566 |\\n| Excess tax benefits from share-based payment arrangements | 90 | 301 | 219 |\\n| Net cash from (used in) financing activities | 2,909 | 225,538 | (18,365 | ) |\\n| Effect of exchange rate changes on cash and cash equivalents | 263 | (253 | ) | (149 | ) |\\n| Net (decrease) increase in cash and cash equivalents | (8,917 | ) | (6,192 | ) | 8,405 |\\n| Cash and cash equivalents—beginning of year | 30,524 | 36,716 | 28,311 |\\n| Cash and cash equivalents—end of year | $ | 21,607 | $ | 30,524 | $ | 36,716 |\\n\\nSee Note 1 to the consolidated financial statements for supplemental cash flow disclosures.\\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\\n38\\n| Consolidated Statements of Stockholders' Equity |\\n| CommonShares | TreasuryShares | PreferredStock | CommonStock | TreasuryStock | AdditionalPaid-inCapital | RetainedEarnings | Accumulated OtherComprehensiveIncome | Total |\\n| Balance at January 1, 2010 | 23,115 | (209 | ) | $ | — | $ | 230 | $ | (3,010 | ) | $ | 178,129 | $ | 156,387 | $ | (13,528 | ) | $ | 318,208 |\\n| Net loss | (5,640 | ) | (5,640 | ) |\\n| Foreign currency translation | (536 | ) | (536 | ) |\\n| Defined benefit pension liability adjustments, net of tax benefit of $1,116 | (1,748 | ) | (1,748 | ) |\\n| Long-term incentive plan | 1,278 | 1,278 |\\n| Exercise of stock options and other | 34 | 46 | 1 | 784 | 1,112 | 1,897 |\\n| Balance at December 31, 2010 | 23,149 | (163 | ) | $ | — | $ | 231 | $ | (2,226 | ) | $ | 180,519 | $ | 150,747 | $ | (15,812 | ) | $ | 313,459 |\\n| Net loss | (1,760 | ) | (1,760 | ) |\\n| Foreign currency translation | (941 | ) | (941 | ) |\\n| Defined benefit pension liability adjustments, net of tax benefit of $1,965 | (3,071 | ) | (3,071 | ) |\\n| Long-term incentive plan | 3,260 | 3,260 |\\n| Exercise of stock options and other | 10 | 14 | 1 | 514 | 817 | 1,332 |\\n| Balance at December 31, 2011 | 23,159 | (149 | ) | $ | — | $ | 232 | $ | (1,712 | ) | $ | 184,596 | $ | 148,987 | $ | (19,824 | ) | $ | 312,279 |\\n| Net loss | (9,748 | ) | — | (9,748 | ) |\\n| Foreign currency translation | 2,369 | 2,369 |\\n| Defined benefit pension liability adjustments, net of tax benefit of $2,312 | (3,616 | ) | (3,616 | ) |\\n| Embedded conversion option, net of tax benefit of $8,285 | 33,752 | 33,752 |\\n| Long-term incentive plan | 1,592 | 1,592 |\\n| Exercise of stock options and other | 52 | 90 | 1,033 | (321 | ) | 712 |\\n| Balance at December 31, 2012 | 23,211 | (59 | ) | $ | — | $ | 232 | $ | (679 | ) | $ | 219,619 | $ | 139,239 | $ | (21,071 | ) | $ | 337,340 |\\n\\nThe accompanying notes to consolidated financial statements are an integral part of these statements.\\n39\\nA. M. Castle & Co.\\nNotes to Consolidated Financial Statements\\nAmounts in thousands except per share data and percentages\\n(1) Basis of Presentation and Significant Accounting Policies\\nNature of operations — A.M. Castle & Co. and its subsidiaries (the “Company”) is a specialty metals and plastics distribution company serving principally the North American market, but with a growing global presence. The Company has operations in the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. The Company provides a broad range of product inventories as well as value-added processing and supply chain services to a wide array of customers, principally within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the global economy. Particular focus is placed on the aerospace and defense, oil and gas, power generation, mining, heavy industrial equipment, marine, office furniture and fixtures, safety products, life science applications, automotive and general manufacturing industries as well as general engineering applications.\\nThe Company’s corporate headquarters are located in Oak Brook, Illinois. The Company has 49 operational service centers located throughout North America (44), Europe (4) and Asia (1).\\nThe Company purchases metals and plastics from many producers. Purchases are made in large lots and held in distribution centers until sold, usually in smaller quantities and often with value-added processing services performed. Orders are primarily filled with materials shipped from Company stock. The materials required to fill the balance of sales are obtained from other sources, such as direct mill shipments to customers or purchases from other distributors. Thousands of customers from a wide array of industries are serviced primarily through the Company’s own sales organization.\\nBasis of presentation — The consolidated financial statements include the accounts of A. M. Castle & Co. and its subsidiaries over which the Company exhibits a controlling interest. The equity method of accounting is used for the Company’s 50% owned joint venture, Kreher Steel Company, LLC (“Kreher”). All inter-company accounts and transactions have been eliminated.\\nReclassification — For comparability, certain 2011 amounts have been reclassified to conform to presentation adopted in 2012.\\nUse of estimates — The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The principal areas of estimation reflected in the consolidated financial statements are accounts receivable allowances, inventory reserves, goodwill and intangible assets, income taxes, pension and other post-employment benefits and share-based compensation and convertible debt feature mark-to-mark adjustments.\\nRevenue recognition — Revenue from the sales of products is recognized when the earnings process is complete and when the title and risk and rewards of ownership have passed to the customer, which is primarily at the time of shipment. Revenue recognized other than at the time of shipment represents less than 3% of the Company’s consolidated net sales for the years ended December 31, 2012, 2011 and 2010. Provisions for allowances related to sales discounts and rebates are recorded based on terms of the sale in the period that the sale is recorded. Management utilizes historical information and the current sales trends of the business to estimate such provisions. The provisions related to discounts and rebates due to customers are recorded as a reduction within net sales in the Company’s consolidated statements of operations and comprehensive loss.\\nThe Company maintains an allowance for doubtful accounts resulting from the inability of customers to make required payments. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific identification of customer receivable balances for which collection is unlikely. The provisions for doubtful accounts is recorded in sales, general and administrative expense in the Company’s consolidated statements of operations and comprehensive loss. Estimates of doubtful accounts are based upon historical write-off experience as a percentage of net sales and judgments about the probable effects of economic conditions on certain customers.\\n40\\nThe Company also maintains an allowance for credit memos for estimated credit memos to be issued against current sales. Estimates of allowance for credit memos are based upon the application of a historical issuance lag period to the average credit memos issued each month.\\nAccounts receivable allowance activity is presented in the table below:\\n| 2012 | 2011 | 2010 |\\n| Balance, beginning of year | $ | 3,584 | $ | 3,848 | $ | 4,195 |\\n| Add Provision charged to expense | 1,420 | 523 | 777 |\\n| Recoveries | 90 | 140 | 186 |\\n| Other | — | 157 | — |\\n| Less Charges against allowance | (1,565 | ) | (1,084 | ) | (1,310 | ) |\\n| Balance, end of year | $ | 3,529 | $ | 3,584 | $ | 3,848 |\\n\\nRevenue from shipping and handling charges is recorded in net sales. Costs incurred in connection with shipping and handling the Company’s products, which are related to third-party carriers or performed by Company personnel are included in warehouse, processing and delivery expenses. For the years ended December 31, 2012, 2011 and 2010, shipping and handling costs included in warehouse, processing and delivery expenses were $36,585, $35,214, and $31,067, respectively.\\nCost of materials — Cost of materials consists of the costs the Company pays for metals, plastics and related inbound freight charges. It excludes depreciation and amortization which are discussed below. The Company accounts for the majority of its inventory on a last-in, first-out (“LIFO”) basis and LIFO adjustments are recorded in cost of materials.\\nOperating expenses — Operating costs and expenses primarily consist of:\\n\\n| • | Warehouse, processing and delivery expenses, including occupancy costs, compensation and employee benefits for warehouse personnel, processing, shipping and handling costs; |\\n\\n| • | Sales expenses, including compensation and employee benefits for sales personnel; |\\n\\n| • | General and administrative expenses, including compensation for executive officers and general management, expenses for professional services primarily attributable to accounting and legal advisory services, bad debt expenses, data communication, computer hardware and maintenance and foreign currency gain or loss; and |\\n\\n| • | Depreciation and amortization expenses, including depreciation for all owned property and equipment, and amortization of various intangible assets. |\\n\\nCash equivalents — Cash equivalents are highly liquid, short-term investments that have an original maturity of 90 days or less.\\nStatement of cash flows — Non-cash investing and financing activities and supplemental disclosures of consolidated cash flow information are as follows:\\n| Year Ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Non-cash investing and financing activities: |\\n| Capital expenditures financed by accounts payable | $ | 479 | $ | 1,123 | $ | 100 |\\n| Capital lease obligations | 1,009 | — | — |\\n| Deferred debt origination fees | — | 886 | — |\\n| Additional purchase price paid in 2012 for Tube Supply acquisition | — | 6,472 | — |\\n| Cash paid during the year for: |\\n| Interest | 34,051 | 7,234 | 4,392 |\\n| Income taxes | 5,557 | 9,555 | 1,631 |\\n| Cash received during the year for: |\\n| Income tax refunds | 3,184 | 6,724 | 4,430 |\\n\\n41\\nInventories — Inventories consist of finished goods. Approximately eighty percent of the Company’s inventories are valued at the lower of LIFO cost or market at December 31, 2012 and 2011. Final inventory determination under the LIFO costing method is made at the end of each fiscal year based on the actual inventory levels and costs at that time. The Company values its LIFO increments using the cost of its latest purchases during the years reported. Current replacement cost of inventories exceeded book value by $139,940 and $138,882 at December 31, 2012 and 2011, respectively. Income taxes would become payable on any realization of this excess from reductions in the level of inventories.\\nDuring 2010, a reduction in inventories resulted in a liquidation of applicable LIFO inventory quantities carried at lower costs in prior years. Cost of materials for 2010 were lower by $12,500, as a result of the liquidations.\\nThe Company maintains allowances for excess and obsolete inventory and physical inventory losses. The excess and obsolete inventory allowance is determined based on specific identification of material, adjusted for expected scrap value to be received. The allowance for physical inventory losses is determined based on historical physical inventory experience.\\nInsurance plans — In August 2009, the Company became a member of a group captive insurance company (the “Captive”) domiciled in Grand Cayman Island. The Captive reinsures losses related to certain of the Company’s workers’ compensation, automobile and general liability risks that occur subsequent to August 2009. Premiums are based on the Company’s loss experience and are accrued as expenses for the period to which the premium relates. Premiums are credited to the Company’s “loss fund” and earn investment income until claims are actually paid. For workers’ compensation, automobile and general liability claims that were incurred prior to August 2009, the Company is self-insured. Self-insurance amounts are capped, for individual claims and in the aggregate, for each policy year by an insurance company. Self-insurance reserves are based on unpaid, known claims (including related administrative fees assessed by the insurance company for claims processing) and a reserve for incurred but not reported claims based on the Company’s historical claims experience and development.\\nThe Company is self-insured for medical insurance for its domestic operations. Self-insurance reserves are maintained based on incurred but not paid claims based on a historical lag.\\nProperty, plant and equipment — Property, plant and equipment are stated at cost and include assets held under capital leases. Expenditures for major additions and improvements are capitalized, while maintenance and repair costs that do not substantially improve or extend the useful lives of the respective assets are expensed in the period in which they are incurred. When items are disposed, the related costs and accumulated depreciation are removed from the accounts and any gain or loss is reflected in income.\\nThe Company provides for depreciation of plant and equipment sufficient to amortize the cost over their estimated useful lives as follows:\\n| Buildings and building improvements | 3 – 40 years |\\n| Plant equipment | 3 – 25 years |\\n| Furniture and fixtures | 2 – 10 years |\\n| Vehicles and office equipment | 3 – 7 years |\\n\\nLeasehold improvements are depreciated over the shorter of their useful lives or the remaining term of the lease. Depreciation is calculated using the straight-line method and depreciation expense for 2012, 2011 and 2010 was $14,024, $13,605 and $13,578, respectively.\\nLong-lived assets — The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to future net cash flows (undiscounted and without interest charges) expected to be generated by the asset or asset group. If future net cash flows are less than the carrying value, the asset or asset group may be impaired. If such assets are impaired, the impairment charge is calculated as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Determining whether impairment has occurred typically requires various estimates and assumptions, including determining which undiscounted cash flows are directly related to the potentially impaired asset, the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. The Company derives the required undiscounted cash flow estimates from historical experience and internal business plans.\\n42\\nGoodwill and intangible assets — The carrying value of the Company’s goodwill is evaluated annually on January 1st of each fiscal year or when certain triggering events occur which require a more current valuation. The Company assesses, at least quarterly, whether any triggering events have occurred.\\nA two-step method is used for determining goodwill impairment. The first step is performed to identify whether a potential impairment exists by comparing each reporting unit’s fair value to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the next step is to measure the amount of impairment loss, if any.\\nThe majority of the Company’s recorded intangible assets were acquired as part of the Transtar and Tube Supply, Inc. (“Tube Supply”) acquisitions in September 2006 and December 2011, respectively, and consist of customer relationships, non-compete agreements, trade names and developed technology. The initial values of the intangible assets were based on a discounted cash flow valuation using assumptions made by management as to future revenues from select customers, the level and pace of attrition in such revenues over time and assumed operating income amounts generated from such revenues. These intangible assets are amortized over their useful lives, which are 4 to 12 years for customer relationships, 3 years for non-compete agreements, 1 to 10 years for trade names, and 3 years for developed technology. Useful lives are estimated by management and determined based on the timeframe over which a significant portion of the estimated future cash flows are expected to be realized from the respective intangible assets. Furthermore, when certain conditions or certain triggering events occur, a separate test of impairment, similar to the impairment test for long-lived assets, is performed. If the intangible asset is deemed to be impaired, such asset will be written down to its fair value.\\nIncome taxes — The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.\\nThe Company records valuation allowances against its deferred tax assets when it is more likely than not that the amounts will not be realized, which will increase the provision for income taxes in the period in which that determination is made.\\nThe Company has undistributed earnings of foreign subsidiaries of approximately $83,352 at December 31, 2012, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result, although due to the potential availability of foreign tax credits and other items, the calculation of such additional taxes is not practicable.\\nThe Company's 50% ownership interest in Kreher (see Note 6) is through a 50% interest in a limited liability corporation (LLC) taxed as a partnership. Kreher has two subsidiaries organized as individually taxed C-Corporations. The Company includes in its income tax provision the income tax liability on its share of Kreher income. The income tax liability of Kreher itself is generally treated as a current income tax expense and the income tax liability associated with the profits of the two subsidiaries of Kreher is treated as a deferred income tax expense. The Company can not independently cause a dividend to be declared by one of Kreher's subsidiaries, therefore no benefit of a dividend received deduction can be recognized in the Company's tax provision until a dividend is declared. If one of Kreher's C-Corporation subsidiaries declares a dividend payable to Kreher, the Company recognizes a benefit for the 80% dividends received deduction on its 50% share of the dividend.\\nThe Company recognizes the tax benefits of uncertain tax positions only if those benefits will more likely than not be sustained upon examination by the relevant tax authorities. Unrecognized tax benefits are subsequently recognized at the time the recognition threshold is met, the tax matter is effectively settled or the statute of limitations expires for the return containing the tax position, whichever is earlier. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that differs from the current estimate.\\nThe Company recognizes interest and penalties related to unrecognized tax benefits within income tax expense. Accrued interest and penalties are included within other long-term liabilities in the consolidated balance sheets.\\nForeign currency — For the majority of the Company’s non-U.S. operations, the functional currency is the local currency. Assets and liabilities of those operations are translated into U.S. dollars using year-end exchange rates, and income and expenses are translated using the average exchange rates for the reporting period. The currency effects of translating financial statements of the Company’s non-U.S. operations which operate in local currency environments are recorded in accumulated other comprehensive income (loss), a separate component of\\n43\\nstockholders’ equity. Transaction gains or losses resulting from foreign currency transactions were not material for any of the years presented.\\nEarnings per share — Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock plus common stock equivalents. Common stock equivalents consist of employee and director stock options, restricted stock awards, other share-based payment awards, and contingently issuable shares related to the Company’s convertible debt which are included in the calculation of weighted average shares outstanding using the treasury stock method, if dilutive.\\nThe following table is a reconciliation of the basic and diluted earnings per share calculations:\\n| 2012 | 2011 | 2010 |\\n| Numerator: |\\n| Net loss | $ | (9,748 | ) | $ | (1,760 | ) | $ | (5,640 | ) |\\n| Denominator: |\\n| Denominator for basic loss per share: |\\n| Weighted average common shares outstanding | 22,993 | 22,983 | 22,708 |\\n| Effect of dilutive securities: |\\n| Outstanding common stock equivalents | — | — | — |\\n| Denominator for diluted loss per share | 22,993 | 22,983 | 22,708 |\\n| Basic loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\\n| Diluted loss per share | $ | (0.42 | ) | $ | (0.08 | ) | $ | (0.25 | ) |\\n| Excluded outstanding share-based awards having an anti-dilutive effect | 994 | 757 | 471 |\\n\\nThe Convertible Notes are dilutive to the extent the Company generates net income and the average stock price during the period is greater than $10.28, the conversion price of the Convertible Notes. The Convertible Notes are only dilutive for the “in the money” portion of the Convertible Notes that could be settled with the Company’s stock. In future periods, absent a fundamental change, (as defined in the Convertible Notes agreement), the outstanding Convertible Notes could increase diluted average shares outstanding by a maximum of approximately 5,600 shares. As of December 31, 2012 and 2011, 1,416 and 1,734 shares, respectively, were excluded from diluted average shares outstanding as there would have been an anti-dilutive effect.\\nFor the years ended December 31, 2012, 2011 and 2010, the participating securities, which represent certain non-vested shares granted by the Company, were less than one percent of total securities. These securities do not participate in the Company’s net losses.\\nConcentrations — The Company serves a wide range of customers within the producer durable equipment, oil and gas, aerospace, heavy industrial equipment, industrial goods, construction equipment, retail, marine and automotive sectors of the economy from locations throughout the United States, Canada, Mexico, France, the United Kingdom, Spain, China and Singapore. Its customer base includes many Fortune 500 companies as well as thousands of medium and smaller sized firms spread across the entire spectrum of metals and plastics using industries. The Company’s customer base is well diversified and, therefore, the Company does not have dependence upon any single customer or a few customers. No single customer represents more than 3% of the Company’s total net sales. Approximately 78% of the Company’s business is conducted from locations in the United States.\\nShare-based compensation — The Company offers share-based compensation to executive and other key employees, as well as its directors. Share-based compensation expense is recorded over the vesting period based on the grant date fair value of the stock award. Stock options have an exercise price equal to the market price of the Company’s stock on the grant date (options granted prior to 2010) or the average closing price of the Company’s stock for the 10 trading days preceding the grant date (options granted in 2010) and have a contractual life of eight to ten years. Options and restricted stock generally vest in one to five years for executives and employees and three years for directors. The Company may either issue shares from treasury or new shares upon share option exercise. Management estimates the probable number of shares which will ultimately vest when calculating the share-based compensation expense for the long-term compensation plans (\\\"LTC Plans\\\"). As of December 31, 2012, the Company’s weighted average forfeiture rate is approximately 33%. The actual number of shares that vest may differ from management’s estimate.\\n44\\nStock options are valued based on the market price of the Company’s stock on the grant date, using a Black-Scholes option-pricing model. The expense associated with stock option awards is recorded on a straight-line basis over the vesting period, net of estimated forfeitures.\\nShare-based compensation expense for restricted share units and non-vested shares in the LTC Plans is established using the market price of the Company’s common stock on the date of grant.\\nFinal award vesting and distribution of performance awards granted under the LTC Plans are determined based on the Company’s actual performance versus the target goals for a three-year consecutive period as defined in each plan. Partial awards can be earned for performance less than the target goal, but in excess of minimum goals; and award distributions above the target can be achieved if the maximum goals are met or exceeded.\\nUnder the 2012, 2011, and 2010 LTC Plans, the potential award for the performance shares granted is partially dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. The grant date fair value of performance shares containing a market-based performance condition awarded under the LTC Plans was estimated using a Monte Carlo simulation.\\nUnder the 2012 and 2011 LTC Plans, the potential award for performance share units containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management's expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\\nUnless covered by a specific change-in-control or severance arrangement, participants to whom restricted stock units, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited.\\nNew Accounting Standards Updates\\nStandards Updates Adopted\\nEffective January 1, 2012, the Company adopted ASU No. 2011-08, “Intangibles – Goodwill and Other.” The objective of this ASU is to simplify how entities test goodwill for impairment. The amendments allow entities to assess qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test per Topic 350, “Intangibles – Goodwill and Other.” The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. The adoption of this ASU impacts the way the Company tests goodwill for impairment. As allowed by this ASU for its January 1, 2012 annual impairment test, the Company did not elect the option to perform a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. Instead the Company followed the two-step method. Refer to Note 8 for the results of the annual goodwill impairment test.\\nEffective January 1, 2012, the Company adopted ASU No. 2011-05, “Presentation of Comprehensive Income.” The amendments in this ASU impact all entities that report items of other comprehensive (loss) income and are effective retrospectively for public entities. The amendments in this ASU eliminate the option to present the components of other comprehensive (loss) income as part of the statement of changes in stockholders’ equity. The amendments provide the entity with the option to present the total of comprehensive (loss) income, the components of net (loss) income and the components of other comprehensive (loss) income either in a single continuous statement of comprehensive (loss) income or in two separate but consecutive statements. Both options require an entity to present each component of net (loss) income along with total net (loss) income, each component of other\\n45\\ncomprehensive (loss) income along with total other comprehensive (loss) income and a total amount for comprehensive (loss) income. The subsequent issuance of ASU 2011-12, “Comprehensive Income” in December 2011 deferred the changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive (loss) income. All other provisions in ASU 2011-05 were effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The presentation requirements associated with the adoption of ASU 2011-05 are reflected in the consolidated statements of operations and comprehensive loss herein.\\nEffective January 1, 2012, the Company adopted ASU No. 2011-04, “Fair Value Measurement.” The amendments in this ASU apply to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s shareholders’ equity in the financial statements. The amendments in this ASU clarify the requirements of the existing standard and include some changes to principles or requirements for measuring or disclosing information about fair value measurements. The adoption of this ASU did not have an impact on the Company's financial condition, liquidity or operating results. The disclosure requirements associated with the adoption of ASU 2011-04 are reflected in Note 10.\\nStandards Updates Issued Not Yet Effective\\nDuring December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU require an entity to disclose information to enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on its financial position, including the effect or potential effect of rights of set off associated with an entity’s recognized assets and recognized liabilities within the scope of Topic 210. The ASU is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The adoption of this ASU may impact the Company’s disclosures in future interim and annual financial statements issued.\\n(2) Acquisition\\nOn December 15, 2011, the Company acquired 100 percent of the outstanding common shares of Tube Supply (the “Acquisition”). The Acquisition was accounted for using the acquisition method. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on estimated fair values at date of acquisition. The nonrecurring fair value measurements are classified as Level 3 in the fair value hierarchy (see Note 10 for the definition of Level 3 inputs).\\nThe results and the assets of Tube Supply are included in the Company’s Metals segment.\\nTube Supply, based in Houston, Texas, is a leading value-added distributor of specialty tubular and bar products for the oil and gas industry. Tube Supply provides high quality products and services primarily to the North American oilfield equipment manufacturing industry. Tube Supply operates two service centers, which are located in Houston, Texas and Edmonton, Alberta. The Acquisition will allow the Company to capitalize on the growing demand and opportunities in the oil and gas sector through new product offerings to an expanded customer base.\\nThe aggregate purchase price was $184,385 and represents the aggregate cash purchase price, including a working capital adjustment. The premium paid in excess of the fair value of the net assets acquired was primarily for the ability to expand the Company’s oil and gas product offerings, as well as to obtain Tube Supply’s skilled, established workforce.\\nDuring 2011, the Company incurred $4,260 of direct acquisition-related costs, which are recorded in Sales, general and administrative expense.\\n46\\nAn allocation of the purchase price to the fair value of the assets acquired and liabilities assumed, which was finalized as of December 2012, is as follows:\\nPurchase Price Allocation\\n| Current assets | $ | 134,817 |\\n| Property, plant and equipment, net | 6,767 |\\n| Other assets | 346 |\\n| Trade name | 7,700 |\\n| Customer relationships | 48,800 |\\n| Non-compete agreements | 1,000 |\\n| Developed technology | 1,400 |\\n| Goodwill | 19,637 |\\n| Total assets acquired | 220,467 |\\n| Current liabilities | 33,211 |\\n| Long-term liabilities | 2,871 |\\n| Total liabilities assumed | 36,082 |\\n| Total purchase price | $ | 184,385 |\\n\\nThe acquired intangible assets have a weighted average useful life of approximately 11.4 years. Useful lives by intangible asset category are as follows: trade name - 10 years, customer relationships - 12 years, non-compete agreements - 3 years and developed technology - 3 years.\\nAt closing, the Company entered into a lease agreement with the former owners of Tube Supply. At December 31, 2012 and 2011, an unfavorable lease liability associated with the lease for a newly constructed distribution center used by Tube Supply of $2,168 and $2,871, respectively, is recorded in other non-current liabilities. The current portion of the unfavorable lease liability in the amount of $645 is included in accrued liabilities in the consolidated balance sheets at December 31, 2012 and 2011. The unfavorable lease liability resulted from the present value of the difference between the estimated fair market value and the executed contract price the Company will pay to lease the property. The unfavorable lease liability will be amortized over the remaining life of the lease.\\nThe goodwill and intangible assets are deductible for tax purposes.\\nThe results of operations of Tube Supply have been included in the Company's consolidated statements of operations and comprehensive loss since December 15, 2011. The net sales and net income for Tube Supply during the period from December 15, 2011 through December 31, 2011 were $7,648 and $901, respectively.\\nThe following unaudited pro forma summary presents the effect of the Acquisition during the years ended December 31, 2011 and 2010 as though the business had been acquired as of January 1, 2010:\\n| Year ended December 31,(Unaudited) |\\n| 2011 | 2010 |\\n| Pro forma net sales | $ | 1,332,176 | $ | 1,069,564 |\\n| Pro forma net income (loss) | 7,033 | (24,268 | ) |\\n| Pro forma basic net income (loss) per share | $ | 0.31 | $ | (1.06 | ) |\\n| Pro forma diluted net income (loss) per share | 0.28 | (1.06 | ) |\\n\\nUnaudited pro forma supplemental information is based upon management estimates and judgments. The unaudited pro forma supplemental information also includes purchase accounting and interest expense adjustments and the related tax effects. The unaudited pro forma supplemental information for the year ended December 31, 2011 excludes direct acquisition-related costs of $4,260 and includes loss on extinguishment of debt of $6,153 and interest costs of $7,366 associated with the underwriting fee for debt financing and the mark-to-market adjustment for the conversion option on the convertible bonds. The unaudited pro forma supplemental information for the year ended December 31, 2010 includes direct acquisition-related costs of $4,260. These pro forma results are not necessarily indicative of what would have occurred if the acquisition had been in effect for the periods presented or of future results. Pro forma financial information is not provided for the year ended December 31, 2012 as a full\\n47\\nyear of post-acquisition results of operations for Tube Supply were included in the Company's consolidated statements of operations and comprehensive loss.\\nSee Note 9 for detailed discussion on the Company’s debt financing structure used to finance the Acquisition.\\n(3) Segment Reporting\\nThe Company distributes and performs processing on both metals and plastics. Although the distribution processes are similar, the customer markets, supplier bases and types of products are different. Additionally, the Company’s Chief Executive Officer, the chief operating decision-maker, reviews and manages these two businesses separately. As such, these businesses are considered reportable segments and are reported accordingly. Neither of the Company’s reportable segments has any unusual working capital requirements.\\nIn its Metals segment, the Company’s marketing strategy focuses on distributing highly engineered specialty grades and alloys of metals as well as providing specialized processing services designed to meet very precise specifications. Core products include alloy, aluminum, stainless, nickel, titanium and carbon. Inventories of these products assume many forms such as plate, sheet, extrusions, round bar, hexagon bar, square and flat bar, tubing and coil. Depending on the size of the facility and the nature of the markets it serves, service centers are equipped as needed with bar saws, plate saws, oxygen and plasma arc flame cutting machinery, trepanning machinery, boring machinery, honing equipment, water-jet cutting, stress relieving and annealing furnaces, surface grinding equipment and sheet shearing equipment. This segment also performs various specialized fabrications for its customers through pre-qualified subcontractors that thermally process, turn, polish and straighten alloy and carbon bar.\\nThe Company’s Plastics segment consists exclusively of a wholly-owned subsidiary that operates as Total Plastics, Inc. (“TPI”), headquartered in Kalamazoo, Michigan, and its wholly-owned subsidiaries. The Plastics segment stocks and distributes a wide variety of plastics in forms that include plate, rod, tube, clear sheet, tape, gaskets and fittings. Processing activities within this segment include cut-to-length, cut-to-shape, bending and forming according to customer specifications. The Plastics segment’s diverse customer base consists of companies in the retail (point-of-purchase), automotive, marine, office furniture and fixtures, safety products, life sciences applications, and general manufacturing industries. TPI has locations throughout the upper northeast and midwest regions of the U.S. and one facility in Florida from which it services a wide variety of users of industrial plastics.\\nThe accounting policies of all segments are the same as described in Note 1. Management evaluates the performance of its business segments based on operating income.\\nThe Company operates locations in the United States, Canada, Mexico, France, the United Kingdom, China and Singapore. No activity from any individual country outside the United States is material, and therefore, foreign activity is reported on an aggregate basis. Net sales are attributed to countries based on the location of the Company’s subsidiary that is selling direct to the customer. Company-wide geographic data as of and for the years ended December 31, 2012, 2011 and 2010 are as follows:\\n| 2012 | 2011 | 2010 |\\n| Net sales |\\n| United States | $ | 988,161 | $ | 895,165 | $ | 757,052 |\\n| All other countries | 282,207 | 237,201 | 186,654 |\\n| Total | $ | 1,270,368 | $ | 1,132,366 | $ | 943,706 |\\n| Long-lived assets |\\n| United States | $ | 68,253 | $ | 72,138 |\\n| All other countries | 11,387 | 10,003 |\\n| Total | $ | 79,640 | $ | 82,141 |\\n\\n48\\nSegment information as of and for the years ended December 31, 2012, 2011 and 2010 is as follows:\\n| NetSales | OperatingIncome(Loss) | TotalAssets | CapitalExpenditures | Depreciation &Amortization |\\n| 2012 |\\n| Metals segment (a) | $ | 1,143,884 | $ | 49,822 | $ | 693,803 | $ | 9,819 | $ | 24,480 |\\n| Plastics segment | 126,484 | 3,188 | 56,149 | 1,831 | 1,387 |\\n| Other (b) | — | (11,865 | ) | 38,854 | — | — |\\n| Consolidated | $ | 1,270,368 | $ | 41,145 | $ | 788,806 | $ | 11,650 | $ | 25,867 |\\n| 2011 |\\n| Metals segment (a) | $ | 1,014,130 | $ | 13,524 | $ | 729,692 | $ | 10,639 | $ | 19,329 |\\n| Plastics segment | 118,236 | 2,860 | 56,171 | 2,228 | 1,143 |\\n| Other (b) | — | (11,190 | ) | 36,460 | — | — |\\n| Consolidated | $ | 1,132,366 | $ | 5,194 | $ | 822,323 | $ | 12,867 | $ | 20,472 |\\n| 2010 |\\n| Metals segment | $ | 841,067 | $ | (5,478 | ) | $ | 454,345 | $ | 6,815 | $ | 19,392 |\\n| Plastics segment | 102,639 | 3,559 | 47,128 | 757 | 1,257 |\\n| Other (b) | — | (7,419 | ) | 27,879 | — | — |\\n| Consolidated | $ | 943,706 | $ | (9,338 | ) | $ | 529,352 | $ | 7,572 | $ | 20,649 |\\n\\n(a) The results of Tube Supply, acquired on December 15, 2011, are included in the Company's Metals segment.\\n(b) “Other” – Operating loss includes the costs of executive, legal and finance departments, which are shared by both the Metals and Plastics segments. The “Other” category’s total assets consist of the Company’s investment in joint venture.\\nBelow are reconciliations of segment data to the consolidated loss before income taxes:\\n| 2012 | 2011 | 2010 |\\n| Operating income (loss) | $ | 41,145 | $ | 5,194 | $ | (9,338 | ) |\\n| Interest expense, net | (41,090 | ) | (9,663 | ) | (4,988 | ) |\\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | (3,991 | ) | — |\\n| Loss on extinguishment of debt | — | (6,153 | ) | — |\\n| Loss before income taxes and equity in earnings of joint venture | (15,542 | ) | (14,613 | ) | (14,326 | ) |\\n| Equity in earnings of joint venture | 7,224 | 11,727 | 5,585 |\\n| Consolidated loss before income taxes | $ | (8,318 | ) | $ | (2,886 | ) | $ | (8,741 | ) |\\n\\n(4) Lease Agreements\\nThe Company has operating and capital leases covering certain warehouse facilities, equipment, automobiles and trucks, with the lapse of time as the basis for all rental payments.\\nFuture minimum rental payments under operating and capital leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2012, are as follows:\\n| Capital | Operating |\\n| 2013 | $ | 415 | $ | 14,401 |\\n| 2014 | 396 | 11,375 |\\n| 2015 | 392 | 10,091 |\\n| 2016 | 197 | 8,702 |\\n| 2017 | — | 8,007 |\\n| Later years | — | 24,130 |\\n| Total future minimum rental payments | $ | 1,400 | $ | 76,706 |\\n\\n49\\nTotal rental payments charged to expense were $15,579 in 2012, $12,362 in 2011, and $13,712 in 2010. Lease extrication charges of $1,215 associated with the consolidation of two of the Company’s facilities in the Metals segment were included in total rental payments charged to expense in 2010 within Warehouse, processing and delivery expense in the consolidated statements of operations and comprehensive loss. There were no lease extrication charges in 2012 and 2011. Total gross value of property, plant and equipment under capital leases was $1,895 and $2,698 in 2012 and 2011, respectively.\\n(5) Employee Benefit Plans\\nPension Plans\\nSubstantially all employees who meet certain requirements of age, length of service and hours worked per year are covered by Company-sponsored pension plans and supplemental pension plan (collectively, the “pension plans”). These pension plans are defined benefit, noncontributory plans. Benefits paid to retirees are based upon age at retirement, years of credited service and average earnings. The Company also has a supplemental pension plan, which is a non-qualified, unfunded plan. The Company uses a December 31 measurement date for the pension plans.\\nThe Company-sponsored pension plans are frozen for all employees except for employees of certain subsidiaries and employees represented by the United Steelworkers of America. The assets of the Company-sponsored pension plans are maintained in a single trust account.\\nThe Company’s funding policy is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act of 1974, commonly called ERISA.\\nComponents of net periodic pension credit are as follows:\\n| 2012 | 2011 | 2010 |\\n| Service cost | $ | 608 | $ | 539 | $ | 623 |\\n| Interest cost | 6,832 | 7,393 | 7,456 |\\n| Expected return on assets | (9,855 | ) | (10,054 | ) | (9,342 | ) |\\n| Amortization of prior service cost | 324 | 324 | 231 |\\n| Amortization of actuarial loss | 594 | 229 | 237 |\\n| Net periodic pension credit | $ | (1,497 | ) | $ | (1,569 | ) | $ | (795 | ) |\\n\\nThe expected 2013 amortization of pension prior service cost and actuarial loss is $323 and $1,942, respectively.\\n50\\nThe status of the plans at December 31, 2012 and 2011 are as follows:\\n| 2012 | 2011 |\\n| Change in projected benefit obligation: |\\n| Projected benefit obligation at beginning of year | $ | 164,407 | $ | 144,235 |\\n| Service cost | 608 | 539 |\\n| Interest cost | 6,832 | 7,393 |\\n| Benefit payments | (6,558 | ) | (6,151 | ) |\\n| Actuarial loss | 15,848 | 18,391 |\\n| Projected benefit obligation at end of year | $ | 181,137 | $ | 164,407 |\\n| Change in plan assets: |\\n| Fair value of plan assets at beginning of year | $ | 174,938 | $ | 157,996 |\\n| Actual return on assets | 18,463 | 22,867 |\\n| Employer contributions | 307 | 226 |\\n| Benefit payments | (6,558 | ) | (6,151 | ) |\\n| Fair value of plan assets at end of year | $ | 187,150 | $ | 174,938 |\\n| Funded status – net prepaid | $ | 6,013 | $ | 10,531 |\\n| Amounts recognized in the consolidated balance sheets consist of: |\\n| Prepaid pension cost | $ | 12,891 | $ | 15,956 |\\n| Accrued liabilities | (309 | ) | (219 | ) |\\n| Pension benefit obligations | (6,569 | ) | (5,206 | ) |\\n| Net amount recognized | $ | 6,013 | $ | 10,531 |\\n| Pre-tax components of accumulated other comprehensive income (loss): |\\n| Unrecognized actuarial loss | $ | (29,778 | ) | $ | (23,131 | ) |\\n| Unrecognized prior service cost | (1,617 | ) | (1,942 | ) |\\n| Total | $ | (31,395 | ) | $ | (25,073 | ) |\\n| Accumulated benefit obligation | $ | 180,551 | $ | 163,874 |\\n\\nFor the plan with an accumulated benefit obligation in excess of plan assets, the projected benefit obligation, accumulated benefit obligation and fair value of plan assets were $5,893, $5,893 and $0, respectively, at December 31, 2012; and $5,425, $5,425 and $0, respectively, at December 31, 2011.\\nThe assumptions used to measure the projected benefit obligations for the Company’s defined benefit pension plans are as follows:\\n| 2012 | 2011 |\\n| Discount rate | 3.50 - 3.75% | 4.25 | % |\\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% |\\n\\nThe assumptions used to determine net periodic pension credit are as follows:\\n| 2012 | 2011 | 2010 |\\n| Discount rate | 4.25 | % | 5.25 | % | 5.75 | % |\\n| Expected long-term rate of return on plan assets | 5.75 | % | 6.50 | % | 6.50 | % |\\n| Projected annual salary increases | 0 - 3.00% | 0 - 3.00% | 0 - 3.00% |\\n\\nThe Company’s expected return on plan assets is derived from reviews of asset allocation strategies and historical and anticipated future long-term performance of individual asset classes. The Company’s analysis gives consideration to historical returns and long-term, prospective rates of return.\\n51\\nThe Company’s pension plan assets are allocated entirely to fixed income securities at December 31, 2012 and 2011.\\nThe Company’s pension plans’ funds are managed in accordance with investment policies recommended by its investment advisor and approved by the Human Resources Committee of the Board of Directors. The overall target portfolio allocation is 100% fixed income securities. These funds’ conformance with style profiles and performance is monitored regularly by management, with the assistance of the Company’s investment advisor. Adjustments are typically made in the subsequent quarters when investment allocations deviate from the target range. The investment advisor provides quarterly reports to management and the Human Resources Committee of the Board of Directors.\\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2012:\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Fixed income securities (1) | $ | 10,562 | $ | 176,610 | $ | — | $ | 187,172 |\\n| Accounts payable – pending trades | (22 | ) |\\n| Total | $ | 187,150 |\\n\\n\\n| (1) | Fixed income securities are comprised of corporate bonds (75%), government bonds (16%), government agencies securities (6%) and other fixed income securities (3%). |\\n\\nThe fair values of the Company’s pension plan assets fall within the following levels of the fair value hierarchy as of December 31, 2011:\\n| Level 1 | Level 2 | Level 3 | Total |\\n| Fixed income securities (2) | $ | 9,949 | $ | 172,694 | $ | — | $ | 182,643 |\\n| Accounts payable – pending trades | (7,705 | ) |\\n| Total | $ | 174,938 |\\n\\n\\n| (2) | Fixed income securities are comprised of corporate bonds (74%), government bonds (16%), government agencies securities (7%) and other fixed income securities (3%). |\\n\\nThe estimated future pension benefit payments are:\\n| 2013 | $ | 7,974 |\\n| 2014 | 8,213 |\\n| 2015 | 8,828 |\\n| 2016 | 9,115 |\\n| 2017 | 9,607 |\\n| 2018 — 2022 | 51,839 |\\n\\nThe Company is also party to certain multi-employer pension plans. The overall cost of such plans to the Company is insignificant. If the Company withdraws from a multi-employer pension plan in the future, it could potentially incur a withdrawal liability at that time.\\nPostretirement Plan\\nThe Company also provides declining value life insurance to its retirees and a maximum of three years of medical coverage to qualified individuals who retire between the ages of 62 and 65. The Company does not fund these benefits in advance, and uses a December 31 measurement date.\\n52\\nComponents of net periodic postretirement benefit cost for 2012, 2011 and 2010 were as follows:\\n| 2012 | 2011 | 2010 |\\n| Service cost | $ | 161 | $ | 164 | $ | 177 |\\n| Interest cost | 170 | 222 | 219 |\\n| Amortization of prior service cost | — | — | 29 |\\n| Amortization of actuarial gain | — | — | (16 | ) |\\n| Net periodic postretirement benefit cost | $ | 331 | $ | 386 | $ | 409 |\\n\\nThe expected 2012, amortization of postretirement prior service cost and actuarial gain are insignificant.\\nThe status of the postretirement benefit plans at December 31, 2012 and 2011 were as follows:\\n| 2012 | 2011 |\\n| Change in accumulated postretirement benefit obligations: |\\n| Accumulated postretirement benefit obligation at beginning of year | $ | 4,635 | $ | 4,339 |\\n| Service cost | 161 | 164 |\\n| Interest cost | 170 | 222 |\\n| Benefit payments | (193 | ) | (100 | ) |\\n| Actuarial (gain) loss | (394 | ) | 10 |\\n| Accumulated postretirement benefit obligation at end of year | $ | 4,379 | $ | 4,635 |\\n| Funded status – net liability | $ | 4,379 | $ | 4,635 |\\n| Amounts recognized in the consolidated balance sheets consist of: |\\n| Accrued liabilities | $ | (296 | ) | $ | (218 | ) |\\n| Postretirement benefit obligations | (4,083 | ) | (4,417 | ) |\\n| Net amount recognized | $ | (4,379 | ) | $ | (4,635 | ) |\\n| Pre-tax components of accumulated other comprehensive income (loss): |\\n| Unrecognized actuarial gain | $ | 661 | $ | 266 |\\n| Total | $ | 661 | $ | 266 |\\n\\nThe assumed health care cost trend rates for medical plans at December 31 were as follows:\\n| 2012 | 2011 | 2010 |\\n| Medical cost trend rate | 8.00 | % | 8.50 | % | 8.00 | % |\\n| Ultimate medical cost trend rate | 5.00 | % | 5.00 | % | 5.00 | % |\\n| Year ultimate medical cost trend rate will be reached | 2019 | 2018 | 2013 |\\n\\nA 1% increase in the health care cost trend rate assumptions would have increased the accumulated postretirement benefit obligation at December 31, 2012 by $259 with no significant impact on the annual periodic postretirement benefit cost. A 1% decrease in the health care cost trend rate assumptions would have decreased the accumulated postretirement benefit obligation at December 31, 2012 by $235 with no significant impact on the annual periodic postretirement benefit cost.\\n53\\nThe weighted average discount rate used to determine the net periodic postretirement benefit costs and the accumulated postretirement benefit obligations were as follows:\\n| 2012 | 2011 | 2010 |\\n| Net periodic postretirement benefit costs | 3.75 | % | 5.25 | % | 5.75 | % |\\n| Accumulated postretirement benefit obligations | 3.50 | % | 3.75 | % | 5.25 | % |\\n\\nRetirement Savings Plan\\nThe Company’s retirement savings plan includes features under Section 401(k) of the Internal Revenue Code. Effective July 1, 2011, the Company’s 401(k) matching contribution was increased to 100% of each dollar on eligible employee contributions up to the first 6% of the employee’s pre-tax compensation and the Company’s fixed contribution of 4% of eligible earnings for all employees was eliminated. Company contributions cliff vest after two years of employment.\\nEffective July 1, 2012, the Company's 401(k) plan was amended to include the U.S. employees of Tube Supply. Employees were eligible to participate in the Company's 401(k) plan immediately. Tube Supply's existing plan assets were rolled over into the Company's 401(k) plan during 2012 as a result of this amendment.\\nThe amounts expensed are summarized below:\\n| 2012 | 2011 | 2010 |\\n| Supplemental contributions and 401(k) match | $ | 5,260 | $ | 4,414 | $ | 1,634 |\\n\\n(6) Joint Venture\\nKreher Steel Co., LLC is a 50% owned joint venture of the Company. It is a metals distributor of bulk quantities of alloy, special bar quality and stainless steel bars, headquartered in Melrose Park, Illinois.\\nThe following information summarizes the Company’s participation in the joint venture as of and for the year ended December 31:\\n| 2012 | 2011 | 2010 |\\n| Equity in earnings of joint venture | $ | 7,224 | $ | 11,727 | $ | 5,585 |\\n| Investment in joint venture | 38,854 | 36,460 | 27,879 |\\n| Sales to joint venture | 455 | 362 | 973 |\\n| Purchases from joint venture | 695 | 884 | 223 |\\n\\nThe following information summarizes financial data for this joint venture as of and for the year ended December 31:\\n| 2012 | 2011 | 2010 |\\n| Revenues | $ | 257,776 | $ | 269,657 | $ | 188,107 |\\n| Net income | 14,603 | 23,643 | 11,035 |\\n| Current assets | 92,421 | 111,263 | 71,611 |\\n| Non-current assets | 26,099 | 22,979 | 17,880 |\\n| Current liabilities | 14,315 | 59,952 | 32,828 |\\n| Non-current liabilities | 27,845 | 3,089 | 2,872 |\\n| Members’ equity | 76,360 | 71,199 | 53,791 |\\n| Capital expenditures | 5,259 | 6,736 | 2,271 |\\n| Depreciation and amortization | 2,034 | 1,603 | 1,720 |\\n\\n54\\n(7) Income Taxes\\n(Loss) Income before income taxes and equity in earnings of joint venture generated by the Company’s U.S. and non-U.S. operations were as follows:\\n| 2012 | 2011 | 2010 |\\n| U.S | $ | (28,398 | ) | $ | (26,321 | ) | $ | (19,420 | ) |\\n| Non-U.S. | 12,856 | 11,708 | 5,094 |\\n\\nThe Company’s income tax expense (benefit) is comprised of the following:\\n| 2012 | 2011 | 2010 |\\n| Federal |\\n| current | $ | (842 | ) | $ | (1,204 | ) | $ | 6,823 |\\n| deferred | (1,542 | ) | (2,041 | ) | (11,270 | ) |\\n| State |\\n| current | 629 | 461 | 17 |\\n| deferred | 401 | (1,218 | ) | (186 | ) |\\n| Foreign |\\n| current | 2,927 | 2,970 | 1,464 |\\n| deferred | (143 | ) | (94 | ) | 51 |\\n| $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\\n\\nThe reconciliation between the Company’s effective tax rate on income or loss and the U.S. federal income tax rate of 35% is as follows:\\n| 2012 | 2011 | 2010 |\\n| Federal income tax at statutory rates | $ | (5,439 | ) | $ | (5,115 | ) | $ | (5,014 | ) |\\n| State income taxes, net of federal income tax benefits | 22 | (1,007 | ) | (313 | ) |\\n| Permanent items: |\\n| Dividends received deductions | (766 | ) | — | — |\\n| Convertible debt mark-to-market - non-deductible | 6,206 | 1,551 |\\n| Other permanent differences | 480 | 662 | 326 |\\n| Federal and state income tax on joint venture | 2,766 | 4,478 | 2,158 |\\n| Rate differential on foreign income | (1,680 | ) | (726 | ) | (755 | ) |\\n| Unrecognized tax benefits | (557 | ) | (576 | ) | 424 |\\n| Audit settlements | 218 | — | — |\\n| State rate changes | (68 | ) | (478 | ) | — |\\n| Other | 248 | 85 | 73 |\\n| Income tax expense (benefit) | $ | 1,430 | $ | (1,126 | ) | $ | (3,101 | ) |\\n| Effective income tax expense rate | 9.2 | % | 7.7 | % | 21.7 | % |\\n\\n55\\nSignificant components of the Company’s deferred tax assets and liabilities are as follows:\\n| 2012 | 2011 |\\n| Deferred tax assets: |\\n| Postretirement benefits | $ | 3,830 | $ | 3,675 |\\n| Deferred compensation | 1,940 | 1,916 |\\n| Deferred gain | — | 271 |\\n| Impairments | 1,452 | 1,311 |\\n| Alternative minimum tax and net operating loss carryforward | 3,487 | 2,635 |\\n| Total deferred tax assets | $ | 10,709 | $ | 9,808 |\\n| Deferred tax liabilities: |\\n| Depreciation | $ | 8,032 | $ | 8,307 |\\n| Inventory | 1,146 | 1,695 |\\n| Pension | 4,240 | 5,742 |\\n| Intangible assets and goodwill | 24,224 | 16,486 |\\n| Other, net | 1,665 | 1,475 |\\n| Total deferred tax liabilities | 39,307 | 33,705 |\\n| Net deferred tax liabilities | $ | 28,598 | $ | 23,897 |\\n\\nAs of December 31, 2012, the Company has federal, state and foreign net operating losses (\\\"NOLs\\\") as follows:\\n| Amount | Expiration Period |\\n| Federal | $ | — |\\n| State | 19,499 | 2015 to 2032 |\\n| Foreign | 2,473 | (a) |\\n\\n(a) Foreign NOLs of $369 expire in 2014 and $2,104 do not expire.\\nBased on all available evidence, including historical and forecasted financial results, the Company determined that it is more likely than not that the federal, state and foreign NOLs that have expiration dates will be realized due to the fact that the Company anticipates it will be able to have sufficient earnings in future years to use the NOL carryforwards prior to expiration. To the extent that the Company does not generate sufficient state or foreign taxable income within the statutory carryforward periods to utilize the NOL carryforwards in the respective jurisdictions, they will expire unused. However, based upon all available evidence, the Company has concluded that it will utilize these NOL carryforwards prior to the expiration period.\\nThe following table shows the net change in the Company’s unrecognized tax benefits:\\n| 2012 | 2011 | 2010 |\\n| Balance as of January 1 | $ | 861 | $ | 1,465 | $ | 726 |\\n| Increases (decreases) in unrecognized tax benefits: |\\n| Due to tax positions taken in prior years | — | 91 | 729 |\\n| Due to tax positions taken during the current year | 45 | 60 | 44 |\\n| Due to settlement with tax authorities | (757 | ) | — | (34 | ) |\\n| Due to expiration of statute | (44 | ) | (755 | ) | — |\\n| Balance as of December 31 | $ | 105 | $ | 861 | $ | 1,465 |\\n\\nUnrecognized tax benefits of $105, $861 and $950 would impact the effective tax rate if recognized as of December 31, 2012, 2011 and 2010, respectively. The accrued interest and penalties related to unrecognized tax benefits were insignificant at December 31, 2012 and 2011. The interest and penalties recorded by the Company were insignificant for the years ended December 31, 2012, 2011 and 2010.\\n56\\nDuring 2012 and 2011, statutes expired on certain unrecognized tax benefits of the Company. The reversal of the reserve of these unrecognized tax benefits was recorded as a component of overall income tax benefit for the years ended December 31, 2012 and 2011, respectively.\\nThe Company or its subsidiaries files income tax returns in the United States federal jurisdiction, 29 states, and 7 foreign jurisdictions.\\nThe following tax years remain open to examination by the major taxing jurisdictions to which the Company is subject:\\n| U.S. Federal | 2010 to 2011 |\\n| U.S. States | 2008 to 2011 |\\n| Foreign | 2007 to 2011 |\\n\\nDuring the second quarter of 2012, audits of the Company’s 2008 and 2009 U.S. federal income tax returns were concluded with no significant assessment. During 2011, the Company recognized $423 of tax benefits, excluding interest, due to the expiration of the statute of limitations for uncertain tax positions taken in prior years. Due to the potential for resolution of the examination or expiration of statutes of limitations, it is reasonably possible that the Company’s gross unrecognized tax benefits may change within the next 12 months by a range of zero to $60.\\nThe Company received its 2010 federal tax refund of $2,025 during February 2012 and its 2009 federal income tax refund of $6,344 during January 2011.\\n(8) Goodwill and Intangible Assets\\nThe changes in carrying amounts of goodwill during the years ended December 31, 2012 and 2011 were as follows:\\n| 2012 | 2011 |\\n| MetalsSegment | PlasticsSegment | Total | MetalsSegment | PlasticsSegment | Total |\\n| Balance as of January 1 |\\n| Goodwill | $ | 117,145 | $ | 12,973 | $ | 130,118 | $ | 97,354 | $ | 12,973 | $ | 110,327 |\\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\\n| 56,928 | 12,973 | 69,901 | 37,137 | 12,973 | 50,110 |\\n| Acquisition of Tube Supply | — | — | — | 19,637 | — | 19,637 |\\n| Currency valuation | 399 | — | 399 | 154 | — | 154 |\\n| Balance as of December 31 |\\n| Goodwill | 117,544 | 12,973 | 130,517 | 117,145 | 12,973 | 130,118 |\\n| Accumulated impairment losses | (60,217 | ) | — | (60,217 | ) | (60,217 | ) | — | (60,217 | ) |\\n| $ | 57,327 | $ | 12,973 | $ | 70,300 | $ | 56,928 | $ | 12,973 | $ | 69,901 |\\n\\nThe Company’s annual test for goodwill impairment is completed as of January 1st each year. Based on its January 1, 2012 test, the Company determined that there was no impairment of goodwill. The Company's year-to-date operating results, among other factors, are considered in determining whether it is more likely than not that the fair value for any reporting unit has declined below its carrying value, which would require the Company to perform an interim goodwill impairment test. Another recession or economic declines in specific industries could change management's expectations of future financial results and/or key valuation assumptions used in determining the fair-value of its reporting units, which could result in a goodwill impairment.\\n57\\nThe following summarizes the components of intangible assets at December 31, 2012 and 2011 :\\n| 2012 | 2011 |\\n| Gross CarryingAmount | AccumulatedAmortization | Gross CarryingAmount | AccumulatedAmortization |\\n| Customer relationships | $ | 119,118 | $ | 45,317 | $ | 118,567 | $ | 34,960 |\\n| Non-compete agreements | 3,888 | 3,235 | 3,888 | 2,902 |\\n| Trade names | 8,297 | 1,188 | 8,249 | 410 |\\n| Developed technology | 1,400 | 486 | 1,400 | 19 |\\n| Total | $ | 132,703 | $ | 50,226 | $ | 132,104 | $ | 38,291 |\\n\\nThe weighted-average amortization period for the intangible assets is 10.8 years, 11.3 years for customer relationships, 9.4 years for trade names, 3 years for non-compete agreements and 3 years for developed technology. Substantially all of the Company’s intangible assets were acquired as part of the acquisitions of Transtar on September 5, 2006 and Tube Supply on December 15, 2011.\\nFor the years ended December 31, 2012, 2011, and 2010, the aggregate amortization expense was $11,843, $6,867 and $7,071, respectively.\\nThe following is a summary of the estimated annual amortization expense for each of the next 5 years:\\n| 2013 | $ | 11,775 |\\n| 2014 | 11,742 |\\n| 2015 | 10,975 |\\n| 2016 | 10,975 |\\n| 2017 | 8,951 |\\n\\n(9) Debt\\nShort-term and long-term debt consisted of the following at December 31, 2012 and 2011:\\n| 2012 | 2011 |\\n| SHORT-TERM DEBT |\\n| Foreign | $ | 500 | $ | 500 |\\n| Total short-term debt | 500 | 500 |\\n| LONG-TERM DEBT |\\n| 12.75% Senior Secured Notes due December 15, 2016 | 225,000 | 225,000 |\\n| 7.0% Convertible Notes due December 15, 2017 | 57,500 | 57,500 |\\n| New Revolving Credit Facility due December 15, 2015 | 39,500 | 35,500 |\\n| Other, primarily capital leases | 1,400 | 244 |\\n| Total long-term debt | 323,400 | 318,244 |\\n| Plus: derivative liability for conversion feature associated with convertible debt | — | 26,440 |\\n| Less: unamortized discount | (26,831 | ) | (30,252 | ) |\\n| Less: current portion | (415 | ) | (192 | ) |\\n| Total long-term portion | 296,154 | 314,240 |\\n| TOTAL SHORT-TERM AND LONG-TERM DEBT | $ | 297,069 | $ | 314,932 |\\n\\nDuring December of 2011, in conjunction with the completion of the Acquisition (see Note 2), the Company issued $225,000 aggregate principal amount of 12.75% Senior Secured Notes due 2016 (the “Secured Notes”), $57,500 aggregate principal amount of 7.0% Convertible Senior Notes due 2017 (the “Convertible Notes”) and entered into a $100,000 senior secured asset based revolving credit facility (the “New Revolving Credit Facility”). Net proceeds from these transactions (collectively referred to as the “Debt Transactions”) were used to complete the Acquisition, repay existing debt and for general corporate purposes. The Company incurred debt origination fees of $18,136\\n58\\nassociated with the Debt Transactions which are primarily being amortized using the effective interest method and recognized interest expense of $3,375 for underwriting fees associated with the debt financing. The Company recognized a loss of $6,153 on the extinguishment of its previously existing debt which included prepayment fees and the write-off of previously existing deferred financing costs.\\nSecured Notes\\nThe Company filed a registration statement with the Securities and Exchange Commission on Form S-4 on April 11, 2012. The registration statement was declared effective on June 12, 2012.\\nOn June 12, 2012, the Company commenced an offer to exchange $225,000 principal amount of 12.75% Secured Notes due 2016, which are registered under the Securities Act of 1933 (the “New Secured Notes”), for $225,000 principal amount of outstanding 12.75% Senior Secured Notes due 2016, which had not been registered under the Securities Act of 1933 (the “Old Secured Notes”). The terms of the New Secured Notes issued are identical in all material respects to the Old Secured Notes, except that the New Secured Notes are registered under the Securities Act of 1933, do not have any of the transfer restrictions, registration rights and additional interest provisions relating to the Old Secured Notes and bear a different CUSIP number from the Old Secured Notes. The Company did not receive any proceeds from the exchange offer.\\nThe New Secured Notes will mature on December 15, 2016. The Company will pay interest on the New Secured Notes at a rate of 12.75% per annum in cash semi-annually. During 2012, interest payments totaling $28,688 were made on June 15, 2012 and December 14, 2012. The New Secured Notes are fully and unconditionally guaranteed, jointly and severally, by certain 100% owned domestic subsidiaries of the Company (the “Note Guarantors”). The New Secured Notes and the related guarantees are secured by a lien on substantially all of the Company's and the Note Guarantors' assets, subject to certain exceptions and permitted liens pursuant to a pledge and security agreement. The terms of the New Secured Notes contain numerous covenants imposing financial and operating restrictions on the Company's business. These covenants place restrictions on the Company's ability and the ability of its subsidiaries to, among other things, pay dividends, redeem stock or make other distributions or restricted payments; incur indebtedness or issue common stock; make certain investments; create liens; agree to payment restrictions affecting certain subsidiaries; consolidate or merge; sell or otherwise transfer or dispose of assets, including equity interests of certain subsidiaries; enter into transactions with affiliates, enter into sale and leaseback transactions; and use the proceeds of permitted sales of the Company's assets. Refer to Note 14 for Guarantor Financial Information disclosure.\\nOn or after December 15, 2014, the Company may redeem some or all of the New Secured Notes at a redemption premium of 106.375% of the principal amount for the 12-month period beginning December 15, 2014 and 100% thereafter, plus accrued and unpaid interest. Prior to December 15, 2014, the Company may redeem up to 35% of the aggregate principal amount of the New Secured Notes at a redemption price of 112.75% of the principal amount, plus accrued and unpaid interest, with the net cash proceeds of certain equity offerings. In addition, the Company may, at its option, redeem some or all of the New Secured Notes at any time prior to December 15, 2014, by paying a “make-whole” premium, plus accrued and unpaid interest.\\nThe New Secured Notes also contain a provision that allows holders of the New Secured Notes to require the Company to repurchase all or any part of the Secured Notes if a change of control triggering event occurs. Under this provision, the repurchase of the New Secured Notes will occur at a purchase price of 101% of the outstanding principal amount, plus accrued and unpaid interest, if any, on such New Secured Notes to the date of repurchase. In addition, upon certain asset sales, the Company may be required to offer to use the net proceeds thereof to purchase some of the New Secured Notes at 100% of the principal amount thereof, plus accrued and unpaid interest.\\nSubject to certain conditions, within 95 days after the end of each fiscal year, the Company must make an offer to purchase New Secured Notes with certain of its excess cash flow for such fiscal year (as defined in the indenture) for such fiscal year, commencing with the fiscal year ending December 31, 2012, at 103% of the principal amount thereof, plus accrued and unpaid interest. For the fiscal year ended December 31, 2012, the Company estimated excess cash flow (as defined in the indenture) to be approximately $17,000 and therefore, an offer to purchase New Secured Notes is required to be made within 95 days of year end.\\nAlthough redemption of the New Secured Notes is outside of the control of the Company, the New Secured Notes in the amount of $17,000 are reported as long-term debt as availability under the Company's revolving credit facility, which is long-term in nature, would be used if redemption occurred.\\n59\\nConvertible Notes\\nThe $50,000 Convertible Notes were issued pursuant to an indenture, dated as of December 15, 2011, among the Company, the Note Guarantors and U.S. Bank National Association, as trustee. The Convertible Notes were issued by the Company at an initial offering price equal to 100% of the principal amount. The Company granted the initial purchaser in the Convertible Notes offering an option, exercisable within 30 days, to purchase up to an additional $7,500 aggregate principal amount of Convertible Notes. The initial purchaser exercised their option in full and, on December 20, 2011, the Company issued an additional $7,500 aggregate principal amount of Convertible Notes.\\nThe Convertible Notes will mature on December 15, 2017. The Company will pay interest on the Convertible Notes at a rate of 7.0% in cash semi-annually. During 2012, interest payments totaling $4,025 were made on June 15, 2012 and December 14, 2012. The Convertible Notes will be fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by the Note Guarantors. The initial conversion rate for the Convertible Notes will be 97.2384 shares of the Company’s common stock per $1 principal amount of Convertible Notes, equivalent to an initial conversion price of approximately $10.28 per share of common stock. The conversion rate will be subject to adjustment, but will not be adjusted for accrued and unpaid interest, if any. In addition, if an event constituting a fundamental change occurs, the Company will in some cases increase the conversion rate for a holder that elects to convert its Convertible Notes in connection with such fundamental change. Upon conversion, the Company will pay and/or deliver, as the case may be, cash, shares of common stock or a combination of cash and shares of common stock, at the Company’s election, together with cash in lieu of fractional shares.\\nHolders may convert their Convertible Notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding June 15, 2017 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the trading price per note for each day of that measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the applicable conversion rate on each such day; (2) during any calendar quarter (and only during such calendar quarter) after the calendar quarter ended December 31, 2011, if the last reported sale price of the Company’s common stock for 20 or more trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is equal to or greater than 130% of the applicable conversion price in effect for each applicable trading day; (3) upon the occurrence of specified corporate events, including certain dividends and distributions; or (4) if the Company calls the Convertible Notes for redemption on or after December 20, 2015. The Convertible Notes will be convertible, regardless of the foregoing circumstances, at any time from, and including, June 15, 2017 through the second scheduled trading day immediately preceding the maturity date.\\nPrior to April 26, 2012, the Company had the option to elect not to issue shares of common stock upon conversion of the Convertible Notes to the extent such election would result in the issuance of more than 19.99% of the common stock outstanding immediately before the issuance of the Convertible Notes until the Company receives shareholder approval for such issuance and shareholder approval of the increase in the number of shares of common stock authorized and available for issuance upon conversion of the Convertible Notes. Since the Company did not have sufficient authorized shares available to share-settle the conversion option in full, the embedded conversion option did not qualify for equity classification and instead was separately valued and accounted for as a derivative liability as of December 31, 2011. The initial value allocated to the derivative liability was $22,330 of the $57,500 principal amount of the Convertible Notes, which represents a discount to the debt to be amortized through interest expense using the effective interest method through the maturity of the Convertible Notes. Accordingly, the effective interest rate used to amortize the debt discount on the Convertible Notes was determined to be 17.78%. During each reporting period prior to April 26, 2012, the derivative liability was marked to fair value through earnings. As of December 31, 2011, the derivative liability, which is classified in long-term debt, had a fair value of $26,440. There was no derivative liability as of December 31, 2012.\\nOn April 26, 2012, at the Company's Annual Meeting of Stockholders, shareholder approval was obtained for the issuance of shares in excess of 20% of the Company's outstanding common stock to satisfy any conversions of the Convertible Notes. Additionally, shareholder approval was obtained to amend the Company's charter to authorize additional shares of common stock from 30,000 to 60,000. With these approvals, the Company now has the ability to share-settle the conversion option in full and therefore, the embedded conversion option is no longer required to be separately valued and accounted for as a derivative liability. As of April 26, 2012, the conversion option's cumulative value of $42,037 was reclassified to additional paid-in capital and will no longer be marked-to-market through earnings. The deferred tax benefit of $8,285 associated with the temporary difference between the financial reporting basis of the derivative liability and its tax basis at the date of issuance (December 15, 2011) was also reclassified to additional paid-in capital.\\n60\\nUpon a fundamental change, subject to certain exceptions, holders may require the Company to repurchase some or all of their Convertible Notes for cash at a repurchase price equal to 100% of the principal amount of the Convertible Notes being repurchased, plus any accrued and unpaid interest.\\nThe Company may not redeem the Convertible Notes prior to December 20, 2015. On or after December 20, 2015, the Company may redeem all or part of the Convertible Notes (except for the Convertible Notes that we are required to repurchase as described above) if the last reported sale price of the Company’s common stock exceeds 135% of the applicable conversion price for 20 or more trading days in a period of 30 consecutive trading days ending on the trading day immediately prior to the date of the redemption notice. The redemption price will equal the sum of 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest, plus a “make-whole premium” payment. The Company must make the \\\"make-whole\\\" premium payments on all Convertible Notes called for redemption including Convertible Notes converted after the date we delivered the notice of redemption. The Company will pay the redemption price in cash except for any non-cash portion of the \\\"make-whole\\\" premium.\\nNew Revolving Credit Facility\\nThe New Revolving Credit Facility consists of a $100,000 senior secured asset-based revolving credit facility (subject to adjustment pursuant to a borrowing base described below), of which (a) up to an aggregate principal amount of $20,000 will be available for a Canadian subfacility, (b) up to an aggregate principal amount of $20,000 will be available for letters of credit and (c) up to an aggregate principal amount of $10,000 will be available for swingline loans. Loans under the New Revolving Credit Facility will be made available to the Company and certain domestic subsidiaries (the “U.S. Borrowers”) in U.S. dollars and the Canadian Borrowers in U.S. dollars and Canadian dollars. The New Revolving Credit Facility will mature on December 15, 2015.\\nAll obligations of the U.S. Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by each direct and indirect, existing and future, domestic subsidiary of the U.S. Borrowers (the “U.S. Subsidiary Guarantors” and together with the U.S. Borrowers, the “U.S. Credit Parties”), subject to certain exceptions for immaterial subsidiaries. All obligations of the Canadian Borrowers under the New Revolving Credit Facility are guaranteed on a senior secured basis by (a) each U.S. Credit Party and (b) each direct and indirect, existing and future, Canadian subsidiary of the Company (the “Canadian Subsidiary Guarantors” and together with the Canadian Borrowers, the “Canadian Credit Parties”; and the U.S. Credit Parties together with the Canadian Credit Parties, the “Credit Parties”), subject to certain exceptions.\\nAll obligations under the New Revolving Credit Facility are secured on a first-priority basis by a perfected security interest in substantially all assets of the Credit Parties (subject to certain exceptions for permitted liens). The New Revolving Credit Facility will rank pari passu in right of payment with the Secured Notes, but, pursuant to the intercreditor agreement, the Secured Notes will be effectively subordinated to the indebtedness under the New Revolving Credit Facility with respect to the collateral.\\nAt the Company’s election, borrowings under the New Revolving Credit Facility will bear interest at variable rates based on (a) a customary base rate plus an applicable margin of between 0.50% and 1.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility) or (b) an adjusted LIBOR rate plus an applicable margin of between 1.50% and 2.00% (depending on quarterly average undrawn availability under the New Revolving Credit Facility). The weighted average interest rate on borrowings under the revolving credit facilities were 2.71% and 1.63% for the year ended December 31, 2012 and 2011, respectively. The Company will pay certain customary recurring fees with respect to the New Revolving Credit Facility.\\nThe New Revolving Credit Facility permits the Company to increase the aggregate amount of the commitments under the New Revolving Credit Facility from time to time in an aggregate amount for all such increases not to exceed $50,000, subject to certain conditions. The existing lenders under the New Revolving Credit Facility are not obligated to provide the incremental commitments.\\nThe New Revolving Credit facility contains a springing financial maintenance covenant requiring the Company to maintain the ratio of EBITDA (as defined in the agreement) to fixed charges of 1.1 to 1.0 when excess availability is less than the greater of 10% of the calculated borrowing base (as defined in the agreement) or $10,000. In addition, if excess availability is less than the greater of 12.5% of the calculated borrowing base (as defined in the agreement) or $12,500, the lender has the right to take full dominion of the Company’s cash collections and apply these proceeds to outstanding loans under the New Revolving Credit Agreement. As of December 31, 2012, the Company’s excess availability of $50,543 was above such thresholds.\\n61\\nNet interest expense reported on the consolidated statements of operations was reduced by interest income from investment of excess cash balances of $222 in 2012, $254 in 2011 and $201 in 2010.\\n(10) Fair Value Measurements\\nThe three-tier value hierarchy the Company utilizes, which prioritizes the inputs used in the valuation methodologies, is:\\nLevel 1—Valuations based on quoted prices for identical assets and liabilities in active markets.\\nLevel 2—Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.\\nLevel 3—Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants.\\nThe fair value of cash, accounts receivable and accounts payable approximate their carrying values. The fair value of cash equivalents are determined using the fair value hierarchy described above. Cash equivalents consisting of money market funds are valued based on quoted prices in active markets and as a result are classified as Level 1.\\nThe Company’s pension plan asset portfolio as of December 31, 2012 and 2011 is primarily invested in fixed income securities, which generally fall within Level 2 of the fair value hierarchy. Fixed income securities in the are valued based on evaluated prices provided to the trustee by independent pricing services. Such prices may be determined by factors which include, but are not limited to, market quotations, yields, maturities, call features, ratings, institutional size trading in similar groups of securities and developments related to specific securities. Refer to Note 5 for pension fair value disclosures.\\nFair Value Measurements of Debt\\nThe fair value of the Company’s Senior Secured Notes as of December 31, 2012 was estimated to be $263,813 compared to a carrying value of $218,335, net of unamortized discount. The fair value for the Senior Secured Notes is determined based on recent trades of the bonds and fall within level 2 of the fair value hierarchy.\\nThe fair value of the Convertible Notes, as of December 31, 2012 was estimated to be approximately $95,000 compared to a carrying value of $37,334, net of unamortized discount. The fair value for the Convertible Notes, which fall within level 3 of the fair value hierarchy, is determined based on similar debt instruments that do not contain a conversion feature, as well as other factors related to the callable nature of the notes.\\nThe main inputs and assumptions into the fair value model for the Convertible Notes at December 31, 2012 were as follows:\\n| Company's stock price at the end of the period | $ | 14.77 |\\n| Expected volatility | 22.3 | % |\\n| Credit spreads | 8.22 | % |\\n| Risk-free interest rate | 0.36 | % |\\n\\nThe estimated fair value of the derivative liability for the conversion feature (refer to table below), which falls within level 3 of the fair value hierarchy, as of December 31, 2011 was computed using a binomial lattice model using the Company’s historical volatility over the term corresponding to the remaining contractual term of the Convertible Notes and observed spreads of similar debt instruments that do not include a conversion feature.\\nAs of December 31, 2012, the estimated fair value of the Company’s debt outstanding under its revolving credit facilities, which falls within level 3 of the fair value hierarchy, is $37,775 compared to its carrying value of $40,000, assuming the current amount of debt outstanding at the end of the year was outstanding until the maturity of the Company’s facility in December 2015. Although borrowings could be materially greater or less than the current amount of borrowings outstanding at the end of the year, it is not practical to estimate the amounts that may be outstanding during the future periods since there is no predetermined borrowing or repayment schedule.\\n62\\nFair Value Measurements of Commodity Hedges\\nThe Company has a commodity hedging program to mitigate risks associated with certain commodity price fluctuations. At December 31, 2012, the Company had executed forward contracts that extend through 2016. The counterparty to these contracts is not considered a credit risk by the Company. At December 31, 2012 and 2011, the notional value associated with forward contracts was $17,191 and $15,486, respectively. The Company recorded, through cost of materials, realized and unrealized losses of $430 and $2,377 during the years ended December 31, 2012 and 2011, respectively, as a result of the decline in the fair value of the contracts. There were no gains or losses recorded for commodity hedges during 2010. Refer to Note 13 for letters of credit outstanding for collateral associated with commodity hedges.\\nThe Company uses information which is representative of readily observable market data when valuing derivative liabilities associated with commodity hedges. The derivative liabilities are classified as Level 2 in the table below.\\nThe liabilities measured at fair value on a recurring basis were as follows:\\n| Level 1 | Level 2 | Level 3 | Total |\\n| As of December 31, 2012: |\\n| Derivative liability for commodity hedges | $ | — | $ | 2,494 | $ | — | $ | 2,494 |\\n| As of December 31, 2011: |\\n| Derivative liability for commodity hedges | $ | — | $ | 2,331 | $ | — | $ | 2,331 |\\n| Derivative liability for conversion feature associated with convertible debt | — | — | 26,440 | 26,440 |\\n\\nThe following reconciliation represents the change in fair value of Level 3 liabilities between January 1, 2012 and December 31, 2012:\\n| Derivative liability forconversion featureassociated withconvertible debt |\\n| Fair value as of January 1 | $ | 26,440 |\\n| Mark-to-market adjustment on conversion feature | 15,597 |\\n| Reclassification from long-term debt to additional paid-in capital | (42,037 | ) |\\n| Fair value as of December 31 | $ | — |\\n\\n(11) Share-based Compensation\\nThe Company accounts for its share-based compensation arrangements by recognizing compensation expense for the fair value of the share awards ratably over their vesting period or a shorter period, as applicable. The consolidated compensation cost recorded for the Company’s share-based compensation arrangements was $2,277, $4,349 and $2,411 for 2012, 2011 and 2010, respectively. The total income tax benefit recognized in the consolidated statements of operations for share-based compensation arrangements was $872, $1,534 and $831 in 2012, 2011 and 2010, respectively. All compensation expense related to share-based compensation arrangements is recorded in sales, general and administrative expense. The unrecognized compensation cost as of December 31, 2012 associated with all share-based payment arrangements is $4,973 and the weighted average period over which it is to be expensed is 1.4 years.\\n| Plan Description | Authorized Shares |\\n| 1995 Directors Stock Option Plan | 188 |\\n| 1996 Restricted Stock and Stock Option Plan | 938 |\\n| 2000 Restricted Stock and Stock Option Plan | 1,200 |\\n| 2004 Restricted Stock, Stock Option and Equity Compensation Plan | 1,350 |\\n| 2008 A. M. Castle & Co. Omnibus Incentive Plan (amended and restated as of April 28, 2011) | 2,750 |\\n\\n63\\nLong-Term Compensation and Incentive Plans\\nOn March 7, 2012, the Human Resources Committee (the “Committee”) of the Board of Directors of the Company approved equity awards under the Company’s 2012 Long-Term Compensation Plan (\\\"2012 LTC Plan\\\") for executive officers and other select personnel. The 2012 LTC Plan awards included restricted stock units (\\\"RSUs\\\") and performance share units (\\\"PSUs\\\"). All 2012 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle & Co. Omnibus Incentive Plan.\\nOn March 2, 2011, the Committee approved equity awards under the Company's 2011 Long-Term Compensation Plan (\\\"2011 LTC Plan\\\") for executive officers and other select personnel. The 2011 LTC Plan awards included RSUs and PSUs. All 2011 LTC Plan awards are subject to the terms of the Company's 2008 A.M. Castle Omnibus Incentive Plan.\\nOn March 18, 2010, the Committee approved equity awards under the Company’s 2010 Long-Term Compensation Plan (“2010 LTC Plan”) for executive officers and other select personnel. The 2010 LTC Plan awards included RSUs, PSUs, and stock options. All 2010 LTC Plan awards are subject to the terms of the Company’s 2008 Restricted Stock, Stock Option and Equity Compensation Plan, amended and restated as of December 9, 2010.\\nUnless covered by a specific change-in-control or severance agreement, participants to whom RSUs, performance shares and other non-vested shares have been granted must be employed by the Company on the vesting date or at the end of the performance period, respectively, or the award will be forfeited. However, for stock option awards, unless a participant is covered by a specific change-in-control or severance agreement, options are forfeited in the event of the termination of employment other than by reason of disability or a retirement.\\nCompensation expense is recognized based on management’s estimate of the total number of share-based awards expected to vest at the end of the service period.\\nRestricted Share Units and Non-Vested Shares\\nThe RSUs granted under the 2012 and 2011 LTC Plans will cliff vest on December 31, 2014 and December 31, 2013, respectively. Approximately 78 RSUs granted under the 2010 LTC Plan cliff vested on December 31, 2012. Each RSU that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\\nThe outstanding non-vested share balance consists of shares issued to the Board of Directors during the second quarter of 2012 and shares issued for retention incentive purposes. The Director shares vest during the second quarter of 2015 and the balance of the shares vest on December 31, 2014. The RSU share balance consists of units granted to employees for incentive purposes.\\nThe fair value of the RSUs and non-vested shares is established using the market price of the Company’s stock on the date of grant.\\nA summary of the non-vested share and RSU activity is as follows:\\n| Shares | Units |\\n| Shares | Weighted-Average GrantDate Fair Value | Units | Weighted-Average GrantDate Fair Value |\\n| Outstanding at January 1, 2012 | 38 | $ | 18.74 | 232 | $ | 14.39 |\\n| Granted | 73 | $ | 12.22 | 309 | $ | 10.60 |\\n| Forfeited | (5 | ) | $ | 17.02 | (158 | ) | $ | 12.44 |\\n| Vested | (33 | ) | $ | 18.95 | (85 | ) | $ | 12.45 |\\n| Outstanding at December 31, 2012 | 73 | $ | 12.22 | 298 | $ | 12.05 |\\n| Expected to vest at December 31, 2012 | 73 | $ | 12.22 | 256 | $ | 12.36 |\\n\\nThe unrecognized compensation cost as of December 31, 2012 associated with RSU and non-vested share awards is $2,758. The total fair value of shares vested during the years ended December 31, 2012, 2011 and 2010 was $1,685, $2,166 and $600, respectively.\\n64\\nPerformance Shares\\nUnder the 2012, 2011 and 2010 LTC Plans, the potential award for the performance shares granted is dependent on the Company’s relative total shareholder return (“RTSR”), which represents a market condition, over a three-year performance period, beginning January 1, 2012, January 1, 2011 and January 1, 2010 and ending December 31, 2014, December 31, 2013 and December 31, 2012, respectively. RTSR is measured against a group of peer companies either in the metals industry or in the industrial products distribution industry (the “RTSR Peer Group”). The 2012, 2011 and 2010 LTC Plans provide with respect to performance shares for (1) a threshold level up to which the threshold level of performance shares will vest, a target performance level at which the target number of performance shares will vest, a maximum performance level at or above which the maximum number of performance shares will vest, and pro rata vesting between the threshold and maximum performance levels and (2) minimum and maximum vesting opportunities ranging from one-half up to two times the target number. The threshold, target and maximum performance levels for RTSR are the 25th, 50th and 75th percentile, respectively, relative to RTSR Peer Group performance. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense for performance awards containing a market condition is recognized regardless of whether the market condition is achieved to the extent the requisite service period condition is met. Each performance share that becomes vested entitles the participant to receive one share of the Company’s common stock. The number of shares delivered may be reduced by the number of shares required to be withheld for federal and state withholding tax requirements (determined at the market price of Company shares at the time of payout).\\nUnder the 2012 and 2011 LTC Plans, the potential award for performance shares containing a non-market-based performance condition is determined based on the Company's actual performance versus Company-specific target goals for Return on Invested Capital (“ROIC”), as defined in the 2012 and 2011 LTC Plans. Under the 2012 LTC Plan, the non-market-based performance condition is determined based on the Company's average actual performance versus Company-specific goals for ROIC for the three-year performance period beginning on January 1st of the year of grant. Under the 2011 LTC Plan, the non-market-based performance condition is determined for any one or more fiscal years during the three-year performance period beginning on January 1st of the year of grant. Partial performance awards can be earned for performance less than the target goal, but in excess of minimum goals and award distributions twice the target can be achieved if the maximum goals are met or exceeded. The number of performance shares, if any, that vest based on the performance achieved during the three-year performance period, will vest at the end of the three-year performance period. Compensation expense recognized is based on management’s expectation of future performance compared to the pre-established performance goals. If the performance goals are not expected to be met, no compensation expense is recognized and any previously recognized compensation expense is reversed.\\nThe grant date fair values of performance shares awarded containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\\n| 2012 | 2011 | 2010 |\\n| Grant Date Fair Value per Share | $ | 13.78 | $ | 23.89 | $ | 12.26 |\\n| Expected volatility | 85.0 | % | 62.0 | % | 61.6 | % |\\n| Risk-free interest rate | 0.40 | % | 1.10 | % | 1.45 | % |\\n| Expected life (in years) | 2.81 | 2.84 | 2.80 |\\n| Expected dividend yield | — | — | — |\\n\\nPerformance awards under the active LTC Plans were granted to the Company's new CEO in October 2012. The grant date fair values of performance shares awarded to the CEO containing the RTSR market-based performance condition was estimated using a Monte Carlo simulation with the following assumptions:\\n| 2012 | 2011 | 2010 |\\n| Grant Date Fair Value per Share | $ | 16.65 | $ | 10.61 | $ | 5.57 |\\n| Expected volatility | 60.7 | % | 60.7 | % | 60.7 | % |\\n| Risk-free interest rate | 0.34 | % | 0.34 | % | 0.34 | % |\\n| Expected life (in years) | 2.21 | 1.21 | 0.21 |\\n| Expected dividend yield | — | — | — |\\n\\n65\\nFinal award vesting and distribution of performance awards granted under the 2010 LTC Plan was determined based on the Company’s actual performance versus the target goals for a three-year consecutive period (as defined in the 2010 Plan). Refer to the table below for the number of shares expected to be issued under 2010 LTC Plan.\\n| Plan Year | Grant Date Fair Value | Estimated Number ofPerformance Shares to be Issued | Maximum Number ofPerformance Shares thatcould Potentially be Issued |\\n| 2012 LTC Plan |\\n| Market-based performance condition | $ | 13.78 | 172 | 244 |\\n| Market-based performance condition (1) | $ | 16.65 | 41 | 58 |\\n| Non-market-based performance condition | $ | 10.02 | — | 244 |\\n| Non-market-based performance condition (1) | $ | 12.74 | — | 58 |\\n| 2011 LTC Plan |\\n| Market-based performance condition | $ | 23.89 | 39 | 131 |\\n| Market-based performance condition (1) | $ | 10.61 | 9 | 32 |\\n| Non-market-based performance condition | $ | 17.13 | — | 131 |\\n| Non-market-based performance condition (1) | $ | 12.74 | — | 32 |\\n| 2010 LTC Plan |\\n| Market-based performance condition | $ | 12.26 | 83 | 237 |\\n| Market-based performance condition (1) | $ | 5.57 | 2 | 5 |\\n\\n(1) Represents the status of performance awards granted under the active LTC Plans in October 2012.\\nThe unrecognized compensation cost as of December 31, 2012 associated with the 2012 and 2011 LTC Plans performance shares is $2,145.\\nStock Options\\nThere were no stock options issued under the 2012 or 2011 LTC Plans. The stock options issued under the 2010 LTC Plan vest and become exercisable three years from the date of the grant. The term of the options is eight years. The exercise price of the options is $12.79 per share. The grant date fair value of $5.71 per share was estimated using the Black-Scholes option-pricing model with the following assumptions:\\n| 2010 |\\n| Expected volatility | 58.5 | % |\\n| Risk-free interest rate | 2.3 | % |\\n| Expected life (in years) | 5.5 |\\n| Expected dividend yield | 1.2 | % |\\n\\n| Shares | WeightedAverageExercise Price | IntrinsicValue | Weighted AverageRemainingContractual Life |\\n| Stock options outstanding at January 1, 2012 | 418 | $ | 12.44 |\\n| Exercised | (16 | ) | $ | 9.11 |\\n| Forfeited | (113 | ) | $ | 15.56 |\\n| Expired | (19 | ) | $ | 12.60 |\\n| Stock options outstanding at December 31, 2012 | 270 | $ | 11.34 | $ | 937 | 3.8 |\\n| Stock options exercisable at December 31, 2012 | 111 | $ | 9.25 | $ | 621 | 1.5 |\\n| Stock options vested or expected to vest as of December 31, 2012 | 259 | $ | 11.28 | $ | 915 | 3.7 |\\n\\n66\\nThe total intrinsic value of options exercised during the years ended December 31, 2012, 2011 and 2010, was $36, $194 and $219, respectively. The unrecognized compensation cost as of December 31, 2012 associated with stock options is $70.\\n(12) Stockholders' Equity\\nShareholder Rights Plan\\nIn August 2012, the Company's Board of Directors adopted a Shareholder Rights Plan (the “Rights Plan”) and declared a dividend of one right for each outstanding share of the Company's common stock outstanding at the close of business on September 11, 2012. Pursuant to the Rights Plan, the Company is issuing one preferred stock purchase right (a “Right”) for each share of common stock outstanding on September 11, 2012. Each Right, once exercisable, represents the right to purchase one one-hundredth of a share (a “Unit”) of Series B Junior Preferred Stock of the Company, without par value, for $54.00, subject to adjustment. The Rights become exercisable in the event any individual person or entity, without Board approval, acquires 10% or more of the Company's common stock, subject to certain exceptions. In these circumstances, each holder of a Right (other than rights held by the acquirer) will be entitled to purchase, at the then-current exercise price of the Right, additional shares of the Company's common stock having a value of twice the exercise price of the Right. Additionally, if the Company is involved in a merger or other business combination transaction with another person after which its common stock does not remain outstanding, each Right will entitle its holder to purchase, at the then-current exercise price of the Right, shares of common stock of the ultimate parent of such other person having a market value of twice the exercise price of the Right. The Rights may be redeemed by the Company for $0.001 per Right at any time until the tenth business day following the first public announcement of an acquisition of beneficial ownership of 10% of the Company's common stock. The Rights Plan will expire on August 30, 2013.\\nAccumulated Other Comprehensive Loss\\nAccumulated other comprehensive loss as reported in the consolidated balance sheets as of December 31, 2012 and 2011 was comprised of the following:\\n| 2012 | 2011 |\\n| Foreign currency translation losses | $ | (2,322 | ) | $ | (4,691 | ) |\\n| Unrecognized pension and postretirement benefit costs, net of tax | (18,749 | ) | (15,133 | ) |\\n| Total accumulated other comprehensive loss | $ | (21,071 | ) | $ | (19,824 | ) |\\n\\n(13) Commitments and Contingent Liabilities\\nAs of December 31, 2012, the Company had $6,794 of irrevocable letters of credit outstanding which primarily consisted of $4,000 for collateral associated with commodity hedges and $1,994 for compliance with the insurance reserve requirements of its workers’ compensation insurance carriers.\\nThe Company is party to a variety of legal proceedings and other claims, including proceedings by government authorities, which arise from the operation of its business. These proceedings are incidental and occur in the normal course of the Company's business affairs. The majority of these claims and proceedings relate to commercial disputes with customers, suppliers, and others; employment, including benefit matters; product quality; and environmental, health and safety claims. It is the opinion of management that the currently expected outcome of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on the consolidated results of operations, financial condition or cash flows of the Company.\\nIn 2011, the Company determined that it inadvertently exported certain aluminum alloy bar that are listed on the U.S. Bureau of Industry and Security's (BIS) Commerce Control List to countries where there is an export license requirement if an exception is not otherwise available. The exports, which occurred in 2011, had a total transaction value of approximately $13 and were made without export licenses. The exports involved five shipments to the Company's wholly-owned subsidiary in China and to a customer in the Philippines. In response thereto, the Company submitted a voluntary self-disclosure describing the nature of these shipments to the Office of Export Enforcement of the Department of Commerce (OEE) in accordance with applicable Export Administration Regulations. The Company previously disclosed similar incidents to BIS in 2008, which were resolved in September 2011 through the payment of a $775 civil penalty and a commitment to satisfy certain compliance and reporting obligations. If it is determined that the Company failed to comply with the applicable U.S. export regulations, the OEE could assess civil penalties of up to $1,250, restrict export privileges or provide an administrative warning.\\n67\\nWhile the ultimate disposition of this matter cannot be predicted with certainty, it is the opinion of management, based on the information available at this time, that the outcome of this matter will not have a material effect on the Company's financial position, results of operations or cash flows.\\n(14) Guarantor Financial Information\\nThe accompanying consolidating financial information has been prepared and presented pursuant to Rule 3-10 of SEC Regulation S-X “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The consolidating financial information presents A. M. Castle & Co. (Parent) and subsidiaries. The consolidating financial information has been prepared on the same basis as the consolidated statements of the Parent. The equity method of accounting is followed within this financial information.\\nIn September 2012, the Company merged Tube Supply, LLC, a guarantor, with the Parent. The Company has reflected this change in its accompanying consolidating financial statements of guarantors and non-guarantors.\\n68\\n| Condensed Consolidating Balance SheetAs of December 31, 2012 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Assets |\\n| Current assets |\\n| Cash and cash equivalents | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\\n| Accounts receivable, less allowance for doubtful accounts | 60,293 | 34,037 | 43,981 | — | 138,311 |\\n| Receivables from affiliates | 95 | 1,118 | 668 | (1,881 | ) | — |\\n| Inventories | 183,189 | 44,874 | 75,777 | (68 | ) | 303,772 |\\n| Prepaid expenses and other current assets | 16,141 | (1,490 | ) | 8,239 | (202 | ) | 22,688 |\\n| Total current assets | 263,050 | 80,216 | 145,263 | (2,151 | ) | 486,378 |\\n| Investment in joint venture | 38,854 | — | — | — | 38,854 |\\n| Goodwill | 12,921 | 41,556 | 15,823 | — | 70,300 |\\n| Intangible assets | 34,343 | 28,325 | 19,809 | — | 82,477 |\\n| Other assets | 28,142 | (98 | ) | 3,113 | — | 31,157 |\\n| Investment in subsidiaries | 245,798 | 11,526 | — | (257,324 | ) | — |\\n| Receivables from affiliates | 62,696 | 83,891 | 3,280 | (149,867 | ) | — |\\n| Property, plant and equipment, net | 52,424 | 15,403 | 11,813 | — | 79,640 |\\n| Total assets | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\\n| Liabilities and Stockholders’ Equity |\\n| Current liabilities |\\n| Accounts payable | $ | 40,510 | $ | 13,434 | $ | 14,046 | $ | — | $ | 67,990 |\\n| Payables due to affiliates | 742 | 95 | 1,044 | (1,881 | ) | — |\\n| Other current liabilities | 26,566 | 3,478 | 8,083 | — | 38,127 |\\n| Current portion of long-term debt and short-term debt | 386 | 1 | 528 | — | 915 |\\n| Total current liabilities | 68,204 | 17,008 | 23,701 | (1,881 | ) | 107,032 |\\n| Long-term debt, less current portion | 292,086 | — | 4,068 | — | 296,154 |\\n| Payables due to affiliates | 12,114 | 11,994 | 125,759 | (149,867 | ) | — |\\n| Deferred income taxes | 14,209 | 18,614 | (473 | ) | — | 32,350 |\\n| Other non-current liabilities | 14,275 | 1,339 | 316 | — | 15,930 |\\n| Stockholders’ equity | 337,340 | 211,864 | 45,730 | (257,594 | ) | 337,340 |\\n| Total liabilities and stockholders’ equity | $ | 738,228 | $ | 260,819 | $ | 199,101 | $ | (409,342 | ) | $ | 788,806 |\\n\\n69\\n| Condensed Consolidating Balance SheetAs of December 31, 2011 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Assets |\\n| Current assets |\\n| Cash and cash equivalents | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\\n| Accounts receivable, less allowance for doubtful accounts | 88,434 | 37,487 | 55,115 | — | 181,036 |\\n| Receivables from affiliates | 273 | 3,495 | 146 | (3,914 | ) | — |\\n| Inventories | 163,776 | 48,980 | 59,547 | (264 | ) | 272,039 |\\n| Prepaid expenses and other current assets | 18,517 | (3,331 | ) | 3,483 | — | 18,669 |\\n| Total current assets | 282,534 | 87,213 | 136,699 | (4,178 | ) | 502,268 |\\n| Investment in joint venture | 36,460 | — | — | — | 36,460 |\\n| Goodwill | 12,921 | 41,556 | 15,424 | — | 69,901 |\\n| Intangible assets | 38,238 | 34,395 | 21,180 | — | 93,813 |\\n| Other assets | 34,691 | 237 | 2,812 | — | 37,740 |\\n| Investment in subsidiaries | 243,823 | 12,151 | — | (255,974 | ) | — |\\n| Receivables from affiliates | 66,878 | 71,041 | 7,292 | (145,211 | ) | — |\\n| Property, plant and equipment, net | 56,266 | 15,416 | 10,459 | — | 82,141 |\\n| Total assets | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\\n| Liabilities and Stockholders’ Equity |\\n| Current liabilities |\\n| Accounts payable | $ | 84,437 | $ | 14,826 | $ | 17,611 | $ | — | $ | 116,874 |\\n| Payables due to affiliates | 1,387 | 76 | 2,451 | (3,914 | ) | — |\\n| Other current liabilities | 25,895 | 4,459 | 5,358 | — | 35,712 |\\n| Current portion of long-term debt and short-term debt | 82 | 50 | 560 | — | 692 |\\n| Total current liabilities | 111,801 | 19,411 | 25,980 | (3,914 | ) | 153,278 |\\n| Long-term debt, less current portion | 303,739 | 1 | 10,500 | — | 314,240 |\\n| Payables due to affiliates | 23,727 | 8,572 | 112,912 | (145,211 | ) | — |\\n| Deferred income taxes | 6,280 | 19,647 | (277 | ) | — | 25,650 |\\n| Other non-current liabilities | 13,985 | 2,324 | 567 | — | 16,876 |\\n| Stockholders’ equity | 312,279 | 212,054 | 44,184 | (256,238 | ) | 312,279 |\\n| Total liabilities and stockholders’ equity | $ | 771,811 | $ | 262,009 | $ | 193,866 | $ | (405,363 | ) | $ | 822,323 |\\n\\n70\\n| Condensed Consolidating Statement of Operations and Comprehensive (Loss) IncomeFor the year ended December 31, 2012 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Net Sales | $ | 755,642 | $ | 270,644 | $ | 282,274 | $ | (38,192 | ) | $ | 1,270,368 |\\n| Costs and expenses: |\\n| Cost of materials (exclusive of depreciation and amortization) | 548,659 | 199,004 | 217,749 | (38,125 | ) | 927,287 |\\n| Warehouse, processing and delivery expense | 91,628 | 32,459 | 24,169 | — | 148,256 |\\n| Sales, general and administrative expense | 75,497 | 30,351 | 21,965 | — | 127,813 |\\n| Depreciation and amortization expense | 12,955 | 8,888 | 4,024 | — | 25,867 |\\n| Operating income (loss) | 26,903 | (58 | ) | 14,367 | (67 | ) | 41,145 |\\n| Interest expense, net | (25,820 | ) | — | (15,270 | ) | — | (41,090 | ) |\\n| Interest expense - unrealized loss on debt conversion option | (15,597 | ) | — | — | — | (15,597 | ) |\\n| Loss before income taxes and equity in earnings of subsidiaries and joint venture | (14,514 | ) | (58 | ) | (903 | ) | (67 | ) | (15,542 | ) |\\n| Income taxes | (1,805 | ) | 475 | 102 | (202 | ) | (1,430 | ) |\\n| Equity in (losses) earnings of subsidiaries | (653 | ) | (1,203 | ) | — | 1,856 | — |\\n| Equity in earnings of joint venture | 7,224 | — | — | — | 7,224 |\\n| Net (loss) income | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\\n| Comprehensive (loss) income: |\\n| Foreign currency translation gains (losses) | 2,369 | 578 | 2,369 | (2,947 | ) | 2,369 |\\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,616 | ) | — | — | — | (3,616 | ) |\\n| Other comprehensive (loss) income | (1,247 | ) | 578 | 2,369 | (2,947 | ) | (1,247 | ) |\\n| Net loss | (9,748 | ) | (786 | ) | (801 | ) | 1,587 | (9,748 | ) |\\n| Comprehensive (loss) income | $ | (10,995 | ) | $ | (208 | ) | $ | 1,568 | $ | (1,360 | ) | $ | (10,995 | ) |\\n\\n71\\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2011 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Net Sales | $ | 621,036 | $ | 283,290 | $ | 237,201 | $ | (9,161 | ) | $ | 1,132,366 |\\n| Costs and expenses: |\\n| Cost of materials (exclusive of depreciation and amortization) | 466,133 | 207,269 | 181,104 | (8,897 | ) | 845,609 |\\n| Warehouse, processing and delivery expense | 80,543 | 33,828 | 20,527 | — | 134,898 |\\n| Sales, general and administrative expense | 74,154 | 31,807 | 20,232 | — | 126,193 |\\n| Depreciation and amortization expense | 8,874 | 8,910 | 2,688 | — | 20,472 |\\n| Operating (loss) income | (8,668 | ) | 1,476 | 12,650 | (264 | ) | 5,194 |\\n| Interest expense, net | (4,982 | ) | — | (4,681 | ) | — | (9,663 | ) |\\n| Interest expense - unrealized loss on debt conversion option | (3,991 | ) | (3,991 | ) |\\n| Loss on extinguishment of debt | (6,153 | ) | — | — | — | (6,153 | ) |\\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (23,794 | ) | 1,476 | 7,969 | (264 | ) | (14,613 | ) |\\n| Income taxes | 3,267 | (433 | ) | (1,708 | ) | — | 1,126 |\\n| Equity in earnings of subsidiaries | 7,040 | (209 | ) | — | (6,831 | ) | — |\\n| Equity in earnings of joint venture | 11,727 | — | — | — | 11,727 |\\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\\n| Comprehensive (loss) income: |\\n| Foreign currency translation (losses) gains | (941 | ) | 1,180 | (941 | ) | (239 | ) | (941 | ) |\\n| Unrecognized pension and postretirement benefit costs, net of tax | (3,071 | ) | — | — | — | (3,071 | ) |\\n| Other comprehensive (loss) income | (4,012 | ) | 1,180 | (941 | ) | (239 | ) | (4,012 | ) |\\n| Net (loss) income | (1,760 | ) | 834 | 6,261 | (7,095 | ) | (1,760 | ) |\\n| Comprehensive (loss) income | $ | (5,772 | ) | $ | 2,014 | $ | 5,320 | $ | (7,334 | ) | $ | (5,772 | ) |\\n\\n72\\n| Condensed Consolidating Statement of Operations Comprehensive (Loss) IncomeFor the year ended December 31, 2010 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Net Sales | $ | 498,848 | $ | 266,491 | $ | 186,654 | $ | (8,287 | ) | $ | 943,706 |\\n| Costs and expenses: |\\n| Cost of materials (exclusive of depreciation and amortization) | 369,865 | 195,184 | 144,092 | (8,287 | ) | 700,854 |\\n| Warehouse, processing and delivery expense | 72,234 | 33,250 | 17,834 | — | 123,318 |\\n| Sales, general and administrative expense | 61,751 | 29,684 | 16,788 | — | 108,223 |\\n| Depreciation and amortization expense | 8,665 | 9,114 | 2,870 | — | 20,649 |\\n| Operating (loss) income | (13,667 | ) | (741 | ) | 5,070 | — | (9,338 | ) |\\n| Interest expense, net | (1,008 | ) | — | (3,980 | ) | — | (4,988 | ) |\\n| (Loss) income before income taxes and equity in earnings of subsidiaries and joint venture | (14,675 | ) | (741 | ) | 1,090 | — | (14,326 | ) |\\n| Income taxes | 3,106 | 420 | (425 | ) | — | 3,101 |\\n| Equity in earnings of subsidiaries | 344 | 110 | — | (454 | ) | — |\\n| Equity in earnings of joint venture | 5,585 | — | — | — | 5,585 |\\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\\n| Comprehensive (loss) income: |\\n| Foreign currency translation (losses) gains | (536 | ) | (2,337 | ) | (536 | ) | 2,873 | (536 | ) |\\n| Unrecognized pension and postretirement benefit costs, net of tax | (1,748 | ) | — | — | — | (1,748 | ) |\\n| Other comprehensive (loss) income | (2,284 | ) | (2,337 | ) | (536 | ) | 2,873 | (2,284 | ) |\\n| Net (loss) income | (5,640 | ) | (211 | ) | 665 | (454 | ) | (5,640 | ) |\\n| Comprehensive (loss) income | $ | (7,924 | ) | $ | (2,548 | ) | $ | 129 | $ | 2,419 | $ | (7,924 | ) |\\n\\n73\\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2012 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Operating activities: |\\n| Net (loss) income | $ | (9,748 | ) | $ | (786 | ) | $ | (801 | ) | $ | 1,587 | $ | (9,748 | ) |\\n| Equity in losses of subsidiaries | 653 | 1,203 | — | (1,856 | ) | — |\\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,688 | 12,951 | (8,809 | ) | 269 | 15,099 |\\n| Net cash from (used in) operating activities | 1,593 | 13,368 | (9,610 | ) | — | 5,351 |\\n| Investing activities: |\\n| Acquisition/Investment of businesses, net of cash acquired | (6,472 | ) | — | — | — | (6,472 | ) |\\n| Capital expenditures | (5,336 | ) | (2,802 | ) | (2,983 | ) | — | (11,121 | ) |\\n| Other investing activities, net | — | 6 | 147 | — | 153 |\\n| Net cash used in investing activities | (11,808 | ) | (2,796 | ) | (2,836 | ) | — | (17,440 | ) |\\n| Financing activities: |\\n| Proceeds from long-term debt, including new revolving credit facility | 756,550 | — | 10,540 | — | 767,090 |\\n| Repayments of long-term debt, including new revolving credit facility | (745,839 | ) | (49 | ) | (16,999 | ) | — | (762,887 | ) |\\n| Payment of debt issue costs | (1,503 | ) | — | — | — | (1,503 | ) |\\n| Net intercompany (repayments) borrowings | (7,431 | ) | (9,428 | ) | 16,859 | — | — |\\n| Other financing | 236 | — | (27 | ) | — | 209 |\\n| Net cash from (used in) financing activities | 2,013 | (9,477 | ) | 10,373 | — | 2,909 |\\n| Effect of exchange rate changes on cash and cash equivalents | — | — | 263 | — | 263 |\\n| (Decrease) increase in cash and cash equivalents | (8,202 | ) | 1,095 | (1,810 | ) | — | (8,917 | ) |\\n| Cash and cash equivalents - beginning of year | 11,534 | 582 | 18,408 | — | 30,524 |\\n| Cash and cash equivalents - end of period | $ | 3,332 | $ | 1,677 | $ | 16,598 | $ | — | $ | 21,607 |\\n\\n74\\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2011 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Operating activities: |\\n| Net (loss) income | $ | (1,760 | ) | $ | 834 | $ | 6,261 | $ | (7,095 | ) | $ | (1,760 | ) |\\n| Equity in earnings of subsidiaries | (7,040 | ) | 209 | — | 6,831 | — |\\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 10,232 | 15,095 | (70,119 | ) | 264 | (44,528 | ) |\\n| Net cash from (used in) operating activities | 1,432 | 16,138 | (63,858 | ) | — | (46,288 | ) |\\n| Investing activities: |\\n| Acquisition/Investment of businesses, net of cash acquired | (175,836 | ) | — | 1,592 | (174,244 | ) |\\n| Capital expenditures | (6,077 | ) | (2,783 | ) | (2,884 | ) | — | (11,744 | ) |\\n| Other investing activities, net | 605 | 136 | 58 | — | 799 |\\n| Net cash used in investing activities | (181,308 | ) | (2,647 | ) | (1,234 | ) | — | (185,189 | ) |\\n| Financing activities: |\\n| Net borrowings (repayments) of debt | 82 | 8 | (25,840 | ) | — | (25,750 | ) |\\n| Proceeds from long-term debt, including new revolving credit facility | 309,625 | — | 10,851 | — | 320,476 |\\n| Repayments of long-term debt, including new revolving credit facility | (52,896 | ) | (55 | ) | (261 | ) | — | (53,212 | ) |\\n| Payment of debt issue costs | (16,380 | ) | — | (253 | ) | — | (16,633 | ) |\\n| Net intercompany (repayments) borrowings | (57,307 | ) | (13,930 | ) | 71,237 | — | — |\\n| Other financing activities, net | 657 | — | — | — | 657 |\\n| Net cash from (used in) financing activities | 183,781 | (13,977 | ) | 55,734 | — | 225,538 |\\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (253 | ) | — | (253 | ) |\\n| Increase (decrease) in cash and cash equivalents | 3,905 | (486 | ) | (9,611 | ) | — | (6,192 | ) |\\n| Cash and cash equivalents - beginning of year | 7,629 | 1,068 | 28,019 | — | 36,716 |\\n| Cash and cash equivalents - end of period | $ | 11,534 | $ | 582 | $ | 18,408 | $ | — | $ | 30,524 |\\n\\n75\\n| Condensed Consolidating Statement of Cash FlowsFor the year ended December 31, 2010 |\\n| Parent | Guarantors | Non-Guarantors | Eliminations | Consolidated |\\n| Operating activities: |\\n| Net (loss) income | $ | (5,640 | ) | $ | (211 | ) | $ | 665 | $ | (454 | ) | $ | (5,640 | ) |\\n| Equity in earnings of subsidiaries | (344 | ) | (110 | ) | — | 454 | — |\\n| Adjustments to reconcile net (loss) income to cash provided by operating activities | 12,721 | 29,562 | 500 | (2,781 | ) | 40,002 |\\n| Net cash from (used in) operating activities | 6,737 | 29,241 | 1,165 | (2,781 | ) | 34,362 |\\n| Investing activities: |\\n| Capital expenditures | (4,244 | ) | (1,267 | ) | (2,061 | ) | — | (7,572 | ) |\\n| Other investing activities, net | 125 | 4 | — | — | 129 |\\n| Net cash used in investing activities | (4,119 | ) | (1,263 | ) | (2,061 | ) | — | (7,443 | ) |\\n| Financing activities: |\\n| Net (repayments) borrowings of debt | (13,720 | ) | — | 2,324 | — | (11,396 | ) |\\n| Repayments of long-term debt | (7,007 | ) | (343 | ) | (404 | ) | — | (7,754 | ) |\\n| Net intercompany borrowings (repayments) | 15,794 | (27,350 | ) | 8,775 | 2,781 | — |\\n| Other financing activities, net | 785 | — | — | — | 785 |\\n| Net cash (used in) from financing activities | (4,148 | ) | (27,693 | ) | 10,695 | 2,781 | (18,365 | ) |\\n| Effect of exchange rate changes on cash and cash equivalents | — | — | (149 | ) | — | (149 | ) |\\n| (Decrease) increase in cash and cash equivalents | (1,530 | ) | 285 | 9,650 | — | 8,405 |\\n| Cash and cash equivalents - beginning of year | 9,159 | 783 | 18,369 | — | 28,311 |\\n| Cash and cash equivalents - end of period | $ | 7,629 | $ | 1,068 | $ | 28,019 | $ | — | $ | 36,716 |\\n\\n76\\n(15) Selected Quarterly Data (Unaudited)\\nThe results of Tube Supply, acquired during December 2011, were included in the 2012 selected quarterly data in the table below.\\n| FirstQuarter | SecondQuarter | ThirdQuarter | FourthQuarter |\\n| 2012 |\\n| Net sales | $ | 362,916 | $ | 329,392 | $ | 304,039 | $ | 274,021 |\\n| Gross profit (a) | 53,810 | 43,763 | 42,867 | 28,518 |\\n| Net (loss) income (c) | (4,300 | ) | (2,978 | ) | 3,173 | (5,643 | ) |\\n| Basic (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.14 | $ | (0.24 | ) |\\n| Diluted (loss) earnings per share | $ | (0.19 | ) | $ | (0.13 | ) | $ | 0.13 | $ | (0.24 | ) |\\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\\n| 2011 |\\n| Net sales | $ | 272,788 | $ | 282,568 | $ | 294,860 | $ | 282,150 |\\n| Gross profit (a) | 33,219 | 35,165 | 33,233 | 29,770 |\\n| Net income (loss) (b) | 2,703 | 3,697 | 3,803 | (11,963 | ) |\\n| Basic earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.17 | $ | (0.52 | ) |\\n| Diluted earnings (loss) per share | $ | 0.12 | $ | 0.16 | $ | 0.16 | $ | (0.52 | ) |\\n| Common stock dividends declared | $ | — | $ | — | $ | — | $ | — |\\n\\n| (a) | Gross profit equals net sales minus cost of materials, warehouse, processing, and delivery costs and less depreciation and amortization expense. |\\n\\n| (b) | Fourth quarter results include fees incurred as a result of the acquisition of Tube Supply and the related debt refinancing in December 2011. The results of Tube Supply are included in the fourth quarter results for the two-week period ended December 31, 2011 and for the entire fiscal year ended December 31, 2012. In addition, a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $3,991 was included in interest expense during the fourth quarter. |\\n\\n| (c) | First and second quarter results include a mark-to-market adjustment related to the conversion option associated with the convertible debt in the amount of $11,340 and $4,257, respectively. Amounts were included in interest expense during the respective quarters. |\\n\\n(16) Subsequent Events\\nOn January 16, 2013, the Company announced restructuring actions, including an organizational restructuring, warehouse realignments and performance improvement programs. The total pre-tax charge associated with these actions is estimated to be approximately $10,000, which is expected to be incurred in the first half of 2013. Of this amount, approximately $3,500 is attributable to employee severance and other employment related benefits, $2,500 is attributable to lease termination costs, $1,600 is attributable to moving costs in conjunction with the warehouse realignments and $2,400 relates to other costs. The Company may identify additional opportunities as it implements the restructuring actions that could impact its overall estimate. In addition, the Company expects to incur capital expenditures of approximately $1,400 in 2013 that are directly associated with the restructuring actions.\\n77\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nTo the Board of Directors and Stockholders of A.M. Castle & Co.\\nOak Brook, Illinois\\nWe have audited the accompanying consolidated balance sheets of A.M. Castle & Co. and subsidiaries (the \\\"Company\\\") as of December 31, 2012 and 2011, and the related consolidated statements of operations and comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits. We did not audit the financial statements of Kreher Steel Company, LLC, a 50% owned joint venture, the Company's investment in which is accounted for by use of the equity method. The Company's equity of $38,854 and $36,460 in Kreher Steel Company, LLC's net assets at December 31, 2012 and 2011, respectively, and of $7,224 and $11,727 in that company's net income for the years then ended are included in the accompanying financial statements. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Kreher Steel Company, LLC, is based solely on the report of the other auditors.\\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\\nIn our opinion, based on our audits and the report of other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of A.M. Castle & Co. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2013 expressed an unqualified opinion on the Company's internal control over financial reporting.\\n/s/ DELOITTE & TOUCHE LLP\\nDELOITTE & TOUCHE LLP\\nChicago, Illinois\\nMarch 11, 2013\\n78\\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED BALANCE SHEETSDecember 31, |\\n| 2012 | 2011 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 3,373,355 | $ | 8,743,820 |\\n| Accounts receivable (net of allowance for doubtful accounts of approximately $1,435,000 in 2012 and $1,335,000 in 2011) | 19,736,301 | 32,461,983 |\\n| Inventory, net | 66,958,361 | 69,297,422 |\\n| Deferred taxes | 271,553 | 29,699 |\\n| Prepaid income taxes | 1,424,064 | 186,889 |\\n| Prepaid expenses and other current assets | 657,039 | 542,689 |\\n| Total current assets | 92,420,673 | 111,262,502 |\\n| Property and equipment |\\n| Land and building | 14,485,343 | 14,334,997 |\\n| Machinery and equipment | 16,533,990 | 11,923,342 |\\n| Furniture, fixtures and office equipment | 2,155,447 | 1,952,447 |\\n| Automobiles and trucks | 990,508 | 871,929 |\\n| Leasehold improvements | 2,334,855 | 1,872,955 |\\n| Construction in progress | 266,129 | 753,234 |\\n| 36,766,272 | 31,708,904 |\\n| Less accumulated depreciation and amortization | 14,719,685 | 12,856,503 |\\n| Property and equipment, net | 22,046,587 | 18,852,401 |\\n| Deferred financing costs, net of amortization | 104,616 | 121,263 |\\n| Goodwill | 3,525,247 | 3,525,247 |\\n| Intangible assets, net of amortization | 275,616 | 398,112 |\\n| Other assets | 146,785 | 81,543 |\\n| $ | 118,519,524 | $ | 134,241,068 |\\n| LIABILITIES AND MEMBER'S CAPITAL |\\n| Current liabilities |\\n| Revolving line of credit | $ | — | $ | 35,000,000 |\\n| Current portion of long-term debt | 211,894 | 215,918 |\\n| Accounts payable | 11,536,613 | 21,094,460 |\\n| Accrued expenses | 2,565,966 | 3,641,502 |\\n| Total current liabilities | 14,314,473 | 59,951,880 |\\n| Revolving line of credit | 24,000,000 | — |\\n| Deferred taxes, non-current | 1,977,273 | 1,008,748 |\\n| Long-term debt, less current portion | 1,867,707 | 2,080,993 |\\n| Commitments and contingencies |\\n| Member's capital | 76,360,071 | 71,199,447 |\\n| $ | 118,519,524 | $ | 134,241,068 |\\n\\n79\\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEYears ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Net revenues | $ | 257,776,157 | $ | 269,657,054 | $ | 188,107,237 |\\n| Cost of sales | 213,490,152 | 219,478,535 | 156,801,397 |\\n| Gross profit | 44,286,005 | 50,178,519 | 31,305,840 |\\n| Operating expenses |\\n| Selling | 12,970,475 | 12,761,204 | 9,729,856 |\\n| General and administrative | 12,657,611 | 9,970,335 | 8,283,347 |\\n| Total operating expenses | 25,628,086 | 22,731,539 | 18,013,203 |\\n| Earnings from operations | 18,657,919 | 27,446,980 | 13,292,637 |\\n| Other expense (income) |\\n| Interest expense | 519,416 | 432,990 | 259,558 |\\n| Interest income | (3,263 | ) | (1,994 | ) | (5,035 | ) |\\n| Other income, net | (169,015 | ) | (180,807 | ) | (152,887 | ) |\\n| Net earnings before taxes | 18,310,781 | 27,196,791 | 13,191,001 |\\n| Income tax provision (benefit) | 3,708,101 | 3,553,382 | 2,155,950 |\\n| NET EARNINGS | 14,602,680 | 23,643,409 | 11,035,051 |\\n| Other comprehensive income |\\n| Foreign currency translation adjustment | 15,554 | — | — |\\n| COMPREHENSIVE INCOME | $ | 14,618,234 | $ | 23,643,409 | $ | 11,035,051 |\\n\\n80\\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF MEMBERS’ CAPITALThree years ended December 31, 2012 |\\n| Accumulated |\\n| other | Total |\\n| Member's | Retained | Accumulated | Treasury | comprehensive | member's |\\n| contribution | earnings | distributions | stock | income | capital |\\n| Balance at January 1, 2010, 400 units | 7,042,411 | 67,379,821 | (23,906,770 | ) | (5,240,092 | ) | — | 45,275,370 |\\n| Net earnings | — | 11,035,051 | — | — | — | 11,035,051 |\\n| Distributions | — | — | (2,519,593 | ) | — | — | (2,519,593 | ) |\\n| Balance at December 31, 2010, 400 units | 7,042,411 | 78,414,872 | (26,426,363 | ) | (5,240,092 | ) | — | 53,790,828 |\\n| Net earnings | — | 23,643,409 | — | — | — | 23,643,409 |\\n| Distributions | — | — | (6,234,790 | ) | — | — | (6,234,790 | ) |\\n| Balance at December 31, 2011, 400 units | 7,042,411 | 102,058,281 | (32,661,153 | ) | (5,240,092 | ) | — | 71,199,447 |\\n| Net earnings | — | 14,602,680 | — | — | — | 14,602,680 |\\n| Distributions | — | — | (9,457,600 | ) | — | — | (9,457,600 | ) |\\n| Foreign currency translation adjustment | — | — | — | — | 15,544 | 15,544 |\\n| Balance at December 31, 2012, 400 units | $ | 7,042,411 | $ | 116,660,961 | $ | (42,118,753 | ) | $ | (5,240,092 | ) | $ | 15,544 | $ | 76,360,071 |\\n\\n81\\n| Kreher Steel Company, LLC and SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWSYears ended December 31, |\\n| 2012 | 2011 | 2010 |\\n| Cash flows from operating activities |\\n| Net earnings | $ | 14,602,680 | $ | 23,643,409 | $ | 11,035,051 |\\n| Adjustments to reconcile net earnings to net cash provided by (used in) operating activities |\\n| Depreciation and amortization | 2,033,956 | 1,602,925 | 1,720,133 |\\n| Deferred taxes | 726,671 | 390,341 | 84,362 |\\n| Bad debt expense | 2,595,710 | 34,779 | 178,911 |\\n| (Gain) loss on sale of property and equipment | (4,851 | ) | 9,790 | 59,676 |\\n| Changes in assets and liabilities |\\n| Accounts receivable | 10,129,971 | (8,508,956 | ) | (8,488,036 | ) |\\n| Inventory | 2,339,061 | (27,383,374 | ) | (11,823,574 | ) |\\n| Prepaid expenses and other assets | (1,400,121 | ) | (58,839 | ) | 182,962 |\\n| Accounts payable | (9,557,992 | ) | 3,900,243 | 1,739,501 |\\n| Accrued expenses | (1,075,536 | ) | 1,215,113 | 388,680 |\\n| Net cash provided by (used in) operating activities | 20,389,549 | (5,154,569 | ) | (4,922,334 | ) |\\n| Cash flows from investing activities |\\n| Purchases of property and equipment | (5,258,846 | ) | (6,735,595 | ) | (2,271,435 | ) |\\n| Proceeds from sale of property and equipment | 145,605 | 19,843 | 256,132 |\\n| Net cash used in investing activities | (5,113,241 | ) | (6,715,752 | ) | (2,015,303 | ) |\\n| Cash flows from financing activities |\\n| Net (decrease) increase in line of credit | (11,000,000 | ) | 22,163,000 | 10,837,000 |\\n| Repayment of long-term debt | (217,310 | ) | (268,089 | ) | (360,000 | ) |\\n| Distributions to member | (9,457,600 | ) | (6,234,790 | ) | (2,519,593 | ) |\\n| Net cash (used in) provided by financing activities | (20,674,910 | ) | 15,660,121 | 7,957,407 |\\n| Effect of exchange rate changes on cash and cash equivalents | 28,137 | — | — |\\n| Net (decrease) increase in cash and cash equivalents | (5,370,465 | ) | 3,789,800 | 1,019,770 |\\n| Cash and cash equivalents at beginning of year | 8,743,820 | 4,954,020 | 3,934,250 |\\n| Cash and cash equivalents at end of year | $ | 3,373,355 | $ | 8,743,820 | $ | 4,954,020 |\\n| Supplemental disclosures of cash flow information |\\n| Cash paid during the year for |\\n| Interest | $ | 422,074 | $ | 350,341 | $ | 171,525 |\\n| Income taxes, net of refunds | 4,855,764 | 2,910,000 | 1,097,409 |\\n| Supplemental disclosures of non-cash investing and financing activities |\\n| Acquisition of machinery and equipment through capital leases | $ | — | $ | — | $ | 150,019 |\\n\\n82\\nNOTE A - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nDescription of Company\\nKreher Steel Company, LLC and Subsidiaries (the Company) was formed as a limited liability company (LLC) on January 11, 1996, and commenced business on May 1, 1996. The LLC member's initial contribution consisted of the net assets of Kreher Steel Co., Inc.\\nThe Company is a national distributor and processor of carbon and alloy steel bar products. The Company has locations throughout the United States and in Edmonton, Canada, and primarily sells in the vicinity of these locations.\\nPrinciples of Consolidation\\nThe Company's financial statements are presented on a consolidated basis and include its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., as well as a branch of Kreher Steel Company, LLC located in Edmonton, Canada. All intercompany transactions and balances have been eliminated.\\nUse of Estimates\\nThe preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments with maturities of three months or less to be cash equivalents. The Company maintains cash balances at financial institutions in the United States of America that are insured by the Federal Deposit Insurance Corporation (FDIC). At December 31, 2012 and 2011, the Company had approximately $2,113,000 and $7,975,000, respectively, in excess of FDIC insured limits. The Company has not experienced any losses related to these balances, and management believes its credit risk to be minimal.\\nShipping and Handling Fees\\nFor the years ended December 31, 2012, 2011 and 2010, shipping and handling costs billed to customers amounted to approximately $1,548,000, $1,431,230 and $899,000, respectively, and were included in selling expenses.\\nFinancial Instruments and Risk Management\\nConcentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base and their dispersion across different businesses and geographic areas. At December 31, 2012, 2011 and 2010, there were no individual customers that made up more than 10% of consolidated sales.\\nThe Company's financial instruments include cash equivalents, accounts receivable, accounts payable and notes payable. The carrying amounts of cash equivalents, accounts receivable, accounts payable and notes payable approximate fair value due to their short-term nature and variable interest rates paid.\\nPrices for steel fluctuate based on worldwide production and, as a result, the Company is subject to the risk of future changing market prices. Furthermore, the Company purchased approximately 6%, 9% and 7% of its inventory from foreign suppliers for the years ended December 31, 2012, 2011 and 2010, respectively.\\nInventory\\nInventory is valued at the lower of cost or market. Cost is determined by the specific identification method. The Company provides a reserve for obsolete and slow-moving inventory. As of December 31, 2012 and 2011, the reserve for obsolete and slow-moving inventory was approximately $810,000 and $583,000, respectively.\\n83\\nChanges in the Company's inventory reserve are as follows at December 31:\\n| 2012 | 2011 |\\n| Beginning balance | $ | 583,346 | $ | 1,778,365 |\\n| Provision (release of provision) | 307,440 | (1,140,966 | ) |\\n| Write-offs | (81,119 | ) | (54,053 | ) |\\n| Total inventory reserve | $ | 809,667 | $ | 583,346 |\\n\\nProperty and Equipment\\nProperty and equipment are stated at cost less accumulated depreciation. Depreciation is based on the straight-line method and the estimated useful lives of the property and equipment. Depreciation of leasehold improvements is based on the estimated useful life or the term of the lease, whichever is shorter. The Company uses an accelerated method of depreciation for tax purposes. Depreciation expense for December 31, 2012, 2011 and 2010, was approximately $1,911,000, $1,467,000 and $1,543,000, respectively.\\nDepreciable lives by asset classification are as follows:\\n| Asset description | Life |\\n| Furniture and fixtures | 5 - 7 years |\\n| Office equipment | 5 - 7 years |\\n| Machinery and equipment | 7 - 10 years |\\n| Automobiles and trucks | 3 - 5 years |\\n| Building and leasehold improvements | 7 - 40 years |\\n\\nRepairs and maintenance are charged to expense when incurred. Expenditures for improvements are capitalized. Upon sale or retirement, the related cost and accumulated depreciation or amortization are removed from the respective accounts, and any resulting gain or loss is included in operations.\\nLong-Lived Assets\\nThe Company reviews the carrying values of its long-lived assets for possible impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be recoverable. Any long-lived assets held for disposal are reported at the lower of their carrying amounts or fair value less cost to sell. No triggering events were identified during each year presented that would require an impairment analysis. Additionally, no assets were held for disposal as of December 31, 2012 or 2011.\\nGoodwill and Intangible Assets\\nGoodwill represents the excess of purchase price paid over the fair values of net assets acquired and liabilities assumed in the Company's acquisitions.\\nIntangible assets include non-competition agreements and non-contractual customer relationships. The fair value of identifiable intangible assets was estimated based on discounted future cash flow projections. Intangible assets are amortized on a straight-line basis over their estimated economic lives. The weighted-average useful life of intangible assets was five years as of December 31, 2012.\\nThe Company evaluates the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset's carrying amount may not be recoverable. Such circumstances could include, but are not limited to, a significant decrease in the market value of the asset, a significant adverse change in the extent or manner in which an asset is used, or an accumulation of costs significantly in excess of the amount originally expected for the acquisition of an asset. No events or changes in circumstances were identified during the year that required an impairment analysis.\\n84\\nManagement is required to evaluate goodwill for impairment on an annual basis. The Company tests for impairment using a two-step process that involves (1) comparing the estimated fair value of the reporting unit to its net book value and (2) comparing the estimated implied fair value of goodwill and intangible assets to its carrying value. Goodwill and intangible assets were valued on the date of the acquisition. As of December 31, 2012 and 2011, there was no impairment of the goodwill or intangible assets acquired based on the analysis performed as of December 31, 2012.\\nRevenue Recognition\\nRevenue from the sale of goods is recognized at the time of shipment, except for revenue from sales of products to certain customers whose contractual terms specify FOB destination. Revenue from sales of products to these customers is recognized at the time of receipt by the customer when title and risk of loss pass to the customer.\\nAccounts Receivable\\nCredit is extended based on an evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable are generally due within 30 days of the negotiated terms and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. The Company maintains reserves for potential losses on receivables and credits from its customers, and these losses have not exceeded management's expectations. The Company determines its allowance for doubtful accounts by considering a number of factors, including the length of time trade accounts receivable are past due, the Company's previous loss history, the customer's current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.\\nEconomic Dependency - Major Suppliers\\nDuring the years ended December 31, 2012, 2011 and 2010, the Company purchased approximately 44%, 45% and 49%, respectively, of its materials from five suppliers.\\nDeferred Financing Costs\\nDeferred financing costs are amortized over the life of the underlying credit agreement or the expected remaining life of the underlying credit agreement.\\nIncome Taxes\\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. Accordingly, no liability or provision for federal and state income taxes attributable to the LLC's operations is included in the accompanying financial statements. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes as they are structured as C Corporations. Special Metals Canada, which is structured as a foreign branch of a domestic company, will pay federal and provincial taxes in Canada. The taxes paid will be reported to the member in order to claim foreign tax credits.\\nThe Company applies a comprehensive model for the financial statement recognition, measurement, classification and disclosure of uncertain tax positions. In the first step of the two-step process, the Company evaluates the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. In the second step, the Company measures the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. As of December 31, 2012 and 2011, the Company determined that there are no uncertain tax positions with a more than 50% likelihood of being realized upon settlement.\\nAdvertising Costs\\nAdvertising costs are charged to expense when the advertisement is first run. The Company expensed advertising costs of approximately $102,000, $80,000 and $62,000 in 2012, 2011 and 2010, respectively.\\n85\\nReclassifications\\nCertain reclassifications of prior-year presentations have been made to conform to the 2012 presentation.\\nNOTE B - INTANGIBLE ASSETS\\nIntangible assets are amortized using the straight-line method, using the remaining useful life, and are as follows at December 31, 2012:\\n| Remaining |\\n| Asset description | useful life |\\n| Non-contractual customer relationships | 2.25 years |\\n\\nThe following is a summary of intangible assets at December 31:\\n| 2012 | 2011 |\\n| Intangible assets |\\n| Finite life |\\n| Non-compete agreements | $ | 220,000 | $ | 220,000 |\\n| Non-contractual customer relationships | 980,000 | 980,000 |\\n| 1,200,000 | 1,200,000 |\\n| Less accumulated amortization | 924,384 | 801,888 |\\n| Net intangible assets | $ | 275,616 | $ | 398,112 |\\n\\nAmortization expense related to identifiable intangible assets was $122,496, $136,245 and $177,492 for the years ended December 31, 2012, 2011 and 2010, respectively. The intangible assets related to the non-compete agreements became fully amortized during 2011. Estimated annual amortization expense as of December 31, 2012, is a follows:\\n| Years ending December 31, |\\n| 2013 | $ | 122,496 |\\n| 2014 | 122,496 |\\n| 2015 | 30,624 |\\n\\nNOTE C - TRANSACTIONS WITH AFFILIATES\\nIncluded in accounts receivable at December 31, 2012, was approximately $3,000 due from companies related through common ownership. There was no amount included in accounts receivable at December 31, 2011, due from companies related through common ownership.\\nIncluded in accounts payable at December 31, 2012 and 2011, was approximately $21,000 and $79,000, respectively, due to companies related through common ownership.\\nSales to and purchases from companies related through common ownership for the year ended December 31, 2012, were approximately $695,000 and $809,000, respectively, for the year ended December 31, 2011, were approximately $851,000 and $2,294,000, respectively, and for the year ended December 31, 2010, were approximately $351,000 and $2,118,000, respectively.\\nNOTE D - ALLOWANCE FOR DOUBTFUL ACCOUNTS\\nChanges in the Company's allowance for doubtful accounts are as follows at December 31:\\n86\\n| 2012 | 2011 |\\n| Beginning balance | $ | 1,335,000 | $ | 1,340,000 |\\n| Bad debt expense | 2,595,710 | 34,779 |\\n| Recoveries | 20,125 | 536 |\\n| Accounts written off | (2,515,835 | ) | (40,315 | ) |\\n| Total allowance for doubtful accounts | $ | 1,435,000 | $ | 1,335,000 |\\n\\nNOTE E - DEBT\\nDebt as of December 31, 2012 and 2011, is as follows:\\n| 2012 | 2011 |\\n| Revolving lines of credit | $ | 24,000,000 | $ | 35,000,000 |\\n| Notes payable |\\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2000) | $ | 875,000 | $ | 950,000 |\\n| Michigan Strategic Fund Limited Obligation Revenue Bonds (2006) | 1,150,000 | 1,245,000 |\\n| Capitalized leases | 54,601 | 101,911 |\\n| Total notes payable | 2,079,601 | 2,296,911 |\\n| Current portion of long-term debt | 211,894 | 215,918 |\\n| Long-term debt | $ | 1,867,707 | $ | 2,080,993 |\\n\\nIn April 2004, the Company entered into a loan agreement. The loan consists of advances on a revolving line of credit, with maximum availability of $25,000,000, with the option of extending the credit to $40,000,000, through April 2009. In May 2007, the Company took that option and refinanced its $25,000,000 secured revolving credit agreement from an asset-based loan to a commercial-based loan, which can be increased to $40,000,000 in $5,000,000 increments. In April 2008, the Company increased the revolving credit to $30,000,000. The Company decreased the revolving credit to $20,000,000 in September 2009. In August 2011, the Company increased the revolving credit to $25,000,000. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $21,000,000 at December 31, 2011. There was a balance of $2,000,000 outstanding on the prime rate portion at a rate of 2.625% (prime minus 0.625%) at December 31, 2011.\\nIn May 2007, the Company's subsidiary, Special Metals, Inc., also entered into a commercial-based loan for $5,000,000, which can be increased to $10,000,000 in $1,000,000 increments. In October 2011, the Company amended the loan agreement and increased the revolving credit to $15,000,000 based on the consolidated availability of the Company. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.22% was $12,000,000 at December 31, 2011. There was no outstanding balance on the LIBOR portion of the loan at December 31, 2011.\\nIn April 2012, the Company entered into a new loan agreement. The loan named both the Company and its subsidiary, Special Metals, Inc., as co-borrowers. The loan is for $50,000,000, which can be increased to $65,000,000 in $5,000,000 increments. The interest charged on the loan is divided into the LIBOR portion and the prime rate portion. The outstanding balance on the LIBOR portion at a rate of 1.21% was $22,000,000 at December 31, 2012. The outstanding balance on the prime rate portion at a rate of 2.75% was $2,000,000 at December 31, 2012. The loan is secured by the Company's receivables, inventory and fixed assets, and expires in April 2017.\\nThe Company is in compliance with all covenants related to the revolving credit agreements and all other notes payable.\\nIn 2000, the Company's subsidiary, Kreher Wire Processing, Inc., obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $4,900,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make annual payments for the letter of credit fee. The bonds mature on May 1, 2016.\\n87\\nIn 2006, Kreher Wire Processing, Inc. obtained a Michigan Strategic Fund Limited Obligation Revenue Bond for $2,695,000. Interest is charged at a variable rate as defined in the agreement. The interest rate as of December 31, 2012 and 2011, was 0.23% and 0.20%, respectively. The Company makes monthly interest payments and annual principal and debt service payments. The Company is also required to make quarterly payments for the letter of credit fee. The bonds mature on October 1, 2021.\\nIn 2010, Special Metals, Inc. entered into several lease agreements that met the criteria for capitalization. At December 31, 2012 and 2011, the gross amount of cost related to capital leases included in machinery and equipment was approximately $150,000. Related accumulated amortization at December 31, 2012 and 2011, was approximately $110,000 and $65,000, respectively. The total rental payments incurred for the years ended December 31, 2012, 2011 and 2010, was approximately $73,000, $73,000 and $33,000, respectively.\\nThe carrying value of debt approximates fair value given the variable nature of the interest rates. Maturities of debt at December 31, 2012, are as follows:\\n| Years ending December 31, |\\n| 2013 | $ | 211,894 |\\n| 2014 | 205,778 |\\n| 2015 | 226,929 |\\n| 2016 | 725,000 |\\n| 2017 | 24,125,000 |\\n| Thereafter | 585,000 |\\n| Total | $ | 26,079,601 |\\n\\nNOTE F - INCOME TAXES\\nAs an LLC, the Company is not subject to federal and state income taxes, and its income or loss is allocated to and reported in the tax returns of its member. The Company provides for income taxes for its wholly owned subsidiaries, Kreher Wire Processing, Inc. and Special Metals, Inc., which are subject to federal and state income taxes. The Company also provides for federal and provincial taxes at Special Metals Canada, which is structured as a foreign branch of a domestic company. The taxes paid will be reported to the member in order to claim foreign tax credits.\\nThe tax effect of temporary differences that give rise to deferred tax assets and liabilities as of December 31, 2012 and 2011, are as follows:\\n| 2012 | 2011 |\\n| Deferred tax assets |\\n| Accounts receivable and inventory reserves | $ | 271,553 | $ | 29,699 |\\n| Deferred tax liabilities |\\n| Amortization of intangibles | (110,246 | ) | (159,245 | ) |\\n| Depreciation and other | (1,867,027 | ) | (849,503 | ) |\\n| Total deferred tax liabilities | (1,977,273 | ) | (1,008,748 | ) |\\n| Net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\\n\\n88\\nThe net current and non-current components of the deferred income taxes recognized in the balance sheets at December 31, 2012 and 2011, are as follows:\\n| 2012 | 2011 |\\n| Net current assets | $ | 271,553 | $ | 29,699 |\\n| Net long-term liabilities | (1,977,273 | ) | (1,008,748 | ) |\\n| Total net deferred tax liabilities | $ | (1,705,720 | ) | $ | (979,049 | ) |\\n\\nIncome tax expense consists of the following components as of December 31:\\n| 2012 | 2011 | 2010 |\\n| Current |\\n| Federal | $ | 2,673,070 | $ | 2,667,703 | $ | 1,845,850 |\\n| State | 398,649 | 495,338 | 225,738 |\\n| Foreign | (90,289 | ) | — | — |\\n| Deferred | 726,671 | 390,341 | 84,362 |\\n| Total income tax expense | $ | 3,708,101 | $ | 3,553,382 | $ | 2,155,950 |\\n\\nThe differences between the federal statutory rate of 34% and the effective rate are due to state income taxes, permanent deductions, settlement of prior returns related to the acquisition and the fact that no tax provisions are recorded for operations attributable to Kreher Steel Company, LLC in the accompanying financial statements. Tax years dated back to December 31, 2009, are open for federal and state tax audit purposes. The total effective rate of the subsidiaries at December 31, 2012, 2011 and 2010, was 20.2%, 13.1% and 16.3%, respectively.\\nA reconciliation of the effective income tax rate to the U.S. statutory tax rate is as follows:\\n| 2012 | 2011 | 2010 |\\n| U.S. statutory tax rate | 34 | % | 34 | % | 34 | % |\\n| Non-taxable LLC income | (16.2 | ) | (21.1 | ) | (20.4 | ) |\\n| State and local taxes - net of federal tax expense | 2.2 | 0.5 | 2.1 |\\n| Foreign taxes | (0.2 | ) | 0.0 | 0.0 |\\n| Other, net | 0.4 | (0.3 | ) | 0.6 |\\n| Effective tax rate | 20.2 | % | 13.1 | % | 16.3 | % |\\n\\n89\\nNOTE G - COMMITMENTS\\nOperating Lease Commitments\\nThe Company leases certain equipment and warehouse space under operating lease obligations with rent escalation clauses for the warehouse space only. Accordingly, the Company has recorded these lease obligations on a straight-line basis and recorded a deferred rent liability of approximately $53,000 and $94,000 for the years ended December 31, 2012 and 2011, respectively. Rent expense, net of sublease income for the years ended December 31, 2012, 2011 and 2010, was approximately $1,339,000, $1,081,000 and $687,000, respectively. The following shows minimum future rental payments for the next five years under these obligations:\\n| Years ending December 31, |\\n| 2,013 | $ | 1,001,042 |\\n| 2,014 | 629,844 |\\n| 2,015 | 596,404 |\\n| 2,016 | 538,668 |\\n| 2017 and thereafter | 421,401 |\\n\\nHealth Insurance\\nThe Company maintains a fully self-insured health insurance plan. Approximately $1,105,000, $1,021,000 and $904,000 were expensed in 2012, 2011 and 2010, respectively, under this plan. The Company also maintains a fully self-insured health insurance plan at one of its wholly owned subsidiaries. Approximately $850,000, $562,000 and $346,000 were expensed for this plan during 2012, 2011 and 2010, respectively.\\nNOTE H - EMPLOYEE BENEFIT PLAN\\nThe Company maintains a qualified plan under Section 401(k) of the Internal Revenue Code. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of the lesser of 60% of eligible compensation or $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company has a non-discretionary match of 100%, up to 4% of what employees elect. The Company also has a profit-sharing match of $500 per participant, which is discretionary. This discretionary match was paid in 2012, 2011 and 2010. Participants are fully vested at all times in their contributions and become fully vested in the Company's contributions over a defined period. The plan is responsible for costs associated with its administration. Approximately $280,000, $200,000 and $153,000 was charged to expense for the years ended December 31, 2012, 2011 and 2010, respectively.\\nThe Company also maintains a qualified plan under Section 401(k) of the Internal Revenue Code at a wholly owned subsidiary. This plan is available for all employees who have completed one year or more of continuous service. The plan allows employees to contribute an annual limit of $17,500 (the federal limit for 2012). The Company will match contributions at the discretion of management. The Company also has a discretionary profit-sharing contribution. Participants are fully vested in all contributions. The plan is responsible for costs associated with its administration. During 2012, 2011 and 2010, approximately $320,000, $240,000 and $210,000, respectively, was charged to expense.\\nNOTE I - CONTINGENCIES\\nThe Company is subject to various legal proceedings that have arisen in the normal course of business. In the opinion of management, these actions, when concluded and determined, will not have a material adverse effect on the financial position or operations of the Company.\\nNOTE J - MEMBER'S CAPITAL\\nThe Company is a single-member LLC and shall continue until December 31, 2045.\\n90\\nNOTE K - SUBSEQUENT EVENTS\\nThe Company evaluated its December 31, 2012, financial statements for subsequent events through February 18, 2013, the date the financial statements were available to be issued. The Company is not aware of any subsequent events that would require recognition or disclosure in the financial statements.\\n91\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nBoard of Directors\\nKreher Steel Company, LLC\\nWe have audited the accompanying consolidated balance sheets of Kreher Steel Company, LLC (a Delaware limited liability company) and Subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, member's capital and cash flows for each of the three years ended December 31, 2012. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.\\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kreher Steel Company, LLC and Subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.\\n/s/ Grant Thornton LLP\\nGrant Thornton LLP\\nChicago, Illinois\\nFebruary 18, 2013\\n92\\nITEM 9 —\\nChanges In and Disagreements With Accountants on Accounting and Financial Disclosure\\nNone.\\nITEM 9A —\\nControls & Procedures\\nDisclosure Controls and Procedures\\nA review and evaluation was performed by the Company’s management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Security Exchange Act of 1934). Based upon that review and evaluation, the CEO and CFO have concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2012.\\n(a) Management’s Annual Report on Internal Control Over Financial Reporting\\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in the Securities Exchange Act of 1934 rule 240.13a-15(f). The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.\\nInternal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\\nThe Company, under the direction of its Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2012 based upon the framework published by the Committee of Sponsoring Organizations of the Treadway Commission, referred to as the Internal Control—Integrated Framework.\\nBased on our evaluation under the framework in Internal Control — Integrated Framework, the Company’s management has concluded that our internal control over financial reporting was effective as of December 31, 2012.\\nThe effectiveness of the Company’s internal control over financial reporting as of December 31, 2012 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their attestation report included in Item 9A of this annual report.\\n(b) Report of Independent Registered Public Accounting Firm\\nTo the Board of Directors and Stockholders of\\nA.M. Castle & Co.\\nOak Brook, Illinois\\nWe have audited the internal control over financial reporting of A.M. Castle & Co. and subsidiaries (the \\\"Company\\\") as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.\\nWe conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.\\n93\\nA company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.\\nBecause of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.\\nIn our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.\\nWe have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2012 of the Company and our report dated March 11, 2013 expressed an unqualified opinion on those financial statements.\\n/s/ DELOITTE & TOUCHE LLP\\nDELOITTE & TOUCHE LLP\\nChicago, Illinois\\nMarch 11, 2013\\n(c) Change in Internal Control Over Financial Reporting\\nAn evaluation was performed by the Company’s management, including the CEO and CFO, of any changes in internal controls over financial reporting that occurred during the last fiscal quarter and that materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting. The evaluation did not identify any change in the Company’s internal control over financial reporting that occurred during the latest fiscal quarter and that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.\\nItem 9B —\\nOther Information\\nNone.\\n94\\nPART III\\nITEM 10 —\\nDirectors, Executive Officers and Corporate Governance\\nInformation regarding our executive officers is included under the heading “Executive Officers of the Registrant” in Part I of this Annual Report on Form 10-K. All additional information required to be filed in Part III, Item 10, Form 10-K, has been included in the sections of the Company's Definitive Proxy Statement for its 2013 annual meeting of shareholders (fiscal 2012 Proxy Statement) dated and to be filed with the Securities and Exchange Commission on or about March 12, 2013 entitled “Proposal 1- Election of Directors,” “Certain Governance Matters,” and “Section 16(A) Beneficial Ownership Reporting Compliance,” and is hereby incorporated by this specific reference.\\nITEM 11 —\\nExecutive Compensation\\nAll information required to be filed in Part III, Item 11, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Compensation Discussion and Analysis,” “Report of the Human Resources Committee,” “Compensation Committee Interlocks and Insider Participation”, “Compensation Risk”, “Non-Employee Director Compensation,” and “Executive Compensation and Other Information” and is hereby incorporated by this specific reference.\\nITEM 12 —\\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\\nThe information required to be filed in Part III, Item 12, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Stock Ownership of Directors, Management and Principal Stockholders” and “Equity Compensation Plan Information” and is hereby incorporated by this specific reference.\\nITEM 13 —\\nCertain Relationships and Related Transactions, and Director Independence\\nAll information required to be filed in Part III, Item 13, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Related Party Transactions” and “Director Independence; Financial Experts” and is hereby incorporated by this specific reference.\\nITEM 14 —\\nPrincipal Accountant Fees and Services\\nAll information required to be filed in Part III, Item 14, Form 10-K, has been included in the sections of the fiscal 2012 Proxy Statement entitled “Audit and Non-Audit Fees” and “Pre-Approval Policy for Audit and Non-Audit Services” and is hereby incorporated by this specific reference.\\n95\\nPART IV\\nITEM 15 —\\nExhibits\\nA. M. Castle & Co.\\nIndex To Financial Statements\\n\\n| Page |\\n| Consolidated Statements of Operations and Comprehensive Loss—For the years ended December 31, 2012, 2011 and 2010 | 36 |\\n| Consolidated Balance Sheets—December 31, 2012 and 2011 | 37 |\\n| Consolidated Statements of Cash Flows—For the years ended December 31, 2012, 2011 and 2010 | 38 |\\n| Consolidated Statements of Stockholders’ Equity – For the years ended December 31, 2012, 2011 and 2010 | 39 |\\n| Notes to Consolidated Financial Statements | 40 |\\n| Report of Independent Registered Public Accounting Firm | 77 |\\n| Kreher Steel Co., LLC Financial Statements | 79 |\\n| Exhibit Index |\\n\\n96\\nThe following exhibits are filed herewith or incorporated by reference.\\n| ExhibitNumber | Description of Exhibit |\\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. |\\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. |\\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). |\\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. |\\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. |\\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. |\\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. |\\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. |\\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. |\\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. |\\n\\n97\\n| ExhibitNumber | Description of Exhibit |\\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. |\\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. |\\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. |\\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. |\\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. |\\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. |\\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. |\\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. |\\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\\n\\n98\\n| ExhibitNumber | Description of Exhibit |\\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. |\\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. |\\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. |\\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. |\\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. |\\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. |\\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. |\\n\\n99\\n| ExhibitNumber | Description of Exhibit |\\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. |\\n| 21.1 | Subsidiaries of Registrant |\\n| 23.1 | Consent of Deloitte & Touche LLP |\\n| 23.2 | Consent of Grant Thornton LLP |\\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. |\\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. |\\n| 101.INS | XBRL Instance Document (1) |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) |\\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) |\\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) |\\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) |\\n\\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\\n| * | These agreements are considered a compensatory plan or arrangement. |\\n\\n100\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n| A. M. Castle & Co. |\\n| (Registrant) |\\n\\n| By: | /s/ Patrick R. Anderson |\\n| Patrick R. Anderson, Vice President—Controller and Chief Accounting Officer |\\n| (Principal Accounting Officer) |\\n| Date: | March 11, 2013 |\\n\\nPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities as shown following their name on this 11th day of March, 2013.\\n| /s/ Brian P. Anderson | /s/ Gary A. Masse | /s/ Ann M. Drake |\\n| Brian P. Anderson, Chairman of the Board | Gary A. Masse, Director | Ann M. Drake, Director |\\n| /s/ Scott J. Dolan | /s/ Scott F. Stephens | /s/ Reuben S. Donnelley |\\n| Scott J. Dolan, President, | Scott F. Stephens, Vice President | Reuben S. Donnelley, Director |\\n| Chief Executive Officer and | and Chief Financial Officer |\\n| Director | (Principal Financial Officer) |\\n| (Principal Executive Officer) |\\n| /s/ Patrick J. Herbert, III | /s/ Terrence J. Keating | /s/ James D. Kelly |\\n| Patrick J. Herbert, III, Director | Terrence J. Keating, Director | James D. Kelly, Director |\\n| /s/ Pamela Forbes Lieberman |\\n| Pamela Forbes Lieberman, Director | John McCartney, Director |\\n\\n101\\nExhibit Index\\nThe following exhibits are filed herewith or incorporated herein by reference:\\n\\n| Exhibit No. | Description | Page |\\n| 2.1 | Stock Purchase Agreement dated as of August 12, 2006 by and among A. M. Castle & Co. and Transtar Holdings #2, LLC. Filed as Exhibit 2.1 to Form 8-K filed August 17, 2006. Commission File No. 1-5415. | — |\\n| 2.2 | Stock Purchase Agreement, dated November 9, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, Inc. Filed as Exhibit 2.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 2.3 | Agreement and Amendment, dated December 15, 2011, by and among A.M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, Tube Supply, Inc. and A.M. Castle & Co. (Canada) Inc. Filed as Exhibit 2.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 2.4 | Second Amendment to the Stock Purchase Agreement, dated January 13, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.3 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\\n| 2.5 | Third Amendment to the Stock Purchase Agreement, dated May 11, 2012, by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). Incorporated by reference to Exhibit 2.4 to the Company's Form S-4/A filed with the SEC on May 25, 2012. Commission File No. 333-180662. | — |\\n| 2.6 | Fourth Amendment to the Stock Purchase Agreement, dated September 13, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-1 |\\n| 2.7 | Fifth Amendment to the Stock Purchase Agreement, dated November 14, 2012 by and among A. M. Castle & Co., Mr. Paul Sorensen, Mr. Jerry Willeford, and Tube Supply, LLC (as successor in interest to Tube Supply Inc.). | E-3 |\\n| 3.1 | Articles of Restatement of the Charter of the Company filed with the State Department of Assessments and Taxation of Maryland on April 27, 2012. Filed as Exhibit 3.1 to Quarterly Report on Form 10-Q for the period ended March 31, 2012, which was filed on May 3, 2012. Commission File No. 1-5415. | — |\\n| 3.2 | By-Laws of the Company as amended on October 28, 2010. Filed as Exhibit 3.2 to Quarterly Report on Form 10-Q for the period ended September 30, 2010, which was filed on November 5, 2010. Commission File No. 1-5415. | — |\\n| 3.3 | Articles Supplementary of the Company. Filed as Exhibit 3.1 to Form 8-A filed on September 6, 2012. Commission File No. 1-5415. | — |\\n| 4.1 | Indenture, dated as of December 15, 2011, among A.M. Castle & Co., the Guarantors, U.S. Bank National Association, as trustee and U.S. Bank National Association, as collateral agent. Filed as Exhibit 4.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 4.2 | Indenture, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and U.S. Bank National Association, as trustee. Filed as Exhibit 4.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 4.3 | Rights Agreement, dated as of August 31, 2012, by and between A.M. Castle & Co. and American Stock Transfer & Trust Company, LLC, as Rights Agent. Filed as Exhibit 4.1 to Form 8-K filed on August 31, 2012. Commission File No. 1-05415. | — |\\n| 10.1* | A. M. Castle & Co. 1995 Director Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 7, 1995. Commission File No. 1-5415. | — |\\n| 10.2* | A. M. Castle & Co. 1996 Restricted Stock and Stock Option Plan. Filed as Exhibit A to Proxy Statement filed March 8, 2006. Commission File No. 1-5415. | — |\\n\\n102\\n| Exhibit No. | Description | Page |\\n| 10.3* | A. M. Castle & Co. 2000 Restricted Stock and Stock Option Plan. Filed as Appendix B to Proxy Statement filed March 23, 2001. Commission File No. 1-5415. | — |\\n| 10.4* | A. M. Castle & Co. 2004 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit D to Proxy Statement filed March 12, 2004. Commission File No. 1-5415. | — |\\n| 10.5* | A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan, as amended and restated as of December 9, 2010. Filed as Exhibit 10.25 to Annual Report on Form 8-K filed on December 15, 2010. Commission File No. 1-5415. | — |\\n| 10.6* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.11 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.7* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.12 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.8* | A. M. Castle & Co. Directors Deferred Compensation Plan, as amended and restated as of October 22, 2008. Filed as Exhibit 10.13 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.9* | A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.14 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.10* | A. M. Castle & Co. Supplemental Pension Plan, as amended and restated, effective as of January 1, 2009. Filed as Exhibit 10.15 to Annual Report on Form 10-K for the period ended December 31, 2008, which was filed on March 12, 2009. Commission File No. 1-5415. | — |\\n| 10.11* | First Amendment to the A. M. Castle & Co. Supplemental 401(k) Savings and Retirement Plan, executed April 15, 2009 (as effective April 27, 2009). Filed as Exhibit 10.1 to Form 8-K filed on April 16, 2009. Commission File No. 1-5415. | — |\\n| 10.12* | Form of A.M. Castle & Co. Indemnification Agreement to be executed with all directors and executive officers. Filed as Exhibit 10.16 to Form 8-K filed on July 29, 2009. Commission File No. 1-5415. | — |\\n| 10.13* | Form of Restricted Stock Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.20 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\\n| 10.14* | Form of Performance Share Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.21 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\\n| 10.15* | Form of Incentive Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.22 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\\n| 10.16* | Form of Non-Qualified Stock Option Award Agreement under A. M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.23 to Form 8-K filed on March 24, 2010. Commission File No. 1-5415. | — |\\n| 10.17* | Form of Non-Employee Director Restricted Stock Award Agreement. Filed as Exhibit 10.1 to Form 8-K filed on April 27, 2010. Commission File No. 1-5415. | — |\\n| 10.18* | Form of Amended and Restated Change of Control Agreement for all executive officers other than the CEO. Filed as Exhibit 10.24 to Form 8-K filed on September 21, 2010. Commission File No. 1-5415. | — |\\n\\n103\\n| Exhibit No. | Description | Page |\\n| 10.19* | Form of Amended and Restated Severance Agreement for executive officers other than the CEO. Filed as Exhibit 10.26 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\\n| 10.20* | CEO Change in Control Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.27 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\\n| 10.21* | CEO Employment/Non-Competition Agreement, as amended and restated December 22, 2010. Filed as Exhibit 10.28 to Form 8-K filed on December 23, 2010. Commission File No. 1-5415. | — |\\n| 10.22* | Form of Performance Share Award Agreement, adopted March 2, 2011, under A.M. Castle & Co. 2008 Restricted Stock, Stock Option and Equity Compensation Plan. Filed as Exhibit 10.29 to Form 8-K filed March 8, 2011. Commission File No. 1-5415. | — |\\n| 10.23* | 2008 A. M. Castle & Co. Omnibus Incentive Plan, as amended and restated as of April 28, 2011. Filed as Exhibit 10.30 to Form 8-K filed May 3, 2011. Commission File No. 1-5415. | — |\\n| 10.24* | Stephen V. Hooks Executive Retention and Severance Agreement, dated October 27, 2011. Filed as Exhibit 10.31 to Form 8-K filed November 1, 2011. Commission File No. 1-5415. | — |\\n| 10.25 | Pledge and Security Agreement, dated as of December 15, 2011, by A.M. Castle & Co., and its subsidiaries that are party thereto, in favor of U.S. Bank National Association, as collateral agent, for the benefit of the Secured Parties. Filed as Exhibit 10.1 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 10.26 | Intercreditor Agreement, dated as of December 15, 2011, among Wells Fargo Bank, National Association, in its capacity as administrative and collateral agent for the First Lien Secured Parties and U.S. Bank National Association, a national banking association, in its capacity as trustee and collateral agend for the Second Lien Secured Parties. Filed as Exhibit 10.2 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 10.27 | Registration Rights Agreement, dated as of December 15, 2011, between A.M. Castle & Co., the Guarantors and Jefferies & Company, Inc., as initial purchaser, for the benefit of the Holders of the Notes. Filed as Exhibit 10.3 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 10.28 | Loan and Security Agreement, dated December 15, 2011, by and among A.M. Castle & Co., Transtar Metals Corp., Advanced Fabricating Technology, LLC, Oliver Steel Plate Co., Paramont Machine Company, LLC, Total Plastics, Inc., Tube Supply, LLC, A.M. Castle & Co. (Canada) Inc., Tube Supply Canada ULC, the other Loan Parties party thereto, the lenders which are now or which hereafter become a party thereto, and Wells Fargo Bank, National Association, a national banking association, in its capacity as administrative agent and collateral agent for Secured Parties. Filed as Exhibit 10.4 to Form 8-K filed November 15, 2011. Commission File No. 1-5415. | — |\\n| 10.29* | Employment Agreement, dated November 9, 2011, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.29 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\\n| 10.30* | Form of Retention Bonus Agreement for certain executive officers in connection with CEO leadership transition, dated May 14, 2012. Filed as Exhibit 10.30 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\\n| 10.31* | Amendment to Employment Agreement, dated May 30, 2012, by and between A. M. Castle & Co. and Mr. Paul Sorensen. Filed as Exhibit 10.31 to Quarterly Report on Form 10-Q for the period ended June 30, 2012, which was filed on August 7, 2012. Commission File No. 1-5415. | — |\\n| 10.32* | Employment Offer Letter dated October 10, 2012, between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.32 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\\n\\n104\\n| Exhibit No. | Description | Page |\\n| 10.33* | Form of Restricted Stock Unit Award Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.33 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\\n| 10.34* | Form of Severance Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.34 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\\n| 10.35* | Form of Change of Control Agreement between A.M. Castle & Co. and Mr. Scott Dolan. Filed as Exhibit 10.35 to Form 8-K/A filed October 15, 2012. Commission File No. 1-5415. | — |\\n| 10.36* | Offer of Chief Commercial Officer dated December 28, 2012, between A.M. Castle & Co. and Mr. Blain Tiffany. Filed as Exhibit 10.36 to Form 8-K filed January 22, 2013. Commission File No. 1-5415. | — |\\n| 21.1 | Subsidiaries of Registrant | E-5 |\\n| 23.1 | Consent of Deloitte & Touche LLP | E-6 |\\n| 23.2 | Consent of Grant Thornton LLP | E-7 |\\n| 31.1 | CEO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-8 |\\n| 31.2 | CFO Certification Pursuant to Section 302 of the Sarbanes Oxley Act of 2002. | E-9 |\\n| 32.1 | CEO and CFO Certification Pursuant to Section 906 of the Sarbanes Oxley Act of 2002. | E-10 |\\n| 101.INS | XBRL Instance Document (1) | — |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document (1) | — |\\n| 101.CAL | XBRL Taxonomy Calculation Linkbase Document (1) | — |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document(1) | — |\\n| 101.LAB | XBRL Taxonomy Label Linkbase Document (1) | — |\\n| 101.PRE | XBRL Taxonomy Presentation Linkbase Document (1) | — |\\n\\n| (1) | Furnished with this report. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing. |\\n| * | These agreements are considered a compensatory plan or arrangement. |\\n\\n105\\n</text>\\n\\nWhat is the total cost incurred by the company for the acquisition of Tube Supply, inclusive of direct acquisition-related costs, CEO transition costs, bad debt reserves for customer bankruptcies, charges for export penalties related to product shipments and underwriting fees associated with debt financing in $ million?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 10.9.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 51,\n \"input_length\": 92719\n}"}}},{"rowIdx":52,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial statements\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED BALANCE SHEETS\nAS OF SEPTEMBER 30, 2021 AND DECEMBER 31, 2020\n(Currency expressed in United States Dollars (“US$”))\n\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| ASSETS |\n| Current assets: |\n| Cash and cash equivalents | $ | 5,722,450 | $ | 506,666 |\n| Due from related parties | 97,500 | — |\n| Accounts receivable, net | 87,803 | 1,897 |\n| Deposits, prepayments and other receivables | 69,623 | 60,532 |\n| Total current assets | 5,977,376 | 569,095 |\n| Non-current assets: |\n| Intangible assets, net | 4,800,000 | 7,200,000 |\n| Property, plant and equipment, net | 11,080 | 18,069 |\n| Right of use assets, net | 529,782 | 79,109 |\n| Total non-current assets | 5,340,862 | 7,297,178 |\n| TOTAL ASSETS | $ | 11,318,238 | $ | 7,866,273 |\n| LIABILITIES AND SHAREHOLDERS’ DEFICIT |\n| Current liabilities: |\n| Accounts payables | $ | 104,680 | $ | 54,256 |\n| Contract liabilities | 35,582 | 18,646 |\n| Accrued liabilities and other payables | 752,640 | 677,572 |\n| Contingent service payable | — | 633,000 |\n| Due to related parties | 24,763 | 1,571,737 |\n| Operating lease liabilities | 167,773 | 36,752 |\n| Total current liabilities | 1,085,438 | 2,991,963 |\n| Non-current liabilities |\n| Operating lease liabilities | 365,539 | 46,453 |\n| TOTAL LIABILITIES | 1,450,977 | 3,038,416 |\n| COMMITMENTS AND CONTINGENCIES |\n| Convertible preferred shares; $ 0.0001 par value, 5,000,000 shares authorized, 4,916,500 and 4,920,000 shares undesignated as of September 30, 2021 and December 31, 2020, respectively |\n| Series A shares: 10,000 shares designated; 8,000 and 8,000 Series A shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 8,000,000 | 8,000,000 |\n| Series B shares: 10,000 shares designated; 2,548 and 2,548 Series B shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 3,412,503 | 3,412,503 |\n| Series B-1 shares: 15,000 shares designated; 160 and 160 Series B-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 466,720 | 466,720 |\n| Series C shares: 15,000 shares designated; 1,552 and 362 Series C shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost | 8,353,373 | 2,151,706 |\n| Series C-1 shares: 30,000 shares designated; 13,984 and 2,885 Series C-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost and stock subscription receivable | 5,057,192 | 1,211,700 |\n| SHAREHOLDERS’ DEFICIT |\n| Series X Super Voting Preferred Stock, $ 0.0001 par value, 3,500 shares designated; 3,500 and 0 Series X shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | — | — |\n| Common shares; $ 0.0001 par value, 95,000,000 shares authorized; 9,695,480 and 7,413,600 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 970 | 742 |\n| Additional paid-in capital | 12,712,290 | 2,227,033 |\n| Accumulated other comprehensive loss | ( 19,478 | ) | ( 55,236 | ) |\n| Accumulated deficit | ( 28,116,309 | ) | ( 12,587,311 | ) |\n| Total shareholders’ deficit | ( 15,422,527 | ) | ( 10,414,772 | ) |\n| TOTAL LIABILITIES AND SHAREHOLDERS’ DEFICIT | $ | 11,318,238 | $ | 7,866,273 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 3 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND\nOTHER COMPREHENSIVE LOSS\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Three months ended | Nine months ended |\n| September 30, | September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue, net |\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\n| Sales – online ordering | 73,518 | — | 73,518 | — |\n| Total revenue | 83,534 | 11,629 | 100,823 | 41,262 |\n| Cost of sales: |\n| Hardware sales | — | ( 585 | ) | ( 165 | ) | ( 2,982 | ) |\n| Software subscription | ( 101,695 | ) | ( 19,731 | ) | ( 206,387 | ) | ( 56,127 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) | — |\n| Total cost of revenue | ( 159,436 | ) | ( 20,316 | ) | ( 264,293 | ) | ( 59,109 | ) |\n| Gross loss | ( 75,902 | ) | ( 8,687 | ) | ( 163,470 | ) | ( 17,847 | ) |\n| Operating expenses: |\n| Sales and marketing expenses | ( 42,843 | ) | — | ( 85,027 | ) | ( 3,125 | ) |\n| Software development costs | ( 9,709 | ) | ( 33,658 | ) | ( 76,698 | ) | ( 139,151 | ) |\n| Impairment loss | — | 4,164 | ( 200,000 | ) | ( 8,778 | ) |\n| General and administrative expenses | ( 8,292,463 | ) | ( 1,580,287 | ) | ( 14,414,362 | ) | ( 2,311,266 | ) |\n| Total operating expenses | ( 8,345,015 | ) | ( 1,609,781 | ) | ( 14,776,087 | ) | ( 2,462,320 | ) |\n| Loss from operations | ( 8,420,917 | ) | ( 1,618,468 | ) | ( 14,939,557 | ) | ( 2,480,167 | ) |\n| Other income (expense): |\n| Interest income | 55 | 3 | 71 | 11 |\n| Interest expense | ( 12,272 | ) | ( 12,261 | ) | ( 36,486 | ) | ( 36,381 | ) |\n| Loss on settlement of litigation | — | — | ( 550,000 | ) | — |\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\n| Total other expense | ( 7,047 | ) | ( 8,521 | ) | ( 579,498 | ) | ( 26,875 | ) |\n| Loss before income taxes | ( 8,427,964 | ) | ( 1,626,989 | ) | ( 15,519,055 | ) | ( 2,507,042 | ) |\n| Income taxes | ( 1,303 | ) | ( 4 | ) | ( 9,943 | ) | ( 15,069 | ) |\n| NET LOSS | $ | ( 8,429,267 | ) | $ | ( 1,626,993 | ) | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\n| Other comprehensive loss: |\n| Foreign currency translation income | 8,859 | 51,183 | 35,758 | 15,249 |\n| COMPREHENSIVE LOSS | $ | ( 8,420,408 | ) | $ | ( 1,575,810 | ) | $ | ( 15,493,240 | ) | $ | ( 2,506,862 | ) |\n| Net loss per share – Basic and Diluted | $ | ( 1 | ) | $ | ( 0 | ) | $ | ( 2 | ) | $ | ( 0 | ) |\n| Weighted average common shares outstanding – Basic and Diluted | 7,823,818 | 6,848,700 | 7,551,842 | 6,847,945 |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 4 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Three months ended September 30, 2021 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\n| Shares | Amount |\n| Balance as of July 1, 2021 | 7,413,600 | $ | 742 | $ | 5,145,228 | $ | ( 28,337 | ) | $ | ( 19,687,042 | ) | $ | ( 14,569,409 | ) |\n| Imputed Interest | — | — | 12,260 | — | — | 12,260 |\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\n| Net loss for the period | — | — | — | — | ( 8,429,267 | ) | ( 8,429,267 | ) |\n| Foreign currency translation adjustment | — | — | — | 8,859 | — | 8,859 |\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\n\n\n| Three months ended September 30, 2020 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\n| Shares | Amount |\n| Balance as of July 1, 2020 | 6,847,200 | $ | 685 | $ | 1,729,064 | $ | ( 31,946 | ) | $ | ( 9,654,441 | ) | $ | ( 7,956,638 | ) |\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\n| Imputed interest | — | — | 12,261 | — | — | 12,261 |\n| Net loss for the period | — | — | — | — | ( 1,626,993 | ) | ( 1,626,993 | ) |\n| Foreign currency translation adjustment | — | — | — | 51,183 | — | 51,183 |\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\n\n\n| 5 |\n\n\n| Nine months ended September 30, 2021 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\n| Shares | Amount |\n| Balance as of January 1, 2021 | 7,413,600 | $ | 742 | $ | 2,227,033 | $ | ( 55,236 | ) | $ | ( 12,587,311 | ) | $ | ( 10,414,772 | ) |\n| Imputed Interest | — | — | 36,380 | — | — | 36,380 |\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\n| Loss on fair value of shares issued for accrued salaries | — | — | 2,894,075 | — | — | 2,894,075 |\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\n| Net loss for the period | — | — | — | — | ( 15,528,998 | ) | ( 15,528,998 | ) |\n| Foreign currency translation adjustment | — | — | — | 35,758 | — | 35,758 |\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\n\n\n| Nine months ended September 30, 2020 |\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\n| Shares | Amount |\n| Balance as of January 1, 2020 | 6,847,200 | $ | 685 | $ | 1,704,944 | $ | 3,988 | $ | ( 8,759,323 | ) | $ | ( 7,049,706 | ) |\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\n| Imputed interest | — | — | 36,381 | — | — | 36,381 |\n| Net loss for the period | — | — | — | — | ( 2,522,111 | ) | ( 2,522,111 | ) |\n| Foreign currency translation adjustment | — | — | — | 15,249 | — | 15,249 |\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 6 |\n\nSOCIETY PASS INCORPORATED\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\n(Currency expressed in United States Dollars (“US$”))\n(Unaudited)\n\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Cash flows from operating activities: |\n| Net loss | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities |\n| Depreciation and amortization | 2,406,648 | 4,447 |\n| Impairment loss | 200,000 | 8,778 |\n| Imputed interest | 36,380 | 36,381 |\n| Loss on settlement of litigation | 550,000 | — |\n| Stock based compensation for services | 10,071,830 | 1,641,877 |\n| Change in operating assets and liabilities: |\n| Accounts receivable | ( 85,906 | ) | ( 19,900 | ) |\n| Inventories | — | ( 7,212 | ) |\n| Deposits, prepayments and other receivables | ( 9,091 | ) | ( 7,005 | ) |\n| Contract liabilities | 16,936 | 8,275 |\n| Accounts payables | 50,424 | 61 |\n| Accrued liabilities and other payables | ( 474,932 | ) | ( 37,960 | ) |\n| Advances to related parties | 127,500 | ( 76,278 | ) |\n| Right of use assets | 28,498 | — |\n| Operating lease liabilities | ( 29,064 | ) | — |\n| Net cash used in operating activities | ( 2,639,775 | ) | ( 970,647 | ) |\n| Cash flows from investing activities: |\n| Purchase of investment assets | ( 200,000 | ) | — |\n| Net cash used in investing activities | ( 200,000 | ) | — |\n| Cash flows from financing activities: |\n| Proceed from the issuance of Series C preferred stock and exercise of warrants | 8,019,461 | 708,960 |\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\n| Effect on exchange rate change on cash and cash equivalents | 36,098 | 16,689 |\n| NET CHANGE IN CASH AND CASH EQUIVALENTS | 5,215,784 | ( 244,998 | ) |\n| CASH AND CASH EQUIVALENT AT BEGINNING OF PERIOD | 506,666 | 606,491 |\n| CASH AND CASH EQUIVALENT AT END OF PERIOD | $ | 5,722,450 | $ | 361,493 |\n| Supplemental disclosure of cash flow information: |\n| Cash paid for interest | $ | 106 | $ | — |\n| Cash paid for income tax | $ | — | $ | — |\n| NON-CASH INVESTING AND FINANCING ACTIVITIES |\n| Impact of adoption of ASC 842 - lease obligation and ROU asset | $ | 479,171 | $ | — |\n| Waiver of related party debt accounted as capital transaction | $ | 1,444,140 | $ | — |\n| Fair value of preferred stock issued for services | $ | 2,948,982 | $ | 793,372 |\n| Fair value of preferred stock accounted and included for issuance cost | $ | 441,642 | $ | — |\n| Common stock issued for accrued salaries | $ | 960,835 | $ | — |\n| Shares cancellation | $ | 15 | $ | — |\n\nSee accompanying notes to unaudited condensed consolidated financial statements.\n\n| 7 |\n\nNOTE－1 DESCRIPTION OF BUSINESS AND ORGANIZATION\nSociety Pass Incorporated (the “Company”) is incorporated in State of Nevada on June 22, 2018 under the name of Food Society Inc. On October 3, 2018, the Company changed its corporate name to Society Pass Incorporated. The Company through its subsidiaries, mainly sells and distributes the hardware and software of Point of Sales (POS) application in Vietnam.\nDescription of subsidiaries incorporated by the Company\n\n| Schedule of Description of subsidiaries |\n| Name | Place and date of incorporation | Principal activities | Particulars of registered/ paid up share Capital | Effective interest held |\n| Society Technology LLC | State of Nevada , January 24, 2019 | IP Licensing | US$1 | 100 % |\n| SOPA Cognitive Analytics Private Limited | India , February 5, 2019 | Computer sciences consultancy and data analytics | INR1,238,470 | 100 % |\n| SOPA Technology Pte. Ltd . | Singapore , June 4, 2019 | Investment holding | SG$1,250,000 | 100 % |\n| SOPA Technology Company Limited | Vietnam , October 1, 2019 | Software production | Registered: VND 2,307,300,000; Paid up: VND 1,034,029,911 | 100 % |\n| Hottab Pte Ltd. (HPL) | Singapore , January 17, 2015 | Software development and marketing for the F&B industry | SG$620,287.75 | 100 % |\n| Hottab Vietnam Co. Ltd | Vietnam , April 17, 2015 | Sale of POS hardware and software | VND 1,000,000,000 | 100 % |\n| Hottab Asset Company Limited | Vietnam , July 25, 2019 | Sale of POS hardware and software | VND 5,000,000,000 | 100 % |\n\nThe Company and its subsidiaries are hereinafter referred to as (the “Company”).\nOn October 29, 2019 with the revised provision dated November 11, 2019, the Company acquired Hottab Pte Ltd and its subsidiaries, at the consideration of $ 1,050,000 consisted of Series C preference shares valued at $ 900,000 and the cash consideration of $ 150,000 . The value of the $900,000 Series C preference shares issued was determined based on the stated value per share of the Company’s shares at the acquisition date. Also, the Company shall pay to the Company additional Series C preference shares with an aggregate value of $ 558,000 (the “Equity Incentive”) in the event the Company able to fulfilled the other terms per their arrangement with in five months from the completion date.\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the forward stock split.\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the reverse stock split.\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\n\n| 8 |\n\nSpun Out\nOn December 31, 2019, the Company recently spun out Food Society Group Limited (Food Business), which aims to develop and commercialize chain of restaurants in Vietnam.\nIn connection with the presentation of the Company’s consolidated financial statements, the Company considered the guidance described in the SEC’s codified Staff Accounting Bulletins, Topic 5, Section Z, paragraph 7, “Accounting for the Spin-off of a subsidiary”.\nThe Company’s initial registration of its securities under the 1933 Securities Act and the spin off transaction of the Food Society Group Limited occurred prior to the effectiveness of the Company’s registration statement.\nThe Company considered the following facts and circumstances in concluding omitting the Food Society Group Limited results of operations and financial position in the consolidated financial statements presented in the registration statement:\n• The Company’s operations as a developer of an e-commerce platform and the Food Society Group Limited operations as a two(2) retail restaurants are in dissimilar business that would ordinarily be distinguished as reportable segments as defined by FASB ASC 280-10-50-10.\n• The Company and the subsidiary have been managed and financed historically as if autonomous\n• The Company and the subsidiary have no common facilities or costs\n• The Company and the subsidiary are operated and financed autonomously after the spinoff, and\n• There are no material financial commitments , guarantees or contingent liabilities to each other after the spin off\nAccordingly, the Company has elected to characterize the spin-off of the Food Society Group Limited as a change in the Company’s reporting and present its historical financial statements as if the Company never had an investment in the subsidiary.\nThis spun off our subsidiary Food Society Group Limited which owns 100% of Vietnam Eats (Hong Kong) Limited which owns 100% of Loft Restaurant Service Trading Company Limited that operates 2 restaurants in Vietnam.\nThomas O’Connor, our former Chief Marketing Officer, serves as the legal representative of Loft Restaurant Service Trading Company Limited. Our Chief Executive Officer and Chairman of our board of directors, Dennis Nguyen., is the Chairman of Food Society Group Limited’s board of directors.\nThe two restaurants were making losses for the financial year of 2019. The Company wanted to focus on building our loyalty technology platform. On December 20, 2019’s Board of Directors meeting the CFO presented the case for the spun off. The board voted on the February 18, 2020 to spin out the Food Society Group Limited via a proportionate distribution of shareholding percentage to the existing shareholders as at December 31, 2019.\nNOTE－2 LIQUIDITY AND CAPITAL RESOURCES\nThe accompanying unaudited condensed consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nThe Company suffered from an accumulated deficit of 28,116,309 at September 30, 2021. The Company incurred continuous net loss of $ 15,528,998 during the nine months ended September 30, 2021. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\n\n| 9 |\n\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $ 26,000,001 and 2,124,999 . In addition, the Company has raised $ 8,019,461 , net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\nThe recent outbreak of COVID-19, which has been declared by the World Health Organization to be a pandemic, has spread across the globe and is impacting worldwide economic activity.. The COVID-19 pandemic has significantly impacted health and economic conditions throughout Vietnam, Singapore and Southeast Asia. National, regional and local governments took a variety of actions to contain the spread of COVID-19, including office and store closures, quarantining suspected COVID-19 patients, and capacity limitations. These developments have significantly impacted the results of operations, financial condition and cash flows of the Company included in this reporting. The impact included the difficulties of working remotely from home including slow Internet connection, the inability of our accounting and financial officers to collaborate as effectively as they would otherwise have in an office environment and issues arising from mandatory state quarantines.\nWhile it is not possible at this time to estimate with sufficient certainty the impact that COVID-19 could have on the Company’s business, the continued spread of COVID-19 and the measures taken by federal, state, local and foreign governments could disrupt the operation of the Company’s business. The COVID-19 outbreak and mitigation measures have also had and may continue to have an adverse impact on global and domestic economic conditions, which could have an adverse effect on the Company’s business and financial condition, including on its potential to conduct financings on terms acceptable to the Company, if at all. In addition, the Company has taken temporary precautionary measures intended to help minimize the risk of the virus to its employees, including temporarily requiring employees to work remotely, and discouraging employee attendance at in-person work-related meetings, which could negatively affect the Company’s business. These measures are continuing. The extent to which the COVID-19 outbreak impacts the Company’s results will depend on future developments that are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity of the virus and the actions to contain its impact.\nNOTE－3 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described in this note and elsewhere in the accompanying condensed consolidated financial statements and notes.\n• Basis of presentation\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\n\n| 10 |\n\n• Use of estimates and assumptions\nIn preparing these condensed consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\n• Basis of consolidation\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\n• Cash and cash equivalents\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $ 5,722,450 and $ 506,666 , respectively.\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $ 250,000 , so there were uninsured balance of $ 4,895,306 and $ 208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\n• Accounts receivable\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $ 0 and $ 0 , respectively.\n• Inventories\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchandized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. The inventories were amounted to $ 0 and $ 0 at September 30, 2021 and December 31, 2020, respectively.\n\n| 11 |\n\n• Property, plant and equipment\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\n\n| Schedule of Expected useful life |\n| Expected useful lives |\n| Computer equipment | 3 years |\n| Office equipment | 5 years |\n\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\n• Impairment of long-lived assets\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\n• Revenue recognition\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\n\n| • | identify the contract with a customer; |\n| • | identify the performance obligations in the contract; |\n| • | determine the transaction price; |\n| • | allocate the transaction price to performance obligations in the contract; and |\n| • | recognize revenue as the performance obligation is satisfied. |\n\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\nConsumer Facing Business\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center.\n| 12 |\n\nRevenue streams for consumer facing business:\nF&B sector\n\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\n\n\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\n\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\nLifestyle sector\n\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream.\nMerchant Facing Business\nRevenue streams for merchant facing business include:\n\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream.\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\n\n| 13 |\n\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\nContract assets\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\nThere were no contract assets at September 30, 2021 and December 31, 2020.\nContract liabilities\nIn accordance with ASC 606-10-45-2, a contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $ 35,582 and $ 18,646 as of September 30, 2021 and December 31, 2020, respectively.\nContract costs\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\n• Incremental costs directly related to a specific contract;\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\n• Costs that are expected to be recovered from the customer.\nNo contract costs are capitalized for the nine months ended September 30, 2021 and 2020.\nNo contract costs are capitalized for the three months ended September 30, 2021 and 2020.\n\n| 14 |\n\n• Software development costs\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $ 76,698 and $ 139,151 , respectively. For three months ended September 30, 2021 and 2020, the software development costs were $ 9,709 and $ 33,658 , respectively.\n• Product warranties\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of September 30, 2021 and December 31, 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\n• Shipping and handling costs\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\n• Sales and marketing\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 85,027 and $ 3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $ 42,843 and $ 0 , respectively.\n• Income tax\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the condensed consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the condensed consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\n\n| 15 |\n\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\n• Uncertain tax positions\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\n• Foreign currencies translation and transactions\nThe reporting currency of the Company is United States Dollar (\"US$\") and the accompanying condensed consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| Schedule of Foreign currencies translation and transactions |\n| September 30, 2021 | September 30, 2020 |\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\n\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\n\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\n\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\n\n| 16 |\n\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $ 8,859 for the three months ended September 30, 2021 as compared to a gain of $ 51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\n• Comprehensive income\nASC Topic 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying condensed consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\n• Leases\nThe Company adopted Topic 842, Leases (“ASC 842”) to determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the condensed consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\n\n| 17 |\n\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\nAs of September 30, 2021 and December 31, 2020, the Company recorded the right of use asset of $ 529,782 and $ 79,109 respectively.\n• Related parties\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\nThe condensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\n• Commitments and contingencies\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\n\n| 18 |\n\n• Fair value of financial instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\n\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\n• Cost of goods sold\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase.\n• Share-based compensation\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\n\n| 19 |\n\n• Business combinations\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\n• Earnings per share\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\n\n| Schedule of Common stock issued |\n| As of September 30, | As of December 31, |\n| 2021 | 2020 |\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\n| Warrants granted | — | — |\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\n| Total: | 6,659,900 | 2,408,600 |\n\n\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\n\n• Segment Reporting\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\n• Emerging Growth Company\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\n\n| 20 |\n\n• Recent Accounting Pronouncements\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\nAccounting Standards Adopted\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have any impact on the financial statements.\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nAccounting Standards Issued, Not Adopted\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\n\n| 21 |\n\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\nNo other new accounting pronouncements were issued or became effective in the period that had, or are expected to have, a material impact on our condensed consolidated Financial Statements.\nNOTE－4 BUSINESS COMBINATION\nOn November 11, 2019, the Company completed the acquisition of 100 % equity interest of Hottab Pte Limited (the “Acquisition”). The total consideration of the acquisition is 156 shares of series C convertible preferred stock, approximately $ 900,000 , cash consideration $ 150,000 and additional series C convertible preferred stock approximately $ 558,000 . The Company accounted for the transaction as an acquisition of a business pursuant to ASC 805, “Business Combinations” (“ASC 805”).\n\n| Schedule of Purchase price allocation |\n| Purchase price allocation: |\n| Fair value of stock at closing | $ | 900,000 |\n| Cash paid | 75,000 |\n| Deferred payments- Cash | 71,422 |\n| Deferred payment- shares | 531,380 |\n| Less cash received | ( 15,337 | ) |\n| Purchase price | $ | 1,562,465 |\n\nThe transaction was accounted for using the acquisition method. Accordingly, goodwill has been measured as the excess of the total consideration over the amounts assigned to the identifiable assets acquired and liabilities assumed based on their preliminary estimated fair values.\nThe deferred payments of $ 633,000 were discounted using the yield on a CCC rated corporate debt for 3-month, 6-month and 9-month maturities, respectively. The implied discount is approximately $ 30,198 , which will be amortized over the term on the payments.\nThe purchase price allocation resulted in $2,766,000 of goodwill, as below:\n\n| Schedule of Acquisition of assets and liability |\n| Acquired assets: |\n| Trade receivables | $ | 6,906 |\n| Other receivables | 1,857 |\n| Total acquired assets | 8,763 |\n| Less: Assumed liabilities |\n| Trade payables | 39,147 |\n| Accrued liabilities and other payable | 68,458 |\n| Amounts due to related parties | 1,080,904 |\n| Deferred revenue | 23,789 |\n| Total Assumed liabilities | 1,212,298 |\n| Fair value of net liabilities assumed | ( 1,203,535 | ) |\n| Goodwill recorded | 2,766,000 |\n| Cash consideration allocated | $ | 1,562,465 |\n\n\n| 22 |\n\nUnder the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the Acquisition, and historical and current market data. The preliminary allocation of the purchase price is based on the best information available and is pending, amongst other things: (i) the finalization of the valuation of the fair values and useful lives of tangible assets acquired; (ii) the finalization of the valuations and useful lives for the intangible assets acquired; (iii) finalization of the valuation of accounts payable and accrued expenses; and (iv) finalization of the fair value of non-cash consideration.\nThe Acquisition was accounted for as a business combination in accordance with ASC 805 “Business Combinations”. The Company has allocated the purchase price consideration based upon the fair value of the identifiable assets acquired and liabilities assumed on the acquisition date. Management of the Company is responsible for determining the fair value of assets acquired, liabilities assumed and intangible assets identified as of the acquisition date and considered a number of factors including valuations from management estimation. Acquisition-related costs incurred for the acquisitions are not material and have been expensed as incurred in general and administrative expense.\nThe goodwill is not expected to be deductible for tax purposes. The goodwill is fully impaired during the year ended December 31, 2019, because there were continuous operating losses and negative cash flows incurred subsequently. Under ASC 350-20-50, the Company recognized the goodwill impairment loss by comparing the actual operating results of Hottab to the profit forecast and a negative performance is resulted.\nDuring the measurement period (which is the period required to obtain all necessary information that existed at the acquisition date, or to conclude that such information is unavailable, not to exceed one year), additional assets or liabilities may be recognized, or there could be changes to the amounts of assets or liabilities previously recognized on a preliminary basis, if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of these assets or liabilities as of that date. No additional assets or liabilities were recognized during the measurement period, or the changes to the amounts of assets or liabilities previously recognized.\nOn September 30, 2021, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $75,000 cash consideration and $558,000 equity incentive. The said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021.\nNOTE－5 REVENUE\nRevenue consisted of the following deliverables:\n\n| Schedule of Revenue |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\n| Sales – online ordering | 73,518 | — | 73,518 | — |\n| $ | 83,534 | $ | 11,629 | $ | 100,823 | $ | 41,262 |\n\n\n| 23 |\n\nIn accordance with ASC 280, Segment Reporting (“ASC 280”), we have two reportable geographic segments:\nSoftware License Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\n\n| Schedule of geographic segments |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Indonesia | $ | 10,016 | $ | 9,788 | $ | 24,813 | $ | 31,604 |\n| Vietnam | — | 1,841 | 2,492 | 9,658 |\n| $ | 10,016 | $ | 11,629 | $ | 27,305 | $ | 41,262 |\n\nOnline Ordering Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\n\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Indonesia | $— | $— | $— | $— |\n| Vietnam | 73,518 | — | 73,518 | — |\n| $ | 73,518 | $ | — | $ | 73,518 | $ | — |\n\nContract liabilities recognized was related to software sales only and the following is reconciliation for the periods:\n\n| Schedule of Contract liabilities |\n| Period ended September 30, 2021 | Year ended December 31, 2020 |\n| (Unaudited) |\n| Contract liabilities, brought forward | $ | 18,646 | $ | 19,843 |\n| Add: recognized as deferred revenue | 35,582 | 47,090 |\n| Less: recognized as current period/year revenue | ( 18,646 | ) | ( 48,287 | ) |\n| Contract liabilities, carried forward | $ | 35,582 | $ | 18,646 |\n\nNOTE－6 INTANGIBLE ASSETS\nAs of September 30, 2021 and December 31, 2020, intangible assets consisted of the following:\n\n| Schedule of intangible assets |\n| Useful life | September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| At cost: |\n| Software platform | 2.5 years | $ | 8,000,000 | $ | 8,000,000 |\n| Other intangible assets | 3 – 5 years | 1,725 | 1,725 |\n| 8,001,725 | 8,001,725 |\n| Less: accumulated amortization | ( 3,201,725 | ) | ( 801,725 | ) |\n| $ | 4,800,000 | $ | 7,200,000 |\n\n\n| 24 |\n\nOn November 1 2018, the Company entered software development agreement with CVO Advisors Pte Ltd (CVO) 2018 to design and build App and Web-based platform for the total consideration of $8,000,000. CVO who is a third party vendor in the business of designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms in Asia. The CVO developer performed and accepted technical work, of software development phase, which was materially completed by December 23, 2018. The Company obtained a third party license (Wallet Factory International Ltd) for their technology build up by CVO.\nThe delivered platform was further developed by the Company’s in-house technology team (based in Noida that Sopa is currently using for the loyalty platform. The platform can be downloaded from Apple store or Googleplay store (i.e. SoPaApp) and the Company’s web version is on www.sopa.asia. The platform was completed developed on September 30, 2020 and has estimated life of 2.5 years. The platform started to be amortized from October 1, 2020.\nFurther, the Company entered subscription agreement with CVO to issued 8,000 shares of preferred stocks for the software development, equal to the aggregate of $ 8,000,000 or at the stated value of $ 1,000 per share.\nPursuant to the subscription agreement entered with CVO, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software development at the stated value of $ 1,000 per share, totaling $8,000,000. CVO performed and accepted the technical work such as designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms. The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\nAlso, owner of CVO entered into call option agreement with the CEO of the Company to sale all the shares of CVO for the sum of $10 per share, as of date, these options were exercised by the CEO of the Company, but the equity holders of CVO Advisors Pte. Ltd. have not honored the exercise of the call. The parties are currently in litigation (refer Note 19). As a result of this option exercise, there was no accounting effect on the Company’s financial statement during the period ended September 30, 2021.\nAmortization of intangible assets attributable to future periods is as follows:\n\n| Schedule of Amortization of intangible assets |\n| Year ending December 31: | Amount |\n| 2021 (remaining period) | $ | 800,000 |\n| 2022 | 3,200,000 |\n| 2023 | 800,000 |\n| Total | $ | 4,800,000 |\n\nAmortization of intangible assets was $ 2,400,000 and $ 1,479 for the nine months ended September 30, 2021 and 2020, respectively.\nAmortization of intangible assets was $ 800,000 and $ 0 for the three months ended September 30, 2021 and 2020, respectively.\nNOTE－ 7 PROPERTY, PLANT AND EQUIPMENT\nProperty, plant and equipment consisted of the following:\n\n| Schedule of Property plant and equipment |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| At cost: |\n| Computer | $ | 29,206 | $ | 29,206 |\n| Office equipment | 1,721 | 1,721 |\n| 30,927 | 30,927 |\n| Less: accumulated depreciation | ( 19,403 | ) | ( 12,755 | ) |\n| Less: exchange difference | ( 444 | ) | ( 103 | ) |\n| $ | 11,080 | $ | 18,069 |\n\nDepreciation expense for the nine months ended September 30, 2021 and 2020 were $ 6,648 and $ 2,968 , respectively.\nDepreciation expense for the three months ended September 30, 2021 and 2020 were $ 2,197 and $ 714 , respectively.\n\n| 25 |\n\nNOTE— 8 ASSET PURCHASE AGREEMENT\nOn February 16, 2021, the Company subsidiary SoPa Technology Pte Ltd (“SoPa Pte Ltd”) acquired certain e-commerce assets from Goodventures Sea Limited (“Goodventures”) pursuant to an Asset Purchase Agreement dated February 16, 2021 (the “Leflair Purchase Agreement”). The acquired assets consisted of intellectual property for it lifestyle e-commerce retail business.\nAs consideration for entering into the Asset Purchase Agreement, the Company agreed to pay Goodventure a total of $ 200,000 in cash payable in installments until April 16, 2021 and 1,500 ordinary shares of SoPa Pte Ltd by April 16, 2021, which represent 15% of the outstanding share capital of SoPa Technology Pte Ltd.\nThe assets acquired by SoPa Pte Ltd under the Leflair Purchase Agreement were substantially all of the assets of an online retail platform that carried the “Leflair” brand name and included a Leflair e-commrce website, Leflair iOs and Android Apps, and backend end infrastructure as well as marketing properties including a customer list and social media pages. In addition, SoPa Technology Ptd Ltd acquired intellectual property such as Leflair logos, trademarks and brands.\nThe Company accounted for this acquisition as an asset acquisition under ASC 805 and that the Company has early adopted the amendments of Regulation S-X dated May 21, 2020 and has concluded that this acquisition was not significant. Accordingly, the presentation of the assets acquired, historical financial statements under Rule 3-05 and related pro forma information under Article 11 of Regulation S-X, respectively, are not required to be presented.\n\n| Schedule of Asset acquisition |\n| Acquired assets: |\n| Intellectual property | $ | 200,000 |\n| Less: Assumed liabilities |\n| Accrued liabilities and other payable | — |\n| Fair value of net assets acquired | 200,000 |\n| Impairment loss recorded | ( 200,000 | ) |\n| Net asset value | $ | — |\n\nThe purchase price of $200,000 shall be allocated amongst the intangible assets acquired, further, these intangible have a short term life as well as the quantum of the value, the company decided to expense it and accounted $ 0 - and $ 200,000 as impairment loss during the three and nine months ended September 30, 2021.\nThe shares issued as part of this transaction do not give the holders the right to influence or control SoPa Pte Ltd. The holders do not have any special voting rights or the right to appoint any board members. SoPa Pte Ltd has not yet issued the shares to the future holders. Since the shares of SoPa Pte Ltd have not yet been issue, no minority interest needs to be recorded as of September 30, 2021.\n\n| 26 |\n\nSoPa Pte Ltd is a private company that was incorporated under the laws of Singapore on June 6, 2019. SoPa Pte Ltd manages Society Pass Incorporated’s operating activities in SEA countries and South Asia. As a pass-through holding company, the value of the 15% interest in the SoPa Pte Ltd to be issued to LeFlair owners has an indeterminate value and no real current value. Society Pass Incorporated plans to record the issuance of the shares at the nominal par value of the shares to be issued to the holders. The value of the assets acquired shall be the value of the cash paid and to be paid to the sellers.\nThe Company has paid $ 200,000 during the period ended September 30, 2021.\nNOTE－9 AMOUNTS DUE FROM (TO) RELATED PARTIES\nAmounts due to related parties consisted of the following:\n\n| Schedule of Amount due to related parties |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Amounts due to related parties (a) | $ | 24,763 | $ | 96,940 |\n| Amounts due to shareholders (b) | — | 738,964 |\n| Amount due to a director (c) | — | 735,833 |\n| $ | 24,763 | $ | 1,571,737 |\n\n(a) The amounts represented temporary advances to the Company including related parties (two officers), which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to related parties balance was $ 24,763 and $ 96,940 as of September 30, 2021 and December 31, 2020, respectively.\n(b) In February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\nThis amounts represented temporary advances to the Company by shareholder, which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 738,964 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to a shareholder balance was $ 0 and $ 738,964 as of September 30, 2021 and December 31, 2020, respectively. Imputed interest is charged at 4.5 % per annum, which was amounted to $ 36,380 and $ 36,381 for the nine months ended September 30, 2021 and 2020, respectively.\n(c) The amount represented paid salaries and bonus to the Director which was unsecured, interest-free and had no fixed terms of repayments. As of June 30, 2021, the Director had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares. During the period ended September 30, 2021, the Company issued those shares at the fair value of $ 3,854,908 , results into the additional compensation expenses of $ 2,894,075 accounted under stock based compensation account. The Company’s due to a director balance was $- 0 and $ 735,833 as of September 30, 2021 and December 31, 2020, respectively.\n\n| 27 |\n\nAmounts due from related parties\nThe director has advance $ 97,500 during the period ended September 30, 2021, subsequently as of date, the same was recovered by the Company.\nNOTE－10 ACCOUNTS PAYABLE AND ACCRUED LIABILITIES\nAccounts payable consisted of the following:\n\n| Schedule of Accounts payable |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Accounts payable | $ | 104,680 | $ | 54,256 |\n| Accrued liabilities and other payables- Related Party (a) | 224,669 | 197,548 |\n| Accrued liabilities and other payables (b) | 527,971 | 480,024 |\n| Total Accounts payable | $ | 857,320 | $ | 731,828 |\n\n(a) The amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 21,701 , $ 70,104 and $ 132,864 , respectively as of September 30, 2021.\nThe amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 5,000 , $ 112,692 and $ 79,856 , respectively as of December 31, 2020.\n(b) Accrued liabilities and other payables consisted of the following:\n\n| Schedule of Accrued liabilities |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Accrued payroll | $ | 54,528 | $ | 58,092 |\n| Other accrual | 154,325 | 146,826 |\n| Other payables (c) | 245,000 | 245,000 |\n| Accrued vat expenses | 19,932 | 1,788 |\n| Accrued taxes | 54,186 | 28,318 |\n| Total Accrued liabilities | $ | 527,971 | $ | 480,024 |\n\n(c) This included $75,000 related to SOSV. In January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. The Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 156 shares of preferred stock series C to Hottab Holding Limited for the 100% acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 outstanding on this account, respectively. (refer footnote#19 for legal update).\n\n| 28 |\n\nNOTE－11 LEASES\nWe adopted ASU No. 2016-02, Leases, on January 1, 2019, the beginning of our fiscal 2019, using the modified retrospective approach. We determine whether an arrangement is a lease at inception. This determination generally depends on whether the arrangement conveys the right to control the use of an identified fixed asset explicitly or implicitly for a period of time in exchange for consideration. Control of an underlying asset is conveyed if we obtain the rights to direct the use of and to obtain substantially all of the economic benefit from the use of the underlying asset. Some of our leases include both lease and non-lease components which are accounted for as a single lease component as we have elected the practical expedient. Some of our operating lease agreements include variable lease costs, primarily taxes, insurance, common area maintenance or increases in rental costs related to inflation. Substantially all of our equipment leases and some of our real estate leases have terms of less than one year and, as such, are accounted for as short-term leases as we have elected the practical expedient.\nOperating leases are included in the right-of-use lease assets, other current liabilities and long-term lease liabilities on the Consolidated Balance Sheet. Right-of-use assets and lease liabilities are recognized at each lease’s commencement date based on the present values of its lease payments over its respective lease term. When a borrowing rate is not explicitly available for a lease, our incremental borrowing rate is used based on information available at the lease’s commencement date to determine the present value of its lease payments. Operating lease payments are recognized on a straight-line basis over the lease term. We had no financing leases as of September 30, 2021 and December 31, 2020.\nThe Company adopts a 5.26 % as weighted average incremental borrowing rate to determine the present value of the lease payments. The weighted average remaining life of the lease was 3.48 year.\nDuring the period ended September 30, 2021, the Company enter into new lease arrangements, and accounted as per ASC 842, the ROU asset and lease obligation of $ 479,171 .\nThe Company excludes short-term leases (those with lease terms of less than one year at inception) from the measurement of lease liabilities or right-of-use assets. The following tables summarize the lease expense for the period ended September 30:\n\n| Schedule of Lease expenses |\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Operating lease expense (per ASC 842) | $ | 13,554 | $ | 6,076 | $ | 31,975 | $ | 21,802 |\n| Short-term lease expense (other than ASC 842) | 63,363 | 4,627 | 66,420 | 31,258 |\n| Total lease expense | $ | 76,917 | $ | 10,703 | $ | 98,395 | $ | 53,060 |\n\nAs of September 30, 2021, right-of-use assets were $ 529,782 and lease liabilities were $ 533,312 .\nAs of December 31, 2020, right-of-use assets were $ 79,109 and lease liabilities were $ 83,205 .\nComponents of Lease Expense\nWe recognize lease expense on a straight-line basis over the term of our operating leases, as reported within “general and administrative” expense on the accompanying consolidated statement of operations.\nFuture Contractual Lease Payments as of September 30, 2021\nThe below table summarizes our (i) minimum lease payments over the next five years, (ii) lease arrangement implied interest, and (iii) present value of future lease payments for the next three years ending September 30:\n\n| Schedule of Future Contractual Lease Payments |\n| Years ended September 30, | Operating lease amount |\n| 2022 | $ | 190,025 |\n| 2023 | 166,530 |\n| 2024 | 147,813 |\n| 2025 | 77,997 |\n| Total | 582,365 |\n| Less: interest | ( 49,053 | ) |\n| Present value of lease liabilities | $ | 533,312 |\n| Less: non-current portion | ( 365,539 | ) |\n| Present value of lease liabilities – current liability | $ | 167,773 |\n\n\n| 29 |\n\nNOTE－12 SHAREHOLDERS’ DEFICIT\nAuthorized stock\nThe Company is authorized to issue two classes of stock. The total number of shares of stock which the Company is authorized to issue is 100,000,000 shares of capital stock, consisting of 95,000,000 shares of common stock, $ 0.0001 par value per share, and 5,000,000 shares of preferred stock, $ 0.0001 par value per share.\nThe holders of the Company’s common stock are entitled to the following rights:\nVoting Rights: Each share of the Company’s common stock entitles its holder to one vote per share on all matters to be voted or consented upon by the stockholders. Holders of the Company’s common stock are not entitled to cumulative voting rights with respect to the election of directors.\nDividend Right: Subject to limitations under Nevada law and preferences that may apply to any shares of preferred stock that the Company may decide to issue in the future, holders of the Company’s common stock are entitled to receive ratably such dividends or other distributions, if any, as may be declared by the Board of the Company out of funds legally available therefor.\nLiquidation Right:. In the event of the liquidation, dissolution or winding up of our business, the holders of the Company’s common stock are entitled to share ratably in the assets available for distribution after the payment of all of the debts and other liabilities of the Company, subject to the prior rights of the holders of the Company’s preferred stock.\nOther Matters: The holders of the Company’s common stock have no subscription, redemption or conversion privileges. The Company’s common stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s common stock are fully paid and non-assessable. The rights, preferences and privileges of the holders of the Company’s common stock are subject to the rights of the holders of shares of any series of preferred stock which the Company may issue in the future.\nCommon stock outstanding\nAs of September 30, 2021 and December 31, 2020, the Company had a total of 9,695,480 and 7,413,600 shares of its common stock issued and outstanding, respectively.\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the forward stock split.\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the reverse stock split.\n\n| 30 |\n\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\nDuring the period ended September 30, 2021 and 2020, the Company issued 824,250 and 1,014,900 shares of common stock for employee services for the value of $ 1,707,557 and $ 1,023,494 , respectively.\nDuring the period ended September 30, 2021 and 2020, the Company issued 1,157,630 and 0 shares of common stock for director’s accrued salaries for the value of $ 960,834 and $ 0 , respectively. The Company accounted $ 2,894,075 additional cost on these share issuance as loss on fair value of shares issued in 2021.\nDuring the period ended September 30, 2021 and 2020, the Company issued 450,000 and 0 shares of common stock for director’s bonus for the value of $ 3,442,499 and $ 0 , respectively.\nDuring the period ended September 30, 2021 and 2020, the Company cancelled 150,000 and 0 shares of common stock at par value.\nWarrants\nIn August 2019, the Company issued 21,000 shares of warrants to one employee for compensation of his service to purchase 21,000 shares of its common stock for the fair value of $17,500. Each share of warrant is converted to one share of common stock at an exercise price of $0.0001. The warrants will expire on the second (2nd) anniversary of the initial date of issuance. As at December 31, 2019, none of the warrants have been exercised. 21,000 shares fully exercised during the year ended December 31, 2020.\nIn December 2020, the Company issued certain numbers of warrants pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant is entitled the holder to purchase one C-1 preferred share at a price of $ 420 per share. The warrants shall be exercisable on or before December 31, 2020 and September 30, 2021. During the nine months ended September 30, 2021, the Company issued 2,120 warrants. During the nine months ended September 30, 2020, the Company issued 1,824 warrants.\nIn December 2020, a total of 838 warrants are exercised in exchanged to 838 Series C-1 preferred shares. (refer note 13 for details).\nOn April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by nine months from the expiration date of September 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\nThe Company determined the fair value using the Black-Scholes option pricing model with the following assumptions for the period ended September 30, 2021 and year ended December 31, 2020:\n\n| Schedule of Stock option assumptions |\n| September 30, 2021 | December 31, 2020 |\n| Dividend rate | 0 | % | 0 | % |\n| Risk-free rate | 2 | % | 2 | % |\n| Weighted average expected life (years) | 9 months | 9 months |\n| Expected volatility | 0 | % | 0 | %(a) |\n| Share price | $ | 0.22 | $ | 0.22 |\n\n\n| (a) | The Company considered no volatility as from inception through the date there is very minimal transaction of the Company common stock. |\n\n\n| 31 |\n\nBelow is a summary of the Company’s issued and outstanding warrants as of September 30, 2021 and December 31, 2020:\n| Schedule of warrants issued and outstanding |\n| Warrants | Weighted average exercise price | Weighted average remaining contractual life (in years) |\n| Outstanding as of December 31, 2019 (a) | 21,000 | $ | 0.0001 | 1.3 |\n| Issued (b) | 4,094 | $ | 420 | 0.9 |\n| Exercised | ( 21,838 | ) | $ | ( 6.34 | ) | 1 |\n| Expired | ( 1,209 | ) | $ | ( 420 | ) | ( 0.6 | ) |\n| Outstanding as of December 31, 2020 | 2,047 | $ | 420 | 0.6 |\n| Issued (b) | 2,120 | $ | 420 | 0.5 |\n| Exercised | ( 238 | ) | $ | ( 420 | ) | — |\n| Expired | — | — | — |\n| Outstanding as of September 30, 2021 (b) | 3,929 | $ | 420 | 0.5 |\n\nThere is no intrinsic value for warrants as of September 30, 2021 and December 31, 2020.\n\n| (a) | Common stock will be issued if those warrants exercise. |\n\n\n| (b) | Preferred stock series C-1 will be issued if those warrants exercise. |\n\nNOTE－13 PREFERRED STOCKS AND WARRANTS\nAs of September 30, 2021 and December 31, 2020, the Company’s preferred stocks have been designated as follow:\n\n| Schedule of Preferred stocks |\n| No. of shares | Stated Value |\n| Series A Convertible Preferred Stock | 10,000 | $ | 1,000 |\n| Series B Convertible Preferred Stock | 10,000 | $ | 1,336 |\n| Series B-1 Convertible Preferred Stock | 15,000 | $ | 2,917 |\n| Series C Convertible Preferred Stock | 15,000 | $ | 5,763 |\n| Series C-1 Convertible Preferred Stock | 30,000 | $ | 420 |\n| Series X Super Voting Preferred Stock | 3,500 | $ | 0.0001 |\n\nAll of the Series A, B, B-1, C, and C-1 Preferred Shares were issued at a value of respective stated value per share. These all Series of Preferred Shares contain a conversion option, are convert into a fixed number of common shares or redeemable with the cash repayment at the liquidation, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the all these Series of Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\nSeries X Super Voting Preferred Stock was issued a par value per share. This Series of Preferred Shares does not contain a conversion option, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the this Series of Preferred Shares within permanent equity in the condensed consolidated balance sheet.\nVoting Rights: (1) The affirmative vote of at least a majority of the holders of each series of preferred stock shall be necessary to:\n\n| (a) | increase or decrease the par value of the shares of the Series A Preferred Stock, alter or change the powers, preferences or rights of the shares of Series A Preferred Stock or create, alter or change the powers, preferences or rights of any other capital stock of the Company if after such alteration or change such capital stock would be senior to or pari passu with Series A Preferred Stock; and |\n\n\n| (a) | adversely affect the shares of Series A Preferred Stock, including in connection with a merger, recapitalization, reorganization or otherwise. |\n\n\n| 32 |\n\n(2) The affirmative vote of at least a majority of the holders of the shares of the Series A Preferred Stock shall be necessary to:\n\n| (a) | enter into a transaction or series of related transactions deemed to be a liquidation, dissolution or winding up of the Corporation, or voluntarily liquidate or dissolve; |\n\n\n| (b) | authorize a merger, acquisition or sale of substantially all of the assets of the Company or any of its subsidiaries (other than a merger exclusively to effect a change of domicile of the Company to another state of the United States); |\n\n\n| (c) | increase or decrease (other than decreases resulting from conversion of the Series A Preferred Stock) the authorized number of shares of the Company’s preferred stock or any series thereof, the number of shares of the Company’s common stock or any series thereof or the number of shares of any other class or series of capital stock of the Company; and |\n\n\n| (d) | any repurchase or redemption of capital stock of the Company except any repurchase or redemption at cost upon the termination of services of a service provider to the Company or the exercise by the Company of contractual rights of first refusal as applied to such capital stock. |\n\nDividend Rights: The holders of the Company’s preferred stock are not entitled to any dividend rights.\nConversion Rights (Series A Preferred Stock): Upon the consummation of this offering, the issued and outstanding shares of Series A Preferred Stock automatically convert into a number of shares of the Company’s common stock equal to the quotient obtained by dividing (x) the aggregate Stated Value of the issued and outstanding Series A Preferred Stock plus any other amounts due to the holders thereof divided by (y) the offering price of the Company’s common stock. If 90 days after conversion, the closing market price of the Company’s common stock as quoted on Nasdaq (the “Market Value”) has decreased below the initial public offering price, each holder of the Series A Preferred Stock shall be issued a warrant to purchase a number of shares of the Company’s common stock equal to 40% of the quotient of the (a) aggregate Stated Value held by such holder before conversion at the initial public offering price and the Market Value of the shares of common stock that were issuable upon conversion divided by (b) the Market Value. The warrants shall have a term of five years and shall be exercisable at the Market Value.\nConversion Rights (Preferred Stock other than Series A and Series X Super Voting Preferred Stock): Upon the consummation of this offering, each issued and outstanding share of Series B Preferred Stock, Series B-1 Preferred Stock, Series C Preferred Stock and Series C-1 Preferred Stock will automatically convert into 750 shares of the Company’s common stock. Series X Super Voting Preferred stock shall not have any rights to convert into the Company’s common stock.\nLiquidation Rights: In the event of any liquidation, dissolution or winding up of the Company, either voluntary or involuntary (a \"Liquidation Event\"), the holders of each series of preferred stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Company to the holders of the Company’s common stock by reason of their ownership thereof, an amount per share in cash equal to the greater of (x) the aggregate Stated Value for all shares of such series of Preferred Stock then held by then or (y) the amount payable per share of the Company’s common stock which such holder of preferred stock would have received if such holder had converted to common stock immediately prior to the Liquidation Event all of such series of preferred stock then held by such holder (the \"Series Stock Liquidation Preference\"). If, upon the occurrence of a Liquidation Event, the funds thus distributed among the holders of the preferred stock shall be insufficient to permit the payment to the holders of the preferred stock the full Series Stock Liquidation Preference for all series, then the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the holders of the preferred stock in proportion to the aggregate Series Liquidation Preferences that would otherwise be payable to each of the holders of preferred stock. Such payment shall constitute payment in full to the holders of the preferred stock upon the Liquidation Event. After such payment shall have been made in full, or funds necessary for such payment shall have been set aside by the Company in trust for the account of the holders of preferred stock, so as to be immediately available for such payment, such holders of preferred stock shall be entitled to no further participation in the distribution of the assets of the Company. The sale of all or substantially all of the assets of the Company, or merger, tender offer or other business combination to which the Company is a party in which the voting stockholders of the Company prior to such transaction do not own a majority of the voting securities of the resulting entity or by which any person or group acquires beneficial ownership of 50% or more of the voting securities of the Company or resulting entity shall be deemed to be a Liquidation Event.\n\n| 33 |\n\nOther Matters: The holders of the Company’s preferred stock have no subscription or redemption privileges and are not subject to redemption. The Company’s Series Preferred Stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s preferred stock are fully paid and non-assessable.\nSeries A Preferred Shares\nDuring the year ended December 31, 2018, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software at the stated value of $ 1,000 per share, totaling $ 8,000,000 . The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\nThere was no Series A Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 8,000 and 8,000 shares of Series A Preferred Shares issued and outstanding, respectively.\nSeries B Preferred Shares\nThere was no Series B Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 2,548 and 2,548 shares of Series B Preferred Shares issued and outstanding, respectively.\nSeries B-1 Preferred Shares\nThere was no Series B-1 Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\nAs of September 30, 2021 and December 31, 2020, there were 160 and 160 shares of Series B-1 Preferred Shares issued and outstanding, respectively.\nSeries C Preferred Shares\nDuring the nine months ended September 30, 2021, the Company issued 1,116 and 74 shares of Series C preferred stock for cash in private placement and consulting services for the value of $ 6,431,508 and $ 426,462 , respectively.\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above Series C private placement accounted $ 195,942 in shares and $ 460,361 in cash.\nThere was no Series C Preferred Shares issued during the nine months ended September 30, 2020.\nAs of September 30, 2021 and December 31, 2020, there were 1,552 and 362 shares of Series C Preferred Shares issued and outstanding, respectively.\nSeries C-1 Preferred Shares\nThe Company accounts for warrants issued in accordance with the guidance on “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” in Topic 480. These warrants did not meet the criteria to be classified as a liability award and therefore were treated as an equity award and classified the Series C-1 Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\n\n| 34 |\n\nDuring the period ended September 30, 2021, the Company issued 6,235 and 4,864 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 2,618,700 (out of which $479,640 is received subsequent to September 30, 2021) and $ 2,042,880 , respectively.\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above series C-1 private placement accounted $ 245,700 in shares and $ 90,748 in cash. There is no issuance cost incurred in 2020.\nDuring the period ended September 30, 2020, the Company issued 1,688 and 571 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 708,960 and $ 239,820 , respectively.\nAs of September 30, 2021 and December 31, 2020, there were 13,984 and 2,885 shares of Series C-1 Preferred Shares issued and outstanding, respectively.\nSeries X Super Voting Preferred Shares\nIn August 2021, the Company created a new series of preferred stock to be titled “Series X Super Voting Preferred Stock,” consisting of 2,000 shares and to provide to such preferred stock certain rights and privileges including but not limited to the right to 10,000 votes per share (post reverse split: 4,000 votes per share) to vote on all matters that may come before the stockholders of the Corporation, voting together with the common stock as a single class on all matters to be voted or consented upon by the stockholders but is not entitled to any dividends, liquidation preference or conversion or redemption rights, so accordingly it is accounted as an equity classification. In September 2021, the Company increased the number of shares designated as Series X Super Voting Preferred to 3,500.\nDuring the period ended September 30, 2021 and 2020, the Company issued 3,500 and 0 shares of Series C-preferred stock at par value, respectively.\nAs of September 30, 2021 and December 31, 2020, there were 3,500 and 0 shares of Series C Preferred Shares issued and outstanding, respectively.\nNOTE－ 14 INCOME TAXES\nFor the nine months ended September 30, 2021 and 2020, the local (“Nevada”) and foreign components of loss before income taxes were comprised of the following:\n\n| Schedule of Loss before income tax |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Tax jurisdiction from: |\n| - Local | $ | 14,272,684 | $ | — |\n| - Foreign | 1,246,371 | 2,507,042 |\n| Loss before income taxes | $ | 15,519,055 | $ | 2,507,042 |\n\nThe provision for income taxes consisted of the following:\n\n| Schedule of provision for income taxes |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Current: |\n| - United States | $ | — | $ | — |\n| - Singapore | — | — |\n| - Vietnam | — | — |\n| - India | 9,943 | 15,069 |\n| Deferred: |\n| - United States | — | — |\n| - Singapore | — | — |\n| - Vietnam | — | — |\n| - India | — | — |\n| Income tax expense | $ | 9,943 | $ | 15,069 |\n\n\n| 35 |\n\nThe effective tax rate in the years presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rate. The Company operates in various countries: Singapore and Vietnam that are subject to taxes in the jurisdictions in which they operate, as follows:\nUnited States\nThe Company is registered in the Nevada and is subject to the tax laws of United States.\nAs of September 30, 2021, the operation in the United states incurred $ 25,094,900 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 5,269,929 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nSingapore\nThe Company’s subsidiary is registered in the Republic of Singapore and is subject to the tax laws of Singapore.\nAs of September 30, 2021, the operation in the Singapore incurred $ 1,437,668 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 230,027 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nVietnam\nThe Company’s subsidiary operating in Vietnam is subject to the Vietnam Income Tax at a standard income tax rate of 20 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\n\n| Schedule of Effective Income Tax Rate Reconciliation |\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Loss before income taxes | $ | ( 450,407 | ) | $ | ( 233,689 | ) |\n| Statutory income tax rate | 20 | % | 20 | % |\n| Income tax expense at statutory rate | ( 90,081 | ) | ( 46,738 | ) |\n| Tax effect of allowance | 90,081 | 46,738 |\n| Income tax expense | $ | — | $ | — |\n\nAs of September 30, 2021, the operation in the Vietnam incurred $ 859,275 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards begin to expire in 2026, if unutilized. The Company has provided for a full valuation allowance against the deferred tax assets of $ 171,855 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\nIndia\nThe Company’s subsidiary operating in India is subject to the India Income Tax at a standard income tax rate of 25 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\n\n| Nine months ended September 30, |\n| 2021 | 2020 |\n| Income before income taxes | $ | 17,716 | $ | ( 182,363 | ) |\n| Statutory income tax rate | 25 | % | 15 | % |\n| Income tax expense at statutory rate | 4,429 | ( 27,354 | ) |\n| Tax effect of allowance | 5,514 | 42,423 |\n| Income tax expense | $ | 9,943 | $ | 15,069 |\n\n\n| 36 |\n\nAs of September 30, 2021, the operation in the India incurred $ 17,716 of net operating gain. The Company has provided for a full tax effect allowance against the current and deferred tax expenses of $ 9,943 .\nThe following table sets forth the significant components of the deferred tax assets and liabilities of the Company as of September 30, 2021 and December 31, 2020:\n\n| Schedule of Deferred Tax Assets and Liabilities |\n| September 30, 2021 | December 31, 2020 |\n| (Unaudited) |\n| Deferred tax assets: |\n| Net operating loss carryforwards |\n| - United States | $ | 5,269,929 | $ | 2,171,941 |\n| - Singapore | 230,027 | 131,985 |\n| - Vietnam | 171,855 | 81,774 |\n| - India | — | — |\n| 5,671,811 | 2,385,700 |\n| Less: valuation allowance | ( 5,671,811 | ) | ( 2,385,700 | ) |\n| Deferred tax assets, net | $ | — | $ | — |\n\nNOTE－ 15 PENSION COSTS\nThe Company is required to make contribution to their employees under a government-mandated defined contribution pension scheme for its eligible full-times employees in all countries operating in the Company. The Company is required to contribute a specified percentage of the participants’ relevant income based on their ages and wages level. During the nine months ended September 30, 2021 and 2020, $ 9,655 and $ 5,199 contributions were made accordingly. During the three months ended September 30, 2021 and 2020, $ 5,669 and $ 3,463 contributions were made accordingly.\nNOTE－ 16 RELATED PARTY TRANSACTIONS\nFrom time to time, the shareholder and director of the Company advanced funds to the Company for working capital purpose. Those advances are unsecured, non-interest bearing and due on demand.\nDuring the three month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 2,854 and 571 shares of Series C-1 preferred stock, at the price of $ 1,198,680 and $ 239,820 , respectively.\nDuring the nine month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 4,314 and 571 shares of Series C-1 preferred stock, at the price of $ 1,811,880 and $ 239,820 , respectively.\nThe Company paid and accrued to the directors, the total salaries of $ 196,108 and $ 22,529 and 201,588 and $ 0 during the three months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued to the directors, the total salaries of $ 611,193 and $ 22,529 and $ 604,378 and $ 0 during the nine months ended September 30, 2021 and 2020, respectively.\n\n| 37 |\n\nDuring the three months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $12,570,943 and $ 810,000 for the stock based compensation to director and employee, respectively.\nDuring the nine months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $ 12,570,943 and 810,000 for the stock based compensation to director and employee, respectively.\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 5,785 and $ 1,259 and $ 8,310 and $ 1,300 during the three months ended September 30, 2021 and 2020, respectively.\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 10,307 and $ 1,259 and $ 35,898 and $ 1,300 during the nine months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued its shareholders, total professional fee of $ 151,342 and $ 102,412 and $ 31,341 and $ 21,000 during the three months ended September 30, 2021 and 2020, respectively.\nThe Company paid and accrued its shareholders, total professional fee of $ 378,785 and $ 123,412 and $ 102,979 and $ 56,0000 during the nine months ended September 30, 2021 and 2020, respectively.\nDuring August and September 2021, the Company issued 3,300 shares of its Series X Super Voting Preferred Stock (the “Super Voting Preferred Stock”) to the founder and Chief Executive Officer, Mr. Dennis Nguyen and 200 shares of the Super Voting Preferred Stock to Chief Financial Officer, Mr. Raynauld Liang.\nIn August 2021, the Company approved the conversion of Inter-Company loan of $1,249,999 due and owing by Sopa Technology PTE. LTD. (“STPL”), by exchange of 8,500 shares of STPL which represents 85% of the total issued and paid-up capital of STPL on a fully diluted basis.\nOn September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 and $ 738,964 were forgiven by the related parties. Also, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $ 75,000 cash consideration and $ 558,000 equity incentive.\nAs of June 30, 2021, Mr. Nguyen had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares.\nHOTTAB Asset Vietnam Co Ltd, a company limited by shares incorporated under the laws of Vietnam on July 25, 2019, is currently wholly-owned by Ngo Cham, an employee of HOTTAB Vietnam Co Ltd. HOTTAB Asset Vietnam Co Ltd manages the Group’s website and apps in Vietnam via a contractual relationship. All profits accrued by HOTTAB Asset Vietnam Co Ltd are paid as management fees to HOTTAB Vietnam Co Ltd. HOTTAB Vietnam Co Ltd has an irrevocable call option to acquire 100% of the equity of HOTTAB Asset Vietnam Co Ltd.\nApart from the transactions and balances detailed elsewhere in these accompanying condensed consolidated financial statements, the Company has no other significant or material related party transactions during the periods presented.\nNOTE－17 CONCENTRATIONS OF RISK\nThe Company is exposed to the following concentrations of risk:\n(a) Major customers\nFor the nine months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Schedule of concentrations of risk |\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Customer A | $ | 24,813 | 25 | % | $ | 19,308 |\n| Customer B | $ | 12,615 | 13 | % | $ | — |\n| Customer C | $ | 58,300 | 58 | % | $ | 68,285 | * |\n\n\n| * | - This included value added taxes (“VAT”) |\n\n\n| 38 |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Customer A | $ | 31,604 | 76 | % | $ | — |\n\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Customer | Revenues | Percentage of revenues |\n| Customer A | $ | 10,016 | 12 | % |\n| Customer B | $ | 12,615 | 13 | % |\n| Customer C | $ | 58,300 | 58 | % |\n\n\n| Three months ended September 30, 2020 |\n| Customer | Revenues | Percentage of revenues |\n| Customer A | $ | 9,789 | 84 | % |\n\nAll customers are located in Vietnam except one located in Indonesia.\n(b) Major vendors\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 30,577 | 27 % | $ | 44,867 |\n| Vendor B | $ | 17,827 | 16 % |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 46,863 | 72 % | $ | — |\n| Vendor B | — | — | — |\n\n\n| 39 |\n\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Purchases | Percentage of purchases |\n| Vendors |\n| Vendor A | $ | — | — |\n\n\n| Three months ended September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | 24,401 | 90 % |\n| Vendor B | — | — |\n\nAll vendors are located in Vietnam.\n(c) Credit risk\nFinancial instruments that are potentially subject to credit risk consist principally of trade receivables. The Company believes the concentration of credit risk in its trade receivables is substantially mitigated by its ongoing credit evaluation process and relatively short collection terms. The Company does not generally require collateral from customers. The Company evaluates the need for an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information.\n(d) Exchange rate risk\nThe reporting currency of the Company is US$, to date the majority of the revenues and costs are denominated in VND, SGD and INR and a significant portion of the assets and liabilities are denominated in VND, SGD and INR. As a result, the Company is exposed to foreign exchange risk as its revenues and results of operations may be affected by fluctuations in the exchange rate between US$ and VND, SGD and INR. If VND, SGD and INR depreciates against US$, the value of VND, SGD and INR revenues and assets as expressed in US$ financial statements will decline. The Company does not hold any derivative or other financial instruments that expose to substantial market risk.\n(e) Economic and political risks\nThe Company's operations are conducted in the Republic of Vietnam. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the Vietnam, and by the general state of the Vietnam economy.\nThe Company's operations in the Vietnam and India are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company's results may be adversely affected by changes in the political and social conditions in the Vietnam and India, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation.\nNOTE－18 COMMITMENTS AND CONTINGENCIES\nAs of September 30, 2021, the Company has no material commitments or contingencies.\nRight issues under Series C-1 preferred stock\nThe Company has issued warrant pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant entitles the holder to purchase two (2) common shares at a price of $168 per share. The warrants shall be exercisable on or before December 31, 2020 and June 30, 2021, respectively. On April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by six months from the expiration date of June 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\n\n| 40 |\n\nFinancing arrangement (due to a shareholder)\nIn February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\nSOSV\nIn January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. On February 2, 2021, the Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 117,000 preferred stock series C to Hottab Holding Limited for the 100 % acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 , outstanding on this account, respectively. (see below for legal update)\nService contracts\nThe Company carries various service contracts on its vendors for repairs, maintenance and inspections. All contracts are short term and can be cancelled.\nMaterial contracts\nOn 28 May 2021, the Company entered into a business cooperation agreement with Paytech Company Limited (“Strategic Partners”) to provide payment integration and loyalty services to the platform that allows merchants to process transactions with consumers. As of date, this program have not started and expected to commence in next year 2022.\nOn 15 August 2021, the Company entered into a business cooperation agreement with Rainbow Loyalty Company Limited (“Strategic Partners”) to provide loyalty services for merchants on the platform. As of date, this program have not started and expected to commence in next year 2022.\nExecutive service agreements\nOn April 1, 2017 the Company entered into an at-will Employment Agreement with Dennis Nguyen, its Chairman and Chief Executive Officer. The Employment Agreement provides for a monthly salary of $ 40,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s salary, he may convert any unpaid salary into common stock of the Company at a share price equal to $ 250 per share. Mr. Nguyen is also entitled to an annual cash bonus of $ 250,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s annual bonus, he may convert any unpaid bonus into common stock of the Company as described above. This provision was inserted into the employment agreement to compensate Mr. Nguyen in stock, at his option, and was to remain operable only until the Company has sufficient cash to pay him his salary in cash. From July 2021 until now, the Company’s cash balance has been at least $ 4 million and the Company has paid Mr. Nguyen his salary in full in every month from July 2021 until now. As a result of these facts, the conversion feature in Mr. Nguyen’s contract became inoperable as of July 1, 2021 and Mr. Nguyen no longer has the option to convert unpaid salary into the Company’s shares. On October 25, 2021, the Company has also amended Mr. Nguyen’s contract to delete the conversion feature to make clear the conversion feature will not be operable in the future. Therefore, the Company will not accrue any expense. Mr. Nguyen is also entitled to participate in all of the other benefits of the Company which are generally available to office employees and other employees of the Company. Mr. Nguyen is not entitled to any severance pay.\nOn September 1, 2021 the Company entered into a 5-year Employment Agreement with Raynauld Liang, its Chief Financial Officer and Singapore Country General Manager. The employment agreement provides Mr. Liang with compensation of (i) an annual base salary of $ 240,000 ; (ii) an annual discretionary incentive cash bonus with a minimum target of 25% of base salary; (iii) 814,950 shares of the Company’s common stock (taking into account the Company’s stock split 1:750 and reverse stock split 1:2.5), of which 651,960 shares are subject to vesting over a two-year period; and (iv) all other executive benefits sponsored by the Company. If a change of control of the Company occurs and if at the time of such change of control the Company’s common stock is trading at a price that is double the initial public offering price, then Mr. Liang will be entitled to a cash bonus equal to three (3) times his base salary. If Mr. Liang is terminated other than for cause or resigns for good reason, he will be entitled to receive continued base salary until the earlier of (x) the anniversary date of such termination and (y) the end of the 5-year term of the employment agreement; provided, however, if the termination is after September 1, 2022, then the period set forth in clause (x) shall be 18 months from the date of the employment agreement. Mr. Liang may terminate the employment agreement at any time other than for good reason with 30 days’ notice to the Company.\n\n| 41 |\n\nLitigation\nFrom time to time, the Company may become involved in various lawsuits and legal proceedings, which arise, in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company’s business. The Company is not aware of any such legal proceedings that will have, individually or in the aggregate, a material adverse effect on its business, financial condition or operating results.\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $ 122,042 .60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims and this action is still in the discovery phase of litigation.\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\n\n| 42 |\n\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\nAs of September 30, 2021, the Company expects no possible loss from these legal proceedings and no provision is accrued accordingly.\n\n| 43 |\n\nNOTE－19 SEGMENT REPORTING\nWe have two reportable segments: (i) e-commerce and (ii) Merchant POS. The e-commerce segment includes the operations of Sopa Technology Company Ltd. Additionally, the Merchant POS segment comprises the operations of Hottab group and SOPA entities except SOPA Technology Company Ltd. Lastly, reported under Merchant POS included acquired operating segment, Hottab group and all SOPA entities except SOPA Technology Company Ltd . Merchant POS includes Hardware sales, subscription sales and e-Commerce includes online ordering such as Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle.\nOur Chief Operating Decision Maker (CODM) evaluate operating segments using the following table presents revenues and gross profits by reportable segment and asset except liability information.\n| Schedule of Segment Reporting |\n| Nine Months Ended September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 335 | $ | 335 |\n| Software subscription | — | 26,970 | 26,970 |\n| Sales – online ordering | 73,518 | — | 73,518 |\n| Total revenue | 73,518 | 27,305 | 100,823 |\n| Cost of sales: |\n| Hardware sales | — | ( 165 | ) | ( 165 | ) |\n| Software subscription | ( 166,761 | ) | ( 39,626 | ) | ( 206,387 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\n| Total cost of revenue | ( 224,502 | ) | ( 39,791 | ) | ( 264,293 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | ( 78,808 | ) | ( 6,219 | ) | ( 85,027 | ) |\n| Software development costs | — | ( 76,698 | ) | ( 76,698 | ) |\n| Impairment loss | ( 200,000 | ) | — | ( 200,000 | ) |\n| General and administrative expenses | ( 73,285 | ) | ( 14,341,077 | ) | ( 14,414,362 | ) |\n| Total operating expenses | ( 352,093 | ) | ( 14,423,994 | ) | ( 14,776,087 | ) |\n| Loss from operations | ( 503,077 | ) | ( 14,436,180 | ) | ( 14,939,557 | ) |\n\n\n| Three Months Ended September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | — | $ | — |\n| Software subscription | — | 10,016 | 10,016 |\n| Sales – online ordering | 73,518 | — | 73,518 |\n| Total revenue | 73,518 | 10,016 | 83,534 |\n| Cost of sales: |\n| Hardware sales | — | — | — |\n| Software subscription | ( 80,557 | ) | ( 21,138 | ) | ( 101,695 | ) |\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\n| Total cost of revenue | ( 138,298 | ) | ( 21,138 | ) | ( 159,436 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | ( 40,744 | ) | ( 2,099 | ) | ( 42,843 | ) |\n| Software development costs | — | ( 9,709 | ) | ( 9,709 | ) |\n| Impairment loss | — | — | — |\n| General and administrative expenses | ( 48,658 | ) | ( 8,243,805 | ) | ( 8,292,463 | ) |\n| Total operating expenses | ( 89,402 | ) | ( 8,255,613 | ) | ( 8,345,015 | ) |\n| Loss from operations | ( 154,182 | ) | ( 8,266,735 | ) | ( 8,420,917 | ) |\n\n| 44 |\n\n\n| September 30, 2021 |\n| e-Commerce | Merchant POS | Total |\n| Identifiable assets | $ | 147,950 | $ | 11,170,288 | $ | 11,318,238 |\n\n\n| December 31, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Identifiable assets | $ | — | $ | 7,866,273 | $ | 7,866,273 |\n\n\n| Nine Months Ended September 30, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 3,510 | $ | 3,510 |\n| Software subscription | — | 37,752 | 37,752 |\n| Sales – online ordering | — | — | — |\n| Total revenue | — | 41,262 | 41,262 |\n| Cost of sales: |\n| Hardware sales | — | ( 2,982 | ) | ( 2,982 | ) |\n| Software subscription | — | ( 56,127 | ) | ( 56,127 | ) |\n| Cost of online ordering | — | — | — |\n| Total cost of revenue | — | ( 59,109 | ) | ( 59,109 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | — | ( 3,125 | ) | ( 3,125 | ) |\n| Software development costs | — | ( 139,151 | ) | ( 139,151 | ) |\n| Impairment loss | — | ( 8,778 | ) | ( 8,778 | ) |\n| General and administrative expenses | — | ( 2,311,266 | ) | ( 2,311,266 | ) |\n| Total operating expenses | — | ( 2,462,320 | ) | ( 2,462,320 | ) |\n| Loss from operations | — | ( 2,480,167 | ) | ( 2,480,167 | ) |\n\n\n| Three Months Ended September 30, 2020 |\n| e-Commerce | Merchant POS | Total |\n| Revenue |\n| Hardware sales | $ | — | $ | 585 | $ | 585 |\n| Software subscription | — | 11,044 | 11,044 |\n| Sales – online ordering | — | — | — |\n| Total revenue | — | 11,629 | 11,629 |\n| Cost of sales: |\n| Hardware sales | — | ( 585 | ) | ( 585 | ) |\n| Software subscription | — | ( 19,731 | ) | ( 19,731 | ) |\n| Cost of online ordering | — | — | — |\n| Total cost of revenue | — | ( 20,316 | ) | ( 20,316 | ) |\n| Operating Expenses |\n| Sales and marketing expenses | — | — | — |\n| Software development costs | — | ( 33,658 | ) | ( 33,658 | ) |\n| Impairment loss | — | 4,164 | 4,164 |\n| General and administrative expenses | — | ( 1,580,287 | ) | ( 1,580,287 | ) |\n| Total operating expenses | — | ( 1,609,781 | ) | ( 1,609,781 | ) |\n| Loss from operations | — | ( 1,618,468 | ) | ( 1,618,468 | ) |\n\n\n| 45 |\n\nNOTE－20 SUBSEQUENT EVENTS\nIn accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued, the Company has evaluated all events or transactions that occurred after September 30, 2021, up through the date the Company issued the unaudited condensed consolidated financial statements.\nOn November 8, 2021, the Company entered into an underwriting agreement (the “Underwriting Agreement”) with Maxim Group LLC, acting as representative to the underwriters (the “Representative”), related to the initial public offering of 2,888,889 shares of the Company’s common stock, par value $ 0.0001 per share (the “Firm Shares”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase up to an additional 433,334 shares of common stock (the “Option Shares”) at a public offering price of $ 9.00 , less discounts and commissions, to cover over-allotments, if any. The Company’s common stock was listed on the Nasdaq Capital Market on November 9, 2021 and began trading on such date. The closings (the “IPO Closings”) of the offering and sale of the Firm Shares and the sale of 236,111 Option Shares occurred on November 12, 2021. Aggregate gross proceeds from the closings related to the Firm Shares and the Option Shares was $ 26,000,001 and $ 2,124,999 , respectively.\nOn December 1, 2021, Leflair Incorporated under the laws of the State of Navada and subsequently share issued to the Company on December 7, 2021 as wholly-owned subsidiary.\nOn December 6, 2021, the Company entered into two consulting agreements with China-America Culture Media Inc. and New Continental Technology Inc., acting as Consultanct to assist the Company in completing certain Business Opportunities with potential partners until February 28, 2023. The consideration of the service are $ 3,250,000 and $ 3,190,000 .\nUpon the IPO Closings, all outstanding shares of preferred stock series A, B, B-1, C and C-1 automatically converted into 888,889 shares, 764,400 shares, 48,000 shares, 465,600 shares and 4,195,200 shares of the Company’s common stock, respectively.\n\n| 46 |\n\n\nItem 2. Management’s discussion and analysis of financial condition and results of operations.\nThe following discussion summarizes the significant factors affecting the operating results, financial condition, liquidity, and cash flows of our Company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data,” the condensed consolidated financial statements and the related notes thereto, and the consolidated financial statements and the related notes thereto all included elsewhere in this report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity, and capital resources, and all other non-historical statements in this discussion are forward-looking statements and are based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed in the Company’s final prospectus for its initial public offering on file with the Secuties and Exchange Commision (the “SEC”), particularly in the sections entitled “Special Note Regarding Forward-Looking Statements” and “Risk Factors.”\nOverview\nWe acquire and operate e-commerce platforms through our direct and indirect wholly-owned subsidiaries, including but not limited to Society Technology LLC, SoPa Technology Pte Ltd, SoPa Cognitive Analytics Pte Ltd, Sopa Technology Co Ltd, HOTTAB Pte Ltd and HOTTAB Vietnam Co Ltd. Along with HOTTAB Asset Vietnam Co Ltd (currently wholly-owned by one employee of HOTTAB Vietnam Co Ltd and contractually operated by HOTTAB Vietnam Co Ltd), these eight companies form the Society Pass Group (the “Group”). The Group currently markets to both consumers and merchants in Vietnam while maintaining an administrative headquarters in Singapore. In Feb 2021,we have acquired an online lifestyle platform of Leflair branded assets (the “Leflair Assets”) as more fully described in “Business – Leflair” and are in the process of integrating the Leflair assets with the SoPa and #HOTTAB platform. On 9 November 2021, the Group have been approved for listing on Nasdaq Capital Market (“Nasdaq”) and will trade under the ticker symbol “SOPA”. The Group is a leading Southeast Asian data-driven loyalty platform with its initial offering of 2,888,889 shares of common stock at a price of US$9.00 per share. After the completion of our initial public offering (“IPO”), we intend to expand our e-commerce ecosystem throughout the rest of SEA and South Asia with particular focuses on Philippines, India and Bangladesh.\nOur ecosystem currently comprises of seven e-commerce interfaces targeting consumers and merchants: SoPa food & beverage (“F&B”) App, SoPa.asia F&B Marketplace website, #HOTTAB Biz App, #HOTTAB POS App, Hottab.net admin website, Leflair App, and Leflair Lifetyle Marketplace website (the “Platform”). Our loyalty-focused and data-driven e-commerce marketing platform interfaces connect consumers with merchants in the F&B and lifestyle sectors, assisting local brick-and-mortar businesses to access new customers and markets to thrive in an increasingly convenience-driven economy. Our Platform integrates with both global and country-specific search engines and applications and accepts international address and phone number data, providing a consumer experience that respects local languages, address formats and customs. Our strategic partners work with us to penetrate local markets, while our Platform allows effortless integration with existing technological applications and websites.\nOur consumer facing business consists of our “SoPa” and “Leflair” brands. Through our SoPa F&B App, and SoPa.asia F&B Marketplace website, we provide frictionless online ordering and delivery experience for consumers in the F&B sector. Our Leflair lifestyle e-commerce platform markets and sells products in three verticals: Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle. Our consumer facing platforms feature an easy-to-navigate, multi-lingual user interface with multiple integrated payment and delivery options\nBranded as “#HOTTAB”, our merchant facing business helps merchants increase revenues and streamline costs with an online and multilingual store front, fully integrated POS software solution, joint marketing program, payment infrastructure, loyalty administration, customer profile analytics, and SME financing packages. Through #HOTTAB Biz App, #HOTTAB POS and Hottab.net merchant administration website interfaces, #HOTTAB functions both online and offline and facilitates transactions, orders, voucher redemption, and rewards. Merchants only need a smart device in order to quickly access our #HOTTAB product ecosystem. In addition, our Customer Care department provides attentive after-sales service.\n\n| 47 |\n\nUpon the expected launch of Society Points in the second half of 2021, consumers will be able to use our Society Points at merchant locations initially throughout Vietnam and then we expect to expand availability of Society Points throughout SEA and South Asia See “Business —Loyalty Points —Society Points.”\nAs of December 6, 2021 we have onboarded over 1.5 million registered consumers and over 5,500 registered merchants on our Platform.\nImpact of the COVID-19 Pandemic\nThe current outbreak of COVID-19 has globally resulted in loss of life, business shutdowns, restrictions on travel, and widespread cancellation of social gatherings. The extent to which the COVID-19 pandemic impacts our business will depend on future developments, which are highly uncertain and cannot be predicted at this time, including:\n\n| • | new information which may emerge concerning the severity of the disease in Vietnam and SEA; |\n\n| • | the duration and spread of the outbreak; |\n\n| • | the severity of travel restrictions imposed by geographic areas in which we operate, mandatory or voluntary business closures; |\n\n| • | regulatory actions taken in response to the pandemic, which may impact merchant operations, consumer and merchant pricing, and our product offerings; |\n\n| • | other business disruptions that affect our workforce; |\n\n| • | the impact on capital and financial markets; and |\n\n| • | action taken throughout the world, including in markets in which we operate, to contain the COVID-19 outbreak or treat its impact. |\n\nIn addition, the current outbreak of COVID-19 has resulted in a widespread global health crisis and adversely affected global economies and financial markets, and similar public health threats could do so in the future. Such events have impacted, and could in the future impact, demand for merchants and consumer purchase patterns, which in turn, could adversely affect our revenue and results of operations.\nSince the onset of the COVID-19 pandemic in March and April 2020, all our POS merchant clients are affected by COVID-19 measures for F&B to temporary stop restaurant dine ins.\n\n| • | Some of our restaurant clients ceased operations permanently and many were closed since June 2020 without any notice of reopening their business to date. |\n\n| • | Our largest POS client, a hotel chain for which we provide POS services to their F&B business in their hotels, ceased operations in two out of nine hotels since April 2020. |\n\n| • | The Company faces challenges to onboard new clients but at the same time losing many existing ones. |\n\nWith the ongoing pandemic, Company faces challenges in our operation as follows;\n\n| • | Disruption of operation in Vietnam, India, Singapore and US where staffs have to work from home. |\n\n| • | The coordination of rebooting of company’s recent asset acquisition of Leflair an ecommerce platform. |\n\n| • | Application of licenses are delayed as government agencies take longer time to review and process time. |\n\n| • | HR process to hire personnel are generally slow due to people not willing to leave their current job, company have to spend more time and resources. |\n\n\n| 48 |\n\nThe spread of COVID-19 has caused us to modify our business practices, including employee travel, employee work locations in certain cases, and cancellation of physical participation in certain meetings, events and conferences and further actions may be taken as required or recommended by government authorities or as we determine are in the best interests of our employees, customers, and other business partners. We are monitoring the global outbreak of the pandemic, in SEA, especially Vietnam and are taking steps in an effort to identify and mitigate the adverse impacts on, and risks to, our business posed by its spread and the governmental and community reactions thereto. See “Risk Factors--Our business may be materially adversely affected by the recent coronavirus (COVID-19) outbreak.\nFinancial Condition\nResults of Operations\nThe following table sets forth certain operational data for the three and nine months ended September 30, 2021 and 2020:\n\n| Three months ended September 30, | Nine months ended September 30, |\n| 2021 | 2020 | 2021 | 2020 |\n| Revenue,net | 83,534 | 11,629 | 100,823 | 41,262 |\n| Cost of revenue | (159,436 | ) | (20,316 | ) | (264,293 | ) | (59,109 | ) |\n| Gross loss | (75,902 | ) | (8,687 | ) | (163,470 | ) | (17,847 | ) |\n| Less operating expenses: |\n| Sales and marketing expenses | (42,843 | ) | — | (85,027 | ) | (3,125 | ) |\n| Software development costs | (9,709 | ) | (33,658 | ) | (76,698 | ) | (139,151 | ) |\n| Impairment loss | — | 4,164 | (200,000 | ) | (8,778 | ) |\n| General and administrative expenses | (8,292,463 | ) | (1,580,287 | ) | (14,414,362 | ) | (2,311,266 | ) |\n| Total operating expenses | (8,345,015 | ) | (1,609,781 | ) | (14,776,087 | ) | (2,462,320 | ) |\n| Loss from operations | (8,420,917 | ) | (1,618,468 | ) | (14,939,557 | ) | (2,480,167 | ) |\n| Other income (expense): |\n| Interest income | 55 | 3 | 71 | 11 |\n| Interest expense | (12,272 | ) | (12,261 | ) | (36,486 | ) | (36,381 | ) |\n| Loss on settlement of litigation | — | — | (550,000 | ) | — |\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\n| Total other expense | (7,047 | ) | (8,521 | ) | (579,498 | ) | (26,875 | ) |\n| Loss before income taxes | (8,427,964 | ) | (1,626,989 | ) | (15,519,055 | ) | (2,507,042 | ) |\n| Income taxes | (1,303 | ) | (4 | ) | (9,943 | ) | (15,069 | ) |\n| NET LOSS | $ | (8,429,267 | ) | $ | (1,626,993 | ) | $ | (15,528,998 | ) | $ | (2,522,111 | ) |\n\nRevenue. We generated revenues of $83,534 and $ 11,629 for the three months ended September 30, 2021 and 2020 respectively. During the nine month ended September 30, 2021 and 2020 we generated revenue of $100,823 and $41,262 respectively. The significant increase in revenue for three months and nine months was due to more merchants were joining our platform to operate their business.\n\n| 49 |\n\nDuring the nine months ended September 30, 2021 and 2020, the following customer exceeded 10% of the Company’s revenues:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Aryaduta Hospitality & Leisure Group | $ | 24,813 | 25 | % | $ | 19,308 |\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % | $ | — |\n| Tiki Smart Logistic | $ | 58,300 | 58 | % | $ | 68,285 | * |\n\n* - This included value added taxes (“VAT”)\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\n| Aryaduta Hospitality & Leisure Group | $ | 31,604 | 76 | % | $ | — |\n\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Customer | Revenues | Percentage of revenues |\n| Aryaduta Hospitality & Leisure Group | $ | 10,016 | 12 | % |\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % |\n| Tiki Smart Logistic | $ | 58,300 | 58 | % |\n\n\n| Three months ended September 30, 2020 |\n| Customer | Revenues | Percentage of revenues |\n| Aryaduta Hospitality & Leisure Group | $ | 9,789 | 84 | % |\n\nAll of our customers are located in Vietnam except one above significant customer located in Indonesia.\nCost of Revenue. We incurred cost of revenue of $159,436 and $20,316 for three months ended September 30, 2021, and 2020 respectively. During the period of nine months ended September 30,2021 and 2020, we incurred cost of revenue of $264,293 and $59,109 respectively. Cost of revenue increased primarily as a result of the fixed subscription cost and the increased in number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\nMajor vendors\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Nine months ended September 30, 2021 | September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 30,577 | 27% | $ | 44,867 |\n| Vendor B | 17,827 | 16% |\n\n\n| Nine months ended September 30, 2020 | September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\n| Vendor A | $ | 46,863 | 72% | $ | — |\n| Vendor B | — | — | — |\n\n\n| 50 |\n\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\n\n| Three months ended September 30, 2021 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | — | — |\n\n\n| Three months ended September 30, 2020 |\n| Vendors | Purchases | Percentage of purchases |\n| Vendor A | $ | 24,201 | 90 | % |\n| Vendor B | — | — |\n\nAll vendors are located in Vietnam.\nGross Loss. We recorded a gross loss of $75,902 and $8,687 for three months ended September,30 2021 and 2020 respectively. During the nine months ended September 30,2021 and 2020, we recorded a gross loss of $163,470 and $17,847 respectively. The increase in gross loss is primarily attributable to fixed subscription cost and the number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\nSales and Marketing Expenses (“S&M”). We incurred S&M expenses of $42,843 and $0 for three months ended September 30, 2021 and 2020 respectively. During nine months ended September 30,2021 and 2020, we have incurred S&M expenses of $85,027 and $3,125 respectively. The increase in S&M is primarily attributable to the increased in sales and promotion expenses related to get more merchants joining our e-commerce platform to operate their business. Also, increase marketing cost to attract attention of customer to our e-commerce platform.\nSoftware Development Cost (“SDC”). We incurred SDC expenses of $9,709 and 33,658 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred SDC exepenses of $76,698 and $139,151 respectively. The decrease in SDC is primarily attributable to the restructuring of our technology development team.\nImpairment Charge (“IC”). We incurred impairment charge of $200,000 and $8,778 for the nine months ended September 30, 2021, and 2020, respectively. No impairment charge imcurred for the three months ended September 30, 2021 and 2020. The increase is primarily attributable to the acquisition of Leflair ecommerce asset which was expensed in the same period due to the short life term of the asset and the quantum of consideration.\nGeneral and Administrative Expenses (“G&A”). We incurred G&A expenses of $8,292,463 and $1,580,287 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred G&A expenses of $14,414,362 and $2,311,266 respectively. The increase in G&A is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq, amortization of intangible assets and Stock based compensation for services.\nLoss on settlement of litigation. On May 21, 2021, the Company has agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum is required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the first payment of $250,000 on May 25, 2021 and complete the settlement sum as provided under the settlement agreement by paying the remaining $300,000 on June 29, 2021. In connection with the settlement, the Company recognized litigation settlement expense and a related accrued liability of $550,000 in the period ended September 30, 2021. There is no such expenses incurred in the comparative period ended September 30, 2020.\n\n| 51 |\n\nIncome Tax Expense. Our income tax expenses for the three months ended September 30,2021 and 2020 was $1,303 and $4 and for nine months ended September 30, 2021 and 2020 was $9,943 and $15,069, respectively.\nNet Loss. As a result for the three months ended September 30, 2021, we incurred a net loss of $8,429,267 as compare to the same period ended September 30,2020 of $1,626,993. During nine month ended September 30, 2021 the Group having loss of $15,528,998, as compared to $2,522,111 for the same period ended September 30, 2020. The increase in net loss is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq and amortization of intangible assets.\nLiquidity and Capital Resources\nAs of September 30, 2021, we had cash and cash equivalents of $5,722,450, accounts receivable of $87,803, deposits, prepayments and other receivables of $69,623 and due from related parties of $97,500.\nAs of December 31, 2020, we had cash and cash equivalents of $506,666, accounts receivable of $1,897, deposits, prepayments and other receivables of $60,532.\nThe accompanying consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nThe Company suffered from an accumulated deficit of $28,116,309 at September 30, 2021. The Company incurred net loss of $15,528,998 during the nine months ended September 30, 2021. These factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of twelve months from the date of issuance of this financial statement, without additional debt or equity financing. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $26,000,001 and 2,124,999. In addition, the Company has raised $8,019,461, net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\nThese consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets and liabilities that may result in the Company not being able to continue as a going concern.\n\n| Nine Months Ended September 30, |\n| 2021 | 2020 |\n| Net cash (used in) operating activities | $ | (2,639,775 | ) | $ | (970,647 | ) |\n| Net cash (used in) investing activities | (200,000 | ) | — |\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\n| Effect on exchange rate change | 36,098 | 16,689 |\n| Net change in cash and cash equivalents | 5,215,784 | (244,998 | ) |\n| Cash and cash equivalent at beginning of period | 506,666 | 606,491 |\n| Cash and cash equivalent at end of period | 5,722,450 | 361,493 |\n\n| 52 |\n\nNet Cash Used In Operating Activities.\nFor the nine months ended September 30, 2021, net cash used in operating activities was $2,639,775, which consisted primarily of a net loss of $15,528,998, offset by increase in stock based compensation for services of $10,071,830, increase in accounts receivables of $85,906, increase in deposits, prepayments and other receivables of $9,091, increase in contract liabilities $16,936, increase in accounts payables of $50,424, decrease in accrued liabilities and other payable of $474,932, increase in advance to related parties of $127,500, decrease in operating lease liabilities of $29,064, increase in depreciation and amortization of $2,406,648, increase in impairment loss of $200,000, increase in loss on settlement of litigation of 550,000.\nFor the nine months ended September 30, 2020, net cash used in operating activities was $970,647, which consisted primarily of net loss of $2,522,111, offset by increase in impairment loss of $8,778, increase in account receivable of $19,900, increase in inventories of $7,212, increase in deposits, prepayment and other receivables of $7005, increase in contract liabilities of $8,275, increase in accounts payable of $61, decrease in accrued liabilities and other payables of $37,960 and decrease in advance to related parties of $76,278.\nWe expect to continue to rely on cash generated through financing from our existing shareholders and private placements of our securities, however, to finance our operations and future acquisitions.\nNet Cash (Used In) Investing Activities.\nFor the nine months ended September 30, 2021, there is net cash of 200,000 being deposit paid for Leflair asset acquisition investing activities.\nFor the nine months ended September 30, 2020, there is no net cash impact on investing activities\nNet Cash Provided By Financing Activities.\nFor the nine months ended September 30, 2021, net cash provided by financing activities was $8,109,461, consisting primarily of funds raised from shareholders for Series C, Series C1 and warrant exercised.\nFor the nine months ended September 30, 2020, net cash provided by financing activities was $708,960, consisting primarily of funds raised from shareholders for Series C and warrant exercised.\nCritical Accounting Policies and Estimate\n• Basis of presentation\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\n\n| 53 |\n\n• Use of estimates and assumptions\nIn preparing these consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\n• Basis of consolidation\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\n• Cash and cash equivalents\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $5,722,450 and $506,666, respectively.\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $250,000, so there were uninsured balance of $4,895,306 and $208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\n• Accounts receivable\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $0 and $0, respectively.\n• Inventories\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchanized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. The inventories were amounted to $0 and $0 at September 30, 2021 and December 31, 2020, respectively.\n\n| 54 |\n\n• Property, plant and equipment\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\n\n| Expected useful lives |\n| Computer equipment | 3 years |\n| Office equipment | 5 years |\n\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\n• Impairment of long-lived assets\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\n• Revenue recognition\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\n\n| • | identify the contract with a customer; |\n| • | identify the performance obligations in the contract; |\n| • | determine the transaction price; |\n| • | allocate the transaction price to performance obligations in the contract; and |\n| • | recognize revenue as the performance obligation is satisfied. |\n\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\nConsumer Facing Business\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center\n| 55 |\n\nRevenue streams for consumer facing business:\nF&B sector\n\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\n\n\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\n\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\nLifestyle sector\n\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream.\nMerchant Facing Business\nRevenue streams for merchant facing business include:\n\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\n\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\n\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\n\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\n\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\n\n| 56 |\n\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\nContract assets\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\nThere were no contract assets at September 30, 2021 and December 31, 2020.\nContract liabilities\nIn accordance with ASC 606-10-45-2, A contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $35,582 and $18,646 as of September 30, 2021 and December 31, 2020, respectively.\nContract costs\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\n• Incremental costs directly related to a specific contract;\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\n• Costs that are expected to be recovered from the customer.\nNo contract costs are capitalized for the three and nine months ended September 30, 2021 and 2020.\n\n| 57 |\n\n• Software development costs\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $76,698 and $139,151, respectively. For three months ended September 30, 2021 and 2020, the software development costs were $9,709 and $33,658, respectively.\n• Product warranties\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of June 30, 2021 and 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\n• Shipping and handling costs\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\n• Sales and marketing\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $85,027 and $3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $42,843 and $0, respectively.\n• Income tax\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\n\n| 58 |\n\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\n• Uncertain tax positions\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\n• Foreign currencies translation and transactions\nThe reporting currency of the Company is United States Dollar (\"US$\") and the accompanying consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\n\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\n\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\n\n| September 30, 2021 | September 30, 2020 |\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\n\n\n| 59 |\n\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $8,859 for the three months ended September 30, 2021 as compared to a gain of $51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange loss or gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\n• Comprehensive income\nASC 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\n• Leases\nThe Company adopted ASC 842, Leases (“ASC 842”) to determines if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\n• Related parties\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting ;parties might be prevented from fully pursuing its own separate interests.\n\n| 60 |\n\nThe condnensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\n• Commitments and contingencies\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\n• Fair value of financial instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\n\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\n\n| 61 |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\n• Cost of goods sold\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase\n• Share-based compensation\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\n• Business combinations\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\n• Earnings per share\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\n\n| 62 |\n\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\n\n| As of September 30, | As of December 31, |\n| 2021 | 2020 |\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\n| Warrants granted | — | — |\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\n| Total: | 6,659,900 | 2,408,600 |\n\n\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\n\n• Segment Reporting\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\nEmerging Growth Company\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\nCritical Accounting Policies and Estimate\n• Recent accounting pronouncements\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\n\n| 63 |\n\nAccounting Standards Adopted\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\nAccounting Standards Issued, Not Adopted\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\n\n| 64 |\n\n\nItem 3. Quantitative and Qualitative Disclosures about Market Risk.\nWe did not have investments and do not utilize derivative financial instruments to manage our interest rate risks.\nItem 4. Controls and Procedures.\nEvaluation of Disclosure Controls and Procedures\nWe maintain disclosure controls and procedures that are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended (the \"Exchange Act\"), is recorded, processed, summarized and reported within the time periods specified in the rules and forms promulgated by the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations to the effectiveness of any system of disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been prevented or detected on a timely basis. Even disclosure controls and procedures determined to be effective can only provide reasonable assurance that their objectives are achieved.\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) pursuant to Rule 13a-15 of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are not effective at the reasonable assurance level.\nOur size has prevented us from being able to employ sufficient resources to enable us to have an adequate level of supervision and segregation of duties. Therefore, it is difficult to effectively segregate accounting duties which comprises a material weakness in internal controls. This lack of segregation of duties leads management to conclude that the Company’s disclosure controls and procedures are not effective to give reasonable assurance that the information required to be disclosed in reports that the Company files under the Exchange Act is recorded, processed, summarized and reported as and when required.\nTo the extent reasonably possible given our limited resources, we intend to take measures to cure the aforementioned weaknesses, including, but not limited to, increasing the capacity of our qualified financial personnel to ensure that accounting policies and procedures are consistent across the organization and that we have adequate control over our Exchange Act reporting disclosures.\nChanges in Internal Control over Financial Reporting\nThere were no changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the quarter ended September 30, 2021 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\n| 65 |\n\nPART II\nOTHER INFORMATION\n\nItem 1. Legal Proceedings.\nThe Company is currently litigating three cases pending in the Supreme Court of the State of New York and one case pending in the United States District Court for the District of New Jersey.\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $122,042.60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims. The judge assigned to this action retired at the end of 2020. A new judge has been assigned and this action is progressing through the discovery phase of litigation.\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\n\n| 66 |\n\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\nAs of September 30, 2021, the Company does not expect any losses from these legal proceedings and accordingly has not accrued any provisions for them.\nItem 1A. Risk Factors.\nAs of the date of this Quarterly Report on Form 10-Q, there have been no material changes to the risk factors disclosed in our Prospectus, filed with the SEC on November 10, 2021, pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNot Applicable\nItem 3. Defaults Upon Senior Securities.\nNot Applicable\nItem 4. Mine Safety Disclosures.\nNot Applicable\nItem 5. Other Information\nNone\n| 67 |\n\n\nItem 6. Exhibits\nEXHIBIT INDEX\n| Exhibit No. | Description |\n| 3.1 | Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.2 | Amended Bylaws of The Registrant (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.3 | Certificate of Designation of Series A Convertible Preferred Stock incorporated by reference to Exhibit 3.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.4 | Certificate of Correction of Series A Certificate of Designation filed May 2019 incorporated by reference to Exhibit 3.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3. | Certificate of Correction to Series A Certificate of Designation filed December 2020 (incorporated by reference to Exhibit 3.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.6 | Certificate of Designation of Series B Convertible Preferred Stock (incorporated by reference to Exhibit 3.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.7 | Certificate of Correction of Series B Certificate of Designation (incorporated by reference to Exhibit 3.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.8 | Certificate of Designation of Series B-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.9 | Certificate of Correction of Series B-1 Certificate of Designation (incorporated by reference to Exhibit 3.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\n| 3.10 | Certificate of Designation of Series C Convertible Preferred Stock (incorporated by reference to Exhibit 3.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.11 | Certificate of Correction of Series C Certificate of Designation (incorporated by reference to Exhibit 3.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.12 | Certificate of Designation of Series C-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.13 | Certificate of Designation for Series X Super Voting Preferred Stock ((incorporated by reference to Exhibit 3.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\n| 3.14 | Certificate of Amendment to Articles of Incorporation to change the authorized capital of the Registrant, filed December 4, 2018 (incorporated by reference to Exhibit 3.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.15 | Certificate of Amendment to Articles of Incorporation to change the name of Registrant, filed October 2, 2018 (incorporated by reference to Exhibit 3.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.16 | Certificate of Amendment to Articles of Incorporation to effect reverse stock split (incorporated by reference to Exhibit 3.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 3.17 | Certificate of Amendment to Series X Super Voting Preferred Certificate of Designation (incorporated by reference to Exhibit 3.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 4.1 | Form of Series C-1 Warrant (incorporated by reference to Exhibit 4.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 4.2 | Form of Underwriter Warrant (incorporated by reference to Exhibit 4.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.1 | Software Set Up, Development and Use License Agreement dated November 15, 2018 between Society Pass Incorporated and Wallet Factory International Limited (incorporated by reference to Exhibit 10.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.2 | Stock Purchase Agreement dated January 10 2019 between HOTTAB PTE. LTD., SOSV IV LLC, General Mobile Corporation and Sanjeev Sapkota (incorporated by reference to Exhibit 10.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.3 | Accelerator Contract for Equity dated January 10, 2019 by and between HOTTAB PTE. LTD., SOV IV LLC and Sanjeev Sapkota (incorporated by reference to Exhibit 10.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.4 | Employment Agreement dated as of April 1, 2017 between Society Pass Incorporated and Dennis Luan Thuc Nguyen (incorporated by reference to Exhibit 10.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.5 | Employment Agreement dated as of September 1, 2020 between Society Pass Incorporated and Liang Wee Leong Raynauld (incorporated by reference to Exhibit 10.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.6 | Asset Purchase Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD. (incorporated by reference to Exhibit 10.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.7 | Shareholders Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD (incorporated by reference to Exhibit 10.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.8 | Food Delivery Partnership Agreement dated as of April 22, 2021 between Hottab Asset Vietnam Co. Ltd and Dream Space Trading Co. Ltd (incorporated by reference to Exhibit 10.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.9 | Food Delivery Partnership Agreement dated as of July 29, 2020 between Hottab Asset Vietnam Co. Ltd and Lala Move Vietnam Co. Ltd (incorporated by reference to Exhibit 10.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.10 | Payment Gateway Agreement dated February 25, 2020 between Hottab Asset Vietnam Co. Ltd and VTC Technology and Digital Content Company (incorporated by reference to Exhibit 10.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.11 | Payment Gateway Agreement dated April 20, 2020 between Hottab Asset Vietnam Co. Ltd and Media Corporation (Vietnam Post Telecommunication Media) (incorporated by reference to Exhibit 10.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.12 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Zion Joint Stock Company (incorporated by reference to Exhibit 10.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.13 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Online Mobile Service Joint Stock Co (incorporated by reference to Exhibit 10.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.14 | Vendor Finance Partnership Agreement, dated as of October 22, 2019 between Hottab Asset Vietnam Co. Ltd and SHBank Finance Co. Ltd (incorporated by reference to Exhibit 10.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.15 | Business Cooperation Agreement dated March 6, 2020 between Hottab Asset Vietnam Co. and Triip Pte. Ltd ((incorporated by reference to Exhibit 10.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.16 | The Registrant’s 2021 Equity Incentive Plan (incorporated by reference to Exhibit 10.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.17 | Business Cooperation Contract dated May 28, 2021 between Paytech, JSC and the Registrant (incorporated by reference to Exhibit 10.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.18 | Business Cooperation Agreement dated August 15, 2021 between Hottab Vietnam Company Limited and Rainbow Loyalty Company Limited (incorporated by reference to Exhibit 10.18 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 10.19 | Amendment to Employment Agreement dated October 25, 2021 between Dennis Nguyen and the Registrant (incorporated by reference to Exhibit 10.19 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\n| 31.1 | Certification of principal executive officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\n| 31.2 | Certification of principal financial officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\n| 32.1* | Certification of principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) promulgated under the Securities Exchange Act of 1934 |\n\n* The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Form 10-Q and are not deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, nor shall they be deemed incorporated by reference into any filing under the Securities Act or the Exchange Act.\n| 68 |\n\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n| SOCIETY PASS INCORPORATED |\n| (Registrant) |\n| Date: December 9, 2021 | By: | /s/ Dennis Nguyen |\n| Dennis Nuguyen |\n| Chief Executive Officer |\n| Date: December 9, 2021 | By: | /s/ Ranauld Liang |\n| Raynauld Liang |\n| Chief Financial Officer |\n\n\n| 69 |\n\n\n</text>\n\nWhat would be the total number of common stock to be issued in 2021 if the IPO price is $10 per share, if the conversion for Series A preferred stocks is its aggregate Stated Value divided by IPO price?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1. Financial statements\\nSOCIETY PASS INCORPORATED\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\nAS OF SEPTEMBER 30, 2021 AND DECEMBER 31, 2020\\n(Currency expressed in United States Dollars (“US$”))\\n\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| ASSETS |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 5,722,450 | $ | 506,666 |\\n| Due from related parties | 97,500 | — |\\n| Accounts receivable, net | 87,803 | 1,897 |\\n| Deposits, prepayments and other receivables | 69,623 | 60,532 |\\n| Total current assets | 5,977,376 | 569,095 |\\n| Non-current assets: |\\n| Intangible assets, net | 4,800,000 | 7,200,000 |\\n| Property, plant and equipment, net | 11,080 | 18,069 |\\n| Right of use assets, net | 529,782 | 79,109 |\\n| Total non-current assets | 5,340,862 | 7,297,178 |\\n| TOTAL ASSETS | $ | 11,318,238 | $ | 7,866,273 |\\n| LIABILITIES AND SHAREHOLDERS’ DEFICIT |\\n| Current liabilities: |\\n| Accounts payables | $ | 104,680 | $ | 54,256 |\\n| Contract liabilities | 35,582 | 18,646 |\\n| Accrued liabilities and other payables | 752,640 | 677,572 |\\n| Contingent service payable | — | 633,000 |\\n| Due to related parties | 24,763 | 1,571,737 |\\n| Operating lease liabilities | 167,773 | 36,752 |\\n| Total current liabilities | 1,085,438 | 2,991,963 |\\n| Non-current liabilities |\\n| Operating lease liabilities | 365,539 | 46,453 |\\n| TOTAL LIABILITIES | 1,450,977 | 3,038,416 |\\n| COMMITMENTS AND CONTINGENCIES |\\n| Convertible preferred shares; $ 0.0001 par value, 5,000,000 shares authorized, 4,916,500 and 4,920,000 shares undesignated as of September 30, 2021 and December 31, 2020, respectively |\\n| Series A shares: 10,000 shares designated; 8,000 and 8,000 Series A shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 8,000,000 | 8,000,000 |\\n| Series B shares: 10,000 shares designated; 2,548 and 2,548 Series B shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 3,412,503 | 3,412,503 |\\n| Series B-1 shares: 15,000 shares designated; 160 and 160 Series B-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 466,720 | 466,720 |\\n| Series C shares: 15,000 shares designated; 1,552 and 362 Series C shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost | 8,353,373 | 2,151,706 |\\n| Series C-1 shares: 30,000 shares designated; 13,984 and 2,885 Series C-1 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively, net of issuance cost and stock subscription receivable | 5,057,192 | 1,211,700 |\\n| SHAREHOLDERS’ DEFICIT |\\n| Series X Super Voting Preferred Stock, $ 0.0001 par value, 3,500 shares designated; 3,500 and 0 Series X shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | — | — |\\n| Common shares; $ 0.0001 par value, 95,000,000 shares authorized; 9,695,480 and 7,413,600 shares issued and outstanding as of September 30, 2021 and December 31, 2020, respectively | 970 | 742 |\\n| Additional paid-in capital | 12,712,290 | 2,227,033 |\\n| Accumulated other comprehensive loss | ( 19,478 | ) | ( 55,236 | ) |\\n| Accumulated deficit | ( 28,116,309 | ) | ( 12,587,311 | ) |\\n| Total shareholders’ deficit | ( 15,422,527 | ) | ( 10,414,772 | ) |\\n| TOTAL LIABILITIES AND SHAREHOLDERS’ DEFICIT | $ | 11,318,238 | $ | 7,866,273 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n\\n| 3 |\\n\\nSOCIETY PASS INCORPORATED\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND\\nOTHER COMPREHENSIVE LOSS\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\\n(Currency expressed in United States Dollars (“US$”))\\n(Unaudited)\\n\\n| Three months ended | Nine months ended |\\n| September 30, | September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Revenue, net |\\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\\n| Sales – online ordering | 73,518 | — | 73,518 | — |\\n| Total revenue | 83,534 | 11,629 | 100,823 | 41,262 |\\n| Cost of sales: |\\n| Hardware sales | — | ( 585 | ) | ( 165 | ) | ( 2,982 | ) |\\n| Software subscription | ( 101,695 | ) | ( 19,731 | ) | ( 206,387 | ) | ( 56,127 | ) |\\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) | — |\\n| Total cost of revenue | ( 159,436 | ) | ( 20,316 | ) | ( 264,293 | ) | ( 59,109 | ) |\\n| Gross loss | ( 75,902 | ) | ( 8,687 | ) | ( 163,470 | ) | ( 17,847 | ) |\\n| Operating expenses: |\\n| Sales and marketing expenses | ( 42,843 | ) | — | ( 85,027 | ) | ( 3,125 | ) |\\n| Software development costs | ( 9,709 | ) | ( 33,658 | ) | ( 76,698 | ) | ( 139,151 | ) |\\n| Impairment loss | — | 4,164 | ( 200,000 | ) | ( 8,778 | ) |\\n| General and administrative expenses | ( 8,292,463 | ) | ( 1,580,287 | ) | ( 14,414,362 | ) | ( 2,311,266 | ) |\\n| Total operating expenses | ( 8,345,015 | ) | ( 1,609,781 | ) | ( 14,776,087 | ) | ( 2,462,320 | ) |\\n| Loss from operations | ( 8,420,917 | ) | ( 1,618,468 | ) | ( 14,939,557 | ) | ( 2,480,167 | ) |\\n| Other income (expense): |\\n| Interest income | 55 | 3 | 71 | 11 |\\n| Interest expense | ( 12,272 | ) | ( 12,261 | ) | ( 36,486 | ) | ( 36,381 | ) |\\n| Loss on settlement of litigation | — | — | ( 550,000 | ) | — |\\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\\n| Total other expense | ( 7,047 | ) | ( 8,521 | ) | ( 579,498 | ) | ( 26,875 | ) |\\n| Loss before income taxes | ( 8,427,964 | ) | ( 1,626,989 | ) | ( 15,519,055 | ) | ( 2,507,042 | ) |\\n| Income taxes | ( 1,303 | ) | ( 4 | ) | ( 9,943 | ) | ( 15,069 | ) |\\n| NET LOSS | $ | ( 8,429,267 | ) | $ | ( 1,626,993 | ) | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\\n| Other comprehensive loss: |\\n| Foreign currency translation income | 8,859 | 51,183 | 35,758 | 15,249 |\\n| COMPREHENSIVE LOSS | $ | ( 8,420,408 | ) | $ | ( 1,575,810 | ) | $ | ( 15,493,240 | ) | $ | ( 2,506,862 | ) |\\n| Net loss per share – Basic and Diluted | $ | ( 1 | ) | $ | ( 0 | ) | $ | ( 2 | ) | $ | ( 0 | ) |\\n| Weighted average common shares outstanding – Basic and Diluted | 7,823,818 | 6,848,700 | 7,551,842 | 6,847,945 |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n\\n| 4 |\\n\\nSOCIETY PASS INCORPORATED\\nCONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ DEFICIT\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\\n(Currency expressed in United States Dollars (“US$”))\\n(Unaudited)\\n\\n| Three months ended September 30, 2021 |\\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\\n| Shares | Amount |\\n| Balance as of July 1, 2021 | 7,413,600 | $ | 742 | $ | 5,145,228 | $ | ( 28,337 | ) | $ | ( 19,687,042 | ) | $ | ( 14,569,409 | ) |\\n| Imputed Interest | — | — | 12,260 | — | — | 12,260 |\\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\\n| Net loss for the period | — | — | — | — | ( 8,429,267 | ) | ( 8,429,267 | ) |\\n| Foreign currency translation adjustment | — | — | — | 8,859 | — | 8,859 |\\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\\n| Shares | Amount |\\n| Balance as of July 1, 2020 | 6,847,200 | $ | 685 | $ | 1,729,064 | $ | ( 31,946 | ) | $ | ( 9,654,441 | ) | $ | ( 7,956,638 | ) |\\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\\n| Imputed interest | — | — | 12,261 | — | — | 12,261 |\\n| Net loss for the period | — | — | — | — | ( 1,626,993 | ) | ( 1,626,993 | ) |\\n| Foreign currency translation adjustment | — | — | — | 51,183 | — | 51,183 |\\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\\n\\n\\n| 5 |\\n\\n\\n| Nine months ended September 30, 2021 |\\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholder’ deficit |\\n| Shares | Amount |\\n| Balance as of January 1, 2021 | 7,413,600 | $ | 742 | $ | 2,227,033 | $ | ( 55,236 | ) | $ | ( 12,587,311 | ) | $ | ( 10,414,772 | ) |\\n| Imputed Interest | — | — | 36,380 | — | — | 36,380 |\\n| Shares issued for services | 1,274,250 | 127 | 5,149,929 | — | — | 5,150,056 |\\n| Shares issued for accrued salaries | 1,157,630 | 116 | 960,718 | — | — | 960,834 |\\n| Loss on fair value of shares issued for accrued salaries | — | — | 2,894,075 | — | — | 2,894,075 |\\n| Share cancellation | ( 150,000 | ) | ( 15 | ) | 15 | — | — | — |\\n| Waiver of related parties debts | — | — | 1,444,140 | — | — | 1,444,140 |\\n| Net loss for the period | — | — | — | — | ( 15,528,998 | ) | ( 15,528,998 | ) |\\n| Foreign currency translation adjustment | — | — | — | 35,758 | — | 35,758 |\\n| Balance as of September 30, 2021 | 9,695,480 | $ | 970 | $ | 12,712,290 | $ | ( 19,478 | ) | $ | ( 28,116,309 | ) | $ | ( 15,422,527 | ) |\\n\\n\\n| Nine months ended September 30, 2020 |\\n| Common stock | Additional paid-in capital | Accumulated other comprehensive (loss) income | Accumulated deficit | Total shareholders’ deficit |\\n| Shares | Amount |\\n| Balance as of January 1, 2020 | 6,847,200 | $ | 685 | $ | 1,704,944 | $ | 3,988 | $ | ( 8,759,323 | ) | $ | ( 7,049,706 | ) |\\n| Issuance of common stock for services | 1,016,400 | — | 848,505 | — | — | 848,505 |\\n| Imputed interest | — | — | 36,381 | — | — | 36,381 |\\n| Net loss for the period | — | — | — | — | ( 2,522,111 | ) | ( 2,522,111 | ) |\\n| Foreign currency translation adjustment | — | — | — | 15,249 | — | 15,249 |\\n| Balance as of September 30, 2020 | 7,863,600 | $ | 685 | $ | 2,589,830 | $ | 19,237 | $ | ( 11,281,434 | ) | $ | ( 8,671,682 | ) |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n\\n| 6 |\\n\\nSOCIETY PASS INCORPORATED\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\nFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020\\n(Currency expressed in United States Dollars (“US$”))\\n(Unaudited)\\n\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Cash flows from operating activities: |\\n| Net loss | $ | ( 15,528,998 | ) | $ | ( 2,522,111 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities |\\n| Depreciation and amortization | 2,406,648 | 4,447 |\\n| Impairment loss | 200,000 | 8,778 |\\n| Imputed interest | 36,380 | 36,381 |\\n| Loss on settlement of litigation | 550,000 | — |\\n| Stock based compensation for services | 10,071,830 | 1,641,877 |\\n| Change in operating assets and liabilities: |\\n| Accounts receivable | ( 85,906 | ) | ( 19,900 | ) |\\n| Inventories | — | ( 7,212 | ) |\\n| Deposits, prepayments and other receivables | ( 9,091 | ) | ( 7,005 | ) |\\n| Contract liabilities | 16,936 | 8,275 |\\n| Accounts payables | 50,424 | 61 |\\n| Accrued liabilities and other payables | ( 474,932 | ) | ( 37,960 | ) |\\n| Advances to related parties | 127,500 | ( 76,278 | ) |\\n| Right of use assets | 28,498 | — |\\n| Operating lease liabilities | ( 29,064 | ) | — |\\n| Net cash used in operating activities | ( 2,639,775 | ) | ( 970,647 | ) |\\n| Cash flows from investing activities: |\\n| Purchase of investment assets | ( 200,000 | ) | — |\\n| Net cash used in investing activities | ( 200,000 | ) | — |\\n| Cash flows from financing activities: |\\n| Proceed from the issuance of Series C preferred stock and exercise of warrants | 8,019,461 | 708,960 |\\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\\n| Effect on exchange rate change on cash and cash equivalents | 36,098 | 16,689 |\\n| NET CHANGE IN CASH AND CASH EQUIVALENTS | 5,215,784 | ( 244,998 | ) |\\n| CASH AND CASH EQUIVALENT AT BEGINNING OF PERIOD | 506,666 | 606,491 |\\n| CASH AND CASH EQUIVALENT AT END OF PERIOD | $ | 5,722,450 | $ | 361,493 |\\n| Supplemental disclosure of cash flow information: |\\n| Cash paid for interest | $ | 106 | $ | — |\\n| Cash paid for income tax | $ | — | $ | — |\\n| NON-CASH INVESTING AND FINANCING ACTIVITIES |\\n| Impact of adoption of ASC 842 - lease obligation and ROU asset | $ | 479,171 | $ | — |\\n| Waiver of related party debt accounted as capital transaction | $ | 1,444,140 | $ | — |\\n| Fair value of preferred stock issued for services | $ | 2,948,982 | $ | 793,372 |\\n| Fair value of preferred stock accounted and included for issuance cost | $ | 441,642 | $ | — |\\n| Common stock issued for accrued salaries | $ | 960,835 | $ | — |\\n| Shares cancellation | $ | 15 | $ | — |\\n\\nSee accompanying notes to unaudited condensed consolidated financial statements.\\n\\n| 7 |\\n\\nNOTE－1 DESCRIPTION OF BUSINESS AND ORGANIZATION\\nSociety Pass Incorporated (the “Company”) is incorporated in State of Nevada on June 22, 2018 under the name of Food Society Inc. On October 3, 2018, the Company changed its corporate name to Society Pass Incorporated. The Company through its subsidiaries, mainly sells and distributes the hardware and software of Point of Sales (POS) application in Vietnam.\\nDescription of subsidiaries incorporated by the Company\\n\\n| Schedule of Description of subsidiaries |\\n| Name | Place and date of incorporation | Principal activities | Particulars of registered/ paid up share Capital | Effective interest held |\\n| Society Technology LLC | State of Nevada , January 24, 2019 | IP Licensing | US$1 | 100 % |\\n| SOPA Cognitive Analytics Private Limited | India , February 5, 2019 | Computer sciences consultancy and data analytics | INR1,238,470 | 100 % |\\n| SOPA Technology Pte. Ltd . | Singapore , June 4, 2019 | Investment holding | SG$1,250,000 | 100 % |\\n| SOPA Technology Company Limited | Vietnam , October 1, 2019 | Software production | Registered: VND 2,307,300,000; Paid up: VND 1,034,029,911 | 100 % |\\n| Hottab Pte Ltd. (HPL) | Singapore , January 17, 2015 | Software development and marketing for the F&B industry | SG$620,287.75 | 100 % |\\n| Hottab Vietnam Co. Ltd | Vietnam , April 17, 2015 | Sale of POS hardware and software | VND 1,000,000,000 | 100 % |\\n| Hottab Asset Company Limited | Vietnam , July 25, 2019 | Sale of POS hardware and software | VND 5,000,000,000 | 100 % |\\n\\nThe Company and its subsidiaries are hereinafter referred to as (the “Company”).\\nOn October 29, 2019 with the revised provision dated November 11, 2019, the Company acquired Hottab Pte Ltd and its subsidiaries, at the consideration of $ 1,050,000 consisted of Series C preference shares valued at $ 900,000 and the cash consideration of $ 150,000 . The value of the $900,000 Series C preference shares issued was determined based on the stated value per share of the Company’s shares at the acquisition date. Also, the Company shall pay to the Company additional Series C preference shares with an aggregate value of $ 558,000 (the “Equity Incentive”) in the event the Company able to fulfilled the other terms per their arrangement with in five months from the completion date.\\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the forward stock split.\\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the period and years presented, unless otherwise indicated, to give effect to the reverse stock split.\\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\\n\\n| 8 |\\n\\nSpun Out\\nOn December 31, 2019, the Company recently spun out Food Society Group Limited (Food Business), which aims to develop and commercialize chain of restaurants in Vietnam.\\nIn connection with the presentation of the Company’s consolidated financial statements, the Company considered the guidance described in the SEC’s codified Staff Accounting Bulletins, Topic 5, Section Z, paragraph 7, “Accounting for the Spin-off of a subsidiary”.\\nThe Company’s initial registration of its securities under the 1933 Securities Act and the spin off transaction of the Food Society Group Limited occurred prior to the effectiveness of the Company’s registration statement.\\nThe Company considered the following facts and circumstances in concluding omitting the Food Society Group Limited results of operations and financial position in the consolidated financial statements presented in the registration statement:\\n• The Company’s operations as a developer of an e-commerce platform and the Food Society Group Limited operations as a two(2) retail restaurants are in dissimilar business that would ordinarily be distinguished as reportable segments as defined by FASB ASC 280-10-50-10.\\n• The Company and the subsidiary have been managed and financed historically as if autonomous\\n• The Company and the subsidiary have no common facilities or costs\\n• The Company and the subsidiary are operated and financed autonomously after the spinoff, and\\n• There are no material financial commitments , guarantees or contingent liabilities to each other after the spin off\\nAccordingly, the Company has elected to characterize the spin-off of the Food Society Group Limited as a change in the Company’s reporting and present its historical financial statements as if the Company never had an investment in the subsidiary.\\nThis spun off our subsidiary Food Society Group Limited which owns 100% of Vietnam Eats (Hong Kong) Limited which owns 100% of Loft Restaurant Service Trading Company Limited that operates 2 restaurants in Vietnam.\\nThomas O’Connor, our former Chief Marketing Officer, serves as the legal representative of Loft Restaurant Service Trading Company Limited. Our Chief Executive Officer and Chairman of our board of directors, Dennis Nguyen., is the Chairman of Food Society Group Limited’s board of directors.\\nThe two restaurants were making losses for the financial year of 2019. The Company wanted to focus on building our loyalty technology platform. On December 20, 2019’s Board of Directors meeting the CFO presented the case for the spun off. The board voted on the February 18, 2020 to spin out the Food Society Group Limited via a proportionate distribution of shareholding percentage to the existing shareholders as at December 31, 2019.\\nNOTE－2 LIQUIDITY AND CAPITAL RESOURCES\\nThe accompanying unaudited condensed consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\\nThe Company suffered from an accumulated deficit of 28,116,309 at September 30, 2021. The Company incurred continuous net loss of $ 15,528,998 during the nine months ended September 30, 2021. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\\n\\n| 9 |\\n\\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $ 26,000,001 and 2,124,999 . In addition, the Company has raised $ 8,019,461 , net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\\nThe recent outbreak of COVID-19, which has been declared by the World Health Organization to be a pandemic, has spread across the globe and is impacting worldwide economic activity.. The COVID-19 pandemic has significantly impacted health and economic conditions throughout Vietnam, Singapore and Southeast Asia. National, regional and local governments took a variety of actions to contain the spread of COVID-19, including office and store closures, quarantining suspected COVID-19 patients, and capacity limitations. These developments have significantly impacted the results of operations, financial condition and cash flows of the Company included in this reporting. The impact included the difficulties of working remotely from home including slow Internet connection, the inability of our accounting and financial officers to collaborate as effectively as they would otherwise have in an office environment and issues arising from mandatory state quarantines.\\nWhile it is not possible at this time to estimate with sufficient certainty the impact that COVID-19 could have on the Company’s business, the continued spread of COVID-19 and the measures taken by federal, state, local and foreign governments could disrupt the operation of the Company’s business. The COVID-19 outbreak and mitigation measures have also had and may continue to have an adverse impact on global and domestic economic conditions, which could have an adverse effect on the Company’s business and financial condition, including on its potential to conduct financings on terms acceptable to the Company, if at all. In addition, the Company has taken temporary precautionary measures intended to help minimize the risk of the virus to its employees, including temporarily requiring employees to work remotely, and discouraging employee attendance at in-person work-related meetings, which could negatively affect the Company’s business. These measures are continuing. The extent to which the COVID-19 outbreak impacts the Company’s results will depend on future developments that are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity of the virus and the actions to contain its impact.\\nNOTE－3 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nThe accompanying unaudited condensed consolidated financial statements reflect the application of certain significant accounting policies as described in this note and elsewhere in the accompanying condensed consolidated financial statements and notes.\\n• Basis of presentation\\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\\n\\n| 10 |\\n\\n• Use of estimates and assumptions\\nIn preparing these condensed consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\\n• Basis of consolidation\\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\\n• Cash and cash equivalents\\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $ 5,722,450 and $ 506,666 , respectively.\\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $ 250,000 , so there were uninsured balance of $ 4,895,306 and $ 208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\\n• Accounts receivable\\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $ 0 and $ 0 , respectively.\\n• Inventories\\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchandized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $ 0 and $ 0 , respectively. The inventories were amounted to $ 0 and $ 0 at September 30, 2021 and December 31, 2020, respectively.\\n\\n| 11 |\\n\\n• Property, plant and equipment\\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\\n\\n| Schedule of Expected useful life |\\n| Expected useful lives |\\n| Computer equipment | 3 years |\\n| Office equipment | 5 years |\\n\\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\\n• Impairment of long-lived assets\\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\\n• Revenue recognition\\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\\n\\n| • | identify the contract with a customer; |\\n| • | identify the performance obligations in the contract; |\\n| • | determine the transaction price; |\\n| • | allocate the transaction price to performance obligations in the contract; and |\\n| • | recognize revenue as the performance obligation is satisfied. |\\n\\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\\nConsumer Facing Business\\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center.\\n| 12 |\\n\\nRevenue streams for consumer facing business:\\nF&B sector\\n\\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\\n\\n\\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\\n\\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\\nLifestyle sector\\n\\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $ 73,518 and $ 0 , respectively revenue from this stream.\\nMerchant Facing Business\\nRevenue streams for merchant facing business include:\\n\\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream.\\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\\n\\n| 13 |\\n\\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\\nContract assets\\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\\nThere were no contract assets at September 30, 2021 and December 31, 2020.\\nContract liabilities\\nIn accordance with ASC 606-10-45-2, a contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $ 35,582 and $ 18,646 as of September 30, 2021 and December 31, 2020, respectively.\\nContract costs\\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\\n• Incremental costs directly related to a specific contract;\\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\\n• Costs that are expected to be recovered from the customer.\\nNo contract costs are capitalized for the nine months ended September 30, 2021 and 2020.\\nNo contract costs are capitalized for the three months ended September 30, 2021 and 2020.\\n\\n| 14 |\\n\\n• Software development costs\\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $ 76,698 and $ 139,151 , respectively. For three months ended September 30, 2021 and 2020, the software development costs were $ 9,709 and $ 33,658 , respectively.\\n• Product warranties\\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of September 30, 2021 and December 31, 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\\n• Shipping and handling costs\\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\\n• Sales and marketing\\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 85,027 and $ 3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $ 42,843 and $ 0 , respectively.\\n• Income tax\\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the condensed consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the condensed consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\\n\\n| 15 |\\n\\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\\n• Uncertain tax positions\\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\\n• Foreign currencies translation and transactions\\nThe reporting currency of the Company is United States Dollar (\\\"US$\\\") and the accompanying condensed consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| Schedule of Foreign currencies translation and transactions |\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\\n\\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\\n\\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\\n\\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\\n\\n| 16 |\\n\\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $ 8,859 for the three months ended September 30, 2021 as compared to a gain of $ 51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\\n• Comprehensive income\\nASC Topic 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying condensed consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\\n• Leases\\nThe Company adopted Topic 842, Leases (“ASC 842”) to determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the condensed consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\\n\\n| 17 |\\n\\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\\nAs of September 30, 2021 and December 31, 2020, the Company recorded the right of use asset of $ 529,782 and $ 79,109 respectively.\\n• Related parties\\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\\nThe condensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\\n• Commitments and contingencies\\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\\n\\n| 18 |\\n\\n• Fair value of financial instruments\\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\\n\\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\\n\\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\\n• Cost of goods sold\\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase.\\n• Share-based compensation\\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\\n\\n| 19 |\\n\\n• Business combinations\\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\\n• Earnings per share\\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\\n\\n| Schedule of Common stock issued |\\n| As of September 30, | As of December 31, |\\n| 2021 | 2020 |\\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\\n| Warrants granted | — | — |\\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\\n| Total: | 6,659,900 | 2,408,600 |\\n\\n\\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\\n\\n• Segment Reporting\\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\\n• Emerging Growth Company\\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\\n\\n| 20 |\\n\\n• Recent Accounting Pronouncements\\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\\nAccounting Standards Adopted\\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have any impact on the financial statements.\\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\\nAccounting Standards Issued, Not Adopted\\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\\n\\n| 21 |\\n\\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\\nNo other new accounting pronouncements were issued or became effective in the period that had, or are expected to have, a material impact on our condensed consolidated Financial Statements.\\nNOTE－4 BUSINESS COMBINATION\\nOn November 11, 2019, the Company completed the acquisition of 100 % equity interest of Hottab Pte Limited (the “Acquisition”). The total consideration of the acquisition is 156 shares of series C convertible preferred stock, approximately $ 900,000 , cash consideration $ 150,000 and additional series C convertible preferred stock approximately $ 558,000 . The Company accounted for the transaction as an acquisition of a business pursuant to ASC 805, “Business Combinations” (“ASC 805”).\\n\\n| Schedule of Purchase price allocation |\\n| Purchase price allocation: |\\n| Fair value of stock at closing | $ | 900,000 |\\n| Cash paid | 75,000 |\\n| Deferred payments- Cash | 71,422 |\\n| Deferred payment- shares | 531,380 |\\n| Less cash received | ( 15,337 | ) |\\n| Purchase price | $ | 1,562,465 |\\n\\nThe transaction was accounted for using the acquisition method. Accordingly, goodwill has been measured as the excess of the total consideration over the amounts assigned to the identifiable assets acquired and liabilities assumed based on their preliminary estimated fair values.\\nThe deferred payments of $ 633,000 were discounted using the yield on a CCC rated corporate debt for 3-month, 6-month and 9-month maturities, respectively. The implied discount is approximately $ 30,198 , which will be amortized over the term on the payments.\\nThe purchase price allocation resulted in $2,766,000 of goodwill, as below:\\n\\n| Schedule of Acquisition of assets and liability |\\n| Acquired assets: |\\n| Trade receivables | $ | 6,906 |\\n| Other receivables | 1,857 |\\n| Total acquired assets | 8,763 |\\n| Less: Assumed liabilities |\\n| Trade payables | 39,147 |\\n| Accrued liabilities and other payable | 68,458 |\\n| Amounts due to related parties | 1,080,904 |\\n| Deferred revenue | 23,789 |\\n| Total Assumed liabilities | 1,212,298 |\\n| Fair value of net liabilities assumed | ( 1,203,535 | ) |\\n| Goodwill recorded | 2,766,000 |\\n| Cash consideration allocated | $ | 1,562,465 |\\n\\n\\n| 22 |\\n\\nUnder the acquisition method of accounting, the total acquisition consideration price was allocated to the assets acquired and liabilities assumed based on their preliminary estimated fair values. The fair value measurements utilize estimates based on key assumptions of the Acquisition, and historical and current market data. The preliminary allocation of the purchase price is based on the best information available and is pending, amongst other things: (i) the finalization of the valuation of the fair values and useful lives of tangible assets acquired; (ii) the finalization of the valuations and useful lives for the intangible assets acquired; (iii) finalization of the valuation of accounts payable and accrued expenses; and (iv) finalization of the fair value of non-cash consideration.\\nThe Acquisition was accounted for as a business combination in accordance with ASC 805 “Business Combinations”. The Company has allocated the purchase price consideration based upon the fair value of the identifiable assets acquired and liabilities assumed on the acquisition date. Management of the Company is responsible for determining the fair value of assets acquired, liabilities assumed and intangible assets identified as of the acquisition date and considered a number of factors including valuations from management estimation. Acquisition-related costs incurred for the acquisitions are not material and have been expensed as incurred in general and administrative expense.\\nThe goodwill is not expected to be deductible for tax purposes. The goodwill is fully impaired during the year ended December 31, 2019, because there were continuous operating losses and negative cash flows incurred subsequently. Under ASC 350-20-50, the Company recognized the goodwill impairment loss by comparing the actual operating results of Hottab to the profit forecast and a negative performance is resulted.\\nDuring the measurement period (which is the period required to obtain all necessary information that existed at the acquisition date, or to conclude that such information is unavailable, not to exceed one year), additional assets or liabilities may be recognized, or there could be changes to the amounts of assets or liabilities previously recognized on a preliminary basis, if new information is obtained about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of these assets or liabilities as of that date. No additional assets or liabilities were recognized during the measurement period, or the changes to the amounts of assets or liabilities previously recognized.\\nOn September 30, 2021, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $75,000 cash consideration and $558,000 equity incentive. The said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021.\\nNOTE－5 REVENUE\\nRevenue consisted of the following deliverables:\\n\\n| Schedule of Revenue |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Hardware sales | $ | — | $ | 585 | $ | 335 | $ | 3,510 |\\n| Software subscription | 10,016 | 11,044 | 26,970 | 37,752 |\\n| Sales – online ordering | 73,518 | — | 73,518 | — |\\n| $ | 83,534 | $ | 11,629 | $ | 100,823 | $ | 41,262 |\\n\\n\\n| 23 |\\n\\nIn accordance with ASC 280, Segment Reporting (“ASC 280”), we have two reportable geographic segments:\\nSoftware License Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\\n\\n| Schedule of geographic segments |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Indonesia | $ | 10,016 | $ | 9,788 | $ | 24,813 | $ | 31,604 |\\n| Vietnam | — | 1,841 | 2,492 | 9,658 |\\n| $ | 10,016 | $ | 11,629 | $ | 27,305 | $ | 41,262 |\\n\\nOnline Ordering Revenues. Sales are based on the countries in which the customer is located. Summarized financial information concerning our geographic segments is shown in the following tables:\\n\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Indonesia | $— | $— | $— | $— |\\n| Vietnam | 73,518 | — | 73,518 | — |\\n| $ | 73,518 | $ | — | $ | 73,518 | $ | — |\\n\\nContract liabilities recognized was related to software sales only and the following is reconciliation for the periods:\\n\\n| Schedule of Contract liabilities |\\n| Period ended September 30, 2021 | Year ended December 31, 2020 |\\n| (Unaudited) |\\n| Contract liabilities, brought forward | $ | 18,646 | $ | 19,843 |\\n| Add: recognized as deferred revenue | 35,582 | 47,090 |\\n| Less: recognized as current period/year revenue | ( 18,646 | ) | ( 48,287 | ) |\\n| Contract liabilities, carried forward | $ | 35,582 | $ | 18,646 |\\n\\nNOTE－6 INTANGIBLE ASSETS\\nAs of September 30, 2021 and December 31, 2020, intangible assets consisted of the following:\\n\\n| Schedule of intangible assets |\\n| Useful life | September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| At cost: |\\n| Software platform | 2.5 years | $ | 8,000,000 | $ | 8,000,000 |\\n| Other intangible assets | 3 – 5 years | 1,725 | 1,725 |\\n| 8,001,725 | 8,001,725 |\\n| Less: accumulated amortization | ( 3,201,725 | ) | ( 801,725 | ) |\\n| $ | 4,800,000 | $ | 7,200,000 |\\n\\n\\n| 24 |\\n\\nOn November 1 2018, the Company entered software development agreement with CVO Advisors Pte Ltd (CVO) 2018 to design and build App and Web-based platform for the total consideration of $8,000,000. CVO who is a third party vendor in the business of designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms in Asia. The CVO developer performed and accepted technical work, of software development phase, which was materially completed by December 23, 2018. The Company obtained a third party license (Wallet Factory International Ltd) for their technology build up by CVO.\\nThe delivered platform was further developed by the Company’s in-house technology team (based in Noida that Sopa is currently using for the loyalty platform. The platform can be downloaded from Apple store or Googleplay store (i.e. SoPaApp) and the Company’s web version is on www.sopa.asia. The platform was completed developed on September 30, 2020 and has estimated life of 2.5 years. The platform started to be amortized from October 1, 2020.\\nFurther, the Company entered subscription agreement with CVO to issued 8,000 shares of preferred stocks for the software development, equal to the aggregate of $ 8,000,000 or at the stated value of $ 1,000 per share.\\nPursuant to the subscription agreement entered with CVO, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software development at the stated value of $ 1,000 per share, totaling $8,000,000. CVO performed and accepted the technical work such as designing, developing, operating computer software applications including mobile and web application for social media, big data, point of sales, loyalty rewards, food delivery and technology platforms. The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\\nAlso, owner of CVO entered into call option agreement with the CEO of the Company to sale all the shares of CVO for the sum of $10 per share, as of date, these options were exercised by the CEO of the Company, but the equity holders of CVO Advisors Pte. Ltd. have not honored the exercise of the call. The parties are currently in litigation (refer Note 19). As a result of this option exercise, there was no accounting effect on the Company’s financial statement during the period ended September 30, 2021.\\nAmortization of intangible assets attributable to future periods is as follows:\\n\\n| Schedule of Amortization of intangible assets |\\n| Year ending December 31: | Amount |\\n| 2021 (remaining period) | $ | 800,000 |\\n| 2022 | 3,200,000 |\\n| 2023 | 800,000 |\\n| Total | $ | 4,800,000 |\\n\\nAmortization of intangible assets was $ 2,400,000 and $ 1,479 for the nine months ended September 30, 2021 and 2020, respectively.\\nAmortization of intangible assets was $ 800,000 and $ 0 for the three months ended September 30, 2021 and 2020, respectively.\\nNOTE－ 7 PROPERTY, PLANT AND EQUIPMENT\\nProperty, plant and equipment consisted of the following:\\n\\n| Schedule of Property plant and equipment |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| At cost: |\\n| Computer | $ | 29,206 | $ | 29,206 |\\n| Office equipment | 1,721 | 1,721 |\\n| 30,927 | 30,927 |\\n| Less: accumulated depreciation | ( 19,403 | ) | ( 12,755 | ) |\\n| Less: exchange difference | ( 444 | ) | ( 103 | ) |\\n| $ | 11,080 | $ | 18,069 |\\n\\nDepreciation expense for the nine months ended September 30, 2021 and 2020 were $ 6,648 and $ 2,968 , respectively.\\nDepreciation expense for the three months ended September 30, 2021 and 2020 were $ 2,197 and $ 714 , respectively.\\n\\n| 25 |\\n\\nNOTE— 8 ASSET PURCHASE AGREEMENT\\nOn February 16, 2021, the Company subsidiary SoPa Technology Pte Ltd (“SoPa Pte Ltd”) acquired certain e-commerce assets from Goodventures Sea Limited (“Goodventures”) pursuant to an Asset Purchase Agreement dated February 16, 2021 (the “Leflair Purchase Agreement”). The acquired assets consisted of intellectual property for it lifestyle e-commerce retail business.\\nAs consideration for entering into the Asset Purchase Agreement, the Company agreed to pay Goodventure a total of $ 200,000 in cash payable in installments until April 16, 2021 and 1,500 ordinary shares of SoPa Pte Ltd by April 16, 2021, which represent 15% of the outstanding share capital of SoPa Technology Pte Ltd.\\nThe assets acquired by SoPa Pte Ltd under the Leflair Purchase Agreement were substantially all of the assets of an online retail platform that carried the “Leflair” brand name and included a Leflair e-commrce website, Leflair iOs and Android Apps, and backend end infrastructure as well as marketing properties including a customer list and social media pages. In addition, SoPa Technology Ptd Ltd acquired intellectual property such as Leflair logos, trademarks and brands.\\nThe Company accounted for this acquisition as an asset acquisition under ASC 805 and that the Company has early adopted the amendments of Regulation S-X dated May 21, 2020 and has concluded that this acquisition was not significant. Accordingly, the presentation of the assets acquired, historical financial statements under Rule 3-05 and related pro forma information under Article 11 of Regulation S-X, respectively, are not required to be presented.\\n\\n| Schedule of Asset acquisition |\\n| Acquired assets: |\\n| Intellectual property | $ | 200,000 |\\n| Less: Assumed liabilities |\\n| Accrued liabilities and other payable | — |\\n| Fair value of net assets acquired | 200,000 |\\n| Impairment loss recorded | ( 200,000 | ) |\\n| Net asset value | $ | — |\\n\\nThe purchase price of $200,000 shall be allocated amongst the intangible assets acquired, further, these intangible have a short term life as well as the quantum of the value, the company decided to expense it and accounted $ 0 - and $ 200,000 as impairment loss during the three and nine months ended September 30, 2021.\\nThe shares issued as part of this transaction do not give the holders the right to influence or control SoPa Pte Ltd. The holders do not have any special voting rights or the right to appoint any board members. SoPa Pte Ltd has not yet issued the shares to the future holders. Since the shares of SoPa Pte Ltd have not yet been issue, no minority interest needs to be recorded as of September 30, 2021.\\n\\n| 26 |\\n\\nSoPa Pte Ltd is a private company that was incorporated under the laws of Singapore on June 6, 2019. SoPa Pte Ltd manages Society Pass Incorporated’s operating activities in SEA countries and South Asia. As a pass-through holding company, the value of the 15% interest in the SoPa Pte Ltd to be issued to LeFlair owners has an indeterminate value and no real current value. Society Pass Incorporated plans to record the issuance of the shares at the nominal par value of the shares to be issued to the holders. The value of the assets acquired shall be the value of the cash paid and to be paid to the sellers.\\nThe Company has paid $ 200,000 during the period ended September 30, 2021.\\nNOTE－9 AMOUNTS DUE FROM (TO) RELATED PARTIES\\nAmounts due to related parties consisted of the following:\\n\\n| Schedule of Amount due to related parties |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| Amounts due to related parties (a) | $ | 24,763 | $ | 96,940 |\\n| Amounts due to shareholders (b) | — | 738,964 |\\n| Amount due to a director (c) | — | 735,833 |\\n| $ | 24,763 | $ | 1,571,737 |\\n\\n(a) The amounts represented temporary advances to the Company including related parties (two officers), which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to related parties balance was $ 24,763 and $ 96,940 as of September 30, 2021 and December 31, 2020, respectively.\\n(b) In February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\\nThis amounts represented temporary advances to the Company by shareholder, which were unsecured, interest-free and had no fixed terms of repayments. On September 30, 2021, the Company received the notifications that the outstanding amounts of $ 738,964 were forgiven by the related parties, the said amount was written off and accounted as capital transaction and therefore credited the additional paid in capital account as of September 30, 2021. The Company’s due to a shareholder balance was $ 0 and $ 738,964 as of September 30, 2021 and December 31, 2020, respectively. Imputed interest is charged at 4.5 % per annum, which was amounted to $ 36,380 and $ 36,381 for the nine months ended September 30, 2021 and 2020, respectively.\\n(c) The amount represented paid salaries and bonus to the Director which was unsecured, interest-free and had no fixed terms of repayments. As of June 30, 2021, the Director had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares. During the period ended September 30, 2021, the Company issued those shares at the fair value of $ 3,854,908 , results into the additional compensation expenses of $ 2,894,075 accounted under stock based compensation account. The Company’s due to a director balance was $- 0 and $ 735,833 as of September 30, 2021 and December 31, 2020, respectively.\\n\\n| 27 |\\n\\nAmounts due from related parties\\nThe director has advance $ 97,500 during the period ended September 30, 2021, subsequently as of date, the same was recovered by the Company.\\nNOTE－10 ACCOUNTS PAYABLE AND ACCRUED LIABILITIES\\nAccounts payable consisted of the following:\\n\\n| Schedule of Accounts payable |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| Accounts payable | $ | 104,680 | $ | 54,256 |\\n| Accrued liabilities and other payables- Related Party (a) | 224,669 | 197,548 |\\n| Accrued liabilities and other payables (b) | 527,971 | 480,024 |\\n| Total Accounts payable | $ | 857,320 | $ | 731,828 |\\n\\n(a) The amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 21,701 , $ 70,104 and $ 132,864 , respectively as of September 30, 2021.\\nThe amount represented due to three related parties in respect to unpaid salaries, unpaid legal fees and unpaid consulting fees amounted to $ 5,000 , $ 112,692 and $ 79,856 , respectively as of December 31, 2020.\\n(b) Accrued liabilities and other payables consisted of the following:\\n\\n| Schedule of Accrued liabilities |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| Accrued payroll | $ | 54,528 | $ | 58,092 |\\n| Other accrual | 154,325 | 146,826 |\\n| Other payables (c) | 245,000 | 245,000 |\\n| Accrued vat expenses | 19,932 | 1,788 |\\n| Accrued taxes | 54,186 | 28,318 |\\n| Total Accrued liabilities | $ | 527,971 | $ | 480,024 |\\n\\n(c) This included $75,000 related to SOSV. In January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. The Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 156 shares of preferred stock series C to Hottab Holding Limited for the 100% acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 outstanding on this account, respectively. (refer footnote#19 for legal update).\\n\\n| 28 |\\n\\nNOTE－11 LEASES\\nWe adopted ASU No. 2016-02, Leases, on January 1, 2019, the beginning of our fiscal 2019, using the modified retrospective approach. We determine whether an arrangement is a lease at inception. This determination generally depends on whether the arrangement conveys the right to control the use of an identified fixed asset explicitly or implicitly for a period of time in exchange for consideration. Control of an underlying asset is conveyed if we obtain the rights to direct the use of and to obtain substantially all of the economic benefit from the use of the underlying asset. Some of our leases include both lease and non-lease components which are accounted for as a single lease component as we have elected the practical expedient. Some of our operating lease agreements include variable lease costs, primarily taxes, insurance, common area maintenance or increases in rental costs related to inflation. Substantially all of our equipment leases and some of our real estate leases have terms of less than one year and, as such, are accounted for as short-term leases as we have elected the practical expedient.\\nOperating leases are included in the right-of-use lease assets, other current liabilities and long-term lease liabilities on the Consolidated Balance Sheet. Right-of-use assets and lease liabilities are recognized at each lease’s commencement date based on the present values of its lease payments over its respective lease term. When a borrowing rate is not explicitly available for a lease, our incremental borrowing rate is used based on information available at the lease’s commencement date to determine the present value of its lease payments. Operating lease payments are recognized on a straight-line basis over the lease term. We had no financing leases as of September 30, 2021 and December 31, 2020.\\nThe Company adopts a 5.26 % as weighted average incremental borrowing rate to determine the present value of the lease payments. The weighted average remaining life of the lease was 3.48 year.\\nDuring the period ended September 30, 2021, the Company enter into new lease arrangements, and accounted as per ASC 842, the ROU asset and lease obligation of $ 479,171 .\\nThe Company excludes short-term leases (those with lease terms of less than one year at inception) from the measurement of lease liabilities or right-of-use assets. The following tables summarize the lease expense for the period ended September 30:\\n\\n| Schedule of Lease expenses |\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Operating lease expense (per ASC 842) | $ | 13,554 | $ | 6,076 | $ | 31,975 | $ | 21,802 |\\n| Short-term lease expense (other than ASC 842) | 63,363 | 4,627 | 66,420 | 31,258 |\\n| Total lease expense | $ | 76,917 | $ | 10,703 | $ | 98,395 | $ | 53,060 |\\n\\nAs of September 30, 2021, right-of-use assets were $ 529,782 and lease liabilities were $ 533,312 .\\nAs of December 31, 2020, right-of-use assets were $ 79,109 and lease liabilities were $ 83,205 .\\nComponents of Lease Expense\\nWe recognize lease expense on a straight-line basis over the term of our operating leases, as reported within “general and administrative” expense on the accompanying consolidated statement of operations.\\nFuture Contractual Lease Payments as of September 30, 2021\\nThe below table summarizes our (i) minimum lease payments over the next five years, (ii) lease arrangement implied interest, and (iii) present value of future lease payments for the next three years ending September 30:\\n\\n| Schedule of Future Contractual Lease Payments |\\n| Years ended September 30, | Operating lease amount |\\n| 2022 | $ | 190,025 |\\n| 2023 | 166,530 |\\n| 2024 | 147,813 |\\n| 2025 | 77,997 |\\n| Total | 582,365 |\\n| Less: interest | ( 49,053 | ) |\\n| Present value of lease liabilities | $ | 533,312 |\\n| Less: non-current portion | ( 365,539 | ) |\\n| Present value of lease liabilities – current liability | $ | 167,773 |\\n\\n\\n| 29 |\\n\\nNOTE－12 SHAREHOLDERS’ DEFICIT\\nAuthorized stock\\nThe Company is authorized to issue two classes of stock. The total number of shares of stock which the Company is authorized to issue is 100,000,000 shares of capital stock, consisting of 95,000,000 shares of common stock, $ 0.0001 par value per share, and 5,000,000 shares of preferred stock, $ 0.0001 par value per share.\\nThe holders of the Company’s common stock are entitled to the following rights:\\nVoting Rights: Each share of the Company’s common stock entitles its holder to one vote per share on all matters to be voted or consented upon by the stockholders. Holders of the Company’s common stock are not entitled to cumulative voting rights with respect to the election of directors.\\nDividend Right: Subject to limitations under Nevada law and preferences that may apply to any shares of preferred stock that the Company may decide to issue in the future, holders of the Company’s common stock are entitled to receive ratably such dividends or other distributions, if any, as may be declared by the Board of the Company out of funds legally available therefor.\\nLiquidation Right:. In the event of the liquidation, dissolution or winding up of our business, the holders of the Company’s common stock are entitled to share ratably in the assets available for distribution after the payment of all of the debts and other liabilities of the Company, subject to the prior rights of the holders of the Company’s preferred stock.\\nOther Matters: The holders of the Company’s common stock have no subscription, redemption or conversion privileges. The Company’s common stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s common stock are fully paid and non-assessable. The rights, preferences and privileges of the holders of the Company’s common stock are subject to the rights of the holders of shares of any series of preferred stock which the Company may issue in the future.\\nCommon stock outstanding\\nAs of September 30, 2021 and December 31, 2020, the Company had a total of 9,695,480 and 7,413,600 shares of its common stock issued and outstanding, respectively.\\nOn February 10, 2021, the Company effected a 750 for 1 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the forward stock split.\\nOn September 21, 2021, the Company effected a 1 for 2.5 stock split of the issued and outstanding shares of the Company’s common stock. The number of authorized shares and par value remain unchanged. All share and per share information in this financial statements and footnotes have been retroactively adjusted for the periods presented, unless otherwise indicated, to give effect to the reverse stock split.\\n\\n| 30 |\\n\\nAn additional result of the stock split was that the stated value of preferred stock, the number of designated shares and outstanding shares of each series of preferred stock was unchanged in accordance to the respective certificate of designations. The number of authorized shares of preferred stock remained unchanged.\\nDuring the period ended September 30, 2021 and 2020, the Company issued 824,250 and 1,014,900 shares of common stock for employee services for the value of $ 1,707,557 and $ 1,023,494 , respectively.\\nDuring the period ended September 30, 2021 and 2020, the Company issued 1,157,630 and 0 shares of common stock for director’s accrued salaries for the value of $ 960,834 and $ 0 , respectively. The Company accounted $ 2,894,075 additional cost on these share issuance as loss on fair value of shares issued in 2021.\\nDuring the period ended September 30, 2021 and 2020, the Company issued 450,000 and 0 shares of common stock for director’s bonus for the value of $ 3,442,499 and $ 0 , respectively.\\nDuring the period ended September 30, 2021 and 2020, the Company cancelled 150,000 and 0 shares of common stock at par value.\\nWarrants\\nIn August 2019, the Company issued 21,000 shares of warrants to one employee for compensation of his service to purchase 21,000 shares of its common stock for the fair value of $17,500. Each share of warrant is converted to one share of common stock at an exercise price of $0.0001. The warrants will expire on the second (2nd) anniversary of the initial date of issuance. As at December 31, 2019, none of the warrants have been exercised. 21,000 shares fully exercised during the year ended December 31, 2020.\\nIn December 2020, the Company issued certain numbers of warrants pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant is entitled the holder to purchase one C-1 preferred share at a price of $ 420 per share. The warrants shall be exercisable on or before December 31, 2020 and September 30, 2021. During the nine months ended September 30, 2021, the Company issued 2,120 warrants. During the nine months ended September 30, 2020, the Company issued 1,824 warrants.\\nIn December 2020, a total of 838 warrants are exercised in exchanged to 838 Series C-1 preferred shares. (refer note 13 for details).\\nOn April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by nine months from the expiration date of September 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\\nThe Company determined the fair value using the Black-Scholes option pricing model with the following assumptions for the period ended September 30, 2021 and year ended December 31, 2020:\\n\\n| Schedule of Stock option assumptions |\\n| September 30, 2021 | December 31, 2020 |\\n| Dividend rate | 0 | % | 0 | % |\\n| Risk-free rate | 2 | % | 2 | % |\\n| Weighted average expected life (years) | 9 months | 9 months |\\n| Expected volatility | 0 | % | 0 | %(a) |\\n| Share price | $ | 0.22 | $ | 0.22 |\\n\\n\\n| (a) | The Company considered no volatility as from inception through the date there is very minimal transaction of the Company common stock. |\\n\\n\\n| 31 |\\n\\nBelow is a summary of the Company’s issued and outstanding warrants as of September 30, 2021 and December 31, 2020:\\n| Schedule of warrants issued and outstanding |\\n| Warrants | Weighted average exercise price | Weighted average remaining contractual life (in years) |\\n| Outstanding as of December 31, 2019 (a) | 21,000 | $ | 0.0001 | 1.3 |\\n| Issued (b) | 4,094 | $ | 420 | 0.9 |\\n| Exercised | ( 21,838 | ) | $ | ( 6.34 | ) | 1 |\\n| Expired | ( 1,209 | ) | $ | ( 420 | ) | ( 0.6 | ) |\\n| Outstanding as of December 31, 2020 | 2,047 | $ | 420 | 0.6 |\\n| Issued (b) | 2,120 | $ | 420 | 0.5 |\\n| Exercised | ( 238 | ) | $ | ( 420 | ) | — |\\n| Expired | — | — | — |\\n| Outstanding as of September 30, 2021 (b) | 3,929 | $ | 420 | 0.5 |\\n\\nThere is no intrinsic value for warrants as of September 30, 2021 and December 31, 2020.\\n\\n| (a) | Common stock will be issued if those warrants exercise. |\\n\\n\\n| (b) | Preferred stock series C-1 will be issued if those warrants exercise. |\\n\\nNOTE－13 PREFERRED STOCKS AND WARRANTS\\nAs of September 30, 2021 and December 31, 2020, the Company’s preferred stocks have been designated as follow:\\n\\n| Schedule of Preferred stocks |\\n| No. of shares | Stated Value |\\n| Series A Convertible Preferred Stock | 10,000 | $ | 1,000 |\\n| Series B Convertible Preferred Stock | 10,000 | $ | 1,336 |\\n| Series B-1 Convertible Preferred Stock | 15,000 | $ | 2,917 |\\n| Series C Convertible Preferred Stock | 15,000 | $ | 5,763 |\\n| Series C-1 Convertible Preferred Stock | 30,000 | $ | 420 |\\n| Series X Super Voting Preferred Stock | 3,500 | $ | 0.0001 |\\n\\nAll of the Series A, B, B-1, C, and C-1 Preferred Shares were issued at a value of respective stated value per share. These all Series of Preferred Shares contain a conversion option, are convert into a fixed number of common shares or redeemable with the cash repayment at the liquidation, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the all these Series of Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\\nSeries X Super Voting Preferred Stock was issued a par value per share. This Series of Preferred Shares does not contain a conversion option, so as a result of this liquidation preference, under U.S GAAP, the Company has classified the this Series of Preferred Shares within permanent equity in the condensed consolidated balance sheet.\\nVoting Rights: (1) The affirmative vote of at least a majority of the holders of each series of preferred stock shall be necessary to:\\n\\n| (a) | increase or decrease the par value of the shares of the Series A Preferred Stock, alter or change the powers, preferences or rights of the shares of Series A Preferred Stock or create, alter or change the powers, preferences or rights of any other capital stock of the Company if after such alteration or change such capital stock would be senior to or pari passu with Series A Preferred Stock; and |\\n\\n\\n| (a) | adversely affect the shares of Series A Preferred Stock, including in connection with a merger, recapitalization, reorganization or otherwise. |\\n\\n\\n| 32 |\\n\\n(2) The affirmative vote of at least a majority of the holders of the shares of the Series A Preferred Stock shall be necessary to:\\n\\n| (a) | enter into a transaction or series of related transactions deemed to be a liquidation, dissolution or winding up of the Corporation, or voluntarily liquidate or dissolve; |\\n\\n\\n| (b) | authorize a merger, acquisition or sale of substantially all of the assets of the Company or any of its subsidiaries (other than a merger exclusively to effect a change of domicile of the Company to another state of the United States); |\\n\\n\\n| (c) | increase or decrease (other than decreases resulting from conversion of the Series A Preferred Stock) the authorized number of shares of the Company’s preferred stock or any series thereof, the number of shares of the Company’s common stock or any series thereof or the number of shares of any other class or series of capital stock of the Company; and |\\n\\n\\n| (d) | any repurchase or redemption of capital stock of the Company except any repurchase or redemption at cost upon the termination of services of a service provider to the Company or the exercise by the Company of contractual rights of first refusal as applied to such capital stock. |\\n\\nDividend Rights: The holders of the Company’s preferred stock are not entitled to any dividend rights.\\nConversion Rights (Series A Preferred Stock): Upon the consummation of this offering, the issued and outstanding shares of Series A Preferred Stock automatically convert into a number of shares of the Company’s common stock equal to the quotient obtained by dividing (x) the aggregate Stated Value of the issued and outstanding Series A Preferred Stock plus any other amounts due to the holders thereof divided by (y) the offering price of the Company’s common stock. If 90 days after conversion, the closing market price of the Company’s common stock as quoted on Nasdaq (the “Market Value”) has decreased below the initial public offering price, each holder of the Series A Preferred Stock shall be issued a warrant to purchase a number of shares of the Company’s common stock equal to 40% of the quotient of the (a) aggregate Stated Value held by such holder before conversion at the initial public offering price and the Market Value of the shares of common stock that were issuable upon conversion divided by (b) the Market Value. The warrants shall have a term of five years and shall be exercisable at the Market Value.\\nConversion Rights (Preferred Stock other than Series A and Series X Super Voting Preferred Stock): Upon the consummation of this offering, each issued and outstanding share of Series B Preferred Stock, Series B-1 Preferred Stock, Series C Preferred Stock and Series C-1 Preferred Stock will automatically convert into 750 shares of the Company’s common stock. Series X Super Voting Preferred stock shall not have any rights to convert into the Company’s common stock.\\nLiquidation Rights: In the event of any liquidation, dissolution or winding up of the Company, either voluntary or involuntary (a \\\"Liquidation Event\\\"), the holders of each series of preferred stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Company to the holders of the Company’s common stock by reason of their ownership thereof, an amount per share in cash equal to the greater of (x) the aggregate Stated Value for all shares of such series of Preferred Stock then held by then or (y) the amount payable per share of the Company’s common stock which such holder of preferred stock would have received if such holder had converted to common stock immediately prior to the Liquidation Event all of such series of preferred stock then held by such holder (the \\\"Series Stock Liquidation Preference\\\"). If, upon the occurrence of a Liquidation Event, the funds thus distributed among the holders of the preferred stock shall be insufficient to permit the payment to the holders of the preferred stock the full Series Stock Liquidation Preference for all series, then the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the holders of the preferred stock in proportion to the aggregate Series Liquidation Preferences that would otherwise be payable to each of the holders of preferred stock. Such payment shall constitute payment in full to the holders of the preferred stock upon the Liquidation Event. After such payment shall have been made in full, or funds necessary for such payment shall have been set aside by the Company in trust for the account of the holders of preferred stock, so as to be immediately available for such payment, such holders of preferred stock shall be entitled to no further participation in the distribution of the assets of the Company. The sale of all or substantially all of the assets of the Company, or merger, tender offer or other business combination to which the Company is a party in which the voting stockholders of the Company prior to such transaction do not own a majority of the voting securities of the resulting entity or by which any person or group acquires beneficial ownership of 50% or more of the voting securities of the Company or resulting entity shall be deemed to be a Liquidation Event.\\n\\n| 33 |\\n\\nOther Matters: The holders of the Company’s preferred stock have no subscription or redemption privileges and are not subject to redemption. The Company’s Series Preferred Stock does not entitle its holders to preemptive rights. All of the outstanding shares of the Company’s preferred stock are fully paid and non-assessable.\\nSeries A Preferred Shares\\nDuring the year ended December 31, 2018, the Company issued 8,000 shares of Series A convertible preferred stock for the purchase of software at the stated value of $ 1,000 per share, totaling $ 8,000,000 . The holder of this series A provided their consent to waive the warrant provision available with them and accordingly the preferred series A accounted in 2018.\\nThere was no Series A Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\\nAs of September 30, 2021 and December 31, 2020, there were 8,000 and 8,000 shares of Series A Preferred Shares issued and outstanding, respectively.\\nSeries B Preferred Shares\\nThere was no Series B Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\\nAs of September 30, 2021 and December 31, 2020, there were 2,548 and 2,548 shares of Series B Preferred Shares issued and outstanding, respectively.\\nSeries B-1 Preferred Shares\\nThere was no Series B-1 Preferred Shares issued during the nine months ended September 30, 2021 and 2020.\\nAs of September 30, 2021 and December 31, 2020, there were 160 and 160 shares of Series B-1 Preferred Shares issued and outstanding, respectively.\\nSeries C Preferred Shares\\nDuring the nine months ended September 30, 2021, the Company issued 1,116 and 74 shares of Series C preferred stock for cash in private placement and consulting services for the value of $ 6,431,508 and $ 426,462 , respectively.\\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above Series C private placement accounted $ 195,942 in shares and $ 460,361 in cash.\\nThere was no Series C Preferred Shares issued during the nine months ended September 30, 2020.\\nAs of September 30, 2021 and December 31, 2020, there were 1,552 and 362 shares of Series C Preferred Shares issued and outstanding, respectively.\\nSeries C-1 Preferred Shares\\nThe Company accounts for warrants issued in accordance with the guidance on “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” in Topic 480. These warrants did not meet the criteria to be classified as a liability award and therefore were treated as an equity award and classified the Series C-1 Preferred Shares within mezzanine equity in the condensed consolidated balance sheet.\\n\\n| 34 |\\n\\nDuring the period ended September 30, 2021, the Company issued 6,235 and 4,864 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 2,618,700 (out of which $479,640 is received subsequent to September 30, 2021) and $ 2,042,880 , respectively.\\nDuring the nine months ended September 30, 2021, the Company incurred the issuance cost on above series C-1 private placement accounted $ 245,700 in shares and $ 90,748 in cash. There is no issuance cost incurred in 2020.\\nDuring the period ended September 30, 2020, the Company issued 1,688 and 571 shares of Series C-1 preferred stock for cash in private placement and consulting services for the value of $ 708,960 and $ 239,820 , respectively.\\nAs of September 30, 2021 and December 31, 2020, there were 13,984 and 2,885 shares of Series C-1 Preferred Shares issued and outstanding, respectively.\\nSeries X Super Voting Preferred Shares\\nIn August 2021, the Company created a new series of preferred stock to be titled “Series X Super Voting Preferred Stock,” consisting of 2,000 shares and to provide to such preferred stock certain rights and privileges including but not limited to the right to 10,000 votes per share (post reverse split: 4,000 votes per share) to vote on all matters that may come before the stockholders of the Corporation, voting together with the common stock as a single class on all matters to be voted or consented upon by the stockholders but is not entitled to any dividends, liquidation preference or conversion or redemption rights, so accordingly it is accounted as an equity classification. In September 2021, the Company increased the number of shares designated as Series X Super Voting Preferred to 3,500.\\nDuring the period ended September 30, 2021 and 2020, the Company issued 3,500 and 0 shares of Series C-preferred stock at par value, respectively.\\nAs of September 30, 2021 and December 31, 2020, there were 3,500 and 0 shares of Series C Preferred Shares issued and outstanding, respectively.\\nNOTE－ 14 INCOME TAXES\\nFor the nine months ended September 30, 2021 and 2020, the local (“Nevada”) and foreign components of loss before income taxes were comprised of the following:\\n\\n| Schedule of Loss before income tax |\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Tax jurisdiction from: |\\n| - Local | $ | 14,272,684 | $ | — |\\n| - Foreign | 1,246,371 | 2,507,042 |\\n| Loss before income taxes | $ | 15,519,055 | $ | 2,507,042 |\\n\\nThe provision for income taxes consisted of the following:\\n\\n| Schedule of provision for income taxes |\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Current: |\\n| - United States | $ | — | $ | — |\\n| - Singapore | — | — |\\n| - Vietnam | — | — |\\n| - India | 9,943 | 15,069 |\\n| Deferred: |\\n| - United States | — | — |\\n| - Singapore | — | — |\\n| - Vietnam | — | — |\\n| - India | — | — |\\n| Income tax expense | $ | 9,943 | $ | 15,069 |\\n\\n\\n| 35 |\\n\\nThe effective tax rate in the years presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rate. The Company operates in various countries: Singapore and Vietnam that are subject to taxes in the jurisdictions in which they operate, as follows:\\nUnited States\\nThe Company is registered in the Nevada and is subject to the tax laws of United States.\\nAs of September 30, 2021, the operation in the United states incurred $ 25,094,900 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 5,269,929 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\\nSingapore\\nThe Company’s subsidiary is registered in the Republic of Singapore and is subject to the tax laws of Singapore.\\nAs of September 30, 2021, the operation in the Singapore incurred $ 1,437,668 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards has no expiration. The Company has provided for a full valuation allowance against the deferred tax assets of $ 230,027 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\\nVietnam\\nThe Company’s subsidiary operating in Vietnam is subject to the Vietnam Income Tax at a standard income tax rate of 20 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\\n\\n| Schedule of Effective Income Tax Rate Reconciliation |\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Loss before income taxes | $ | ( 450,407 | ) | $ | ( 233,689 | ) |\\n| Statutory income tax rate | 20 | % | 20 | % |\\n| Income tax expense at statutory rate | ( 90,081 | ) | ( 46,738 | ) |\\n| Tax effect of allowance | 90,081 | 46,738 |\\n| Income tax expense | $ | — | $ | — |\\n\\nAs of September 30, 2021, the operation in the Vietnam incurred $ 859,275 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards begin to expire in 2026, if unutilized. The Company has provided for a full valuation allowance against the deferred tax assets of $ 171,855 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future.\\nIndia\\nThe Company’s subsidiary operating in India is subject to the India Income Tax at a standard income tax rate of 25 % during its tax year. The reconciliation of income tax rate to the effective income tax rate for the nine months ended September 30, 2021 and 2020 is as follows:\\n\\n| Nine months ended September 30, |\\n| 2021 | 2020 |\\n| Income before income taxes | $ | 17,716 | $ | ( 182,363 | ) |\\n| Statutory income tax rate | 25 | % | 15 | % |\\n| Income tax expense at statutory rate | 4,429 | ( 27,354 | ) |\\n| Tax effect of allowance | 5,514 | 42,423 |\\n| Income tax expense | $ | 9,943 | $ | 15,069 |\\n\\n\\n| 36 |\\n\\nAs of September 30, 2021, the operation in the India incurred $ 17,716 of net operating gain. The Company has provided for a full tax effect allowance against the current and deferred tax expenses of $ 9,943 .\\nThe following table sets forth the significant components of the deferred tax assets and liabilities of the Company as of September 30, 2021 and December 31, 2020:\\n\\n| Schedule of Deferred Tax Assets and Liabilities |\\n| September 30, 2021 | December 31, 2020 |\\n| (Unaudited) |\\n| Deferred tax assets: |\\n| Net operating loss carryforwards |\\n| - United States | $ | 5,269,929 | $ | 2,171,941 |\\n| - Singapore | 230,027 | 131,985 |\\n| - Vietnam | 171,855 | 81,774 |\\n| - India | — | — |\\n| 5,671,811 | 2,385,700 |\\n| Less: valuation allowance | ( 5,671,811 | ) | ( 2,385,700 | ) |\\n| Deferred tax assets, net | $ | — | $ | — |\\n\\nNOTE－ 15 PENSION COSTS\\nThe Company is required to make contribution to their employees under a government-mandated defined contribution pension scheme for its eligible full-times employees in all countries operating in the Company. The Company is required to contribute a specified percentage of the participants’ relevant income based on their ages and wages level. During the nine months ended September 30, 2021 and 2020, $ 9,655 and $ 5,199 contributions were made accordingly. During the three months ended September 30, 2021 and 2020, $ 5,669 and $ 3,463 contributions were made accordingly.\\nNOTE－ 16 RELATED PARTY TRANSACTIONS\\nFrom time to time, the shareholder and director of the Company advanced funds to the Company for working capital purpose. Those advances are unsecured, non-interest bearing and due on demand.\\nDuring the three month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 2,854 and 571 shares of Series C-1 preferred stock, at the price of $ 1,198,680 and $ 239,820 , respectively.\\nDuring the nine month ended September 30, 2021 and 2020, the Company rendered the consultancy service with related parties for the issuance of 4,314 and 571 shares of Series C-1 preferred stock, at the price of $ 1,811,880 and $ 239,820 , respectively.\\nThe Company paid and accrued to the directors, the total salaries of $ 196,108 and $ 22,529 and 201,588 and $ 0 during the three months ended September 30, 2021 and 2020, respectively.\\nThe Company paid and accrued to the directors, the total salaries of $ 611,193 and $ 22,529 and $ 604,378 and $ 0 during the nine months ended September 30, 2021 and 2020, respectively.\\n\\n| 37 |\\n\\nDuring the three months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $12,570,943 and $ 810,000 for the stock based compensation to director and employee, respectively.\\nDuring the nine months ended September 30, 2021 and 2020, the Company issued 2,134,042 and 3000 shares of Common stock, at the price of $ 12,570,943 and 810,000 for the stock based compensation to director and employee, respectively.\\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 5,785 and $ 1,259 and $ 8,310 and $ 1,300 during the three months ended September 30, 2021 and 2020, respectively.\\nThe company subsidiaries paid and accrued their two officers, total professional fee of $ 10,307 and $ 1,259 and $ 35,898 and $ 1,300 during the nine months ended September 30, 2021 and 2020, respectively.\\nThe Company paid and accrued its shareholders, total professional fee of $ 151,342 and $ 102,412 and $ 31,341 and $ 21,000 during the three months ended September 30, 2021 and 2020, respectively.\\nThe Company paid and accrued its shareholders, total professional fee of $ 378,785 and $ 123,412 and $ 102,979 and $ 56,0000 during the nine months ended September 30, 2021 and 2020, respectively.\\nDuring August and September 2021, the Company issued 3,300 shares of its Series X Super Voting Preferred Stock (the “Super Voting Preferred Stock”) to the founder and Chief Executive Officer, Mr. Dennis Nguyen and 200 shares of the Super Voting Preferred Stock to Chief Financial Officer, Mr. Raynauld Liang.\\nIn August 2021, the Company approved the conversion of Inter-Company loan of $1,249,999 due and owing by Sopa Technology PTE. LTD. (“STPL”), by exchange of 8,500 shares of STPL which represents 85% of the total issued and paid-up capital of STPL on a fully diluted basis.\\nOn September 30, 2021, the Company received the notifications that the outstanding amounts of $ 72,176 and $ 738,964 were forgiven by the related parties. Also, the Company served the notification to a related party that certain terms under call option agreement and side letter were no longer effective, in case of non-fulfillment with the milestone conditions as set out in the agreements amounts of $ 75,000 cash consideration and $ 558,000 equity incentive.\\nAs of June 30, 2021, Mr. Nguyen had $ 960,833 in accrued, but unpaid compensation which could be converted to shares by dividing that amount by the employment agreement conversion price of $ 0.83 to produce 1,157,630 shares.\\nHOTTAB Asset Vietnam Co Ltd, a company limited by shares incorporated under the laws of Vietnam on July 25, 2019, is currently wholly-owned by Ngo Cham, an employee of HOTTAB Vietnam Co Ltd. HOTTAB Asset Vietnam Co Ltd manages the Group’s website and apps in Vietnam via a contractual relationship. All profits accrued by HOTTAB Asset Vietnam Co Ltd are paid as management fees to HOTTAB Vietnam Co Ltd. HOTTAB Vietnam Co Ltd has an irrevocable call option to acquire 100% of the equity of HOTTAB Asset Vietnam Co Ltd.\\nApart from the transactions and balances detailed elsewhere in these accompanying condensed consolidated financial statements, the Company has no other significant or material related party transactions during the periods presented.\\nNOTE－17 CONCENTRATIONS OF RISK\\nThe Company is exposed to the following concentrations of risk:\\n(a) Major customers\\nFor the nine months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\\n\\n| Schedule of concentrations of risk |\\n| Nine months ended September 30, 2021 | September 30, 2021 |\\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\\n| Customer A | $ | 24,813 | 25 | % | $ | 19,308 |\\n| Customer B | $ | 12,615 | 13 | % | $ | — |\\n| Customer C | $ | 58,300 | 58 | % | $ | 68,285 | * |\\n\\n\\n| * | - This included value added taxes (“VAT”) |\\n\\n\\n| 38 |\\n\\n\\n| Nine months ended September 30, 2020 | September 30, 2020 |\\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\\n| Customer A | $ | 31,604 | 76 | % | $ | — |\\n\\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\\n\\n| Three months ended September 30, 2021 |\\n| Customer | Revenues | Percentage of revenues |\\n| Customer A | $ | 10,016 | 12 | % |\\n| Customer B | $ | 12,615 | 13 | % |\\n| Customer C | $ | 58,300 | 58 | % |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Customer | Revenues | Percentage of revenues |\\n| Customer A | $ | 9,789 | 84 | % |\\n\\nAll customers are located in Vietnam except one located in Indonesia.\\n(b) Major vendors\\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\\n\\n| Nine months ended September 30, 2021 | September 30, 2021 |\\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\\n| Vendor A | $ | 30,577 | 27 % | $ | 44,867 |\\n| Vendor B | $ | 17,827 | 16 % |\\n\\n\\n| Nine months ended September 30, 2020 | September 30, 2020 |\\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\\n| Vendor A | $ | 46,863 | 72 % | $ | — |\\n| Vendor B | — | — | — |\\n\\n\\n| 39 |\\n\\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\\n\\n| Three months ended September 30, 2021 |\\n| Purchases | Percentage of purchases |\\n| Vendors |\\n| Vendor A | $ | — | — |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Vendors | Purchases | Percentage of purchases |\\n| Vendor A | $ | 24,401 | 90 % |\\n| Vendor B | — | — |\\n\\nAll vendors are located in Vietnam.\\n(c) Credit risk\\nFinancial instruments that are potentially subject to credit risk consist principally of trade receivables. The Company believes the concentration of credit risk in its trade receivables is substantially mitigated by its ongoing credit evaluation process and relatively short collection terms. The Company does not generally require collateral from customers. The Company evaluates the need for an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information.\\n(d) Exchange rate risk\\nThe reporting currency of the Company is US$, to date the majority of the revenues and costs are denominated in VND, SGD and INR and a significant portion of the assets and liabilities are denominated in VND, SGD and INR. As a result, the Company is exposed to foreign exchange risk as its revenues and results of operations may be affected by fluctuations in the exchange rate between US$ and VND, SGD and INR. If VND, SGD and INR depreciates against US$, the value of VND, SGD and INR revenues and assets as expressed in US$ financial statements will decline. The Company does not hold any derivative or other financial instruments that expose to substantial market risk.\\n(e) Economic and political risks\\nThe Company's operations are conducted in the Republic of Vietnam. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the Vietnam, and by the general state of the Vietnam economy.\\nThe Company's operations in the Vietnam and India are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company's results may be adversely affected by changes in the political and social conditions in the Vietnam and India, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation.\\nNOTE－18 COMMITMENTS AND CONTINGENCIES\\nAs of September 30, 2021, the Company has no material commitments or contingencies.\\nRight issues under Series C-1 preferred stock\\nThe Company has issued warrant pursuant to the Series C-1 Subscription Agreement. Each redeemable warrant entitles the holder to purchase two (2) common shares at a price of $168 per share. The warrants shall be exercisable on or before December 31, 2020 and June 30, 2021, respectively. On April 19, 2021, the Company extended the termination date of the Warrant issued to Preferred series C-1 holder by six months from the expiration date of June 30, 2021 to December 31, 2021. The Company considers this warrant as permanent equity per ASC 815-40-35-2. As such, there is no value assigned to this extension.\\n\\n| 40 |\\n\\nFinancing arrangement (due to a shareholder)\\nIn February 2018, the Company entered into MOU with Connect Investment Pte Ltd (Enter Asia) for capital alliance for approximately 27% of shareholdings in the Company. Further, in August 2018, the said MOU was modified and shareholding was revised from 27% to 10% in the Company. However, subsequently in October 2020, it was agreed between both the parties to cease the said MOU with the understanding that there is no current and future obligation with either of them i.e. neither EnterAsia to make investment in the Company nor the Company to issue shares to EnterAsia. Further, the EnterAsia is going to get the shares of the Hottab Holdings Ltd (HHL) for the amount so far invested in the Company and therefore the amount due to EnterAsia is reclassified into the amount due to shareholder “Hottab Holdings Ltd”.\\nSOSV\\nIn January 2019, the HPL entered into stock purchase agreement and accelerator contract for equity (ACE) with SOSV IV LLC (SOSV) whereby the HPL will issue shares representing 5% of their capital stock for the amounts of $ 168,000 in three tranche (a) SOSV to pay to the HPL $ 75,000 for integration of Mobile Only Accelerator (MOX) software development kit, (b) SOSV to pay on behalf of the HPL $ 48,000 upon MOX successful application and setting up subsidiary, and (c) SOSV to pay on behalf of the HPL $ 45,000 for setting program for services. The Company received first tranche of $ 75,000 only and thereafter no other two tranche received by the HPL, however, the outcome of the deal did not results success and so later the HPL have not issued any shares to the SOSV, therefore the arrangement amount of $ 75,000 accounted as loan from SOSV. On February 2, 2021, the Company sent the legal letter to the SOSV intimating that the Company acquired HPL by issuing 117,000 preferred stock series C to Hottab Holding Limited for the 100 % acquisition of HPL. As of September 30, 2021 and December 31, 2020, the Company had a total of $ 75,000 and $ 75,000 , outstanding on this account, respectively. (see below for legal update)\\nService contracts\\nThe Company carries various service contracts on its vendors for repairs, maintenance and inspections. All contracts are short term and can be cancelled.\\nMaterial contracts\\nOn 28 May 2021, the Company entered into a business cooperation agreement with Paytech Company Limited (“Strategic Partners”) to provide payment integration and loyalty services to the platform that allows merchants to process transactions with consumers. As of date, this program have not started and expected to commence in next year 2022.\\nOn 15 August 2021, the Company entered into a business cooperation agreement with Rainbow Loyalty Company Limited (“Strategic Partners”) to provide loyalty services for merchants on the platform. As of date, this program have not started and expected to commence in next year 2022.\\nExecutive service agreements\\nOn April 1, 2017 the Company entered into an at-will Employment Agreement with Dennis Nguyen, its Chairman and Chief Executive Officer. The Employment Agreement provides for a monthly salary of $ 40,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s salary, he may convert any unpaid salary into common stock of the Company at a share price equal to $ 250 per share. Mr. Nguyen is also entitled to an annual cash bonus of $ 250,000 ; provided that until the Company has adequate reserves to pay Mr. Nguyen’s annual bonus, he may convert any unpaid bonus into common stock of the Company as described above. This provision was inserted into the employment agreement to compensate Mr. Nguyen in stock, at his option, and was to remain operable only until the Company has sufficient cash to pay him his salary in cash. From July 2021 until now, the Company’s cash balance has been at least $ 4 million and the Company has paid Mr. Nguyen his salary in full in every month from July 2021 until now. As a result of these facts, the conversion feature in Mr. Nguyen’s contract became inoperable as of July 1, 2021 and Mr. Nguyen no longer has the option to convert unpaid salary into the Company’s shares. On October 25, 2021, the Company has also amended Mr. Nguyen’s contract to delete the conversion feature to make clear the conversion feature will not be operable in the future. Therefore, the Company will not accrue any expense. Mr. Nguyen is also entitled to participate in all of the other benefits of the Company which are generally available to office employees and other employees of the Company. Mr. Nguyen is not entitled to any severance pay.\\nOn September 1, 2021 the Company entered into a 5-year Employment Agreement with Raynauld Liang, its Chief Financial Officer and Singapore Country General Manager. The employment agreement provides Mr. Liang with compensation of (i) an annual base salary of $ 240,000 ; (ii) an annual discretionary incentive cash bonus with a minimum target of 25% of base salary; (iii) 814,950 shares of the Company’s common stock (taking into account the Company’s stock split 1:750 and reverse stock split 1:2.5), of which 651,960 shares are subject to vesting over a two-year period; and (iv) all other executive benefits sponsored by the Company. If a change of control of the Company occurs and if at the time of such change of control the Company’s common stock is trading at a price that is double the initial public offering price, then Mr. Liang will be entitled to a cash bonus equal to three (3) times his base salary. If Mr. Liang is terminated other than for cause or resigns for good reason, he will be entitled to receive continued base salary until the earlier of (x) the anniversary date of such termination and (y) the end of the 5-year term of the employment agreement; provided, however, if the termination is after September 1, 2022, then the period set forth in clause (x) shall be 18 months from the date of the employment agreement. Mr. Liang may terminate the employment agreement at any time other than for good reason with 30 days’ notice to the Company.\\n\\n| 41 |\\n\\nLitigation\\nFrom time to time, the Company may become involved in various lawsuits and legal proceedings, which arise, in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company’s business. The Company is not aware of any such legal proceedings that will have, individually or in the aggregate, a material adverse effect on its business, financial condition or operating results.\\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $ 122,042 .60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims and this action is still in the discovery phase of litigation.\\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\\n\\n| 42 |\\n\\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\\nAs of September 30, 2021, the Company expects no possible loss from these legal proceedings and no provision is accrued accordingly.\\n\\n| 43 |\\n\\nNOTE－19 SEGMENT REPORTING\\nWe have two reportable segments: (i) e-commerce and (ii) Merchant POS. The e-commerce segment includes the operations of Sopa Technology Company Ltd. Additionally, the Merchant POS segment comprises the operations of Hottab group and SOPA entities except SOPA Technology Company Ltd. Lastly, reported under Merchant POS included acquired operating segment, Hottab group and all SOPA entities except SOPA Technology Company Ltd . Merchant POS includes Hardware sales, subscription sales and e-Commerce includes online ordering such as Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle.\\nOur Chief Operating Decision Maker (CODM) evaluate operating segments using the following table presents revenues and gross profits by reportable segment and asset except liability information.\\n| Schedule of Segment Reporting |\\n| Nine Months Ended September 30, 2021 |\\n| e-Commerce | Merchant POS | Total |\\n| Revenue |\\n| Hardware sales | $ | — | $ | 335 | $ | 335 |\\n| Software subscription | — | 26,970 | 26,970 |\\n| Sales – online ordering | 73,518 | — | 73,518 |\\n| Total revenue | 73,518 | 27,305 | 100,823 |\\n| Cost of sales: |\\n| Hardware sales | — | ( 165 | ) | ( 165 | ) |\\n| Software subscription | ( 166,761 | ) | ( 39,626 | ) | ( 206,387 | ) |\\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\\n| Total cost of revenue | ( 224,502 | ) | ( 39,791 | ) | ( 264,293 | ) |\\n| Operating Expenses |\\n| Sales and marketing expenses | ( 78,808 | ) | ( 6,219 | ) | ( 85,027 | ) |\\n| Software development costs | — | ( 76,698 | ) | ( 76,698 | ) |\\n| Impairment loss | ( 200,000 | ) | — | ( 200,000 | ) |\\n| General and administrative expenses | ( 73,285 | ) | ( 14,341,077 | ) | ( 14,414,362 | ) |\\n| Total operating expenses | ( 352,093 | ) | ( 14,423,994 | ) | ( 14,776,087 | ) |\\n| Loss from operations | ( 503,077 | ) | ( 14,436,180 | ) | ( 14,939,557 | ) |\\n\\n\\n| Three Months Ended September 30, 2021 |\\n| e-Commerce | Merchant POS | Total |\\n| Revenue |\\n| Hardware sales | $ | — | $ | — | $ | — |\\n| Software subscription | — | 10,016 | 10,016 |\\n| Sales – online ordering | 73,518 | — | 73,518 |\\n| Total revenue | 73,518 | 10,016 | 83,534 |\\n| Cost of sales: |\\n| Hardware sales | — | — | — |\\n| Software subscription | ( 80,557 | ) | ( 21,138 | ) | ( 101,695 | ) |\\n| Cost of online ordering | ( 57,741 | ) | — | ( 57,741 | ) |\\n| Total cost of revenue | ( 138,298 | ) | ( 21,138 | ) | ( 159,436 | ) |\\n| Operating Expenses |\\n| Sales and marketing expenses | ( 40,744 | ) | ( 2,099 | ) | ( 42,843 | ) |\\n| Software development costs | — | ( 9,709 | ) | ( 9,709 | ) |\\n| Impairment loss | — | — | — |\\n| General and administrative expenses | ( 48,658 | ) | ( 8,243,805 | ) | ( 8,292,463 | ) |\\n| Total operating expenses | ( 89,402 | ) | ( 8,255,613 | ) | ( 8,345,015 | ) |\\n| Loss from operations | ( 154,182 | ) | ( 8,266,735 | ) | ( 8,420,917 | ) |\\n\\n| 44 |\\n\\n\\n| September 30, 2021 |\\n| e-Commerce | Merchant POS | Total |\\n| Identifiable assets | $ | 147,950 | $ | 11,170,288 | $ | 11,318,238 |\\n\\n\\n| December 31, 2020 |\\n| e-Commerce | Merchant POS | Total |\\n| Identifiable assets | $ | — | $ | 7,866,273 | $ | 7,866,273 |\\n\\n\\n| Nine Months Ended September 30, 2020 |\\n| e-Commerce | Merchant POS | Total |\\n| Revenue |\\n| Hardware sales | $ | — | $ | 3,510 | $ | 3,510 |\\n| Software subscription | — | 37,752 | 37,752 |\\n| Sales – online ordering | — | — | — |\\n| Total revenue | — | 41,262 | 41,262 |\\n| Cost of sales: |\\n| Hardware sales | — | ( 2,982 | ) | ( 2,982 | ) |\\n| Software subscription | — | ( 56,127 | ) | ( 56,127 | ) |\\n| Cost of online ordering | — | — | — |\\n| Total cost of revenue | — | ( 59,109 | ) | ( 59,109 | ) |\\n| Operating Expenses |\\n| Sales and marketing expenses | — | ( 3,125 | ) | ( 3,125 | ) |\\n| Software development costs | — | ( 139,151 | ) | ( 139,151 | ) |\\n| Impairment loss | — | ( 8,778 | ) | ( 8,778 | ) |\\n| General and administrative expenses | — | ( 2,311,266 | ) | ( 2,311,266 | ) |\\n| Total operating expenses | — | ( 2,462,320 | ) | ( 2,462,320 | ) |\\n| Loss from operations | — | ( 2,480,167 | ) | ( 2,480,167 | ) |\\n\\n\\n| Three Months Ended September 30, 2020 |\\n| e-Commerce | Merchant POS | Total |\\n| Revenue |\\n| Hardware sales | $ | — | $ | 585 | $ | 585 |\\n| Software subscription | — | 11,044 | 11,044 |\\n| Sales – online ordering | — | — | — |\\n| Total revenue | — | 11,629 | 11,629 |\\n| Cost of sales: |\\n| Hardware sales | — | ( 585 | ) | ( 585 | ) |\\n| Software subscription | — | ( 19,731 | ) | ( 19,731 | ) |\\n| Cost of online ordering | — | — | — |\\n| Total cost of revenue | — | ( 20,316 | ) | ( 20,316 | ) |\\n| Operating Expenses |\\n| Sales and marketing expenses | — | — | — |\\n| Software development costs | — | ( 33,658 | ) | ( 33,658 | ) |\\n| Impairment loss | — | 4,164 | 4,164 |\\n| General and administrative expenses | — | ( 1,580,287 | ) | ( 1,580,287 | ) |\\n| Total operating expenses | — | ( 1,609,781 | ) | ( 1,609,781 | ) |\\n| Loss from operations | — | ( 1,618,468 | ) | ( 1,618,468 | ) |\\n\\n\\n| 45 |\\n\\nNOTE－20 SUBSEQUENT EVENTS\\nIn accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued, the Company has evaluated all events or transactions that occurred after September 30, 2021, up through the date the Company issued the unaudited condensed consolidated financial statements.\\nOn November 8, 2021, the Company entered into an underwriting agreement (the “Underwriting Agreement”) with Maxim Group LLC, acting as representative to the underwriters (the “Representative”), related to the initial public offering of 2,888,889 shares of the Company’s common stock, par value $ 0.0001 per share (the “Firm Shares”), at a public offering price of $ 9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase up to an additional 433,334 shares of common stock (the “Option Shares”) at a public offering price of $ 9.00 , less discounts and commissions, to cover over-allotments, if any. The Company’s common stock was listed on the Nasdaq Capital Market on November 9, 2021 and began trading on such date. The closings (the “IPO Closings”) of the offering and sale of the Firm Shares and the sale of 236,111 Option Shares occurred on November 12, 2021. Aggregate gross proceeds from the closings related to the Firm Shares and the Option Shares was $ 26,000,001 and $ 2,124,999 , respectively.\\nOn December 1, 2021, Leflair Incorporated under the laws of the State of Navada and subsequently share issued to the Company on December 7, 2021 as wholly-owned subsidiary.\\nOn December 6, 2021, the Company entered into two consulting agreements with China-America Culture Media Inc. and New Continental Technology Inc., acting as Consultanct to assist the Company in completing certain Business Opportunities with potential partners until February 28, 2023. The consideration of the service are $ 3,250,000 and $ 3,190,000 .\\nUpon the IPO Closings, all outstanding shares of preferred stock series A, B, B-1, C and C-1 automatically converted into 888,889 shares, 764,400 shares, 48,000 shares, 465,600 shares and 4,195,200 shares of the Company’s common stock, respectively.\\n\\n| 46 |\\n\\n\\nItem 2. Management’s discussion and analysis of financial condition and results of operations.\\nThe following discussion summarizes the significant factors affecting the operating results, financial condition, liquidity, and cash flows of our Company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data,” the condensed consolidated financial statements and the related notes thereto, and the consolidated financial statements and the related notes thereto all included elsewhere in this report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity, and capital resources, and all other non-historical statements in this discussion are forward-looking statements and are based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed in the Company’s final prospectus for its initial public offering on file with the Secuties and Exchange Commision (the “SEC”), particularly in the sections entitled “Special Note Regarding Forward-Looking Statements” and “Risk Factors.”\\nOverview\\nWe acquire and operate e-commerce platforms through our direct and indirect wholly-owned subsidiaries, including but not limited to Society Technology LLC, SoPa Technology Pte Ltd, SoPa Cognitive Analytics Pte Ltd, Sopa Technology Co Ltd, HOTTAB Pte Ltd and HOTTAB Vietnam Co Ltd. Along with HOTTAB Asset Vietnam Co Ltd (currently wholly-owned by one employee of HOTTAB Vietnam Co Ltd and contractually operated by HOTTAB Vietnam Co Ltd), these eight companies form the Society Pass Group (the “Group”). The Group currently markets to both consumers and merchants in Vietnam while maintaining an administrative headquarters in Singapore. In Feb 2021,we have acquired an online lifestyle platform of Leflair branded assets (the “Leflair Assets”) as more fully described in “Business – Leflair” and are in the process of integrating the Leflair assets with the SoPa and #HOTTAB platform. On 9 November 2021, the Group have been approved for listing on Nasdaq Capital Market (“Nasdaq”) and will trade under the ticker symbol “SOPA”. The Group is a leading Southeast Asian data-driven loyalty platform with its initial offering of 2,888,889 shares of common stock at a price of US$9.00 per share. After the completion of our initial public offering (“IPO”), we intend to expand our e-commerce ecosystem throughout the rest of SEA and South Asia with particular focuses on Philippines, India and Bangladesh.\\nOur ecosystem currently comprises of seven e-commerce interfaces targeting consumers and merchants: SoPa food & beverage (“F&B”) App, SoPa.asia F&B Marketplace website, #HOTTAB Biz App, #HOTTAB POS App, Hottab.net admin website, Leflair App, and Leflair Lifetyle Marketplace website (the “Platform”). Our loyalty-focused and data-driven e-commerce marketing platform interfaces connect consumers with merchants in the F&B and lifestyle sectors, assisting local brick-and-mortar businesses to access new customers and markets to thrive in an increasingly convenience-driven economy. Our Platform integrates with both global and country-specific search engines and applications and accepts international address and phone number data, providing a consumer experience that respects local languages, address formats and customs. Our strategic partners work with us to penetrate local markets, while our Platform allows effortless integration with existing technological applications and websites.\\nOur consumer facing business consists of our “SoPa” and “Leflair” brands. Through our SoPa F&B App, and SoPa.asia F&B Marketplace website, we provide frictionless online ordering and delivery experience for consumers in the F&B sector. Our Leflair lifestyle e-commerce platform markets and sells products in three verticals: Fashion & Accessories, Beauty & Personal Care, and Home & Lifestyle. Our consumer facing platforms feature an easy-to-navigate, multi-lingual user interface with multiple integrated payment and delivery options\\nBranded as “#HOTTAB”, our merchant facing business helps merchants increase revenues and streamline costs with an online and multilingual store front, fully integrated POS software solution, joint marketing program, payment infrastructure, loyalty administration, customer profile analytics, and SME financing packages. Through #HOTTAB Biz App, #HOTTAB POS and Hottab.net merchant administration website interfaces, #HOTTAB functions both online and offline and facilitates transactions, orders, voucher redemption, and rewards. Merchants only need a smart device in order to quickly access our #HOTTAB product ecosystem. In addition, our Customer Care department provides attentive after-sales service.\\n\\n| 47 |\\n\\nUpon the expected launch of Society Points in the second half of 2021, consumers will be able to use our Society Points at merchant locations initially throughout Vietnam and then we expect to expand availability of Society Points throughout SEA and South Asia See “Business —Loyalty Points —Society Points.”\\nAs of December 6, 2021 we have onboarded over 1.5 million registered consumers and over 5,500 registered merchants on our Platform.\\nImpact of the COVID-19 Pandemic\\nThe current outbreak of COVID-19 has globally resulted in loss of life, business shutdowns, restrictions on travel, and widespread cancellation of social gatherings. The extent to which the COVID-19 pandemic impacts our business will depend on future developments, which are highly uncertain and cannot be predicted at this time, including:\\n\\n| • | new information which may emerge concerning the severity of the disease in Vietnam and SEA; |\\n\\n| • | the duration and spread of the outbreak; |\\n\\n| • | the severity of travel restrictions imposed by geographic areas in which we operate, mandatory or voluntary business closures; |\\n\\n| • | regulatory actions taken in response to the pandemic, which may impact merchant operations, consumer and merchant pricing, and our product offerings; |\\n\\n| • | other business disruptions that affect our workforce; |\\n\\n| • | the impact on capital and financial markets; and |\\n\\n| • | action taken throughout the world, including in markets in which we operate, to contain the COVID-19 outbreak or treat its impact. |\\n\\nIn addition, the current outbreak of COVID-19 has resulted in a widespread global health crisis and adversely affected global economies and financial markets, and similar public health threats could do so in the future. Such events have impacted, and could in the future impact, demand for merchants and consumer purchase patterns, which in turn, could adversely affect our revenue and results of operations.\\nSince the onset of the COVID-19 pandemic in March and April 2020, all our POS merchant clients are affected by COVID-19 measures for F&B to temporary stop restaurant dine ins.\\n\\n| • | Some of our restaurant clients ceased operations permanently and many were closed since June 2020 without any notice of reopening their business to date. |\\n\\n| • | Our largest POS client, a hotel chain for which we provide POS services to their F&B business in their hotels, ceased operations in two out of nine hotels since April 2020. |\\n\\n| • | The Company faces challenges to onboard new clients but at the same time losing many existing ones. |\\n\\nWith the ongoing pandemic, Company faces challenges in our operation as follows;\\n\\n| • | Disruption of operation in Vietnam, India, Singapore and US where staffs have to work from home. |\\n\\n| • | The coordination of rebooting of company’s recent asset acquisition of Leflair an ecommerce platform. |\\n\\n| • | Application of licenses are delayed as government agencies take longer time to review and process time. |\\n\\n| • | HR process to hire personnel are generally slow due to people not willing to leave their current job, company have to spend more time and resources. |\\n\\n\\n| 48 |\\n\\nThe spread of COVID-19 has caused us to modify our business practices, including employee travel, employee work locations in certain cases, and cancellation of physical participation in certain meetings, events and conferences and further actions may be taken as required or recommended by government authorities or as we determine are in the best interests of our employees, customers, and other business partners. We are monitoring the global outbreak of the pandemic, in SEA, especially Vietnam and are taking steps in an effort to identify and mitigate the adverse impacts on, and risks to, our business posed by its spread and the governmental and community reactions thereto. See “Risk Factors--Our business may be materially adversely affected by the recent coronavirus (COVID-19) outbreak.\\nFinancial Condition\\nResults of Operations\\nThe following table sets forth certain operational data for the three and nine months ended September 30, 2021 and 2020:\\n\\n| Three months ended September 30, | Nine months ended September 30, |\\n| 2021 | 2020 | 2021 | 2020 |\\n| Revenue,net | 83,534 | 11,629 | 100,823 | 41,262 |\\n| Cost of revenue | (159,436 | ) | (20,316 | ) | (264,293 | ) | (59,109 | ) |\\n| Gross loss | (75,902 | ) | (8,687 | ) | (163,470 | ) | (17,847 | ) |\\n| Less operating expenses: |\\n| Sales and marketing expenses | (42,843 | ) | — | (85,027 | ) | (3,125 | ) |\\n| Software development costs | (9,709 | ) | (33,658 | ) | (76,698 | ) | (139,151 | ) |\\n| Impairment loss | — | 4,164 | (200,000 | ) | (8,778 | ) |\\n| General and administrative expenses | (8,292,463 | ) | (1,580,287 | ) | (14,414,362 | ) | (2,311,266 | ) |\\n| Total operating expenses | (8,345,015 | ) | (1,609,781 | ) | (14,776,087 | ) | (2,462,320 | ) |\\n| Loss from operations | (8,420,917 | ) | (1,618,468 | ) | (14,939,557 | ) | (2,480,167 | ) |\\n| Other income (expense): |\\n| Interest income | 55 | 3 | 71 | 11 |\\n| Interest expense | (12,272 | ) | (12,261 | ) | (36,486 | ) | (36,381 | ) |\\n| Loss on settlement of litigation | — | — | (550,000 | ) | — |\\n| Other income | 5,170 | 3,737 | 6,917 | 9,495 |\\n| Total other expense | (7,047 | ) | (8,521 | ) | (579,498 | ) | (26,875 | ) |\\n| Loss before income taxes | (8,427,964 | ) | (1,626,989 | ) | (15,519,055 | ) | (2,507,042 | ) |\\n| Income taxes | (1,303 | ) | (4 | ) | (9,943 | ) | (15,069 | ) |\\n| NET LOSS | $ | (8,429,267 | ) | $ | (1,626,993 | ) | $ | (15,528,998 | ) | $ | (2,522,111 | ) |\\n\\nRevenue. We generated revenues of $83,534 and $ 11,629 for the three months ended September 30, 2021 and 2020 respectively. During the nine month ended September 30, 2021 and 2020 we generated revenue of $100,823 and $41,262 respectively. The significant increase in revenue for three months and nine months was due to more merchants were joining our platform to operate their business.\\n\\n| 49 |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the following customer exceeded 10% of the Company’s revenues:\\n\\n| Nine months ended September 30, 2021 | September 30, 2021 |\\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\\n| Aryaduta Hospitality & Leisure Group | $ | 24,813 | 25 | % | $ | 19,308 |\\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % | $ | — |\\n| Tiki Smart Logistic | $ | 58,300 | 58 | % | $ | 68,285 | * |\\n\\n* - This included value added taxes (“VAT”)\\n\\n| Nine months ended September 30, 2020 | September 30, 2020 |\\n| Customer | Revenues | Percentage of revenues | Accounts receivable |\\n| Aryaduta Hospitality & Leisure Group | $ | 31,604 | 76 | % | $ | — |\\n\\nFor the three months ended September 30, 2021 and 2020, the customers who accounted for 10% or more of the Company’s revenues and its outstanding receivable balances at year-end dates, are presented as follows:\\n\\n| Three months ended September 30, 2021 |\\n| Customer | Revenues | Percentage of revenues |\\n| Aryaduta Hospitality & Leisure Group | $ | 10,016 | 12 | % |\\n| PayDollars-Payment Gateway | $ | 12,615 | 13 | % |\\n| Tiki Smart Logistic | $ | 58,300 | 58 | % |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Customer | Revenues | Percentage of revenues |\\n| Aryaduta Hospitality & Leisure Group | $ | 9,789 | 84 | % |\\n\\nAll of our customers are located in Vietnam except one above significant customer located in Indonesia.\\nCost of Revenue. We incurred cost of revenue of $159,436 and $20,316 for three months ended September 30, 2021, and 2020 respectively. During the period of nine months ended September 30,2021 and 2020, we incurred cost of revenue of $264,293 and $59,109 respectively. Cost of revenue increased primarily as a result of the fixed subscription cost and the increased in number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\\nMajor vendors\\nFor the nine months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\\n\\n| Nine months ended September 30, 2021 | September 30, 2021 |\\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\\n| Vendor A | $ | 30,577 | 27% | $ | 44,867 |\\n| Vendor B | 17,827 | 16% |\\n\\n\\n| Nine months ended September 30, 2020 | September 30, 2020 |\\n| Vendors | Purchases | Percentage of purchases | Accounts payable |\\n| Vendor A | $ | 46,863 | 72% | $ | — |\\n| Vendor B | — | — | — |\\n\\n\\n| 50 |\\n\\nFor the three months ended September 30, 2021 and 2020, the vendors who accounts for 10% or more of the Company’s hardware purchases and software cost its outstanding payable balances as at year-end dates, are presented as follows:\\n\\n| Three months ended September 30, 2021 |\\n| Vendors | Purchases | Percentage of purchases |\\n| Vendor A | $ | — | — |\\n\\n\\n| Three months ended September 30, 2020 |\\n| Vendors | Purchases | Percentage of purchases |\\n| Vendor A | $ | 24,201 | 90 | % |\\n| Vendor B | — | — |\\n\\nAll vendors are located in Vietnam.\\nGross Loss. We recorded a gross loss of $75,902 and $8,687 for three months ended September,30 2021 and 2020 respectively. During the nine months ended September 30,2021 and 2020, we recorded a gross loss of $163,470 and $17,847 respectively. The increase in gross loss is primarily attributable to fixed subscription cost and the number of headcounts arising from the acquisition of e-commerce assets from Goodventures Sea Limited.\\nSales and Marketing Expenses (“S&M”). We incurred S&M expenses of $42,843 and $0 for three months ended September 30, 2021 and 2020 respectively. During nine months ended September 30,2021 and 2020, we have incurred S&M expenses of $85,027 and $3,125 respectively. The increase in S&M is primarily attributable to the increased in sales and promotion expenses related to get more merchants joining our e-commerce platform to operate their business. Also, increase marketing cost to attract attention of customer to our e-commerce platform.\\nSoftware Development Cost (“SDC”). We incurred SDC expenses of $9,709 and 33,658 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred SDC exepenses of $76,698 and $139,151 respectively. The decrease in SDC is primarily attributable to the restructuring of our technology development team.\\nImpairment Charge (“IC”). We incurred impairment charge of $200,000 and $8,778 for the nine months ended September 30, 2021, and 2020, respectively. No impairment charge imcurred for the three months ended September 30, 2021 and 2020. The increase is primarily attributable to the acquisition of Leflair ecommerce asset which was expensed in the same period due to the short life term of the asset and the quantum of consideration.\\nGeneral and Administrative Expenses (“G&A”). We incurred G&A expenses of $8,292,463 and $1,580,287 for three months ended September 30, 2021 and 2020 respectively. During the nine months ended September 30, 2021 and 2020, we incurred G&A expenses of $14,414,362 and $2,311,266 respectively. The increase in G&A is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq, amortization of intangible assets and Stock based compensation for services.\\nLoss on settlement of litigation. On May 21, 2021, the Company has agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum is required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the first payment of $250,000 on May 25, 2021 and complete the settlement sum as provided under the settlement agreement by paying the remaining $300,000 on June 29, 2021. In connection with the settlement, the Company recognized litigation settlement expense and a related accrued liability of $550,000 in the period ended September 30, 2021. There is no such expenses incurred in the comparative period ended September 30, 2020.\\n\\n| 51 |\\n\\nIncome Tax Expense. Our income tax expenses for the three months ended September 30,2021 and 2020 was $1,303 and $4 and for nine months ended September 30, 2021 and 2020 was $9,943 and $15,069, respectively.\\nNet Loss. As a result for the three months ended September 30, 2021, we incurred a net loss of $8,429,267 as compare to the same period ended September 30,2020 of $1,626,993. During nine month ended September 30, 2021 the Group having loss of $15,528,998, as compared to $2,522,111 for the same period ended September 30, 2020. The increase in net loss is primarily attributable to the professional cost associated with cost related to company filing for listing on Nasdaq and amortization of intangible assets.\\nLiquidity and Capital Resources\\nAs of September 30, 2021, we had cash and cash equivalents of $5,722,450, accounts receivable of $87,803, deposits, prepayments and other receivables of $69,623 and due from related parties of $97,500.\\nAs of December 31, 2020, we had cash and cash equivalents of $506,666, accounts receivable of $1,897, deposits, prepayments and other receivables of $60,532.\\nThe accompanying consolidated financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\\nThe Company suffered from an accumulated deficit of $28,116,309 at September 30, 2021. The Company incurred net loss of $15,528,998 during the nine months ended September 30, 2021. These factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of twelve months from the date of issuance of this financial statement, without additional debt or equity financing. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders. Management believes the Company is currently pursuing additional financing for its operations. However, there is no assurance that the Company will be successful in securing sufficient funds to sustain the operations.\\nThe registration statement for the Company’s Initial Public Offering became effective on November 8, 2021. On November 8, 2021, the Company entered into an underwriting agreement with Maxim Group LLC, related to the offering of 2,888,889 shares of the Company’s common stock (the “Firm Share”), at a public offering price of $9.00 per share. Under the terms of the Underwriting Agreement, the Company has granted the Underwriters an option, exercisable for 45 days, to purchase an additional 236,111 shares of common stock (the “Option Shares”) to cover over-allotments. The Company has raised funding from Initial Public Offering and Option shares of $26,000,001 and 2,124,999. In addition, the Company has raised $8,019,461, net of issuance cost in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements respectively in the form of equity subsequent to issuance of the audit report on the Company’s December 31, 2020 financial statements and based upon the capital raised, the Company believes it has sufficient liquidity to meet its working capital requirements for the next 12 months. As a result the Company has mitigated any doubts about its ability to continue as a going concern\\nThese consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets and liabilities that may result in the Company not being able to continue as a going concern.\\n\\n| Nine Months Ended September 30, |\\n| 2021 | 2020 |\\n| Net cash (used in) operating activities | $ | (2,639,775 | ) | $ | (970,647 | ) |\\n| Net cash (used in) investing activities | (200,000 | ) | — |\\n| Net cash provided by financing activities | 8,019,461 | 708,960 |\\n| Effect on exchange rate change | 36,098 | 16,689 |\\n| Net change in cash and cash equivalents | 5,215,784 | (244,998 | ) |\\n| Cash and cash equivalent at beginning of period | 506,666 | 606,491 |\\n| Cash and cash equivalent at end of period | 5,722,450 | 361,493 |\\n\\n| 52 |\\n\\nNet Cash Used In Operating Activities.\\nFor the nine months ended September 30, 2021, net cash used in operating activities was $2,639,775, which consisted primarily of a net loss of $15,528,998, offset by increase in stock based compensation for services of $10,071,830, increase in accounts receivables of $85,906, increase in deposits, prepayments and other receivables of $9,091, increase in contract liabilities $16,936, increase in accounts payables of $50,424, decrease in accrued liabilities and other payable of $474,932, increase in advance to related parties of $127,500, decrease in operating lease liabilities of $29,064, increase in depreciation and amortization of $2,406,648, increase in impairment loss of $200,000, increase in loss on settlement of litigation of 550,000.\\nFor the nine months ended September 30, 2020, net cash used in operating activities was $970,647, which consisted primarily of net loss of $2,522,111, offset by increase in impairment loss of $8,778, increase in account receivable of $19,900, increase in inventories of $7,212, increase in deposits, prepayment and other receivables of $7005, increase in contract liabilities of $8,275, increase in accounts payable of $61, decrease in accrued liabilities and other payables of $37,960 and decrease in advance to related parties of $76,278.\\nWe expect to continue to rely on cash generated through financing from our existing shareholders and private placements of our securities, however, to finance our operations and future acquisitions.\\nNet Cash (Used In) Investing Activities.\\nFor the nine months ended September 30, 2021, there is net cash of 200,000 being deposit paid for Leflair asset acquisition investing activities.\\nFor the nine months ended September 30, 2020, there is no net cash impact on investing activities\\nNet Cash Provided By Financing Activities.\\nFor the nine months ended September 30, 2021, net cash provided by financing activities was $8,109,461, consisting primarily of funds raised from shareholders for Series C, Series C1 and warrant exercised.\\nFor the nine months ended September 30, 2020, net cash provided by financing activities was $708,960, consisting primarily of funds raised from shareholders for Series C and warrant exercised.\\nCritical Accounting Policies and Estimate\\n• Basis of presentation\\nThe accompanying unaudited interim consolidated condensed financial statements of Society Pass Incorporated have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals necessary for a fair statement of financial position, results of operations and cash flows, have been included. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the financial statements and the accompanying notes included in the Company’s registration statement on Form S-1 for the year ended December 31, 2020. The year-end balance sheet data presented for comparative purposes was derived from audited financial statements, but does not include all disclosures required by GAAP. The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the operating results for the year ending December 31, 2021 or for any other subsequent interim period.\\n\\n| 53 |\\n\\n• Use of estimates and assumptions\\nIn preparing these consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. If actual results significantly differ from the Company’s estimates, the Company’s financial condition and results of operations could be materially impacted. Significant estimates in the period include the allowance for doubtful accounts on accounts and other receivables, assumptions used in assessing right of use assets, imputed interest on due to related parties, and impairment of long-term assets, business acquisition allocation of purchase consideration, and deferred tax valuation allowance.\\n• Basis of consolidation\\nThe condensed consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. In addition, certain amounts in the prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.\\n• Cash and cash equivalents\\nCash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. As of September 30, 2021 and December 31, 2020, the cash and cash equivalent was amounted to $5,722,450 and $506,666, respectively.\\nThe Company currently has bank deposits with financial institutions in the U.S. which does not exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $250,000, so there were uninsured balance of $4,895,306 and $208,635 in parent entity as of September 30, 2021 and December 31, 2020, respectively. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. All uninsured bank deposits are held at high quality credit institutions.\\n• Accounts receivable\\nAccounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from completion of service. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of fiscal year, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company considers the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of September 30, 2021 and December 31, 2020, the allowance for doubtful accounts amounted to $0 and $0, respectively.\\n• Inventories\\nInventories are stated at the lower of cost or net realizable value, cost being determined on a first-in-first-out method. Costs include hardware equipment and peripheral costs which are purchased from the Company’s suppliers as merchanized goods. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. During the nine months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. During the three months ended September 30, 2021 and 2020, the Company recorded an allowance for obsolete inventories of $0 and $0, respectively. The inventories were amounted to $0 and $0 at September 30, 2021 and December 31, 2020, respectively.\\n\\n| 54 |\\n\\n• Property, plant and equipment\\nPlant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values:\\n\\n| Expected useful lives |\\n| Computer equipment | 3 years |\\n| Office equipment | 5 years |\\n\\nExpenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations.\\n• Impairment of long-lived assets\\nIn accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as plant and equipment and intangible assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the periods presented.\\n• Revenue recognition\\nThe Company adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). Under ASU 2014-09, the Company applies the following five steps in order to determine the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements:\\n\\n| • | identify the contract with a customer; |\\n| • | identify the performance obligations in the contract; |\\n| • | determine the transaction price; |\\n| • | allocate the transaction price to performance obligations in the contract; and |\\n| • | recognize revenue as the performance obligation is satisfied. |\\n\\nThe revenues are generated from a diversified a mix of marketplace activities and the services of the Company provide merchants to help them grow their businesses. The revenue streams consist of Consumer Facing revenues and Merchant Facing revenues.\\nConsumer Facing Business\\nThe Company’s performance obligation includes providing connectivity between merchant and consumer, generally through an online ordering platform. The platform allows merchants to create account, place menu and track their sale reports on the merchant facing application. The platform also allows the consumers to create account and make orders from merchants on the consumer facing application. The platform allows delivering company to accept online delivery request and ship order from merchant to consumer.\\nThe Company also has online lifestyle platform allow customers to purchase high-end brands of all catergories: Under the Company’s smart search engine, consumers search or review their favorite brands among hundreds of choices in Apparel, Bags & Shoes, Accessory, Health & Beauty, Home & Lifestyle, International, Women, Men and Kids & Babies categories. The platform also allow consumers order from hundreds of vendor choices with personalized promotions based on purchase history and location. The platform has also partnered up with a Vietnam-based delivery company, Tikinow, to offer seamless delivery of product from merchant to consumer’s home or office at the touch of a button. Consumers place orders for delivery or pickup at the Company’s logistics center\\n| 55 |\\n\\nRevenue streams for consumer facing business:\\nF&B sector\\n\\n| 1) | Ordering fees comprise the fees that the different types of merchants pay for every completed transaction on the Platform, exclusive of delivery fees charged. Monthly/annual subscription fees or 10% commission on order value on each successful order will be charged. |\\n\\n\\n| 2) | Delivery fees include an upfront fixed fee and additional variable fees based on the distance. Various percentage of commission will be charged as delivery fee on each successful order received and delivered. |\\n\\nThe Company recognizes revenues from consumer facing business upon the completion of delivery and services rendered.\\nDuring the period ended September 30, 2021 and 2020, the Company have not generated any revenue from this stream.\\nLifestyle sector\\n\\n| 1) | Customer placed orders on the website / app, sales orders report will be generated in the system. The Company will start to proceed to packaging and delivering customer. The sales recognised. |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $73,518 and $0, respectively revenue from this stream.\\nMerchant Facing Business\\nRevenue streams for merchant facing business include:\\n\\n| 1) | Subscription fees consist of the fees that the Company charge merchants to get on the Merchant Marketing Program; |\\n\\n| 2) | The Company provides optional add-on software services which includes Analytics and Chatbox capabilities at a fixed fee per month. |\\n\\n| 3) | The Company collects commissions when they sell third party hardware and equipment (cashier stations, waiter tablets and printers) to merchants. |\\n\\n| 4) | Vendor Financing. The Company collects brokerage fees whenever the Company facilitates financing transactions between merchants and one of the Company’s partner financial institutions. |\\n\\nDuring the nine months ended September 30, 2021 and 2020, the Company have generated $26,970 and $37,752, respectively revenue from this stream. During the three months ended September 30, 2021 and 2020, the Company have generated $10,016 and $11,044, respectively revenue from this stream\\nHardware Product Revenues — the Company generally is involved with the sale of on-premise appliances and end-point devices. The single performance obligation is to transfer the hardware product (which is to be installed with its licensed software integral to the functionality of the hardware product). The entire transaction price is allocated to the hardware product and is generally recognized as revenue at the time of delivery because the customer obtains control of the product at that point in time. It is concluded that control generally transfers at that point in time because the customer has title to the hardware, physical possession, and a present obligation to pay for the hardware. Payments for hardware contracts are generally due 30 to 90 days after shipment of the hardware product.\\n\\n| 56 |\\n\\nThe Company records revenues from the sales of third-party products on a “gross” basis pursuant to ASC 606-10 Revenue Recognition – Revenue from Contracts with Customers, when the Company controls the specified good before it is transferred to the end customer and have the risks and rewards as principal in the transaction, such as responsibility for fulfillment, retaining the risk for collection, and establishing the price of the products. If these indicators have not been met, or if indicators of net revenue reporting specified in ASC 606-10 are present in the arrangement, revenue is recognized net of related direct costs.\\nSoftware License Revenues — The Company’s performance obligation includes providing connectivity to software, generally through a monthly subscription, where the Company typically satisfies its performance obligations prior to the submission of invoices to the customer for such services. The Company’s software sale arrangements grant customers the right to access and use the software products which are to be installed with the relevant hardware for connectivity at the outset of an arrangement, and to be entitled to both technical support and software upgrades and enhancements during the term of the agreement. The term of the subscription period is generally 12 months, with the automatic renewal of another one year, and the subscription license service is billed monthly, quarterly or annually. Sales are generally recorded in the month the service is provided. For clients who are billed on an annual basis, deferred revenue is recorded and amortized over the life of the contract. Payments are generally due 30 to 90 days after delivery of the software licenses.\\nThe Company records its revenues on hardware product and software license, net of value added taxes (“VAT”) upon the services are rendered and the title and risk of loss of hardware products are fully transferred to the customers. The Company is subject to VAT which is levied on the majority of the hardware products at the rate of 10% on the invoiced value of sales.\\nContract assets\\nIn accordance with ASC 606-10-45-3, contract asset is when the Company’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. The Company will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment.\\nThere were no contract assets at September 30, 2021 and December 31, 2020.\\nContract liabilities\\nIn accordance with ASC 606-10-45-2, A contract liability is Company’s obligation to transfer goods or services to a customer when the customer prepays consideration or when the customer’s consideration is due for goods and services that the Company will yet provide whichever happens earlier.\\nContract liabilities represent amounts collected from, or invoiced to, customers in excess of revenues recognized, primarily from the billing of annual subscription agreements. The value of contract liabilities will increase or decrease based on the timing of invoices and recognition of revenue. The Company’s contract liability balance was $35,582 and $18,646 as of September 30, 2021 and December 31, 2020, respectively.\\nContract costs\\nUnder ASC-606, the Company applies the following three steps in order to evaluate the costs to be capitalized as it fulfills following three criteria:\\n• Incremental costs directly related to a specific contract;\\n• Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract; and\\n• Costs that are expected to be recovered from the customer.\\nNo contract costs are capitalized for the three and nine months ended September 30, 2021 and 2020.\\n\\n| 57 |\\n\\n• Software development costs\\nIn accordance with the relevant FASB accounting guidance regarding the development of software to be sold, leased, or marketed, the Company expenses such costs as they are incurred until technological feasibility has been established, at and after which time these costs are capitalized until the product is available for general release to customers. Once the technological feasibility is established per ASC 985-20, the Company capitalizes costs associated with the acquisition or development of major software for internal and external use in the balance sheet. Costs incurred to enhance the Company’s software products, after general market release of the services using the products, is expensed in the period they are incurred. The Company only capitalizes subsequent additions, modifications or upgrades to internally developed software to the extent that such changes allow the software to perform a task it previously did not perform. The Company also expenses website costs as incurred.\\nResearch and development expenditures in the development of its own software are charged to operations as incurred. Based on the software development process, technological feasibility is established upon completion of a working model, which also requires certification and extensive testing. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release are immaterial. For the nine months ended September 30, 2021 and 2020, the software development costs were $76,698 and $139,151, respectively. For three months ended September 30, 2021 and 2020, the software development costs were $9,709 and $33,658, respectively.\\n• Product warranties\\nThe Company’s provision for estimated future warranty costs is based upon historical relationship of warranty claims to sales. Based upon historical sales trends and warranties provided by the Company’s suppliers, the Company has concluded that no warranty liability is required as of June 30, 2021 and 2020. To date, product allowance and returns have been minimal and, based on its experience, the Company believes that returns of its products will continue to be minimal.\\n• Shipping and handling costs\\nNo shipping and handling costs are associated with the distribution of the products to the customers which are borne by the Company’s suppliers or distributors.\\n• Sales and marketing\\nSales and marketing expenses include payroll, employee benefits and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $85,027 and $3,125 for the nine months ended September 30, 2021 and 2020, respectively. For three months ended September 30, 2021 and 2020, the Advertising expense were $42,843 and $0, respectively.\\n• Income tax\\nThe Company adopted the ASC 740 Income Tax provisions of paragraph 740-10-25-13, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the consolidated financial statements. Under paragraph 740-10-25-13, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent (50%) likelihood of being realized upon ultimate settlement. Paragraph 740-10-25-13 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. The Company had no material adjustments to its liabilities for unrecognized income tax benefits according to the provisions of paragraph 740-10-25-13.\\n\\n| 58 |\\n\\nThe estimated future tax effects of temporary differences between the tax basis of assets and liabilities are reported in the accompanying balance sheets, as well as tax credit carry-backs and carry-forwards. The Company periodically reviews the recoverability of deferred tax assets recorded on its balance sheets and provides valuation allowances as management deems necessary.\\nThe Company and its wholly-owned foreign subsidiary, is subject to income taxes in the jurisdictions in which it operates. Significant judgment is required in determining the provision for income tax. There are many transactions and calculations undertaken during the ordinary course of business for which the ultimate tax determination is uncertain. The company recognizes liabilities for anticipated tax audit issues based on the Company’s current understanding of the tax law. Where the final tax outcome of these matters is different from the carrying amounts, such differences will impact the current and deferred tax provisions in the period in which such determination is made.\\n• Uncertain tax positions\\nThe Company did not take any uncertain tax positions and had no adjustments to its income tax liabilities or benefits pursuant to the ASC 740 provisions of Section 740-10-25 for the three and nine months ended September 30, 2021 and 2020.\\n• Foreign currencies translation and transactions\\nThe reporting currency of the Company is United States Dollar (\\\"US$\\\") and the accompanying consolidated financial statements have been expressed in US$. In addition, the Company’s subsidiary is operating in the Republic of Vietnam and India and maintains its books and record in its local currency, Vietnam Dong (“VND”) and Indian Rupee (“INR), respectively, which are the functional currency as being the primary currency of the economic environment in which their operations are conducted. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Shareholders’ equity is translated using the historical rates. Revenues and expenses are translated at average rates prevailing during the year. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of changes in shareholder’s equity.\\nTranslation of amounts from SGD$ into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end SGD$:US$ exchange rate | $ | 0.73534 | $ | 0.73118 |\\n| Period average SGD$:US$ exchange rate | $ | 0.74658 | $ | 0.71922 |\\n\\nTranslation of amounts from VND into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end VND$:US$ exchange rate | $ | 0.000044 | $ | 0.000043 |\\n| Period average VND$:US$ exchange rate | $ | 0.000043 | $ | 0.000043 |\\n\\nTranslation of amounts from INR into US$ has been made at the following exchange rates for the three and nine months ended September 30, 2021 and 2020:\\n\\n| September 30, 2021 | September 30, 2020 |\\n| Period-end INR$:US$ exchange rate | $ | 0.013463 | $ | 0.013570 |\\n| Period average INR$:US$ exchange rate | $ | 0.013576 | $ | 0.013490 |\\n\\n\\n| 59 |\\n\\nTranslation gains and losses that arise from exchange rate fluctuations from transactions denominated in a currency other than the functional currency are translated, as the case may be, at the rate on the date of the transaction and included in the results of operations as incurred.\\nForeign Exchange Loss (Gain). We recorded a foreign exchange gain of $8,859 for the three months ended September 30, 2021 as compared to a gain of $51,183 for the same period in 2020. Foreign exchange gains and losses are primarily unrealized (non-cash) in nature and results from the re-measuring of specific transactions and monetary accounts in a currency other than the functional currency. For example, a U.S. Dollar transaction which occurs in Singapore is re-measured at the period-end to Singapore dollar amount if it has not been settled previously. The foreign exchange loss or gain for the three months ended September 30, 2021 was due to an increase in the value of the Singapore Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Singapore dollar to the U.S. Dollar increased 0.56%. At September 30, 2021, the exchange rate was 0.73534 as compared to 0.73118 at September 30, 2020. In addition, a U.S. Dollar transaction which occurs in India is re-measured at the period-end to India dollar amount if it has not been settled previously. The foreign exchange loss for the three months ended September 30, 2021 was due to an increase in the value of the India Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the India dollar to the U.S. Dollar increased 0.79%. At September 30, 2021, the exchange rate was 0.013463 as compared to 0.013570 at September 30, 2020. A U.S. Dollar transaction which occurs in Vietnam is re-measured at the period-end to Vietnameses dollar amount if it has not been settled previously. The foreign exchange gain for the three months ended September 30, 2021 was due to an increase in the value of the Vietnamese Dollar compared to the U.S. Dollar. From September 30, 2020 to September 30, 2021, the Vietnamese dollar to the U.S. Dollar increased 2.32%. At September 30, 2021, the exchange rate was 0.000044 as compared to 0.000043 at September 30, 2020.\\n• Comprehensive income\\nASC 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying consolidated statements of changes in shareholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit.\\n• Leases\\nThe Company adopted ASC 842, Leases (“ASC 842”) to determines if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities in the consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in the condensed consolidated balance sheets.\\nROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally use the incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.\\nIn accordance with the guidance in ASC 842, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.). Subsequently, the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on the respective relative fair values to the lease components and non-lease components.\\n• Related parties\\nThe Company follows the ASC 850-10, Related Party for the identification of related parties and disclosure of related party transactions.\\nPursuant to section 850-10-20 the related parties include a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and Income-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting ;parties might be prevented from fully pursuing its own separate interests.\\n\\n| 60 |\\n\\nThe condnensed consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include: a) the nature of the relationship(s) involved; b) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; c) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d) amount due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\\n• Commitments and contingencies\\nThe Company follows the ASC 450-20, Commitments to report accounting for contingencies. Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or un-asserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or un-asserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potentially material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely affect the Company’s business, financial position, and results of operations or cash flows.\\n• Fair value of financial instruments\\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and has adopted paragraph 820-10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, paragraph 820-10-35-37 of the FASB Accounting Standards Codification establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by paragraph 820-10-35-37 of the FASB Accounting Standards Codification are described below:\\n\\n| Level 1 | Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\\n| Level 2 | Pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\\n| Level 3 | Pricing inputs that are generally observable inputs and not corroborated by market data. |\\n\\n\\n| 61 |\\n\\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\\nThe carrying amounts of the Company’s financial assets and liabilities, such as cash and cash equivalents, accounts receivable, deposits, prepayments and other receivables, contract liabilities, accrued liabilities and other payables, amounts due to related parties and operating lease liabilities, approximate their fair values because of the short maturity of these instruments.\\n• Cost of goods sold\\nCost of goods sold consists of the cost of hardware, software and payroll, which are directly attributable to the sales of products. The cost also consists of costs of materials which has been sold attributable to the sales of high-end products. Additional costs may include freight paid to acquire the goods, custom duties, sales or use taxes not recoverable paid on materials used, and any fee for purchase\\n• Share-based compensation\\nPursuant to ASU 2018-07, the Company follows ASC 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards (employee or non employee), are measured at grant-date fair value of the equity instruments that an entity is obligated to issue. Restricted stock units are valued using the market price of the Company’s common shares on the date of grant. As of September 30, 2021, those shares issued for service compensations were immediately vested, and therefore this amount is thus recognized as expense with an offset to preferred or September 30, 2021 and 2020, the stock-based compensations are recorded in the General and administrative expenses within the Condensed Consolidated Statements of Operations and Other Comprehensive Loss.”\\n• Business combinations\\nThe Company follows ASC 805, Business Combinations (“ASC 805”) and ASC 810-10-65, Consolidation. ASC 805 requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “fair value.” The statement applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under ASC 805, all business combinations are accounted for by applying the acquisition method. Accounting for goodwill requires significant management estimates and judgment. Management performs periodic reviews of the carrying value of goodwill to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of goodwill to become impaired. A write-down of the carrying value of goodwill could result in a non-cash charge, which could have an adverse effect on the Company’s results of operations.\\n• Earnings per share\\nBasic per share amounts are calculated using the weighted average shares outstanding during the year, excluding unvested restricted stock units. The Company uses the treasury stock method to determine the dilutive effect of stock options and other dilutive instruments. Under the treasury stock method, only “in the money” dilutive instruments impact the diluted calculations in computing diluted earnings per share. Diluted calculations reflect the weighted average incremental common shares that would be issued upon exercise of dilutive options assuming the proceeds would be used to repurchase shares at average market prices for the period.\\n\\n| 62 |\\n\\nAs of September 30, 2021 and December 31, 2020, the Company has the number of shares of common stock to be issued upon conversion of below:\\n\\n| As of September 30, | As of December 31, |\\n| 2021 | 2020 |\\n| Series A Convertible Preferred Stock (a) | 8,000 | 8,000 |\\n| Series B Convertible Preferred Stock | 764,400 | 764,400 |\\n| Series B-1 Convertible Preferred Stock | 48,000 | 48,000 |\\n| Series C Convertible Preferred Stock | 465,600 | 108,600 |\\n| Series C-1 Convertible Preferred Stock | 4,195,200 | 865,500 |\\n| Warrants granted | — | — |\\n| Warrants granted with Series C-1 Convertible Preferred Stock | 1,178,700 | 614,100 |\\n| Total: | 6,659,900 | 2,408,600 |\\n\\n\\n| (a) | The Series A the conversion formula is aggregate Stated Value divided by IPO price (Stated Value for each Series A preferred share is $1,000). There are 8,000 shares of Series A Preferred Stock issued and outstanding (10,000 shares are designated Series A). The conversion formula would be $8 million (the aggregate stated value) divided by IPO price. |\\n\\n• Segment Reporting\\nASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in condensed consolidated financial statements. For the nine months ended September 30, 2021 and 2020, the Company operates in two reportable operating segment.\\nEmerging Growth Company\\nWe are an “emerging growth company” under the JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (i) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (iii) comply with any new requirements adopted by the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. However, we have elected to “opt out” of the extended transition period discussed in (i) and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards are required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.\\nCritical Accounting Policies and Estimate\\n• Recent accounting pronouncements\\nFrom time to time, new accounting pronouncements are issued by the Financial Accounting Standard Board (“FASB”) or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.\\n\\n| 63 |\\n\\nAccounting Standards Adopted\\nIn August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (“ASU 2018-13”), which eliminates, adds and modifies certain disclosure requirements for fair value measurements. The amendment is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\\nIn November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (“ASU 2018-18”), which clarifies the interaction between ASC 808, Collaborative Arrangements and ASC 606, Revenue from Contracts with Customers. Certain transactions between participants in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer. In addition, ASU 2018-18 precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 should be applied retrospectively to the date of initial application of ASC 606. This guidance is effective for interim and fiscal periods beginning after December 15, 2019. The Company has evaluated and the adoption of this does not have an any impact on the financial statements.\\nAccounting Standards Issued, Not Adopted\\nIn June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). This ASU requires measurement and recognition of expected credit losses for financial assets. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. ASU 2016-13 is effective for the Company beginning January 1, 2023. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the potential effect of this standard on its financial statements. The Company does not expect this standard to have a material impact on its financial statements.\\nIn December 2019, the FASB issued ASU No. 2019-12, Income Taxes: Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2020, with early adoption permitted. Adoption of the standard requires certain changes to be made prospectively, with some changes to be made retrospectively. The Company does not expect the adoption of this standard to have a material impact on its financial position, results of operations or cash flows.\\nIn March 2020, the FASB issued ASU 2020-03, “Codification Improvements to Financial Instruments”: The amendments in this update are to clarify, correct errors in, or make minor improvements to a variety of ASC topics. The changes in ASU 2020-03 are not expected to have a significant effect on current accounting practices. The ASU improves various financial instrument topics in the Codification to increase stakeholder awareness of the amendments and to expedite the improvement process by making the Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. The ASU is effective for smaller reporting companies for fiscal years beginning after December 15, 2022 with early application permitted. The Company is currently evaluating the impact the adoption of this guidance may have on its consolidated financial statements.\\nIn August 2020, the FASB issued ASU 2020-06 Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40) related to the measurement and disclosure requirements for convertible instruments and contracts in an entity's own equity. The pronouncement simplifies and adds disclosure requirements for the accounting and measurement of convertible instruments and the settlement assessment for contracts in an entity's own equity. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2021 and early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.\\n\\n| 64 |\\n\\n\\nItem 3. Quantitative and Qualitative Disclosures about Market Risk.\\nWe did not have investments and do not utilize derivative financial instruments to manage our interest rate risks.\\nItem 4. Controls and Procedures.\\nEvaluation of Disclosure Controls and Procedures\\nWe maintain disclosure controls and procedures that are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended (the \\\"Exchange Act\\\"), is recorded, processed, summarized and reported within the time periods specified in the rules and forms promulgated by the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations to the effectiveness of any system of disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been prevented or detected on a timely basis. Even disclosure controls and procedures determined to be effective can only provide reasonable assurance that their objectives are achieved.\\nAs of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) pursuant to Rule 13a-15 of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are not effective at the reasonable assurance level.\\nOur size has prevented us from being able to employ sufficient resources to enable us to have an adequate level of supervision and segregation of duties. Therefore, it is difficult to effectively segregate accounting duties which comprises a material weakness in internal controls. This lack of segregation of duties leads management to conclude that the Company’s disclosure controls and procedures are not effective to give reasonable assurance that the information required to be disclosed in reports that the Company files under the Exchange Act is recorded, processed, summarized and reported as and when required.\\nTo the extent reasonably possible given our limited resources, we intend to take measures to cure the aforementioned weaknesses, including, but not limited to, increasing the capacity of our qualified financial personnel to ensure that accounting policies and procedures are consistent across the organization and that we have adequate control over our Exchange Act reporting disclosures.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the quarter ended September 30, 2021 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\\n| 65 |\\n\\nPART II\\nOTHER INFORMATION\\n\\nItem 1. Legal Proceedings.\\nThe Company is currently litigating three cases pending in the Supreme Court of the State of New York and one case pending in the United States District Court for the District of New Jersey.\\nTwo cases are employment actions filed by former employees who seek compensation alleged to be due pursuant to agreements with the Company. Both of the employees are represented by the same counsel and filed their cases in the Supreme Court of the State of New York, County of New York, in December 2019.\\nIn one of those actions, a former employee claims entitlement to compensation and a bonus totaling $566,000 and 39,000-58,500 shares of Company common stock, together with costs. The Company responded to the complaint and also asserted counterclaims in the proceeding for $1,500,000 to $4,000,000 plus punitive damages, together with interest and costs, arising from, inter alia, the former employee’s breach of contract, unfair competition, misappropriation of trade secrets and breach of fiduciary duty. The former employee has responded to the Company’s counterclaims and this action is in the discovery phase of the litigation.\\nIn the other employment action, another former employee claims entitlement to salary payments and expense reimbursement in the amount of $122,042.60, plus liquidated damages, together with costs. This former employee also claims entitlement to 516,300 to 760,800 shares of the Company’s common stock. In addition, this action also includes claims by a plaintiff-entity alleging entitlement to $8 million in shares of the Company’s Series A Preferred stock. The Company responded to the complaint and also asserted counterclaims against the former employee in the proceeding for $1,500,000 to $2,000,000 plus punitive damages, together with costs, arising from, inter alia, the former employee’s breach of contract, breach of fiduciary duty, tortious interference and fraud. The former employee has responded to the Company’s counterclaims. The judge assigned to this action retired at the end of 2020. A new judge has been assigned and this action is progressing through the discovery phase of litigation.\\nThe third case also involves one of those former employees; therein, a Company affiliate filed suit in February 2020 seeking enforcement, by way of specific performance, of an agreement which entitles the affiliate to purchase all of the 99 percent of the shares of the plaintiff-entity which alleges entitlement to $8 million in shares of the Company’s Series A Preferred Stock in one of the employment actions described above. The former employee has responded to the Company’s complaint in this action with a motion to dismiss, which was later withdrawn by same, and then by way of an answer without counterclaims. The judge assigned to this action has announced his retirement and the case has not yet been reassigned.\\nThe Company was in an AAA arbitration defending allegations of breach of an agreement. The Demand for Arbitration therein, dated August 25, 2020, asserted that the Petitioner, an LLC, had an agreement with the Company and its CEO granting the Petitioner the right to require the Company to redeem certain common stock in the Company for a cash payment.\\nThe Demand alleged that the Petitioner submitted a Redemption Notice, as required under the alleged agreement, obligating the Company to redeem the shares. The Demand alleged that the failure of the Company to redeem the shares and pay Petitioner further obligated the Company to provide additional common stock to the Petitioner. The amount alleged to be due to the Petitioner as of July 31, 2020 was said to be $590,461.94 and growing daily while the number of additional common stock shares alleged to be due to Petitioner as of July 31, 2020 was said to be 708,542,582 and growing, daily.\\nIn order to avoid an adverse award, the Company agreed to settle the matter for the sum of $550,000. No additional shares were included in the settlement agreement. The settlement sum was required to be paid in two tranches, with $250,000 to have been paid on or before May 28, 2021 and the remaining $300,000 to be paid on or before June 30, 2021. The Company made the required settlement payments and the matter is now considered closed.\\n\\n| 66 |\\n\\nOn or about March 5, 2021, SOSV IV LLC (“SOSV”) sent a demand letter to the Company in regard to its investment in Hottab Pte. Ltd. (“Hottab”).\\nIn this letter, and the subsequently filed lawsuits, SOSV alleges that it entered into an investment arrangement with Hottab in which SOSV was to receive five percent (5%) of the common stock of Hottab and entered into an Accelerator Contract for Equity (the “ACE”) pursuant to which it alleges to have invested a sum of $168,000 with Hottab. These events are alleged to have taken place prior to the Company’s acquisition of Hottab. SOSV alleges that the Company subsequently acquired all of the outstanding shares of Hottab, which it alleges triggered a liquidity event clause under the ACE requiring the Company, by way of its ownership of Hottab, to pay SOSV twice its investment, or $336,000.\\nSOSV further alleges that subsequent to a term sheet between the Company and Hottab being executed, the Company entered into an agreement to purchase one hundred percent (100%) of the issued and outstanding shares of Hottab from Hottab Holdings Limited (“Hottab Holdings”). As SOSV does not have any interest in Hottab Holdings, it did not receive any consideration as allegedly provided under the ACE.\\nUpon these allegations, SOSV asserts causes of action sounding in fraudulent misrepresentation/concealment, breach of contract, breach of the covenant of good faith and fair dealing, quantum meruit and/or unjust enrichment, promissory estoppel, oppression of minority shareholder, and breach of fiduciary duties. SOSV seeks damages in the amount of $336,000.00 in addition damages equal to the value of SOSV’s alleged equity in Hottab or in the alternative shares of the Company in an amount equal to SOSV’s ownership interest in Hottab at the time of the purchase of Hottab’s shares from Hottab Holdings.\\nInitially, SOSV filed suit in the District Court for New Jersey on June 10, 2021. SOSV voluntarily dismissed its New Jersey lawsuit and on October 29, 2021, re-filed the action in the Southern District of New York. The New York lawsuit was also voluntarily dismissed by SOSV. However, SOSV may choose to re-file its lawsuit.\\nThe Company denies the accusations of SOSV and intends to vigorously defend this matter if the action is re-filed. As the lawsuit has been voluntarily dismissed, there have been no proceedings and we are unable to prognosticate a likelihood of success, or whether SOSV will re-file the action.\\nAs of September 30, 2021 and December 31, 2020, the Company had a total of $75,000 and $75,000 outstanding on this account, respectively.\\nAs of September 30, 2021, the Company does not expect any losses from these legal proceedings and accordingly has not accrued any provisions for them.\\nItem 1A. Risk Factors.\\nAs of the date of this Quarterly Report on Form 10-Q, there have been no material changes to the risk factors disclosed in our Prospectus, filed with the SEC on November 10, 2021, pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNot Applicable\\nItem 3. Defaults Upon Senior Securities.\\nNot Applicable\\nItem 4. Mine Safety Disclosures.\\nNot Applicable\\nItem 5. Other Information\\nNone\\n| 67 |\\n\\n\\nItem 6. Exhibits\\nEXHIBIT INDEX\\n| Exhibit No. | Description |\\n| 3.1 | Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.2 | Amended Bylaws of The Registrant (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.3 | Certificate of Designation of Series A Convertible Preferred Stock incorporated by reference to Exhibit 3.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.4 | Certificate of Correction of Series A Certificate of Designation filed May 2019 incorporated by reference to Exhibit 3.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3. | Certificate of Correction to Series A Certificate of Designation filed December 2020 (incorporated by reference to Exhibit 3.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.6 | Certificate of Designation of Series B Convertible Preferred Stock (incorporated by reference to Exhibit 3.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.7 | Certificate of Correction of Series B Certificate of Designation (incorporated by reference to Exhibit 3.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.8 | Certificate of Designation of Series B-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.9 | Certificate of Correction of Series B-1 Certificate of Designation (incorporated by reference to Exhibit 3.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\\n| 3.10 | Certificate of Designation of Series C Convertible Preferred Stock (incorporated by reference to Exhibit 3.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.11 | Certificate of Correction of Series C Certificate of Designation (incorporated by reference to Exhibit 3.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.12 | Certificate of Designation of Series C-1 Convertible Preferred Stock (incorporated by reference to Exhibit 3.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.13 | Certificate of Designation for Series X Super Voting Preferred Stock ((incorporated by reference to Exhibit 3.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 20210. |\\n| 3.14 | Certificate of Amendment to Articles of Incorporation to change the authorized capital of the Registrant, filed December 4, 2018 (incorporated by reference to Exhibit 3.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.15 | Certificate of Amendment to Articles of Incorporation to change the name of Registrant, filed October 2, 2018 (incorporated by reference to Exhibit 3.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.16 | Certificate of Amendment to Articles of Incorporation to effect reverse stock split (incorporated by reference to Exhibit 3.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 3.17 | Certificate of Amendment to Series X Super Voting Preferred Certificate of Designation (incorporated by reference to Exhibit 3.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 4.1 | Form of Series C-1 Warrant (incorporated by reference to Exhibit 4.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 4.2 | Form of Underwriter Warrant (incorporated by reference to Exhibit 4.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.1 | Software Set Up, Development and Use License Agreement dated November 15, 2018 between Society Pass Incorporated and Wallet Factory International Limited (incorporated by reference to Exhibit 10.1 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.2 | Stock Purchase Agreement dated January 10 2019 between HOTTAB PTE. LTD., SOSV IV LLC, General Mobile Corporation and Sanjeev Sapkota (incorporated by reference to Exhibit 10.2 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.3 | Accelerator Contract for Equity dated January 10, 2019 by and between HOTTAB PTE. LTD., SOV IV LLC and Sanjeev Sapkota (incorporated by reference to Exhibit 10.3 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.4 | Employment Agreement dated as of April 1, 2017 between Society Pass Incorporated and Dennis Luan Thuc Nguyen (incorporated by reference to Exhibit 10.4 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.5 | Employment Agreement dated as of September 1, 2020 between Society Pass Incorporated and Liang Wee Leong Raynauld (incorporated by reference to Exhibit 10.5 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.6 | Asset Purchase Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD. (incorporated by reference to Exhibit 10.6 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.7 | Shareholders Agreement dated February 16, 2021 between Goodventures Sea Limited and Sopa Technology PTE. LTD (incorporated by reference to Exhibit 10.7 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.8 | Food Delivery Partnership Agreement dated as of April 22, 2021 between Hottab Asset Vietnam Co. Ltd and Dream Space Trading Co. Ltd (incorporated by reference to Exhibit 10.8 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.9 | Food Delivery Partnership Agreement dated as of July 29, 2020 between Hottab Asset Vietnam Co. Ltd and Lala Move Vietnam Co. Ltd (incorporated by reference to Exhibit 10.9 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.10 | Payment Gateway Agreement dated February 25, 2020 between Hottab Asset Vietnam Co. Ltd and VTC Technology and Digital Content Company (incorporated by reference to Exhibit 10.10 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.11 | Payment Gateway Agreement dated April 20, 2020 between Hottab Asset Vietnam Co. Ltd and Media Corporation (Vietnam Post Telecommunication Media) (incorporated by reference to Exhibit 10.11 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.12 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Zion Joint Stock Company (incorporated by reference to Exhibit 10.12 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.13 | Payment Gateway Agreement dated August 31, 2020 between Hottab Asset Vietnam Co. Ltd and Online Mobile Service Joint Stock Co (incorporated by reference to Exhibit 10.13 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.14 | Vendor Finance Partnership Agreement, dated as of October 22, 2019 between Hottab Asset Vietnam Co. Ltd and SHBank Finance Co. Ltd (incorporated by reference to Exhibit 10.14 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.15 | Business Cooperation Agreement dated March 6, 2020 between Hottab Asset Vietnam Co. and Triip Pte. Ltd ((incorporated by reference to Exhibit 10.15 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.16 | The Registrant’s 2021 Equity Incentive Plan (incorporated by reference to Exhibit 10.16 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.17 | Business Cooperation Contract dated May 28, 2021 between Paytech, JSC and the Registrant (incorporated by reference to Exhibit 10.17 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.18 | Business Cooperation Agreement dated August 15, 2021 between Hottab Vietnam Company Limited and Rainbow Loyalty Company Limited (incorporated by reference to Exhibit 10.18 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 10.19 | Amendment to Employment Agreement dated October 25, 2021 between Dennis Nguyen and the Registrant (incorporated by reference to Exhibit 10.19 to the Registrant’s Registration Statement No. 333-258056, initially filed on July 20, 2021). |\\n| 31.1 | Certification of principal executive officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\\n| 31.2 | Certification of principal financial officer pursuant to Rule 13a-14(A) promulgated under the Securities Exchange Act of 1934 |\\n| 32.1* | Certification of principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) promulgated under the Securities Exchange Act of 1934 |\\n\\n* The certifications furnished in Exhibit 32.1 hereto are deemed to accompany this Form 10-Q and are not deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, nor shall they be deemed incorporated by reference into any filing under the Securities Act or the Exchange Act.\\n| 68 |\\n\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n| SOCIETY PASS INCORPORATED |\\n| (Registrant) |\\n| Date: December 9, 2021 | By: | /s/ Dennis Nguyen |\\n| Dennis Nuguyen |\\n| Chief Executive Officer |\\n| Date: December 9, 2021 | By: | /s/ Ranauld Liang |\\n| Raynauld Liang |\\n| Chief Financial Officer |\\n\\n\\n| 69 |\\n\\n\\n</text>\\n\\nWhat would be the total number of common stock to be issued in 2021 if the IPO price is $10 per share, if the conversion for Series A preferred stocks is its aggregate Stated Value divided by IPO price?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 7459900.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 52,\n \"input_length\": 62394\n}"}}},{"rowIdx":53,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nPART I—FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nBoise Cascade Company\nConsolidated Statements of Operations\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands, except per-share data) |\n| Sales | $ | 1,544,329 | $ | 2,326,282 |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230,635 | 1,729,896 |\n| Depreciation and amortization | 31,186 | 20,543 |\n| Selling and distribution expenses | 128,788 | 146,651 |\n| General and administrative expenses | 26,463 | 26,052 |\n| Other (income) expense, net | ( 345 ) | ( 2,488 ) |\n| 1,416,727 | 1,920,654 |\n| Income from operations | 127,602 | 405,628 |\n| Foreign currency exchange gain (loss) | ( 73 ) | 132 |\n| Pension expense (excluding service costs) | ( 41 ) | ( 171 ) |\n| Interest expense | ( 6,361 ) | ( 6,254 ) |\n| Interest income | 9,685 | 65 |\n| Change in fair value of interest rate swaps | ( 804 ) | 2,066 |\n| 2,406 | ( 4,162 ) |\n| Income before income taxes | 130,008 | 401,466 |\n| Income tax provision | ( 33,275 ) | ( 98,866 ) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Weighted average common shares outstanding: |\n| Basic | 39,593 | 39,474 |\n| Diluted | 39,838 | 39,768 |\n| Net income per common share: |\n| Basic | $ | 2.44 | $ | 7.67 |\n| Diluted | $ | 2.43 | $ | 7.61 |\n| Dividends declared per common share | $ | 0.15 | $ | 0.12 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n1\nBoise Cascade Company\nConsolidated Statements of Comprehensive Income\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Other comprehensive income, net of tax |\n| Defined benefit pension plans |\n| Amortization of actuarial loss, net of tax of $ 2 and $ 5 , respectively | 6 | 16 |\n| Effect of settlements, net of tax of $ — and $ 32 , respectively | — | 98 |\n| Other comprehensive income, net of tax | 6 | 114 |\n| Comprehensive income | $ | 96,739 | $ | 302,714 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n2\nBoise Cascade Company\nConsolidated Balance Sheets\n(unaudited)\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| ASSETS |\n| Current |\n| Cash and cash equivalents | $ | 1,000,721 | $ | 998,344 |\n| Receivables |\n| Trade, less allowances of $ 4,341 and $ 3,264 | 417,515 | 297,237 |\n| Related parties | 196 | 19 |\n| Other | 13,821 | 23,023 |\n| Inventories | 738,798 | 697,551 |\n| Prepaid expenses and other | 20,666 | 47,878 |\n| Total current assets | 2,191,717 | 2,064,052 |\n| Property and equipment, net | 772,734 | 770,023 |\n| Operating lease right-of-use assets | 52,441 | 55,582 |\n| Finance lease right-of-use assets | 25,883 | 26,501 |\n| Timber deposits | 8,299 | 7,519 |\n| Goodwill | 137,958 | 137,958 |\n| Intangible assets, net | 157,133 | 161,433 |\n| Deferred income taxes | 6,135 | 6,116 |\n| Other assets | 9,887 | 11,330 |\n| Total assets | $ | 3,362,187 | $ | 3,240,514 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n3\nBoise Cascade Company\nConsolidated Balance Sheets (continued)\n(unaudited)\n| March 31,2023 | December 31,2022 |\n| (thousands, except per-share data) |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current |\n| Accounts payable |\n| Trade | $ | 400,455 | $ | 269,785 |\n| Related parties | 1,420 | 1,019 |\n| Accrued liabilities |\n| Compensation and benefits | 79,606 | 142,463 |\n| Interest payable | 5,088 | 9,955 |\n| Other | 93,579 | 122,606 |\n| Total current liabilities | 580,148 | 545,828 |\n| Debt |\n| Long-term debt | 444,614 | 444,392 |\n| Other |\n| Compensation and benefits | 33,280 | 33,226 |\n| Operating lease liabilities, net of current portion | 45,681 | 48,668 |\n| Finance lease liabilities, net of current portion | 29,549 | 30,022 |\n| Deferred income taxes | 66,855 | 63,454 |\n| Other long-term liabilities | 17,540 | 16,949 |\n| 192,905 | 192,319 |\n| Commitments and contingent liabilities |\n| Stockholders' equity |\n| Preferred stock, $ 0.01 par value per share; 50,000 shares authorized, no shares issued and outstanding | — | — |\n| Common stock, $ 0.01 par value per share; 300,000 shares authorized, 44,983 and 44,827 shares issued, respectively | 450 | 448 |\n| Treasury stock, 5,392 and 5,367 shares at cost, respectively | ( 140,391 ) | ( 138,909 ) |\n| Additional paid-in capital | 548,611 | 551,215 |\n| Accumulated other comprehensive loss | ( 514 ) | ( 520 ) |\n| Retained earnings | 1,736,364 | 1,645,741 |\n| Total stockholders' equity | 2,144,520 | 2,057,975 |\n| Total liabilities and stockholders' equity | $ | 3,362,187 | $ | 3,240,514 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n4\nBoise Cascade Company\nConsolidated Statements of Cash Flows\n(unaudited)\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Cash provided by (used for) operations |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Items in net income not using (providing) cash |\n| Depreciation and amortization, including deferred financing costs and other | 31,853 | 20,993 |\n| Stock-based compensation | 3,324 | 2,392 |\n| Pension expense | 41 | 171 |\n| Deferred income taxes | 3,393 | ( 729 ) |\n| Change in fair value of interest rate swaps | 804 | ( 2,066 ) |\n| Other | ( 518 ) | ( 2,412 ) |\n| Decrease (increase) in working capital |\n| Receivables | ( 111,253 ) | ( 218,018 ) |\n| Inventories | ( 41,247 ) | ( 143,997 ) |\n| Prepaid expenses and other | ( 1,428 ) | ( 3,227 ) |\n| Accounts payable and accrued liabilities | 36,181 | 147,425 |\n| Pension contributions | ( 136 ) | ( 655 ) |\n| Income taxes payable | 28,631 | 95,352 |\n| Other | 1,614 | 1,116 |\n| Net cash provided by operations | 47,992 | 198,945 |\n| Cash provided by (used for) investment |\n| Expenditures for property and equipment | ( 30,063 ) | ( 17,448 ) |\n| Proceeds from sales of assets and other | 565 | 2,581 |\n| Net cash used for investment | ( 29,498 ) | ( 14,867 ) |\n| Cash provided by (used for) financing |\n| Dividends paid on common stock | ( 8,258 ) | ( 5,939 ) |\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 3,930 ) |\n| Treasury stock purchased | ( 1,482 ) | — |\n| Other | ( 451 ) | ( 395 ) |\n| Net cash used for financing | ( 16,117 ) | ( 10,264 ) |\n| Net increase in cash and cash equivalents | 2,377 | 173,814 |\n| Balance at beginning of the period | 998,344 | 748,907 |\n| Balance at end of the period | $ | 1,000,721 | $ | 922,721 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n5\nBoise Cascade Company\nConsolidated Statements of Stockholders' Equity\n(unaudited)\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\n| Shares | Amount | Shares | Amount |\n| (thousands) |\n| Balance at December 31, 2022 | 44,827 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 551,215 | $ | ( 520 ) | $ | 1,645,741 | $ | 2,057,975 |\n| Net income | 96,733 | 96,733 |\n| Other comprehensive income | 6 | 6 |\n| Common stock issued | 156 | 2 | 2 |\n| Treasury stock purchased | 25 | ( 1,482 ) | ( 1,482 ) |\n| Stock-based compensation | 3,324 | 3,324 |\n| Common stock dividends ($ 0.15 per share) | ( 6,110 ) | ( 6,110 ) |\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 5,926 ) |\n| Other | ( 2 ) | ( 2 ) |\n| Balance at March 31, 2023 | 44,983 | $ | 450 | 5,392 | $ | ( 140,391 ) | $ | 548,611 | $ | ( 514 ) | $ | 1,736,364 | $ | 2,144,520 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n6\nBoise Cascade Company\nConsolidated Statements of Stockholders' Equity (continued)\n(unaudited)\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\n| Shares | Amount | Shares | Amount |\n| (thousands) |\n| Balance at December 31, 2021 | 44,698 | $ | 447 | 5,367 | $ | ( 138,909 ) | $ | 543,249 | $ | ( 1,047 ) | $ | 948,879 | $ | 1,352,619 |\n| Net income | 302,600 | 302,600 |\n| Other comprehensive income | 114 | 114 |\n| Common stock issued | 117 | 1 | 1 |\n| Stock-based compensation | 2,392 | 2,392 |\n| Common stock dividends ($ 0.12 per share) | ( 5,133 ) | ( 5,133 ) |\n| Tax withholding payments on stock-based awards | ( 3,930 ) | ( 3,930 ) |\n| Proceeds from exercise of stock options | 27 | 27 |\n| Other | ( 1 ) | ( 1 ) |\n| Balance at March 31, 2022 | 44,815 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 541,737 | $ | ( 933 ) | $ | 1,246,346 | $ | 1,648,689 |\n\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\n7\nCondensed Notes to Unaudited Quarterly Consolidated Financial Statements\n1. Nature of Operations and Consolidation\nNature of Operations\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \"Boise Cascade,\" \"we,\" and \"our\" refer to Boise Cascade Company and its consolidated subsidiaries. We are one of the largest producers of engineered wood products (EWP) and plywood in North America and a leading United States wholesale distributor of building products.\nWe operate our business using two reportable segments: (1) Wood Products, which primarily manufactures EWP and plywood, and (2) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. For more information, see Note 12, Segment Information.\nConsolidation\nThe accompanying quarterly consolidated financial statements have not been audited by an independent registered public accounting firm but, in the opinion of management, include all adjustments necessary to present fairly the financial position, results of operations, cash flows, and stockholders' equity for the interim periods presented. Except as disclosed within these condensed notes to unaudited quarterly consolidated financial statements, the adjustments made were of a normal, recurring nature. Certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted. The quarterly consolidated financial statements include the accounts of Boise Cascade and its subsidiaries after elimination of intercompany balances and transactions. Quarterly results are not necessarily indicative of results that may be expected for the full year. These condensed notes to unaudited quarterly consolidated financial statements should be read in conjunction with our 2022 Form 10-K and the other reports we file with the Securities and Exchange Commission.\n2. Summary of Significant Accounting Policies\nAccounting Policies\nThe complete summary of significant accounting policies is included in Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K.\nUse of Estimates\nThe preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories, goodwill, intangible assets, and other long-lived assets; legal contingencies; guarantee obligations; indemnifications; assumptions used in retirement, medical, and workers' compensation benefits; assumptions used in the determination of right-of-use (ROU) assets and related lease liabilities; stock-based compensation; fair value measurements; income taxes; and vendor and customer rebates, among others. These estimates and assumptions are based on management's best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates resulting from continuing changes in the economic environment will be reflected in the consolidated financial statements in future periods.\n8\nRevenue Recognition\nRevenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. For revenue disaggregated by major product line for each reportable segment, see Note 12, Segment Information.\nFees for shipping and handling charged to customers for sales transactions are included in \"Sales\" in our Consolidated Statements of Operations. When control over products has transferred to the customer, we have elected to recognize costs related to shipping and handling as fulfillment costs. For our Wood Products segment, costs related to shipping and handling are included in \"Materials, labor, and other operating expenses (excluding depreciation)\" in our Consolidated Statements of Operations. In our Wood Products segment, we view our shipping and handling costs as a cost of the manufacturing process and the movement of product to our end customers. For our BMD segment, costs related to shipping and handling of $ 53.5 million and $ 56.3 million for the three months ended March 31, 2023 and 2022, respectively, are included in \"Selling and distribution expenses\" in our Consolidated Statements of Operations. In our BMD segment, our activities relate to the purchase and resale of finished products, and excluding shipping and handling costs from \"Materials, labor, and other operating expenses (excluding depreciation)\" provides us a clearer view of our operating performance and the effectiveness of our sales and purchasing functions.\nCustomer Rebates and Allowances\nRebates are provided to our customers and our customers' customers based on the volume of their purchases, among other factors such as customer loyalty, conversion, and commitment, as well as temporary protection from price increases. We provide the rebates to increase the sell-through of our products. Rebates are generally estimated based on the expected amount to be paid and recorded as a decrease in \"Sales.\" At March 31, 2023 and December 31, 2022, we had $ 58.7 million and $ 92.9 million, respectively, of rebates payable to our customers recorded in \"Accrued liabilities, Other\" on our Consolidated Balance Sheets. We adjust our estimate of revenue at the earlier of when the probability of rebates paid changes or when the amounts become fixed. There have not been significant changes to our estimates of rebates, although it is reasonably possible that a change in the estimate may occur.\nVendor Rebates and Allowances\nWe receive rebates and allowances from our vendors under a number of different programs, including vendor marketing programs. At March 31, 2023 and December 31, 2022, we had $ 9.0 million and $ 17.8 million, respectively, of vendor rebates and allowances recorded in \"Receivables, Other\" on our Consolidated Balance Sheets. Rebates and allowances received from our vendors are recognized as a reduction of \"Materials, labor, and other operating expenses (excluding depreciation)\" when the product is sold, unless the rebates and allowances are linked to a specific incremental cost to sell a vendor's product. Amounts received from vendors that are linked to specific selling and distribution expenses are recognized as a reduction of \"Selling and distribution expenses\" in the period the expense is incurred.\nLeases\nWe primarily lease land, building, and equipment under operating and finance leases. We determine if an arrangement is a lease at inception and assess lease classification as either operating or finance at lease inception or upon modification. Substantially all of our leases with initial terms greater than one year are for real estate, including distribution centers, corporate headquarters, land, and other office space. Substantially all of these lease agreements have fixed payment terms based on the passage of time and are recorded in our BMD segment. Many of our leases include fixed escalation clauses, renewal options and/or termination options that are factored into our determination of lease term and lease payments when appropriate. Renewal options generally range from one to ten years with fixed payment terms similar to those in the original lease agreements. Some lease agreements provide us with the option to purchase the leased property at market value. Our lease agreements do not contain any residual value guarantees.\nROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the lease commencement date based on the estimated present value of fixed lease payments over the lease term. The current portion of our operating and finance lease liabilities are recorded in \"Accrued liabilities, Other\" on our Consolidated Balance Sheets.\nWe use our estimated incremental borrowing rate, which is derived from information available at the lease commencement date, in determining the present value of lease payments. In determining our incremental borrowing rates, we\n9\ngive consideration to publicly available interest rates for instruments with similar characteristics, including credit rating, term, and collateralization.\nFor purposes of determining straight-line rent expense, the lease term is calculated from the date we first take possession of the facility, including any periods of free rent and any renewal option periods we are reasonably certain of exercising. Variable lease expense generally includes reimbursement of actual costs for common area maintenance, property taxes, and insurance on leased real estate and are recorded as incurred. Most of our operating lease expense was recorded in \"Selling and distribution expenses\" in our Consolidated Statements of Operations. In addition, we do not separate lease and non-lease components for all of our leases.\nOur short-term leases primarily include equipment rentals with lease terms on a month-to-month basis, which provide for our seasonal needs and flexibility in the use of equipment. Our short-term leases also include certain real estate for which either party has the right to cancel upon providing notice of 30 to 90 days. We do not recognize ROU assets or lease liabilities for short-term leases.\nInventories\nInventories included the following (work in process is not material):\n\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Finished goods and work in process | $ | 640,858 | $ | 596,328 |\n| Logs | 50,154 | 54,921 |\n| Other raw materials and supplies | 47,786 | 46,302 |\n| $ | 738,798 | $ | 697,551 |\n\nProperty and Equipment\nProperty and equipment consisted of the following asset classes:\n\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Land | $ | 61,806 | $ | 60,211 |\n| Buildings | 242,484 | 231,087 |\n| Improvements | 70,419 | 69,832 |\n| Mobile equipment, information technology, and office furniture | 215,460 | 210,666 |\n| Machinery and equipment | 993,900 | 989,338 |\n| Construction in progress | 45,348 | 41,899 |\n| 1,629,417 | 1,603,033 |\n| Less: accumulated depreciation | ( 856,683 ) | ( 833,010 ) |\n| $ | 772,734 | $ | 770,023 |\n\n10\nFair Value\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy under GAAP gives the highest priority to quoted market prices (Level 1) and the lowest priority to unobservable inputs (Level 3). In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value (Level 1). If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, we use quoted prices for similar assets and liabilities or inputs that are observable either directly or indirectly (Level 2). If quoted prices for identical or similar assets are not available or are unobservable, we may use internally developed valuation models, whose inputs include bid prices, and third-party valuations utilizing underlying asset assumptions (Level 3).\nFinancial Instruments\nOur financial instruments are cash and cash equivalents, accounts receivable, accounts payable, long-term debt, and an interest rate swap. Our cash is recorded at cost, which approximates fair value, and our cash equivalents are money market funds. As of March 31, 2023 and December 31, 2022, we held $ 981.1 million and $ 954.4 million, respectively, in money market funds that are measured at fair value on a recurring basis using Level 1 inputs. The recorded values of accounts receivable and accounts payable approximate fair values based on their short-term nature. At March 31, 2023 and December 31, 2022, the book value of our fixed-rate debt for each period was $ 400.0 million, and the fair value was estimated to be $ 348.0 million and $ 348.5 million, respectively. The difference between the book value and the fair value is derived from the difference between the period-end market interest rate and the stated rate of our fixed-rate, long-term debt. We estimated the fair value of our fixed-rate debt using quoted market prices of our debt in inactive markets (Level 2 inputs). The interest rate on our variable-rate debt is based on market conditions such as the Secured Overnight Financing Rate (SOFR) or a base rate. Because the interest rate on the variable-rate debt is based on current market conditions, we believe that the estimated fair value of the outstanding balance on our variable-rate debt approximates book value. As discussed below, we also have an interest rate swap to mitigate our variable interest rate exposure, the fair value of which is measured based on Level 2 inputs.\nInterest Rate Risk and Interest Rate Swap\nWe are exposed to interest rate risk arising from fluctuations in variable-rate SOFR on our term loan and when we have loan amounts outstanding on our Revolving Credit Facility. At March 31, 2023, we had $ 50.0 million of variable-rate debt outstanding based on one-month term SOFR . Our objective is to limit the variability of interest payments on our debt. To meet this objective, we enter into receive-variable, pay-fixed interest rate swaps to mitigate the variable-rate cash flow exposure with fixed-rate cash flows. In accordance with our risk management strategy, we actively monitor our interest rate exposure and use derivative instruments from time to time to manage the related risk. We do not speculate using derivative instruments.\nAt March 31, 2023, we had one interest rate swap agreement, which we entered into in 2020 and commenced in February 2022. Under the interest rate swap, we receive one-month SOFR plus a spread adjustment of 0.10 % variable interest rate payments and make fixed interest rate payments, thereby fixing the interest rate on $ 50.0 million of variable rate debt exposure. Payments on this interest rate swap, with a notional principal amount of $ 50.0 million, are due on a monthly basis at an annual fixed rate of 0.41 %, and this swap expires in June 2025.\nThe interest rate swap agreement was not designated as a cash flow hedge, and as a result, all changes in the fair value are recognized in \"Change in fair value of interest rate swaps\" in our Consolidated Statements of Operations rather than through other comprehensive income. At March 31, 2023 and December 31, 2022, we recorded long-term assets of $ 4.0 million and $ 4.8 million, respectively, in \"Other assets\" on our Consolidated Balance Sheets, representing the fair value of the interest rate swap agreement. The swap was valued based on observable inputs for similar assets and liabilities and other observable inputs for interest rates and yield curves (Level 2 inputs).\nConcentration of Credit Risk\nWe are exposed to credit risk related to customer accounts receivable. In order to manage credit risk, we consider customer concentrations and current economic trends and monitor the creditworthiness of significant customers based on ongoing credit evaluations. At March 31, 2023, receivables from two customers accounted for approximately 19 % and 12 % of total receivables. At December 31, 2022, receivables from these two customers accounted for approximately 17 % and 14 % of total receivables. No other customer accounted for 10% or more of total receivables.\n11\nNew and Recently Adopted Accounting Standards\nThere were no accounting standards recently issued that had or are expected to have a material impact on our consolidated financial statements and associated disclosures.\n3. Income Taxes\nFor the three months ended March 31, 2023 and 2022, we recorded $ 33.3 million and $ 98.9 million, respectively, of income tax expense and had an effective rate of 25.6 % and 24.6 %, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21 % and the effective tax rate was the effect of state taxes.\nDuring the three months ended March 31, 2023 and 2022, cash paid for taxes, net of refunds received, were $ 1.2 million and $ 4.2 million, respectively.\n4. Net Income Per Common Share\nBasic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Weighted average common shares outstanding for the basic net income per common share calculation includes certain vested restricted stock units (RSUs) and performance stock units (PSUs) as there are no conditions under which those shares will not be issued. Diluted net income per common share is computed by dividing net income by the combination of the weighted average number of common shares outstanding during the period and other potentially dilutive weighted average common shares. Other potentially dilutive weighted average common shares include the dilutive effect of stock options, RSUs, and PSUs for each period using the treasury stock method. Under the treasury stock method, the exercise price of a share and the amount of compensation expense, if any, for future service that has not yet been recognized are assumed to be used to repurchase shares in the current period.\nThe following table sets forth the computation of basic and diluted net income per common share:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands, except per-share data) |\n| Net income | $ | 96,733 | $ | 302,600 |\n| Weighted average common shares outstanding during the period (for basic calculation) | 39,593 | 39,474 |\n| Dilutive effect of other potential common shares | 245 | 294 |\n| Weighted average common shares and potential common shares (for diluted calculation) | 39,838 | 39,768 |\n| Net income per common share - Basic | $ | 2.44 | $ | 7.67 |\n| Net income per common share - Diluted | $ | 2.43 | $ | 7.61 |\n\nThe computation of the dilutive effect of other potential common shares excludes stock awards representing an insignificant number of shares of common stock in both the three months ended March 31, 2023 and 2022. Under the treasury stock method, the inclusion of these stock awards would have been antidilutive.\n12\n5. Acquisition\nWe account for acquisition transactions in accordance with ASC 805, Business Combinations. Accordingly, the results of operations of the acquiree are included in our consolidated financial statements from the acquisition date. The consideration transferred is allocated to the identifiable assets acquired and liabilities assumed based on estimated fair values at the acquisition date, with any excess recorded as goodwill. Transaction-related costs are expensed in the period the costs are incurred. During the measurement period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding adjustment to goodwill.\nOn July 25, 2022, our wholly-owned subsidiary, Boise Cascade Wood Products, L.L.C., completed the acquisition of 100 % of the equity interest in Coastal Plywood, and its plywood manufacturing operations located in Havana, Florida, and Chapman, Alabama, for a purchase price of $ 515.2 million, including a post-closing adjustment of $ 1.6 million based upon a working capital target (the Acquisition).\nThe following table summarizes the final allocations of the purchase price to the assets acquired and liabilities assumed, based on our estimates of the fair value at the date of the Acquisition:\n| Acquisition Date Fair Value |\n| (thousands) |\n| Accounts receivable | $ | 16,123 |\n| Inventories | 22,977 |\n| Property and equipment | 251,329 |\n| Other assets | 1,809 |\n| Intangible assets: |\n| Trade name | 700 |\n| Customer relationships | 153,600 |\n| Goodwill | 77,576 |\n| Assets acquired | 524,114 |\n| Accounts payable and accrued liabilities | 6,299 |\n| Other long-term liabilities | 2,578 |\n| Liabilities assumed | 8,877 |\n| Net assets acquired | $ | 515,237 |\n\n13\n6. Goodwill and Intangible Assets\nGoodwill represents the excess of the purchase price and related costs over the fair value of the net tangible and intangible assets of businesses acquired.\nThe carrying amount of our goodwill by segment is as follows:\n| BuildingMaterialsDistribution | Wood Products | Total |\n| (thousands) |\n| Balance at December 31, 2022 and March 31, 2023 | $ | 11,792 | $ | 126,166 | $ | 137,958 |\n\nAt March 31, 2023 and December 31, 2022, intangible assets represented the values assigned to trade names and trademarks and customer relationships. We maintain trademarks for our manufactured wood products, particularly EWP. Our key registered trademarks are perpetual in duration as long as we continue to timely file all post registration maintenance documents related thereto. These trade names and trademarks have indefinite lives, are not amortized, and have a carrying amount of $ 8.9 million. In 2022, we acquired a trade name and customer relationships as discussed in Note 5, Acquisition. The acquired trade name has a useful life of one year . The weighted-average useful life for customer relationships from the date of purchase is approximately 10 years. For the three months ended March 31, 2023 and 2022 we recognized $ 4.3 million and $ 0.3 million, respectively, of amortization expense for intangible assets.\nIntangible assets consisted of the following:\n| March 31, 2023 |\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\n| (thousands) |\n| Trade names and trademarks | $ | 9,600 | $ | ( 467 ) | $ | 9,133 |\n| Customer relationships | 166,050 | ( 18,050 ) | 148,000 |\n| $ | 175,650 | $ | ( 18,517 ) | $ | 157,133 |\n\n| December 31, 2022 |\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\n| (thousands) |\n| Trade names and trademarks | $ | 9,600 | $ | ( 292 ) | $ | 9,308 |\n| Customer relationships | 166,050 | ( 13,925 ) | 152,125 |\n| $ | 175,650 | $ | ( 14,217 ) | $ | 161,433 |\n\n7. Debt\nLong-term debt consisted of the following:\n| March 31,2023 | December 31,2022 |\n| (thousands) |\n| Asset-based revolving credit facility due 2027 | $ | — | $ | — |\n| Asset-based credit facility term loan due 2027 | 50,000 | 50,000 |\n| 4.875% senior notes due 2030 | 400,000 | 400,000 |\n| Deferred financing costs | ( 5,386 ) | ( 5,608 ) |\n| Long-term debt | $ | 444,614 | $ | 444,392 |\n\n14\nAsset-Based Credit Facility\nOn May 15, 2015, Boise Cascade and its principal operating subsidiaries, Boise Cascade Wood Products, L.L.C., and Boise Cascade Building Materials Distribution, L.L.C., as borrowers, and Boise Cascade Wood Products Holdings Corp., as guarantor, entered into an Amended and Restated Credit Agreement, as amended, (the Amended Agreement) with Wells Fargo Capital Finance, LLC, as administrative agent, and the banks named therein as lenders. The Amended Agreement includes a $ 400 million senior secured asset-based revolving credit facility (Revolving Credit Facility) and a $ 50.0 million term loan (ABL Term Loan) maturing on the earlier of (a) September 9, 2027 and (b) 90 days prior to the maturity of our $ 400 million of 4.875 % senior notes due July 1, 2030 (or the maturity date of any permitted refinancing indebtedness or permitted upsized refinancing indebtedness in respect thereof). Interest on borrowings under our Revolving Credit Facility and ABL Term Loan are payable monthly. Borrowings under the Amended Agreement are constrained by a borrowing base formula dependent upon levels of eligible receivables and inventory reduced by outstanding borrowings and letters of credit (Availability).\nThe Amended Agreement is secured by a first-priority security interest in substantially all of our assets, except for property and equipment. The proceeds of borrowings under the agreement are available for working capital and other general corporate purposes.\nThe Amended Agreement contains customary nonfinancial covenants, including a negative pledge covenant and restrictions on new indebtedness, investments, distributions to equity holders, asset sales, and affiliate transactions, the scope of which are dependent on the Availability existing from time to time. The Amended Agreement also contains a requirement that we meet a 1 :1 fixed-charge coverage ratio (FCCR), applicable only if Availability falls below the greater of (a) 10 % of the Line Cap (as defined in the Amended Agreement) and (b) $ 35 million. Availability exceeded the minimum threshold amounts required for testing of the FCCR at all times since entering into the Amended Agreement, and Availability at March 31, 2023 was $ 395.9 million.\nThe Amended Agreement permits us to pay dividends only if at the time of payment (a) no default has occurred or is continuing (or would result from such payment) under the Amended Agreement, and (b) either (i) pro forma Excess Availability (as defined in the Amended Agreement) is equal to or exceeds the greater of (x) 20 % of the Line Cap and (y) $ 75 million or (ii) (x) pro forma Excess Availability is equal to or exceeds the greater of (1) 15 % of Line Cap and (2) $ 55 million and (y) our fixed-charge coverage ratio is greater than or equal to 1 :1 on a pro forma basis.\nRevolving Credit Facility\nInterest rates under the Revolving Credit Facility are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.25 % to 1.50 % for loans based on SOFR and from 0.25 % to 0.50 % for loans based on the base rate. The spread is determined on the basis of a pricing grid that results in a higher spread as average quarterly Availability declines. Both SOFR options include an additional credit spread adjustment of 0.10 %. Letters of credit are subject to a fronting fee payable to the issuing bank and a fee payable to the lenders equal to the Term SOFR margin rate. In addition, we are required to pay an unused commitment fee at a rate of 0.20 % per annum of the average unused portion of the lending commitments.\nAt both March 31, 2023 and December 31, 2022, we had no borrowings outstanding under the Revolving Credit Facility and $ 4.1 million and $ 3.8 million, respectively, of letters of credit outstanding. These letters of credit and borrowings, if any, reduce availability under the Revolving Credit Facility by an equivalent amount.\nABL Term Loan\nThe ABL Term Loan was provided by institutions within the Farm Credit system. Borrowings under the ABL Term Loan may be repaid from time to time at the discretion of the borrowers without premium or penalty. However, any principal amount of ABL Term Loan repaid may not be subsequently re-borrowed.\nInterest rates under the ABL Term Loan are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.75 % to 2.00 % for SOFR rate loans and from 0.75 % to 1.00 % for base rate loans, both dependent on the amount of Average Excess Availability (as defined in the Amended Agreement). Both SOFR options include an additional credit spread adjustment of 0.10 %. During the three months ended March 31, 2023, the average interest rate on the ABL Term Loan was approximately 6.36 %.\nWe have received and expect to continue receiving patronage credits under the ABL Term Loan. Patronage credits are distributions of profits from banks in the Farm Credit system, which are cooperatives that are required to distribute profits to\n15\ntheir members. Patronage distributions, which are generally made in cash, are received in the year after they are earned. Patronage credits are recorded as a reduction to interest expense in the year earned. After giving effect to expected patronage distributions, the effective average net interest rate on the ABL Term Loan was approximately 5.4 % during the three months ended March 31, 2023.\n2030 Notes\nOn July 27, 2020, we issued $ 400 million of 4.875 % senior notes due July 1, 2030 (2030 Notes) through a private placement that was exempt from the registration requirements of the Securities Act. Interest on our 2030 Notes is payable semiannually in arrears on January 1 and July 1. The 2030 Notes are guaranteed by each of our existing and future direct or indirect domestic subsidiaries that is a guarantor under our Amended Agreement.\nThe 2030 Notes are senior unsecured obligations and rank equally with all of the existing and future senior indebtedness of Boise Cascade Company and of the guarantors, senior to all of their existing and future subordinated indebtedness, effectively subordinated to all of their present and future senior secured indebtedness (including all borrowings with respect to our Amended Agreement to the extent of the value of the assets securing such indebtedness), and structurally subordinated to the indebtedness of any subsidiaries that do not guarantee the 2030 Notes.\nThe terms of the indenture governing the 2030 Notes, among other things, limit the ability of Boise Cascade and our restricted subsidiaries to: incur additional debt; declare or pay dividends; redeem stock or make other distributions to stockholders; make investments; create liens on assets; consolidate, merge or transfer substantially all of their assets; enter into transactions with affiliates; and sell or transfer certain assets. The indenture governing the 2030 Notes permits us to pay dividends only if at the time of payment (i) no default has occurred or is continuing (or would result from such payment) under the indenture, and (ii) our consolidated leverage ratio is no greater than 3.5 :1, or (iii) the dividend, together with other dividends since the issue date, would not exceed our \"builder\" basket under the indenture. In addition, the indenture includes certain specific baskets for the payment of dividends.\nThe indenture governing the 2030 Notes provides for customary events of default and remedies.\nInterest Rate Swap\nFor information on interest rate swap, see Interest Rate Risk and Interest Rate Swap of Note 2, Summary of Significant Accounting Policies.\nCash Paid for Interest\nFor the three months ended March 31, 2023 and 2022, cash payments for interest were $ 10.4 million and $ 10.6 million, respectively.\n16\n8. Leases\nLease Costs\nThe components of lease expense were as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Operating lease cost | $ | 3,317 | $ | 3,561 |\n| Finance lease cost |\n| Amortization of right-of-use assets | 618 | 626 |\n| Interest on lease liabilities | 560 | 587 |\n| Variable lease cost | 1,385 | 1,034 |\n| Short-term lease cost | 1,551 | 1,312 |\n| Sublease income | ( 53 ) | ( 112 ) |\n| Total lease cost | $ | 7,378 | $ | 7,008 |\n\nOther Information\nSupplemental cash flow information related to leases was as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Cash paid for amounts included in the measurement of lease liabilities |\n| Operating cash flows from operating leases | $ | 3,366 | $ | 3,440 |\n| Operating cash flows from finance leases | 560 | 587 |\n| Financing cash flows from finance leases | 451 | 422 |\n| Right-of-use assets obtained in exchange for lease obligations |\n| Operating leases | 92 | — |\n| Finance leases | — | — |\n\n17\nOther information related to leases was as follows:\n| March 31, 2023 | December 31, 2022 |\n| Weighted-average remaining lease term (years) |\n| Operating leases | 7 | 7 |\n| Finance leases | 14 | 14 |\n| Weighted-average discount rate |\n| Operating leases | 6.0 | % | 6.0 | % |\n| Finance leases | 7.6 | % | 7.6 | % |\n\nAs of March 31, 2023, our minimum lease payment requirements for noncancelable operating and finance leases are as follows:\n| Operating Leases | Finance Leases |\n| (thousands) |\n| Remainder of 2023 | $ | 10,162 | $ | 3,046 |\n| 2024 | 12,104 | 4,052 |\n| 2025 | 10,385 | 3,735 |\n| 2026 | 7,200 | 3,581 |\n| 2027 | 6,497 | 3,649 |\n| Thereafter | 23,633 | 33,086 |\n| Total future minimum lease payments | 69,981 | 51,149 |\n| Less: interest | ( 14,015 ) | ( 19,746 ) |\n| Total lease obligations | 55,966 | 31,403 |\n| Less: current obligations | ( 10,285 ) | ( 1,854 ) |\n| Long-term lease obligations | $ | 45,681 | $ | 29,549 |\n\n9. Stock-Based Compensation\nIn first quarter 2023 and 2022, we granted two types of stock-based awards under our incentive plan: performance stock units (PSUs) and restricted stock units (RSUs).\nPSU and RSU Awards\nDuring the three months ended March 31, 2023, we granted 93,282 PSUs to our officers and other employees, subject to performance and service conditions. For the officers, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade's 2023 return on invested capital (ROIC), as approved by our compensation committee in accordance with the related grant agreement. We define ROIC as net operating profit after taxes (NOPAT) divided by average invested capital (based on a rolling thirteen-month average). We define NOPAT as net income plus after-tax financing expense. Invested capital is defined as total assets plus capitalized lease expense, less cash, cash equivalents, and current liabilities, excluding short-term debt. For the other employees, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade’s 2023 EBITDA, defined as income before interest (interest expense and interest income), income taxes, and depreciation and amortization, as approved by executive management, determined in accordance with the related grant agreement. Because the PSUs contain a performance condition, we record compensation expense over the requisite service period based on the most probable number of shares expected to vest.\nDuring the three months ended March 31, 2022, we granted 66,180 PSUs to our officers and other employees, subject to performance and service conditions. During the 2022 performance period, officers and other employees earned 152 % and 200 %, respectively, of the target based on Boise Cascade's 2022 ROIC and EBITDA, as applicable, determined by our compensation committee and executive management, as applicable, in accordance with the related grant agreements.\nThe PSUs granted to officers generally vest in a single installment three years from the date of grant, while the PSUs granted to other employees vest in three equal tranches each year after the grant date.\n18\nDuring the three months ended March 31, 2023 and 2022, we granted an aggregate of 115,060 and 81,523 RSUs, respectively, to our officers, other employees, and nonemployee directors with only service conditions. The RSUs granted to officers and other employees vest in three equal tranches each year after the grant date. The RSUs granted to nonemployee directors vest in a single installment after a one year period.\nWe based the fair value of PSU and RSU awards on the closing market price of our common stock on the grant date. During the three months ended March 31, 2023 and 2022, the total fair value of PSUs and RSUs vested was $ 16.8 million and $ 12.0 million, respectively.\nThe following summarizes the activity of our PSUs and RSUs awarded under our incentive plan for the three months ended March 31, 2023:\n| PSUs | RSUs |\n| Number of shares | Weighted Average Grant-Date Fair Value | Number of shares | Weighted Average Grant-Date Fair Value |\n| Outstanding, December 31, 2022 | 317,854 | $ | 51.46 | 155,339 | $ | 65.17 |\n| Granted | 93,282 | 69.33 | 115,060 | 69.33 |\n| Performance condition adjustment (a) | 39,873 | 79.80 | — | — |\n| Vested | ( 154,794 ) | 40.61 | ( 87,632 ) | 60.64 |\n| Forfeited | ( 5,399 ) | 68.55 | ( 3,200 ) | 70.32 |\n| Outstanding, March 31, 2023 | 290,816 | $ | 66.54 | 179,567 | $ | 69.96 |\n\n_______________________________\n(a) Represents additional PSUs granted during the three months ended March 31, 2023, related to above-target achievement of the 2022 performance condition described above.\nCompensation Expense\nWe record compensation expense over the awards' vesting period and account for share-based award forfeitures as they occur, rather than making estimates of future forfeitures. Any shares not vested are forfeited. We recognize compensation expense for stock awards with only service conditions on a straight-line basis over the requisite service period. Most of our stock-based compensation expense was recorded in \"General and administrative expenses\" in our Consolidated Statements of Operations. Total stock-based compensation recognized from PSUs and RSUs, net of forfeitures, was as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| PSUs | $ | 1,814 | $ | 1,306 |\n| RSUs | 1,510 | 1,086 |\n| Total | $ | 3,324 | $ | 2,392 |\n\nThe related tax benefit for the three months ended March 31, 2023 and 2022, was $ 0.9 million and $ 0.6 million respectively. As of March 31, 2023, total unrecognized compensation expense related to nonvested share-based compensation arrangements was $ 23.7 million. This expense is expected to be recognized over a weighted-average period of 2.2 years.\n19\n10. Stockholders' Equity\nDividends\nOn November 14, 2017, we announced that our board of directors approved a dividend policy to pay quarterly cash dividends to holders of our common stock. For more information regarding our dividend declarations and payments made during each of the three months ended March 31, 2023 and 2022, see \"Common stock dividends\" on our Consolidated Statements of Stockholders' Equity.\nOn May 4, 2023 , our board of directors declared a quarterly dividend of $ 0.15 per share on our common stock, as well as a special dividend of $ 3.00 per share on our common stock, both payable on June 15, 2023 , to stockholders of record on June 1, 2023 . For a description of the restrictions in our asset-based credit facility and the indenture governing our senior notes on our ability to pay dividends, see Note 7, Debt.\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\nStock Repurchase\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During the three months ended March 31, 2023, we repurchased 24,727 shares under the Program at a cost of $ 1.5 million, or an average of $ 59.91 per share. The shares were purchased with cash on hand and are recorded as \"Treasury stock\" on our Consolidated Balance Sheet. As of March 31, 2023, there were 1,972,262 shares of common stock that may yet be purchased under the Program.\n11. Transactions With Related Party\nLouisiana Timber Procurement Company, L.L.C. (LTP) is an unconsolidated variable-interest entity that is 50 % owned by us and 50 % owned by Packaging Corporation of America (PCA). LTP procures sawtimber, pulpwood, residual chips, and other residual wood fiber to meet the wood and fiber requirements of us and PCA in Louisiana. We are not the primary beneficiary of LTP as we do not have power to direct the activities that most significantly affect the economic performance of LTP. Accordingly, we do not consolidate LTP's results in our financial statements.\nSales\nRelated-party sales to LTP from our Wood Products segment in our Consolidated Statements of Operations were $ 3.0 million and $ 3.7 million, respectively, during the three months ended March 31, 2023 and 2022. These sales are recorded in \"Sales\" in our Consolidated Statements of Operations.\nCosts and Expenses\nRelated-party wood fiber purchases from LTP were $ 20.1 million and $ 20.8 million, respectively, during the three months ended March 31, 2023 and 2022. These costs are recorded in \"Materials, labor, and other operating expenses (excluding depreciation)\" in our Consolidated Statements of Operations.\n20\n12. Segment Information\nWe operate our business using two reportable segments: Wood Products and BMD. We measure and evaluate our reportable segments based on net sales and segment operating income (loss). Accordingly, our chief operating decision maker reviews the performance of the company and allocates resources based primarily on net sales and segment operating income (loss) for our business segments. Unallocated corporate costs are presented as reconciling items to arrive at operating income. There are no differences in our basis of measurement of segment profit or loss from those disclosed in Note 16, Segment Information, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K.\nWood Products and BMD segment sales to external customers, including related parties, by product line, are as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (millions) |\n| Wood Products (a) |\n| LVL (b) | $ | 7.4 | $ | 1.7 |\n| I-joists (b) | 4.7 | ( 2.2 ) |\n| Other engineered wood products (b) | 7.4 | 11.8 |\n| Plywood and veneer | 91.3 | 161.2 |\n| Lumber | 23.6 | 17.7 |\n| Byproducts | 24.3 | 19.1 |\n| Other | 6.5 | 5.2 |\n| 165.1 | 214.5 |\n| Building Materials Distribution |\n| Commodity | 547.5 | 1,102.0 |\n| General line | 533.6 | 615.1 |\n| Engineered wood products | 298.1 | 394.7 |\n| 1,379.2 | 2,111.8 |\n| $ | 1,544.3 | $ | 2,326.3 |\n\n___________________________________\n(a) Amounts represent sales to external customers. Sales are calculated after intersegment sales eliminations to our BMD segment.\n(b) Sales of EWP to external customers are net of the cost of all EWP rebates and sales allowances provided at various stages of the supply chain (including distributors, dealers, and homebuilders). For both the three months ended March 31, 2023 and 2022, approximately 79 % of Wood Products' EWP sales volumes were to our BMD segment.\n21\nAn analysis of our operations by segment is as follows:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net sales by segment |\n| Wood Products | $ | 437,428 | $ | 558,944 |\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\n| Intersegment eliminations (a) | ( 272,341 ) | ( 344,495 ) |\n| Total net sales | $ | 1,544,329 | $ | 2,326,282 |\n| Segment operating income |\n| Wood Products | $ | 69,395 | $ | 190,116 |\n| Building Materials Distribution | 69,685 | 225,892 |\n| Total segment operating income | 139,080 | 416,008 |\n| Unallocated corporate costs | ( 11,478 ) | ( 10,380 ) |\n| Income from operations | $ | 127,602 | $ | 405,628 |\n\n___________________________________\n(a) Primarily represents intersegment sales from our Wood Products segment to our BMD segment.\n13. Commitments, Legal Proceedings and Contingencies, and Guarantees\nCommitments\nWe are a party to a number of long-term log supply agreements that are discussed in Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K. In addition, we have purchase obligations for goods and services, capital expenditures, and raw materials entered into in the normal course of business. As of March 31, 2023, there have been no material changes to the above commitments disclosed in the 2022 Form 10-K.\nLegal Proceedings and Contingencies\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\nGuarantees\nWe provide guarantees, indemnifications, and assurances to others. Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K describes the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in the 2022 Form 10-K.\n22\n\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nUnderstanding Our Financial Information\nThis Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes in \"Item 1. Financial Statements\" of this Form 10-Q, as well as our 2022 Form 10-K. The following discussion includes statements regarding our expectations with respect to our future performance, liquidity, and capital resources. Such statements, along with any other nonhistorical statements in the discussion, are forward-looking. These forward-looking statements include, without limitation, any statement that may predict, indicate, or imply future results, performance, or achievements and may contain the words \"may,\" \"will,\" \"expect,\" \"believe,\" \"should,\" \"plan,\" \"anticipate,\" and other similar expressions. All of these forward-looking statements are based on estimates and assumptions made by our management that, although believed by us to be reasonable, are inherently uncertain. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in \"Item 1A. Risk Factors\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission (the SEC). We do not assume an obligation to update any forward-looking statement. Our future actual results may differ materially from those contained in or implied by any of the forward-looking statements in this Form 10-Q.\nBackground\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \"Boise Cascade,\" \"we,\" and \"our\" refer to Boise Cascade Company and its consolidated subsidiaries. Boise Cascade is a large, vertically-integrated wood products manufacturer and building materials distributor. We have two reportable segments: (i) Wood Products, which primarily manufactures engineered wood products (EWP) and plywood; and (ii) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. Our products are used in the construction of new residential housing, including single-family, multi-family, and manufactured homes, the repair-and-remodeling of existing housing, the construction of light industrial and commercial buildings, and industrial applications. For more information, see Note 12, Segment Information, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nExecutive Overview\nWe recorded income from operations of $127.6 million during the three months ended March 31, 2023, compared with income from operations of $405.6 million during the three months ended March 31, 2022. In our Wood Products segment, income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, from $190.1 million for the three months ended March 31, 2022, due primarily to lower plywood sales prices, lower EWP sales volumes, higher per-unit conversion costs, and an increase in depreciation and amortization expense due to the acquisition of two plywood facilities located in Havana, Florida, and Chapman, Alabama, on July 25, 2022 (the Acquisition). These decreases were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists). In our BMD segment, income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022, driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million. These changes are discussed further in \"Our Operating Results\" below.\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $395.9 million of undrawn committed bank line availability, for total available liquidity of $1,396.7 million. We had $444.6 million of outstanding debt at March 31, 2023. We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. A further description of our cash sources and uses for the three-month comparative periods are discussed in \"Liquidity and Capital Resources\" below.\nDemand for the products we manufacture, as well as the products we purchase and distribute, is correlated with new residential construction, residential repair-and-remodeling activity and light commercial construction. U.S. housing starts in March 2023 were approximately 1.42 million on a seasonally adjusted annual rate basis, as reported by the U.S. Census Bureau. In addition, mortgage rates have declined from peak levels in late 2022, and measures of builder sentiment have improved from fourth quarter 2022 levels. However, home affordability remains a challenge for consumers, and the Federal Reserve's ongoing actions in response to inflationary data and what impacts these actions have on future mortgage rates and the broader economy\n23\nwill influence the near-term demand environment. As such, the full year outlook for 2023 is uncertain and is reflected in various industry forecasts for 2023 U.S. housing starts that generally range from 1.2 million to 1.4 million units, compared with actual housing starts of 1.55 million in 2022, as reported by the U.S. Census Bureau. Regarding home improvement spending, the age of U.S. housing stock and elevated levels of homeowner equity have provided a favorable backdrop for repair-and-remodel spending. However, industry forecasts project continued moderation of year-over-year growth in renovation spending, and economic uncertainty may also negatively impact homeowners' further investment in their residences.\nAs a manufacturer of certain commodity products, we have sales and profitability exposure to declines in commodity product prices and rising input costs. Our distribution business purchases and resells a broad mix of commodity products with periods of increasing prices providing the opportunity for higher sales and increased margins, while declining price environments expose us to declines in sales and profitability. Future commodity product pricing and commodity input costs may be volatile in response to economic uncertainties, industry operating rates, transportation constraints or disruptions, net import and export activity, inventory levels in various distribution channels, and seasonal demand patterns. In addition, EWP volumes will continue to be influenced by demand for new residential construction, particularly single-family housing starts and we expect further EWP price erosion in the second quarter.\nFactors That Affect Our Operating Results and Trends\nOur results of operations and financial performance are influenced by a variety of factors, including the following:\n•the commodity nature of a portion of our products and their price movements, which are driven largely by industry capacity and operating rates, industry cycles that affect supply and demand, and net import and export activity;\n•general economic conditions, including but not limited to housing starts, repair-and-remodeling activity, light commercial construction, inventory levels of new and existing homes for sale, foreclosure rates, interest rates, inflation, unemployment rates, household formation rates, prospective home buyers' access to and cost of financing, and housing affordability, that ultimately affect demand for our products;\n•the highly competitive nature of our industry;\n•declines in demand for our products due to competing technologies or materials, as well as changes in building code provisions;\n•disruptions to information systems used to process and store customer, employee, and vendor information, as well as the technology that manages our operations and other business processes;\n•material disruptions and/or major equipment failure at our manufacturing facilities;\n•labor disruptions, shortages of skilled and technical labor, or increased labor costs;\n•the need to successfully formulate and implement succession plans for key members of our management team;\n•product shortages, loss of key suppliers, and our dependence on third-party suppliers and manufacturers;\n•the cost and availability of third-party transportation services used to deliver the goods we manufacture and distribute, as well as our raw materials;\n•cost and availability of raw materials, including wood fiber and glues and resins;\n•our ability to successfully and efficiently complete and integrate acquisitions;\n•the concentration of our sales among a relatively small group of customers, as well as the financial condition and creditworthiness of our customers;\n•impairment of our long-lived assets, goodwill, and/or intangible assets;\n•substantial ongoing capital investment costs, including those associated with acquisitions, and the difficulty in offsetting fixed costs related to those investments;\n24\n•our indebtedness, including the possibility that we may not generate sufficient cash flows from operations or that future borrowings may not be available in amounts sufficient to fulfill our debt obligations and fund other liquidity needs;\n•restrictive covenants contained in our debt agreements;\n•compliance with data privacy and security laws and regulations;\n•the impacts of climate change and related legislative and regulatory responses intended to reduce climate change;\n•cost of compliance with government regulations, in particular, environmental regulations;\n•the enactment of tax reform legislation;\n•exposure to product liability, product warranty, casualty, construction defect, and other claims;\n•fluctuations in the market for our equity; and\n•the other factors described in \"Item 1A. Risk Factors\" in our 2022 Form 10-K.\n25\nOur Operating Results\nThe following tables set forth our operating results in dollars and as a percentage of sales for the three months ended March 31, 2023 and 2022:\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (millions) |\n| Sales | $ | 1,544.3 | $ | 2,326.3 |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230.6 | 1,729.9 |\n| Depreciation and amortization | 31.2 | 20.5 |\n| Selling and distribution expenses | 128.8 | 146.7 |\n| General and administrative expenses | 26.5 | 26.1 |\n| Other (income) expense, net | (0.3) | (2.5) |\n| 1,416.7 | 1,920.7 |\n| Income from operations | $ | 127.6 | $ | 405.6 |\n| (percentage of sales) |\n| Sales | 100.0 | % | 100.0 | % |\n| Costs and expenses |\n| Materials, labor, and other operating expenses (excluding depreciation) | 79.7 | % | 74.4 | % |\n| Depreciation and amortization | 2.0 | 0.9 |\n| Selling and distribution expenses | 8.3 | 6.3 |\n| General and administrative expenses | 1.7 | 1.1 |\n| Other (income) expense, net | — | (0.1) |\n| 91.7 | % | 82.6 | % |\n| Income from operations | 8.3 | % | 17.4 | % |\n\n26\nSales Volumes and Prices\nSet forth below are historical U.S. housing starts data, segment sales volumes and average net selling prices for the principal products sold by our Wood Products segment, and sales mix and gross margin information for our BMD segment for the three months ended March 31, 2023 and 2022.\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| U.S. Housing Starts (a) |\n| Single-family | 190.5 | 266.8 |\n| Multi-family | 129.4 | 122.9 |\n| 319.9 | 389.7 |\n| (thousands) |\n| Segment Sales |\n| Wood Products | $ | 437,428 | $ | 558,944 |\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\n| Intersegment eliminations | (272,341) | (344,495) |\n| Total sales | $ | 1,544,329 | $ | 2,326,282 |\n| Wood Products | (millions) |\n| Sales Volumes |\n| Laminated veneer lumber (LVL) (cubic feet) | 3.6 | 4.6 |\n| I-joists (equivalent lineal feet) | 39 | 65 |\n| Plywood (sq. ft.) (3/8\" basis) | 406 | 317 |\n| Wood Products | (dollars per unit) |\n| Average Net Selling Prices |\n| Laminated veneer lumber (LVL) (cubic foot) | $ | 31.17 | $ | 26.40 |\n| I-joists (1,000 equivalent lineal feet) | 2,168 | 1,877 |\n| Plywood (1,000 sq. ft.) (3/8\" basis) | 367 | 689 |\n| (percentage of Building Materials Distribution sales) |\n| Building Materials Distribution |\n| Product Line Sales |\n| Commodity | 39.7 | % | 52.2 | % |\n| General line | 38.7 | % | 29.1 | % |\n| Engineered wood products | 21.6 | % | 18.7 | % |\n| Gross margin percentage (b) | 14.8 | % | 18.0 | % |\n\n_______________________________________\n(a) Actual U.S. housing starts data reported by the U.S. Census Bureau.\n(b) We define gross margin as \"Sales\" less \"Materials, labor, and other operating expenses (excluding depreciation).\" Substantially all costs included in \"Materials, labor, and other operating expenses (excluding depreciation)\" for our BMD segment are for inventory purchased for resale. Gross margin percentage is gross margin as a percentage of segment sales.\n27\nSales\nFor the three months ended March 31, 2023, total sales decreased $782.0 million, or 34%, to $1,544.3 million from $2,326.3 million during the three months ended March 31, 2022. As described below, the decrease in sales was driven by the changes in sales prices and volumes for the products we manufacture and distribute with single-family residential construction activity being the key demand driver of our sales. In first quarter 2023, total U.S. housing starts decreased 18%, driven by a decrease in single-family housing starts of 29% compared with the same period in 2022. Average composite lumber and average composite panel prices for the three months ended March 31, 2023 were 67% and 59% lower, respectively, than in the same period in the prior year, as reflected by Random Lengths composite lumber and panel pricing.\nWood Products. Sales, including sales to our BMD segment, decreased $121.5 million, or 22%, to $437.4 million for the three months ended March 31, 2023, from $558.9 million for the three months ended March 31, 2022. The decrease in sales was driven by lower plywood sales prices of 47%, resulting in decreased sales of $130.6 million. In addition, lower sales volumes of I-joists and LVL (collectively referred to as EWP) of 41% and 22%, respectively, resulted in decreased sales of $50.0 million and $26.4 million, respectively. EWP sales volumes decreased due to a decline in housing starts. I-joist volumes were also impacted by the availability of product substitutes and construction methods in certain geographies that reduce the wood floor opportunity. These decreases were offset partially by higher sales volumes for plywood of 28%, resulting in increased sales of $61.3 million. In addition, higher sales prices for LVL and I-joists of 18% and 16%, respectively, resulted in increased sales of $17.4 million and $11.3 million, respectively. The increase in EWP pricing was due to realizations of previously announced price increases and the expiration of certain temporary price protection arrangements.\nBuilding Materials Distribution. Sales decreased $732.6 million, or 35%, to $1,379.2 million for the three months ended March 31, 2023, from $2,111.8 million for the three months ended March 31, 2022. Compared with the same quarter in the prior year, the overall decrease in sales was driven by sales price and sales volume decreases of 20% and 15%, respectively. By product line, commodity sales decreased 50%, or $554.5 million; general line product sales decreased 13%, or $81.6 million; and sales of EWP (substantially all of which are sourced through our Wood Products segment) decreased 24%, or $96.5 million.\nCosts and Expenses\nMaterials, labor, and other operating expenses (excluding depreciation) decreased $499.3 million, or 29%, to $1,230.6 million for the three months ended March 31, 2023, compared with $1,729.9 million during the same period in the prior year. In our Wood Products segment, materials, labor, and other operating expenses decreased due to lower EWP sales volumes, as well as lower per-unit costs of OSB (used in the manufacture of I-joists) of approximately 19%, compared with first quarter 2022, as well as decreased other manufacturing costs, offset partially by increased labor costs. However, materials, labor, and other operating expenses as a percentage of sales (MLO rate) in our Wood Products segment increased by 1,340 basis points. The increase in the MLO rate was primarily the result of lower plywood sales prices, resulting in decreased leveraging of labor, wood fiber, and other manufacturing costs. In BMD, the decrease in materials, labor, and other operating expenses was driven by lower purchased materials costs as a result of lower sales volumes and lower commodity prices, compared with first quarter 2022. However, the BMD segment MLO rate increased by 330 basis points compared with first quarter 2022, driven primarily by lower margin percentages on our commodity product sales. In our BMD Segment, periods of increasing prices provide the opportunity for higher sales and increased margins, while declining price environments generally result in declines in sales and profitability.\nDepreciation and amortization expenses increased $10.7 million, or 52%, to $31.2 million for the three months ended March 31, 2023, compared with $20.5 million during the same period in the prior year. The increase was due primarily to the Acquisition on July 25, 2022, and other capital expenditures.\nSelling and distribution expenses decreased $17.9 million, or 12%, to $128.8 million for the three months ended March 31, 2023, compared with $146.7 million during the same period in the prior year, primarily as a result of lower incentive compensation expenses of $20.0 million, offset partially by an increase in shipping and handling costs and discretionary expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\nGeneral and administrative expenses increased $0.4 million, or 2%, to $26.5 million for the three months ended March 31, 2023, compared with $26.1 million for the same period in the prior year, primarily due to an increase in professional fees and employee-related expenses, offset partially by lower incentive compensation expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\n28\nFor the three months ended March 31, 2023, other income (expense), net, was $0.3 million of income, compared with $2.5 million of income for the three months ended March 31, 2022. Other income for the three months ended March 31, 2022 primarily included earn-out income related to a previous asset sale in our Wood Products segment.\nIncome From Operations\nIncome from operations decreased $278.0 million to $127.6 million for the three months ended March 31, 2023, compared with $405.6 million for the three months ended March 31, 2022.\nWood Products. Segment income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, compared with $190.1 million for the three months ended March 31, 2022. The decrease in segment income was due primarily to lower plywood sales prices and lower EWP sales volumes. In addition, segment income was negatively impacted by higher per-unit conversion costs and an increase in depreciation and amortization expense of $10.7 million related to the Acquisition. These decreases in segment income were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists).\nBuilding Materials Distribution. Segment income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022. The decline in segment income was driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million.\nCorporate. Unallocated corporate expenses increased $1.1 million to $11.5 million for the three months ended March 31, 2023, from $10.4 million for the same period in the prior year. The increase was due primarily to an increase in professional fees.\nOther\nInterest Income. Interest income increased $9.6 million to $9.7 million for the three months ended March 31, 2023, from $0.1 million for the three months ended March 31, 2022. The increase was due primarily to higher interest rates on cash equivalents and increases in the average balances of cash equivalents.\nChange in fair value of interest rate swaps. For information related to our interest rate swap, see the discussion under \"Interest Rate Risk and Interest Rate Swap\" of Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nIncome Tax Provision\nFor the three months ended March 31, 2023 and 2022, we recorded $33.3 million and $98.9 million, respectively, of income tax expense and had an effective rate of 25.6% and 24.6%, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21% and the effective tax rate was the effect of state taxes.\nLiquidity and Capital Resources\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $444.6 million of debt. At March 31, 2023, we had $1,396.7 million of available liquidity (cash and cash equivalents and undrawn committed bank line availability). We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. Further descriptions of our cash sources and uses for the three month comparative periods are noted below.\nWe believe that our cash flows from operations, combined with our current cash levels and available borrowing capacity, will be adequate to fund debt service requirements and provide cash, as required, to support our ongoing operations, capital expenditures, lease obligations, working capital, income tax payments, and to pay cash dividends to holders of our common stock over the next 12 months. We expect to fund our seasonal and intra-month working capital requirements in 2023 from cash on hand and, if necessary, borrowings under our revolving credit facility.\n29\nSources and Uses of Cash\nWe generate cash primarily from sales of our products, as well as short-term and long-term borrowings. Our primary uses of cash are for expenses related to the manufacture and distribution of building products, including inventory purchased for resale, wood fiber, labor, energy, and glues and resins. In addition to paying for ongoing operating costs, we use cash to invest in our business, service our debt and lease obligations, and return cash to our shareholders through dividends or common stock repurchases. Below is a discussion of our sources and uses of cash for operating activities, investing activities, and financing activities.\n| Three Months EndedMarch 31 |\n| 2023 | 2022 |\n| (thousands) |\n| Net cash provided by operations | $ | 47,992 | $ | 198,945 |\n| Net cash used for investment | (29,498) | (14,867) |\n| Net cash used for financing | (16,117) | (10,264) |\n\nOperating Activities\nFor the three months ended March 31, 2023, our operating activities generated $48.0 million of cash, compared with $198.9 million of cash generated in the same period in 2022. The $150.9 million decrease in cash provided by operations was due primarily to a decrease in income from operations, offset partially by a lesser year-over-year increase in working capital and a decrease in cash paid for taxes, net of refunds, of $2.9 million. Working capital increased $117.7 million during the three months ended March 31, 2023, compared with a $217.8 million increase for the same period in the prior year. See \"Our Operating Results\" in this Management's Discussion and Analysis of Financial Condition and Results of Operations for more information related to factors affecting our operating results.\nThe increase in working capital during both periods was primarily attributable to higher receivables and inventories, offset by an increase in accounts payable and accrued liabilities. The increases in receivables in both periods primarily reflect increased sales of approximately 26% and 49%, comparing sales for the months of March 2023 and 2022 with sales for the months of December 2022 and 2021, respectively. Inventories increased during the three months ended March 31, 2023 in preparation for the spring building season. During the three months ended March 31, 2022 inventories increased primarily due to increased cost of inventory purchased for resale and higher production costs for our manufactured products. The increase in accounts payable and accrued liabilities as of March 31, 2023 was related to the increase in inventories, offset partially by employee incentive compensation payouts made during the quarter and lower accrued rebates. The increase in accounts payable and accrued liabilities as of March 31, 2022 was related to the increase in inventories and higher accrued rebates, offset partially by employee incentive compensation payouts made during first quarter 2022.\nInvestment Activities\nDuring the three months ended March 31, 2023 and 2022, we used $30.1 million and $17.4 million, respectively, of cash for purchases of property and equipment, including business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. During the three months ended March 31, 2022, we received $2.5 million of earn-out income related to a previous asset sale in our Wood Products segment.\nWe expect capital expenditures in 2023 to total approximately $120 million to $140 million. We expect our capital spending in 2023 will be for business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. Our 2023 capital expenditures range includes funding for greenfield distribution centers in South Carolina and Texas, projects at our mills in the southeast to expand our EWP capacity, and the purchase of property to house an additional door shop assembly operation in Kansas City, Missouri. This level of capital expenditures could increase or decrease as a result of several factors, including acquisitions, efforts to further accelerate organic growth, exercise of lease purchase options, our financial results, future economic conditions, availability of engineering and construction resources, and timing and availability of equipment purchases.\nFinancing Activities\nDuring the three months ended March 31, 2023, our financing activities used $16.1 million of cash, including $8.3 million for common stock dividend payments, $5.9 million of tax withholding payments on stock-based awards, and $1.5\n30\nmillion for the repurchase of 24,727 shares of our common stock. During the three months ended March 31, 2023, we did not borrow under our revolving credit facility, and therefore have no borrowings outstanding on the facility as of March 31, 2023.\nDuring the three months ended March 31, 2022, our financing activities used $10.3 million of cash, including $5.9 million for common stock dividend payments and $3.9 million of tax withholding payments on stock-based awards. During the three months ended March 31, 2022, we did not borrow under our revolving credit facility.\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\nFor more information related to our debt transactions and structure, our dividend policy, and our stock repurchase program, see the discussion in Note 7, Debt, and Note 10, Stockholders' Equity, respectively, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" of this Form 10-Q.\nOther Material Cash Requirements\nFor information about other material cash requirements, see Liquidity and Capital Resources in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in other material cash requirements outside the ordinary course of business since December 31, 2022.\nGuarantees\nNote 9, Debt, and Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \"Item 8. Financial Statements and Supplementary Data\" in our 2022 Form 10-K describe the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in our 2022 Form 10-K.\nSeasonal Influences\nWe are exposed to fluctuations in quarterly sales volumes and expenses due to seasonal factors. These seasonal factors are common in the building products industry. Seasonal changes in levels of building activity affect our building products businesses, which are dependent on housing starts, repair-and-remodeling activities, and light commercial construction activities. We typically report lower sales volumes in the first and fourth quarters due to the impact of poor weather on the construction market, and we generally have higher sales volumes in the second and third quarters, reflecting an increase in construction due to more favorable weather conditions. We typically have higher working capital in the first and second quarters in preparation and response to the building season. Seasonally cold weather increases costs, especially energy consumption costs, at most of our manufacturing facilities.\nEmployees\nAs of April 30, 2023, we had approximately 6,660 employees. Approximately 19% of these employees work pursuant to collective bargaining agreements. As of April 30, 2023, we had ten collective bargaining agreements. One agreement covering approximately 80 employees at our Canadian EWP facility expired on December 31, 2022, but the terms and conditions of this agreement remain in effect pending negotiation of a new agreement. We may not be able to renew this agreement or may renew it on terms that are less favorable to us than the current agreement. If any of these agreements are not renewed or extended upon their termination, we could experience a material labor disruption, strike, or significantly increased labor costs at one or more of our facilities, either in the course of negotiations of a labor agreement or otherwise. Labor disruptions or shortages could prevent us from meeting customer demands or result in increased costs, thereby reducing our sales and profitability.\n31\nDisclosures of Financial Market Risks\nIn the normal course of business, we are exposed to financial risks such as changes in commodity prices, interest rates, and foreign currency exchange rates. As of March 31, 2023, there have been no material changes to financial market risks disclosed in our 2022 Form 10-K.\nEnvironmental\nAs of March 31, 2023, there have been no material changes to environmental issues disclosed in our 2022 Form 10-K. For additional information, see Environmental in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K.\nCritical Accounting Estimates\nCritical accounting estimates are those that are most important to the portrayal of our financial condition and results. These estimates require management's most difficult, subjective, or complex judgments, often as a result of the need to estimate matters that are inherently uncertain. We review the development, selection, and disclosure of our critical accounting estimates with the Audit Committee of our board of directors. For information about critical accounting estimates, see Critical Accounting Estimates in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. At March 31, 2023, there have been no material changes to our critical accounting estimates from those disclosed in our 2022 Form 10-K.\nNew and Recently Adopted Accounting Standards\nFor information related to new and recently adopted accounting standards, see \"New and Recently Adopted Accounting Standards\" in Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \"Item 1. Financial Statements\" in this Form 10-Q.\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nFor information relating to quantitative and qualitative disclosures about market risk, see the discussion under \"Item 7A. Quantitative and Qualitative Disclosures About Market Risk\" and under the headings \"Disclosures of Financial Market Risks\" and \"Financial Instruments\" in \"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in our exposure to market risk from those disclosed in our 2022 Form 10-K.\n\nITEM 4. CONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nWe maintain \"disclosure controls and procedures,\" as defined in Rule 13a-15(e) under the Exchange Act. We have designed these controls and procedures to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Form 10-Q, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. We have also designed our disclosure controls to provide reasonable assurance that such information is accumulated and communicated to our senior management, including our chief executive officer (CEO) and our chief financial officer (CFO), as appropriate, to allow them to make timely decisions regarding our required disclosures. Based on their evaluation, our CEO and CFO have concluded that as of March 31, 2023, our disclosure controls and procedures were effective.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n32\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\nSEC regulations require us to disclose certain information about proceedings arising under federal, state or local environmental provisions if we reasonably believe that such proceedings may result in monetary sanctions above a stated threshold. Pursuant to the SEC regulations, we use a threshold of $1 million or more for purposes of determining whether disclosure of any such proceedings is required.\nITEM 1A. RISK FACTORS\nThis report on Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about our expectations, anticipated financial results, projected capital expenditures, and future business prospects, are forward-looking statements. You can identify these statements by our use of words such as \"may,\" \"will,\" \"expect,\" \"believe,\" \"should,\" \"plan,\" \"anticipate,\" and other similar expressions. You can find examples of these statements throughout this report, including \"Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.\" We cannot guarantee that our actual results will be consistent with the forward-looking statements we make in this report. You should review carefully the risk factors listed in \"Item 1A. Risk Factors\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission. We do not assume an obligation to update any forward-looking statement.\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nPurchase of Equity Securities by the Issuer and Affiliated Purchasers\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During first quarter 2023, we repurchased 24,727 shares under the Program at a cost of $1.5 million, or an average of $59.91 per share. Set forth below is information regarding the Company's share repurchases during the first quarter ended March 31, 2023.\n| Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | The Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs |\n| January 1, 2023 - January 31, 2023 | — | $ | — | — | 1,996,989 |\n| February 1, 2023 - February 28, 2023 | — | — | — | 1,996,989 |\n| March 1, 2023 - March 31, 2023 | 24,727 | 59.91 | 24,727 | 1,972,262 |\n| Total | 24,727 | $ | 59.91 | 24,727 | 1,972,262 |\n\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\nNone.\nITEM 4. MINE SAFETY DISCLOSURES\nNot applicable.\n33\n\nITEM 5. OTHER INFORMATION\nNone.\nITEM 6. EXHIBITS\n| Number | Description |\n| 10.1 | Form of 2023 Restricted Stock Unit Agreement |\n| 10.2 | Form of 2023 Performance Stock Unit Agreement |\n| 10.3 | Form of 2023 Director Restricted Stock Unit Agreement |\n| 10.4 | Ninth Amendment to Amended and Restated Credit Agreement, dated March 31, 2023, by and among the Lenders identified on the signature pages thereof, Wells Fargo Capital Finance, LLC, as administrative agent, Boise Cascade Company, and the other Borrowers identified on the signature pages thereof |\n| 31.1 | CEO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | CFO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | CEO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | CFO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n34\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\n| BOISE CASCADE COMPANY |\n| /s/ Kelly E. Hibbs |\n| Kelly E. HibbsSenior Vice President, Chief Financial Officer and Treasurer |\n\nDate: May 4, 2023\n35\n</text>\n\nWhat is the percentage increase in finance cost from the year 2022 to 2023 in relation to the net income for each year in percentage?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nPART I—FINANCIAL INFORMATION\\nITEM 1. FINANCIAL STATEMENTS\\nBoise Cascade Company\\nConsolidated Statements of Operations\\n(unaudited)\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands, except per-share data) |\\n| Sales | $ | 1,544,329 | $ | 2,326,282 |\\n| Costs and expenses |\\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230,635 | 1,729,896 |\\n| Depreciation and amortization | 31,186 | 20,543 |\\n| Selling and distribution expenses | 128,788 | 146,651 |\\n| General and administrative expenses | 26,463 | 26,052 |\\n| Other (income) expense, net | ( 345 ) | ( 2,488 ) |\\n| 1,416,727 | 1,920,654 |\\n| Income from operations | 127,602 | 405,628 |\\n| Foreign currency exchange gain (loss) | ( 73 ) | 132 |\\n| Pension expense (excluding service costs) | ( 41 ) | ( 171 ) |\\n| Interest expense | ( 6,361 ) | ( 6,254 ) |\\n| Interest income | 9,685 | 65 |\\n| Change in fair value of interest rate swaps | ( 804 ) | 2,066 |\\n| 2,406 | ( 4,162 ) |\\n| Income before income taxes | 130,008 | 401,466 |\\n| Income tax provision | ( 33,275 ) | ( 98,866 ) |\\n| Net income | $ | 96,733 | $ | 302,600 |\\n| Weighted average common shares outstanding: |\\n| Basic | 39,593 | 39,474 |\\n| Diluted | 39,838 | 39,768 |\\n| Net income per common share: |\\n| Basic | $ | 2.44 | $ | 7.67 |\\n| Diluted | $ | 2.43 | $ | 7.61 |\\n| Dividends declared per common share | $ | 0.15 | $ | 0.12 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n1\\nBoise Cascade Company\\nConsolidated Statements of Comprehensive Income\\n(unaudited)\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Net income | $ | 96,733 | $ | 302,600 |\\n| Other comprehensive income, net of tax |\\n| Defined benefit pension plans |\\n| Amortization of actuarial loss, net of tax of $ 2 and $ 5 , respectively | 6 | 16 |\\n| Effect of settlements, net of tax of $ — and $ 32 , respectively | — | 98 |\\n| Other comprehensive income, net of tax | 6 | 114 |\\n| Comprehensive income | $ | 96,739 | $ | 302,714 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n2\\nBoise Cascade Company\\nConsolidated Balance Sheets\\n(unaudited)\\n| March 31,2023 | December 31,2022 |\\n| (thousands) |\\n| ASSETS |\\n| Current |\\n| Cash and cash equivalents | $ | 1,000,721 | $ | 998,344 |\\n| Receivables |\\n| Trade, less allowances of $ 4,341 and $ 3,264 | 417,515 | 297,237 |\\n| Related parties | 196 | 19 |\\n| Other | 13,821 | 23,023 |\\n| Inventories | 738,798 | 697,551 |\\n| Prepaid expenses and other | 20,666 | 47,878 |\\n| Total current assets | 2,191,717 | 2,064,052 |\\n| Property and equipment, net | 772,734 | 770,023 |\\n| Operating lease right-of-use assets | 52,441 | 55,582 |\\n| Finance lease right-of-use assets | 25,883 | 26,501 |\\n| Timber deposits | 8,299 | 7,519 |\\n| Goodwill | 137,958 | 137,958 |\\n| Intangible assets, net | 157,133 | 161,433 |\\n| Deferred income taxes | 6,135 | 6,116 |\\n| Other assets | 9,887 | 11,330 |\\n| Total assets | $ | 3,362,187 | $ | 3,240,514 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n3\\nBoise Cascade Company\\nConsolidated Balance Sheets (continued)\\n(unaudited)\\n| March 31,2023 | December 31,2022 |\\n| (thousands, except per-share data) |\\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\\n| Current |\\n| Accounts payable |\\n| Trade | $ | 400,455 | $ | 269,785 |\\n| Related parties | 1,420 | 1,019 |\\n| Accrued liabilities |\\n| Compensation and benefits | 79,606 | 142,463 |\\n| Interest payable | 5,088 | 9,955 |\\n| Other | 93,579 | 122,606 |\\n| Total current liabilities | 580,148 | 545,828 |\\n| Debt |\\n| Long-term debt | 444,614 | 444,392 |\\n| Other |\\n| Compensation and benefits | 33,280 | 33,226 |\\n| Operating lease liabilities, net of current portion | 45,681 | 48,668 |\\n| Finance lease liabilities, net of current portion | 29,549 | 30,022 |\\n| Deferred income taxes | 66,855 | 63,454 |\\n| Other long-term liabilities | 17,540 | 16,949 |\\n| 192,905 | 192,319 |\\n| Commitments and contingent liabilities |\\n| Stockholders' equity |\\n| Preferred stock, $ 0.01 par value per share; 50,000 shares authorized, no shares issued and outstanding | — | — |\\n| Common stock, $ 0.01 par value per share; 300,000 shares authorized, 44,983 and 44,827 shares issued, respectively | 450 | 448 |\\n| Treasury stock, 5,392 and 5,367 shares at cost, respectively | ( 140,391 ) | ( 138,909 ) |\\n| Additional paid-in capital | 548,611 | 551,215 |\\n| Accumulated other comprehensive loss | ( 514 ) | ( 520 ) |\\n| Retained earnings | 1,736,364 | 1,645,741 |\\n| Total stockholders' equity | 2,144,520 | 2,057,975 |\\n| Total liabilities and stockholders' equity | $ | 3,362,187 | $ | 3,240,514 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n4\\nBoise Cascade Company\\nConsolidated Statements of Cash Flows\\n(unaudited)\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Cash provided by (used for) operations |\\n| Net income | $ | 96,733 | $ | 302,600 |\\n| Items in net income not using (providing) cash |\\n| Depreciation and amortization, including deferred financing costs and other | 31,853 | 20,993 |\\n| Stock-based compensation | 3,324 | 2,392 |\\n| Pension expense | 41 | 171 |\\n| Deferred income taxes | 3,393 | ( 729 ) |\\n| Change in fair value of interest rate swaps | 804 | ( 2,066 ) |\\n| Other | ( 518 ) | ( 2,412 ) |\\n| Decrease (increase) in working capital |\\n| Receivables | ( 111,253 ) | ( 218,018 ) |\\n| Inventories | ( 41,247 ) | ( 143,997 ) |\\n| Prepaid expenses and other | ( 1,428 ) | ( 3,227 ) |\\n| Accounts payable and accrued liabilities | 36,181 | 147,425 |\\n| Pension contributions | ( 136 ) | ( 655 ) |\\n| Income taxes payable | 28,631 | 95,352 |\\n| Other | 1,614 | 1,116 |\\n| Net cash provided by operations | 47,992 | 198,945 |\\n| Cash provided by (used for) investment |\\n| Expenditures for property and equipment | ( 30,063 ) | ( 17,448 ) |\\n| Proceeds from sales of assets and other | 565 | 2,581 |\\n| Net cash used for investment | ( 29,498 ) | ( 14,867 ) |\\n| Cash provided by (used for) financing |\\n| Dividends paid on common stock | ( 8,258 ) | ( 5,939 ) |\\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 3,930 ) |\\n| Treasury stock purchased | ( 1,482 ) | — |\\n| Other | ( 451 ) | ( 395 ) |\\n| Net cash used for financing | ( 16,117 ) | ( 10,264 ) |\\n| Net increase in cash and cash equivalents | 2,377 | 173,814 |\\n| Balance at beginning of the period | 998,344 | 748,907 |\\n| Balance at end of the period | $ | 1,000,721 | $ | 922,721 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n5\\nBoise Cascade Company\\nConsolidated Statements of Stockholders' Equity\\n(unaudited)\\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\\n| Shares | Amount | Shares | Amount |\\n| (thousands) |\\n| Balance at December 31, 2022 | 44,827 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 551,215 | $ | ( 520 ) | $ | 1,645,741 | $ | 2,057,975 |\\n| Net income | 96,733 | 96,733 |\\n| Other comprehensive income | 6 | 6 |\\n| Common stock issued | 156 | 2 | 2 |\\n| Treasury stock purchased | 25 | ( 1,482 ) | ( 1,482 ) |\\n| Stock-based compensation | 3,324 | 3,324 |\\n| Common stock dividends ($ 0.15 per share) | ( 6,110 ) | ( 6,110 ) |\\n| Tax withholding payments on stock-based awards | ( 5,926 ) | ( 5,926 ) |\\n| Other | ( 2 ) | ( 2 ) |\\n| Balance at March 31, 2023 | 44,983 | $ | 450 | 5,392 | $ | ( 140,391 ) | $ | 548,611 | $ | ( 514 ) | $ | 1,736,364 | $ | 2,144,520 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n6\\nBoise Cascade Company\\nConsolidated Statements of Stockholders' Equity (continued)\\n(unaudited)\\n| Common Stock | Treasury Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Retained Earnings | Total |\\n| Shares | Amount | Shares | Amount |\\n| (thousands) |\\n| Balance at December 31, 2021 | 44,698 | $ | 447 | 5,367 | $ | ( 138,909 ) | $ | 543,249 | $ | ( 1,047 ) | $ | 948,879 | $ | 1,352,619 |\\n| Net income | 302,600 | 302,600 |\\n| Other comprehensive income | 114 | 114 |\\n| Common stock issued | 117 | 1 | 1 |\\n| Stock-based compensation | 2,392 | 2,392 |\\n| Common stock dividends ($ 0.12 per share) | ( 5,133 ) | ( 5,133 ) |\\n| Tax withholding payments on stock-based awards | ( 3,930 ) | ( 3,930 ) |\\n| Proceeds from exercise of stock options | 27 | 27 |\\n| Other | ( 1 ) | ( 1 ) |\\n| Balance at March 31, 2022 | 44,815 | $ | 448 | 5,367 | $ | ( 138,909 ) | $ | 541,737 | $ | ( 933 ) | $ | 1,246,346 | $ | 1,648,689 |\\n\\nSee accompanying condensed notes to unaudited quarterly consolidated financial statements.\\n7\\nCondensed Notes to Unaudited Quarterly Consolidated Financial Statements\\n1. Nature of Operations and Consolidation\\nNature of Operations\\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \\\"Boise Cascade,\\\" \\\"we,\\\" and \\\"our\\\" refer to Boise Cascade Company and its consolidated subsidiaries. We are one of the largest producers of engineered wood products (EWP) and plywood in North America and a leading United States wholesale distributor of building products.\\nWe operate our business using two reportable segments: (1) Wood Products, which primarily manufactures EWP and plywood, and (2) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. For more information, see Note 12, Segment Information.\\nConsolidation\\nThe accompanying quarterly consolidated financial statements have not been audited by an independent registered public accounting firm but, in the opinion of management, include all adjustments necessary to present fairly the financial position, results of operations, cash flows, and stockholders' equity for the interim periods presented. Except as disclosed within these condensed notes to unaudited quarterly consolidated financial statements, the adjustments made were of a normal, recurring nature. Certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted. The quarterly consolidated financial statements include the accounts of Boise Cascade and its subsidiaries after elimination of intercompany balances and transactions. Quarterly results are not necessarily indicative of results that may be expected for the full year. These condensed notes to unaudited quarterly consolidated financial statements should be read in conjunction with our 2022 Form 10-K and the other reports we file with the Securities and Exchange Commission.\\n2. Summary of Significant Accounting Policies\\nAccounting Policies\\nThe complete summary of significant accounting policies is included in Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K.\\nUse of Estimates\\nThe preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories, goodwill, intangible assets, and other long-lived assets; legal contingencies; guarantee obligations; indemnifications; assumptions used in retirement, medical, and workers' compensation benefits; assumptions used in the determination of right-of-use (ROU) assets and related lease liabilities; stock-based compensation; fair value measurements; income taxes; and vendor and customer rebates, among others. These estimates and assumptions are based on management's best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates resulting from continuing changes in the economic environment will be reflected in the consolidated financial statements in future periods.\\n8\\nRevenue Recognition\\nRevenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. For revenue disaggregated by major product line for each reportable segment, see Note 12, Segment Information.\\nFees for shipping and handling charged to customers for sales transactions are included in \\\"Sales\\\" in our Consolidated Statements of Operations. When control over products has transferred to the customer, we have elected to recognize costs related to shipping and handling as fulfillment costs. For our Wood Products segment, costs related to shipping and handling are included in \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" in our Consolidated Statements of Operations. In our Wood Products segment, we view our shipping and handling costs as a cost of the manufacturing process and the movement of product to our end customers. For our BMD segment, costs related to shipping and handling of $ 53.5 million and $ 56.3 million for the three months ended March 31, 2023 and 2022, respectively, are included in \\\"Selling and distribution expenses\\\" in our Consolidated Statements of Operations. In our BMD segment, our activities relate to the purchase and resale of finished products, and excluding shipping and handling costs from \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" provides us a clearer view of our operating performance and the effectiveness of our sales and purchasing functions.\\nCustomer Rebates and Allowances\\nRebates are provided to our customers and our customers' customers based on the volume of their purchases, among other factors such as customer loyalty, conversion, and commitment, as well as temporary protection from price increases. We provide the rebates to increase the sell-through of our products. Rebates are generally estimated based on the expected amount to be paid and recorded as a decrease in \\\"Sales.\\\" At March 31, 2023 and December 31, 2022, we had $ 58.7 million and $ 92.9 million, respectively, of rebates payable to our customers recorded in \\\"Accrued liabilities, Other\\\" on our Consolidated Balance Sheets. We adjust our estimate of revenue at the earlier of when the probability of rebates paid changes or when the amounts become fixed. There have not been significant changes to our estimates of rebates, although it is reasonably possible that a change in the estimate may occur.\\nVendor Rebates and Allowances\\nWe receive rebates and allowances from our vendors under a number of different programs, including vendor marketing programs. At March 31, 2023 and December 31, 2022, we had $ 9.0 million and $ 17.8 million, respectively, of vendor rebates and allowances recorded in \\\"Receivables, Other\\\" on our Consolidated Balance Sheets. Rebates and allowances received from our vendors are recognized as a reduction of \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" when the product is sold, unless the rebates and allowances are linked to a specific incremental cost to sell a vendor's product. Amounts received from vendors that are linked to specific selling and distribution expenses are recognized as a reduction of \\\"Selling and distribution expenses\\\" in the period the expense is incurred.\\nLeases\\nWe primarily lease land, building, and equipment under operating and finance leases. We determine if an arrangement is a lease at inception and assess lease classification as either operating or finance at lease inception or upon modification. Substantially all of our leases with initial terms greater than one year are for real estate, including distribution centers, corporate headquarters, land, and other office space. Substantially all of these lease agreements have fixed payment terms based on the passage of time and are recorded in our BMD segment. Many of our leases include fixed escalation clauses, renewal options and/or termination options that are factored into our determination of lease term and lease payments when appropriate. Renewal options generally range from one to ten years with fixed payment terms similar to those in the original lease agreements. Some lease agreements provide us with the option to purchase the leased property at market value. Our lease agreements do not contain any residual value guarantees.\\nROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the lease commencement date based on the estimated present value of fixed lease payments over the lease term. The current portion of our operating and finance lease liabilities are recorded in \\\"Accrued liabilities, Other\\\" on our Consolidated Balance Sheets.\\nWe use our estimated incremental borrowing rate, which is derived from information available at the lease commencement date, in determining the present value of lease payments. In determining our incremental borrowing rates, we\\n9\\ngive consideration to publicly available interest rates for instruments with similar characteristics, including credit rating, term, and collateralization.\\nFor purposes of determining straight-line rent expense, the lease term is calculated from the date we first take possession of the facility, including any periods of free rent and any renewal option periods we are reasonably certain of exercising. Variable lease expense generally includes reimbursement of actual costs for common area maintenance, property taxes, and insurance on leased real estate and are recorded as incurred. Most of our operating lease expense was recorded in \\\"Selling and distribution expenses\\\" in our Consolidated Statements of Operations. In addition, we do not separate lease and non-lease components for all of our leases.\\nOur short-term leases primarily include equipment rentals with lease terms on a month-to-month basis, which provide for our seasonal needs and flexibility in the use of equipment. Our short-term leases also include certain real estate for which either party has the right to cancel upon providing notice of 30 to 90 days. We do not recognize ROU assets or lease liabilities for short-term leases.\\nInventories\\nInventories included the following (work in process is not material):\\n\\n| March 31,2023 | December 31,2022 |\\n| (thousands) |\\n| Finished goods and work in process | $ | 640,858 | $ | 596,328 |\\n| Logs | 50,154 | 54,921 |\\n| Other raw materials and supplies | 47,786 | 46,302 |\\n| $ | 738,798 | $ | 697,551 |\\n\\nProperty and Equipment\\nProperty and equipment consisted of the following asset classes:\\n\\n| March 31,2023 | December 31,2022 |\\n| (thousands) |\\n| Land | $ | 61,806 | $ | 60,211 |\\n| Buildings | 242,484 | 231,087 |\\n| Improvements | 70,419 | 69,832 |\\n| Mobile equipment, information technology, and office furniture | 215,460 | 210,666 |\\n| Machinery and equipment | 993,900 | 989,338 |\\n| Construction in progress | 45,348 | 41,899 |\\n| 1,629,417 | 1,603,033 |\\n| Less: accumulated depreciation | ( 856,683 ) | ( 833,010 ) |\\n| $ | 772,734 | $ | 770,023 |\\n\\n10\\nFair Value\\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy under GAAP gives the highest priority to quoted market prices (Level 1) and the lowest priority to unobservable inputs (Level 3). In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value (Level 1). If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, we use quoted prices for similar assets and liabilities or inputs that are observable either directly or indirectly (Level 2). If quoted prices for identical or similar assets are not available or are unobservable, we may use internally developed valuation models, whose inputs include bid prices, and third-party valuations utilizing underlying asset assumptions (Level 3).\\nFinancial Instruments\\nOur financial instruments are cash and cash equivalents, accounts receivable, accounts payable, long-term debt, and an interest rate swap. Our cash is recorded at cost, which approximates fair value, and our cash equivalents are money market funds. As of March 31, 2023 and December 31, 2022, we held $ 981.1 million and $ 954.4 million, respectively, in money market funds that are measured at fair value on a recurring basis using Level 1 inputs. The recorded values of accounts receivable and accounts payable approximate fair values based on their short-term nature. At March 31, 2023 and December 31, 2022, the book value of our fixed-rate debt for each period was $ 400.0 million, and the fair value was estimated to be $ 348.0 million and $ 348.5 million, respectively. The difference between the book value and the fair value is derived from the difference between the period-end market interest rate and the stated rate of our fixed-rate, long-term debt. We estimated the fair value of our fixed-rate debt using quoted market prices of our debt in inactive markets (Level 2 inputs). The interest rate on our variable-rate debt is based on market conditions such as the Secured Overnight Financing Rate (SOFR) or a base rate. Because the interest rate on the variable-rate debt is based on current market conditions, we believe that the estimated fair value of the outstanding balance on our variable-rate debt approximates book value. As discussed below, we also have an interest rate swap to mitigate our variable interest rate exposure, the fair value of which is measured based on Level 2 inputs.\\nInterest Rate Risk and Interest Rate Swap\\nWe are exposed to interest rate risk arising from fluctuations in variable-rate SOFR on our term loan and when we have loan amounts outstanding on our Revolving Credit Facility. At March 31, 2023, we had $ 50.0 million of variable-rate debt outstanding based on one-month term SOFR . Our objective is to limit the variability of interest payments on our debt. To meet this objective, we enter into receive-variable, pay-fixed interest rate swaps to mitigate the variable-rate cash flow exposure with fixed-rate cash flows. In accordance with our risk management strategy, we actively monitor our interest rate exposure and use derivative instruments from time to time to manage the related risk. We do not speculate using derivative instruments.\\nAt March 31, 2023, we had one interest rate swap agreement, which we entered into in 2020 and commenced in February 2022. Under the interest rate swap, we receive one-month SOFR plus a spread adjustment of 0.10 % variable interest rate payments and make fixed interest rate payments, thereby fixing the interest rate on $ 50.0 million of variable rate debt exposure. Payments on this interest rate swap, with a notional principal amount of $ 50.0 million, are due on a monthly basis at an annual fixed rate of 0.41 %, and this swap expires in June 2025.\\nThe interest rate swap agreement was not designated as a cash flow hedge, and as a result, all changes in the fair value are recognized in \\\"Change in fair value of interest rate swaps\\\" in our Consolidated Statements of Operations rather than through other comprehensive income. At March 31, 2023 and December 31, 2022, we recorded long-term assets of $ 4.0 million and $ 4.8 million, respectively, in \\\"Other assets\\\" on our Consolidated Balance Sheets, representing the fair value of the interest rate swap agreement. The swap was valued based on observable inputs for similar assets and liabilities and other observable inputs for interest rates and yield curves (Level 2 inputs).\\nConcentration of Credit Risk\\nWe are exposed to credit risk related to customer accounts receivable. In order to manage credit risk, we consider customer concentrations and current economic trends and monitor the creditworthiness of significant customers based on ongoing credit evaluations. At March 31, 2023, receivables from two customers accounted for approximately 19 % and 12 % of total receivables. At December 31, 2022, receivables from these two customers accounted for approximately 17 % and 14 % of total receivables. No other customer accounted for 10% or more of total receivables.\\n11\\nNew and Recently Adopted Accounting Standards\\nThere were no accounting standards recently issued that had or are expected to have a material impact on our consolidated financial statements and associated disclosures.\\n3. Income Taxes\\nFor the three months ended March 31, 2023 and 2022, we recorded $ 33.3 million and $ 98.9 million, respectively, of income tax expense and had an effective rate of 25.6 % and 24.6 %, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21 % and the effective tax rate was the effect of state taxes.\\nDuring the three months ended March 31, 2023 and 2022, cash paid for taxes, net of refunds received, were $ 1.2 million and $ 4.2 million, respectively.\\n4. Net Income Per Common Share\\nBasic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Weighted average common shares outstanding for the basic net income per common share calculation includes certain vested restricted stock units (RSUs) and performance stock units (PSUs) as there are no conditions under which those shares will not be issued. Diluted net income per common share is computed by dividing net income by the combination of the weighted average number of common shares outstanding during the period and other potentially dilutive weighted average common shares. Other potentially dilutive weighted average common shares include the dilutive effect of stock options, RSUs, and PSUs for each period using the treasury stock method. Under the treasury stock method, the exercise price of a share and the amount of compensation expense, if any, for future service that has not yet been recognized are assumed to be used to repurchase shares in the current period.\\nThe following table sets forth the computation of basic and diluted net income per common share:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands, except per-share data) |\\n| Net income | $ | 96,733 | $ | 302,600 |\\n| Weighted average common shares outstanding during the period (for basic calculation) | 39,593 | 39,474 |\\n| Dilutive effect of other potential common shares | 245 | 294 |\\n| Weighted average common shares and potential common shares (for diluted calculation) | 39,838 | 39,768 |\\n| Net income per common share - Basic | $ | 2.44 | $ | 7.67 |\\n| Net income per common share - Diluted | $ | 2.43 | $ | 7.61 |\\n\\nThe computation of the dilutive effect of other potential common shares excludes stock awards representing an insignificant number of shares of common stock in both the three months ended March 31, 2023 and 2022. Under the treasury stock method, the inclusion of these stock awards would have been antidilutive.\\n12\\n5. Acquisition\\nWe account for acquisition transactions in accordance with ASC 805, Business Combinations. Accordingly, the results of operations of the acquiree are included in our consolidated financial statements from the acquisition date. The consideration transferred is allocated to the identifiable assets acquired and liabilities assumed based on estimated fair values at the acquisition date, with any excess recorded as goodwill. Transaction-related costs are expensed in the period the costs are incurred. During the measurement period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding adjustment to goodwill.\\nOn July 25, 2022, our wholly-owned subsidiary, Boise Cascade Wood Products, L.L.C., completed the acquisition of 100 % of the equity interest in Coastal Plywood, and its plywood manufacturing operations located in Havana, Florida, and Chapman, Alabama, for a purchase price of $ 515.2 million, including a post-closing adjustment of $ 1.6 million based upon a working capital target (the Acquisition).\\nThe following table summarizes the final allocations of the purchase price to the assets acquired and liabilities assumed, based on our estimates of the fair value at the date of the Acquisition:\\n| Acquisition Date Fair Value |\\n| (thousands) |\\n| Accounts receivable | $ | 16,123 |\\n| Inventories | 22,977 |\\n| Property and equipment | 251,329 |\\n| Other assets | 1,809 |\\n| Intangible assets: |\\n| Trade name | 700 |\\n| Customer relationships | 153,600 |\\n| Goodwill | 77,576 |\\n| Assets acquired | 524,114 |\\n| Accounts payable and accrued liabilities | 6,299 |\\n| Other long-term liabilities | 2,578 |\\n| Liabilities assumed | 8,877 |\\n| Net assets acquired | $ | 515,237 |\\n\\n13\\n6. Goodwill and Intangible Assets\\nGoodwill represents the excess of the purchase price and related costs over the fair value of the net tangible and intangible assets of businesses acquired.\\nThe carrying amount of our goodwill by segment is as follows:\\n| BuildingMaterialsDistribution | Wood Products | Total |\\n| (thousands) |\\n| Balance at December 31, 2022 and March 31, 2023 | $ | 11,792 | $ | 126,166 | $ | 137,958 |\\n\\nAt March 31, 2023 and December 31, 2022, intangible assets represented the values assigned to trade names and trademarks and customer relationships. We maintain trademarks for our manufactured wood products, particularly EWP. Our key registered trademarks are perpetual in duration as long as we continue to timely file all post registration maintenance documents related thereto. These trade names and trademarks have indefinite lives, are not amortized, and have a carrying amount of $ 8.9 million. In 2022, we acquired a trade name and customer relationships as discussed in Note 5, Acquisition. The acquired trade name has a useful life of one year . The weighted-average useful life for customer relationships from the date of purchase is approximately 10 years. For the three months ended March 31, 2023 and 2022 we recognized $ 4.3 million and $ 0.3 million, respectively, of amortization expense for intangible assets.\\nIntangible assets consisted of the following:\\n| March 31, 2023 |\\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\\n| (thousands) |\\n| Trade names and trademarks | $ | 9,600 | $ | ( 467 ) | $ | 9,133 |\\n| Customer relationships | 166,050 | ( 18,050 ) | 148,000 |\\n| $ | 175,650 | $ | ( 18,517 ) | $ | 157,133 |\\n\\n| December 31, 2022 |\\n| Gross CarryingAmount | AccumulatedAmortization | Net CarryingAmount |\\n| (thousands) |\\n| Trade names and trademarks | $ | 9,600 | $ | ( 292 ) | $ | 9,308 |\\n| Customer relationships | 166,050 | ( 13,925 ) | 152,125 |\\n| $ | 175,650 | $ | ( 14,217 ) | $ | 161,433 |\\n\\n7. Debt\\nLong-term debt consisted of the following:\\n| March 31,2023 | December 31,2022 |\\n| (thousands) |\\n| Asset-based revolving credit facility due 2027 | $ | — | $ | — |\\n| Asset-based credit facility term loan due 2027 | 50,000 | 50,000 |\\n| 4.875% senior notes due 2030 | 400,000 | 400,000 |\\n| Deferred financing costs | ( 5,386 ) | ( 5,608 ) |\\n| Long-term debt | $ | 444,614 | $ | 444,392 |\\n\\n14\\nAsset-Based Credit Facility\\nOn May 15, 2015, Boise Cascade and its principal operating subsidiaries, Boise Cascade Wood Products, L.L.C., and Boise Cascade Building Materials Distribution, L.L.C., as borrowers, and Boise Cascade Wood Products Holdings Corp., as guarantor, entered into an Amended and Restated Credit Agreement, as amended, (the Amended Agreement) with Wells Fargo Capital Finance, LLC, as administrative agent, and the banks named therein as lenders. The Amended Agreement includes a $ 400 million senior secured asset-based revolving credit facility (Revolving Credit Facility) and a $ 50.0 million term loan (ABL Term Loan) maturing on the earlier of (a) September 9, 2027 and (b) 90 days prior to the maturity of our $ 400 million of 4.875 % senior notes due July 1, 2030 (or the maturity date of any permitted refinancing indebtedness or permitted upsized refinancing indebtedness in respect thereof). Interest on borrowings under our Revolving Credit Facility and ABL Term Loan are payable monthly. Borrowings under the Amended Agreement are constrained by a borrowing base formula dependent upon levels of eligible receivables and inventory reduced by outstanding borrowings and letters of credit (Availability).\\nThe Amended Agreement is secured by a first-priority security interest in substantially all of our assets, except for property and equipment. The proceeds of borrowings under the agreement are available for working capital and other general corporate purposes.\\nThe Amended Agreement contains customary nonfinancial covenants, including a negative pledge covenant and restrictions on new indebtedness, investments, distributions to equity holders, asset sales, and affiliate transactions, the scope of which are dependent on the Availability existing from time to time. The Amended Agreement also contains a requirement that we meet a 1 :1 fixed-charge coverage ratio (FCCR), applicable only if Availability falls below the greater of (a) 10 % of the Line Cap (as defined in the Amended Agreement) and (b) $ 35 million. Availability exceeded the minimum threshold amounts required for testing of the FCCR at all times since entering into the Amended Agreement, and Availability at March 31, 2023 was $ 395.9 million.\\nThe Amended Agreement permits us to pay dividends only if at the time of payment (a) no default has occurred or is continuing (or would result from such payment) under the Amended Agreement, and (b) either (i) pro forma Excess Availability (as defined in the Amended Agreement) is equal to or exceeds the greater of (x) 20 % of the Line Cap and (y) $ 75 million or (ii) (x) pro forma Excess Availability is equal to or exceeds the greater of (1) 15 % of Line Cap and (2) $ 55 million and (y) our fixed-charge coverage ratio is greater than or equal to 1 :1 on a pro forma basis.\\nRevolving Credit Facility\\nInterest rates under the Revolving Credit Facility are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.25 % to 1.50 % for loans based on SOFR and from 0.25 % to 0.50 % for loans based on the base rate. The spread is determined on the basis of a pricing grid that results in a higher spread as average quarterly Availability declines. Both SOFR options include an additional credit spread adjustment of 0.10 %. Letters of credit are subject to a fronting fee payable to the issuing bank and a fee payable to the lenders equal to the Term SOFR margin rate. In addition, we are required to pay an unused commitment fee at a rate of 0.20 % per annum of the average unused portion of the lending commitments.\\nAt both March 31, 2023 and December 31, 2022, we had no borrowings outstanding under the Revolving Credit Facility and $ 4.1 million and $ 3.8 million, respectively, of letters of credit outstanding. These letters of credit and borrowings, if any, reduce availability under the Revolving Credit Facility by an equivalent amount.\\nABL Term Loan\\nThe ABL Term Loan was provided by institutions within the Farm Credit system. Borrowings under the ABL Term Loan may be repaid from time to time at the discretion of the borrowers without premium or penalty. However, any principal amount of ABL Term Loan repaid may not be subsequently re-borrowed.\\nInterest rates under the ABL Term Loan are based, at our election, on either Daily Simple SOFR, Term SOFR, or a base rate, as defined in the Amended Agreement, plus a spread over the index elected that ranges from 1.75 % to 2.00 % for SOFR rate loans and from 0.75 % to 1.00 % for base rate loans, both dependent on the amount of Average Excess Availability (as defined in the Amended Agreement). Both SOFR options include an additional credit spread adjustment of 0.10 %. During the three months ended March 31, 2023, the average interest rate on the ABL Term Loan was approximately 6.36 %.\\nWe have received and expect to continue receiving patronage credits under the ABL Term Loan. Patronage credits are distributions of profits from banks in the Farm Credit system, which are cooperatives that are required to distribute profits to\\n15\\ntheir members. Patronage distributions, which are generally made in cash, are received in the year after they are earned. Patronage credits are recorded as a reduction to interest expense in the year earned. After giving effect to expected patronage distributions, the effective average net interest rate on the ABL Term Loan was approximately 5.4 % during the three months ended March 31, 2023.\\n2030 Notes\\nOn July 27, 2020, we issued $ 400 million of 4.875 % senior notes due July 1, 2030 (2030 Notes) through a private placement that was exempt from the registration requirements of the Securities Act. Interest on our 2030 Notes is payable semiannually in arrears on January 1 and July 1. The 2030 Notes are guaranteed by each of our existing and future direct or indirect domestic subsidiaries that is a guarantor under our Amended Agreement.\\nThe 2030 Notes are senior unsecured obligations and rank equally with all of the existing and future senior indebtedness of Boise Cascade Company and of the guarantors, senior to all of their existing and future subordinated indebtedness, effectively subordinated to all of their present and future senior secured indebtedness (including all borrowings with respect to our Amended Agreement to the extent of the value of the assets securing such indebtedness), and structurally subordinated to the indebtedness of any subsidiaries that do not guarantee the 2030 Notes.\\nThe terms of the indenture governing the 2030 Notes, among other things, limit the ability of Boise Cascade and our restricted subsidiaries to: incur additional debt; declare or pay dividends; redeem stock or make other distributions to stockholders; make investments; create liens on assets; consolidate, merge or transfer substantially all of their assets; enter into transactions with affiliates; and sell or transfer certain assets. The indenture governing the 2030 Notes permits us to pay dividends only if at the time of payment (i) no default has occurred or is continuing (or would result from such payment) under the indenture, and (ii) our consolidated leverage ratio is no greater than 3.5 :1, or (iii) the dividend, together with other dividends since the issue date, would not exceed our \\\"builder\\\" basket under the indenture. In addition, the indenture includes certain specific baskets for the payment of dividends.\\nThe indenture governing the 2030 Notes provides for customary events of default and remedies.\\nInterest Rate Swap\\nFor information on interest rate swap, see Interest Rate Risk and Interest Rate Swap of Note 2, Summary of Significant Accounting Policies.\\nCash Paid for Interest\\nFor the three months ended March 31, 2023 and 2022, cash payments for interest were $ 10.4 million and $ 10.6 million, respectively.\\n16\\n8. Leases\\nLease Costs\\nThe components of lease expense were as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Operating lease cost | $ | 3,317 | $ | 3,561 |\\n| Finance lease cost |\\n| Amortization of right-of-use assets | 618 | 626 |\\n| Interest on lease liabilities | 560 | 587 |\\n| Variable lease cost | 1,385 | 1,034 |\\n| Short-term lease cost | 1,551 | 1,312 |\\n| Sublease income | ( 53 ) | ( 112 ) |\\n| Total lease cost | $ | 7,378 | $ | 7,008 |\\n\\nOther Information\\nSupplemental cash flow information related to leases was as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Cash paid for amounts included in the measurement of lease liabilities |\\n| Operating cash flows from operating leases | $ | 3,366 | $ | 3,440 |\\n| Operating cash flows from finance leases | 560 | 587 |\\n| Financing cash flows from finance leases | 451 | 422 |\\n| Right-of-use assets obtained in exchange for lease obligations |\\n| Operating leases | 92 | — |\\n| Finance leases | — | — |\\n\\n17\\nOther information related to leases was as follows:\\n| March 31, 2023 | December 31, 2022 |\\n| Weighted-average remaining lease term (years) |\\n| Operating leases | 7 | 7 |\\n| Finance leases | 14 | 14 |\\n| Weighted-average discount rate |\\n| Operating leases | 6.0 | % | 6.0 | % |\\n| Finance leases | 7.6 | % | 7.6 | % |\\n\\nAs of March 31, 2023, our minimum lease payment requirements for noncancelable operating and finance leases are as follows:\\n| Operating Leases | Finance Leases |\\n| (thousands) |\\n| Remainder of 2023 | $ | 10,162 | $ | 3,046 |\\n| 2024 | 12,104 | 4,052 |\\n| 2025 | 10,385 | 3,735 |\\n| 2026 | 7,200 | 3,581 |\\n| 2027 | 6,497 | 3,649 |\\n| Thereafter | 23,633 | 33,086 |\\n| Total future minimum lease payments | 69,981 | 51,149 |\\n| Less: interest | ( 14,015 ) | ( 19,746 ) |\\n| Total lease obligations | 55,966 | 31,403 |\\n| Less: current obligations | ( 10,285 ) | ( 1,854 ) |\\n| Long-term lease obligations | $ | 45,681 | $ | 29,549 |\\n\\n9. Stock-Based Compensation\\nIn first quarter 2023 and 2022, we granted two types of stock-based awards under our incentive plan: performance stock units (PSUs) and restricted stock units (RSUs).\\nPSU and RSU Awards\\nDuring the three months ended March 31, 2023, we granted 93,282 PSUs to our officers and other employees, subject to performance and service conditions. For the officers, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade's 2023 return on invested capital (ROIC), as approved by our compensation committee in accordance with the related grant agreement. We define ROIC as net operating profit after taxes (NOPAT) divided by average invested capital (based on a rolling thirteen-month average). We define NOPAT as net income plus after-tax financing expense. Invested capital is defined as total assets plus capitalized lease expense, less cash, cash equivalents, and current liabilities, excluding short-term debt. For the other employees, the number of shares actually awarded will range from 0 % to 200 % of the target amount, depending upon Boise Cascade’s 2023 EBITDA, defined as income before interest (interest expense and interest income), income taxes, and depreciation and amortization, as approved by executive management, determined in accordance with the related grant agreement. Because the PSUs contain a performance condition, we record compensation expense over the requisite service period based on the most probable number of shares expected to vest.\\nDuring the three months ended March 31, 2022, we granted 66,180 PSUs to our officers and other employees, subject to performance and service conditions. During the 2022 performance period, officers and other employees earned 152 % and 200 %, respectively, of the target based on Boise Cascade's 2022 ROIC and EBITDA, as applicable, determined by our compensation committee and executive management, as applicable, in accordance with the related grant agreements.\\nThe PSUs granted to officers generally vest in a single installment three years from the date of grant, while the PSUs granted to other employees vest in three equal tranches each year after the grant date.\\n18\\nDuring the three months ended March 31, 2023 and 2022, we granted an aggregate of 115,060 and 81,523 RSUs, respectively, to our officers, other employees, and nonemployee directors with only service conditions. The RSUs granted to officers and other employees vest in three equal tranches each year after the grant date. The RSUs granted to nonemployee directors vest in a single installment after a one year period.\\nWe based the fair value of PSU and RSU awards on the closing market price of our common stock on the grant date. During the three months ended March 31, 2023 and 2022, the total fair value of PSUs and RSUs vested was $ 16.8 million and $ 12.0 million, respectively.\\nThe following summarizes the activity of our PSUs and RSUs awarded under our incentive plan for the three months ended March 31, 2023:\\n| PSUs | RSUs |\\n| Number of shares | Weighted Average Grant-Date Fair Value | Number of shares | Weighted Average Grant-Date Fair Value |\\n| Outstanding, December 31, 2022 | 317,854 | $ | 51.46 | 155,339 | $ | 65.17 |\\n| Granted | 93,282 | 69.33 | 115,060 | 69.33 |\\n| Performance condition adjustment (a) | 39,873 | 79.80 | — | — |\\n| Vested | ( 154,794 ) | 40.61 | ( 87,632 ) | 60.64 |\\n| Forfeited | ( 5,399 ) | 68.55 | ( 3,200 ) | 70.32 |\\n| Outstanding, March 31, 2023 | 290,816 | $ | 66.54 | 179,567 | $ | 69.96 |\\n\\n_______________________________\\n(a) Represents additional PSUs granted during the three months ended March 31, 2023, related to above-target achievement of the 2022 performance condition described above.\\nCompensation Expense\\nWe record compensation expense over the awards' vesting period and account for share-based award forfeitures as they occur, rather than making estimates of future forfeitures. Any shares not vested are forfeited. We recognize compensation expense for stock awards with only service conditions on a straight-line basis over the requisite service period. Most of our stock-based compensation expense was recorded in \\\"General and administrative expenses\\\" in our Consolidated Statements of Operations. Total stock-based compensation recognized from PSUs and RSUs, net of forfeitures, was as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| PSUs | $ | 1,814 | $ | 1,306 |\\n| RSUs | 1,510 | 1,086 |\\n| Total | $ | 3,324 | $ | 2,392 |\\n\\nThe related tax benefit for the three months ended March 31, 2023 and 2022, was $ 0.9 million and $ 0.6 million respectively. As of March 31, 2023, total unrecognized compensation expense related to nonvested share-based compensation arrangements was $ 23.7 million. This expense is expected to be recognized over a weighted-average period of 2.2 years.\\n19\\n10. Stockholders' Equity\\nDividends\\nOn November 14, 2017, we announced that our board of directors approved a dividend policy to pay quarterly cash dividends to holders of our common stock. For more information regarding our dividend declarations and payments made during each of the three months ended March 31, 2023 and 2022, see \\\"Common stock dividends\\\" on our Consolidated Statements of Stockholders' Equity.\\nOn May 4, 2023 , our board of directors declared a quarterly dividend of $ 0.15 per share on our common stock, as well as a special dividend of $ 3.00 per share on our common stock, both payable on June 15, 2023 , to stockholders of record on June 1, 2023 . For a description of the restrictions in our asset-based credit facility and the indenture governing our senior notes on our ability to pay dividends, see Note 7, Debt.\\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\\nStock Repurchase\\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During the three months ended March 31, 2023, we repurchased 24,727 shares under the Program at a cost of $ 1.5 million, or an average of $ 59.91 per share. The shares were purchased with cash on hand and are recorded as \\\"Treasury stock\\\" on our Consolidated Balance Sheet. As of March 31, 2023, there were 1,972,262 shares of common stock that may yet be purchased under the Program.\\n11. Transactions With Related Party\\nLouisiana Timber Procurement Company, L.L.C. (LTP) is an unconsolidated variable-interest entity that is 50 % owned by us and 50 % owned by Packaging Corporation of America (PCA). LTP procures sawtimber, pulpwood, residual chips, and other residual wood fiber to meet the wood and fiber requirements of us and PCA in Louisiana. We are not the primary beneficiary of LTP as we do not have power to direct the activities that most significantly affect the economic performance of LTP. Accordingly, we do not consolidate LTP's results in our financial statements.\\nSales\\nRelated-party sales to LTP from our Wood Products segment in our Consolidated Statements of Operations were $ 3.0 million and $ 3.7 million, respectively, during the three months ended March 31, 2023 and 2022. These sales are recorded in \\\"Sales\\\" in our Consolidated Statements of Operations.\\nCosts and Expenses\\nRelated-party wood fiber purchases from LTP were $ 20.1 million and $ 20.8 million, respectively, during the three months ended March 31, 2023 and 2022. These costs are recorded in \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" in our Consolidated Statements of Operations.\\n20\\n12. Segment Information\\nWe operate our business using two reportable segments: Wood Products and BMD. We measure and evaluate our reportable segments based on net sales and segment operating income (loss). Accordingly, our chief operating decision maker reviews the performance of the company and allocates resources based primarily on net sales and segment operating income (loss) for our business segments. Unallocated corporate costs are presented as reconciling items to arrive at operating income. There are no differences in our basis of measurement of segment profit or loss from those disclosed in Note 16, Segment Information, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K.\\nWood Products and BMD segment sales to external customers, including related parties, by product line, are as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (millions) |\\n| Wood Products (a) |\\n| LVL (b) | $ | 7.4 | $ | 1.7 |\\n| I-joists (b) | 4.7 | ( 2.2 ) |\\n| Other engineered wood products (b) | 7.4 | 11.8 |\\n| Plywood and veneer | 91.3 | 161.2 |\\n| Lumber | 23.6 | 17.7 |\\n| Byproducts | 24.3 | 19.1 |\\n| Other | 6.5 | 5.2 |\\n| 165.1 | 214.5 |\\n| Building Materials Distribution |\\n| Commodity | 547.5 | 1,102.0 |\\n| General line | 533.6 | 615.1 |\\n| Engineered wood products | 298.1 | 394.7 |\\n| 1,379.2 | 2,111.8 |\\n| $ | 1,544.3 | $ | 2,326.3 |\\n\\n___________________________________\\n(a) Amounts represent sales to external customers. Sales are calculated after intersegment sales eliminations to our BMD segment.\\n(b) Sales of EWP to external customers are net of the cost of all EWP rebates and sales allowances provided at various stages of the supply chain (including distributors, dealers, and homebuilders). For both the three months ended March 31, 2023 and 2022, approximately 79 % of Wood Products' EWP sales volumes were to our BMD segment.\\n21\\nAn analysis of our operations by segment is as follows:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Net sales by segment |\\n| Wood Products | $ | 437,428 | $ | 558,944 |\\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\\n| Intersegment eliminations (a) | ( 272,341 ) | ( 344,495 ) |\\n| Total net sales | $ | 1,544,329 | $ | 2,326,282 |\\n| Segment operating income |\\n| Wood Products | $ | 69,395 | $ | 190,116 |\\n| Building Materials Distribution | 69,685 | 225,892 |\\n| Total segment operating income | 139,080 | 416,008 |\\n| Unallocated corporate costs | ( 11,478 ) | ( 10,380 ) |\\n| Income from operations | $ | 127,602 | $ | 405,628 |\\n\\n___________________________________\\n(a) Primarily represents intersegment sales from our Wood Products segment to our BMD segment.\\n13. Commitments, Legal Proceedings and Contingencies, and Guarantees\\nCommitments\\nWe are a party to a number of long-term log supply agreements that are discussed in Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K. In addition, we have purchase obligations for goods and services, capital expenditures, and raw materials entered into in the normal course of business. As of March 31, 2023, there have been no material changes to the above commitments disclosed in the 2022 Form 10-K.\\nLegal Proceedings and Contingencies\\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\\nGuarantees\\nWe provide guarantees, indemnifications, and assurances to others. Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K describes the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in the 2022 Form 10-K.\\n22\\n\\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nUnderstanding Our Financial Information\\nThis Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes in \\\"Item 1. Financial Statements\\\" of this Form 10-Q, as well as our 2022 Form 10-K. The following discussion includes statements regarding our expectations with respect to our future performance, liquidity, and capital resources. Such statements, along with any other nonhistorical statements in the discussion, are forward-looking. These forward-looking statements include, without limitation, any statement that may predict, indicate, or imply future results, performance, or achievements and may contain the words \\\"may,\\\" \\\"will,\\\" \\\"expect,\\\" \\\"believe,\\\" \\\"should,\\\" \\\"plan,\\\" \\\"anticipate,\\\" and other similar expressions. All of these forward-looking statements are based on estimates and assumptions made by our management that, although believed by us to be reasonable, are inherently uncertain. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in \\\"Item 1A. Risk Factors\\\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission (the SEC). We do not assume an obligation to update any forward-looking statement. Our future actual results may differ materially from those contained in or implied by any of the forward-looking statements in this Form 10-Q.\\nBackground\\nBoise Cascade Company is a building products company headquartered in Boise, Idaho. As used in this Form 10-Q, the terms \\\"Boise Cascade,\\\" \\\"we,\\\" and \\\"our\\\" refer to Boise Cascade Company and its consolidated subsidiaries. Boise Cascade is a large, vertically-integrated wood products manufacturer and building materials distributor. We have two reportable segments: (i) Wood Products, which primarily manufactures engineered wood products (EWP) and plywood; and (ii) Building Materials Distribution (BMD), which is a wholesale distributor of building materials. Our products are used in the construction of new residential housing, including single-family, multi-family, and manufactured homes, the repair-and-remodeling of existing housing, the construction of light industrial and commercial buildings, and industrial applications. For more information, see Note 12, Segment Information, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \\\"Item 1. Financial Statements\\\" of this Form 10-Q.\\nExecutive Overview\\nWe recorded income from operations of $127.6 million during the three months ended March 31, 2023, compared with income from operations of $405.6 million during the three months ended March 31, 2022. In our Wood Products segment, income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, from $190.1 million for the three months ended March 31, 2022, due primarily to lower plywood sales prices, lower EWP sales volumes, higher per-unit conversion costs, and an increase in depreciation and amortization expense due to the acquisition of two plywood facilities located in Havana, Florida, and Chapman, Alabama, on July 25, 2022 (the Acquisition). These decreases were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists). In our BMD segment, income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022, driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million. These changes are discussed further in \\\"Our Operating Results\\\" below.\\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $395.9 million of undrawn committed bank line availability, for total available liquidity of $1,396.7 million. We had $444.6 million of outstanding debt at March 31, 2023. We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. A further description of our cash sources and uses for the three-month comparative periods are discussed in \\\"Liquidity and Capital Resources\\\" below.\\nDemand for the products we manufacture, as well as the products we purchase and distribute, is correlated with new residential construction, residential repair-and-remodeling activity and light commercial construction. U.S. housing starts in March 2023 were approximately 1.42 million on a seasonally adjusted annual rate basis, as reported by the U.S. Census Bureau. In addition, mortgage rates have declined from peak levels in late 2022, and measures of builder sentiment have improved from fourth quarter 2022 levels. However, home affordability remains a challenge for consumers, and the Federal Reserve's ongoing actions in response to inflationary data and what impacts these actions have on future mortgage rates and the broader economy\\n23\\nwill influence the near-term demand environment. As such, the full year outlook for 2023 is uncertain and is reflected in various industry forecasts for 2023 U.S. housing starts that generally range from 1.2 million to 1.4 million units, compared with actual housing starts of 1.55 million in 2022, as reported by the U.S. Census Bureau. Regarding home improvement spending, the age of U.S. housing stock and elevated levels of homeowner equity have provided a favorable backdrop for repair-and-remodel spending. However, industry forecasts project continued moderation of year-over-year growth in renovation spending, and economic uncertainty may also negatively impact homeowners' further investment in their residences.\\nAs a manufacturer of certain commodity products, we have sales and profitability exposure to declines in commodity product prices and rising input costs. Our distribution business purchases and resells a broad mix of commodity products with periods of increasing prices providing the opportunity for higher sales and increased margins, while declining price environments expose us to declines in sales and profitability. Future commodity product pricing and commodity input costs may be volatile in response to economic uncertainties, industry operating rates, transportation constraints or disruptions, net import and export activity, inventory levels in various distribution channels, and seasonal demand patterns. In addition, EWP volumes will continue to be influenced by demand for new residential construction, particularly single-family housing starts and we expect further EWP price erosion in the second quarter.\\nFactors That Affect Our Operating Results and Trends\\nOur results of operations and financial performance are influenced by a variety of factors, including the following:\\n•the commodity nature of a portion of our products and their price movements, which are driven largely by industry capacity and operating rates, industry cycles that affect supply and demand, and net import and export activity;\\n•general economic conditions, including but not limited to housing starts, repair-and-remodeling activity, light commercial construction, inventory levels of new and existing homes for sale, foreclosure rates, interest rates, inflation, unemployment rates, household formation rates, prospective home buyers' access to and cost of financing, and housing affordability, that ultimately affect demand for our products;\\n•the highly competitive nature of our industry;\\n•declines in demand for our products due to competing technologies or materials, as well as changes in building code provisions;\\n•disruptions to information systems used to process and store customer, employee, and vendor information, as well as the technology that manages our operations and other business processes;\\n•material disruptions and/or major equipment failure at our manufacturing facilities;\\n•labor disruptions, shortages of skilled and technical labor, or increased labor costs;\\n•the need to successfully formulate and implement succession plans for key members of our management team;\\n•product shortages, loss of key suppliers, and our dependence on third-party suppliers and manufacturers;\\n•the cost and availability of third-party transportation services used to deliver the goods we manufacture and distribute, as well as our raw materials;\\n•cost and availability of raw materials, including wood fiber and glues and resins;\\n•our ability to successfully and efficiently complete and integrate acquisitions;\\n•the concentration of our sales among a relatively small group of customers, as well as the financial condition and creditworthiness of our customers;\\n•impairment of our long-lived assets, goodwill, and/or intangible assets;\\n•substantial ongoing capital investment costs, including those associated with acquisitions, and the difficulty in offsetting fixed costs related to those investments;\\n24\\n•our indebtedness, including the possibility that we may not generate sufficient cash flows from operations or that future borrowings may not be available in amounts sufficient to fulfill our debt obligations and fund other liquidity needs;\\n•restrictive covenants contained in our debt agreements;\\n•compliance with data privacy and security laws and regulations;\\n•the impacts of climate change and related legislative and regulatory responses intended to reduce climate change;\\n•cost of compliance with government regulations, in particular, environmental regulations;\\n•the enactment of tax reform legislation;\\n•exposure to product liability, product warranty, casualty, construction defect, and other claims;\\n•fluctuations in the market for our equity; and\\n•the other factors described in \\\"Item 1A. Risk Factors\\\" in our 2022 Form 10-K.\\n25\\nOur Operating Results\\nThe following tables set forth our operating results in dollars and as a percentage of sales for the three months ended March 31, 2023 and 2022:\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (millions) |\\n| Sales | $ | 1,544.3 | $ | 2,326.3 |\\n| Costs and expenses |\\n| Materials, labor, and other operating expenses (excluding depreciation) | 1,230.6 | 1,729.9 |\\n| Depreciation and amortization | 31.2 | 20.5 |\\n| Selling and distribution expenses | 128.8 | 146.7 |\\n| General and administrative expenses | 26.5 | 26.1 |\\n| Other (income) expense, net | (0.3) | (2.5) |\\n| 1,416.7 | 1,920.7 |\\n| Income from operations | $ | 127.6 | $ | 405.6 |\\n| (percentage of sales) |\\n| Sales | 100.0 | % | 100.0 | % |\\n| Costs and expenses |\\n| Materials, labor, and other operating expenses (excluding depreciation) | 79.7 | % | 74.4 | % |\\n| Depreciation and amortization | 2.0 | 0.9 |\\n| Selling and distribution expenses | 8.3 | 6.3 |\\n| General and administrative expenses | 1.7 | 1.1 |\\n| Other (income) expense, net | — | (0.1) |\\n| 91.7 | % | 82.6 | % |\\n| Income from operations | 8.3 | % | 17.4 | % |\\n\\n26\\nSales Volumes and Prices\\nSet forth below are historical U.S. housing starts data, segment sales volumes and average net selling prices for the principal products sold by our Wood Products segment, and sales mix and gross margin information for our BMD segment for the three months ended March 31, 2023 and 2022.\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| U.S. Housing Starts (a) |\\n| Single-family | 190.5 | 266.8 |\\n| Multi-family | 129.4 | 122.9 |\\n| 319.9 | 389.7 |\\n| (thousands) |\\n| Segment Sales |\\n| Wood Products | $ | 437,428 | $ | 558,944 |\\n| Building Materials Distribution | 1,379,242 | 2,111,833 |\\n| Intersegment eliminations | (272,341) | (344,495) |\\n| Total sales | $ | 1,544,329 | $ | 2,326,282 |\\n| Wood Products | (millions) |\\n| Sales Volumes |\\n| Laminated veneer lumber (LVL) (cubic feet) | 3.6 | 4.6 |\\n| I-joists (equivalent lineal feet) | 39 | 65 |\\n| Plywood (sq. ft.) (3/8\\\" basis) | 406 | 317 |\\n| Wood Products | (dollars per unit) |\\n| Average Net Selling Prices |\\n| Laminated veneer lumber (LVL) (cubic foot) | $ | 31.17 | $ | 26.40 |\\n| I-joists (1,000 equivalent lineal feet) | 2,168 | 1,877 |\\n| Plywood (1,000 sq. ft.) (3/8\\\" basis) | 367 | 689 |\\n| (percentage of Building Materials Distribution sales) |\\n| Building Materials Distribution |\\n| Product Line Sales |\\n| Commodity | 39.7 | % | 52.2 | % |\\n| General line | 38.7 | % | 29.1 | % |\\n| Engineered wood products | 21.6 | % | 18.7 | % |\\n| Gross margin percentage (b) | 14.8 | % | 18.0 | % |\\n\\n_______________________________________\\n(a) Actual U.S. housing starts data reported by the U.S. Census Bureau.\\n(b) We define gross margin as \\\"Sales\\\" less \\\"Materials, labor, and other operating expenses (excluding depreciation).\\\" Substantially all costs included in \\\"Materials, labor, and other operating expenses (excluding depreciation)\\\" for our BMD segment are for inventory purchased for resale. Gross margin percentage is gross margin as a percentage of segment sales.\\n27\\nSales\\nFor the three months ended March 31, 2023, total sales decreased $782.0 million, or 34%, to $1,544.3 million from $2,326.3 million during the three months ended March 31, 2022. As described below, the decrease in sales was driven by the changes in sales prices and volumes for the products we manufacture and distribute with single-family residential construction activity being the key demand driver of our sales. In first quarter 2023, total U.S. housing starts decreased 18%, driven by a decrease in single-family housing starts of 29% compared with the same period in 2022. Average composite lumber and average composite panel prices for the three months ended March 31, 2023 were 67% and 59% lower, respectively, than in the same period in the prior year, as reflected by Random Lengths composite lumber and panel pricing.\\nWood Products. Sales, including sales to our BMD segment, decreased $121.5 million, or 22%, to $437.4 million for the three months ended March 31, 2023, from $558.9 million for the three months ended March 31, 2022. The decrease in sales was driven by lower plywood sales prices of 47%, resulting in decreased sales of $130.6 million. In addition, lower sales volumes of I-joists and LVL (collectively referred to as EWP) of 41% and 22%, respectively, resulted in decreased sales of $50.0 million and $26.4 million, respectively. EWP sales volumes decreased due to a decline in housing starts. I-joist volumes were also impacted by the availability of product substitutes and construction methods in certain geographies that reduce the wood floor opportunity. These decreases were offset partially by higher sales volumes for plywood of 28%, resulting in increased sales of $61.3 million. In addition, higher sales prices for LVL and I-joists of 18% and 16%, respectively, resulted in increased sales of $17.4 million and $11.3 million, respectively. The increase in EWP pricing was due to realizations of previously announced price increases and the expiration of certain temporary price protection arrangements.\\nBuilding Materials Distribution. Sales decreased $732.6 million, or 35%, to $1,379.2 million for the three months ended March 31, 2023, from $2,111.8 million for the three months ended March 31, 2022. Compared with the same quarter in the prior year, the overall decrease in sales was driven by sales price and sales volume decreases of 20% and 15%, respectively. By product line, commodity sales decreased 50%, or $554.5 million; general line product sales decreased 13%, or $81.6 million; and sales of EWP (substantially all of which are sourced through our Wood Products segment) decreased 24%, or $96.5 million.\\nCosts and Expenses\\nMaterials, labor, and other operating expenses (excluding depreciation) decreased $499.3 million, or 29%, to $1,230.6 million for the three months ended March 31, 2023, compared with $1,729.9 million during the same period in the prior year. In our Wood Products segment, materials, labor, and other operating expenses decreased due to lower EWP sales volumes, as well as lower per-unit costs of OSB (used in the manufacture of I-joists) of approximately 19%, compared with first quarter 2022, as well as decreased other manufacturing costs, offset partially by increased labor costs. However, materials, labor, and other operating expenses as a percentage of sales (MLO rate) in our Wood Products segment increased by 1,340 basis points. The increase in the MLO rate was primarily the result of lower plywood sales prices, resulting in decreased leveraging of labor, wood fiber, and other manufacturing costs. In BMD, the decrease in materials, labor, and other operating expenses was driven by lower purchased materials costs as a result of lower sales volumes and lower commodity prices, compared with first quarter 2022. However, the BMD segment MLO rate increased by 330 basis points compared with first quarter 2022, driven primarily by lower margin percentages on our commodity product sales. In our BMD Segment, periods of increasing prices provide the opportunity for higher sales and increased margins, while declining price environments generally result in declines in sales and profitability.\\nDepreciation and amortization expenses increased $10.7 million, or 52%, to $31.2 million for the three months ended March 31, 2023, compared with $20.5 million during the same period in the prior year. The increase was due primarily to the Acquisition on July 25, 2022, and other capital expenditures.\\nSelling and distribution expenses decreased $17.9 million, or 12%, to $128.8 million for the three months ended March 31, 2023, compared with $146.7 million during the same period in the prior year, primarily as a result of lower incentive compensation expenses of $20.0 million, offset partially by an increase in shipping and handling costs and discretionary expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\\nGeneral and administrative expenses increased $0.4 million, or 2%, to $26.5 million for the three months ended March 31, 2023, compared with $26.1 million for the same period in the prior year, primarily due to an increase in professional fees and employee-related expenses, offset partially by lower incentive compensation expenses during the three months ended March 31, 2023 compared with the same period in the prior year.\\n28\\nFor the three months ended March 31, 2023, other income (expense), net, was $0.3 million of income, compared with $2.5 million of income for the three months ended March 31, 2022. Other income for the three months ended March 31, 2022 primarily included earn-out income related to a previous asset sale in our Wood Products segment.\\nIncome From Operations\\nIncome from operations decreased $278.0 million to $127.6 million for the three months ended March 31, 2023, compared with $405.6 million for the three months ended March 31, 2022.\\nWood Products. Segment income decreased $120.7 million to $69.4 million for the three months ended March 31, 2023, compared with $190.1 million for the three months ended March 31, 2022. The decrease in segment income was due primarily to lower plywood sales prices and lower EWP sales volumes. In addition, segment income was negatively impacted by higher per-unit conversion costs and an increase in depreciation and amortization expense of $10.7 million related to the Acquisition. These decreases in segment income were offset partially by higher EWP sales prices and higher plywood sales volumes, as well as lower OSB costs (used in the manufacture of I-joists).\\nBuilding Materials Distribution. Segment income decreased $156.2 million to $69.7 million for the three months ended March 31, 2023, from $225.9 million for the three months ended March 31, 2022. The decline in segment income was driven by a gross margin decrease of $177.3 million, resulting primarily from lower margins on commodity products and lower sales volumes, offset partially by decreased selling and distribution expenses of $20.3 million.\\nCorporate. Unallocated corporate expenses increased $1.1 million to $11.5 million for the three months ended March 31, 2023, from $10.4 million for the same period in the prior year. The increase was due primarily to an increase in professional fees.\\nOther\\nInterest Income. Interest income increased $9.6 million to $9.7 million for the three months ended March 31, 2023, from $0.1 million for the three months ended March 31, 2022. The increase was due primarily to higher interest rates on cash equivalents and increases in the average balances of cash equivalents.\\nChange in fair value of interest rate swaps. For information related to our interest rate swap, see the discussion under \\\"Interest Rate Risk and Interest Rate Swap\\\" of Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \\\"Item 1. Financial Statements\\\" of this Form 10-Q.\\nIncome Tax Provision\\nFor the three months ended March 31, 2023 and 2022, we recorded $33.3 million and $98.9 million, respectively, of income tax expense and had an effective rate of 25.6% and 24.6%, respectively. For both periods, the primary reason for the difference between the federal statutory income tax rate of 21% and the effective tax rate was the effect of state taxes.\\nLiquidity and Capital Resources\\nWe ended first quarter 2023 with $1,000.7 million of cash and cash equivalents and $444.6 million of debt. At March 31, 2023, we had $1,396.7 million of available liquidity (cash and cash equivalents and undrawn committed bank line availability). We generated $2.4 million of cash during the three months ended March 31, 2023, as cash provided by operations was offset partially by capital spending, dividends paid on our common stock, and tax withholding payments on stock-based awards. Further descriptions of our cash sources and uses for the three month comparative periods are noted below.\\nWe believe that our cash flows from operations, combined with our current cash levels and available borrowing capacity, will be adequate to fund debt service requirements and provide cash, as required, to support our ongoing operations, capital expenditures, lease obligations, working capital, income tax payments, and to pay cash dividends to holders of our common stock over the next 12 months. We expect to fund our seasonal and intra-month working capital requirements in 2023 from cash on hand and, if necessary, borrowings under our revolving credit facility.\\n29\\nSources and Uses of Cash\\nWe generate cash primarily from sales of our products, as well as short-term and long-term borrowings. Our primary uses of cash are for expenses related to the manufacture and distribution of building products, including inventory purchased for resale, wood fiber, labor, energy, and glues and resins. In addition to paying for ongoing operating costs, we use cash to invest in our business, service our debt and lease obligations, and return cash to our shareholders through dividends or common stock repurchases. Below is a discussion of our sources and uses of cash for operating activities, investing activities, and financing activities.\\n| Three Months EndedMarch 31 |\\n| 2023 | 2022 |\\n| (thousands) |\\n| Net cash provided by operations | $ | 47,992 | $ | 198,945 |\\n| Net cash used for investment | (29,498) | (14,867) |\\n| Net cash used for financing | (16,117) | (10,264) |\\n\\nOperating Activities\\nFor the three months ended March 31, 2023, our operating activities generated $48.0 million of cash, compared with $198.9 million of cash generated in the same period in 2022. The $150.9 million decrease in cash provided by operations was due primarily to a decrease in income from operations, offset partially by a lesser year-over-year increase in working capital and a decrease in cash paid for taxes, net of refunds, of $2.9 million. Working capital increased $117.7 million during the three months ended March 31, 2023, compared with a $217.8 million increase for the same period in the prior year. See \\\"Our Operating Results\\\" in this Management's Discussion and Analysis of Financial Condition and Results of Operations for more information related to factors affecting our operating results.\\nThe increase in working capital during both periods was primarily attributable to higher receivables and inventories, offset by an increase in accounts payable and accrued liabilities. The increases in receivables in both periods primarily reflect increased sales of approximately 26% and 49%, comparing sales for the months of March 2023 and 2022 with sales for the months of December 2022 and 2021, respectively. Inventories increased during the three months ended March 31, 2023 in preparation for the spring building season. During the three months ended March 31, 2022 inventories increased primarily due to increased cost of inventory purchased for resale and higher production costs for our manufactured products. The increase in accounts payable and accrued liabilities as of March 31, 2023 was related to the increase in inventories, offset partially by employee incentive compensation payouts made during the quarter and lower accrued rebates. The increase in accounts payable and accrued liabilities as of March 31, 2022 was related to the increase in inventories and higher accrued rebates, offset partially by employee incentive compensation payouts made during first quarter 2022.\\nInvestment Activities\\nDuring the three months ended March 31, 2023 and 2022, we used $30.1 million and $17.4 million, respectively, of cash for purchases of property and equipment, including business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. During the three months ended March 31, 2022, we received $2.5 million of earn-out income related to a previous asset sale in our Wood Products segment.\\nWe expect capital expenditures in 2023 to total approximately $120 million to $140 million. We expect our capital spending in 2023 will be for business improvement and quality/efficiency projects, replacement and expansion projects, and ongoing environmental compliance. Our 2023 capital expenditures range includes funding for greenfield distribution centers in South Carolina and Texas, projects at our mills in the southeast to expand our EWP capacity, and the purchase of property to house an additional door shop assembly operation in Kansas City, Missouri. This level of capital expenditures could increase or decrease as a result of several factors, including acquisitions, efforts to further accelerate organic growth, exercise of lease purchase options, our financial results, future economic conditions, availability of engineering and construction resources, and timing and availability of equipment purchases.\\nFinancing Activities\\nDuring the three months ended March 31, 2023, our financing activities used $16.1 million of cash, including $8.3 million for common stock dividend payments, $5.9 million of tax withholding payments on stock-based awards, and $1.5\\n30\\nmillion for the repurchase of 24,727 shares of our common stock. During the three months ended March 31, 2023, we did not borrow under our revolving credit facility, and therefore have no borrowings outstanding on the facility as of March 31, 2023.\\nDuring the three months ended March 31, 2022, our financing activities used $10.3 million of cash, including $5.9 million for common stock dividend payments and $3.9 million of tax withholding payments on stock-based awards. During the three months ended March 31, 2022, we did not borrow under our revolving credit facility.\\nFuture dividend declarations, including amount per share, record date and payment date, will be made at the discretion of our board of directors and will depend upon, among other things, legal capital requirements and surplus, our future operations and earnings, general financial condition, material cash requirements, restrictions imposed by our asset-based credit facility and the indenture governing our senior notes, applicable laws, and other factors that our board of directors may deem relevant.\\nFor more information related to our debt transactions and structure, our dividend policy, and our stock repurchase program, see the discussion in Note 7, Debt, and Note 10, Stockholders' Equity, respectively, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \\\"Item 1. Financial Statements\\\" of this Form 10-Q.\\nOther Material Cash Requirements\\nFor information about other material cash requirements, see Liquidity and Capital Resources in \\\"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in other material cash requirements outside the ordinary course of business since December 31, 2022.\\nGuarantees\\nNote 9, Debt, and Note 17, Commitments, Legal Proceedings and Contingencies, and Guarantees, of the Notes to Consolidated Financial Statements in \\\"Item 8. Financial Statements and Supplementary Data\\\" in our 2022 Form 10-K describe the nature of our guarantees, including the approximate terms of the guarantees, how the guarantees arose, the events or circumstances that would require us to perform under the guarantees, and the maximum potential undiscounted amounts of future payments we could be required to make. As of March 31, 2023, there have been no material changes to the guarantees disclosed in our 2022 Form 10-K.\\nSeasonal Influences\\nWe are exposed to fluctuations in quarterly sales volumes and expenses due to seasonal factors. These seasonal factors are common in the building products industry. Seasonal changes in levels of building activity affect our building products businesses, which are dependent on housing starts, repair-and-remodeling activities, and light commercial construction activities. We typically report lower sales volumes in the first and fourth quarters due to the impact of poor weather on the construction market, and we generally have higher sales volumes in the second and third quarters, reflecting an increase in construction due to more favorable weather conditions. We typically have higher working capital in the first and second quarters in preparation and response to the building season. Seasonally cold weather increases costs, especially energy consumption costs, at most of our manufacturing facilities.\\nEmployees\\nAs of April 30, 2023, we had approximately 6,660 employees. Approximately 19% of these employees work pursuant to collective bargaining agreements. As of April 30, 2023, we had ten collective bargaining agreements. One agreement covering approximately 80 employees at our Canadian EWP facility expired on December 31, 2022, but the terms and conditions of this agreement remain in effect pending negotiation of a new agreement. We may not be able to renew this agreement or may renew it on terms that are less favorable to us than the current agreement. If any of these agreements are not renewed or extended upon their termination, we could experience a material labor disruption, strike, or significantly increased labor costs at one or more of our facilities, either in the course of negotiations of a labor agreement or otherwise. Labor disruptions or shortages could prevent us from meeting customer demands or result in increased costs, thereby reducing our sales and profitability.\\n31\\nDisclosures of Financial Market Risks\\nIn the normal course of business, we are exposed to financial risks such as changes in commodity prices, interest rates, and foreign currency exchange rates. As of March 31, 2023, there have been no material changes to financial market risks disclosed in our 2022 Form 10-K.\\nEnvironmental\\nAs of March 31, 2023, there have been no material changes to environmental issues disclosed in our 2022 Form 10-K. For additional information, see Environmental in \\\"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our 2022 Form 10-K.\\nCritical Accounting Estimates\\nCritical accounting estimates are those that are most important to the portrayal of our financial condition and results. These estimates require management's most difficult, subjective, or complex judgments, often as a result of the need to estimate matters that are inherently uncertain. We review the development, selection, and disclosure of our critical accounting estimates with the Audit Committee of our board of directors. For information about critical accounting estimates, see Critical Accounting Estimates in \\\"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our 2022 Form 10-K. At March 31, 2023, there have been no material changes to our critical accounting estimates from those disclosed in our 2022 Form 10-K.\\nNew and Recently Adopted Accounting Standards\\nFor information related to new and recently adopted accounting standards, see \\\"New and Recently Adopted Accounting Standards\\\" in Note 2, Summary of Significant Accounting Policies, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in \\\"Item 1. Financial Statements\\\" in this Form 10-Q.\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nFor information relating to quantitative and qualitative disclosures about market risk, see the discussion under \\\"Item 7A. Quantitative and Qualitative Disclosures About Market Risk\\\" and under the headings \\\"Disclosures of Financial Market Risks\\\" and \\\"Financial Instruments\\\" in \\\"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in our 2022 Form 10-K. As of March 31, 2023, there have been no material changes in our exposure to market risk from those disclosed in our 2022 Form 10-K.\\n\\nITEM 4. CONTROLS AND PROCEDURES\\nEvaluation of Disclosure Controls and Procedures\\nWe maintain \\\"disclosure controls and procedures,\\\" as defined in Rule 13a-15(e) under the Exchange Act. We have designed these controls and procedures to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Form 10-Q, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. We have also designed our disclosure controls to provide reasonable assurance that such information is accumulated and communicated to our senior management, including our chief executive officer (CEO) and our chief financial officer (CFO), as appropriate, to allow them to make timely decisions regarding our required disclosures. Based on their evaluation, our CEO and CFO have concluded that as of March 31, 2023, our disclosure controls and procedures were effective.\\nChanges in Internal Control Over Financial Reporting\\nThere were no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n32\\nPART II—OTHER INFORMATION\\nITEM 1. LEGAL PROCEEDINGS\\nWe are a party to legal proceedings that arise in the ordinary course of our business, including commercial liability claims, premises claims, environmental claims, and employment-related claims, among others. As of the date of this filing, we do not believe that we are party to any legal action that could reasonably be expected to have, individually or in the aggregate, a material adverse effect on our financial position, results of operations, or cash flows.\\nSEC regulations require us to disclose certain information about proceedings arising under federal, state or local environmental provisions if we reasonably believe that such proceedings may result in monetary sanctions above a stated threshold. Pursuant to the SEC regulations, we use a threshold of $1 million or more for purposes of determining whether disclosure of any such proceedings is required.\\nITEM 1A. RISK FACTORS\\nThis report on Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about our expectations, anticipated financial results, projected capital expenditures, and future business prospects, are forward-looking statements. You can identify these statements by our use of words such as \\\"may,\\\" \\\"will,\\\" \\\"expect,\\\" \\\"believe,\\\" \\\"should,\\\" \\\"plan,\\\" \\\"anticipate,\\\" and other similar expressions. You can find examples of these statements throughout this report, including \\\"Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.\\\" We cannot guarantee that our actual results will be consistent with the forward-looking statements we make in this report. You should review carefully the risk factors listed in \\\"Item 1A. Risk Factors\\\" in our 2022 Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission. We do not assume an obligation to update any forward-looking statement.\\nITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nPurchase of Equity Securities by the Issuer and Affiliated Purchasers\\nOn July 28, 2022, our board of directors authorized the repurchase of an additional 1.5 million shares of our common stock. This increase was in addition to the remaining authorized shares under our prior common stock repurchase program that was authorized on February 25, 2015 (the Program). Share repurchases may be made on an opportunistic basis, through open market transactions, privately negotiated transactions, or by other means in accordance with applicable federal securities laws. We are not obligated to purchase any shares and there is no set date that the Program will expire. Our board of directors may increase or decrease the number of shares under the Program or terminate the Program in its discretion at any time. During first quarter 2023, we repurchased 24,727 shares under the Program at a cost of $1.5 million, or an average of $59.91 per share. Set forth below is information regarding the Company's share repurchases during the first quarter ended March 31, 2023.\\n| Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | The Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs |\\n| January 1, 2023 - January 31, 2023 | — | $ | — | — | 1,996,989 |\\n| February 1, 2023 - February 28, 2023 | — | — | — | 1,996,989 |\\n| March 1, 2023 - March 31, 2023 | 24,727 | 59.91 | 24,727 | 1,972,262 |\\n| Total | 24,727 | $ | 59.91 | 24,727 | 1,972,262 |\\n\\nITEM 3. DEFAULTS UPON SENIOR SECURITIES\\nNone.\\nITEM 4. MINE SAFETY DISCLOSURES\\nNot applicable.\\n33\\n\\nITEM 5. OTHER INFORMATION\\nNone.\\nITEM 6. EXHIBITS\\n| Number | Description |\\n| 10.1 | Form of 2023 Restricted Stock Unit Agreement |\\n| 10.2 | Form of 2023 Performance Stock Unit Agreement |\\n| 10.3 | Form of 2023 Director Restricted Stock Unit Agreement |\\n| 10.4 | Ninth Amendment to Amended and Restated Credit Agreement, dated March 31, 2023, by and among the Lenders identified on the signature pages thereof, Wells Fargo Capital Finance, LLC, as administrative agent, Boise Cascade Company, and the other Borrowers identified on the signature pages thereof |\\n| 31.1 | CEO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | CFO Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | CEO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | CFO Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | Inline XBRL Instance Document |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\n34\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\n| BOISE CASCADE COMPANY |\\n| /s/ Kelly E. Hibbs |\\n| Kelly E. HibbsSenior Vice President, Chief Financial Officer and Treasurer |\\n\\nDate: May 4, 2023\\n35\\n</text>\\n\\nWhat is the percentage increase in finance cost from the year 2022 to 2023 in relation to the net income for each year in percentage?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 391.2.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 53,\n \"input_length\": 24586\n}"}}},{"rowIdx":54,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1.\nFINANCIAL STATEMENTS\nARDELYX, INC.\nCondensed Balance Sheets\n(In thousands, except share and per share amounts)\n\n| June 30,2014 | December 31,2013 |\n| (Unaudited) |\n| Assets |\n| Current assets: |\n| Cash and cash equivalents | $ | 117,814 | $ | 34,435 |\n| Accounts receivable | 3,025 | 6,436 |\n| Prepaid expenses and other current assets | 1,308 | 965 |\n| Total current assets | 122,147 | 41,836 |\n| Property and equipment, net | 1,138 | 530 |\n| Other assets | 13 | 358 |\n| Restricted cash | 180 | 180 |\n| Total assets | $ | 123,478 | $ | 42,904 |\n| Liabilities, convertible preferred stock, and stockholders’ equity (deficit) |\n| Current liabilities: |\n| Accounts payable | $ | 2,308 | $ | 2,284 |\n| Accrued compensation and benefits | 802 | 927 |\n| Other accrued liabilities | 1,003 | 95 |\n| Deferred rent | — | 5 |\n| Deferred revenue, current portion | 23,221 | 13,828 |\n| Total current liabilities | 27,334 | 17,139 |\n| Deferred revenue, non-current | 33,170 | 26,470 |\n| Convertible preferred stock warrant liability | — | 6,456 |\n| Liabilities related to early exercise of options | 107 | 163 |\n| Total liabilities | 60,611 | 50,228 |\n| Commitments and contingencies |\n| Convertible preferred stock, $0.0001 par value per share — no shares and 108,829,748 shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares and 11,517,222 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | 56,155 |\n| Stockholders’ equity (deficit): |\n| Preferred stock, $0.0001 par value; 5,000,000 shares and no shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | — |\n| Common stock, $0.0001 par value — 300,000,000 and 130,360,121 shares authorized as of June 30, 2014 and December 31, 2013, respectively; 18,335,620 and 1,225,481 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | 2 | — |\n| Additional paid-in capital | 130,836 | 5,174 |\n| Accumulated deficit | (67,971 | ) | (68,653 | ) |\n| Total stockholders’ equity (deficit) | 62,867 | (63,479 | ) |\n| Total liabilities, convertible preferred stock, and stockholders’ equity (deficit) | $ | 123,478 | $ | 42,904 |\n\nSee accompanying notes.\n2\nARDELYX, INC.\nCondensed Statements of Operations and Comprehensive Income (Loss)\n(Unaudited)\n(In thousands, except share and per share amounts)\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Revenue: |\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 9,743 | $ | 3,978 |\n| Collaborative development revenue | 2,630 | 5,302 | 7,944 | 9,869 |\n| Total revenue | 9,137 | 7,291 | 17,687 | 13,847 |\n| Operating expenses: |\n| Research and development | 5,183 | 7,234 | 12,820 | 13,173 |\n| General and administrative | 1,203 | 908 | 2,580 | 1,935 |\n| Total operating expenses | 6,386 | 8,142 | 15,400 | 15,108 |\n| Income (loss) from operations | 2,751 | (851 | ) | 2,287 | (1,261 | ) |\n| Other expense, net | (8 | ) | (4 | ) | (12 | ) | (29 | ) |\n| Change in fair value of preferred stock warrant liability | 1,010 | — | (1,593 | ) | — |\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 682 | (1,290 | ) |\n| Provision for income taxes | — | 36 | — | 71 |\n| Net income (loss) and comprehensive income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\n| Net income (loss) attributable to common stockholders: |\n| Basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Shares used to compute net income (loss) per share attributable to common stockholders: |\n| Basic | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Diluted | 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n\nSee accompanying notes.\n3\nARDELYX, INC.\nCondensed Statements of Cash Flows\n(Unaudited)\n(In thousands)\n\n| Six Months Ended June 30, |\n| 2014 | 2013 |\n| Operating activities |\n| Net income (loss) | $ | 682 | $ | (1,361 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\n| Depreciation and amortization expense | 128 | 356 |\n| Stock-based compensation | 163 | 190 |\n| Change in fair value of preferred stock warrant liability | 1,593 | — |\n| Changes in operating assets and liabilities: |\n| Accounts receivable | 3,411 | (3,912 | ) |\n| Prepaid and other current assets | (343 | ) | (496 | ) |\n| Other assets | 345 | (731 | ) |\n| Accounts payable | 24 | 1,131 |\n| Accrued compensation and benefits | (125 | ) | (377 | ) |\n| Other accrued liabilities | 908 | (572 | ) |\n| Deferred revenue | 16,093 | (2,863 | ) |\n| Deferred rent | (5 | ) | (262 | ) |\n| Net cash provided by (used in) operating activities | 22,874 | (8,897 | ) |\n| Investing activities |\n| Purchases of property and equipment | (736 | ) | (257 | ) |\n| Net cash used in investing activities | (736 | ) | (257 | ) |\n| Financing activities |\n| Proceeds from issuance of common stock | 61,241 | 2 |\n| Repurchase of unvested common stock | — | (2 | ) |\n| Net cash provided by financing activities | 61,241 | — |\n| Net increase (decrease) in cash and cash equivalents | 83,379 | (9,154 | ) |\n| Cash and cash equivalents at beginning of period | 34,435 | 32,903 |\n| Cash and cash equivalents at end of period | $ | 117,814 | $ | 23,749 |\n\nSee accompanying notes.\n4\nARDELYX, INC.\nNotes to the Unaudited Interim Condensed Financial Statements\n1. Organization and Basis of Presentation\nArdelyx, Inc. (the “Company”) is a clinical stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal tract to treat cardio-renal, gastrointestinal and metabolic diseases. The Company has developed a drug discovery and design platform enabling it, in a rapid and cost-efficient manner, to discover and design novel drug candidates. The Company was incorporated in Delaware on October 17, 2007, under the name Nteryx and changed its name to Ardelyx, Inc. in June 2008.\nThe Company operates in only one business segment, which is the development of biopharmaceutical products.\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) and following the requirements of the Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. GAAP can be condensed or omitted. These financial statements have been prepared on the same basis as the Company’s annual financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments that are necessary for a fair statement of the Company’s financial information. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the year ending December 31, 2014 or for any other interim period or for any other future year. The balance sheet as of December 31, 2013 has been derived from audited financial statements at that date but does not include all of the information required by U.S. GAAP for complete financial statements.\nThe accompanying condensed financial statements and related financial information should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 31, 2013 included in the Company’s Prospectus filed pursuant to Rule 424(b)(4) on June 19, 2014 with the SEC (the “Prospectus”).\nReverse Stock Split\nOn June 18, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective resulting in a reverse split of the Company’s common stock and convertible preferred stock at a 1-for-9 ratio (the “Reverse Stock Split”). The par value and the authorized shares of the common stock and convertible preferred stock were not adjusted as a result of the Reverse Stock Split. All issued and outstanding common stock, convertible preferred stock, warrants for preferred stock, options for common stock and per share amounts contained in the financial statements have been retroactively adjusted to reflect this Reverse Stock Split for all periods presented.\nInitial Public Offering\nOn June 18, 2014, the Company’s registration statement on Form S-1 (File No. 333-196090) relating to the initial public offering (the “IPO”) of its common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time the Company sold 4,928,900 shares of its common stock, which included the exercise in full by the underwriters of the IPO of their option to purchase 642,900 additional shares of the Company’s common stock. The Company received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by the Company.\nOn June 24, 2014, prior to the closing of the IPO, all outstanding shares of convertible preferred stock converted into 11,517,222 shares of common stock with the related carrying value of $56.2 million reclassified to common stock and additional paid-in capital. In addition, all convertible preferred stock warrants were net exercised and converted into common stock and the related convertible preferred stock warrant liability was reclassified to additional paid-in capital.\nOn June 24, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective and the number of shares of capital stock the Company is authorized to issue was increased to 305,000,000 shares, of which 300,000,000 shares may be common stock and 5,000,000 shares may be preferred stock. Both the common stock and preferred stock have a par value of $0.0001 per share. There are no shares of preferred stock outstanding at June 30, 2014.\n5\n2. Summary of Significant Accounting Policies\nUse of Estimates\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates its estimates, including those related to revenue recognition, clinical trial accruals, income taxes, and stock-based compensation. Management bases its estimates on historical experience and on various other market-specific and relevant assumptions that management believes to be reasonable under the circumstances. Actual results may differ from those estimates.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments purchased with an original maturity date of 90 days or less on the date of purchase to be cash equivalents. The Company invests its cash in bank deposits and money market accounts.\nRestricted Cash\nThe Company is required to guarantee the credit limit on its corporate credit card with a certificate of deposit of $100,000. The collateral will be released upon the cancellation of the corporate credit card.\nThe Company is required under its facility lease agreement to maintain a line of credit with a bank in the amount of $80,000 for the benefit of the lessor. The line of credit is secured by a cash deposit with the bank. The cash deposit will be released upon expiration of the line of credit.\nComprehensive Income (Loss)\nComprehensive income (loss) is composed of two components: net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to gains and losses that under GAAP are recorded as an element of stockholders’ equity (deficit), but are excluded from net income (loss). The Company did not record any transactions within other comprehensive income (loss) in the periods presented and, therefore, the net income (loss) and comprehensive income (loss) were the same for all periods presented.\nRevenue Recognition\nRevenue from research activities made under collaboration partnership agreements are recognized as the services are provided and when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. Revenue generated from research and licensing agreements typically includes up-front signing or license fees, cost reimbursements, research services, minimum sublicense fees, milestone payments, and royalties on future licensees’ product sales.\nFor revenue agreements with multiple-element arrangements, such as license and development agreements, the Company allocates revenue to each non-contingent deliverable based on the relative selling price of each deliverable. When applying the relative selling price method, the Company determines the selling price for each deliverable using vendor-specific objective evidence or third-party evidence. If neither exists, the Company uses its best estimate of selling price for that deliverable. Revenue allocated is then recognized when the four basic revenue recognition criteria are met for each deliverable.\nThe Company recognizes revenue from upfront payments ratably over the term of its estimated period of performance under the agreement which is recorded as licensing revenue. Reimbursements for development costs incurred under the Company’s license agreement with AstraZeneca are classified as collaborative development revenue. The Company recognizes cost reimbursement revenue under collaboration partnership agreements as the related research and development costs for services are rendered. Deferred revenue represents the portion of research or license payments received which has not been earned.\nRevenues from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestones. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. The Company will recognize revenue associated with the non-substantive milestones upon achievement of the milestone if there are no undelivered elements and it has no remaining performance obligations. The Company will account for sales-based milestones as royalties that will be recognized as revenue upon achievement of the milestone.\n6\nNet Income (Loss) per Share Attributable to Common Stockholders\nBasic net income (loss) per share attributable to common stockholders is calculated by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Prior to the Company’s IPO of its common stock, the Company’s Series A and Series B convertible preferred stock was entitled to receive dividends of up to $0.8181 and $0.2781 per share, respectively, prior and in preference to any declaration or payment of any dividend on common stock and thereafter participate pro rata on an as converted basis with the common stock holders on any distributions to common stockholders. The convertible preferred shares were therefore considered to be participating securities. As a result, the Company calculated the net income (loss) per share using the two-class method. Accordingly, the net income (loss) attributable to common stockholders is derived from the net income (loss) for the period and, in periods in which the Company has net income attributable to common stockholders, an adjustment is made for the noncumulative dividends and allocations of earnings to participating securities based on their outstanding shareholder rights. Under the two-class method, the net loss attributable to common stockholders is not allocated to the convertible preferred stock as the convertible preferred stock did not have a contractual obligation to share in the Company’s losses. The diluted net income per share attributable to common stockholders is computed by giving effect to all potential dilutive common stock equivalents outstanding for the period. In periods when we have incurred a net loss, convertible preferred stock, options to purchase common stock and convertible preferred stock warrants are considered common stock equivalents but have been excluded from the calculation of diluted net loss per share attributable to common stockholders as their effect is antidilutive.\nRecent Accounting Pronouncement\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update (“ASU”) 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. The Company adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time the Company may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. The Company has not yet selected a transition method nor has the Company determined the impact of the new standard on its financial statements and related disclosures.\n3. Fair Value Measurements\nFinancial assets and liabilities are recorded at fair value. The carrying amounts of certain of the Company’s financial instruments, including cash equivalents, accounts receivable and accounts payable, are valued at cost, which approximates fair value due to their short maturities. The accounting guidance for fair value provides a framework for measuring fair value, and requires certain new disclosures about how fair value is determined. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting guidance also establishes a three-level valuation hierarchy that prioritizes the inputs to valuation techniques used to measure fair value based upon whether such inputs are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions made by the reporting entity.\nThe three-level hierarchy for the inputs to valuation techniques is briefly summarized as follows:\n\n| Level 1 | – | Observable inputs such as quoted prices (unadjusted) for identical instruments in active markets. |\n| Level 2 | – | Observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or model-derived valuations whose significant inputs are observable. |\n| Level 3 | – | Unobservable inputs that reflect the reporting entity’s own assumptions. |\n\n7\nThe following table sets forth the fair value of the Company’s financial assets and liabilities measured on a recurring basis by level within the fair value hierarchy:\n\n| June 30, 2014 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (In thousands) |\n| Assets: |\n| Money market funds | $ | 116,653 | $ | 116,653 | $ | — | $ | — |\n| Certificates of deposit | 180 | — | 180 | — |\n| Total | $ | 116,833 | $ | 116,653 | $ | 180 | $ | — |\n\n\n| December 31, 2013 |\n| Total | Level 1 | Level 2 | Level 3 |\n| (In thousands) |\n| Assets: |\n| Money market funds | $ | 32,472 | $ | 32,472 | $ | — | $ | — |\n| Certificates of deposit | 180 | — | 180 | — |\n| Total | $ | 32,652 | $ | 32,472 | $ | 180 | $ | — |\n| Liabilities: |\n| Convertible preferred stock warrant liability | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\n| Total | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\n\nWhere quoted prices are available in an active market, securities are classified as Level 1. The Company classifies money market funds as Level 1. When quoted market prices are not available for the specific security, then the Company estimates fair value by using benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. The Company classifies certificates of deposit as Level 2. In certain cases where there is limited activity or less transparency around inputs to valuation, securities are classified as Level 3. There were no transfers between Level 1 and Level 2 during the periods presented.\nLevel 3 liabilities that are measured at fair value on a recurring basis consist of the preferred stock warrant liability, which was measured using the probability weighted expected return method that calculated the probability of the Company going public or being acquired, and the option-pricing method for remaining private in the near to mid-term. The fair value of the preferred stock warrant liability as of December 31, 2013 was estimated using such scenarios that were weighted based on the Company’s estimate of the probability of each scenario: 20% for IPO; 10% for merger and 70% for stay private as of December 31, 2013. The preferred stock warrant liability was remeasured prior to the net exercise of the warrants using the IPO price. At the end of each reporting period, the change in estimated fair value during the period is recorded in change in fair value of convertible preferred stock warrant liability in the statements of operations and comprehensive income (loss). Generally, increases or decreases in the fair value of the underlying convertible preferred stock would result in a directionally similar impact in the fair value measurement of the warrant liability. The preferred stock warrants were net exercised and converted to common stock upon the completion of the IPO and are no longer subject to remeasurement.\nThe following table sets forth a summary of the changes in the estimated fair value of the Company’s preferred stock warrants which were measured at fair value on a recurring basis (in thousands):\n\n| ConvertiblePreferred StockWarrant Liability |\n| Balance at December 31, 2013 | $ | 6,456 |\n| Net increase in fair value of warrant liabilities upon revaluation | 1,593 |\n| Reclassification of warrant liability to additional paid-in capital | (8,049 | ) |\n| Balance at June 30, 2014 | $ | — |\n\n8\n4. Collaboration and Licensing agreements\nAstraZeneca AB (“AstraZeneca”)\nUnder the terms of the AstraZeneca collaboration partnership agreement, the Company received an up-front license fee of $35.0 million in October 2012 and a $15.0 million payment in December 2013, which are both being recognized as revenue on a straight-line basis over the estimated period of performance, which is currently estimated to be December 2016. AstraZeneca reimburses the Company for its internal and external development-related costs. These reimbursements are recognized as collaborative development revenue when the development-related costs are incurred.\nIn May 2014, the Company received from AstraZeneca a $25.0 million payment as a result of the dosing of the first patient in the Phase 2b clinical trial in hyperphosphatemia. As the $25.0 million did not meet the criteria to be considered the achievement of a substantive milestone for accounting purposes, the amount was recorded as deferred revenue when received and is being recognized as revenue on a straight-line basis over the remaining estimated period of performance under the AstraZeneca collaboration partnership agreement, which is currently estimated to be December 2016.\nAs of June 30, 2014, the Company was eligible to receive future contingent payments up to a total of $795.0 million, which is comprised of future development milestones up to an additional $197.5 million and launch, commercialization, and sales milestones up to an additional $597.5 million. The contingent payments are triggered upon the activities expected to be undertaken by AstraZeneca. Revenue from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestone. The Company will recognize revenue associated with non-substantive milestones upon achievement of the milestones if there are no undelivered elements and it has no remaining performance obligation. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance.\nFor the three months ended June 30, 2014 and 2013, the Company recognized revenue of $6.5 million and $2.0 million, respectively, related to amortization of the up-front and other license fees, and $2.6 million and $5.3 million for collaborative development services. For the six months ended June 30, 2014 and 2013, the Company recognized revenues of $9.7 million and $4.0 million, respectively, related to amortization of the up-front and other license fees, and $7.9 million and $9.9 million for collaborative development services. As of June 30, 2014 and December 31, 2013, the Company had total deferred revenue of $56.4 million and $40.3 million related to the AstraZeneca license agreement.\nSanofi SA (“Sanofi”)\nIn February 2014, the Company entered into a License Option and License Agreement with Sanofi (“Option and License Agreement”) for its NaP2b phosphate transport inhibitor program. NaP2b is an intestinal phosphate transporter whose activity accounts for a significant portion of dietary phosphate absorption in humans. The inhibition of NaP2b is believed to have utility for the treatment of hyperphosphatemia (elevated serum phosphate) in patients with end stage renal disease (ESRD) and other forms of chronic kidney disease (CKD). Under the Option and License Agreement, the Company granted Sanofi an exclusive worldwide license to conduct research utilizing the Company’s small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize the Company’s NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under the Option and License Agreement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the Option and License Agreement, the Company received a payment of $1.25 million, which was recognized as revenue after the Company provided to Sanofi the background know-how, listed patents, and materials (together, the “Technology Transfer Deliverables”) in May 2014 pursuant to the Option and License Agreement.\nThe Company has the potential to earn future development, regulatory and commercial milestone payments of up to $196.8 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, the Company will receive tiered royalties ranging from mid-single digits into the low double digits. As part of the arrangement with Sanofi, the Company retains an option to participate in co-promotional activities in the United States. Future potential milestone payments do not meet the criteria to be considered substantive milestones, and therefore will be treated as other contingent consideration and recognized as revenue as they are achieved as the Company has no performance obligations under the Option and License Agreement. No milestones have been received since the inception of the agreement.\n9\n5. Stock Incentive Plan\nAs of June 30, 2014, a total of 2,149,021 shares of common stock had been reserved for issuance under the 2008 Plan, and no shares are available for future grant. The 2014 Equity Incentive Award Plan (“2014 Plan”) became effective on June 18, 2014, immediately prior to the time the Company’s Registration Statement on Form S-1 became effective. Under the 2014 Plan, 1,419,328 shares of common stock were initially reserved for issuance pursuant to a variety of stock-based compensation awards, including stock options, stock appreciation rights, or SARs, restricted stock awards, restricted stock unit awards, deferred stock awards, deferred stock unit awards, dividend equivalent awards, stock payment awards and performance awards. In addition, 35,221 shares that had been available for future awards under the 2008 Plan as of June 18, 2014, were added to the initial reserve available under the 2014 Plan, bringing the total reserve upon the effective date of the 2014 Plan to 1,454,549. The number of shares initially reserved for issuance or transfer pursuant to awards under the 2014 Plan will be increased by (i) the number of shares represented by awards outstanding under 2008 Plan on June 18, 2014, that are forfeited or lapse unexercised (ii) if approved by the Administrator of the 2014 Plan, an annual increase on the first day of each fiscal year beginning in 2015 and ending in 2024, equal to the lesser of (A) four percent (4.0%) of the shares of stock outstanding (on an as converted basis) on the last day of the immediately preceding fiscal year and (B) such smaller number of shares of stock as determined by our board of directors; provided, however, that no more than 10,683,053 shares of stock may be issued upon the exercise of incentive stock options. The Company also adopted the 2014 Employee Stock Purchase Plan (ESPP) and initially reserved 202,762 shares of common stock as of its effective date of June 18, 2014. If approved by the Administrator of the ESPP, on the first day of each calendar year, beginning in 2015 and ending in 2024, the number of shares in the reserve will increase by at least an amount equal to the lesser of (i) one percent (1.0%) of the shares of common stock outstanding on the last day of the immediately preceding fiscal year and (ii) such number of shares of common stock as determined by the board of directors; provided, however, no more than 2,230,374 shares of our common stock may be issued under the ESPP.\nThe following table summarizes activity under the 2008 Plan and the 2014 Plan, including grants to nonemployees and restricted stock issued:\n\n| Shares Availablefor Grant | OptionsOutstanding | WeightedAverageExercise Priceper Share | AggregateIntrinsicValue(in thousands) |\n| Balances at December 31, 2013 | 3,914 | 1,162,829 | $ | 1.03 |\n| Options authorized under the 2008 Plan | 33,333 | — |\n| Options authorized under the 2014 Plan | 1,419,328 | — |\n| Options granted | (63,888 | ) | 63,888 | 13.95 |\n| Options cancelled | 1,862 | (1,862 | ) | 0.77 |\n| Options exercised | — | (92,781 | ) | 0.60 |\n| Balances at June 30, 2014 | 1,394,549 | 1,132,074 | $ | 1.79 | $ | 16,050 |\n| Vested at June 30, 2014 | 576,049 | $ | 0.91 | $ | 8,678 |\n| Expected to vest at June 30, 2014 | 1,132,074 | $ | 1.79 | $ | 16,050 |\n\nThe weighted-average grant-date estimated fair value of options granted during the three and six months ended June 30, 2014 was $10.98 and $10.96, respectively, and during the three and six months ended June 30, 2013 was $0 and $2.65 per share, respectively. The aggregate intrinsic value was calculated as the difference between the exercise price of the options and the estimated fair value of the Company’s common stock of $15.97 per share as of June 30, 2014.\nLiability for Early Exercise of Stock Options\nAs of June 30, 2014 and December 31, 2013, there were 193,447 and 286,217 shares of common stock outstanding, respectively, subject to the Company’s right of repurchase at prices ranging from $0.27 to $1.08 per share. As of June 30, 2014 and December 31, 2013, the Company recorded $107,000 and $163,000, respectively, as liabilities associated with shares issued with repurchase rights.\n10\nStock-based Compensation\nTotal stock-based compensation recognized was as follows (in thousands):\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Research and development | $ | 38 | $ | 50 | $ | 75 | $ | 99 |\n| General and administrative | 61 | 32 | 88 | 91 |\n| Total | $ | 99 | $ | 82 | $ | 163 | $ | 190 |\n\nAs of June 30, 2014 and December 31, 2013, there was $1.1 million and $549,000, respectively, of unrecognized stock-based compensation expense, net of estimated forfeitures, related to unvested share options with a weighted-average remaining recognition period of 1.6 and 1.8 years.\nThe fair value of stock option awards to employees was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Expected term (years) | 5.77 | — | 5.79 | 6.08 |\n| Volatility | 101 | % | — | 101 | % | 97 | % |\n| Risk-free interest rate | 1.76 | % | — | 1.77 | % | 1.05 | % |\n| Dividend yield | — | % | — | — | % | — | % |\n\nFor the three months ended June 30, 2013, there were no stock options granted.\n6. Net Income (Loss) per Share Attributable to Common Stockholders\nThe following table sets forth the computation of the unaudited basic and diluted net income (loss) per share attributable to common stockholders (in thousands, except share and per share data):\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\n| Noncumulative dividends on convertible preferred stock | (1,099 | ) | — | (682 | ) | — |\n| Undistributed earnings allocated to participating securities | (2,139 | ) | — | — | — |\n| Net income (loss) attributable to common stockholders, basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Adjustment to undistributed earnings allocated to participating securities | 188 | — | — | — |\n| Net income (loss) attributable to common stockholders, diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\n| Basic shares: |\n| Weighted average common shares outstanding | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Diluted shares: |\n| Weighted average effect of dilutive stock options | 765,672 | — | — | — |\n| Weighted average convertible preferred stock warrants outstanding | 527,205 | — | — | — |\n| 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\n| Net income (loss) per share attributable to common stockholders: |\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\n\n11\nThe following outstanding shares of common stock equivalents were excluded from the computation of diluted net income (loss) per share attributable to common stockholders for the periods presented because including them would have been antidilutive:\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Convertible preferred stock | — | 11,517,222 | — | 11,517,222 |\n| Options to purchase common stock | 12,459 | 1,215,262 | 1,132,074 | 1,215,262 |\n| Warrants to purchase convertible preferred stock | — | 574,953 | — | 574,953 |\n| Total | 12,459 | 13,307,437 | 1,132,074 | 13,307,437 |\n\n7. Related Party Transactions\nAs part of the consulting arrangement with the spouse of an executive of the Company to provide research and development services related to clinical operations, the Company incurred expenses of $60,000 and $64,000 for services rendered during the three months ended June 30, 2014 and 2013, respectively and $120,000 and $126,000 for services rendered during the six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014 and December 31, 2013, the Company owed $20,000 and $18,000, respectively, to the individual, which is recorded in accounts payable.\n12\n\n\nITEM 2.\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.\nYou should read the following discussion in conjunction with our condensed financial statements (unaudited) and related notes included elsewhere in this report. This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. All statements other than statements of historical facts contained in this report are forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “could,” “will,” “would,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “intend,” “predict,” “seek,” “contemplate,” “potential” or “continue” or the negative of these terms or other comparable terminology. These forward-looking statements, include, but are not limited to, the initiation, timing, progress and results of our preclinical studies and clinical trials, and our research and development programs; our ability to advance product candidates into, and successfully complete, clinical trials; our receipt of future milestone payments and/or royalties, and the expected timing of such payments; our collaborators’ exercise of their license options; the commercialization of our product candidates; the implementation of our business model, strategic plans for our business, product candidates and technology; the scope of protection we are able to establish and maintain for intellectual property rights covering our product candidates and technology; estimates of our expenses, future revenues, capital requirements and our needs for additional financing; the timing or likelihood of regulatory filings and approvals; our ability to maintain and establish collaborations or obtain additional government grant funding; our use of proceeds from our IPO; our financial performance; and developments relating to our competitors and our industry. These statements reflect our current views with respect to future events or our future financial performance, are based on assumptions, and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Factors that may cause actual results to differ materially from current expectations include, among other things, those listed under “Risk Factors” in the Prospectus or described elsewhere in this Quarterly Report on Form 10-Q. These forward-looking statements speak only as of the date hereof. Except as required by law, we assume no obligation to update or revise these forward-looking statements for any reason, even if new information becomes available in the future. Unless the context requires otherwise, in this Quarterly Report on Form 10-Q, the terms “Ardelyx,” “Company,” “we,” “us” and “our” refer to Ardelyx, Inc., a Delaware corporation.\nOverview\nWe are a clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal, or GI, tract to treat cardio-renal, GI and metabolic diseases. We have developed a proprietary drug discovery and design platform enabling us, in a rapid and cost-efficient manner, to discover and design novel drug candidates. Utilizing our platform, we discovered and designed our lead product candidate, tenapanor, which in preclinical and clinical studies has consistently demonstrated the ability to reduce the absorption of dietary sodium and phosphorus. To enhance our proprietary drug discovery and design platform, we have developed a cell-culture system to simulate gut tissues called the Ardelyx Primary Enterocyte and Colonocyte Culture System, or APECCS. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. In addition to tenapanor, we have discovered small molecule NaP2b inhibitors for the treatment of hyperphosphatemia in end stage renal disease, or ESRD, a program we have licensed to Sanofi S.A., or Sanofi. We are also independently advancing three other discovery and lead development programs focused in cardio-renal, GI and metabolic diseases.\nIn October 2012, we entered into a collaboration partnership with AstraZeneca AB, or AstraZeneca, for the worldwide development and commercialization of tenapanor. AstraZeneca is responsible for all of the development and commercialization costs for tenapanor, and we have retained an option to co-promote in the United States. Together with AstraZeneca, we are evaluating tenapanor in three Phase 2 clinical trials in patients with ESRD, late-stage CKD, and constipation-predominant irritable bowel syndrome, or IBS-C. If we exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. In December 2013, we entered into an amendment to the license agreement to acknowledge the intention of AstraZeneca to commence development of tenapanor for the treatment of hyperphosphatemia in ESRD patients and to provide additional clarification for certain payments. There was no change in the total consideration that we could receive under the agreement.\nThrough our participation with AstraZeneca on a development collaboration committee, we are involved in the management and oversight of the development of tenapanor and participation will continue until all of Phase 2 clinical trials with tenapanor have been completed. In addition, we are directly responsible for the conduct of certain specified clinical trials being conducted with tenapanor. AstraZeneca reimburses us for our internal and external costs related to those development efforts, and any other development efforts that may be assigned to us by the development collaboration committee. We were initially responsible for supplying tenapanor for use in development. The agreement also obligates us to transfer the technology and other necessary information such that AstraZeneca will be able to assume the responsibility for the supply of the drug product for use in later-stage clinical trials.\n13\nUnder the terms of the agreement with AstraZeneca, we received a $35.0 million upfront payment and we are eligible to receive up to $237.5 million in development milestones, of which we have received $40.0 million as of June 30, 2014. The $40.0 million in development milestones consists of a payment of $15.0 million that we received in December 2013 and a payment of $25.0 million that we received in May 2014 as a result of the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014. In addition to the $237.5 million in total development milestones, we are also eligible to receive up to $597.5 million in sales and launch milestones. Through June 30, 2014, we also received $29.1 million in reimbursement for our development efforts provided under the agreement. We are also eligible to receive incremental tiered royalties based on aggregate annual net sales of each licensed product starting in the high single digits and increasing to high teen percentages as annual net sales increase, subject to an increase related to our co-fund election, if we decide to make such an election.\nWe have identified the deliverables within the arrangement as a license to the technology, the initial supply of the compound of the licensed product for use in development, and ongoing development activities through completion of all Phase 2 clinical trials to be conducted with tenapanor, which are accounted for as a single unit of accounting. We have concluded that the license is not a separate unit of accounting. It does not have stand-alone value to AstraZeneca, separable from the development services to be performed pursuant to the agreement, as AstraZeneca is unable to use the license for its intended purpose without our performance of the development services, which includes the initial supply of the compound of the licensed product. As a result, we recognize revenue from the $35.0 million up-front payment on a straight-line basis over the period from the effective date of the agreement through the completion of all Phase 2 clinical trials to be conducted with tenapanor, which we currently estimate to be December 2016, and we recognize revenue from the $15.0 million and the $25.0 million development milestone payments on a straight-line basis over the same estimated completion date.\nIn 2014, we entered into an option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under our arrangement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the license option and license agreement, we received an upfront payment of $1.25 million and are responsible for up to $0.2 million of patent costs, at which point any additional patent costs will be fully reimbursed to us by Sanofi. We have the potential to earn future development, regulatory and commercial milestone payments of up to $196.75 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, we will receive tiered royalties ranging from the mid-single digits into the low double digits. As part of our agreement with Sanofi, we retain an option to co-promote licensed products in the United States. We recognized the $1.25 million to revenue after we completed the Technology Transfer Deliverables in May 2014 pursuant to the Option and License Agreement.\nOur revenue to date has been generated from collaboration and license revenue pursuant to our license agreements with AstraZeneca, and Sanofi. We have not generated any commercial product revenue. As of June 30, 2014, we had accumulated deficit of $68.0 million. We have incurred significant losses in the past and may continue to incur significant losses in the future as we advance our unpartnered preclinical programs. The significance of future losses will be dependent in part on whether AstraZeneca continues to develop and advance tenapanor, and whether Sanofi exercises its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors, which in either case would result in milestone payments to us. There can be no assurance that we will receive additional collaboration revenue in the future.\nInitial Public Offering\nOn June 18, 2014, our registration statement on Form S-1 (File No. 333-196090) relating to the IPO of our common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time we sold 4,928,900 shares of our common stock, which included 642,900 shares of common stock purchased by the underwriters upon the full exercise of their option to purchase additional shares of common stock. We received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by us.\n14\nFinancial Operations Overview\nRevenue\nOur revenue to date has been generated from non-refundable license payments and reimbursements for research and development expenses under our license agreements. We recognize revenue from upfront payments ratably over the term of our estimated period of performance under the agreement which we consider to be licensing revenue. In addition to receiving upfront payments, we may also be entitled to milestone and other contingent payments upon achieving predefined objectives. Such payments are recorded as revenue when we achieve the underlying milestone if it is deemed to be a substantive milestone at the date the arrangement is entered into. To the extent that non-substantive milestones are achieved and we have remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. Reimbursements from AstraZeneca for development costs incurred under our license and collaboration agreement with them are classified as collaborative development revenue.\nResearch and Development Expenses\nResearch and development expenses represent costs incurred to conduct research, such as the discovery and development of our unpartnered product candidates, as well as the development of product candidates pursuant to our license agreement with AstraZeneca. We recognize all research and development costs as they are incurred.\nResearch and development expenses consist of the following:\n| | external research and development expenses incurred under agreements with consultants, third-party contract research organizations, or CROs, and investigative sites where a substantial portion of our clinical studies are conducted, and with contract manufacturing organizations, or CMOs, where our clinical supplies are produced; |\n\n| | employee-related expenses, which include salaries, benefits and stock-based compensation; and |\n\n| | facilities and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, depreciation and amortization expense and other supplies. |\n\nPrior to the execution of our license agreement with AstraZeneca in October 2012, we incurred $18.0 million in research and development expenses related to tenapanor. Following the execution of the license agreement and through June 30, 2014, we incurred $30.2 million in research and development expenses related to tenapanor, all of which are reimbursed by AstraZeneca under the license agreement. The reimbursements are recognized in collaborative development revenue in the Statement of Operations and Comprehensive Income (Loss).\nThe following table summarizes our research and development expenses during the three and six months ended June 30, 2014 and 2013 (in thousands):\n\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\n| 2014 | 2013 | 2014 | 2013 |\n| Discovery research expense | $ | 2,562 | $ | 2,052 | $ | 4,922 | $ | 3,761 |\n| AstraZeneca collaboration development expense | 2,621 | 5,182 | 7,898 | 9,412 |\n| Total research and development expenses | $ | 5,183 | $ | 7,234 | $ | 12,820 | $ | 13,173 |\n\nWe expect our unpartnered research and development expenses will increase in the future as we progress our internal product candidates, advance our discovery research projects into the preclinical stage and continue our early stage research including further development of our APECCS cell-culture system. The process of conducting preclinical studies and clinical trials necessary to obtain regulatory approval is costly and time consuming. We or our collaboration partners may never succeed in achieving marketing approval for any of our product candidates. The probability of success of each of the product candidates may be affected by numerous factors, including preclinical data, clinical data, competition, manufacturing capability and commercial viability.\nMost of our product development programs are at an early stage; therefore, the successful development of our product candidates is highly uncertain and may not result in approved products. Completion dates and completion costs can vary significantly for each product candidate and are difficult to predict. Given the uncertainty associated with clinical trial enrollment and the risks inherent in the development process, we are unable to determine the duration and completion costs of current or future clinical trials of our product candidates or if and to what extent we will generate revenues from the commercialization and sale of any of our product candidates. We anticipate that we and our collaboration partners will make determinations as to which programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to each product candidate’s commercial potential. We will need to raise additional\n15\ncapital or may seek additional collaboration partnerships in the future in order to complete the development and commercialization of our product candidates.\nGeneral and Administrative\nGeneral and administrative expenses includes personnel costs, travel expenses and other expenses for outside professional services, including legal, human resources, audit and accounting services. Personnel costs includes salaries, bonus, benefits and stock-based compensation. We expect to incur additional expenses as a result of being a public company following the completion of our IPO in June 2014, including expenses to comply with the rules and regulations applicable to companies listed on a national securities exchange and costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, as well as increases in expenses for additional insurance, investor relations activities and other administration and professional services.\nChange in Fair Value of Convertible Preferred Stock Warrant Liability\nChange in fair value of convertible preferred stock warrant liability was the fair value remeasurement of our liability related to our convertible preferred stock warrants. We recorded adjustments to the estimated fair value of the convertible preferred stock warrants until they were net exercised prior to the completion of our IPO and then converted into common stock. At that time, the convertible preferred stock warrant liability was reclassified to additional paid-in capital and we no longer record any related periodic fair value adjustments.\nProvision for Income Taxes\nWe did not record a provision for income taxes for the three and six months ended June 30, 2014 because we expect to generate a net operating loss for the year ending December 31, 2014. Our deferred tax assets continue to be fully offset by a valuation allowance.\nProvision for income taxes for the 2013 periods consists of California state income taxes as we were required to pay the Alternative Minimum Tax for the $35.0 million upfront payment received from AstraZeneca in 2012.\nCritical Accounting Polices and Estimates\nThe discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no significant and material changes in our critical accounting policies during the three and six months ended June 30, 2014, as compared to those disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in the Prospectus filed with the SEC on June 19, 2014.\n16\nResults of Operations\nComparison of the Three Months Ended June 30, 2014 and 2013\n\n| Three Months Ended June 30, | Dollar Change |\n| 2014 | 2013 |\n| (In thousands) |\n| Revenue: |\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 4,518 |\n| Collaborative development revenue | 2,630 | 5,302 | (2,672 | ) |\n| Total revenue | 9,137 | 7,291 | 1,846 |\n| Operating expenses: |\n| Research and development | 5,183 | 7,234 | (2,051 | ) |\n| General and administrative | 1,203 | 908 | 295 |\n| Total operating expenses | 6,386 | 8,142 | (1,756 | ) |\n| Income (loss) from operations | 2,751 | (851 | ) | 3,602 |\n| Other expense, net | (8 | ) | (4 | ) | (4 | ) |\n| Change in fair value of preferred stock warrant liability | 1,010 | — | 1,010 |\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 4,608 |\n| Provision for income taxes | — | 36 | (36 | ) |\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 4,644 |\n\nRevenue\nLicensing revenue for the three months ended June 30, 2014 was $6.5 million, an increase of $4.5 million, or 227%, compared to licensing revenue of $2.0 million for the three months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized pursuant to the Option and License Agreement with Sanofi.\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the three months ended June 30, 2014 was $2.6 million, a decrease of $2.7 million, or 50%, compared to $5.3 million for the three months ended June 30, 2013. The decrease was primarily because of a decrease in our development activities related to the clinical trials that are a part of the AstraZeneca agreement.\nResearch and Development\nResearch and development expenses were $5.2 million for the three months ended June 30, 2014, a decrease of $2.1 million, or 28%, compared to $7.2 million for the three months ended June 30, 2013. The decrease was primarily driven by a $2.6 million decrease in development activities related to tenapanor conducted by Ardelyx in accordance with the AstraZeneca agreement. Discovery research expenses increased by $0.5 million due to an increase in our research activities for non-partnered programs.\nGeneral and Administrative\nGeneral and administrative expenses were $1.2 million for the three months ended June 30, 2014, an increase of $0.3 million, or 32%, compared to $0.9 million for the three months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.1 million and an increase of $0.1 million in personnel related expenses.\nChange in Fair Value of Preferred Stock Warrant Liability\nChange in fair value of preferred stock warrant liability was $1.0 million of income for the three months ended June 30, 2014 compared to zero for the three months ended June 30, 2013. The change was due to a decrease in the fair value of our convertible preferred stock over the three month period.\n17\nComparison of the Six Months Ended June 30, 2014 and 2013\n| Six Months Ended June 30, | Dollar Change |\n| 2014 | 2013 |\n| (In thousands) |\n| Revenue: |\n| Licensing revenue | $ | 9,743 | $ | 3,978 | $ | 5,765 |\n| Collaborative development revenue | 7,944 | 9,869 | (1,925 | ) |\n| Total revenue | 17,687 | 13,847 | 3,840 |\n| Operating expenses: |\n| Research and development | 12,820 | 13,173 | (353 | ) |\n| General and administrative | 2,580 | 1,935 | 645 |\n| Total operating expenses | 15,400 | 15,108 | 292 |\n| Income (loss) from operations | 2,287 | (1,261 | ) | 3,548 |\n| Other expense, net | (12 | ) | (29 | ) | 17 |\n| Change in fair value of preferred stock warrant liability | (1,593 | ) | — | (1,593 | ) |\n| Income (loss) before provision for income taxes | 682 | (1,290 | ) | 1,972 |\n| Provision for income taxes | — | 71 | (71 | ) |\n| Net income (loss) | $ | 682 | $ | (1,361 | ) | $ | 2,043 |\n\nRevenue\nLicensing revenue for the six months ended June 30, 2014 was $9.7 million, an increase of $5.8 million, or 145%, compared to total licensing revenue of $4.0 million for the six months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized in May 2014 pursuant to the Option and License Agreement with Sanofi.\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the six months ended June 30, 2014 was $7.9 million, a decrease of $1.9 million, or 20%, compared to $9.9 million for the six months ended June 30, 2013. The decrease was due to a decrease in our development activities primarily related to the clinical trials that are a part of the AstraZeneca agreement.\nResearch and Development\nResearch and development expenses were $12.8 million for the six months ended June 30, 2014, a decrease of $0.4 million, or 3%, compared to $13.2 million for the six months ended June 30, 2013. The decrease in AstraZeneca collaboration development expense of $1.5 million was primarily driven by the decrease in development activities related to tenapanor conducted by Ardelyx under the license agreement with AstraZeneca. Discovery research expenses increased by $1.2 million due to an increase in our research activities for non-partnered programs.\nGeneral and Administrative\nGeneral and administrative expenses were $2.6 million for the six months ended June 30, 2014, an increase of $0.6 million, or 33%, compared to $1.9 million for the six months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.4 million and an increase of $0.2 million personnel related expenses.\nChange in Fair Value of Preferred Stock Warrant Liability\nChange in fair value of preferred stock warrant liability was $1.6 million for the six months ended June 30, 2014, an increase of $1.6 million compared to zero for the six months ended June 30, 2013. The increase was due to an increase in the fair value of our convertible preferred stock over the six month period.\n18\nLiquidity and Capital Resources\nAs of June 30, 2014, we had cash and cash equivalents totaling $117.8 million. In connection with our IPO, we received cash proceeds of $61.2 million, net of underwriters’ discounts and commissions and expenses paid by the Company in June 2014. Prior to the IPO, we funded our operations primarily with cash flows from the sales of our convertible preferred stock in private placements and from the upfront payments and other collaboration related payments received from our collaboration partners AstraZeneca and Sanofi.\nOur primary uses of cash are to fund operating expenses, primarily research and development expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses.\nWe believe that our existing capital resources as of June 30, 2014 will be sufficient to meet our projected operating requirements for at least the next 12 months. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development expenditures. We currently have no credit facility or committed sources of capital other than potential milestones receivable under our current collaboration partnerships. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaboration partnerships with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. Our future funding requirements will depend on many factors, including the following:\n| | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\n\n| | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of the receipt of such payments, if any; |\n\n| | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\n\n| | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\n\n| | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\n\n| | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\n\n| | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\n\n| | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\n\n| | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\n\n| | the cash requirements of any future acquisitions or discovery of product candidates; |\n\n| | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\n\n| | the time and cost necessary to respond to technological and market developments; and |\n\n| | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\n\n19\nThe following table summarizes our cash flows for the periods indicated (in thousands):\n\n| Six MonthsEnded June 30, |\n| 2014 | 2013 |\n| Cash provided by (used in) operating activities | $ | 22,874 | $ | (8,897 | ) |\n| Cash used in investing activities | (736 | ) | (257 | ) |\n| Cash provided by financing activities | 61,241 | — |\n| Net increase (decrease) in cash and cash equivalents | $ | 83,379 | $ | (9,154 | ) |\n\nCash Flows from Operating Activities\nCash provided by operating activities for the six months ended June 30, 2014 was $22.9 million, consisting of net income of $0.7 million, non-cash charges of $0.1 million for depreciation and amortization expense, $0.2 million for stock-based compensation, $1.6 million for the change in the fair value remeasurement of our convertible preferred stock warrant liability and a net increase of $20.3 million in our net operating assets and liabilities. The changes in our net operating assets and liabilities was primarily due to a $16.1 million increase in deferred revenue which was mainly driven by the $25.0 million payment received in May 2014 in connection with our agreement with AstraZeneca, a $3.4 million decrease in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $0.9 million increase in our other accrued liabilities due to the timing of payments.\nCash used in operating activities for the six months ended June 30, 2013 was $8.9 million, consisting of a net loss of $1.4 million, which was partially offset by non-cash charges of $0.4 million for depreciation and amortization, $0.2 million for stock-based compensation and a net decrease of $8.1 million in our net operating assets and liabilities. The cash used as a result of the changes in our net operating assets and liabilities was due primarily to a $2.9 million decrease in deferred revenue which was mainly driven by the amortization of the $35.0 million up-front payment received in connection with our agreement with AstraZeneca and a $3.9 million increase in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $1.2 million increase in prepaid expenses and other assets related to advance payments made to vendors for clinical development activities. These changes were partially offset by a $1.1 million increase in our accounts payable due to the timing of payments.\nCash Flows from Investing Activities\nCash used in investing activities for the six months ended June 30, 2014 and 2013 of $0.7 million and $0.3 million was related to our acquisition of property and equipment related to the expansion of our laboratory and related equipment.\nCash Flows from Financing Activities\nCash provided by financing activities for the six months ended June 30, 2014 was due to the IPO proceeds of $61.2 million.\nOff-Balance Sheet Arrangements\nAs of June 30, 2014, we did not have any off-balance sheet arrangements or any holdings in variable interest entities.\nRecent Accounting Pronouncement\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. We adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, or ASU 2014-09, which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time we may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. We have not yet selected a transition method nor have we determined the impact of the new standard on our financial statements and related disclosures\n20\n\n\nITEM 3.\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe are exposed to market risks in the ordinary course of our business. These risks primarily include risk related to interest rate sensitivities. We had cash and cash equivalents of $117.8 million as of June 30, 2014, which consist of bank deposits and money market funds. Such interest-earning instruments carry a degree of interest rate risk; however, historical fluctuations in interest income have not been significant. We had no outstanding debt as of June 30, 2014.\n\n\nITEM 4.\nCONTROLS AND PROCEDURES\nEvaluation of Disclosure Controls and Procedures\nAs required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2014. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2014, our Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2014, our disclosure controls and procedures were effective at the reasonable assurance level.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\nPART II. OTHER INFORMATION\n\n\nITEM 1.\nLEGAL PROCEEDINGS\nWe are not currently a party to any material litigation or other material legal proceedings.\n\n\nITEM 1A.\nRISK FACTORS\nOur business involves significant risks, some of which are described below. You should carefully consider these risks, as well as other information in this Quarterly Report on Form 10-Q, including our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The occurrence of any of the events or developments described below could harm our business, financial condition, results of operations, cash flows, the trading price of our common stock and our growth prospects. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.\nRisks Related to Our Limited Operating History, Financial Condition and Capital Requirements\nWe have a limited operating history, have incurred significant losses since our inception and we will incur losses in the future. We have only one product candidate in clinical trials and no product sales, which, together with our limited operating history, makes it difficult to assess our future viability.\nWe are a clinical-stage biopharmaceutical company with a limited operating history. Biopharmaceutical product development is a highly speculative undertaking and involves a substantial degree of risk. To date, we have focused substantially all of our efforts on our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. To date, we have not commercialized any products or generated any revenue from the sale of products. We are not profitable and have incurred losses in each year since our inception in October 2007, and we do not know whether or when we will become profitable. We have only a limited operating history upon which to evaluate our business and prospects. We continue to incur significant research, development and other expenses related to our ongoing operations. Our net loss\n21\nfor the years ended December 31, 2012 and 2013 was $9.8 million and $6.6 million, respectively. While we had a net income of $3.8 million and $0.7 million, respectively, for the three and six months ended June 30, 2014, this performance may not be indicative of future performance. As of June 30, 2014, we had an accumulated deficit of $68.0 million.\nIf we do not receive anticipated milestone payments from our collaboration partners, AstraZeneca AB, or AstraZeneca and Sanofi S.A., or Sanofi, our operating losses will substantially increase for the foreseeable future as we continue our discovery, research, development, manufacturing and commercialization activities. There can be no assurance that we will receive any potential milestones under our agreements with AstraZeneca and/or Sanofi. For a discussion of the risks associated with our preclinical and clinical development programs with, and potential for milestone payments from, AstraZeneca and Sanofi, see below under “—Risks Related to Our Business.”\nEven if we receive the anticipated milestone payments or receive royalty payments from our collaboration partners, we may not be able to achieve or sustain profitability. For example, we may choose to exercise our right to co-fund a portion of the first Phase 3 clinical development program for tenapanor, incurring expenses of up to $40.0 million, and we would likely incur continued operating losses during the period we are co-funding the program. In addition, our receipt of milestone payments from our collaboration partners may not result in the recognition of revenue in the period received, as we may be required to amortize the milestone payment over a period of time. Depending upon such requirement and the period of amortization, we may continue to incur losses even after the receipt of such milestone payments. Therefore, there can be no assurance that our losses will not increase into the future. Our prior losses, combined with possible future losses, have had and will continue to have an adverse effect on our stockholders’ equity and working capital. Further, the net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance.\nWe have never generated any revenue from product sales and may never be profitable.\nWe have no products approved for sale and have never generated any revenue from product sales. Our ability to generate revenue from product sales and achieve profitability depends on our ability, and the ability of our collaboration partners, to successfully complete the development of and obtain the regulatory and marketing approvals necessary to commercialize one or more of our product candidates. We do not anticipate generating revenue from product sales for the foreseeable future. Our ability to generate future revenue from product sales or pursuant to milestone payments depends heavily on many factors, including but not limited to:\n| • | the completion of research and preclinical and clinical development of our product candidates; |\n\n| • | together with our collaboration partners, obtaining regulatory approvals for our product candidates; |\n\n| • | the ability of our collaboration partners to successfully commercialize and/or our ability to commercialize or co-promote, if we so choose, our product candidates; |\n\n| • | developing a sustainable and scalable manufacturing process for any approved product candidates and establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate (in amount and quality) products to support clinical development and the market demand for our product candidates, if approved; |\n\n| • | obtaining market acceptance of our product candidates, if approved, as viable treatment options; |\n\n| • | addressing any competing technological and market developments; |\n\n| • | identifying, assessing, acquiring, in-licensing and/or developing new product candidates; |\n\n| • | negotiating favorable terms in any collaboration partnership, licensing or other arrangements into which we may enter; |\n\n| • | maintaining, protecting, and expanding our portfolio of intellectual property rights, including patents, trade secrets, and know-how, and our ability to develop, manufacture and commercialize our product candidates and products without infringing intellectual property rights of others; and |\n\n| • | attracting, hiring, and retaining qualified personnel. |\n\nIn cases where we, or our collaboration partners, are successful in obtaining regulatory approvals to market one or more of our product candidates, our revenue will be dependent, in part, upon the size of the markets in the territories for which regulatory approval is granted, the accepted price for the product, the ability to get reimbursement at any price and whether we have royalty and/or co-promotion rights for that territory. If the number of patients suitable for our product candidates is not as significant as we estimate, the indication approved by regulatory authorities is narrower than we expect, or the reasonably accepted population for treatment is narrowed by competition, physician choice or treatment guidelines, we may not generate significant revenue from the sale of such products, even if approved. Even if we achieve profitability in the future, we may not be able to sustain profitability in subsequent periods. Our failure to generate revenue from product sales would likely depress our market value and could impair our ability to raise capital, expand our business, discover or develop other product candidates or continue our operations. A decline in the value of our common stock could cause our stockholders to lose all or part of their investment.\n22\nWe may require substantial additional financing to achieve our goals, and a failure to obtain this necessary capital when needed on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product development or other operations.\nSince our inception, most of our resources have been dedicated to our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. As of June 30, 2014, we had working capital of $94.8 million, including capital resources consisting of cash and cash equivalents of $117.8 million. We believe that we will continue to expend substantial resources for the foreseeable future, including costs associated with research and development, conducting preclinical studies and clinical trials, obtaining regulatory approvals and sales and marketing. Because the outcome of any clinical trial and/or regulatory approval process is highly uncertain, we cannot reasonably estimate the actual amounts necessary to successfully complete the development, regulatory approval process and commercialization or co-promotion of any of our product candidates.\nBased on our current operating plan, we believe that our existing capital resources will allow us to fund our operating plan through at least the next 12 months. However, our operating plan may change as a result of many factors currently unknown to us, and we may need to seek additional funds sooner than planned. Our future funding requirements will depend on many factors, including, but not limited to:\n| • | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which case we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\n\n| • | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of receipt of such payments, if any; |\n\n| • | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\n\n| • | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\n\n| • | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\n\n| • | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\n\n| • | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\n\n| • | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\n\n| • | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\n\n| • | the cash requirements of any future acquisitions or discovery of product candidates; |\n\n| • | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\n\n| • | the time and cost necessary to respond to technological and market developments; and |\n\n| • | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\n\nAdditional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to delay, limit, reduce or terminate our research and development activities, preclinical and clinical trials for our product candidates for which we retain such responsibility and our establishment and maintenance of sales and marketing capabilities or other activities that may be necessary to commercialize or co-promote our product candidates.\n23\nRisks Related to Our Business\nWe are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized.\nTo date, we have invested a significant amount of our efforts and financial resources in the research and development of tenapanor, which is currently our lead product candidate and only product candidate in clinical trials. In particular, together with AstraZeneca, our collaboration partner for tenapanor, we have completed six Phase 1 and two Phase 2 trials and are currently conducting three Phase 2 trials and one Phase 1 study. Our near-term prospects, including our ability to finance our operations through the receipt of milestone payments and generate revenue from product sales, will depend heavily on the successful development and AstraZeneca’s commercialization of tenapanor, if approved. The clinical and commercial success of tenapanor will depend on a number of factors, including the following:\n| • | the timely completion of the ongoing clinical trials of tenapanor, which will depend substantially upon the satisfactory performance of third-party contractors; |\n\n| • | whether tenapanor’s safety and efficacy profile is satisfactory to the U.S. Food and Drug Administration, or FDA, and foreign regulatory authorities to warrant marketing approval; |\n\n| • | the timely completion of the ongoing chronic kidney disease, or CKD, Phase 2a clinical trial, which will depend substantially upon our ability to identify principal investigators with patient populations suitable for study, and the ability of those principal investigators to successfully enroll those patients into the trial; |\n\n| • | the results of a long-term rat carcinogenicity study required for approval of tenapanor, which will not be known for at least two and half years, and which may be delayed for a significant period of time for reasons outside of the control of AstraZeneca, particularly if AstraZeneca is required to restart or modify the study for any reason; |\n\n| • | whether FDA or foreign regulatory authorities require additional clinical trials prior to approval to market tenapanor; |\n\n| • | the prevalence and severity of adverse side effects of tenapanor; |\n\n| • | the timely receipt of necessary marketing approvals from the FDA and foreign regulatory authorities; |\n\n| • | the ability of AstraZeneca and us through our co-promotion rights, if we choose to exercise such rights and are not precluded from doing so under the terms of our agreement with AstraZeneca or any subsequent co-promotion agreements, to successfully commercialize tenapanor, if approved for marketing and sale by the FDA or foreign regulatory authorities, including educating physicians and patients about the benefits, administration and use of tenapanor; |\n\n| • | achieving and maintaining compliance with all regulatory requirements applicable to tenapanor; |\n\n| • | acceptance of tenapanor as safe and effective by patients and the medical community; |\n\n| • | the availability, perceived advantages, relative cost, relative safety and relative efficacy of alternative and competing treatments; |\n\n| • | obtaining and sustaining an adequate level of coverage and reimbursement for tenapanor by third-party payors; |\n\n| • | the effectiveness of AstraZeneca’s marketing, sales and distribution strategy and operations; |\n\n| • | the ability of AstraZeneca, or any third-party manufacturer it contracts with, to successfully scale up the manufacturing process for tenapanor, which has not yet been demonstrated, and to manufacture supplies of tenapanor and to develop, validate and maintain a commercially viable manufacturing process that is compliant with current good manufacturing practice, or cGMP, requirements; |\n\n| • | enforcing intellectual property rights in and to tenapanor; |\n\n| • | avoiding third-party interference, opposition, derivation or similar proceedings with respect to our patent rights, and avoiding other challenges to our patent rights and patent infringement claims; and |\n\n| • | a continued acceptable safety profile of tenapanor following approval. |\n\nMost of these factors are beyond our control, including clinical development, the regulatory submission process, manufacturing, marketing and sales efforts of AstraZeneca.\nAs a first-in-class drug, tenapanor, has not been extensively studied in humans and the nonclinical and clinical data on its effect in the human body is limited to the trials and studies that we and AstraZeneca have completed. As a first-in-class drug, there is a higher likelihood that approval may not be attained as compared to a class of drugs with approved products. We cannot be certain that tenapanor will be successful in preclinical studies, clinical trials or receive regulatory approval. For example, like phosphate binders, treatment with tenapanor in patients with end stage renal disease, or ESRD, may be significantly impacted by such patient’s adherence to a restrictive low phosphorus diet, and as such, adherence may be a factor in demonstrating the efficacy of tenapanor in clinical trials for this patient population. Further, it may not be possible or practicable to demonstrate, or if approved, to market on the basis of,\n24\ncertain of the benefits we believe tenapanor possesses, including the reduction of sodium absorption in patients with CKD, which is unlikely to be an endpoint to be considered for approval in CKD patients. Additionally, the reduction of serum phosphorus is currently an approvable endpoint in ESRD, but not in the broader CKD patient population in the United States. If the number of patients in the market for tenapanor or the price that the market can bear is not as significant as we estimate, we may not generate significant revenue from sales of tenapanor, if approved. Accordingly, there can be no assurance that tenapanor will ever be successfully commercialized or that we will ever generate revenue from sales of tenapanor. If we and AstraZeneca are not successful in completing the development of, obtaining approval for, and commercializing tenapanor, or are significantly delayed in doing so, our business will be materially harmed.\nWe are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.\nIn October 2012, we entered into a license agreement with AstraZeneca granting it an exclusive worldwide license to our small molecule NHE3 inhibitor program, which includes our lead product candidate, tenapanor, for all indications. Under this agreement, AstraZeneca has responsibility for completing all nonclinical and clinical development and obtaining and maintaining regulatory approval for tenapanor from the FDA and regulatory agencies outside of the United States. Ultimately, if tenapanor is advanced through clinical trials and receives marketing approval from the FDA or comparable foreign regulatory agencies, AstraZeneca will be responsible for the commercialization of tenapanor, subject to our right to elect to participate in certain co-promotion activities in the United States. The potential for us to obtain future development milestone payments and, ultimately, generate revenue from royalties from tenapanor depends entirely on the successful development, regulatory approval, marketing and commercialization of tenapanor by AstraZeneca. In addition to the risks inherent in the development of a drug product candidate, our collaboration partnership with AstraZeneca may not be successful due to a number of important factors, including the following:\n| • | prior to the 175th day after the database lock for the ongoing Phase 2b clinical trial in hyperphosphatemic ESRD patients, AstraZeneca may terminate the license for any reason with 30 -days’ prior written notice and thereafter AstraZeneca may terminate the license with 120- days’ prior written notice; |\n\n| • | AstraZeneca has the unilateral ability to choose not to develop tenapanor for one or more indications for which it has been or is currently being evaluated, provided it pursues at least one indication, and AstraZeneca may choose to pursue an indication that is not in our strategic best interest or to delay the pursuit of, or forego an indication, even if clinical data is supportive of further development for such indication; |\n\n| • | AstraZeneca may choose not to develop and commercialize tenapanor in all relevant markets; |\n\n| • | AstraZeneca may take considerably more time advancing tenapanor through the clinical and regulatory process than we currently anticipate, which could materially delay the achievement of milestones and, consequently the receipt of milestone payments from AstraZeneca; |\n\n\n| • | AstraZeneca’s obligation to use “commercially reasonable efforts” with regard to the development, regulatory approval, manufacture and commercialization of tenapanor under our agreement leaves AstraZeneca with discretion in determining the efforts and resources that it will apply to the development, regulatory approval, manufacture and commercialization of tenapanor; |\n\n| • | subject to our right to elect to participate in co-promotion activities in the United States, AstraZeneca controls all aspects of the commercialization of tenapanor; |\n\n| • | AstraZeneca is obligated to reimburse a specified amount for the current constipation-predominant irritable bowel syndrome, or IBS-C, Phase 2b clinical trial, and despite our efforts to keep costs below that amount, we may be required to spend more than that to complete the trial, and if we do so, we will not be reimbursed for those excess amounts by AstraZeneca; |\n\n| • | AstraZeneca’s recent strategic withdrawal from selling gastrointestinal, or GI, products and the differing treatment of the IBS-C indication in our agreement implies that AstraZeneca may choose not to develop the IBS-C indication, even if our current Phase 2b clinical trial were successful; |\n\n| • | AstraZeneca may change the focus of its development and commercialization efforts or pursue higher-priority programs and, accordingly, reduce the efforts and resources allocated to tenapanor, which will have the direct effect of reducing our co-promotion activities as our level of co-promotion is limited to a percentage of the overall commercialization activities; |\n\n| • | AstraZeneca may fail to develop a commercially viable formulation or manufacturing process for tenapanor, and may fail to manufacture or supply sufficient drug substance of tenapanor for commercial use, if approved, which could result in lost revenue; |\n\n25\n\n| • | AstraZeneca may not comply with all applicable regulatory requirements or may fail to report safety data in accordance with all applicable regulatory requirements; |\n\n| • | AstraZeneca may sublicense its rights with respect to tenapanor to one or more third parties without our consent; |\n\n| • | AstraZeneca may not dedicate the resources that would be necessary to carry tenapanor through clinical development or may not obtain the necessary regulatory approvals; |\n\n| • | if AstraZeneca is acquired during the term of our collaboration partnership, the acquiror may have different strategic priorities that could cause it to terminate our agreement or reduce its commitment to our collaboration partnership; and |\n\n| • | if our agreement with AstraZeneca terminates, we will no longer have rights to receive potential revenue under the agreement with AstraZeneca for future milestones or royalties, in which case we would need to identify alternative means to continue the development, manufacture and commercialization of tenapanor, alone or with others. |\n\nThe timing and amount of any milestone and royalty payments we may receive under our agreement will depend on, among other things, the efforts, allocation of resources, and successful development and commercialization of tenapanor by AstraZeneca under our agreement. There can be no assurance that any of the development and regulatory milestones will be achieved or that we will receive any future milestone payments under the agreement. In addition, in certain circumstances we may believe that we have achieved a particular milestone and AstraZeneca may disagree with our belief. In that case, receipt of that milestone payment may be delayed or may never be received, which may require us to adjust our operating plans.\nIf AstraZeneca does not perform in the manner we expect or fulfill its responsibilities in a timely manner, or at all, the clinical development, regulatory approval and commercialization efforts related to tenapanor could be delayed or terminated and it could become necessary for us to assume the responsibility at our own expense for the clinical development of tenapanor. In that event, we would likely be required to substantially limit the size and scope of the development and commercialization of tenapanor or seek additional financing to fund further development, or to identify alternative collaboration partners for tenapanor, and our potential to generate future revenue from royalties and milestone payments from tenapanor would be significantly reduced or delayed and our business would be materially and adversely harmed.\nOur election to co-fund the first Phase 3 clinical development program for tenapanor must be made in a limited time period prior to the initiation of the first pivotal clinical trial for tenapanor and, as a result, we may make a substantial capital investment for a product candidate based on limited clinical data.\nUnder our agreement with AstraZeneca, we may elect to participate in the funding of the first Phase 3 clinical development program for the first indication of tenapanor by investing a co-funding amount of $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. We may exercise this right only for a limited period of 60 days following AstraZeneca’s determination to proceed to the first Phase 3 clinical development program for tenapanor for a specific indication. An election to participate in the co-fund will be based, in part, on our analysis as to the likelihood of success of the Phase 3 clinical development program and the potential for regulatory approval to commercialize tenapanor. As a result, we will be required to make a substantial capital investment in tenapanor prior to the initiation of the first pivotal clinical trial and if tenapanor is unsuccessful in its pivotal trial or if it never receives regulatory approval, we will not receive any financial return on this capital investment.\nWe have not yet negotiated our agreement with AstraZeneca specifying all of the terms of our co-promotion right.\nPursuant to our license agreement with AstraZeneca, we have retained a co-promotion right with respect to tenapanor in the United States. While the license agreement includes the material terms of our co-promotion right, we and AstraZeneca mutually agreed to negotiate a separate agreement specifying the detailed activities and responsibilities in respect of the marketing and co-promotion of tenapanor following our election to exercise our co-promotion rights. If we elect to exercise our co-promotion rights, the separate agreement we negotiated with AstraZeneca may place restrictions or additional obligations on us, including financial obligations. Any restrictions or additional obligations may restrict our co-promotion activities or involve more significant financial obligations than we currently anticipate.\nExercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.\nOur agreement with AstraZeneca prohibits us from using the same sales force to co-promote tenapanor as we do to promote other products that compete with tenapanor or with any other products that are then being actively promoted by AstraZeneca or its affiliates. If we elect to co-promote tenapanor, we may therefore be required to have a separate sales forces to promote other products we may elect to co-promote under our agreement with Sanofi, or other products we develop and commercialize on our own, should any of such products be competitive with tenapanor or with any other products promoted by AstraZeneca or its affiliates. The exercise of the co-promotion right under our agreement with AstraZeneca, could adversely affect the efficiency and cost of our promotion efforts for\n26\nour products and, effectively, may prohibit us from exercising our co-promotion rights under our agreement with Sanofi or with respect to other co-promotion rights with future collaboration partners.\nIf Sanofi does not exercise its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors or if it exercises the option and subsequently terminates any development program under its collaboration partnership with us, any potential milestone payments or revenue from product sales under this collaboration partnership will be significantly reduced or non-existent, and our results of operations and financial condition will be materially and adversely affected.\nIn February 2014, we entered into a license option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors, which we refer to as our RDX002 program, solely for the purpose of completing activities under a preclinical development plan. We believe the inhibition of NaP2b, an intestinal phosphate transporter, would provide utility for the treatment of hyperphosphatemia in ESRD patients, which is also the lead indication for which we and AstraZeneca are developing tenapanor.\nUnder the terms of this agreement, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi may exercise this option at any time following the effective date of the agreement and ending 45 days after the filing of an investigational new drug application, or IND, subject to certain exceptions, and if Sanofi does not file an IND on or before the 40th month anniversary of the completion of the technology transfer phase, the agreement will terminate.\nIf Sanofi does not exercise its option under its agreement with us, or terminates its rights and obligations with respect to the development program or the entire agreement, then depending on the timing of such event:\n| • | the development of our NaP2b inhibitor program may be terminated or significantly delayed; |\n\n| • | we would bear all of the risks and costs related to the further development and commercialization of product candidates that were previously the subject of the agreement if we decided to continue work under the NaP2b inhibitor program independently; |\n\n| • | we would not be eligible to receive any of the remaining development or regulatory milestone payments or royalties on product sales; |\n\n| • | in order to fund further development and commercialization of the NaP2b program, we may need to raise additional capital if we choose to internally pursue the development of the program, or we may need to seek out and establish alternative collaboration partnerships with third-party collaboration partners for the program, which may not be possible, or we may not be able to do so on terms which are acceptable to us, in which case it may be necessary for us to limit the size or scope of the programs or increase our expenditures and seek additional funding by other means; and |\n\n| • | our cash expenditures could increase significantly if it is necessary for us to hire additional employees and allocate scarce resources to the development and commercialization of the NaP2b program. |\n\nAny of these events would have a material adverse effect on our results of operations and financial condition.\nIn addition, we may be effectively prohibited from co-promoting any product candidates arising from the NaP2b program if we have previously exercised our co-promotion right under our agreement with AstraZeneca. For additional information regarding the effect of exercising our co-promotion right with AstraZeneca, see the risk factor above titled “Exercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.”\nClinical drug development involves a lengthy and expensive process with an uncertain outcome, and we may encounter substantial delays in our clinical studies. Furthermore, results of earlier studies and trials may not be predictive of future trial results.\nBefore obtaining marketing approval from regulatory authorities for the sale of our product candidates, we, or our collaboration partners, must conduct extensive clinical studies to demonstrate the safety and efficacy of the product candidates in humans. Clinical testing is expensive and can take many years to complete, and its outcome is inherently uncertain. Failure can occur at any time during the clinical trial process. For example, in a Phase 2a study evaluating tenapanor in ESRD patients with fluid overload, while pharmacological activity of tenapanor was confirmed, the study failed to meet the primary endpoint of a statistically significant difference between tenapanor and placebo in change in interdialytic weight gain from baseline to week 4. The results of preclinical and clinical studies of our product candidates may not be predictive of the results of later-stage clinical trials. For example, the positive results generated to date in preclinical and clinical studies for tenapanor do not ensure that the ongoing Phase 2a and Phase 2b clinical trials, or future clinical trials, will demonstrate similar results. Product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed through preclinical studies and initial clinical trials. A number of companies in the pharmaceutical, biopharmaceutical and biotechnology industries have suffered significant setbacks in advanced clinical trials for similar indications that we are pursuing due to lack of efficacy or adverse safety profiles, notwithstanding promising\n27\nresults in earlier studies, and we cannot be certain that we will not face similar setbacks. Even if our clinical trials are completed, the results may not be sufficient to obtain regulatory approval for our product candidates.\nWe may experience delays in our ongoing or future trials, and we do not know whether future clinical trials will begin on time, need to be redesigned, enroll an adequate number of patients on time or be completed on schedule, if at all. Clinical trials can be delayed or terminated for a variety of reasons, including delay or failure to:\n| • | obtain regulatory approval to commence a trial, if applicable; |\n\n| • | reach agreement on acceptable terms with prospective contract research organizations, or CROs, and clinical trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites; |\n\n| • | obtain institutional review board, or IRB, approval at each site; |\n\n| • | recruit suitable patients in a timely manner to participate in our trials; |\n\n| • | have patients complete a trial or return for post-treatment follow-up; |\n\n| • | ensure that clinical sites observe trial protocol, comply with good clinical practices, or GCPs, or continue to participate in a trial; |\n\n| • | address any patient safety concerns that arise during the course of a trial; |\n\n| • | address any conflicts with new or existing laws or regulations; |\n\n| • | initiate or add a sufficient number of clinical trial sites; or |\n\n| • | manufacture sufficient quantities of product candidate for use in clinical trials. |\n\nPatient enrollment is a significant factor in the timing of clinical trials and is affected by many factors, including the size and nature of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the trial, the design of the clinical trial, competing clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the drug being studied in relation to other available therapies, including any new drugs or treatments that may be approved for the indications we are investigating. We and AstraZeneca have experienced a delay in the enrollment of the ongoing Phase 2a clinical trial in CKD patients due to the restrictive eligibility criteria, and, although we have initiated efforts to increase enrollment by initiating new sites and amending the protocol, there can be no assurances that our efforts will be successful in increasing the rate of enrollment to complete this study on time, if at all.\nWe could also encounter delays if a clinical trial is suspended or terminated by us, our collaboration partner for the product candidate, by the IRBs of the institutions in which such trials are being conducted, by an independent data safety monitoring board, or DSMB, for such trial or by the FDA or other regulatory authorities. Such authorities may suspend or terminate a clinical trial due to a number of factors, including failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols, inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using a drug, changes in governmental regulations or administrative actions or lack of adequate funding to continue the clinical trial.\nFurther, conducting clinical trials in foreign countries presents additional risks that may delay completion of clinical trials. These risks include the failure of physicians or enrolled patients in foreign countries to adhere to clinical protocol as a result of differences in healthcare services or cultural customs, managing additional administrative burdens associated with foreign regulatory schemes and political and economic risks relevant to such foreign countries. In addition, the FDA may determine that the clinical trial results obtained in foreign subjects do not represent the safety and efficacy of a product candidate when administered in U.S. patients and are thus not supportive of an NDA approval in the United States. As part of our effort to increase the rate of enrollment in the ongoing Phase 2a clinical trial in CKD patients, we and AstraZeneca have initiated sites in Germany. For the reasons stated above, these efforts may not improve the rate of enrollment in this study, or generate results that can be used to support the development of tenapanor.\nIf there are delays in the completion of, or termination of, any clinical trial of our product candidates, the commercial prospects of our product candidates may be harmed, and our ability to generate revenue from product sales from any of these product candidates will be delayed. In addition, any delays in completing the clinical trials will increase costs, slow down our product candidate development and approval process and jeopardize the ability to commence product sales and generate revenue from product sales. Any of these occurrences may significantly harm our business, financial condition and prospects. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of regulatory approval of our product candidates.\n28\nOur unlicensed product candidates are at an early stage of development and we may not be successful in our efforts to develop these products or expand our pipeline of product candidates.\nA key element of our strategy is to expand our pipeline of products candidates utilizing our proprietary drug discovery and design platform and to advance such product candidates through clinical development. Our current unlicensed product candidates are in the discovery and lead identification stages of preclinical development and will require substantial preclinical and clinical development, testing and regulatory approval prior to commercialization. In particular, tenapanor is our only product candidate in clinical trials and our other product candidates are in the preclinical stage with significant research and development required before we could file an IND with regulatory authorities to begin clinical studies. Of the large number of drugs in development, only a small percentage of such drugs successfully complete the FDA regulatory approval process and are commercialized. Accordingly, even if we are able to continue to fund our development programs, there can be no assurance that any product candidates will reach the clinic or be successfully developed or commercialized.\nResearch programs to identify product candidates require substantial technical, financial and human resources, whether or not any product candidates are ultimately identified. Although our research and development efforts to date have resulted in several development programs, we may not be able to develop product candidates that are safe and effective. Our research programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development or commercialization for many reasons, including the following:\n| • | the research methodology used and our drug discovery and design platform may not be successful in identifying potential product candidates; |\n\n| • | competitors may develop alternatives that render our product candidates obsolete or less attractive; |\n\n| • | product candidates we develop may nevertheless be covered by third parties’ patents or other exclusive rights; |\n\n| • | the market for a product candidate may change during our program so that the continued development of that product candidate is no longer reasonable; |\n\n| • | a product candidate may on further study be shown to have harmful side effects or other characteristics that indicate it is unlikely to be effective or otherwise does not meet applicable regulatory criteria; |\n\n| • | a product candidate may not be capable of being produced in commercial quantities at an acceptable cost, or at all; and |\n\n| • | a product candidate may not be accepted as safe and effective by patients, the medical community or third-party payors, if applicable. |\n\nEven if we are successful in continuing to expand our pipeline, through our own research and development efforts or by pursuing in-licensing or acquisition of product candidates, the potential product candidates for which we identify or acquire rights may not be suitable for clinical development, including as a result of being shown to have harmful side effects or other characteristics that indicate that they are unlikely to receive marketing approval and achieve market acceptance. If we do not successfully develop and commercialize a product pipeline, we may not be able to generate revenue from product sales in future periods or ever achieve profitability.\nOur proprietary drug discovery and design platform, and, in particular, APECCS, is a new approach to the discovery, design and development of new product candidates and may not result in any products of commercial value.\nWe have developed a proprietary drug discovery and design platform to enable the identification, screening, testing, design and development of new product candidates, and we recently we enhanced this platform with the addition of APECCS. We plan to utilize APECCS to identify new and potentially novel targets in the GI tract. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. However, there can be no assurance that APECCS will work or that any of these potential targets or other aspects of our proprietary drug discovery and design platform will yield product candidates that could enter clinical development and, ultimately, be commercially valuable.\nAlthough we expect to continue to enhance the capabilities of our APECCS system by advancing the cell culture and screening process and/or acquiring new technologies to broaden the scope of APECCS, we may not be successful in any of our enhancement and development efforts. For example, we may not be able to enter into agreements on suitable terms to obtain technologies required to develop certain capabilities of APECCS. In addition, we may not be successful in developing the conditions necessary to grow multiple segments of intestine or from multiple species, or otherwise develop assays or cell cultures necessary to expand these capabilities. If our enhancement or development efforts are unsuccessful, we may not be able to advance our drug discovery capabilities as quickly as we expect or identify as many potential drugable targets as we desire.\n29\nWe may expend our limited resources to pursue a particular product candidate or indication and fail to capitalize on product candidates or indications that may be more profitable or for which there is a greater likelihood of success.\nBecause we have limited financial and managerial resources, we have focused on research programs and product candidates that relate to discovery and development of non-systemic drugs that work in the GI tract. As a result, we may forego or delay pursuit of opportunities with other product candidates or for other indications that later prove to have greater commercial potential. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products. If we do not accurately evaluate the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through collaboration partnerships, licensing or other royalty arrangements in cases in which it would have been more advantageous for us to retain sole development and commercialization rights to such product candidate.\nWe rely on third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may be unable to obtain regulatory approval for or commercialize our product candidates.\nWe do not have the ability to independently conduct clinical trials and, in some cases, preclinical or nonclinical studies. We rely on medical institutions, clinical investigators, contract laboratories, collaboration partners and other third parties, such as CROs, to conduct clinical trials on our product candidates. The third parties with whom we contract for execution of the clinical trials we are conducting with AstraZeneca, as well as those third parties with whom we will contract for execution of clinical trials for our internal programs, play a significant role in the conduct of these trials and the subsequent collection and analysis of data. However, these third parties are not our employees, and except for contractual duties and obligations, we control only certain aspects of their activities and have limited ability to control the amount or timing of resources that they devote to our programs. Although we rely, and will continue to rely, on these third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials, we remain responsible for ensuring that each of our studies and clinical trials is conducted in accordance with the applicable protocol, legal, regulatory and scientific standards and our reliance on third parties does not relieve us of our regulatory responsibilities. We and these third parties are required to comply with current good laboratory practices, or GLPs, for preclinical and nonclinical studies, and good clinical practices, or GCPs, for clinical studies. GLPs and GCPs are regulations and guidelines enforced by the FDA, the Competent Authorities of the Member States of the European Economic Area, or EEA, and comparable foreign regulatory authorities for all of our products in preclinical and clinical development, respectively. Regulatory authorities enforce GCPs through periodic inspections of trial sponsors, principal investigators and trial sites. If we or any of our third party contractors fail to comply with applicable regulatory requirements, including GCPs, the clinical data generated in our clinical trials may be deemed unreliable and the FDA, the European Medicines Agency, or EMA, or comparable foreign regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. There can be no assurance that upon inspection by a given regulatory authority, such regulatory authority will determine that any of our clinical trials comply with GCP regulations. In addition, our clinical trials must be conducted with product produced under cGMP regulations. Our failure to comply with these regulations may require us to repeat clinical trials, which would delay the regulatory approval process.\nEven if our product candidates obtain regulatory approval, they may never achieve market acceptance or commercial success, which will depend, in part, upon the degree of acceptance among physicians, patients, patient advocacy groups, health care payors and the medical community.\nEven if our product candidates obtain FDA or other regulatory approvals, and are ultimately commercialized, our product candidates may not achieve market acceptance among physicians, patients, third-party payors, patient advocacy groups, health care payors and the medical community. Market acceptance of our product candidates for which marketing approval is obtained depends on a number of factors, including:\n| • | the efficacy of the products as demonstrated in clinical trials; |\n\n| • | the prevalence and severity of any side effects and overall safety profile of the product; |\n\n| • | the clinical indications for which the product is approved; |\n\n| • | advantages over existing therapies; |\n\n| • | acceptance by physicians, major operators of clinics and patients of the product as a safe and effective treatment; |\n\n| • | relative convenience and ease of administration of our products; |\n\n| • | the potential and perceived advantages of our product candidates over current treatment options or alternative treatments, including future alternative treatments; |\n\n| • | the cost of treatment in relation to alternative treatments and willingness to pay for our products, if approved, on the part of physicians and patients; |\n\n30\n\n| • | the availability of alternative products and their ability to meet market demand; |\n\n| • | the strength of our or our collaboration partners’ marketing and distribution organizations; |\n\n| • | the quality of our relationships with patient advocacy groups; and |\n\n| • | sufficient third-party coverage or reimbursement. |\n\nAny failure by our product candidates that obtain regulatory approval to achieve market acceptance or commercial success would adversely affect our results of operations.\nOur product candidates may cause undesirable side effects or have other properties that could delay our clinical trials, or delay or prevent regulatory approval, limit the commercial profile of an approved label, or result in significant negative consequences following regulatory approval, if any. If any of our product candidates receives marketing approval and we or others later identify undesirable side effects caused by the product candidate, the ability to market the product candidates could be compromised.\nUndesirable side effects caused by our product candidates could cause us, our collaboration partners, or regulatory authorities to interrupt, delay or halt clinical trials, result in the delay or denial of regulatory approval by the FDA or other comparable foreign regulatory authorities or limit the commercial profile of an approved label. To date, patients treated with tenapanor have experienced drug-related side effects including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. In the event that trials conducted by us or AstraZeneca with tenapanor, or trials we conduct with our other product candidates, reveal an unacceptable severity and prevalence of these or other side effects, such trials could be suspended or terminated and the FDA or comparable foreign regulatory authorities could order AstraZeneca or us to cease further development of or deny approval of tenapanor, or any such other product candidate, for any or all targeted indications. The drug-related side effects could affect patient recruitment or the ability of enrolled patients to complete the trial or result in potential product liability claims. Any of these occurrences may harm our business, financial condition and prospects significantly.\nIn addition, in the event that any of our product candidates receives regulatory approval and we or others later identify undesirable side effects caused by one of our products, a number of potentially significant negative consequences could occur, including:\n| • | regulatory authorities may withdraw their approval of the product or seize the product; |\n\n| • | we, or our collaboration partners, may be required to recall the product; |\n\n| • | additional restrictions may be imposed on the marketing of the particular product or the manufacturing processes for the product or any component thereof, including the imposition of a Risk Evaluation and Mitigation Strategies, or REMS, plan that may require creation of a Medication Guide outlining the risks of such side effects for distribution to patients, as well as elements to assure safe use of the product, such as a patient registry and training and certification of prescribers; |\n\n| • | we, or our collaboration partners, may be subject to fines, injunctions or the imposition of civil or criminal penalties; |\n\n| • | regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication; |\n\n| • | we could be sued and held liable for harm caused to patients; |\n\n| • | the product may become less competitive; and |\n\n| • | our reputation may suffer |\n\nAny of the foregoing events could prevent us, or our collaboration partners, from achieving or maintaining market acceptance of a particular product candidate, if approved, and could result in the loss of significant revenue to us, which would materially and adversely affect our results of operations and business.\nWe face substantial competition and our competitors may discover, develop or commercialize products faster or more successfully than us.\nThe biotechnology and pharmaceutical industries are highly competitive, and we face significant competition from companies in the biotechnology, pharmaceutical and other related markets that are researching and marketing products designed to address diseases that we are currently developing products to treat. If approved for marketing by the FDA or other regulatory agencies, tenapanor, or our other product candidates, would compete against existing treatments. For example, tenapanor will, if approved, compete directly with phosphate binders for the treatment of hyperphosphatemia in patients with ESRD, including sevelamer hydrochloride (Renagel) and sevelamer carbonate (Renvela), which were launched by Genzyme. Impax Laboratories, Inc. launched an authorized generic version of sevelamer carbonate in April 2014 and is expected to launch a generic version of sevelamer hydrochloride in September 2014. In addition to the currently marketed phosphate binders, we are aware of several other binders in development such as ferric citrate (Zerenex), an iron-based binder in Phase 3 being developed in the United States by Keryx and approved in Japan, and fermagate (Alpharen), an iron-based binder in Phase 2 being developed by Opko Health.\n31\nWhile there are no treatments for CKD that have been proven to reverse the disease, we are aware of one agent, CLP-1001, being developed by Sorbent Therapeutics, which is an orally administered, non-systemic exchange resin that binds both sodium and potassium as well as protons that showed positive effects in CKD patients with heart failure in a Phase 2a clinical trial and which showed the ability to increase fecal sodium. We believe this agent, if approved, may be competitive with tenapanor to treat CKD and ESRD patients. We are aware of certain investigational drugs that were being developed for delaying kidney decline as measured by estimated glomerular filtration rate, or eGFR. Among other products, Concert Pharmaceuticals is developing CTP-499 which showed protective effects on kidney function at 48 weeks in a Phase 2 clinical trial in patients with CKD and type 2 diabetes.\nNumerous treatments exist for constipation and the constipation component of IBS-C, many of which are over-the-counter. These include psyllium husk (such as Metamucil), methylcellulose (such as Citrucel), calcium polycarbophil (such as FiberCon), lactulose (such as Cephulac), polyethylene glycol (such as MiraLax), sennosides (such as Exlax), bisacodyl (such as Ducolax), docusate sodium (such as Colace), magnesium hydroxide (such as Milk of Magnesia), saline enemas (such as Fleet) and sorbitol. These agents are generally inexpensive and work well to relieve temporary constipation. We are also aware of two prescription drugs currently on the U.S. market that are approved to treat IBS-C, Linzess (linaclotide), which was developed by Ironwood Pharmaceuticals and was approved in 2012 and 2013 for IBS-C and chronic constipation in both the United States and in Europe, and Amitiza (lubiprostone), which was first approved in the United States in 2006 and is currently marketed by Sucampo and Takeda for treatment of chronic idiopathic constipation, or CIC, IBS-C and opioid induced constipation, or OIC.\nIt is possible that our competitors will develop and market drugs or other treatments that are less expensive and more effective than our product candidates, or that will render our product candidates obsolete. It is also possible that our competitors will commercialize competing drugs or treatments before we, or our collaboration partners, can launch any products developed from our product candidates. We also anticipate that we will face increased competition in the future as new companies enter into our target markets.\nMany of our competitors have materially greater name recognition and financial, manufacturing, marketing, research and drug development resources than we do. Additional mergers and acquisitions in the biotechnology and pharmaceutical industries may result in even more resources being concentrated in our competitors. Large pharmaceutical companies in particular have extensive expertise in preclinical and clinical testing and in obtaining regulatory approvals for drugs. In addition, academic institutions, government agencies, and other public and private organizations conducting research may seek patent protection with respect to potentially competitive products or technologies. These organizations may also establish exclusive collaboration partnerships or licensing relationships with our competitors.\nWe currently have no sales organization. If we are unable to establish sales capabilities on our own or through third parties, we may not be able to co-promote tenapanor, if approved, or commercialize or co-promote any of our other product candidates.\nWe currently do not have a sales organization. In order to co-promote tenapanor or commercialize or co-promote any of our other product candidates, we must build our marketing, sales, distribution, managerial and other non-technical capabilities or make arrangements with third parties to perform these services, and we may not be successful in doing so. If one or more of our product candidates receives regulatory approval, we expect to establish a specialty sales organization with technical expertise and supporting distribution capabilities to co-promote and/or commercialize our product candidates, which will be expensive and time consuming. As a company, we have no prior experience in the marketing, sale and distribution of pharmaceutical products and there are significant risks involved in building and managing a sales organization, including our ability to hire, retain, and incentivize qualified individuals, generate sufficient sales leads, provide adequate training to sales and marketing personnel, comply with regulatory requirements applicable to the marketing and sale of drug products and effectively manage a geographically dispersed sales and marketing team. Any failure or delay in the development of our internal sales, marketing and distribution capabilities would adversely impact the commercialization of these products.\nWe may choose to collaborate with third parties that have direct sales forces and established distribution systems, either to augment our own sales force and distribution systems or in lieu of our own sales force and distribution systems. If we are unable to enter into such arrangements on acceptable terms or at all, we may not be able to successfully commercialize our product candidates.\n32\nWe rely completely on third parties to manufacture our preclinical and clinical drug supplies, and we intend to rely on third parties to produce commercial supplies of any approved product candidate. Our business would be harmed if those third parties fail to obtain approval of the FDA, Competent Authorities of the Member States of the EEA or comparable regulatory authorities, fail to provide us with sufficient quantities of drug product, or fail to do so at acceptable quality levels or prices.\nWe do not currently have, nor do we plan to acquire, the infrastructure or capability internally to manufacture our preclinical and clinical drug supplies for use in the conduct of our preclinical and clinical studies, and we lack the resources and the capability to manufacture any of our product candidates on a clinical or commercial scale. The facilities used by our contract manufacturers to manufacture any drug products must be approved by the FDA pursuant to inspections that will be conducted after an NDA is submitted to the FDA. We do not control the manufacturing process of our product candidates, and, other than with respect to tenapanor, we are completely dependent on our contract manufacturing partners for compliance with the regulatory requirements, known as cGMPs, for manufacture of both active drug substances and finished drug products. Under our agreement with AstraZeneca, the manufacturing of tenapanor is the responsibility of AstraZeneca. We are entirely dependent on AstraZeneca for all aspects of the manufacturing and validation process, as well as providing all commercial supply of tenapanor. For additional information regarding the risks of our dependence on AstraZeneca, see the risk factors above titled “We are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized” and “We are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.”\nIf our contract manufacturers cannot successfully manufacture material that conforms to our specifications and the strict regulatory requirements of the FDA or others, they will not be able to secure and/or maintain regulatory approval for their manufacturing facilities. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel. If the FDA or a comparable foreign regulatory authority does not approve these facilities for the manufacture of our product candidates or if it withdraws any such approval in the future, we may need to find alternative manufacturing facilities, which would significantly impact our ability to develop, obtain regulatory approval for or market our product candidates, if approved.\nWe rely on our manufacturers to purchase from third-party suppliers the materials necessary to produce our product candidates for our clinical studies. There are a limited number of suppliers for raw materials that we use to manufacture our drugs, and there may be a need to identify alternate suppliers to prevent a possible disruption of the manufacture of the materials necessary to produce our product candidates for our clinical studies, and, if approved, ultimately for commercial sale. We do not have any control over the process or timing of the acquisition of these raw materials by our manufacturers. Although we generally do not begin a clinical study unless we believe we have on hand, or will be able to manufacture a sufficient supply of a product candidate to complete such study, any significant delay or discontinuity in the supply of a product candidate, or the raw material components thereof, for an ongoing clinical study due to the need to replace a third-party manufacturer could considerably delay completion of our clinical studies, product testing, and potential regulatory approval of our product candidates, which could harm our business and results of operations.\nThird-party payor coverage and reimbursement status of newly-approved products is uncertain. Failure to obtain or maintain adequate coverage and reimbursement for our products, if approved, could limit our ability to market those products and decrease our ability to generate revenue.\nThe pricing, coverage and reimbursement of our product candidates, if approved, must be adequate to support a commercial infrastructure. The availability and adequacy of coverage and reimbursement by governmental and private payors are essential for most patients to be able to afford treatments such as ours, assuming approval. Sales of our product candidates will depend substantially, both domestically and abroad, on the extent to which the costs of our product candidates will be paid for by health maintenance, managed care, pharmacy benefit, and similar healthcare management organizations, or reimbursed by government authorities, private health insurers, and other third-party payors. If coverage and reimbursement are not available, or are available only to limited levels, we may not be able to successfully commercialize our product candidates. Even if coverage is provided, the approved reimbursement amount may not be high enough to allow us to establish or maintain pricing sufficient to realize a return on our investment.\nThere is significant uncertainty related to the insurance coverage and reimbursement of newly approved products. In the United States, the principal decisions about coverage and reimbursement for new drugs are typically made by the Centers for Medicare & Medicaid Services, or CMS, an agency within the U.S. Department of Health and Human Services responsible for administering the Medicare program, as CMS decides whether and to what extent a new drug will be covered and reimbursed under Medicare. Private payors tend to follow the coverage reimbursement policies established by CMS to a substantial degree. It is difficult to predict what CMS will decide with respect to reimbursement for products such as ours.\n33\nIn July 2010, CMS released its final rule to implement a bundled prospective payment system for the treatment of ESRD patients as required by the Medicare Improvements for Patients and Providers Act, or MIPPA. The bundled payment covers a bundle of items and services routinely required for dialysis treatments furnished to Medicare beneficiaries in Medicare-certified ESRD facilities or at their home, including the cost of certain routine drugs. The final rule delayed the inclusion of oral medications without intravenous equivalents in the bundled payment until January 1, 2014 and in April 2014, President Obama signed the Protecting Access to Medicare Act of 2014, which further extends this implementation date to January 1, 2024. As a result of the recent legislation, beginning in 2024, ESRD-related drugs will be included in the bundle and separate Medicare reimbursement will no longer be available for such drugs, as it is today under Medicare Part D. While it is too early to project the full impact bundling may have on the industry, the impact could potentially cause dramatic price reductions for tenapanor, if approved. We and AstraZeneca may be unable to sell tenapanor, if approved, to dialysis providers on a profitable basis if third-party payors reduce their current levels of payment, or if our costs of production increase faster than increases in reimbursement levels.\nOutside the United States, international operations are generally subject to extensive governmental price controls and other market regulations, and we believe the increasing emphasis on cost-containment initiatives in Europe, Canada, China and other countries has and will continue to put pressure on the pricing and usage of our product candidates. In many countries, the prices of medical products are subject to varying price control mechanisms as part of national health systems. Other countries allow companies to fix their own prices for medicinal products, but monitor and control company profits. Additional foreign price controls or other changes in pricing regulation could restrict the amount that we are able to charge for our product candidates. Accordingly, in markets outside the United States, the reimbursement for our products may be reduced compared with the United States and may be insufficient to generate commercially reasonable revenue and profits.\nMoreover, increasing efforts by governmental and third-party payors in the United States and abroad to cap or reduce healthcare costs may cause such organizations to limit both coverage and the level of reimbursement for new products approved and, as a result, these caps may not cover or provide adequate payment for our product candidates. We expect to experience pricing pressures in connection with the sale of any of our product candidates due to the trend toward managed healthcare, the increasing influence of health maintenance organizations, and additional legislative changes. The downward pressure on healthcare costs in general, particularly prescription drugs and surgical procedures and other treatments, has become very intense. As a result, increasingly high barriers are being erected to the entry of new products.\nIf product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of our product candidates.\nWe face an inherent risk of product liability as a result of the clinical testing of our product candidates and will face an even greater risk if we commercialize any products. For example, we may be sued if any product we develop allegedly causes injury or is found to be otherwise unsuitable during product testing, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product, negligence, strict liability, and a breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of our product candidates. Even successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, liability claims may result in:\n| • | decreased demand for our product candidates; |\n\n| • | injury to our reputation; |\n\n| • | withdrawal of clinical trial participants; |\n\n| • | costs to defend the related litigation; |\n\n| • | a diversion of management’s time and our resources; |\n\n| • | substantial monetary awards to trial participants or patients; |\n\n| • | regulatory investigations, product recalls or withdrawals, or labeling, marketing or promotional restrictions; |\n\n| • | loss of revenue; and |\n\n| • | the inability to commercialize or co-promote our product candidates. |\n\nOur inability to obtain and maintain sufficient product liability insurance at an acceptable cost and scope of coverage to protect against potential product liability claims could prevent or inhibit the commercialization of any products we develop. We currently carry product liability insurance covering use in our clinical trials in the amount of $10.0 million in the aggregate. Although we maintain such insurance, any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions and deductibles, and we may be subject to a product liability claim for which we have no coverage. We will\n34\nhave to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance, and we may not have, or be able to obtain, sufficient capital to pay such amounts. Moreover, in the future, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses.\nWe are highly dependent on the services of our President and Chief Executive Officer, Michael Raab, our Chief Scientific Officer, Dominique Charmot, Ph.D., and our Vice President of Drug Development, David Rosenbaum, Ph.D., and if we are not able to retain these members of our management or recruit additional management, clinical and scientific personnel, our business will suffer.\nOur success depends in part on our continued ability to attract, retain and motivate highly qualified personnel. In particular, we are highly dependent upon Michael Raab, our President and Chief Executive Officer, Dominique Charmot, Ph.D., our Chief Scientific Officer, and David Rosenbaum, Ph.D., our Vice President of Drug Development. The loss of services of any of these individuals could delay or prevent the successful development of our product pipeline, completion of our planned clinical trials or the commercialization of our product candidates. Although we have entered into employment agreements with our senior management team, including Mr. Raab and Drs. Charmot and Rosenbaum, these agreements are terminable at will with or without notice and, therefore, we may not be able to retain their services as expected. Although we have not historically experienced unique difficulties attracting and retaining qualified employees, we could experience such problems in the future. For example, competition for qualified personnel in the biotechnology and pharmaceuticals field is intense due to the limited number of individuals who possess the skills and experience required by our industry. In addition to the competition for personnel, the San Francisco Bay area in particular is characterized by a high cost of living. As such, we could have difficulty attracting experienced personnel to our company and may be required to expend significant financial resources in our employee recruitment and retention efforts.\nWe will need to significantly increase the size of our organization, and we may experience difficulties in managing growth.\nAs of June 30, 2014, we had 36 full-time employees. We will need to continue to expand our managerial, operational, finance and other resources in order to manage our operations, preclinical and clinical trials, research and development activities, regulatory filings, manufacturing and supply activities, and any marketing and commercialization activities, including co-promotion activities. Our management, personnel, systems and facilities currently in place may not be adequate to support this future growth. Our need to effectively execute our growth strategy requires that we:\n| • | expand our general and administrative functions; |\n\n| • | establish and build a marketing and commercial organization; |\n\n| • | identify, recruit, retain, incentivize and integrate additional employees; |\n\n| • | manage our internal development efforts effectively while carrying out our contractual obligations to third parties; and |\n\n| • | continue to improve our operational, legal, financial and management controls, reporting systems and procedures. |\n\nIf we are not able to attract, retain and motivate necessary personnel to accomplish our business objectives, we may experience constraints that will significantly impede the achievement of our development objectives, our ability to raise additional capital and our ability to implement our business strategy.\nWe incur significant costs as a result of operating as a public company, and our management will devote substantial time to new compliance initiatives. We may fail to comply with the rules that apply to public companies, including Section 404 of the Sarbanes-Oxley Act of 2002, which could result in sanctions or other penalties that would harm our business.\nWe incur significant legal, accounting and other expenses as a public company, including costs resulting from public company reporting obligations under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and regulations regarding corporate governance practices. The listing requirements of The NASDAQ Global Market require that we satisfy certain corporate governance requirements relating to director independence, distributing annual and interim reports, stockholder meetings, approvals and voting, soliciting proxies, conflicts of interest and a code of conduct. Our management and other personnel will need to devote a substantial amount of time to ensure that we comply with all of these requirements, and we will need to hire additional accounting and financial staff with appropriate public company reporting experience and technical accounting knowledge. Moreover, the reporting requirements, rules and regulations will increase our legal and financial compliance costs and will make some activities more time consuming and costly. Any changes we make to comply with these obligations may not be sufficient to allow us to satisfy our obligations as a public company on a timely basis, or at all. These reporting requirements, rules and regulations, coupled with the increase in potential litigation exposure associated with being a public company, could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or board committees or to serve as executive officers, or to obtain certain types of insurance, including directors’ and officers’ insurance, on acceptable terms.\n35\nIn addition, we expect to implement an enterprise resource planning, or ERP, system for our company in connection with becoming a public reporting company. An ERP system is intended to combine and streamline the management of our financial, accounting, human resources, sales and marketing and other functions, enabling us to manage operations and track performance more effectively. However, an ERP system will require us to complete many processes and procedures for the effective use of the system or to run our business using the system, which may result in substantial costs. Additionally, during the conversion process, we may be limited in our ability to convert any business that we acquire to the ERP. Any disruptions or difficulties in implementing or using an ERP system could adversely affect our controls and harm our business, including our ability to forecast or make sales and collect our receivables. Moreover, such disruption or difficulties could result in unanticipated costs and diversion of management attention.\nWe are subject to Section 404 of The Sarbanes-Oxley Act of 2002, or Section 404, and the related rules of the Securities and Exchange Commission, or SEC, which generally require our management and independent registered public accounting firm to report on the effectiveness of our internal control over financial reporting. Beginning with the second annual report that we will be required to file with the SEC, Section 404 requires an annual management assessment of the effectiveness of our internal control over financial reporting. However, for so long as we remain an emerging growth company as defined in the Jumpstart Our Business Startups Act of 2012, or JOBS Act, we intend to take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404. Once we are no longer an emerging growth company or, if prior to such date, we opt to no longer take advantage of the applicable exemption, we will be required to include an opinion from our independent registered public accounting firm on the effectiveness of our internal controls over financial reporting. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\nTo date, we have not conducted any other review of our internal control for the purpose of providing the reports required by Section 404 and the related SEC rules. During the course of our review and testing, we may identify deficiencies and be unable to remediate them before we must provide the required reports. Furthermore, if we have a material weakness in our internal controls over financial reporting, we may not detect errors on a timely basis and our financial statements may be materially misstated. We or our independent registered public accounting firm may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting, which could harm our operating results, cause investors to lose confidence in our reported financial information and cause the trading price of our stock to fall. In addition, as a public company we are required to file accurate and timely quarterly and annual reports with the SEC under the Exchange Act. Any failure to report our financial results on an accurate and timely basis could result in sanctions, lawsuits, delisting of our shares from The NASDAQ Global Market or other adverse consequences that would materially harm our business.\nWe may form additional collaboration partnerships in the future with respect to our independent programs, and we may not realize the benefits of such collaborations.\nWe may form collaboration partnerships, create joint ventures or enter into licensing arrangements with third parties with respect to our independent programs that we believe will complement or augment our existing business. We have historically engaged, and intend to continue to engage, in partnering discussions with a range of pharmaceutical and biotechnology companies and could enter into new collaboration partnerships at any time. We face significant competition in seeking appropriate collaboration partners, and the negotiation process to secure appropriate terms is time-consuming and complex. Any delays in identifying suitable collaboration partners and entering into agreements to develop our product candidates could also delay the commercialization of our product candidates, which may reduce their competitiveness even if they reach the market. Moreover, we may not be successful in our efforts to establish such a collaboration partnership for any future product candidates and programs on terms that are acceptable to us, or at all. This may be because our product candidates and programs may be deemed to be at too early of a stage of development for collaborative effort, our research and development pipeline may be viewed as insufficient, and/or third parties may not view our product candidates and programs as having sufficient potential for commercialization, including the likelihood of an adequate safety and efficacy profile. Even if we are successful in entering into a collaboration partnership or license arrangement, there is no guarantee that the collaboration partnership will be successful, or that any future collaboration partner will commit sufficient resources to the development, regulatory approval, and commercialization effort for such products, or that such alliances will result in us achieving revenues that justify such transactions.\n36\nWe may engage in strategic transactions that could impact our liquidity, increase our expenses and present significant distractions to our management.\nWe intend to consider strategic transactions, such as acquisitions of companies, asset purchases, and or in-licensing of products, product candidates or technologies. Additional potential transactions that we may consider include a variety of different business arrangements, including spin-offs, collaboration partnerships, joint ventures, restructurings, divestitures, business combinations and investments. Any such transaction may require us to incur non-recurring or other charges, may increase our near- and long-term expenditures and may pose significant integration challenges or disrupt our management or business, which could adversely affect our operations and financial results. For example, these transactions may entail numerous operational and financial risks, including:\n| • | up-front, milestone and royalty payments, equity investments and financial support of new research and development candidates including increase of personnel, all of which may be substantial; |\n\n| • | exposure to unknown liabilities; |\n\n| • | disruption of our business and diversion of our management’s time and attention in order to develop acquired products, product candidates or technologies; |\n\n| • | incurrence of substantial debt or dilutive issuances of equity securities to pay for acquisitions; |\n\n\n| • | higher-than-expected acquisition and integration costs; |\n\n| • | write-downs of assets or goodwill or impairment charges; |\n\n| • | increased amortization expenses; |\n\n| • | difficulty and cost in combining the operations and personnel of any acquired businesses with our operations and personnel; |\n\n| • | impairment of relationships with key suppliers or customers of any acquired businesses due to changes in management and ownership; and |\n\n| • | inability to retain key employees of any acquired businesses. |\n\nAccordingly, although there can be no assurance that we will undertake or successfully complete any transactions of the nature described above, any transactions that we do complete may be subject to the foregoing or other risks and could have a material adverse effect on our business, results of operations, financial condition and prospects.\nIf we seek and obtain approval to commercialize our product candidates outside of the United States, or otherwise engage in business outside of the United States, a variety of risks associated with international operations could materially adversely affect our business.\nWe may decide to seek marketing approval for certain of our product candidates outside the United States or otherwise engage in business outside the United States, including entering into contractual agreements with third-parties. We expect that we will be subject to additional risks related to entering into these international business markets and relationships, including:\n| • | different regulatory requirements for drug approvals in foreign countries; |\n\n| • | differing United States and foreign drug import and export rules; |\n\n| • | reduced protection for intellectual property rights in foreign countries; |\n\n| • | unexpected changes in tariffs, trade barriers and regulatory requirements; |\n\n| • | different reimbursement systems, and different competitive drugs; |\n\n| • | economic weakness, including inflation, or political instability in particular foreign economies and markets; |\n\n| • | compliance with tax, employment, immigration and labor laws for employees living or traveling abroad; |\n\n| • | foreign taxes, including withholding of payroll taxes; |\n\n| • | foreign currency fluctuations, which could result in increased operating expenses and reduced revenues, and other obligations incident to doing business in another country; |\n\n| • | workforce uncertainty in countries where labor unrest is more common than in the United States; |\n\n| • | production shortages resulting from any events affecting raw material supply or manufacturing capabilities abroad; |\n\n| • | potential liability resulting from development work conducted by these distributors; and |\n\n| • | business interruptions resulting from geopolitical actions, including war and terrorism, or natural disasters. |\n\n37\nOur business involves the use of hazardous materials and we and third-parties with whom we contract must comply with environmental laws and regulations, which can be expensive and restrict how we do business.\nOur research and development activities involve the controlled storage, use and disposal of hazardous materials, including the components of our product candidates and other hazardous compounds. We and manufacturers and suppliers with whom we may contract are subject to laws and regulations governing the use, manufacture, storage, handling and disposal of these hazardous materials. In some cases, these hazardous materials and various wastes resulting from their use are stored at our and our manufacturers’ facilities pending their use and disposal. We cannot eliminate the risk of contamination, which could cause an interruption of our commercialization efforts, research and development efforts and business operations, environmental damage resulting in costly clean-up and liabilities under applicable laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. We cannot guarantee that that the safety procedures utilized by third-party manufacturers and suppliers with whom we may contract will comply with the standards prescribed by laws and regulations or will eliminate the risk of accidental contamination or injury from these materials. In such an event, we may be held liable for any resulting damages and such liability could exceed our resources and state or federal or other applicable authorities may curtail our use of certain materials and/or interrupt our business operations. Furthermore, environmental laws and regulations are complex, change frequently and have tended to become more stringent. We cannot predict the impact of such changes and cannot be certain of our future compliance. We do not currently carry biological or hazardous waste insurance coverage.\nOur internal computer systems, or those of our CROs or other contractors or consultants, may fail or suffer security breaches, which could result in a material disruption of our product development programs.\nDespite the implementation of security measures, our internal computer systems and those of our CROs and other contractors and consultants are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failures. While we have not experienced any such system failure, accident or security breach to date, if such an event were to occur and cause interruptions in our operations, it could result in a material disruption of our programs. For example, the loss of clinical trial data from completed or ongoing clinical trials for any of our product candidates could result in delays in our regulatory approval efforts and significantly increase our costs to recover or reproduce the data. To the extent that any disruption or security breach results in a loss of or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we could incur liability and the further development of our product candidates could be delayed.\nWe may be adversely affected by the current global economic environment.\nOur ability to attract and retain collaboration partners or customers, invest in and grow our business and meet our financial obligations depends on our operating and financial performance, which, in turn, is subject to numerous factors, including the prevailing economic conditions and financial, business and other factors beyond our control, such as the rate of unemployment, the number of uninsured persons in the United States and inflationary pressures. Our results of operations could be adversely affected by general conditions in the global economy and in the global financial markets. The recent global financial crisis caused extreme volatility and disruptions in the capital and credit markets. We cannot anticipate all the ways in which the current global economic climate and global financial market conditions could adversely impact our business.\nWe are exposed to risks associated with reduced profitability and the potential financial instability of our collaboration partners or customers, many of which may be adversely affected by volatile conditions in the financial markets. For example, unemployment and underemployment, and the resultant loss of insurance, may decrease the demand for healthcare services and pharmaceuticals. If fewer patients are seeking medical care because they do not have insurance coverage, our collaboration partners or customers may experience reductions in revenues, profitability and/or cash flow that could lead them to reduce their support of our programs or financing activities. If collaboration partners or customers are not successful in generating sufficient revenue or are precluded from securing financing, they may not be able to pay, or may delay payment of, accounts receivable that are owed to us. In addition, the volatility in the financial markets could cause significant fluctuations in the interest rate and currency markets. We currently do not hedge for these risks. The foregoing events, in turn, could adversely affect our financial condition and liquidity. In addition, if economic challenges in the United States result in widespread and prolonged unemployment, either regionally or on a national basis, prior to the effectiveness of certain provisions of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act, collectively known as the Affordable Care Act, a substantial number of people may become uninsured or underinsured. To the extent economic challenges result in fewer individuals pursuing or being able to afford our product candidates once commercialized, our business, results of operations, financial condition and cash flows could be adversely affected.\nWe may be adversely affected by earthquakes or other natural disasters and our business continuity and disaster recovery plans may not adequately protect us from a serious disaster.\nOur corporate headquarters and other facilities are located in the San Francisco Bay Area, which in the past has experienced severe earthquakes. We do not carry earthquake insurance. Earthquakes or other natural disasters could severely disrupt our operations, and have a material adverse effect on our business, results of operations, financial condition and prospects.\n38\nIf a natural disaster, power outage or other event occurred that prevented us from using all or a significant portion of our headquarters, that damaged critical infrastructure, such as our enterprise financial systems or manufacturing resource planning and enterprise quality systems, or that otherwise disrupted operations, it may be difficult or, in certain cases, impossible for us to continue our business for a substantial period of time. The disaster recovery and business continuity plans we have in place currently are limited and are unlikely to prove adequate in the event of a serious disaster or similar event. We may incur substantial expenses as a result of the limited nature of our disaster recovery and business continuity plans, which, particularly when taken together with our lack of earthquake insurance, could have a material adverse effect on our business.\nRisks Related to Government Regulation\nThe regulatory approval processes of the FDA and comparable foreign authorities are lengthy, time consuming and inherently unpredictable. If we are ultimately unable to obtain regulatory approval for our product candidates, our business will be substantially harmed.\nThe research, testing, manufacturing, labeling, approval, selling, import, export, marketing and distribution of drug products are subject to extensive regulation by the FDA and other regulatory authorities in the United States and other countries, which regulations differ from country to country. Neither we nor any of our collaboration partners is permitted to market any drug product in the United States until we receive marketing approval from the FDA. We have not submitted an application or obtained marketing approval for any of our product candidates anywhere in the world. Obtaining regulatory approval of a new drug application, or NDA, can be a lengthy, expensive and uncertain process. In addition, failure to comply with FDA and other applicable United States and foreign regulatory requirements may subject us to administrative or judicially imposed sanctions or other actions, including:\n| • | warning letters; |\n\n| • | civil and criminal penalties; |\n\n| • | injunctions; |\n\n| • | withdrawal of regulatory approval of products; |\n\n| • | product seizure or detention; |\n\n| • | product recalls; |\n\n| • | total or partial suspension of production; and |\n\n| • | refusal to approve pending NDAs or supplements to approved NDAs. |\n\nPrior to obtaining approval to commercialize a drug candidate in the United States or abroad, we or our collaboration partners must demonstrate with substantial evidence from well-controlled clinical trials, and to the satisfaction of the FDA or other foreign regulatory agencies, that such drug candidates are safe and effective for their intended uses. The number of nonclinical studies and clinical trials that will be required for FDA approval varies depending on the drug candidate, the disease or condition that the drug candidate is designed to address, and the regulations applicable to any particular drug candidate. Results from nonclinical studies and clinical trials can be interpreted in different ways. Even if we believe the nonclinical or clinical data for our drug candidates are promising, such data may not be sufficient to support approval by the FDA and other regulatory authorities. Administering drug candidates to humans may produce undesirable side effects, which could interrupt, delay or halt clinical trials and result in the FDA or other regulatory authorities denying approval of a drug candidate for any or all targeted indications.\nThe time required to obtain approval by the FDA and comparable foreign authorities is unpredictable, typically takes many years following the commencement of clinical studies, and depends upon numerous factors. The FDA and comparable foreign authorities have substantial discretion in the approval process and we may encounter matters with the FDA or such comparable authorities that requires us to expend additional time and resources and delay or prevent the approval of our product candidates. For example, the FDA may require us to conduct additional studies or trials for drug product either prior to or post-approval, such as additional drug-drug interaction studies or safety or efficacy studies or trials, or it may object to elements of our clinical development program such as the number of subjects in our current clinical trials from the United States. In addition, approval policies, regulations or the type and amount of clinical data necessary to gain approval may change during the course of a product candidate’s clinical development and may vary among jurisdictions, which may cause delays in the approval or result in a decision not to approve an application for regulatory approval. Despite the time and expense exerted, failure can occur at any stage. Applications for our product candidates could fail to receive regulatory approval for many reasons, including but not limited to the following:\n| • | the FDA or comparable foreign regulatory authorities may disagree with the design or implementation of our, or our collaboration partners’, clinical studies; |\n\n| • | the population studied in the clinical program may not be sufficiently broad or representative to assure safety in the full population for which approval is sought; |\n\n39\n\n| • | the FDA or comparable foreign regulatory authorities may disagree with the interpretation of data from preclinical studies or clinical studies; |\n\n| • | the data collected from clinical studies of our product candidates may not be sufficient to support the submission of a NDA or other submission or to obtain regulatory approval in the United States or elsewhere; |\n\n| • | we or our collaboration partners may be unable to demonstrate to the FDA or comparable foreign regulatory authorities that a product candidate’s risk-benefit ratio for its proposed indication is acceptable; |\n\n| • | the FDA or comparable foreign regulatory authorities may fail to approve the manufacturing processes, test procedures and specifications, or facilities of third-party manufacturers responsible for clinical and commercial supplies; and |\n\n| • | the approval policies or regulations of the FDA or comparable foreign regulatory authorities may significantly change in a manner rendering our clinical data insufficient for approval. |\n\nThis lengthy approval process, as well as the unpredictability of the results of clinical studies, may result in our failure and/or that of our collaboration partners to obtain regulatory approval to market any of our product candidates, which would significantly harm our business, results of operations, and prospects. Additionally, if the FDA requires that we conduct additional clinical studies, places limitations in our label, delays approval to market our product candidates or limits the use of our products, our business and results of operations may be harmed.\nIn addition, even if we were to obtain approval, regulatory authorities may approve any of our product candidates for fewer or more limited indications than we request, may not approve the price we intend to charge for our products, may grant approval contingent on the performance of costly post-marketing clinical trials, or may approve a product candidate with a label that does not include the labeling claims necessary or desirable for the successful commercialization of that product candidate. Any of the foregoing scenarios could materially harm the commercial prospects for our product candidates.\nEven if we receive regulatory approval for a product candidate, we will be subject to ongoing regulatory obligations and continued regulatory review, which may result in significant additional expense. Additionally, any product candidates, if approved, could be subject to labeling and other restrictions and market withdrawal, and we may be subject to penalties if we fail to comply with regulatory requirements or experience unanticipated problems with our products.\nEven if a drug is approved by the FDA or foreign regulatory authorities, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. These requirements include submissions of safety and other post-marketing information and reports, registration, as well as continued compliance with cGMPs and GCPs for any clinical trials that we conduct post-approval. As such, we and our third party contract manufacturers will be subject to continual review and periodic inspections to assess compliance with regulatory requirements. Accordingly, we and others with whom we work must continue to expend time, money, and effort in all areas of regulatory compliance, including manufacturing, production, and quality control. Regulatory authorities may also impose significant restrictions on a product’s indicated uses or marketing or impose ongoing requirements for potentially costly post-marketing studies. Furthermore, any new legislation addressing drug safety issues could result in delays or increased costs to assure compliance.\nWe will also be required to report certain adverse reactions and production problems, if any, to the FDA, and to comply with requirements concerning advertising and promotion for our products. Promotional communications with respect to prescription drugs are subject to a variety of legal and regulatory restrictions and must be consistent with the information in the product’s approved label. As such, we may not promote our products for indications or uses for which they do not have FDA approval.\nLater discovery of previously unknown problems with a product, including adverse events of unanticipated severity or frequency, or with our third-party manufacturers or manufacturing processes, or failure to comply with regulatory requirements, may result in, among other things:\n| • | warning letters, fines or holds on clinical trials; |\n\n| • | restrictions on the marketing or manufacturing of the product, withdrawal of the product from the market or voluntary or mandatory product recalls; |\n\n| • | injunctions or the imposition of civil or criminal penalties; |\n\n| • | suspension or revocation of existing regulatory approvals; |\n\n| • | suspension of any of our ongoing clinical trials; |\n\n| • | refusal to approve pending applications or supplements to approved applications submitted by us; |\n\n| • | restrictions on our or our contract manufacturers’ operations; or |\n\n40\n\n| • | product seizure or detention, or refusal to permit the import or export of products. |\n\nAny government investigation of alleged violations of law could require us to expend significant time and resources in response, and could generate negative publicity. Any failure to comply with ongoing regulatory requirements may significantly and adversely affect our ability to commercialize our product candidates. If regulatory sanctions are applied or if regulatory approval is withdrawn, the value of our company and our operating results will be adversely affected.\nIn addition, the FDA’s policies may change and additional government regulations may be enacted that could prevent, limit or delay regulatory approval of our product candidates. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or if we are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained, which would adversely affect our business, prospects and ability to achieve or sustain profitability.\nWe and our collaboration partners and contract manufacturers are subject to significant regulation with respect to manufacturing our product candidates. The manufacturing facilities on which we rely may not continue to meet regulatory requirements or may not be able to meet supply demands.\nAll entities involved in the preparation of product candidates for clinical studies or commercial sale, including our existing contract manufacturers for our product candidates and AstraZeneca, and those contract manufacturers it may rely upon with respect to the manufacture of tenapanor, are subject to extensive regulation. Components of a finished therapeutic product approved for commercial sale or used in late-stage clinical studies must be manufactured in accordance with cGMP. These regulations govern manufacturing processes and procedures (including record keeping) and the implementation and operation of quality systems to control and assure the quality of investigational products and products approved for sale. Poor control of production processes can lead to the introduction of contaminants or to inadvertent changes in the properties or stability of our product candidates that may not be detectable in final product testing. We, our collaboration partners, or our contract manufacturers must supply all necessary documentation in support of an NDA or comparable regulatory filing on a timely basis and must adhere to cGMP regulations enforced by the FDA and other regulatory agencies through their facilities inspection programs. Some of our contract manufacturers have never produced a commercially approved pharmaceutical product and therefore have not obtained the requisite regulatory authority approvals to do so. The facilities and quality systems of some or all of our collaboration partners and third-party contractors must pass a pre-approval inspection for compliance with the applicable regulations as a condition of regulatory approval of our product candidates. In addition, the regulatory authorities may, at any time, audit or inspect a manufacturing facility involved with the preparation of our product candidates or our other potential products or the associated quality systems for compliance with the regulations applicable to the activities being conducted. Although we oversee the contract manufacturers, we cannot control the manufacturing process of, and are completely dependent on, other than with respect to tenapanor, our contract manufacturing partners for compliance with the regulatory requirements. AstraZeneca is fully responsible for the manufacture of tenapanor, and we are entirely dependent upon AstraZeneca for compliance with the regulatory requirements. If these facilities do not pass a pre-approval plant inspection, regulatory approval of the products may not be granted or may be substantially delayed until any violations are corrected to the satisfaction of the regulatory authority, if ever. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel.\nThe regulatory authorities also may, at any time following approval of a product for sale, audit the manufacturing facilities of our collaboration partners and third-party contractors. If any such inspection or audit identifies a failure to comply with applicable regulations or if a violation of our product specifications or applicable regulations occurs independent of such an inspection or audit, we or the relevant regulatory authority may require remedial measures that may be costly and/or time consuming for us or a third party to implement, and that may include the temporary or permanent suspension of a clinical study or commercial sales or the temporary or permanent suspension of production or closure of a facility. Any such remedial measures imposed upon us or third parties with whom we contract could materially harm our business.\nIf we, our collaboration partners, or any of our third-party manufacturers fail to maintain regulatory compliance, the FDA or other applicable regulatory authority can impose regulatory sanctions including, among other things, refusal to approve a pending application for a new drug product, withdrawal of an approval, or suspension of production. As a result, our business, financial condition, and results of operations may be materially harmed.\nAdditionally, if supply from one approved manufacturer is interrupted, an alternative manufacturer would need to be qualified through an NDA, a supplemental NDA or equivalent foreign regulatory filing, which could result in further delay. The regulatory agencies may also require additional studies if a new manufacturer is relied upon for commercial production. Switching manufacturers may involve substantial costs and is likely to result in a delay in our desired clinical and commercial timelines.\n41\nThese factors could cause us to incur higher costs and could cause the delay or termination of clinical studies, regulatory submissions, required approvals, or commercialization of our product candidates. Furthermore, if our suppliers fail to meet contractual requirements and we are unable to secure one or more replacement suppliers capable of production at a substantially equivalent cost, our clinical studies may be delayed or we could lose potential revenue.\nIf we fail to comply or are found to have failed to comply with FDA and other regulations related to the promotion of our products for unapproved uses, we could be subject to criminal penalties, substantial fines or other sanctions and damage awards.\nThe regulations relating to the promotion of products for unapproved uses are complex and subject to substantial interpretation by the FDA and other government agencies. If tenapanor, or our other product candidates, receives marketing approval, we and our collaborating partners will be restricted from marketing the product outside of its approved labeling, also referred to as off-label promotion. However, physicians may nevertheless prescribe an approved product to their patients in a manner that is inconsistent with the approved label, which is an off-label use. We intend to implement compliance and training programs designed to ensure that our sales and marketing practices comply with applicable regulations regarding off-label promotion. Notwithstanding these programs, the FDA or other government agencies may allege or find that our practices constitute prohibited promotion of our product candidates for unapproved uses. We also cannot be sure that our employees will comply with company policies and applicable regulations regarding the promotion of products for unapproved uses.\nOver the past several years, a significant number of pharmaceutical and biotechnology companies have been the target of inquiries and investigations by various federal and state regulatory, investigative, prosecutorial and administrative entities in connection with the promotion of products for unapproved uses and other sales practices, including the Department of Justice and various U.S. Attorneys’ Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission and various state Attorneys General offices. These investigations have alleged violations of various federal and state laws and regulations, including claims asserting antitrust violations, violations of the Food, Drug and Cosmetic Act, the False Claims Act, the Prescription Drug Marketing Act, anti-kickback laws, and other alleged violations in connection with the promotion of products for unapproved uses, pricing and Medicare and/or Medicaid reimbursement. Many of these investigations originate as “qui tam” actions under the False Claims Act. Under the False Claims Act, any individual can bring a claim on behalf of the government alleging that a person or entity has presented a false claim, or caused a false claim to be submitted, to the government for payment. The person bringing a qui tam suit is entitled to a share of any recovery or settlement. Qui tam suits, also commonly referred to as “whistleblower suits,” are often brought by current or former employees. In a qui tam suit, the government must decide whether to intervene and prosecute the case. If it declines, the individual may pursue the case alone.\nIf the FDA or any other governmental agency initiates an enforcement action against us or if we are the subject of a qui tam suit and it is determined that we violated prohibitions relating to the promotion of products for unapproved uses, we could be subject to substantial civil or criminal fines or damage awards and other sanctions such as consent decrees and corporate integrity agreements pursuant to which our activities would be subject to ongoing scrutiny and monitoring to ensure compliance with applicable laws and regulations. Any such fines, awards or other sanctions would have an adverse effect on our revenue, business, financial prospects and reputation.\nIf approved, tenapanor and our other product candidates may cause or contribute to adverse medical events that we are required to report to regulatory agencies and if we fail to do so we could be subject to sanctions that would materially harm our business.\nSome participants in clinical studies of tenapanor have reported adverse effects after being treated with tenapanor, including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. If we are successful in commercializing any products, FDA and foreign regulatory agency regulations require that we report certain information about adverse medical events if those products may have caused or contributed to those adverse events. The timing of our obligation to report would be triggered by the date we become aware of the adverse event as well as the nature of the event. We may fail to report adverse events we become aware of within the prescribed timeframe. We may also fail to appreciate that we have become aware of a reportable adverse event, especially if it is not reported to us as an adverse event or if it is an adverse event that is unexpected or removed in time from the use of our products. If we fail to comply with our reporting obligations, the FDA or a foreign regulatory agency could take action, including criminal prosecution, the imposition of civil monetary penalties, seizure of our products or delay in approval or clearance of future products.\n42\nOur employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in misconduct or other improper activities, including noncompliance with regulatory standards and requirements.\nWe are exposed to the risk that our employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate: (1) FDA regulations, including those laws that require the reporting of true, complete and accurate information to the FDA; (2) manufacturing standards; (3) federal and state healthcare fraud and abuse laws and regulations; or (4) laws that require the reporting of true and accurate financial information and data. Specifically, sales, marketing and business arrangements in the healthcare industry are subject to extensive laws and regulations intended to prevent fraud, kickbacks, self-dealing and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements. These activities also include the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. It is not always possible to identify and deter misconduct by employees and other third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, and curtailment of our operations, any of which could adversely affect our ability to operate our business and our results of operations.\nFailure to obtain regulatory approvals in foreign jurisdictions would prevent us from marketing our products internationally.\nIn order to market any product in the EEA (which is composed of the 28 Member States of the European Union plus Norway, Iceland and Liechtenstein), and many other foreign jurisdictions, separate regulatory approvals are required. In the EEA, medicinal products can only be commercialized after obtaining a Marketing Authorization, or MA. Before granting the MA, the EMA or the competent authorities of the Member States of the EEA make an assessment of the risk-benefit balance of the product on the basis of scientific criteria concerning its quality, safety and efficacy.\nThe approval procedures vary among countries and can involve additional clinical testing, and the time required to obtain approval may differ from that required to obtain FDA approval. Clinical trials conducted in one country may not be accepted by regulatory authorities in other countries. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one or more foreign regulatory authorities does not ensure approval by regulatory authorities in other foreign countries or by the FDA. However, a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in others. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not be able to file for regulatory approvals or to do so on a timely basis, and even if we do file we may not receive necessary approvals to commercialize our products in any market.\nWe and our collaboration partners may be subject to healthcare laws, regulation and enforcement; our failure or the failure of our collaboration partners to comply with these laws could have a material adverse effect on our results of operations and financial conditions.\nAlthough we do not currently have any products on the market, once we begin commercializing our products, we and our collaboration partners may be subject to additional healthcare statutory and regulatory requirements and enforcement by the federal government and the states and foreign governments in which we conduct our business. The laws that may affect our ability to operate as a commercial organization include:\n| • | the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, receiving, offering or paying remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual for, or the purchase, order or recommendation of, any good or service for which payment may be made under federal healthcare programs such as the Medicare and Medicaid programs; |\n\n| • | federal false claims laws which prohibit, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other third-party payors that are false or fraudulent; |\n\n| • | federal criminal laws that prohibit executing a scheme to defraud any healthcare benefit program or making false statements relating to healthcare matters; |\n\n| • | the federal Health Insurance Portability and Accountability Act of 1996, as amended by the Health Information Technology for Economic and Clinical Health Act, which governs the conduct of certain electronic healthcare transactions and protects the security and privacy of protected health information; |\n\n43\n\n| • | the federal physician sunshine requirements under the Affordable Care Act, which requires manufacturers of drugs, devices, biologics, and medical supplies to report annually to the CMS information related to payments and other transfers of value to physicians, other healthcare providers, and teaching hospitals, and ownership and investment interests held by physicians and other healthcare providers and their immediate family members; |\n\n| • | state law equivalents of each of the above federal laws, such as anti-kickback and false claims laws which may apply to items or services reimbursed by any third-party payor, including commercial insurers; |\n\n| • | state laws that require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines and the applicable compliance guidance promulgated by the federal government, or otherwise restrict payments that may be made to healthcare providers and other potential referral sources; |\n\n| • | state laws that require drug manufacturers to report information related to payments and other transfers of value to physicians and other healthcare providers or marketing expenditures; and state laws governing the privacy and security of health information in certain circumstances, many of which differ from each other in significant ways, thus complicating compliance efforts; and |\n\n| • | European and other foreign law equivalents of each of the laws, including reporting requirements detailing interactions with and payments to healthcare providers. |\n\nBecause of the breadth of these laws and the narrowness of the statutory exceptions and safe harbors available, it is possible that some of our business activities could be subject to challenge under one or more of such laws. The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Further, the Affordable Care Act, among other things, amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes. A person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. In addition, the Affordable Care Act provides that the government may assert that a claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims statutes. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business. If our operations are found to be in violation of any of the laws described above or any other governmental laws and regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, the curtailment or restructuring of our operations, the exclusion from participation in federal and state healthcare programs and imprisonment, any of which could adversely affect our ability to market our products and adversely impact our financial results.\nLegislative or regulatory healthcare reforms in the United States may make it more difficult and costly for us to obtain regulatory clearance or approval of our product candidates and to produce, market and distribute our products after clearance or approval is obtained.\nFrom time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the regulatory clearance or approval, manufacture, and marketing of regulated products or the reimbursement thereof. In addition, FDA regulations and guidance are often revised or reinterpreted by the FDA in ways that may significantly affect our business and our products. Any new regulations or revisions or reinterpretations of existing regulations may impose additional costs or lengthen review times of our product candidates. We cannot determine what effect changes in regulations, statutes, legal interpretation or policies, when and if promulgated, enacted or adopted may have on our business in the future. Such changes could, among other things, require:\n| • | additional clinical trials to be conducted prior to obtaining approval; |\n\n| • | changes to manufacturing methods; |\n\n| • | recall, replacement, or discontinuance of one or more of our products; and |\n\n| • | additional record keeping. |\n\nEach of these would likely entail substantial time and cost and could materially harm our business and our financial results. In addition, delays in receipt of or failure to receive regulatory clearances or approvals for any future products would harm our business, financial condition and results of operations.\nIn addition, the full impact of recent healthcare reform and other changes in the healthcare industry and in healthcare spending is currently unknown, and may adversely affect our business model. In the United States, the Affordable Care Act was enacted in 2010 with a goal of reducing the cost of healthcare and substantially changing the way healthcare is financed by both government and private insurers. The Affordable Care Act, among other things, increased the minimum Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program and extended the rebate program to individuals enrolled in Medicaid managed care organizations, established annual fees and taxes on manufacturers of certain branded prescription drugs, and created a new Medicare\n44\nPart D coverage gap discount program, in which manufacturers must agree to offer 50% point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period as a condition for the manufacturer’s outpatient drugs to be covered under Medicare Part D.\nIn addition, other legislative changes have been proposed and adopted in the United States since the Affordable Care Act was enacted. On August 2, 2011, the Budget Control Act of 2011 created measures for spending reductions by Congress. A Joint Select Committee on Deficit Reduction, tasked with recommending a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, was unable to reach required goals, thereby triggering the legislation’s automatic reduction to several government programs. This included aggregate reductions of Medicare payments to providers of 2% per fiscal year, which went into effect on April 1, 2013. On January 2, 2013, the ATRA was signed into law, which, among other things, further reduced Medicare payments to several providers, including hospitals.\nIt is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect the demand for any drug products for which we may obtain regulatory approval, our ability to set a price that we believe is fair for our products, our ability to obtain coverage and reimbursement approval for a product, our ability to generate revenues and achieve or maintain profitability, and the level of taxes that we are required to pay.\nRisks Related to Intellectual Property\nWe may become subject to claims alleging infringement of third parties’ patents or proprietary rights and/or claims seeking to invalidate our patents, which would be costly, time consuming and, if successfully asserted against us, delay or prevent the development and commercialization of tenapanor or any other product candidates.\nThere have been many lawsuits and other proceedings asserting infringement or misappropriation of patents and other intellectual property rights in the pharmaceutical and biotechnology industries. There can be no assurances that we will not be subject to claims alleging that the manufacture, use or sale of tenapanor or any other product candidates nor that any activities conducted by us, infringes existing or future third-party patents, or that such claims, if any, will not be successful. Because patent applications can take many years to issue and may be confidential for 18 months or more after filing, and because pending patent claims can be revised before issuance, there may be applications now pending which may later result in issued patents that may be infringed by the manufacture, use or sale of tenapanor or other product candidates or by the operation of our business. Moreover, we may face patent infringement claims from non-practicing entities that have no relevant product revenue and against whom our own patent portfolio may thus have no deterrent effect. We may be unaware of one or more issued patents that would be infringed by the manufacture, sale or use of tenapanor or our other product candidates.\nWe may be subject to third-party patent infringement claims in the future against us or our collaboration partners that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages, including treble damages and attorney’s fees if we are found to be willfully infringing a third party’s patents. We may be required to indemnify future collaboration partners against such claims. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If a patent infringement suit were brought against us or our collaboration partners, we or they could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit. As a result of patent infringement claims, or in order to avoid potential claims, we or our collaboration partners may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we or our collaboration partners were able to obtain a license, the rights may be nonexclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or forced to redesign it, or to cease some aspect of our business operations if, as a result of actual or threatened patent infringement claims, we or our collaboration partners are unable to enter into licenses on acceptable terms. Even if we are successful in defending against such claims, such litigation can be expensive and time consuming to litigate and would divert management’s attention from our core business. Any of these events could harm our business significantly.\nIn addition to infringement claims against us, if third parties prepare and file patent applications in the United States that also claim technology similar or identical to ours, we may have to participate in interference or derivation proceedings in the United States Patent and Trademark Office, or the USPTO, to determine which party is entitled to a patent on the disputed invention. We may also become involved in similar opposition proceedings in the European Patent Office or similar offices in other jurisdictions regarding our intellectual property rights with respect to our products and technology. Since patent applications are confidential for a period of time after filing, we cannot be certain that we were the first to file any patent application related to our product candidates.\n45\nIf our intellectual property related to our product candidates is not adequate or if we are not able to protect our trade secrets or our confidential information, we may not be able to compete effectively in our market.\nWe rely upon a combination of patents, trade secret protection and confidentiality agreements to protect the intellectual property related to our product candidates, our drug discovery and development platform and our development programs. Any disclosure to or misappropriation by third parties of our confidential or proprietary information could enable competitors to quickly duplicate or surpass our technological achievements, thus eroding our competitive position in our market.\nThe strength of patents in the biotechnology and pharmaceutical field involves complex legal and scientific questions and can be uncertain. The patent applications that we own or license may fail to result in issued patents in the United States or in foreign countries. Additionally, our research and development efforts may result in product candidates for which patent protection is limited or not available. Even if patents do successfully issue, third parties may challenge the validity, enforceability or scope thereof, which may result in such patents being narrowed, invalidated or held unenforceable. For example, U.S. patents can be challenged by any person before the new USPTO Patent Trial and Appeals Board at any time before one year after that person is served an infringement complaint based on the patents. Patents granted by the European Patent Office may be similarly opposed by any person within nine months from the publication of the grant. Similar proceedings are available in other jurisdictions, and in the United States, Europe and other jurisdictions third parties can raise questions of validity with a patent office even before a patent has granted. Furthermore, even if they are unchallenged, our patents and patent applications may not adequately protect our intellectual property or prevent others from designing around our claims. For example, a third party may develop a competitive product that provides therapeutic benefits similar to one or more of our product candidates but has a sufficiently different composition to fall outside the scope of our patent protection. If the breadth or strength of protection provided by the patents and patent applications we hold or pursue with respect to our product candidates is successfully challenged, then our ability to commercialize such product candidates could be negatively affected, and we may face unexpected competition that could have a material adverse impact on our business. Further, if we encounter delays in our clinical trials, the period of time during which we or our collaboration partners could market tenapanor or other product candidates under patent protection would be reduced.\nEven where laws provide protection, costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and the outcome of such litigation would be uncertain. If we or one of our collaboration partners were to initiate legal proceedings against a third party to enforce a patent covering the product candidate, the defendant could counterclaim that our patent is invalid and/or unenforceable. In patent litigation in the United States, defendant counterclaims alleging invalidity and/or unenforceability are commonplace. Grounds for a validity challenge could be an alleged failure to meet any of several statutory requirements, including lack of novelty, obviousness or non-enablement. Grounds for an unenforceability assertion could be an allegation that someone connected with prosecution of the patent withheld relevant information from the USPTO, or made a misleading statement, during prosecution. The outcome following legal assertions of invalidity and unenforceability is unpredictable. With respect to validity, for example, we cannot be certain that there is no invalidating prior art, of which we and the patent examiner were unaware during prosecution. If a defendant were to prevail on a legal assertion of invalidity and/or unenforceability against our intellectual property related to a product candidate, we would lose at least part, and perhaps all, of the patent protection on such product candidate. Such a loss of patent protection would have a material adverse impact on our business. Moreover, our competitors could counterclaim that we infringe their intellectual property, and some of our competitors have substantially greater intellectual property portfolios than we do.\nWe also rely on trade secret protection and confidentiality agreements to protect proprietary know-how that may not be patentable, processes for which patents may be difficult to obtain and/or enforce and any other elements of our drug discovery and development processes that involve proprietary know-how, information or technology that is not covered by patents. Although we require all of our employees, consultants, advisors and any third parties who have access to our proprietary know-how, information or technology, to assign their inventions to us, and endeavor to execute confidentiality agreements with all such parties, we cannot be certain that we have executed such agreements with all parties who may have helped to develop our intellectual property or who had access to our proprietary information, nor can we be certain that our agreements will not be breached by such consultants, advisors or third parties, or by our former employees. The breach of such agreements by individuals or entities who are actively involved in the discovery and design of our potential drug candidates, or in the development of our discovery and design platform, including APECCS, could require us to pursue legal action to protect our trade secrets and confidential information, which would be expensive, and the outcome of which would be unpredictable. If we are not successful in prohibiting the continued breach of such agreements, our business could be negatively impacted. We cannot guarantee that our trade secrets and other confidential proprietary information will not be disclosed or that competitors will not otherwise gain access to our trade secrets or independently develop substantially equivalent information and techniques.\n46\nFurther, the laws of some foreign countries do not protect proprietary rights to the same extent or in the same manner as the laws of the United States. As a result, we may encounter significant problems in protecting and defending our intellectual property both in the United States and abroad. If we are unable to prevent material disclosure of the intellectual property related to our technologies to third parties, we will not be able to establish or maintain a competitive advantage in our market, which could materially adversely affect our business, results of operations and financial condition.\nIf we or our collaboration partners do not obtain patent term extension in the United States under the Hatch-Waxman Act and in foreign countries under similar legislation, thereby potentially extending the term of marketing exclusivity for our product candidates, our business may be materially harmed.\nDepending upon the timing, duration and specifics of FDA marketing approval of our product candidates, if any, one of the U.S. patents covering each of such approved product(s) or the use thereof may be eligible for up to five years of patent term restoration under the Hatch-Waxman Act. The Hatch-Waxman Act allows a maximum of one patent to be extended per FDA approved product. Patent term extension also may be available in certain foreign countries upon regulatory approval of our product candidates. Nevertheless, we or our collaboration partners may not be granted patent term extension either in the United States or in any foreign country because of, for example, failing to apply within applicable deadlines, failing to apply prior to expiration of relevant patents or otherwise failing to satisfy applicable requirements. Moreover, the term of extension, as well as the scope of patent protection during any such extension, afforded by the governmental authority could be less than we request.\nIf we are unable to obtain patent term extension or restoration, or the term of any such extension is less than we or our collaboration partners request, the period during which we or our collaboration partners will have the right to exclusively market our product will be shortened and our competitors may obtain approval of competing products following our patent expiration, and our revenue could be reduced, possibly materially.\nChanges in U.S. patent law could diminish the value of patents in general, thereby impairing our ability to protect our products.\nAs is the case with other biopharmaceutical companies, our success is heavily dependent on intellectual property, particularly patents. Obtaining and enforcing patents in the biopharmaceutical industry involve both technological and legal complexity. Therefore, obtaining and enforcing biopharmaceutical patents is costly, time consuming and inherently uncertain. In addition, the United States has recently enacted and is currently implementing wide-ranging patent reform legislation, including the Leahy-Smith America Invents Act signed into law on September 16, 2011. That Act includes a number of significant changes to U.S. patent law. These include provisions that affect the way patent applications are prosecuted and new venues and opportunities for competitors to challenge patent portfolios. Because of that Act, the U.S. patent system is now a “first to file” system, which may make it more difficult to obtain patent protection for inventions and increase the uncertainties and costs surrounding the prosecution of our or our collaboration partners’ patent applications and the enforcement or defense of our or our collaboration partners’ issued patents, all of which could materially adversely affect our business, results of operations and financial condition.\nThe United States Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. In addition to increasing uncertainty with regard to our ability to obtain patents in the future, this combination of events has created uncertainty with respect to the value of patents once obtained. Depending on future actions by the U.S. Congress, the federal courts, and the USPTO, the laws and regulations governing patents could change in unpredictable ways that would weaken our ability to obtain new patents or to enforce our existing patents and patents that we might obtain in the future.\nObtaining and maintaining our patent protection depends on compliance with various procedural, document submission, fee payment and other requirements imposed by governmental patent agencies, and our patent protection could be reduced or eliminated for non-compliance with these requirements.\nThe USPTO and various foreign patent agencies require compliance with a number of procedural, documentary, fee payment and other provisions to maintain patent applications and issued patents. Noncompliance with these requirements can result in abandonment or lapse of a patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. In such an event, competitors might be able to enter the market earlier than would otherwise have been the case.\nWe may not be able to enforce our intellectual property rights throughout the world.\nThe laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. The legal systems of some countries, particularly developing countries, do not favor the enforcement of patents and other intellectual property protection, especially those relating to life sciences. This could make it difficult for us to stop the infringement of our patents or the misappropriation of our other intellectual property rights. For example, many foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties.\n47\nProceedings to enforce our patent rights in foreign jurisdictions, whether or not successful, could result in substantial costs and divert our efforts and attention from other aspects of our business. Furthermore, while we intend to protect our intellectual property rights in our expected significant markets, we cannot ensure that we will be able to initiate or maintain similar efforts in all jurisdictions in which we may wish to market our products. Accordingly, our efforts to protect our intellectual property rights in such countries may be inadequate. In addition, changes in the law and legal decisions by courts in the United States and foreign countries may affect our ability to obtain and enforce adequate intellectual property protection for our technology.\nWe may be subject to claims that we or our employees have misappropriated the intellectual property, including know-how or trade secrets, of a third party, or claiming ownership of what we regard as our own intellectual property.\nMany of our employees, consultants and contractors were previously employed at or engaged by other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Some of these employees, consultants and contractors, executed proprietary rights, non-disclosure and non-competition agreements in connection with such previous employment. Although we try to ensure that our employees, consultants and contractors do not use the intellectual property and other proprietary information or know-how or trade secrets of others in their work for us, and do not perform work for us that is in conflict with their obligations to another employer or any other entity, we may be subject to claims that we or these employees, consultants and contractors have used or disclosed such intellectual property, including know-how, trade secrets or other proprietary information. In addition, an employee, advisor or consultant who performs work for us may have obligations to a third party that are in conflict with their obligations to us, and as a result such third party may claim an ownership interest in the intellectual property arising out of work performed for us. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel, or access to consultants and contractors. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to management.\nIn addition, while we typically require our employees, consultants and contractors who may be involved in the development of intellectual property to execute agreements assigning such intellectual property to us, we may be unsuccessful in executing such an agreement with each party who in fact develops intellectual property that we regard as our own, which may result in claims by or against us related to the ownership of such intellectual property. If we fail in prosecuting or defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights. Even if we are successful in prosecuting or defending against such claims, litigation could result in substantial costs and be a distraction to our management and scientific personnel.\nRisks Related to Our Common Stock\nOur stock price may be volatile and our stockholders may not be able to resell shares of our common stock at or above the price they paid.\nThe trading price of our common stock is highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. These factors include those discussed in this “Risk Factors” section of this Quarterly Report on Form 10Q and others such as:\n| • | results from, or any delays in, clinical trial programs relating to our product candidates, including the ongoing and planned clinical trials for tenapanor; |\n\n| • | ability to commercialize or obtain regulatory approval for our product candidates, or delays in commercializing or obtaining regulatory approval; |\n\n| • | announcements of regulatory approval or a complete response letter to tenapanor, or specific label indications or patient populations for its use, or changes or delays in the regulatory review process; |\n\n| • | announcements relating to future collaboration partnerships or our existing collaboration partnerships with AstraZeneca and/or Sanofi, including decisions regarding the exercise by AstraZeneca or Sanofi of their options or any termination by them of any development program under their collaboration partnerships with us; |\n\n| • | our election, and the related announcement, to exercise our co-fund right with respect to the first Phase 3 clinical development program for tenapanor; |\n\n| • | announcements of therapeutic innovations or new products by us or our competitors; |\n\n| • | adverse actions taken by regulatory agencies with respect to our clinical trials, manufacturing supply chain or sales and marketing activities; |\n\n| • | changes or developments in laws or regulations applicable to our product candidates; |\n\n| • | any adverse changes to our relationship with any manufacturers or suppliers; |\n\n\n| • | the success of our testing and clinical trials; |\n\n48\n\n| • | the success of our efforts to acquire or license or discover additional product candidates; |\n\n| • | any intellectual property infringement actions in which we may become involved; |\n\n| • | announcements concerning our competitors or the pharmaceutical industry in general; |\n\n| • | achievement of expected product sales and profitability; |\n\n| • | manufacture, supply or distribution shortages; |\n\n| • | actual or anticipated fluctuations in our operating results; |\n\n| • | FDA or other U.S. or foreign regulatory actions affecting us or our industry or other healthcare reform measures in the United States; |\n\n| • | changes in financial estimates or recommendations by securities analysts; |\n\n| • | trading volume of our common stock; |\n\n| • | sales of our common stock by us, our executive officers and directors or our stockholders in the future; |\n\n| • | general economic and market conditions and overall fluctuations in the United States equity markets; and |\n\n| • | the loss of any of our key scientific or management personnel. |\n\nIn addition, the stock markets in general, and the markets for pharmaceutical, biopharmaceutical and biotechnology stocks in particular, have experienced extreme volatility that may have been unrelated to the operating performance of the issuer. These broad market fluctuations may adversely affect the trading price or liquidity of our common stock. In the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the issuer. If any of our stockholders were to bring such a lawsuit against us, we could incur substantial costs defending the lawsuit and the attention of our management would be diverted from the operation of our business, which could seriously harm our financial position. Any adverse determination in litigation could also subject us to significant liabilities.\nAn active, liquid and orderly market for our common stock may not develop or be sustained\nWe completed our IPO in June 2014. Prior to that, there had been no public market for shares of our common stock. Following our IPO, the trading volume of our common stock on The NASDAQ Global Market has been limited, and an active public market for our shares may not develop or, if it develops, be sustained.\nWe cannot predict the extent in which investor interest in our company will lead to the development of, or sustain an active trading market on The NASDAQ Global Market or otherwise or how liquid that market might become. The lack of an active market may impair our stockholders’ ability to sell their shares at the time they wish to sell them or at a price that they consider reasonable. An inactive market may also impair our ability to raise capital by selling shares and may impair our ability to acquire other businesses or technologies or in-license new product candidates using our shares as consideration.\nIf securities or industry analysts do not continue to publish research or reports about our business, or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline.\nThe trading market for our common stock is influenced by the research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or misleading opinion regarding us, our business model, our intellectual property or our stock performance, or if our clinical trials and operating results fail to meet the expectations of analysts, our stock price would likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.\nWe are an “emerging growth company” and as a result of the reduced disclosure and governance requirements applicable to emerging growth companies, our common stock may be less attractive to investors.\nWe are an “emerging growth company,” as defined in the JOBS Act, and we intend to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. If some investors find our common stock less attractive as a result of our reliance on the JOBS Act exemption, there may be a less active trading market for our common stock and our stock price may be more volatile. We may take advantage of these reporting exemptions until we are no longer an emerging growth company. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in\n49\nwhich we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\nIf we sell shares of our common stock in future financings, stockholders may experience immediate dilution and, as a result, our stock price may decline.\nWe may from time to time issue additional shares of common stock at a discount from the current trading price of our common stock. As a result, our stockholders would experience immediate dilution upon the purchase of any shares of our common stock sold at such discount. In addition, as opportunities present themselves, we may enter into financing or similar arrangements in the future, including the issuance of debt securities, preferred stock or common stock. If we issue common stock or securities convertible into common stock, our common stockholders would experience additional dilution and, as a result, our stock price may decline.\nSales of a substantial number of shares of our common stock in the public market could cause our stock price to fall.\nIf our existing stockholders sell, or indicate an intention to sell, substantial amounts of our common stock in the public market after the lock-up and other legal restrictions on resale in connection with our IPO lapse, the trading price of our common stock could decline. As of June 30, 2014, we had 18,529,067 shares of common stock outstanding. Of those shares, the 4,101,632 shares sold in our IPO are freely tradable, without restriction (except as otherwise applicable), in the public market. The remaining 827,268 shares sold in our IPO are subject to the lock-up agreements pertaining to our IPO.\nThe lock-up agreements pertaining to our IPO will expire on December 15, 2014. After the lock-up agreements expire, as of June 30, 2014, up to an additional 14,427,435 shares of common stock will be eligible for sale in the public market, 12,826,261 of which are held by current directors, executive officers and other affiliates and may be subject to Rule 144 under the Securities Act of 1933, or the Securities Act.\nIn addition, as of June 30, 2014, 1.1 million shares of common stock that are subject to outstanding options, will become eligible for sale in the public market to the extent permitted by the provisions of various vesting schedules, the lock-up agreements and Rule 144 and Rule 701 under the Securities Act. If these additional shares of common stock are sold, or if it is perceived that they will be sold, in the public market, the trading price of our common stock could decline.\nThe holders of approximately 12.4 million shares of our outstanding common stock as of June 30, 2014, are entitled to rights with respect to the registration of their shares under the Securities Act, subject to vesting schedules and to the lock-up agreements described above. Registration of these shares under the Securities Act would result in the shares becoming freely tradable without restriction under the Securities Act, except for shares purchased by affiliates. Any sales of securities by these stockholders could have a material adverse effect on the trading price of our common stock.\nOur principal stockholders and management own a significant percentage of our stock and will be able to exert significant control over matters subject to stockholder approval.\nAs of June 30, 2014, our executive officers, directors, holders of 5% or more of our capital stock and their respective affiliates beneficially owned approximately two-thirds of our outstanding voting stock. Therefore, these stockholders will have the ability to influence us through this ownership position. These stockholders may be able to determine all matters requiring stockholder approval. For example, these stockholders may be able to control elections of directors, amendments of our organizational documents, or approval of any merger, sale of assets, or other major corporate transaction. This may prevent or discourage unsolicited acquisition proposals or offers for our common stock that certain stockholders may feel are in their best interest as one of our stockholders.\nWe have broad discretion to determine how to use the funds raised in our IPO, and may use them in ways that may not enhance our operating results or the price of our common stock.\nOur management has broad discretion over the use of proceeds from our IPO, and we could spend the proceeds from this offering in ways our stockholders may not agree with or that do not yield a favorable return, if at all. We currently intend to use substantially all of the net proceeds of this offering to fund continued discovery and development efforts for our preclinical product candidates, the exercise of our right to co-fund the first Phase 3 clinical development program for tenapanor, if we decide to exercise such right, expenses related to the development of APECCS, and the balance for working capital and general corporate purposes, which will include facilities expansion and the pursuit of other research and discovery efforts and could also include the acquisition or in-license of other products, product candidates or technologies. However, our use of these proceeds may differ substantially from our current plans. If we do not invest or apply the proceeds of this offering in ways that improve our operating results, we may fail to achieve expected financial results, which could cause our stock price to decline.\n50\nProvisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable and may lead to entrenchment of management.\nOur amended and restated certificate of incorporation and amended and restated bylaws contain provisions that could significantly reduce the value of our shares to a potential acquirer or delay or prevent changes in control or changes in our management without the consent of our board of directors. The provisions in our charter documents include the following:\n| • | a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors; |\n\n| • | no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates; |\n\n| • | the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors; |\n\n| • | the required approval of at least 66 2/3% of the shares entitled to vote to remove a director for cause, and the prohibition on removal of directors without cause; |\n\n| • | the ability of our board of directors to authorize the issuance of shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquiror; |\n\n| • | the ability of our board of directors to alter our bylaws without obtaining stockholder approval; |\n\n| • | the required approval of at least 66 2/3% of the shares entitled to vote at an election of directors to adopt, amend or repeal our bylaws or repeal the provisions of our amended and restated certificate of incorporation regarding the election and removal of directors; |\n\n| • | a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders; |\n\n| • | the requirement that a special meeting of stockholders may be called only by the chairman of the board of directors, the chief executive officer, the president or the board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors; and |\n\n| • | advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us. |\n\nIn addition, these provisions would apply even if we were to receive an offer that some stockholders may consider beneficial.\nWe are also subject to the anti-takeover provisions contained in Section 203 of the Delaware General Corporation Law. Under Section 203, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other exceptions, the board of directors has approved the transaction.\nClaims for indemnification by our directors and officers may reduce our available funds to satisfy successful third-party claims against us and may reduce the amount of money available to us.\nOur amended and restated certificate of incorporation and amended and restated bylaws provide that we will indemnify our directors and officers, in each case to the fullest extent permitted by Delaware law.\nIn addition, as permitted by Section 145 of the Delaware General Corporation Law, our amended and restated bylaws and our indemnification agreements that we have entered into with our directors and officers provide that:\n| • | We will indemnify our directors and officers for serving us in those capacities or for serving other business enterprises at our request, to the fullest extent permitted by Delaware law. Delaware law provides that a corporation may indemnify such person if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of the registrant and, with respect to any criminal proceeding, had no reasonable cause to believe such person’s conduct was unlawful. |\n\n| • | We may, in our discretion, indemnify employees and agents in those circumstances where indemnification is permitted by applicable law. |\n\n51\n\n| • | We are required to advance expenses, as incurred, to our directors and officers in connection with defending a proceeding, except that such directors or officers shall undertake to repay such advances if it is ultimately determined that such person is not entitled to indemnification. |\n\n| • | We will not be obligated pursuant to our amended and restated bylaws to indemnify a person with respect to proceedings initiated by that person against us or our other indemnitees, except with respect to proceedings authorized by our board of directors or brought to enforce a right to indemnification. |\n\n| • | The rights conferred in our amended and restated bylaws are not exclusive, and we are authorized to enter into indemnification agreements with our directors, officers, employees and agents and to obtain insurance to indemnify such persons. |\n\n| • | We may not retroactively amend our amended and restated bylaw provisions to reduce our indemnification obligations to directors, officers, employees and agents. |\n\nWe do not currently intend to pay dividends on our common stock, and, consequently, our stockholders’ ability to achieve a return on their investment will depend on appreciation in the price of our common stock.\nWe do not currently intend to pay any cash dividends on our common stock for the foreseeable future. We currently intend to invest our future earnings, if any, to fund our growth. Additionally, the terms of our loan and security agreements could restrict our ability to pay dividends. Therefore, our stockholders are not likely to receive any dividends on our common stock for the foreseeable future. Since we do not intend to pay dividends, our stockholders’ ability to receive a return on their investment will depend on any future appreciation in the market value of our common stock. There is no guarantee that our common stock will appreciate or even maintain the price at which our holders have purchased it.\n\n\nITEM 2.\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\nUnregistered Sales of Equity Securities\nFrom April 1, 2014 through June 30, 2014, we sold and issued the following unregistered securities:\n1. In June 2014, upon the closing of our IPO, all of our then-outstanding shares of convertible preferred stock automatically converted into 11,517,222 shares of common stock, and all of our then-outstanding Series B warrants were net exercised into 571,244 shares of our common stock at an exercise price of $0.09 per share. The issuance of such shares of common stock was exempt from the registration requirements of the Securities Act pursuant to Section 3(a)(9) and Section 4(a)(2) of the Securities Act of 1933, as amended.\n2. We granted stock option to employees and directors under our 2008 Stock Incentive Plan and our 2014 Equity Incentive Plan covering an aggregate of 63,888 shares of common stock at a weighted average exercise price of $13.95 per share.\nUse of Proceeds\nOn June 18, 2014, the U.S. Securities and Exchange Commission declared effective our registration statement on Form S-1 (File No. 333-196090), as amended, filed in connection with our IPO. Pursuant to the registration statement, we registered the offer and sale of 4,286,000 shares of our common stock with an aggregate offering price of $60.0 million. With the full exercise of the underwriters’ over-allotment option, we sold and issued 4,928,900 shares of our common stock at a price to the public of $14.00 per share for an aggregate offering price of approximately $69.0 million. The managing underwriters of the offering were Citigroup Global Markets Inc., Leerink Partners LLC, JMP Securities LLC and Wedbush Securities Inc. After deducting underwriting discounts, commissions and offering expenses paid or payable by us of $7.8 million, the net proceeds from the offering were $61.2 million. No offering expenses were paid or are payable, directly or indirectly, to our directors or officers, to persons owning 10% or more of any class of our equity securities or to any of our affiliates.\nThe net proceeds from the IPO have been invested in money market funds.\nThere has been no material change in the expected use of the net proceeds from our IPO as described in our prospectus relating to our IPO.\n\n\nITEM 3.\nDefaults upon Senior Securities\nNot applicable.\n52\n\n\nITEM 4.\nMine Safety Disclosures\nNot applicable\n\n\nITEM 5.\nOther Information\nNone.\n\n\nITEM 6.\nExhibits\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(b) |\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6.(c) |\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.16 |\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\n\n53\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\n| 101.INS* | XBRL Instance Document | X |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n\n| # | Indicates management contract or compensatory plan. |\n\n\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\n\n54\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Ardelyx, Inc. |\n| Date: August 8, 2014 | By: | /s/ Michael Raab |\n| Michael Raab President Chief Executive Officer and Director (Principal Executive Officer) |\n\n55\nEXHIBIT INDEX\nExhibit Index\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/204 | 10.6(b) |\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(c) |\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.17 |\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\n\n56\n\n| Incorporated by Reference |\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\n| 101.INS* | XBRL Instance Document | X |\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\n\n\n| # | Indicates management contract or compensatory plan. |\n\n\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\n\n57\n\n</text>\n\nWhat is the increase in the overall exercise value of the options from December 31, 2013 to June 30, 2014, considering the balances at these dates and their respective weighted average exercise price per share (in thousands of dollars)?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nITEM 1.\\nFINANCIAL STATEMENTS\\nARDELYX, INC.\\nCondensed Balance Sheets\\n(In thousands, except share and per share amounts)\\n\\n| June 30,2014 | December 31,2013 |\\n| (Unaudited) |\\n| Assets |\\n| Current assets: |\\n| Cash and cash equivalents | $ | 117,814 | $ | 34,435 |\\n| Accounts receivable | 3,025 | 6,436 |\\n| Prepaid expenses and other current assets | 1,308 | 965 |\\n| Total current assets | 122,147 | 41,836 |\\n| Property and equipment, net | 1,138 | 530 |\\n| Other assets | 13 | 358 |\\n| Restricted cash | 180 | 180 |\\n| Total assets | $ | 123,478 | $ | 42,904 |\\n| Liabilities, convertible preferred stock, and stockholders’ equity (deficit) |\\n| Current liabilities: |\\n| Accounts payable | $ | 2,308 | $ | 2,284 |\\n| Accrued compensation and benefits | 802 | 927 |\\n| Other accrued liabilities | 1,003 | 95 |\\n| Deferred rent | — | 5 |\\n| Deferred revenue, current portion | 23,221 | 13,828 |\\n| Total current liabilities | 27,334 | 17,139 |\\n| Deferred revenue, non-current | 33,170 | 26,470 |\\n| Convertible preferred stock warrant liability | — | 6,456 |\\n| Liabilities related to early exercise of options | 107 | 163 |\\n| Total liabilities | 60,611 | 50,228 |\\n| Commitments and contingencies |\\n| Convertible preferred stock, $0.0001 par value per share — no shares and 108,829,748 shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares and 11,517,222 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | 56,155 |\\n| Stockholders’ equity (deficit): |\\n| Preferred stock, $0.0001 par value; 5,000,000 shares and no shares authorized as of June 30, 2014 and December 31, 2013, respectively; no shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | — | — |\\n| Common stock, $0.0001 par value — 300,000,000 and 130,360,121 shares authorized as of June 30, 2014 and December 31, 2013, respectively; 18,335,620 and 1,225,481 shares issued and outstanding as of June 30, 2014 and December 31, 2013, respectively | 2 | — |\\n| Additional paid-in capital | 130,836 | 5,174 |\\n| Accumulated deficit | (67,971 | ) | (68,653 | ) |\\n| Total stockholders’ equity (deficit) | 62,867 | (63,479 | ) |\\n| Total liabilities, convertible preferred stock, and stockholders’ equity (deficit) | $ | 123,478 | $ | 42,904 |\\n\\nSee accompanying notes.\\n2\\nARDELYX, INC.\\nCondensed Statements of Operations and Comprehensive Income (Loss)\\n(Unaudited)\\n(In thousands, except share and per share amounts)\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Revenue: |\\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 9,743 | $ | 3,978 |\\n| Collaborative development revenue | 2,630 | 5,302 | 7,944 | 9,869 |\\n| Total revenue | 9,137 | 7,291 | 17,687 | 13,847 |\\n| Operating expenses: |\\n| Research and development | 5,183 | 7,234 | 12,820 | 13,173 |\\n| General and administrative | 1,203 | 908 | 2,580 | 1,935 |\\n| Total operating expenses | 6,386 | 8,142 | 15,400 | 15,108 |\\n| Income (loss) from operations | 2,751 | (851 | ) | 2,287 | (1,261 | ) |\\n| Other expense, net | (8 | ) | (4 | ) | (12 | ) | (29 | ) |\\n| Change in fair value of preferred stock warrant liability | 1,010 | — | (1,593 | ) | — |\\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 682 | (1,290 | ) |\\n| Provision for income taxes | — | 36 | — | 71 |\\n| Net income (loss) and comprehensive income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\\n| Net income (loss) attributable to common stockholders: |\\n| Basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\\n| Diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\\n| Shares used to compute net income (loss) per share attributable to common stockholders: |\\n| Basic | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\\n| Diluted | 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\\n| Net income (loss) per share attributable to common stockholders: |\\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\\n\\nSee accompanying notes.\\n3\\nARDELYX, INC.\\nCondensed Statements of Cash Flows\\n(Unaudited)\\n(In thousands)\\n\\n| Six Months Ended June 30, |\\n| 2014 | 2013 |\\n| Operating activities |\\n| Net income (loss) | $ | 682 | $ | (1,361 | ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |\\n| Depreciation and amortization expense | 128 | 356 |\\n| Stock-based compensation | 163 | 190 |\\n| Change in fair value of preferred stock warrant liability | 1,593 | — |\\n| Changes in operating assets and liabilities: |\\n| Accounts receivable | 3,411 | (3,912 | ) |\\n| Prepaid and other current assets | (343 | ) | (496 | ) |\\n| Other assets | 345 | (731 | ) |\\n| Accounts payable | 24 | 1,131 |\\n| Accrued compensation and benefits | (125 | ) | (377 | ) |\\n| Other accrued liabilities | 908 | (572 | ) |\\n| Deferred revenue | 16,093 | (2,863 | ) |\\n| Deferred rent | (5 | ) | (262 | ) |\\n| Net cash provided by (used in) operating activities | 22,874 | (8,897 | ) |\\n| Investing activities |\\n| Purchases of property and equipment | (736 | ) | (257 | ) |\\n| Net cash used in investing activities | (736 | ) | (257 | ) |\\n| Financing activities |\\n| Proceeds from issuance of common stock | 61,241 | 2 |\\n| Repurchase of unvested common stock | — | (2 | ) |\\n| Net cash provided by financing activities | 61,241 | — |\\n| Net increase (decrease) in cash and cash equivalents | 83,379 | (9,154 | ) |\\n| Cash and cash equivalents at beginning of period | 34,435 | 32,903 |\\n| Cash and cash equivalents at end of period | $ | 117,814 | $ | 23,749 |\\n\\nSee accompanying notes.\\n4\\nARDELYX, INC.\\nNotes to the Unaudited Interim Condensed Financial Statements\\n1. Organization and Basis of Presentation\\nArdelyx, Inc. (the “Company”) is a clinical stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal tract to treat cardio-renal, gastrointestinal and metabolic diseases. The Company has developed a drug discovery and design platform enabling it, in a rapid and cost-efficient manner, to discover and design novel drug candidates. The Company was incorporated in Delaware on October 17, 2007, under the name Nteryx and changed its name to Ardelyx, Inc. in June 2008.\\nThe Company operates in only one business segment, which is the development of biopharmaceutical products.\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) and following the requirements of the Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. GAAP can be condensed or omitted. These financial statements have been prepared on the same basis as the Company’s annual financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments that are necessary for a fair statement of the Company’s financial information. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the year ending December 31, 2014 or for any other interim period or for any other future year. The balance sheet as of December 31, 2013 has been derived from audited financial statements at that date but does not include all of the information required by U.S. GAAP for complete financial statements.\\nThe accompanying condensed financial statements and related financial information should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 31, 2013 included in the Company’s Prospectus filed pursuant to Rule 424(b)(4) on June 19, 2014 with the SEC (the “Prospectus”).\\nReverse Stock Split\\nOn June 18, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective resulting in a reverse split of the Company’s common stock and convertible preferred stock at a 1-for-9 ratio (the “Reverse Stock Split”). The par value and the authorized shares of the common stock and convertible preferred stock were not adjusted as a result of the Reverse Stock Split. All issued and outstanding common stock, convertible preferred stock, warrants for preferred stock, options for common stock and per share amounts contained in the financial statements have been retroactively adjusted to reflect this Reverse Stock Split for all periods presented.\\nInitial Public Offering\\nOn June 18, 2014, the Company’s registration statement on Form S-1 (File No. 333-196090) relating to the initial public offering (the “IPO”) of its common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time the Company sold 4,928,900 shares of its common stock, which included the exercise in full by the underwriters of the IPO of their option to purchase 642,900 additional shares of the Company’s common stock. The Company received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by the Company.\\nOn June 24, 2014, prior to the closing of the IPO, all outstanding shares of convertible preferred stock converted into 11,517,222 shares of common stock with the related carrying value of $56.2 million reclassified to common stock and additional paid-in capital. In addition, all convertible preferred stock warrants were net exercised and converted into common stock and the related convertible preferred stock warrant liability was reclassified to additional paid-in capital.\\nOn June 24, 2014, the Company’s Amended and Restated Certificate of Incorporation became effective and the number of shares of capital stock the Company is authorized to issue was increased to 305,000,000 shares, of which 300,000,000 shares may be common stock and 5,000,000 shares may be preferred stock. Both the common stock and preferred stock have a par value of $0.0001 per share. There are no shares of preferred stock outstanding at June 30, 2014.\\n5\\n2. Summary of Significant Accounting Policies\\nUse of Estimates\\nThe preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, management evaluates its estimates, including those related to revenue recognition, clinical trial accruals, income taxes, and stock-based compensation. Management bases its estimates on historical experience and on various other market-specific and relevant assumptions that management believes to be reasonable under the circumstances. Actual results may differ from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments purchased with an original maturity date of 90 days or less on the date of purchase to be cash equivalents. The Company invests its cash in bank deposits and money market accounts.\\nRestricted Cash\\nThe Company is required to guarantee the credit limit on its corporate credit card with a certificate of deposit of $100,000. The collateral will be released upon the cancellation of the corporate credit card.\\nThe Company is required under its facility lease agreement to maintain a line of credit with a bank in the amount of $80,000 for the benefit of the lessor. The line of credit is secured by a cash deposit with the bank. The cash deposit will be released upon expiration of the line of credit.\\nComprehensive Income (Loss)\\nComprehensive income (loss) is composed of two components: net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to gains and losses that under GAAP are recorded as an element of stockholders’ equity (deficit), but are excluded from net income (loss). The Company did not record any transactions within other comprehensive income (loss) in the periods presented and, therefore, the net income (loss) and comprehensive income (loss) were the same for all periods presented.\\nRevenue Recognition\\nRevenue from research activities made under collaboration partnership agreements are recognized as the services are provided and when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. Revenue generated from research and licensing agreements typically includes up-front signing or license fees, cost reimbursements, research services, minimum sublicense fees, milestone payments, and royalties on future licensees’ product sales.\\nFor revenue agreements with multiple-element arrangements, such as license and development agreements, the Company allocates revenue to each non-contingent deliverable based on the relative selling price of each deliverable. When applying the relative selling price method, the Company determines the selling price for each deliverable using vendor-specific objective evidence or third-party evidence. If neither exists, the Company uses its best estimate of selling price for that deliverable. Revenue allocated is then recognized when the four basic revenue recognition criteria are met for each deliverable.\\nThe Company recognizes revenue from upfront payments ratably over the term of its estimated period of performance under the agreement which is recorded as licensing revenue. Reimbursements for development costs incurred under the Company’s license agreement with AstraZeneca are classified as collaborative development revenue. The Company recognizes cost reimbursement revenue under collaboration partnership agreements as the related research and development costs for services are rendered. Deferred revenue represents the portion of research or license payments received which has not been earned.\\nRevenues from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestones. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. The Company will recognize revenue associated with the non-substantive milestones upon achievement of the milestone if there are no undelivered elements and it has no remaining performance obligations. The Company will account for sales-based milestones as royalties that will be recognized as revenue upon achievement of the milestone.\\n6\\nNet Income (Loss) per Share Attributable to Common Stockholders\\nBasic net income (loss) per share attributable to common stockholders is calculated by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Prior to the Company’s IPO of its common stock, the Company’s Series A and Series B convertible preferred stock was entitled to receive dividends of up to $0.8181 and $0.2781 per share, respectively, prior and in preference to any declaration or payment of any dividend on common stock and thereafter participate pro rata on an as converted basis with the common stock holders on any distributions to common stockholders. The convertible preferred shares were therefore considered to be participating securities. As a result, the Company calculated the net income (loss) per share using the two-class method. Accordingly, the net income (loss) attributable to common stockholders is derived from the net income (loss) for the period and, in periods in which the Company has net income attributable to common stockholders, an adjustment is made for the noncumulative dividends and allocations of earnings to participating securities based on their outstanding shareholder rights. Under the two-class method, the net loss attributable to common stockholders is not allocated to the convertible preferred stock as the convertible preferred stock did not have a contractual obligation to share in the Company’s losses. The diluted net income per share attributable to common stockholders is computed by giving effect to all potential dilutive common stock equivalents outstanding for the period. In periods when we have incurred a net loss, convertible preferred stock, options to purchase common stock and convertible preferred stock warrants are considered common stock equivalents but have been excluded from the calculation of diluted net loss per share attributable to common stockholders as their effect is antidilutive.\\nRecent Accounting Pronouncement\\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update (“ASU”) 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. The Company adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time the Company may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. The Company has not yet selected a transition method nor has the Company determined the impact of the new standard on its financial statements and related disclosures.\\n3. Fair Value Measurements\\nFinancial assets and liabilities are recorded at fair value. The carrying amounts of certain of the Company’s financial instruments, including cash equivalents, accounts receivable and accounts payable, are valued at cost, which approximates fair value due to their short maturities. The accounting guidance for fair value provides a framework for measuring fair value, and requires certain new disclosures about how fair value is determined. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting guidance also establishes a three-level valuation hierarchy that prioritizes the inputs to valuation techniques used to measure fair value based upon whether such inputs are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions made by the reporting entity.\\nThe three-level hierarchy for the inputs to valuation techniques is briefly summarized as follows:\\n\\n| Level 1 | – | Observable inputs such as quoted prices (unadjusted) for identical instruments in active markets. |\\n| Level 2 | – | Observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or model-derived valuations whose significant inputs are observable. |\\n| Level 3 | – | Unobservable inputs that reflect the reporting entity’s own assumptions. |\\n\\n7\\nThe following table sets forth the fair value of the Company’s financial assets and liabilities measured on a recurring basis by level within the fair value hierarchy:\\n\\n| June 30, 2014 |\\n| Total | Level 1 | Level 2 | Level 3 |\\n| (In thousands) |\\n| Assets: |\\n| Money market funds | $ | 116,653 | $ | 116,653 | $ | — | $ | — |\\n| Certificates of deposit | 180 | — | 180 | — |\\n| Total | $ | 116,833 | $ | 116,653 | $ | 180 | $ | — |\\n\\n\\n| December 31, 2013 |\\n| Total | Level 1 | Level 2 | Level 3 |\\n| (In thousands) |\\n| Assets: |\\n| Money market funds | $ | 32,472 | $ | 32,472 | $ | — | $ | — |\\n| Certificates of deposit | 180 | — | 180 | — |\\n| Total | $ | 32,652 | $ | 32,472 | $ | 180 | $ | — |\\n| Liabilities: |\\n| Convertible preferred stock warrant liability | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\\n| Total | $ | 6,456 | $ | — | $ | — | $ | 6,456 |\\n\\nWhere quoted prices are available in an active market, securities are classified as Level 1. The Company classifies money market funds as Level 1. When quoted market prices are not available for the specific security, then the Company estimates fair value by using benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. The Company classifies certificates of deposit as Level 2. In certain cases where there is limited activity or less transparency around inputs to valuation, securities are classified as Level 3. There were no transfers between Level 1 and Level 2 during the periods presented.\\nLevel 3 liabilities that are measured at fair value on a recurring basis consist of the preferred stock warrant liability, which was measured using the probability weighted expected return method that calculated the probability of the Company going public or being acquired, and the option-pricing method for remaining private in the near to mid-term. The fair value of the preferred stock warrant liability as of December 31, 2013 was estimated using such scenarios that were weighted based on the Company’s estimate of the probability of each scenario: 20% for IPO; 10% for merger and 70% for stay private as of December 31, 2013. The preferred stock warrant liability was remeasured prior to the net exercise of the warrants using the IPO price. At the end of each reporting period, the change in estimated fair value during the period is recorded in change in fair value of convertible preferred stock warrant liability in the statements of operations and comprehensive income (loss). Generally, increases or decreases in the fair value of the underlying convertible preferred stock would result in a directionally similar impact in the fair value measurement of the warrant liability. The preferred stock warrants were net exercised and converted to common stock upon the completion of the IPO and are no longer subject to remeasurement.\\nThe following table sets forth a summary of the changes in the estimated fair value of the Company’s preferred stock warrants which were measured at fair value on a recurring basis (in thousands):\\n\\n| ConvertiblePreferred StockWarrant Liability |\\n| Balance at December 31, 2013 | $ | 6,456 |\\n| Net increase in fair value of warrant liabilities upon revaluation | 1,593 |\\n| Reclassification of warrant liability to additional paid-in capital | (8,049 | ) |\\n| Balance at June 30, 2014 | $ | — |\\n\\n8\\n4. Collaboration and Licensing agreements\\nAstraZeneca AB (“AstraZeneca”)\\nUnder the terms of the AstraZeneca collaboration partnership agreement, the Company received an up-front license fee of $35.0 million in October 2012 and a $15.0 million payment in December 2013, which are both being recognized as revenue on a straight-line basis over the estimated period of performance, which is currently estimated to be December 2016. AstraZeneca reimburses the Company for its internal and external development-related costs. These reimbursements are recognized as collaborative development revenue when the development-related costs are incurred.\\nIn May 2014, the Company received from AstraZeneca a $25.0 million payment as a result of the dosing of the first patient in the Phase 2b clinical trial in hyperphosphatemia. As the $25.0 million did not meet the criteria to be considered the achievement of a substantive milestone for accounting purposes, the amount was recorded as deferred revenue when received and is being recognized as revenue on a straight-line basis over the remaining estimated period of performance under the AstraZeneca collaboration partnership agreement, which is currently estimated to be December 2016.\\nAs of June 30, 2014, the Company was eligible to receive future contingent payments up to a total of $795.0 million, which is comprised of future development milestones up to an additional $197.5 million and launch, commercialization, and sales milestones up to an additional $597.5 million. The contingent payments are triggered upon the activities expected to be undertaken by AstraZeneca. Revenue from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestone. The Company will recognize revenue associated with non-substantive milestones upon achievement of the milestones if there are no undelivered elements and it has no remaining performance obligation. To the extent that non-substantive milestones are achieved and the Company has remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance.\\nFor the three months ended June 30, 2014 and 2013, the Company recognized revenue of $6.5 million and $2.0 million, respectively, related to amortization of the up-front and other license fees, and $2.6 million and $5.3 million for collaborative development services. For the six months ended June 30, 2014 and 2013, the Company recognized revenues of $9.7 million and $4.0 million, respectively, related to amortization of the up-front and other license fees, and $7.9 million and $9.9 million for collaborative development services. As of June 30, 2014 and December 31, 2013, the Company had total deferred revenue of $56.4 million and $40.3 million related to the AstraZeneca license agreement.\\nSanofi SA (“Sanofi”)\\nIn February 2014, the Company entered into a License Option and License Agreement with Sanofi (“Option and License Agreement”) for its NaP2b phosphate transport inhibitor program. NaP2b is an intestinal phosphate transporter whose activity accounts for a significant portion of dietary phosphate absorption in humans. The inhibition of NaP2b is believed to have utility for the treatment of hyperphosphatemia (elevated serum phosphate) in patients with end stage renal disease (ESRD) and other forms of chronic kidney disease (CKD). Under the Option and License Agreement, the Company granted Sanofi an exclusive worldwide license to conduct research utilizing the Company’s small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize the Company’s NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under the Option and License Agreement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the Option and License Agreement, the Company received a payment of $1.25 million, which was recognized as revenue after the Company provided to Sanofi the background know-how, listed patents, and materials (together, the “Technology Transfer Deliverables”) in May 2014 pursuant to the Option and License Agreement.\\nThe Company has the potential to earn future development, regulatory and commercial milestone payments of up to $196.8 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, the Company will receive tiered royalties ranging from mid-single digits into the low double digits. As part of the arrangement with Sanofi, the Company retains an option to participate in co-promotional activities in the United States. Future potential milestone payments do not meet the criteria to be considered substantive milestones, and therefore will be treated as other contingent consideration and recognized as revenue as they are achieved as the Company has no performance obligations under the Option and License Agreement. No milestones have been received since the inception of the agreement.\\n9\\n5. Stock Incentive Plan\\nAs of June 30, 2014, a total of 2,149,021 shares of common stock had been reserved for issuance under the 2008 Plan, and no shares are available for future grant. The 2014 Equity Incentive Award Plan (“2014 Plan”) became effective on June 18, 2014, immediately prior to the time the Company’s Registration Statement on Form S-1 became effective. Under the 2014 Plan, 1,419,328 shares of common stock were initially reserved for issuance pursuant to a variety of stock-based compensation awards, including stock options, stock appreciation rights, or SARs, restricted stock awards, restricted stock unit awards, deferred stock awards, deferred stock unit awards, dividend equivalent awards, stock payment awards and performance awards. In addition, 35,221 shares that had been available for future awards under the 2008 Plan as of June 18, 2014, were added to the initial reserve available under the 2014 Plan, bringing the total reserve upon the effective date of the 2014 Plan to 1,454,549. The number of shares initially reserved for issuance or transfer pursuant to awards under the 2014 Plan will be increased by (i) the number of shares represented by awards outstanding under 2008 Plan on June 18, 2014, that are forfeited or lapse unexercised (ii) if approved by the Administrator of the 2014 Plan, an annual increase on the first day of each fiscal year beginning in 2015 and ending in 2024, equal to the lesser of (A) four percent (4.0%) of the shares of stock outstanding (on an as converted basis) on the last day of the immediately preceding fiscal year and (B) such smaller number of shares of stock as determined by our board of directors; provided, however, that no more than 10,683,053 shares of stock may be issued upon the exercise of incentive stock options. The Company also adopted the 2014 Employee Stock Purchase Plan (ESPP) and initially reserved 202,762 shares of common stock as of its effective date of June 18, 2014. If approved by the Administrator of the ESPP, on the first day of each calendar year, beginning in 2015 and ending in 2024, the number of shares in the reserve will increase by at least an amount equal to the lesser of (i) one percent (1.0%) of the shares of common stock outstanding on the last day of the immediately preceding fiscal year and (ii) such number of shares of common stock as determined by the board of directors; provided, however, no more than 2,230,374 shares of our common stock may be issued under the ESPP.\\nThe following table summarizes activity under the 2008 Plan and the 2014 Plan, including grants to nonemployees and restricted stock issued:\\n\\n| Shares Availablefor Grant | OptionsOutstanding | WeightedAverageExercise Priceper Share | AggregateIntrinsicValue(in thousands) |\\n| Balances at December 31, 2013 | 3,914 | 1,162,829 | $ | 1.03 |\\n| Options authorized under the 2008 Plan | 33,333 | — |\\n| Options authorized under the 2014 Plan | 1,419,328 | — |\\n| Options granted | (63,888 | ) | 63,888 | 13.95 |\\n| Options cancelled | 1,862 | (1,862 | ) | 0.77 |\\n| Options exercised | — | (92,781 | ) | 0.60 |\\n| Balances at June 30, 2014 | 1,394,549 | 1,132,074 | $ | 1.79 | $ | 16,050 |\\n| Vested at June 30, 2014 | 576,049 | $ | 0.91 | $ | 8,678 |\\n| Expected to vest at June 30, 2014 | 1,132,074 | $ | 1.79 | $ | 16,050 |\\n\\nThe weighted-average grant-date estimated fair value of options granted during the three and six months ended June 30, 2014 was $10.98 and $10.96, respectively, and during the three and six months ended June 30, 2013 was $0 and $2.65 per share, respectively. The aggregate intrinsic value was calculated as the difference between the exercise price of the options and the estimated fair value of the Company’s common stock of $15.97 per share as of June 30, 2014.\\nLiability for Early Exercise of Stock Options\\nAs of June 30, 2014 and December 31, 2013, there were 193,447 and 286,217 shares of common stock outstanding, respectively, subject to the Company’s right of repurchase at prices ranging from $0.27 to $1.08 per share. As of June 30, 2014 and December 31, 2013, the Company recorded $107,000 and $163,000, respectively, as liabilities associated with shares issued with repurchase rights.\\n10\\nStock-based Compensation\\nTotal stock-based compensation recognized was as follows (in thousands):\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Research and development | $ | 38 | $ | 50 | $ | 75 | $ | 99 |\\n| General and administrative | 61 | 32 | 88 | 91 |\\n| Total | $ | 99 | $ | 82 | $ | 163 | $ | 190 |\\n\\nAs of June 30, 2014 and December 31, 2013, there was $1.1 million and $549,000, respectively, of unrecognized stock-based compensation expense, net of estimated forfeitures, related to unvested share options with a weighted-average remaining recognition period of 1.6 and 1.8 years.\\nThe fair value of stock option awards to employees was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Expected term (years) | 5.77 | — | 5.79 | 6.08 |\\n| Volatility | 101 | % | — | 101 | % | 97 | % |\\n| Risk-free interest rate | 1.76 | % | — | 1.77 | % | 1.05 | % |\\n| Dividend yield | — | % | — | — | % | — | % |\\n\\nFor the three months ended June 30, 2013, there were no stock options granted.\\n6. Net Income (Loss) per Share Attributable to Common Stockholders\\nThe following table sets forth the computation of the unaudited basic and diluted net income (loss) per share attributable to common stockholders (in thousands, except share and per share data):\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 682 | $ | (1,361 | ) |\\n| Noncumulative dividends on convertible preferred stock | (1,099 | ) | — | (682 | ) | — |\\n| Undistributed earnings allocated to participating securities | (2,139 | ) | — | — | — |\\n| Net income (loss) attributable to common stockholders, basic | $ | 515 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\\n| Adjustment to undistributed earnings allocated to participating securities | 188 | — | — | — |\\n| Net income (loss) attributable to common stockholders, diluted | $ | 703 | $ | (891 | ) | $ | — | $ | (1,361 | ) |\\n| Basic shares: |\\n| Weighted average common shares outstanding | 2,611,259 | 1,102,093 | 1,937,509 | 1,072,583 |\\n| Diluted shares: |\\n| Weighted average effect of dilutive stock options | 765,672 | — | — | — |\\n| Weighted average convertible preferred stock warrants outstanding | 527,205 | — | — | — |\\n| 3,904,136 | 1,102,093 | 1,937,509 | 1,072,583 |\\n| Net income (loss) per share attributable to common stockholders: |\\n| Basic | $ | 0.20 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\\n| Diluted | $ | 0.18 | $ | (0.81 | ) | $ | — | $ | (1.27 | ) |\\n\\n11\\nThe following outstanding shares of common stock equivalents were excluded from the computation of diluted net income (loss) per share attributable to common stockholders for the periods presented because including them would have been antidilutive:\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Convertible preferred stock | — | 11,517,222 | — | 11,517,222 |\\n| Options to purchase common stock | 12,459 | 1,215,262 | 1,132,074 | 1,215,262 |\\n| Warrants to purchase convertible preferred stock | — | 574,953 | — | 574,953 |\\n| Total | 12,459 | 13,307,437 | 1,132,074 | 13,307,437 |\\n\\n7. Related Party Transactions\\nAs part of the consulting arrangement with the spouse of an executive of the Company to provide research and development services related to clinical operations, the Company incurred expenses of $60,000 and $64,000 for services rendered during the three months ended June 30, 2014 and 2013, respectively and $120,000 and $126,000 for services rendered during the six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014 and December 31, 2013, the Company owed $20,000 and $18,000, respectively, to the individual, which is recorded in accounts payable.\\n12\\n\\n\\nITEM 2.\\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.\\nYou should read the following discussion in conjunction with our condensed financial statements (unaudited) and related notes included elsewhere in this report. This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. All statements other than statements of historical facts contained in this report are forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “could,” “will,” “would,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “intend,” “predict,” “seek,” “contemplate,” “potential” or “continue” or the negative of these terms or other comparable terminology. These forward-looking statements, include, but are not limited to, the initiation, timing, progress and results of our preclinical studies and clinical trials, and our research and development programs; our ability to advance product candidates into, and successfully complete, clinical trials; our receipt of future milestone payments and/or royalties, and the expected timing of such payments; our collaborators’ exercise of their license options; the commercialization of our product candidates; the implementation of our business model, strategic plans for our business, product candidates and technology; the scope of protection we are able to establish and maintain for intellectual property rights covering our product candidates and technology; estimates of our expenses, future revenues, capital requirements and our needs for additional financing; the timing or likelihood of regulatory filings and approvals; our ability to maintain and establish collaborations or obtain additional government grant funding; our use of proceeds from our IPO; our financial performance; and developments relating to our competitors and our industry. These statements reflect our current views with respect to future events or our future financial performance, are based on assumptions, and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Factors that may cause actual results to differ materially from current expectations include, among other things, those listed under “Risk Factors” in the Prospectus or described elsewhere in this Quarterly Report on Form 10-Q. These forward-looking statements speak only as of the date hereof. Except as required by law, we assume no obligation to update or revise these forward-looking statements for any reason, even if new information becomes available in the future. Unless the context requires otherwise, in this Quarterly Report on Form 10-Q, the terms “Ardelyx,” “Company,” “we,” “us” and “our” refer to Ardelyx, Inc., a Delaware corporation.\\nOverview\\nWe are a clinical-stage biopharmaceutical company focused on the discovery, development and commercialization of innovative, non-systemic, small molecule therapeutics that work exclusively in the gastrointestinal, or GI, tract to treat cardio-renal, GI and metabolic diseases. We have developed a proprietary drug discovery and design platform enabling us, in a rapid and cost-efficient manner, to discover and design novel drug candidates. Utilizing our platform, we discovered and designed our lead product candidate, tenapanor, which in preclinical and clinical studies has consistently demonstrated the ability to reduce the absorption of dietary sodium and phosphorus. To enhance our proprietary drug discovery and design platform, we have developed a cell-culture system to simulate gut tissues called the Ardelyx Primary Enterocyte and Colonocyte Culture System, or APECCS. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. In addition to tenapanor, we have discovered small molecule NaP2b inhibitors for the treatment of hyperphosphatemia in end stage renal disease, or ESRD, a program we have licensed to Sanofi S.A., or Sanofi. We are also independently advancing three other discovery and lead development programs focused in cardio-renal, GI and metabolic diseases.\\nIn October 2012, we entered into a collaboration partnership with AstraZeneca AB, or AstraZeneca, for the worldwide development and commercialization of tenapanor. AstraZeneca is responsible for all of the development and commercialization costs for tenapanor, and we have retained an option to co-promote in the United States. Together with AstraZeneca, we are evaluating tenapanor in three Phase 2 clinical trials in patients with ESRD, late-stage CKD, and constipation-predominant irritable bowel syndrome, or IBS-C. If we exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. In December 2013, we entered into an amendment to the license agreement to acknowledge the intention of AstraZeneca to commence development of tenapanor for the treatment of hyperphosphatemia in ESRD patients and to provide additional clarification for certain payments. There was no change in the total consideration that we could receive under the agreement.\\nThrough our participation with AstraZeneca on a development collaboration committee, we are involved in the management and oversight of the development of tenapanor and participation will continue until all of Phase 2 clinical trials with tenapanor have been completed. In addition, we are directly responsible for the conduct of certain specified clinical trials being conducted with tenapanor. AstraZeneca reimburses us for our internal and external costs related to those development efforts, and any other development efforts that may be assigned to us by the development collaboration committee. We were initially responsible for supplying tenapanor for use in development. The agreement also obligates us to transfer the technology and other necessary information such that AstraZeneca will be able to assume the responsibility for the supply of the drug product for use in later-stage clinical trials.\\n13\\nUnder the terms of the agreement with AstraZeneca, we received a $35.0 million upfront payment and we are eligible to receive up to $237.5 million in development milestones, of which we have received $40.0 million as of June 30, 2014. The $40.0 million in development milestones consists of a payment of $15.0 million that we received in December 2013 and a payment of $25.0 million that we received in May 2014 as a result of the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014. In addition to the $237.5 million in total development milestones, we are also eligible to receive up to $597.5 million in sales and launch milestones. Through June 30, 2014, we also received $29.1 million in reimbursement for our development efforts provided under the agreement. We are also eligible to receive incremental tiered royalties based on aggregate annual net sales of each licensed product starting in the high single digits and increasing to high teen percentages as annual net sales increase, subject to an increase related to our co-fund election, if we decide to make such an election.\\nWe have identified the deliverables within the arrangement as a license to the technology, the initial supply of the compound of the licensed product for use in development, and ongoing development activities through completion of all Phase 2 clinical trials to be conducted with tenapanor, which are accounted for as a single unit of accounting. We have concluded that the license is not a separate unit of accounting. It does not have stand-alone value to AstraZeneca, separable from the development services to be performed pursuant to the agreement, as AstraZeneca is unable to use the license for its intended purpose without our performance of the development services, which includes the initial supply of the compound of the licensed product. As a result, we recognize revenue from the $35.0 million up-front payment on a straight-line basis over the period from the effective date of the agreement through the completion of all Phase 2 clinical trials to be conducted with tenapanor, which we currently estimate to be December 2016, and we recognize revenue from the $15.0 million and the $25.0 million development milestone payments on a straight-line basis over the same estimated completion date.\\nIn 2014, we entered into an option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors. In addition, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi is advancing this program towards first-in-human clinical trials. Under our arrangement, Sanofi is responsible for all of the costs and expenses for research and preclinical activities and, should it exercise its option, for the development and commercialization efforts under the program. Under the license option and license agreement, we received an upfront payment of $1.25 million and are responsible for up to $0.2 million of patent costs, at which point any additional patent costs will be fully reimbursed to us by Sanofi. We have the potential to earn future development, regulatory and commercial milestone payments of up to $196.75 million if Sanofi continues to advance the program into development and through commercialization. If a NaP2b inhibitor is commercialized by Sanofi as a result of this program, we will receive tiered royalties ranging from the mid-single digits into the low double digits. As part of our agreement with Sanofi, we retain an option to co-promote licensed products in the United States. We recognized the $1.25 million to revenue after we completed the Technology Transfer Deliverables in May 2014 pursuant to the Option and License Agreement.\\nOur revenue to date has been generated from collaboration and license revenue pursuant to our license agreements with AstraZeneca, and Sanofi. We have not generated any commercial product revenue. As of June 30, 2014, we had accumulated deficit of $68.0 million. We have incurred significant losses in the past and may continue to incur significant losses in the future as we advance our unpartnered preclinical programs. The significance of future losses will be dependent in part on whether AstraZeneca continues to develop and advance tenapanor, and whether Sanofi exercises its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors, which in either case would result in milestone payments to us. There can be no assurance that we will receive additional collaboration revenue in the future.\\nInitial Public Offering\\nOn June 18, 2014, our registration statement on Form S-1 (File No. 333-196090) relating to the IPO of our common stock was declared effective by the SEC. The IPO closed on June 24, 2014 at which time we sold 4,928,900 shares of our common stock, which included 642,900 shares of common stock purchased by the underwriters upon the full exercise of their option to purchase additional shares of common stock. We received cash proceeds of $61.2 million from the IPO, net of underwriting discounts and commissions and expenses paid by us.\\n14\\nFinancial Operations Overview\\nRevenue\\nOur revenue to date has been generated from non-refundable license payments and reimbursements for research and development expenses under our license agreements. We recognize revenue from upfront payments ratably over the term of our estimated period of performance under the agreement which we consider to be licensing revenue. In addition to receiving upfront payments, we may also be entitled to milestone and other contingent payments upon achieving predefined objectives. Such payments are recorded as revenue when we achieve the underlying milestone if it is deemed to be a substantive milestone at the date the arrangement is entered into. To the extent that non-substantive milestones are achieved and we have remaining performance obligations, milestones are deferred and recognized as revenue over the estimated remaining period of performance. Reimbursements from AstraZeneca for development costs incurred under our license and collaboration agreement with them are classified as collaborative development revenue.\\nResearch and Development Expenses\\nResearch and development expenses represent costs incurred to conduct research, such as the discovery and development of our unpartnered product candidates, as well as the development of product candidates pursuant to our license agreement with AstraZeneca. We recognize all research and development costs as they are incurred.\\nResearch and development expenses consist of the following:\\n| | external research and development expenses incurred under agreements with consultants, third-party contract research organizations, or CROs, and investigative sites where a substantial portion of our clinical studies are conducted, and with contract manufacturing organizations, or CMOs, where our clinical supplies are produced; |\\n\\n| | employee-related expenses, which include salaries, benefits and stock-based compensation; and |\\n\\n| | facilities and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, depreciation and amortization expense and other supplies. |\\n\\nPrior to the execution of our license agreement with AstraZeneca in October 2012, we incurred $18.0 million in research and development expenses related to tenapanor. Following the execution of the license agreement and through June 30, 2014, we incurred $30.2 million in research and development expenses related to tenapanor, all of which are reimbursed by AstraZeneca under the license agreement. The reimbursements are recognized in collaborative development revenue in the Statement of Operations and Comprehensive Income (Loss).\\nThe following table summarizes our research and development expenses during the three and six months ended June 30, 2014 and 2013 (in thousands):\\n\\n| Three Months EndedJune 30, | Six Months EndedJune 30, |\\n| 2014 | 2013 | 2014 | 2013 |\\n| Discovery research expense | $ | 2,562 | $ | 2,052 | $ | 4,922 | $ | 3,761 |\\n| AstraZeneca collaboration development expense | 2,621 | 5,182 | 7,898 | 9,412 |\\n| Total research and development expenses | $ | 5,183 | $ | 7,234 | $ | 12,820 | $ | 13,173 |\\n\\nWe expect our unpartnered research and development expenses will increase in the future as we progress our internal product candidates, advance our discovery research projects into the preclinical stage and continue our early stage research including further development of our APECCS cell-culture system. The process of conducting preclinical studies and clinical trials necessary to obtain regulatory approval is costly and time consuming. We or our collaboration partners may never succeed in achieving marketing approval for any of our product candidates. The probability of success of each of the product candidates may be affected by numerous factors, including preclinical data, clinical data, competition, manufacturing capability and commercial viability.\\nMost of our product development programs are at an early stage; therefore, the successful development of our product candidates is highly uncertain and may not result in approved products. Completion dates and completion costs can vary significantly for each product candidate and are difficult to predict. Given the uncertainty associated with clinical trial enrollment and the risks inherent in the development process, we are unable to determine the duration and completion costs of current or future clinical trials of our product candidates or if and to what extent we will generate revenues from the commercialization and sale of any of our product candidates. We anticipate that we and our collaboration partners will make determinations as to which programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to each product candidate’s commercial potential. We will need to raise additional\\n15\\ncapital or may seek additional collaboration partnerships in the future in order to complete the development and commercialization of our product candidates.\\nGeneral and Administrative\\nGeneral and administrative expenses includes personnel costs, travel expenses and other expenses for outside professional services, including legal, human resources, audit and accounting services. Personnel costs includes salaries, bonus, benefits and stock-based compensation. We expect to incur additional expenses as a result of being a public company following the completion of our IPO in June 2014, including expenses to comply with the rules and regulations applicable to companies listed on a national securities exchange and costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, as well as increases in expenses for additional insurance, investor relations activities and other administration and professional services.\\nChange in Fair Value of Convertible Preferred Stock Warrant Liability\\nChange in fair value of convertible preferred stock warrant liability was the fair value remeasurement of our liability related to our convertible preferred stock warrants. We recorded adjustments to the estimated fair value of the convertible preferred stock warrants until they were net exercised prior to the completion of our IPO and then converted into common stock. At that time, the convertible preferred stock warrant liability was reclassified to additional paid-in capital and we no longer record any related periodic fair value adjustments.\\nProvision for Income Taxes\\nWe did not record a provision for income taxes for the three and six months ended June 30, 2014 because we expect to generate a net operating loss for the year ending December 31, 2014. Our deferred tax assets continue to be fully offset by a valuation allowance.\\nProvision for income taxes for the 2013 periods consists of California state income taxes as we were required to pay the Alternative Minimum Tax for the $35.0 million upfront payment received from AstraZeneca in 2012.\\nCritical Accounting Polices and Estimates\\nThe discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no significant and material changes in our critical accounting policies during the three and six months ended June 30, 2014, as compared to those disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in the Prospectus filed with the SEC on June 19, 2014.\\n16\\nResults of Operations\\nComparison of the Three Months Ended June 30, 2014 and 2013\\n\\n| Three Months Ended June 30, | Dollar Change |\\n| 2014 | 2013 |\\n| (In thousands) |\\n| Revenue: |\\n| Licensing revenue | $ | 6,507 | $ | 1,989 | $ | 4,518 |\\n| Collaborative development revenue | 2,630 | 5,302 | (2,672 | ) |\\n| Total revenue | 9,137 | 7,291 | 1,846 |\\n| Operating expenses: |\\n| Research and development | 5,183 | 7,234 | (2,051 | ) |\\n| General and administrative | 1,203 | 908 | 295 |\\n| Total operating expenses | 6,386 | 8,142 | (1,756 | ) |\\n| Income (loss) from operations | 2,751 | (851 | ) | 3,602 |\\n| Other expense, net | (8 | ) | (4 | ) | (4 | ) |\\n| Change in fair value of preferred stock warrant liability | 1,010 | — | 1,010 |\\n| Income (loss) before provision for income taxes | 3,753 | (855 | ) | 4,608 |\\n| Provision for income taxes | — | 36 | (36 | ) |\\n| Net income (loss) | $ | 3,753 | $ | (891 | ) | $ | 4,644 |\\n\\nRevenue\\nLicensing revenue for the three months ended June 30, 2014 was $6.5 million, an increase of $4.5 million, or 227%, compared to licensing revenue of $2.0 million for the three months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized pursuant to the Option and License Agreement with Sanofi.\\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the three months ended June 30, 2014 was $2.6 million, a decrease of $2.7 million, or 50%, compared to $5.3 million for the three months ended June 30, 2013. The decrease was primarily because of a decrease in our development activities related to the clinical trials that are a part of the AstraZeneca agreement.\\nResearch and Development\\nResearch and development expenses were $5.2 million for the three months ended June 30, 2014, a decrease of $2.1 million, or 28%, compared to $7.2 million for the three months ended June 30, 2013. The decrease was primarily driven by a $2.6 million decrease in development activities related to tenapanor conducted by Ardelyx in accordance with the AstraZeneca agreement. Discovery research expenses increased by $0.5 million due to an increase in our research activities for non-partnered programs.\\nGeneral and Administrative\\nGeneral and administrative expenses were $1.2 million for the three months ended June 30, 2014, an increase of $0.3 million, or 32%, compared to $0.9 million for the three months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.1 million and an increase of $0.1 million in personnel related expenses.\\nChange in Fair Value of Preferred Stock Warrant Liability\\nChange in fair value of preferred stock warrant liability was $1.0 million of income for the three months ended June 30, 2014 compared to zero for the three months ended June 30, 2013. The change was due to a decrease in the fair value of our convertible preferred stock over the three month period.\\n17\\nComparison of the Six Months Ended June 30, 2014 and 2013\\n| Six Months Ended June 30, | Dollar Change |\\n| 2014 | 2013 |\\n| (In thousands) |\\n| Revenue: |\\n| Licensing revenue | $ | 9,743 | $ | 3,978 | $ | 5,765 |\\n| Collaborative development revenue | 7,944 | 9,869 | (1,925 | ) |\\n| Total revenue | 17,687 | 13,847 | 3,840 |\\n| Operating expenses: |\\n| Research and development | 12,820 | 13,173 | (353 | ) |\\n| General and administrative | 2,580 | 1,935 | 645 |\\n| Total operating expenses | 15,400 | 15,108 | 292 |\\n| Income (loss) from operations | 2,287 | (1,261 | ) | 3,548 |\\n| Other expense, net | (12 | ) | (29 | ) | 17 |\\n| Change in fair value of preferred stock warrant liability | (1,593 | ) | — | (1,593 | ) |\\n| Income (loss) before provision for income taxes | 682 | (1,290 | ) | 1,972 |\\n| Provision for income taxes | — | 71 | (71 | ) |\\n| Net income (loss) | $ | 682 | $ | (1,361 | ) | $ | 2,043 |\\n\\nRevenue\\nLicensing revenue for the six months ended June 30, 2014 was $9.7 million, an increase of $5.8 million, or 145%, compared to total licensing revenue of $4.0 million for the six months ended June 30, 2013. The increase was primarily due to the increased amounts recognized from the $15.0 million development milestone payment we received in December 2013 related to the amendment to the AstraZeneca agreement and the $25.0 million development milestone payment we received in May 2014 related to the dosing of the first patient in the Phase 2b ESRD clinical trial in hyperphosphatemia in April 2014, which are both being recognized ratably over our expected period of performance under the agreement. The estimated period of performance is based on the completion of all of the Phase 2 clinical trials for tenapanor. We estimate that the end of all Phase 2 clinical trials will be December 2016. The expected period of performance is reviewed quarterly and adjusted, as needed, to reflect the progress of clinical studies. The remaining increase was due to the $1.25 million we recognized in May 2014 pursuant to the Option and License Agreement with Sanofi.\\nCollaborative development revenue consists of our development expenses that are reimbursable to us by AstraZeneca as part of our license agreement. Collaborative development revenue for the six months ended June 30, 2014 was $7.9 million, a decrease of $1.9 million, or 20%, compared to $9.9 million for the six months ended June 30, 2013. The decrease was due to a decrease in our development activities primarily related to the clinical trials that are a part of the AstraZeneca agreement.\\nResearch and Development\\nResearch and development expenses were $12.8 million for the six months ended June 30, 2014, a decrease of $0.4 million, or 3%, compared to $13.2 million for the six months ended June 30, 2013. The decrease in AstraZeneca collaboration development expense of $1.5 million was primarily driven by the decrease in development activities related to tenapanor conducted by Ardelyx under the license agreement with AstraZeneca. Discovery research expenses increased by $1.2 million due to an increase in our research activities for non-partnered programs.\\nGeneral and Administrative\\nGeneral and administrative expenses were $2.6 million for the six months ended June 30, 2014, an increase of $0.6 million, or 33%, compared to $1.9 million for the six months ended June 30, 2013. The increase was primarily due to an increase in professional services fees of $0.4 million and an increase of $0.2 million personnel related expenses.\\nChange in Fair Value of Preferred Stock Warrant Liability\\nChange in fair value of preferred stock warrant liability was $1.6 million for the six months ended June 30, 2014, an increase of $1.6 million compared to zero for the six months ended June 30, 2013. The increase was due to an increase in the fair value of our convertible preferred stock over the six month period.\\n18\\nLiquidity and Capital Resources\\nAs of June 30, 2014, we had cash and cash equivalents totaling $117.8 million. In connection with our IPO, we received cash proceeds of $61.2 million, net of underwriters’ discounts and commissions and expenses paid by the Company in June 2014. Prior to the IPO, we funded our operations primarily with cash flows from the sales of our convertible preferred stock in private placements and from the upfront payments and other collaboration related payments received from our collaboration partners AstraZeneca and Sanofi.\\nOur primary uses of cash are to fund operating expenses, primarily research and development expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable and accrued expenses.\\nWe believe that our existing capital resources as of June 30, 2014 will be sufficient to meet our projected operating requirements for at least the next 12 months. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development expenditures. We currently have no credit facility or committed sources of capital other than potential milestones receivable under our current collaboration partnerships. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates and the extent to which we may enter into additional collaboration partnerships with third parties to participate in their development and commercialization, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. Our future funding requirements will depend on many factors, including the following:\\n| | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\\n\\n| | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of the receipt of such payments, if any; |\\n\\n| | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\\n\\n| | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\\n\\n| | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\\n\\n| | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\\n\\n| | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\\n\\n| | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\\n\\n| | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\\n\\n| | the cash requirements of any future acquisitions or discovery of product candidates; |\\n\\n| | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\\n\\n| | the time and cost necessary to respond to technological and market developments; and |\\n\\n| | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\\n\\n19\\nThe following table summarizes our cash flows for the periods indicated (in thousands):\\n\\n| Six MonthsEnded June 30, |\\n| 2014 | 2013 |\\n| Cash provided by (used in) operating activities | $ | 22,874 | $ | (8,897 | ) |\\n| Cash used in investing activities | (736 | ) | (257 | ) |\\n| Cash provided by financing activities | 61,241 | — |\\n| Net increase (decrease) in cash and cash equivalents | $ | 83,379 | $ | (9,154 | ) |\\n\\nCash Flows from Operating Activities\\nCash provided by operating activities for the six months ended June 30, 2014 was $22.9 million, consisting of net income of $0.7 million, non-cash charges of $0.1 million for depreciation and amortization expense, $0.2 million for stock-based compensation, $1.6 million for the change in the fair value remeasurement of our convertible preferred stock warrant liability and a net increase of $20.3 million in our net operating assets and liabilities. The changes in our net operating assets and liabilities was primarily due to a $16.1 million increase in deferred revenue which was mainly driven by the $25.0 million payment received in May 2014 in connection with our agreement with AstraZeneca, a $3.4 million decrease in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $0.9 million increase in our other accrued liabilities due to the timing of payments.\\nCash used in operating activities for the six months ended June 30, 2013 was $8.9 million, consisting of a net loss of $1.4 million, which was partially offset by non-cash charges of $0.4 million for depreciation and amortization, $0.2 million for stock-based compensation and a net decrease of $8.1 million in our net operating assets and liabilities. The cash used as a result of the changes in our net operating assets and liabilities was due primarily to a $2.9 million decrease in deferred revenue which was mainly driven by the amortization of the $35.0 million up-front payment received in connection with our agreement with AstraZeneca and a $3.9 million increase in our accounts receivable due to the timing of payments received from AstraZeneca for reimbursable costs incurred under our licensing agreement and a $1.2 million increase in prepaid expenses and other assets related to advance payments made to vendors for clinical development activities. These changes were partially offset by a $1.1 million increase in our accounts payable due to the timing of payments.\\nCash Flows from Investing Activities\\nCash used in investing activities for the six months ended June 30, 2014 and 2013 of $0.7 million and $0.3 million was related to our acquisition of property and equipment related to the expansion of our laboratory and related equipment.\\nCash Flows from Financing Activities\\nCash provided by financing activities for the six months ended June 30, 2014 was due to the IPO proceeds of $61.2 million.\\nOff-Balance Sheet Arrangements\\nAs of June 30, 2014, we did not have any off-balance sheet arrangements or any holdings in variable interest entities.\\nRecent Accounting Pronouncement\\nIn July 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the law. We adopted this amendment as of January 1, 2014, which did not have a significant impact on the balance sheet.\\nIn May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, or ASU 2014-09, which converges the FASB and the International Accounting Standards Board standards on revenue recognition. Areas of revenue recognition that will be affected include, but are not limited to, transfer of control, variable consideration, allocation of transfer pricing, licenses, time value of money, contract costs and disclosures. This guidance is effective for the fiscal years and interim reporting periods beginning after December 15, 2016, at which time we may adopt the new standard under the full retrospective method or the modified retrospective method. Early adoption is not permitted. We have not yet selected a transition method nor have we determined the impact of the new standard on our financial statements and related disclosures\\n20\\n\\n\\nITEM 3.\\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nWe are exposed to market risks in the ordinary course of our business. These risks primarily include risk related to interest rate sensitivities. We had cash and cash equivalents of $117.8 million as of June 30, 2014, which consist of bank deposits and money market funds. Such interest-earning instruments carry a degree of interest rate risk; however, historical fluctuations in interest income have not been significant. We had no outstanding debt as of June 30, 2014.\\n\\n\\nITEM 4.\\nCONTROLS AND PROCEDURES\\nEvaluation of Disclosure Controls and Procedures\\nAs required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2014. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2014, our Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2014, our disclosure controls and procedures were effective at the reasonable assurance level.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\nPART II. OTHER INFORMATION\\n\\n\\nITEM 1.\\nLEGAL PROCEEDINGS\\nWe are not currently a party to any material litigation or other material legal proceedings.\\n\\n\\nITEM 1A.\\nRISK FACTORS\\nOur business involves significant risks, some of which are described below. You should carefully consider these risks, as well as other information in this Quarterly Report on Form 10-Q, including our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The occurrence of any of the events or developments described below could harm our business, financial condition, results of operations, cash flows, the trading price of our common stock and our growth prospects. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.\\nRisks Related to Our Limited Operating History, Financial Condition and Capital Requirements\\nWe have a limited operating history, have incurred significant losses since our inception and we will incur losses in the future. We have only one product candidate in clinical trials and no product sales, which, together with our limited operating history, makes it difficult to assess our future viability.\\nWe are a clinical-stage biopharmaceutical company with a limited operating history. Biopharmaceutical product development is a highly speculative undertaking and involves a substantial degree of risk. To date, we have focused substantially all of our efforts on our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. To date, we have not commercialized any products or generated any revenue from the sale of products. We are not profitable and have incurred losses in each year since our inception in October 2007, and we do not know whether or when we will become profitable. We have only a limited operating history upon which to evaluate our business and prospects. We continue to incur significant research, development and other expenses related to our ongoing operations. Our net loss\\n21\\nfor the years ended December 31, 2012 and 2013 was $9.8 million and $6.6 million, respectively. While we had a net income of $3.8 million and $0.7 million, respectively, for the three and six months ended June 30, 2014, this performance may not be indicative of future performance. As of June 30, 2014, we had an accumulated deficit of $68.0 million.\\nIf we do not receive anticipated milestone payments from our collaboration partners, AstraZeneca AB, or AstraZeneca and Sanofi S.A., or Sanofi, our operating losses will substantially increase for the foreseeable future as we continue our discovery, research, development, manufacturing and commercialization activities. There can be no assurance that we will receive any potential milestones under our agreements with AstraZeneca and/or Sanofi. For a discussion of the risks associated with our preclinical and clinical development programs with, and potential for milestone payments from, AstraZeneca and Sanofi, see below under “—Risks Related to Our Business.”\\nEven if we receive the anticipated milestone payments or receive royalty payments from our collaboration partners, we may not be able to achieve or sustain profitability. For example, we may choose to exercise our right to co-fund a portion of the first Phase 3 clinical development program for tenapanor, incurring expenses of up to $40.0 million, and we would likely incur continued operating losses during the period we are co-funding the program. In addition, our receipt of milestone payments from our collaboration partners may not result in the recognition of revenue in the period received, as we may be required to amortize the milestone payment over a period of time. Depending upon such requirement and the period of amortization, we may continue to incur losses even after the receipt of such milestone payments. Therefore, there can be no assurance that our losses will not increase into the future. Our prior losses, combined with possible future losses, have had and will continue to have an adverse effect on our stockholders’ equity and working capital. Further, the net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance.\\nWe have never generated any revenue from product sales and may never be profitable.\\nWe have no products approved for sale and have never generated any revenue from product sales. Our ability to generate revenue from product sales and achieve profitability depends on our ability, and the ability of our collaboration partners, to successfully complete the development of and obtain the regulatory and marketing approvals necessary to commercialize one or more of our product candidates. We do not anticipate generating revenue from product sales for the foreseeable future. Our ability to generate future revenue from product sales or pursuant to milestone payments depends heavily on many factors, including but not limited to:\\n| • | the completion of research and preclinical and clinical development of our product candidates; |\\n\\n| • | together with our collaboration partners, obtaining regulatory approvals for our product candidates; |\\n\\n| • | the ability of our collaboration partners to successfully commercialize and/or our ability to commercialize or co-promote, if we so choose, our product candidates; |\\n\\n| • | developing a sustainable and scalable manufacturing process for any approved product candidates and establishing and maintaining supply and manufacturing relationships with third parties that can provide adequate (in amount and quality) products to support clinical development and the market demand for our product candidates, if approved; |\\n\\n| • | obtaining market acceptance of our product candidates, if approved, as viable treatment options; |\\n\\n| • | addressing any competing technological and market developments; |\\n\\n| • | identifying, assessing, acquiring, in-licensing and/or developing new product candidates; |\\n\\n| • | negotiating favorable terms in any collaboration partnership, licensing or other arrangements into which we may enter; |\\n\\n| • | maintaining, protecting, and expanding our portfolio of intellectual property rights, including patents, trade secrets, and know-how, and our ability to develop, manufacture and commercialize our product candidates and products without infringing intellectual property rights of others; and |\\n\\n| • | attracting, hiring, and retaining qualified personnel. |\\n\\nIn cases where we, or our collaboration partners, are successful in obtaining regulatory approvals to market one or more of our product candidates, our revenue will be dependent, in part, upon the size of the markets in the territories for which regulatory approval is granted, the accepted price for the product, the ability to get reimbursement at any price and whether we have royalty and/or co-promotion rights for that territory. If the number of patients suitable for our product candidates is not as significant as we estimate, the indication approved by regulatory authorities is narrower than we expect, or the reasonably accepted population for treatment is narrowed by competition, physician choice or treatment guidelines, we may not generate significant revenue from the sale of such products, even if approved. Even if we achieve profitability in the future, we may not be able to sustain profitability in subsequent periods. Our failure to generate revenue from product sales would likely depress our market value and could impair our ability to raise capital, expand our business, discover or develop other product candidates or continue our operations. A decline in the value of our common stock could cause our stockholders to lose all or part of their investment.\\n22\\nWe may require substantial additional financing to achieve our goals, and a failure to obtain this necessary capital when needed on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product development or other operations.\\nSince our inception, most of our resources have been dedicated to our research and development activities, including developing our lead product candidate, tenapanor, and developing our proprietary drug discovery and design platform. As of June 30, 2014, we had working capital of $94.8 million, including capital resources consisting of cash and cash equivalents of $117.8 million. We believe that we will continue to expend substantial resources for the foreseeable future, including costs associated with research and development, conducting preclinical studies and clinical trials, obtaining regulatory approvals and sales and marketing. Because the outcome of any clinical trial and/or regulatory approval process is highly uncertain, we cannot reasonably estimate the actual amounts necessary to successfully complete the development, regulatory approval process and commercialization or co-promotion of any of our product candidates.\\nBased on our current operating plan, we believe that our existing capital resources will allow us to fund our operating plan through at least the next 12 months. However, our operating plan may change as a result of many factors currently unknown to us, and we may need to seek additional funds sooner than planned. Our future funding requirements will depend on many factors, including, but not limited to:\\n| • | our decision whether or not to exercise our right to co-fund the first Phase 3 clinical development program for tenapanor, in which case we may invest $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor; |\\n\\n| • | the achievement of development and regulatory milestones resulting in the payment to us from our collaboration partners of contractual milestone payments and the timing of receipt of such payments, if any; |\\n\\n| • | the progress, timing, scope, results and costs of our preclinical studies and clinical trials for our product candidates that have not been licensed, including the ability to enroll patients in a timely manner for clinical trials; |\\n\\n| • | the time and cost necessary to obtain regulatory approvals for our product candidates that have not been licensed and the costs of post-marketing studies that could be required by regulatory authorities; |\\n\\n| • | our ability and the ability of our collaboration partners to successfully commercialize and/or co-promote our product candidates; |\\n\\n| • | the manufacturing, selling and marketing costs associated with product candidates, including the cost and timing of building our sales and marketing capabilities; |\\n\\n| • | our ability to establish and maintain collaboration partnerships, in-license/out-license or other similar arrangements and the financial terms of such agreements; |\\n\\n| • | the timing, receipt, and amount of sales of, or royalties on, our future products, if any; |\\n\\n| • | the sales price and the availability of adequate third-party reimbursement for our product candidates; |\\n\\n| • | the cash requirements of any future acquisitions or discovery of product candidates; |\\n\\n| • | the number and scope of preclinical and discovery programs that we decide to pursue or initiate; |\\n\\n| • | the time and cost necessary to respond to technological and market developments; and |\\n\\n| • | the costs of filing, prosecuting, maintaining, defending and enforcing any patent claims and other intellectual property rights, including litigation costs and the outcome of such litigation, including costs of defending any claims of infringement brought by others in connection with the development, manufacture or commercialization of our product candidates. |\\n\\nAdditional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to delay, limit, reduce or terminate our research and development activities, preclinical and clinical trials for our product candidates for which we retain such responsibility and our establishment and maintenance of sales and marketing capabilities or other activities that may be necessary to commercialize or co-promote our product candidates.\\n23\\nRisks Related to Our Business\\nWe are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized.\\nTo date, we have invested a significant amount of our efforts and financial resources in the research and development of tenapanor, which is currently our lead product candidate and only product candidate in clinical trials. In particular, together with AstraZeneca, our collaboration partner for tenapanor, we have completed six Phase 1 and two Phase 2 trials and are currently conducting three Phase 2 trials and one Phase 1 study. Our near-term prospects, including our ability to finance our operations through the receipt of milestone payments and generate revenue from product sales, will depend heavily on the successful development and AstraZeneca’s commercialization of tenapanor, if approved. The clinical and commercial success of tenapanor will depend on a number of factors, including the following:\\n| • | the timely completion of the ongoing clinical trials of tenapanor, which will depend substantially upon the satisfactory performance of third-party contractors; |\\n\\n| • | whether tenapanor’s safety and efficacy profile is satisfactory to the U.S. Food and Drug Administration, or FDA, and foreign regulatory authorities to warrant marketing approval; |\\n\\n| • | the timely completion of the ongoing chronic kidney disease, or CKD, Phase 2a clinical trial, which will depend substantially upon our ability to identify principal investigators with patient populations suitable for study, and the ability of those principal investigators to successfully enroll those patients into the trial; |\\n\\n| • | the results of a long-term rat carcinogenicity study required for approval of tenapanor, which will not be known for at least two and half years, and which may be delayed for a significant period of time for reasons outside of the control of AstraZeneca, particularly if AstraZeneca is required to restart or modify the study for any reason; |\\n\\n| • | whether FDA or foreign regulatory authorities require additional clinical trials prior to approval to market tenapanor; |\\n\\n| • | the prevalence and severity of adverse side effects of tenapanor; |\\n\\n| • | the timely receipt of necessary marketing approvals from the FDA and foreign regulatory authorities; |\\n\\n| • | the ability of AstraZeneca and us through our co-promotion rights, if we choose to exercise such rights and are not precluded from doing so under the terms of our agreement with AstraZeneca or any subsequent co-promotion agreements, to successfully commercialize tenapanor, if approved for marketing and sale by the FDA or foreign regulatory authorities, including educating physicians and patients about the benefits, administration and use of tenapanor; |\\n\\n| • | achieving and maintaining compliance with all regulatory requirements applicable to tenapanor; |\\n\\n| • | acceptance of tenapanor as safe and effective by patients and the medical community; |\\n\\n| • | the availability, perceived advantages, relative cost, relative safety and relative efficacy of alternative and competing treatments; |\\n\\n| • | obtaining and sustaining an adequate level of coverage and reimbursement for tenapanor by third-party payors; |\\n\\n| • | the effectiveness of AstraZeneca’s marketing, sales and distribution strategy and operations; |\\n\\n| • | the ability of AstraZeneca, or any third-party manufacturer it contracts with, to successfully scale up the manufacturing process for tenapanor, which has not yet been demonstrated, and to manufacture supplies of tenapanor and to develop, validate and maintain a commercially viable manufacturing process that is compliant with current good manufacturing practice, or cGMP, requirements; |\\n\\n| • | enforcing intellectual property rights in and to tenapanor; |\\n\\n| • | avoiding third-party interference, opposition, derivation or similar proceedings with respect to our patent rights, and avoiding other challenges to our patent rights and patent infringement claims; and |\\n\\n| • | a continued acceptable safety profile of tenapanor following approval. |\\n\\nMost of these factors are beyond our control, including clinical development, the regulatory submission process, manufacturing, marketing and sales efforts of AstraZeneca.\\nAs a first-in-class drug, tenapanor, has not been extensively studied in humans and the nonclinical and clinical data on its effect in the human body is limited to the trials and studies that we and AstraZeneca have completed. As a first-in-class drug, there is a higher likelihood that approval may not be attained as compared to a class of drugs with approved products. We cannot be certain that tenapanor will be successful in preclinical studies, clinical trials or receive regulatory approval. For example, like phosphate binders, treatment with tenapanor in patients with end stage renal disease, or ESRD, may be significantly impacted by such patient’s adherence to a restrictive low phosphorus diet, and as such, adherence may be a factor in demonstrating the efficacy of tenapanor in clinical trials for this patient population. Further, it may not be possible or practicable to demonstrate, or if approved, to market on the basis of,\\n24\\ncertain of the benefits we believe tenapanor possesses, including the reduction of sodium absorption in patients with CKD, which is unlikely to be an endpoint to be considered for approval in CKD patients. Additionally, the reduction of serum phosphorus is currently an approvable endpoint in ESRD, but not in the broader CKD patient population in the United States. If the number of patients in the market for tenapanor or the price that the market can bear is not as significant as we estimate, we may not generate significant revenue from sales of tenapanor, if approved. Accordingly, there can be no assurance that tenapanor will ever be successfully commercialized or that we will ever generate revenue from sales of tenapanor. If we and AstraZeneca are not successful in completing the development of, obtaining approval for, and commercializing tenapanor, or are significantly delayed in doing so, our business will be materially harmed.\\nWe are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.\\nIn October 2012, we entered into a license agreement with AstraZeneca granting it an exclusive worldwide license to our small molecule NHE3 inhibitor program, which includes our lead product candidate, tenapanor, for all indications. Under this agreement, AstraZeneca has responsibility for completing all nonclinical and clinical development and obtaining and maintaining regulatory approval for tenapanor from the FDA and regulatory agencies outside of the United States. Ultimately, if tenapanor is advanced through clinical trials and receives marketing approval from the FDA or comparable foreign regulatory agencies, AstraZeneca will be responsible for the commercialization of tenapanor, subject to our right to elect to participate in certain co-promotion activities in the United States. The potential for us to obtain future development milestone payments and, ultimately, generate revenue from royalties from tenapanor depends entirely on the successful development, regulatory approval, marketing and commercialization of tenapanor by AstraZeneca. In addition to the risks inherent in the development of a drug product candidate, our collaboration partnership with AstraZeneca may not be successful due to a number of important factors, including the following:\\n| • | prior to the 175th day after the database lock for the ongoing Phase 2b clinical trial in hyperphosphatemic ESRD patients, AstraZeneca may terminate the license for any reason with 30 -days’ prior written notice and thereafter AstraZeneca may terminate the license with 120- days’ prior written notice; |\\n\\n| • | AstraZeneca has the unilateral ability to choose not to develop tenapanor for one or more indications for which it has been or is currently being evaluated, provided it pursues at least one indication, and AstraZeneca may choose to pursue an indication that is not in our strategic best interest or to delay the pursuit of, or forego an indication, even if clinical data is supportive of further development for such indication; |\\n\\n| • | AstraZeneca may choose not to develop and commercialize tenapanor in all relevant markets; |\\n\\n| • | AstraZeneca may take considerably more time advancing tenapanor through the clinical and regulatory process than we currently anticipate, which could materially delay the achievement of milestones and, consequently the receipt of milestone payments from AstraZeneca; |\\n\\n\\n| • | AstraZeneca’s obligation to use “commercially reasonable efforts” with regard to the development, regulatory approval, manufacture and commercialization of tenapanor under our agreement leaves AstraZeneca with discretion in determining the efforts and resources that it will apply to the development, regulatory approval, manufacture and commercialization of tenapanor; |\\n\\n| • | subject to our right to elect to participate in co-promotion activities in the United States, AstraZeneca controls all aspects of the commercialization of tenapanor; |\\n\\n| • | AstraZeneca is obligated to reimburse a specified amount for the current constipation-predominant irritable bowel syndrome, or IBS-C, Phase 2b clinical trial, and despite our efforts to keep costs below that amount, we may be required to spend more than that to complete the trial, and if we do so, we will not be reimbursed for those excess amounts by AstraZeneca; |\\n\\n| • | AstraZeneca’s recent strategic withdrawal from selling gastrointestinal, or GI, products and the differing treatment of the IBS-C indication in our agreement implies that AstraZeneca may choose not to develop the IBS-C indication, even if our current Phase 2b clinical trial were successful; |\\n\\n| • | AstraZeneca may change the focus of its development and commercialization efforts or pursue higher-priority programs and, accordingly, reduce the efforts and resources allocated to tenapanor, which will have the direct effect of reducing our co-promotion activities as our level of co-promotion is limited to a percentage of the overall commercialization activities; |\\n\\n| • | AstraZeneca may fail to develop a commercially viable formulation or manufacturing process for tenapanor, and may fail to manufacture or supply sufficient drug substance of tenapanor for commercial use, if approved, which could result in lost revenue; |\\n\\n25\\n\\n| • | AstraZeneca may not comply with all applicable regulatory requirements or may fail to report safety data in accordance with all applicable regulatory requirements; |\\n\\n| • | AstraZeneca may sublicense its rights with respect to tenapanor to one or more third parties without our consent; |\\n\\n| • | AstraZeneca may not dedicate the resources that would be necessary to carry tenapanor through clinical development or may not obtain the necessary regulatory approvals; |\\n\\n| • | if AstraZeneca is acquired during the term of our collaboration partnership, the acquiror may have different strategic priorities that could cause it to terminate our agreement or reduce its commitment to our collaboration partnership; and |\\n\\n| • | if our agreement with AstraZeneca terminates, we will no longer have rights to receive potential revenue under the agreement with AstraZeneca for future milestones or royalties, in which case we would need to identify alternative means to continue the development, manufacture and commercialization of tenapanor, alone or with others. |\\n\\nThe timing and amount of any milestone and royalty payments we may receive under our agreement will depend on, among other things, the efforts, allocation of resources, and successful development and commercialization of tenapanor by AstraZeneca under our agreement. There can be no assurance that any of the development and regulatory milestones will be achieved or that we will receive any future milestone payments under the agreement. In addition, in certain circumstances we may believe that we have achieved a particular milestone and AstraZeneca may disagree with our belief. In that case, receipt of that milestone payment may be delayed or may never be received, which may require us to adjust our operating plans.\\nIf AstraZeneca does not perform in the manner we expect or fulfill its responsibilities in a timely manner, or at all, the clinical development, regulatory approval and commercialization efforts related to tenapanor could be delayed or terminated and it could become necessary for us to assume the responsibility at our own expense for the clinical development of tenapanor. In that event, we would likely be required to substantially limit the size and scope of the development and commercialization of tenapanor or seek additional financing to fund further development, or to identify alternative collaboration partners for tenapanor, and our potential to generate future revenue from royalties and milestone payments from tenapanor would be significantly reduced or delayed and our business would be materially and adversely harmed.\\nOur election to co-fund the first Phase 3 clinical development program for tenapanor must be made in a limited time period prior to the initiation of the first pivotal clinical trial for tenapanor and, as a result, we may make a substantial capital investment for a product candidate based on limited clinical data.\\nUnder our agreement with AstraZeneca, we may elect to participate in the funding of the first Phase 3 clinical development program for the first indication of tenapanor by investing a co-funding amount of $20.0 million, $30.0 million or $40.0 million to acquire an increase of 1%, 2% or 3%, respectively, in the royalties payable to us by AstraZeneca on net sales of tenapanor. We may exercise this right only for a limited period of 60 days following AstraZeneca’s determination to proceed to the first Phase 3 clinical development program for tenapanor for a specific indication. An election to participate in the co-fund will be based, in part, on our analysis as to the likelihood of success of the Phase 3 clinical development program and the potential for regulatory approval to commercialize tenapanor. As a result, we will be required to make a substantial capital investment in tenapanor prior to the initiation of the first pivotal clinical trial and if tenapanor is unsuccessful in its pivotal trial or if it never receives regulatory approval, we will not receive any financial return on this capital investment.\\nWe have not yet negotiated our agreement with AstraZeneca specifying all of the terms of our co-promotion right.\\nPursuant to our license agreement with AstraZeneca, we have retained a co-promotion right with respect to tenapanor in the United States. While the license agreement includes the material terms of our co-promotion right, we and AstraZeneca mutually agreed to negotiate a separate agreement specifying the detailed activities and responsibilities in respect of the marketing and co-promotion of tenapanor following our election to exercise our co-promotion rights. If we elect to exercise our co-promotion rights, the separate agreement we negotiated with AstraZeneca may place restrictions or additional obligations on us, including financial obligations. Any restrictions or additional obligations may restrict our co-promotion activities or involve more significant financial obligations than we currently anticipate.\\nExercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.\\nOur agreement with AstraZeneca prohibits us from using the same sales force to co-promote tenapanor as we do to promote other products that compete with tenapanor or with any other products that are then being actively promoted by AstraZeneca or its affiliates. If we elect to co-promote tenapanor, we may therefore be required to have a separate sales forces to promote other products we may elect to co-promote under our agreement with Sanofi, or other products we develop and commercialize on our own, should any of such products be competitive with tenapanor or with any other products promoted by AstraZeneca or its affiliates. The exercise of the co-promotion right under our agreement with AstraZeneca, could adversely affect the efficiency and cost of our promotion efforts for\\n26\\nour products and, effectively, may prohibit us from exercising our co-promotion rights under our agreement with Sanofi or with respect to other co-promotion rights with future collaboration partners.\\nIf Sanofi does not exercise its option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors or if it exercises the option and subsequently terminates any development program under its collaboration partnership with us, any potential milestone payments or revenue from product sales under this collaboration partnership will be significantly reduced or non-existent, and our results of operations and financial condition will be materially and adversely affected.\\nIn February 2014, we entered into a license option and license agreement with Sanofi under which we granted Sanofi an exclusive worldwide license to conduct research utilizing our small molecule NaP2b inhibitors, which we refer to as our RDX002 program, solely for the purpose of completing activities under a preclinical development plan. We believe the inhibition of NaP2b, an intestinal phosphate transporter, would provide utility for the treatment of hyperphosphatemia in ESRD patients, which is also the lead indication for which we and AstraZeneca are developing tenapanor.\\nUnder the terms of this agreement, Sanofi has the option to obtain an exclusive license to develop, manufacture and commercialize our NaP2b inhibitors. Sanofi may exercise this option at any time following the effective date of the agreement and ending 45 days after the filing of an investigational new drug application, or IND, subject to certain exceptions, and if Sanofi does not file an IND on or before the 40th month anniversary of the completion of the technology transfer phase, the agreement will terminate.\\nIf Sanofi does not exercise its option under its agreement with us, or terminates its rights and obligations with respect to the development program or the entire agreement, then depending on the timing of such event:\\n| • | the development of our NaP2b inhibitor program may be terminated or significantly delayed; |\\n\\n| • | we would bear all of the risks and costs related to the further development and commercialization of product candidates that were previously the subject of the agreement if we decided to continue work under the NaP2b inhibitor program independently; |\\n\\n| • | we would not be eligible to receive any of the remaining development or regulatory milestone payments or royalties on product sales; |\\n\\n| • | in order to fund further development and commercialization of the NaP2b program, we may need to raise additional capital if we choose to internally pursue the development of the program, or we may need to seek out and establish alternative collaboration partnerships with third-party collaboration partners for the program, which may not be possible, or we may not be able to do so on terms which are acceptable to us, in which case it may be necessary for us to limit the size or scope of the programs or increase our expenditures and seek additional funding by other means; and |\\n\\n| • | our cash expenditures could increase significantly if it is necessary for us to hire additional employees and allocate scarce resources to the development and commercialization of the NaP2b program. |\\n\\nAny of these events would have a material adverse effect on our results of operations and financial condition.\\nIn addition, we may be effectively prohibited from co-promoting any product candidates arising from the NaP2b program if we have previously exercised our co-promotion right under our agreement with AstraZeneca. For additional information regarding the effect of exercising our co-promotion right with AstraZeneca, see the risk factor above titled “Exercising our co-promotion right under our license agreement with AstraZeneca may restrict our future commercialization and/or co-promotion activities.”\\nClinical drug development involves a lengthy and expensive process with an uncertain outcome, and we may encounter substantial delays in our clinical studies. Furthermore, results of earlier studies and trials may not be predictive of future trial results.\\nBefore obtaining marketing approval from regulatory authorities for the sale of our product candidates, we, or our collaboration partners, must conduct extensive clinical studies to demonstrate the safety and efficacy of the product candidates in humans. Clinical testing is expensive and can take many years to complete, and its outcome is inherently uncertain. Failure can occur at any time during the clinical trial process. For example, in a Phase 2a study evaluating tenapanor in ESRD patients with fluid overload, while pharmacological activity of tenapanor was confirmed, the study failed to meet the primary endpoint of a statistically significant difference between tenapanor and placebo in change in interdialytic weight gain from baseline to week 4. The results of preclinical and clinical studies of our product candidates may not be predictive of the results of later-stage clinical trials. For example, the positive results generated to date in preclinical and clinical studies for tenapanor do not ensure that the ongoing Phase 2a and Phase 2b clinical trials, or future clinical trials, will demonstrate similar results. Product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed through preclinical studies and initial clinical trials. A number of companies in the pharmaceutical, biopharmaceutical and biotechnology industries have suffered significant setbacks in advanced clinical trials for similar indications that we are pursuing due to lack of efficacy or adverse safety profiles, notwithstanding promising\\n27\\nresults in earlier studies, and we cannot be certain that we will not face similar setbacks. Even if our clinical trials are completed, the results may not be sufficient to obtain regulatory approval for our product candidates.\\nWe may experience delays in our ongoing or future trials, and we do not know whether future clinical trials will begin on time, need to be redesigned, enroll an adequate number of patients on time or be completed on schedule, if at all. Clinical trials can be delayed or terminated for a variety of reasons, including delay or failure to:\\n| • | obtain regulatory approval to commence a trial, if applicable; |\\n\\n| • | reach agreement on acceptable terms with prospective contract research organizations, or CROs, and clinical trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites; |\\n\\n| • | obtain institutional review board, or IRB, approval at each site; |\\n\\n| • | recruit suitable patients in a timely manner to participate in our trials; |\\n\\n| • | have patients complete a trial or return for post-treatment follow-up; |\\n\\n| • | ensure that clinical sites observe trial protocol, comply with good clinical practices, or GCPs, or continue to participate in a trial; |\\n\\n| • | address any patient safety concerns that arise during the course of a trial; |\\n\\n| • | address any conflicts with new or existing laws or regulations; |\\n\\n| • | initiate or add a sufficient number of clinical trial sites; or |\\n\\n| • | manufacture sufficient quantities of product candidate for use in clinical trials. |\\n\\nPatient enrollment is a significant factor in the timing of clinical trials and is affected by many factors, including the size and nature of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the trial, the design of the clinical trial, competing clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the drug being studied in relation to other available therapies, including any new drugs or treatments that may be approved for the indications we are investigating. We and AstraZeneca have experienced a delay in the enrollment of the ongoing Phase 2a clinical trial in CKD patients due to the restrictive eligibility criteria, and, although we have initiated efforts to increase enrollment by initiating new sites and amending the protocol, there can be no assurances that our efforts will be successful in increasing the rate of enrollment to complete this study on time, if at all.\\nWe could also encounter delays if a clinical trial is suspended or terminated by us, our collaboration partner for the product candidate, by the IRBs of the institutions in which such trials are being conducted, by an independent data safety monitoring board, or DSMB, for such trial or by the FDA or other regulatory authorities. Such authorities may suspend or terminate a clinical trial due to a number of factors, including failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols, inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using a drug, changes in governmental regulations or administrative actions or lack of adequate funding to continue the clinical trial.\\nFurther, conducting clinical trials in foreign countries presents additional risks that may delay completion of clinical trials. These risks include the failure of physicians or enrolled patients in foreign countries to adhere to clinical protocol as a result of differences in healthcare services or cultural customs, managing additional administrative burdens associated with foreign regulatory schemes and political and economic risks relevant to such foreign countries. In addition, the FDA may determine that the clinical trial results obtained in foreign subjects do not represent the safety and efficacy of a product candidate when administered in U.S. patients and are thus not supportive of an NDA approval in the United States. As part of our effort to increase the rate of enrollment in the ongoing Phase 2a clinical trial in CKD patients, we and AstraZeneca have initiated sites in Germany. For the reasons stated above, these efforts may not improve the rate of enrollment in this study, or generate results that can be used to support the development of tenapanor.\\nIf there are delays in the completion of, or termination of, any clinical trial of our product candidates, the commercial prospects of our product candidates may be harmed, and our ability to generate revenue from product sales from any of these product candidates will be delayed. In addition, any delays in completing the clinical trials will increase costs, slow down our product candidate development and approval process and jeopardize the ability to commence product sales and generate revenue from product sales. Any of these occurrences may significantly harm our business, financial condition and prospects. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of regulatory approval of our product candidates.\\n28\\nOur unlicensed product candidates are at an early stage of development and we may not be successful in our efforts to develop these products or expand our pipeline of product candidates.\\nA key element of our strategy is to expand our pipeline of products candidates utilizing our proprietary drug discovery and design platform and to advance such product candidates through clinical development. Our current unlicensed product candidates are in the discovery and lead identification stages of preclinical development and will require substantial preclinical and clinical development, testing and regulatory approval prior to commercialization. In particular, tenapanor is our only product candidate in clinical trials and our other product candidates are in the preclinical stage with significant research and development required before we could file an IND with regulatory authorities to begin clinical studies. Of the large number of drugs in development, only a small percentage of such drugs successfully complete the FDA regulatory approval process and are commercialized. Accordingly, even if we are able to continue to fund our development programs, there can be no assurance that any product candidates will reach the clinic or be successfully developed or commercialized.\\nResearch programs to identify product candidates require substantial technical, financial and human resources, whether or not any product candidates are ultimately identified. Although our research and development efforts to date have resulted in several development programs, we may not be able to develop product candidates that are safe and effective. Our research programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development or commercialization for many reasons, including the following:\\n| • | the research methodology used and our drug discovery and design platform may not be successful in identifying potential product candidates; |\\n\\n| • | competitors may develop alternatives that render our product candidates obsolete or less attractive; |\\n\\n| • | product candidates we develop may nevertheless be covered by third parties’ patents or other exclusive rights; |\\n\\n| • | the market for a product candidate may change during our program so that the continued development of that product candidate is no longer reasonable; |\\n\\n| • | a product candidate may on further study be shown to have harmful side effects or other characteristics that indicate it is unlikely to be effective or otherwise does not meet applicable regulatory criteria; |\\n\\n| • | a product candidate may not be capable of being produced in commercial quantities at an acceptable cost, or at all; and |\\n\\n| • | a product candidate may not be accepted as safe and effective by patients, the medical community or third-party payors, if applicable. |\\n\\nEven if we are successful in continuing to expand our pipeline, through our own research and development efforts or by pursuing in-licensing or acquisition of product candidates, the potential product candidates for which we identify or acquire rights may not be suitable for clinical development, including as a result of being shown to have harmful side effects or other characteristics that indicate that they are unlikely to receive marketing approval and achieve market acceptance. If we do not successfully develop and commercialize a product pipeline, we may not be able to generate revenue from product sales in future periods or ever achieve profitability.\\nOur proprietary drug discovery and design platform, and, in particular, APECCS, is a new approach to the discovery, design and development of new product candidates and may not result in any products of commercial value.\\nWe have developed a proprietary drug discovery and design platform to enable the identification, screening, testing, design and development of new product candidates, and we recently we enhanced this platform with the addition of APECCS. We plan to utilize APECCS to identify new and potentially novel targets in the GI tract. We have also identified over 3,800 proteins on the inner surface of the gut, many of which we believe may be drug targets. However, there can be no assurance that APECCS will work or that any of these potential targets or other aspects of our proprietary drug discovery and design platform will yield product candidates that could enter clinical development and, ultimately, be commercially valuable.\\nAlthough we expect to continue to enhance the capabilities of our APECCS system by advancing the cell culture and screening process and/or acquiring new technologies to broaden the scope of APECCS, we may not be successful in any of our enhancement and development efforts. For example, we may not be able to enter into agreements on suitable terms to obtain technologies required to develop certain capabilities of APECCS. In addition, we may not be successful in developing the conditions necessary to grow multiple segments of intestine or from multiple species, or otherwise develop assays or cell cultures necessary to expand these capabilities. If our enhancement or development efforts are unsuccessful, we may not be able to advance our drug discovery capabilities as quickly as we expect or identify as many potential drugable targets as we desire.\\n29\\nWe may expend our limited resources to pursue a particular product candidate or indication and fail to capitalize on product candidates or indications that may be more profitable or for which there is a greater likelihood of success.\\nBecause we have limited financial and managerial resources, we have focused on research programs and product candidates that relate to discovery and development of non-systemic drugs that work in the GI tract. As a result, we may forego or delay pursuit of opportunities with other product candidates or for other indications that later prove to have greater commercial potential. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or profitable market opportunities. Our spending on current and future research and development programs and product candidates for specific indications may not yield any commercially viable products. If we do not accurately evaluate the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through collaboration partnerships, licensing or other royalty arrangements in cases in which it would have been more advantageous for us to retain sole development and commercialization rights to such product candidate.\\nWe rely on third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, we may be unable to obtain regulatory approval for or commercialize our product candidates.\\nWe do not have the ability to independently conduct clinical trials and, in some cases, preclinical or nonclinical studies. We rely on medical institutions, clinical investigators, contract laboratories, collaboration partners and other third parties, such as CROs, to conduct clinical trials on our product candidates. The third parties with whom we contract for execution of the clinical trials we are conducting with AstraZeneca, as well as those third parties with whom we will contract for execution of clinical trials for our internal programs, play a significant role in the conduct of these trials and the subsequent collection and analysis of data. However, these third parties are not our employees, and except for contractual duties and obligations, we control only certain aspects of their activities and have limited ability to control the amount or timing of resources that they devote to our programs. Although we rely, and will continue to rely, on these third parties to conduct some of our preclinical and nonclinical studies and all of our clinical trials, we remain responsible for ensuring that each of our studies and clinical trials is conducted in accordance with the applicable protocol, legal, regulatory and scientific standards and our reliance on third parties does not relieve us of our regulatory responsibilities. We and these third parties are required to comply with current good laboratory practices, or GLPs, for preclinical and nonclinical studies, and good clinical practices, or GCPs, for clinical studies. GLPs and GCPs are regulations and guidelines enforced by the FDA, the Competent Authorities of the Member States of the European Economic Area, or EEA, and comparable foreign regulatory authorities for all of our products in preclinical and clinical development, respectively. Regulatory authorities enforce GCPs through periodic inspections of trial sponsors, principal investigators and trial sites. If we or any of our third party contractors fail to comply with applicable regulatory requirements, including GCPs, the clinical data generated in our clinical trials may be deemed unreliable and the FDA, the European Medicines Agency, or EMA, or comparable foreign regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. There can be no assurance that upon inspection by a given regulatory authority, such regulatory authority will determine that any of our clinical trials comply with GCP regulations. In addition, our clinical trials must be conducted with product produced under cGMP regulations. Our failure to comply with these regulations may require us to repeat clinical trials, which would delay the regulatory approval process.\\nEven if our product candidates obtain regulatory approval, they may never achieve market acceptance or commercial success, which will depend, in part, upon the degree of acceptance among physicians, patients, patient advocacy groups, health care payors and the medical community.\\nEven if our product candidates obtain FDA or other regulatory approvals, and are ultimately commercialized, our product candidates may not achieve market acceptance among physicians, patients, third-party payors, patient advocacy groups, health care payors and the medical community. Market acceptance of our product candidates for which marketing approval is obtained depends on a number of factors, including:\\n| • | the efficacy of the products as demonstrated in clinical trials; |\\n\\n| • | the prevalence and severity of any side effects and overall safety profile of the product; |\\n\\n| • | the clinical indications for which the product is approved; |\\n\\n| • | advantages over existing therapies; |\\n\\n| • | acceptance by physicians, major operators of clinics and patients of the product as a safe and effective treatment; |\\n\\n| • | relative convenience and ease of administration of our products; |\\n\\n| • | the potential and perceived advantages of our product candidates over current treatment options or alternative treatments, including future alternative treatments; |\\n\\n| • | the cost of treatment in relation to alternative treatments and willingness to pay for our products, if approved, on the part of physicians and patients; |\\n\\n30\\n\\n| • | the availability of alternative products and their ability to meet market demand; |\\n\\n| • | the strength of our or our collaboration partners’ marketing and distribution organizations; |\\n\\n| • | the quality of our relationships with patient advocacy groups; and |\\n\\n| • | sufficient third-party coverage or reimbursement. |\\n\\nAny failure by our product candidates that obtain regulatory approval to achieve market acceptance or commercial success would adversely affect our results of operations.\\nOur product candidates may cause undesirable side effects or have other properties that could delay our clinical trials, or delay or prevent regulatory approval, limit the commercial profile of an approved label, or result in significant negative consequences following regulatory approval, if any. If any of our product candidates receives marketing approval and we or others later identify undesirable side effects caused by the product candidate, the ability to market the product candidates could be compromised.\\nUndesirable side effects caused by our product candidates could cause us, our collaboration partners, or regulatory authorities to interrupt, delay or halt clinical trials, result in the delay or denial of regulatory approval by the FDA or other comparable foreign regulatory authorities or limit the commercial profile of an approved label. To date, patients treated with tenapanor have experienced drug-related side effects including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. In the event that trials conducted by us or AstraZeneca with tenapanor, or trials we conduct with our other product candidates, reveal an unacceptable severity and prevalence of these or other side effects, such trials could be suspended or terminated and the FDA or comparable foreign regulatory authorities could order AstraZeneca or us to cease further development of or deny approval of tenapanor, or any such other product candidate, for any or all targeted indications. The drug-related side effects could affect patient recruitment or the ability of enrolled patients to complete the trial or result in potential product liability claims. Any of these occurrences may harm our business, financial condition and prospects significantly.\\nIn addition, in the event that any of our product candidates receives regulatory approval and we or others later identify undesirable side effects caused by one of our products, a number of potentially significant negative consequences could occur, including:\\n| • | regulatory authorities may withdraw their approval of the product or seize the product; |\\n\\n| • | we, or our collaboration partners, may be required to recall the product; |\\n\\n| • | additional restrictions may be imposed on the marketing of the particular product or the manufacturing processes for the product or any component thereof, including the imposition of a Risk Evaluation and Mitigation Strategies, or REMS, plan that may require creation of a Medication Guide outlining the risks of such side effects for distribution to patients, as well as elements to assure safe use of the product, such as a patient registry and training and certification of prescribers; |\\n\\n| • | we, or our collaboration partners, may be subject to fines, injunctions or the imposition of civil or criminal penalties; |\\n\\n| • | regulatory authorities may require the addition of labeling statements, such as a “black box” warning or a contraindication; |\\n\\n| • | we could be sued and held liable for harm caused to patients; |\\n\\n| • | the product may become less competitive; and |\\n\\n| • | our reputation may suffer |\\n\\nAny of the foregoing events could prevent us, or our collaboration partners, from achieving or maintaining market acceptance of a particular product candidate, if approved, and could result in the loss of significant revenue to us, which would materially and adversely affect our results of operations and business.\\nWe face substantial competition and our competitors may discover, develop or commercialize products faster or more successfully than us.\\nThe biotechnology and pharmaceutical industries are highly competitive, and we face significant competition from companies in the biotechnology, pharmaceutical and other related markets that are researching and marketing products designed to address diseases that we are currently developing products to treat. If approved for marketing by the FDA or other regulatory agencies, tenapanor, or our other product candidates, would compete against existing treatments. For example, tenapanor will, if approved, compete directly with phosphate binders for the treatment of hyperphosphatemia in patients with ESRD, including sevelamer hydrochloride (Renagel) and sevelamer carbonate (Renvela), which were launched by Genzyme. Impax Laboratories, Inc. launched an authorized generic version of sevelamer carbonate in April 2014 and is expected to launch a generic version of sevelamer hydrochloride in September 2014. In addition to the currently marketed phosphate binders, we are aware of several other binders in development such as ferric citrate (Zerenex), an iron-based binder in Phase 3 being developed in the United States by Keryx and approved in Japan, and fermagate (Alpharen), an iron-based binder in Phase 2 being developed by Opko Health.\\n31\\nWhile there are no treatments for CKD that have been proven to reverse the disease, we are aware of one agent, CLP-1001, being developed by Sorbent Therapeutics, which is an orally administered, non-systemic exchange resin that binds both sodium and potassium as well as protons that showed positive effects in CKD patients with heart failure in a Phase 2a clinical trial and which showed the ability to increase fecal sodium. We believe this agent, if approved, may be competitive with tenapanor to treat CKD and ESRD patients. We are aware of certain investigational drugs that were being developed for delaying kidney decline as measured by estimated glomerular filtration rate, or eGFR. Among other products, Concert Pharmaceuticals is developing CTP-499 which showed protective effects on kidney function at 48 weeks in a Phase 2 clinical trial in patients with CKD and type 2 diabetes.\\nNumerous treatments exist for constipation and the constipation component of IBS-C, many of which are over-the-counter. These include psyllium husk (such as Metamucil), methylcellulose (such as Citrucel), calcium polycarbophil (such as FiberCon), lactulose (such as Cephulac), polyethylene glycol (such as MiraLax), sennosides (such as Exlax), bisacodyl (such as Ducolax), docusate sodium (such as Colace), magnesium hydroxide (such as Milk of Magnesia), saline enemas (such as Fleet) and sorbitol. These agents are generally inexpensive and work well to relieve temporary constipation. We are also aware of two prescription drugs currently on the U.S. market that are approved to treat IBS-C, Linzess (linaclotide), which was developed by Ironwood Pharmaceuticals and was approved in 2012 and 2013 for IBS-C and chronic constipation in both the United States and in Europe, and Amitiza (lubiprostone), which was first approved in the United States in 2006 and is currently marketed by Sucampo and Takeda for treatment of chronic idiopathic constipation, or CIC, IBS-C and opioid induced constipation, or OIC.\\nIt is possible that our competitors will develop and market drugs or other treatments that are less expensive and more effective than our product candidates, or that will render our product candidates obsolete. It is also possible that our competitors will commercialize competing drugs or treatments before we, or our collaboration partners, can launch any products developed from our product candidates. We also anticipate that we will face increased competition in the future as new companies enter into our target markets.\\nMany of our competitors have materially greater name recognition and financial, manufacturing, marketing, research and drug development resources than we do. Additional mergers and acquisitions in the biotechnology and pharmaceutical industries may result in even more resources being concentrated in our competitors. Large pharmaceutical companies in particular have extensive expertise in preclinical and clinical testing and in obtaining regulatory approvals for drugs. In addition, academic institutions, government agencies, and other public and private organizations conducting research may seek patent protection with respect to potentially competitive products or technologies. These organizations may also establish exclusive collaboration partnerships or licensing relationships with our competitors.\\nWe currently have no sales organization. If we are unable to establish sales capabilities on our own or through third parties, we may not be able to co-promote tenapanor, if approved, or commercialize or co-promote any of our other product candidates.\\nWe currently do not have a sales organization. In order to co-promote tenapanor or commercialize or co-promote any of our other product candidates, we must build our marketing, sales, distribution, managerial and other non-technical capabilities or make arrangements with third parties to perform these services, and we may not be successful in doing so. If one or more of our product candidates receives regulatory approval, we expect to establish a specialty sales organization with technical expertise and supporting distribution capabilities to co-promote and/or commercialize our product candidates, which will be expensive and time consuming. As a company, we have no prior experience in the marketing, sale and distribution of pharmaceutical products and there are significant risks involved in building and managing a sales organization, including our ability to hire, retain, and incentivize qualified individuals, generate sufficient sales leads, provide adequate training to sales and marketing personnel, comply with regulatory requirements applicable to the marketing and sale of drug products and effectively manage a geographically dispersed sales and marketing team. Any failure or delay in the development of our internal sales, marketing and distribution capabilities would adversely impact the commercialization of these products.\\nWe may choose to collaborate with third parties that have direct sales forces and established distribution systems, either to augment our own sales force and distribution systems or in lieu of our own sales force and distribution systems. If we are unable to enter into such arrangements on acceptable terms or at all, we may not be able to successfully commercialize our product candidates.\\n32\\nWe rely completely on third parties to manufacture our preclinical and clinical drug supplies, and we intend to rely on third parties to produce commercial supplies of any approved product candidate. Our business would be harmed if those third parties fail to obtain approval of the FDA, Competent Authorities of the Member States of the EEA or comparable regulatory authorities, fail to provide us with sufficient quantities of drug product, or fail to do so at acceptable quality levels or prices.\\nWe do not currently have, nor do we plan to acquire, the infrastructure or capability internally to manufacture our preclinical and clinical drug supplies for use in the conduct of our preclinical and clinical studies, and we lack the resources and the capability to manufacture any of our product candidates on a clinical or commercial scale. The facilities used by our contract manufacturers to manufacture any drug products must be approved by the FDA pursuant to inspections that will be conducted after an NDA is submitted to the FDA. We do not control the manufacturing process of our product candidates, and, other than with respect to tenapanor, we are completely dependent on our contract manufacturing partners for compliance with the regulatory requirements, known as cGMPs, for manufacture of both active drug substances and finished drug products. Under our agreement with AstraZeneca, the manufacturing of tenapanor is the responsibility of AstraZeneca. We are entirely dependent on AstraZeneca for all aspects of the manufacturing and validation process, as well as providing all commercial supply of tenapanor. For additional information regarding the risks of our dependence on AstraZeneca, see the risk factors above titled “We are substantially dependent on the success of our lead product candidate, tenapanor, which may not be successful in nonclinical studies or clinical trials, receive regulatory approval or be successfully commercialized” and “We are dependent on AstraZeneca for the development, regulatory approval, manufacture and commercialization of our small molecule NHE3 inhibitor program, which includes tenapanor, and if AstraZeneca fails to perform as expected, or is unable to obtain the required regulatory approvals for tenapanor, the potential for us to generate future revenue from milestone and royalty payments from tenapanor would be significantly reduced and our business would be materially and adversely harmed.”\\nIf our contract manufacturers cannot successfully manufacture material that conforms to our specifications and the strict regulatory requirements of the FDA or others, they will not be able to secure and/or maintain regulatory approval for their manufacturing facilities. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel. If the FDA or a comparable foreign regulatory authority does not approve these facilities for the manufacture of our product candidates or if it withdraws any such approval in the future, we may need to find alternative manufacturing facilities, which would significantly impact our ability to develop, obtain regulatory approval for or market our product candidates, if approved.\\nWe rely on our manufacturers to purchase from third-party suppliers the materials necessary to produce our product candidates for our clinical studies. There are a limited number of suppliers for raw materials that we use to manufacture our drugs, and there may be a need to identify alternate suppliers to prevent a possible disruption of the manufacture of the materials necessary to produce our product candidates for our clinical studies, and, if approved, ultimately for commercial sale. We do not have any control over the process or timing of the acquisition of these raw materials by our manufacturers. Although we generally do not begin a clinical study unless we believe we have on hand, or will be able to manufacture a sufficient supply of a product candidate to complete such study, any significant delay or discontinuity in the supply of a product candidate, or the raw material components thereof, for an ongoing clinical study due to the need to replace a third-party manufacturer could considerably delay completion of our clinical studies, product testing, and potential regulatory approval of our product candidates, which could harm our business and results of operations.\\nThird-party payor coverage and reimbursement status of newly-approved products is uncertain. Failure to obtain or maintain adequate coverage and reimbursement for our products, if approved, could limit our ability to market those products and decrease our ability to generate revenue.\\nThe pricing, coverage and reimbursement of our product candidates, if approved, must be adequate to support a commercial infrastructure. The availability and adequacy of coverage and reimbursement by governmental and private payors are essential for most patients to be able to afford treatments such as ours, assuming approval. Sales of our product candidates will depend substantially, both domestically and abroad, on the extent to which the costs of our product candidates will be paid for by health maintenance, managed care, pharmacy benefit, and similar healthcare management organizations, or reimbursed by government authorities, private health insurers, and other third-party payors. If coverage and reimbursement are not available, or are available only to limited levels, we may not be able to successfully commercialize our product candidates. Even if coverage is provided, the approved reimbursement amount may not be high enough to allow us to establish or maintain pricing sufficient to realize a return on our investment.\\nThere is significant uncertainty related to the insurance coverage and reimbursement of newly approved products. In the United States, the principal decisions about coverage and reimbursement for new drugs are typically made by the Centers for Medicare & Medicaid Services, or CMS, an agency within the U.S. Department of Health and Human Services responsible for administering the Medicare program, as CMS decides whether and to what extent a new drug will be covered and reimbursed under Medicare. Private payors tend to follow the coverage reimbursement policies established by CMS to a substantial degree. It is difficult to predict what CMS will decide with respect to reimbursement for products such as ours.\\n33\\nIn July 2010, CMS released its final rule to implement a bundled prospective payment system for the treatment of ESRD patients as required by the Medicare Improvements for Patients and Providers Act, or MIPPA. The bundled payment covers a bundle of items and services routinely required for dialysis treatments furnished to Medicare beneficiaries in Medicare-certified ESRD facilities or at their home, including the cost of certain routine drugs. The final rule delayed the inclusion of oral medications without intravenous equivalents in the bundled payment until January 1, 2014 and in April 2014, President Obama signed the Protecting Access to Medicare Act of 2014, which further extends this implementation date to January 1, 2024. As a result of the recent legislation, beginning in 2024, ESRD-related drugs will be included in the bundle and separate Medicare reimbursement will no longer be available for such drugs, as it is today under Medicare Part D. While it is too early to project the full impact bundling may have on the industry, the impact could potentially cause dramatic price reductions for tenapanor, if approved. We and AstraZeneca may be unable to sell tenapanor, if approved, to dialysis providers on a profitable basis if third-party payors reduce their current levels of payment, or if our costs of production increase faster than increases in reimbursement levels.\\nOutside the United States, international operations are generally subject to extensive governmental price controls and other market regulations, and we believe the increasing emphasis on cost-containment initiatives in Europe, Canada, China and other countries has and will continue to put pressure on the pricing and usage of our product candidates. In many countries, the prices of medical products are subject to varying price control mechanisms as part of national health systems. Other countries allow companies to fix their own prices for medicinal products, but monitor and control company profits. Additional foreign price controls or other changes in pricing regulation could restrict the amount that we are able to charge for our product candidates. Accordingly, in markets outside the United States, the reimbursement for our products may be reduced compared with the United States and may be insufficient to generate commercially reasonable revenue and profits.\\nMoreover, increasing efforts by governmental and third-party payors in the United States and abroad to cap or reduce healthcare costs may cause such organizations to limit both coverage and the level of reimbursement for new products approved and, as a result, these caps may not cover or provide adequate payment for our product candidates. We expect to experience pricing pressures in connection with the sale of any of our product candidates due to the trend toward managed healthcare, the increasing influence of health maintenance organizations, and additional legislative changes. The downward pressure on healthcare costs in general, particularly prescription drugs and surgical procedures and other treatments, has become very intense. As a result, increasingly high barriers are being erected to the entry of new products.\\nIf product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of our product candidates.\\nWe face an inherent risk of product liability as a result of the clinical testing of our product candidates and will face an even greater risk if we commercialize any products. For example, we may be sued if any product we develop allegedly causes injury or is found to be otherwise unsuitable during product testing, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product, negligence, strict liability, and a breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of our product candidates. Even successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, liability claims may result in:\\n| • | decreased demand for our product candidates; |\\n\\n| • | injury to our reputation; |\\n\\n| • | withdrawal of clinical trial participants; |\\n\\n| • | costs to defend the related litigation; |\\n\\n| • | a diversion of management’s time and our resources; |\\n\\n| • | substantial monetary awards to trial participants or patients; |\\n\\n| • | regulatory investigations, product recalls or withdrawals, or labeling, marketing or promotional restrictions; |\\n\\n| • | loss of revenue; and |\\n\\n| • | the inability to commercialize or co-promote our product candidates. |\\n\\nOur inability to obtain and maintain sufficient product liability insurance at an acceptable cost and scope of coverage to protect against potential product liability claims could prevent or inhibit the commercialization of any products we develop. We currently carry product liability insurance covering use in our clinical trials in the amount of $10.0 million in the aggregate. Although we maintain such insurance, any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions and deductibles, and we may be subject to a product liability claim for which we have no coverage. We will\\n34\\nhave to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insurance, and we may not have, or be able to obtain, sufficient capital to pay such amounts. Moreover, in the future, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses.\\nWe are highly dependent on the services of our President and Chief Executive Officer, Michael Raab, our Chief Scientific Officer, Dominique Charmot, Ph.D., and our Vice President of Drug Development, David Rosenbaum, Ph.D., and if we are not able to retain these members of our management or recruit additional management, clinical and scientific personnel, our business will suffer.\\nOur success depends in part on our continued ability to attract, retain and motivate highly qualified personnel. In particular, we are highly dependent upon Michael Raab, our President and Chief Executive Officer, Dominique Charmot, Ph.D., our Chief Scientific Officer, and David Rosenbaum, Ph.D., our Vice President of Drug Development. The loss of services of any of these individuals could delay or prevent the successful development of our product pipeline, completion of our planned clinical trials or the commercialization of our product candidates. Although we have entered into employment agreements with our senior management team, including Mr. Raab and Drs. Charmot and Rosenbaum, these agreements are terminable at will with or without notice and, therefore, we may not be able to retain their services as expected. Although we have not historically experienced unique difficulties attracting and retaining qualified employees, we could experience such problems in the future. For example, competition for qualified personnel in the biotechnology and pharmaceuticals field is intense due to the limited number of individuals who possess the skills and experience required by our industry. In addition to the competition for personnel, the San Francisco Bay area in particular is characterized by a high cost of living. As such, we could have difficulty attracting experienced personnel to our company and may be required to expend significant financial resources in our employee recruitment and retention efforts.\\nWe will need to significantly increase the size of our organization, and we may experience difficulties in managing growth.\\nAs of June 30, 2014, we had 36 full-time employees. We will need to continue to expand our managerial, operational, finance and other resources in order to manage our operations, preclinical and clinical trials, research and development activities, regulatory filings, manufacturing and supply activities, and any marketing and commercialization activities, including co-promotion activities. Our management, personnel, systems and facilities currently in place may not be adequate to support this future growth. Our need to effectively execute our growth strategy requires that we:\\n| • | expand our general and administrative functions; |\\n\\n| • | establish and build a marketing and commercial organization; |\\n\\n| • | identify, recruit, retain, incentivize and integrate additional employees; |\\n\\n| • | manage our internal development efforts effectively while carrying out our contractual obligations to third parties; and |\\n\\n| • | continue to improve our operational, legal, financial and management controls, reporting systems and procedures. |\\n\\nIf we are not able to attract, retain and motivate necessary personnel to accomplish our business objectives, we may experience constraints that will significantly impede the achievement of our development objectives, our ability to raise additional capital and our ability to implement our business strategy.\\nWe incur significant costs as a result of operating as a public company, and our management will devote substantial time to new compliance initiatives. We may fail to comply with the rules that apply to public companies, including Section 404 of the Sarbanes-Oxley Act of 2002, which could result in sanctions or other penalties that would harm our business.\\nWe incur significant legal, accounting and other expenses as a public company, including costs resulting from public company reporting obligations under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and regulations regarding corporate governance practices. The listing requirements of The NASDAQ Global Market require that we satisfy certain corporate governance requirements relating to director independence, distributing annual and interim reports, stockholder meetings, approvals and voting, soliciting proxies, conflicts of interest and a code of conduct. Our management and other personnel will need to devote a substantial amount of time to ensure that we comply with all of these requirements, and we will need to hire additional accounting and financial staff with appropriate public company reporting experience and technical accounting knowledge. Moreover, the reporting requirements, rules and regulations will increase our legal and financial compliance costs and will make some activities more time consuming and costly. Any changes we make to comply with these obligations may not be sufficient to allow us to satisfy our obligations as a public company on a timely basis, or at all. These reporting requirements, rules and regulations, coupled with the increase in potential litigation exposure associated with being a public company, could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or board committees or to serve as executive officers, or to obtain certain types of insurance, including directors’ and officers’ insurance, on acceptable terms.\\n35\\nIn addition, we expect to implement an enterprise resource planning, or ERP, system for our company in connection with becoming a public reporting company. An ERP system is intended to combine and streamline the management of our financial, accounting, human resources, sales and marketing and other functions, enabling us to manage operations and track performance more effectively. However, an ERP system will require us to complete many processes and procedures for the effective use of the system or to run our business using the system, which may result in substantial costs. Additionally, during the conversion process, we may be limited in our ability to convert any business that we acquire to the ERP. Any disruptions or difficulties in implementing or using an ERP system could adversely affect our controls and harm our business, including our ability to forecast or make sales and collect our receivables. Moreover, such disruption or difficulties could result in unanticipated costs and diversion of management attention.\\nWe are subject to Section 404 of The Sarbanes-Oxley Act of 2002, or Section 404, and the related rules of the Securities and Exchange Commission, or SEC, which generally require our management and independent registered public accounting firm to report on the effectiveness of our internal control over financial reporting. Beginning with the second annual report that we will be required to file with the SEC, Section 404 requires an annual management assessment of the effectiveness of our internal control over financial reporting. However, for so long as we remain an emerging growth company as defined in the Jumpstart Our Business Startups Act of 2012, or JOBS Act, we intend to take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404. Once we are no longer an emerging growth company or, if prior to such date, we opt to no longer take advantage of the applicable exemption, we will be required to include an opinion from our independent registered public accounting firm on the effectiveness of our internal controls over financial reporting. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\\nTo date, we have not conducted any other review of our internal control for the purpose of providing the reports required by Section 404 and the related SEC rules. During the course of our review and testing, we may identify deficiencies and be unable to remediate them before we must provide the required reports. Furthermore, if we have a material weakness in our internal controls over financial reporting, we may not detect errors on a timely basis and our financial statements may be materially misstated. We or our independent registered public accounting firm may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting, which could harm our operating results, cause investors to lose confidence in our reported financial information and cause the trading price of our stock to fall. In addition, as a public company we are required to file accurate and timely quarterly and annual reports with the SEC under the Exchange Act. Any failure to report our financial results on an accurate and timely basis could result in sanctions, lawsuits, delisting of our shares from The NASDAQ Global Market or other adverse consequences that would materially harm our business.\\nWe may form additional collaboration partnerships in the future with respect to our independent programs, and we may not realize the benefits of such collaborations.\\nWe may form collaboration partnerships, create joint ventures or enter into licensing arrangements with third parties with respect to our independent programs that we believe will complement or augment our existing business. We have historically engaged, and intend to continue to engage, in partnering discussions with a range of pharmaceutical and biotechnology companies and could enter into new collaboration partnerships at any time. We face significant competition in seeking appropriate collaboration partners, and the negotiation process to secure appropriate terms is time-consuming and complex. Any delays in identifying suitable collaboration partners and entering into agreements to develop our product candidates could also delay the commercialization of our product candidates, which may reduce their competitiveness even if they reach the market. Moreover, we may not be successful in our efforts to establish such a collaboration partnership for any future product candidates and programs on terms that are acceptable to us, or at all. This may be because our product candidates and programs may be deemed to be at too early of a stage of development for collaborative effort, our research and development pipeline may be viewed as insufficient, and/or third parties may not view our product candidates and programs as having sufficient potential for commercialization, including the likelihood of an adequate safety and efficacy profile. Even if we are successful in entering into a collaboration partnership or license arrangement, there is no guarantee that the collaboration partnership will be successful, or that any future collaboration partner will commit sufficient resources to the development, regulatory approval, and commercialization effort for such products, or that such alliances will result in us achieving revenues that justify such transactions.\\n36\\nWe may engage in strategic transactions that could impact our liquidity, increase our expenses and present significant distractions to our management.\\nWe intend to consider strategic transactions, such as acquisitions of companies, asset purchases, and or in-licensing of products, product candidates or technologies. Additional potential transactions that we may consider include a variety of different business arrangements, including spin-offs, collaboration partnerships, joint ventures, restructurings, divestitures, business combinations and investments. Any such transaction may require us to incur non-recurring or other charges, may increase our near- and long-term expenditures and may pose significant integration challenges or disrupt our management or business, which could adversely affect our operations and financial results. For example, these transactions may entail numerous operational and financial risks, including:\\n| • | up-front, milestone and royalty payments, equity investments and financial support of new research and development candidates including increase of personnel, all of which may be substantial; |\\n\\n| • | exposure to unknown liabilities; |\\n\\n| • | disruption of our business and diversion of our management’s time and attention in order to develop acquired products, product candidates or technologies; |\\n\\n| • | incurrence of substantial debt or dilutive issuances of equity securities to pay for acquisitions; |\\n\\n\\n| • | higher-than-expected acquisition and integration costs; |\\n\\n| • | write-downs of assets or goodwill or impairment charges; |\\n\\n| • | increased amortization expenses; |\\n\\n| • | difficulty and cost in combining the operations and personnel of any acquired businesses with our operations and personnel; |\\n\\n| • | impairment of relationships with key suppliers or customers of any acquired businesses due to changes in management and ownership; and |\\n\\n| • | inability to retain key employees of any acquired businesses. |\\n\\nAccordingly, although there can be no assurance that we will undertake or successfully complete any transactions of the nature described above, any transactions that we do complete may be subject to the foregoing or other risks and could have a material adverse effect on our business, results of operations, financial condition and prospects.\\nIf we seek and obtain approval to commercialize our product candidates outside of the United States, or otherwise engage in business outside of the United States, a variety of risks associated with international operations could materially adversely affect our business.\\nWe may decide to seek marketing approval for certain of our product candidates outside the United States or otherwise engage in business outside the United States, including entering into contractual agreements with third-parties. We expect that we will be subject to additional risks related to entering into these international business markets and relationships, including:\\n| • | different regulatory requirements for drug approvals in foreign countries; |\\n\\n| • | differing United States and foreign drug import and export rules; |\\n\\n| • | reduced protection for intellectual property rights in foreign countries; |\\n\\n| • | unexpected changes in tariffs, trade barriers and regulatory requirements; |\\n\\n| • | different reimbursement systems, and different competitive drugs; |\\n\\n| • | economic weakness, including inflation, or political instability in particular foreign economies and markets; |\\n\\n| • | compliance with tax, employment, immigration and labor laws for employees living or traveling abroad; |\\n\\n| • | foreign taxes, including withholding of payroll taxes; |\\n\\n| • | foreign currency fluctuations, which could result in increased operating expenses and reduced revenues, and other obligations incident to doing business in another country; |\\n\\n| • | workforce uncertainty in countries where labor unrest is more common than in the United States; |\\n\\n| • | production shortages resulting from any events affecting raw material supply or manufacturing capabilities abroad; |\\n\\n| • | potential liability resulting from development work conducted by these distributors; and |\\n\\n| • | business interruptions resulting from geopolitical actions, including war and terrorism, or natural disasters. |\\n\\n37\\nOur business involves the use of hazardous materials and we and third-parties with whom we contract must comply with environmental laws and regulations, which can be expensive and restrict how we do business.\\nOur research and development activities involve the controlled storage, use and disposal of hazardous materials, including the components of our product candidates and other hazardous compounds. We and manufacturers and suppliers with whom we may contract are subject to laws and regulations governing the use, manufacture, storage, handling and disposal of these hazardous materials. In some cases, these hazardous materials and various wastes resulting from their use are stored at our and our manufacturers’ facilities pending their use and disposal. We cannot eliminate the risk of contamination, which could cause an interruption of our commercialization efforts, research and development efforts and business operations, environmental damage resulting in costly clean-up and liabilities under applicable laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. We cannot guarantee that that the safety procedures utilized by third-party manufacturers and suppliers with whom we may contract will comply with the standards prescribed by laws and regulations or will eliminate the risk of accidental contamination or injury from these materials. In such an event, we may be held liable for any resulting damages and such liability could exceed our resources and state or federal or other applicable authorities may curtail our use of certain materials and/or interrupt our business operations. Furthermore, environmental laws and regulations are complex, change frequently and have tended to become more stringent. We cannot predict the impact of such changes and cannot be certain of our future compliance. We do not currently carry biological or hazardous waste insurance coverage.\\nOur internal computer systems, or those of our CROs or other contractors or consultants, may fail or suffer security breaches, which could result in a material disruption of our product development programs.\\nDespite the implementation of security measures, our internal computer systems and those of our CROs and other contractors and consultants are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failures. While we have not experienced any such system failure, accident or security breach to date, if such an event were to occur and cause interruptions in our operations, it could result in a material disruption of our programs. For example, the loss of clinical trial data from completed or ongoing clinical trials for any of our product candidates could result in delays in our regulatory approval efforts and significantly increase our costs to recover or reproduce the data. To the extent that any disruption or security breach results in a loss of or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we could incur liability and the further development of our product candidates could be delayed.\\nWe may be adversely affected by the current global economic environment.\\nOur ability to attract and retain collaboration partners or customers, invest in and grow our business and meet our financial obligations depends on our operating and financial performance, which, in turn, is subject to numerous factors, including the prevailing economic conditions and financial, business and other factors beyond our control, such as the rate of unemployment, the number of uninsured persons in the United States and inflationary pressures. Our results of operations could be adversely affected by general conditions in the global economy and in the global financial markets. The recent global financial crisis caused extreme volatility and disruptions in the capital and credit markets. We cannot anticipate all the ways in which the current global economic climate and global financial market conditions could adversely impact our business.\\nWe are exposed to risks associated with reduced profitability and the potential financial instability of our collaboration partners or customers, many of which may be adversely affected by volatile conditions in the financial markets. For example, unemployment and underemployment, and the resultant loss of insurance, may decrease the demand for healthcare services and pharmaceuticals. If fewer patients are seeking medical care because they do not have insurance coverage, our collaboration partners or customers may experience reductions in revenues, profitability and/or cash flow that could lead them to reduce their support of our programs or financing activities. If collaboration partners or customers are not successful in generating sufficient revenue or are precluded from securing financing, they may not be able to pay, or may delay payment of, accounts receivable that are owed to us. In addition, the volatility in the financial markets could cause significant fluctuations in the interest rate and currency markets. We currently do not hedge for these risks. The foregoing events, in turn, could adversely affect our financial condition and liquidity. In addition, if economic challenges in the United States result in widespread and prolonged unemployment, either regionally or on a national basis, prior to the effectiveness of certain provisions of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act, collectively known as the Affordable Care Act, a substantial number of people may become uninsured or underinsured. To the extent economic challenges result in fewer individuals pursuing or being able to afford our product candidates once commercialized, our business, results of operations, financial condition and cash flows could be adversely affected.\\nWe may be adversely affected by earthquakes or other natural disasters and our business continuity and disaster recovery plans may not adequately protect us from a serious disaster.\\nOur corporate headquarters and other facilities are located in the San Francisco Bay Area, which in the past has experienced severe earthquakes. We do not carry earthquake insurance. Earthquakes or other natural disasters could severely disrupt our operations, and have a material adverse effect on our business, results of operations, financial condition and prospects.\\n38\\nIf a natural disaster, power outage or other event occurred that prevented us from using all or a significant portion of our headquarters, that damaged critical infrastructure, such as our enterprise financial systems or manufacturing resource planning and enterprise quality systems, or that otherwise disrupted operations, it may be difficult or, in certain cases, impossible for us to continue our business for a substantial period of time. The disaster recovery and business continuity plans we have in place currently are limited and are unlikely to prove adequate in the event of a serious disaster or similar event. We may incur substantial expenses as a result of the limited nature of our disaster recovery and business continuity plans, which, particularly when taken together with our lack of earthquake insurance, could have a material adverse effect on our business.\\nRisks Related to Government Regulation\\nThe regulatory approval processes of the FDA and comparable foreign authorities are lengthy, time consuming and inherently unpredictable. If we are ultimately unable to obtain regulatory approval for our product candidates, our business will be substantially harmed.\\nThe research, testing, manufacturing, labeling, approval, selling, import, export, marketing and distribution of drug products are subject to extensive regulation by the FDA and other regulatory authorities in the United States and other countries, which regulations differ from country to country. Neither we nor any of our collaboration partners is permitted to market any drug product in the United States until we receive marketing approval from the FDA. We have not submitted an application or obtained marketing approval for any of our product candidates anywhere in the world. Obtaining regulatory approval of a new drug application, or NDA, can be a lengthy, expensive and uncertain process. In addition, failure to comply with FDA and other applicable United States and foreign regulatory requirements may subject us to administrative or judicially imposed sanctions or other actions, including:\\n| • | warning letters; |\\n\\n| • | civil and criminal penalties; |\\n\\n| • | injunctions; |\\n\\n| • | withdrawal of regulatory approval of products; |\\n\\n| • | product seizure or detention; |\\n\\n| • | product recalls; |\\n\\n| • | total or partial suspension of production; and |\\n\\n| • | refusal to approve pending NDAs or supplements to approved NDAs. |\\n\\nPrior to obtaining approval to commercialize a drug candidate in the United States or abroad, we or our collaboration partners must demonstrate with substantial evidence from well-controlled clinical trials, and to the satisfaction of the FDA or other foreign regulatory agencies, that such drug candidates are safe and effective for their intended uses. The number of nonclinical studies and clinical trials that will be required for FDA approval varies depending on the drug candidate, the disease or condition that the drug candidate is designed to address, and the regulations applicable to any particular drug candidate. Results from nonclinical studies and clinical trials can be interpreted in different ways. Even if we believe the nonclinical or clinical data for our drug candidates are promising, such data may not be sufficient to support approval by the FDA and other regulatory authorities. Administering drug candidates to humans may produce undesirable side effects, which could interrupt, delay or halt clinical trials and result in the FDA or other regulatory authorities denying approval of a drug candidate for any or all targeted indications.\\nThe time required to obtain approval by the FDA and comparable foreign authorities is unpredictable, typically takes many years following the commencement of clinical studies, and depends upon numerous factors. The FDA and comparable foreign authorities have substantial discretion in the approval process and we may encounter matters with the FDA or such comparable authorities that requires us to expend additional time and resources and delay or prevent the approval of our product candidates. For example, the FDA may require us to conduct additional studies or trials for drug product either prior to or post-approval, such as additional drug-drug interaction studies or safety or efficacy studies or trials, or it may object to elements of our clinical development program such as the number of subjects in our current clinical trials from the United States. In addition, approval policies, regulations or the type and amount of clinical data necessary to gain approval may change during the course of a product candidate’s clinical development and may vary among jurisdictions, which may cause delays in the approval or result in a decision not to approve an application for regulatory approval. Despite the time and expense exerted, failure can occur at any stage. Applications for our product candidates could fail to receive regulatory approval for many reasons, including but not limited to the following:\\n| • | the FDA or comparable foreign regulatory authorities may disagree with the design or implementation of our, or our collaboration partners’, clinical studies; |\\n\\n| • | the population studied in the clinical program may not be sufficiently broad or representative to assure safety in the full population for which approval is sought; |\\n\\n39\\n\\n| • | the FDA or comparable foreign regulatory authorities may disagree with the interpretation of data from preclinical studies or clinical studies; |\\n\\n| • | the data collected from clinical studies of our product candidates may not be sufficient to support the submission of a NDA or other submission or to obtain regulatory approval in the United States or elsewhere; |\\n\\n| • | we or our collaboration partners may be unable to demonstrate to the FDA or comparable foreign regulatory authorities that a product candidate’s risk-benefit ratio for its proposed indication is acceptable; |\\n\\n| • | the FDA or comparable foreign regulatory authorities may fail to approve the manufacturing processes, test procedures and specifications, or facilities of third-party manufacturers responsible for clinical and commercial supplies; and |\\n\\n| • | the approval policies or regulations of the FDA or comparable foreign regulatory authorities may significantly change in a manner rendering our clinical data insufficient for approval. |\\n\\nThis lengthy approval process, as well as the unpredictability of the results of clinical studies, may result in our failure and/or that of our collaboration partners to obtain regulatory approval to market any of our product candidates, which would significantly harm our business, results of operations, and prospects. Additionally, if the FDA requires that we conduct additional clinical studies, places limitations in our label, delays approval to market our product candidates or limits the use of our products, our business and results of operations may be harmed.\\nIn addition, even if we were to obtain approval, regulatory authorities may approve any of our product candidates for fewer or more limited indications than we request, may not approve the price we intend to charge for our products, may grant approval contingent on the performance of costly post-marketing clinical trials, or may approve a product candidate with a label that does not include the labeling claims necessary or desirable for the successful commercialization of that product candidate. Any of the foregoing scenarios could materially harm the commercial prospects for our product candidates.\\nEven if we receive regulatory approval for a product candidate, we will be subject to ongoing regulatory obligations and continued regulatory review, which may result in significant additional expense. Additionally, any product candidates, if approved, could be subject to labeling and other restrictions and market withdrawal, and we may be subject to penalties if we fail to comply with regulatory requirements or experience unanticipated problems with our products.\\nEven if a drug is approved by the FDA or foreign regulatory authorities, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. These requirements include submissions of safety and other post-marketing information and reports, registration, as well as continued compliance with cGMPs and GCPs for any clinical trials that we conduct post-approval. As such, we and our third party contract manufacturers will be subject to continual review and periodic inspections to assess compliance with regulatory requirements. Accordingly, we and others with whom we work must continue to expend time, money, and effort in all areas of regulatory compliance, including manufacturing, production, and quality control. Regulatory authorities may also impose significant restrictions on a product’s indicated uses or marketing or impose ongoing requirements for potentially costly post-marketing studies. Furthermore, any new legislation addressing drug safety issues could result in delays or increased costs to assure compliance.\\nWe will also be required to report certain adverse reactions and production problems, if any, to the FDA, and to comply with requirements concerning advertising and promotion for our products. Promotional communications with respect to prescription drugs are subject to a variety of legal and regulatory restrictions and must be consistent with the information in the product’s approved label. As such, we may not promote our products for indications or uses for which they do not have FDA approval.\\nLater discovery of previously unknown problems with a product, including adverse events of unanticipated severity or frequency, or with our third-party manufacturers or manufacturing processes, or failure to comply with regulatory requirements, may result in, among other things:\\n| • | warning letters, fines or holds on clinical trials; |\\n\\n| • | restrictions on the marketing or manufacturing of the product, withdrawal of the product from the market or voluntary or mandatory product recalls; |\\n\\n| • | injunctions or the imposition of civil or criminal penalties; |\\n\\n| • | suspension or revocation of existing regulatory approvals; |\\n\\n| • | suspension of any of our ongoing clinical trials; |\\n\\n| • | refusal to approve pending applications or supplements to approved applications submitted by us; |\\n\\n| • | restrictions on our or our contract manufacturers’ operations; or |\\n\\n40\\n\\n| • | product seizure or detention, or refusal to permit the import or export of products. |\\n\\nAny government investigation of alleged violations of law could require us to expend significant time and resources in response, and could generate negative publicity. Any failure to comply with ongoing regulatory requirements may significantly and adversely affect our ability to commercialize our product candidates. If regulatory sanctions are applied or if regulatory approval is withdrawn, the value of our company and our operating results will be adversely affected.\\nIn addition, the FDA’s policies may change and additional government regulations may be enacted that could prevent, limit or delay regulatory approval of our product candidates. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or if we are not able to maintain regulatory compliance, we may lose any marketing approval that we may have obtained, which would adversely affect our business, prospects and ability to achieve or sustain profitability.\\nWe and our collaboration partners and contract manufacturers are subject to significant regulation with respect to manufacturing our product candidates. The manufacturing facilities on which we rely may not continue to meet regulatory requirements or may not be able to meet supply demands.\\nAll entities involved in the preparation of product candidates for clinical studies or commercial sale, including our existing contract manufacturers for our product candidates and AstraZeneca, and those contract manufacturers it may rely upon with respect to the manufacture of tenapanor, are subject to extensive regulation. Components of a finished therapeutic product approved for commercial sale or used in late-stage clinical studies must be manufactured in accordance with cGMP. These regulations govern manufacturing processes and procedures (including record keeping) and the implementation and operation of quality systems to control and assure the quality of investigational products and products approved for sale. Poor control of production processes can lead to the introduction of contaminants or to inadvertent changes in the properties or stability of our product candidates that may not be detectable in final product testing. We, our collaboration partners, or our contract manufacturers must supply all necessary documentation in support of an NDA or comparable regulatory filing on a timely basis and must adhere to cGMP regulations enforced by the FDA and other regulatory agencies through their facilities inspection programs. Some of our contract manufacturers have never produced a commercially approved pharmaceutical product and therefore have not obtained the requisite regulatory authority approvals to do so. The facilities and quality systems of some or all of our collaboration partners and third-party contractors must pass a pre-approval inspection for compliance with the applicable regulations as a condition of regulatory approval of our product candidates. In addition, the regulatory authorities may, at any time, audit or inspect a manufacturing facility involved with the preparation of our product candidates or our other potential products or the associated quality systems for compliance with the regulations applicable to the activities being conducted. Although we oversee the contract manufacturers, we cannot control the manufacturing process of, and are completely dependent on, other than with respect to tenapanor, our contract manufacturing partners for compliance with the regulatory requirements. AstraZeneca is fully responsible for the manufacture of tenapanor, and we are entirely dependent upon AstraZeneca for compliance with the regulatory requirements. If these facilities do not pass a pre-approval plant inspection, regulatory approval of the products may not be granted or may be substantially delayed until any violations are corrected to the satisfaction of the regulatory authority, if ever. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel.\\nThe regulatory authorities also may, at any time following approval of a product for sale, audit the manufacturing facilities of our collaboration partners and third-party contractors. If any such inspection or audit identifies a failure to comply with applicable regulations or if a violation of our product specifications or applicable regulations occurs independent of such an inspection or audit, we or the relevant regulatory authority may require remedial measures that may be costly and/or time consuming for us or a third party to implement, and that may include the temporary or permanent suspension of a clinical study or commercial sales or the temporary or permanent suspension of production or closure of a facility. Any such remedial measures imposed upon us or third parties with whom we contract could materially harm our business.\\nIf we, our collaboration partners, or any of our third-party manufacturers fail to maintain regulatory compliance, the FDA or other applicable regulatory authority can impose regulatory sanctions including, among other things, refusal to approve a pending application for a new drug product, withdrawal of an approval, or suspension of production. As a result, our business, financial condition, and results of operations may be materially harmed.\\nAdditionally, if supply from one approved manufacturer is interrupted, an alternative manufacturer would need to be qualified through an NDA, a supplemental NDA or equivalent foreign regulatory filing, which could result in further delay. The regulatory agencies may also require additional studies if a new manufacturer is relied upon for commercial production. Switching manufacturers may involve substantial costs and is likely to result in a delay in our desired clinical and commercial timelines.\\n41\\nThese factors could cause us to incur higher costs and could cause the delay or termination of clinical studies, regulatory submissions, required approvals, or commercialization of our product candidates. Furthermore, if our suppliers fail to meet contractual requirements and we are unable to secure one or more replacement suppliers capable of production at a substantially equivalent cost, our clinical studies may be delayed or we could lose potential revenue.\\nIf we fail to comply or are found to have failed to comply with FDA and other regulations related to the promotion of our products for unapproved uses, we could be subject to criminal penalties, substantial fines or other sanctions and damage awards.\\nThe regulations relating to the promotion of products for unapproved uses are complex and subject to substantial interpretation by the FDA and other government agencies. If tenapanor, or our other product candidates, receives marketing approval, we and our collaborating partners will be restricted from marketing the product outside of its approved labeling, also referred to as off-label promotion. However, physicians may nevertheless prescribe an approved product to their patients in a manner that is inconsistent with the approved label, which is an off-label use. We intend to implement compliance and training programs designed to ensure that our sales and marketing practices comply with applicable regulations regarding off-label promotion. Notwithstanding these programs, the FDA or other government agencies may allege or find that our practices constitute prohibited promotion of our product candidates for unapproved uses. We also cannot be sure that our employees will comply with company policies and applicable regulations regarding the promotion of products for unapproved uses.\\nOver the past several years, a significant number of pharmaceutical and biotechnology companies have been the target of inquiries and investigations by various federal and state regulatory, investigative, prosecutorial and administrative entities in connection with the promotion of products for unapproved uses and other sales practices, including the Department of Justice and various U.S. Attorneys’ Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission and various state Attorneys General offices. These investigations have alleged violations of various federal and state laws and regulations, including claims asserting antitrust violations, violations of the Food, Drug and Cosmetic Act, the False Claims Act, the Prescription Drug Marketing Act, anti-kickback laws, and other alleged violations in connection with the promotion of products for unapproved uses, pricing and Medicare and/or Medicaid reimbursement. Many of these investigations originate as “qui tam” actions under the False Claims Act. Under the False Claims Act, any individual can bring a claim on behalf of the government alleging that a person or entity has presented a false claim, or caused a false claim to be submitted, to the government for payment. The person bringing a qui tam suit is entitled to a share of any recovery or settlement. Qui tam suits, also commonly referred to as “whistleblower suits,” are often brought by current or former employees. In a qui tam suit, the government must decide whether to intervene and prosecute the case. If it declines, the individual may pursue the case alone.\\nIf the FDA or any other governmental agency initiates an enforcement action against us or if we are the subject of a qui tam suit and it is determined that we violated prohibitions relating to the promotion of products for unapproved uses, we could be subject to substantial civil or criminal fines or damage awards and other sanctions such as consent decrees and corporate integrity agreements pursuant to which our activities would be subject to ongoing scrutiny and monitoring to ensure compliance with applicable laws and regulations. Any such fines, awards or other sanctions would have an adverse effect on our revenue, business, financial prospects and reputation.\\nIf approved, tenapanor and our other product candidates may cause or contribute to adverse medical events that we are required to report to regulatory agencies and if we fail to do so we could be subject to sanctions that would materially harm our business.\\nSome participants in clinical studies of tenapanor have reported adverse effects after being treated with tenapanor, including diarrhea, nausea, flatulence, abdominal discomfort, abdominal pain, abdominal distention and changes in electrolytes. If we are successful in commercializing any products, FDA and foreign regulatory agency regulations require that we report certain information about adverse medical events if those products may have caused or contributed to those adverse events. The timing of our obligation to report would be triggered by the date we become aware of the adverse event as well as the nature of the event. We may fail to report adverse events we become aware of within the prescribed timeframe. We may also fail to appreciate that we have become aware of a reportable adverse event, especially if it is not reported to us as an adverse event or if it is an adverse event that is unexpected or removed in time from the use of our products. If we fail to comply with our reporting obligations, the FDA or a foreign regulatory agency could take action, including criminal prosecution, the imposition of civil monetary penalties, seizure of our products or delay in approval or clearance of future products.\\n42\\nOur employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in misconduct or other improper activities, including noncompliance with regulatory standards and requirements.\\nWe are exposed to the risk that our employees, independent contractors, principal investigators, CROs, collaboration partners, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate: (1) FDA regulations, including those laws that require the reporting of true, complete and accurate information to the FDA; (2) manufacturing standards; (3) federal and state healthcare fraud and abuse laws and regulations; or (4) laws that require the reporting of true and accurate financial information and data. Specifically, sales, marketing and business arrangements in the healthcare industry are subject to extensive laws and regulations intended to prevent fraud, kickbacks, self-dealing and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements. These activities also include the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. It is not always possible to identify and deter misconduct by employees and other third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, and curtailment of our operations, any of which could adversely affect our ability to operate our business and our results of operations.\\nFailure to obtain regulatory approvals in foreign jurisdictions would prevent us from marketing our products internationally.\\nIn order to market any product in the EEA (which is composed of the 28 Member States of the European Union plus Norway, Iceland and Liechtenstein), and many other foreign jurisdictions, separate regulatory approvals are required. In the EEA, medicinal products can only be commercialized after obtaining a Marketing Authorization, or MA. Before granting the MA, the EMA or the competent authorities of the Member States of the EEA make an assessment of the risk-benefit balance of the product on the basis of scientific criteria concerning its quality, safety and efficacy.\\nThe approval procedures vary among countries and can involve additional clinical testing, and the time required to obtain approval may differ from that required to obtain FDA approval. Clinical trials conducted in one country may not be accepted by regulatory authorities in other countries. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one or more foreign regulatory authorities does not ensure approval by regulatory authorities in other foreign countries or by the FDA. However, a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in others. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not be able to file for regulatory approvals or to do so on a timely basis, and even if we do file we may not receive necessary approvals to commercialize our products in any market.\\nWe and our collaboration partners may be subject to healthcare laws, regulation and enforcement; our failure or the failure of our collaboration partners to comply with these laws could have a material adverse effect on our results of operations and financial conditions.\\nAlthough we do not currently have any products on the market, once we begin commercializing our products, we and our collaboration partners may be subject to additional healthcare statutory and regulatory requirements and enforcement by the federal government and the states and foreign governments in which we conduct our business. The laws that may affect our ability to operate as a commercial organization include:\\n| • | the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, receiving, offering or paying remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual for, or the purchase, order or recommendation of, any good or service for which payment may be made under federal healthcare programs such as the Medicare and Medicaid programs; |\\n\\n| • | federal false claims laws which prohibit, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other third-party payors that are false or fraudulent; |\\n\\n| • | federal criminal laws that prohibit executing a scheme to defraud any healthcare benefit program or making false statements relating to healthcare matters; |\\n\\n| • | the federal Health Insurance Portability and Accountability Act of 1996, as amended by the Health Information Technology for Economic and Clinical Health Act, which governs the conduct of certain electronic healthcare transactions and protects the security and privacy of protected health information; |\\n\\n43\\n\\n| • | the federal physician sunshine requirements under the Affordable Care Act, which requires manufacturers of drugs, devices, biologics, and medical supplies to report annually to the CMS information related to payments and other transfers of value to physicians, other healthcare providers, and teaching hospitals, and ownership and investment interests held by physicians and other healthcare providers and their immediate family members; |\\n\\n| • | state law equivalents of each of the above federal laws, such as anti-kickback and false claims laws which may apply to items or services reimbursed by any third-party payor, including commercial insurers; |\\n\\n| • | state laws that require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines and the applicable compliance guidance promulgated by the federal government, or otherwise restrict payments that may be made to healthcare providers and other potential referral sources; |\\n\\n| • | state laws that require drug manufacturers to report information related to payments and other transfers of value to physicians and other healthcare providers or marketing expenditures; and state laws governing the privacy and security of health information in certain circumstances, many of which differ from each other in significant ways, thus complicating compliance efforts; and |\\n\\n| • | European and other foreign law equivalents of each of the laws, including reporting requirements detailing interactions with and payments to healthcare providers. |\\n\\nBecause of the breadth of these laws and the narrowness of the statutory exceptions and safe harbors available, it is possible that some of our business activities could be subject to challenge under one or more of such laws. The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Further, the Affordable Care Act, among other things, amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes. A person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. In addition, the Affordable Care Act provides that the government may assert that a claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims statutes. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business. If our operations are found to be in violation of any of the laws described above or any other governmental laws and regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, the curtailment or restructuring of our operations, the exclusion from participation in federal and state healthcare programs and imprisonment, any of which could adversely affect our ability to market our products and adversely impact our financial results.\\nLegislative or regulatory healthcare reforms in the United States may make it more difficult and costly for us to obtain regulatory clearance or approval of our product candidates and to produce, market and distribute our products after clearance or approval is obtained.\\nFrom time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the regulatory clearance or approval, manufacture, and marketing of regulated products or the reimbursement thereof. In addition, FDA regulations and guidance are often revised or reinterpreted by the FDA in ways that may significantly affect our business and our products. Any new regulations or revisions or reinterpretations of existing regulations may impose additional costs or lengthen review times of our product candidates. We cannot determine what effect changes in regulations, statutes, legal interpretation or policies, when and if promulgated, enacted or adopted may have on our business in the future. Such changes could, among other things, require:\\n| • | additional clinical trials to be conducted prior to obtaining approval; |\\n\\n| • | changes to manufacturing methods; |\\n\\n| • | recall, replacement, or discontinuance of one or more of our products; and |\\n\\n| • | additional record keeping. |\\n\\nEach of these would likely entail substantial time and cost and could materially harm our business and our financial results. In addition, delays in receipt of or failure to receive regulatory clearances or approvals for any future products would harm our business, financial condition and results of operations.\\nIn addition, the full impact of recent healthcare reform and other changes in the healthcare industry and in healthcare spending is currently unknown, and may adversely affect our business model. In the United States, the Affordable Care Act was enacted in 2010 with a goal of reducing the cost of healthcare and substantially changing the way healthcare is financed by both government and private insurers. The Affordable Care Act, among other things, increased the minimum Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program and extended the rebate program to individuals enrolled in Medicaid managed care organizations, established annual fees and taxes on manufacturers of certain branded prescription drugs, and created a new Medicare\\n44\\nPart D coverage gap discount program, in which manufacturers must agree to offer 50% point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period as a condition for the manufacturer’s outpatient drugs to be covered under Medicare Part D.\\nIn addition, other legislative changes have been proposed and adopted in the United States since the Affordable Care Act was enacted. On August 2, 2011, the Budget Control Act of 2011 created measures for spending reductions by Congress. A Joint Select Committee on Deficit Reduction, tasked with recommending a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, was unable to reach required goals, thereby triggering the legislation’s automatic reduction to several government programs. This included aggregate reductions of Medicare payments to providers of 2% per fiscal year, which went into effect on April 1, 2013. On January 2, 2013, the ATRA was signed into law, which, among other things, further reduced Medicare payments to several providers, including hospitals.\\nIt is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect the demand for any drug products for which we may obtain regulatory approval, our ability to set a price that we believe is fair for our products, our ability to obtain coverage and reimbursement approval for a product, our ability to generate revenues and achieve or maintain profitability, and the level of taxes that we are required to pay.\\nRisks Related to Intellectual Property\\nWe may become subject to claims alleging infringement of third parties’ patents or proprietary rights and/or claims seeking to invalidate our patents, which would be costly, time consuming and, if successfully asserted against us, delay or prevent the development and commercialization of tenapanor or any other product candidates.\\nThere have been many lawsuits and other proceedings asserting infringement or misappropriation of patents and other intellectual property rights in the pharmaceutical and biotechnology industries. There can be no assurances that we will not be subject to claims alleging that the manufacture, use or sale of tenapanor or any other product candidates nor that any activities conducted by us, infringes existing or future third-party patents, or that such claims, if any, will not be successful. Because patent applications can take many years to issue and may be confidential for 18 months or more after filing, and because pending patent claims can be revised before issuance, there may be applications now pending which may later result in issued patents that may be infringed by the manufacture, use or sale of tenapanor or other product candidates or by the operation of our business. Moreover, we may face patent infringement claims from non-practicing entities that have no relevant product revenue and against whom our own patent portfolio may thus have no deterrent effect. We may be unaware of one or more issued patents that would be infringed by the manufacture, sale or use of tenapanor or our other product candidates.\\nWe may be subject to third-party patent infringement claims in the future against us or our collaboration partners that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages, including treble damages and attorney’s fees if we are found to be willfully infringing a third party’s patents. We may be required to indemnify future collaboration partners against such claims. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If a patent infringement suit were brought against us or our collaboration partners, we or they could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit. As a result of patent infringement claims, or in order to avoid potential claims, we or our collaboration partners may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we or our collaboration partners were able to obtain a license, the rights may be nonexclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or forced to redesign it, or to cease some aspect of our business operations if, as a result of actual or threatened patent infringement claims, we or our collaboration partners are unable to enter into licenses on acceptable terms. Even if we are successful in defending against such claims, such litigation can be expensive and time consuming to litigate and would divert management’s attention from our core business. Any of these events could harm our business significantly.\\nIn addition to infringement claims against us, if third parties prepare and file patent applications in the United States that also claim technology similar or identical to ours, we may have to participate in interference or derivation proceedings in the United States Patent and Trademark Office, or the USPTO, to determine which party is entitled to a patent on the disputed invention. We may also become involved in similar opposition proceedings in the European Patent Office or similar offices in other jurisdictions regarding our intellectual property rights with respect to our products and technology. Since patent applications are confidential for a period of time after filing, we cannot be certain that we were the first to file any patent application related to our product candidates.\\n45\\nIf our intellectual property related to our product candidates is not adequate or if we are not able to protect our trade secrets or our confidential information, we may not be able to compete effectively in our market.\\nWe rely upon a combination of patents, trade secret protection and confidentiality agreements to protect the intellectual property related to our product candidates, our drug discovery and development platform and our development programs. Any disclosure to or misappropriation by third parties of our confidential or proprietary information could enable competitors to quickly duplicate or surpass our technological achievements, thus eroding our competitive position in our market.\\nThe strength of patents in the biotechnology and pharmaceutical field involves complex legal and scientific questions and can be uncertain. The patent applications that we own or license may fail to result in issued patents in the United States or in foreign countries. Additionally, our research and development efforts may result in product candidates for which patent protection is limited or not available. Even if patents do successfully issue, third parties may challenge the validity, enforceability or scope thereof, which may result in such patents being narrowed, invalidated or held unenforceable. For example, U.S. patents can be challenged by any person before the new USPTO Patent Trial and Appeals Board at any time before one year after that person is served an infringement complaint based on the patents. Patents granted by the European Patent Office may be similarly opposed by any person within nine months from the publication of the grant. Similar proceedings are available in other jurisdictions, and in the United States, Europe and other jurisdictions third parties can raise questions of validity with a patent office even before a patent has granted. Furthermore, even if they are unchallenged, our patents and patent applications may not adequately protect our intellectual property or prevent others from designing around our claims. For example, a third party may develop a competitive product that provides therapeutic benefits similar to one or more of our product candidates but has a sufficiently different composition to fall outside the scope of our patent protection. If the breadth or strength of protection provided by the patents and patent applications we hold or pursue with respect to our product candidates is successfully challenged, then our ability to commercialize such product candidates could be negatively affected, and we may face unexpected competition that could have a material adverse impact on our business. Further, if we encounter delays in our clinical trials, the period of time during which we or our collaboration partners could market tenapanor or other product candidates under patent protection would be reduced.\\nEven where laws provide protection, costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and the outcome of such litigation would be uncertain. If we or one of our collaboration partners were to initiate legal proceedings against a third party to enforce a patent covering the product candidate, the defendant could counterclaim that our patent is invalid and/or unenforceable. In patent litigation in the United States, defendant counterclaims alleging invalidity and/or unenforceability are commonplace. Grounds for a validity challenge could be an alleged failure to meet any of several statutory requirements, including lack of novelty, obviousness or non-enablement. Grounds for an unenforceability assertion could be an allegation that someone connected with prosecution of the patent withheld relevant information from the USPTO, or made a misleading statement, during prosecution. The outcome following legal assertions of invalidity and unenforceability is unpredictable. With respect to validity, for example, we cannot be certain that there is no invalidating prior art, of which we and the patent examiner were unaware during prosecution. If a defendant were to prevail on a legal assertion of invalidity and/or unenforceability against our intellectual property related to a product candidate, we would lose at least part, and perhaps all, of the patent protection on such product candidate. Such a loss of patent protection would have a material adverse impact on our business. Moreover, our competitors could counterclaim that we infringe their intellectual property, and some of our competitors have substantially greater intellectual property portfolios than we do.\\nWe also rely on trade secret protection and confidentiality agreements to protect proprietary know-how that may not be patentable, processes for which patents may be difficult to obtain and/or enforce and any other elements of our drug discovery and development processes that involve proprietary know-how, information or technology that is not covered by patents. Although we require all of our employees, consultants, advisors and any third parties who have access to our proprietary know-how, information or technology, to assign their inventions to us, and endeavor to execute confidentiality agreements with all such parties, we cannot be certain that we have executed such agreements with all parties who may have helped to develop our intellectual property or who had access to our proprietary information, nor can we be certain that our agreements will not be breached by such consultants, advisors or third parties, or by our former employees. The breach of such agreements by individuals or entities who are actively involved in the discovery and design of our potential drug candidates, or in the development of our discovery and design platform, including APECCS, could require us to pursue legal action to protect our trade secrets and confidential information, which would be expensive, and the outcome of which would be unpredictable. If we are not successful in prohibiting the continued breach of such agreements, our business could be negatively impacted. We cannot guarantee that our trade secrets and other confidential proprietary information will not be disclosed or that competitors will not otherwise gain access to our trade secrets or independently develop substantially equivalent information and techniques.\\n46\\nFurther, the laws of some foreign countries do not protect proprietary rights to the same extent or in the same manner as the laws of the United States. As a result, we may encounter significant problems in protecting and defending our intellectual property both in the United States and abroad. If we are unable to prevent material disclosure of the intellectual property related to our technologies to third parties, we will not be able to establish or maintain a competitive advantage in our market, which could materially adversely affect our business, results of operations and financial condition.\\nIf we or our collaboration partners do not obtain patent term extension in the United States under the Hatch-Waxman Act and in foreign countries under similar legislation, thereby potentially extending the term of marketing exclusivity for our product candidates, our business may be materially harmed.\\nDepending upon the timing, duration and specifics of FDA marketing approval of our product candidates, if any, one of the U.S. patents covering each of such approved product(s) or the use thereof may be eligible for up to five years of patent term restoration under the Hatch-Waxman Act. The Hatch-Waxman Act allows a maximum of one patent to be extended per FDA approved product. Patent term extension also may be available in certain foreign countries upon regulatory approval of our product candidates. Nevertheless, we or our collaboration partners may not be granted patent term extension either in the United States or in any foreign country because of, for example, failing to apply within applicable deadlines, failing to apply prior to expiration of relevant patents or otherwise failing to satisfy applicable requirements. Moreover, the term of extension, as well as the scope of patent protection during any such extension, afforded by the governmental authority could be less than we request.\\nIf we are unable to obtain patent term extension or restoration, or the term of any such extension is less than we or our collaboration partners request, the period during which we or our collaboration partners will have the right to exclusively market our product will be shortened and our competitors may obtain approval of competing products following our patent expiration, and our revenue could be reduced, possibly materially.\\nChanges in U.S. patent law could diminish the value of patents in general, thereby impairing our ability to protect our products.\\nAs is the case with other biopharmaceutical companies, our success is heavily dependent on intellectual property, particularly patents. Obtaining and enforcing patents in the biopharmaceutical industry involve both technological and legal complexity. Therefore, obtaining and enforcing biopharmaceutical patents is costly, time consuming and inherently uncertain. In addition, the United States has recently enacted and is currently implementing wide-ranging patent reform legislation, including the Leahy-Smith America Invents Act signed into law on September 16, 2011. That Act includes a number of significant changes to U.S. patent law. These include provisions that affect the way patent applications are prosecuted and new venues and opportunities for competitors to challenge patent portfolios. Because of that Act, the U.S. patent system is now a “first to file” system, which may make it more difficult to obtain patent protection for inventions and increase the uncertainties and costs surrounding the prosecution of our or our collaboration partners’ patent applications and the enforcement or defense of our or our collaboration partners’ issued patents, all of which could materially adversely affect our business, results of operations and financial condition.\\nThe United States Supreme Court has ruled on several patent cases in recent years, either narrowing the scope of patent protection available in certain circumstances or weakening the rights of patent owners in certain situations. In addition to increasing uncertainty with regard to our ability to obtain patents in the future, this combination of events has created uncertainty with respect to the value of patents once obtained. Depending on future actions by the U.S. Congress, the federal courts, and the USPTO, the laws and regulations governing patents could change in unpredictable ways that would weaken our ability to obtain new patents or to enforce our existing patents and patents that we might obtain in the future.\\nObtaining and maintaining our patent protection depends on compliance with various procedural, document submission, fee payment and other requirements imposed by governmental patent agencies, and our patent protection could be reduced or eliminated for non-compliance with these requirements.\\nThe USPTO and various foreign patent agencies require compliance with a number of procedural, documentary, fee payment and other provisions to maintain patent applications and issued patents. Noncompliance with these requirements can result in abandonment or lapse of a patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. In such an event, competitors might be able to enter the market earlier than would otherwise have been the case.\\nWe may not be able to enforce our intellectual property rights throughout the world.\\nThe laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. The legal systems of some countries, particularly developing countries, do not favor the enforcement of patents and other intellectual property protection, especially those relating to life sciences. This could make it difficult for us to stop the infringement of our patents or the misappropriation of our other intellectual property rights. For example, many foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties.\\n47\\nProceedings to enforce our patent rights in foreign jurisdictions, whether or not successful, could result in substantial costs and divert our efforts and attention from other aspects of our business. Furthermore, while we intend to protect our intellectual property rights in our expected significant markets, we cannot ensure that we will be able to initiate or maintain similar efforts in all jurisdictions in which we may wish to market our products. Accordingly, our efforts to protect our intellectual property rights in such countries may be inadequate. In addition, changes in the law and legal decisions by courts in the United States and foreign countries may affect our ability to obtain and enforce adequate intellectual property protection for our technology.\\nWe may be subject to claims that we or our employees have misappropriated the intellectual property, including know-how or trade secrets, of a third party, or claiming ownership of what we regard as our own intellectual property.\\nMany of our employees, consultants and contractors were previously employed at or engaged by other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Some of these employees, consultants and contractors, executed proprietary rights, non-disclosure and non-competition agreements in connection with such previous employment. Although we try to ensure that our employees, consultants and contractors do not use the intellectual property and other proprietary information or know-how or trade secrets of others in their work for us, and do not perform work for us that is in conflict with their obligations to another employer or any other entity, we may be subject to claims that we or these employees, consultants and contractors have used or disclosed such intellectual property, including know-how, trade secrets or other proprietary information. In addition, an employee, advisor or consultant who performs work for us may have obligations to a third party that are in conflict with their obligations to us, and as a result such third party may claim an ownership interest in the intellectual property arising out of work performed for us. We are not aware of any threatened or pending claims related to these matters, but in the future litigation may be necessary to defend against such claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel, or access to consultants and contractors. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to management.\\nIn addition, while we typically require our employees, consultants and contractors who may be involved in the development of intellectual property to execute agreements assigning such intellectual property to us, we may be unsuccessful in executing such an agreement with each party who in fact develops intellectual property that we regard as our own, which may result in claims by or against us related to the ownership of such intellectual property. If we fail in prosecuting or defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights. Even if we are successful in prosecuting or defending against such claims, litigation could result in substantial costs and be a distraction to our management and scientific personnel.\\nRisks Related to Our Common Stock\\nOur stock price may be volatile and our stockholders may not be able to resell shares of our common stock at or above the price they paid.\\nThe trading price of our common stock is highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. These factors include those discussed in this “Risk Factors” section of this Quarterly Report on Form 10Q and others such as:\\n| • | results from, or any delays in, clinical trial programs relating to our product candidates, including the ongoing and planned clinical trials for tenapanor; |\\n\\n| • | ability to commercialize or obtain regulatory approval for our product candidates, or delays in commercializing or obtaining regulatory approval; |\\n\\n| • | announcements of regulatory approval or a complete response letter to tenapanor, or specific label indications or patient populations for its use, or changes or delays in the regulatory review process; |\\n\\n| • | announcements relating to future collaboration partnerships or our existing collaboration partnerships with AstraZeneca and/or Sanofi, including decisions regarding the exercise by AstraZeneca or Sanofi of their options or any termination by them of any development program under their collaboration partnerships with us; |\\n\\n| • | our election, and the related announcement, to exercise our co-fund right with respect to the first Phase 3 clinical development program for tenapanor; |\\n\\n| • | announcements of therapeutic innovations or new products by us or our competitors; |\\n\\n| • | adverse actions taken by regulatory agencies with respect to our clinical trials, manufacturing supply chain or sales and marketing activities; |\\n\\n| • | changes or developments in laws or regulations applicable to our product candidates; |\\n\\n| • | any adverse changes to our relationship with any manufacturers or suppliers; |\\n\\n\\n| • | the success of our testing and clinical trials; |\\n\\n48\\n\\n| • | the success of our efforts to acquire or license or discover additional product candidates; |\\n\\n| • | any intellectual property infringement actions in which we may become involved; |\\n\\n| • | announcements concerning our competitors or the pharmaceutical industry in general; |\\n\\n| • | achievement of expected product sales and profitability; |\\n\\n| • | manufacture, supply or distribution shortages; |\\n\\n| • | actual or anticipated fluctuations in our operating results; |\\n\\n| • | FDA or other U.S. or foreign regulatory actions affecting us or our industry or other healthcare reform measures in the United States; |\\n\\n| • | changes in financial estimates or recommendations by securities analysts; |\\n\\n| • | trading volume of our common stock; |\\n\\n| • | sales of our common stock by us, our executive officers and directors or our stockholders in the future; |\\n\\n| • | general economic and market conditions and overall fluctuations in the United States equity markets; and |\\n\\n| • | the loss of any of our key scientific or management personnel. |\\n\\nIn addition, the stock markets in general, and the markets for pharmaceutical, biopharmaceutical and biotechnology stocks in particular, have experienced extreme volatility that may have been unrelated to the operating performance of the issuer. These broad market fluctuations may adversely affect the trading price or liquidity of our common stock. In the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the issuer. If any of our stockholders were to bring such a lawsuit against us, we could incur substantial costs defending the lawsuit and the attention of our management would be diverted from the operation of our business, which could seriously harm our financial position. Any adverse determination in litigation could also subject us to significant liabilities.\\nAn active, liquid and orderly market for our common stock may not develop or be sustained\\nWe completed our IPO in June 2014. Prior to that, there had been no public market for shares of our common stock. Following our IPO, the trading volume of our common stock on The NASDAQ Global Market has been limited, and an active public market for our shares may not develop or, if it develops, be sustained.\\nWe cannot predict the extent in which investor interest in our company will lead to the development of, or sustain an active trading market on The NASDAQ Global Market or otherwise or how liquid that market might become. The lack of an active market may impair our stockholders’ ability to sell their shares at the time they wish to sell them or at a price that they consider reasonable. An inactive market may also impair our ability to raise capital by selling shares and may impair our ability to acquire other businesses or technologies or in-license new product candidates using our shares as consideration.\\nIf securities or industry analysts do not continue to publish research or reports about our business, or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline.\\nThe trading market for our common stock is influenced by the research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or misleading opinion regarding us, our business model, our intellectual property or our stock performance, or if our clinical trials and operating results fail to meet the expectations of analysts, our stock price would likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.\\nWe are an “emerging growth company” and as a result of the reduced disclosure and governance requirements applicable to emerging growth companies, our common stock may be less attractive to investors.\\nWe are an “emerging growth company,” as defined in the JOBS Act, and we intend to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. If some investors find our common stock less attractive as a result of our reliance on the JOBS Act exemption, there may be a less active trading market for our common stock and our stock price may be more volatile. We may take advantage of these reporting exemptions until we are no longer an emerging growth company. We will remain an emerging growth company until the earlier of (1) the last day of the fiscal year following the fifth anniversary of the completion of our IPO (December 31, 2019), (2) the last day of the fiscal year in which we have total annual gross revenue of at least $1.0 billion, or (3) the last day of the fiscal year in\\n49\\nwhich we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.\\nIf we sell shares of our common stock in future financings, stockholders may experience immediate dilution and, as a result, our stock price may decline.\\nWe may from time to time issue additional shares of common stock at a discount from the current trading price of our common stock. As a result, our stockholders would experience immediate dilution upon the purchase of any shares of our common stock sold at such discount. In addition, as opportunities present themselves, we may enter into financing or similar arrangements in the future, including the issuance of debt securities, preferred stock or common stock. If we issue common stock or securities convertible into common stock, our common stockholders would experience additional dilution and, as a result, our stock price may decline.\\nSales of a substantial number of shares of our common stock in the public market could cause our stock price to fall.\\nIf our existing stockholders sell, or indicate an intention to sell, substantial amounts of our common stock in the public market after the lock-up and other legal restrictions on resale in connection with our IPO lapse, the trading price of our common stock could decline. As of June 30, 2014, we had 18,529,067 shares of common stock outstanding. Of those shares, the 4,101,632 shares sold in our IPO are freely tradable, without restriction (except as otherwise applicable), in the public market. The remaining 827,268 shares sold in our IPO are subject to the lock-up agreements pertaining to our IPO.\\nThe lock-up agreements pertaining to our IPO will expire on December 15, 2014. After the lock-up agreements expire, as of June 30, 2014, up to an additional 14,427,435 shares of common stock will be eligible for sale in the public market, 12,826,261 of which are held by current directors, executive officers and other affiliates and may be subject to Rule 144 under the Securities Act of 1933, or the Securities Act.\\nIn addition, as of June 30, 2014, 1.1 million shares of common stock that are subject to outstanding options, will become eligible for sale in the public market to the extent permitted by the provisions of various vesting schedules, the lock-up agreements and Rule 144 and Rule 701 under the Securities Act. If these additional shares of common stock are sold, or if it is perceived that they will be sold, in the public market, the trading price of our common stock could decline.\\nThe holders of approximately 12.4 million shares of our outstanding common stock as of June 30, 2014, are entitled to rights with respect to the registration of their shares under the Securities Act, subject to vesting schedules and to the lock-up agreements described above. Registration of these shares under the Securities Act would result in the shares becoming freely tradable without restriction under the Securities Act, except for shares purchased by affiliates. Any sales of securities by these stockholders could have a material adverse effect on the trading price of our common stock.\\nOur principal stockholders and management own a significant percentage of our stock and will be able to exert significant control over matters subject to stockholder approval.\\nAs of June 30, 2014, our executive officers, directors, holders of 5% or more of our capital stock and their respective affiliates beneficially owned approximately two-thirds of our outstanding voting stock. Therefore, these stockholders will have the ability to influence us through this ownership position. These stockholders may be able to determine all matters requiring stockholder approval. For example, these stockholders may be able to control elections of directors, amendments of our organizational documents, or approval of any merger, sale of assets, or other major corporate transaction. This may prevent or discourage unsolicited acquisition proposals or offers for our common stock that certain stockholders may feel are in their best interest as one of our stockholders.\\nWe have broad discretion to determine how to use the funds raised in our IPO, and may use them in ways that may not enhance our operating results or the price of our common stock.\\nOur management has broad discretion over the use of proceeds from our IPO, and we could spend the proceeds from this offering in ways our stockholders may not agree with or that do not yield a favorable return, if at all. We currently intend to use substantially all of the net proceeds of this offering to fund continued discovery and development efforts for our preclinical product candidates, the exercise of our right to co-fund the first Phase 3 clinical development program for tenapanor, if we decide to exercise such right, expenses related to the development of APECCS, and the balance for working capital and general corporate purposes, which will include facilities expansion and the pursuit of other research and discovery efforts and could also include the acquisition or in-license of other products, product candidates or technologies. However, our use of these proceeds may differ substantially from our current plans. If we do not invest or apply the proceeds of this offering in ways that improve our operating results, we may fail to achieve expected financial results, which could cause our stock price to decline.\\n50\\nProvisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable and may lead to entrenchment of management.\\nOur amended and restated certificate of incorporation and amended and restated bylaws contain provisions that could significantly reduce the value of our shares to a potential acquirer or delay or prevent changes in control or changes in our management without the consent of our board of directors. The provisions in our charter documents include the following:\\n| • | a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors; |\\n\\n| • | no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates; |\\n\\n| • | the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors; |\\n\\n| • | the required approval of at least 66 2/3% of the shares entitled to vote to remove a director for cause, and the prohibition on removal of directors without cause; |\\n\\n| • | the ability of our board of directors to authorize the issuance of shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquiror; |\\n\\n| • | the ability of our board of directors to alter our bylaws without obtaining stockholder approval; |\\n\\n| • | the required approval of at least 66 2/3% of the shares entitled to vote at an election of directors to adopt, amend or repeal our bylaws or repeal the provisions of our amended and restated certificate of incorporation regarding the election and removal of directors; |\\n\\n| • | a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders; |\\n\\n| • | the requirement that a special meeting of stockholders may be called only by the chairman of the board of directors, the chief executive officer, the president or the board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors; and |\\n\\n| • | advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us. |\\n\\nIn addition, these provisions would apply even if we were to receive an offer that some stockholders may consider beneficial.\\nWe are also subject to the anti-takeover provisions contained in Section 203 of the Delaware General Corporation Law. Under Section 203, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other exceptions, the board of directors has approved the transaction.\\nClaims for indemnification by our directors and officers may reduce our available funds to satisfy successful third-party claims against us and may reduce the amount of money available to us.\\nOur amended and restated certificate of incorporation and amended and restated bylaws provide that we will indemnify our directors and officers, in each case to the fullest extent permitted by Delaware law.\\nIn addition, as permitted by Section 145 of the Delaware General Corporation Law, our amended and restated bylaws and our indemnification agreements that we have entered into with our directors and officers provide that:\\n| • | We will indemnify our directors and officers for serving us in those capacities or for serving other business enterprises at our request, to the fullest extent permitted by Delaware law. Delaware law provides that a corporation may indemnify such person if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of the registrant and, with respect to any criminal proceeding, had no reasonable cause to believe such person’s conduct was unlawful. |\\n\\n| • | We may, in our discretion, indemnify employees and agents in those circumstances where indemnification is permitted by applicable law. |\\n\\n51\\n\\n| • | We are required to advance expenses, as incurred, to our directors and officers in connection with defending a proceeding, except that such directors or officers shall undertake to repay such advances if it is ultimately determined that such person is not entitled to indemnification. |\\n\\n| • | We will not be obligated pursuant to our amended and restated bylaws to indemnify a person with respect to proceedings initiated by that person against us or our other indemnitees, except with respect to proceedings authorized by our board of directors or brought to enforce a right to indemnification. |\\n\\n| • | The rights conferred in our amended and restated bylaws are not exclusive, and we are authorized to enter into indemnification agreements with our directors, officers, employees and agents and to obtain insurance to indemnify such persons. |\\n\\n| • | We may not retroactively amend our amended and restated bylaw provisions to reduce our indemnification obligations to directors, officers, employees and agents. |\\n\\nWe do not currently intend to pay dividends on our common stock, and, consequently, our stockholders’ ability to achieve a return on their investment will depend on appreciation in the price of our common stock.\\nWe do not currently intend to pay any cash dividends on our common stock for the foreseeable future. We currently intend to invest our future earnings, if any, to fund our growth. Additionally, the terms of our loan and security agreements could restrict our ability to pay dividends. Therefore, our stockholders are not likely to receive any dividends on our common stock for the foreseeable future. Since we do not intend to pay dividends, our stockholders’ ability to receive a return on their investment will depend on any future appreciation in the market value of our common stock. There is no guarantee that our common stock will appreciate or even maintain the price at which our holders have purchased it.\\n\\n\\nITEM 2.\\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS\\nUnregistered Sales of Equity Securities\\nFrom April 1, 2014 through June 30, 2014, we sold and issued the following unregistered securities:\\n1. In June 2014, upon the closing of our IPO, all of our then-outstanding shares of convertible preferred stock automatically converted into 11,517,222 shares of common stock, and all of our then-outstanding Series B warrants were net exercised into 571,244 shares of our common stock at an exercise price of $0.09 per share. The issuance of such shares of common stock was exempt from the registration requirements of the Securities Act pursuant to Section 3(a)(9) and Section 4(a)(2) of the Securities Act of 1933, as amended.\\n2. We granted stock option to employees and directors under our 2008 Stock Incentive Plan and our 2014 Equity Incentive Plan covering an aggregate of 63,888 shares of common stock at a weighted average exercise price of $13.95 per share.\\nUse of Proceeds\\nOn June 18, 2014, the U.S. Securities and Exchange Commission declared effective our registration statement on Form S-1 (File No. 333-196090), as amended, filed in connection with our IPO. Pursuant to the registration statement, we registered the offer and sale of 4,286,000 shares of our common stock with an aggregate offering price of $60.0 million. With the full exercise of the underwriters’ over-allotment option, we sold and issued 4,928,900 shares of our common stock at a price to the public of $14.00 per share for an aggregate offering price of approximately $69.0 million. The managing underwriters of the offering were Citigroup Global Markets Inc., Leerink Partners LLC, JMP Securities LLC and Wedbush Securities Inc. After deducting underwriting discounts, commissions and offering expenses paid or payable by us of $7.8 million, the net proceeds from the offering were $61.2 million. No offering expenses were paid or are payable, directly or indirectly, to our directors or officers, to persons owning 10% or more of any class of our equity securities or to any of our affiliates.\\nThe net proceeds from the IPO have been invested in money market funds.\\nThere has been no material change in the expected use of the net proceeds from our IPO as described in our prospectus relating to our IPO.\\n\\n\\nITEM 3.\\nDefaults upon Senior Securities\\nNot applicable.\\n52\\n\\n\\nITEM 4.\\nMine Safety Disclosures\\nNot applicable\\n\\n\\nITEM 5.\\nOther Information\\nNone.\\n\\n\\nITEM 6.\\nExhibits\\n\\n| Incorporated by Reference |\\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(b) |\\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6.(c) |\\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.16 |\\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\\n\\n53\\n\\n| Incorporated by Reference |\\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\\n| 101.INS* | XBRL Instance Document | X |\\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\\n\\n\\n| # | Indicates management contract or compensatory plan. |\\n\\n\\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\\n\\n54\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| Ardelyx, Inc. |\\n| Date: August 8, 2014 | By: | /s/ Michael Raab |\\n| Michael Raab President Chief Executive Officer and Director (Principal Executive Officer) |\\n\\n55\\nEXHIBIT INDEX\\nExhibit Index\\n\\n| Incorporated by Reference |\\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\\n| 3.1 | Amended and Restated Certificate of Incorporation. | 8-K | 6/24/2014 | 3.1 |\\n| 3.2 | Amended and Restated Bylaws. | 8-K | 6/24/2014 | 3.2 |\\n| 4.1 | Reference is made to exhibits 3.1 and 3.2. |\\n| 4.2 | Form of Common Stock Certificate. | S-1/A | 6/18/2014 | 4.2 |\\n| 10.1(a)# | Ardelyx, Inc. 2014 Equity Incentive Award Plan. | S-8 | 7/14/2014 | 99.3 |\\n| 10.1(b)# | Form of Stock Option Grant Notice and Stock Option Agreement under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/204 | 10.6(b) |\\n| 10.1(c)# | Form of Restricted Stock Award Agreement and Restricted Stock Unit Award Grant Notice under the 2014 Equity Incentive Award Plan. | S-1/A | 6/18/2014 | 10.6(c) |\\n| 10.2# | Form of Indemnification Agreement for directors and officers. | S-1/A | 6/9/2014 | 10.7 |\\n| 10.3# | Amended and Restated Executive Employment Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Michael Raab | S-1/A | 6/9/2014 | 10.8 |\\n| 10.4# | Change in Control Severance Agreement, dated as of June 6, 2014, by and between Ardelyx, Inc. and Dominique Charmot, Ph.D | S-1/A | 6/9/2014 | 10.9 |\\n| 10.5# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Mark Kaufmann | S-1/A | 6/9/2014 | 10.15 |\\n| 10.6# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Elizabeth Grammer, Esq | S-1/A | 6/9/2014 | 10.16 |\\n| 10.7# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and Jeffrey Jacobs, Ph.D | S-1/A | 6/9/2014 | 10.17 |\\n| 10.8# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and George Jue. | S-1/A | 6/9/2014 | 10.18 |\\n| 10.9# | Amended and Restated Change in Control Severance Agreement, dated June 6, 2014, by and between Ardelyx, Inc. and David Rosenbaum, Ph.D | S-1/A | 6/9/2014 | 10.19 |\\n| 10.10# | Ardelyx, Inc. 2014 Employee Stock Purchase Plan. | S-8 | 7/14/2014 | 99.6 |\\n| 10.11# | Non-Employee Director Compensation Program. | S-1/A | 6/9/2014 | 10.21 |\\n| 31.1 | Certification of Principal Executive Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\\n| 31.2 | Certification of Principal Financial Officer Required Under Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended. | X |\\n\\n56\\n\\n| Incorporated by Reference |\\n| ExhibitNumber | Exhibit Description | Form | Date | Number | FiledHerewith |\\n| 32.1 | Certification of Principal Executive Officer and Principal Financial Officer Required Under Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C §1350. | X |\\n| 101.INS* | XBRL Instance Document | X |\\n| 101.SCH* | XBRL Taxonomy Extension Schema Document | X |\\n| 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document | X |\\n| 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document | X |\\n| 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document | X |\\n| 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document | X |\\n\\n\\n| # | Indicates management contract or compensatory plan. |\\n\\n\\n| * | In accordance with Rule 406T of Regulation S-T, the Interactive Data Files in Exhibits 101.INS; 101.SCH; 101.CAL; 101.DEF; 101.LAB and 101.PRE are deemed not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Act of 1934, as amended, and otherwise are not subject to liability under those sections. |\\n\\n57\\n\\n</text>\\n\\nWhat is the increase in the overall exercise value of the options from December 31, 2013 to June 30, 2014, considering the balances at these dates and their respective weighted average exercise price per share (in thousands of dollars)?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 828.6985899999999.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 54,\n \"input_length\": 53707\n}"}}},{"rowIdx":55,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. Business\nThe Company\n1. Organizational History\nWe are the result of a share exchange transaction completed in March 2004 between the shareholders of Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah, and the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 3 |\n\n\n2. Overview of Business\nWe develop, manufacture, distribute and market innovative, cost-effective and environmentally safe bio-technological products for agriculture. Our products are designed to enhance the quality of human life by increasing the value, quality and productivity of crops and decreasing the negative environmental impact of chemicals and other wastes.\n\n| 4 |\n\n\nBio-fertilizers\nWe have developed six bio-fertilizer products with bacillus species (“bacillus spp”) and/or photosynthetic bacteria as core ingredients. Some of our products contain ingredients of both photosynthesis and bacillus bacteria. Bacillus spp is a species of bacteria that interacts with plants and promotes biological processes. It is highly effective for promoting plant growth, enhancing yield, improving quality and elevating resistances. Photosynthetic bacteria are a group of green and purple bacteria. Bacterial photosynthesis differs from green plant photosynthesis in that bacterial photosynthesis occurs in an anaerobic environment and does not produce oxygen. Photosynthetic bacteria can enhance the photosynthetic capacity of green plants by increasing the utilization of sunlight, which helps keep the photosynthetic process at a vigorous level, enhances the capacity of plants to transform inorganic materials to organic products, and boosts overall plant health and productivity.\nOur bacillus bacteria based fertilizers are protected by patents. In 2004, we acquired patent no. ZL 93101635.5 entitled “Highly Effective Composite Bacteria for Enhancing Yield and the Related Methodology for Manufacturing” from China Agricultural University (“CAU”) for the aggregate purchase of $480,411, consisting of $60,411 in cash and 5,000 shares of our common stock, valued at $84.00 per share (aggregate value of $420,000). Our photosynthetic bacteria based fertilizers are also protected by trade secret laws.\nThe patent acquired from CAU covers six different species of bacillus which have been tested as bio-fertilizers to enhance yield and plant health. The production methods of the six species are also patented. The patent has expired on February 19, 2013.There are no limitations under this agreement on our exclusive use of the patent. Pursuant to our agreement with CAU, the University agreed to provide research and technology support services at no additional cost to us in the event we decide to use the patent to produce commercial products. These research and technology support services include: (1) furnishing faculty or graduate-level researchers to help bacteria culturing, sampling, testing, trial production and production formula adjustment; (2) providing production technology and procedures to turn the products into powder form while keeping live required bacteria in the products; (3) establishing quality standards and quality control systems; (4) providing testing and research support for us to obtain necessary sale permits from the Chinese government; and (5) cooperation in developing derivative products.\nOn January 5, 2011, the State Intellectual Property Office of the PRC (“Intellectual Property Office”) granted Kiwa two Certificates of Patent of Invention for (1) “A cucumber dedicated composite anti-continuous cropping effect probiotics and their specific strains with related application” with patent number of “ZL 2008 1 0144492.6”; and (2) “Cotton dedicated composite anti-continuous cropping effect probiotics and their special strains with related application” with patent number of “ZL 2008 1 0144491.1” These two patents have been developed by Kiwa-CAU R&D Center. These two patents will expire on August 5, 2028. These two patents can be used to develop specific environment-friendly bio-fertilizer.\nWe have obtained five fertilizer registration certificates from the Chinese government - four covering our bacillus bacteria fertilizer and one covering our photosynthetic bacteria fertilizer. The five registration certificates are: (1) Microorganism Microbial Inoculum Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (2) Photosynthetic Bacteria Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (3) Amino Acid Foliar Fomular Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (4) Organic Fertilizer Registration Certificate issued by Agriculture Department of Shandong Province; and (5) Organic Matter-Decomposing Inoculants Registration Certificate issued by the PRC Ministry of Agriculture on February 16, 2008. Protected by these five fertilizer registration certificates and five trademarks under the names of “KANGTAN” (Chinese translation name for Kiwa), “ZHIGUANGYOU,” “PUGUANGFU,” “JINWA” and “KANGGUAN,” we have developed six series of bio-fertilizer products with bacillus spp and/or photosynthetic bacteria as core ingredients. Valid period of fertilizer registration certificates is five years and may be extended for another five years upon application from the owner of fertilizer registration certificates. The Company has determined to re-apply the Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture.\n\n| 5 |\n\n\nKiwa-CAU Research and Development Center\nIn July 2006, we established a new research center with CAU which is known as Kiwa-CAU Bio-Tech Research & Development Center (the “Kiwa-CAU R&D Center”). Pursuant to an agreement between CAU and Kiwa Shandong dated November 14, 2006, Kiwa agreed to contribute RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Under the above agreement, the Kiwa-CAU R&D Center is responsible for fulfilling the overall research-and-development functions of Kiwa Shandong, including: (1) development of new technologies and new products (which will be shared by Kiwa and CAU); (2) subsequent perfection of existing product-related technologies; and (3) training quality-control personnel and technicians and technical support for marketing activities. The Company has spent $224,704 and $178,388 for its research and development activities during the years ended December 31, 2016 and 2015, respectively. The costs incurred by Company’s research and development activities are not borne directly by customers.\nDuring fiscal 2014, Kiwa-CAU R&D Center had successfully isolated several strains of endophytic bacillus from plants. A number of strains had been observed to have the capability of boosting crop yield and dispelling chemical pesticide residual from soil. These strains could be used for developing not only new biological preparation but also environmental protection preparation.\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa dated November 14, 2006, Kiwa agreed to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement was ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006. The Company has negotiated a follow-up Cooperation Agreement for the technologies with China Agricultural University.\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\nOn February 23, 2017, the Company agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\n\n| 6 |\n\n\nOther\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. As a result of this Agreement, Kiwa renamed Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd., which replaced Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. The Company paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities.\nThereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\nOn December 17, 2015, we entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfilled the requirements of reduction of content of heavy metals in soil and improved crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n\n| 7 |\n\n\nOn February 27, 2017, the Company signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\n\nITEM 1A. Risk Factors\nSmaller reporting companies are not required to provide the information required by this item.\n\n| 8 |\n\n\n\nITEM 1B. Unresolved Staff Comments\nNone.\n\nITEM 2. Properties\nIn June 2002, Kiwa Shandong entered into an agreement with Zoucheng Municipal Government granting us the use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, we have the option to pay a fee of approximately RMB 480,000 (approximately $78,155) per acre for the land use right at the expiration of the 10-year period. We may not transfer or pledge the temporary land use right. In the same agreement, we have also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. On February 11, 2017 Kiwa Bio-Tech Products (Shandong) entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\nITEM 3. Legal Proceedings\nNone.\n\nITEM 4. Mine Safety Disclosures\nNot applicable.\nPart II\n\nITEM 5. Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities\nMarket Information\nThe Company’s common stock has been quoted on the OTCQB under the symbol “KWBT” since March 30, 2004.\nThe following table sets forth the high and low bid quotations per share of our common stock as reported on the OTCQB for the periods indicated. The high and low bid quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. All prices are adjusted to reflect the Company’s one for 200 reverse split which went effective January 28, 2016.\n\n| Fiscal Year 2016 | High | Low |\n| First Quarter | $ | 2.24 | $ | 0.20 |\n| Second Quarter | $ | 1.98 | $ | 1.30 |\n| Third Quarter | $ | 1.65 | $ | 0.62 |\n| Fourth Quarter | $ | 1.43 | $ | 0.80 |\n\n\n| Fiscal Year 2015 | High | Low |\n| First Quarter | $ | 1.47 | $ | 0.12 |\n| Second Quarter | $ | 0.44 | $ | 0.02 |\n| Third Quarter | $ | 0.32 | $ | 0.12 |\n| Fourth Quarter | $ | 0.70 | $ | 0.12 |\n\nHolders\nAs of December 31, 2016, there were approximately 461 shareholders of record of our common shares.\nDividend Policy\nWe have not paid any dividends on our common shares since our inception and do not anticipate that dividends will be paid at any time in the immediate future.\nEquity Compensation Plan Information\nThe information required by Item 5 regarding securities authorized for issuance under equity compensation plans is included in Item 12 of this report.\n\n| 9 |\n\n\nRecent Sales of Unregistered Securities\nThe following is a list of securities issued for cash or converted with debentures or as stock compensation to consultants during the period from January 1, 2016 through April 14, 2017, which were not registered under the Securities Act:\n\n| Name of Purchaser | Issue Date | Security | Shares | Consideration |\n| YVONNE WANG | 3/24/16 | Common | 240,000 | Debenture Conversion |\n| WEI LI | 3/24/16 | Common | 2,900,000 | Debenture Conversion |\n| MARK E. CRONE | 3/25/16 | Common | 1,000 | Legal Fees |\n| ZENG MIN QING | 5/24/16 | Common | 125,000 | Stock Purchase |\n| CHENG TZU-YUN | 5/24/16 | Common | 50,000 | Stock Purchase |\n| ZHIMING ZHU | 5/24/16 | Common | 45,000 | Stock Purchase |\n| HANG ZHAO | 7/20/16 | Common | 20,000 | Stock Purchase |\n| SHIWEI XIE | 7/20/16 | Common | 10,000 | Stock Purchase |\n| XIAOQIANG YU | 7/20/16 | Common | 30,000 | Stock Purchase |\n| HANG ZHAO | 8/10/16 | Common | 20,000 | Stock Purchase |\n| XIAOQIANG YU | 8/10/16 | Common | 10,000 | Stock Purchase |\n| XIANGRON CHEN | 8/10/16 | Common | 40,000 | Stock Purchase |\n| JIMMY ZHOU | 8/24/16 | Common | 101,947 | Consultant Fees |\n| WEIHONG SHAN | 10/6/16 | Common | 150,000 | Stock Purchase |\n| LIFENG LIU | 10/6/16 | Common | 100,000 | Stock Purchase |\n| ZHENPING LI | 10/6/16 | Common | 100,000 | Stock Purchase |\n| QI JIANG | 10/6/16 | Common | 550,000 | Stock Purchase |\n| LEI HOU | 10/6/16 | Common | 100,000 | Stock Purchase |\n| BING ZHANG | 10/6/16 | Common | 150,000 | Stock Purchase |\n| DEMEI YANG | 10/6/16 | Common | 150,000 | Stock Purchase |\n| WSMG ADVISORS, INC. | 10/6/16 | Common | 100,000 | Consultant Fees |\n| EQUITIES.COM, INC | 10/6/16 | Common | 30,808 | Consultant Fees |\n| GENG LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\n| LIXIN TIAN | 10/19/16 | Common | 500,000 | Consultant Fees |\n| XU LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\n| QINGKE XING | 10/19/16 | Common | 60,000 | Consultant Fees |\n| GROWTH CIRCLE INC. | 10/19/16 | Common | 20,000 | Consultant Fees |\n| WILLIAM FARRANCE | 11/29/16 | Common | 125,000 | Stock Purchase |\n| JUNWEI ZHENG | 3/3/17 | Common | 920,000 | Stock Purchase |\n| YUAN WANG | 3/3/17 | Common | 80,000 | Stock Purchase |\n| YUAN WANG | 3/3/17 | Common | 70,000 | Consultant Fees |\n\n\nITEM 6. Selected Financial Data\nNot required.\n\nITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nThis Annual Report on Form 10-K for the fiscal year ended December 31, 2016 contains “forward-looking” statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, as amended, including statements that include the words “believes,” “expects,” “anticipates,” or similar expressions. These forward-looking statements include, among others, statements concerning our expectations regarding our working capital requirements, financing requirements, business, growth prospects, competition and results of operations, and other statements of expectations, beliefs, future plans and strategies, anticipated events or trends, and similar expressions concerning matters that are not historical facts. The forward-looking statements in this Annual Report on Form 10-K for the fiscal year ended December 31, 2016 involve known and unknown risks, uncertainties and other factors (described in “Business-Risk Factors” under Item 1) that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by the forward-looking statements contained herein.\nOverview\nThe Company took its present corporate form in March 2004 when the shareholders of Tintic Gold Mining Company, a Utah public corporation (“Tintic”), entered into a share exchange transaction with the shareholders of Kiwa BVI, a privately-held British Virgin Islands corporation that left the shareholders of Kiwa BVI owning a majority of Tintic and Kiwa BVI a wholly-owned subsidiary of Tintic, see “Business - The Company” under Item 1. For accounting purposes this transaction was treated as an acquisition of Tintic Gold Mining Company by Kiwa BVI in the form of a reverse triangular merger and a recapitalization of Kiwa BVI and its wholly owned subsidiary, Kiwa Shandong. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the Organizational Chart on page 4, above. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 10 |\n\n\nWe generated revenue in fiscal year 2016. We incurred a net income of $963,296 and a net loss $677,358 during fiscal 2016 and 2015, respectively.\nDue to our limited revenues, we have relied on the proceeds from loans from both unrelated and related parties to provide the resources necessary to fund the development of our business plan and operations. Our financing activities generated $1,053,358 and $148,009 during fiscal 2016 and 2015, respectively. These funds are insufficient to execute our business plan as currently contemplated, which may result in the risks described in “Risk Factors” under Item 1 - Business.\nGoing Concern\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622. Although the company’s operations for the year ended December 31, 2016 resulted net income of $963,296, it had an accumulated deficit of $19,489,400 and stockholders’ deficiency of $5,601,213 at December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\nThe Company already raised additional fund through equity financing and plans to raise additional funds from domestic and foreign banks and/or financial institutions to increase working capital in order to meet capital demands. Please refer to Note 15 (Subsequent Evens) for additional information.\nTrends and Uncertainties in Regulation and Government Policy in China\nForeign Exchange Policy Changes\nChina is considering allowing its currency to be freely exchangeable for other major currencies. This change will result in greater liquidity for revenues generated in Renminbi (“RMB”). We would benefit by having easier access to and greater flexibility with capital generated in and held in the form of RMB. The majority of our assets are located in China and most of our earnings are currently generated in China, and are therefore denominated in RMB. Changes in the RMB-U.S. Dollar exchange rate will impact our reported results of operations and financial condition. In the event that RMB appreciates over the next year as compared to the U.S. Dollar, our earnings will benefit from the appreciation of the RMB. However, if we have to use U.S. Dollars to invest in our Chinese operations, we will suffer from the depreciation of U.S. Dollars against the RMB. On the other hand, if the value of the RMB were to depreciate compared to the U.S. Dollar, then our reported earnings and financial condition would be adversely affected when converted to U.S. Dollars.\nOn July 21, 2005, the People’s Bank of China announced it would appreciate the RMB, increasing the RMB-U.S. Dollar exchange rate from approximately US$1.00 = RMB 8.28 to approximately US$1.00 = RMB 8.11. So far the trend of such appreciation continues. The exchange rate of U.S. Dollar against RMB on December 31, 2016 was US$1.00 = RMB 6.945.\nCritical Accounting Policies and Estimates\nWe prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under current circumstances. Actual results may differ from these estimates as a result of different assumptions or conditions.\nThe following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. In addition, you should refer to our accompanying audited balance sheets as of December 31, 2016 and 2015, and the audited statements of comprehensive loss, equity movement and cash flows for the fiscal years ended December 31, 2016 and 2015, and the related notes thereto, for further discussion of our accounting policies.\nFair value of warrants and options\nWe have adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements.\n\n| 11 |\n\n\nWe also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements.\nWe calculate the fair value of the warrants and options using the Black-Scholes Model.\nIncome Taxes\nThe Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\nMajor Customers and Suppliers.\nBio-fertilizer products\nDuring 2016, the following were Kiwa’s major customers:\n1. Qingzhou City Agricultural Production Materials Co., Ltd. second wholesale department (11.3% of sales)\n2. Huarong County Yinfeng fertilizer industry LTD. (81% of sales)\nDuring 2016, the following were Kiwa’s major suppliers:\n1. Weifang Druek Fertilizer Co., Ltd (92% of Subcontractor Production)\n2 Lianyungang Chuangyi Logistics Co., Ltd (Logistics provider)\n3. Linshu Shangrun Color Printing Co., Ltd (Packing provider)\nResults of Operations\nNet Sales\nNet sales were $9,617,845 and $0 for the years ended December 31, 2016 and 2015, respectively.\nCost of Sales\nCost of sales was $7,672,451 and $0 for the years ended December 31, 2016 and 2015, respectively.\nGross Profit/Loss\nGross profit for fiscal 2016 was $1,945,394 compared to $0 for fiscal 2015.\nLicensing Revenue\nLicensing revenue totaled $786,329 for the year ended December 31, 2016.\nGeneral and Administrative\nGeneral and administrative expenses were $874,097 and $313,589 for the years ended December 31, 2016 and 2015, respectively, an increase of $560,508 or 178%. General and administrative expenses include professional fees, officers’ compensation, depreciation and amortization, salaries, travel and entertainment, rent, office expense and telephone expense etc.\n\n| 12 |\n\n\nResearch and Development\nResearch and development expenses increased significantly by $45,445 or 25% to $224,433 for the year ended December 31, 2016, compared to $178,988 for the prior comparable period. Research and development expense mainly consists of the expenses of maintaining Kiwa-CAU R&D Center, which began operation in July 2006 (see “Business-Intellectual Property and Product Lines- Kiwa-CAU R&D Center” under Item 1 in Part I). On November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. During the years ended December 31, 2016 and 2015, the Company accrued $224,433 and $178,988 for research and development respectively.\nPenalty Expense\nWe charged $77,575 and $72,512 of liquidated damages in connection with the 6% Notes to penalty expenses during the years ended December 31, 2016 and 2015, respectively. The increase of penalty expense was mainly due to accrued and unpaid interest on the 6% Notes.\nInterest Expenses\nNet interest expense was $112,977 and $112,629 in the fiscal years of 2016 and 2015, respectively, representing a increase of $348 or 0.3%.\nNet Income & (Loss)\nDuring the fiscal year 2016, net income was $963,296, comparing with net loss $677,358 for the same period of 2015, representing an increase of $1,640,654.\nComprehensive Gain & (Loss)\nComprehensive income increased by $1,446,652 from $(253,293) for fiscal 2015, as compared to $1,193,359 for the comparable year of 2016.\nLiquidity and Capital Resources\nSince inception of our ag-biotech business in 2002, we have relied on the proceeds from the sale of our equity securities and loans from both unrelated and related parties to provide the resources necessary to fund our operations and the execution of our business plan. During fiscal 2016 and 2015, we raised $1,053,358 and $148,009 in total from stock purchase agreements and related party loans. To some extent, these advances improved our short-term liquidity. However, as of December 31, 2016, our current liabilities substantially exceeded current assets by $5,729,622, reflecting a current ratio of 0.4451, whereas current liabilities exceeded current assets by $11,103.261, reflecting a current ratio of 0.0043 as of December 31, 2015. During the years ended December 31, 2016 and 2015, we did not issue any shares resulting from the conversion of principal of the 6% Notes into our common stock.\n\n| 13 |\n\n\nAs of December 31, 2016 and 2015, we had cash of $13,469 and $721, respectively. The change is outlined as follows:\nDuring the fiscal year of 2016, net cash used in our operating activities was $1,142,9741, compared to $150,208 for the comparable period of 2015. Such cash was mainly used for maintaining operations of a public company and working capital for our bio-fertilizer business.\nDuring the fiscal year of 2016, we incurred approximately $79,083 in investment activity, including $34,112 in acquiring a subsidiary.\nDuring the year ended December 31, 2016, we generated cash inflow for $1,053,358 from financing activities, compared to $148,009 of cash inflow during the year ended December 31, 2015, from financing activities.\nAs of December 31, 2016, we had an accumulated deficit of $19,489,400, down from $20,324,812 deficit at December 31, 2015, as a result of a net income of $967,296 including $127,884 for statutory reserve for the year ended December 31, 2016 and compared to a net loss of $677,358 for 2015.\nWe still require additional working capital to accomplish our business objectives and to sustain our operations. Continuously, we intend to raise additional capital through the issuance of debt or equity securities to fund the development of our planned business operations, although there can be no assurance that we will be successful in obtaining this financing. The following factors, among others, may significantly harm our ability to obtain required additional financing.\nGiven the facts that:\n\n| (1) | Outstanding 6% Notes. As of December 31, 2016, the amount of outstanding 6% Notes was $150,250. The 6% Notes have been in default since June 2009. |\n| (2) | Outstanding note payable of $360,000 as of December 31, 2016. This note has been in default since July 2007. |\n\nContractual Obligations\n(1) Operation of Kiwa-CAU R&D Center\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa Shandong dated November 14, 2006, Kiwa Shandong agrees to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement is ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006.\n(2) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n\n| 14 |\n\n\n(3) Strategic cooperation with two institutes in China\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015.\n(4) Acquisition of Caber Holdings LTD (Hong Kong Baina Group Co. LTD) in China\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. When this acquisition is completed, Kiwa will rename Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. Kiwa Baiao Co. Ltd will replace Kiwa’s current subsidiary in China - Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) - to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. As of December 31, 2015, the Company has paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities. Thereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\n(5) Distribution agreement with Kangtan Gerui Bio-Tech in China\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n(6) Lease payments\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\nOff-Balance Sheet Arrangements\nAt December 31, 2016, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise had we engaged in such relationships.\nRecent Accounting Pronouncements\nSee Note 2 to the Consolidated Financial Statements under Item 8, Part II.\n\n| 15 |\n\n\n\nITEM 7A. Quantitative and Qualitative Disclosures about Market Risk\nNot required.\n\nITEM 8. Financial Statements and Supplementary Data\nThe full text of our audited consolidated financial statements as of December 31, 2016 and 2015 begins on page F-1 of this annual report.\n\nITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure\nOn February 15, 2017, the Board of Directors of Kiwa Bio-Tech Products Group Corporation (“Kiwa” or “Company”) decided to engage DYH & Co. as independent principal accountant and auditor to report on the Company’s financial statements for the fiscal year ended December 31, 2016, including performing the required quarterly reviews.\nIn conjunction with the new engagement, the Company has dismissed its former accountant, Paritz & Co., P.A., Hackensack, NJ (“Paritz”), as the Company’s principal accountant effective February 22, 2016. Paritz has served the Company well since 2013. Under Item 304 of Regulation S-K, the reason for the auditor change is dismissal, not resignation nor declining to stand for re-election.\nDuring the two most recent fiscal years and the interim period through the date of the dismissal, there were no disagreements with Paritz on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to Paritz’s satisfaction, would have caused Paritz to make reference to the subject matter of the disagreements in connection with its reports.\n\nITEM 9A. Controls and Procedures\nDisclosure Controls and Procedures\nOur management, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), has evaluated the effectiveness of our disclosure controls and procedures as defined in SEC Rules 13a-15(e) and 15d-15(e) as of the end of the period covered by this Annual Report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management including our CEO and CFO, to allow timely decisions regarding required disclosures. Based on their evaluation, our CEO and CFO have concluded that, as of December 31, 2016, our disclosure controls and procedures were ineffective.\nManagement Report on Internal Control over Financial Reporting\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published consolidated financial statements. Internal control over financial reporting is promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation.\nOur management has conducted, with the participation of our CEO and CFO, an assessment, including testing of the effectiveness, of our internal control over financial reporting as of December 31, 2016. Management’s assessment of internal control over financial reporting was conducted using the criteria in Internal Control over Financial Reporting - Guidance for Smaller Public Companies issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on such evaluation, management identified deficiencies that were determined to be a material weakness.\nA material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Because of the material weakness described below, management concluded that our internal control over financial reporting was ineffective as of December 31, 2016.\n\n| 16 |\n\n\nThe specific material weakness identified by the Company’s management as of December 31, 2016 is described as follows:\n\n| ● | The Company did not have sufficient and skilled accounting personnel with an appropriate level of technical accounting knowledge and experience in the application of accounting principles generally accepted in the United States of America commensurate with the Company’s financial reporting requirements, which resulted in a number of internal control deficiencies that were identified as being significant. The Company’s management determined that the number and nature of these significant deficiencies, when aggregated, constituted a material weakness. |\n| ● | The Company lacks qualified resources to perform the internal audit functions properly. In addition, the scope and effectiveness of the Company’s internal audit function are yet to be developed. |\n| ● | We currently do not have an audit committee. |\n\nRemediation Initiative\n\n| ● | We are committed to establishing the internal audit functions but due to limited qualified resources in the region, we were not able to hire sufficient internal audit resources before the end of 2016. However, internally we established a central management center to recruit more senior qualified people in order to improve our internal control procedures. Externally, we are looking forward to engaging an accounting firm to assist the Company in improving the Company’s internal control system based on COSO Framework. |\n| ● | We intend to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. |\n\nConclusion\nDespite the material weakness and deficiencies reported above, the Company’s management believes that its consolidated financial statements included in this report fairly present in all material respects the Company’s financial condition, results of operations and cash flows for the periods presented and that this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report.\nThis Annual Report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this Annual Report.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the fiscal year ended December 31, 2016 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n\nITEM 9B. Other Information\nNone.\n\n| 17 |\n\n\nPart III\n\nITEM 10. Directors, Executive Officers and Corporate Governance\nDirectors and Executive Officers\nSet forth below are the names of our directors and executive officers, their ages, their offices with us, if any, their principal occupations or employment for the past five years. The directors listed below will serve until the Company’s next annual meeting of the stockholders:\n\n| Name | Age | Position | Director Since |\n| Yvonne Wang | 39 | Acting President, CEO and CFO and Director | 2015 |\n| Feng Li | 28 | Secretary and Director | 2015 |\n| Qi Wang | 49 | Vice President of Technology, Director | 2007 |\n| Yong Lin Song Xiao Qiang Yu | 50 39 | CTO, Director of Technology and Director Sales and Marketing Director | 2017 2016 |\n\nYvonne Wang Ms. Wang became our Chairman in November 2015. She served as corporate Secretary from 2005 to 2015. Prior to 2005, she served as an executive assistant and a manager of the Company’s U.S. office between April 2003 and September 2005. She obtained her B.S. degree of Business Administration from University of Phoenix.\nOn August 11, 2106 became Company’s acting president, CEO and CFO.\nFeng Li became our Secretary and a Director in 2015. From 2011- 2012, Ms. Li has served as an assistant project manager for SCHSAsia, a boutique business consulting firm specializing in events and project management for overseas company wishing to expand into the Asia Pacific arena. From 2012 until 2014, Ms. Li served as a campaigner for WildAid China Office, a non-profit organization with focus on raising public awareness on wildlife and climate change related issues.\nQi Wang became our Vice President - Technical on July 19, 2005 and was elected as one of our directors of the Company on July 18, 2007. Prof. Wang has also acted as Director of Kiwa-CAU R&D Center since July 2006. Prof. Wang served as a Professor and Advisor for Ph.D. students in the Department of Plant Pathology, China Agricultural University (“CAU”) since January 2005. Prior to that, he served as an assistant professor and lecturer of CAU since June 1997. He obtained his master degree and Ph.D. in agricultural science from CAU in July 1994 and July 1997, respectively. Prof. Wang received his bachelor’s degree of science from Inner Mongolia Agricultural University in July 1989. He is a committee member of various scientific institutes in China, including the National Research and Application Center for Increasing-Yield Bacteria, Chinese Society of Plant Pathology, Chinese Association of Animal Science and Veterinary Medicine. Prof. Wang’s unique expertise in the field of agriculture offers significant knowledge and experience to the Board of Directors when making critical operational decisions.\nYong Lin Song became our CTO and Director of Technology responsible for the Company’s R&D operations on March 2016 and as one of our directors of the Company on March 2017. Mr. Song is a senior agronomist at the Institute of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. He has 29 years of experience in microbial R&D and technology promotion and has led many national agricultural projects. In 2001, he was responsible for technological achievement transformation and technology promotion of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. In 2009, he served as deputy secretary general of the Chinese Society of Plant Nutrition and Fertilizer Science.\nXiao Qiang Yu became our Sales and Marketing Director on June 2016 and is responsible for managing the overall marketing strategy of Kiwa, which includes brand expansion, sale targets, strategic planning and corporate communications. Mr. Yu participated in Chinese fertilizer market since 1999. Mr. Yu has over 15 years of marketing, management and strategy experience from two major fertilizer companies in China.\n\n| 18 |\n\n\nFamily Relationships\nThere are no family relationships among our directors or executive officers.\nInvolvement in Certain Legal Proceedings\nNone of our directors or executive officers has, during the past ten years:\n\n| (a) | Had any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time; |\n| (b) | Been convicted in a criminal proceeding or subject to a pending criminal proceeding; |\n| (c) | Been subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction or any federal or state authority, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities, futures, commodities or banking activities; and |\n| (d) | Been found by a court of competent jurisdiction (in a civil action), the Securities and Exchange Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended, or vacated. |\n\nSection 16(a) Beneficial Ownership Compliance\nSection 16(a) of the Securities Exchange Act of 1934 requires our officers, directors and certain persons holding more than 10 percent of a registered class of our common stock to file with the SEC initial reports of ownership and reports of changes in ownership of our common stock. Officers, directors and certain other shareholders are required by the SEC to furnish the Company with copies of all Section 16(a) forms they file. To the best of the Company’s knowledge, based solely upon a review of the copies of such reports, the Company believes that all Section 16(a) filing requirements applicable to its officers, directors and certain other shareholders were complied with during the fiscal year ended December 31, 2016.\nCode of Ethics\nWe have adopted a Code of Business Conduct and Ethics (the “Code”) that is applicable to all employees, consultants and members of the Board of Directors, including the Chief Executive Officer, Chief Financial Officer and Secretary. This Code embodies our commitment to conduct business in accordance with the highest ethical standards and applicable laws, rules and regulations. We will provide any person a copy of the Code, without charge, upon written request to the Company’s Secretary. Requests should be addressed in writing to Ms. Yvonne Wang; 310 N. Indian Hill Blvd., #702 Claremont, California 91711.\nBoard Composition; Audit Committee and Financial Expert\nOur Board of Directors is currently composed of four members: Yvonne Wang, Feng Li, Qi Wang and Yong Lin Song. All board actions require the approval of a majority of the directors in attendance at a meeting at which a quorum is present.\n\n| 19 |\n\n\nWe currently do not have an audit committee. We intend, however, to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. Currently such functions are performed by our Board of Directors.\nThe Board does not have a “financial expert” as defined by SEC rules implementing Section 407 of the Sarbanes-Oxley Act.\nBoard meetings and committees; annual meeting attendance.\nDuring fiscal year 2016, the Board of Directors did not have any meetings.\n\nITEM 11. Executive Compensation\nWe currently have no Compensation Committee. The Board of Directors is currently performing the duties and responsibilities of Compensation Committee. In addition, we have no formal compensation policy. We decide on our executives’ compensation based on average compensation levels of similar companies in the U.S. or China, depending on consideration of many factors such as where the executive works. Our Chief Executive Officer’s compensation is approved by the Board of Directors. Other named executive officers’ compensation are proposed by our Chief Executive Officer and approved by the Board of Directors.\nOur Stock Incentive Plan is administered by the Board of Directors. Any amendment to our Stock Incentive Plan requires majority approval of the stockholders of the Company.\nThe Company had no officers or directors whose total compensation during either 2016 or 2015 exceeded $100,000.\nCurrently, the main forms of compensation provided to each of our executive officers are: (1) annual salary; (2) non-equity Incentive Plan; and (3) the granting of incentive stock options subject to approval by our Board of Directors.\nSummary Compensation Table\nSummary Compensation Table\n\n| Name and principal position | Year | Salary ($) | Bonus ($) | Stock Awards ($) | Option Awards ($) | Non-Equity Incentive Plan Compensation ($) | Nonqualified Deferred Compensation Earnings ($) | All Other Compensation ($) | Total ($) |\n| (a) | (b) | (c) | (d) | (e) | (f) | (g) | (h) | (i) | (j) |\n| Yvonne Wang, | 2016 | 84,000 | Nil | Nil | Nil | Nil | Nil | Nil | 84,000 |\n| Acting President, CEO and CFO | 2015 | 51,000 | Nil | Nil | Nil | Nil | Nil | Nil | 51,000 |\n| Yong Lin Song, | 2016 | 29,828 | Nil | Nil | Nil | Nil | Nil | Nil | 29,828 |\n| CTO, Director of Technology | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\n| Xiao Qiang Yu, | 2016 | 30,259 | Nil | Nil | Nil | Nil | Nil | Nil | 30,259 |\n| Sales and Marketing Director | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\n\nEmployment Contracts and Termination of Employment and Change of Control Arrangements\nThere are no compensatory plans or arrangements with respect to a named executive officer that would result in payments or installments in excess of $100,000 upon the resignation, retirement or other termination of such executive officer’s employment with us or from a change-in-control.\n\n| 20 |\n\n\nStock Incentive Plan and Option Grants\n2016 Stock Incentive Plan\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter, were approved of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan. The Plan is a key aspect of our compensation program, designed to attract, retain, and motivate the highly qualified individuals required for our long-term success.\nNo options were granted under the Plan during 2016.\nOption Exercises and Stock Vested\nNo stock options were exercised by any officers or directors during 2016 and 2015. We did not adjust or amend the exercise price of any stock options previously awarded to any named executive officers during 2016 and 2015.\n\n| 21 |\n\n\nDirector Compensation for 2016\nWe currently have no policy in effect for providing compensation to our directors for their services on our Board of Directors, and did not compensate our directors in 2016 for services performed as directors.\n\nITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\nThe following table sets forth as of April 7, 2017 certain information with respect to the beneficial ownership of our common stock by (i) each of our executive officers, (ii) each person who is known by us to beneficially own more than 5% of our outstanding common stock, and (iii) all of our directors and executive officers as a group. Percentage ownership is calculated based on 9,798,981 shares of our common stock and 500,000 shares of our Series A Preferred Stock outstanding as of April 7, 2017. None of the shares listed below are issuable pursuant to stock options or warrants of the Company.\n\n| Title of class | Name and Address of Beneficial Ownership(1) | Amount and Nature of Beneficial Owner (2) | Percentage of class |\n| Common Stock | Yvonne Wang | 240,000 | 2.45 | % |\n| Common Stock | Feng Li (3) | 1,965,326 | 20.06 | % |\n| Common Stock | Qi Wang | - | - |\n| Common Stock | Yong Lin Song | - | - |\n| Common Stock | All officers and directors as a group | 2,205,326 | 22.51 | % |\n| Ser. A Pref. Stock | Yvonne Wang | 250,000 | 50.00 | % |\n| Ser. A Pref. Stock | Feng Li | 250,000 | 50.00 | % |\n| Ser. A Pref. Stock | All officers and directors as a group | 500,000 | 100.00 | % |\n| 5% Holders: |\n| Common Stock | Troniya Industrial Incubator, Inc. | 1,000,000 | 10.21 | % |\n| Common Stock | Liu Geng | 500,000 | 5.10 | % |\n| Common Stock | Liu Xu | 500,000 | 5.10 | % |\n| Common Stock | Tian Lixin | 500,000 | 5.10 | % |\n| Common Stock | Zheng JunWei | 920,000 | 9.39 | % |\n| Common Stock | Wei Li (3) | 1,965,326 | 20.06 | % |\n\n\n| (1) | The address for all holders is 310 N. Indian Hill Blvd, #702, Claremont, CA 91711. |\n| (2) | In determining beneficial ownership of our Common Stock and Series A Preferred Stock, the number of shares shown includes shares which the beneficial owner may acquire upon exercise of debentures, warrants and options which may be acquired within 60 days. Unless otherwise stated, each beneficial owner has sole power to vote and dispose of its shares. |\n| (3) | Includes 61,784 shares of common stock held by All Star Technology, Inc., a British Virgin Islands international business company. Feng Li’s father, Wei Li, exercises voting and investment control over the shares held by All Star Technology, Inc. Wei Li is a principal stockholder of All Star Technology, Inc. and may be deemed to beneficially own such shares, but disclaims beneficial ownership in such shares held by All Star Technology, Inc. except to the extent of his pecuniary interest therein. Mr. Li has pledged all of his common stock of the Company as collateral security for the Company’s obligations under certain 6% Convertible Notes owed by the Company. |\n\n\n| 22 |\n\n\nChange in Control\nNone.\n\nITEM 13. Certain Relationships and Related Transactions, and Director Independence\nFor description of transactions with related parties, see Note 6 to Consolidated Financial Statements under Item 8 in Part II.\nUnder the independence standard set forth in Rule 4200(a) (15) of the Market Place Rules of the Nasdaq Stock Market, which is the independence standard that we have chosen to report under.\n\nITEM 14. Principal Accountant Fees and Services\nFees Paid to Independent Public Accountants for 2016 and 2015.\nAudit Fees\nAll of the services described below were approved by our board of directors prior to performance of such services. The board of directors has determined that the payments made to its independent accountants for these services are compatible with maintaining such auditor’s independence.\nThe aggregate audit fees for 2016 and 2015 paid and payable to DYH & Company and Paritz & Company, P.A. were approximately $38,000 and $30,500, respectively. The amounts include: (1) fees for professional services rendered by DYH & Company and Paritz & Company, P.A. in connection with the audit of our consolidated financial statements; (2) reviews of our quarterly reports on the Form 10-Q.\n\n| 23 |\n\n\nAudit-Related Fees\nAudit-related fees for 2016 and 2015 were $nil.\nTax Fees\nTax service fees billed by Paritz & Co., P.A. as tax consultant for 2016 and 2015 were $3,400 and $2,750, respectively.\nAll Other Fees\nNone.\nPolicy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors\nSince we did not have a formal audit committee, our board of directors served as our audit committee. We have not adopted pre-approval policies and procedures with respect to our accountants in 2016. All of the services provided and fees charged by our independent registered accounting firms in 2016 were approved by the board of directors.\n\n| 24 |\n\n\nPart IV\n\nITEM 15. Exhibits and Financial Statement Schedules\n\n| Exhibit No. | Description |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\n| 32.1 | Certification of Chief Executive Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2 | Certification of Chief Financial Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n\n\n| 25 |\n\n\nKiwa Bio-Tech Products Group Corporation\nSignatures\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\nDate: April 17, 2017\n\n| KIWA BIO-TECH PRODUCTS GROUP CORPORATION. |\n| By: | /s/ Yvonne Wang |\n| Yvonne Wang Chief Executive Officer (Principal Executive Officer) |\n| By: | /s/ Yvonne Wang |\n| Yvonne Wang Chief Financial Officer (Principal Financial and Accounting Officer) |\n\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf of the registrant and in the capacities and on the dates indicated.\n\n| /s/ Yvonne Wang | Chief Executive Officer and Director | April 17, 2017 |\n| Yvonne Wang | (Principal Executive Officer) |\n| /s/ Yvonne Wang | Chief Financial Officer | April 17, 2017 |\n| Yvonne Wang | (Principal Financial and Accounting Officer) |\n| /s/ Feng Li | Secretary and Director | April 17, 2017 |\n| Feng Li |\n| /s/ Qi Wang | Vice President of Technology and Director | April 17, 2017 |\n| Qi Wang |\n| /s/ Yong Lin Song | CTO, Director of Technology and Director | April 17, 2017 |\n| Yong Lin Song |\n\n\n| 26 |\n\n\nKiwa Bio-Tech Products Group Corporation\nIndex to Consolidated Financial Statements\n\n| Page |\n| Reports of Independent Registered Public Accounting Firms | F-1 |\n| Consolidated Balance Sheets | F-3 |\n| Consolidated Statements of Comprehensive Income (Loss) | F-4 |\n| Consolidated Statements of Stockholders’ Deficiency | F-5 |\n| Consolidated Statements of Cash Flows | F-6 |\n| Notes to Consolidated Financial Statements | F-7 |\n\n\n| 27 |\n\n\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo Board of Directors and the Stockholders of\nKiwa Bio-Tech Products Group Corporation\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporations as of December 31, 2015 and the related consolidated statement of comprehensive loss, changes in stockholders’ deficiency and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.\nWe conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2015, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.\n/s/ Paritz & Company, P.A.\nHackensack, New Jersey\nApril 14, 2016\n\n| F-1 |\n\n\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\nTo the Board of Directors and Stockholders of Kiwa Bio-Tech Products Group Corporation\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the related statements of income, comprehensive income, stockholders’ equity, and cash flows for the year ended December 31, 2016. Kiwa Bio-Tech Products Group Corporation’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the results of its operations and its cash flows for the year ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America.\nThe accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company’s current liabilities substantially exceeded its current assets by $5,729,622 at December 31, 2016. Although the Company reported net income approximately $963,296 for its fiscal year ended December 31, 2016, it had an accumulated deficit of $19,489,400 as of December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regarding to these matters are described in Note 3, which include raising additional equity financing. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n/s/ DYH & Company\nIrvine, California\nApril 17, 2017\n\n| F-2 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED BALANCE SHEETS\n\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 13,469 | $ | 721 |\n| Accounts receivable | 1,122,754 | - |\n| Prepaid expenses | 92,504 | - |\n| Other receivable | 1,561,331 | 47,453 |\n| Advance to suppliers | 1,805,044 | - |\n| Total current assets | 4,595,102 | 48,174 |\n| Property, plant and equipment - net | 59,778 | 2,807 |\n| Deposit | 34,519 | - |\n| Goodwill | 34,112 | - |\n| Total non-current assets | 128,409 | 2,807 |\n| Total assets | $ | 4,723,511 | $ | 50,981 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIENCY |\n| Current liabilities |\n| Accounts payable | $ | 1,318,802 | $ | 269,360 |\n| Accrued expenses | 35,715 | 30,887 |\n| Advances from customers | 12,883 | 13,800 |\n| Construction costs payable | 255,539 | 273,722 |\n| Due to related parties - trade | 1,283,215 | 1,143,978 |\n| Due to related parties - non-trade | 100,798 | 3,166,198 |\n| Convertible notes payable | 150,250 | 150,250 |\n| Notes payable | 360,000 | 360,000 |\n| Unsecured loans payable | 1,655,343 | 1,773,131 |\n| Salary payable | 1,688,353 | 1,632,881 |\n| Taxes payable | 919,255 | 478,209 |\n| Penalty payable | 482,327 | 404,752 |\n| Interest payable | 1,042,661 | 930,062 |\n| Other payables | 1,019,583 | 524,205 |\n| Total current liabilities | 10,324,724 | 11,151,435 |\n| SHAREHOLDER’S EQUITY |\n| Preferred stock - $0.001 par value, Authorized 20,000,000 shares. Issued and outstanding 500,000 and 500,000 shares at December 31, 2016 and 2015, respectively. | 500 | 500 |\n| Common stock - $0.001 per value. Authorized 100,000,000 shares. Issued and outstanding $8,728,981 and 2,000,000 shares at December 31, 2016 and 2015 | 8,729 | 2,000 |\n| Additional paid-in capital | 13,789,990 | 9,490,837 |\n| Statutory Reserve | 127,884 | - |\n| Accumulated deficit | (19,489,400 | ) | (20,324,812 | ) |\n| Accumulated other comprehensive loss | (38,916 | ) | (268,979 | ) |\n| Total stockholders’ deficiency | (5,601,213 | ) | (11,100,454 | ) |\n| Total liabilities and shareholder’s equity | $ | 4,723,511 | $ | 50,981 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-3 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)\n\n| Years Ended December 31, |\n| 2016 | 2015 |\n| Revenue | $ | 9,617,845 | $ | - |\n| Cost of goods sold | 7,672,451 | - |\n| Gross profit | 1,945,394 | - |\n| Operating expenses |\n| Research and development | 224,433 | 178,988 |\n| Selling expenses | 49,295 | - |\n| General and administrative | 874,097 | 313,589 |\n| Total operating expenses | 1,147,825 | 492,577 |\n| Operating income (loss) | 797,569 | (492,577 | ) |\n| Other income |\n| License revenue | 786,329 | - |\n| Other expense |\n| Penalty expense | (77,575 | ) | (72,152 | ) |\n| Interest expense | (112,977 | ) | (112,629 | ) |\n| Other expense | (3,770 | ) | - |\n| Total other expense | (194,322 | ) | (184,781 | ) |\n| Net income (loss) before income tax | 1,389,576 | (677,358 | ) |\n| Income tax provision | (426,280 | ) | - |\n| Net income (loss) | 963,296 | (677,358 | ) |\n| Other comprehensive income |\n| Foreign currency translation adjustment | 230,063 | 424,065 |\n| Total comprehensive income (loss) | $ | 1,193,359 | $ | (253,293 | ) |\n| Net income (loss) per common share - basic | $ | 0.17 | $ | (0.34 | ) |\n| Net income (loss) per common share - diluted | $ | 0.11 | $ | (0.34 | ) |\n| Weighted average number of common shares outstanding - basic | 5,645,263 | 2,000,000 |\n| Weighted average number of common shares outstanding - diluted | 8,872,655 | 2,000,000 |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-4 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIENCY\n\n| Common Stock | Preferred Stock | Additional Paid-in | Statutory | Accumulated | Accumulated Other Comprehensive | Total Stockholders’ |\n| Shares | Amount | Shares | Amount | Capital | Reserve | Deficit | Loss | Deficiency |\n| Balance, December 31, 2014 (Restated) | 2,000,000 | $ | 2,000 | - | $ | - | $ | 8,491,337 | $ | - | $ | (19,647,454 | ) | $ | (693,044 | ) | $ | (11,847,161 | ) |\n| Issuance of 500,000 shares of preferred stock as debt cancellation on December 14, 2015 | - | - | 500,000 | 500 | 999,500 | - | - | 1,000,000 |\n| Net loss | - | - | - | - | - | (677,358 | ) | - | (677,358 | ) |\n| Foreign currency translation adjustment | - | - | - | - | - | - | - | 424,065 | 424,065 |\n| Balance, December 31, 2015 | 2,000,000 | 2,000 | 500,000 | 500 | 9,490,837 | - | (20,324,812 | ) | (268,979 | ) | (11,100,454 | ) |\n| Issuance of common shares for cash | 1,775,000 | 1,775 | - | - | 857,884 | - | 859,659 |\n| Issuance of common shares for Liabilities settlement | 3,243,173 | 3,243 | - | - | 3,188,731 | - | 3,191,974 |\n| Issuance of common shares for consulting service | 1,710,808 | 1,711 | - | - | 252,539 | - | 254,250 |\n| Net income | - | - | - | - | - | 127,884 | 835,412 | 963,296 |\n| Foreign currency translation adjustments | 230,063 | 230,063 |\n| Balance, December 31, 2016 | 8,728,981 | $ | 8,729 | 500,000 | $ | 500 | $ | 13,789,991 | $ | 127,884 | $ | (19,489,400 | ) | $ | (38,916 | ) | $ | (5,601,212 | ) |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-5 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n\n| Years Ended December 31, |\n| 2016 | 2015 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 963,296 | $ | (677,358 | ) |\n| Adjustments to reconcile net loss to net cash used in operating activities: |\n| Depreciation | 23,980 | 4,352 |\n| Bad debt | 55,240 | - |\n| Provision for penalty payable | 77,575 | 72,152 |\n| Accrued interest on convertible notes and note payable | 112,599 | 112,538 |\n| Changes in operating assets and liabilities: | - | - |\n| Accounts receivable | (1,229,249 | ) | - |\n| Other receivable | (1,619,623 | ) | - |\n| Advance to supplier | (1,887,446 | ) | - |\n| Prepaid expense | (59,154 | ) | - |\n| Deposit | (36,095 | ) | (33,921 | ) |\n| Account payable | 1,116,061 | - |\n| Accrued expense | 7,117 | - |\n| Salary payable | 93,860 | 125,924 |\n| Taxes payable | 494,397 | 62,915 |\n| Due to related parties - trade | 217,293 | 178,988 |\n| Other payables | 527,175 | 4,202 |\n| Net cash used in operating activities | (1,142,974 | ) | (150,208 | ) |\n| Cash flows from investing activities: |\n| Purchase of property, plant and equipment | (79,083 | ) | - |\n| Net cash used in investing activities | (79,083 | ) | - |\n| Cash flows from financing activities: |\n| Proceeds from related parties, net of payments to related parties | 139,085 | 148,009 |\n| Proceeds from sale of common stock | 914,273 | - |\n| Net cash provided by financing activities | 1,053,358 | 148,009 |\n| Effect of exchange rate change | 181,447 | (43 | ) |\n| Cash and cash equivalents: |\n| Net increase (decrease) | 12,748 | (2,242 | ) |\n| Balance at beginning of year | 721 | 2,963 |\n| Balance at end of year | $ | 13,469 | $ | 721 |\n| Non-cash financing activities: |\n| Issuance of common stock for debts settlement | $ | 3,137,359 | $ | 1,000,000 |\n| Issuance of common stock for consulting service | 254,250 |\n| Supplemental Disclosures of Cash flow Information: |\n| Cash paid for interest | $ | $ | - |\n| Cash paid for income taxes | $ | $ | - |\n\nThe accompanying notes are an integral part of these consolidated financial statements.\n\n| F-6 |\n\n\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\nDECEMBER 31, 2016\n1. Description of Business and Organization\nOrganization – Kiwa Bio-Tech Products Group Corporation (“the Company”) is the result of a share exchange transaction accomplished on March 12, 2004 between the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002 and Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, the Company completed its reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin ”). Kiwa Tianjin has been dissolved since July, 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\nBusiness – The Company’s business plan is to develop and market innovative, manufacture, distribute cost-effective and environmentally safe bio-technological products for agriculture markets primarily in China. The Company has acquired technologies to produce and market bio-fertilizer.\n2. Summary of Significant Accounting Policies\nPrinciple of Consolidation - These consolidated financial statements include the financial statements of the Company and its wholly-owned subsidiaries, Kiwa BVI, Hong Kong Baina Group Holding Company, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd, Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”). All significant inter-company balances or transactions are eliminated on consolidation.\nReverse Split - On January 14, 2016, the Company filed a Certificate of Amendment of its Certificate of Incorporation with the State of Delaware with reference to a 1-for-200 reverse stock split with respect to its Common Stock with effective date of January 28, 2016. In connection with the reverse split, the Company’s authorized capital was amended to be 120,000,000 shares, comprising 100,000,000 shares of Common Stock par value $0.001 and 20,000,000 shares of Preferred Stock par value $0.001. All relevant information relating to numbers of shares, options and per share information have been retrospectively adjusted to reflect the reverse stock split for all periods presented.\nUse of Estimates - The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant accounting estimates include the valuation of securities issued, deferred tax assets and related valuation allowance.\n\n| F-7 |\n\n\nCertain of our estimates, including evaluating the collectability of accounts receivable and the fair market value of long-lived assets, could be affected by external conditions, including those unique to our industry, and general economic conditions. It is possible that these external factors could have an effect on our estimates that could cause actual results to differ from our estimates. We re-evaluate all of our accounting estimates annually based on these conditions and record adjustments when necessary.\nCash and Cash Equivalents\nThe Company considers all highly liquid investments with a maturity of three months or less to be cash and cash equivalents. At times, such investments may be in excess of Federal Deposit Insurance Corporation (FDIC) insurance limit.\nAccounts Receivables - Accounts receivables represent customer accounts receivables. The allowance for doubtful accounts is based on a combination of current sales, historical charge offs and specific accounts identified as high risk. Uncollectible accounts receivable are charged against the allowance for doubtful accounts when all reasonable efforts to collect the amounts due have been exhausted. Such allowances, if any, would be recorded in the period the impairment is identified.\nAllowance for doubtful accounts\nThe Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts. The Company’s estimate is based on historical collection experience and a review of the current status of trade accounts receivable. It is reasonably possible that the Company’s estimate of the allowance for doubtful accounts will change. There was no allowance for doubtful accounts at December 31, 2016 and December 31, 2015.\nInventories - Inventories are stated at the lower of cost, determined on the weighted average method, and net realizable value. Work in progress and finished goods are composed of direct material, direct labor and a portion of manufacturing overhead. Net realizable value is the estimated selling price in the ordinary course of business, less estimated costs to complete and dispose.\nProperty, plant and equipment - Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Gains or losses on disposals are reflected as gain or loss in the year of disposal. The cost of improvements that extend the life of property, plant and equipment are capitalized. These capitalized costs may include structural improvements, equipment and fixtures. All ordinary repair and maintenance costs are expensed as incurred. Depreciation for financial reporting purposes is provided using the straight-line method over the estimated useful lives of the assets as follows:\n\n| Useful Life |\n| (In years) |\n| Buildings | 30 - 35 |\n| Machinery and equipment | 5 - 10 |\n| Automobiles | 8 |\n| Office equipment | 2 - 5 |\n| Computer software | 3 |\n\nImpairment of Long-Lived Assets - The Company’s long-lived assets consist of property, equipment and intangible assets. The Company evaluates its investment in long-lived assets, including property and equipment, for recoverability whenever events or changes in circumstances indicate the net carrying amount may not be recoverable. Judgments regarding potential impairment are based on legal factors, market conditions and operational performance indicators, among others. In assessing the impairment of property and equipment, the Company makes assumptions regarding the estimated future cash flows and other factors to determine the fair value of the respective assets.\nFair value of warrants and options - The Company adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements. The Company also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements. The Company calculates the fair value of the warrants and options using the Black-Scholes Model.\n\n| F-8 |\n\n\nRevenue Recognition – The Company applies paragraph 605-10-S99-1 of the FASB Accounting Standards Codification for revenue recognition. The Company recognizes revenue when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) the product has been shipped or the services have been rendered to the customer, (iii) the sales price is fixed or determinable, and (iv) collectability is reasonably assured.\nThe Company derives its revenues from sales contracts with its customer with revenues being generated upon delivery of products. Persuasive evidence of an arrangement is demonstrated via invoice; and the sales price to the customer is fixed upon acceptance of the purchase order and there is no separate sales rebate, discount, or volume incentive.\nShipping and Handling Costs - Substantially all costs of shipping and handling of products to customers are included in selling. Shipping and handling costs for the years ended December 31, 2016 and 2015 were $480,892 and $ nil, respectively.\nIncome Taxes - The Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\nForeign Currency Translation and Other Comprehensive Income - The Company uses United States dollars (“US Dollar” or “US$” or “$”) for financial reporting purposes. However, the Company maintains the books and records in its functional currency, Chinese Renminbi (“RMB”), being the primary currency of the economic environment in which its operations are conducted. In general, the Company translates its assets and liabilities into U.S. dollars using the applicable exchange rates prevailing at the balance sheet date, and the statement of comprehensive loss and the statement of cash flow are translated at average exchange rates during the reporting period. Equity accounts are translated at historical rates. Adjustments resulting from the translation of the Company’s financial statements are recorded as accumulated other comprehensive income.\nOther comprehensive income for the years ended December 31, 2016 and 2015 represented foreign currency translation adjustments and were included in the consolidated statements of comprehensive loss.\nThe exchange rates used to translate amounts in RMB into U.S. Dollars for the purposes of preparing the consolidated financial statements were as follows:\n\n| As of December 31, |\n| 2016 | 2015 |\n| Balance sheet items, except for equity accounts | 6.94 | 6.4857 |\n\n\n| Years ended December 31, |\n| 2016 | 2015 |\n| Items in the statements of comprehensive loss | 6.62 | 6.2281 |\n\nAdvertising Costs - The Company charges all advertising costs to expense as incurred. The total amounts of advertising costs charged to selling, general and administrative expense were $nil for the years ended December 31, 2016 and 2015, respectively.\nResearch and Development Costs - Research and development costs are charged to expense as incurred. During the years ended December 31, 2016 and 2015, research and development costs were $224,433 and $178,988, respectively.\n\n| F-9 |\n\n\nNet Loss Per Common Share - Basic loss per common share is calculated by dividing net loss attributable to Kiwa stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted loss per common share includes dilutive effect of dilutive securities (stock options, warrants, convertible debt, stock subscription and other stock commitments issuable). These potentially dilutive securities were not included in the calculation of loss per share for the periods presented because the Company incurred a loss during such periods and thus the effect would have been anti-dilutive. Accordingly, basic and diluted loss per common share is the same for all periods presented. As of December 31, 2016 and 2015, potentially dilutive securities aggregated 8,872,655 (632,204 post-reverse split shares) and 126,440,833 (632,204 post-reverse split shares) shares of common stock, respectively.\nFair Value of Financial Instruments\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and paragraph 820- 10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 establishes a framework for measuring fair value with U.S. GAAP, and expands disclosures about fair value measurements.\nTo increase consistency and comparability in fair value measurements and related disclosures, Paragraph 820-10-35-37 establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by Paragraph 820-10-35-37 are described below:\n\n| ● | Level 1: quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\n| ● | Level 2: pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\n| ● | Level 3: Pricing inputs that are generally observable inputs and not corroborated by market data. |\n\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\nThe carrying amount of the Company’s financial assets and liabilities, such as cash and cash equivalent, prepaid expenses, accounts payable and accrued expenses, approximate their fair value because of the short maturity of those instruments.\nTransactions involving related parties cannot be presumed to be carried out on an arm’s-length basis, as the requisite conditions of competitive, free-market dealings may not exist. Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions unless such representations can be substantiated.\nIt is not however practical to determine the fair value of advances from stockholders, if any, due to their related party nature.\n\n| F-10 |\n\n\nRelated Parties\nThe Company follows subtopic 850-10 of the FASB Accounting Standards Codification for the identification of related parties and disclosure of related party transactions. Pursuant to Section 850-10-20 the related parties include: a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly Influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\nThe consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated financial statements is not required in those statements. The disclosures shall include: a. the nature of the relationship(s) involved; b. a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the consolidated financial statements; c. the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d. amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\nCommitments and Contingencies\nThe Company follows subtopic 450-20 of the FASB Accounting Standards Codification to report accounting for contingencies. Certain conditions may exist as of the date the consolidated financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\n\n| F-11 |\n\n\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potential material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely\nStock Based Compensation\nThe Company accounts for employee and non-employee stock awards under ASC 718, whereby equity instruments issued to employees for services are recorded based on the fair value of the instrument issued and those issued to non-employees are recorded based on the fair value of the consideration received or the fair value of the equity instrument, whichever is more reliably measurable.\nNo stock based compensation was issued or outstanding as of December 31, 2016 and 2015.\nIncome Tax Provision\nIncome taxes are accounted for using the asset and liability method. Deferred income taxes are provided for temporary differences in recognizing certain income, expense and credit items for financial reporting purposes and tax reporting purposes. Such deferred income taxes primarily relate to the difference between the tax basis of assets and liabilities and their financial reporting amounts. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized. There were no material deferred tax assets or liabilities as of December 31, 2016 and December 31, 2015.\nAs of December 31, 2016, and 2015, the Company did not identify any material uncertain tax positions. As of December 31, 2016, the Company’s returns are subject to examination by federal and state taxing authorities, generally for three years and four years, respectively, after they are filed.\nNet Income (Loss) Per Common Share\nNet income (loss) per common share is computed pursuant to section 260-10-45 of the FASB Accounting Standards Codification. Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.\n\n| F-12 |\n\n\nDiluted net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of shares of common stock and potentially outstanding shares of common stock during the period to reflect the potential dilution that could occur from common shares issuable through contingent shares issuance arrangement, stock options or warrants.\nThere were no potentially dilutive debt or equity instruments issued and outstanding at any time during the twelve-month periods ended December 31, 2016 and 2015.\nCash Flows Reporting\nThe Company adopted paragraph 230-10-45-24 of the FASB Accounting Standards Codification for cash flows reporting, classifies cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category, and uses the indirect or reconciliation method (“Indirect method”) as defined by paragraph 230-10-45-25 of the FASB Accounting Standards Codification to report net cash flow from operating activities by adjusting net income to reconcile it to net cash flow from operating activities by removing the effects of (a) all deferrals of past operating cash receipts and payments and all accruals of expected future operating cash receipts and payments and (b) all items that are included in net income that do not affect operating cash receipts and payments. The Company reports the reporting currency equivalent of foreign currency cash flows, using the current exchange rate at the time of the cash flows and the effect of exchange rate changes on cash held in foreign currencies is reported as a separate item in the reconciliation of beginning and ending balances of cash and cash equivalents and separately provides information about investing and financing activities not resulting in cash receipts or payments in the period pursuant to paragraph 830-230-45-1 of the FASB Accounting Standards Codification.\nSubsequent Events\nThe Company follows the guidance in Section 855-10-50 of the FASB Accounting Standards Codification for the disclosure of subsequent events. The Company will evaluate subsequent events through the date when the financial statements were issued. Pursuant to ASU 2010-09 of the FASB Accounting Standards Codification, the Company as an SEC filer considers its financial statements issued when they are widely distributed to users, such as through filing them on EDGAR.\nRecent accounting pronouncements\nIn November 2015, FASB issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes.” ASU 2015-17 requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\nIn January 2016, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 requires equity investments to be measured at fair value with changes in fair value recognized in net income; simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; requires separate presentation of financial assets and financial liabilities by measurement category and form of financial assets on the balance sheet or the accompanying notes to the financial statements and clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU 2016-01 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\n\n| F-13 |\n\n\nIn March 2016, the FASB issued ASU 2016-09—Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The amendments in this guidance are relating to employee share-based compensation. Under the new guidance, we are required to recognize the tax effects of stock compensation as income tax expense or benefit in the income statement and treat the tax effects of exercised or vested awards as discrete items in the reporting period in which they occur. Excess tax benefits are required to be classified as operating activities, and shares we withhold on behalf of employees for tax purposes are required to be classified as financing activities. We may make an accounting policy election to continue to estimate the number of awards that are expected to vest or account for forfeitures when they occur. The threshold to qualify for equity classification permits withholding up to the maximum statutory tax rates. This guidance is required to be adopted in the first quarter of 2017. We are currently evaluating the impact this guidance will have on our consolidated financial statements.\nIn August 2016, the FASB issued ASU 2016-15—Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). The amendments in this guidance on eight specific cash flow issues with regard to how cash receipts and cash payments are presented and classified in the statement of cash flows in order to clarify existing guidance and reduce diversity in practice. The guidance is required to be adopted in the first quarter of 2018 on a retrospective basis, unless it is impracticable to apply, in which case it should be applied prospectively as of the earliest date practicable. Early adoption is permitted. We are currently evaluating the impact this guidance will have on our consolidated statement of cash flows.\nIn January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business.” The amendments in this guidance are clarifying the definition of a business to assist entities when determining whether an integrated set of assets and activities meets the definition of a business. The update provides that when substantially all the fair value of the assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this new guidance is not expected to have a material impact on our consolidated financial statements.\nIn January 2017, the FASB issued ASU 2017-04—Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this guidance to eliminate the requirement to calculate the implied fair value of goodwill to measure goodwill impairment charge (Step 2). As a result, an impairment charge will equal the amount by which a reporting unit’s carrying amount exceeds its fair value, not to exceed the amount of goodwill allocated to the reporting unit. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The amendment should be applied on a prospective basis. The guidance is effective for goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for goodwill impairment tests performed after January 1, 2017. The impact of this guidance for the Company will depend on the outcomes of future goodwill impairment tests.\nThere were other updates recently issued. The Company does not believe that other than disclosed above, the recently issued, but not yet adopted, accounting pronouncements will have a material impact on its financial position, results of operations or cash flows.\nGoodwill and Other Intangibles\nIn accordance with Accounting Standards Update (ASU) No. 2014-02, management evaluates goodwill on an annual basis in the fourth quarter of more frequently if management believes indicators of impairment exist. Such indicators could, but are not limited to (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. The Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. If management concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, management conducts a two-step quantitative goodwill impairment test. The first step of the impairment test involves comparing the fair value of the applicable reporting unit with its carrying value. The Company estimates the fair value of its reporting units using a combination of the income, or discounted cash flows, approach and the market approach, with utilizes comparable companies’ data. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, management performs the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount, by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. The Company’s evaluation of goodwill completed during the year resulted in no impairment losses.\n3. Going Concern\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622, had an accumulated deficit of $19,489,400, and stockholders’ deficiency of $5,601,213. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\nThe management of the Company already raised additional equity during the first quarter of 2017 for approximately $1,000,000. (Please refer to Note 14 for additional information) The Company is generating additional revenue while seeking additional equity financing. Management is very optimistic about the Company’s continue profitability for the coming years.\n4. Property, Plant and Equipment\nProperty, plant and equipment, net consisted of the following:\n\n| December 31, 2016 | December 31, 2015 |\n| Property, Plant and Equipment |\n| Buildings | $ | - | $ | 1,308,785 |\n| Machinery and equipment | - | 595,623 |\n| Automobiles | - | 85,769 |\n| Office equipment | 942 | 104,843 |\n| Furniture | 8,276 | - |\n| Leasehold improvement | 70,871 | - |\n| Computer software | - | 22,304 |\n| Property, plant and equipment - total | $ | 80,089 | $ | 2,117,324 |\n| Less: accumulated depreciation | (20,311 | ) | (762,791 | ) |\n| Less: impairment on long-lived assets | - | (1,351,726 | ) |\n| Property, plant and equipment - net | $ | 59,778 | $ | 2,807 |\n\nThe building is on a piece of land the use right of which was granted to Kiwa Bio-Tech Products (Shandong) Co., Ltd. by local government free for 10 years and then for another 20 years on a fee calculated according to Kiwa Shandong’s net profit. Since Kiwa Shandong did not generate any net profit, no fee is payable.\nDepreciation expense was $22,340 and $4,352 for the years ended December 31, 2016 and 2015, respectively.\nImpairment on long-lived assets was $nil for the years ended December 31, 2016 and 2015, respectively.\nAll of our property, plant and equipment have been held as collateral to secure the 6% Notes (see Note 8).\n5. Goodwill\nOn November 30, 2015, Kiwa Bio-tech Products Group Ltd in BVI (\"Kiwa BVI\") entered an acquisition agreement with shareholders of Caber Holdings Ltd. (“Acquiree”) in Hong Kong to acquire 100 percent entity interest of the acquiree, including a wholly owned subsidiary, Oriental Baina Co., Ltd. in Beijing for US$30,000. The acquisition was completed in January, 2016. On the acquisition date, there was no any asset or liability acquired, and thus no fair value was allocated to asset and liability. Including legal fee and government fees, the total payment of approximately $34,112 ($30,000 plus legal fee and government fees totaled $4,112) was recorded as goodwill. The fair value of the goodwill is tested prior to the year-end 2016, and management determined there is no impairment to the goodwill as of December 31, 2016.\n6. Construction Costs Payable\nConstruction costs payable represents remaining amounts to be paid for the first phase of construction of bio-fertilizer facility in Shandong. The balance of construction costs payable as of December 31, 2016 and 2015 was $255,539 and $273,722, respectively.\n\n| F-14 |\n\n\n7. Related Party Transactions\nAmounts due to related parties consisted of the following as of December 31, 2016 and 2015:\n\n| Item | Nature | Notes | December 31, 2016 | December 31, 2015 |\n| Mr. Wei Li (“Mr. Li”) | Non-trade | (1 | ) | $ | - | $ | 2,879,307 |\n| Kangtai Xinnong Agriculture Tech (Beijing) Co., Ltd. (“Kangtai”) | Non-trade | (2 | ) | - | (12,173 | ) |\n| Ms. Yvonne Wang (“Ms. Wang”) | Non-trade | (3 | ) | 100,798 | 299,064 |\n| Subtotal | 100,798 | 3,166,198 |\n| Kiwa-CAU R&D Center | Trade | (4 | ) | 1,122,754 | 1,125,553 |\n| CAAS IARRP and IAED Institutes | Trade | (5 | ) | 160,461 | 18,425 |\n| Subtotal | 1,283,215 | 1,143,978 |\n| Total | $ | 1,384,013 | $ | 4,310,176 |\n\n(1) Mr. Li\nMr. Li was the Chairman of the Board until November 20, 2015 and was the Chief Executive Officer of the Company until July 1, 2015.\nAdvances and Loans\nOn December 14, 2015, Mr. Li assigned $500,000 of obligation owed by the Company to his daughter, Feng Li. On the same day, Feng Li subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agreed to the concurrent cancellation of debt owed by the Company.\nOn March 24, 2016, the Company issued 2,900,000 shares of common stock to Mr. Li to settle down entire outstanding balance of $2,879,307. Subsequently in June 2016, Mr. Li transferred 1,000,000 shares to Troniya Industria Incubator Co., Ltd as a personal collateral for RMB 3.2 million received in Kiwa Baiao Bio-Tech (Beijing) Co., Ltd.’s account.\nGuarantees for the Company\nMr. Li has pledged without any compensation from the Company all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes (see Note 9).\n(2) Kangtai\nKangtai is a private company and is 64% owned by Mr. Li. Mr. Li is the Chairman of Kangtai.\n(3) Ms. Wang\nMs. Wang is the Secretary of the Company until November 20, 2015. Effective as of November 20, 2015, the Company appointed Ms. Wang as the Chairman of the Board. Effective August 11, 2016, the Company’s Board of Directors has assigned Ms. Wang the additional titles of Acting President, Acting Chief Executive Officer and Acting Chief Financial Officer.\nOn December 14, 2015, Ms. Wang subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agrees to the concurrent cancellation of debt owed by the Company.\nOn March 24, 2016, the Company issued 240,000 shares of common stock to Ms. Wang to pay off the loan balance of $240,000. During the year ended December 31, 2016, Ms. Wang paid various expenses on behalf of the Company. As of December 31, 2016, the amount due to Ms. Wang was $100,798.\n\n| F-15 |\n\n\n(4) Kiwa-CAU R&D Center\nIn November 2006, Kiwa and China Agricultural University (the “CAU”) agreed to jointly establish a new research and development center, named Kiwa-CAU R&D Center. The term of the agreement was ten years commencing July 1, 2006.\n\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Prof. Qi Wang, a director of the Company, is also the director of Kiwa-CAU R&D Center. The Company recorded $75,528 and $160,563 research and development expenses related to this R&D Center for the years ended December 31, 2016 and 2015, respectively. |\n\n(5) CAAS IARRP and IAED Institutes\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). The term of the Agreement was three years commencing November 20, 2015.\n\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company's directors effective since November 20, 2015 until March 13, 2017. The Company recorded $149,176 and $18,425 research and development expenses related to the institutes, for the years ended December 31, 2016 and 2015, respectively, |\n\nResearch and Development expenses for the years ended December 31, 2016 and 2015, totaled $224,704 and $178,988, respectively.\n8. Unsecured Loans Payable\nUnsecured loans payable consisted of the following:\n\n| Item | December 31, 2016 | December 31, 2015 |\n| Unsecured loan payable to Zoucheng Municipal Government, non-interest bearing, becoming due within three years from Kiwa Shandong’s first profitable year on a formula basis, interest has not been imputed due to the undeterminable repayment date | $ | 1,269,880 | $ | 1,387,668 |\n| Unsecured loan payable to Zoucheng Science & Technology Bureau, non-interest bearing, it is due in Kiwa Shandong’s first profitable year, interest has not been imputed due to the undeterminable repayment date | 385,463 | 385,463 |\n| Total | $ | 1,655,343 | $ | 1,773,131 |\n\nThe Company qualifies for non-interest bearing loans under a Chinese government sponsored program to encourage economic development in certain industries and locations in China. To qualify for the favorable loan terms, a company must meet the following criteria: (1) be a technology company with innovative technology or product (as determined by the Science Bureau of the central Chinese government); (2) operate in specific industries that the Chinese government has determined are important to encourage development, such as agriculture, environmental, education, and others; and (3) be located in an undeveloped area such as Zoucheng, Shandong Province, where the manufacturing facility of the Company is located.\nAccording to the Company’s project agreement, Zoucheng Municipal Government granted the Company use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, the Company has the option to pay a fee of RMB 480,000 ($77,100) per acre for the land use right after the 10-year period until May 2012. The Company may not transfer or pledge the temporary land use right. The Company also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, the Company invested approximately $2 million for the property, plant and equipment of the project and these assets were impaired as of December 31, 2016.\n\n| F-16 |\n\n\n9. Convertible Notes Payable\nConvertible notes payable consists of 6% secured convertible notes issued to FirsTrust Group Inc. on June 29, 2006. The notes beard interest at 6% and were due on June 29, 2009. Once the note is pass due, the interest rate increased to 15% per annum. The Company accrued $22,977 and $22,538 interest expense on convertible notes for the years ended December 31, 2016 and 2015, respectively. Interest payable to FirstTrust Group Inc. totaled $183,361 and $160,762 at December 31, 2016 and 2015, respectively.\nThe conversion price of the 6% Notes is based on a 40% discount to the average of the trading price of the Company’s common stock on the OTC Bulletin Board over a 20-day trading period. The conversion price is also adjusted for certain subsequent issuances of equity securities of the Company at prices below the conversion price then in effect. The 6% Notes contain a volume limitation that prohibits the holder from further converting the 6% Notes if doing so would cause the holder and its affiliates to hold more than 4.99% of the Company’s outstanding common stock. In addition, the holder of the 6% Notes agrees that they may not convert more than their pro-rata share (based on original principal amount) of the greater of $120,000 principal amount of the 6% Notes per calendar month or the average daily dollar volume calculated during the 10 business days prior to a conversion, per conversion. This conversion limit has since been eliminated pursuant to an agreement by the Company and the Purchasers.\nThe Company incurs a financial penalty in cash or shares at the option of the Company (equal to 2% of the outstanding amount of the Notes per month plus accrued and unpaid interest on the Notes, prorated for partial months) if it breaches this or other affirmative covenants in the Purchase Agreement, including a covenant to maintain a sufficient number of authorized shares under its Certificate of Incorporation to cover at least 110% of the stock issuable upon full conversion of the Notes. Pursuant to the relevant provisions for liquidated damages in the Purchase Agreement, the Company has accrued the penalty of $77,575 and $72,152 for the years ended December 31, 2016 and 2015, respectively.\nThe 6% Notes require the Company to procure the Purchaser’s consent prior to taking certain actions including the payment of dividends, repurchasing stock, incurring debt, guaranteeing obligations, merging or restructuring the Company, or selling significant assets.\nThe Company’s obligations under the 6% Notes are secured by a first priority security interest in the Company’s intellectual property pursuant to an Intellectual Property Security Agreement with the Purchasers, and by a first priority security interest in all of the Company’s other assets pursuant to a Security Agreement with the Purchasers. In addition, Mr. Li, the Company’s former Chief Executive Officer until July 1, 2015, has pledged all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes. The intellectual property pledged had a cost of $592,901 which carrying value of $179,897 was fully impaired during the year ended December 31, 2009.\n\n| F-17 |\n\n\n10. Note payable\nOn May 29, 2007, the Company issued a $360,000 promissory note to an unrelated individual. This note bears interest at 18% per annum and due on July 27, 2007. This note is currently in default and bears interest of 25% per annum (the “Default rate”) until paid in full. This note is secured by a pledge of 6,178,336 (post-reverse split 30,892) shares of the Company’s common stock owned by Investlink (China) Limited, a British Virgin Island corporation. The Company accrued $90,000 and $90,000 interest expense on note payable for the years ended December 31, 2016 and 2015, respectively.\n11.Stockholders’ Deficiency\nOn December 14, 2015, the Company issued 500,000 shares of preferred stock for the aggregate amount of $1,000,000 as debt cancellation owed to two related party individuals (see Note 7).\nIn March, 2016, the Company issued 3,140,000 shares of common stock to Mr. Li and Ms. Wang for debt and salary payable settlement for an aggregate amount of $3,141,000 (See Note 7). In addition, the Company issued 101,947 common shares to Jimmy Zhou, former CEO in August 2016, to settle payable to him for $50,974. All of issuances of common shares for settlement of debts were based the stock price on the transaction dates.\nDuring the year, the Company issued 1,775,000 common shares for cash at $0.8 per share for an aggregate subscribe price equivalent to $1,420,000, of which $859,659 has received while approximately $560,341 remaining subscribe receivable at December 31, 2016.\nDuring the year ended December 31, 2016, the Company issued 1,711,808 common shares to four consulting companies as compensation for their consulting service received, totaled $254,250 approximately for the year ended December 31, 2016.\n12. Stock-based Compensation\nOn December 12, 2006, the Company granted options for 2,000,000 shares (10,000 post-reverse split shares) of its common stock under its 2004 Stock Incentive Plan. Summary of options issued and outstanding at December 31, 2016 and 2015 and the movements during the years then ended are as follows:\n\n| F-18 |\n\n\n\n| Number of underlying shares | Weighted- Average Exercise Price Per Share | Aggregate Intrinsic Value | Weighted- Average Contractual Life Remaining in Years |\n| Outstanding at December 31, 2014 | 6,163 | $ | 35 | $ | - | 2 |\n| Exercised | - | - | - |\n| Expired | - | - | - |\n| Forfeited | - | - | - |\n| Outstanding at December 31, 2015 | 6,163 | $ | 35 | $ | - | 1 |\n| Exercised | - | - | - |\n| Expired | 6,163 | $ | 35 | - |\n| Forfeited | - | - | - |\n| Outstanding at December 31, 2016 | - | - | $ | - | - |\n| Exercisable at December 31, 2016 | - | - | $ | - | - |\n\nAs of December 31, 2016, no stock options or other stock-based compensation was outstanding and all prior grants of stock options had expired as of that date.\n13. Income Tax\nIn accordance with the current tax laws in China, Kiwa Shandong is subject to a corporate income tax rate of 25% on its taxable income. However, Kiwa Shandong has not provided for any corporate income taxes since it had no taxable income for the years ended December 31, 2016 and 2015.\nNo provision for taxes is made for U.S. income tax as the Company has no taxable income in the U.S. In accordance with the relevant tax laws in the British Virgin Islands, Kiwa BVI, as an International Business Company, is exempt from income taxes.\nA reconciliation of the provision for income taxes determined at the local income tax rate to the Company’s effective income tax rate is as follows:\n\n| Years ended December 31, |\n| 2016 | 2015 |\n| Pre-tax income (loss) | $ | 1,389,576 | $ | (677,358 | ) |\n| U.S. federal corporate income tax rate | 34 | % | 34 | % |\n| Income tax computed at U.S. federal corporate income tax rate | 472,456 | (230,302 | ) |\n| Reconciling items: |\n| Rate differential for PRC earnings | (139,923 | ) | 22,439 |\n| Change of valuation allowance | 301,813 | 171,993 |\n| Non-deductible expenses | (208,066 | ) | 35,870 |\n| Effective tax expense | $ | 426,280 | $ | - |\n\n\n| F-19 |\n\n\nThe Company had deferred tax assets as follows:\n\n| December 31, 2016 | December 31, 2015 |\n| Net operating losses carried forward | $ | 3,475,563 | $ | 3,398,402 |\n| Less: Valuation allowance | (3,475,563 | ) | (3,398,402 | ) |\n| Net deferred tax assets | $ | - | $ | - |\n\nAs of December 31, 2016 and 2015, the Company had approximately $3.5 million and $8 million net operating loss carryforwards available to reduce future taxable income. Net operating loss of the Company could be carried forward and taken against any taxable income for a period of not more than twenty years from the year of the initial loss pursuant to Section 172 of the Internal Revenue Code of 1986, as amended. The net operating loss of Kiwa Shandong could be carried forward for a period of not more than five years from the year of the initial loss pursuant to relevant PRC tax laws and regulations. It is more likely than not that the deferred tax assets cannot be utilized in the future because there will not be significant future earnings from the entity which generated the net operating loss. Therefore, the Company recorded a full valuation allowance on its deferred tax assets.\nAs of December 31, 2016 and 2015, the Company has no material unrecognized tax benefits which would favorably affect the effective income tax rate in future periods and does not believe that there will be any significant increases or decreases of unrecognized tax benefits within the next twelve months. No interest or penalties relating to income tax matters have been imposed on the Company during the two years ended December 31, 2016 and 2015, and no provision for interest and penalties is deemed necessary as of December 31, 2016 and 2015.\nAccording to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational errors made by the taxpayer or its withholding agent. The statute of limitations extends to five years under special circumstances, which are not clearly defined. In the case of a related party transaction, the statute of limitation is ten years. There is no statute of limitation in the case of tax evasion.\n14. Commitments and Contingencies\nThe Company has the following material contractual obligations:\n(1) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\n(2) Strategic cooperation with two institutes in China\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\n\n| F-20 |\n\n\n(3) Distribution agreement with Kangtan Gerui Bio-Tech in China\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\n(4) Lease payments\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\nThe future lease payments at December 31, 2016 are summarized below.\n\n| Beijing Office | Beijing Apartment | Shenzhen Office | Total |\n| 2017 | $ | 139,462 | $ | 3,632 | $ | 4,328 | $ | 147,422 |\n| 2018 | $ | 44,555 | - | - | $ | 44,555 |\n| Thereafter | - | - | - | - |\n\n15. Subsequent Events\nThe Company has evaluated the existence of significant events subsequent to the balance sheet date through the date these financial statements were issued and has determined that there were no subsequent events or transactions which would require recognition or disclosure in the financial statements, other than noted herein.\nOn February 11, 2017, the Company executed an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) whereby the Company transferred all of its right, title and interest in Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Shandong”) to the Transferee for the RMB equivalent of US$1.00. In connection with the transaction, the Transferee received all assets of Shandong which are estimated to be approximately RMB 14,057,713 at the effective date and assumed all liabilities of Shandong which are estimated to be approximately RMB 59,446,513 at the effective date. In connection with this transaction, Transferee agreed to indemnify the Company for any liability or claims of any third party(ies) against Shandong or the Company for five (5) years. The transaction is subject to obtaining Chinese government approval for the transaction, which the parties agrees to use their best efforts to obtain prior to December 31, 2017. The completion of transfer is under government processing.\n\n| F-21 |\n\n\nOn February 15, 2017, the Company completed the sale of 1,000,000 shares of Kiwa Common Stock (each a “Share”) at a price of $1.00 per share (total sale proceeds were $1,000,000) to Junwei Zheng in a private transaction which was exempt from registration under Section 4(a)(2) of the Securities Act of 1933, as amended (the “Act”) and Regulation S promulgated under the Act since, among other things, the transaction did not involve a public offering and the securities were acquired for investment purposes only and not with a view to or for sale in connection with any distribution thereof and were purchased by an investor who is not a resident of the United States. The net proceeds will be used for the further development of Kiwa products and distribution, as well as for general working capital.\nOn February 23, 2017, the Company has agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\nOn February 27, 2017, the Company has signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company, the Company was converted from a Delaware corporation to a Nevada corporation by filing of Articles of Conversion and Articles of Incorporation in the State of Nevada and filing a Certificate of Dissolution in the State of Delaware.\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan.\nOn March 13, 2017, Yong Change Wu was removed as a director of the Company by the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company. Immediately thereafter, the Board appointed Yong Lin Song as a director of the Company to be effective immediately.\n\n| F-22 |\n\n\n\n</text>\n\nWhat is the total amount spent by the company on research and development, and acquisitions from 2004 to 2016 in US dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nITEM 1. Business\\nThe Company\\n1. Organizational History\\nWe are the result of a share exchange transaction completed in March 2004 between the shareholders of Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah, and the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n\\n| 3 |\\n\\n\\n2. Overview of Business\\nWe develop, manufacture, distribute and market innovative, cost-effective and environmentally safe bio-technological products for agriculture. Our products are designed to enhance the quality of human life by increasing the value, quality and productivity of crops and decreasing the negative environmental impact of chemicals and other wastes.\\n\\n| 4 |\\n\\n\\nBio-fertilizers\\nWe have developed six bio-fertilizer products with bacillus species (“bacillus spp”) and/or photosynthetic bacteria as core ingredients. Some of our products contain ingredients of both photosynthesis and bacillus bacteria. Bacillus spp is a species of bacteria that interacts with plants and promotes biological processes. It is highly effective for promoting plant growth, enhancing yield, improving quality and elevating resistances. Photosynthetic bacteria are a group of green and purple bacteria. Bacterial photosynthesis differs from green plant photosynthesis in that bacterial photosynthesis occurs in an anaerobic environment and does not produce oxygen. Photosynthetic bacteria can enhance the photosynthetic capacity of green plants by increasing the utilization of sunlight, which helps keep the photosynthetic process at a vigorous level, enhances the capacity of plants to transform inorganic materials to organic products, and boosts overall plant health and productivity.\\nOur bacillus bacteria based fertilizers are protected by patents. In 2004, we acquired patent no. ZL 93101635.5 entitled “Highly Effective Composite Bacteria for Enhancing Yield and the Related Methodology for Manufacturing” from China Agricultural University (“CAU”) for the aggregate purchase of $480,411, consisting of $60,411 in cash and 5,000 shares of our common stock, valued at $84.00 per share (aggregate value of $420,000). Our photosynthetic bacteria based fertilizers are also protected by trade secret laws.\\nThe patent acquired from CAU covers six different species of bacillus which have been tested as bio-fertilizers to enhance yield and plant health. The production methods of the six species are also patented. The patent has expired on February 19, 2013.There are no limitations under this agreement on our exclusive use of the patent. Pursuant to our agreement with CAU, the University agreed to provide research and technology support services at no additional cost to us in the event we decide to use the patent to produce commercial products. These research and technology support services include: (1) furnishing faculty or graduate-level researchers to help bacteria culturing, sampling, testing, trial production and production formula adjustment; (2) providing production technology and procedures to turn the products into powder form while keeping live required bacteria in the products; (3) establishing quality standards and quality control systems; (4) providing testing and research support for us to obtain necessary sale permits from the Chinese government; and (5) cooperation in developing derivative products.\\nOn January 5, 2011, the State Intellectual Property Office of the PRC (“Intellectual Property Office”) granted Kiwa two Certificates of Patent of Invention for (1) “A cucumber dedicated composite anti-continuous cropping effect probiotics and their specific strains with related application” with patent number of “ZL 2008 1 0144492.6”; and (2) “Cotton dedicated composite anti-continuous cropping effect probiotics and their special strains with related application” with patent number of “ZL 2008 1 0144491.1” These two patents have been developed by Kiwa-CAU R&D Center. These two patents will expire on August 5, 2028. These two patents can be used to develop specific environment-friendly bio-fertilizer.\\nWe have obtained five fertilizer registration certificates from the Chinese government - four covering our bacillus bacteria fertilizer and one covering our photosynthetic bacteria fertilizer. The five registration certificates are: (1) Microorganism Microbial Inoculum Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (2) Photosynthetic Bacteria Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (3) Amino Acid Foliar Fomular Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture; (4) Organic Fertilizer Registration Certificate issued by Agriculture Department of Shandong Province; and (5) Organic Matter-Decomposing Inoculants Registration Certificate issued by the PRC Ministry of Agriculture on February 16, 2008. Protected by these five fertilizer registration certificates and five trademarks under the names of “KANGTAN” (Chinese translation name for Kiwa), “ZHIGUANGYOU,” “PUGUANGFU,” “JINWA” and “KANGGUAN,” we have developed six series of bio-fertilizer products with bacillus spp and/or photosynthetic bacteria as core ingredients. Valid period of fertilizer registration certificates is five years and may be extended for another five years upon application from the owner of fertilizer registration certificates. The Company has determined to re-apply the Fertilizer Registration Certificate issued by the PRC Ministry of Agriculture.\\n\\n| 5 |\\n\\n\\nKiwa-CAU Research and Development Center\\nIn July 2006, we established a new research center with CAU which is known as Kiwa-CAU Bio-Tech Research & Development Center (the “Kiwa-CAU R&D Center”). Pursuant to an agreement between CAU and Kiwa Shandong dated November 14, 2006, Kiwa agreed to contribute RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Under the above agreement, the Kiwa-CAU R&D Center is responsible for fulfilling the overall research-and-development functions of Kiwa Shandong, including: (1) development of new technologies and new products (which will be shared by Kiwa and CAU); (2) subsequent perfection of existing product-related technologies; and (3) training quality-control personnel and technicians and technical support for marketing activities. The Company has spent $224,704 and $178,388 for its research and development activities during the years ended December 31, 2016 and 2015, respectively. The costs incurred by Company’s research and development activities are not borne directly by customers.\\nDuring fiscal 2014, Kiwa-CAU R&D Center had successfully isolated several strains of endophytic bacillus from plants. A number of strains had been observed to have the capability of boosting crop yield and dispelling chemical pesticide residual from soil. These strains could be used for developing not only new biological preparation but also environmental protection preparation.\\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa dated November 14, 2006, Kiwa agreed to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement was ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006. The Company has negotiated a follow-up Cooperation Agreement for the technologies with China Agricultural University.\\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\\nOn February 23, 2017, the Company agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\\n\\n| 6 |\\n\\n\\nOther\\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. As a result of this Agreement, Kiwa renamed Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd., which replaced Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. The Company paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities.\\nThereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\\nOn December 17, 2015, we entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfilled the requirements of reduction of content of heavy metals in soil and improved crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\\n\\n| 7 |\\n\\n\\nOn February 27, 2017, the Company signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\\n\\nITEM 1A. Risk Factors\\nSmaller reporting companies are not required to provide the information required by this item.\\n\\n| 8 |\\n\\n\\n\\nITEM 1B. Unresolved Staff Comments\\nNone.\\n\\nITEM 2. Properties\\nIn June 2002, Kiwa Shandong entered into an agreement with Zoucheng Municipal Government granting us the use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, we have the option to pay a fee of approximately RMB 480,000 (approximately $78,155) per acre for the land use right at the expiration of the 10-year period. We may not transfer or pledge the temporary land use right. In the same agreement, we have also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. On February 11, 2017 Kiwa Bio-Tech Products (Shandong) entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n\\nITEM 3. Legal Proceedings\\nNone.\\n\\nITEM 4. Mine Safety Disclosures\\nNot applicable.\\nPart II\\n\\nITEM 5. Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities\\nMarket Information\\nThe Company’s common stock has been quoted on the OTCQB under the symbol “KWBT” since March 30, 2004.\\nThe following table sets forth the high and low bid quotations per share of our common stock as reported on the OTCQB for the periods indicated. The high and low bid quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. All prices are adjusted to reflect the Company’s one for 200 reverse split which went effective January 28, 2016.\\n\\n| Fiscal Year 2016 | High | Low |\\n| First Quarter | $ | 2.24 | $ | 0.20 |\\n| Second Quarter | $ | 1.98 | $ | 1.30 |\\n| Third Quarter | $ | 1.65 | $ | 0.62 |\\n| Fourth Quarter | $ | 1.43 | $ | 0.80 |\\n\\n\\n| Fiscal Year 2015 | High | Low |\\n| First Quarter | $ | 1.47 | $ | 0.12 |\\n| Second Quarter | $ | 0.44 | $ | 0.02 |\\n| Third Quarter | $ | 0.32 | $ | 0.12 |\\n| Fourth Quarter | $ | 0.70 | $ | 0.12 |\\n\\nHolders\\nAs of December 31, 2016, there were approximately 461 shareholders of record of our common shares.\\nDividend Policy\\nWe have not paid any dividends on our common shares since our inception and do not anticipate that dividends will be paid at any time in the immediate future.\\nEquity Compensation Plan Information\\nThe information required by Item 5 regarding securities authorized for issuance under equity compensation plans is included in Item 12 of this report.\\n\\n| 9 |\\n\\n\\nRecent Sales of Unregistered Securities\\nThe following is a list of securities issued for cash or converted with debentures or as stock compensation to consultants during the period from January 1, 2016 through April 14, 2017, which were not registered under the Securities Act:\\n\\n| Name of Purchaser | Issue Date | Security | Shares | Consideration |\\n| YVONNE WANG | 3/24/16 | Common | 240,000 | Debenture Conversion |\\n| WEI LI | 3/24/16 | Common | 2,900,000 | Debenture Conversion |\\n| MARK E. CRONE | 3/25/16 | Common | 1,000 | Legal Fees |\\n| ZENG MIN QING | 5/24/16 | Common | 125,000 | Stock Purchase |\\n| CHENG TZU-YUN | 5/24/16 | Common | 50,000 | Stock Purchase |\\n| ZHIMING ZHU | 5/24/16 | Common | 45,000 | Stock Purchase |\\n| HANG ZHAO | 7/20/16 | Common | 20,000 | Stock Purchase |\\n| SHIWEI XIE | 7/20/16 | Common | 10,000 | Stock Purchase |\\n| XIAOQIANG YU | 7/20/16 | Common | 30,000 | Stock Purchase |\\n| HANG ZHAO | 8/10/16 | Common | 20,000 | Stock Purchase |\\n| XIAOQIANG YU | 8/10/16 | Common | 10,000 | Stock Purchase |\\n| XIANGRON CHEN | 8/10/16 | Common | 40,000 | Stock Purchase |\\n| JIMMY ZHOU | 8/24/16 | Common | 101,947 | Consultant Fees |\\n| WEIHONG SHAN | 10/6/16 | Common | 150,000 | Stock Purchase |\\n| LIFENG LIU | 10/6/16 | Common | 100,000 | Stock Purchase |\\n| ZHENPING LI | 10/6/16 | Common | 100,000 | Stock Purchase |\\n| QI JIANG | 10/6/16 | Common | 550,000 | Stock Purchase |\\n| LEI HOU | 10/6/16 | Common | 100,000 | Stock Purchase |\\n| BING ZHANG | 10/6/16 | Common | 150,000 | Stock Purchase |\\n| DEMEI YANG | 10/6/16 | Common | 150,000 | Stock Purchase |\\n| WSMG ADVISORS, INC. | 10/6/16 | Common | 100,000 | Consultant Fees |\\n| EQUITIES.COM, INC | 10/6/16 | Common | 30,808 | Consultant Fees |\\n| GENG LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\\n| LIXIN TIAN | 10/19/16 | Common | 500,000 | Consultant Fees |\\n| XU LIU | 10/19/16 | Common | 500,000 | Consultant Fees |\\n| QINGKE XING | 10/19/16 | Common | 60,000 | Consultant Fees |\\n| GROWTH CIRCLE INC. | 10/19/16 | Common | 20,000 | Consultant Fees |\\n| WILLIAM FARRANCE | 11/29/16 | Common | 125,000 | Stock Purchase |\\n| JUNWEI ZHENG | 3/3/17 | Common | 920,000 | Stock Purchase |\\n| YUAN WANG | 3/3/17 | Common | 80,000 | Stock Purchase |\\n| YUAN WANG | 3/3/17 | Common | 70,000 | Consultant Fees |\\n\\n\\nITEM 6. Selected Financial Data\\nNot required.\\n\\nITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nThis Annual Report on Form 10-K for the fiscal year ended December 31, 2016 contains “forward-looking” statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, as amended, including statements that include the words “believes,” “expects,” “anticipates,” or similar expressions. These forward-looking statements include, among others, statements concerning our expectations regarding our working capital requirements, financing requirements, business, growth prospects, competition and results of operations, and other statements of expectations, beliefs, future plans and strategies, anticipated events or trends, and similar expressions concerning matters that are not historical facts. The forward-looking statements in this Annual Report on Form 10-K for the fiscal year ended December 31, 2016 involve known and unknown risks, uncertainties and other factors (described in “Business-Risk Factors” under Item 1) that could cause our actual results, performance or achievements to differ materially from those expressed in or implied by the forward-looking statements contained herein.\\nOverview\\nThe Company took its present corporate form in March 2004 when the shareholders of Tintic Gold Mining Company, a Utah public corporation (“Tintic”), entered into a share exchange transaction with the shareholders of Kiwa BVI, a privately-held British Virgin Islands corporation that left the shareholders of Kiwa BVI owning a majority of Tintic and Kiwa BVI a wholly-owned subsidiary of Tintic, see “Business - The Company” under Item 1. For accounting purposes this transaction was treated as an acquisition of Tintic Gold Mining Company by Kiwa BVI in the form of a reverse triangular merger and a recapitalization of Kiwa BVI and its wholly owned subsidiary, Kiwa Shandong. On July 21, 2004, we completed our reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the Organizational Chart on page 4, above. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin”). Kiwa Tianjin has been dissolved since July 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n\\n| 10 |\\n\\n\\nWe generated revenue in fiscal year 2016. We incurred a net income of $963,296 and a net loss $677,358 during fiscal 2016 and 2015, respectively.\\nDue to our limited revenues, we have relied on the proceeds from loans from both unrelated and related parties to provide the resources necessary to fund the development of our business plan and operations. Our financing activities generated $1,053,358 and $148,009 during fiscal 2016 and 2015, respectively. These funds are insufficient to execute our business plan as currently contemplated, which may result in the risks described in “Risk Factors” under Item 1 - Business.\\nGoing Concern\\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622. Although the company’s operations for the year ended December 31, 2016 resulted net income of $963,296, it had an accumulated deficit of $19,489,400 and stockholders’ deficiency of $5,601,213 at December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\\nThe Company already raised additional fund through equity financing and plans to raise additional funds from domestic and foreign banks and/or financial institutions to increase working capital in order to meet capital demands. Please refer to Note 15 (Subsequent Evens) for additional information.\\nTrends and Uncertainties in Regulation and Government Policy in China\\nForeign Exchange Policy Changes\\nChina is considering allowing its currency to be freely exchangeable for other major currencies. This change will result in greater liquidity for revenues generated in Renminbi (“RMB”). We would benefit by having easier access to and greater flexibility with capital generated in and held in the form of RMB. The majority of our assets are located in China and most of our earnings are currently generated in China, and are therefore denominated in RMB. Changes in the RMB-U.S. Dollar exchange rate will impact our reported results of operations and financial condition. In the event that RMB appreciates over the next year as compared to the U.S. Dollar, our earnings will benefit from the appreciation of the RMB. However, if we have to use U.S. Dollars to invest in our Chinese operations, we will suffer from the depreciation of U.S. Dollars against the RMB. On the other hand, if the value of the RMB were to depreciate compared to the U.S. Dollar, then our reported earnings and financial condition would be adversely affected when converted to U.S. Dollars.\\nOn July 21, 2005, the People’s Bank of China announced it would appreciate the RMB, increasing the RMB-U.S. Dollar exchange rate from approximately US$1.00 = RMB 8.28 to approximately US$1.00 = RMB 8.11. So far the trend of such appreciation continues. The exchange rate of U.S. Dollar against RMB on December 31, 2016 was US$1.00 = RMB 6.945.\\nCritical Accounting Policies and Estimates\\nWe prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under current circumstances. Actual results may differ from these estimates as a result of different assumptions or conditions.\\nThe following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. In addition, you should refer to our accompanying audited balance sheets as of December 31, 2016 and 2015, and the audited statements of comprehensive loss, equity movement and cash flows for the fiscal years ended December 31, 2016 and 2015, and the related notes thereto, for further discussion of our accounting policies.\\nFair value of warrants and options\\nWe have adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements.\\n\\n| 11 |\\n\\n\\nWe also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements.\\nWe calculate the fair value of the warrants and options using the Black-Scholes Model.\\nIncome Taxes\\nThe Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\\nMajor Customers and Suppliers.\\nBio-fertilizer products\\nDuring 2016, the following were Kiwa’s major customers:\\n1. Qingzhou City Agricultural Production Materials Co., Ltd. second wholesale department (11.3% of sales)\\n2. Huarong County Yinfeng fertilizer industry LTD. (81% of sales)\\nDuring 2016, the following were Kiwa’s major suppliers:\\n1. Weifang Druek Fertilizer Co., Ltd (92% of Subcontractor Production)\\n2 Lianyungang Chuangyi Logistics Co., Ltd (Logistics provider)\\n3. Linshu Shangrun Color Printing Co., Ltd (Packing provider)\\nResults of Operations\\nNet Sales\\nNet sales were $9,617,845 and $0 for the years ended December 31, 2016 and 2015, respectively.\\nCost of Sales\\nCost of sales was $7,672,451 and $0 for the years ended December 31, 2016 and 2015, respectively.\\nGross Profit/Loss\\nGross profit for fiscal 2016 was $1,945,394 compared to $0 for fiscal 2015.\\nLicensing Revenue\\nLicensing revenue totaled $786,329 for the year ended December 31, 2016.\\nGeneral and Administrative\\nGeneral and administrative expenses were $874,097 and $313,589 for the years ended December 31, 2016 and 2015, respectively, an increase of $560,508 or 178%. General and administrative expenses include professional fees, officers’ compensation, depreciation and amortization, salaries, travel and entertainment, rent, office expense and telephone expense etc.\\n\\n| 12 |\\n\\n\\nResearch and Development\\nResearch and development expenses increased significantly by $45,445 or 25% to $224,433 for the year ended December 31, 2016, compared to $178,988 for the prior comparable period. Research and development expense mainly consists of the expenses of maintaining Kiwa-CAU R&D Center, which began operation in July 2006 (see “Business-Intellectual Property and Product Lines- Kiwa-CAU R&D Center” under Item 1 in Part I). On November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. During the years ended December 31, 2016 and 2015, the Company accrued $224,433 and $178,988 for research and development respectively.\\nPenalty Expense\\nWe charged $77,575 and $72,512 of liquidated damages in connection with the 6% Notes to penalty expenses during the years ended December 31, 2016 and 2015, respectively. The increase of penalty expense was mainly due to accrued and unpaid interest on the 6% Notes.\\nInterest Expenses\\nNet interest expense was $112,977 and $112,629 in the fiscal years of 2016 and 2015, respectively, representing a increase of $348 or 0.3%.\\nNet Income & (Loss)\\nDuring the fiscal year 2016, net income was $963,296, comparing with net loss $677,358 for the same period of 2015, representing an increase of $1,640,654.\\nComprehensive Gain & (Loss)\\nComprehensive income increased by $1,446,652 from $(253,293) for fiscal 2015, as compared to $1,193,359 for the comparable year of 2016.\\nLiquidity and Capital Resources\\nSince inception of our ag-biotech business in 2002, we have relied on the proceeds from the sale of our equity securities and loans from both unrelated and related parties to provide the resources necessary to fund our operations and the execution of our business plan. During fiscal 2016 and 2015, we raised $1,053,358 and $148,009 in total from stock purchase agreements and related party loans. To some extent, these advances improved our short-term liquidity. However, as of December 31, 2016, our current liabilities substantially exceeded current assets by $5,729,622, reflecting a current ratio of 0.4451, whereas current liabilities exceeded current assets by $11,103.261, reflecting a current ratio of 0.0043 as of December 31, 2015. During the years ended December 31, 2016 and 2015, we did not issue any shares resulting from the conversion of principal of the 6% Notes into our common stock.\\n\\n| 13 |\\n\\n\\nAs of December 31, 2016 and 2015, we had cash of $13,469 and $721, respectively. The change is outlined as follows:\\nDuring the fiscal year of 2016, net cash used in our operating activities was $1,142,9741, compared to $150,208 for the comparable period of 2015. Such cash was mainly used for maintaining operations of a public company and working capital for our bio-fertilizer business.\\nDuring the fiscal year of 2016, we incurred approximately $79,083 in investment activity, including $34,112 in acquiring a subsidiary.\\nDuring the year ended December 31, 2016, we generated cash inflow for $1,053,358 from financing activities, compared to $148,009 of cash inflow during the year ended December 31, 2015, from financing activities.\\nAs of December 31, 2016, we had an accumulated deficit of $19,489,400, down from $20,324,812 deficit at December 31, 2015, as a result of a net income of $967,296 including $127,884 for statutory reserve for the year ended December 31, 2016 and compared to a net loss of $677,358 for 2015.\\nWe still require additional working capital to accomplish our business objectives and to sustain our operations. Continuously, we intend to raise additional capital through the issuance of debt or equity securities to fund the development of our planned business operations, although there can be no assurance that we will be successful in obtaining this financing. The following factors, among others, may significantly harm our ability to obtain required additional financing.\\nGiven the facts that:\\n\\n| (1) | Outstanding 6% Notes. As of December 31, 2016, the amount of outstanding 6% Notes was $150,250. The 6% Notes have been in default since June 2009. |\\n| (2) | Outstanding note payable of $360,000 as of December 31, 2016. This note has been in default since July 2007. |\\n\\nContractual Obligations\\n(1) Operation of Kiwa-CAU R&D Center\\nPursuant to the agreement on joint incorporation of the research and development center between CAU and Kiwa Shandong dated November 14, 2006, Kiwa Shandong agrees to invest RMB 1 million (approximately $160,000) each year to fund research at the R&D Center. The term of this agreement is ten years starting from July 1, 2006. Prof. Qi Wang, who became one of our directors in July 2007, has acted as the Director of Kiwa-CAU R&D Center since July 2006.\\n(2) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n\\n| 14 |\\n\\n\\n(3) Strategic cooperation with two institutes in China\\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015.\\n(4) Acquisition of Caber Holdings LTD (Hong Kong Baina Group Co. LTD) in China\\nOn November 30, 2015, we entered into an acquisition agreement (the “Agreement”) with the shareholders of Caber Holdings LTD, whose Chinese name is Hong Kong Baina Group Co., Ltd, located in Hong Kong (“Baina Hong Kong”), and Oriental Baina Co. Ltd. (hereinafter referred to as “Baina Beijing”), Baina Hong Kong’s wholly-owned subsidiary in Beijing, China. When this acquisition is completed, Kiwa will rename Baina Beijing to Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. Kiwa Baiao Co. Ltd will replace Kiwa’s current subsidiary in China - Kiwa Bio-Tech (Shandong) Co., Ltd (“Kiwa Shandong”) - to operate Kiwa’s bio-fertilizer market expansion and become Kiwa’s platform for future acquisitions of new agricultural-related projects in China. In accordance with the terms of the Agreement, Kiwa agreed to pay US$30,000 to the Baina Hong Kong Shareholders for the acquisition of 100% of the equity of Baina Hong Kong. As of December 31, 2015, the Company has paid RMB 220,000 (approximately $34,000) for the acquisition. The acquisition was completed on January 7, 2016. Both Baina Hong Kong and Baina Beijing had no activities before the acquisition date and had no assets and liabilities. Thereafter, Baina Beijing formed two new subsidiaries—Kiwa Bio-Tech (Shenzhen) Co., Ltd (Registered in Shenzhen on November 2016); Kangdu Bio-Tech Hebei Co., Ltd. (Registered in Hebei on December 2106) to operate in specific markets in China.\\n(5) Distribution agreement with Kangtan Gerui Bio-Tech in China\\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\\n(6) Lease payments\\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\\nOff-Balance Sheet Arrangements\\nAt December 31, 2016, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise had we engaged in such relationships.\\nRecent Accounting Pronouncements\\nSee Note 2 to the Consolidated Financial Statements under Item 8, Part II.\\n\\n| 15 |\\n\\n\\n\\nITEM 7A. Quantitative and Qualitative Disclosures about Market Risk\\nNot required.\\n\\nITEM 8. Financial Statements and Supplementary Data\\nThe full text of our audited consolidated financial statements as of December 31, 2016 and 2015 begins on page F-1 of this annual report.\\n\\nITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure\\nOn February 15, 2017, the Board of Directors of Kiwa Bio-Tech Products Group Corporation (“Kiwa” or “Company”) decided to engage DYH & Co. as independent principal accountant and auditor to report on the Company’s financial statements for the fiscal year ended December 31, 2016, including performing the required quarterly reviews.\\nIn conjunction with the new engagement, the Company has dismissed its former accountant, Paritz & Co., P.A., Hackensack, NJ (“Paritz”), as the Company’s principal accountant effective February 22, 2016. Paritz has served the Company well since 2013. Under Item 304 of Regulation S-K, the reason for the auditor change is dismissal, not resignation nor declining to stand for re-election.\\nDuring the two most recent fiscal years and the interim period through the date of the dismissal, there were no disagreements with Paritz on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to Paritz’s satisfaction, would have caused Paritz to make reference to the subject matter of the disagreements in connection with its reports.\\n\\nITEM 9A. Controls and Procedures\\nDisclosure Controls and Procedures\\nOur management, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), has evaluated the effectiveness of our disclosure controls and procedures as defined in SEC Rules 13a-15(e) and 15d-15(e) as of the end of the period covered by this Annual Report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management including our CEO and CFO, to allow timely decisions regarding required disclosures. Based on their evaluation, our CEO and CFO have concluded that, as of December 31, 2016, our disclosure controls and procedures were ineffective.\\nManagement Report on Internal Control over Financial Reporting\\nOur management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published consolidated financial statements. Internal control over financial reporting is promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting, no matter how well designed, has inherent limitations and may not prevent or detect misstatements. Therefore, even effective internal control over financial reporting can only provide reasonable assurance with respect to the financial statement preparation and presentation.\\nOur management has conducted, with the participation of our CEO and CFO, an assessment, including testing of the effectiveness, of our internal control over financial reporting as of December 31, 2016. Management’s assessment of internal control over financial reporting was conducted using the criteria in Internal Control over Financial Reporting - Guidance for Smaller Public Companies issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on such evaluation, management identified deficiencies that were determined to be a material weakness.\\nA material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Because of the material weakness described below, management concluded that our internal control over financial reporting was ineffective as of December 31, 2016.\\n\\n| 16 |\\n\\n\\nThe specific material weakness identified by the Company’s management as of December 31, 2016 is described as follows:\\n\\n| ● | The Company did not have sufficient and skilled accounting personnel with an appropriate level of technical accounting knowledge and experience in the application of accounting principles generally accepted in the United States of America commensurate with the Company’s financial reporting requirements, which resulted in a number of internal control deficiencies that were identified as being significant. The Company’s management determined that the number and nature of these significant deficiencies, when aggregated, constituted a material weakness. |\\n| ● | The Company lacks qualified resources to perform the internal audit functions properly. In addition, the scope and effectiveness of the Company’s internal audit function are yet to be developed. |\\n| ● | We currently do not have an audit committee. |\\n\\nRemediation Initiative\\n\\n| ● | We are committed to establishing the internal audit functions but due to limited qualified resources in the region, we were not able to hire sufficient internal audit resources before the end of 2016. However, internally we established a central management center to recruit more senior qualified people in order to improve our internal control procedures. Externally, we are looking forward to engaging an accounting firm to assist the Company in improving the Company’s internal control system based on COSO Framework. |\\n| ● | We intend to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. |\\n\\nConclusion\\nDespite the material weakness and deficiencies reported above, the Company’s management believes that its consolidated financial statements included in this report fairly present in all material respects the Company’s financial condition, results of operations and cash flows for the periods presented and that this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report.\\nThis Annual Report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this Annual Report.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the fiscal year ended December 31, 2016 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n\\nITEM 9B. Other Information\\nNone.\\n\\n| 17 |\\n\\n\\nPart III\\n\\nITEM 10. Directors, Executive Officers and Corporate Governance\\nDirectors and Executive Officers\\nSet forth below are the names of our directors and executive officers, their ages, their offices with us, if any, their principal occupations or employment for the past five years. The directors listed below will serve until the Company’s next annual meeting of the stockholders:\\n\\n| Name | Age | Position | Director Since |\\n| Yvonne Wang | 39 | Acting President, CEO and CFO and Director | 2015 |\\n| Feng Li | 28 | Secretary and Director | 2015 |\\n| Qi Wang | 49 | Vice President of Technology, Director | 2007 |\\n| Yong Lin Song Xiao Qiang Yu | 50 39 | CTO, Director of Technology and Director Sales and Marketing Director | 2017 2016 |\\n\\nYvonne Wang Ms. Wang became our Chairman in November 2015. She served as corporate Secretary from 2005 to 2015. Prior to 2005, she served as an executive assistant and a manager of the Company’s U.S. office between April 2003 and September 2005. She obtained her B.S. degree of Business Administration from University of Phoenix.\\nOn August 11, 2106 became Company’s acting president, CEO and CFO.\\nFeng Li became our Secretary and a Director in 2015. From 2011- 2012, Ms. Li has served as an assistant project manager for SCHSAsia, a boutique business consulting firm specializing in events and project management for overseas company wishing to expand into the Asia Pacific arena. From 2012 until 2014, Ms. Li served as a campaigner for WildAid China Office, a non-profit organization with focus on raising public awareness on wildlife and climate change related issues.\\nQi Wang became our Vice President - Technical on July 19, 2005 and was elected as one of our directors of the Company on July 18, 2007. Prof. Wang has also acted as Director of Kiwa-CAU R&D Center since July 2006. Prof. Wang served as a Professor and Advisor for Ph.D. students in the Department of Plant Pathology, China Agricultural University (“CAU”) since January 2005. Prior to that, he served as an assistant professor and lecturer of CAU since June 1997. He obtained his master degree and Ph.D. in agricultural science from CAU in July 1994 and July 1997, respectively. Prof. Wang received his bachelor’s degree of science from Inner Mongolia Agricultural University in July 1989. He is a committee member of various scientific institutes in China, including the National Research and Application Center for Increasing-Yield Bacteria, Chinese Society of Plant Pathology, Chinese Association of Animal Science and Veterinary Medicine. Prof. Wang’s unique expertise in the field of agriculture offers significant knowledge and experience to the Board of Directors when making critical operational decisions.\\nYong Lin Song became our CTO and Director of Technology responsible for the Company’s R&D operations on March 2016 and as one of our directors of the Company on March 2017. Mr. Song is a senior agronomist at the Institute of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. He has 29 years of experience in microbial R&D and technology promotion and has led many national agricultural projects. In 2001, he was responsible for technological achievement transformation and technology promotion of Agricultural Resources and Regional Planning, Chinese Academy of Agricultural Sciences. In 2009, he served as deputy secretary general of the Chinese Society of Plant Nutrition and Fertilizer Science.\\nXiao Qiang Yu became our Sales and Marketing Director on June 2016 and is responsible for managing the overall marketing strategy of Kiwa, which includes brand expansion, sale targets, strategic planning and corporate communications. Mr. Yu participated in Chinese fertilizer market since 1999. Mr. Yu has over 15 years of marketing, management and strategy experience from two major fertilizer companies in China.\\n\\n| 18 |\\n\\n\\nFamily Relationships\\nThere are no family relationships among our directors or executive officers.\\nInvolvement in Certain Legal Proceedings\\nNone of our directors or executive officers has, during the past ten years:\\n\\n| (a) | Had any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time; |\\n| (b) | Been convicted in a criminal proceeding or subject to a pending criminal proceeding; |\\n| (c) | Been subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction or any federal or state authority, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities, futures, commodities or banking activities; and |\\n| (d) | Been found by a court of competent jurisdiction (in a civil action), the Securities and Exchange Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended, or vacated. |\\n\\nSection 16(a) Beneficial Ownership Compliance\\nSection 16(a) of the Securities Exchange Act of 1934 requires our officers, directors and certain persons holding more than 10 percent of a registered class of our common stock to file with the SEC initial reports of ownership and reports of changes in ownership of our common stock. Officers, directors and certain other shareholders are required by the SEC to furnish the Company with copies of all Section 16(a) forms they file. To the best of the Company’s knowledge, based solely upon a review of the copies of such reports, the Company believes that all Section 16(a) filing requirements applicable to its officers, directors and certain other shareholders were complied with during the fiscal year ended December 31, 2016.\\nCode of Ethics\\nWe have adopted a Code of Business Conduct and Ethics (the “Code”) that is applicable to all employees, consultants and members of the Board of Directors, including the Chief Executive Officer, Chief Financial Officer and Secretary. This Code embodies our commitment to conduct business in accordance with the highest ethical standards and applicable laws, rules and regulations. We will provide any person a copy of the Code, without charge, upon written request to the Company’s Secretary. Requests should be addressed in writing to Ms. Yvonne Wang; 310 N. Indian Hill Blvd., #702 Claremont, California 91711.\\nBoard Composition; Audit Committee and Financial Expert\\nOur Board of Directors is currently composed of four members: Yvonne Wang, Feng Li, Qi Wang and Yong Lin Song. All board actions require the approval of a majority of the directors in attendance at a meeting at which a quorum is present.\\n\\n| 19 |\\n\\n\\nWe currently do not have an audit committee. We intend, however, to establish an audit committee of the board of directors as soon as practicable. We envision that the audit committee will be primarily responsible for reviewing the services performed by our independent auditors, evaluating our accounting policies and our system of internal controls. Currently such functions are performed by our Board of Directors.\\nThe Board does not have a “financial expert” as defined by SEC rules implementing Section 407 of the Sarbanes-Oxley Act.\\nBoard meetings and committees; annual meeting attendance.\\nDuring fiscal year 2016, the Board of Directors did not have any meetings.\\n\\nITEM 11. Executive Compensation\\nWe currently have no Compensation Committee. The Board of Directors is currently performing the duties and responsibilities of Compensation Committee. In addition, we have no formal compensation policy. We decide on our executives’ compensation based on average compensation levels of similar companies in the U.S. or China, depending on consideration of many factors such as where the executive works. Our Chief Executive Officer’s compensation is approved by the Board of Directors. Other named executive officers’ compensation are proposed by our Chief Executive Officer and approved by the Board of Directors.\\nOur Stock Incentive Plan is administered by the Board of Directors. Any amendment to our Stock Incentive Plan requires majority approval of the stockholders of the Company.\\nThe Company had no officers or directors whose total compensation during either 2016 or 2015 exceeded $100,000.\\nCurrently, the main forms of compensation provided to each of our executive officers are: (1) annual salary; (2) non-equity Incentive Plan; and (3) the granting of incentive stock options subject to approval by our Board of Directors.\\nSummary Compensation Table\\nSummary Compensation Table\\n\\n| Name and principal position | Year | Salary ($) | Bonus ($) | Stock Awards ($) | Option Awards ($) | Non-Equity Incentive Plan Compensation ($) | Nonqualified Deferred Compensation Earnings ($) | All Other Compensation ($) | Total ($) |\\n| (a) | (b) | (c) | (d) | (e) | (f) | (g) | (h) | (i) | (j) |\\n| Yvonne Wang, | 2016 | 84,000 | Nil | Nil | Nil | Nil | Nil | Nil | 84,000 |\\n| Acting President, CEO and CFO | 2015 | 51,000 | Nil | Nil | Nil | Nil | Nil | Nil | 51,000 |\\n| Yong Lin Song, | 2016 | 29,828 | Nil | Nil | Nil | Nil | Nil | Nil | 29,828 |\\n| CTO, Director of Technology | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\\n| Xiao Qiang Yu, | 2016 | 30,259 | Nil | Nil | Nil | Nil | Nil | Nil | 30,259 |\\n| Sales and Marketing Director | 2015 | Nil | Nil | Nil | Nil | Nil | Nil | Nil | Nil |\\n\\nEmployment Contracts and Termination of Employment and Change of Control Arrangements\\nThere are no compensatory plans or arrangements with respect to a named executive officer that would result in payments or installments in excess of $100,000 upon the resignation, retirement or other termination of such executive officer’s employment with us or from a change-in-control.\\n\\n| 20 |\\n\\n\\nStock Incentive Plan and Option Grants\\n2016 Stock Incentive Plan\\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter, were approved of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan. The Plan is a key aspect of our compensation program, designed to attract, retain, and motivate the highly qualified individuals required for our long-term success.\\nNo options were granted under the Plan during 2016.\\nOption Exercises and Stock Vested\\nNo stock options were exercised by any officers or directors during 2016 and 2015. We did not adjust or amend the exercise price of any stock options previously awarded to any named executive officers during 2016 and 2015.\\n\\n| 21 |\\n\\n\\nDirector Compensation for 2016\\nWe currently have no policy in effect for providing compensation to our directors for their services on our Board of Directors, and did not compensate our directors in 2016 for services performed as directors.\\n\\nITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\\nThe following table sets forth as of April 7, 2017 certain information with respect to the beneficial ownership of our common stock by (i) each of our executive officers, (ii) each person who is known by us to beneficially own more than 5% of our outstanding common stock, and (iii) all of our directors and executive officers as a group. Percentage ownership is calculated based on 9,798,981 shares of our common stock and 500,000 shares of our Series A Preferred Stock outstanding as of April 7, 2017. None of the shares listed below are issuable pursuant to stock options or warrants of the Company.\\n\\n| Title of class | Name and Address of Beneficial Ownership(1) | Amount and Nature of Beneficial Owner (2) | Percentage of class |\\n| Common Stock | Yvonne Wang | 240,000 | 2.45 | % |\\n| Common Stock | Feng Li (3) | 1,965,326 | 20.06 | % |\\n| Common Stock | Qi Wang | - | - |\\n| Common Stock | Yong Lin Song | - | - |\\n| Common Stock | All officers and directors as a group | 2,205,326 | 22.51 | % |\\n| Ser. A Pref. Stock | Yvonne Wang | 250,000 | 50.00 | % |\\n| Ser. A Pref. Stock | Feng Li | 250,000 | 50.00 | % |\\n| Ser. A Pref. Stock | All officers and directors as a group | 500,000 | 100.00 | % |\\n| 5% Holders: |\\n| Common Stock | Troniya Industrial Incubator, Inc. | 1,000,000 | 10.21 | % |\\n| Common Stock | Liu Geng | 500,000 | 5.10 | % |\\n| Common Stock | Liu Xu | 500,000 | 5.10 | % |\\n| Common Stock | Tian Lixin | 500,000 | 5.10 | % |\\n| Common Stock | Zheng JunWei | 920,000 | 9.39 | % |\\n| Common Stock | Wei Li (3) | 1,965,326 | 20.06 | % |\\n\\n\\n| (1) | The address for all holders is 310 N. Indian Hill Blvd, #702, Claremont, CA 91711. |\\n| (2) | In determining beneficial ownership of our Common Stock and Series A Preferred Stock, the number of shares shown includes shares which the beneficial owner may acquire upon exercise of debentures, warrants and options which may be acquired within 60 days. Unless otherwise stated, each beneficial owner has sole power to vote and dispose of its shares. |\\n| (3) | Includes 61,784 shares of common stock held by All Star Technology, Inc., a British Virgin Islands international business company. Feng Li’s father, Wei Li, exercises voting and investment control over the shares held by All Star Technology, Inc. Wei Li is a principal stockholder of All Star Technology, Inc. and may be deemed to beneficially own such shares, but disclaims beneficial ownership in such shares held by All Star Technology, Inc. except to the extent of his pecuniary interest therein. Mr. Li has pledged all of his common stock of the Company as collateral security for the Company’s obligations under certain 6% Convertible Notes owed by the Company. |\\n\\n\\n| 22 |\\n\\n\\nChange in Control\\nNone.\\n\\nITEM 13. Certain Relationships and Related Transactions, and Director Independence\\nFor description of transactions with related parties, see Note 6 to Consolidated Financial Statements under Item 8 in Part II.\\nUnder the independence standard set forth in Rule 4200(a) (15) of the Market Place Rules of the Nasdaq Stock Market, which is the independence standard that we have chosen to report under.\\n\\nITEM 14. Principal Accountant Fees and Services\\nFees Paid to Independent Public Accountants for 2016 and 2015.\\nAudit Fees\\nAll of the services described below were approved by our board of directors prior to performance of such services. The board of directors has determined that the payments made to its independent accountants for these services are compatible with maintaining such auditor’s independence.\\nThe aggregate audit fees for 2016 and 2015 paid and payable to DYH & Company and Paritz & Company, P.A. were approximately $38,000 and $30,500, respectively. The amounts include: (1) fees for professional services rendered by DYH & Company and Paritz & Company, P.A. in connection with the audit of our consolidated financial statements; (2) reviews of our quarterly reports on the Form 10-Q.\\n\\n| 23 |\\n\\n\\nAudit-Related Fees\\nAudit-related fees for 2016 and 2015 were $nil.\\nTax Fees\\nTax service fees billed by Paritz & Co., P.A. as tax consultant for 2016 and 2015 were $3,400 and $2,750, respectively.\\nAll Other Fees\\nNone.\\nPolicy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors\\nSince we did not have a formal audit committee, our board of directors served as our audit committee. We have not adopted pre-approval policies and procedures with respect to our accountants in 2016. All of the services provided and fees charged by our independent registered accounting firms in 2016 were approved by the board of directors.\\n\\n| 24 |\\n\\n\\nPart IV\\n\\nITEM 15. Exhibits and Financial Statement Schedules\\n\\n| Exhibit No. | Description |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 |\\n| 32.1 | Certification of Chief Executive Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2 | Certification of Chief Financial Officer, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\\n\\n\\n| 25 |\\n\\n\\nKiwa Bio-Tech Products Group Corporation\\nSignatures\\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\nDate: April 17, 2017\\n\\n| KIWA BIO-TECH PRODUCTS GROUP CORPORATION. |\\n| By: | /s/ Yvonne Wang |\\n| Yvonne Wang Chief Executive Officer (Principal Executive Officer) |\\n| By: | /s/ Yvonne Wang |\\n| Yvonne Wang Chief Financial Officer (Principal Financial and Accounting Officer) |\\n\\nPursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf of the registrant and in the capacities and on the dates indicated.\\n\\n| /s/ Yvonne Wang | Chief Executive Officer and Director | April 17, 2017 |\\n| Yvonne Wang | (Principal Executive Officer) |\\n| /s/ Yvonne Wang | Chief Financial Officer | April 17, 2017 |\\n| Yvonne Wang | (Principal Financial and Accounting Officer) |\\n| /s/ Feng Li | Secretary and Director | April 17, 2017 |\\n| Feng Li |\\n| /s/ Qi Wang | Vice President of Technology and Director | April 17, 2017 |\\n| Qi Wang |\\n| /s/ Yong Lin Song | CTO, Director of Technology and Director | April 17, 2017 |\\n| Yong Lin Song |\\n\\n\\n| 26 |\\n\\n\\nKiwa Bio-Tech Products Group Corporation\\nIndex to Consolidated Financial Statements\\n\\n| Page |\\n| Reports of Independent Registered Public Accounting Firms | F-1 |\\n| Consolidated Balance Sheets | F-3 |\\n| Consolidated Statements of Comprehensive Income (Loss) | F-4 |\\n| Consolidated Statements of Stockholders’ Deficiency | F-5 |\\n| Consolidated Statements of Cash Flows | F-6 |\\n| Notes to Consolidated Financial Statements | F-7 |\\n\\n\\n| 27 |\\n\\n\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nTo Board of Directors and the Stockholders of\\nKiwa Bio-Tech Products Group Corporation\\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporations as of December 31, 2015 and the related consolidated statement of comprehensive loss, changes in stockholders’ deficiency and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.\\nWe conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.\\nIn our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2015, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.\\n/s/ Paritz & Company, P.A.\\nHackensack, New Jersey\\nApril 14, 2016\\n\\n| F-1 |\\n\\n\\nREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM\\nTo the Board of Directors and Stockholders of Kiwa Bio-Tech Products Group Corporation\\nWe have audited the accompanying consolidated balance sheet of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the related statements of income, comprehensive income, stockholders’ equity, and cash flows for the year ended December 31, 2016. Kiwa Bio-Tech Products Group Corporation’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.\\nWe conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.\\nIn our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kiwa Bio-Tech Products Group Corporation as of December 31, 2016, and the results of its operations and its cash flows for the year ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America.\\nThe accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company’s current liabilities substantially exceeded its current assets by $5,729,622 at December 31, 2016. Although the Company reported net income approximately $963,296 for its fiscal year ended December 31, 2016, it had an accumulated deficit of $19,489,400 as of December 31, 2016. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regarding to these matters are described in Note 3, which include raising additional equity financing. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.\\n/s/ DYH & Company\\nIrvine, California\\nApril 17, 2017\\n\\n| F-2 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nCONSOLIDATED BALANCE SHEETS\\n\\n| December 31, 2016 | December 31, 2015 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 13,469 | $ | 721 |\\n| Accounts receivable | 1,122,754 | - |\\n| Prepaid expenses | 92,504 | - |\\n| Other receivable | 1,561,331 | 47,453 |\\n| Advance to suppliers | 1,805,044 | - |\\n| Total current assets | 4,595,102 | 48,174 |\\n| Property, plant and equipment - net | 59,778 | 2,807 |\\n| Deposit | 34,519 | - |\\n| Goodwill | 34,112 | - |\\n| Total non-current assets | 128,409 | 2,807 |\\n| Total assets | $ | 4,723,511 | $ | 50,981 |\\n| LIABILITIES AND STOCKHOLDERS’ DEFICIENCY |\\n| Current liabilities |\\n| Accounts payable | $ | 1,318,802 | $ | 269,360 |\\n| Accrued expenses | 35,715 | 30,887 |\\n| Advances from customers | 12,883 | 13,800 |\\n| Construction costs payable | 255,539 | 273,722 |\\n| Due to related parties - trade | 1,283,215 | 1,143,978 |\\n| Due to related parties - non-trade | 100,798 | 3,166,198 |\\n| Convertible notes payable | 150,250 | 150,250 |\\n| Notes payable | 360,000 | 360,000 |\\n| Unsecured loans payable | 1,655,343 | 1,773,131 |\\n| Salary payable | 1,688,353 | 1,632,881 |\\n| Taxes payable | 919,255 | 478,209 |\\n| Penalty payable | 482,327 | 404,752 |\\n| Interest payable | 1,042,661 | 930,062 |\\n| Other payables | 1,019,583 | 524,205 |\\n| Total current liabilities | 10,324,724 | 11,151,435 |\\n| SHAREHOLDER’S EQUITY |\\n| Preferred stock - $0.001 par value, Authorized 20,000,000 shares. Issued and outstanding 500,000 and 500,000 shares at December 31, 2016 and 2015, respectively. | 500 | 500 |\\n| Common stock - $0.001 per value. Authorized 100,000,000 shares. Issued and outstanding $8,728,981 and 2,000,000 shares at December 31, 2016 and 2015 | 8,729 | 2,000 |\\n| Additional paid-in capital | 13,789,990 | 9,490,837 |\\n| Statutory Reserve | 127,884 | - |\\n| Accumulated deficit | (19,489,400 | ) | (20,324,812 | ) |\\n| Accumulated other comprehensive loss | (38,916 | ) | (268,979 | ) |\\n| Total stockholders’ deficiency | (5,601,213 | ) | (11,100,454 | ) |\\n| Total liabilities and shareholder’s equity | $ | 4,723,511 | $ | 50,981 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n\\n| F-3 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)\\n\\n| Years Ended December 31, |\\n| 2016 | 2015 |\\n| Revenue | $ | 9,617,845 | $ | - |\\n| Cost of goods sold | 7,672,451 | - |\\n| Gross profit | 1,945,394 | - |\\n| Operating expenses |\\n| Research and development | 224,433 | 178,988 |\\n| Selling expenses | 49,295 | - |\\n| General and administrative | 874,097 | 313,589 |\\n| Total operating expenses | 1,147,825 | 492,577 |\\n| Operating income (loss) | 797,569 | (492,577 | ) |\\n| Other income |\\n| License revenue | 786,329 | - |\\n| Other expense |\\n| Penalty expense | (77,575 | ) | (72,152 | ) |\\n| Interest expense | (112,977 | ) | (112,629 | ) |\\n| Other expense | (3,770 | ) | - |\\n| Total other expense | (194,322 | ) | (184,781 | ) |\\n| Net income (loss) before income tax | 1,389,576 | (677,358 | ) |\\n| Income tax provision | (426,280 | ) | - |\\n| Net income (loss) | 963,296 | (677,358 | ) |\\n| Other comprehensive income |\\n| Foreign currency translation adjustment | 230,063 | 424,065 |\\n| Total comprehensive income (loss) | $ | 1,193,359 | $ | (253,293 | ) |\\n| Net income (loss) per common share - basic | $ | 0.17 | $ | (0.34 | ) |\\n| Net income (loss) per common share - diluted | $ | 0.11 | $ | (0.34 | ) |\\n| Weighted average number of common shares outstanding - basic | 5,645,263 | 2,000,000 |\\n| Weighted average number of common shares outstanding - diluted | 8,872,655 | 2,000,000 |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n\\n| F-4 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIENCY\\n\\n| Common Stock | Preferred Stock | Additional Paid-in | Statutory | Accumulated | Accumulated Other Comprehensive | Total Stockholders’ |\\n| Shares | Amount | Shares | Amount | Capital | Reserve | Deficit | Loss | Deficiency |\\n| Balance, December 31, 2014 (Restated) | 2,000,000 | $ | 2,000 | - | $ | - | $ | 8,491,337 | $ | - | $ | (19,647,454 | ) | $ | (693,044 | ) | $ | (11,847,161 | ) |\\n| Issuance of 500,000 shares of preferred stock as debt cancellation on December 14, 2015 | - | - | 500,000 | 500 | 999,500 | - | - | 1,000,000 |\\n| Net loss | - | - | - | - | - | (677,358 | ) | - | (677,358 | ) |\\n| Foreign currency translation adjustment | - | - | - | - | - | - | - | 424,065 | 424,065 |\\n| Balance, December 31, 2015 | 2,000,000 | 2,000 | 500,000 | 500 | 9,490,837 | - | (20,324,812 | ) | (268,979 | ) | (11,100,454 | ) |\\n| Issuance of common shares for cash | 1,775,000 | 1,775 | - | - | 857,884 | - | 859,659 |\\n| Issuance of common shares for Liabilities settlement | 3,243,173 | 3,243 | - | - | 3,188,731 | - | 3,191,974 |\\n| Issuance of common shares for consulting service | 1,710,808 | 1,711 | - | - | 252,539 | - | 254,250 |\\n| Net income | - | - | - | - | - | 127,884 | 835,412 | 963,296 |\\n| Foreign currency translation adjustments | 230,063 | 230,063 |\\n| Balance, December 31, 2016 | 8,728,981 | $ | 8,729 | 500,000 | $ | 500 | $ | 13,789,991 | $ | 127,884 | $ | (19,489,400 | ) | $ | (38,916 | ) | $ | (5,601,212 | ) |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n\\n| F-5 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n\\n| Years Ended December 31, |\\n| 2016 | 2015 |\\n| Cash flows from operating activities: |\\n| Net income (loss) | $ | 963,296 | $ | (677,358 | ) |\\n| Adjustments to reconcile net loss to net cash used in operating activities: |\\n| Depreciation | 23,980 | 4,352 |\\n| Bad debt | 55,240 | - |\\n| Provision for penalty payable | 77,575 | 72,152 |\\n| Accrued interest on convertible notes and note payable | 112,599 | 112,538 |\\n| Changes in operating assets and liabilities: | - | - |\\n| Accounts receivable | (1,229,249 | ) | - |\\n| Other receivable | (1,619,623 | ) | - |\\n| Advance to supplier | (1,887,446 | ) | - |\\n| Prepaid expense | (59,154 | ) | - |\\n| Deposit | (36,095 | ) | (33,921 | ) |\\n| Account payable | 1,116,061 | - |\\n| Accrued expense | 7,117 | - |\\n| Salary payable | 93,860 | 125,924 |\\n| Taxes payable | 494,397 | 62,915 |\\n| Due to related parties - trade | 217,293 | 178,988 |\\n| Other payables | 527,175 | 4,202 |\\n| Net cash used in operating activities | (1,142,974 | ) | (150,208 | ) |\\n| Cash flows from investing activities: |\\n| Purchase of property, plant and equipment | (79,083 | ) | - |\\n| Net cash used in investing activities | (79,083 | ) | - |\\n| Cash flows from financing activities: |\\n| Proceeds from related parties, net of payments to related parties | 139,085 | 148,009 |\\n| Proceeds from sale of common stock | 914,273 | - |\\n| Net cash provided by financing activities | 1,053,358 | 148,009 |\\n| Effect of exchange rate change | 181,447 | (43 | ) |\\n| Cash and cash equivalents: |\\n| Net increase (decrease) | 12,748 | (2,242 | ) |\\n| Balance at beginning of year | 721 | 2,963 |\\n| Balance at end of year | $ | 13,469 | $ | 721 |\\n| Non-cash financing activities: |\\n| Issuance of common stock for debts settlement | $ | 3,137,359 | $ | 1,000,000 |\\n| Issuance of common stock for consulting service | 254,250 |\\n| Supplemental Disclosures of Cash flow Information: |\\n| Cash paid for interest | $ | $ | - |\\n| Cash paid for income taxes | $ | $ | - |\\n\\nThe accompanying notes are an integral part of these consolidated financial statements.\\n\\n| F-6 |\\n\\n\\nKIWA BIO-TECH PRODUCTS GROUP CORPORATION\\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\\nDECEMBER 31, 2016\\n1. Description of Business and Organization\\nOrganization – Kiwa Bio-Tech Products Group Corporation (“the Company”) is the result of a share exchange transaction accomplished on March 12, 2004 between the shareholders of Kiwa Bio-Tech Products Group Ltd. (“Kiwa BVI”), a company originally organized under the laws of the British Virgin Islands on June 5, 2002 and Tintic Gold Mining Company (“Tintic”), a corporation originally incorporated in the state of Utah on June 14, 1933 to perform mining operations in Utah. The share exchange resulted in a change of control of Tintic, with former Kiwa BVI stockholders owning approximately 89% of Tintic on a fully diluted basis and Kiwa BVI surviving as a wholly-owned subsidiary of Tintic. Subsequent to the share exchange transaction, Tintic changed its name to Kiwa Bio-Tech Products Group Corporation. On July 21, 2004, the Company completed its reincorporation in the State of Delaware. On March 8, 2017, we completed our reincorporation in the State of Nevada.\\nThe Company operates through a series of subsidiaries in the Peoples Republic of China as detailed in the following Organizational Chart. The Company had previously operated its business through its subsidiaries Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”) and Tianjin Kiwa Feed Co., Ltd. (“Kiwa Tianjin ”). Kiwa Tianjin has been dissolved since July, 11, 2012. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\nBusiness – The Company’s business plan is to develop and market innovative, manufacture, distribute cost-effective and environmentally safe bio-technological products for agriculture markets primarily in China. The Company has acquired technologies to produce and market bio-fertilizer.\\n2. Summary of Significant Accounting Policies\\nPrinciple of Consolidation - These consolidated financial statements include the financial statements of the Company and its wholly-owned subsidiaries, Kiwa BVI, Hong Kong Baina Group Holding Company, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd, Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Kiwa Shandong”). All significant inter-company balances or transactions are eliminated on consolidation.\\nReverse Split - On January 14, 2016, the Company filed a Certificate of Amendment of its Certificate of Incorporation with the State of Delaware with reference to a 1-for-200 reverse stock split with respect to its Common Stock with effective date of January 28, 2016. In connection with the reverse split, the Company’s authorized capital was amended to be 120,000,000 shares, comprising 100,000,000 shares of Common Stock par value $0.001 and 20,000,000 shares of Preferred Stock par value $0.001. All relevant information relating to numbers of shares, options and per share information have been retrospectively adjusted to reflect the reverse stock split for all periods presented.\\nUse of Estimates - The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant accounting estimates include the valuation of securities issued, deferred tax assets and related valuation allowance.\\n\\n| F-7 |\\n\\n\\nCertain of our estimates, including evaluating the collectability of accounts receivable and the fair market value of long-lived assets, could be affected by external conditions, including those unique to our industry, and general economic conditions. It is possible that these external factors could have an effect on our estimates that could cause actual results to differ from our estimates. We re-evaluate all of our accounting estimates annually based on these conditions and record adjustments when necessary.\\nCash and Cash Equivalents\\nThe Company considers all highly liquid investments with a maturity of three months or less to be cash and cash equivalents. At times, such investments may be in excess of Federal Deposit Insurance Corporation (FDIC) insurance limit.\\nAccounts Receivables - Accounts receivables represent customer accounts receivables. The allowance for doubtful accounts is based on a combination of current sales, historical charge offs and specific accounts identified as high risk. Uncollectible accounts receivable are charged against the allowance for doubtful accounts when all reasonable efforts to collect the amounts due have been exhausted. Such allowances, if any, would be recorded in the period the impairment is identified.\\nAllowance for doubtful accounts\\nThe Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts. The Company’s estimate is based on historical collection experience and a review of the current status of trade accounts receivable. It is reasonably possible that the Company’s estimate of the allowance for doubtful accounts will change. There was no allowance for doubtful accounts at December 31, 2016 and December 31, 2015.\\nInventories - Inventories are stated at the lower of cost, determined on the weighted average method, and net realizable value. Work in progress and finished goods are composed of direct material, direct labor and a portion of manufacturing overhead. Net realizable value is the estimated selling price in the ordinary course of business, less estimated costs to complete and dispose.\\nProperty, plant and equipment - Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Gains or losses on disposals are reflected as gain or loss in the year of disposal. The cost of improvements that extend the life of property, plant and equipment are capitalized. These capitalized costs may include structural improvements, equipment and fixtures. All ordinary repair and maintenance costs are expensed as incurred. Depreciation for financial reporting purposes is provided using the straight-line method over the estimated useful lives of the assets as follows:\\n\\n| Useful Life |\\n| (In years) |\\n| Buildings | 30 - 35 |\\n| Machinery and equipment | 5 - 10 |\\n| Automobiles | 8 |\\n| Office equipment | 2 - 5 |\\n| Computer software | 3 |\\n\\nImpairment of Long-Lived Assets - The Company’s long-lived assets consist of property, equipment and intangible assets. The Company evaluates its investment in long-lived assets, including property and equipment, for recoverability whenever events or changes in circumstances indicate the net carrying amount may not be recoverable. Judgments regarding potential impairment are based on legal factors, market conditions and operational performance indicators, among others. In assessing the impairment of property and equipment, the Company makes assumptions regarding the estimated future cash flows and other factors to determine the fair value of the respective assets.\\nFair value of warrants and options - The Company adopted ASC Topic 815, “Accounting for Derivative Instruments and Hedging Activities” to recognize warrants relating to loans and warrants issued to consultants as compensation as derivative instruments in our consolidated financial statements. The Company also adopted ASC Topic 718, “Share Based Payment” to recognize options granted to employees as derivative instruments in our consolidated financial statements. The Company calculates the fair value of the warrants and options using the Black-Scholes Model.\\n\\n| F-8 |\\n\\n\\nRevenue Recognition – The Company applies paragraph 605-10-S99-1 of the FASB Accounting Standards Codification for revenue recognition. The Company recognizes revenue when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) the product has been shipped or the services have been rendered to the customer, (iii) the sales price is fixed or determinable, and (iv) collectability is reasonably assured.\\nThe Company derives its revenues from sales contracts with its customer with revenues being generated upon delivery of products. Persuasive evidence of an arrangement is demonstrated via invoice; and the sales price to the customer is fixed upon acceptance of the purchase order and there is no separate sales rebate, discount, or volume incentive.\\nShipping and Handling Costs - Substantially all costs of shipping and handling of products to customers are included in selling. Shipping and handling costs for the years ended December 31, 2016 and 2015 were $480,892 and $ nil, respectively.\\nIncome Taxes - The Company accounts for income taxes under the provisions of FASB ASC Topic 740, “Income Tax,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that the assets will not be recovered.\\nASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We have no material uncertain tax positions for any of the reporting periods presented.\\nForeign Currency Translation and Other Comprehensive Income - The Company uses United States dollars (“US Dollar” or “US$” or “$”) for financial reporting purposes. However, the Company maintains the books and records in its functional currency, Chinese Renminbi (“RMB”), being the primary currency of the economic environment in which its operations are conducted. In general, the Company translates its assets and liabilities into U.S. dollars using the applicable exchange rates prevailing at the balance sheet date, and the statement of comprehensive loss and the statement of cash flow are translated at average exchange rates during the reporting period. Equity accounts are translated at historical rates. Adjustments resulting from the translation of the Company’s financial statements are recorded as accumulated other comprehensive income.\\nOther comprehensive income for the years ended December 31, 2016 and 2015 represented foreign currency translation adjustments and were included in the consolidated statements of comprehensive loss.\\nThe exchange rates used to translate amounts in RMB into U.S. Dollars for the purposes of preparing the consolidated financial statements were as follows:\\n\\n| As of December 31, |\\n| 2016 | 2015 |\\n| Balance sheet items, except for equity accounts | 6.94 | 6.4857 |\\n\\n\\n| Years ended December 31, |\\n| 2016 | 2015 |\\n| Items in the statements of comprehensive loss | 6.62 | 6.2281 |\\n\\nAdvertising Costs - The Company charges all advertising costs to expense as incurred. The total amounts of advertising costs charged to selling, general and administrative expense were $nil for the years ended December 31, 2016 and 2015, respectively.\\nResearch and Development Costs - Research and development costs are charged to expense as incurred. During the years ended December 31, 2016 and 2015, research and development costs were $224,433 and $178,988, respectively.\\n\\n| F-9 |\\n\\n\\nNet Loss Per Common Share - Basic loss per common share is calculated by dividing net loss attributable to Kiwa stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted loss per common share includes dilutive effect of dilutive securities (stock options, warrants, convertible debt, stock subscription and other stock commitments issuable). These potentially dilutive securities were not included in the calculation of loss per share for the periods presented because the Company incurred a loss during such periods and thus the effect would have been anti-dilutive. Accordingly, basic and diluted loss per common share is the same for all periods presented. As of December 31, 2016 and 2015, potentially dilutive securities aggregated 8,872,655 (632,204 post-reverse split shares) and 126,440,833 (632,204 post-reverse split shares) shares of common stock, respectively.\\nFair Value of Financial Instruments\\nThe Company follows paragraph 825-10-50-10 of the FASB Accounting Standards Codification for disclosures about fair value of its financial instruments and paragraph 820- 10-35-37 of the FASB Accounting Standards Codification (“Paragraph 820-10-35-37”) to measure the fair value of its financial instruments. Paragraph 820-10-35-37 establishes a framework for measuring fair value with U.S. GAAP, and expands disclosures about fair value measurements.\\nTo increase consistency and comparability in fair value measurements and related disclosures, Paragraph 820-10-35-37 establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three (3) broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three (3) levels of fair value hierarchy defined by Paragraph 820-10-35-37 are described below:\\n\\n| ● | Level 1: quoted market prices available in active markets for identical assets or liabilities as of the reporting date. |\\n| ● | Level 2: pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. |\\n| ● | Level 3: Pricing inputs that are generally observable inputs and not corroborated by market data. |\\n\\nFinancial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.\\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\\nThe fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.\\nThe carrying amount of the Company’s financial assets and liabilities, such as cash and cash equivalent, prepaid expenses, accounts payable and accrued expenses, approximate their fair value because of the short maturity of those instruments.\\nTransactions involving related parties cannot be presumed to be carried out on an arm’s-length basis, as the requisite conditions of competitive, free-market dealings may not exist. Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions unless such representations can be substantiated.\\nIt is not however practical to determine the fair value of advances from stockholders, if any, due to their related party nature.\\n\\n| F-10 |\\n\\n\\nRelated Parties\\nThe Company follows subtopic 850-10 of the FASB Accounting Standards Codification for the identification of related parties and disclosure of related party transactions. Pursuant to Section 850-10-20 the related parties include: a) affiliates of the Company; b) entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825–10–15, to be accounted for by the equity method by the investing entity; c) trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management; d) principal owners of the Company; e) management of the Company; f) other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and g) other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly Influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.\\nThe consolidated financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated financial statements is not required in those statements. The disclosures shall include: a. the nature of the relationship(s) involved; b. a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the consolidated financial statements; c. the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and d. amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.\\nCommitments and Contingencies\\nThe Company follows subtopic 450-20 of the FASB Accounting Standards Codification to report accounting for contingencies. Certain conditions may exist as of the date the consolidated financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein.\\n\\n| F-11 |\\n\\n\\nIf the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s consolidated financial statements. If the assessment indicates that a potential material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, and an estimate of the range of possible losses, if determinable and material, would be disclosed.\\nLoss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Management does not believe, based upon information available at this time that these matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, there is no assurance that such matters will not materially and adversely\\nStock Based Compensation\\nThe Company accounts for employee and non-employee stock awards under ASC 718, whereby equity instruments issued to employees for services are recorded based on the fair value of the instrument issued and those issued to non-employees are recorded based on the fair value of the consideration received or the fair value of the equity instrument, whichever is more reliably measurable.\\nNo stock based compensation was issued or outstanding as of December 31, 2016 and 2015.\\nIncome Tax Provision\\nIncome taxes are accounted for using the asset and liability method. Deferred income taxes are provided for temporary differences in recognizing certain income, expense and credit items for financial reporting purposes and tax reporting purposes. Such deferred income taxes primarily relate to the difference between the tax basis of assets and liabilities and their financial reporting amounts. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized. There were no material deferred tax assets or liabilities as of December 31, 2016 and December 31, 2015.\\nAs of December 31, 2016, and 2015, the Company did not identify any material uncertain tax positions. As of December 31, 2016, the Company’s returns are subject to examination by federal and state taxing authorities, generally for three years and four years, respectively, after they are filed.\\nNet Income (Loss) Per Common Share\\nNet income (loss) per common share is computed pursuant to section 260-10-45 of the FASB Accounting Standards Codification. Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.\\n\\n| F-12 |\\n\\n\\nDiluted net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of shares of common stock and potentially outstanding shares of common stock during the period to reflect the potential dilution that could occur from common shares issuable through contingent shares issuance arrangement, stock options or warrants.\\nThere were no potentially dilutive debt or equity instruments issued and outstanding at any time during the twelve-month periods ended December 31, 2016 and 2015.\\nCash Flows Reporting\\nThe Company adopted paragraph 230-10-45-24 of the FASB Accounting Standards Codification for cash flows reporting, classifies cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category, and uses the indirect or reconciliation method (“Indirect method”) as defined by paragraph 230-10-45-25 of the FASB Accounting Standards Codification to report net cash flow from operating activities by adjusting net income to reconcile it to net cash flow from operating activities by removing the effects of (a) all deferrals of past operating cash receipts and payments and all accruals of expected future operating cash receipts and payments and (b) all items that are included in net income that do not affect operating cash receipts and payments. The Company reports the reporting currency equivalent of foreign currency cash flows, using the current exchange rate at the time of the cash flows and the effect of exchange rate changes on cash held in foreign currencies is reported as a separate item in the reconciliation of beginning and ending balances of cash and cash equivalents and separately provides information about investing and financing activities not resulting in cash receipts or payments in the period pursuant to paragraph 830-230-45-1 of the FASB Accounting Standards Codification.\\nSubsequent Events\\nThe Company follows the guidance in Section 855-10-50 of the FASB Accounting Standards Codification for the disclosure of subsequent events. The Company will evaluate subsequent events through the date when the financial statements were issued. Pursuant to ASU 2010-09 of the FASB Accounting Standards Codification, the Company as an SEC filer considers its financial statements issued when they are widely distributed to users, such as through filing them on EDGAR.\\nRecent accounting pronouncements\\nIn November 2015, FASB issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes.” ASU 2015-17 requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\\nIn January 2016, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 requires equity investments to be measured at fair value with changes in fair value recognized in net income; simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; requires separate presentation of financial assets and financial liabilities by measurement category and form of financial assets on the balance sheet or the accompanying notes to the financial statements and clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU 2016-01 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company does not expect these changes to have a material impact on the Company’s consolidated financial statements.\\n\\n| F-13 |\\n\\n\\nIn March 2016, the FASB issued ASU 2016-09—Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The amendments in this guidance are relating to employee share-based compensation. Under the new guidance, we are required to recognize the tax effects of stock compensation as income tax expense or benefit in the income statement and treat the tax effects of exercised or vested awards as discrete items in the reporting period in which they occur. Excess tax benefits are required to be classified as operating activities, and shares we withhold on behalf of employees for tax purposes are required to be classified as financing activities. We may make an accounting policy election to continue to estimate the number of awards that are expected to vest or account for forfeitures when they occur. The threshold to qualify for equity classification permits withholding up to the maximum statutory tax rates. This guidance is required to be adopted in the first quarter of 2017. We are currently evaluating the impact this guidance will have on our consolidated financial statements.\\nIn August 2016, the FASB issued ASU 2016-15—Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). The amendments in this guidance on eight specific cash flow issues with regard to how cash receipts and cash payments are presented and classified in the statement of cash flows in order to clarify existing guidance and reduce diversity in practice. The guidance is required to be adopted in the first quarter of 2018 on a retrospective basis, unless it is impracticable to apply, in which case it should be applied prospectively as of the earliest date practicable. Early adoption is permitted. We are currently evaluating the impact this guidance will have on our consolidated statement of cash flows.\\nIn January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business.” The amendments in this guidance are clarifying the definition of a business to assist entities when determining whether an integrated set of assets and activities meets the definition of a business. The update provides that when substantially all the fair value of the assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this new guidance is not expected to have a material impact on our consolidated financial statements.\\nIn January 2017, the FASB issued ASU 2017-04—Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this guidance to eliminate the requirement to calculate the implied fair value of goodwill to measure goodwill impairment charge (Step 2). As a result, an impairment charge will equal the amount by which a reporting unit’s carrying amount exceeds its fair value, not to exceed the amount of goodwill allocated to the reporting unit. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The amendment should be applied on a prospective basis. The guidance is effective for goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for goodwill impairment tests performed after January 1, 2017. The impact of this guidance for the Company will depend on the outcomes of future goodwill impairment tests.\\nThere were other updates recently issued. The Company does not believe that other than disclosed above, the recently issued, but not yet adopted, accounting pronouncements will have a material impact on its financial position, results of operations or cash flows.\\nGoodwill and Other Intangibles\\nIn accordance with Accounting Standards Update (ASU) No. 2014-02, management evaluates goodwill on an annual basis in the fourth quarter of more frequently if management believes indicators of impairment exist. Such indicators could, but are not limited to (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. The Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. If management concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, management conducts a two-step quantitative goodwill impairment test. The first step of the impairment test involves comparing the fair value of the applicable reporting unit with its carrying value. The Company estimates the fair value of its reporting units using a combination of the income, or discounted cash flows, approach and the market approach, with utilizes comparable companies’ data. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, management performs the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount, by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. The Company’s evaluation of goodwill completed during the year resulted in no impairment losses.\\n3. Going Concern\\nThe consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.\\nAs of December 31, 2016, the Company’s current liabilities substantially exceeded its current assets by $5,729,622, had an accumulated deficit of $19,489,400, and stockholders’ deficiency of $5,601,213. These circumstances, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The financial statements also do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern.\\nThe management of the Company already raised additional equity during the first quarter of 2017 for approximately $1,000,000. (Please refer to Note 14 for additional information) The Company is generating additional revenue while seeking additional equity financing. Management is very optimistic about the Company’s continue profitability for the coming years.\\n4. Property, Plant and Equipment\\nProperty, plant and equipment, net consisted of the following:\\n\\n| December 31, 2016 | December 31, 2015 |\\n| Property, Plant and Equipment |\\n| Buildings | $ | - | $ | 1,308,785 |\\n| Machinery and equipment | - | 595,623 |\\n| Automobiles | - | 85,769 |\\n| Office equipment | 942 | 104,843 |\\n| Furniture | 8,276 | - |\\n| Leasehold improvement | 70,871 | - |\\n| Computer software | - | 22,304 |\\n| Property, plant and equipment - total | $ | 80,089 | $ | 2,117,324 |\\n| Less: accumulated depreciation | (20,311 | ) | (762,791 | ) |\\n| Less: impairment on long-lived assets | - | (1,351,726 | ) |\\n| Property, plant and equipment - net | $ | 59,778 | $ | 2,807 |\\n\\nThe building is on a piece of land the use right of which was granted to Kiwa Bio-Tech Products (Shandong) Co., Ltd. by local government free for 10 years and then for another 20 years on a fee calculated according to Kiwa Shandong’s net profit. Since Kiwa Shandong did not generate any net profit, no fee is payable.\\nDepreciation expense was $22,340 and $4,352 for the years ended December 31, 2016 and 2015, respectively.\\nImpairment on long-lived assets was $nil for the years ended December 31, 2016 and 2015, respectively.\\nAll of our property, plant and equipment have been held as collateral to secure the 6% Notes (see Note 8).\\n5. Goodwill\\nOn November 30, 2015, Kiwa Bio-tech Products Group Ltd in BVI (\\\"Kiwa BVI\\\") entered an acquisition agreement with shareholders of Caber Holdings Ltd. (“Acquiree”) in Hong Kong to acquire 100 percent entity interest of the acquiree, including a wholly owned subsidiary, Oriental Baina Co., Ltd. in Beijing for US$30,000. The acquisition was completed in January, 2016. On the acquisition date, there was no any asset or liability acquired, and thus no fair value was allocated to asset and liability. Including legal fee and government fees, the total payment of approximately $34,112 ($30,000 plus legal fee and government fees totaled $4,112) was recorded as goodwill. The fair value of the goodwill is tested prior to the year-end 2016, and management determined there is no impairment to the goodwill as of December 31, 2016.\\n6. Construction Costs Payable\\nConstruction costs payable represents remaining amounts to be paid for the first phase of construction of bio-fertilizer facility in Shandong. The balance of construction costs payable as of December 31, 2016 and 2015 was $255,539 and $273,722, respectively.\\n\\n| F-14 |\\n\\n\\n7. Related Party Transactions\\nAmounts due to related parties consisted of the following as of December 31, 2016 and 2015:\\n\\n| Item | Nature | Notes | December 31, 2016 | December 31, 2015 |\\n| Mr. Wei Li (“Mr. Li”) | Non-trade | (1 | ) | $ | - | $ | 2,879,307 |\\n| Kangtai Xinnong Agriculture Tech (Beijing) Co., Ltd. (“Kangtai”) | Non-trade | (2 | ) | - | (12,173 | ) |\\n| Ms. Yvonne Wang (“Ms. Wang”) | Non-trade | (3 | ) | 100,798 | 299,064 |\\n| Subtotal | 100,798 | 3,166,198 |\\n| Kiwa-CAU R&D Center | Trade | (4 | ) | 1,122,754 | 1,125,553 |\\n| CAAS IARRP and IAED Institutes | Trade | (5 | ) | 160,461 | 18,425 |\\n| Subtotal | 1,283,215 | 1,143,978 |\\n| Total | $ | 1,384,013 | $ | 4,310,176 |\\n\\n(1) Mr. Li\\nMr. Li was the Chairman of the Board until November 20, 2015 and was the Chief Executive Officer of the Company until July 1, 2015.\\nAdvances and Loans\\nOn December 14, 2015, Mr. Li assigned $500,000 of obligation owed by the Company to his daughter, Feng Li. On the same day, Feng Li subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agreed to the concurrent cancellation of debt owed by the Company.\\nOn March 24, 2016, the Company issued 2,900,000 shares of common stock to Mr. Li to settle down entire outstanding balance of $2,879,307. Subsequently in June 2016, Mr. Li transferred 1,000,000 shares to Troniya Industria Incubator Co., Ltd as a personal collateral for RMB 3.2 million received in Kiwa Baiao Bio-Tech (Beijing) Co., Ltd.’s account.\\nGuarantees for the Company\\nMr. Li has pledged without any compensation from the Company all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes (see Note 9).\\n(2) Kangtai\\nKangtai is a private company and is 64% owned by Mr. Li. Mr. Li is the Chairman of Kangtai.\\n(3) Ms. Wang\\nMs. Wang is the Secretary of the Company until November 20, 2015. Effective as of November 20, 2015, the Company appointed Ms. Wang as the Chairman of the Board. Effective August 11, 2016, the Company’s Board of Directors has assigned Ms. Wang the additional titles of Acting President, Acting Chief Executive Officer and Acting Chief Financial Officer.\\nOn December 14, 2015, Ms. Wang subscribed for the purchase of 250,000 shares of preferred stock for the aggregate amount of $500,000, and agrees to the concurrent cancellation of debt owed by the Company.\\nOn March 24, 2016, the Company issued 240,000 shares of common stock to Ms. Wang to pay off the loan balance of $240,000. During the year ended December 31, 2016, Ms. Wang paid various expenses on behalf of the Company. As of December 31, 2016, the amount due to Ms. Wang was $100,798.\\n\\n| F-15 |\\n\\n\\n(4) Kiwa-CAU R&D Center\\nIn November 2006, Kiwa and China Agricultural University (the “CAU”) agreed to jointly establish a new research and development center, named Kiwa-CAU R&D Center. The term of the agreement was ten years commencing July 1, 2006.\\n\\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to fund research at Kiwa-CAU R&D Center. Prof. Qi Wang, a director of the Company, is also the director of Kiwa-CAU R&D Center. The Company recorded $75,528 and $160,563 research and development expenses related to this R&D Center for the years ended December 31, 2016 and 2015, respectively. |\\n\\n(5) CAAS IARRP and IAED Institutes\\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). The term of the Agreement was three years commencing November 20, 2015.\\n\\n| ● | Pursuant to the agreement, Kiwa agree to invest RMB 1 million (approximately $160,000) each year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company's directors effective since November 20, 2015 until March 13, 2017. The Company recorded $149,176 and $18,425 research and development expenses related to the institutes, for the years ended December 31, 2016 and 2015, respectively, |\\n\\nResearch and Development expenses for the years ended December 31, 2016 and 2015, totaled $224,704 and $178,988, respectively.\\n8. Unsecured Loans Payable\\nUnsecured loans payable consisted of the following:\\n\\n| Item | December 31, 2016 | December 31, 2015 |\\n| Unsecured loan payable to Zoucheng Municipal Government, non-interest bearing, becoming due within three years from Kiwa Shandong’s first profitable year on a formula basis, interest has not been imputed due to the undeterminable repayment date | $ | 1,269,880 | $ | 1,387,668 |\\n| Unsecured loan payable to Zoucheng Science & Technology Bureau, non-interest bearing, it is due in Kiwa Shandong’s first profitable year, interest has not been imputed due to the undeterminable repayment date | 385,463 | 385,463 |\\n| Total | $ | 1,655,343 | $ | 1,773,131 |\\n\\nThe Company qualifies for non-interest bearing loans under a Chinese government sponsored program to encourage economic development in certain industries and locations in China. To qualify for the favorable loan terms, a company must meet the following criteria: (1) be a technology company with innovative technology or product (as determined by the Science Bureau of the central Chinese government); (2) operate in specific industries that the Chinese government has determined are important to encourage development, such as agriculture, environmental, education, and others; and (3) be located in an undeveloped area such as Zoucheng, Shandong Province, where the manufacturing facility of the Company is located.\\nAccording to the Company’s project agreement, Zoucheng Municipal Government granted the Company use of at least 15.7 acres in Shandong Province, China at no cost for 10 years to construct a manufacturing facility. Under the agreement, the Company has the option to pay a fee of RMB 480,000 ($77,100) per acre for the land use right after the 10-year period until May 2012. The Company may not transfer or pledge the temporary land use right. The Company also committed to invest approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, the Company invested approximately $2 million for the property, plant and equipment of the project and these assets were impaired as of December 31, 2016.\\n\\n| F-16 |\\n\\n\\n9. Convertible Notes Payable\\nConvertible notes payable consists of 6% secured convertible notes issued to FirsTrust Group Inc. on June 29, 2006. The notes beard interest at 6% and were due on June 29, 2009. Once the note is pass due, the interest rate increased to 15% per annum. The Company accrued $22,977 and $22,538 interest expense on convertible notes for the years ended December 31, 2016 and 2015, respectively. Interest payable to FirstTrust Group Inc. totaled $183,361 and $160,762 at December 31, 2016 and 2015, respectively.\\nThe conversion price of the 6% Notes is based on a 40% discount to the average of the trading price of the Company’s common stock on the OTC Bulletin Board over a 20-day trading period. The conversion price is also adjusted for certain subsequent issuances of equity securities of the Company at prices below the conversion price then in effect. The 6% Notes contain a volume limitation that prohibits the holder from further converting the 6% Notes if doing so would cause the holder and its affiliates to hold more than 4.99% of the Company’s outstanding common stock. In addition, the holder of the 6% Notes agrees that they may not convert more than their pro-rata share (based on original principal amount) of the greater of $120,000 principal amount of the 6% Notes per calendar month or the average daily dollar volume calculated during the 10 business days prior to a conversion, per conversion. This conversion limit has since been eliminated pursuant to an agreement by the Company and the Purchasers.\\nThe Company incurs a financial penalty in cash or shares at the option of the Company (equal to 2% of the outstanding amount of the Notes per month plus accrued and unpaid interest on the Notes, prorated for partial months) if it breaches this or other affirmative covenants in the Purchase Agreement, including a covenant to maintain a sufficient number of authorized shares under its Certificate of Incorporation to cover at least 110% of the stock issuable upon full conversion of the Notes. Pursuant to the relevant provisions for liquidated damages in the Purchase Agreement, the Company has accrued the penalty of $77,575 and $72,152 for the years ended December 31, 2016 and 2015, respectively.\\nThe 6% Notes require the Company to procure the Purchaser’s consent prior to taking certain actions including the payment of dividends, repurchasing stock, incurring debt, guaranteeing obligations, merging or restructuring the Company, or selling significant assets.\\nThe Company’s obligations under the 6% Notes are secured by a first priority security interest in the Company’s intellectual property pursuant to an Intellectual Property Security Agreement with the Purchasers, and by a first priority security interest in all of the Company’s other assets pursuant to a Security Agreement with the Purchasers. In addition, Mr. Li, the Company’s former Chief Executive Officer until July 1, 2015, has pledged all of his common stock of the Company as collateral for the Company’s obligations under the 6% Notes. The intellectual property pledged had a cost of $592,901 which carrying value of $179,897 was fully impaired during the year ended December 31, 2009.\\n\\n| F-17 |\\n\\n\\n10. Note payable\\nOn May 29, 2007, the Company issued a $360,000 promissory note to an unrelated individual. This note bears interest at 18% per annum and due on July 27, 2007. This note is currently in default and bears interest of 25% per annum (the “Default rate”) until paid in full. This note is secured by a pledge of 6,178,336 (post-reverse split 30,892) shares of the Company’s common stock owned by Investlink (China) Limited, a British Virgin Island corporation. The Company accrued $90,000 and $90,000 interest expense on note payable for the years ended December 31, 2016 and 2015, respectively.\\n11.Stockholders’ Deficiency\\nOn December 14, 2015, the Company issued 500,000 shares of preferred stock for the aggregate amount of $1,000,000 as debt cancellation owed to two related party individuals (see Note 7).\\nIn March, 2016, the Company issued 3,140,000 shares of common stock to Mr. Li and Ms. Wang for debt and salary payable settlement for an aggregate amount of $3,141,000 (See Note 7). In addition, the Company issued 101,947 common shares to Jimmy Zhou, former CEO in August 2016, to settle payable to him for $50,974. All of issuances of common shares for settlement of debts were based the stock price on the transaction dates.\\nDuring the year, the Company issued 1,775,000 common shares for cash at $0.8 per share for an aggregate subscribe price equivalent to $1,420,000, of which $859,659 has received while approximately $560,341 remaining subscribe receivable at December 31, 2016.\\nDuring the year ended December 31, 2016, the Company issued 1,711,808 common shares to four consulting companies as compensation for their consulting service received, totaled $254,250 approximately for the year ended December 31, 2016.\\n12. Stock-based Compensation\\nOn December 12, 2006, the Company granted options for 2,000,000 shares (10,000 post-reverse split shares) of its common stock under its 2004 Stock Incentive Plan. Summary of options issued and outstanding at December 31, 2016 and 2015 and the movements during the years then ended are as follows:\\n\\n| F-18 |\\n\\n\\n\\n| Number of underlying shares | Weighted- Average Exercise Price Per Share | Aggregate Intrinsic Value | Weighted- Average Contractual Life Remaining in Years |\\n| Outstanding at December 31, 2014 | 6,163 | $ | 35 | $ | - | 2 |\\n| Exercised | - | - | - |\\n| Expired | - | - | - |\\n| Forfeited | - | - | - |\\n| Outstanding at December 31, 2015 | 6,163 | $ | 35 | $ | - | 1 |\\n| Exercised | - | - | - |\\n| Expired | 6,163 | $ | 35 | - |\\n| Forfeited | - | - | - |\\n| Outstanding at December 31, 2016 | - | - | $ | - | - |\\n| Exercisable at December 31, 2016 | - | - | $ | - | - |\\n\\nAs of December 31, 2016, no stock options or other stock-based compensation was outstanding and all prior grants of stock options had expired as of that date.\\n13. Income Tax\\nIn accordance with the current tax laws in China, Kiwa Shandong is subject to a corporate income tax rate of 25% on its taxable income. However, Kiwa Shandong has not provided for any corporate income taxes since it had no taxable income for the years ended December 31, 2016 and 2015.\\nNo provision for taxes is made for U.S. income tax as the Company has no taxable income in the U.S. In accordance with the relevant tax laws in the British Virgin Islands, Kiwa BVI, as an International Business Company, is exempt from income taxes.\\nA reconciliation of the provision for income taxes determined at the local income tax rate to the Company’s effective income tax rate is as follows:\\n\\n| Years ended December 31, |\\n| 2016 | 2015 |\\n| Pre-tax income (loss) | $ | 1,389,576 | $ | (677,358 | ) |\\n| U.S. federal corporate income tax rate | 34 | % | 34 | % |\\n| Income tax computed at U.S. federal corporate income tax rate | 472,456 | (230,302 | ) |\\n| Reconciling items: |\\n| Rate differential for PRC earnings | (139,923 | ) | 22,439 |\\n| Change of valuation allowance | 301,813 | 171,993 |\\n| Non-deductible expenses | (208,066 | ) | 35,870 |\\n| Effective tax expense | $ | 426,280 | $ | - |\\n\\n\\n| F-19 |\\n\\n\\nThe Company had deferred tax assets as follows:\\n\\n| December 31, 2016 | December 31, 2015 |\\n| Net operating losses carried forward | $ | 3,475,563 | $ | 3,398,402 |\\n| Less: Valuation allowance | (3,475,563 | ) | (3,398,402 | ) |\\n| Net deferred tax assets | $ | - | $ | - |\\n\\nAs of December 31, 2016 and 2015, the Company had approximately $3.5 million and $8 million net operating loss carryforwards available to reduce future taxable income. Net operating loss of the Company could be carried forward and taken against any taxable income for a period of not more than twenty years from the year of the initial loss pursuant to Section 172 of the Internal Revenue Code of 1986, as amended. The net operating loss of Kiwa Shandong could be carried forward for a period of not more than five years from the year of the initial loss pursuant to relevant PRC tax laws and regulations. It is more likely than not that the deferred tax assets cannot be utilized in the future because there will not be significant future earnings from the entity which generated the net operating loss. Therefore, the Company recorded a full valuation allowance on its deferred tax assets.\\nAs of December 31, 2016 and 2015, the Company has no material unrecognized tax benefits which would favorably affect the effective income tax rate in future periods and does not believe that there will be any significant increases or decreases of unrecognized tax benefits within the next twelve months. No interest or penalties relating to income tax matters have been imposed on the Company during the two years ended December 31, 2016 and 2015, and no provision for interest and penalties is deemed necessary as of December 31, 2016 and 2015.\\nAccording to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational errors made by the taxpayer or its withholding agent. The statute of limitations extends to five years under special circumstances, which are not clearly defined. In the case of a related party transaction, the statute of limitation is ten years. There is no statute of limitation in the case of tax evasion.\\n14. Commitments and Contingencies\\nThe Company has the following material contractual obligations:\\n(1) Investment in manufacturing and research facilities in Zoucheng, Shandong Province in China\\nAccording to the Project Agreement with Zoucheng Municipal Government in 2002, we have committed to investing approximately $18 million to $24 million for developing the manufacturing and research facilities in Zoucheng, Shandong Province. As of December 31, 2016, we had invested approximately $1.91 million for the project. On February 11, 2017, the Company entered an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) to transfer all of shareholders’ right, title and interest in Kiwa Shandong to the Transferee for USD $1.00. Currently, the completion of transfer is under the government processing.\\n(2) Strategic cooperation with two institutes in China\\nOn November 5, 2015, the Company signed a strategic cooperation agreement (the “Agreement”) with China Academy of Agricultural Science (“CAAS”)’s Institute of Agricultural Resources & Regional Planning (“IARRP”) and Institute of Agricultural Economy & Development (“IAED”). Pursuant to the Agreement, the Company will form a strategic partnership with the two institutes and establish an “International Cooperation Platform for Internet and Safe Agricultural Products”. To fund the cooperation platform’s R&D activities, the Company will provide RMB 1 million (approximately $160,000) per year to the Spatial Agriculture Planning Method & Applications Innovation Team that belongs to the Institutes. The term of the Agreement is for three years beginning November 20, 2015. Prof. Yong Chang Wu, the authorized representative of IARRP, CAAS, is also one of the Company’s directors effective since November 20, 2015 until March 13, 2017.\\n\\n| F-20 |\\n\\n\\n(3) Distribution agreement with Kangtan Gerui Bio-Tech in China\\nOn December 17, 2015, Kiwa Bio-Tech Products Group Corporation (the “Company”) entered into a distribution agreement (the “Agreement”) with Kangtan Gerui (Beijing) Bio-Tech Co., Ltd. (“Gerui”) and formally awarded Gerui a right to sell and distribute the Company’s fertilizer products in 3 major agricultural regions of China— Hainan Province, Hunan Province and Xinjiang Autonomous Region. The Company’s Research and Development department has been conducting application experiments in Hainan and Hunan Provinces since August 2015, in accordance with the market requirements. The experiment data indicates that the Company’s fertilizer products have fulfill the requirements of reduction of content of heavy metals in soil and improve crop yield. Gerui was founded in Beijing in April 2015 and relies on the sales network of China’s Supply and Marketing Cooperatives system. Currently, the Company and Gerui do not hold any interest in each other; however, a collaboration and integration may take place in the future. The term of the Agreement is for a period of three years commencing December 17, 2015. In September 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd obtained a fertilizer sales permit from the Chinese government and began to sale the products directly to customers in those 3 major agricultural regions.\\n(4) Lease payments\\n(1) On April 29, 2016, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an office lease agreement with two-year team. Monthly lease payment and building management fee totaled RMB 77,867 or approximately USD $11,622.\\n(2) On November 11, 2017, Kiwa Baiao Bio-Tech (Beijing) Co., Ltd. entered an apartment lease agreement for its employees. The lease term is one year with monthly lease payment of RMB 6,000 or approximately USD $896.\\n(3) In March 1, 2017, Kiwa Bio-Tech (Shenzhen) Co., Ltd, a newly established subsidiary entered an office lease agreement with one-year term. Monthly lease payment is RMB 29,000 or approximately of USD $4,320.\\nThe future lease payments at December 31, 2016 are summarized below.\\n\\n| Beijing Office | Beijing Apartment | Shenzhen Office | Total |\\n| 2017 | $ | 139,462 | $ | 3,632 | $ | 4,328 | $ | 147,422 |\\n| 2018 | $ | 44,555 | - | - | $ | 44,555 |\\n| Thereafter | - | - | - | - |\\n\\n15. Subsequent Events\\nThe Company has evaluated the existence of significant events subsequent to the balance sheet date through the date these financial statements were issued and has determined that there were no subsequent events or transactions which would require recognition or disclosure in the financial statements, other than noted herein.\\nOn February 11, 2017, the Company executed an Equity Transfer Agreement with Dian Shi Cheng Jing (Beijing) Technology Co. (“Transferee”) whereby the Company transferred all of its right, title and interest in Kiwa Bio-Tech Products (Shandong) Co., Ltd. (“Shandong”) to the Transferee for the RMB equivalent of US$1.00. In connection with the transaction, the Transferee received all assets of Shandong which are estimated to be approximately RMB 14,057,713 at the effective date and assumed all liabilities of Shandong which are estimated to be approximately RMB 59,446,513 at the effective date. In connection with this transaction, Transferee agreed to indemnify the Company for any liability or claims of any third party(ies) against Shandong or the Company for five (5) years. The transaction is subject to obtaining Chinese government approval for the transaction, which the parties agrees to use their best efforts to obtain prior to December 31, 2017. The completion of transfer is under government processing.\\n\\n| F-21 |\\n\\n\\nOn February 15, 2017, the Company completed the sale of 1,000,000 shares of Kiwa Common Stock (each a “Share”) at a price of $1.00 per share (total sale proceeds were $1,000,000) to Junwei Zheng in a private transaction which was exempt from registration under Section 4(a)(2) of the Securities Act of 1933, as amended (the “Act”) and Regulation S promulgated under the Act since, among other things, the transaction did not involve a public offering and the securities were acquired for investment purposes only and not with a view to or for sale in connection with any distribution thereof and were purchased by an investor who is not a resident of the United States. The net proceeds will be used for the further development of Kiwa products and distribution, as well as for general working capital.\\nOn February 23, 2017, the Company has agreed to a strategic relationship with ETS (Tianjin) Biological Science and Technology Development Co., Ltd. (“ETS”). The partnership will include the deployment and strategic use of ETS biotechnology to produce of bio-fertilizers for use in both China and internationally. Kiwa and ETS, together with the certain Chinese government departments, will work together to enhance China’s microbial fertilizer industry standards and China’s food safety industry chain standards. The parties will work together on the development of microbial technology and products in agriculture, environmental protection, soil management and other fields. Relying on the Chinese Academy of Sciences, ETS Environmental and Agricultural Microbial Technology Research Center and biotechnology project research results, Kiwa has introduced the ETS core technology to complete bio-fertilizer upgrading, transformation and to develop new product lines. In order to meet the growing global consumer demand to increase food supply and develop sustainable farming we are applying sustainable use of biotechnology and the use of biotechnology products to replace chemical products, which will strengthen environmental protection and promote international cooperation. As a result of strict management of many agricultural chemicals, such chemicals will continue to be abandoned, resulting is a growing demand for bio-fertilizers. It has been widely accepted that the application of ETS biotechnology facilitates agricultural sustainability and helps to protect the soil and improve grain output. The technology focuses on keeping soil healthy by restoring healthy microbes that are naturally present in healthy soils. As the technology gains worldwide recognition, it is imperative to popularize bio-fertilizer in developing countries to fulfill the needs of growing populations and promote environmentally friendly agriculture. Through the cooperation of Kiwa and ETS, the parties aim to enhance the usage of the bio-fertilizers in China. The cooperation will bring technological transformation and support for Kiwa to improve its existing manufacturing techniques. Kiwa and ETS will also collaborate to establish a comprehensive platform for producing, supplying, and marketing in China. Ultimately, Kiwa would look to introduce these products to the international market, including the United States.\\nOn February 27, 2017, the Company has signed a strategic cooperation agreement with the Beijing Zhongpin Agricultural Science and Technology Development Center (“Zhongpin Center”). Zhongpin Center is the Chinese Agricultural Science and Technology Innovation and Development Committee’s executive implementation agency (referred to as the Agricultural Science and Technology Commission). The Agricultural Science and Technology Commission is set up by the Chinese Central Government for the construction of the National Ecological Security Agriculture Industrial Chain standardization system. This includes the establishment of National Ecology Safe Agricultural Industrial Parks to build China’s Ecological Security and Agricultural Industrial in an orderly business environment, including completion of the National Soil Remediation Program and governance of the various government functions of the institutions. Through the guidance and support by the Zhongpin Center, Kiwa will participate and be involved in China’s National Soil Remediation Program and construction of the National Ecological Security Agriculture Industrial Chain Standardization System’s operation and process.\\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company, the Company was converted from a Delaware corporation to a Nevada corporation by filing of Articles of Conversion and Articles of Incorporation in the State of Nevada and filing a Certificate of Dissolution in the State of Delaware.\\nOn March 8, 2017, pursuant to the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the Kiwa Bio-Tech Products Group Corporation 2016 Employee, Director and Consultant Stock Plan.\\nOn March 13, 2017, Yong Change Wu was removed as a director of the Company by the consent of the holders of a majority of the votes entitled to be cast on the matter and the approval of the majority of the directors of the Company. Immediately thereafter, the Board appointed Yong Lin Song as a director of the Company to be effective immediately.\\n\\n| F-22 |\\n\\n\\n\\n</text>\\n\\nWhat is the total amount spent by the company on research and development, and acquisitions from 2004 to 2016 in US dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 2517503.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 55,\n \"input_length\": 35732\n}"}}},{"rowIdx":56,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nITEM 1. FINANCIAL STATEMENTS\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| September 30, | December 31, |\n| (in thousands, except share data) | 2022 | 2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\n| Restricted cash | 18,079 | 16,015 |\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\n| Total current assets | 1,103,155 | 1,104,314 |\n| Property and equipment, net | 69,084 | 63,696 |\n| Goodwill | 2,246,053 | 2,206,004 |\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\n| Other assets | 120,644 | 67,582 |\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities |\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\n| Accounts payable | 267,684 | 277,366 |\n| Accrued compensation and benefits | 109,935 | 139,157 |\n| Other accrued expenses | 161,246 | 164,133 |\n| Deferred revenues | 47,441 | 50,467 |\n| Total current liabilities | 601,010 | 645,520 |\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\n| Deferred income tax liabilities | 456,755 | 483,165 |\n| Warrant liability | 733 | 22,189 |\n| Other long-term liabilities | 109,421 | 92,218 |\n| Total liabilities | 3,192,510 | 3,271,974 |\n| Commitments and contingencies (Note 10) |\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\n| Equity attributable to stockholders of Advantage Solutions Inc. |\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\n| Additional paid in capital | 3,398,477 | 3,373,278 |\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n3\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\n| Other comprehensive loss, net of tax: |\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\n| Net income per common share: |\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Weighted-average number of common shares: |\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n4\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(UNAUDITED)\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n5\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n6\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income | $ | 44,437 | $ | 29,535 |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\n| Depreciation and amortization | 173,997 | 181,450 |\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\n| Stock-based compensation | 29,906 | 28,617 |\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\n| Loss on disposal of property and equipment | 608 | 6,327 |\n| Loss on divestiture | 2,953 | — |\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\n| Accounts payable | ( 7,914 | ) | 37,294 |\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\n| Deferred revenues | ( 156 | ) | 2,869 |\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\n| Net cash provided by operating activities | 81,950 | 101,068 |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\n| Proceeds from divestiture | 1,896 | — |\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Borrowings under lines of credit | 140,333 | 51,685 |\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\n| Proceeds from issuance of long-term debt | 266 | — |\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\n| Proceeds from issuance of common stock | 3,320 | 794 |\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\n| Contribution from noncontrolling interest | 5,217 | — |\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\n| SUPPLEMENTAL CASH FLOW INFORMATION |\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n7\nADVANTAGE SOLUTIONS INC.\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\n9\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n\n| (in thousands) |\n| Consideration: |\n| Cash | $ | 74,146 |\n| Holdback | 810 |\n| Fair value of contingent consideration | 510 |\n| Total consideration | $ | 75,466 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 9,409 |\n| Other assets | 3,446 |\n| Identifiable intangible assets | 25,546 |\n| Total assets | 38,401 |\n| Liabilities |\n| Accounts payable | 7,363 |\n| Deferred tax liabilities and other | 8,744 |\n| Total liabilities | 16,107 |\n| Redeemable noncontrolling interest | 1,987 |\n| Noncontrolling interest | 974 |\n| Total identifiable net assets | 19,333 |\n| Goodwill arising from acquisitions | $ | 56,133 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 24,413 | 6 years |\n| Trade names | 1,133 | 10 years |\n| Total identifiable intangible assets | $ | 25,546 |\n| (in thousands) |\n| Consideration |\n| Cash | $ | 40,046 |\n| Holdbacks | 13,599 |\n| Fair value of contingent consideration | 19,883 |\n| Total consideration | $ | 73,528 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 12,834 |\n| Other assets | 4,400 |\n| Property and equipment | 1,001 |\n| Identifiable intangible assets | 36,210 |\n| Total assets | 54,445 |\n| Liabilities |\n| Total liabilities | 21,758 |\n| Redeemable noncontrolling interest | 1,804 |\n| Total identifiable net assets | 30,883 |\n| Goodwill arising from acquisitions | $ | 42,645 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 27,860 | 7 years |\n| Trade Names | 5,250 | 5 years |\n| Developed technology | 3,100 | 7 years |\n| Total identifiable intangible assets | $ | 36,210 |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\n\n\n| Sales | Marketing | Total |\n| (in thousands) |\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\n| Acquisitions | 32,087 | 13,315 | 45,402 |\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\n| Acquisitions | 5,672 | 50,461 | 56,133 |\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\n| September 30, 2022 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\n| December 31, 2021 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\n| (in thousands) |\n| Remainder of 2022 | $ | 49,782 |\n| 2023 | 197,530 |\n| 2024 | 196,181 |\n| 2025 | 190,153 |\n| 2026 | 186,203 |\n| Thereafter | 430,226 |\n| Total amortization expense | $ | 1,250,075 |\n\n\n| September 30, | December 31, |\n| (in thousands) | 2022 | 2021 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\n| Notes | 775,000 | 775,000 |\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\n| Other | 1,492 | 1,113 |\n| Total long-term debt | 2,082,418 | 2,093,075 |\n| Less: current portion | 14,704 | 14,397 |\n| Less: debt issuance costs | 43,123 | 49,796 |\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\n\n| September 30, 2022 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Liabilities measured at fair value |\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\n| December 31, 2021 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Liabilities measured at fair value |\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\n| Warrant liability | 22,189 | — | — | 22,189 |\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\n| September 30, |\n| (in thousands) | 2022 | 2021 |\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\n| Fair value of acquisitions | 510 | 19,883 |\n| Changes in fair value | 5,448 | 6,977 |\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\n| Measurement period adjustments | — | ( 1,181 | ) |\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\n| End of the period | $ | 40,431 | $ | 65,112 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at September 30, 2022 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\n| Notes | 775,000 | 723,486 |\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\n| Other | 1,492 | 1,492 |\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at December 31, 2021 |\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\n| Notes | 775,000 | 894,611 |\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\n| Other | 1,113 | 1,113 |\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\n\n\n| Revenues | Accounts Receivable |\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\n\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\n| (in thousands) | Sales | Marketing | Total |\n| Three Months Ended September 30, 2022 |\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\n| Three Months Ended September 30, 2021 |\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\n| (in thousands) | Sales | Marketing | Total |\n| Nine Months Ended September 30, 2022 |\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\n| Nine Months Ended September 30, 2021 |\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\n\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\n| Performance Share Units | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\n| Granted | 5,393,085 | $ | 5.66 |\n| Distributed | 660,880 | $ | 13.09 |\n| Forfeited | 684,261 | $ | 8.19 |\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\n| Number of RSUs | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\n| Granted | 6,302,801 | $ | 5.74 |\n| Distributed | 1,338,213 | $ | 10.61 |\n| Forfeited | 869,955 | $ | 8.02 |\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\n| September 30, |\n| 2022 |\n| Share Price | $ | 5.99 |\n| Dividend yield | 0.0 | % |\n| Expected volatility | 30.0 | % |\n| Risk-free interest rate | 2.0 | % |\n| Expected term (years) | 6.5 |\n\n\n| (in thousands) |\n| Balance at January 1, 2022 | $ | 1,893 |\n| Fair value at acquisition | 1,987 |\n| Net income attributable to redeemable noncontrolling interests | 124 |\n| Dividend distribution | ( 223 | ) |\n| Foreign currency translation adjustment | ( 428 | ) |\n| Balance at September 30, 2022 | $ | 3,353 |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\n| Basic earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n\n24\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\n25\n\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nForward-Looking Statements\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\nExecutive Overview\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\nWe have two reportable segments: sales and marketing.\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\n26\nBusiness Combination with Conyers Park\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\nImpacts of the COVID-19 Pandemic\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\nSummary\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\nFactors Affecting Our Business and Financial Reporting\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\n27\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\n28\nHow We Assess the Performance of Our Business\nRevenues\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\n29\nCost of Revenues\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\nOther (Income) Expenses\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\nInterest Expense\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\nDepreciation and Amortization\nAmortization Expense\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\n30\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\nDepreciation Expense\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\nIncome Taxes\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\nCash Flows\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\nAdjusted Net Income\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nAdjusted EBITDA and Adjusted EBITDA by Segment\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\n31\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\n| Other Financial Data |\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\n\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\nComparison of the Three Months Ended September 30, 2022 and 2021\nRevenues\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\n\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\n32\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\nOperating Income\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\n\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\n33\nInterest Expense, net\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\nNet Income\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\n\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\nComparison of the Nine Months Ended September 30, 2022 and 2021\nRevenues\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\n\n34\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\nOperating Income\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\n\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\n35\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\nInterest Expense, net\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\nNet Income\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\n\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\n36\nNon-GAAP Financial Measures\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Add: |\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\n\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\n37\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\n\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Add: |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\n\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\n\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\n| Add: |\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\n\n38\n\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\n| Add: |\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\n\n\n\n\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\n\n39\nLiquidity and Capital Resources\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\nCash Flows\nA summary of our cash operating, investing and financing activities are shown in the following table:\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\n\nNet Cash Provided by Operating Activities\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\nNet Cash Used in Investing Activities\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\nNet Cash Used in Financing Activities\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\n40\nDescription of Credit Facilities\nSenior Secured Credit Facilities\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\nRevolving Credit Facility\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\n41\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\nTerm Loan Facility\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\n42\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\nSenior Secured Notes\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\nInterest and maturity\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\nGuarantees\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\nSecurity and Ranking\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\n43\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\nOptional redemption for the Notes\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\nRestrictive covenants\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\nEvents of default\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\nFuture Cash Requirement\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\n44\nCash and Cash Equivalents Held Outside the United States\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\nCritical Accounting Policies and Estimates\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\nRecently Issued Accounting Pronouncements\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\n45\n\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nForeign Currency Risk\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\nInterest Rate Risk\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\n46\n\nITEM 4. CONTROLS AND PROCEDURES\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\n47\nPART II - OTHER INFORMATION\n\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\nEmployment-Related Matters\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\nProceedings Relating to Take 5\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\nArbitration Proceedings Related to Take 5\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\n48\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\nOther Legal Matters Related to Take 5\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n\nITEM 1A. RISK FACTORS\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\nSummary of Principal Risks Associated with Our Business\nSet forth below is a summary of some of the principal risks we face:\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\n•developments with respect to retailers that are out of our control;\n•our ability to continue to generate significant operating cash flow;\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\n•our reliance on continued access to retailers’ platforms;\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\n•client procurement strategies putting additional operational and financial pressure on our services;\n•our ability to maintain proper and effective internal control over financial reporting in the future;\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\n•our ability to avoid or manage business conflicts among competing brands;\n49\n•difficulties in integrating acquired businesses;\n•our substantial indebtedness and our ability to refinance at favorable rates;\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\n•our ability to respond to changes in digital practices and policies;\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\n•the ability to maintain applicable listing standards;\n•changes in applicable laws or regulations; and\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\nRisks Related to the Company’s Business and Industry\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\n•our ability to hire, timely train and retain talented individuals for our workforce;\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\n50\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\n•our ability to generate sufficient cash to service our substantial indebtedness;\n•our ability to maintain our credit rating;\n•our ability to offer high-quality customer support and maintain our reputation;\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\n•our ability to maintain our corporate culture;\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\n51\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\nInflation may adversely affect our operating results.\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\n52\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\nOur largest clients generate a significant portion of our revenues.\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\n53\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\n54\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\nWe may encounter significant difficulties integrating acquired businesses.\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\n55\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\n•the diversion of management attention to integration matters;\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\n•difficulties in assimilating, attracting and retaining key personnel;\n•challenges in keeping existing clients and obtaining new clients;\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\n56\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\n•costs of customizing services for clients outside of the United States;\n•the burdens of complying with a wide variety of foreign laws;\n•potential difficulty in enforcing contracts;\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\n•reduced protection for intellectual property rights;\n•increased financial accounting and reporting complexity;\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\n•exposure to foreign currency exchange rate fluctuations;\n•exposure to local economic conditions;\n•limitations on the repatriation of funds or profits from foreign operations;\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\n57\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\n58\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\n59\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\n60\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\n61\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\n62\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\nOur business is seasonal in nature and quarterly operating results can fluctuate.\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\n63\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\n64\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\n65\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\n•changes in the valuation of our deferred tax assets and liabilities;\n•expected timing and amount of the release of any tax valuation allowance;\n•tax effects of equity-based compensation;\n•changes in tax laws, regulations or interpretations thereof; or\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\n66\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\nRisks Related to Ownership of Our Common Stock\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\n•not permitting the use of cumulative voting for the election of directors;\n•permitting the removal of directors only for cause;\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\n67\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\n68\nAn active, liquid trading market for our Class A common stock may not be available.\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\n•you may not be able to liquidate your investment in shares of Class A common stock;\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\n•the market price of shares of Class A common stock may experience significant price volatility; and\n•there may be less efficiency in carrying out your purchase and sale orders.\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\n•quarterly variations in our operating results compared to market expectations;\n•changes in preferences of our clients;\n•announcements of new products or services or significant price reductions;\n•the size of our public float;\n•fluctuations in stock market prices and volumes;\n•defaults on our indebtedness;\n•changes in senior management or key personnel;\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\n•the payment of any dividends thereon in shares of our common stock;\n•changes in financial estimates or recommendations by securities analysts;\n•negative earnings or other announcements by us;\n•downgrades in our credit ratings;\n•material litigation or governmental investigations;\n•issuances of capital stock;\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\n69\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nRisks Related to Indebtedness\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\n70\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\nThe elimination of LIBOR after June 2023 may affect our financial results\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\n71\nGeneral Risk Factors\nOur business and financial results may be affected by various litigation and regulatory proceedings.\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\nOur insurance may not provide adequate levels of coverage against claims.\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\nWe have incurred and will continue to incur increased costs as a public company.\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nOur management has limited experience in operating a public company.\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\n72\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone\n\nItem 3. Defaults Upon Senior Securities\nNone\n\nItem 4. Mine Safety Disclosures\nNone\n73\n\nItem 5. Other Information\nNone\n\nItem 6. Exhibits\n74\nSignatures 75\n2\nPART I - FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n\n| September 30, | December 31, |\n| (in thousands, except share data) | 2022 | 2021 |\n| ASSETS |\n| Current assets |\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\n| Restricted cash | 18,079 | 16,015 |\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\n| Total current assets | 1,103,155 | 1,104,314 |\n| Property and equipment, net | 69,084 | 63,696 |\n| Goodwill | 2,246,053 | 2,206,004 |\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\n| Other assets | 120,644 | 67,582 |\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\n| Current liabilities |\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\n| Accounts payable | 267,684 | 277,366 |\n| Accrued compensation and benefits | 109,935 | 139,157 |\n| Other accrued expenses | 161,246 | 164,133 |\n| Deferred revenues | 47,441 | 50,467 |\n| Total current liabilities | 601,010 | 645,520 |\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\n| Deferred income tax liabilities | 456,755 | 483,165 |\n| Warrant liability | 733 | 22,189 |\n| Other long-term liabilities | 109,421 | 92,218 |\n| Total liabilities | 3,192,510 | 3,271,974 |\n| Commitments and contingencies (Note 10) |\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\n| Equity attributable to stockholders of Advantage Solutions Inc. |\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\n| Additional paid in capital | 3,398,477 | 3,373,278 |\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n3\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\n| Other comprehensive loss, net of tax: |\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\n| Net income per common share: |\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Weighted-average number of common shares: |\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n4\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\n(UNAUDITED)\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n5\n\n| Accumulated | Advantage |\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\n\n\n| Accumulated | Advantage |\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\n| (in thousands, except share data) |\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\n| Comprehensive income (loss) |\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n6\nADVANTAGE SOLUTIONS INC.\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| CASH FLOWS FROM OPERATING ACTIVITIES |\n| Net income | $ | 44,437 | $ | 29,535 |\n| Adjustments to reconcile net income to net cash provided by operating activities |\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\n| Depreciation and amortization | 173,997 | 181,450 |\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\n| Stock-based compensation | 29,906 | 28,617 |\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\n| Loss on disposal of property and equipment | 608 | 6,327 |\n| Loss on divestiture | 2,953 | — |\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\n| Accounts payable | ( 7,914 | ) | 37,294 |\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\n| Deferred revenues | ( 156 | ) | 2,869 |\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\n| Net cash provided by operating activities | 81,950 | 101,068 |\n| CASH FLOWS FROM INVESTING ACTIVITIES |\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\n| Proceeds from divestiture | 1,896 | — |\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\n| CASH FLOWS FROM FINANCING ACTIVITIES |\n| Borrowings under lines of credit | 140,333 | 51,685 |\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\n| Proceeds from issuance of long-term debt | 266 | — |\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\n| Proceeds from issuance of common stock | 3,320 | 794 |\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\n| Contribution from noncontrolling interest | 5,217 | — |\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\n| SUPPLEMENTAL CASH FLOW INFORMATION |\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\n\nSee Notes to the Condensed Consolidated Financial Statements.\n7\nADVANTAGE SOLUTIONS INC.\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\n9\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\n\n| (in thousands) |\n| Consideration: |\n| Cash | $ | 74,146 |\n| Holdback | 810 |\n| Fair value of contingent consideration | 510 |\n| Total consideration | $ | 75,466 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 9,409 |\n| Other assets | 3,446 |\n| Identifiable intangible assets | 25,546 |\n| Total assets | 38,401 |\n| Liabilities |\n| Accounts payable | 7,363 |\n| Deferred tax liabilities and other | 8,744 |\n| Total liabilities | 16,107 |\n| Redeemable noncontrolling interest | 1,987 |\n| Noncontrolling interest | 974 |\n| Total identifiable net assets | 19,333 |\n| Goodwill arising from acquisitions | $ | 56,133 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 24,413 | 6 years |\n| Trade names | 1,133 | 10 years |\n| Total identifiable intangible assets | $ | 25,546 |\n| (in thousands) |\n| Consideration |\n| Cash | $ | 40,046 |\n| Holdbacks | 13,599 |\n| Fair value of contingent consideration | 19,883 |\n| Total consideration | $ | 73,528 |\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\n| Assets |\n| Accounts receivable | $ | 12,834 |\n| Other assets | 4,400 |\n| Property and equipment | 1,001 |\n| Identifiable intangible assets | 36,210 |\n| Total assets | 54,445 |\n| Liabilities |\n| Total liabilities | 21,758 |\n| Redeemable noncontrolling interest | 1,804 |\n| Total identifiable net assets | 30,883 |\n| Goodwill arising from acquisitions | $ | 42,645 |\n| (in thousands) | Amount | WeightedAverageUseful Life |\n| Client relationships | $ | 27,860 | 7 years |\n| Trade Names | 5,250 | 5 years |\n| Developed technology | 3,100 | 7 years |\n| Total identifiable intangible assets | $ | 36,210 |\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\n\n\n| Sales | Marketing | Total |\n| (in thousands) |\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\n| Acquisitions | 32,087 | 13,315 | 45,402 |\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\n| Acquisitions | 5,672 | 50,461 | 56,133 |\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\n| September 30, 2022 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\n| December 31, 2021 |\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\n| Finite-lived intangible assets: |\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\n| Indefinite-lived intangible assets: |\n| Trade names | 900,000 | — | 900,000 |\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\n| (in thousands) |\n| Remainder of 2022 | $ | 49,782 |\n| 2023 | 197,530 |\n| 2024 | 196,181 |\n| 2025 | 190,153 |\n| 2026 | 186,203 |\n| Thereafter | 430,226 |\n| Total amortization expense | $ | 1,250,075 |\n\n\n| September 30, | December 31, |\n| (in thousands) | 2022 | 2021 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\n| Notes | 775,000 | 775,000 |\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\n| Other | 1,492 | 1,113 |\n| Total long-term debt | 2,082,418 | 2,093,075 |\n| Less: current portion | 14,704 | 14,397 |\n| Less: debt issuance costs | 43,123 | 49,796 |\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\n\n| September 30, 2022 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\n| Liabilities measured at fair value |\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\n| December 31, 2021 |\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\n| Assets measured at fair value |\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\n| Liabilities measured at fair value |\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\n| Warrant liability | 22,189 | — | — | 22,189 |\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\n| September 30, |\n| (in thousands) | 2022 | 2021 |\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\n| Fair value of acquisitions | 510 | 19,883 |\n| Changes in fair value | 5,448 | 6,977 |\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\n| Measurement period adjustments | — | ( 1,181 | ) |\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\n| End of the period | $ | 40,431 | $ | 65,112 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at September 30, 2022 |\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\n| Notes | 775,000 | 723,486 |\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\n| Other | 1,492 | 1,492 |\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\n| Balance at December 31, 2021 |\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\n| Notes | 775,000 | 894,611 |\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\n| Other | 1,113 | 1,113 |\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\n\n\n| Revenues | Accounts Receivable |\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\n\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\n| (in thousands) | Sales | Marketing | Total |\n| Three Months Ended September 30, 2022 |\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\n| Three Months Ended September 30, 2021 |\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\n| (in thousands) | Sales | Marketing | Total |\n| Nine Months Ended September 30, 2022 |\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\n| Nine Months Ended September 30, 2021 |\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\n\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\n| Performance Share Units | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\n| Granted | 5,393,085 | $ | 5.66 |\n| Distributed | 660,880 | $ | 13.09 |\n| Forfeited | 684,261 | $ | 8.19 |\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\n| Number of RSUs | Weighted Average GrantDate Fair Value |\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\n| Granted | 6,302,801 | $ | 5.74 |\n| Distributed | 1,338,213 | $ | 10.61 |\n| Forfeited | 869,955 | $ | 8.02 |\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\n| September 30, |\n| 2022 |\n| Share Price | $ | 5.99 |\n| Dividend yield | 0.0 | % |\n| Expected volatility | 30.0 | % |\n| Risk-free interest rate | 2.0 | % |\n| Expected term (years) | 6.5 |\n\n\n| (in thousands) |\n| Balance at January 1, 2022 | $ | 1,893 |\n| Fair value at acquisition | 1,987 |\n| Net income attributable to redeemable noncontrolling interests | 124 |\n| Dividend distribution | ( 223 | ) |\n| Foreign currency translation adjustment | ( 428 | ) |\n| Balance at September 30, 2022 | $ | 3,353 |\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\n| Basic earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n| Diluted earnings per share computation: |\n| Numerator: |\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\n| Denominator: |\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\n\n24\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\n25\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nForward-Looking Statements\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\nExecutive Overview\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\nWe have two reportable segments: sales and marketing.\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\n26\nBusiness Combination with Conyers Park\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\nImpacts of the COVID-19 Pandemic\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\nSummary\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\nFactors Affecting Our Business and Financial Reporting\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\n27\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\n28\nHow We Assess the Performance of Our Business\nRevenues\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\n29\nCost of Revenues\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\nOther (Income) Expenses\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\nInterest Expense\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\nDepreciation and Amortization\nAmortization Expense\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\n30\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\nDepreciation Expense\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\nIncome Taxes\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\nCash Flows\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\nAdjusted Net Income\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nAdjusted EBITDA and Adjusted EBITDA by Segment\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\n31\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\n| Other (income) expenses: |\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\n| Other Financial Data |\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\n\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\nComparison of the Three Months Ended September 30, 2022 and 2021\nRevenues\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\n\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\n32\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\nOperating Income\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\n\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\n33\nInterest Expense, net\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\nNet Income\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Three Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\n\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\nComparison of the Nine Months Ended September 30, 2022 and 2021\nRevenues\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\n\n34\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\nCost of Revenues\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\nSelling, General and Administrative Expenses\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\nDepreciation and Amortization Expense\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\nOperating Income\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\n\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\n35\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\nChange in Fair Value of Warrant Liability\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\nInterest Expense, net\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\nProvision for Income Taxes\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\nNet Income\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\nAdjusted Net Income\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\nAdjusted EBITDA and Adjusted EBITDA by Segment\n\n| Nine Months Ended September 30, | Change |\n| (amounts in thousands) | 2022 | 2021 | $ | % |\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\n\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\n36\nNon-GAAP Financial Measures\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\n| Add: |\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\n\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\n37\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\n\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\n| Add: |\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\n\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\n\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\n| Add: |\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\n\n38\n\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| (in thousands) |\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\n| Add: |\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\n\n\n\n\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\n\n39\nLiquidity and Capital Resources\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\nCash Flows\nA summary of our cash operating, investing and financing activities are shown in the following table:\n\n| Nine Months Ended September 30, |\n| (in thousands) | 2022 | 2021 |\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\n\nNet Cash Provided by Operating Activities\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\nNet Cash Used in Investing Activities\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\nNet Cash Used in Financing Activities\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\n40\nDescription of Credit Facilities\nSenior Secured Credit Facilities\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\nRevolving Credit Facility\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\n41\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\nTerm Loan Facility\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\n42\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\nSenior Secured Notes\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\nInterest and maturity\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\nGuarantees\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\nSecurity and Ranking\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\n43\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\nOptional redemption for the Notes\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\nRestrictive covenants\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\nEvents of default\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\nFuture Cash Requirement\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\n44\nCash and Cash Equivalents Held Outside the United States\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\nOff-Balance Sheet Arrangements\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\nCritical Accounting Policies and Estimates\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\nRecently Issued Accounting Pronouncements\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\n45\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nForeign Currency Risk\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\nInterest Rate Risk\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\n46\nITEM 4. CONTROLS AND PROCEDURES\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\n47\nPART II - OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\nEmployment-Related Matters\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\nProceedings Relating to Take 5\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\nArbitration Proceedings Related to Take 5\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\n48\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\nOther Legal Matters Related to Take 5\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\nITEM 1A. RISK FACTORS\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\nSummary of Principal Risks Associated with Our Business\nSet forth below is a summary of some of the principal risks we face:\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\n•developments with respect to retailers that are out of our control;\n•our ability to continue to generate significant operating cash flow;\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\n•our reliance on continued access to retailers’ platforms;\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\n•client procurement strategies putting additional operational and financial pressure on our services;\n•our ability to maintain proper and effective internal control over financial reporting in the future;\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\n•our ability to avoid or manage business conflicts among competing brands;\n49\n•difficulties in integrating acquired businesses;\n•our substantial indebtedness and our ability to refinance at favorable rates;\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\n•our ability to respond to changes in digital practices and policies;\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\n•the ability to maintain applicable listing standards;\n•changes in applicable laws or regulations; and\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\nRisks Related to the Company’s Business and Industry\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\n•our ability to hire, timely train and retain talented individuals for our workforce;\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\n50\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\n•our ability to generate sufficient cash to service our substantial indebtedness;\n•our ability to maintain our credit rating;\n•our ability to offer high-quality customer support and maintain our reputation;\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\n•our ability to maintain our corporate culture;\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\n51\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\nInflation may adversely affect our operating results.\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\n52\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\nOur largest clients generate a significant portion of our revenues.\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\n53\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\n54\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\nWe may encounter significant difficulties integrating acquired businesses.\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\n55\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\n•the diversion of management attention to integration matters;\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\n•difficulties in assimilating, attracting and retaining key personnel;\n•challenges in keeping existing clients and obtaining new clients;\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\n56\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\n•costs of customizing services for clients outside of the United States;\n•the burdens of complying with a wide variety of foreign laws;\n•potential difficulty in enforcing contracts;\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\n•reduced protection for intellectual property rights;\n•increased financial accounting and reporting complexity;\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\n•exposure to foreign currency exchange rate fluctuations;\n•exposure to local economic conditions;\n•limitations on the repatriation of funds or profits from foreign operations;\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\n57\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\n58\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\n59\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\n60\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\n61\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\n62\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\nOur business is seasonal in nature and quarterly operating results can fluctuate.\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\n63\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\n64\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\n65\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\n•changes in the valuation of our deferred tax assets and liabilities;\n•expected timing and amount of the release of any tax valuation allowance;\n•tax effects of equity-based compensation;\n•changes in tax laws, regulations or interpretations thereof; or\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\n66\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\nRisks Related to Ownership of Our Common Stock\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\n•not permitting the use of cumulative voting for the election of directors;\n•permitting the removal of directors only for cause;\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\n67\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\n68\nAn active, liquid trading market for our Class A common stock may not be available.\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\n•you may not be able to liquidate your investment in shares of Class A common stock;\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\n•the market price of shares of Class A common stock may experience significant price volatility; and\n•there may be less efficiency in carrying out your purchase and sale orders.\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\n•quarterly variations in our operating results compared to market expectations;\n•changes in preferences of our clients;\n•announcements of new products or services or significant price reductions;\n•the size of our public float;\n•fluctuations in stock market prices and volumes;\n•defaults on our indebtedness;\n•changes in senior management or key personnel;\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\n•the payment of any dividends thereon in shares of our common stock;\n•changes in financial estimates or recommendations by securities analysts;\n•negative earnings or other announcements by us;\n•downgrades in our credit ratings;\n•material litigation or governmental investigations;\n•issuances of capital stock;\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\n69\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\nRisks Related to Indebtedness\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\n70\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\nThe elimination of LIBOR after June 2023 may affect our financial results\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\n71\nGeneral Risk Factors\nOur business and financial results may be affected by various litigation and regulatory proceedings.\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\nOur insurance may not provide adequate levels of coverage against claims.\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\nWe have incurred and will continue to incur increased costs as a public company.\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\nOur management has limited experience in operating a public company.\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\n72\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\nNone\nItem 3. Defaults Upon Senior Securities\nNone\nItem 4. Mine Safety Disclosures\nNone\n73\nItem 5. Other Information\nNone\nITEM 6. Exhibits\nThe following exhibits are filed with this Report:\n\n| ExhibitNumber | Description |\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\n| 32.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\n| 32.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\n\n***\n74\nSIGNATURES\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| ADVANTAGE SOLUTIONS INC. |\n| By: | /s/ Jill Griffin |\n| Jill Griffin |\n| Chief Executive Officer (Principal Executive Officer) |\n| Date: | November 9, 2022 |\n| By: | /s/ Brian Stevens |\n| Brian Stevens |\n| Chief Financial Officer and Chief Operating |\n| Officer (Principal Financial Officer) |\n| Date: | November 9, 2022 |\n\n75\n</text>\n\nWhat is the percentage change in the company's total net worth between July 1, 2021 and September 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nITEM 1. FINANCIAL STATEMENTS\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n(UNAUDITED)\\n\\n| September 30, | December 31, |\\n| (in thousands, except share data) | 2022 | 2021 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\\n| Restricted cash | 18,079 | 16,015 |\\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\\n| Total current assets | 1,103,155 | 1,104,314 |\\n| Property and equipment, net | 69,084 | 63,696 |\\n| Goodwill | 2,246,053 | 2,206,004 |\\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\\n| Other assets | 120,644 | 67,582 |\\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\\n| Current liabilities |\\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\\n| Accounts payable | 267,684 | 277,366 |\\n| Accrued compensation and benefits | 109,935 | 139,157 |\\n| Other accrued expenses | 161,246 | 164,133 |\\n| Deferred revenues | 47,441 | 50,467 |\\n| Total current liabilities | 601,010 | 645,520 |\\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\\n| Deferred income tax liabilities | 456,755 | 483,165 |\\n| Warrant liability | 733 | 22,189 |\\n| Other long-term liabilities | 109,421 | 92,218 |\\n| Total liabilities | 3,192,510 | 3,271,974 |\\n| Commitments and contingencies (Note 10) |\\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\\n| Equity attributable to stockholders of Advantage Solutions Inc. |\\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\\n| Additional paid in capital | 3,398,477 | 3,373,278 |\\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n3\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\\n(UNAUDITED)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\\n| Other (income) expenses: |\\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\\n| Other comprehensive loss, net of tax: |\\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\\n| Net income per common share: |\\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Weighted-average number of common shares: |\\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n4\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\n(UNAUDITED)\\n\\n| Accumulated | Advantage |\\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\\n\\n\\n| Accumulated | Advantage |\\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n5\\n\\n| Accumulated | Advantage |\\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\\n\\n\\n| Accumulated | Advantage |\\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n6\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n\\n| Nine Months Ended September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| CASH FLOWS FROM OPERATING ACTIVITIES |\\n| Net income | $ | 44,437 | $ | 29,535 |\\n| Adjustments to reconcile net income to net cash provided by operating activities |\\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\\n| Depreciation and amortization | 173,997 | 181,450 |\\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\\n| Stock-based compensation | 29,906 | 28,617 |\\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\\n| Loss on disposal of property and equipment | 608 | 6,327 |\\n| Loss on divestiture | 2,953 | — |\\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\\n| Accounts payable | ( 7,914 | ) | 37,294 |\\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\\n| Deferred revenues | ( 156 | ) | 2,869 |\\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\\n| Net cash provided by operating activities | 81,950 | 101,068 |\\n| CASH FLOWS FROM INVESTING ACTIVITIES |\\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\\n| Proceeds from divestiture | 1,896 | — |\\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\\n| CASH FLOWS FROM FINANCING ACTIVITIES |\\n| Borrowings under lines of credit | 140,333 | 51,685 |\\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\\n| Proceeds from issuance of long-term debt | 266 | — |\\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\\n| Proceeds from issuance of common stock | 3,320 | 794 |\\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\\n| Contribution from noncontrolling interest | 5,217 | — |\\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\\n| SUPPLEMENTAL CASH FLOW INFORMATION |\\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n7\\nADVANTAGE SOLUTIONS INC.\\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(UNAUDITED)\\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\\n9\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\\n\\n| (in thousands) |\\n| Consideration: |\\n| Cash | $ | 74,146 |\\n| Holdback | 810 |\\n| Fair value of contingent consideration | 510 |\\n| Total consideration | $ | 75,466 |\\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\\n| Assets |\\n| Accounts receivable | $ | 9,409 |\\n| Other assets | 3,446 |\\n| Identifiable intangible assets | 25,546 |\\n| Total assets | 38,401 |\\n| Liabilities |\\n| Accounts payable | 7,363 |\\n| Deferred tax liabilities and other | 8,744 |\\n| Total liabilities | 16,107 |\\n| Redeemable noncontrolling interest | 1,987 |\\n| Noncontrolling interest | 974 |\\n| Total identifiable net assets | 19,333 |\\n| Goodwill arising from acquisitions | $ | 56,133 |\\n| (in thousands) | Amount | WeightedAverageUseful Life |\\n| Client relationships | $ | 24,413 | 6 years |\\n| Trade names | 1,133 | 10 years |\\n| Total identifiable intangible assets | $ | 25,546 |\\n| (in thousands) |\\n| Consideration |\\n| Cash | $ | 40,046 |\\n| Holdbacks | 13,599 |\\n| Fair value of contingent consideration | 19,883 |\\n| Total consideration | $ | 73,528 |\\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\\n| Assets |\\n| Accounts receivable | $ | 12,834 |\\n| Other assets | 4,400 |\\n| Property and equipment | 1,001 |\\n| Identifiable intangible assets | 36,210 |\\n| Total assets | 54,445 |\\n| Liabilities |\\n| Total liabilities | 21,758 |\\n| Redeemable noncontrolling interest | 1,804 |\\n| Total identifiable net assets | 30,883 |\\n| Goodwill arising from acquisitions | $ | 42,645 |\\n| (in thousands) | Amount | WeightedAverageUseful Life |\\n| Client relationships | $ | 27,860 | 7 years |\\n| Trade Names | 5,250 | 5 years |\\n| Developed technology | 3,100 | 7 years |\\n| Total identifiable intangible assets | $ | 36,210 |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\\n\\n\\n| Sales | Marketing | Total |\\n| (in thousands) |\\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\\n| Acquisitions | 32,087 | 13,315 | 45,402 |\\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\\n| Acquisitions | 5,672 | 50,461 | 56,133 |\\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\\n| September 30, 2022 |\\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\\n| Finite-lived intangible assets: |\\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\\n| Indefinite-lived intangible assets: |\\n| Trade names | 900,000 | — | 900,000 |\\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\\n| December 31, 2021 |\\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\\n| Finite-lived intangible assets: |\\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\\n| Indefinite-lived intangible assets: |\\n| Trade names | 900,000 | — | 900,000 |\\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\\n| (in thousands) |\\n| Remainder of 2022 | $ | 49,782 |\\n| 2023 | 197,530 |\\n| 2024 | 196,181 |\\n| 2025 | 190,153 |\\n| 2026 | 186,203 |\\n| Thereafter | 430,226 |\\n| Total amortization expense | $ | 1,250,075 |\\n\\n\\n| September 30, | December 31, |\\n| (in thousands) | 2022 | 2021 |\\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\\n| Notes | 775,000 | 775,000 |\\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\\n| Other | 1,492 | 1,113 |\\n| Total long-term debt | 2,082,418 | 2,093,075 |\\n| Less: current portion | 14,704 | 14,397 |\\n| Less: debt issuance costs | 43,123 | 49,796 |\\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\\n\\n| September 30, 2022 |\\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\\n| Assets measured at fair value |\\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\\n| Liabilities measured at fair value |\\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\\n| December 31, 2021 |\\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\\n| Assets measured at fair value |\\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\\n| Liabilities measured at fair value |\\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\\n| Warrant liability | 22,189 | — | — | 22,189 |\\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\\n| September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\\n| Fair value of acquisitions | 510 | 19,883 |\\n| Changes in fair value | 5,448 | 6,977 |\\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\\n| Measurement period adjustments | — | ( 1,181 | ) |\\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\\n| End of the period | $ | 40,431 | $ | 65,112 |\\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\\n| Balance at September 30, 2022 |\\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\\n| Notes | 775,000 | 723,486 |\\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\\n| Other | 1,492 | 1,492 |\\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\\n| Balance at December 31, 2021 |\\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\\n| Notes | 775,000 | 894,611 |\\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\\n| Other | 1,113 | 1,113 |\\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\\n\\n\\n| Revenues | Accounts Receivable |\\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\\n\\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\\n| (in thousands) | Sales | Marketing | Total |\\n| Three Months Ended September 30, 2022 |\\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\\n| Three Months Ended September 30, 2021 |\\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\\n| (in thousands) | Sales | Marketing | Total |\\n| Nine Months Ended September 30, 2022 |\\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\\n| Nine Months Ended September 30, 2021 |\\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\\n\\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\\n| Performance Share Units | Weighted Average GrantDate Fair Value |\\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\\n| Granted | 5,393,085 | $ | 5.66 |\\n| Distributed | 660,880 | $ | 13.09 |\\n| Forfeited | 684,261 | $ | 8.19 |\\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\\n| Number of RSUs | Weighted Average GrantDate Fair Value |\\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\\n| Granted | 6,302,801 | $ | 5.74 |\\n| Distributed | 1,338,213 | $ | 10.61 |\\n| Forfeited | 869,955 | $ | 8.02 |\\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\\n| September 30, |\\n| 2022 |\\n| Share Price | $ | 5.99 |\\n| Dividend yield | 0.0 | % |\\n| Expected volatility | 30.0 | % |\\n| Risk-free interest rate | 2.0 | % |\\n| Expected term (years) | 6.5 |\\n\\n\\n| (in thousands) |\\n| Balance at January 1, 2022 | $ | 1,893 |\\n| Fair value at acquisition | 1,987 |\\n| Net income attributable to redeemable noncontrolling interests | 124 |\\n| Dividend distribution | ( 223 | ) |\\n| Foreign currency translation adjustment | ( 428 | ) |\\n| Balance at September 30, 2022 | $ | 3,353 |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\\n| Basic earnings per share computation: |\\n| Numerator: |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\\n| Denominator: |\\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Diluted earnings per share computation: |\\n| Numerator: |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\\n| Denominator: |\\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n\\n24\\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\\n25\\n\\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nForward-Looking Statements\\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\\nExecutive Overview\\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\\nWe have two reportable segments: sales and marketing.\\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\\n26\\nBusiness Combination with Conyers Park\\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\\nImpacts of the COVID-19 Pandemic\\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\\nSummary\\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\\nFactors Affecting Our Business and Financial Reporting\\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\\n27\\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\\n28\\nHow We Assess the Performance of Our Business\\nRevenues\\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\\n29\\nCost of Revenues\\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\\nOther (Income) Expenses\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\\nInterest Expense\\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\\nDepreciation and Amortization\\nAmortization Expense\\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\\n30\\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\\nDepreciation Expense\\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\\nIncome Taxes\\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\\nCash Flows\\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\\nAdjusted Net Income\\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\\n31\\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\\n| Other (income) expenses: |\\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\\n| Other Financial Data |\\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\\n\\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\\nComparison of the Three Months Ended September 30, 2022 and 2021\\nRevenues\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\\n\\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\\n32\\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\\nCost of Revenues\\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\\nDepreciation and Amortization Expense\\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\\nOperating Income\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\\n\\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\\n33\\nInterest Expense, net\\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\\nProvision for Income Taxes\\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\\nNet Income\\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\\nAdjusted Net Income\\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\\n\\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\\nComparison of the Nine Months Ended September 30, 2022 and 2021\\nRevenues\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\\n\\n34\\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\\nCost of Revenues\\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\\nDepreciation and Amortization Expense\\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\\nOperating Income\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\\n\\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\\n35\\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\\nInterest Expense, net\\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\\nProvision for Income Taxes\\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\\nNet Income\\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\\nAdjusted Net Income\\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\\n\\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\\n36\\nNon-GAAP Financial Measures\\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\\n| Add: |\\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\\n\\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\\n37\\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\\n\\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\\n| Add: |\\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\\n\\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\\n\\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\\n| Add: |\\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\\n\\n38\\n\\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\\n| Add: |\\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\\n\\n\\n\\n\\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\\n\\n39\\nLiquidity and Capital Resources\\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\\nCash Flows\\nA summary of our cash operating, investing and financing activities are shown in the following table:\\n\\n| Nine Months Ended September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\\n\\nNet Cash Provided by Operating Activities\\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\\nNet Cash Used in Investing Activities\\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\\nNet Cash Used in Financing Activities\\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\\n40\\nDescription of Credit Facilities\\nSenior Secured Credit Facilities\\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\\nRevolving Credit Facility\\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\\n41\\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\\nTerm Loan Facility\\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\\n42\\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\\nSenior Secured Notes\\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\\nInterest and maturity\\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\\nGuarantees\\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\\nSecurity and Ranking\\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\\n43\\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\\nOptional redemption for the Notes\\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\\nRestrictive covenants\\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\\nEvents of default\\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\\nFuture Cash Requirement\\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\\n44\\nCash and Cash Equivalents Held Outside the United States\\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\\nOff-Balance Sheet Arrangements\\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\\nCritical Accounting Policies and Estimates\\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\\nRecently Issued Accounting Pronouncements\\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\\n45\\n\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nForeign Currency Risk\\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\\nInterest Rate Risk\\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\\n46\\n\\nITEM 4. CONTROLS AND PROCEDURES\\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\\n47\\nPART II - OTHER INFORMATION\\n\\nITEM 1. LEGAL PROCEEDINGS\\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\\nEmployment-Related Matters\\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\\nProceedings Relating to Take 5\\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\\nArbitration Proceedings Related to Take 5\\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\\n48\\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\\nOther Legal Matters Related to Take 5\\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\\n\\nITEM 1A. RISK FACTORS\\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\\nSummary of Principal Risks Associated with Our Business\\nSet forth below is a summary of some of the principal risks we face:\\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\\n•developments with respect to retailers that are out of our control;\\n•our ability to continue to generate significant operating cash flow;\\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\\n•our reliance on continued access to retailers’ platforms;\\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\\n•client procurement strategies putting additional operational and financial pressure on our services;\\n•our ability to maintain proper and effective internal control over financial reporting in the future;\\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\\n•our ability to avoid or manage business conflicts among competing brands;\\n49\\n•difficulties in integrating acquired businesses;\\n•our substantial indebtedness and our ability to refinance at favorable rates;\\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\\n•our ability to respond to changes in digital practices and policies;\\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\\n•the ability to maintain applicable listing standards;\\n•changes in applicable laws or regulations; and\\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\\nRisks Related to the Company’s Business and Industry\\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\\n•our ability to hire, timely train and retain talented individuals for our workforce;\\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\\n50\\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\\n•our ability to generate sufficient cash to service our substantial indebtedness;\\n•our ability to maintain our credit rating;\\n•our ability to offer high-quality customer support and maintain our reputation;\\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\\n•our ability to maintain our corporate culture;\\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\\n51\\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\\nInflation may adversely affect our operating results.\\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\\n52\\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\\nOur largest clients generate a significant portion of our revenues.\\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\\n53\\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\\n54\\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\\nWe may encounter significant difficulties integrating acquired businesses.\\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\\n55\\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\\n•the diversion of management attention to integration matters;\\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\\n•difficulties in assimilating, attracting and retaining key personnel;\\n•challenges in keeping existing clients and obtaining new clients;\\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\\n56\\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\\n•costs of customizing services for clients outside of the United States;\\n•the burdens of complying with a wide variety of foreign laws;\\n•potential difficulty in enforcing contracts;\\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\\n•reduced protection for intellectual property rights;\\n•increased financial accounting and reporting complexity;\\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\\n•exposure to foreign currency exchange rate fluctuations;\\n•exposure to local economic conditions;\\n•limitations on the repatriation of funds or profits from foreign operations;\\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\\n57\\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\\n58\\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\\n59\\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\\n60\\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\\n61\\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\\n62\\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\\nOur business is seasonal in nature and quarterly operating results can fluctuate.\\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\\n63\\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\\n64\\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\\n65\\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\\n•changes in the valuation of our deferred tax assets and liabilities;\\n•expected timing and amount of the release of any tax valuation allowance;\\n•tax effects of equity-based compensation;\\n•changes in tax laws, regulations or interpretations thereof; or\\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\\n66\\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\\nRisks Related to Ownership of Our Common Stock\\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\\n•not permitting the use of cumulative voting for the election of directors;\\n•permitting the removal of directors only for cause;\\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\\n67\\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\\n68\\nAn active, liquid trading market for our Class A common stock may not be available.\\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\\n•you may not be able to liquidate your investment in shares of Class A common stock;\\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\\n•the market price of shares of Class A common stock may experience significant price volatility; and\\n•there may be less efficiency in carrying out your purchase and sale orders.\\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\\n•quarterly variations in our operating results compared to market expectations;\\n•changes in preferences of our clients;\\n•announcements of new products or services or significant price reductions;\\n•the size of our public float;\\n•fluctuations in stock market prices and volumes;\\n•defaults on our indebtedness;\\n•changes in senior management or key personnel;\\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\\n•the payment of any dividends thereon in shares of our common stock;\\n•changes in financial estimates or recommendations by securities analysts;\\n•negative earnings or other announcements by us;\\n•downgrades in our credit ratings;\\n•material litigation or governmental investigations;\\n•issuances of capital stock;\\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\\n69\\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\nRisks Related to Indebtedness\\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\\n70\\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\\nThe elimination of LIBOR after June 2023 may affect our financial results\\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\\n71\\nGeneral Risk Factors\\nOur business and financial results may be affected by various litigation and regulatory proceedings.\\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\\nOur insurance may not provide adequate levels of coverage against claims.\\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\\nWe have incurred and will continue to incur increased costs as a public company.\\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\\nOur management has limited experience in operating a public company.\\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\\n72\\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nNone\\n\\nItem 3. Defaults Upon Senior Securities\\nNone\\n\\nItem 4. Mine Safety Disclosures\\nNone\\n73\\n\\nItem 5. Other Information\\nNone\\n\\nItem 6. Exhibits\\n74\\nSignatures 75\\n2\\nPART I - FINANCIAL INFORMATION\\nITEM 1. FINANCIAL STATEMENTS\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED BALANCE SHEETS\\n(UNAUDITED)\\n\\n| September 30, | December 31, |\\n| (in thousands, except share data) | 2022 | 2021 |\\n| ASSETS |\\n| Current assets |\\n| Cash and cash equivalents | $ | 96,215 | $ | 164,622 |\\n| Restricted cash | 18,079 | 16,015 |\\n| Accounts receivable, net of allowance for expected credit losses of $ 13,648 and $ 15,916 , respectively | 833,432 | 797,677 |\\n| Prepaid expenses and other current assets | 155,429 | 126,000 |\\n| Total current assets | 1,103,155 | 1,104,314 |\\n| Property and equipment, net | 69,084 | 63,696 |\\n| Goodwill | 2,246,053 | 2,206,004 |\\n| Other intangible assets, net | 2,150,075 | 2,287,514 |\\n| Investments in unconsolidated affiliates | 124,815 | 125,158 |\\n| Other assets | 120,644 | 67,582 |\\n| Total assets | $ | 5,813,826 | $ | 5,854,268 |\\n| LIABILITIES AND STOCKHOLDERS’ EQUITY |\\n| Current liabilities |\\n| Current portion of long-term debt | $ | 14,704 | $ | 14,397 |\\n| Accounts payable | 267,684 | 277,366 |\\n| Accrued compensation and benefits | 109,935 | 139,157 |\\n| Other accrued expenses | 161,246 | 164,133 |\\n| Deferred revenues | 47,441 | 50,467 |\\n| Total current liabilities | 601,010 | 645,520 |\\n| Long-term debt, net of current portion | 2,024,591 | 2,028,882 |\\n| Deferred income tax liabilities | 456,755 | 483,165 |\\n| Warrant liability | 733 | 22,189 |\\n| Other long-term liabilities | 109,421 | 92,218 |\\n| Total liabilities | 3,192,510 | 3,271,974 |\\n| Commitments and contingencies (Note 10) |\\n| Redeemable noncontrolling interest | 3,353 | 1,893 |\\n| Equity attributable to stockholders of Advantage Solutions Inc. |\\n| Common stock, $ 0.0001 par value, 3,290,000,000 shares authorized; 319,675,888 and 316,963,552 shares issued and outstanding as of September 30, 2022 and December 31, 2021, respectively | 32 | 32 |\\n| Additional paid in capital | 3,398,477 | 3,373,278 |\\n| Accumulated deficit | ( 823,212 | ) | ( 866,607 | ) |\\n| Loans to Karman Topco L.P. | ( 6,357 | ) | ( 6,340 | ) |\\n| Accumulated other comprehensive loss | ( 29,978 | ) | ( 4,479 | ) |\\n| Treasury stock, at cost; 1,610,014 shares as of September 30, 2022 and December 31, 2021 | ( 12,567 | ) | ( 12,567 | ) |\\n| Total equity attributable to stockholders of Advantage Solutions Inc. | 2,526,395 | 2,483,317 |\\n| Nonredeemable noncontrolling interest | 91,568 | 97,084 |\\n| Total stockholders’ equity | 2,617,963 | 2,580,401 |\\n| Total liabilities, redeemable noncontrolling interest, and stockholders’ equity | $ | 5,813,826 | $ | 5,854,268 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n3\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME\\n(UNAUDITED)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in thousands, except share and per share data) | 2022 | 2021 | 2022 | 2021 |\\n| Revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\\n| Cost of revenues (exclusive of depreciation and amortization shown separately below) | 908,523 | 766,253 | 2,536,256 | 2,117,818 |\\n| Selling, general, and administrative expenses | 37,945 | 37,742 | 138,594 | 124,830 |\\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\\n| Total operating expenses | 1,004,253 | 863,158 | 2,848,847 | 2,424,098 |\\n| Operating income | 46,842 | 65,602 | 98,132 | 145,637 |\\n| Other (income) expenses: |\\n| Change in fair value of warrant liability | ( 1,100 | ) | ( 3,491 | ) | ( 21,456 | ) | ( 5,024 | ) |\\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\\n| Total other expenses | 22,457 | 32,999 | 42,172 | 99,520 |\\n| Income before income taxes | 24,385 | 32,603 | 55,960 | 46,117 |\\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\\n| Net income | 23,227 | 24,327 | 44,437 | 29,535 |\\n| Less: net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | 21,059 | 23,311 | 43,395 | 29,316 |\\n| Other comprehensive loss, net of tax: |\\n| Foreign currency translation adjustments | ( 13,616 | ) | ( 2,443 | ) | ( 25,499 | ) | ( 4,239 | ) |\\n| Total comprehensive income attributable to stockholders of Advantage Solutions Inc. | $ | 7,443 | $ | 20,868 | $ | 17,896 | $ | 25,077 |\\n| Net income per common share: |\\n| Basic | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Diluted | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Weighted-average number of common shares: |\\n| Basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n4\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY\\n(UNAUDITED)\\n\\n| Accumulated | Advantage |\\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at July 1, 2022 | 318,465,449 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,390,899 | $ | ( 844,271 | ) | $ | ( 6,351 | ) | $ | ( 16,362 | ) | $ | 2,511,380 | $ | 90,109 | $ | 2,601,489 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | — | — | 21,059 | — | — | 21,059 | 2,092 | 23,151 |\\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 13,616 | ) | ( 13,616 | ) | ( 6,824 | ) | ( 20,440 | ) |\\n| Total comprehensive income (loss) | 7,443 | ( 4,732 | ) | 2,711 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 828 | ) | — | — | — | ( 828 | ) | — | ( 828 | ) |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 470,786 | — | — | — | 1,667 | — | — | — | 1,667 | — | 1,667 |\\n| Shares issued under 2020 Incentive Award Plan | 739,653 | — | — | — | — | — | — | — | — | — | — |\\n| Stock-based compensation expense | — | — | — | — | 6,739 | — | — | — | 6,739 | — | 6,739 |\\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | $ | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\\n\\n\\n| Accumulated | Advantage |\\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at July 1, 2021 | 318,496,390 | $ | 32 | $ | 3,361,262 | $ | ( 915,096 | ) | $ | ( 6,328 | ) | $ | ( 1,122 | ) | $ | 2,438,748 | $ | 95,916 | $ | 2,534,664 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | 23,311 | — | — | 23,311 | 973 | 24,284 |\\n| Foreign currency translation adjustments | — | — | — | — | — | ( 2,443 | ) | ( 2,443 | ) | ( 2,305 | ) | ( 4,748 | ) |\\n| Total comprehensive income (loss) | 20,868 | ( 1,332 | ) | 19,536 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 6 | ) | — | ( 6 | ) | — | ( 6 | ) |\\n| Redemption of noncontrolling interest | — | — | ( 16 | ) | — | — | — | ( 16 | ) | — | ( 16 | ) |\\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 6,030 | ) | — | — | — | ( 6,030 | ) | — | ( 6,030 | ) |\\n| Shares issued upon exercise of warrants | 1 | — | — | — | — | — | — | — | — |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\\n| Stock-based compensation expense | — | — | 8,413 | — | — | — | 8,413 | — | 8,413 |\\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n5\\n\\n| Accumulated | Advantage |\\n| Common Stock | Treasury Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at January 1, 2022 | 316,963,552 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,373,278 | $ | ( 866,607 | ) | $ | ( 6,340 | ) | $ | ( 4,479 | ) | $ | 2,483,317 | $ | 97,084 | $ | 2,580,401 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | — | — | 43,395 | — | — | 43,395 | 918 | 44,313 |\\n| Foreign currency translation adjustments | — | — | — | — | — | — | — | ( 25,499 | ) | ( 25,499 | ) | ( 12,625 | ) | ( 38,124 | ) |\\n| Total comprehensive income (loss) | — | — | — | — | — | — | — | — | 17,896 | ( 11,707 | ) | 6,189 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | — | — | ( 17 | ) | — | ( 17 | ) | — | ( 17 | ) |\\n| Increase in noncontrolling interest | — | — | — | — | — | — | — | — | — | 6,191 | 6,191 |\\n| Equity-based compensation of Karman Topco L.P. | — | — | — | — | ( 7,142 | ) | — | — | — | ( 7,142 | ) | — | ( 7,142 | ) |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 713,213 | — | — | — | 3,320 | — | — | — | 3,320 | — | 3,320 |\\n| Shares issued under 2020 Incentive Award Plan | 1,999,123 | — | — | — | — | — | — | — | — | — | — |\\n| Stock-based compensation expense | — | — | — | — | 29,021 | — | — | — | 29,021 | — | 29,021 |\\n| Balance at September 30, 2022 | 319,675,888 | $ | 32 | 1,610,014 | $ | ( 12,567 | ) | $ | 3,398,477 | $ | ( 823,212 | ) | $ | ( 6,357 | ) | $ | ( 29,978 | ) | $ | 2,526,395 | $ | 91,568 | $ | 2,617,963 |\\n\\n\\n| Accumulated | Advantage |\\n| Common Stock | Additional | Loans | Other | Solutions Inc. | Nonredeemable | Total |\\n| Paid-in | Accumulated | to | Comprehensive | Stockholders' | Noncontrolling | Stockholders' |\\n| Shares | Amount | Capital | Deficit | Topco | Income (Loss) | Equity | Interests | Equity |\\n| (in thousands, except share data) |\\n| Balance at January 1, 2021 | 318,425,182 | $ | 32 | $ | 3,348,546 | $ | ( 921,101 | ) | $ | ( 6,316 | ) | $ | 674 | $ | 2,421,835 | $ | 96,954 | $ | 2,518,789 |\\n| Comprehensive income (loss) |\\n| Net income | — | — | — | 29,316 | — | — | 29,316 | 190 | 29,506 |\\n| Foreign currency translation adjustments | — | — | — | — | — | ( 4,239 | ) | ( 4,239 | ) | ( 2,796 | ) | ( 7,035 | ) |\\n| Total comprehensive income (loss) | 25,077 | ( 2,606 | ) | 22,471 |\\n| Interest on loans to Karman Topco L.P. | — | — | — | — | ( 18 | ) | — | ( 18 | ) | — | ( 18 | ) |\\n| Redemption of noncontrolling interest | — | — | ( 452 | ) | — | — | — | ( 452 | ) | 236 | ( 216 | ) |\\n| Equity-based compensation of Karman Topco L.P. | — | — | ( 13,140 | ) | — | — | — | ( 13,140 | ) | — | ( 13,140 | ) |\\n| Shares issued under 2020 Incentive Award Plan | 24,784 | — | — | — | — | — | — | — | — |\\n| Shares issued upon vesting of restricted stock units | 41,424 | — | — | — | — | — | — | — | — |\\n| Shares issued under 2020 Employee Stock Purchase Plan | 77,172 | — | 736 | — | — | — | 736 | — | 736 |\\n| Shares issued upon exercise of warrants | 5,001 | — | 58 | — | — | — | 58 | — | 58 |\\n| Stock-based compensation expense | — | — | 28,617 | — | — | — | 28,617 | — | 28,617 |\\n| Balance at September 30, 2021 | 318,573,563 | $ | 32 | $ | 3,364,365 | $ | ( 891,785 | ) | $ | ( 6,334 | ) | $ | ( 3,565 | ) | $ | 2,462,713 | $ | 94,584 | $ | 2,557,297 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n6\\nADVANTAGE SOLUTIONS INC.\\nCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n\\n| Nine Months Ended September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| CASH FLOWS FROM OPERATING ACTIVITIES |\\n| Net income | $ | 44,437 | $ | 29,535 |\\n| Adjustments to reconcile net income to net cash provided by operating activities |\\n| Noncash interest (income) expense, net | ( 34,419 | ) | 2,893 |\\n| Depreciation and amortization | 173,997 | 181,450 |\\n| Change in fair value of warrant liability | ( 21,456 | ) | ( 5,024 | ) |\\n| Fair value adjustments related to contingent consideration | 5,448 | 6,977 |\\n| Deferred income taxes | ( 28,561 | ) | ( 17,468 | ) |\\n| Equity-based compensation of Karman Topco L.P. | ( 7,142 | ) | ( 13,140 | ) |\\n| Stock-based compensation | 29,906 | 28,617 |\\n| Equity in earnings of unconsolidated affiliates | ( 6,480 | ) | ( 6,222 | ) |\\n| Distribution received from unconsolidated affiliates | 1,339 | 1,154 |\\n| Loss on disposal of property and equipment | 608 | 6,327 |\\n| Loss on divestiture | 2,953 | — |\\n| Changes in operating assets and liabilities, net of effects from purchases of businesses: |\\n| Accounts receivable, net | ( 45,383 | ) | ( 121,036 | ) |\\n| Prepaid expenses and other assets | ( 45,087 | ) | ( 64,716 | ) |\\n| Accounts payable | ( 7,914 | ) | 37,294 |\\n| Accrued compensation and benefits | ( 26,316 | ) | 16,684 |\\n| Deferred revenues | ( 156 | ) | 2,869 |\\n| Other accrued expenses and other liabilities | 46,176 | 14,874 |\\n| Net cash provided by operating activities | 81,950 | 101,068 |\\n| CASH FLOWS FROM INVESTING ACTIVITIES |\\n| Purchase of businesses, net of cash acquired | ( 74,146 | ) | ( 40,046 | ) |\\n| Purchase of investment in unconsolidated affiliates | ( 775 | ) | ( 2,000 | ) |\\n| Purchase of property and equipment | ( 30,037 | ) | ( 24,106 | ) |\\n| Proceeds from divestiture | 1,896 | — |\\n| Net cash used in investing activities | ( 103,062 | ) | ( 66,152 | ) |\\n| CASH FLOWS FROM FINANCING ACTIVITIES |\\n| Borrowings under lines of credit | 140,333 | 51,685 |\\n| Payments on lines of credit | ( 139,684 | ) | ( 102,493 | ) |\\n| Proceeds from issuance of long-term debt | 266 | — |\\n| Principal payments on long-term debt | ( 10,427 | ) | ( 10,133 | ) |\\n| Proceeds from issuance of common stock | 3,320 | 794 |\\n| Contingent consideration payments | ( 23,164 | ) | ( 6,247 | ) |\\n| Holdback payments | ( 8,557 | ) | ( 2,389 | ) |\\n| Contribution from noncontrolling interest | 5,217 | — |\\n| Redemption of noncontrolling interest | ( 224 | ) | ( 216 | ) |\\n| Net cash used in financing activities | ( 32,920 | ) | ( 68,999 | ) |\\n| Net effect of foreign currency changes on cash | ( 12,311 | ) | ( 1,476 | ) |\\n| Net change in cash, cash equivalents and restricted cash | ( 66,343 | ) | ( 35,559 | ) |\\n| Cash, cash equivalents and restricted cash, beginning of period | 180,637 | 219,966 |\\n| Cash, cash equivalents and restricted cash, end of period | $ | 114,294 | $ | 184,407 |\\n| SUPPLEMENTAL CASH FLOW INFORMATION |\\n| Purchase of property and equipment recorded in accounts payable and accrued expenses | $ | 1,409 | $ | 322 |\\n\\nSee Notes to the Condensed Consolidated Financial Statements.\\n7\\nADVANTAGE SOLUTIONS INC.\\nNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS\\n(UNAUDITED)\\n1. Organization and Significant Accounting Policies Advantage Solutions Inc. (the “Company”) is a provider of outsourced solutions to consumer goods companies and retailers. The Company’s Class A common stock is listed on the Nasdaq Global Select Market under the symbol “ADV” and warrants to purchase the Class A common stock at an exercise price of $ 11.50 per share are listed on the Nasdaq Global Select Market under the symbol “ADVWW”. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries. The unaudited condensed consolidated financial statements do not include all of the information required by accounting principles generally accepted in the United States (“GAAP”). The Condensed Consolidated Balance Sheet at December 31, 2021 was derived from the audited Consolidated Balance Sheet at that date and does not include all the disclosures required by GAAP. In the opinion of management, all adjustments which are of a normal recurring nature and necessary for a fair statement of the results as of September 30, 2022 and for the three and nine months ended September 30, 2022 and 2021 have been reflected in the condensed consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2021 and the related footnotes thereto. Operating results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. COVID-19 Pandemic Beginning in March 2020 and continuing through the first quarter of 2021, the Company’s services experienced the most severe effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of the Company’s services and markets. Globally, the most impacted services were the Company's experiential services. Most services began to recover in April 2021, and the recovery has continued through the third quarter of 2022. Impact of the War in Ukraine The Company has a minority interest in a European company that has majority-ownership interests in local agencies in Russia. During the first quarter of 2022, the war in Ukraine resulted in the imposition of sanctions by the United States, the United Kingdom, and the European Union, that affected, and continues to affect, the cross-border operations of businesses operating in Russia. In addition, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding the Company's ability to recover its investment in operations in Russia, as well as the Company's ability to exercise control or influence over operations by the local agencies in Russia. As a result, the Company intends to use its influence to cause the European company to dispose of its ownership interests in the local agencies in Russia. Accordingly, the Company recorded pretax charges of $ 2.8 million in the first quarter of 2022, primarily consisting of its proportionate share of the net investment in its Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income. Recent Accounting StandardsAccounting Standards Recently Adopted by the CompanyIn March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on 8 Financial Reporting. This guidance provides optional expedients and exceptions for GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate if certain criteria are met. The amendments in this update are effective for reporting periods that include or are subsequent to March 12, 2020 and must be applied prospectively to contract modifications and hedging relationships through December 31, 2022. On April 1, 2022, the Company adopted the standard prospectively and determined that the adoption of this accounting guidance did not have a material impact on its condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU No. 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP, simplifies the contract settlement assessment for equity classification, requires the use of the if-converted method for all convertible instruments in the diluted earnings per share calculation and expands disclosure requirements. The adoption of this accounting standard, under the full retrospective method, did not have a material impact on the Company's condensed consolidated financial statements and use of the if-converted method did not have an impact on the Company's overall earnings per share calculation.On January 1, 2022, the Company adopted ASU 2021-04, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the FASB Emerging Issues Task Force). The guidance clarifies certain aspects of the current guidance to promote consistency among reporting of an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity-classified after modification or exchange. The guidance is applied prospectively to all modifications or exchanges that occur on or after the date of adoption and the adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements.On January 1, 2022, the Company adopted ASU 2021-10, Government Assistance (Topic 832): Disclosures by Business Entities about Government Assistance. This update requires annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy. The guidance is applied prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application. The adoption of this accounting standard did not have a material impact on the Company’s condensed consolidated financial statements. Accounting Standards Recently Issued but Not Yet Adopted by the CompanyIn October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 606): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires that an entity recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606 as if it had originated the contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements, if the acquiree prepared financial statements in accordance with GAAP. The amendment in this update is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendment in this update. The Company is evaluating the potential impact of this adoption on its consolidated financial statements. All other new accounting pronouncements issued, but not yet effective or adopted have been deemed to be not relevant to the Company and, accordingly, are not expected to have a material impact once adopted.\\n9\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Sales brand-centric services | $ | 343,478 | $ | 330,740 | $ | 1,005,707 | $ | 946,147 |\\n| Sales retail-centric services | 302,768 | 266,399 | 836,640 | 746,960 |\\n| Total sales revenues | 646,246 | 597,139 | 1,842,347 | 1,693,107 |\\n| Marketing brand-centric services | 143,241 | 142,554 | 393,155 | 381,358 |\\n| Marketing retail-centric services | 261,608 | 189,067 | 711,477 | 495,270 |\\n| Total marketing revenues | 404,849 | 331,621 | 1,104,632 | 876,628 |\\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 2,946,979 | $ | 2,569,735 |\\n\\n| (in thousands) |\\n| Consideration: |\\n| Cash | $ | 74,146 |\\n| Holdback | 810 |\\n| Fair value of contingent consideration | 510 |\\n| Total consideration | $ | 75,466 |\\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\\n| Assets |\\n| Accounts receivable | $ | 9,409 |\\n| Other assets | 3,446 |\\n| Identifiable intangible assets | 25,546 |\\n| Total assets | 38,401 |\\n| Liabilities |\\n| Accounts payable | 7,363 |\\n| Deferred tax liabilities and other | 8,744 |\\n| Total liabilities | 16,107 |\\n| Redeemable noncontrolling interest | 1,987 |\\n| Noncontrolling interest | 974 |\\n| Total identifiable net assets | 19,333 |\\n| Goodwill arising from acquisitions | $ | 56,133 |\\n| (in thousands) | Amount | WeightedAverageUseful Life |\\n| Client relationships | $ | 24,413 | 6 years |\\n| Trade names | 1,133 | 10 years |\\n| Total identifiable intangible assets | $ | 25,546 |\\n| (in thousands) |\\n| Consideration |\\n| Cash | $ | 40,046 |\\n| Holdbacks | 13,599 |\\n| Fair value of contingent consideration | 19,883 |\\n| Total consideration | $ | 73,528 |\\n| Recognized amounts of identifiable assets acquired and liabilities assumed: |\\n| Assets |\\n| Accounts receivable | $ | 12,834 |\\n| Other assets | 4,400 |\\n| Property and equipment | 1,001 |\\n| Identifiable intangible assets | 36,210 |\\n| Total assets | 54,445 |\\n| Liabilities |\\n| Total liabilities | 21,758 |\\n| Redeemable noncontrolling interest | 1,804 |\\n| Total identifiable net assets | 30,883 |\\n| Goodwill arising from acquisitions | $ | 42,645 |\\n| (in thousands) | Amount | WeightedAverageUseful Life |\\n| Client relationships | $ | 27,860 | 7 years |\\n| Trade Names | 5,250 | 5 years |\\n| Developed technology | 3,100 | 7 years |\\n| Total identifiable intangible assets | $ | 36,210 |\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Revenues | $ | 1,052,274 | $ | 963,576 | $ | 2,962,479 | $ | 2,719,111 |\\n| Net income | $ | 21,467 | $ | 23,896 | $ | 46,461 | $ | 32,590 |\\n\\n\\n| Sales | Marketing | Total |\\n| (in thousands) |\\n| Balance at January 1, 2021 | $ | 1,462,378 | $ | 700,961 | $ | 2,163,339 |\\n| Acquisitions | 32,087 | 13,315 | 45,402 |\\n| Measurement period adjustments | 179 | ( 1,043 | ) | ( 864 | ) |\\n| Foreign exchange translation effects | ( 1,873 | ) | — | ( 1,873 | ) |\\n| Balance at December 31, 2021 | $ | 1,492,771 | $ | 713,233 | $ | 2,206,004 |\\n| Acquisitions | 5,672 | 50,461 | 56,133 |\\n| Measurement period adjustments | ( 446 | ) | — | ( 446 | ) |\\n| Foreign exchange translation effects | ( 15,638 | ) | — | ( 15,638 | ) |\\n| Balance at September 30, 2022 | $ | 1,482,359 | $ | 763,694 | $ | 2,246,053 |\\n| September 30, 2022 |\\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\\n| Finite-lived intangible assets: |\\n| Client relationships | 14 years | $ | 2,486,064 | $ | 1,290,842 | $ | 1,195,222 |\\n| Trade names | 8 years | 135,271 | 84,067 | 51,204 |\\n| Developed technology | 5 years | 13,260 | 9,870 | 3,390 |\\n| Covenant not to compete | 5 years | 6,100 | 5,841 | 259 |\\n| Total finite-lived intangible assets | 2,640,695 | 1,390,620 | 1,250,075 |\\n| Indefinite-lived intangible assets: |\\n| Trade names | 900,000 | — | 900,000 |\\n| Total other intangible assets | $ | 3,540,695 | $ | 1,390,620 | $ | 2,150,075 |\\n| December 31, 2021 |\\n| (amounts in thousands) | Weighted Average Useful Life | Gross CarryingValue | AccumulatedAmortization | Net Carrying Value |\\n| Finite-lived intangible assets: |\\n| Client relationships | 14 years | $ | 2,480,167 | $ | 1,158,732 | $ | 1,321,435 |\\n| Trade names | 8 years | 138,206 | 78,355 | 59,851 |\\n| Developed technology | 5 years | 13,260 | 8,206 | 5,054 |\\n| Covenant not to compete | 5 years | 6,100 | 4,926 | 1,174 |\\n| Total finite-lived intangible assets | 2,637,733 | 1,250,219 | 1,387,514 |\\n| Indefinite-lived intangible assets: |\\n| Trade names | 900,000 | — | 900,000 |\\n| Total other intangible assets | $ | 3,537,733 | $ | 1,250,219 | $ | 2,287,514 |\\n| (in thousands) |\\n| Remainder of 2022 | $ | 49,782 |\\n| 2023 | 197,530 |\\n| 2024 | 196,181 |\\n| 2025 | 190,153 |\\n| 2026 | 186,203 |\\n| Thereafter | 430,226 |\\n| Total amortization expense | $ | 1,250,075 |\\n\\n\\n| September 30, | December 31, |\\n| (in thousands) | 2022 | 2021 |\\n| Term Loan Facility | $ | 1,301,813 | $ | 1,311,750 |\\n| Notes | 775,000 | 775,000 |\\n| Government loans for COVID-19 relief | 4,113 | 5,212 |\\n| Other | 1,492 | 1,113 |\\n| Total long-term debt | 2,082,418 | 2,093,075 |\\n| Less: current portion | 14,704 | 14,397 |\\n| Less: debt issuance costs | 43,123 | 49,796 |\\n| Long-term debt, net of current portion | $ | 2,024,591 | $ | 2,028,882 |\\n\\n| September 30, 2022 |\\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\\n| Assets measured at fair value |\\n| Derivative financial instruments | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\\n| Total assets measured at fair value | $ | 49,149 | $ | — | $ | 49,149 | $ | — |\\n| Liabilities measured at fair value |\\n| Warrant liability | $ | 733 | $ | — | $ | 733 | $ | — |\\n| Contingent consideration liabilities | 40,431 | — | — | 40,431 |\\n| Total liabilities measured at fair value | $ | 41,164 | $ | — | $ | 733 | $ | 40,431 |\\n| December 31, 2021 |\\n| (in thousands) | Fair Value | Level 1 | Level 2 | Level 3 |\\n| Assets measured at fair value |\\n| Derivative financial instruments | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\\n| Total assets measured at fair value | $ | 10,164 | $ | — | $ | 10,164 | $ | — |\\n| Liabilities measured at fair value |\\n| Derivative financial instruments | $ | 385 | $ | — | $ | 385 | $ | — |\\n| Warrant liability | 22,189 | — | — | 22,189 |\\n| Contingent consideration liabilities | 58,366 | — | — | 58,366 |\\n| Total liabilities measured at fair value | $ | 80,940 | $ | — | $ | 385 | $ | 80,555 |\\n| September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| Beginning of the period | $ | 58,366 | $ | 45,901 |\\n| Fair value of acquisitions | 510 | 19,883 |\\n| Changes in fair value | 5,448 | 6,977 |\\n| Payments | ( 23,164 | ) | ( 6,399 | ) |\\n| Measurement period adjustments | — | ( 1,181 | ) |\\n| Foreign exchange translation effects | ( 729 | ) | ( 69 | ) |\\n| End of the period | $ | 40,431 | $ | 65,112 |\\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\\n| Balance at September 30, 2022 |\\n| Term Loan Facility | $ | 1,301,813 | $ | 1,329,741 |\\n| Notes | 775,000 | 723,486 |\\n| Government loans for COVID-19 relief | 4,113 | 4,306 |\\n| Other | 1,492 | 1,492 |\\n| Total long-term debt | $ | 2,082,418 | $ | 2,059,025 |\\n| (in thousands) | Carrying Value | Fair Value(Level 2) |\\n| Balance at December 31, 2021 |\\n| Term Loan Facility | $ | 1,311,750 | $ | 1,406,552 |\\n| Notes | 775,000 | 894,611 |\\n| Government loans for COVID-19 relief | 5,212 | 5,615 |\\n| Other | 1,113 | 1,113 |\\n| Total long-term debt | $ | 2,093,075 | $ | 2,307,891 |\\n\\n\\n| Revenues | Accounts Receivable |\\n| Three Months Ended September 30, | Nine Months Ended September 30, | As of September 30, | As of December 31, |\\n| (in thousands) | 2022 | 2021 | 2022 | 2021 | 2022 | 2021 |\\n| Client 1 | $ | 450 | $ | — | $ | 1,275 | $ | — | $ | 301 | $ | 176 |\\n| Client 2 | 136 | 42 | 668 | 75 | 289 | 160 |\\n| Client 3 | 147 | 124 | 455 | 457 | 129 | 190 |\\n| All other clients | 30 | 1,452 | 152 | 6,694 | 16 | 10 |\\n| Total | $ | 763 | $ | 1,618 | $ | 2,550 | $ | 7,226 | $ | 735 | $ | 536 |\\n\\n8. Income TaxesThe Company’s effective tax rates were 4.7 % and 25.4 % for the three months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the three months pretax book income differences and the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the three months ended September 30, 2022, no t included in the three months ended September 30, 2021.The Company’s effective tax rates were 20.6 % and 36.0 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate is based upon the estimated income or loss before taxes for the year, by jurisdiction, and adjusted for estimated permanent tax adjustments. The fluctuation in the Company’s effective tax rate was primarily due to the nine months pretax book income differences, the discrete impact of $ 5.0 million to remeasure the deferred tax liability as a result of a reduction in the Company's blended state tax rate driven primarily by a Pennsylvania statutory tax rate change for the nine months ended September 30, 2022, offset by a shortfall adjustment of $ 2.4 million of stock based compensation for the nine months ended September 30, 2022. On August 16, 2022, the U.S. government enacted the Inflation Reduction Act (“IRA”), which imposes a new corporate alternative minimum tax (“CAMT”), an excise tax on stock buybacks, and significant tax incentives for energy and climate initiatives, among other provisions. The Company does not expect the CAMT to have a material impact on its consolidated financial statements.\\n| (in thousands) | Sales | Marketing | Total |\\n| Three Months Ended September 30, 2022 |\\n| Revenues | $ | 646,246 | $ | 404,849 | $ | 1,051,095 |\\n| Depreciation and amortization | $ | 39,798 | $ | 17,987 | $ | 57,785 |\\n| Operating income | $ | 31,765 | $ | 15,077 | $ | 46,842 |\\n| Three Months Ended September 30, 2021 |\\n| Revenues | $ | 597,139 | $ | 331,621 | $ | 928,760 |\\n| Depreciation and amortization | $ | 41,515 | $ | 17,648 | $ | 59,163 |\\n| Operating income | $ | 51,906 | $ | 13,696 | $ | 65,602 |\\n| (in thousands) | Sales | Marketing | Total |\\n| Nine Months Ended September 30, 2022 |\\n| Revenues | $ | 1,842,347 | $ | 1,104,632 | $ | 2,946,979 |\\n| Depreciation and amortization | $ | 121,310 | $ | 52,687 | $ | 173,997 |\\n| Operating income | $ | 65,915 | $ | 32,217 | $ | 98,132 |\\n| Nine Months Ended September 30, 2021 |\\n| Revenues | $ | 1,693,107 | $ | 876,628 | $ | 2,569,735 |\\n| Depreciation and amortization | $ | 128,789 | $ | 52,661 | $ | 181,450 |\\n| Operating income | $ | 131,727 | $ | 13,910 | $ | 145,637 |\\n\\n10. Commitments and ContingenciesLitigationThe Company is involved in various legal matters that arise in the ordinary course of its business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages, or penalties. The Company has accrued amounts in connection with certain legal matters, including with respect to certain of the matters described below. There can be no assurance, however, that these accruals will be sufficient to cover such matters or other legal matters or that such matters or other legal matters will not materially or adversely affect the Company’s financial position, liquidity, or results of operations.Employment MattersThe Company has also been involved in various litigation, including purported class or representative actions with respect to matters arising under the California Labor Code and Private Attorneys General Act. The Company has retained outside counsel to represent it in these matters and is vigorously defending its interests. Legal Matters Related to Take 5On April 1, 2018, the Company acquired certain assets and assumed liabilities of Take 5 Media Group (“Take 5”). In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, the Company commenced an investigation into Take 5’s operations. In July 2019, as a result of the Company’s investigation, the Company determined that revenue during the fiscal year ended December 31, 2018 attributable to the Take 5 business had been recognized for services that were not performed on behalf of clients of Take 5 and that inaccurate reports were made to Take 5 clients about those services (referred to as the “Take 5 Matter”). As a result of these findings, in July 2019, the Company terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since the Company’s acquisition of Take 5. 20 USAO and FBI Voluntary Disclosure and Investigation Related to Take 5The Company voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5, a line of business that the Company closed in July 2019. The Company intends to cooperate in this and any other governmental investigations that may arise in connection with the Take 5 Matter. At this time, the Company cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and is unable to estimate the potential impact such an investigation may have on the Company. Arbitration Proceedings Related to Take 5In August 2019, as a result of the Take 5 Matter, the Company provided a written indemnification claim notice to the sellers of Take 5 (the “Take 5 Sellers”) seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement (the “Take 5 APA”), as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings against the Company, alleging breach of the Take 5 APA as a result of the Company’s decision to terminate the operations of the Take 5 business, and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest, fees and costs). In 2020, the Take 5 sellers amended their statement of claim to allege defamation, relating to statements the Company made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. The Company filed its response to the Take 5 Sellers’ claims, and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings. In October 2022, the arbitrator made a final award in favor of the Company. The Company is currently unable to estimate if or when it will be able to collect any amounts associated with this arbitration. Other Legal Matters Related to Take 5The Take 5 Matter may result in additional litigation against the Company, including lawsuits from clients, or governmental investigations, which may expose the Company to potential liability in excess of the amounts being offered by the Company as refunds to Take 5 clients. The Company is currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on the Company’s financial position, liquidity, or results of operations. Although the Company has insurance covering certain liabilities, the insurance may not be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\\n| (in thousands, except share and per share data) Performance Period | Number ofSharesThreshold | Number ofSharesTarget | Number ofSharesMaximum | WeightedAverage FairValue perShare | Maximum Remaining Unrecognized Compensation Expense | Weighted-average remaining requisite service periods |\\n| January 1, 2022— December 31, 2022 | 2,479,997 | 4,959,993 | 7,439,990 | $ | 5.63 | $ | 80,689 | 1.5 years |\\n| January 1, 2021— December 31, 2021 | 1,121,698 | 1,121,698 | 1,319,458 | $ | 13.17 | $ | 4,982 | 1.1 years |\\n| Performance Share Units | Weighted Average GrantDate Fair Value |\\n| Outstanding at January 1, 2022 | 2,609,079 | $ | 13.07 |\\n| Granted | 5,393,085 | $ | 5.66 |\\n| Distributed | 660,880 | $ | 13.09 |\\n| Forfeited | 684,261 | $ | 8.19 |\\n| PSU performance adjustment | ( 377,572 | ) | $ | 11.19 |\\n| Outstanding at September 30, 2022 | 6,279,451 | $ | 7.22 |\\n| Number of RSUs | Weighted Average GrantDate Fair Value |\\n| Outstanding at January 1, 2022 | 3,660,553 | $ | 10.64 |\\n| Granted | 6,302,801 | $ | 5.74 |\\n| Distributed | 1,338,213 | $ | 10.61 |\\n| Forfeited | 869,955 | $ | 8.02 |\\n| Outstanding at September 30, 2022 | 7,755,186 | $ | 6.96 |\\n| September 30, |\\n| 2022 |\\n| Share Price | $ | 5.99 |\\n| Dividend yield | 0.0 | % |\\n| Expected volatility | 30.0 | % |\\n| Risk-free interest rate | 2.0 | % |\\n| Expected term (years) | 6.5 |\\n\\n\\n| (in thousands) |\\n| Balance at January 1, 2022 | $ | 1,893 |\\n| Fair value at acquisition | 1,987 |\\n| Net income attributable to redeemable noncontrolling interests | 124 |\\n| Dividend distribution | ( 223 | ) |\\n| Foreign currency translation adjustment | ( 428 | ) |\\n| Balance at September 30, 2022 | $ | 3,353 |\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (in thousands, except share and earnings per share data) | 2022 | 2021 | 2022 | 2021 |\\n| Basic earnings per share computation: |\\n| Numerator: |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\\n| Denominator: |\\n| Weighted average common shares - basic | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Basic earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n| Diluted earnings per share computation: |\\n| Numerator: |\\n| Net income attributable to stockholders of Advantage Solutions Inc. | $ | 21,059 | $ | 23,311 | $ | 43,395 | $ | 29,316 |\\n| Denominator: |\\n| Weighted average common shares outstanding | 318,821,895 | 318,563,497 | 318,345,565 | 318,213,337 |\\n| Performance and Restricted Stock Units | 602,566 | 1,450,668 | 496,968 | 1,335,011 |\\n| Employee stock purchase plan and stock options | 300,604 | 106,469 | 348,271 | 106,469 |\\n| Weighted average common shares - diluted | 319,725,065 | 320,120,634 | 319,190,804 | 319,654,817 |\\n| Diluted earnings per common share | $ | 0.07 | $ | 0.07 | $ | 0.14 | $ | 0.09 |\\n\\n24\\n14. Subsequent EventsIn October 2022, the Company granted 2,153,900 RSUs and 1,170,000 stock options, with an estimated aggregate grant date fair value of $ 4.8 million and $ 1.2 million, respectively.\\n25\\nITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nForward-Looking Statements\\nThis Quarterly Report on Form 10-Q (this “Quarterly Report”), including the section titled “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements that are based on current expectations, estimates, forecasts and projections about us, our future performance, our business, our beliefs and our management’s assumptions. Such words as “expect,” “anticipate,” “outlook,” “could,” “target,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “should,” “may,” “assume” and “continue” as well as variations of such words and similar expressions are intended to identify such forward-looking statements, although not all forward-looking statements contain such terms. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time the statements are made. We caution you that actual outcomes and results may differ materially from what is expressed, implied or forecasted by our forward-looking statements. More information regarding these risks and uncertainties and other important factors that could cause actual results to differ materially from those in the forward-looking statements is set forth in Part II, Item 1A “Risk Factors” of this report. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements after the distribution of this report, whether as a result of new information, future events, changes in assumptions or otherwise.\\nExecutive Overview\\nWe are a leading business solutions provider to consumer goods manufacturers and retailers. We have a strong platform of competitively advantaged sales and marketing services built over multiple decades – essential, business critical services like headquarter sales, retail merchandising, in-store sampling, digital commerce and shopper marketing. For brands and retailers of all sizes, we help get the right products on the shelf (whether physical or digital) and into the hands of consumers (however they shop). We use a scaled platform to innovate as a trusted partner with our clients, solving problems to increase their efficiency and effectiveness across a broad range of channels.\\nWe have two reportable segments: sales and marketing.\\nThrough our sales segment, which generated approximately 62.5% and 65.9% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we offer headquarter sales representation services to consumer goods manufacturers, for whom we prepare and present to retailers a business case to increase distribution of manufacturers’ products and optimize how they are displayed, priced and promoted. We also make in-store merchandising visits for both manufacturer and retailer clients to ensure the products we represent are adequately stocked and properly displayed.\\nThrough our marketing segment, which generated approximately 37.5% and 34.1% of our total revenues in the nine months ended September 30, 2022 and 2021, respectively, we help brands and retailers reach consumers through two main categories within the marketing segment. The first and largest category is our retail experiential business, also known as in-store sampling or demonstrations, where we manage highly customized large-scale sampling programs (both in-store and online) for leading retailers. The second category is our collection of specialized agency services, in which we provide private label services to retailers and develop granular marketing programs for brands and retailers through our shopper, consumer and digital marketing agencies.\\n26\\nBusiness Combination with Conyers Park\\nOn October 28, 2020, Conyers Park II Acquisition Corp. (“Conyers Park”), a Delaware corporation, consummated a merger with ASI Intermediate Corp. (“ASI”), formerly known as Advantage Solutions Inc., with ASI surviving the merger as a wholly owned subsidiary of Conyers Park (the “Merger” and, together with the other transactions contemplated by the merger agreement, the “Transactions”). On October 28, 2020, and in connection with the closing of the Transactions, Conyers Park changed its name to Advantage Solutions Inc.\\nImpacts of the COVID-19 Pandemic\\nBeginning in March 2020 and continuing through the first quarter of 2021, our services experienced the effects from reductions in client spending due to the economic impact related to the COVID-19 pandemic. While mixed by services and geography, the spending reductions impacted all of our services and markets. Globally, the most impacted services were our experiential services. Most services began to improve in April 2021, and the improvement has continued through the third quarter of 2022.\\nSummary\\nOur financial performance for the three months ended September 30, 2022 as compared to the three months ended September 30, 2021 includes:\\n•Revenues increased by $122.3 million, or 13.2%, to $1,051.1 million;\\n•Operating income decreased by $18.8 million, or 28.6%, to $46.8 million;\\n•Net income decreased by $1.1 million, or 4.5% to $23.2 million;\\n•Adjusted Net Income increased by $3.6 million, or 6.1%, to $62.7 million; and\\n•Adjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million.\\nOur financial performance for the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021 includes:\\n•Revenues increased by $377.2 million, or 14.7% to $2,947.0 million;\\n•Operating income decreased by $47.5 million, or 32.6% to $98.1 million;\\n•Net income increased by $14.9 million, or 50.5% to $44.4 million;\\n•Adjusted Net Income increased by $5.8 million, or 3.9% to $152.5 million; and\\n•Adjusted EBITDA decreased by $43.8 million, or 11.9% to $323.3 million.\\nDuring the nine months ended September 30, 2022, we acquired four businesses. The aggregate purchase price was $75.5 million, of which $74.1 million was paid in cash, $0.5 million in contingent consideration and $0.8 million in holdback.\\nFactors Affecting Our Business and Financial Reporting\\nThere are a number of factors, in addition to the impact of the COVID-19 pandemic and inflation, that affect the performance of our business and the comparability of our results from period to period including:\\n•Organic Growth. Part of our strategy is to generate organic growth by expanding our existing client relationships, continuing to win new clients, pursuing channel expansion and new industry opportunities, enhancing our digital technology solutions, developing our international platform, delivering operational efficiencies and expanding into logical adjacencies. We believe that by pursuing\\n27\\nthese organic growth opportunities we will be able to continue to enhance our value proposition to our clients and thereby grow our business.\\n•Acquisitions. We have grown and expect to continue to grow our business in part by acquiring quality businesses, both domestic and international. Excluding the 2017 acquisition of Daymon Worldwide Inc., we have completed 73 acquisitions from January 2014 to November 9, 2022, ranging in purchase prices from approximately $0.3 million to $98.5 million. Many of our acquisition agreements include contingent consideration arrangements, which are described below. We have completed acquisitions at what we believe are attractive purchase prices and have regularly structured our agreements to result in the generation of long-lived tax assets, which have in turn reduced our effective purchase prices when incorporating the value of those tax assets. We continue to look for strategic acquisitions that can be completed at attractive purchase prices.\\n•Contingent Consideration. Many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of financial performance thresholds by the operations attributable to the acquired businesses. The contingent consideration arrangements are based upon our valuations of the acquired businesses and are intended to share the investment risk with the sellers of such businesses if projected financial results are not achieved. The fair values of these contingent consideration arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates. For each transaction, we estimate the fair value of contingent consideration payments as part of the initial purchase price. We review and assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from our initial estimates. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in “Selling, general and administrative expenses” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\n•Depreciation and Amortization. As a result of the acquisition of our business by Karman Topco L.P. (“Topco”) on July 25, 2014 (the “2014 Topco Acquisition”), we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived. The amortization of such intangible assets recorded in our consolidated financial statements has a significant impact on our operating income (loss) and net income (loss). Our historical acquisitions have increased, and future acquisitions likely will increase, our intangible assets. We do not believe the amortization expense associated with the intangibles created from our purchase accounting adjustments reflect a material economic cost to our business. Unlike depreciation expense which has an economic cost reflected by the fact that we must re-invest in property and equipment to maintain the asset base delivering our results of operations, we do not have any capital re-investment requirements associated with the acquired intangibles, such as client relationships and trade names, that comprise the majority of the finite-lived intangibles that create our amortization expense.\\n•Foreign Exchange Fluctuations. Our financial results are affected by fluctuations in the exchange rate between the U.S. dollar and other currencies, primarily Canadian dollars, British pounds and euros, due to our operations in such foreign jurisdictions. See also “ —Quantitative and Qualitative Disclosure of Market Risk—Foreign Currency Risk.”\\n•Seasonality. Our quarterly results are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters, as a result of higher consumer spending. We generally record slightly lower revenues in the first fiscal quarter of each year, as our clients begin to roll out new programs for the year, and consumer spending generally is less in the first fiscal quarter than other quarters. Timing of our clients’ marketing expenses, associated with marketing campaigns and new product launches, can also result in fluctuations from one quarter to another.\\n28\\nHow We Assess the Performance of Our Business\\nRevenues\\nRevenues related to our sales segment are primarily comprised of commissions, fee-for-service and cost-plus fees for providing retail merchandising services, category and space management, headquarter relationship management, technology solutions and administrative services. A small portion of our arrangements include performance incentive provisions, which allow us to earn additional revenues on our performance relative to specified quantitative or qualitative goals. We recognize the incentive portion of revenues under these arrangements when the related services are transferred to the customer.\\nMarketing segment revenues are primarily recognized in the form of a fee-for-service (including retainer fees, fees charged to clients based on hours incurred, project-based fees or fees for executing in-person consumer engagements or experiences, which engagements or experiences we refer to as events), commissions or on a cost-plus basis, in each case, related to services including experiential marketing, shopper and consumer marketing services, private label development or our digital, social and media services.\\nGiven our acquisition strategy, we analyze our financial performance, in part, by measuring revenue growth in two ways—revenue growth attributable to organic activities and revenue growth attributable to acquisitions, which we refer to as organic revenues and acquired revenues, respectively.\\nWe define organic revenues as any revenues that are not acquired revenues. Our organic revenues exclude the impacts of acquisitions and divestitures, when applicable, which improves comparability of our results from period to period.\\nIn general, when we acquire a business, the acquisition includes a contingent consideration arrangement (e.g., an earn-out provision) and, accordingly, we separately track the relevant metrics associated with the earnout agreement of the acquired business. In such cases, we consider revenues generated by such a business during the 12 months following its acquisition to be acquired revenues. For example, if we completed an acquisition on July 1, 2021 for a business that included a contingent consideration arrangement, we would consider revenues from the acquired business from July 1, 2021 to June 30, 2022 to be acquired revenues. We generally consider growth attributable to the financial performance of an acquired business after the 12-month anniversary of the date of acquisition to be organic.\\nIn limited cases, when the acquisition of an acquired business does not include a contingent consideration arrangement, or we otherwise do not separately track the financial performance of the acquired business due to operational integration, we consider the revenues that the business generated in the 12 months prior to its acquisition to be our acquired revenues for the 12 months following its acquisition, and any differences in revenues actually generated during the 12 months after its acquisition to be organic. For example, if we completed an acquisition on July 1, 2021 for a business that did not include a contingent consideration arrangement, we would consider the amount of revenues from the acquired business from July 1, 2020 to June 30, 2021 to be acquired revenues during the period from July 1, 2021 to June 30, 2022, with any differences from that amount actually generated during the latter period to be organic revenues.\\nAll revenues generated by our acquired businesses are considered to be organic revenues after the 12-month anniversary of the date of acquisition.\\nWhen we divest a business, we consider the revenues that the divested business generated in the 12 months prior to its divestiture to be subtracted from acquired revenues for the 12 months following its divestiture. For example, if we completed a divestiture on July 1, 2021 for a business, we would consider the amount of revenues from the divested business from July 1, 2020 to June 30, 2021 to be subtracted from acquired revenues during the period from July 1, 2021 to June 30, 2022.\\nWe measure organic revenue growth and acquired revenue growth by comparing the organic revenues or acquired revenues, respectively, period over period, net of any divestitures.\\n29\\nCost of Revenues\\nOur cost of revenues consists of both fixed and variable expenses primarily attributable to the hiring, training, compensation and benefits provided to both full-time and part-time associates, as well as other project-related expenses. A number of costs associated with our associates are subject to external factors, including inflation, increases in market specific wages and minimum wage rates at federal, state and municipal levels and minimum pay levels for exempt roles. Additionally, when we enter into certain new client relationships, we may experience an initial increase in expenses associated with hiring, training and other items needed to launch the new relationship.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses consist primarily of salaries, payroll taxes and benefits for corporate personnel. Other overhead costs include information technology, occupancy costs for corporate personnel, professional services fees, including accounting and legal services, and other general corporate expenses. Additionally, included in selling, general and administrative expenses are costs associated with the changes in fair value of the contingent consideration of acquisitions and other acquisition-related costs. Acquisition-related costs are comprised of fees related to change of equity ownership, transaction costs, professional fees, due diligence and integration activities.\\nOther (Income) Expenses\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents a non-cash (income) expense resulting from a fair value adjustment to warrant liability with respect to the private placement warrants. Based on the period of time the public warrants have now been trading, we determined the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants at the respective period end, which is inherently less subjective and judgmental given it is based on observable inputs. Previously, the fair value of the warrant liability was based on the input assumptions used in the Black-Scholes option pricing model, including our stock price at the end of the reporting period, the implied volatility or other inputs to the model and the number of private placement warrants outstanding, which may vary from period to period. We believe these amounts are not correlated to future business operations.\\nInterest Expense\\nInterest expense relates primarily to borrowings under the Senior Secured Credit Facilities as described below. See “ —Liquidity and Capital Resources.”\\nDepreciation and Amortization\\nAmortization Expense\\nIncluded in our depreciation and amortization expense is amortization of acquired intangible assets. We have ascribed value to identifiable intangible assets other than goodwill in our purchase price allocations for companies we have acquired. These assets include, but are not limited to, client relationships and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of the assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to future acquired intangible assets.\\n30\\nAs a result of the 2014 Topco Acquisition, we acquired significant intangible assets, the value of which is amortized, on a straight-line basis, over 15 years from the date of the 2014 Topco Acquisition, unless determined to be indefinite-lived.\\nDepreciation Expense\\nDepreciation expense relates to the property and equipment that we own, which represented less than 1% of our total assets at September 30, 2022 and 2021, respectively.\\nIncome Taxes\\nIncome tax expense and our effective tax rates can be affected by many factors, including state apportionment factors, our acquisition strategy, tax incentives and credits available to us, changes in judgment regarding our ability to realize our deferred tax assets, changes in our worldwide mix of pre-tax losses or earnings, changes in existing tax laws and our assessment of uncertain tax positions.\\nCash Flows\\nWe have positive cash flow characteristics, as described below, due to the limited required capital investment in the fixed assets and working capital needs to operate our business in the normal course. See “ —Liquidity and Capital Resources.”\\nOur principal sources of liquidity are cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions and repayment of debt.\\nAdjusted Net Income\\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) changes in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii) other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) changes in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\\n31\\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to Adjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for Net income, our most directly comparable measure presented on a GAAP basis.\\nResults of Operations for the Three and Nine Months Ended September 30, 2022 and 2021\\nThe following table sets forth items derived from the Company’s consolidated statements of operations for the three and nine months ended September 30, 2022 and 2021 in dollars and as a percentage of total revenues.\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| (amounts in thousands) | 2022 | 2021 | 2022 | 2021 |\\n| Revenues | $ | 1,051,095 | 100.0 | % | $ | 928,760 | 100.0 | % | $ | 2,946,979 | 100.0 | % | $ | 2,569,735 | 100.0 | % |\\n| Cost of revenues | 908,523 | 86.4 | % | 766,253 | 82.5 | % | 2,536,256 | 86.1 | % | 2,117,818 | 82.4 | % |\\n| Selling, general, and administrative expenses | 37,945 | 3.6 | % | 37,742 | 4.1 | % | 138,594 | 4.7 | % | 124,830 | 4.9 | % |\\n| Depreciation and amortization | 57,785 | 5.5 | % | 59,163 | 6.4 | % | 173,997 | 5.9 | % | 181,450 | 7.1 | % |\\n| Total expenses | 1,004,253 | 95.5 | % | 863,158 | 92.9 | % | 2,848,847 | 96.7 | % | 2,424,098 | 94.3 | % |\\n| Operating income | 46,842 | 4.5 | % | 65,602 | 7.1 | % | 98,132 | 3.3 | % | 145,637 | 5.7 | % |\\n| Other (income) expenses: |\\n| Change in fair value of warrant liability | (1,100 | ) | (0.1 | )% | (3,491 | ) | (0.4 | )% | (21,456 | ) | (0.7 | )% | (5,024 | ) | (0.2 | )% |\\n| Interest expense, net | 23,557 | 2.2 | % | 36,490 | 3.9 | % | 63,628 | 2.2 | % | 104,544 | 4.1 | % |\\n| Total other expenses | 22,457 | 2.1 | % | 32,999 | 3.6 | % | 42,172 | 1.4 | % | 99,520 | 3.9 | % |\\n| Income before income taxes | 24,385 | 2.3 | % | 32,603 | 3.5 | % | 55,960 | 1.9 | % | 46,117 | 1.8 | % |\\n| Provision for income taxes | 1,158 | 0.1 | % | 8,276 | 0.9 | % | 11,523 | 0.4 | % | 16,582 | 0.6 | % |\\n| Net income | $ | 23,227 | 2.2 | % | $ | 24,327 | 2.6 | % | $ | 44,437 | 1.5 | % | $ | 29,535 | 1.1 | % |\\n| Other Financial Data |\\n| Adjusted Net Income(1) | $ | 62,682 | 6.0 | % | $ | 59,101 | 6.4 | % | $ | 152,541 | 5.2 | % | $ | 146,762 | 5.7 | % |\\n| Adjusted EBITDA(1) | $ | 118,268 | 11.3 | % | $ | 133,756 | 14.4 | % | $ | 323,329 | 11.0 | % | $ | 367,155 | 14.3 | % |\\n\\n(1)Adjusted Net Income and Adjusted EBITDA are financial measures that are not calculated in accordance with GAAP. For a discussion of our presentation of Adjusted Net Income and Adjusted EBITDA and reconciliations of Net income to Adjusted Net Income and Adjusted EBITDA, see “—Non-GAAP Financial Measures.”\\nComparison of the Three Months Ended September 30, 2022 and 2021\\nRevenues\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 646,246 | $ | 597,139 | $ | 49,107 | 8.2 | % |\\n| Marketing | 404,849 | 331,621 | 73,228 | 22.1 | % |\\n| Total revenues | $ | 1,051,095 | $ | 928,760 | $ | 122,335 | 13.2 | % |\\n\\nTotal revenues increased by $122.3 million, or 13.2%, during the three months ended September 30, 2022, as compared to the three months ended September 30, 2021.\\nThe sales segment revenues increased $49.1 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $23.6 million were revenues from acquired\\n32\\nbusinesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $17.0 million, the segment experienced an increase of $42.5 million in organic revenues primarily due to growth in our retail merchandising services and international businesses, partially offset by a decrease in our third party selling and retailing services.\\nThe marketing segment revenues increased $73.2 million during the three months ended September 30, 2022 as compared to the three months ended September 30, 2021, of which $11.0 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $5.7 million, the segment experienced an increase of $67.9 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\\nCost of Revenues\\nCost of revenues as a percentage of revenues for the three months ended September 30, 2022 was 86.4%, as compared to 82.5% for the three months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses as a percentage of revenues for the three months ended September 30, 2022 was 3.6%, compared to 4.1% for the three months ended September 30, 2021, primarily due to the change in fair value adjustments related to contingent consideration and a decrease in legal fees associated with the Take 5 Matter.\\nDepreciation and Amortization Expense\\nDepreciation and amortization expense decreased by $1.4 million, or 2.3%, to $57.8 million for the three months ended September 30, 2022 compared to $59.2 million for the three months ended September 30, 2021, which stayed relatively consistent year over year.\\nOperating Income\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 31,765 | $ | 51,906 | $ | (20,141 | ) | (38.8 | )% |\\n| Marketing | 15,077 | 13,696 | 1,381 | 10.1 | % |\\n| Total operating income | $ | 46,842 | $ | 65,602 | $ | (18,760 | ) | (28.6 | )% |\\n\\nIn the sales segment, the decrease in operating income during the three months ended September 30, 2022 was due to a shift in revenue mix and ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nIn the marketing segment, the increase in operating income during the three months ended September 30, 2022 was due to the growth in revenues, partially offset by the increase in cost of revenues as described above.\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents $1.1 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the three months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\\n33\\nInterest Expense, net\\nInterest expense, net decreased $12.9 million, or 35.4%, to $23.6 million for the three months ended September 30, 2022, from $36.5 million for the three months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\\nProvision for Income Taxes\\nProvision for income taxes was $1.2 million for the three months ended September 30, 2022 as compared to $8.3 million of provision for income taxes for the three months ended September 30, 2021. The fluctuation was primarily attributable to the decrease in pre-tax income during the three months ended September 30, 2022 and decrease of $4.3 million of discrete items for the three months ended September 30, 2022.\\nNet Income\\nNet income was $23.2 million for the three months ended September 30, 2022, compared to net income of $24.3 million for the three months ended September 30, 2021. The decrease in net income was primarily driven by the decrease in operating income as described above, offset by the decrease in interest expense, net and provision for income taxes.\\nAdjusted Net Income\\nThe increase in Adjusted Net Income for the three months ended September 30, 2022 was attributable to the decrease in interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\n\\n| Three Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 76,172 | $ | 95,199 | $ | (19,027 | ) | (20.0 | )% |\\n| Marketing | 42,096 | 38,557 | 3,539 | 9.2 | % |\\n| Total Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | (15,488 | ) | (11.6 | )% |\\n\\nAdjusted EBITDA decreased by $15.5 million, or 11.6%, to $118.3 million for the three months ended September 30, 2022, from $133.8 million for the three months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\\nComparison of the Nine Months Ended September 30, 2022 and 2021\\nRevenues\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 1,842,347 | $ | 1,693,107 | $ | 149,240 | 8.8 | % |\\n| Marketing | 1,104,632 | 876,628 | 228,004 | 26.0 | % |\\n| Total revenues | $ | 2,946,979 | $ | 2,569,735 | $ | 377,244 | 14.7 | % |\\n\\n34\\nTotal revenues increased by $377.2 million, or 14.7%, during the nine months ended September 30, 2022, as compared to the nine months ended September 30, 2021.\\nThe sales segment revenues increased $149.2 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $114.2 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $33.9 million, the segment experienced an increase of $68.9 million in organic revenues primarily due to our European joint venture which experienced continued recoveries from temporary reduction in services as a result of the COVID-19 pandemic and growth in our retail merchandising services partially offset by a decrease in our foodservice and third party selling and retailing services.\\nThe marketing segment revenues increased $228.0 million during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021, of which $23.1 million were revenues from acquired businesses. Excluding revenues from acquired businesses and unfavorable foreign exchange rates of $11.6 million, the segment experienced an increase of $216.5 million in organic revenues. The increase in revenues was primarily due to an increase in our in-store product demonstration and sampling services which continue to recover from the temporary suspensions as a result of the COVID-19 pandemic, partially offset by a decrease in certain of our client media spend.\\nCost of Revenues\\nCost of revenues as a percentage of revenues for the nine months ended September 30, 2022 was 86.1%, as compared to 82.4% for the nine months ended September 30, 2021. The increase as a percentage of revenues was largely attributable to the change in the revenue mix of our services as a result of recoveries from the COVID-19 pandemic and acquired businesses, and the ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses.\\nSelling, General and Administrative Expenses\\nSelling, general and administrative expenses as a percentage of revenues for the nine months ended September 30, 2022 was 4.7%, compared to 4.9% for the nine months ended September 30, 2021.\\nDepreciation and Amortization Expense\\nDepreciation and amortization expense decreased by $7.5 million or 4.1% to $174.0 million for the nine months ended September 30, 2022 compared to $181.5 million for the nine months ended September 30, 2021. The decrease was primarily due to a decrease in depreciation expenses from our internally developed software.\\nOperating Income\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 65,915 | $ | 131,727 | $ | (65,812 | ) | (50.0 | %) |\\n| Marketing | 32,217 | 13,910 | 18,307 | 131.6 | % |\\n| Total operating income | $ | 98,132 | $ | 145,637 | $ | (47,505 | ) | (32.6 | %) |\\n\\nIn the sales segment, the decrease in operating income during the nine months ended September 30, 2022 was primarily attributable to a shift in revenue mix, ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses, the change in fair value adjustments related to contingent consideration, and an increase in stock-based compensation expense, partially offset by a decrease in depreciation expense.\\n35\\nIn the marketing segment, the increase in operating income during the nine months ended September 30, 2022 was primarily attributable to the growth in revenues, partially offset by the increase in cost of revenues as described above and the change in fair value adjustments related to contingent consideration.\\nChange in Fair Value of Warrant Liability\\nChange in fair value of warrant liability represents $21.5 million of non-cash gain resulting from a fair value adjustment to warrant liability with respect to the private placement warrants for the nine months ended September 30, 2022, approximating the fair value with the warrant price of the public warrants.\\nInterest Expense, net\\nInterest expense, net decreased $40.9 million, or 39.1%, to $63.6 million for the nine months ended September 30, 2022, from $104.5 million for the nine months ended September 30, 2021. The decrease in interest expense, net was primarily due to the increase in fair value changes in derivatives instruments.\\nProvision for Income Taxes\\nProvision for income taxes was $11.5 million for the nine months ended September 30, 2022 as compared to $16.6 million for the nine months ended September 30, 2021. The fluctuation was primarily attributable to the increase in pre-tax income during the nine months ended September 30, 2022, partially offset by a decrease of $7.4 million of discrete items.\\nNet Income\\nNet income was $44.4 million for the nine months ended September 30, 2022, compared to net income of $29.5 million for the nine months ended September 30, 2021. The increase in net income was primarily driven by the decrease in change in fair value of warrant liability, interest expense, net, and provision for income taxes, partially offset by the decrease in operating income as described above.\\nAdjusted Net Income\\nThe increase in Adjusted Net Income for the nine months ended September 30, 2022 was attributable to the decrease in change in fair value of warrant liability, and interest expense, net as described above. For a reconciliation of Adjusted Net Income to Net income, see “ —Non-GAAP Financial Measures.”\\nAdjusted EBITDA and Adjusted EBITDA by Segment\\n\\n| Nine Months Ended September 30, | Change |\\n| (amounts in thousands) | 2022 | 2021 | $ | % |\\n| Sales | $ | 216,158 | $ | 268,798 | $ | (52,640 | ) | (19.6 | )% |\\n| Marketing | 107,171 | 98,357 | 8,814 | 9.0 | % |\\n| Total Adjusted EBITDA | $ | 323,329 | $ | 367,155 | $ | (43,826 | ) | (11.9 | )% |\\n\\nAdjusted EBITDA decreased by $43.8 million, or 11.9%, to $323.3 million for the nine months ended September 30, 2022, from $367.2 million for the nine months ended September 30, 2021. In the sales segment, the decrease in Adjusted EBITDA was primarily attributable to the increase in cost of revenues as described above. In the marketing segment, the increase in the Adjusted EBITDA was primarily attributable to the growth in revenues as described above. For a reconciliation of Adjusted EBITDA to Net income, see “—Non-GAAP Financial Measures.”\\n36\\nNon-GAAP Financial Measures\\nAdjusted Net Income is a non-GAAP financial measure. Adjusted Net Income means Net income before (i) impairment of goodwill and indefinite-lived assets, (ii) amortization of intangible assets, (iii) equity-based compensation of Topco, (iv) change in fair value of warrant liability, (v) fair value adjustments of contingent consideration related to acquisitions, (vi) acquisition-related expenses, (vii) costs associated with COVID-19, net of benefits received, (viii) EBITDA for economic interests in investments, (ix) restructuring expenses, (x) litigation expenses (recovery), (xi) costs associated with the Take 5 Matter, (xii) related tax adjustments and (xiii)other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted Net Income because we use it as a supplemental measure to evaluate the performance of our business in a way that also considers our ability to generate profit without the impact of items that we do not believe are indicative of our operating performance or are unusual or infrequent in nature and aid in the comparability of our performance from period to period. Adjusted Net Income should not be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\\nA reconciliation of Adjusted Net Income to Net income is provided in the following table:\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\\n| Less: Net income attributable to noncontrolling interest | 2,168 | 1,016 | 1,042 | 219 |\\n| Add: |\\n| Equity -based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\\n| Amortization of intangible assets(g) | 49,997 | 49,786 | 150,930 | 148,396 |\\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Tax adjustments related to non-GAAP adjustments(j) | (16,215 | ) | (15,262 | ) | (49,168 | ) | (47,113 | ) |\\n| Adjusted Net Income | $ | 62,682 | $ | 59,101 | $ | 152,541 | $ | 146,762 |\\n\\nAdjusted EBITDA and Adjusted EBITDA by segment are supplemental non-GAAP financial measures of our operating performance. Adjusted EBITDA means Net income before (i) interest expense, net, (ii) provision for income taxes, (iii) depreciation, (iv) impairment of goodwill and indefinite-lived assets, (v) amortization of intangible assets, (vi) equity-based compensation of Topco, (vii) change in fair value of warrant liability, (viii) stock-based compensation expense, (ix) fair value adjustments of contingent consideration related to acquisitions, (x) acquisition-related expenses, (xi) costs associated with COVID-19, net of benefits received, (xii) EBITDA for economic interests in investments, (xiii) restructuring expenses, (xiv) litigation expenses (recovery), (xv) costs associated with the Take 5 Matter and (xvi) other adjustments that management believes are helpful in evaluating our operating performance.\\nWe present Adjusted EBITDA and Adjusted EBITDA by segment because they are key operating measures used by us to assess our financial performance. These measures adjust for items that we believe do not reflect the ongoing operating performance of our business, such as certain noncash items, unusual or infrequent items or items that change from period to period without any material relevance to our operating performance. We evaluate these measures in conjunction with our results according to GAAP because we believe they provide a more complete understanding of factors and trends affecting our business than GAAP measures alone. Furthermore, the agreements governing our indebtedness contain covenants and other tests based on measures substantially similar to\\n37\\nAdjusted EBITDA. Neither Adjusted EBITDA nor Adjusted EBITDA by segment should be considered as an alternative for our Net income, our most directly comparable measure presented on a GAAP basis.\\nA reconciliation of Adjusted EBITDA to Net income is provided in the following table:\\n\\n| Consolidated | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Net income | $ | 23,227 | $ | 24,327 | $ | 44,437 | $ | 29,535 |\\n| Add: |\\n| Interest expense, net | 23,557 | 36,490 | 63,628 | 104,544 |\\n| Provision for income taxes | 1,158 | 8,276 | 11,523 | 16,582 |\\n| Depreciation and amortization | 57,785 | 59,163 | 173,997 | 181,450 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (828 | ) | (5,575 | ) | (7,142 | ) | (10,031 | ) |\\n| Change in fair value of warrant liability | (1,100 | ) | (3,491 | ) | (21,456 | ) | (5,024 | ) |\\n| Stock-based compensation expense(b) | 7,174 | 7,854 | 29,906 | 25,497 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (340 | ) | 3,221 | 5,448 | 5,776 |\\n| Acquisition-related expenses(d) | 4,260 | 5,110 | 19,843 | 13,053 |\\n| EBITDA for economic interests in investments(k) | (2,474 | ) | (3,620 | ) | (7,546 | ) | (6,616 | ) |\\n| Restructuring expenses(e) | 3,562 | (394 | ) | 4,458 | 10,636 |\\n| Litigation(f) | — | (92 | ) | (800 | ) | (910 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 2,009 | 1,087 | 4,945 | (948 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Adjusted EBITDA | $ | 118,268 | $ | 133,756 | $ | 323,329 | $ | 367,155 |\\n\\nFinancial information by segment, including a reconciliation of Adjusted EBITDA by segment to operating income, the closest GAAP financial measure, is provided in the following table:\\n\\n| Sales Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Operating income | $ | 31,765 | $ | 51,906 | $ | 65,915 | $ | 131,727 |\\n| Add: |\\n| Depreciation and amortization | 39,798 | 41,515 | 121,310 | 128,789 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (320 | ) | (4,844 | ) | (4,004 | ) | (7,360 | ) |\\n| Stock-based compensation expense(b) | 4,080 | 4,371 | 18,009 | 13,795 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | (1,901 | ) | 192 | 4,992 | (4,057 | ) |\\n| Acquisition-related expenses(d) | 2,880 | 3,899 | 13,734 | 9,499 |\\n| EBITDA for economic interests in investments(k) | (2,656 | ) | (3,832 | ) | (8,018 | ) | (7,429 | ) |\\n| Restructuring expenses(e) | 2,360 | 1,273 | 3,519 | 3,229 |\\n| Litigation(f) | — | (68 | ) | (100 | ) | (584 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 166 | 787 | 801 | 1,189 |\\n| Sales Segment Adjusted EBITDA | $ | 76,172 | $ | 95,199 | $ | 216,158 | $ | 268,798 |\\n\\n38\\n\\n| Marketing Segment | Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| (in thousands) |\\n| Operating income | $ | 15,077 | $ | 13,696 | $ | 32,217 | $ | 13,910 |\\n| Add: |\\n| Depreciation and amortization | 17,987 | 17,648 | 52,687 | 52,661 |\\n| Equity-based compensation of Karman Topco L.P.(a) | (508 | ) | (731 | ) | (3,138 | ) | (2,671 | ) |\\n| Stock-based compensation expense(b) | 3,094 | 3,483 | 11,897 | 11,702 |\\n| Fair value adjustments related to contingent consideration related to acquisitions(c) | 1,561 | 3,029 | 456 | 9,833 |\\n| Acquisition-related expenses(d) | 1,380 | 1,211 | 6,109 | 3,554 |\\n| EBITDA for economic interests in investments(k) | 182 | 212 | 472 | 813 |\\n| Restructuring expenses(e) | 1,202 | (1,667 | ) | 939 | 7,407 |\\n| Litigation(f) | — | (24 | ) | (700 | ) | (326 | ) |\\n| Costs associated with COVID-19, net of benefits received(h) | 1,843 | 300 | 4,144 | (2,137 | ) |\\n| Costs associated with the Take 5 Matter(i) | 278 | 1,400 | 2,088 | 3,611 |\\n| Marketing Segment Adjusted EBITDA | $ | 42,096 | $ | 38,557 | $ | 107,171 | $ | 98,357 |\\n\\n\\n\\n\\n| (a) | Represents expenses related to (i) equity-based compensation expense associated with grants of Common Series D Units of Topco made to one of the Advantage Sponsors (as defined below) and (ii) equity-based compensation expense associated with the Common Series C Units of Topco. |\\n| (b) | Represents non-cash compensation expense related to the 2020 Incentive Award Plan and the 2020 Employee Stock Purchase Plan. |\\n| (c) | Represents adjustments to the estimated fair value of our contingent consideration liabilities related to our acquisitions. See Note 6—Fair Value of Financial Instruments to our unaudited condensed financial statements for the three and nine months ended September 30, 2022 and 2021. |\\n| (d) | Represents fees and costs associated with activities related to our acquisitions and restructuring activities, including professional fees, due diligence, and integration activities. |\\n| (e) | Represents fees and costs associated with various internal reorganization activities among our consolidated entities. |\\n| (f) | Represents legal settlements that are unusual or infrequent costs associated with our operating activities. |\\n| (g) | Represents the amortization of intangible assets recorded in connection with the 2014 Topco Acquisition and our other acquisitions. |\\n| (h) | Represents (i) costs related to implementation of strategies for workplace safety in response to COVID-19, including employee-relief fund, additional sick pay for front-line associates, medical benefit payments for furloughed associates, and personal protective equipment; and (ii) benefits received from government grants for COVID-19 relief. |\\n| (i) | Represents costs associated with the Take 5 Matter, primarily, professional fees and other related costs, for the three and nine months ended September 30, 2022 and 2021, respectively. |\\n| (j) | Represents the tax provision or benefit associated with the adjustments above, taking into account the Company’s applicable tax rates, after excluding adjustments related to items that do not have a related tax impact. |\\n| (k) | Represents additions to reflect our proportional share of Adjusted EBITDA related to our equity method investments and reductions to remove the Adjusted EBITDA related to the minority ownership percentage of the entities that we fully consolidate in our financial statements. |\\n\\n39\\nLiquidity and Capital Resources\\nOur principal sources of liquidity were cash flows from operations, borrowings under the Revolving Credit Facility, and other debt. Our principal uses of cash are operating expenses, working capital requirements, acquisitions, interest on debt and repayment of debt.\\nCash Flows\\nA summary of our cash operating, investing and financing activities are shown in the following table:\\n\\n| Nine Months Ended September 30, |\\n| (in thousands) | 2022 | 2021 |\\n| Net cash provided by operating activities | $ | 81,950 | $ | 101,068 |\\n| Net cash used in investing activities | (103,062 | ) | (66,152 | ) |\\n| Net cash used in financing activities | (32,920 | ) | (68,999 | ) |\\n| Net effect of foreign currency fluctuations on cash | (12,311 | ) | (1,476 | ) |\\n| Net change in cash, cash equivalents and restricted cash | $ | (66,343 | ) | $ | (35,559 | ) |\\n\\nNet Cash Provided by Operating Activities\\nNet cash used in operating activities during the nine months ended September 30, 2022 consisted of net income of $44.4 million adjusted for certain non-cash items, including depreciation and amortization of $174.0 million and effects of changes in working capital. Net cash provided by operating activities during the nine months ended September 30, 2021 consisted of net income of $29.5 million adjusted for certain non-cash items, including depreciation and amortization of $181.5 million and effects of changes in working capital. The decrease in cash provided by operating activities during the nine months ended September 30, 2022 relative to the same period in 2021 was primarily due to ongoing investment and inflationary impact in recruiting, wage, and employee benefit expenses during the nine months ended September 30, 2022.\\nNet Cash Used in Investing Activities\\nNet cash used in investing activities during the nine months ended September 30, 2022 primarily consisted of the purchase of businesses, net of cash acquired of $74.4 million and purchase of property and equipment of $30.0 million. Net cash used in investing activities during the nine months ended September 30, 2021 primarily consisted of the purchase of businesses, net of cash acquired of $40.0 million and purchase of property and equipment of $24.1 million.\\nNet Cash Used in Financing Activities\\nWe primarily finance our growth through cash flows from operations, however, we also incur long-term debt or borrow under lines of credit when necessary to execute acquisitions. Additionally, many of our acquisition agreements include contingent consideration arrangements, which are generally based on the achievement of future financial performance by the operations attributable to the acquired companies. The portion of the cash payment up to the acquisition date fair value of the contingent consideration liability are classified as financing outflows, and amounts paid in excess of the acquisition date fair value of that liability are classified as operating outflows.\\nCash flows used in financing activities during the nine months ended September 30, 2022 were primarily related to payments of contingent consideration and holdback payments of $31.7 million, repayment of principal on our Term Loan Facility of $9.9 million, partially offset by $3.3 million related to proceeds from the issuance of Class A common stock and $5.2 million of contribution from noncontrolling interest. Cash flows related to financing activities during the nine months ended September 30, 2021 were primarily related to borrowings of $51.7 million and repayment of $102.7 million on the Revolving Credit Facility and our lines of credit and $8.6 million related to payments of contingent consideration and holdback payments.\\n40\\nDescription of Credit Facilities\\nSenior Secured Credit Facilities\\nIn connection with the consummation of the Transactions, Advantage Sales & Marketing Inc. (the “Borrower”), an indirect wholly-owned subsidiary of the Company, entered into (i) a senior secured asset-based revolving credit facility in an aggregate principal amount of up to $400.0 million, subject to borrowing base capacity (as may be amended from time to time, the “Revolving Credit Facility”) and (ii) a secured first lien term loan credit facility in an aggregate principal amount of $1.325 billion (as may be amended from time to time, the “Term Loan Facility” and together with the Revolving Credit Facility, the “Senior Secured Credit Facilities”).\\nRevolving Credit Facility\\nOur Revolving Credit Facility provides for revolving loans and letters of credit in an aggregate amount of up to $400.0 million, subject to borrowing base capacity. Letters of credit are limited to the lesser of (a) $150.0 million and (b) the aggregate unused amount of commitments under our Revolving Credit Facility then in effect. Loans under the Revolving Credit Facility may be denominated in either U.S. dollars or Canadian dollars. Bank of America, N.A., is administrative agent and ABL Collateral Agent. The Revolving Credit Facility is scheduled to mature in October 2025. We may use borrowings under the Revolving Credit Facility to fund working capital and for other general corporate purposes, including permitted acquisitions and other investments. As of September 30, 2022, we had unused capacity under our Revolving Credit Facility available to us of $400.0 million, subject to borrowing base limitations (without giving effect to approximately $54.5 million of outstanding letters of credit and the borrowing base limitations for additional borrowings).\\nBorrowings under the Revolving Credit Facility are limited by borrowing base calculations based on the sum of specified percentages of eligible accounts receivable plus specified percentages of qualified cash, minus the amount of any applicable reserves. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Revolving Credit Facility are 2.00%, 2.25% or 2.50%, with respect to Eurodollar rate borrowings and 1.00%, 1.25% or 1.50%, with respect to base rate borrowings, in each case depending on average excess availability under the Revolving Credit Facility. The Borrower’s ability to draw under the Revolving Credit Facility or issue letters of credit thereunder will be conditioned upon, among other things, the Borrower’s delivery of prior written notice of a borrowing or issuance, as applicable, the Borrower’s ability to reaffirm the representations and warranties contained in the credit agreement governing the Revolving Credit Facility and the absence of any default or event of default thereunder.\\nThe Borrower’s obligations under the Revolving Credit Facility are guaranteed by Karman Intermediate Corp. (“Holdings”) and all of the Borrower’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) (the “Guarantors”). The Revolving Credit Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Borrower’s Revolving Credit Facility has a first-priority lien on the current asset collateral and a second-priority lien on security interests in the fixed asset collateral (second in priority to the liens securing the Notes and the Term Loan Facility discussed below), in each case, subject to other permitted liens.\\nThe Revolving Credit Facility has the following fees: (i) an unused line fee of 0.375% or 0.250% per annum of the unused portion of the Revolving Credit Facility, depending on average excess availability under the Revolving Credit Facility; (ii) a letter of credit participation fee on the aggregate stated amount of each letter of credit equal to the applicable margin for adjusted Eurodollar rate loans, as applicable; and (iii) certain other customary fees and expenses of the lenders and agents thereunder.\\nThe Revolving Credit Facility contains customary covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, make acquisitions, loans, advances or investments, pay dividends, sell or\\n41\\notherwise transfer assets, optionally prepay or modify terms of any junior indebtedness, enter into transactions with affiliates or change our line of business. The Revolving Credit Facility will require the maintenance of a fixed charge coverage ratio (as set forth in the credit agreement governing the Revolving Credit Facility) of 1.00 to 1.00 at the end of each fiscal quarter when excess availability is less than the greater of $25 million and 10% of the lesser of the borrowing base and maximum borrowing capacity. Such fixed charge coverage ratio will be tested at the end of each quarter until such time as excess availability exceeds the level set forth above.\\nThe Revolving Credit Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated and the lending commitments terminated. Such events of default include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, material pension-plan events, certain change of control events and other customary events of default.\\nOn October 28, 2021, the Borrower and Holdings entered into the First Amendment to ABL Revolving Credit Agreement (the “ABL Amendment”), which amended the ABL Revolving Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, the lenders from time to time party thereto and Bank of America, as administrative agent. The ABL Amendment was entered into by the Borrower to amend certain terms and provisions, including (i) reducing the interest rate floor for Eurocurrency rate loans from 0.50% to 0.00% and base rate loans from 1.50% to 1.00%, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with the Secured Oversight Financing Rate (“SOFR”) or another interest rate benchmark to reflect the most recent standards and practices used in the industry.\\nTerm Loan Facility\\nThe Term Loan Facility is a term loan facility denominated in U.S. dollars in an aggregate principal amount of $1.325 billion. Borrowings under the Term Loan Facility amortize in equal quarterly installments in an amount equal to 1.00% per annum of the principal amount. Borrowings will bear interest at a floating rate, which can be either an adjusted Eurodollar rate plus an applicable margin or, at the Borrower’s option, a base rate plus an applicable margin. The applicable margins for the Term Loan Facility are 4.50% with respect to Eurodollar rate borrowings and 3.50% with respect to base rate borrowings.\\nThe Borrower may voluntarily prepay loans or reduce commitments under the Term Loan Facility, in whole or in part, subject to minimum amounts, with prior notice but without premium or penalty (other than a 1.00% premium on any prepayment in connection with a repricing transaction prior to the date that is six months after the effective date of the First Lien Amendment).\\nThe Borrower will be required to prepay the Term Loan Facility with 100% of the net cash proceeds of certain asset sales (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios) and subject to certain reinvestment rights, 100% of the net cash proceeds of certain debt issuances and 50% of excess cash flow (such percentage subject to reduction based on the achievement of specific first lien net leverage ratios).\\nThe Borrower’s obligations under the Term Loan Facility are guaranteed by Holdings and the Guarantors. Our Term Loan Facility is secured by a lien on substantially all of Holdings’, the Borrower’s and the Guarantors’ assets (subject to certain permitted exceptions). The Term Loan Facility has a first-priority lien on the fixed asset collateral (equal in priority with the liens securing the Notes) and a second-priority lien on security interests in the current asset collateral (second in priority to the liens securing the Revolving Credit Facility), in each case, subject to other permitted liens.\\nThe Term Loan Facility contains certain customary negative covenants, including, but not limited to, restrictions on the Borrower’s ability and that of our restricted subsidiaries to merge and consolidate with other companies, incur indebtedness, grant liens or security interests on assets, pay dividends or make other restricted payments, sell or otherwise transfer assets or enter into transactions with affiliates.\\n42\\nThe Term Loan Facility provides that, upon the occurrence of certain events of default, the Borrower’s obligations thereunder may be accelerated. Such events of default will include payment defaults to the lenders thereunder, material inaccuracies of representations and warranties, covenant defaults, cross-defaults to other material indebtedness, voluntary and involuntary bankruptcy, insolvency, corporate arrangement, winding-up, liquidation or similar proceedings, material money judgments, change of control and other customary events of default.\\nOn October 28, 2021 (the “First Lien Amendment Effective Date”), the Borrower, Holdings, and certain of the Borrower’s subsidiaries, entered into Amendment No. 1 to the First Lien Credit Agreement (the “First Lien Amendment”), which amended the First Lien Credit Agreement, dated October 28, 2020, by and among the Borrower, Holdings, Bank of America, as administrative agent and collateral agent, each lender party from time to time thereto, and the other parties thereto. The First Lien Amendment was entered into by the Borrower to reduce the applicable interest rate on the term loan to 5.25% per annum, resulting in estimated interest savings of approximately $9.9 million or $7.3 million, net of tax, per annum. Additional terms and provisions amended include (i) resetting the period for six months following the First Lien Amendment Effective Date in which a 1.00% prepayment premium shall apply to any prepayment of the term loan in connection with certain repricing events, and (ii) updating the provisions by which U.S. Dollar LIBOR will eventually be replaced with SOFR or another interest rate benchmark to reflect the most recent standards and practices used in the industry and by Bank of America.\\nSenior Secured Notes\\nIn connection with the Transactions, Advantage Solutions FinCo LLC (“Finco”) issued $775.0 million aggregate principal amount of 6.50% Senior Secured Notes due 2028 (the “Notes”). Substantially concurrently with the Transactions, Finco merged with and into Advantage Sales & Marketing Inc. (in its capacity as the issuer of the Notes, the “Issuer”), with the Issuer continuing as the surviving entity and assuming the obligations of Finco. The Notes were sold to BofA Securities, Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC and Apollo Global Securities, LLC. The Notes were resold to certain non-U.S. persons pursuant to Regulation S under the Securities Act of 1933, as amended (the “Securities Act”), and to persons reasonably believed to be qualified institutional buyers pursuant to Rule 144A under the Securities Act at a purchase price equal to 100% of their principal amount. The terms of the Notes are governed by an Indenture, dated as of October 28, 2020 (the “Indenture”), among Finco, the Issuer, the guarantors named therein (the “Notes Guarantors”) and Wilmington Trust, National Association, as trustee and collateral agent.\\nInterest and maturity\\nInterest on the Notes is payable semi-annually in arrears on May 15 and November 15 at a rate of 6.50% per annum, commencing on May 15, 2021. The Notes will mature on November 15, 2028.\\nGuarantees\\nThe Notes are guaranteed by Holdings and each of the Issuer’s direct and indirect wholly owned material U.S. subsidiaries (subject to certain permitted exceptions) and Canadian subsidiaries (subject to certain permitted exceptions, including exceptions based on immateriality thresholders of aggregate assets and revenues of Canadian subsidiaries) that is a borrower or guarantor under the Term Loan Facility.\\nSecurity and Ranking\\nThe Notes and the related guarantees are the general, senior secured obligations of the Issuer and the Notes Guarantors, are secured on a first-priority pari passu basis by security interests on the fixed asset collateral (equal in priority with liens securing the Term Loan Facility), and are secured on a second-priority basis by security interests on the current asset collateral (second in priority to the liens securing the Revolving Credit Facility and equal in priority with liens securing the Term Loan Facility), in each case, subject to certain limitations and exceptions and permitted liens.\\n43\\nThe Notes and related guarantees rank (i) equally in right of payment with all of the Issuer’s and the Guarantors’ senior indebtedness, without giving effect to collateral arrangements (including the Senior Secured Credit Facilities) and effectively equal to all of the Issuer’s and the Guarantors’ senior indebtedness secured on the same priority basis as the Notes, including the Term Loan Facility, (ii) effectively subordinated to any of the Issuer’s and the Guarantors’ indebtedness that is secured by assets that do not constitute collateral for the Notes to the extent of the value of the assets securing such indebtedness and to indebtedness that is secured by a senior-priority lien, including the Revolving Credit Facility to the extent of the value of the current asset collateral and (iii) structurally subordinated to the liabilities of the Issuer’s non-Guarantor subsidiaries.\\nOptional redemption for the Notes\\nThe Notes are redeemable on or after November 15, 2023 at the applicable redemption prices specified in the Indenture plus accrued and unpaid interest. The Notes may also be redeemed at any time prior to November 15, 2023 at a redemption price equal to 100% of the aggregate principal amount of such Notes to be redeemed plus a “make-whole” premium, plus accrued and unpaid interest. In addition, the Issuer may redeem up to 40% of the original aggregate principal amount of Notes before November 15, 2023 with the net cash proceeds of certain equity offerings at a redemption price equal to 106.5% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to November 15, 2023 the Issuer may redeem during each calendar year up to 10% of the original aggregate principal amount of the Notes at a redemption price equal to 103% of the aggregate principal amount of such Notes to be redeemed, plus accrued and unpaid interest. If the Issuer or its restricted subsidiaries sell certain of their respective assets or experience specific kinds of changes of control, subject to certain exceptions, the Issuer must offer to purchase the Notes at par. In connection with any offer to purchase all Notes, if holders of no less than 90% of the aggregate principal amount of Notes validly tender their Notes, the Issuer is entitled to redeem any remaining Notes at the price offered to each holder.\\nRestrictive covenants\\nThe Notes are subject to covenants that, among other things limit the Issuer’s ability and its restricted subsidiaries’ ability to: incur additional indebtedness or guarantee indebtedness; pay dividends or make other distributions in respect of, or repurchase or redeem, the Issuer’s or a parent entity’s capital stock; prepay, redeem or repurchase certain indebtedness; issue certain preferred stock or similar equity securities; make loans and investments; sell or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Issuer’s subsidiaries’ ability to pay dividends; and consolidate, merge or sell all or substantially all of the Issuer’s assets. Most of these covenants will be suspended on the Notes so long as they have investment grade ratings from both Moody’s Investors Service, Inc. and S&P Global Ratings and so long as no default or event of default under the Indenture has occurred and is continuing.\\nEvents of default\\nThe following constitute events of default under the Notes, among others: default in the payment of interest; default in the payment of principal; failure to comply with covenants; failure to pay other indebtedness after final maturity or acceleration of other indebtedness exceeding a specified amount; certain events of bankruptcy; failure to pay a judgment for payment of money exceeding a specified aggregate amount; voidance of subsidiary guarantees; failure of any material provision of any security document or intercreditor agreement to be in full force and effect; and lack of perfection of liens on a material portion of the collateral, in each case subject to applicable grace periods.\\nFuture Cash Requirement\\nThere were no material changes to our contractual future cash requirements from those disclosed in our 2021 Annual Report.\\n44\\nCash and Cash Equivalents Held Outside the United States\\nAs of September 30, 2022 and December 31, 2021, $71.6 million and $86.2 million, respectively, of our cash and cash equivalents were held by foreign subsidiaries. As of September 30, 2022, and December 31, 2021, $21.6 million and $40.0 million, respectively, of our cash and cash equivalents were held by foreign branches.\\nWe assessed our determination as to our indefinite reinvestment intent for certain of our foreign subsidiaries and recorded a deferred tax liability of approximately $2.5 million of withholding tax as of December 31, 2021 for unremitted earnings in Canada with respect to which the Company does not have an indefinite reinvestment assertion. We will continue to evaluate our cash needs, however we currently do not intend, nor do we foresee a need, to repatriate funds from the foreign subsidiaries except for Canada. We have continued to assert indefinite reinvestment on all other earnings as it is necessary for continuing operations and to grow the business. If at a point in the future our assertion changes, we will evaluate tax-efficient means to repatriate the income. In addition, we expect existing domestic cash and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as debt repayment and capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.\\nIf we should require more capital in the United States than is generated by our domestic operations, for example, to fund significant discretionary activities such as business acquisitions, we could elect to repatriate future earnings from foreign jurisdictions. These alternatives could result in higher tax expense or increased interest expense. We consider the majority of the undistributed earnings of our foreign subsidiaries, as of December 31, 2021, to be indefinitely reinvested and, accordingly, no provision has been made for taxes in excess of the $2.5 million noted above.\\nOff-Balance Sheet Arrangements\\nWe do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.\\nCritical Accounting Policies and Estimates\\nOur critical accounting policies and estimates are included in our 2021 Annual Report and did not materially change during the nine months ended September 30, 2022.\\nRecently Issued Accounting Pronouncements\\nSee the information set forth in Note 1, Organization and Significant Accounting Policies – Recent Accounting Standards, to our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2022 and 2021 included in “Part I, Financial Information—Item 1. Financial Statements” in this Quarterly Report.\\n45\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nForeign Currency Risk\\nOur exposure to foreign currency exchange rate fluctuations is primarily the result of foreign subsidiaries and foreign branches primarily domiciled in Europe and Canada. We use financial derivative instruments to hedge foreign currency exchange rate risks associated with our Canadian subsidiary.\\nThe assets and liabilities of our foreign subsidiaries and foreign branches, whose functional currencies are primarily Canadian dollars, British pounds and euros, respectively, are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. The cumulative translation effects for subsidiaries using a functional currency other than the U.S. dollar are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. We estimate that had the exchange rate in each country unfavorably changed by ten percent relative to the U.S. dollar, our consolidated income before taxes would have decreased by approximately $2.5 million for the nine months ended September 30, 2022.\\nInterest Rate Risk\\nInterest rate exposure relates primarily to the effect of interest rate changes on borrowings outstanding under the Term Loan Facility, Revolving Credit Facility and Notes.\\nWe manage our interest rate risk through the use of derivative financial instruments. Specifically, we have entered into interest rate cap agreements to manage our exposure to potential interest rate increases that may result from fluctuations in LIBOR. We do not designate these derivatives as hedges for accounting purposes, and as a result, all changes in the fair value of derivatives, used to hedge interest rates, are recorded in “Interest expense, net” in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\nAs of September 30, 2022, we had interest rate cap contracts on an additional $650.0 million of notional value of principal from other financial institutions, with a maturity date of December 16, 2024 to manage our exposure to interest rate movements on variable rate credit facilities when one-month LIBOR on term loans exceeding a cap of 0.75%. The aggregate fair value of our interest rate caps represented an outstanding net asset of $49.1 million as of September 30, 2022.\\nHolding other variables constant, a change of one-eighth percentage point in the weighted average interest rate above the floor of 0.75% on the Term Loan Facility and Revolving Credit Facility would have resulted in an increase of $0.7 million in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022.\\nIn the future, in order to manage our interest rate risk, we may refinance our existing debt, enter into additional interest rate cap agreements or modify our existing interest rate cap agreement. However, we do not intend or expect to enter into derivative or interest rate cap transactions for speculative purposes.\\n46\\nITEM 4. CONTROLS AND PROCEDURES\\nOur management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2022, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\\nThere were no changes in internal control over financial reporting that occurred during the quarter ended September 30, 2022, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.\\nIn designing and evaluating our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints, and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.\\n47\\nPART II - OTHER INFORMATION\\nITEM 1. LEGAL PROCEEDINGS\\nWe are involved in various legal matters that arise in the ordinary course of our business. Some of these legal matters purport or may be determined to be class and/or representative actions, or seek substantial damages or penalties. Some of these legal matters relate to disputes regarding acquisitions. In connection with certain of the below matters and other legal matters, we have accrued amounts that we believe are appropriate. There can be no assurance, however, that the above matters and other legal matters will not result in us having to make payments in excess of such accruals or that the above matters or other legal matters will not materially or adversely affect our business, financial position or results of operations.\\nEmployment-Related Matters\\nWe have also been involved in various litigation, including purported class or representative actions with respect to matters arising under the U.S. Fair Labor Standards Act, California’s Labor Code (the “Labor Code”) and California’s Labor Code Private Attorneys General Act (“PAGA”). Many involve allegations for allegedly failing to pay wages and/or overtime, failing to provide meal and rest breaks and failing to pay reporting time pay, waiting time penalties and other penalties.\\nA former employee filed a complaint in California Superior Court, Santa Clara County in July 2017, which seeks civil damages and penalties on behalf of the plaintiff and similarly situated persons for various alleged wage and hour violations under the Labor Code, including failure to pay wages and/or overtime, failure to provide meal and rest breaks, failure to pay reporting time pay, waiting time penalties and penalties pursuant to PAGA. We filed a motion for summary judgment. The court granted our motion for summary judgment in March 2020, and the plaintiff filed an appeal of the court’s ruling in May 2020. We have retained outside counsel to represent us and intend to vigorously defend our interests in this matter.\\nProceedings Relating to Take 5\\nThe following proceedings relate to the Take 5 Matter, which is discussed in greater detail in “PART I, Financial Information —Item 1. Financial Statements—Note 10. Commitments and Contingencies” and “Risk Factors — Risks Related to the Company’s Business and Industry” in this Quarterly Report.\\nUSAO and FBI Voluntary Disclosure and Investigation Related to Take 5\\nIn connection with the Take 5 Matter, we voluntarily disclosed to the United States Attorney’s Office and the Federal Bureau of Investigation certain misconduct occurring at Take 5. We intend to cooperate in this and any other governmental investigation that may arise in connection with the Take 5 Matter. At this time, we cannot predict the ultimate outcome of any investigation related to the Take 5 Matter and are unable to estimate the potential impact such an investigation may have on us.\\nArbitration Proceedings Related to Take 5\\nIn August 2019, as a result of the Take 5 Matter, we provided a written indemnification claim notice to the sellers of Take 5, or the Take 5 Sellers, seeking monetary damages (including interest, fees and costs) based on allegations of breach of the asset purchase agreement, or Take 5 APA, as well as fraud. In September 2019, the Take 5 Sellers initiated arbitration proceedings in the state of Delaware against us, alleging breach of the Take 5 APA as a result of our decision to terminate the operations of the Take 5 business and seeking monetary damages equal to all unpaid earn-out payments under the Take 5 APA (plus interest fees and costs). In 2020, the Take 5 Sellers amended their statement of claim to allege defamation, relating to statements we made to customers in connection with terminating the operations of the Take 5 business, and seeking monetary damages for the alleged injury to their reputation. We have filed our response to the Take 5 Sellers’ claims and asserted indemnification, fraud and other claims against the Take 5 Sellers as counterclaims and cross-claims in the arbitration proceedings.\\n48\\nIn October 2022, the arbitrator made a final award in our favor. We are currently unable to estimate if or when we will be able to collect any amounts associated with this arbitration.\\nOther Legal Matters Related to Take 5\\nThe Take 5 Matter may result in additional litigation against us, including lawsuits from clients, or governmental investigations, which may expose us to potential liability in excess of the amounts being offered by us as refunds to Take 5 clients. We are currently unable to determine the amount of any potential liability, costs or expenses (above the amounts already being offered as refunds) that may result from any lawsuits or investigations associated with the Take 5 Matter or determine whether any such issues will have any future material adverse effect on our financial position, liquidity or results of operations. Although we have insurance covering certain liabilities, we cannot assure that the insurance will be sufficient to cover any potential liability or expenses associated with the Take 5 Matter.\\nITEM 1A. RISK FACTORS\\nInvesting in our securities involves risks. Before you make a decision regarding our securities, in addition to the risks and uncertainties discussed above under “Forward-Looking Statements,” you should carefully consider the specific risks set forth herein. If any of these risks actually occur, it may materially harm our business, financial condition, liquidity and results of operations. As a result, the market price of our securities could decline, and you could lose all or part of your investment. Additionally, the risks and uncertainties described in this Quarterly Report are not the only risks and uncertainties that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may become material and adversely affect our business. The following discussion should be read in conjunction with the financial statements and notes to the financial statements included herein.\\nSummary of Principal Risks Associated with Our Business\\nSet forth below is a summary of some of the principal risks we face:\\n•the COVID-19 pandemic and the measures taken to mitigate its spread including its adverse effects on our business, results of operations, financial condition and liquidity;\\n•market-driven wage changes or changes to labor laws or wage or job classification regulations, including minimum wage;\\n•our ability to hire, timely train, and retain talented individuals for our workforce, and to maintain our corporate culture as we grow;\\n•developments with respect to retailers that are out of our control;\\n•our ability to continue to generate significant operating cash flow;\\n•consolidation within the industry of our clients creating pressure on the nature and pricing of our services;\\n•our reliance on continued access to retailers’ platforms;\\n•consumer goods manufacturers and retailers reviewing and changing their sales, retail, marketing, and technology programs and relationships;\\n•our ability to successfully develop and maintain relevant omni-channel services for our clients in an evolving industry and to otherwise adapt to significant technological change;\\n•client procurement strategies putting additional operational and financial pressure on our services;\\n•our ability to maintain proper and effective internal control over financial reporting in the future;\\n•potential and actual harms to our business arising from the matter related to the 2018 acquisition of Take 5 Media Group (the “Take 5 Matter”);\\n•our ability to identify attractive acquisition targets, acquire them at attractive prices, and successfully integrate the acquired businesses;\\n•our ability to avoid or manage business conflicts among competing brands;\\n49\\n•difficulties in integrating acquired businesses;\\n•our substantial indebtedness and our ability to refinance at favorable rates;\\n•limitations, restrictions, and business decisions involving our joint ventures and minority investments;\\n•our ability to respond to changes in digital practices and policies;\\n•exposure to foreign currency exchange rate fluctuations and risks related to our international operations;\\n•disruptions in global financial markets relating to terrorist attacks or geopolitical risk and the recent conflict between Russia and Ukraine;\\n•the ability to maintain applicable listing standards;\\n•changes in applicable laws or regulations; and\\n•the possibility that we may be adversely affected by other political, economic, business, and/or competitive factors.\\nRisks Related to the Company’s Business and Industry\\nThe COVID-19 pandemic and the measures taken to mitigate its spread have had, and are likely to continue to have, an adverse effect on our business, results of operations, financial condition and liquidity.\\nThe COVID-19 pandemic, including the measures taken to mitigate its spread, have had, and are likely to continue to have, adverse effects on our business and operations. There are many uncertainties regarding the current COVID-19 pandemic, including the scope of potential public health issues, the anticipated duration of the pandemic and the extent of local and worldwide social, political and economic disruption it has caused and may cause in the future. To date, the COVID-19 pandemic and measures taken to mitigate the spread of COVID-19, including restrictions on large gatherings, closures of face-to-face events and indoor dining facilities, “shelter in place” health orders and travel restrictions, have had far-reaching direct and indirect impacts on many aspects of our operations, including temporary termination of certain in-store demonstration services and other services, as well as on consumer behavior and purchasing patterns, in particular with respect to the foodservice industries, and declines in consumer demand for restaurant, school and hotel dining, where we promote our clients’ products. Since March 2020, our marketing segment has experienced a significant decline in revenues, primarily due to the temporary suspension or reduction of certain in-store demonstration services and decreased demand in our digital marketing services, both of which we believe were caused by the COVID-19 pandemic and the various governmental and private responses to the pandemic, and which may continue in the future. In our sales segment, we have experienced significant shifts in consumer spending preferences and habits. We can provide no assurances that the strength of that segment will continue or that we will be able to continue to evolve our business in the future as the COVID-19 pandemic continues to impact our clients’ businesses.\\nWe have taken several actions in response to these business disruptions, including reducing certain of our discretionary expenditures, reducing our real estate foot print, through lease terminations and amendments (including abandoning several office leases prior to reaching termination agreements with its landlords), eliminating non-essential travel and terminating, furloughing or instituting pay reductions and deferrals for some of our associates. However, the pandemic has had, and may continue to have, an adverse effect on our results of operations, including our revenues, our financial condition and liquidity.\\nThe COVID-19 pandemic also may have the effect of heightening many of the other risks described in these “Risk Factors”, including:\\n•potential changes in the policies of retailers in response to the COVID-19 pandemic, including changes to or restrictions on their outsourcing of sales and marketing functions and restrictions on the performance of in-store demonstration services, if permitted at all;\\n•potential changes in the demand for services by our clients in response to the COVID-19 pandemic;\\n•our ability to hire, timely train and retain talented individuals for our workforce;\\n•disruptions, delays and strains in certain domestic and internal supply changes that have had, and may continue to have, a negative effect on the flow or availability of certain products;\\n50\\n•the need for us to adapt to technological change and otherwise develop and maintain omni-channel solutions;\\n•our ability to generate sufficient cash to service our substantial indebtedness;\\n•our ability to maintain our credit rating;\\n•our ability to offer high-quality customer support and maintain our reputation;\\n•our ability to identify, perform adequate diligence on and consummate acquisitions of attractive business targets, and then subsequently integrate such acquired businesses;\\n•our ability to maintain our corporate culture;\\n•severe disruption and instability in the U.S. and global financial markets or deteriorations in credit and financing conditions, which could make it difficult for us to access debt and equity capital on attractive terms, or at all;\\n•our ability to effectively manage our operations while a significant amount of our associates continue to work remotely due to the COVID-19 pandemic;\\n•deteriorating economic conditions, declines in labor force participation rates, public transportation disruptions or other disruptions as a result of the COVID-19 pandemic;\\n•potential cost-saving strategies implemented by clients that reduce fees paid to third-party service providers such as ourselves; and\\n•our ability to implement additional internal control measures to improve our internal control over financial reporting.\\nWe cannot predict the full extent to which the COVID-19 pandemic may affect our business, financial condition, results of operations and liquidity as such effects will depend on how the COVID-19 pandemic and the measures taken in response to the COVID-19 pandemic continue to develop. However, these effects may continue, evolve or increase in severity, each of which could further negatively impact our business, financial condition, results of operations and liquidity.\\nMarket-driven wage increases and changes to wage or job classification regulations, including minimum wages could adversely affect our business, financial condition or results of operations.\\nMarket competition has and may continue to cause us to increase the salaries or wages paid to our associates or the benefits packages that they receive. If we experience further market-driven increases in salaries, wage rates or benefits or if we fail to increase our offered salaries, wages or benefits packages competitively, the quality of our workforce could decline, causing our client service to suffer. Low unemployment rates or lower levels of labor force participation rates may increase the likelihood or impact of such market pressures. Any of these changes affecting wages or benefits for our associates could adversely affect our business, financial condition or results of operations.\\nChanges in labor laws related to employee hours, wages, job classification and benefits, including health care benefits, could adversely affect our business, financial condition or results of operations. As of September 30, 2022, we employed approximately 75,000 associates, many of whom are paid above, but near, applicable minimum wages, and their wages may be affected by changes in minimum wage laws.\\nAdditionally, many of our salaried associates are paid at rates that could be impacted by changes to minimum pay levels for exempt roles. Certain state or municipal jurisdictions in which we operate have recently increased their minimum wage by a significant amount, and other jurisdictions are considering or plan to implement similar actions, which may increase our labor costs. Any increases at the federal, state or municipal level to the minimum pay rate required to remain exempt from overtime pay may adversely affect our business, financial condition or results of operations.\\nAn inability to hire, timely train and retain talented individuals for our workforce could slow our growth and adversely impact our ability to operate our business.\\nOur ability to meet our workforce needs, while controlling associate-related costs, including salaries, wages and benefits, is subject to numerous external factors, including the availability of talented persons in the workforce in the local markets in which we operate, prevailing unemployment rates and competitive wage rates in such\\n51\\nmarkets. We may find that there is an insufficient number of qualified individuals to fill our associate positions with the qualifications we seek. Competition in these communities for qualified staff could require us to pay higher wages and provide greater benefits, especially if there is significant improvement in regional or national economic conditions. We must also train and, in some circumstances, certify these associates under our policies and practices and any applicable legal requirements. If we are unable to hire, timely train or retain talented individuals may result in higher turnover and increased labor costs, and could compromise the quality of our service, all of which could adversely affect our business.\\nInflation may adversely affect our operating results.\\nInflationary factors such as increases in the labor costs, material costs and overhead costs may adversely affect our operating results. A high rate of inflation, including a continuation of inflation at the current rate, has had and may continue to have an adverse effect on our ability to maintain attractive levels of gross margin and general and administrative expenses as a percentage of total revenue, if we are unable to pass on these costs through increased prices, revised budget estimates, or offset them in other ways.\\nOur business and results of operations are affected by developments with and policies of retailers that are out of our control.\\nA limited number of national retailers account for a large percentage of sales for our consumer goods manufacturer clients. We expect that a significant portion of these clients’ sales will continue to be made through a relatively small number of retailers and that this percentage may increase if the growth of mass retailers and the trend of retailer consolidation continues. As a result, changes in the strategies of large retailers, including a reduction in the number of brands that these retailers carry or an increase in shelf space that they dedicate to private label products, could materially reduce the value of our services to these clients or these clients’ use of our services and, in turn, our revenues and profitability. Many retailers have critically analyzed the number and variety of brands they sell, and have reduced or discontinued the sale of certain of our clients’ product lines at their stores, and more retailers may continue to do so. If this continues to occur and these clients are unable to improve distribution for their products at other retailers, our business or results of operations could be adversely affected. These trends may be accelerated as a result of the COVID-19 pandemic.\\nAdditionally, many retailers, including several of the largest retailers in North America, which own and operate a significant number of the locations at which we provide our services, have implemented or may implement in the future, policies that designate certain service providers to be the exclusive provider or one of their preferred providers for specified services, including many of the services that we provide to such retailers or our clients.\\nSome of these designations apply across all of such retailers’ stores, while other designations are limited to specific regions. If we are unable to respond effectively to the expectations and demands of such retailers or if retailers do not designate us as their exclusive provider or one of their preferred providers for any reason, they could reduce or restrict the services that we are permitted to perform for our clients at their facilities or require our clients to purchase services from other designated services providers, which include our competitors, either of which could adversely affect our business or results of operations.\\nConsolidation in the industries we serve could put pressure on the pricing of our services, which could adversely affect our business, financial condition or results of operations.\\nConsolidation in the consumer goods and retail industries we serve could reduce aggregate demand for our services in the future and could adversely affect our business or our results of operations. In October 2022, The Kroger Co. and Albertsons Companies, Inc., two large retailers, announced an agreement to merge their businesses together with an anticipated closing in 2024. When companies consolidate, the services they previously purchased separately are often purchased by the combined entity, leading to the termination of relationships with certain service providers or demands for reduced fees and commissions. The combined company may also choose to insource certain functions that were historically outsourced, resulting in the termination of existing relationships with third-party service providers. While we attempt to mitigate the revenue impact of any consolidation by maintaining existing or winning new service arrangements with the combined companies, there can be no assurance as to the degree to which we will be able to do so as consolidation continues in the industries we serve, and our business, financial condition or results of operations may be adversely affected.\\n52\\nConsumer goods manufacturers and retailers may periodically review and change their sales, retail, marketing and technology programs and relationships to our detriment.\\nThe consumer goods manufacturers and retailers to whom we provide our business solutions operate in highly competitive and rapidly changing environments. From time to time these parties may put their sales, retail, marketing and technology programs and relationships up for competitive review, which may increase in frequency as a result of the COVID-19 pandemic and its impacts on the consumer goods manufacturers and retailer industries. We have occasionally lost accounts with significant clients as a result of these reviews in the past, and our clients are typically able to reduce or cancel current or future spending on our services on short notice for any reason. We believe that key competitive considerations for retaining existing and winning new accounts include our ability to develop solutions that meet the needs of these manufacturers and retailers in this environment, the quality and effectiveness of our services and our ability to operate efficiently. To the extent that we are not able to develop these solutions, maintain the quality and effectiveness of our services or operate efficiently, we may not be able to retain key clients, and our business, financial condition or results of operations may be adversely affected.\\nOur largest clients generate a significant portion of our revenues.\\nOur three largest clients generated approximately 11% of our revenues in the fiscal year ended December 31, 2021. These clients are generally able to reduce or cancel spending on our services on short notice for any reason. A significant reduction in spending on our services by our largest clients, or the loss of one or more of our largest clients, if not replaced by new clients or an increase in business from existing clients, would adversely affect our business and results of operations. In addition, when large retailers suspend or reduce in-store demonstration services, such as in response to the COVID-19 pandemic, our business and results of operations can be adversely affected.\\nWe are reliant on continued access to retailer platforms on commercially reasonable terms for the provision of certain of our e-commerce services in which our clients’ products are resold by us, as the vendor of record, directly to the consumer.\\nA portion of the e-commerce services we provide involve the purchase and resale by us, as the vendor of record, of our clients’ products through retailer platforms. The control that retailers such as Amazon have over the access and fee structures and/or pricing for products on their platforms could impact the volume of purchases of these products made on their platform and our revenues from the provision of such e-commerce services. If such retailers establish terms that restrict the offering of these products on their platform, significantly impact the financial terms on which such products are offered, or do not approve the inclusion of such products on their platform, our business could be negatively impacted. Additionally, we also generally rely on a retailer’s payment processing services for purchases made on its platform by consumers. To the extent such payment processing services are offered to us on less favorable terms, or become unavailable to us for any reason, our costs of revenue with respect to this aspect of our business could increase, and our margins could be materially adversely impacted. We cannot assure you that we will be successful in maintaining access to these retailer platforms on commercially reasonable terms, or at all.\\nThe retail industry is evolving, and if we do not successfully develop and maintain relevant omni-channel services for our clients, our business, financial condition or results of operations could be adversely impacted.\\nHistorically, substantially all of our sales segment revenues were generated by sales and services that ultimately occurred in traditional retail stores. The retail industry is evolving, as demonstrated by the number of retailers that offer both traditional retail stores and e-commerce platforms or exclusively e-commerce platforms. In addition, the COVID-19 pandemic has placed pressure on the traditional retail store model, including store closures, changes in consumer spending, and extensive health and safety risks and compliance requirements. Consumers are increasingly using computers, tablets, mobile phones and other devices to comparison shop, determine product availability and complete purchases online, a trend that has accelerated during the COVID-19 pandemic, and which may continue thereafter. If consumers continue to purchase more products online and e-commerce continues to displace brick-and-mortar retail sales, there may be a decrease in the demand for certain of our services. Omni-channel retailing is rapidly evolving and we believe we will need to keep pace with the changing consumer expectations and new developments by our competitors.\\n53\\nWhile we continue to seek to develop effective omni-channel solutions for our clients that support both their e-commerce and traditional retail needs, there can be no assurances that these efforts will result in revenue gains sufficient to offset potential decreases associated with a decline in traditional retail sales or that we will be able to maintain our position as a leader in our industry. If we are unable to provide, improve or develop innovative digital services and solutions in a timely manner or at all, our business, financial condition or results of operations could be adversely impacted.\\nWe may be unable to adapt to significant technological change, which could adversely affect our business, financial condition or results of operations.\\nWe operate businesses that require sophisticated data collection, processing and software for analysis and insights. Some of the technologies supporting the industries we serve are changing rapidly, particularly as a result of the COVID-19 pandemic. We will be required to continue to adapt to changing technologies, either by developing and marketing new services or by enhancing our existing services, to meet client demand.\\nMoreover, the introduction of new services embodying new technologies, including automation of certain of our in-store services, and the emergence of new industry standards could render existing services obsolete. Our continued success will depend on our ability to adapt to changing technologies, manage and process increasing amounts of data and information and improve the performance, features and reliability of our existing services in response to changing client and industry demands. We may experience difficulties that could delay or prevent the successful design, development, testing, introduction or marketing of our services. New services or enhancements to existing services may not adequately meet the requirements of current and prospective clients or achieve market acceptance.\\nOur ability to maintain our competitive position depends on our ability to attract and retain talented executives.\\nWe believe that our continued success depends to a significant extent upon the efforts, abilities and relationships of our senior executives and the strength of our middle management team. Although we have entered into employment agreements with certain of our senior executives, each of them may terminate their employment with us at any time. The replacement of any of our senior executives likely would involve significant time and costs and may significantly delay or prevent the achievement of our business objectives and could therefore have an adverse impact on our business. In addition, we do not carry any “key person” insurance policies that could offset potential loss of service under applicable circumstances. Furthermore, if we are unable to attract and retain a talented team of middle management executives, it may be difficult to maintain the expertise and industry relationships that our clients value, and they may terminate or reduce their relationship with us.\\nClient procurement and fee reduction strategies could put additional operational and financial pressure on our services or negatively impact our relationships, business, financial condition or results of operations.\\nMany of our clients seek opportunities to reduce their costs through procurement strategies that reduce fees paid to third-party service providers. As a result, certain of our clients have sought, and may continue to seek, more aggressive terms from us, including with respect to pricing and payment terms. Such activities put operational and financial pressure on our business, which could limit the amounts we earn or delay the timing of our cash receipts. Such activities may also cause disputes with our clients or negatively impact our relationships or financial results. Our clients have experienced, and may continue to experience, increases in their expenses associated with materials and logistics, which may cause them to reduce expenses elsewhere. While we attempt to mitigate negative implications to client relationships and the revenue impact of any pricing pressure by aligning our revenues opportunity with satisfactory client outcomes, there can be no assurance as to the degree to which we will be able to do so successfully. Additionally, price concessions can lead to margin compression, which in turn could adversely affect our business, financial condition or results of operations.\\nIf we fail to offer high-quality customer support, our business and reputation may suffer.\\nHigh-quality education, training and customer support are important for successful marketing and sales and for the renewal of existing customers. Providing this education, training and support requires that our personnel who manage our online training resource or provide customer support have specific inbound experience domain knowledge and expertise, making it more difficult for us to hire qualified personnel and to scale up our support operations. The importance of high-quality customer support will increase as we expand our business and pursue\\n54\\nnew customers. If we do not help our customers use multiple applications and provide effective ongoing support, our ability to sell additional functionality and services to, or to retain, existing customers may suffer and our reputation with existing or potential customers may be harmed.\\nWe may be adversely affected if clients reduce their outsourcing of sales and marketing functions.\\nOur business and growth strategies depend in large part on companies continuing to elect to outsource sales and marketing functions. Our clients and potential clients will outsource if they perceive that outsourcing may provide quality services at a lower overall cost and permit them to focus on their core business activities and have done so in the past. We cannot be certain that the industry trend to outsource will continue or not be reversed or that clients that have historically outsourced functions will not decide to perform these functions themselves. Unfavorable developments with respect to outsourcing could adversely affect our business, financial conditions and results of operations.\\nWe previously identified material weaknesses in our internal control over financial reporting. If we fail to maintain proper and effective internal control over financial reporting in the future, our ability to produce accurate and timely financial statements could be impaired, investors’ views of us could be harmed, and we could be subject to enforcement actions by the SEC.\\nDuring 2021, we completed the remediation measures related to the material weaknesses previously identified and concluded that our internal control over financial reporting was effective as of December 31, 2021. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. If we are unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and adversely impact our stock price.\\nIf we are unable to identify attractive acquisition targets, acquire them at attractive prices or successfully integrate the acquired businesses, we may be unsuccessful in growing our business.\\nA significant portion of our growth has been as a result of our acquisition of complementary businesses that grow our service offerings, expand our geographic reach and strengthen valuable relationships with clients. However, there can be no assurance that we will find attractive acquisition targets, that we will acquire them at attractive prices, that we will succeed at effectively managing the integration of acquired businesses into our existing operations or that such acquired businesses or technologies will be well received by our clients, potential clients or our investors. We could also encounter higher-than-expected earn-out payments, unforeseen transaction- and integration-related costs or delays or other circumstances such as disputes with or the loss of key or other personnel from acquired businesses, challenges or delays in integrating systems or technology of acquired businesses, a deterioration in our associate and client relationships, harm to our reputation with clients, interruptions in our business activities or unforeseen or higher-than-expected inherited liabilities. Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies or the diversion of management time and attention.\\nIn order for us to continue to grow our business through acquisitions we will need to identify appropriate acquisition opportunities and acquire them at attractive prices. We may choose to pay cash, incur debt or issue equity securities to pay for any such acquisition. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations. The sale of equity to finance any such acquisition could result in dilution to our stockholders.\\nWe may encounter significant difficulties integrating acquired businesses.\\nThe integration of any businesses is a complex, costly and time-consuming process. As a result, we have devoted, and will continue to devote, significant management attention and resources to integrating acquired businesses. The failure to meet the challenges involved in integrating businesses and to realize the anticipated benefits of any acquisition could cause an interruption of, or a loss of momentum in, the activities of our combined\\n55\\nbusiness and could adversely affect our results of operations. The difficulties of combining acquired businesses with our own include, among others:\\n•the diversion of management attention to integration matters;\\n•difficulties in integrating functional roles, processes and systems, including accounting systems;\\n•challenges in conforming standards, controls, procedures and accounting and other policies, business cultures and compensation structures between the two companies;\\n•difficulties in assimilating, attracting and retaining key personnel;\\n•challenges in keeping existing clients and obtaining new clients;\\n•difficulties in achieving anticipated cost savings, synergies, business opportunities and growth prospects from an acquisition;\\n•difficulties in managing the expanded operations of a significantly larger and more complex business;\\n•contingent liabilities, including contingent tax liabilities or litigation, that may be larger than expected; and\\n•potential unknown liabilities, adverse consequences or unforeseen increased expenses associated with an acquisition, including possible adverse tax consequences to the combined business pursuant to changes in applicable tax laws or regulations.\\nMany of these factors are outside of our control, and any one of them could result in increased costs, decreased expected revenues and diversion of management time and energy, all of which could adversely impact our business and results of operations. These difficulties have been enhanced further during the COVID-19 pandemic as a result of our office closures and work-from home policies, which may hinder assimilation of key personnel.\\nIf we are not able to successfully integrate an acquisition, if we incur significantly greater costs to achieve the expected synergies than we anticipate or if activities related to the expected synergies have unintended consequences, our business, financial condition or results of operations could be adversely affected.\\nOur corporate culture has contributed to our success and, if we are unable to maintain it as we evolve, our business, operating results and financial condition could be harmed.\\nWe believe our corporate culture has been a significant factor in our success. However, as our company evolves, including through acquisitions and the impacts of the COVID-19 pandemic, such as working remotely and reductions in workforce, it may be difficult to maintain our culture, which could reduce our ability to innovate and operate effectively. The failure to maintain the key aspects of our culture as our organization evolves could result in decreased employee satisfaction, increased difficulty in attracting top talent, increased turnover and compromised the quality of our client service, all of which are important to our success and to the effective execution of our business strategy. If we are unable to maintain our corporate culture as we evolve and execute our growth strategies, our business, operating results and financial condition could be harmed.\\nAcquiring new clients and retaining existing clients depends on our ability to avoid or manage business conflicts among competing brands.\\nOur ability to acquire new clients and to retain existing clients, whether by expansion of our own operations or through an acquired business may in some cases be limited by the other parties’ perceptions of, or policies concerning, perceived competitive conflicts arising from our other relationships. Some of our contracts expressly restrict our ability to represent competitors of the counterparty. These perceived competitive conflicts may also become more challenging to avoid or manage as a result of continued consolidation in the consumer goods and retail industries and our own acquisitions. If we are unable to avoid or manage business conflicts among competing manufacturers and retailers, we may be unable to acquire new clients or be forced to terminate existing client relationships, and in either case, our business and results of operations may be adversely affected.\\nLimitations, restrictions and business decisions involving our joint ventures and minority investments may adversely affect our growth and results of operations.\\n56\\nWe have made substantial investments in joint ventures and minority investments and may use these and other similar methods to expand our service offerings and geographical coverage in the future. These arrangements typically involve other business services companies as partners that may be competitors of ours in certain markets. Joint venture agreements may place limitations or restrictions on our services. As part of our joint venture with, and investments in Smollan, we are restricted under certain circumstances from making direct acquisitions and otherwise expanding our service offerings into markets outside of North America and Europe. As a result of our acquisition of Daymon Worldwide Inc. pursuant to the terms of our arrangements with Smollan and our joint venture, Smollan and our joint venture may elect to purchase from us, and have purchased, certain Daymon business units that operate outside of North America. If Smollan or our joint venture do not elect to purchase those business units, we may, under certain circumstances, elect to retain, sell or discontinue those business units. The limitations and restrictions tied to our joint venture and minority investments limit our potential business opportunities and reduce the economic opportunity for certain prospective international investments and operations. Additionally, though we control our joint ventures, we may rely upon our equity partners or local management for operational and compliance matters associated with our joint ventures or minority investments. Moreover, our other equity partners and minority investments may have business interests, strategies or goals that are inconsistent with ours. Business decisions, including actions or omissions, of a joint venture or other equity partner or management for a business unit may adversely affect the value of our investment, result in litigation or regulatory action against us or adversely affect our growth and results of operations.\\nOur international operations expose us to risks that could impede growth in the future, and our attempts to grow our business internationally may not be successful.\\nWe continue to explore opportunities in major international markets. International operations expose us to various additional risks that could adversely affect our business, including:\\n•costs of customizing services for clients outside of the United States;\\n•the burdens of complying with a wide variety of foreign laws;\\n•potential difficulty in enforcing contracts;\\n•being subject to U.S. laws and regulations governing international operations, including the U.S. Foreign Corrupt Practices Act and sanctions regimes;\\n•being subject to foreign anti-bribery laws in the jurisdictions in which we operate, such as the UK Bribery Act;\\n•reduced protection for intellectual property rights;\\n•increased financial accounting and reporting complexity;\\n•additional legal compliance requirements, including custom and import requirements with respect to products imported to and exported across international borders;\\n•exposure to foreign currency exchange rate fluctuations;\\n•exposure to local economic conditions;\\n•limitations on the repatriation of funds or profits from foreign operations;\\n•exposure to local or regional political conditions, including adverse tax policies and civil unrest;\\n•the risks of a natural disaster, public health crisis (including the occurrence of a contagious disease or illness, such as the coronavirus), an outbreak of war (such as Russia's invasion of Ukraine), the escalation of hostilities and acts of terrorism in the jurisdictions in which we operate; and\\n•the disparate impact of the COVID-19 pandemic, including the measures taken to mitigate its spread, across various jurisdictions.\\nAdditionally, the withdrawal of the United Kingdom from the European Union, or “Brexit,” has created economic and political uncertainty, including volatility in global financial markets and the value of foreign currencies. The impact of Brexit may not be fully realized for several years. Additionally, in many countries outside of the United States, there has not been a historical practice of using third parties to provide sales and marketing services. Accordingly, while it is part of our strategy to expand into international markets, it may be difficult for us to grow our international business units on a timely basis, or at all.\\nThe ongoing conflict between Russia and Ukraine may adversely affect our business and results of operations.\\n57\\nGiven the nature of our business and our international operations, political, economic, and other conditions in foreign countries and regions, including geopolitical risks such as those arising from the current conflict between Russia and Ukraine, may adversely affect our business and results of operations. The broader consequences of this conflict, which may include further sanctions, embargoes, regional instability, and geopolitical shifts; disruptions to transportation and distribution routes, or strategic decisions to alter certain routes; potential retaliatory action by the Russian government against companies, including us, including nationalization of foreign businesses and/or assets in Russia; increased tensions between the United States and countries in which we operate; and the extent of the conflict’s effect on our business and results of operations as well as the global economy, cannot be predicted.\\nAdditionally, we have a minority interest in a European company that owns majority interests in local agencies in Russia. In addition to the imposition of sanctions by the United States, the United Kingdom, and the European Union that affect the cross-border operations of businesses operating in Russia, Russian regulators have imposed currency restrictions and regulations that created uncertainty regarding our ability to recover our investment in operations in Russia, as well as our ability to exercise control or influence involving operations by the local agencies in Russia. As a result, we intend to use our influence to cause the European company to dispose of our ownership interests in the local agencies in Russia. Accordingly, we recorded pretax charges of $2.8 million in the first quarter of 2022, primarily consisting of our proportionate share of the net investment in our Russian interest in “Selling, general, and administrative expenses” in the Condensed Consolidated Statements of Operations and Comprehensive Income.\\nTo the extent the current conflict between Russia and Ukraine adversely affects our business, particularly in Russia, it may also have the effect of heightening many other risks disclosed in our 2021 Annual Report and this Quarterly Report, any of which could materially and adversely affect our business and results of operations. Such risks include, but are not limited to, adverse effects on macroeconomic conditions, including inflation and business spending; disruptions to our information technology infrastructure, including through cyberattack, ransom attack, or cyber-intrusion; adverse changes in international trade policies and relations; our ability to maintain or increase our prices, our ability to implement and execute our business strategy, disruptions in global supply chains, our exposure to foreign currency fluctuations, and constraints, volatility, or disruption in the capital markets, difficulty staffing and managing impacted operations, and the recoverability of assets in the region.\\nWe may be subject to unionization, work stoppages, slowdowns or increased labor costs.\\nCurrently, none of our associates in the United States are represented by a union. However, our associates have the right under the National Labor Relations Act to choose union representation. If all or a significant number of our associates become unionized and the terms of any collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. Moreover, if a significant number of our associates participate in labor unions, it could put us at increased risk of labor strikes and disruption of our operations or adversely affect our growth and results of operations. In December 2019, a union which commonly represents employees in the supermarket industry filed a petition with the National Labor Relations Board to represent approximately 120 of our associates who work in and around Boston. An election was held, and based on certified results of the election we prevailed in this election. Notwithstanding this successful election, we could face future union organization efforts or elections, which could lead to additional costs, distract management or otherwise harm our business.\\nIf goodwill or other intangible assets in connection with our acquisitions become impaired, we could take significant non-cash charges against earnings.\\nWe have made acquisitions to complement and expand the services we offer and intend to continue to do so when attractive acquisition opportunities exist in the market. As a result of prior acquisitions, including the acquisition of our business in 2014 by our current parent entity, Topco, we have goodwill and intangible assets recorded on our balance sheet of $2.2 billion and $2.2 billion, respectively, as of September 30, 2022, as further described in Note 4 to our condensed consolidated financial statements for the three and nine months ended September 30, 2022.\\nUnder accounting guidelines, we must assess, at least annually, whether the value of goodwill and other intangible assets has been impaired. We have recognized non-cash goodwill and non-cash intangible asset impairment charges, and we can make no assurances that we will not record any additional impairment charges in\\n58\\nthe future. Any future reduction or impairment of the value of goodwill or other intangible assets will similarly result in charges against earnings, which could adversely affect our reported financial results in future periods.\\nFailures in, or incidents involving, our technology infrastructure could damage our business, reputation and brand and substantially harm our business and results of operations.\\nOur business is highly dependent on our ability to manage operations and process a large number of transactions on a daily basis. We rely heavily on our operating, payroll, financial, accounting and other data processing systems which require substantial support and maintenance, and may be subject to disabilities, errors, or other harms. If our data and network infrastructure were to fail, or if we were to suffer a data security breach, or an interruption or degradation of services in our data center, third-party cloud, and other infrastructure environments, we could lose important data, which could harm our business and reputation, and cause us to incur significant liabilities. Our facilities, as well as the facilities of third-parties that provide or maintain, or have access to our data or network infrastructure, are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cyber security attacks, terrorist attacks, power losses, telecommunications failures and similar events. In the event that our or any third-party provider’s systems or service abilities are hindered by any of the events discussed above, our ability to operate may be impaired. Our information technology systems, and the information technology systems of our current or future third-party vendors, collaborators, consultants and service providers, could be penetrated by internal or external parties intent on extracting information, corrupting information, stealing intellectual property or trade secrets, or disrupting business processes. A third party’s decision to close facilities or terminate services without adequate notice, or other unanticipated problems, could adversely impact our operations. Any of the aforementioned risks may be augmented if our or any third-party provider’s business continuity and disaster recovery plans prove to be inadequate in preventing the loss of data, service interruptions, disruptions to our operations or damages to important systems or facilities. Our data center, third-party cloud, and managed service provider infrastructure also could be subject to break-ins, cyber-attacks (including through the use of malware, software bugs, computer viruses, ransomware, social engineering, and denial of service), sabotage, intentional acts of vandalism and other misconduct, from a spectrum of actors ranging in sophistication from threats common to most industries to more advanced and persistent, highly organized adversaries. Any security breach or incident, including personal data breaches, that we experience could result in unauthorized access to, or misuse, modification, destruction or unauthorized acquisition of, our internal sensitive corporate data, such as personal data, financial data, trade secrets, intellectual property, or other competitively sensitive or confidential data. Such unauthorized access, misuse, acquisition, or modification of sensitive data may result in data loss, corruption or alteration, interruptions in our operations or damage to our computer hardware or systems or those of our employees or customers. Our systems have been the target of cyber-attacks. Although we have taken and continue to take steps to enhance our cybersecurity posture, we cannot assure that future cyber incidents will not occur or that our systems will not be targeted or breached in the future. Any such breach or unauthorized access could result in a disruption of the Company’s operations, the theft, unauthorized use or publication of the Company’s intellectual property, other proprietary information or the personal information of customers, employees, licensees or suppliers, a reduction of the revenues the Company is able to generate from its operations, damage to the Company’s brand and reputation, a loss of confidence in the security of the Company’s business and products, and significant legal and financial exposure. If any such incident results in litigation, we may be required to make significant expenditures in the course of such litigation and may be required to pay significant amounts in damages. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any events that cause interruptions in our service. Significant unavailability of our services due to attacks could cause us to incur significant liability, could cause users to cease using our services and materially and adversely affect our business, prospects, financial condition and results of operations.\\nWe use complex software in our technology infrastructure, which we seek to continually update and improve. Replacing such systems is often time-consuming and expensive and can also be intrusive to daily business operations. Further, we may not always be successful in executing these upgrades and improvements, which may result in a failure of our systems. We may experience periodic system interruptions from time to time. Any slowdown or failure of our underlying technology infrastructure could harm our business and reputation, which could materially adversely affect our results of operations. Our disaster recovery plan or those of our third-party providers may be inadequate, and our business interruption insurance may not be sufficient to compensate us for the losses that could occur.\\n59\\nFailure to comply with federal, state and foreign laws and regulations relating to privacy, data protection and consumer protection, or the expansion of current or the enactment of new laws or regulations relating to privacy, data protection and consumer protection, could adversely affect our business and our financial condition.\\nA variety of federal, state and foreign laws and regulations govern the collection, use, retention, sharing and security of personal information. The information, security and privacy requirements imposed by such governmental laws and regulations relating to privacy, data protection and consumer protection are increasingly demanding, quickly evolving and may be subject to differing interpretations or legal theories among regulators, enforcers, and civil litigants. These requirements may not be harmonized, may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another or may conflict with other rules or our practices. As a result, our practices may not have complied or may not comply in the future with all such laws, regulations, requirements and obligations. Our actual or perceived failure to comply with such laws and regulations could result in fines, investigations, enforcement actions, penalties, sanctions, claims for damages by affected individuals, and damage to our reputation, among other negative consequences, any of which could have a material adverse effect on its financial performance.\\nCertain aspects of our business and/or the data it collects is subject to the California Consumer Protection Act of 2018 (“CCPA”), which became effective in 2020 and regulates the collection, use and processing of personal information relating to California residents, and which grants certain privacy rights to California residents, including rights to request access to and to request deletion of personal information relating to such individuals under certain circumstances. Compliance with the new obligations imposed by the CCPA depends in part on how its requirements are interpreted and applied by the California attorney general and courts. Alleged violations of the CCPA may result in substantial civil penalties or statutory damages when applied at scale, up to $2,500 per violation or $7,500 per intentional violation of any CCPA requirement, which may be applied on a per-person or per-record basis. The CCPA also establishes a private right of action if certain personal information of individuals is subject to an unauthorized access and exfiltration, theft, or disclosure as a result of a business’s violation of the duty to implement and maintain reasonable security procedures and practices, which authorizes statutory damages $100 to $750 per person per incident even if there is no actual harm or damage to plaintiffs. This private right of action may increase the likelihood of, and risks associated with, data breach litigation. Further, in November 2020, the State of California adopted the California Privacy Rights Act of 2020 (“CPRA”) which goes into effect January 1, 2023 and is enforceable starting on July 1, 2023. The CPRA expands and amends the CCPA, including additional and strengthened privacy rights for California residents, new requirements regarding sensitive data and data sharing for digital advertising, and tripled damages for violations involving children’s data. Also on January 1, 2023, the CCPA – as amended by the CPRA – will be newly applicable to personal information collected for employment-related purposes as well as from business-to-business contacts, creating new regulatory obligations as to datasets that until then had been largely exempt from the CCPA. The CPRA includes a 12-month “look-back” provision that requires businesses to map out all information retained since January 1, 2022. The CPRA also establishes a dedicated privacy regulator under California law, with rulemaking and enforcement responsibilities. Certain regulations implementing the CPRA are expected in draft and final form by the end of 2022, with potentially additional regulations to be proposed following the CPRA’s January 1, 2023 effective date.\\nFour other states – Virginia, Colorado, Connecticut, and Utah – have passed their own comprehensive privacy laws to go into effect in 2023. Like the CCPA and CPRA, these laws regulate the collection, use, processing, and sharing of personal information relating to residents of each state respectively, and grants certain privacy rights to those residents. The new state laws also have key differences from the CCPA and CPRA, such as requiring affirmative consent before businesses may process sensitive personal information, requiring data protection assessments, and requiring contracts between data controllers and data processors that direct data processors to assist data controllers in performing their obligations, as well as other differences among them. Each law is enforceable by its own state’s attorney general – for example, violation of the Virginia or Utah laws will cost up to $7,500 per violation – and none include an explicit private right of action. Other states are expected to consider and potentially pass similar privacy laws in 2023.\\nCertain aspects of our business and/or the data it collects is may also be subject to international privacy laws and regulations, many of which, such as the General Data Privacy Regulation (“GDPR”) and national laws implementing or supplementing the GDPR, such as the United Kingdom Data Protection Law 2018 (which retains\\n60\\nkey features of GDPR post-Brexit), as well as the EU’s Privacy and Electronic Communications Directive (“ePrivacy Directive”), are significantly more stringent than those currently enforced in the United States. The GDPR requires companies to meet requirements regarding the handling of personal data of individuals located in the European Economic Area (the “EEA”). The GDPR imposes mandatory data breach notification requirements subject to a 72-hour notification deadline. The GDPR also includes significant penalties for noncompliance, which may result in monetary penalties of up to the higher of €20.0 million or 4% of a group’s worldwide turnover for the preceding financial year for the most serious violations. The GDPR and other similar regulations such as the ePrivacy Directive and related member state regulations and directives require companies to give specific types of notice and informed consent is in many cases required for the placement of a cookie or similar technologies on a user’s device for online tracking for behavioral advertising and other purposes and for direct electronic marketing, and the GDPR also imposes additional conditions in order to satisfy such consent, such as a prohibition on pre-checked tick boxes and bundled consents. Enforcement of the GDPR and related regulations varies by each EU Member State and is ongoing. Further laws and regulations on these topics are forthcoming, including the ePrivacy Directive’s proposed successor, the Regulation on Privacy and Electronic Communications (“ePrivacy Regulation”), as well as the Digital Services Act (“DSA”) and Digital Markets Act (“DMA”). The GDPR may increase our responsibility and liability in relation to personal data that we process where that processing is subject to the GDPR. In addition, we may be required to put in place additional mechanisms to ensure compliance with the GDPR, including GDPR requirements as implemented by individual countries. Compliance with the GDPR will be a rigorous and time-intensive process that may increase our cost of doing business or require us to change our business practices.\\nIn addition, under GDPR, transfers of personal data are prohibited to countries outside of the EEA that have not been determined by the European Commission to provide adequate protections for personal data, including the United States. There are mechanisms to permit the transfer of personal data from the EEA to the United States, but there is also uncertainty as to the future of such mechanisms, which have been under consistent scrutiny and challenge. In July 2020, decision of the Court of Justice of the European Union invalidated the EU-U.S. Privacy Shield Framework, a means that previously permitted transfers of personal data from the EEA to companies in the United States that certified adherence to the Privacy Shield Framework. While the Biden Administration issued an executive order in October 2022 mandating new legal safeguards over U.S. national security agencies’ access and use of EU and U.S. personal data, it is currently unclear what, if any, formal arrangement may replace the Privacy Shield Framework. Standard contractual clauses approved by the European Commission to permit transfers from the EU to third countries currently remain as a basis on which to transfer personal data from the EEA to other countries. Standard contractual clauses are also subject to legal challenge, and in November 2020, the European Commission published a draft of updated standard contractual clauses. In January 2022, for example, Austria’s data protection authority determined that the use of Google Analytics violated the GDPR and the Court of Justice of the European Union’s “Schrems II” decision on international data transfers. We presently rely on standard contractual clauses to transfer personal data from EEA member countries, and we may be impacted by changes in law as a result of future review or invalidation of, or changes to, this mechanism by European courts or regulators. While we will continue to undertake efforts to conform to current regulatory obligations and evolving best practices, we may be unsuccessful in conforming to permitted means of transferring personal data from the European Economic Area. We may also experience hesitancy, reluctance, or refusal by European or multi-national customers to continue to use some of our services due to the potential risk exposure of personal data transfers and the current data protection obligations imposed on them by certain data protection authorities. Such customers may also view any alternative approaches to the transfer of any personal data as being too costly, too burdensome, or otherwise objectionable, and therefore may decide not to do business with us if the transfer of personal data is a necessary requirement.\\nAlthough we take reasonable efforts to comply with all applicable laws and regulations and have invested and continue to invest human and technology resources into data privacy compliance efforts, there can be no assurance that we will not be subject to regulatory action, including fines, in the event of an incident or other claim. Data protection laws and requirements may also be enacted, interpreted or applied in a manner that creates inconsistent or contradictory requirements on companies that operate across jurisdictions. We or our third-party service providers could be adversely affected if legislation or regulations are expanded to require changes in our or our third-party service providers’ business practices or if governing jurisdictions interpret or implement their legislation or regulations in ways that negatively affect our or our third-party service providers’ business, results of operations or financial condition. For example, we may find it necessary to establish alternative systems to maintain personal data in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of\\n61\\nour business, all of which may adversely affect our results from operations. Further, any inability to adequately address privacy concerns in connection with our solutions, or comply with applicable privacy or data protection laws, regulations and policies, could result in additional cost and liability to us, and adversely affect our ability to offer our solutions. GDPR, CCPA, CPRA and other similar laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, increase our operating costs, require significant management time and attention and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices. Our systems may not be able to satisfy these changing requirements and manufacturer, retailer and associate expectations, or may require significant additional investments or time in order to do so.\\nWe expect that new industry standards, laws and regulations will continue to be proposed regarding privacy, data protection and information security in many jurisdictions, including the European e-Privacy Regulation, which is currently in draft form, as well as at the U.S. federal and state levels. In addition, new data processes and datasets associated with emerging technologies are coming under increased regulatory scrutiny, such as biometrics and automated decision-making. We cannot yet determine the impact such future laws, regulations and standards may have on our business. Complying with these evolving obligations is challenging, time consuming and expensive, and federal regulators, state attorneys general and plaintiff’s attorneys have been, and will likely continue to be, active in this space. Expanding definitions and interpretations of what constitutes “personal data” (or the equivalent) within the United States, the EEA and elsewhere may increase our compliance costs and legal liability. For example, various state privacy proposals have included a private right of action for basic privacy violations which, if passed, would dramatically increase both the legal costs of defending frivolous lawsuits and the penalties and costs associated with alleged violations.\\nA data breach or any failure, or perceived failure, by us to comply with any federal, state or foreign privacy or consumer protection-related laws, regulations or other principles or orders to which we may be subject or other legal obligations relating to privacy or consumer protection could adversely affect our reputation, brand and business, and may result in fines, enforcement actions, sanctions, claims (including claims for damages by affected individuals), investigations, proceedings or actions against us by governmental entities or others, or other penalties or liabilities or require us to change our operations and/or cease using certain data sets, among other negative consequences, any of which could have a material adverse effect on our business. Moreover, the proliferation of supply chain-based cyberattacks and vendor security incidents increases these potential risks and costs even in cases where the attack did not target us, occur on our systems, or result from any action or inaction by us. Depending on the nature of the information compromised, we may also have obligations to notify users, law enforcement, regulators, business partners or payment companies about the incident and provide some form of remedy, such as refunds or identity theft monitoring services, for the individuals affected by the incident.\\nThe Take 5 Matter may lead to additional harms, risks and uncertainties for us, including litigation and governmental investigations, a reduction in revenue, a potential deterioration in our relationships or reputation and a loss in investor confidence.\\nOn April 1, 2018, we acquired certain assets and assumed certain liabilities of Take 5 Media Group. In June 2019, as a result of a review of internal allegations related to inconsistency of data provided by Take 5 to its clients, we commenced an investigation into Take 5’s operations. In July 2019, as a result of our investigation, we terminated all operations of Take 5, including the use of its associated trade names and the offering of its services to its clients and offered refunds to Take 5 clients of collected revenues attributable to Take 5 since our acquisition of Take 5.\\nAs a result of these matters, we may be subject to a number of additional harms, risks and uncertainties, including substantial costs for professional services fee, potential lawsuits by clients or other interested parties who claim to have been harmed by the misconduct at Take 5, other costs and fees related to the Take 5 Matter (in excess of the amounts already offered as refunds), potential governmental investigations arising from the Take 5 Matter, a reduction in our current and anticipated revenue and a potential deterioration in our associate and client relationships or our reputation. In addition, if we do not prevail in any litigation or governmental investigation related to these matters, we could be subject to costs related to such litigation or governmental investigation, including equitable relief, civil monetary damages, treble damages, repayment or criminal penalties, which may not be covered by insurance or may materially increase our insurance costs. We have incurred and will continue to incur additional substantial professional fees regardless of the outcome of any such litigation or governmental\\n62\\ninvestigation. In addition, there can be no assurance to what degree, if any, we will be able to recover any such costs or damages from the former owners of Take 5 or whether such former owners of Take 5 engaged in further unknown improper activities that may subject us to further costs or damages, including potential reputational harm. Likewise, such events have caused and may cause further diversion of our management’s time and attention. Any adverse outcome related to these matters cannot be predicted at this time, and may materially harm our business, reputation, financial condition and/or results of operations, or the trading price of our securities.\\nOur business is seasonal in nature and quarterly operating results can fluctuate.\\nOur services are seasonal in nature, with the fourth fiscal quarter typically generating a higher proportion of our revenues than other fiscal quarters. Adverse events, such as deteriorating economic conditions, higher unemployment, higher gas prices, public transportation disruptions, public health crises (including the COVID-19 pandemic) or unanticipated adverse weather, could result in lower-than-planned sales during key revenue-producing seasons. For example, frequent or unusually heavy snowfall, ice storms, rainstorms, windstorms or other extreme weather conditions over a prolonged period could make it difficult for consumers to travel to retail stores or foodservice locations. Such events could lead to lower revenues, negatively impacting our financial condition and results of operations.\\nOur business is competitive, and increased competition could adversely affect our business and results of operations.\\nThe sales, marketing and merchandising services industry is competitive. We face competition from a few other large, national or super-regional agencies as well as many niche and regional agencies. Remaining competitive in this industry requires that we closely monitor and respond to trends in all industry sectors. We cannot assure you that we will be able to anticipate and respond successfully to such trends in a timely manner. Moreover, some of our competitors may choose to sell services competitive to ours at lower prices by accepting lower margins and profitability or may be able to sell services competitive to ours at lower prices due to proprietary ownership of data or technical superiority, which could negatively impact the rates that we can charge. If we are unable to compete successfully, it could have a material adverse effect on our business, financial condition and our results of operations. If certain competitors were to combine into integrated sales, marketing and merchandising services companies, additional sales, marketing and merchandising service companies were to enter the market or existing participants in this industry were to become more competitive, including through technological innovation such as social media and crowdsourcing, it could have a material adverse effect on our business, financial condition or results of operations.\\nDamage to our reputation could negatively impact our business, financial condition and results of operations.\\nOur reputation and the quality of our brand are critical to our business and success in existing markets and will be critical to our success as we enter new markets. We believe that we have built our reputation on the high quality of our sales and marketing services, our commitment to our clients and our performance-based culture, and we must protect and grow the value of our brand in order for us to continue to be successful. Any incident that erodes client loyalty to our brand could significantly reduce its value and damage our business. Also, there has been a marked increase in the use of social media platforms and similar devices, including blogs, social media websites, Twitter and other forms of internet-based communications that provide individuals with access to a broad audience of consumers and other interested persons. Many social media platforms immediately publish the content their subscribers and participants post, often without filters or checks on accuracy of the content posted. Information concerning us may be posted on such platforms at any time. Information posted may be adverse to our interests or may be inaccurate, each of which may harm our performance, prospects or business. The harm may be immediate without affording us an opportunity for redress or correction.\\nWe rely on third parties to provide certain data and services in connection with the provision of our services.\\nWe rely on third parties to provide certain data and services for use in connection with the provision of our services. For example, we contract with third parties to obtain the raw data on retail product sales and inventories. These suppliers of data may impose restrictions on our use of such data, fail to adhere to our quality control standards, increase the price they charge us for this data or refuse altogether to license the data to us. If we are unable to use such third-party data and services or if we are unable to contract with third parties, when necessary,\\n63\\nour business, financial condition or our results of operations could be adversely affected. In the event that such data and services are unavailable for our use or the cost of acquiring such data and services increases, our business could be adversely affected.\\nWe may be unable to timely and effectively respond to changes in digital practices and policies, which could adversely affect our business, financial condition or results of operations.\\nChanges to practices and policies of operating systems, websites and other digital platforms, including, without limitation, Apple’s or Android’s transparency policies, may reduce the quantity and quality of the data and metrics that can be collected or used by us and our clients or reduce the value of our digital services. These limitations may adversely affect both our and our clients’ ability to effectively target and measure the performance of our digital services. In addition, our clients and third party vendors routinely evaluate their digital practices and policies, and if in the future they determine to modify such practices and policies for any reasons, including, without limitation, privacy, targeting, age or content concerns, this could decrease the desire for our digital services as compared to other alternatives. If we are unable to timely or effectively respond to changes in digital practices and policies, or if our clients do not believe that our digital services will generate a competitive return on investment relative to alternatives, then our business, financial condition or results of operations could be adversely affected.\\nWe may not be able to adequately protect our intellectual property, which, in turn, could harm the value of our brands and adversely affect our business.\\nOur ability to implement our business plan successfully depends in part on our ability to further build brand recognition using our trade names, service marks, trademarks, proprietary products and other intellectual property, including our name and logos. We rely on U.S. and foreign trademark, copyright and trade secret laws, as well as license agreements, nondisclosure agreements and confidentiality and other contractual provisions to protect our intellectual property. Nevertheless, these laws and procedures may not be adequate to prevent unauthorized parties from attempting to copy or otherwise obtain our processes and technology or deter our competitors from developing similar business solutions and concepts, and adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and other intellectual property.\\nThe success of our business depends on our continued ability to use our existing trademarks and service marks to increase brand awareness and further develop our brand in both domestic and international markets. We have registered and applied to register our trade names, service marks and trademarks in the United States and foreign jurisdictions. However, the steps we have taken to protect our intellectual property in the United States and in foreign countries may not be adequate, and third parties may misappropriate, dilute, infringe upon or otherwise harm the value of our intellectual property. If any of our registered or unregistered trademarks, trade names or service marks is challenged, infringed, circumvented or declared generic or determined to be infringing on other marks, it could have an adverse effect on our sales or market position. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain jurisdictions. This could make it difficult to stop the infringement or misappropriation of our intellectual property rights in foreign jurisdictions.\\nWe rely upon trade secrets and other confidential and proprietary know‑how to develop and maintain our competitive position. While it is our policy to enter into agreements imposing nondisclosure and confidentiality obligations upon our employees and third parties to protect our intellectual property, these obligations may be breached, may not provide meaningful protection for our trade secrets or proprietary know‑how, or adequate remedies may not be available in the event of an unauthorized access, use or disclosure of our trade secrets and know‑how. Furthermore, despite the existence of such nondisclosure and confidentiality agreements, or other contractual restrictions, we may not be able to prevent the unauthorized disclosure or use of our confidential proprietary information or trade secrets by consultants, vendors and employees. In addition, others could obtain knowledge of our trade secrets through independent development or other legal means.\\nAny claims or litigation initiated by us to protect our proprietary technology could be time consuming, costly and divert the attention of our technical and management resources. If we choose to go to court to stop a third party from infringing our intellectual property, that third party may ask the court to rule that our intellectual property rights are invalid and/or should not be enforced against that third party. Even if the action that we take to protect\\n64\\nour intellectual property rights is successful, any infringement may still have a material adverse effect on our business, financial condition and results of operations.\\nWe may be subject to claims of infringement of third-party intellectual property rights that are costly to defend, result in the diversion of management’s time and efforts, require the payment of damages, limit our ability to use particular technologies in the future or prevent us from marketing our existing or future products and services.\\nThird parties may assert that we infringe, misappropriate or otherwise violate their intellectual property, including with respect to our digital solutions and other technologies that are important to our business, and may sue us for intellectual property infringement. We may not be aware of whether our products or services do or will infringe existing or future patents or the intellectual property rights of others. In addition, there can be no assurance that one or more of our competitors who have developed competing technologies or our other competitors will not be granted patents for their technology and allege that we have infringed on such patents.\\nAny claims that our business infringes the intellectual property rights of others, regardless of the merit or resolution of such claims, could incur substantial costs, and the time and attention of our management and other personnel may be diverted in pursuing these proceedings. An adverse determination in any intellectual property claim could require us to pay damages, be subject to an injunction, and/or stop using our technologies, trademarks, copyrighted works and other material found to be in violation of another party’s rights, and could prevent us from licensing our technologies to others unless we enter into royalty or licensing arrangements with the prevailing party or are able to redesign our products and services to avoid infringement. With respect to any third-party intellectual property that we use or wish to use in our business (whether or not asserted against us in litigation), we may not be able to enter into licensing or other arrangements with the owner of such intellectual property at a reasonable cost or on reasonable terms. Any of the foregoing could harm our commercial success.\\nWe are dependent on proprietary technology licensed from others. If we lose our licenses, we may not be able to continue developing our products.\\nWe have obtained licenses that give us rights to third party intellectual property that is necessary or useful to our business. These license agreements may impose various royalty and other obligations on us. One or more of our licensors may allege that we have breached our license agreement with them, and could seek to terminate our license, which could adversely affect our competitive business position and harm our business prospects. In addition, any claims brought against us by our licensors could be costly, time-consuming and divert the attention of our management and key personnel from our business operations.\\nConsumer goods manufacturers and retailers, including some of our clients, are subject to extensive governmental regulation and we and they may be subject to enforcement in the event of noncompliance with applicable requirements.\\nConsumer goods manufacturers and retailers, including some of our clients, are subject to a broad range of federal, state, local and international laws and regulations governing, among other things, the research, development, manufacture, distribution, marketing and post-market reporting of consumer products. These include laws administered by the U.S. Food and Drug Administration (the “FDA”), the U.S. Drug Enforcement Administration, the U.S. Federal Trade Commission, the U.S. Department of Agriculture and other federal, state, local and international regulatory authorities. For example, certain of our clients market and sell products containing cannabidiol (“CBD”). CBD products are subject to a number of federal, state, local and international laws and regulations restricting their use in certain categories of products and in certain jurisdictions. In particular, the FDA has publicly stated it is prohibited to sell into interstate commerce food, beverages or dietary supplements that contain CBD. These laws are broad in scope and subject to evolving interpretations, which could require us to incur costs associated with new or modified compliance requirements or require us or our clients to alter or limit our activities, including marketing and promotion, of such products, or to remove them from the market altogether.\\nIf a regulatory authority determines that we or our current or future clients have not complied with the applicable regulatory requirements, our business may be materially impacted and we or our clients could be subject to enforcement actions or loss of business. We cannot predict the nature of any future laws, regulations, interpretations or applications of the laws, nor can we determine what effect additional laws, regulations or administrative policies and procedures, if and when enacted, promulgated and implemented, could have on our business.\\n65\\nWe may be subject to claims for products for which we are the vendor of record or may otherwise be in the chain of title.\\nFor certain of our clients’ products, we become the vendor of record or otherwise may be in the chain of title. For these products, we could be subject to potential claims for misbranded, adulterated, contaminated, damaged or spoiled products, or could be subject to liability in connection with claims related to infringement of intellectual property, product liability, product recalls or other liabilities arising in connection with the sale or marketing of these products. As a result, we could be subject to claims or lawsuits (including potential class action lawsuits), and we could incur liabilities that are not insured or exceed our insurance coverage or for which the manufacturer of the product does not indemnify us. Even if product claims against us are not successful or fully pursued, these claims could be costly and time consuming and may require our management to spend time defending the claims rather than operating our business.\\nA product that has been actually or allegedly misbranded, adulterated or damaged or is actually or allegedly defective could result in product withdrawals or recalls, destruction of product inventory, negative publicity and substantial costs of compliance or remediation. Any of these events, including a significant product liability judgment against us, could result in monetary damages and/or a loss of demand for our products, both of which could have an adverse effect on our business or results of operations.\\nWe generate revenues and incur expenses throughout the world that are subject to exchange rate fluctuations, and our results of operations may suffer due to currency translations.\\nOur U.S. operations earn revenues and incur expenses primarily in U.S. dollars, while our international operations earn revenues and incur expenses primarily in Canadian dollars, British pounds or euros. Because of currency exchange rate fluctuations, including possible devaluations, we are subject to currency translation exposure on the results of our operations, in addition to economic exposure. There has been, and may continue to be, volatility in currency exchange rates as a result of the United Kingdom’s withdrawal from the European Union, especially between the U.S. dollar and the British pound. These risks could adversely impact our business or results of operations.\\nFluctuations in our tax obligations and effective tax rate and realization of our deferred tax assets may result in volatility of our operating results.\\nWe are subject to taxes by the U.S. federal, state, local and foreign tax authorities, and our tax liabilities will be affected by the allocation of expenses to differing jurisdictions. We record tax expense based on our estimates of future payments, which may include reserves for uncertain tax positions in multiple tax jurisdictions, and valuation allowances related to certain net deferred tax assets. At any one time, many tax years may be subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these matters. We expect that throughout the year there could be ongoing variability in our quarterly tax rates as events occur and exposures are evaluated. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:\\n•changes in the valuation of our deferred tax assets and liabilities;\\n•expected timing and amount of the release of any tax valuation allowance;\\n•tax effects of equity-based compensation;\\n•changes in tax laws, regulations or interpretations thereof; or\\n•future earnings being lower than anticipated in jurisdictions where we have lower statutory tax rates and higher than anticipated earnings in jurisdictions where we have higher statutory tax rates.\\nIn addition, our effective tax rate in a given financial statement period may be materially impacted by a variety of factors including but not limited to changes in the mix and level of earnings, varying tax rates in the different jurisdictions in which we operate, fluctuations in the valuation allowance, deductibility of certain items or changes to existing accounting rules or regulations. Further, tax legislation may be enacted in the future which could negatively impact our current or future tax structure and effective tax rates. We may be subject to audits of\\n66\\nour income, sales and other transaction taxes by U.S. federal, state, local and foreign taxing authorities. Outcomes from these audits could have an adverse effect on our operating results and financial condition.\\nRisks Related to Ownership of Our Common Stock\\nWe are controlled by Topco, the Advantage Sponsors, and the CP Sponsor, whose economic and other interests in our business may be different from yours.\\nOur authorized capital stock consists of 3,290,000,000 shares of Class A common stock, and as of November 8, 2022, certain equityholders of Topco (the “Advantage Sponsors”), Topco and Conyers Park II Sponsor LLC, an affiliate of Centerview Capital Management, LLC, which was Conyers Park’s sponsor prior to the Merger (the “CP Sponsor”), collectively own 254,310,000 shares, or 79.55% (including 65.30% held by Topco), of our outstanding Class A common stock. Subject to applicable law, the Advantage Sponsors, through their direct ownership of our common stock and their ownership of equity interests of Topco, and the CP Sponsor are able to exert significant influence in the election of our directors and control actions to be taken by our stockholders, including amendments to our third amended and restated certificate of incorporation and approval of mergers, sales of substantially all of our assets, and other significant corporate transactions. It is possible that the interests of Topco, the Advantage Sponsors and the CP Sponsor may in some circumstances conflict with our interests and the interests of our other stockholders, including you.\\nWe are a controlled company within the meaning of the Nasdaq Stock Market LLC listing requirements and as a result, may rely on exemptions from certain corporate governance requirements. To the extent we rely on such exemptions, you will not have the same protections afforded to stockholders of companies that are subject to such corporate governance requirements.\\nBecause of the voting power over our company held by Topco, the Advantage Sponsors, and the CP Sponsor and the voting arrangement between such parties, we are considered a controlled company for the purposes of the Nasdaq Stock Market LLC (“Nasdaq”) listing requirements. As such, we are exempt from the corporate governance requirements that our board of directors, compensation committee, and nominating and corporate governance committee meet the standard of independence established by those corporate governance requirements. The independence standards are intended to ensure that directors who meet the independence standards are free of any conflicting interest that could influence their actions as directors.\\nWe do not currently utilize the exemptions afforded to a controlled company, though we are entitled to do so. To the extent we utilize these exemptions, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of Nasdaq.\\nThe anti-takeover provisions of our certificate of incorporation and bylaws could prevent or delay a change in control of us, even if such change in control would be beneficial to our stockholders.\\nProvisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could discourage, delay, or prevent a merger, acquisition, or other change in control of us, even if such change in control would be beneficial to our stockholders. These include:\\n•authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;\\n•provision for a classified board of directors so that not all members of our board of directors are elected at one time;\\n•not permitting the use of cumulative voting for the election of directors;\\n•permitting the removal of directors only for cause;\\n•limiting the ability of stockholders to call special meetings; •requiring all stockholder actions to be taken at a meeting of our stockholders;\\n•requiring approval of the holders of at least two-thirds of the shares entitled to vote at an election of directors to adopt, amend, or repeal the proposed bylaws or repeal the provisions of the third amended and restated certificate of incorporation regarding the election and removal of directors; and\\n67\\n•establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.\\nIn addition, although we have opted out of Section 203 of the Delaware General Corporation Law (“DGCL”), our certificate of incorporation contain similar provisions providing that we may not engage in certain “business combinations” with any “interested stockholder” for a three-year period following the time that the stockholder became an interested stockholder, subject to certain exceptions. Generally, a “business combination” includes a merger, asset, or stock sale or other transaction resulting in a financial benefit to the interested stockholder.\\nSubject to certain exceptions, an “interested stockholder” is a person who, together with that person’s affiliates and associates, owns, or within the previous three years owned, 15% or more of our outstanding voting stock.\\nUnder certain circumstances, this provision will make it more difficult for a person who would be an “interested stockholder” to effect various business combinations with us for a three-year period. These provisions also may have the effect of preventing changes in our board of directors and may make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.\\nMoreover, our certificate of incorporation provides that Topco and its affiliates do not constitute “interested stockholders” for purposes of this provision, and thus any business combination transaction between us and Topco and its affiliates would not be subject to the protections otherwise provided by this provision. Topco and its affiliates are not prohibited from selling a controlling interest in us to a third party and may do so without your approval and without providing for a purchase of your shares of common stock, subject to the lock-up restrictions applicable to Topco. Accordingly, your shares of common stock may be worth less than they would be if Topco and its affiliates did not maintain voting control over us.\\nThe provisions of our certificate of incorporation and bylaws requiring exclusive venue in the Court of Chancery in the State of Delaware or the federal district courts of the United States of America for certain types of lawsuits may have the effect of discouraging lawsuits against our directors and officers.\\nOur certificate of incorporation and bylaws require, to the fullest extent permitted by law, that (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders, (iii) any action asserting a claim against us arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim against us governed by the internal affairs doctrine will have to be brought only in the Court of Chancery in the State of Delaware (or the federal district court for the District of Delaware or other state courts of the State of Delaware if the Court of Chancery in the State of Delaware does not have jurisdiction).\\nOur certificate of incorporation and bylaws also require that the federal district courts of the United States of America will be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act; however, there is uncertainty as to whether a court would enforce such provision, and investors cannot waive compliance with federal securities laws and the rules and regulations thereunder. Although we believe these provisions benefit us by providing increased consistency in the application of applicable law in the types of lawsuits to which they apply, the provisions may have the effect of discouraging lawsuits against our directors and officers. These provisions do not apply to any suits brought to enforce any liability or duty created by the Exchange Act or any other claim for which the federal courts of the United States have exclusive jurisdiction.\\nBecause we have no current plans to pay cash dividends on our Class A common stock, you may not receive any return on investment unless you sell your Class A common stock for a price greater than that which you paid for it.\\nWe have no current plans to pay cash dividends on our Class A common stock. The declaration, amount and payment of any future dividends on our Class A common stock will be at the discretion of our board of directors and will depend upon our results of operations, financial condition, capital requirements, and other factors that our board of directors deems relevant. The payment of cash dividends is also restricted under the terms of the agreements governing our debt and our ability to pay dividend may also be restricted by the terms of any future credit agreement or any securities we or our subsidiaries may issue.\\n68\\nAn active, liquid trading market for our Class A common stock may not be available.\\nWe cannot predict the extent to which investor interest in our company will lead to availability of a trading market on Nasdaq or otherwise in the future or how active and liquid that market may be for our Class A common stock. If an active and liquid trading market is not available, you may have difficulty selling any of our Class A common stock. Among other things, in the absence of a liquid public trading market:\\n•you may not be able to liquidate your investment in shares of Class A common stock;\\n•you may not be able to resell your shares of Class A common stock at or above the price attributed to them in the Transactions;\\n•the market price of shares of Class A common stock may experience significant price volatility; and\\n•there may be less efficiency in carrying out your purchase and sale orders.\\nThe trading price of our Class A common stock may be volatile or may decline regardless of our operating performance.\\nThe market prices for our Class A common stock are likely to be volatile and may fluctuate significantly in response to a number of factors, most of which we cannot control, including:\\n•quarterly variations in our operating results compared to market expectations;\\n•changes in preferences of our clients;\\n•announcements of new products or services or significant price reductions;\\n•the size of our public float;\\n•fluctuations in stock market prices and volumes;\\n•defaults on our indebtedness;\\n•changes in senior management or key personnel;\\n•the granting, vesting, or exercise of employee stock options, restricted stock, or other equity rights;\\n•the payment of any dividends thereon in shares of our common stock;\\n•changes in financial estimates or recommendations by securities analysts;\\n•negative earnings or other announcements by us;\\n•downgrades in our credit ratings;\\n•material litigation or governmental investigations;\\n•issuances of capital stock;\\n•global economic, legal, and regulatory factors unrelated to our performance, including the COVID-19 pandemic; or\\n•the realization of any risks described in this Quarterly Report under “Risk Factors.”\\nIn addition, in the past, stockholders have instituted securities class action litigation against companies following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.\\nWe cannot provide any guaranty that we will continue to repurchase our common stock pursuant to our stock repurchase program.\\nIn November 2021, our board of directors authorized a share repurchase program, under which we may repurchase up to $100 million of our outstanding Class A common stock (the “2021 Share Repurchase Program”). As of September 30, 2022, the remaining amount available for repurchase pursuant to the 2021 Share Repurchase Program is $87.4 million. However, we are not obligated to make any further purchases under the 2021 Share Repurchase Program and we may suspend or permanently discontinue this program at any time or significantly reduce the amount of repurchases under the program. Any announcement of a suspension, discontinuance or reduction of this program may negatively impact our reputation and investor confidence.\\n69\\nThe valuation of our private placement warrants could increase the volatility in our net income (loss) in our consolidated statements of earnings (loss).\\nThe change in fair value of our private placement warrants is determined using the fair value of the liability classified private placement warrants by approximating the value with the share price of the public warrants. The change in fair value of warrant liability represents the mark-to-market fair value adjustments to the outstanding private placement warrants issued in connection with the initial public offering of Conyers Park. Significant changes in share price of the public warrants may adversely affect the volatility in our net income (loss) in our Condensed Consolidated Statements of Operations and Comprehensive Income.\\nRisks Related to Indebtedness\\nWe need to continue to generate significant operating cash flow in order to fund acquisitions and to service our debt.\\nOur business currently generates operating cash flow, which we use to fund acquisitions to grow our business and to service our substantial indebtedness. If, because of loss of revenue, pressure on pricing from customers, increases in our costs (including increases in costs related to servicing our indebtedness or labor costs), general economic, financial, competitive, legislative, regulatory conditions or other factors, including any acceleration of the foregoing as a result of the COVID-19 pandemic, many of which are outside of our control our business generates less operating cash flow, we may not have sufficient funds to grow our business or to service our indebtedness.\\nIf we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the agreements governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the lenders under our credit facilities could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under our credit agreements to avoid being in default. If we or any of our subsidiaries breach the covenants under our credit agreements and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our credit agreements, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation.\\nOur substantial indebtedness could adversely affect our financial health, restrict our activities, and affect our ability to meet our obligations.\\nWe have a significant amount of indebtedness. As of September 30, 2022, we had total indebtedness of $2.1 billion, excluding debt issuance costs, with an additional $54.5 million of letters of credit outstanding under our revolving credit facility. The agreements governing our indebtedness contain customary covenants that restrict us from taking certain actions, such as incurring additional debt, permitting liens on pledged assets, making investments, paying dividends or making distributions to equity holders, prepaying junior debt, engaging in mergers or restructurings, and selling assets, among other things, which may restrict our ability to successfully execute on our business plan. For a more detailed description of the covenants and material terms of our material indebtedness, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in this Quarterly Report.\\nDespite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could increase the risks associated with our indebtedness.\\nWe and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain conditions, as of September 30, 2022, the agreements governing our indebtedness would have permitted us to borrow up to an additional $345.5 million under our revolving credit facility. In addition, we and our subsidiaries have, and will have, the ability to incur additional indebtedness as incremental facilities under our credit agreement\\n70\\nand we or our subsidiaries may issue additional notes in the future. If additional debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could increase.\\nFailure to maintain our credit ratings could adversely affect our liquidity, capital position, ability to hedge certain financial risks, borrowing costs, and access to capital markets.\\nOur credit risk is evaluated by the major independent rating agencies, and such agencies have in the past downgraded, and could in the future downgrade, our ratings. Our credit rating may impact the interest rates on any future indebtedness as well as the applicability of certain covenants in the agreements governing our indebtedness. We cannot assure you that we will be able to maintain our current credit ratings, and any additional, actual or anticipated changes or downgrades in our credit ratings, including any announcement that our ratings are under further review for a downgrade, may have a negative impact on our liquidity, capital position, ability to hedge certain financial risks, and access to capital markets.\\nOur variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.\\nBorrowings under our credit facilities are at variable rates of interest and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease. On a pro forma basis, assuming no other prepayments of the credit facility and that our revolving credit facility is fully drawn (and to the extent that LIBOR is in excess of the 0.00% and 0.75% floors applicable to our revolving credit facility and our term loan credit facility, respectively), each one-eighth percentage point change in interest rates would result in an approximately $1.0 million change in interest expense, net of gains from interest rate caps, for the nine months ended September 30, 2022. In the future, we may enter into interest rate swaps that involve the exchange of floating- for fixed-rate interest payments in order to reduce interest rate volatility or risk. However, we may not maintain interest rate swaps with respect to any of our variable rate indebtedness, and any swaps we enter into may not fully or effectively mitigate our interest rate risk.\\nThe elimination of LIBOR after June 2023 may affect our financial results\\nCertain of our financial arrangements, including the Senior Secured Credit Facilities, were made at variable rates that use the London Interbank Offered Rate, or LIBOR (or metrics derived from or related to LIBOR), as a benchmark for establishing the interest rate. All LIBOR tenors relevant to us will cease to be published or will no longer be representative after June 30, 2023. This means that any of our LIBOR-based borrowings that extend beyond June 30, 2023 will need to be converted to a replacement rate. In the U.S., the Alternative Reference Rates Committee (the “ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York has recommended the Secured Overnight Financing Rate (“SOFR”) plus a recommended spread adjustment as LIBOR’s replacement. There are significant differences between LIBOR and SOFR, such as LIBOR being an unsecured lending rate while SOFR is a secured lending rate, and SOFR being an overnight rate while LIBOR reflects term rates at different maturities. If our LIBOR-based financing arrangements are converted to SOFR, the differences between LIBOR and SOFR, plus the recommended spread adjustment, could result in interest costs that are higher than if LIBOR remained available, which could adversely impact our operating results. Although SOFR is the ARRC’s recommended replacement rate, it is also possible that lenders and other counterparties may instead choose alternative replacement rates that may differ from LIBOR in ways similar to SOFR or in other ways that would result in higher interest costs for us. There is no assurance that any alternative reference rate, including SOFR, will be similar to, or produce the same value or economic equivalence as, LIBOR, and there continues to be uncertainty regarding the nature of potential changes to and future utilization of specific LIBOR tenors, the development and acceptance of SOFR or alternative reference rates, and other reforms. These consequences cannot be entirely predicted and could have an adverse impact on the market value for or value of LIBOR-linked securities, loans and other financial obligations or extensions of credit held by or due to us. Changes in market interest rates may influence our financing costs, returns on financial investments and the valuation of derivative contracts and could reduce our earnings and cash flows.\\n71\\nGeneral Risk Factors\\nOur business and financial results may be affected by various litigation and regulatory proceedings.\\nWe are subject to litigation and regulatory proceedings in the normal course of business and could become subject to additional claims in the future. These proceedings have included, and in the future may include, matters involving personnel and employment issues, workers’ compensation, personal and property injury, disputes relating to acquisitions (including contingent consideration), governmental investigations and other proceedings. Some historical and current legal proceedings and future legal proceedings may purport to be brought as class actions or representative basis on behalf of similarly situated parties including with respect to employment-related matters. We cannot be certain of the ultimate outcomes of any such claims, and resolution of these types of matters against us may result in significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely affect our business or financial results. See “Legal Proceedings.”\\nWe are subject to many federal, state, local and international laws with which compliance is both costly and complex.\\nOur business is subject to various, and sometimes complex, laws and regulations, including those that have been or may be implemented in response to the COVID-19 pandemic. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state, local and international governmental authorities. We may incur substantial costs in order to maintain compliance with these existing laws and regulations. In addition, our costs of compliance may increase if existing laws and regulations are revised or reinterpreted or if new laws and regulations become applicable to our operations. These costs could have an adverse impact on our business or results of operations. Moreover, our failure to comply with these laws and regulations, as interpreted and enforced, could lead to fines, penalties or management distraction or otherwise harm our business.\\nOur insurance may not provide adequate levels of coverage against claims.\\nWe believe that we maintain insurance customary for businesses of our size and type. However, there are types of losses we may incur that cannot be insured against or that we believe are not economically reasonable to insure. Further, insurance may not continue to be available to us on acceptable terms, if at all, and, if available, coverage may not be adequate. If we are unable to obtain insurance at an acceptable cost or on acceptable terms, we could be exposed to significant losses.\\nWe have incurred and will continue to incur increased costs as a public company.\\nAs a public company, we have incurred and will continue to incur significant legal, accounting, insurance, and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with the Sarbanes-Oxley Act and related rules implemented by the SEC. The expenses incurred by public companies for reporting and corporate governance purposes generally have been increasing. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly, although we are currently unable to estimate these costs with any degree of certainty. In estimating these costs, we took into account expenses related to insurance, legal, accounting, and compliance activities, as well as other expenses not currently incurred. These laws and regulations could also make it more difficult or costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on our board committees, or as our executive officers. Furthermore, if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A common stock, fines, sanctions, and other regulatory action and potentially civil litigation.\\nOur management has limited experience in operating a public company.\\nOur executive officers have limited experience in the management of a publicly traded company. Our management team may not successfully or effectively manage our transition to a public company that will be\\n72\\nsubject to significant regulatory oversight and reporting obligations under federal securities laws. Their limited experience in dealing with the increasingly complex laws pertaining to public companies could be a significant disadvantage in that it is likely that an increasing amount of their time may be devoted to these activities which will result in less time being devoted to the management and growth of the Company. We may not have adequate personnel with the appropriate level of knowledge, experience, and training in the accounting policies, practices or internal control over financial reporting required of public companies in the United States. The development and implementation of the standards and controls necessary for the Company to achieve the level of accounting standards required of a public company in the United States may require costs greater than expected. It is possible that we will be required to expand our employee base and hire additional employees to support our operations as a public company which will increase our operating costs in future periods.\\nIf securities analysts do not publish research or reports about our business or if they publish negative evaluations of our common stock, the price of our Class A common stock could decline.\\nThe trading market for our Class A common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If few analysts commence coverage of us, the trading price of our stock could be negatively affected. Even with analyst coverage, if one or more of the analysts covering our business downgrade their evaluations of our stock, the price of our Class A common stock could decline. If one or more of these analysts cease to cover our common stock, we could lose visibility in the market for our Class A common stock, which in turn could cause our Class A common stock price to decline.\\nSubstantial future sales of our Class A common stock, or the perception in the public markets that these sales may occur, may depress our stock price.\\nSales of substantial amounts of our common stock in the public market, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Certain shares of our common stock are freely tradable without restriction under the Securities Act, except for any shares of our common stock that may be held or acquired by our directors, executive officers, and other affiliates, as that term is defined in the Securities Act, which are to be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available. Topco, the Advantage Sponsors, the CP Sponsor and members of our management have rights, subject to certain conditions, to require us to file registration statements covering Topco’s shares of our common stock or to include shares in registration statements that we may file for ourselves or other stockholders. In each of November 2020 and March 2021, we filed a registration statement on Form S-1 under which certain of our shareholders may sell, from time to time, 50,000,000 shares and 255,465,000 shares of our Class A common stock, respectively, that, if sold, will be freely tradable without restriction under the Securities Act. In the event a large number of shares of Class A common stock are sold in the public market, such sales could reduce the market price of our Class A common stock.\\nWe may also issue shares of our common stock or securities convertible into our common stock from time to time in connection with financings, acquisitions, investments, or otherwise. Any such issuance could result in ownership dilution to you as a stockholder and cause the trading price of our common stock to decline.\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds\\nNone\\nItem 3. Defaults Upon Senior Securities\\nNone\\nItem 4. Mine Safety Disclosures\\nNone\\n73\\nItem 5. Other Information\\nNone\\nITEM 6. Exhibits\\nThe following exhibits are filed with this Report:\\n\\n| ExhibitNumber | Description |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934 |\\n| 32.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\\n| 32.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 |\\n| 101.INS | Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) |\\n\\n***\\n74\\nSIGNATURES\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| ADVANTAGE SOLUTIONS INC. |\\n| By: | /s/ Jill Griffin |\\n| Jill Griffin |\\n| Chief Executive Officer (Principal Executive Officer) |\\n| Date: | November 9, 2022 |\\n| By: | /s/ Brian Stevens |\\n| Brian Stevens |\\n| Chief Financial Officer and Chief Operating |\\n| Officer (Principal Financial Officer) |\\n| Date: | November 9, 2022 |\\n\\n75\\n</text>\\n\\nWhat is the percentage change in the company's total net worth between July 1, 2021 and September 30, 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 0.8929388668478347.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 56,\n \"input_length\": 115276\n}"}}},{"rowIdx":57,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1 – Financial Statements\n3\n Consolidated Balance Sheets (Unaudited) 3\n Consolidated Statements of Income (Unaudited) 4\n Consolidated Statements of Comprehensive Income (Unaudited) 5\n Consolidated Statements of Cash Flows (Unaudited) 6\n Notes to Consolidated Financial Statements (Unaudited) 7\n Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations 28\n Item 3 – Quantitative and Qualitative Disclosure about Market Risk 44\n Item 4 – Controls and Procedures 45\n PART II – Other Information 46\n Item 1 – Legal Proceedings 46\n Item 1A – Risk Factors 46\n Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 46\n Item 3 – Defaults Upon Senior Securities 47\n Item 5 – Other Information 48\n Item 6 – Exhibits 48\n SIGNATURES 49\nCertifications\n2\nPART 1 – FINANCIAL INFORMATION\nItem 1 - Financial Statements\n\nREADING INTERNATIONAL, INC.\nCONSOLIDATED BALANCE SHEETS\n(Unaudited; U.S. dollars in thousands, except share information)\n\n\n| |\n| |\n| | March 31, | December 31, |\n| | 2019 | 2018 |\n| ASSETS | (unaudited) |\n| Current Assets: |\n| Cash and cash equivalents | $ | 12,648 | $ | 13,127 |\n| Receivables | 7,094 | 8,045 |\n| Inventory | 1,165 | 1,419 |\n| Prepaid and other current assets | 9,642 | 7,667 |\n| Total current assets | 30,549 | 30,258 |\n| Operating property, net | 257,402 | 257,667 |\n| Operating lease right-of-use assets | 229,266 | — |\n| Investment and development property, net | 95,156 | 86,804 |\n| Investment in unconsolidated joint ventures | 4,958 | 5,121 |\n| Goodwill | 20,836 | 19,445 |\n| Intangible assets, net | 3,694 | 7,369 |\n| Deferred tax asset, net | 26,483 | 26,235 |\n| Other assets | 6,199 | 6,129 |\n| Total assets | $ | 674,543 | $ | 439,028 |\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\n| Current Liabilities: |\n| Accounts payable and accrued liabilities | $ | 23,492 | $ | 26,154 |\n| Film rent payable | 6,559 | 8,661 |\n| Debt - current portion | 40,077 | 30,393 |\n| Derivative financial instruments - current portion | 52 | 41 |\n| Taxes payable - current | 571 | 1,710 |\n| Deferred current revenue | 7,712 | 9,264 |\n| Operating lease liabilities - current portion | 19,797 | — |\n| Other current liabilities | 9,525 | 9,305 |\n| Total current liabilities | 107,785 | 85,528 |\n| Debt - long-term portion | 113,816 | 106,286 |\n| Derivative financial instruments - non-current portion | 203 | 145 |\n| Subordinated debt, net | 26,116 | 26,061 |\n| Noncurrent tax liabilities | 11,737 | 11,530 |\n| Operating lease liabilities - non-current portion | 222,594 | — |\n| Other liabilities | 12,346 | 28,931 |\n| Total liabilities | 494,597 | 258,481 |\n| Commitments and contingencies (Note 13) |\n| Stockholders’ equity: |\n| Class A non-voting common stock, par value $0.01, 100,000,000 shares authorized, |\n| 33,172,823 issued and 21,249,935 outstanding at March 31, 2019 and 33,112,337 issued and 21,194,748 outstanding at December 31, 2018 | 233 | 232 |\n| Class B voting common stock, par value $0.01, 20,000,000 shares authorized and |\n| 1,680,590 issued and outstanding at March 31, 2019 and December 31, 2018 | 17 | 17 |\n| Nonvoting preferred stock, par value $0.01, 12,000 shares authorized and no issued |\n| or outstanding shares at March 31, 2019 and December 31, 2018 | — | — |\n| Additional paid-in capital | 147,472 | 147,452 |\n| Retained earnings | 45,563 | 47,616 |\n| Treasury shares | (25,231) | (25,222) |\n| Accumulated other comprehensive income | 7,625 | 6,115 |\n| Total Reading International, Inc. stockholders’ equity | 175,679 | 176,210 |\n| Noncontrolling interests | 4,267 | 4,337 |\n| Total stockholders’ equity | 179,946 | 180,547 |\n| Total liabilities and stockholders’ equity | $ | 674,543 | $ | 439,028 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n3\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF INCOME\n(Unaudited; U.S. dollars in thousands, except per share data)\n\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Revenue |\n| Cinema | $ | 57,986 | $ | 72,255 |\n| Real estate | 3,565 | 3,617 |\n| Total revenue | 61,551 | 75,872 |\n| Costs and expenses |\n| Cinema | (48,329) | (54,948) |\n| Real estate | (2,445) | (2,384) |\n| Depreciation and amortization | (5,594) | (5,250) |\n| General and administrative | (6,484) | (7,597) |\n| Total costs and expenses | (62,852) | (70,179) |\n| Operating income (loss) | (1,301) | 5,693 |\n| Interest expense, net | (1,852) | (1,594) |\n| Other income (expense) | (20) | (82) |\n| Income (loss) before income tax expense and equity earnings of unconsolidated joint ventures | (3,173) | 4,017 |\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\n| Income (loss) before income taxes | (3,139) | 4,274 |\n| Income tax benefit (expense) | 1,042 | (1,170) |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\n| Net income (loss) attributable to Reading International, Inc. common shareholders | $ | (2,081) | $ | 3,082 |\n| Basic earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\n| Diluted earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\n| Weighted average number of shares outstanding–basic | 22,920,486 | 22,967,237 |\n| Weighted average number of shares outstanding–diluted | 23,124,106 | 23,132,989 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n4\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(Unaudited; U.S. dollars in thousands)\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Foreign currency translation gain (loss) | 1,526 | (803) |\n| Gain (loss) on cash flow hedges | (69) | — |\n| Other | 53 | 50 |\n| Comprehensive income (loss) | (587) | 2,351 |\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\n| Less: comprehensive income (loss) attributable to noncontrolling interests | 1 | (3) |\n| Comprehensive income (loss) attributable to Reading International, Inc. | $ | (572) | $ | 2,332 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n5\nREADING INTERNATIONAL, INC.\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(Unaudited; U.S. dollars in thousands)\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| | 2019 | 2018 |\n| Operating Activities |\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Equity earnings of unconsolidated joint ventures | (34) | (257) |\n| Distributions of earnings from unconsolidated joint ventures | 249 | 236 |\n| Amortization of operating leases | 5,895 | — |\n| Amortization of finance leases | 41 | — |\n| Change in operating lease liabilities | (5,754) | — |\n| Interest on hedged derivatives | (5) | — |\n| Change in net deferred tax assets | (150) | 172 |\n| Depreciation and amortization | 5,594 | 5,250 |\n| Other amortization | 341 | 224 |\n| Stock based compensation expense | 280 | 379 |\n| Net changes in operating assets and liabilities: |\n| Receivables | 993 | 3,205 |\n| Prepaid and other assets | (1,957) | (2,309) |\n| Payments for accrued pension | (171) | (2,404) |\n| Accounts payable and accrued expenses | (2,204) | 1,997 |\n| Film rent payable | (2,132) | (5,790) |\n| Taxes payable | (1,151) | 150 |\n| Deferred revenue and other liabilities | (1,579) | (1,505) |\n| Net cash provided by (used in) operating activities | (3,841) | 2,452 |\n| Investing Activities |\n| Purchases of and additions to operating and investment properties | (11,476) | (23,231) |\n| Acquisition of business combinations | (1,380) | — |\n| Change in restricted cash | 243 | (260) |\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) |\n| Financing Activities |\n| Repayment of long-term borrowings | (6,113) | (9,707) |\n| Repayment of finance lease principle | (41) | — |\n| Proceeds from borrowings | 22,349 | 25,998 |\n| Repurchase of Class A Nonvoting Common Stock | (9) | (317) |\n| (Cash paid) proceeds from the exercise of stock options | (259) | 203 |\n| Noncontrolling interest contributions | 18 | 27 |\n| Noncontrolling interest distributions | (27) | (43) |\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 |\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) |\n| Net decrease in cash and cash equivalents | (479) | (5,000) |\n| Cash and cash equivalents at January 1 | 13,127 | 13,668 |\n| Cash and cash equivalents at March 31 | $ | 12,648 | $ | 8,668 |\n| Supplemental Disclosures |\n| Interest paid | $ | 2,304 | $ | 2,121 |\n| Income taxes paid | 1,883 | 808 |\n| Non-Cash Transactions |\n| Additions to operating and investing properties through accrued expenses | 3,423 | 4,530 |\n\n\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\n6\nREADING INTERNATIONAL, INC.\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)\nNote 1 – Description of Business and Segment Reporting\nThe Company\nReading International, Inc., a Nevada corporation (“RDI” and collectively with our consolidated subsidiaries and corporate predecessors, the “Company”, “Reading” and “we”, “us”, or “our”), was incorporated in 1999. Our businesses consist primarily of:\n| · | the operation, development and ownership of multiplex cinemas in the United States, Australia, and New Zealand; and, |\n\n| · | the development, ownership, operation and/or rental of retail, commercial and live venue real estate assets in Australia, New Zealand, and the United States. |\n\n\nBusiness Segments\nReported below are the operating segments of the Company for which separate financial information is available and evaluated regularly by the Chief Executive Officer, the chief operating decision-maker of the Company. As part of our real estate activities, we hold undeveloped land in urban and suburban centers in Australia, New Zealand, and the United States.\n\nThe table below summarizes the results of operations for each of our business segments for the quarter ended March 31, 2019 and 2018, respectively. Operating expense includes costs associated with the day-to-day operations of the cinemas and the management of rental properties, including our live theater assets.\n\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Revenue: |\n| Cinema exhibition | $ | 57,986 | $ | 72,255 |\n| Real estate | 5,431 | 6,008 |\n| Inter-segment elimination | (1,866) | (2,391) |\n| | $ | 61,551 | $ | 75,872 |\n| Segment operating income (loss): |\n| Cinema exhibition | $ | 2,642 | $ | 10,285 |\n| Real estate | 1,159 | 1,681 |\n| | $ | 3,801 | $ | 11,966 |\n\n\nA reconciliation of segment operating income to income before income taxes is as follows:\n\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Segment operating income (loss) | $ | 3,801 | $ | 11,966 |\n| Unallocated corporate expense |\n| Depreciation and amortization expense | (61) | (117) |\n| General and administrative expense | (5,041) | (6,156) |\n| Interest expense, net | (1,852) | (1,594) |\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\n| Other income (expense) | (20) | (82) |\n| Income (loss) before income tax expense | $ | (3,139) | $ | 4,274 |\n\nNote 2 – Summary of Significant Accounting Policies\n\nBasis of Consolidation\nThe accompanying consolidated financial statements include the accounts of the Company’s wholly-owned subsidiaries as well as majority-owned subsidiaries that the Company controls, and should be read in conjunction with the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2018 (“2018 Form 10-K”). All significant intercompany balances and transactions have been eliminated on consolidation. These consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim reporting with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X of the Securities and Exchange Commission (“SEC”). As such, they do not include\n7\nall information and footnotes required by U.S. GAAP for complete financial statements. We believe that we have included all normal and recurring adjustments necessary for a fair presentation of the results for the interim period.\n\nOperating results for the quarter ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.\n\nUse of Estimates\nThe preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and footnotes thereto. Significant estimates include (i) projections we make regarding the recoverability and impairment of our assets (including goodwill and intangibles), (ii) valuations of our derivative instruments, (iii) recoverability of our deferred tax assets, (iv) estimation of breakage and redemption experience rates, which drive how we recognize breakage on our gift card and gift certificates, and revenue from our customer loyalty program, and (v) allocation of insurance proceeds to various recoverable components. Actual results may differ from those estimates.\n\nRecently Adopted and Issued Accounting Pronouncements\n\nAdopted:\n\nAccounting Standards Update (“ASU”) 2016-02 Leases: In February 2016, the Financial Accounting Standards Board (“FASB”) issued a new accounting standard, ASC 842 Leases, to increase transparency and comparability among organizations by requiring the recognition of right-of-use (\"ROU\") assets and lease liabilities on the balance sheet. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. A modified retrospective transition approach is required for lessees with capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.\n\nOn January 1, 2019, we adopted the new accounting standard Accounting Standards Codification (“ASC”) 842 Leases using the modified retrospective method. We recognized the cumulative effect of initially applying the new leasing standard as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The standard had a material impact on our consolidated balance sheets, but not on our consolidated income statements or statements of cash flow.\n\n\n| |\n| (Dollars in thousands) | Balance atDecember 31,2018 | Adjustmentsdue to ASC842 | Balance atJanuary 1,2019 |\n| Assets |\n| Operating property, net | $ | 257,667 | $ | 370 | $ | 258,037 |\n| Operating lease right-of-use assets | — | 232,319 | 232,319 |\n| Intangible assets, net | 7,369 | (3,542) | 3,827 |\n| Deferred tax asset, net | 26,235 | 82 | 26,317 |\n| Liabilities |\n| Operating lease liabilities | $ | — | $ | 245,280 | $ | 245,280 |\n| Other non-current liabilities | 28,931 | (16,033) | 12,898 |\n| Stockholders' Equity |\n| Non-controlling interest | $ | 4,337 | $ | (46) | $ | 4,291 |\n| Retained earnings | 47,616 | 28 | 47,644 |\n\n\n\n\n| |\n| | Period Ended March 31, 2019 |\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\n| Cinema costs and expenses | $ | 48,329 | $ | 48,334 | $ | (5) |\n| Depreciation and amortization | 5,594 | 5,552 | 42 |\n| General and administrative | 6,484 | 6,528 | (44) |\n| Interest expense, net | 1,852 | 1,849 | 3 |\n| Income tax (benefit) expense | 1,042 | 1,041 | 1 |\n| Net income (loss) | $ | (2,097) | $ | (2,094) | $ | 3 |\n\n8\n\n\n\n| |\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\n| Assets |\n| Operating property, net | $ | 257,402 | $ | 257,072 | $ | 330 |\n| Intangible assets | 3,694 | 7,151 | (3,457) |\n| Operating lease right-of-use assets | 229,266 | — | 229,266 |\n| Deferred tax asset, net | 26,483 | 26,400 | 83 |\n| Liabilities |\n| Other current liabilities | $ | 9,525 | $ | 9,363 | $ | 162 |\n| Operating lease liabilities, current | 19,797 | — | 19,797 |\n| Other non-current liabilities | 12,346 | 28,643 | (16,297) |\n| Operating lease liabilities, non-current | 222,594 | — | 222,594 |\n| Stockholders' Equity |\n| Retained earnings | $ | 45,563 | $ | 45,585 | $ | (22) |\n\n\n\n| 1) | ASU 2014-09 Revenue from Contracts with Customers: On January 1, 2018, we adopted the new accounting standard ASC 606 Revenue from Contracts with Customers using the modified retrospective method. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings. The comparative information was not restated. Adoption of this standard has no material effect on our consolidated financial statements. |\n\n\n| 2) | On January 1, 2018, the Company adopted ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, a consensus of the FASB Emerging Issues Task Force. This standard requires that amounts generally described as restricted cash and cash equivalents should be combined with unrestricted cash and cash equivalents when reconciling the beginning and end of period balances on the statement of cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\n\n\n| 3) | On January 1, 2018, the Company adopted ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments). The standard applies to eight (8) specific cash flow classification issues, reducing the current and potential future diversity in the presentation of certain cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\n\n\n| 4) | On January 1, 2018, the Company adopted ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This standard (i) requires that an employer disaggregate the service cost component from the other components of net benefit cost, and (ii) specifies how to present the service cost component and the other components of net benefit cost in the income statement and (iii) allows only the service cost component of net benefit cost to be eligible for capitalization. Adoption of this standard has no material impact on our consolidated financial statements. |\n\n\n| 5) | On January 1, 2018, the Company adopted ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This ASU provides that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the asset is not a “business”, thus reducing the number of transactions that need further evaluation for business combination. The standard has no material impact on our current consolidated financial statements, and we do not expect it to be applicable to our consolidated financial statements in the near term unless we enter into a definitive business acquisition transaction. |\n\n\nIssued:\n\n| v | ASUs Effective 2019 and Beyond |\n\n| · | Goodwill Impairment Simplification (ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment) |\n\n\nIssued by FASB in January 2017, this standard removes the second step of the two-step impairment test for measuring goodwill and is to be applied on a prospective basis only. The new standard is effective for the Company on January 1, 2020, including interim periods within the year of adoption. Early adoption is permitted for interim or annual goodwill impairment\n9\ntests performed on testing dates after January 1, 2017. It is not anticipated that adoption of this standard will have any material impact on our consolidated financial statements.\n\nPrior period financial statement correction of immaterial errors\n\nDuring the third quarter of 2018, we identified immaterial errors related to the accounting for straight line rent receivable from tenants in our real estate operations dating back to 2015. These errors resulted in an understatement of real estate revenue.\n\nWe assessed the materiality of these errors on our financial statements for prior periods in accordance with the SEC Staff Accounting Bulletin (“SAB”) No. 99, Materiality, codified in ASC 250, Presentation of Financial Statements, and concluded that they were not material to any prior annual or interim periods. However, the aggregate amount of $440k related to the prior period immaterial errors through June 30, 2018, would have been material to the quarterly accounts with our current Consolidated Statements of Income. Consequently, in accordance with ASC 250 (specifically SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements), we have corrected these errors for all prior periods presented by revising the consolidated financial statements and other financial information included herein.\n\nThe following is a summary of the previously issued financial statement line items for all periods and statements included in this report.\n\nConsolidated Statements of Income:\n\n\n| |\n| | Three Months Ended March 31, 2018 |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Real estate revenue | $ | 3,567 | $ | 50 | $ | 3,617 |\n| Total revenue | 75,822 | 50 | 75,872 |\n| Operating income (loss) | 5,643 | 50 | 5,693 |\n| Income before income taxes | 4,224 | 50 | 4,274 |\n| Income tax benefit (expense) | (1,155) | (15) | (1,170) |\n| Net income (loss) | 3,069 | 35 | 3,104 |\n| Net income (loss) attributable to Reading International, Inc. common shareholders | 3,047 | 35 | 3,082 |\n| |\n| Basic earnings (loss) per share | $ | 0.13 | $ | — | $ | 0.13 |\n| Diluted earnings (loss) per share | 0.13 | — | 0.13 |\n\n\nConsolidated Balance Sheets:\n\n\n\n\n| |\n| | Summary of Equity |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Equity at January 1, 2018 | $ | 176,910 | $ | 377 | $ | 177,287 |\n| Net income (loss) | 3,047 | 35 | 3,082 |\n| Equity at March 31, 2018 | $ | 179,423 | $ | 412 | $ | 179,835 |\n\n\n\nConsolidated Statements of Cash Flows:\n\n\n| |\n| | Three Months Ended March 31, 2018 |\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\n| Net income (loss) | $ | 3,069 | $ | 35 | $ | 3,104 |\n| Change in net deferred tax assets | 157 | 15 | 172 |\n| Prepaid and other assets | (2,259) | (50) | (2,309) |\n| Net cash provided by operating activities | $ | 2,452 | $ | — | $ | 2,452 |\n\n10\nNote 3 – Operations in Foreign Currency\n\nWe have significant assets in Australia and New Zealand. Historically, we have conducted our Australian and New Zealand operations (collectively “foreign operations”) on a self-funding basis where we use cash flows generated by our foreign operations to pay for the expense of foreign operations. Our Australian and New Zealand assets and liabilities are translated from their functional currencies of Australian dollar (“AU$”) and New Zealand dollar (“NZ$”), respectively, to the U.S. dollar based on the exchange rate as of March 31, 2019. The carrying value of the assets and liabilities of our foreign operations fluctuates as a result of changes in the exchange rates between the functional currencies of the foreign operations and the U.S. dollar. The translation adjustments are accumulated in the Accumulated Other Comprehensive Income in the Consolidated Balance Sheets.\n\nDue to the natural-hedge nature of our funding policy, we have not historically used derivative financial instruments to hedge against the risk of foreign currency exposure. However, in certain circumstances, we move funds between jurisdictions where circumstances encouraged us to do so from an overall economic standpoint. Going forward, particularly in light of recent tax law changes, we intend to take a more global view of our financial resources, and to be more flexible in making use of resources from one jurisdiction in other jurisdictions.\n\nPresented in the table below are the currency exchange rates for Australia and New Zealand:\n\n\n| |\n| |\n| | Foreign Currency / USD |\n| | As of andfor thequarterended | As of andfor thetwelve monthsended | As of andfor thequarterended |\n| | March 31, 2019 | December 31, 2018 | March 31, 2018 |\n| Spot Rate |\n| Australian Dollar | 0.7104 | 0.7046 | 0.7690 |\n| New Zealand Dollar | 0.6820 | 0.6711 | 0.7239 |\n| Average Rate |\n| Australian Dollar | 0.7123 | 0.7479 | 0.7861 |\n| New Zealand Dollar | 0.6816 | 0.6930 | 0.7275 |\n\nNote 4 – Earnings Per Share\n\nBasic earnings per share (“EPS”) is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common and common equivalent shares outstanding during the period and is calculated using the treasury stock method for equity-based compensation awards.\n\nThe following table sets forth the computation of basic and diluted EPS and a reconciliation of the weighted average number of common and common equivalent shares outstanding:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands, except share data) | 2019 | 2018 |\n| Numerator: |\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 |\n| Denominator: |\n| Weighted average number of common stock – basic | 22,920,486 | 22,967,237 |\n| Weighted average dilutive impact of awards | 203,620 | 165,752 |\n| Weighted average number of common stock – diluted | 23,124,106 | 23,132,989 |\n| Basic earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\n| Diluted earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\n| Awards excluded from diluted earnings (loss) per share | 496,089 | — |\n\n\nOur weighted average number of common stock - basic decreased, primarily as a result of the repurchase of shares of Class A Non-Voting Common Stock pursuant to our current stock repurchase program offset by the issuance of shares due to the exercise of share options and vesting of restricted stock units.\n11\nNote 5 – Property and Equipment\n\nOperating Property, net\n\nAs of March 31, 2019 and December 31, 2018, property associated with our operating activities is summarized as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Land | $ | 76,110 | $ | 75,689 |\n| Building and improvements | 151,525 | 149,734 |\n| Leasehold improvements | 56,160 | 55,299 |\n| Fixtures and equipment | 171,674 | 167,943 |\n| Construction-in-progress | 3,185 | 3,478 |\n| Total cost | 458,654 | 452,143 |\n| Less: accumulated depreciation | (201,252) | (194,476) |\n| Operating property, net | $ | 257,402 | $ | 257,667 |\n\n\nDepreciation expense for operating property was $5.4 million for the quarter ended March 31, 2019 and $4.7 million for the quarter ended March 31, 2018.\n\nInvestment and Development Property, net\n\nAs of March 31, 2019 and December 31, 2018, our investment and development property is summarized below:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Land | $ | 24,310 | $ | 24,371 |\n| Building | 1,900 | 1,900 |\n| Construction-in-progress (including capitalized interest) | 68,946 | 60,533 |\n| Investment and development property | $ | 95,156 | $ | 86,804 |\n\n\nConstruction-in-Progress – Operating and Investing Properties\n\nConstruction-in-Progress balances are included in both our operating and development properties. The balances of our major projects along with the movements for the three months ended March 31, 2019 are shown below:\n\n\n| |\n| |\n| (Dollars in thousands) | Balance,December 31,2018 | Additions during the period(1) | Completedduring theperiod | Foreigncurrencytranslation | Balance,March 31,2019 |\n| Union Square development | $ | 55,634 | $ | 7,724 | $ | — | $ | (1) | $ | 63,357 |\n| Newmarket Property development | 9 | 4 | — | — | 13 |\n| Courtenay Central development | 5,571 | 234 | — | 94 | 5,899 |\n| Cinema developments and improvements | 1,664 | 3,551 | (3,997) | 4 | 1,222 |\n| Other real estate projects | 1,133 | 528 | (27) | 6 | 1,640 |\n| Total | $ | 64,011 | $ | 12,041 | $ | (4,024) | $ | 103 | $ | 72,131 |\n\n\n| (1) | Includes capitalized interest of $1.3 million for the quarter ended March 31, 2019. |\n\n\nReal Estate Transactions\n\nPurchase of Income Producing Property at Auburn/Redyard, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 square foot office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. With this acquisition, Auburn/Redyard now represents approximately 519,992 square feet (48,309 square meters) of land, with approximately 1,620 feet (498 meters) of uninterrupted frontage to Parramatta Road, a major Sydney arterial motorway.\n\n12\nPurchase of Land at Cannon Park in Townsville, Australia – On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel of land at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights with respect to that parcel.\n\nNote 6 – Investments in Unconsolidated Joint Ventures\n\nOur investments in unconsolidated joint ventures are accounted for under the equity method of accounting.\n\nThe table below summarizes our active investment holdings in two (2) unconsolidated joint ventures as of March 31, 2019 and December 31, 2018:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | Interest | 2019 | 2018 |\n| Rialto Cinemas | 50.0% | $ | 1,224 | $ | 1,260 |\n| Mt. Gravatt | 33.3% | 3,734 | 3,861 |\n| Total investments | $ | 4,958 | $ | 5,121 |\n\n\nFor the quarter ended March 31, 2019 and 2018, the recognized share of equity earnings from our investments in unconsolidated joint ventures are as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Rialto Cinemas | $ | (56) | $ | 70 |\n| Mt. Gravatt | 90 | 187 |\n| Total equity earnings | $ | 34 | $ | 257 |\n\nNote 7 – Goodwill and Intangible Assets\n\nThe table below summarizes goodwill by business segment as of March 31, 2019 and December 31, 2018.\n\n\n| |\n| |\n| (Dollars in thousands) | Cinema | Real Estate | Total |\n| Balance at, December 31, 2018 | $ | 14,221 | $ | 5,224 | $ | 19,445 |\n| Change in goodwill due to a purchase of business combination | 1,248 | — | 1,248 |\n| Foreign currency translation adjustment | 143 | — | 143 |\n| Balance at, March 31, 2019 | $ | 15,612 | $ | 5,224 | $ | 20,836 |\n\n\nThe Company is required to test goodwill and other intangible assets for impairment on an annual basis and, if current events or circumstances require, on an interim basis. Our next annual evaluation of goodwill and other intangible assets is scheduled during the fourth quarter of 2019. To test the impairment of goodwill, the Company compares the fair value of each reporting unit to its carrying amount, including the goodwill, to determine if there is potential goodwill impairment. A reporting unit is generally one level below the operating segment. As of March 31, 2019, we were not aware that any events indicating potential impairment of goodwill had occurred.\n\nThe tables below summarize intangible assets other than goodwill as of March 31, 2019 and December 31, 2018, respectively.\n\n\n| |\n| |\n| | As of March 31, 2019 |\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\n| Gross carrying amount | $ | 15,069 | $ | 7,255 | $ | 1,999 | $ | 24,323 |\n| Less: Accumulated amortization | (14,260) | (5,269) | (1,100) | (20,629) |\n| Net intangible assets other than goodwill | $ | 809 | $ | 1,986 | $ | 899 | $ | 3,694 |\n\n\n13\n\n| |\n| |\n| | As of December 31, 2018 |\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\n| Gross carrying amount | $ | 28,592 | $ | 7,254 | $ | 1,951 | $ | 37,797 |\n| Less: Accumulated amortization | (24,145) | (5,207) | (1,076) | (30,428) |\n| Net intangible assets other than goodwill | $ | 4,447 | $ | 2,047 | $ | 875 | $ | 7,369 |\n\n\nBeneficial leases were amortized over the life of the lease up to 30 years up until January 1, 2019, when under ASC 842 they were incorporated into the relevant right-of-use asset. Trade names are amortized based on the accelerated amortization method over their estimated useful life of 30 years, and other intangible assets are amortized over their estimated useful lives of up to 30 years (except for transferrable liquor licenses, which are indefinite-lived assets). The table below summarizes the amortization expense of intangible assets for the quarter ended March 31, 2019.\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Beneficial lease amortization | $ | 79 | $ | 207 |\n| Other amortization | 22 | 93 |\n| Total intangible assets amortization | $ | 101 | $ | 300 |\n\nNote 8 – Prepaid and Other Assets\n\nPrepaid and other assets are summarized as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Prepaid and other current assets |\n| Prepaid expenses | $ | 2,105 | $ | 1,761 |\n| Prepaid rent | 1,020 | 930 |\n| Prepaid taxes | 1,026 | 646 |\n| Income taxes receivable | 4,106 | 2,704 |\n| Deposits | 242 | 242 |\n| Investment in marketable securities | 44 | 42 |\n| Restricted cash | 1,099 | 1,342 |\n| Total prepaid and other current assets | $ | 9,642 | $ | 7,667 |\n| Other non-current assets |\n| Straight-line rent | 4,219 | 4,150 |\n| Other non-cinema and non-rental real estate assets | 1,134 | 1,134 |\n| Investment in Reading International Trust I | 838 | 838 |\n| Long-term deposits | 8 | 7 |\n| Long-term restricted cash | — | — |\n| Total other non-current assets | $ | 6,199 | $ | 6,129 |\n\nNote 9 – Income Taxes\n\nThe interim provision for income taxes is different from the amount determined by applying the U.S. federal statutory rate to consolidated income before taxes. The differences are attributable to foreign tax rate differential, unrecognized tax benefits, and foreign tax credits. Our effective tax rate was 33.2% and 27.3% for the three months ended March 31, 2019 and 2018, respectively. The change between 2019 and 2018 is primarily related to decrease in benefits from foreign tax credits and increase in valuation allowance related to our foreign operation.\n\n14\nNote 10 – Debt\n\nThe Company’s borrowings at March 31, 2019 and December 31, 2018, net of deferred financing costs and including the impact of interest rate derivatives on effective interest rates, are summarized below:\n\n\n| |\n| |\n| | As of March 31, 2019 |\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterest Rate | Effective Interest Rate(2) |\n| Denominated in USD |\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,116 | 6.75% | 6.75% |\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 30,000 | 30,000 | 5.02% | 5.02% |\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | 3,500 | 3,500 | 5.52% | 5.52% |\n| Banc of America digital projector loan (USA) | December 28, 2019 | 1,979 | 1,979 | 1,979 | 5.00% | 5.00% |\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 18,978 | 18,978 | 18,768 | 3.25% | 3.25% |\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,864 | 4.54% | 4.54% |\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,437 | 9,437 | 9,319 | 4.64% / 4.44% | 4.61% |\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 33,934 | 32,463 | 6.76% / 12.51% | 8.02% |\n| Denominated in foreign currency (\"FC\") (3) |\n| NAB Corporate Term Loan (AU) | December 31, 2023 | 85,248 | 40,138 | 40,111 | 2.70% | 2.70% |\n| Westpac Bank Corporate (NZ) | December 31, 2023 | 21,824 | 9,889 | 9,889 | 3.80% | 3.80% |\n| | $ | 290,879 | $ | 183,768 | $ | 180,009 |\n\n\n| (1) | Net of deferred financing costs amounting to $3.8 million. |\n\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of March 31, 2019. |\n\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of March 31, 2019. |\n\n\n| |\n| |\n| | As of December 31, 2018 |\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterestRate | Effective Interest Rate (2) |\n| Denominated in USD |\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,061 | 6.52% | 6.52% |\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 25,000 | 25,000 | 5.02% | 5.02% |\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | — | — | 5.48% | 5.48% |\n| Banc of America digital projector loan (USA) | December 28, 2019 | 2,604 | 2,604 | 2,604 | 5.00% | 5.00% |\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 19,086 | 19,086 | 18,838 | 3.25% | 3.25% |\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,857 | 4.88% | 4.88% |\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,495 | 9,495 | 9,373 | 4.64% / 4.44% | 4.61% |\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 27,182 | 25,280 | 6.76% / 12.51% | 8.35% |\n| Denominated in foreign currency (\"FC\")(3) |\n| NAB Corporate Loan Facility (AU) | December 31, 2023 | 46,856 | 37,696 | 37,660 | 3.05% | 3.05% |\n| Westpac Corporate Credit Facility (NZ) | December 31, 2023 | 21,475 | 10,067 | 10,067 | 3.80% | 3.80% |\n| | $ | 252,929 | $ | 167,043 | $ | 162,740 |\n\n\n| (1) | Net of deferred financing costs amounting to $4.3 million. |\n\n\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of December 31, 2018. |\n\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of December 31, 2018. |\n\n\nOur loan arrangements are presented, net of the deferred financing costs, on the face of our consolidated balance sheet as follows:\n\n\n| |\n| |\n| | March 31, | December 31, |\n| Balance Sheet Caption | 2019 | 2018 |\n| Debt - current portion | $ | 40,077 | $ | 30,393 |\n| Debt - long-term portion | 113,816 | 106,286 |\n| Subordinated debt | 26,116 | 26,061 |\n| Total borrowings | $ | 180,009 | $ | 162,740 |\n\n\n15\nMinetta and Orpheum Theatres Loan\n\nOn October 12, 2018, we refinanced our $7.5 million loan with Santander Bank, which is secured by our Minetta and Orpheum Theatres, with a loan for a five year term of $8.0 million. Such modification was not considered to be substantial under US GAAP.\n\nBanc of America Digital Projector Loan\n\nOn February 5, 2018, we purchased our U.S. digital cinema projectors, which had previously been held on operating leases, using a $4.6 million loan from Banc of America. We made further U.S. digital projector purchases, of projectors similarly held on other operating leases, in March and April 2018, increasing this loan to $4.9 million. This loan carries an interest rate of 5% and is due and payable December 28, 2019.\n\nBank of America Credit Facility\n\nOn March 3, 2016, we amended our $55.0 million credit facility with Bank of America to permit real property acquisition loans. This amendment reduces the applicable consolidated leverage ratio covenant by 0.25% and modifies the term of the facility based on the earlier of the eighteen months from the date of such borrowing or the maturity date of the credit agreement. Such modification was not considered substantial in accordance with U.S. GAAP. On March 5, 2019, this Credit Facility was extended for six (6) months to May 1, 2020.\n\n44 Union Square Construction Financing\n\nOn December 29, 2016, we closed on our new construction finance facilities totaling $57.5 million to fund the non-equity portion of the anticipated construction costs of the redevelopment of our property at 44 Union Square in New York City. The combined facilities consist of $50.0 million in aggregate loans (comprised of three loan tranches) from Bank of the Ozarks (“BOTO”), and a $7.5 million mezzanine loan from Tammany Mezz Investor, LLC, an affiliate of Fisher Brothers. At December 31, 2016, Bank of the Ozarks advanced $8.0 million to repay the then existing $8.0 million loan with East West Bank. As of March 31, 2019, an additional $26.4 million had been advanced under the senior loan facility, along with the full $7.5 million available under the mezzanine loan facility.\n\nU.S. Corporate Office Term Loan\n\nOn December 13, 2016, we obtained a ten-year $8.4 million mortgage loan on our new Los Angeles Corporate Headquarters at a fixed annual interest rate of 4.64%. This loan provided for a second loan upon completion of certain improvements. On June 26, 2017, we obtained a further $1.5 million under this provision at a fixed annual interest rate of 4.44%.\n\nBank of America Line of Credit\n\nIn October 2016, the term of this $5.0 million line of credit was extended to October 31, 2019. Such modification was not considered to be substantial under US GAAP.\n\nCinema 1,2,3 Term Loan\n\nOn August 31, 2016, Sutton Hill Properties LLC (“SHP”), a 75% subsidiary of RDI, refinanced its $15.0 million Santander Bank term loan with a new lender, Valley National Bank. This new $20.0 million loan is collateralized by our Cinema 1,2,3 property and bears an interest rate of 3.25% per annum, with principal installments and accruing interest paid monthly. The new loan matures on September 1, 2019, with a one-time option to extend maturity date for another year. The Company presently intends to exercise that option and to extend the maturity date until September 1, 2020.\n\nWestpac Bank Corporate Credit Facility (NZ)\n\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was not renewed.\n\nAustralian NAB Corporate Term Loan (AU)\n\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0\n16\nmillion Corporate Loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a Bank Guarantee Facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\nNote 11 – Other Liabilities\n\nOther liabilities are summarized as follows:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Current liabilities |\n| Lease liability | $ | 5,900 | $ | 5,900 |\n| Liability for demolition costs | 2,664 | 2,630 |\n| Accrued pension | 684 | 684 |\n| Security deposit payable | 88 | 84 |\n| Finance lease liabilities | 162 | — |\n| Other | 27 | 7 |\n| Other current liabilities | $ | 9,525 | $ | 9,305 |\n| Other liabilities |\n| Straight-line rent | $ | — | $ | 16,362 |\n| Lease make-good provision | 5,722 | 5,614 |\n| Accrued pension | 4,544 | 4,670 |\n| Environmental reserve | 1,656 | 1,656 |\n| Deferred revenue - real estate | 9 | 32 |\n| Acquired leases | 47 | 91 |\n| Finance lease liabilities | 169 | — |\n| Other | 199 | 506 |\n| Other liabilities | $ | 12,346 | $ | 28,931 |\n\n\nOn August 29, 2014, the Supplemental Executive Retirement Plan (“SERP”) that has been effective since March 1, 2007, was ended and replaced in accordance with the terms of a pension annuity. As a result of the termination of the SERP program, the accrued pension liability of $7.6 million was reversed and replaced with this pension annuity liability of $7.5 million. The valuation of the liability is based on the present value of $10.2 million discounted at a rate of 4.25% over a 15-year term, resulting in a monthly payment of $57,000. The discount rate of 4.25% has been applied since 2014 to determine the net periodic benefit cost and plan benefit obligation and is expected to be used in future years. The discounted value of $2.7 million (which is the difference between the estimated payout of $10.2 million and the present value of $7.5 million) as of August 29, 2014 will be amortized and expensed based on the 15-year term. In addition, the accumulated actuarial loss of $3.1 million recorded, as part of other comprehensive income will also be amortized based on the 15-year term.\n\nIn February 2018 we made a payment of $2.4 million relating to the annuity representing payments for the 42 months outstanding at the time. Monthly ongoing payments of $57,000 are now being made.\n\nAs a result of the above, included in our current and non-current liabilities are accrued pension costs of $5.2 million at March 31, 2019. The benefits of our pension plan are fully vested and therefore no service costs were recognized for the quarter ended March 31, 2019 and 2018. Our pension plan is unfunded.\n\nDuring the quarter ended March 31, 2019, the interest cost was $51,000 and actuarial loss was $51,000. During the quarter ended March 31, 2018, the interest cost was $45,000 and actuarial loss was $52,000.\n17\nNote 12 – Accumulated Other Comprehensive Income\n\nThe following table summarizes the changes in each component of accumulated other comprehensive income attributable to RDI:\n\n\n| |\n| |\n| (Dollars in thousands) | ForeignCurrencyItems | UnrealizedGain (Losses)on Available-for-SaleInvestments | AccruedPensionService Costs | Hedge Accounting Reserve | Total |\n| Balance at January 1, 2019 | $ | 8,687 | $ | 3 | $ | (2,438) | $ | (137) | $ | 6,115 |\n| |\n| Change related to derivatives |\n| Total change in hedge fair value recorded in Other Comprehensive Income | — | — | — | (81) | (81) |\n| Amounts reclassified from accumulated other comprehensive income | — | — | — | 12 | 12 |\n| Net change related to derivatives | — | — | — | (69) | (69) |\n| |\n| Net current-period other comprehensive income (loss) | 1,526 | 2 | 51 | (69) | 1,510 |\n| Balance at March 31, 2019 | $ | 10,213 | $ | 5 | $ | (2,387) | $ | (206) | $ | 7,625 |\n\nNote 13 – Commitments and Contingencies\n\nLitigation General\n\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims, including legal costs.\n| · | Where we are a plaintiff, we accrue legal fees as incurred on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which recoveries typically work out to be approximately 60% of the amounts actually spent where first-class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party. |\n\n| · | Where we are a defendant, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. From time-to-time, we are involved with claims and lawsuits arising in the ordinary course of our business that may include contractual obligations, insurance claims, tax claims, employment matters, and anti-trust issues, among other matters. |\n\n\nAll of these matters require significant judgments based on the facts known to us. These judgments are inherently uncertain and can change significantly when additional facts become known. We provide accruals for matters that have probable likelihood of occurrence and can be properly estimated as to their expected negative outcome. We do not record expected gains until the proceeds are received by us. However, we typically make no accruals for potential costs of defense, as such amounts are inherently uncertain and dependent upon the scope, extent and aggressiveness of the activities of the applicable plaintiff.\n\nEnvironmental and Asbestos Claims on Reading Legacy Operations\nCertain of our subsidiaries were historically involved in railroad operations, coal mining, and manufacturing. Also, certain of these subsidiaries appear in the chain-of-title of properties that may suffer from pollution. Accordingly, certain of these subsidiaries have, from time-to-time, been named in and may in the future be named in various actions brought under applicable environmental laws. Also, we are in the real estate development business and may encounter from time-to-time unanticipated environmental conditions at properties that we have acquired for development. These environmental conditions can increase the cost of such projects and adversely affect the value and potential for profit of such projects. We do not currently believe that our exposure under applicable environmental laws is material in amount.\n\nFrom time to time, there are claims brought against us relating to the exposure of former employees of our railroad operations to asbestos and coal dust. These are generally covered by an insurance settlement reached in September 1990 with our insurance providers. However, this insurance settlement does not cover litigation by people who were not our employees and who may claim second-hand exposure to asbestos, coal dust and/or other chemicals or elements now recognized as potentially causing cancer in humans. Our known exposure to these types of claims, asserted or probable of being asserted, is not material.\n\n18\nCotter Jr. Derivative Litigation\n\nThis action was originally brought by James J. Cotter, Jr. (“Cotter Jr.”) in June, 2015 in the Nevada District Court against all of the Directors of the Company and against the Company as a nominal defendant: James J. Cotter, Jr., individually and derivatively on behalf of Reading International, Inc. vs. Margaret Cotter, et al.” Case No,: A-15-719860-V. Summary judgment has been entered against Cotter, Jr., and in favor of all defendants and a $1.55 million cost judgment has been entered against Cotter, Jr., and in favor of our Company. Cotter, Jr. has appealed both judgements. Our application for $5.9 million in attorney’s fees was denied, and we have appealed that determination. The issues on appeal are currently being briefed. No date for oral argument has been set. It is unlikely that any hearing will be held this year. As the Directors and Officers Liability Insurance Policy covering Cotter, Jr.’s claims in the Derivative Case ($10.0 million) has been exhausted, the financial burden of defending our Directors against these claims, as required by applicable Nevada Law, has fallen upon our Company. During 2018, out-of-pocket third party costs in the amount of approximately $3.5 million were incurred by our Company in defending against these claims. In the quarter ended March 31, 2019, an additional $387,000 had been accrued, relating principally to the preparation of appellate briefs with respect to the Derivative Litigation.\nNote 14 – Non-controlling Interests\n\nThese are composed of the following enterprises:\n| · | Australia Country Cinemas Pty Ltd. - 25% noncontrolling interest owned by Panorama Cinemas for 21st Century Pty Ltd.; |\n\n| · | Shadow View Land and Farming, LLC - 50% noncontrolling membership interest owned by either the estate of Mr. James J. Cotter, Sr. (the “Cotter Estate”) and/or the James J. Cotter, Sr. Living Trust (the “Cotter Trust”); and, |\n\n| · | Sutton Hill Properties, LLC - 25% noncontrolling interest owned by Sutton Hill Capital, LLC (which in turn is 50% owned by the Cotter Estate and/or the Cotter Trust). |\n\n\nThe components of noncontrolling interests are as follows:\n\n| |\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Australian Country Cinemas, Pty Ltd | $ | 27 | $ | 89 |\n| Shadow View Land and Farming, LLC | 2,156 | 2,153 |\n| Sutton Hill Properties, LLC | 2,084 | 2,095 |\n| Noncontrolling interests in consolidated subsidiaries | $ | 4,267 | $ | 4,337 |\n\n\nThe components of income attributable to noncontrolling interests are as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Australian Country Cinemas, Pty Ltd | $ | 9 | $ | 41 |\n| Shadow View Land and Farming, LLC | (14) | (13) |\n| Sutton Hill Properties, LLC | (11) | (6) |\n| Net income (loss) attributable to noncontrolling interests | $ | (16) | $ | 22 |\n\n\n19\nSummary of Controlling and Noncontrolling Stockholders’ Equity\n\nA summary of the changes in controlling and noncontrolling stockholders’ equity is as follows:\n\n\n\n| |\n| |\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\n| Equity at January 1, 2019 | $ | 176,210 | $ | 4,337 | $ | 180,547 |\n| Adjustments to opening retained earnings on adoption of ASC 842 | 28 | (46) | (18) |\n| Net income (loss) | (2,081) | (16) | (2,097) |\n| Increase in additional paid in capital | 21 | — | 21 |\n| Treasury stock purchased | (9) | — | (9) |\n| Contributions from noncontrolling stockholders | — | 18 | 18 |\n| Distributions to noncontrolling stockholders | — | (27) | (27) |\n| Accumulated other comprehensive income | 1,510 | 1 | 1,511 |\n| Equity at March 31, 2019 | $ | 175,679 | $ | 4,267 | $ | 179,946 |\n| |\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\n| Equity at January 1, 2018 | $ | 177,287 | $ | 4,331 | $ | 181,618 |\n| Adjustments to opening retained earnings on adoption of ASC 606 | 194 | (2) | 192 |\n| Net income (loss) | 3,082 | 22 | 3,104 |\n| Increase in additional paid in capital | 339 | — | 339 |\n| Treasury stock purchased | (317) | — | (317) |\n| Contributions from noncontrolling stockholders | — | 27 | 27 |\n| Distributions to noncontrolling stockholders | — | (43) | (43) |\n| Accumulated other comprehensive loss | (750) | (3) | (753) |\n| Equity at March 31, 2018 | $ | 179,835 | $ | 4,332 | $ | 184,167 |\n\nNote 15 – Stock-Based Compensation and Stock Repurchases\n\nEmployee and Director Stock Option Plan\n\nThe Company may grant stock options and other share-based payment awards of our Common Stock to eligible employees, directors, and consultants under the 2010 Stock Incentive Plan (the “Plan”). The aggregate total number of shares of the Common Stock authorized for issuance under the Plan is 2,197,460.\n\nDuring the Company’s 2017 Annual Stockholders’ Meeting held on November 7, 2017, the Company's stockholders, upon recommendation of the Board of Directors, approved an amendment to the Plan to increase the number of shares of common stock issuable under the Plan by an additional 947,460 shares. The effect of the increase is to restore the amount of shares of Common Stock available under the Plan from the 302,540 shares available as of September 30, 2017, back up to its original reserve of 1,250,000 shares. As of March 31, 2019, we had 789,869 shares remaining for future issuances.\n\nSince the adoption of the Plan in 2010, the Company has granted awards primarily in the form of stock options. In the 1st quarter of 2016, the Company started to award restricted stock units (“RSUs”) to directors and certain members of management. Stock options are generally granted at exercise prices equal to the grant-date market prices and typically expire no later than five years from the grant date. In contrast to a stock option where the grantee buys the Company’s share at an exercise price determined on grant date, an RSU entitles the grantee to receive one share for every RSU based on a vesting plan. At the discretion of our Compensation and Stock Options Committee, the vesting period of stock options and RSUs granted to employees ranges from zero to four years. Grants to directors and certain executive officers are subject to Board approval. At the time the options are exercised or RSUs vest and are settled, at the discretion of management, we will issue treasury shares or make a new issuance of shares to the option or RSU holder.\n\nStock Options\nWe estimate the grant-date fair value of our stock options using the Black-Scholes option-valuation model, which takes into account assumptions such as the dividend yield, the risk-free interest rate, the expected stock price volatility, and the expected life of the options. We expense the estimated grant-date fair values of options over the vesting period on a straight-line basis. Based on our\n20\nhistorical experience, the “deemed exercise” of expiring in-the-money options and the relative market price to strike price of the options, we have not hereto estimated any forfeitures of vested or unvested options.\n\nThere were 219,408 stock options issued in the quarter ended March 31, 2019. The weighted average assumptions used in the option-valuation model were as follows:\n\n\n| |\n| |\n| | Three Months Ended March 31, |\n| | 2019 | 2018 |\n| Stock option exercise price | $ | 16.12 | $ | — |\n| Risk-free interest rate | 2.42% | 0.00% |\n| Expected dividend yield | — | — |\n| Expected option life in years | 3.75 | — |\n| Expected volatility | 23.32% | 0.00% |\n| Weighted average fair value | $ | 3.50 | $ | — |\n\n\nFor the quarters ended March 31, 2019 and 2018, we recorded compensation expense of $70,000 and $85,000, respectively. At March 31, 2019, the total unrecognized estimated compensation expense related to non-vested stock options was $1.5 million, which we expect to recognize over a weighted average vesting period of 2.11 years. The intrinsic, unrealized value of all options outstanding, vested and expected to vest, at March 31, 2019 was $2.0 million, of which 91% are currently exercisable.\n\nThe following table summarizes the number of options outstanding and exercisable as of March 31, 2019 and December 31, 2018:\n\n| |\n| |\n| | Outstanding Stock Options - Class A Shares |\n| | Numberof Options | WeightedAverageExercise Price | WeightedAverageRemainingYears ofContractualLife | AggregateIntrinsicValue |\n| | Class A | Class A | Class A | Class A |\n| Balance - December 31, 2017 | 524,589 | $ | 12.50 | 3.15 | $ | 3,054,325 |\n| Granted | 126,840 | 16.40 | — | — |\n| Exercised | (60,000) | 6.02 | — | 610,249 |\n| Forfeited | (4,960) | 12.08 | — | — |\n| Balance - December 31, 2018 | 586,469 | $ | 14.01 | 2.88 | $ | 1,530,528 |\n| Granted | 219,408 | 16.12 | — | — |\n| Exercised | (67,500) | 13.42 | — | 185,175 |\n| Forfeited | (25,000) | 13.42 | — | — |\n| Balance - March 31, 2019 | 713,377 | $ | 14.74 | 3.53 | $ | 1,993,628 |\n\n\n21\nRestricted Stock Units\nWe estimate the grant-date fair values of our RSUs using the Company’s stock price at grant-date and record such fair values as compensation expense over the vesting period on a straight-line basis. The following table summarizes the status of the RSUs granted to-date as of March 31, 2019:\n\n| |\n| |\n| | Outstanding Restricted Stock Units |\n| | RSU Grants (in units) | Vested, | Unvested, | Forfeited, |\n| Grant Date | Directors | Management | TotalGrants | March 31,2019 | March 31,2019 | March 31,2019 |\n| March 10, 2016 | 35,147 | 27,381 | 62,528 | 55,684 | 6,844 |\n| April 11, 2016 | — | 5,625 | 5,625 | 2,815 | 2,293 | 517 |\n| March 23, 2017 | 30,681 | 32,463 | 63,144 | 46,919 | 16,225 |\n| August 29, 2017 | — | 7,394 | 7,394 | 3,698 | 3,696 |\n| January 2, 2018 | 29,393 | — | 29,393 | 29,393 | — |\n| April 12, 2018 | — | 29,596 | 29,596 | — | 29,596 |\n| April 13, 2018 | — | 14,669 | 14,669 | — | 14,669 |\n| July 6, 2018 | — | 932 | 932 | — | — | 932 |\n| November 7, 2018 | 23,010 | — | 23,010 | — | 23,010 |\n| March 13, 2019 | — | 24,366 | 24,366 | — | 24,366 |\n| March 14, 2019 | — | 23,327 | 23,327 | — | 23,327 |\n| Total | 118,231 | 165,753 | 283,984 | 138,509 | 144,026 | 1,449 |\n\n\nRSU awards to management vest 25% at the end of each year for 4 years. Prior to November 7, 2018, RSU awards to directors vested 100% in January of the following year in which such RSUs were granted. At the November 7, 2018 Board meeting, it was determined that it would be more appropriate for the vesting of RSUs to align with the directors’ term of office. Accordingly, the RSUs granted on November 7, 2018, will vest upon the earlier of (i) the first anniversary of grant and (ii) the date of the next annual meeting of stockholders. This means that on the date of the annual meeting of stockholders on May 7, 2019, the RSUs granted to directors on November 7, 2018 vested. Due to the fact that the Company has moved up its annual meeting of stockholders from November to May this year, this created a shorter than normal vesting period for the RSUs issued on November 7, 2018. In order to adjust for this factor, the directors have determined that the award of RSUs to be made immediately following the 2019 Annual Meeting of Stockholders will be $35,000 or one half of last year's annual grant. For the quarter ended March 31, 2019 and 2018, we recorded compensation expense of $209,000 and $294,000, respectively. The total unrecognized compensation expense related to the non-vested RSUs was $1.9 million as of March 31, 2019, which we expect to recognize over a weighted average vesting period of 1.1 years.\n\nStock Repurchase Program\n\nOn March 2, 2017, the Company's Board of Directors authorized management, at its discretion, to spend up to an aggregate of $25.0 million to acquire shares of Reading’s Class A Common Stock. The previously approved stock repurchase program, which allowed management to spend up to an aggregate of $10.0 million to acquire shares of Reading’s Class A Common Stock, was completed as of December 31, 2016. On March 14, 2019, the Board of Directors extended this stock buy-back program for two years, through March 2, 2021. The Board of Directors did not increase the authorized amount which was $16.2 million at March 31, 2019.\n\nThe repurchase program allows Reading to repurchase its shares in accordance with the requirements of the SEC on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. All purchases are subject to the availability of shares at prices that are acceptable to Reading, and accordingly, no assurances can be given as to the timing or number of shares that may ultimately be acquired pursuant to this authorization.\n\nUnder the stock repurchase program, as of March 31, 2019, the Company has reacquired 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs) to-date. 566 shares of Class A Common Stock were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019.\n\n22\nNote 16 - Leases\n\nIn all leases, whether we are the lessor or lessee, we define lease term as the non-cancellable term of the lease plus any renewals covered by renewal options that are reasonably certain of exercise based on our assessment of economic factors relevant to the lessee. The non-cancellable term of the lease commences on the date the lessor makes the underlying property in the lease available to the lessee, irrespective of when lease payments begin under the contract.\n\nAs Lessee\n\nWe have operating leases for certain cinemas and corporate offices, and finance leases for certain equipment assets. Our leases have remaining lease terms of 1 to 20 years, with certain leases having options to extend to up to a further 20 years.\n\nContracts are analyzed in accordance with the criteria set out in ASC 842 to determine if there is a lease present. For contracts that contain an operating lease, we account for the lease component and the non-lease component together as a single component. For contracts that contain a finance lease we account for the lease component and the non-lease component separately in accordance with ASC 842.\n\nIn leases where we are the lessee, we recognize a right of use asset and lease liability at lease commencement, which is measured by discounting lease payments using our incremental borrowing rate applicable to the lease term and currency of the lease as the discount rate. Subsequent amortization of the right of use asset and accretion of the lease liability for an operating lease is recognized as a single lease cost, on a straight line basis, over the term of the lease. A finance lease right-of-use asset is depreciated on a straight line basis over the lesser of the useful life of the leased asset or the lease term. Interest on each finance lease liability is determined as the amount that results in a constant periodic discount rate on the remaining balance of the liability. Property taxes and other non-lease costs are accounted for on an accrual basis.\n\nLease payments for our cinema operating leases consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics.\nThe components of lease expense were as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Lease cost |\n| Finance lease cost: | — |\n| Amortization of right-of-use assets | $ | 41 | $ | — |\n| Interest on lease liabilities | 3 | — |\n| Operating lease cost | 7,921 | — |\n| Variable lease cost | 105 | — |\n| Total lease cost | $ | 8,070 | $ | — |\n\n\n\nSupplemental cash flow information related to leases was as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Cash flows relating to lease cost |\n| Cash paid for amounts included in the measurement of lease liabilities: |\n| Operating cash flows from finance leases | $ | 44 | $ | — |\n| Operating cash flows from operating leases | 7,780 | — |\n| Right-of-use assets obtained in exchange for new finance lease liabilities | — | — |\n| Right-of-use assets obtained in exchange for new operating lease liabilities | 2,181 | — |\n\n23\n\n\n\nSupplemental balance sheet information related to leases was as follows:\n\n\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Operating leases |\n| Operating lease right-of-use assets | $ | 229,266 | $ | — |\n| Operating lease liabilities - current portion | 19,797 | — |\n| Operating lease liabilities - non-current portion | 222,594 | — |\n| Total operating lease liabilities | $ | 242,391 | $ | — |\n| Finance leases |\n| Property plant and equipment, gross | 372 | — |\n| Accumulated depreciation | (41) | — |\n| Property plant and equipment, net | $ | 331 | $ | — |\n| Other current liabilities | 162 | — |\n| Other long-term liabilities | 169 | — |\n| Total finance lease liabilities | $ | 331 | $ | — |\n| |\n| Other information |\n| Weighted-average remaining lease term - finance leases | 3 | — |\n| Weighted-average remaining lease term - operating leases | 11 | — |\n| Weighted-average discount rate - finance leases | 5.05% | — |\n| Weighted-average discount rate - operating leases | 4.97% | — |\n\n\n\nMaturity of leases were as follows:\n\n\n| |\n| (Dollars in thousands) | Operating leases | Finance leases |\n| 2019 | $ | 23,566 | $ | 133 |\n| 2020 | 31,434 | 101 |\n| 2021 | 31,717 | 53 |\n| 2022 | 31,901 | 43 |\n| 2023 | 31,018 | 28 |\n| Thereafter | 169,221 | — |\n| Total lease payments | $ | 318,857 | $ | 358 |\n| Less imputed interest | (76,466) | (27) |\n| Total | $ | 242,391 | $ | 331 |\n\n\n\nAs of March 31, 2019, we have additional operating leases, primarily for cinemas, that have not yet commenced of approximately $26.0 million. These operating leases will commence between fiscal year 2019 and fiscal year 2021 with lease terms of 15 to 20 years.\n\nAs Lessor\n\nThe Company has entered into various leases as a lessor for our owned real estate properties. These leases vary in length between 1 and 20 years, with certain leases containing options to extend at the behest of the applicable tenants. Lease components consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics. No terms exist by which a lessee is able to purchase the underlying asset.\n\nWe recognize lease payments for operating leases as property revenue on a straight-line basis over the lease term. Lease incentive payments we make to lessees are amortized as a reduction in property revenue over the lease term.\n24\nLease income relating to operating lease payments was as follows:\n\n\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Components of lease income |\n| Lease payments | $ | 2,229 | $ | 2,423 |\n| Variable lease payments | 265 | 80 |\n| Total lease income | $ | 2,494 | $ | 2,503 |\n\n\n\nThe book value of underlying assets under operating leases from owned assets was as follows:\n\n\n| |\n| | March 31, | December 31, |\n| (Dollars in thousands) | 2019 | 2018 |\n| Building and improvements |\n| Gross balance | $ | 68,483 | $ | 67,887 |\n| Accumulated depreciation | (18,375) | (17,709) |\n| Net Book Value | $ | 50,108 | $ | 50,178 |\n\n\n\n\nMaturity of leases were as follows:\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n| |\n| (Dollars in thousands) | Operating leases |\n| 2019 | $ | 6,470 |\n| 2020 | 7,439 |\n| 2021 | 6,830 |\n| 2022 | 5,961 |\n| 2023 | 5,187 |\n| Thereafter | 10,295 |\n| Total | $ | 42,182 |\n\n\n\n\n\n\n\n\n\n\n\n\nNote 17 – Hedge Accounting\n\nAs of March 31, 2019 and March 31, 2018, the Company held interest rate derivatives in the total notional amount of $8.0 million and $nil, respectively.\n\nThe derivatives are recorded on the balance sheet at fair value and are included in the following line items:\n\n\n| |\n| | Liability Derivatives |\n| | March 31, | December 31, |\n| | 2019 | 2018 |\n| (Dollars in thousands) | Balance sheet location | Fair value | Balance sheet location | Fair value |\n| Interest rate contracts | Derivative financial instruments - current portion | $ | 52 | Derivative financial instruments - current portion | $ | 41 |\n| | Derivative financial instruments - non-current portion | 203 | Derivative financial instruments - non-current portion | 145 |\n| Total derivatives designated as hedging instruments | $ | 255 | $ | 186 |\n| Total derivatives | $ | 255 | $ | 186 |\n\n\n\n\n\n25\n\n\nWe have no derivatives designated as hedging instruments which are in asset positions.\n\nThe changes in fair value are recorded in Other Comprehensive Income and released into interest expense in the same period(s) in which the hedged transactions affect earnings. In the quarter to March 31, 2019 and March 31, 2018, respectively, the derivative instruments affected Comprehensive Income as follows:\n\n\n\n| |\n| (Dollars in thousands) | Location of Loss Recognized in Income on Derivatives | Amount of Loss Recognized in Income on Derivatives |\n| | 2019 | 2018 |\n| Interest rate contracts | Interest expense, net | $ | 12 | $ | — |\n| Total | $ | 12 | $ | — |\n\n\n\n| |\n| | Loss Recognized in OCI on Derivatives (Effective Portion) | Loss Reclassified from OCI into Income (Effective Portion) | Loss Recognized in Income on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing) |\n| (Dollars in thousands) | Amount | Line Item | Amount | Line Item | Amount |\n| | 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\n| Interest rate contracts | $ | 81 | $ | — | Interest expense, net | $ | 12 | $ | — | Interest expense, net | $ | — | $ | — |\n| Total | $ | 81 | $ | — | $ | 12 | $ | — | $ | — | $ | — |\n\n\n\nNote 18 – Fair Value Measurements\n\nASC 820, Fair Value Measurement establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The statement requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:\n| · | Level 1: Quoted market prices in active markets for identical assets or liabilities; |\n\n| · | Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and, |\n\n| · | Level 3: Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\n\nAs of March 31, 2019 and December 31, 2018 material financial assets and financial liabilities were carried and measured at fair value on a recurring basis.\n\nThe following tables summarize our financial liabilities that are carried at cost and measured at fair value on a non-recurring basis as of March 31, 2019 and December 31, 2018, by level within the fair value hierarchy.\n\n\n| |\n| |\n| | Fair Value Measurement at March 31, 2019 |\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\n| Notes payable | $ | 155,855 | $ | — | $ | — | $ | 159,871 | $ | 159,871 |\n| Subordinated debt | 27,913 | — | — | 19,162 | 19,162 |\n| | $ | 183,768 | $ | — | $ | — | $ | 179,033 | $ | 179,033 |\n\n\n\n| |\n| |\n| | Fair Value Measurement at December 31, 2018 |\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\n| Notes payable | $ | 139,130 | $ | — | $ | — | $ | 143,564 | $ | 143,564 |\n| Subordinated debt | 27,913 | — | — | 18,895 | 18,895 |\n| | $ | 167,043 | $ | — | $ | — | $ | 162,459 | $ | 162,459 |\n\n\n| (1) | These balances are presented before any deduction for deferred financing costs. |\n\n26\n\nFollowing is a description of the valuation methodologies used to estimate the fair value of our financial assets and liabilities. There have been no changes in the methodologies used at March 31, 2019 and December 31, 2018.\n| · | Level 1 investments in marketable securities primarily consist of investments associated with the ownership of marketable securities in U.S. and New Zealand. These investments are valued based on observable market quotes on the last trading date of the reporting period. |\n\n| · | Level 2 derivative financial instruments are valued based on discounted cash flow models that incorporate observable inputs such as interest rates and yield curves from the derivative counterparties. The credit valuation adjustments associated with our non-performance risk and counterparty credit risk are incorporated in the fair value estimates of our derivatives. As of March 31, 2019 and December 31, 2018, we concluded that the credit valuation adjustments were not significant to the overall valuation of our derivatives. |\n\n| · | Level 3 borrowings include our secured and unsecured notes payable, trust preferred securities and other debt instruments. The borrowings are valued based on discounted cash flow models that incorporate appropriate market discount rates. We calculated the market discount rate by obtaining period-end treasury rates for fixed-rate debt, or LIBOR for variable-rate debt, for maturities that correspond to the maturities of our debt, adding appropriate credit spreads derived from information obtained from third-party financial institutions. These credit spreads take into account factors such as our credit rate, debt maturity, types of borrowings, and the loan-to-value ratios of the debt. |\n\n\nThe Company’s financial instruments also include cash, cash equivalents, receivables and accounts payable. The carrying values of these financial instruments approximate the fair values due to their short maturities. Additionally, there were no transfers of assets and liabilities between levels 1, 2, or 3 during the quarter ended March 31, 2019 and March 31, 2018.\nNote 19 – Business Combination\n\nOn January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019.\n\nThe total purchase price was allocated to the identifiable assets acquired based on our preliminary estimates of their fair values on the acquisition date. There were no liabilities assumed. As of March 31, 2019, the Company is still finalizing its allocation and this may result in potential adjustments within the one-year measurement period from acquisition date. The determination of the fair values of the acquired assets (and the related determination of their estimated lives) requires significant judgment.\n\nOur preliminary purchase price allocation is as follows:\n\n\n| |\n| | Preliminary Purchase Price |\n| | Allocation |\n| (Dollars in thousands) | US Dollars(1) | AU dollars |\n| Tangible Assets |\n| Operating property: |\n| Fixtures and equipment | $ | 153 | $ | 213 |\n| Intangible Assets |\n| Goodwill | 1,248 | 1,734 |\n| Total assets acquired | 1,401 | 1,947 |\n| |\n| Net assets acquired | $ | 1,401 | $ | 1,947 |\n\n\n| (1) | The balances were translated into U.S. Dollars based on the applicable exchange rate as of the date of acquisition, January 30, 2019. |\n\n\n\n\n\n27\nThis MD&A should be read in conjunction with the accompanying unaudited consolidated financial statements included in Part I, Item 1 (Financial Statements). The foregoing discussions and analyses contain certain forward-looking statements. Please refer to the “Forward Looking Statements” included at the conclusion of this section and our “Risk Factors” set forth in our 2018 Form 10-K, Part 1, Item 1A and the Risk Factors set out below.\n\n\nItem 2 – Management’s Discussions and Analysis (“MD&A”) of Financial Condition and Results of Operations\n\nBUSINESS OVERVIEW\n\nWe are an internationally diversified company principally focused on the development, lease or ownership, and operation of entertainment and real estate assets in the United States, Australia, and New Zealand. As of March 31, 2019, we operate in two business segments:\n| · | Cinema exhibition, through our 60 multiplex cinemas; and, |\n\n| · | Real estate, including real estate development and the rental of retail, commercial and live theatre assets. |\n\n\nWe believe that these two business segments complement one another, as we can use the comparatively consistent cash flows generated by our cinema operations to fund the front-end cash demands of our real estate development business.\n\nCinema Exhibition\nWe manage our worldwide cinema exhibition businesses under various brands:\n| · | in the U.S., under the following brands: Reading Cinemas, Angelika Film Centers, Consolidated Theatres, and City Cinemas; |\n\n| · | in Australia, under the Reading Cinemas brand; and, |\n\n| · | in New Zealand, under the Reading Cinemas and Rialto Cinemas brands. |\n\n\nShown in the following table are the number of locations and theater screens in our theater circuit in each country, by state/territory/ region and indicating our cinema brands and our interest in the underlying assets as of March 31, 2019:\n\n\n| |\n| |\n| | State / Territory / | Location | Screen | Interest in AssetUnderlying the Cinema |\n| Country | Region | Count | Count | Leased | Owned | Operating Brands |\n| United States | Hawaii | 9 | 98 | 9 | Consolidated Theatres |\n| | California | 7 | 88 | 7 | Reading Cinemas, Angelika Film Center |\n| | New York(3) | 6 | 23 | 5 | 1 | Angelika Film Center, City Cinemas |\n| | Texas | 2 | 13 | 2 | Angelika Film Center |\n| | New Jersey | 1 | 12 | 1 | Reading Cinemas |\n| | Virginia | 1 | 8 | 1 | Angelika Film Center |\n| | Washington DC | 1 | 3 | 1 | Angelika Film Center |\n| | U.S. Total | 27 | 245 | 26 | 1 |\n| Australia | New South Wales | 6 | 44 | 4 | 2 | Reading Cinemas |\n| | Victoria | 6 | 43 | 6 | Reading Cinemas |\n| | Queensland | 5 | 50 | 2 | 3 | Reading Cinemas, Event Cinemas(1) |\n| | Western Australia | 2 | 16 | 1 | 1 | Reading Cinemas |\n| | South Australia | 2 | 15 | 2 | Reading Cinemas |\n| | Tasmania | 1 | 4 | 1 | Reading Cinemas |\n| | Australia Total | 22 | 172 | 16 | 6 |\n| New Zealand | Wellington | 2 | 15 | 1 | 1 | Reading Cinemas |\n| | Otago | 3 | 15 | 2 | 1 | Reading Cinemas, Rialto Cinemas(2) |\n| | Auckland | 2 | 15 | 2 | Reading Cinemas, Rialto Cinemas(2) |\n| | Canterbury | 1 | 8 | 1 | Reading Cinemas |\n| | Southland | 1 | 5 | 1 | Reading Cinemas |\n| | Bay of Plenty | 1 | 5 | 1 | Reading Cinemas |\n| | Hawke's Bay | 1 | 4 | 1 | Reading Cinemas |\n| | New Zealand Total | 11 | 67 | 6 | 5 |\n| GRAND TOTAL | 60 | 484 | 48 | 12 |\n\n\n| (1) | The Company has a 33.3% unincorporated joint venture interest in a 16-screen cinema located in Mt. Gravatt, Queensland managed by Event Cinemas. |\n\n| (2) | The Company is a 50% joint venture partner in two (2) New Zealand Rialto cinemas. We are responsible for the booking of these cinemas and our joint venture partner, Event Cinemas, manages their day-to-day operations. |\n\n| (3) | Our New York statistics include one (1) managed cinema, with a four-screen total. |\n\n\n28\nReal Estate\nWe engage in real estate development and the ownership, and rental or licensing to third parties of retail, commercial and live theater assets. We own the fee interests in all three of our live theaters, and in 12 of our cinemas (as presented in the preceding table). Our real estate business creates long-term value for our stockholders through the continuous improvement and development of our investment and operating properties, including our entertainment-themed centers (“ETCs”).\n\nOur real estate activities have historically consisted principally of:\n| · | the ownership of fee or long-term leasehold interests in properties used in our cinema exhibition activities or which were acquired for the development of cinemas or cinema-based real estate development projects; |\n\n| · | the acquisition and development of fee interests in land; |\n\n| · | the licensing to production companies of the use of our live theatres; and, |\n\n| · | the redevelopment of our existing fee-owned cinema or live theatre sites to their highest and best use. |\n\n\nCinema Exhibition\nOur cinema revenue consists primarily of admissions, Food & Beverage (“F&B”), advertising and theater rentals. Cinema operating expense consists of the costs directly attributable to the operation of the cinemas, including film rent expense, operating costs, and occupancy costs. Cinema revenue and expense fluctuate with the availability of quality first run films and the numbers of weeks such first run films stay in the market. For a breakdown of our current cinema assets that we own and/or manage, please see Part I, Item 1 – Our Business of our 2018 Form 10-K.\n\nWhile our capital projects in recent years have been focused in growing our real estate segment, we have over the past two years placed special emphasis on the expansion and upgrading of our cinema exhibition portfolio, as discussed below:\n\nCinema Additions (including re-openings)\nThe latest additions and enhancements to our cinema portfolio are as follows:\n| · | Opening our first dine-in concept, “Spotlight” in the United States: On March 30, 2018 we finished the conversion of one wing (six auditoriums) at our Reading Cinema in Murrieta, California (Cal Oaks) to our dine-in concept brand, “Spotlight”. |\n\n| · | AU and NZ Additions/Refurbishments On January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019. For the first quarter of 2019, we invested in two additional Gold Lounge auditoriums at our Harbour Town cinema. In 2017 and 2018, we improved eight theaters: Belmont, Rouse Hill, Courtenay Central, Napier, Charlestown, Elizabeth, Auburn and Rotorua. |\n\n| · | U.S. Refurbishments For the first quarter of 2019, we continued investing in refurbishments primarily at our Mililani cinema. During 2017 and 2018, we continued to invest in the refurbishment and enhancements of our existing cinemas, as contemplated by our strategic plan. During this period, seven locations had significant refurbishment work performed: our Cal Oaks, Valley Plaza and Grossmont locations in California; our Ward, Pearlridge and Mililani locations in Hawaii; and our Manville location in New Jersey. Continuing with our strategic plan, since 2017, we converted (or are in the process of conversion), 74 of our 245 U.S. auditoriums to luxury recliner seating. |\n\nCinema Pipeline\nDuring 2019, we currently plan to upgrade or begin the upgrade of 11 cinemas in the U.S., Australia, and New Zealand.\n\nWe have entered into lease agreements for four new cinemas in Australia (25 screens), which we anticipate will come on line in 2019 - 2021.\n\nOur focus with respect to new cinemas is on featuring state-of-the-art projection and sound, luxury recliner seating, enhanced F&B (typically including alcohol service) and typically at least one major TITAN type presentation screen. Our focus is on providing best in class services and amenities that will differentiate us from in-home and mobile viewing options. We believe that a night at the movies should be a special and premium experience and, indeed, that it must be in order to compete with the variety of options being offered to consumers through other platforms.\n\nThroughout 2019, we will also be focusing on the rollout and enhancement of our proprietary on-line ticketing capabilities and social media interfaces. These are intended to enhance the convenience of our offering and to promote customer affinity with the experience and product that we are offering.\n\n29\nCinema Closures\nWe evaluate the performance of each of our cinemas and, in some instances, we may decide to close an operation when it is not economically viable to continue to operate from the location. We did not close any theaters leased from third parties in 2018 or to date in 2019. While some of our theaters have encountered new competition, and while we believe that others will benefit from planned refurbishment and upgrading, none of our leased theaters are currently slated for closure.\n\nDuring January 2019, we closed our Courtenay Central cinema in Wellington, New Zealand due to seismic concerns. We are currently assessing the redevelopment of that property. It is currently anticipated that the cinema component will be upgraded and restored in connection with any such redevelopment.\n\nUpgrades to our Film Exhibition Technology and Theatre Amenities\nWe continue to focus in areas of the matured cinema business where we believe we have growth potential and ultimately, provide long-term value to our stockholders. These are (i) upgrading of our existing cinemas and (ii) developing new cinemas to provide our customers with premium offerings, including state-of-the-art presentation (including sound, lounges and bar service) and luxury seating. As of March 31, 2019, the upgrades to our theater circuits’ film exhibition technology and amenities are summarized in the following table:\n\n| |\n| |\n| | LocationCount | ScreenCount |\n| Screen Format |\n| Digital (all cinemas in our theatre circuit) | 60 | 484 |\n| IMAX | 1 | 1 |\n| TITAN XC and LUXE | 18 | 20 |\n| Dine-in Service |\n| Gold Lounge (AU/NZ)(1) | 10 | 27 |\n| Premium (AU/NZ)(2) | 11 | 21 |\n| Spotlight (U.S.)(3) | 1 | 6 |\n| Upgraded Food & Beverage menu (U.S.)(4) | 14 | n/a |\n| Premium Seating (recliner seating features) | 22 | 142 |\n| Liquor Licenses Obtained(5) | 28 | n/a |\n\n| (1) | Gold Lounge: This is our \"First Class Full Dine-in Service\" in our Australian and New Zealand cinemas, which includes upgraded F&B menu (with alcoholic beverages), luxury recliner seating features (intimate 25-50 seat cinemas) and waiter service. |\n\n| (2) | Premium Service: This is our \"Business Class Dine-in Service\" in our Australian and New Zealand cinemas, which typically includes upgraded F&B menu (some with alcoholic beverages) and may include luxury recliner seating features (less intimate 80-seat cinemas), but no waiter service. |\n\n| (3) | Spotlight Service: On March 30, 2018 we opened “Spotlight” our first dine-in cinema concept in the United States at Cal Oaks. Six of our 17 auditoriums at this theater feature this dine-in concept. |\n\n| (4) | Upgraded Food & Beverage Menu: Fourteen of our US theaters feature an elevated food and beverage menu served from a common counter, which includes, without limitation, beer, wine and/or spirits and a food menu beyond traditional concessions. We have worked with former Food Network executives to create a menu of locally inspired and freshly prepared items. |\n\n| (5) | Liquor Licenses: Licenses are applicable at each cinema location, rather than each theatre auditorium. For accounting purposes, we capitalize the cost of successfully purchasing or applying for liquor licenses meeting certain thresholds as an intangible asset due to long-term economic benefits derived on future sales of alcoholic beverages. |\n\n\nReal Estate\nOur operating properties currently consists of the following assets:\n| · | our Newmarket, Queensland ETC, our Belmont, Western Australia ETC, our Auburn, New South Wales ETC, our Townsville, Queensland ETC and our Wellington, New Zealand ETC; and, |\n\n| · | two (2) single-auditorium live theatres in Manhattan (Minetta Lane and Orpheum) and a four-auditorium live theater complex (including the accompanying ancillary retail and commercial tenants) in Chicago (The Royal George); and, |\n\n| · | our US Headquarters building in Culver City, California and our Australia corporate office building in Melbourne, Australia; and, |\n\n| · | the ancillary retail and commercial space at some of our non-ETC cinema properties. |\n\n\nIn February 2018, we entered into a one-year license agreement with Audible, Inc. a subsidiary of Amazon, at the Minetta Lane Theatre. This agreement was extended through March 2020, with an option to extend for one additional year through March 2021. Audible intends to continue to produce one to two character plays and special engagements for live performance, to record those productions making them available through Audible streaming service.\n\nIn addition, we have various parcels of unimproved real estate held for development in Australia and New Zealand and certain unimproved land in the United States, including some that was used in our legacy activities.\n30\n\nOur key real estate transactions in recent years are as follows:\n\nStrategic Acquisitions\n| · | Purchase of Land at Cannon Park, Australia. On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights. |\n\n| · | Purchase of Property in Auburn, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. The final settlement payment was made in early October 2018. |\n\n\nValue-creating Opportunities\nWe are engaged in several real estate development projects to take our properties to their highest and best use. The most notable of these value-creating projects are as follows:\n| · | Redevelopment of 44 Union Square Property in New York, USA. We secured construction financing for our 44 Union Square property in December 2016 and have entered into a guaranteed maximum price construction management agreement with an affiliate of CNY. We anticipate that the project will be ready for the commencement of tenant fit-out in the second quarter of 2019. Retail and office leasing interest to date has been strong and, while no assurances can be given, we are currently in exclusive negotiations with respect to long-term leases covering approximately 90% of the net rentable area of the building. This redevelopment will add approximately 23,000 square footage of rentable space to the current square footage of the building for an approximate total of 73,322 square feet of rentable space, inclusive of anticipated BOMA (Building Owners and Managers Association) adjustments and subject to lease negotiations and the final tenant mix. |\n\n| · | Expansion Project for our Newmarket Shopping Center at an affluent suburb of Brisbane, Australia. In December 2017 we opened our eight-screen Reading Cinema with TITAN LUXE, including 10,355 square feet of additional retail space and 124 parking spaces. As of March 31, 2019, approximately 80% of this new retail space has been leased. |\n\n| · | Courtenay Central Re-Development in Wellington, New Zealand. – Located in the heart of Wellington - New Zealand’s capital city – this center is comprised of 161,071 square feet of land situated proximate to the Te Papa Tongarewa Museum (attracting over 1.5 million visitors annually), across the street from the site of Wellington’s newly announced convention center (estimated to open its doors in 2022) and at a major public transit hub. Damage from the 2016 earthquake necessitated demolition of our nine-story parking garage at the site. Further, unrelated seismic issues have caused us to close the existing cinema and significant portions of the retail structure while we reevaluate the property for redevelopment as an entertainment themed urban center with a major food and grocery component. Wellington continues to be rated as one of the top cities in the world in which to live, and we continue to believe that the Courtenay Central site is located in one of the most vibrant and growing commercial and entertainment precincts of Wellington. |\n\n\n31\n\n| § | Cinema 1,2,3 Redevelopment – In June 2017, we entered into an exclusive dealing and pre-development agreement with our adjoining neighbors, 260-264 LLC, to jointly develop the properties, currently home to Cinemas 1,2,3 and Anassa Taverna. Under the terms of the agreement, Reading and 260-264 LLC worked together on a comprehensive mixed-use plan to co-develop the properties located on 3rd Avenue, between 59th Street and 60th Streets, in New York City. The parties completed an initial feasibility study, analyzing various retail, entertainment and residential uses for the site and during 2018 continued to work on the terms of a final agreement for the development of the combined property. We do not presently believe that we will be able to come to an agreement with our neighbors for a joint development of our properties and, have, accordingly, begun developing plans for an approximately 96,000 square foot mixed use stand-alone development. Our Cinemas 1,2,3, property is located on Third Avenue in New York City, between 59th and 60th Streets across from Bloomingdales. |\n\n| · | Manukau Land Rezoning – In August 2016, the Auckland City Council up-zoned 64.0 acres of our property in Manukau from agricultural to light industrial use. The remaining 6.4 acres were already zoned for heavy industrial use. Our zoning enhancement goal having been achieved, in 2018, we worked with adjoining landholders to jointly advance necessary infrastructure improvement issues. We estimate that our property will support approximately 1.6 million square feet of improvements. We see this property as a future value realization opportunity for us. This tract is adjacent to the Auckland Airport, which is currently undergoing a major improvement and expansion project. |\n\n\nCorporate Matters\n\n| § | Stock Repurchase Program – Our Board approved a $25-million repurchase program approved on March 2, 2017, and extended on March 14, 2019, and extended it on March 14, 2019. Under this authorization Reading may repurchase its Class A Common Stock from time to time in accordance with the requirements of the Securities and Exchange Commission on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. The new authorization continues through March 2, 2021. To date we have repurchased 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs). 566 shares were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019. |\n\n\nOur Financing Strategy\n\nOur treasury management is focused on cash management using cash balances to reduce debt. We have used cash generated from operations and other excess cash, to the extent not needed for capital expenditures, to pay down our loans and credit facilities providing us flexibility on our available loan facilities for future use and, thereby, reducing interest charges. On a periodic basis, we review the maturities of our borrowing arrangements and negotiate for renewals and extensions where necessary in the current circumstances.\n\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0 million corporate loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a bank guarantee facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\n\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was removed.\n\nOn March 5, 2019, we extended our current Bank of America credit facilities until May 1, 2020 (the $55.0 million credit line). We anticipate refinancing this credit line during the second quarter of 2019.\n\nRefer to our 2018 Form 10-K for more details on our cinema and real estate segments.\n32\nRESULTS OF OPERATIONS\n\nThe table below summarizes the results of operations for each of our principal business segments along with the non-segment information for the three months ended March 31, 2019 and March 31, 2018:\n\n\n| |\n| | Three Months Ended | % Change |\n| (Dollars in thousands) | March 31,2019 | March 31,2018 | Fav/(Unfav) |\n| SEGMENT RESULTS |\n| | Revenue |\n| | Cinema exhibition | $ | 57,986 | $ | 72,255 | (20) | % |\n| | Real estate | 5,431 | 6,008 | (10) | % |\n| | Inter-segment elimination | (1,866) | (2,391) | 22 | % |\n| | Total revenue | 61,551 | 75,872 | (19) | % |\n| | Operating expense |\n| | Cinema exhibition | (50,195) | (57,339) | 12 | % |\n| | Real estate | (2,445) | (2,384) | (3) | % |\n| | Inter-segment elimination | 1,866 | 2,391 | (22) | % |\n| | Total operating expense | (50,774) | (57,332) | 11 | % |\n| | Depreciation and amortization |\n| | Cinema exhibition | (4,157) | (3,765) | (10) | % |\n| | Real estate | (1,376) | (1,369) | (1) | % |\n| | Total depreciation and amortization | (5,533) | (5,134) | (8) | % |\n| | General and administrative expense |\n| | Cinema exhibition | (992) | (866) | (15) | % |\n| | Real estate | (451) | (574) | 21 | % |\n| | Total general and administrative expense | (1,443) | (1,440) | - | % |\n| | Segment operating income |\n| | Cinema exhibition | 2,642 | 10,285 | (74) | % |\n| | Real estate | 1,159 | 1,681 | (31) | % |\n| | Total segment operating income | $ | 3,801 | $ | 11,966 | (68) | % |\n| NON-SEGMENT RESULTS |\n| | Depreciation and amortization expense | (61) | (117) | 48 | % |\n| | General and administrative expense | (5,041) | (6,156) | 18 | % |\n| | Interest expense, net | (1,852) | (1,594) | (16) | % |\n| | Equity earnings of unconsolidated joint ventures | 34 | 257 | (87) | % |\n| | Other income (expense) | (20) | (82) | 76 | % |\n| | Income before income taxes | (3,139) | 4,274 | (> 100) | % |\n| | Income tax benefit (expense) | 1,042 | (1,170) | > 100 | % |\n| Net income (loss) | (2,097) | 3,104 | (> 100) | % |\n| | Less: net (income) loss attributable to noncontrolling interests | (16) | 22 | (> 100) | % |\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 | (> 100) | % |\n| Basic EPS | $ | (0.09) | $ | 0.13 | (> 100) | % |\n\n“nm – not meaningful”\nConsolidated and Non-Segment Results:\n\n1st Quarter Net Results\n\nNet income attributable to RDI common stockholders decreased by $5.2 million to a $(2.1) million loss. Basic EPS for the quarter ended March 31, 2019 decreased by $0.22 to $(0.09) from the prior-year quarter, mainly attributable to decreases in revenue in both the Cinema and Real Estate business segments.\n\nRevenue for the three months ended March 31, 2019 decreased by 19%or $14.3 million, to $61.6 million compared to the same period prior year. The revenue decrease was due to a decrease in revenues from our cinema business primarily due to the weak film slate experienced by the Cinema business segment worldwide, the closure of our cinema in Courtenay Central due to seismic concerns, and a decrease in revenues from the Real Estate business segment primarily due to the closure of most of the net rentable area of Courtenay Central due to seismic concerns. Overseas revenues were also adversely impacted by the continued weakness of the Australian and New Zealand Dollar compared to the U.S. dollar.\n\nU.S. admissions for the first quarter 2019 were down 19% falling from $24.7 million to $19.9 million for the same period in the prior year. According to industry sources, U.S. box office for the period was down 16%, falling from $2.5 billion to $2.1 billion. Australia and New Zealand Box Office saw similar declines. Again, in the case of New Zealand, the situation was exacerbated by the closure of our cinema at Courtenay Central. Due to the fact that our occupancy costs with respect to our cinema operations are fixed, the decrease in revenues disproportionally impacts the earnings from these operations, even though our film rent, cinema level labor and costs of goods sold are largely variable.\n\n33\nLooking forward, The Avengers: Endgame has been setting box office records, having grossed more than $620 million in North America and more than $2.2 billion worldwide since its opening weekend of April 25, 2019.\n\nNon-Segment General & Administrative Expenses\nNon-segment general and administrative expense for the quarter ended March 31, 2019 decreased by 18%, or $1.1 million, to $5.0 million compared to the same period of the prior year, respectively. This decrease mainly relates to lower legal expenses, offset by an increase in administrative occupancy cost in New Zealand attributable to the temporary closure of our administrative offices at Courtenay Central and need to lease replacement office space in Wellington.\n\nIncome Tax Expense\nIncome tax expense for the quarter ended March 31, 2019, decreased 189%, or $2.2 million compared to the same quarter prior year. The change between 2019 and 2018 is primarily related to the pretax loss in the first quarter of 2019.\nBusiness Segment Results\n\nAt March 31, 2019, we leased or owned and operated 60 cinemas with 484 screens, which includes (i) one managed cinema with 4 (four) screens and (ii) our interests in certain unconsolidated joint ventures that total 3 (three) cinemas with 29 screens. In the first quarter of 2019, we acquired a proven 4-screen cinema in Devonport, Tasmania, Australia, increasing our cinema count to 60 and our screen count to 484. We also (i) owned and operated 5 (five) ETCs located in Newmarket Village (a suburb of Brisbane), Belmont (a suburb of Perth), Auburn (a suburb of Sydney) and Townsville (a suburb of Cannon Park) in Australia and Wellington in New Zealand, (ii) owned and operated our headquarters office buildings in Culver City (an emerging high-tech and communications hub in Los Angeles County) and Melbourne, Australia, (iii) owned and operated the fee interests in three developed commercial properties in Manhattan and Chicago improved with live theaters comprising 6 (six) stages and ancillary retail and commercial space (our fourth live theatre was closed at the end of 2015 as part of the redevelopment of 44 Union Square in New York City), (iv) owned a 75% managing member interest in a limited liability company, which in turn owns the fee interest in Cinemas 1,2,3, (v) held for development approximately 70.4 acres of developable industrial land located next to the Auckland Airport in New Zealand, (vi) owned a 50% managing member interest in a limited liability company, which in turn owns a 202-acre property in Coachella, California that is zoned approximately 150 acres for single-family residential use (maximum 550 homes) and approximately 50 acres for high density mixed use in the U.S., that is held for development, and, (vii) owned 197 acres principally in Pennsylvania from our legacy railroad business, including the Reading Viaduct in downtown Philadelphia.\n\nThe Company transacts business in Australia and New Zealand and is subject to risks associated with changing foreign currency exchange rates. The Australian and New Zealand dollars based on the spot rate weakened versus prior three month period against the U.S. dollar slightly negatively impacting the value of our assets and liabilities. The average rate for the three months ended March 31, 2019 and 2018 has also weakened by 9.4% and 6.3% respectively. This has decreased the value of our Australian and New Zealand revenues and expenses. Refer to Note 3 – Operations in Foreign Currency for further information.\n\n34\nCinema Exhibition\n\nThe following table details our cinema exhibition segment operating results for the three months ended March 31, 2019 and March 31, 2018, respectively:\n\n\n| |\n| | % Change |\n| | Three Months Ended | Fav/(Unfav) |\n| (Dollars in thousands) | March 31,2019 | % of Revenue | March 31,2018 | % of Revenue | Three Months Ended |\n| REVENUE |\n| | United States | Admissions revenue | $ | 19,913 | 34% | $ | 24,706 | 34% | (19) | % |\n| | Food & beverage revenue | 9,575 | 17% | 10,765 | 15% | (11) | % |\n| | Advertising and other revenue | 2,545 | 4% | 2,516 | 3% | 1 | % |\n| | $ | 32,033 | 55% | $ | 37,987 | 53% | (16) | % |\n| | Australia | Admissions revenue | $ | 14,037 | 24% | $ | 17,051 | 24% | (18) | % |\n| | Food & beverage revenue | 6,061 | 10% | 7,837 | 11% | (23) | % |\n| | Advertising and other revenue | 1,343 | 2% | 1,829 | 3% | (27) | % |\n| | $ | 21,441 | 37% | $ | 26,717 | 37% | (20) | % |\n| | New Zealand | Admissions revenue | $ | 2,991 | 5% | $ | 4,934 | 7% | (39) | % |\n| | Food & beverage revenue | 1,309 | 3% | 2,266 | 3% | (42) | % |\n| | Advertising and other revenue | 212 | 0% | 351 | 0% | (40) | % |\n| | $ | 4,512 | 8% | $ | 7,551 | 10% | (40) | % |\n| |\n| | Total revenue | $ | 57,986 | 100% | $ | 72,255 | 100% | (20) | % |\n| OPERATING EXPENSE |\n| | United States | Film rent and advertising cost | $ | (10,127) | 17% | $ | (12,875) | 18% | 21 | % |\n| | Food & beverage cost | (2,322) | 4% | (2,302) | 3% | (1) | % |\n| | Occupancy expense | (6,945) | 12% | (7,202) | 10% | 4 | % |\n| | Other operating expense | (10,174) | 18% | (9,942) | 14% | (2) | % |\n| | $ | (29,568) | 51% | $ | (32,321) | 45% | 9 | % |\n| | Australia | Film rent and advertising cost | $ | (6,279) | 11% | $ | (7,699) | 11% | 18 | % |\n| | Food & beverage cost | (1,115) | 2% | (1,594) | 2% | 30 | % |\n| | Occupancy expense | (3,962) | 7% | (4,251) | 6% | 7 | % |\n| | Other operating expense | (5,415) | 9% | (5,754) | 8% | 6 | % |\n| | $ | (16,771) | 29% | $ | (19,298) | 27% | 13 | % |\n| | New Zealand | Film rent and advertising cost | $ | (1,336) | 3% | $ | (2,232) | 3% | 40 | % |\n| | Food & beverage cost | (292) | 1% | (491) | 1% | 41 | % |\n| | Occupancy expense | (803) | 1% | (1,344) | 2% | 40 | % |\n| | Other operating expense | (1,425) | 2% | (1,653) | 2% | 14 | % |\n| | $ | (3,856) | 7% | $ | (5,720) | 8% | 33 | % |\n| |\n| | Total operating expense | $ | (50,195) | 87% | $ | (57,339) | 79% | 12 | % |\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\n| | United States | Depreciation and amortization | $ | (2,626) | 5% | $ | (2,121) | 3% | (24) | % |\n| | General and administrative expense | (604) | 1% | (545) | 1% | (11) | % |\n| | $ | (3,230) | 6% | $ | (2,666) | 4% | (21) | % |\n| | Australia | Depreciation and amortization | $ | (1,181) | 2% | $ | (1,204) | 2% | 2 | % |\n| | General and administrative expense | (387) | 1% | (299) | 0% | (29) | % |\n| | $ | (1,568) | 3% | $ | (1,503) | 2% | (4) | % |\n| | New Zealand | Depreciation and amortization | $ | (350) | 1% | $ | (440) | 1% | 20 | % |\n| | General and administrative expense | (1) | 0% | (22) | 0% | 95 | % |\n| | $ | (351) | 1% | $ | (462) | 1% | 24 | % |\n| |\n| | Total depreciation, amortization, general and administrative expense | $ | (5,149) | 10% | $ | (4,631) | 6% | (11) | % |\n| OPERATING INCOME – CINEMA |\n| | United States | $ | (765) | (1)% | $ | 3,000 | 4% | (126) | % |\n| | Australia | 3,102 | 5% | 5,916 | 8% | (48) | % |\n| | New Zealand | 305 | 1% | 1,369 | 2% | (78) | % |\n| | Total Cinema operating income | $ | 2,642 | 5% | $ | 10,285 | 14% | (74) | % |\n\n\n“nm – not meaningful”\n\n35\n1st Quarter Results\n\nCinema Segment operating income\nCinema segment operating income decreased by 74%, or $7.6 million, to $2.6 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily driven by decreased operating income in the U.S., Australia, and New Zealand, which was due to a decrease in attendance worldwide, and fluctuations in average ticket price (“ATP”), and spend per patron (“SPP”) as outlined below.\n\nRevenue\nCinema revenue decreased by 20%, or $14.3 million, to $58.0 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily attributable to a weak foreign currency exchange rate, and a weak film slate worldwide.\n\nThe top box office performers for the first quarter of 2019 included “Captain Marvel”, ($5.1 million), “Aquaman,” ($2.9 million) and “How to Train Your Dragon: The Hidden World,” ($2.7 million), did not stack up well against the top films for the same period 2018, which included major films such as “Black Panther,” “Jumanji: Welcome to the Jungle,” and “The Greatest Showman,” (which combined totaled $15.0 million). We believe that the first quarter of 2019 results are principally the product of the film available for cinema exhibition, and not a reflection of declining consumer interest in cinema as a beyond-the-home source of entertainment.\n\nBelow are the changes in our cinema revenue by market:\n| · | U.S. cinema revenue decreased by 16%, or $6.0 million, to $32.0 million, due to a 22% decrease in attendance, offset by a 12% increase SPP, and a 4% increase in ATP. |\n\n| · | Australia cinema revenue decreased by 20%, or $5.3 million, to $21.4 million, primarily due to a 15% decrease in attendance, a 9% decrease in SPP, and a 4% decrease in ATP. |\n\n| · | New Zealand cinema revenue decreased by 40%, or $3.0 million, to $4.5 million versus the same period in 2018, due to a decrease of 40% in attendance, while ATP and SPP remained relatively flat. The decrease in New Zealand was materially greater than that in the U.S. and Australia due to the closure of our Courtenay Central cinema in January. |\n\n\nMore recently “Avengers:Endgame” had the biggest box office opening of any film since the opening weekend of April 25, 2019 with $620 million in North America box office and $2.2 billion in worldwide box office. Slated for release this spring and summer are a number of potentially strong box office performers, including “John Wick Chapter 3,” “Aladdin”, “Godzilla: King of the Monsters”, “Men in Black: International,” “Toy Story 4,” and “Spider-Man: Far From Home.”\n\nOperating expense\nOperating expense for the quarter ended March 31, 2019 decreased by 12%, to $50.2 million primarily attributable to (i) lower film rent expense driven by lower admissions revenue, and (ii) lower F&B costs due to lower F&B revenue primarily in Australia and New Zealand.\n\nOperating expense as a percentage of gross revenue has increased to 87% for the first quarter of 2019, compared to 79% for the same period in 2018, due to the lower than anticipated revenue in our box office and the fact that our occupancy costs are generally fixed, and cannot be adjusted to reflect such lower admission levels.\n\nDepreciation, amortization, general and administrative expense\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 increased by 11%, or $0.5 million, to $5.1 million mainly due to the depreciation related to the completion of our capital improvements placed into service in the U.S.\n36\nReal Estate\nThe following table details our real estate segment operating results for the three months ended March 31, 2019 and 2018, respectively:\n\n\n\n| |\n| | % Change |\n| | Three Months Ended | Fav/(Unfav) |\n| (Dollars in thousands) | March 31,2019 | % ofRevenue | March 31,2018 | % ofRevenue | Three Months Ended |\n| REVENUE |\n| | United States | Live theater rental and ancillary income | $ | 936 | 17% | $ | 599 | 10% | 56 | % |\n| | Property rental income | 52 | 1% | 56 | 1% | (7) | % |\n| | 988 | 18% | 655 | 11% | 51 | % |\n| | Australia | Property rental income | 3,916 | 72% | 4,154 | 69% | (6) | % |\n| | New Zealand | Property rental income | 527 | 10% | 1,199 | 20% | (56) | % |\n| |\n| | Total revenue | $ | 5,431 | 100% | $ | 6,008 | 100% | (10) | % |\n| OPERATING EXPENSE |\n| | United States | Live theater cost | $ | (298) | 5% | $ | (296) | 5% | (1) | % |\n| | Property cost | (158) | 3% | (134) | 2% | (18) | % |\n| | Occupancy expense | (151) | 3% | (163) | 3% | 7 | % |\n| | (607) | 11% | (593) | 10% | (2) | % |\n| | Australia | Property cost | (701) | 13% | (752) | 13% | 7 | % |\n| | Occupancy expense | (692) | 13% | (567) | 9% | (22) | % |\n| | (1,393) | 26% | (1,319) | 22% | (6) | % |\n| | New Zealand | Property cost | (298) | 5% | (321) | 5% | 7 | % |\n| | Occupancy expense | (147) | 3% | (150) | 2% | 2 | % |\n| | (445) | 8% | (471) | 8% | 6 | % |\n| |\n| | Total operating expense | $ | (2,445) | 45% | $ | (2,383) | 40% | (3) | % |\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\n| | United States | Depreciation and amortization | $ | (195) | 4% | $ | (192) | 3% | (2) | % |\n| | General and administrative expense | (159) | 3% | (163) | 3% | 2 | % |\n| | (354) | 7% | (355) | 6% | - | % |\n| | Australia | Depreciation and amortization | $ | (926) | 17% | $ | (909) | 15% | (2) | % |\n| | General and administrative expense | (292) | 5% | (411) | 7% | 29 | % |\n| | (1,218) | 22% | (1,320) | 22% | 8 | % |\n| | New Zealand | Depreciation and amortization | (256) | 5% | (269) | 4% | 5 | % |\n| | General and administrative expense | — | 0% | — | 0% | - | % |\n| | (256) | 5% | (269) | 4% | 5 | % |\n| |\n| | Total depreciation, amortization, general and administrative expense | $ | (1,828) | 34% | $ | (1,944) | 32% | 6 | % |\n| OPERATING INCOME - REAL ESTATE |\n| | United States | $ | 27 | 0% | $ | (293) | (5)% | 109 | % |\n| | Australia | 1,305 | 24% | 1,515 | 25% | (14) | % |\n| | New Zealand | (174) | (3)% | 459 | 8% | (138) | % |\n| | Total real estate operating income | $ | 1,158 | 21% | $ | 1,681 | 28% | (31) | % |\n\n\n1st Quarter Results\n\nReal Estate Segment income\nReal estate segment operating income decreased by 31%, or $0.5 million, to $1.2 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily due to the closure of most of the net rentable area of Courtenay Central; offset by an increase in Live Theatre segment revenue of 56%, or $0.3 million, to $0.9 million.\n\nRevenue\nReal estate revenue for the quarter decreased by 10%, or $0.6 million, to $5.4 million primarily due to a weak foreign currency exchange rate and a decrease in revenues from our New Zealand segment, principally related to the closure of portions of Courtenay Central.\n\nOperating expense\nOperating expense for the quarter ended March 31, 2019 remained flat at $2.4 million.\n\nDepreciation, amortization, general and administrative expense\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 decreased by 6%, or $0.1 million, to $1.8 million primarily driven by a weak foreign currency exchange rate and a decrease in general and administrative expenses in Australia.\n\nLIQUIDITY AND CAPITAL RESOURCES\n\nOur cinema exhibition business plan is to enhance our current cinemas where it is financially reasonable to do so; develop our specialty cinemas in select markets; expand our food and beverage offering, and continue on an opportunistic basis, to identify, develop, and acquire cinema properties that allow us to leverage our cinema expertise over a larger operating base.\n37\n\nOur real estate business is to complete the redevelopment of 44 Union Square in New York City; to reassess and master-plan the Cinemas 1,2,3 property for redevelopment as a stand-alone 96,000 square foot mixed use property and in the interim to continue to use it as a cinema; to continue the build-out of our Newmarket Village and Auburn ETCs and the master planning of the expansion of our Townsville ETC in Australia; to master plan and consider the redevelopment of our Courtenay Central site in New Zealand into an urban entertainment center with a focus on cinema exhibition, food and beverage, and grocery store uses; and in Manukau, New Zealand, to develop in concert with other major land owners, of plans for the development of the infrastructure needed to support the construction of income-producing improvements; and to continue to be sensitive to opportunities to convert our entertainment assets to higher and better uses, or, where appropriate, to dispose of such assets. We will also continue to explore potential synergistic acquisitions that may not readily fall into either our cinema or real estate segment.\nThe success of our Company is dependent on our ability to execute these business plans effectively through our available resources (both cash and available borrowing facilities) while still timely addressing our liquidity risk. Liquidity risk is the risk relating to our ability to meet our financial obligations when they come due. At the present, our financial obligations arise mainly from capital expenditure needs, working capital requirements, and debt servicing requirements. We manage the liquidity risk by ensuring our ability to generate sufficient cash flows from operating activities and to obtain adequate, reasonable financing or extension of maturity dates under reasonable arrangements, and/or to convert non-performing or non-strategic assets into cash.\n\nAt March 31, 2019, our consolidated cash and cash equivalents totaled $12.6 million. Of this amount, $3.2 million and $0.7 million were held by our Australian and New Zealand subsidiaries, respectively. Our intention is to indefinitely reinvest Australian earnings locally, but not indefinitely reinvest New Zealand earnings. If the Australian earnings were used to fund U.S. operations, they would be subject to additional state income taxes upon repatriation.\n\nThe changes in cash and cash equivalents for the three months ended March 31, 2019 and 2018 are discussed as follows:\n\n\n| |\n| |\n| | Three Months Ended |\n| | March 31, |\n| (Dollars in thousands) | 2019 | 2018 | % Change |\n| Net cash provided by (used in) operating activities | $ | (3,841) | $ | 2,452 | (257) | % |\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) | (46) | % |\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 | 2 | % |\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) | 147 | % |\n| Increase (decrease) in cash and cash equivalents | $ | (479) | $ | (5,000) | 90 | % |\n\n\nOperating activities\nCash provided by (used in) operating activities for the first three months of 2019 decreased by $6.3 million, to ($3.8) million primarily driven by $4.7 million lower cash inflows from operating activities as well as a $1.5 million decrease in net operating assets.\n\nInvesting activities\nCash used in investing activities during the three months ended March 31, 2019 decreased by $10.9 million compared to the same period in 2018, to net cash used of $12.6 million, primarily due to a decrease in our cinema refurbishment activities compared to the 2018 quarter and the substantial completion of the upgrading and expansion of our Newmarket and Auburn/Redyard ETCs in 2018. It is anticipated that spending on our cinema activities will pick up over the remainder of the year.\n\nFinancing Activities\nThe $15.9 million net cash provided by financing activities during the three months ended March 31, 2019 was primarily related to $22.3 million of new borrowings, offset by $6.1 million of loan repayments. Proceeds from these new borrowings related principally to the ongoing construction of our 44 Union Square project in Manhattan of $6.7 million and to fund the capital improvements in our cinemas and real estate segments.\n\nOn March 2, 2017, the Board of Directors authorized a stock repurchase program to repurchase up to $25.0 million of Reading’s Class A Common Stock. The Board on March 14, 2019, extended that program to March 2, 2021. At March 31, 2019, there was $16.2 million of capacity remaining in that authorization.\n38\n\nWe manage our cash, investments and capital structure so we are able to meet the short-term and long-term obligations of our business, while maintaining financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable investment and financing within the overall constraints of our financial strategy. In recent years, our treasury management has been focused on more aggressive cash management using cash balances to reduce debt. In earlier years, we maintained significant cash balances in our bank accounts. We have used cash generated from operations and other excess cash, to the extent not needed for any capital expenditures, to pay down our loans and credit facilities providing us some flexibility on our available loan facilities for future use and thereby, reducing interest charges.\n\n\nThe table below presents the changes in our total available resources (cash and borrowings), debt-to-equity ratio, working capital and other relevant information addressing our liquidity for the three months ended March 31, 2019 and preceding four years:\n\n\n| |\n| |\n| | As of andfor the3-MonthsEnded | Year Ended December 31 |\n| ($ in thousands) | 3/31/2019 | 2018 | 2017 | 2016 | 2015 (2) |\n| Total Resources (cash and borrowings) |\n| Cash and cash equivalents (unrestricted) | $ | 12,648 | $ | 13,127 | $ | 13,668 | $ | 19,017 | $ | 19,702 |\n| Unused borrowing facility | 107,111 | 85,886 | 137,231 | 117,599 | 70,134 |\n| Restricted for capital projects (1) | 23,566 | 30,318 | 62,280 | 62,024 | 10,263 |\n| Unrestricted capacity | 83,545 | 55,568 | 74,951 | 55,575 | 59,871 |\n| Total resources at period end | 119,759 | 99,013 | 150,899 | 136,616 | 89,836 |\n| Total unrestricted resources at period end | 96,193 | 68,695 | 88,619 | 74,592 | 79,573 |\n| Debt-to-Equity Ratio |\n| Total contractual facility | $ | 290,879 | $ | 252,929 | $ | 271,732 | $ | 266,134 | $ | 207,075 |\n| Total debt (gross of deferred financing costs) | 184,099 | 167,043 | 134,501 | 148,535 | 130,941 |\n| Current | 40,077 | 30,393 | 8,109 | 567 | 15,000 |\n| Non-current | 143,691 | 136,650 | 126,392 | 147,968 | 115,941 |\n| Finance lease liabilities | 331 | — | — | — | — |\n| Total book equity(2) | 179,946 | 180,547 | 181,618 | 146,890 | 138,951 |\n| Debt-to-equity ratio | 1.02 | 0.93 | 0.74 | 1.01 | 0.94 |\n| Changes in Working Capital |\n| Working capital (deficit) (3) | $ | (77,236) | $ | (55,270) | $ | (46,971) | $ | 6,655 | $ | (35,581) |\n| Current ratio | 0.28 | 0.35 | 0.42 | 1.10 | 0.51 |\n| Capital Expenditures (including acquisitions) | $ | 11,476 | $ | 56,827 | $ | 76,708 | $ | 49,166 | $ | 53,119 |\n\n\n| (1) | This relates to the construction facilities specifically negotiated for: (i) Union Square redevelopment project, obtained in December 2016, and (ii) New Zealand construction projects, obtained in May 2015. The New Zealand construction loan expired December 31, 2018. |\n\n| (2) | Certain 2015 balances included the restatement impact as a result of a change in accounting principle (see Note 2 – Summary of Significant Accounting Policies – Accounting Changes). Certain 2017 and 2016 balances included the restatement impact as a result of a prior period financial statement correction of immaterial errors (see Note 2 – Summary of Significant Accounting Policies – Prior Period Financial Statement Correction of Immaterial Errors). |\n\n| (3) | Typically our working capital (deficit) is negative as we receive revenue from our cinema business ahead of the time that we have to pay our associated liabilities. We use the money we receive to pay down our borrowings in the first instance |\n\n\nCONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES\n\nThe following table provides information with respect to the maturities and scheduled principal repayments of our recorded contractual obligations and certain of our commitments and contingencies, either recorded or off-balance sheet, as of March 31, 2019:\n\n\n| |\n| |\n| (Dollars in thousands) | 2019 | 2020 | 2021 | 2022 | 2023 | Thereafter | Total |\n| Debt(1) | $ | 40,016 | $ | 48,799 | $ | 258 | $ | 270 | $ | 58,309 | $ | 8,204 | $ | 155,856 |\n| Operating leases, including imputed interest | 23,566 | 31,434 | 31,717 | 31,901 | 31,018 | 169,221 | 318,857 |\n| Finance leases, including imputed interest | 131 | 101 | 53 | 43 | 30 | — | 358 |\n| Subordinated debt(1) | — | — | — | — | — | 27,913 | 27,913 |\n| Pension liability | 513 | 684 | 684 | 684 | 684 | 1,979 | 5,228 |\n| Village East purchase option(3) | 5,900 | — | — | — | — | — | 5,900 |\n| Estimated interest on debt (2) | 7,717 | 6,098 | 5,156 | 5,157 | 5,134 | 7,498 | 36,761 |\n| Total | $ | 77,844 | $ | 87,116 | $ | 37,868 | $ | 38,055 | $ | 95,175 | $ | 214,815 | $ | 550,873 |\n\n\n| (1) | Information is presented gross of deferred financing costs. |\n\n| (2) | Estimated interest on debt is based on the anticipated loan balances for future periods and current applicable interest rates. |\n\n| (3) | Represents the lease liability of the option associated with the ground lease purchase of the Village East Cinema. |\n\n\nRefer to Note 13 – Commitments and Contingencies for additional information.\n\n\n\n39\nLitigation\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims.\n\nWhere we are the plaintiffs, we expense all legal fees on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which typically work out to be approximately 60% of the amounts actually spent where first class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party.\n\nWhere we are the defendants, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. Please refer to Item 3 – Legal Proceedings in our 2018 Form 10-K for more information. There have been no material changes to our litigation since our 2018 Form 10-K, except as set forth in Note 13 – Commitments and Contingencies in the accompanying consolidated financial statements included in this Form 10-Q.\n\nOff-Balance Sheet Arrangements\n\nSee Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein on this report, there are no off-balance sheet arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in the financial condition, revenue or expense, results of operations, liquidity, capital expenditures or capital resources.\n\nCRITICAL ACCOUNTING POLICIES\n\nWe believe that the application of the following accounting policies requires significant judgments and estimates in the preparation of our Consolidated Financial Statements and hence, are critical to our business operations and the understanding of our financial results:\n\n(i) Impairment of Long-lived Assets (other than Goodwill and Intangible Assets with indefinite lives) – we evaluate our long-lived assets and finite-lived intangible assets using historical and projected data of cash flows as our primary indicator of potential impairment and we take into consideration the seasonality of our business. If the sum of the estimated, undiscounted future cash flows is less than the carrying amount of the asset, then an impairment is recognized for the amount by which the carrying value of the asset exceeds its estimated fair value based on an appraisal or a discounted cash flow calculation. For certain non-income producing properties or for those assets with no consistent historical or projected cash flows, we obtain appraisals or other evidence to evaluate whether there are impairment indicators for these assets.\n\nBesides the write-down of the carrying amount of our parking structure adjacent to our Courtenay Central ETC in Wellington, New Zealand due to earthquake damage during the 4th quarter of 2016, no other impairment losses were recorded for long-lived and finite-lived intangible assets for the three years ended December 31, 2018. Refer to Note 20 – Insurance Recoveries on Impairment and Related Losses due to Earthquake in the 2018 Form 10-K for further details.\n\n(ii) Impairment of Goodwill and Intangible Assets with indefinite lives – goodwill and intangible assets with indefinite useful lives are not amortized, but instead, tested for impairment at least annually on a reporting unit basis. The impairment evaluation is based on the present value of estimated future cash flows of each reporting unit plus the expected terminal value. There are significant assumptions and estimates used in determining the future cash flows and terminal value. The most significant assumptions include our cost of debt and cost of equity assumptions that comprise the weighted average cost of capital for each reporting unit. Accordingly, actual results could vary materially from such estimates.\n\nNo impairment losses were recorded for goodwill and indefinite-lived intangible assets for the three months ended March 31, 2019.\n\nFINANCIAL RISK MANAGEMENT\n\nInternational Business Risks\nOur international operations are subject to a variety of risks, including the following:\n\n| · | Currency Risk: while we report our earnings and net assets in U.S. dollars, substantial portions of our revenue and of our obligations are denominated in either Australian or New Zealand dollars. The value of these currencies can vary significantly compared to the U.S. dollar and compared to each other. We do not hedge the currency risk, but rather have relied upon the 40 |\n| natural hedges that exist as a result of the fact that our film costs are typically fixed as a percentage of the box office, and our local operating costs and obligations are likewise typically denominated in local currencies. However, we do have intercompany debt and our ability to service this debt could be adversely impacted by declines in the relative value of the Australian and New Zealand dollar compared to the U.S. dollar. Also, our use of local borrowings to mitigate the business risk of currency fluctuations has reduced our flexibility to move cash between jurisdictions. Set forth below is a chart of the exchange ratios between these three currencies since 1996: |\n\n\n\n\nIn recent periods, we have repaid intercompany debt and used the proceeds to fund capital investment in the United States. Accordingly, our debt levels in Australia are higher than they would have been if funds had not been returned for such purposes. On a company wide basis, this means that a reduction in the relative strength of the U.S. dollar versus the Australian dollar and/or the New Zealand dollar will effectively raise the overall cost of our borrowing and capital and make it more expensive to return funds from the United States to Australia and New Zealand.\n\nOur exposure to interest rate risk arises out of our intermediate term floating-rate borrowings. To manage the risk, we utilize interest rate derivative contracts to convert certain floating-rate borrowings into fixed-rate borrowings. It is the Company’s policy to enter into interest rate derivative transactions only to the extent considered necessary to meet its objectives as stated above. The Company does not enter into these transactions or any other hedging transactions for speculative purposes.\n\nInflation\n\nWe continually monitor inflation and the effects of changing prices. Inflation increases the cost of goods and services used. Competitive conditions in many of our markets restrict our ability to recover fully the higher costs of acquired goods and services through price increases. We attempt to mitigate the impact of inflation by implementing continuous process improvement solutions to enhance productivity and efficiency and, as a result, lower costs and operating expenses. The effects of inflation have not had a material impact on our operations and the resulting financial position or liquidity.\n\n\n\n41\n\nFORWARD LOOKING STATEMENTS\n\nOur statements in this interim quarterly report contain a variety of forward-looking statements as defined by the Securities Litigation Reform Act of 1995. Forward-looking statements reflect only our expectations regarding future events and operating performance and necessarily speak only as of the date the information was prepared. No guarantees can be given that our expectation will in fact be realized, in whole or in part. You can recognize these statements by our use of words such as, by way of example, “may”, “will”, “expect”, “believe”, and “anticipate” or other similar terminology.\n\nThese forward-looking statements reflect our expectation after having considered a variety of risks and uncertainties. However, they are necessarily the product of internal discussion and do not necessarily completely reflect the views of individual members of our Board of Directors or of our management team. Individual Board members and individual members of our management team may have a different view as to the risks and uncertainties involved, and may have different views as to future events or our operating performance.\n\nAmong the factors that could cause actual results to differ materially from those expressed in or underlying our forward-looking statements are the following:\n| · | with respect to our cinema operations: |\n\n| o | the number and attractiveness to moviegoers of the films released in future periods; |\n\n| o | the amount of money spent by film distributors to promote their motion pictures; |\n\n| o | the licensing fees and terms required by film distributors from motion picture exhibitors in order to exhibit their films; |\n\n| o | the comparative attractiveness of motion pictures as a source of entertainment and willingness and/or ability of consumers (i) to spend their dollars on entertainment and (ii) to spend their entertainment dollars on movies in and outside the home environment; |\n\n| o | the extent to which we encounter competition from other cinema exhibitors, from other sources of outside-the-home entertainment, and from inside-the-home entertainment options, such as “home theaters” and competitive film product distribution technology, such as, by way of example, cable, satellite broadcast and Blu-ray/DVD rentals and sales, and so called “movies on demand;” |\n\n| o | the cost and impact of improvements to our cinemas, such as improved seating, enhanced food and beverage offerings and other improvements; |\n\n| o | disruptions from theater improvements; and |\n\n| o | the extent to and the efficiency with which we are able to integrate acquisitions of cinema circuits with our existing operations. |\n\n| · | with respect to our real estate development and operation activities: |\n\n| o | the rental rates and capitalization rates applicable to the markets in which we operate and the quality of properties that we own; |\n\n| o | the extent to which we can obtain on a timely basis the various land use approvals and entitlements needed to develop our properties; |\n\n| o | the risks and uncertainties associated with real estate development; |\n\n| o | the availability and cost of labor and materials; |\n\n| o | the ability to obtain all permits to construct improvements; |\n\n| o | the ability to finance improvements; |\n\n| o | the disruptions from construction; |\n\n| o | the possibility of construction delays, work stoppage and material shortage; |\n\n| o | competition for development sites and tenants; |\n\n| o | environmental remediation issues; |\n\n| o | the extent to which our cinemas can continue to serve as an anchor tenant that will, in turn, be influenced by the same factors as will influence generally the results of our cinema operations; |\n\n| o | the increased depreciation and amortization expenses as construction projects transition to leased real property; |\n\n| o | the ability to negotiate and execute joint venture opportunities and relationships; and |\n\n| o | certain of our activities are in geologically active areas, creating a risk of damage and/or disruption of real estate and/or cinema businesses from earthquakes. |\n\n42\n\n| · | with respect to our operations generally as an international company involved in both the development and operation of cinemas and the development and operation of real estate and previously engaged for many years in the railroad business in the United States: |\n\n| o | our ability to renew, extend or renegotiate our loans that mature in 2019; |\n\n| o | our ability to grow our Company and provide value to our stockholders; |\n\n| o | our ongoing access to borrowed funds and capital and the interest that must be paid on that debt and the returns that must be paid on such capital; |\n\n| o | expenses, management and Board distraction and other effects of the litigation efforts mounted by James Cotter, Jr. against the Company, including his efforts to cause a sale of voting control of the Company; |\n\n| o | the relative values of the currency used in the countries in which we operate; |\n\n| o | changes in government regulation, including by way of example, the costs resulting from the implementation of the requirements of Sarbanes-Oxley; |\n\n| o | our labor relations and costs of labor (including future government requirements with respect to pension liabilities, disability insurance and health coverage, and vacations and leave); |\n\n| o | our exposure from time to time to legal claims and to uninsurable risks such as those related to our historic railroad operations, including potential environmental claims and health-related claims relating to alleged exposure to asbestos or other substances now or in the future recognized as being possible causes of cancer or other health related problems; |\n\n| o | our exposure to cyber-security risks, including misappropriation of customer information or other breaches of information security; |\n\n| o | changes in future effective tax rates and the results of currently ongoing and future potential audits by taxing authorities having jurisdiction over our various companies; and |\n\n| o | changes in applicable accounting policies and practices. |\n\n\nThe above list is not necessarily exhaustive, as business is by definition unpredictable and risky, and subject to influence by numerous factors outside of our control, such as changes in government regulation or policy, competition, interest rates, supply, technological innovation, changes in consumer taste, the weather, and the extent to which consumers in our markets have the economic wherewithal to spend money on beyond-the-home entertainment. Refer to Item 1A Risk factors in the 2018 Form 10-K annual report for more information.\n\nGiven the variety and unpredictability of the factors that will ultimately influence our businesses and our results of operation, it naturally follows that no guarantees can be given that any of our forward-looking statements will ultimately prove to be correct. Actual results will undoubtedly vary and there is no guarantee as to how our securities will perform either when considered in isolation or when compared to other securities or investment opportunities.\n\nFinally, we undertake no obligation to update publicly or to revise any of our forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable law. Accordingly, you should always note the date to which our forward-looking statements speak.\n\nAdditionally, certain of the presentations included in this interim quarterly report may contain “non-GAAP financial measures.” In such case, a reconciliation of this information to our GAAP financial statements will be made available in connection with such statements.\n43\n\nItem 3 –\nQuantitative and Qualitative Disclosure about Market Risk\n\nThe SEC requires that registrants include information about potential effects of changes in currency exchange and interest rates in their filings. Several alternatives, all with some limitations, have been offered. We base the following discussion on a sensitivity analysis that models the effects of fluctuations in currency exchange rates and interest rates. This analysis is constrained by several factors, including the following:\n| · | It is based on a single point in time; and |\n\n| · | It does not include the effects of other complex market reactions that would arise from the changes modeled. |\n\nAlthough the results of such an analysis may be useful as a benchmark, they should not be viewed as forecasts.\nAt March 31, 2019, approximately 33% and 11% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), respectively, including approximately $3.9 million in cash and cash equivalents. At December 31, 2018, approximately 36% and 14% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), including approximately $5.5 million in cash and cash equivalents.\n\nOur policy in Australia and New Zealand is to match revenues and expenses, whenever possible, in local currencies. As a result, we have procured a majority of our expenses in Australia and New Zealand in local currencies. Despite this natural hedge, recent movements in foreign currencies have had an effect on our current earnings. Although foreign currency has had an effect on our current earnings, the effect of the translation adjustment on our assets and liabilities noted in our other comprehensive income was an increase of $1.5 million for the three months ended March 31, 2019. As we continue to progress our acquisition and development activities in Australia and New Zealand, we cannot assure you that the foreign currency effect on our earnings will not be material in the future.\n\nHistorically, our policy has been to borrow in local currencies to finance the development and construction of our long-term assets in Australia and New Zealand whenever possible. As a result, the borrowings in local currencies have provided somewhat of a natural hedge against the foreign currency exchange exposure. Even so, and as a result of our issuance of subordinated Trust Preferred Securities in 2007, and their subsequent partial repayment, approximately 44% and 64% of our Australian and New Zealand assets, respectively, remain subject to such exposure, unless we elect to hedge our foreign currency exchange between the US and Australian and New Zealand dollars. If the foreign currency rates were to fluctuate by 10%, the resulting change in Australian and New Zealand assets would be $9.9 million and $4.6 million, respectively, and the change in our quarterly net income (loss) would be $0.2 million and ($0.1) million, respectively. Presently, we have no plan to hedge such exposure.\n\nWe record unrealized foreign currency translation gains or losses that could materially affect our financial position. As of March 31, 2019 and December 31, 2018, the balance of cumulative foreign currency translation adjustments was approximately $10.2 million gain and $8.7 million gain, respectively.\n\nHistorically, we maintain most of our cash and cash equivalent balances in short-term money market instruments with original maturities of three months or less. Due to the short-term nature of such investments, a change of 1% in short-term interest rates would not have a material effect on our financial condition.\n\nWe have a combination of fixed and variable interest rate loans. In connection with our variable interest rate loans, a change of approximately 1% in short-term interest rates would have resulted in approximately $239,000 increase or decrease in our quarterly interest expense.\n\nFor further discussion on market risks, please refer to International Business Risks included in Item 2, Part 1 of this Form 10-Q.\n44\n\nItem 4 –\nControls and Procedures\n\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\n\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such, term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based upon that evaluation, we concluded that, as of March 31, 2019, our disclosure controls and procedures were effective.\n\nChanges in Internal Control over Financial Reporting\n\nThere were no other changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended March 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n45\nPART II – Other Information\n\n\nItem 1 – Legal Proceedings\n\nThe information required under Part II, Item 1 (Legal Proceedings) is incorporated by reference to the information contained in Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein in Part I, Item 1 (Financial Statements) on this Quarterly Report on Form 10-Q.\n\nIn the quarter ended March 31, 2019, the arbitration relating to the termination of Cotter, Jr.’s employment with our Company (Reading International, Inc. v. James J. Cotter, AAA Case No. 01-15-0004-2384, filed July 2015) was resolved. While our Company was the named claimant, this matter relates essentially to Cotter, Jr.’s claims for compensation and damages related to his termination as our Company’s president and chief executive officer which were originally included in the Derivative Action described in Note 13, above. The Arbitrator has determined that, while Cotter, Jr. did breach his obligations under his Employment Agreement with our Company, Cotter, Jr’s breaches were not sufficiently material to allow our Company relief from its obligations under the Employment Agreement to pay certain specified separation amounts, totaling $313,000 (the “Separation Payment Amount”). The arbitrator awarded this amount, plus interest at the rate of 10% from June 12, 2016, until the award was paid in full on March 6, 2019. The reserve set up by the Company in 2015 with respect to this claim has been reversed. The Arbitrator denied on substantive grounds Cotter, Jr’s claims for consequential damages and for damages based on various tort theories (including defamation) and/or upon wrongful termination claims and denied, on jurisdictional grounds, Cotter Jr’s claims that the unvested stock options granted to him under his Employment Agreement did not expire upon his termination and continued to be exercisable by him so long as he continued as a director of our Company. In total, Cotter, Jr., claimed specified damages in excess of $1,000,000 plus unspecified tort damages. While the award was less than half of the amount claimed by Cotter, Jr., and while finding that Cotter, Jr., was in breach of his agreement with our Company, the Arbitrator nevertheless determined that Cotter, Jr. was the prevailing party and awarded Cotter, Jr. $443,000 of his requested $787,769 in attorney’s fees and costs. The Arbitrator also assessed the costs of the arbitration against our Company and ordered a reimbursement of such costs paid to date by Cotter Jr. in the amount of $14,250. This amount is reflected in our Company’s financial statements. The determinations of the Arbitrator are final and binding on the parties, and not subject to appeal.\n\nFor further details on our legal proceedings, please refer to Item 3, Legal Proceedings, contained in our 2018 Form 10-K.\n\n\nItem 1A – Risk Factors\n\nThere have been no material changes in risk factors as previously disclosed in our 2018 Form 10-K.\n\n\nItem 2 – Unregistered Sales of Equity Securities and Use of Proceeds\n\nThere were no unregistered sales of equity securities during the periods covered by this report.\n\nThe following table summarizes our repurchases under the March 2, 2017, stock repurchase program up until March 31, 2019:\n\n| |\n| |\n| Period | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as part of our Stock Buy-Back Program | Approximate Dollar Value of Shares that may yet be Purchased under the Stock Buy-Back Program |\n| March 2017 | 41,899 | $ | 15.99 | 41,899 | $ | 24,330,149 |\n| May 2017 | 98,816 | $ | 15.78 | 98,816 | $ | 22,771,316 |\n| June 2017 | 70,234 | $ | 16.39 | 70,234 | $ | 21,620,212 |\n| August 2017 | 160,489 | $ | 15.82 | 160,489 | $ | 19,081,288 |\n| September 2017 | 31,718 | $ | 15.77 | 31,718 | $ | 18,581,038 |\n| December 2017 | 6,567 | $ | 16.01 | 6,567 | $ | 18,475,900 |\n| February 2018 | 8,500 | $ | 16.98 | 8,500 | $ | 18,331,570 |\n| March 2018 | 10,138 | $ | 16.99 | 10,138 | $ | 18,159,364 |\n| April 2018 | 5,000 | $ | 16.12 | 5,000 | $ | 18,078,764 |\n| December 2018 | 125,700 | $ | 15.24 | 125,700 | $ | 16,162,529 |\n| March 2019 | 566 | $ | 16.08 | 566 | $ | 16,153,428 |\n| Total | 559,627 | $ | 15.81 | 559,627 | $ | 16,153,428 |\n\n\nFor a description of grants of stock to certain executives, see the Stock Based Compensation section under see Note 15 – Equity and Stock-Based Compensation to our Consolidated Financial Statements.\n46\n\n\nItem 3 – Defaults upon Senior Securities\n\nNone.\n\n\nItem 4 – Mine Safety Disclosure\n\nNot applicable.\n\n\n47\n\nItem 5 –\nOther Information\nNone\n\n\nItem 6 –\nExhibits\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n| |\n| 31.1 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\n| 31.2 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\n| 32 | Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith. |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema |\n| 101.CAL | XBRL Taxonomy Extension Calculation |\n| 101.DEF | XBRL Taxonomy Extension Definition |\n| 101.LAB | XBRL Taxonomy Extension Labels |\n| 101.PRE | XBRL Taxonomy Extension Presentation |\n\n\n48\nSIGNATURES\n\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\n\nREADING INTERNATIONAL, INC.\n\nDate: May 10, 2019\n\nBy: /s/ Ellen M. Cotter\nEllen M. Cotter\nChief Executive Officer\n\nDate: May 10, 2019\n\nBy: /s/ Gilbert Avanes\nGilbert Avanes\nInterim Chief Financial Officer\n\n\n\n\n\n\n49\n</text>\n\nWhat is the increase or decrease in the percentage of net income to net cash provided by operating activities from 2018 to 2019?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1 – Financial Statements\\n3\\n Consolidated Balance Sheets (Unaudited) 3\\n Consolidated Statements of Income (Unaudited) 4\\n Consolidated Statements of Comprehensive Income (Unaudited) 5\\n Consolidated Statements of Cash Flows (Unaudited) 6\\n Notes to Consolidated Financial Statements (Unaudited) 7\\n Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations 28\\n Item 3 – Quantitative and Qualitative Disclosure about Market Risk 44\\n Item 4 – Controls and Procedures 45\\n PART II – Other Information 46\\n Item 1 – Legal Proceedings 46\\n Item 1A – Risk Factors 46\\n Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 46\\n Item 3 – Defaults Upon Senior Securities 47\\n Item 5 – Other Information 48\\n Item 6 – Exhibits 48\\n SIGNATURES 49\\nCertifications\\n2\\nPART 1 – FINANCIAL INFORMATION\\nItem 1 - Financial Statements\\n\\nREADING INTERNATIONAL, INC.\\nCONSOLIDATED BALANCE SHEETS\\n(Unaudited; U.S. dollars in thousands, except share information)\\n\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| | 2019 | 2018 |\\n| ASSETS | (unaudited) |\\n| Current Assets: |\\n| Cash and cash equivalents | $ | 12,648 | $ | 13,127 |\\n| Receivables | 7,094 | 8,045 |\\n| Inventory | 1,165 | 1,419 |\\n| Prepaid and other current assets | 9,642 | 7,667 |\\n| Total current assets | 30,549 | 30,258 |\\n| Operating property, net | 257,402 | 257,667 |\\n| Operating lease right-of-use assets | 229,266 | — |\\n| Investment and development property, net | 95,156 | 86,804 |\\n| Investment in unconsolidated joint ventures | 4,958 | 5,121 |\\n| Goodwill | 20,836 | 19,445 |\\n| Intangible assets, net | 3,694 | 7,369 |\\n| Deferred tax asset, net | 26,483 | 26,235 |\\n| Other assets | 6,199 | 6,129 |\\n| Total assets | $ | 674,543 | $ | 439,028 |\\n| LIABILITIES AND STOCKHOLDERS' EQUITY |\\n| Current Liabilities: |\\n| Accounts payable and accrued liabilities | $ | 23,492 | $ | 26,154 |\\n| Film rent payable | 6,559 | 8,661 |\\n| Debt - current portion | 40,077 | 30,393 |\\n| Derivative financial instruments - current portion | 52 | 41 |\\n| Taxes payable - current | 571 | 1,710 |\\n| Deferred current revenue | 7,712 | 9,264 |\\n| Operating lease liabilities - current portion | 19,797 | — |\\n| Other current liabilities | 9,525 | 9,305 |\\n| Total current liabilities | 107,785 | 85,528 |\\n| Debt - long-term portion | 113,816 | 106,286 |\\n| Derivative financial instruments - non-current portion | 203 | 145 |\\n| Subordinated debt, net | 26,116 | 26,061 |\\n| Noncurrent tax liabilities | 11,737 | 11,530 |\\n| Operating lease liabilities - non-current portion | 222,594 | — |\\n| Other liabilities | 12,346 | 28,931 |\\n| Total liabilities | 494,597 | 258,481 |\\n| Commitments and contingencies (Note 13) |\\n| Stockholders’ equity: |\\n| Class A non-voting common stock, par value $0.01, 100,000,000 shares authorized, |\\n| 33,172,823 issued and 21,249,935 outstanding at March 31, 2019 and 33,112,337 issued and 21,194,748 outstanding at December 31, 2018 | 233 | 232 |\\n| Class B voting common stock, par value $0.01, 20,000,000 shares authorized and |\\n| 1,680,590 issued and outstanding at March 31, 2019 and December 31, 2018 | 17 | 17 |\\n| Nonvoting preferred stock, par value $0.01, 12,000 shares authorized and no issued |\\n| or outstanding shares at March 31, 2019 and December 31, 2018 | — | — |\\n| Additional paid-in capital | 147,472 | 147,452 |\\n| Retained earnings | 45,563 | 47,616 |\\n| Treasury shares | (25,231) | (25,222) |\\n| Accumulated other comprehensive income | 7,625 | 6,115 |\\n| Total Reading International, Inc. stockholders’ equity | 175,679 | 176,210 |\\n| Noncontrolling interests | 4,267 | 4,337 |\\n| Total stockholders’ equity | 179,946 | 180,547 |\\n| Total liabilities and stockholders’ equity | $ | 674,543 | $ | 439,028 |\\n\\n\\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\\n3\\nREADING INTERNATIONAL, INC.\\nCONSOLIDATED STATEMENTS OF INCOME\\n(Unaudited; U.S. dollars in thousands, except per share data)\\n\\n\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| | 2019 | 2018 |\\n| Revenue |\\n| Cinema | $ | 57,986 | $ | 72,255 |\\n| Real estate | 3,565 | 3,617 |\\n| Total revenue | 61,551 | 75,872 |\\n| Costs and expenses |\\n| Cinema | (48,329) | (54,948) |\\n| Real estate | (2,445) | (2,384) |\\n| Depreciation and amortization | (5,594) | (5,250) |\\n| General and administrative | (6,484) | (7,597) |\\n| Total costs and expenses | (62,852) | (70,179) |\\n| Operating income (loss) | (1,301) | 5,693 |\\n| Interest expense, net | (1,852) | (1,594) |\\n| Other income (expense) | (20) | (82) |\\n| Income (loss) before income tax expense and equity earnings of unconsolidated joint ventures | (3,173) | 4,017 |\\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\\n| Income (loss) before income taxes | (3,139) | 4,274 |\\n| Income tax benefit (expense) | 1,042 | (1,170) |\\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\\n| Net income (loss) attributable to Reading International, Inc. common shareholders | $ | (2,081) | $ | 3,082 |\\n| Basic earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\\n| Diluted earnings (loss) per share attributable to Reading International, Inc. shareholders | $ | (0.09) | $ | 0.13 |\\n| Weighted average number of shares outstanding–basic | 22,920,486 | 22,967,237 |\\n| Weighted average number of shares outstanding–diluted | 23,124,106 | 23,132,989 |\\n\\n\\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\\n4\\nREADING INTERNATIONAL, INC.\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\\n(Unaudited; U.S. dollars in thousands)\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| | 2019 | 2018 |\\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\\n| Foreign currency translation gain (loss) | 1,526 | (803) |\\n| Gain (loss) on cash flow hedges | (69) | — |\\n| Other | 53 | 50 |\\n| Comprehensive income (loss) | (587) | 2,351 |\\n| Less: net income (loss) attributable to noncontrolling interests | (16) | 22 |\\n| Less: comprehensive income (loss) attributable to noncontrolling interests | 1 | (3) |\\n| Comprehensive income (loss) attributable to Reading International, Inc. | $ | (572) | $ | 2,332 |\\n\\n\\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\\n5\\nREADING INTERNATIONAL, INC.\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n(Unaudited; U.S. dollars in thousands)\\n\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| | 2019 | 2018 |\\n| Operating Activities |\\n| Net income (loss) | $ | (2,097) | $ | 3,104 |\\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\\n| Equity earnings of unconsolidated joint ventures | (34) | (257) |\\n| Distributions of earnings from unconsolidated joint ventures | 249 | 236 |\\n| Amortization of operating leases | 5,895 | — |\\n| Amortization of finance leases | 41 | — |\\n| Change in operating lease liabilities | (5,754) | — |\\n| Interest on hedged derivatives | (5) | — |\\n| Change in net deferred tax assets | (150) | 172 |\\n| Depreciation and amortization | 5,594 | 5,250 |\\n| Other amortization | 341 | 224 |\\n| Stock based compensation expense | 280 | 379 |\\n| Net changes in operating assets and liabilities: |\\n| Receivables | 993 | 3,205 |\\n| Prepaid and other assets | (1,957) | (2,309) |\\n| Payments for accrued pension | (171) | (2,404) |\\n| Accounts payable and accrued expenses | (2,204) | 1,997 |\\n| Film rent payable | (2,132) | (5,790) |\\n| Taxes payable | (1,151) | 150 |\\n| Deferred revenue and other liabilities | (1,579) | (1,505) |\\n| Net cash provided by (used in) operating activities | (3,841) | 2,452 |\\n| Investing Activities |\\n| Purchases of and additions to operating and investment properties | (11,476) | (23,231) |\\n| Acquisition of business combinations | (1,380) | — |\\n| Change in restricted cash | 243 | (260) |\\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) |\\n| Financing Activities |\\n| Repayment of long-term borrowings | (6,113) | (9,707) |\\n| Repayment of finance lease principle | (41) | — |\\n| Proceeds from borrowings | 22,349 | 25,998 |\\n| Repurchase of Class A Nonvoting Common Stock | (9) | (317) |\\n| (Cash paid) proceeds from the exercise of stock options | (259) | 203 |\\n| Noncontrolling interest contributions | 18 | 27 |\\n| Noncontrolling interest distributions | (27) | (43) |\\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 |\\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) |\\n| Net decrease in cash and cash equivalents | (479) | (5,000) |\\n| Cash and cash equivalents at January 1 | 13,127 | 13,668 |\\n| Cash and cash equivalents at March 31 | $ | 12,648 | $ | 8,668 |\\n| Supplemental Disclosures |\\n| Interest paid | $ | 2,304 | $ | 2,121 |\\n| Income taxes paid | 1,883 | 808 |\\n| Non-Cash Transactions |\\n| Additions to operating and investing properties through accrued expenses | 3,423 | 4,530 |\\n\\n\\nSee accompanying Notes to the Unaudited Consolidated Financial Statements.\\n6\\nREADING INTERNATIONAL, INC.\\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)\\nNote 1 – Description of Business and Segment Reporting\\nThe Company\\nReading International, Inc., a Nevada corporation (“RDI” and collectively with our consolidated subsidiaries and corporate predecessors, the “Company”, “Reading” and “we”, “us”, or “our”), was incorporated in 1999. Our businesses consist primarily of:\\n| · | the operation, development and ownership of multiplex cinemas in the United States, Australia, and New Zealand; and, |\\n\\n| · | the development, ownership, operation and/or rental of retail, commercial and live venue real estate assets in Australia, New Zealand, and the United States. |\\n\\n\\nBusiness Segments\\nReported below are the operating segments of the Company for which separate financial information is available and evaluated regularly by the Chief Executive Officer, the chief operating decision-maker of the Company. As part of our real estate activities, we hold undeveloped land in urban and suburban centers in Australia, New Zealand, and the United States.\\n\\nThe table below summarizes the results of operations for each of our business segments for the quarter ended March 31, 2019 and 2018, respectively. Operating expense includes costs associated with the day-to-day operations of the cinemas and the management of rental properties, including our live theater assets.\\n\\n\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Revenue: |\\n| Cinema exhibition | $ | 57,986 | $ | 72,255 |\\n| Real estate | 5,431 | 6,008 |\\n| Inter-segment elimination | (1,866) | (2,391) |\\n| | $ | 61,551 | $ | 75,872 |\\n| Segment operating income (loss): |\\n| Cinema exhibition | $ | 2,642 | $ | 10,285 |\\n| Real estate | 1,159 | 1,681 |\\n| | $ | 3,801 | $ | 11,966 |\\n\\n\\nA reconciliation of segment operating income to income before income taxes is as follows:\\n\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Segment operating income (loss) | $ | 3,801 | $ | 11,966 |\\n| Unallocated corporate expense |\\n| Depreciation and amortization expense | (61) | (117) |\\n| General and administrative expense | (5,041) | (6,156) |\\n| Interest expense, net | (1,852) | (1,594) |\\n| Equity earnings of unconsolidated joint ventures | 34 | 257 |\\n| Other income (expense) | (20) | (82) |\\n| Income (loss) before income tax expense | $ | (3,139) | $ | 4,274 |\\n\\nNote 2 – Summary of Significant Accounting Policies\\n\\nBasis of Consolidation\\nThe accompanying consolidated financial statements include the accounts of the Company’s wholly-owned subsidiaries as well as majority-owned subsidiaries that the Company controls, and should be read in conjunction with the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2018 (“2018 Form 10-K”). All significant intercompany balances and transactions have been eliminated on consolidation. These consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim reporting with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X of the Securities and Exchange Commission (“SEC”). As such, they do not include\\n7\\nall information and footnotes required by U.S. GAAP for complete financial statements. We believe that we have included all normal and recurring adjustments necessary for a fair presentation of the results for the interim period.\\n\\nOperating results for the quarter ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.\\n\\nUse of Estimates\\nThe preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and footnotes thereto. Significant estimates include (i) projections we make regarding the recoverability and impairment of our assets (including goodwill and intangibles), (ii) valuations of our derivative instruments, (iii) recoverability of our deferred tax assets, (iv) estimation of breakage and redemption experience rates, which drive how we recognize breakage on our gift card and gift certificates, and revenue from our customer loyalty program, and (v) allocation of insurance proceeds to various recoverable components. Actual results may differ from those estimates.\\n\\nRecently Adopted and Issued Accounting Pronouncements\\n\\nAdopted:\\n\\nAccounting Standards Update (“ASU”) 2016-02 Leases: In February 2016, the Financial Accounting Standards Board (“FASB”) issued a new accounting standard, ASC 842 Leases, to increase transparency and comparability among organizations by requiring the recognition of right-of-use (\\\"ROU\\\") assets and lease liabilities on the balance sheet. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. A modified retrospective transition approach is required for lessees with capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.\\n\\nOn January 1, 2019, we adopted the new accounting standard Accounting Standards Codification (“ASC”) 842 Leases using the modified retrospective method. We recognized the cumulative effect of initially applying the new leasing standard as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The standard had a material impact on our consolidated balance sheets, but not on our consolidated income statements or statements of cash flow.\\n\\n\\n| |\\n| (Dollars in thousands) | Balance atDecember 31,2018 | Adjustmentsdue to ASC842 | Balance atJanuary 1,2019 |\\n| Assets |\\n| Operating property, net | $ | 257,667 | $ | 370 | $ | 258,037 |\\n| Operating lease right-of-use assets | — | 232,319 | 232,319 |\\n| Intangible assets, net | 7,369 | (3,542) | 3,827 |\\n| Deferred tax asset, net | 26,235 | 82 | 26,317 |\\n| Liabilities |\\n| Operating lease liabilities | $ | — | $ | 245,280 | $ | 245,280 |\\n| Other non-current liabilities | 28,931 | (16,033) | 12,898 |\\n| Stockholders' Equity |\\n| Non-controlling interest | $ | 4,337 | $ | (46) | $ | 4,291 |\\n| Retained earnings | 47,616 | 28 | 47,644 |\\n\\n\\n\\n\\n| |\\n| | Period Ended March 31, 2019 |\\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\\n| Cinema costs and expenses | $ | 48,329 | $ | 48,334 | $ | (5) |\\n| Depreciation and amortization | 5,594 | 5,552 | 42 |\\n| General and administrative | 6,484 | 6,528 | (44) |\\n| Interest expense, net | 1,852 | 1,849 | 3 |\\n| Income tax (benefit) expense | 1,042 | 1,041 | 1 |\\n| Net income (loss) | $ | (2,097) | $ | (2,094) | $ | 3 |\\n\\n8\\n\\n\\n\\n| |\\n| (Dollars in thousands) | As Reported,March 31, 2019 | BalancesWithoutAdoption ofASC 842 | Effect ofchangeHigher /(Lower) |\\n| Assets |\\n| Operating property, net | $ | 257,402 | $ | 257,072 | $ | 330 |\\n| Intangible assets | 3,694 | 7,151 | (3,457) |\\n| Operating lease right-of-use assets | 229,266 | — | 229,266 |\\n| Deferred tax asset, net | 26,483 | 26,400 | 83 |\\n| Liabilities |\\n| Other current liabilities | $ | 9,525 | $ | 9,363 | $ | 162 |\\n| Operating lease liabilities, current | 19,797 | — | 19,797 |\\n| Other non-current liabilities | 12,346 | 28,643 | (16,297) |\\n| Operating lease liabilities, non-current | 222,594 | — | 222,594 |\\n| Stockholders' Equity |\\n| Retained earnings | $ | 45,563 | $ | 45,585 | $ | (22) |\\n\\n\\n\\n| 1) | ASU 2014-09 Revenue from Contracts with Customers: On January 1, 2018, we adopted the new accounting standard ASC 606 Revenue from Contracts with Customers using the modified retrospective method. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings. The comparative information was not restated. Adoption of this standard has no material effect on our consolidated financial statements. |\\n\\n\\n| 2) | On January 1, 2018, the Company adopted ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, a consensus of the FASB Emerging Issues Task Force. This standard requires that amounts generally described as restricted cash and cash equivalents should be combined with unrestricted cash and cash equivalents when reconciling the beginning and end of period balances on the statement of cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\\n\\n\\n| 3) | On January 1, 2018, the Company adopted ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments). The standard applies to eight (8) specific cash flow classification issues, reducing the current and potential future diversity in the presentation of certain cash flows. Adoption of this standard has no material effect on our consolidated statement of cash flows. |\\n\\n\\n| 4) | On January 1, 2018, the Company adopted ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This standard (i) requires that an employer disaggregate the service cost component from the other components of net benefit cost, and (ii) specifies how to present the service cost component and the other components of net benefit cost in the income statement and (iii) allows only the service cost component of net benefit cost to be eligible for capitalization. Adoption of this standard has no material impact on our consolidated financial statements. |\\n\\n\\n| 5) | On January 1, 2018, the Company adopted ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This ASU provides that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the asset is not a “business”, thus reducing the number of transactions that need further evaluation for business combination. The standard has no material impact on our current consolidated financial statements, and we do not expect it to be applicable to our consolidated financial statements in the near term unless we enter into a definitive business acquisition transaction. |\\n\\n\\nIssued:\\n\\n| v | ASUs Effective 2019 and Beyond |\\n\\n| · | Goodwill Impairment Simplification (ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment) |\\n\\n\\nIssued by FASB in January 2017, this standard removes the second step of the two-step impairment test for measuring goodwill and is to be applied on a prospective basis only. The new standard is effective for the Company on January 1, 2020, including interim periods within the year of adoption. Early adoption is permitted for interim or annual goodwill impairment\\n9\\ntests performed on testing dates after January 1, 2017. It is not anticipated that adoption of this standard will have any material impact on our consolidated financial statements.\\n\\nPrior period financial statement correction of immaterial errors\\n\\nDuring the third quarter of 2018, we identified immaterial errors related to the accounting for straight line rent receivable from tenants in our real estate operations dating back to 2015. These errors resulted in an understatement of real estate revenue.\\n\\nWe assessed the materiality of these errors on our financial statements for prior periods in accordance with the SEC Staff Accounting Bulletin (“SAB”) No. 99, Materiality, codified in ASC 250, Presentation of Financial Statements, and concluded that they were not material to any prior annual or interim periods. However, the aggregate amount of $440k related to the prior period immaterial errors through June 30, 2018, would have been material to the quarterly accounts with our current Consolidated Statements of Income. Consequently, in accordance with ASC 250 (specifically SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements), we have corrected these errors for all prior periods presented by revising the consolidated financial statements and other financial information included herein.\\n\\nThe following is a summary of the previously issued financial statement line items for all periods and statements included in this report.\\n\\nConsolidated Statements of Income:\\n\\n\\n| |\\n| | Three Months Ended March 31, 2018 |\\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\\n| Real estate revenue | $ | 3,567 | $ | 50 | $ | 3,617 |\\n| Total revenue | 75,822 | 50 | 75,872 |\\n| Operating income (loss) | 5,643 | 50 | 5,693 |\\n| Income before income taxes | 4,224 | 50 | 4,274 |\\n| Income tax benefit (expense) | (1,155) | (15) | (1,170) |\\n| Net income (loss) | 3,069 | 35 | 3,104 |\\n| Net income (loss) attributable to Reading International, Inc. common shareholders | 3,047 | 35 | 3,082 |\\n| |\\n| Basic earnings (loss) per share | $ | 0.13 | $ | — | $ | 0.13 |\\n| Diluted earnings (loss) per share | 0.13 | — | 0.13 |\\n\\n\\nConsolidated Balance Sheets:\\n\\n\\n\\n\\n| |\\n| | Summary of Equity |\\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\\n| Equity at January 1, 2018 | $ | 176,910 | $ | 377 | $ | 177,287 |\\n| Net income (loss) | 3,047 | 35 | 3,082 |\\n| Equity at March 31, 2018 | $ | 179,423 | $ | 412 | $ | 179,835 |\\n\\n\\n\\nConsolidated Statements of Cash Flows:\\n\\n\\n| |\\n| | Three Months Ended March 31, 2018 |\\n| (Dollars in thousands) | As Reported | Adjustment | As Revised |\\n| Net income (loss) | $ | 3,069 | $ | 35 | $ | 3,104 |\\n| Change in net deferred tax assets | 157 | 15 | 172 |\\n| Prepaid and other assets | (2,259) | (50) | (2,309) |\\n| Net cash provided by operating activities | $ | 2,452 | $ | — | $ | 2,452 |\\n\\n10\\nNote 3 – Operations in Foreign Currency\\n\\nWe have significant assets in Australia and New Zealand. Historically, we have conducted our Australian and New Zealand operations (collectively “foreign operations”) on a self-funding basis where we use cash flows generated by our foreign operations to pay for the expense of foreign operations. Our Australian and New Zealand assets and liabilities are translated from their functional currencies of Australian dollar (“AU$”) and New Zealand dollar (“NZ$”), respectively, to the U.S. dollar based on the exchange rate as of March 31, 2019. The carrying value of the assets and liabilities of our foreign operations fluctuates as a result of changes in the exchange rates between the functional currencies of the foreign operations and the U.S. dollar. The translation adjustments are accumulated in the Accumulated Other Comprehensive Income in the Consolidated Balance Sheets.\\n\\nDue to the natural-hedge nature of our funding policy, we have not historically used derivative financial instruments to hedge against the risk of foreign currency exposure. However, in certain circumstances, we move funds between jurisdictions where circumstances encouraged us to do so from an overall economic standpoint. Going forward, particularly in light of recent tax law changes, we intend to take a more global view of our financial resources, and to be more flexible in making use of resources from one jurisdiction in other jurisdictions.\\n\\nPresented in the table below are the currency exchange rates for Australia and New Zealand:\\n\\n\\n| |\\n| |\\n| | Foreign Currency / USD |\\n| | As of andfor thequarterended | As of andfor thetwelve monthsended | As of andfor thequarterended |\\n| | March 31, 2019 | December 31, 2018 | March 31, 2018 |\\n| Spot Rate |\\n| Australian Dollar | 0.7104 | 0.7046 | 0.7690 |\\n| New Zealand Dollar | 0.6820 | 0.6711 | 0.7239 |\\n| Average Rate |\\n| Australian Dollar | 0.7123 | 0.7479 | 0.7861 |\\n| New Zealand Dollar | 0.6816 | 0.6930 | 0.7275 |\\n\\nNote 4 – Earnings Per Share\\n\\nBasic earnings per share (“EPS”) is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is calculated by dividing the net income attributable to the Company’s common stockholders by the weighted average number of common and common equivalent shares outstanding during the period and is calculated using the treasury stock method for equity-based compensation awards.\\n\\nThe following table sets forth the computation of basic and diluted EPS and a reconciliation of the weighted average number of common and common equivalent shares outstanding:\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands, except share data) | 2019 | 2018 |\\n| Numerator: |\\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 |\\n| Denominator: |\\n| Weighted average number of common stock – basic | 22,920,486 | 22,967,237 |\\n| Weighted average dilutive impact of awards | 203,620 | 165,752 |\\n| Weighted average number of common stock – diluted | 23,124,106 | 23,132,989 |\\n| Basic earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\\n| Diluted earnings (loss) per share attributable to RDI common stockholders | $ | (0.09) | $ | 0.13 |\\n| Awards excluded from diluted earnings (loss) per share | 496,089 | — |\\n\\n\\nOur weighted average number of common stock - basic decreased, primarily as a result of the repurchase of shares of Class A Non-Voting Common Stock pursuant to our current stock repurchase program offset by the issuance of shares due to the exercise of share options and vesting of restricted stock units.\\n11\\nNote 5 – Property and Equipment\\n\\nOperating Property, net\\n\\nAs of March 31, 2019 and December 31, 2018, property associated with our operating activities is summarized as follows:\\n\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Land | $ | 76,110 | $ | 75,689 |\\n| Building and improvements | 151,525 | 149,734 |\\n| Leasehold improvements | 56,160 | 55,299 |\\n| Fixtures and equipment | 171,674 | 167,943 |\\n| Construction-in-progress | 3,185 | 3,478 |\\n| Total cost | 458,654 | 452,143 |\\n| Less: accumulated depreciation | (201,252) | (194,476) |\\n| Operating property, net | $ | 257,402 | $ | 257,667 |\\n\\n\\nDepreciation expense for operating property was $5.4 million for the quarter ended March 31, 2019 and $4.7 million for the quarter ended March 31, 2018.\\n\\nInvestment and Development Property, net\\n\\nAs of March 31, 2019 and December 31, 2018, our investment and development property is summarized below:\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Land | $ | 24,310 | $ | 24,371 |\\n| Building | 1,900 | 1,900 |\\n| Construction-in-progress (including capitalized interest) | 68,946 | 60,533 |\\n| Investment and development property | $ | 95,156 | $ | 86,804 |\\n\\n\\nConstruction-in-Progress – Operating and Investing Properties\\n\\nConstruction-in-Progress balances are included in both our operating and development properties. The balances of our major projects along with the movements for the three months ended March 31, 2019 are shown below:\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | Balance,December 31,2018 | Additions during the period(1) | Completedduring theperiod | Foreigncurrencytranslation | Balance,March 31,2019 |\\n| Union Square development | $ | 55,634 | $ | 7,724 | $ | — | $ | (1) | $ | 63,357 |\\n| Newmarket Property development | 9 | 4 | — | — | 13 |\\n| Courtenay Central development | 5,571 | 234 | — | 94 | 5,899 |\\n| Cinema developments and improvements | 1,664 | 3,551 | (3,997) | 4 | 1,222 |\\n| Other real estate projects | 1,133 | 528 | (27) | 6 | 1,640 |\\n| Total | $ | 64,011 | $ | 12,041 | $ | (4,024) | $ | 103 | $ | 72,131 |\\n\\n\\n| (1) | Includes capitalized interest of $1.3 million for the quarter ended March 31, 2019. |\\n\\n\\nReal Estate Transactions\\n\\nPurchase of Income Producing Property at Auburn/Redyard, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 square foot office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. With this acquisition, Auburn/Redyard now represents approximately 519,992 square feet (48,309 square meters) of land, with approximately 1,620 feet (498 meters) of uninterrupted frontage to Parramatta Road, a major Sydney arterial motorway.\\n\\n12\\nPurchase of Land at Cannon Park in Townsville, Australia – On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel of land at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights with respect to that parcel.\\n\\nNote 6 – Investments in Unconsolidated Joint Ventures\\n\\nOur investments in unconsolidated joint ventures are accounted for under the equity method of accounting.\\n\\nThe table below summarizes our active investment holdings in two (2) unconsolidated joint ventures as of March 31, 2019 and December 31, 2018:\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | Interest | 2019 | 2018 |\\n| Rialto Cinemas | 50.0% | $ | 1,224 | $ | 1,260 |\\n| Mt. Gravatt | 33.3% | 3,734 | 3,861 |\\n| Total investments | $ | 4,958 | $ | 5,121 |\\n\\n\\nFor the quarter ended March 31, 2019 and 2018, the recognized share of equity earnings from our investments in unconsolidated joint ventures are as follows:\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Rialto Cinemas | $ | (56) | $ | 70 |\\n| Mt. Gravatt | 90 | 187 |\\n| Total equity earnings | $ | 34 | $ | 257 |\\n\\nNote 7 – Goodwill and Intangible Assets\\n\\nThe table below summarizes goodwill by business segment as of March 31, 2019 and December 31, 2018.\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | Cinema | Real Estate | Total |\\n| Balance at, December 31, 2018 | $ | 14,221 | $ | 5,224 | $ | 19,445 |\\n| Change in goodwill due to a purchase of business combination | 1,248 | — | 1,248 |\\n| Foreign currency translation adjustment | 143 | — | 143 |\\n| Balance at, March 31, 2019 | $ | 15,612 | $ | 5,224 | $ | 20,836 |\\n\\n\\nThe Company is required to test goodwill and other intangible assets for impairment on an annual basis and, if current events or circumstances require, on an interim basis. Our next annual evaluation of goodwill and other intangible assets is scheduled during the fourth quarter of 2019. To test the impairment of goodwill, the Company compares the fair value of each reporting unit to its carrying amount, including the goodwill, to determine if there is potential goodwill impairment. A reporting unit is generally one level below the operating segment. As of March 31, 2019, we were not aware that any events indicating potential impairment of goodwill had occurred.\\n\\nThe tables below summarize intangible assets other than goodwill as of March 31, 2019 and December 31, 2018, respectively.\\n\\n\\n| |\\n| |\\n| | As of March 31, 2019 |\\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\\n| Gross carrying amount | $ | 15,069 | $ | 7,255 | $ | 1,999 | $ | 24,323 |\\n| Less: Accumulated amortization | (14,260) | (5,269) | (1,100) | (20,629) |\\n| Net intangible assets other than goodwill | $ | 809 | $ | 1,986 | $ | 899 | $ | 3,694 |\\n\\n\\n13\\n\\n| |\\n| |\\n| | As of December 31, 2018 |\\n| (Dollars in thousands) | BeneficialLeases | TradeName | OtherIntangibleAssets | Total |\\n| Gross carrying amount | $ | 28,592 | $ | 7,254 | $ | 1,951 | $ | 37,797 |\\n| Less: Accumulated amortization | (24,145) | (5,207) | (1,076) | (30,428) |\\n| Net intangible assets other than goodwill | $ | 4,447 | $ | 2,047 | $ | 875 | $ | 7,369 |\\n\\n\\nBeneficial leases were amortized over the life of the lease up to 30 years up until January 1, 2019, when under ASC 842 they were incorporated into the relevant right-of-use asset. Trade names are amortized based on the accelerated amortization method over their estimated useful life of 30 years, and other intangible assets are amortized over their estimated useful lives of up to 30 years (except for transferrable liquor licenses, which are indefinite-lived assets). The table below summarizes the amortization expense of intangible assets for the quarter ended March 31, 2019.\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Beneficial lease amortization | $ | 79 | $ | 207 |\\n| Other amortization | 22 | 93 |\\n| Total intangible assets amortization | $ | 101 | $ | 300 |\\n\\nNote 8 – Prepaid and Other Assets\\n\\nPrepaid and other assets are summarized as follows:\\n\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Prepaid and other current assets |\\n| Prepaid expenses | $ | 2,105 | $ | 1,761 |\\n| Prepaid rent | 1,020 | 930 |\\n| Prepaid taxes | 1,026 | 646 |\\n| Income taxes receivable | 4,106 | 2,704 |\\n| Deposits | 242 | 242 |\\n| Investment in marketable securities | 44 | 42 |\\n| Restricted cash | 1,099 | 1,342 |\\n| Total prepaid and other current assets | $ | 9,642 | $ | 7,667 |\\n| Other non-current assets |\\n| Straight-line rent | 4,219 | 4,150 |\\n| Other non-cinema and non-rental real estate assets | 1,134 | 1,134 |\\n| Investment in Reading International Trust I | 838 | 838 |\\n| Long-term deposits | 8 | 7 |\\n| Long-term restricted cash | — | — |\\n| Total other non-current assets | $ | 6,199 | $ | 6,129 |\\n\\nNote 9 – Income Taxes\\n\\nThe interim provision for income taxes is different from the amount determined by applying the U.S. federal statutory rate to consolidated income before taxes. The differences are attributable to foreign tax rate differential, unrecognized tax benefits, and foreign tax credits. Our effective tax rate was 33.2% and 27.3% for the three months ended March 31, 2019 and 2018, respectively. The change between 2019 and 2018 is primarily related to decrease in benefits from foreign tax credits and increase in valuation allowance related to our foreign operation.\\n\\n14\\nNote 10 – Debt\\n\\nThe Company’s borrowings at March 31, 2019 and December 31, 2018, net of deferred financing costs and including the impact of interest rate derivatives on effective interest rates, are summarized below:\\n\\n\\n| |\\n| |\\n| | As of March 31, 2019 |\\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterest Rate | Effective Interest Rate(2) |\\n| Denominated in USD |\\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,116 | 6.75% | 6.75% |\\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 30,000 | 30,000 | 5.02% | 5.02% |\\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | 3,500 | 3,500 | 5.52% | 5.52% |\\n| Banc of America digital projector loan (USA) | December 28, 2019 | 1,979 | 1,979 | 1,979 | 5.00% | 5.00% |\\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 18,978 | 18,978 | 18,768 | 3.25% | 3.25% |\\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,864 | 4.54% | 4.54% |\\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,437 | 9,437 | 9,319 | 4.64% / 4.44% | 4.61% |\\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 33,934 | 32,463 | 6.76% / 12.51% | 8.02% |\\n| Denominated in foreign currency (\\\"FC\\\") (3) |\\n| NAB Corporate Term Loan (AU) | December 31, 2023 | 85,248 | 40,138 | 40,111 | 2.70% | 2.70% |\\n| Westpac Bank Corporate (NZ) | December 31, 2023 | 21,824 | 9,889 | 9,889 | 3.80% | 3.80% |\\n| | $ | 290,879 | $ | 183,768 | $ | 180,009 |\\n\\n\\n| (1) | Net of deferred financing costs amounting to $3.8 million. |\\n\\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of March 31, 2019. |\\n\\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of March 31, 2019. |\\n\\n\\n| |\\n| |\\n| | As of December 31, 2018 |\\n| (Dollars in thousands) | Maturity Date | ContractualFacility | Balance,Gross | Balance, Net(1) | StatedInterestRate | Effective Interest Rate (2) |\\n| Denominated in USD |\\n| Trust Preferred Securities (USA) | April 30, 2027 | $ | 27,913 | $ | 27,913 | $ | 26,061 | 6.52% | 6.52% |\\n| Bank of America Credit Facility (USA) | May 1, 2020 | 55,000 | 25,000 | 25,000 | 5.02% | 5.02% |\\n| Bank of America Line of Credit (USA) | October 31, 2019 | 5,000 | — | — | 5.48% | 5.48% |\\n| Banc of America digital projector loan (USA) | December 28, 2019 | 2,604 | 2,604 | 2,604 | 5.00% | 5.00% |\\n| Cinema 1, 2, 3 Term Loan (USA) | September 1, 2019 | 19,086 | 19,086 | 18,838 | 3.25% | 3.25% |\\n| Minetta & Orpheum Theatres Loan (USA) | November 1, 2023 | 8,000 | 8,000 | 7,857 | 4.88% | 4.88% |\\n| U.S. Corporate Office Term Loan (USA) | January 1, 2027 | 9,495 | 9,495 | 9,373 | 4.64% / 4.44% | 4.61% |\\n| Union Square Construction Financing (USA) | December 29, 2019 | 57,500 | 27,182 | 25,280 | 6.76% / 12.51% | 8.35% |\\n| Denominated in foreign currency (\\\"FC\\\")(3) |\\n| NAB Corporate Loan Facility (AU) | December 31, 2023 | 46,856 | 37,696 | 37,660 | 3.05% | 3.05% |\\n| Westpac Corporate Credit Facility (NZ) | December 31, 2023 | 21,475 | 10,067 | 10,067 | 3.80% | 3.80% |\\n| | $ | 252,929 | $ | 167,043 | $ | 162,740 |\\n\\n\\n| (1) | Net of deferred financing costs amounting to $4.3 million. |\\n\\n\\n| (2) | Both interest rate derivatives associated with the Trust Preferred Securities and Bank of America Credit Facility expired in October 2017 so the effective interest rate no longer applies as of December 31, 2018. |\\n\\n| (3) | The contractual facilities and outstanding balances of the foreign currency denominated borrowings were translated into U.S. dollars based on the applicable exchange rates as of December 31, 2018. |\\n\\n\\nOur loan arrangements are presented, net of the deferred financing costs, on the face of our consolidated balance sheet as follows:\\n\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| Balance Sheet Caption | 2019 | 2018 |\\n| Debt - current portion | $ | 40,077 | $ | 30,393 |\\n| Debt - long-term portion | 113,816 | 106,286 |\\n| Subordinated debt | 26,116 | 26,061 |\\n| Total borrowings | $ | 180,009 | $ | 162,740 |\\n\\n\\n15\\nMinetta and Orpheum Theatres Loan\\n\\nOn October 12, 2018, we refinanced our $7.5 million loan with Santander Bank, which is secured by our Minetta and Orpheum Theatres, with a loan for a five year term of $8.0 million. Such modification was not considered to be substantial under US GAAP.\\n\\nBanc of America Digital Projector Loan\\n\\nOn February 5, 2018, we purchased our U.S. digital cinema projectors, which had previously been held on operating leases, using a $4.6 million loan from Banc of America. We made further U.S. digital projector purchases, of projectors similarly held on other operating leases, in March and April 2018, increasing this loan to $4.9 million. This loan carries an interest rate of 5% and is due and payable December 28, 2019.\\n\\nBank of America Credit Facility\\n\\nOn March 3, 2016, we amended our $55.0 million credit facility with Bank of America to permit real property acquisition loans. This amendment reduces the applicable consolidated leverage ratio covenant by 0.25% and modifies the term of the facility based on the earlier of the eighteen months from the date of such borrowing or the maturity date of the credit agreement. Such modification was not considered substantial in accordance with U.S. GAAP. On March 5, 2019, this Credit Facility was extended for six (6) months to May 1, 2020.\\n\\n44 Union Square Construction Financing\\n\\nOn December 29, 2016, we closed on our new construction finance facilities totaling $57.5 million to fund the non-equity portion of the anticipated construction costs of the redevelopment of our property at 44 Union Square in New York City. The combined facilities consist of $50.0 million in aggregate loans (comprised of three loan tranches) from Bank of the Ozarks (“BOTO”), and a $7.5 million mezzanine loan from Tammany Mezz Investor, LLC, an affiliate of Fisher Brothers. At December 31, 2016, Bank of the Ozarks advanced $8.0 million to repay the then existing $8.0 million loan with East West Bank. As of March 31, 2019, an additional $26.4 million had been advanced under the senior loan facility, along with the full $7.5 million available under the mezzanine loan facility.\\n\\nU.S. Corporate Office Term Loan\\n\\nOn December 13, 2016, we obtained a ten-year $8.4 million mortgage loan on our new Los Angeles Corporate Headquarters at a fixed annual interest rate of 4.64%. This loan provided for a second loan upon completion of certain improvements. On June 26, 2017, we obtained a further $1.5 million under this provision at a fixed annual interest rate of 4.44%.\\n\\nBank of America Line of Credit\\n\\nIn October 2016, the term of this $5.0 million line of credit was extended to October 31, 2019. Such modification was not considered to be substantial under US GAAP.\\n\\nCinema 1,2,3 Term Loan\\n\\nOn August 31, 2016, Sutton Hill Properties LLC (“SHP”), a 75% subsidiary of RDI, refinanced its $15.0 million Santander Bank term loan with a new lender, Valley National Bank. This new $20.0 million loan is collateralized by our Cinema 1,2,3 property and bears an interest rate of 3.25% per annum, with principal installments and accruing interest paid monthly. The new loan matures on September 1, 2019, with a one-time option to extend maturity date for another year. The Company presently intends to exercise that option and to extend the maturity date until September 1, 2020.\\n\\nWestpac Bank Corporate Credit Facility (NZ)\\n\\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was not renewed.\\n\\nAustralian NAB Corporate Term Loan (AU)\\n\\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0\\n16\\nmillion Corporate Loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a Bank Guarantee Facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\\nNote 11 – Other Liabilities\\n\\nOther liabilities are summarized as follows:\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Current liabilities |\\n| Lease liability | $ | 5,900 | $ | 5,900 |\\n| Liability for demolition costs | 2,664 | 2,630 |\\n| Accrued pension | 684 | 684 |\\n| Security deposit payable | 88 | 84 |\\n| Finance lease liabilities | 162 | — |\\n| Other | 27 | 7 |\\n| Other current liabilities | $ | 9,525 | $ | 9,305 |\\n| Other liabilities |\\n| Straight-line rent | $ | — | $ | 16,362 |\\n| Lease make-good provision | 5,722 | 5,614 |\\n| Accrued pension | 4,544 | 4,670 |\\n| Environmental reserve | 1,656 | 1,656 |\\n| Deferred revenue - real estate | 9 | 32 |\\n| Acquired leases | 47 | 91 |\\n| Finance lease liabilities | 169 | — |\\n| Other | 199 | 506 |\\n| Other liabilities | $ | 12,346 | $ | 28,931 |\\n\\n\\nOn August 29, 2014, the Supplemental Executive Retirement Plan (“SERP”) that has been effective since March 1, 2007, was ended and replaced in accordance with the terms of a pension annuity. As a result of the termination of the SERP program, the accrued pension liability of $7.6 million was reversed and replaced with this pension annuity liability of $7.5 million. The valuation of the liability is based on the present value of $10.2 million discounted at a rate of 4.25% over a 15-year term, resulting in a monthly payment of $57,000. The discount rate of 4.25% has been applied since 2014 to determine the net periodic benefit cost and plan benefit obligation and is expected to be used in future years. The discounted value of $2.7 million (which is the difference between the estimated payout of $10.2 million and the present value of $7.5 million) as of August 29, 2014 will be amortized and expensed based on the 15-year term. In addition, the accumulated actuarial loss of $3.1 million recorded, as part of other comprehensive income will also be amortized based on the 15-year term.\\n\\nIn February 2018 we made a payment of $2.4 million relating to the annuity representing payments for the 42 months outstanding at the time. Monthly ongoing payments of $57,000 are now being made.\\n\\nAs a result of the above, included in our current and non-current liabilities are accrued pension costs of $5.2 million at March 31, 2019. The benefits of our pension plan are fully vested and therefore no service costs were recognized for the quarter ended March 31, 2019 and 2018. Our pension plan is unfunded.\\n\\nDuring the quarter ended March 31, 2019, the interest cost was $51,000 and actuarial loss was $51,000. During the quarter ended March 31, 2018, the interest cost was $45,000 and actuarial loss was $52,000.\\n17\\nNote 12 – Accumulated Other Comprehensive Income\\n\\nThe following table summarizes the changes in each component of accumulated other comprehensive income attributable to RDI:\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | ForeignCurrencyItems | UnrealizedGain (Losses)on Available-for-SaleInvestments | AccruedPensionService Costs | Hedge Accounting Reserve | Total |\\n| Balance at January 1, 2019 | $ | 8,687 | $ | 3 | $ | (2,438) | $ | (137) | $ | 6,115 |\\n| |\\n| Change related to derivatives |\\n| Total change in hedge fair value recorded in Other Comprehensive Income | — | — | — | (81) | (81) |\\n| Amounts reclassified from accumulated other comprehensive income | — | — | — | 12 | 12 |\\n| Net change related to derivatives | — | — | — | (69) | (69) |\\n| |\\n| Net current-period other comprehensive income (loss) | 1,526 | 2 | 51 | (69) | 1,510 |\\n| Balance at March 31, 2019 | $ | 10,213 | $ | 5 | $ | (2,387) | $ | (206) | $ | 7,625 |\\n\\nNote 13 – Commitments and Contingencies\\n\\nLitigation General\\n\\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims, including legal costs.\\n| · | Where we are a plaintiff, we accrue legal fees as incurred on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which recoveries typically work out to be approximately 60% of the amounts actually spent where first-class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party. |\\n\\n| · | Where we are a defendant, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. From time-to-time, we are involved with claims and lawsuits arising in the ordinary course of our business that may include contractual obligations, insurance claims, tax claims, employment matters, and anti-trust issues, among other matters. |\\n\\n\\nAll of these matters require significant judgments based on the facts known to us. These judgments are inherently uncertain and can change significantly when additional facts become known. We provide accruals for matters that have probable likelihood of occurrence and can be properly estimated as to their expected negative outcome. We do not record expected gains until the proceeds are received by us. However, we typically make no accruals for potential costs of defense, as such amounts are inherently uncertain and dependent upon the scope, extent and aggressiveness of the activities of the applicable plaintiff.\\n\\nEnvironmental and Asbestos Claims on Reading Legacy Operations\\nCertain of our subsidiaries were historically involved in railroad operations, coal mining, and manufacturing. Also, certain of these subsidiaries appear in the chain-of-title of properties that may suffer from pollution. Accordingly, certain of these subsidiaries have, from time-to-time, been named in and may in the future be named in various actions brought under applicable environmental laws. Also, we are in the real estate development business and may encounter from time-to-time unanticipated environmental conditions at properties that we have acquired for development. These environmental conditions can increase the cost of such projects and adversely affect the value and potential for profit of such projects. We do not currently believe that our exposure under applicable environmental laws is material in amount.\\n\\nFrom time to time, there are claims brought against us relating to the exposure of former employees of our railroad operations to asbestos and coal dust. These are generally covered by an insurance settlement reached in September 1990 with our insurance providers. However, this insurance settlement does not cover litigation by people who were not our employees and who may claim second-hand exposure to asbestos, coal dust and/or other chemicals or elements now recognized as potentially causing cancer in humans. Our known exposure to these types of claims, asserted or probable of being asserted, is not material.\\n\\n18\\nCotter Jr. Derivative Litigation\\n\\nThis action was originally brought by James J. Cotter, Jr. (“Cotter Jr.”) in June, 2015 in the Nevada District Court against all of the Directors of the Company and against the Company as a nominal defendant: James J. Cotter, Jr., individually and derivatively on behalf of Reading International, Inc. vs. Margaret Cotter, et al.” Case No,: A-15-719860-V. Summary judgment has been entered against Cotter, Jr., and in favor of all defendants and a $1.55 million cost judgment has been entered against Cotter, Jr., and in favor of our Company. Cotter, Jr. has appealed both judgements. Our application for $5.9 million in attorney’s fees was denied, and we have appealed that determination. The issues on appeal are currently being briefed. No date for oral argument has been set. It is unlikely that any hearing will be held this year. As the Directors and Officers Liability Insurance Policy covering Cotter, Jr.’s claims in the Derivative Case ($10.0 million) has been exhausted, the financial burden of defending our Directors against these claims, as required by applicable Nevada Law, has fallen upon our Company. During 2018, out-of-pocket third party costs in the amount of approximately $3.5 million were incurred by our Company in defending against these claims. In the quarter ended March 31, 2019, an additional $387,000 had been accrued, relating principally to the preparation of appellate briefs with respect to the Derivative Litigation.\\nNote 14 – Non-controlling Interests\\n\\nThese are composed of the following enterprises:\\n| · | Australia Country Cinemas Pty Ltd. - 25% noncontrolling interest owned by Panorama Cinemas for 21st Century Pty Ltd.; |\\n\\n| · | Shadow View Land and Farming, LLC - 50% noncontrolling membership interest owned by either the estate of Mr. James J. Cotter, Sr. (the “Cotter Estate”) and/or the James J. Cotter, Sr. Living Trust (the “Cotter Trust”); and, |\\n\\n| · | Sutton Hill Properties, LLC - 25% noncontrolling interest owned by Sutton Hill Capital, LLC (which in turn is 50% owned by the Cotter Estate and/or the Cotter Trust). |\\n\\n\\nThe components of noncontrolling interests are as follows:\\n\\n| |\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Australian Country Cinemas, Pty Ltd | $ | 27 | $ | 89 |\\n| Shadow View Land and Farming, LLC | 2,156 | 2,153 |\\n| Sutton Hill Properties, LLC | 2,084 | 2,095 |\\n| Noncontrolling interests in consolidated subsidiaries | $ | 4,267 | $ | 4,337 |\\n\\n\\nThe components of income attributable to noncontrolling interests are as follows:\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Australian Country Cinemas, Pty Ltd | $ | 9 | $ | 41 |\\n| Shadow View Land and Farming, LLC | (14) | (13) |\\n| Sutton Hill Properties, LLC | (11) | (6) |\\n| Net income (loss) attributable to noncontrolling interests | $ | (16) | $ | 22 |\\n\\n\\n19\\nSummary of Controlling and Noncontrolling Stockholders’ Equity\\n\\nA summary of the changes in controlling and noncontrolling stockholders’ equity is as follows:\\n\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\\n| Equity at January 1, 2019 | $ | 176,210 | $ | 4,337 | $ | 180,547 |\\n| Adjustments to opening retained earnings on adoption of ASC 842 | 28 | (46) | (18) |\\n| Net income (loss) | (2,081) | (16) | (2,097) |\\n| Increase in additional paid in capital | 21 | — | 21 |\\n| Treasury stock purchased | (9) | — | (9) |\\n| Contributions from noncontrolling stockholders | — | 18 | 18 |\\n| Distributions to noncontrolling stockholders | — | (27) | (27) |\\n| Accumulated other comprehensive income | 1,510 | 1 | 1,511 |\\n| Equity at March 31, 2019 | $ | 175,679 | $ | 4,267 | $ | 179,946 |\\n| |\\n| (Dollars in thousands) | ControllingStockholders’Equity | NoncontrollingStockholders’Equity | TotalStockholders’Equity |\\n| Equity at January 1, 2018 | $ | 177,287 | $ | 4,331 | $ | 181,618 |\\n| Adjustments to opening retained earnings on adoption of ASC 606 | 194 | (2) | 192 |\\n| Net income (loss) | 3,082 | 22 | 3,104 |\\n| Increase in additional paid in capital | 339 | — | 339 |\\n| Treasury stock purchased | (317) | — | (317) |\\n| Contributions from noncontrolling stockholders | — | 27 | 27 |\\n| Distributions to noncontrolling stockholders | — | (43) | (43) |\\n| Accumulated other comprehensive loss | (750) | (3) | (753) |\\n| Equity at March 31, 2018 | $ | 179,835 | $ | 4,332 | $ | 184,167 |\\n\\nNote 15 – Stock-Based Compensation and Stock Repurchases\\n\\nEmployee and Director Stock Option Plan\\n\\nThe Company may grant stock options and other share-based payment awards of our Common Stock to eligible employees, directors, and consultants under the 2010 Stock Incentive Plan (the “Plan”). The aggregate total number of shares of the Common Stock authorized for issuance under the Plan is 2,197,460.\\n\\nDuring the Company’s 2017 Annual Stockholders’ Meeting held on November 7, 2017, the Company's stockholders, upon recommendation of the Board of Directors, approved an amendment to the Plan to increase the number of shares of common stock issuable under the Plan by an additional 947,460 shares. The effect of the increase is to restore the amount of shares of Common Stock available under the Plan from the 302,540 shares available as of September 30, 2017, back up to its original reserve of 1,250,000 shares. As of March 31, 2019, we had 789,869 shares remaining for future issuances.\\n\\nSince the adoption of the Plan in 2010, the Company has granted awards primarily in the form of stock options. In the 1st quarter of 2016, the Company started to award restricted stock units (“RSUs”) to directors and certain members of management. Stock options are generally granted at exercise prices equal to the grant-date market prices and typically expire no later than five years from the grant date. In contrast to a stock option where the grantee buys the Company’s share at an exercise price determined on grant date, an RSU entitles the grantee to receive one share for every RSU based on a vesting plan. At the discretion of our Compensation and Stock Options Committee, the vesting period of stock options and RSUs granted to employees ranges from zero to four years. Grants to directors and certain executive officers are subject to Board approval. At the time the options are exercised or RSUs vest and are settled, at the discretion of management, we will issue treasury shares or make a new issuance of shares to the option or RSU holder.\\n\\nStock Options\\nWe estimate the grant-date fair value of our stock options using the Black-Scholes option-valuation model, which takes into account assumptions such as the dividend yield, the risk-free interest rate, the expected stock price volatility, and the expected life of the options. We expense the estimated grant-date fair values of options over the vesting period on a straight-line basis. Based on our\\n20\\nhistorical experience, the “deemed exercise” of expiring in-the-money options and the relative market price to strike price of the options, we have not hereto estimated any forfeitures of vested or unvested options.\\n\\nThere were 219,408 stock options issued in the quarter ended March 31, 2019. The weighted average assumptions used in the option-valuation model were as follows:\\n\\n\\n| |\\n| |\\n| | Three Months Ended March 31, |\\n| | 2019 | 2018 |\\n| Stock option exercise price | $ | 16.12 | $ | — |\\n| Risk-free interest rate | 2.42% | 0.00% |\\n| Expected dividend yield | — | — |\\n| Expected option life in years | 3.75 | — |\\n| Expected volatility | 23.32% | 0.00% |\\n| Weighted average fair value | $ | 3.50 | $ | — |\\n\\n\\nFor the quarters ended March 31, 2019 and 2018, we recorded compensation expense of $70,000 and $85,000, respectively. At March 31, 2019, the total unrecognized estimated compensation expense related to non-vested stock options was $1.5 million, which we expect to recognize over a weighted average vesting period of 2.11 years. The intrinsic, unrealized value of all options outstanding, vested and expected to vest, at March 31, 2019 was $2.0 million, of which 91% are currently exercisable.\\n\\nThe following table summarizes the number of options outstanding and exercisable as of March 31, 2019 and December 31, 2018:\\n\\n| |\\n| |\\n| | Outstanding Stock Options - Class A Shares |\\n| | Numberof Options | WeightedAverageExercise Price | WeightedAverageRemainingYears ofContractualLife | AggregateIntrinsicValue |\\n| | Class A | Class A | Class A | Class A |\\n| Balance - December 31, 2017 | 524,589 | $ | 12.50 | 3.15 | $ | 3,054,325 |\\n| Granted | 126,840 | 16.40 | — | — |\\n| Exercised | (60,000) | 6.02 | — | 610,249 |\\n| Forfeited | (4,960) | 12.08 | — | — |\\n| Balance - December 31, 2018 | 586,469 | $ | 14.01 | 2.88 | $ | 1,530,528 |\\n| Granted | 219,408 | 16.12 | — | — |\\n| Exercised | (67,500) | 13.42 | — | 185,175 |\\n| Forfeited | (25,000) | 13.42 | — | — |\\n| Balance - March 31, 2019 | 713,377 | $ | 14.74 | 3.53 | $ | 1,993,628 |\\n\\n\\n21\\nRestricted Stock Units\\nWe estimate the grant-date fair values of our RSUs using the Company’s stock price at grant-date and record such fair values as compensation expense over the vesting period on a straight-line basis. The following table summarizes the status of the RSUs granted to-date as of March 31, 2019:\\n\\n| |\\n| |\\n| | Outstanding Restricted Stock Units |\\n| | RSU Grants (in units) | Vested, | Unvested, | Forfeited, |\\n| Grant Date | Directors | Management | TotalGrants | March 31,2019 | March 31,2019 | March 31,2019 |\\n| March 10, 2016 | 35,147 | 27,381 | 62,528 | 55,684 | 6,844 |\\n| April 11, 2016 | — | 5,625 | 5,625 | 2,815 | 2,293 | 517 |\\n| March 23, 2017 | 30,681 | 32,463 | 63,144 | 46,919 | 16,225 |\\n| August 29, 2017 | — | 7,394 | 7,394 | 3,698 | 3,696 |\\n| January 2, 2018 | 29,393 | — | 29,393 | 29,393 | — |\\n| April 12, 2018 | — | 29,596 | 29,596 | — | 29,596 |\\n| April 13, 2018 | — | 14,669 | 14,669 | — | 14,669 |\\n| July 6, 2018 | — | 932 | 932 | — | — | 932 |\\n| November 7, 2018 | 23,010 | — | 23,010 | — | 23,010 |\\n| March 13, 2019 | — | 24,366 | 24,366 | — | 24,366 |\\n| March 14, 2019 | — | 23,327 | 23,327 | — | 23,327 |\\n| Total | 118,231 | 165,753 | 283,984 | 138,509 | 144,026 | 1,449 |\\n\\n\\nRSU awards to management vest 25% at the end of each year for 4 years. Prior to November 7, 2018, RSU awards to directors vested 100% in January of the following year in which such RSUs were granted. At the November 7, 2018 Board meeting, it was determined that it would be more appropriate for the vesting of RSUs to align with the directors’ term of office. Accordingly, the RSUs granted on November 7, 2018, will vest upon the earlier of (i) the first anniversary of grant and (ii) the date of the next annual meeting of stockholders. This means that on the date of the annual meeting of stockholders on May 7, 2019, the RSUs granted to directors on November 7, 2018 vested. Due to the fact that the Company has moved up its annual meeting of stockholders from November to May this year, this created a shorter than normal vesting period for the RSUs issued on November 7, 2018. In order to adjust for this factor, the directors have determined that the award of RSUs to be made immediately following the 2019 Annual Meeting of Stockholders will be $35,000 or one half of last year's annual grant. For the quarter ended March 31, 2019 and 2018, we recorded compensation expense of $209,000 and $294,000, respectively. The total unrecognized compensation expense related to the non-vested RSUs was $1.9 million as of March 31, 2019, which we expect to recognize over a weighted average vesting period of 1.1 years.\\n\\nStock Repurchase Program\\n\\nOn March 2, 2017, the Company's Board of Directors authorized management, at its discretion, to spend up to an aggregate of $25.0 million to acquire shares of Reading’s Class A Common Stock. The previously approved stock repurchase program, which allowed management to spend up to an aggregate of $10.0 million to acquire shares of Reading’s Class A Common Stock, was completed as of December 31, 2016. On March 14, 2019, the Board of Directors extended this stock buy-back program for two years, through March 2, 2021. The Board of Directors did not increase the authorized amount which was $16.2 million at March 31, 2019.\\n\\nThe repurchase program allows Reading to repurchase its shares in accordance with the requirements of the SEC on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. All purchases are subject to the availability of shares at prices that are acceptable to Reading, and accordingly, no assurances can be given as to the timing or number of shares that may ultimately be acquired pursuant to this authorization.\\n\\nUnder the stock repurchase program, as of March 31, 2019, the Company has reacquired 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs) to-date. 566 shares of Class A Common Stock were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019.\\n\\n22\\nNote 16 - Leases\\n\\nIn all leases, whether we are the lessor or lessee, we define lease term as the non-cancellable term of the lease plus any renewals covered by renewal options that are reasonably certain of exercise based on our assessment of economic factors relevant to the lessee. The non-cancellable term of the lease commences on the date the lessor makes the underlying property in the lease available to the lessee, irrespective of when lease payments begin under the contract.\\n\\nAs Lessee\\n\\nWe have operating leases for certain cinemas and corporate offices, and finance leases for certain equipment assets. Our leases have remaining lease terms of 1 to 20 years, with certain leases having options to extend to up to a further 20 years.\\n\\nContracts are analyzed in accordance with the criteria set out in ASC 842 to determine if there is a lease present. For contracts that contain an operating lease, we account for the lease component and the non-lease component together as a single component. For contracts that contain a finance lease we account for the lease component and the non-lease component separately in accordance with ASC 842.\\n\\nIn leases where we are the lessee, we recognize a right of use asset and lease liability at lease commencement, which is measured by discounting lease payments using our incremental borrowing rate applicable to the lease term and currency of the lease as the discount rate. Subsequent amortization of the right of use asset and accretion of the lease liability for an operating lease is recognized as a single lease cost, on a straight line basis, over the term of the lease. A finance lease right-of-use asset is depreciated on a straight line basis over the lesser of the useful life of the leased asset or the lease term. Interest on each finance lease liability is determined as the amount that results in a constant periodic discount rate on the remaining balance of the liability. Property taxes and other non-lease costs are accounted for on an accrual basis.\\n\\nLease payments for our cinema operating leases consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics.\\nThe components of lease expense were as follows:\\n\\n\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Lease cost |\\n| Finance lease cost: | — |\\n| Amortization of right-of-use assets | $ | 41 | $ | — |\\n| Interest on lease liabilities | 3 | — |\\n| Operating lease cost | 7,921 | — |\\n| Variable lease cost | 105 | — |\\n| Total lease cost | $ | 8,070 | $ | — |\\n\\n\\n\\nSupplemental cash flow information related to leases was as follows:\\n\\n\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Cash flows relating to lease cost |\\n| Cash paid for amounts included in the measurement of lease liabilities: |\\n| Operating cash flows from finance leases | $ | 44 | $ | — |\\n| Operating cash flows from operating leases | 7,780 | — |\\n| Right-of-use assets obtained in exchange for new finance lease liabilities | — | — |\\n| Right-of-use assets obtained in exchange for new operating lease liabilities | 2,181 | — |\\n\\n23\\n\\n\\n\\nSupplemental balance sheet information related to leases was as follows:\\n\\n\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Operating leases |\\n| Operating lease right-of-use assets | $ | 229,266 | $ | — |\\n| Operating lease liabilities - current portion | 19,797 | — |\\n| Operating lease liabilities - non-current portion | 222,594 | — |\\n| Total operating lease liabilities | $ | 242,391 | $ | — |\\n| Finance leases |\\n| Property plant and equipment, gross | 372 | — |\\n| Accumulated depreciation | (41) | — |\\n| Property plant and equipment, net | $ | 331 | $ | — |\\n| Other current liabilities | 162 | — |\\n| Other long-term liabilities | 169 | — |\\n| Total finance lease liabilities | $ | 331 | $ | — |\\n| |\\n| Other information |\\n| Weighted-average remaining lease term - finance leases | 3 | — |\\n| Weighted-average remaining lease term - operating leases | 11 | — |\\n| Weighted-average discount rate - finance leases | 5.05% | — |\\n| Weighted-average discount rate - operating leases | 4.97% | — |\\n\\n\\n\\nMaturity of leases were as follows:\\n\\n\\n| |\\n| (Dollars in thousands) | Operating leases | Finance leases |\\n| 2019 | $ | 23,566 | $ | 133 |\\n| 2020 | 31,434 | 101 |\\n| 2021 | 31,717 | 53 |\\n| 2022 | 31,901 | 43 |\\n| 2023 | 31,018 | 28 |\\n| Thereafter | 169,221 | — |\\n| Total lease payments | $ | 318,857 | $ | 358 |\\n| Less imputed interest | (76,466) | (27) |\\n| Total | $ | 242,391 | $ | 331 |\\n\\n\\n\\nAs of March 31, 2019, we have additional operating leases, primarily for cinemas, that have not yet commenced of approximately $26.0 million. These operating leases will commence between fiscal year 2019 and fiscal year 2021 with lease terms of 15 to 20 years.\\n\\nAs Lessor\\n\\nThe Company has entered into various leases as a lessor for our owned real estate properties. These leases vary in length between 1 and 20 years, with certain leases containing options to extend at the behest of the applicable tenants. Lease components consist of fixed base rent, and for certain leases, variable lease payments consisting of contracted percentages of revenue, changes in the relevant CPI, and/or other contracted financial metrics. No terms exist by which a lessee is able to purchase the underlying asset.\\n\\nWe recognize lease payments for operating leases as property revenue on a straight-line basis over the lease term. Lease incentive payments we make to lessees are amortized as a reduction in property revenue over the lease term.\\n24\\nLease income relating to operating lease payments was as follows:\\n\\n\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Components of lease income |\\n| Lease payments | $ | 2,229 | $ | 2,423 |\\n| Variable lease payments | 265 | 80 |\\n| Total lease income | $ | 2,494 | $ | 2,503 |\\n\\n\\n\\nThe book value of underlying assets under operating leases from owned assets was as follows:\\n\\n\\n| |\\n| | March 31, | December 31, |\\n| (Dollars in thousands) | 2019 | 2018 |\\n| Building and improvements |\\n| Gross balance | $ | 68,483 | $ | 67,887 |\\n| Accumulated depreciation | (18,375) | (17,709) |\\n| Net Book Value | $ | 50,108 | $ | 50,178 |\\n\\n\\n\\n\\nMaturity of leases were as follows:\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n| |\\n| (Dollars in thousands) | Operating leases |\\n| 2019 | $ | 6,470 |\\n| 2020 | 7,439 |\\n| 2021 | 6,830 |\\n| 2022 | 5,961 |\\n| 2023 | 5,187 |\\n| Thereafter | 10,295 |\\n| Total | $ | 42,182 |\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\nNote 17 – Hedge Accounting\\n\\nAs of March 31, 2019 and March 31, 2018, the Company held interest rate derivatives in the total notional amount of $8.0 million and $nil, respectively.\\n\\nThe derivatives are recorded on the balance sheet at fair value and are included in the following line items:\\n\\n\\n| |\\n| | Liability Derivatives |\\n| | March 31, | December 31, |\\n| | 2019 | 2018 |\\n| (Dollars in thousands) | Balance sheet location | Fair value | Balance sheet location | Fair value |\\n| Interest rate contracts | Derivative financial instruments - current portion | $ | 52 | Derivative financial instruments - current portion | $ | 41 |\\n| | Derivative financial instruments - non-current portion | 203 | Derivative financial instruments - non-current portion | 145 |\\n| Total derivatives designated as hedging instruments | $ | 255 | $ | 186 |\\n| Total derivatives | $ | 255 | $ | 186 |\\n\\n\\n\\n\\n\\n25\\n\\n\\nWe have no derivatives designated as hedging instruments which are in asset positions.\\n\\nThe changes in fair value are recorded in Other Comprehensive Income and released into interest expense in the same period(s) in which the hedged transactions affect earnings. In the quarter to March 31, 2019 and March 31, 2018, respectively, the derivative instruments affected Comprehensive Income as follows:\\n\\n\\n\\n| |\\n| (Dollars in thousands) | Location of Loss Recognized in Income on Derivatives | Amount of Loss Recognized in Income on Derivatives |\\n| | 2019 | 2018 |\\n| Interest rate contracts | Interest expense, net | $ | 12 | $ | — |\\n| Total | $ | 12 | $ | — |\\n\\n\\n\\n| |\\n| | Loss Recognized in OCI on Derivatives (Effective Portion) | Loss Reclassified from OCI into Income (Effective Portion) | Loss Recognized in Income on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing) |\\n| (Dollars in thousands) | Amount | Line Item | Amount | Line Item | Amount |\\n| | 2019 | 2018 | 2019 | 2018 | 2019 | 2018 |\\n| Interest rate contracts | $ | 81 | $ | — | Interest expense, net | $ | 12 | $ | — | Interest expense, net | $ | — | $ | — |\\n| Total | $ | 81 | $ | — | $ | 12 | $ | — | $ | — | $ | — |\\n\\n\\n\\nNote 18 – Fair Value Measurements\\n\\nASC 820, Fair Value Measurement establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The statement requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:\\n| · | Level 1: Quoted market prices in active markets for identical assets or liabilities; |\\n\\n| · | Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and, |\\n\\n| · | Level 3: Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. |\\n\\nAs of March 31, 2019 and December 31, 2018 material financial assets and financial liabilities were carried and measured at fair value on a recurring basis.\\n\\nThe following tables summarize our financial liabilities that are carried at cost and measured at fair value on a non-recurring basis as of March 31, 2019 and December 31, 2018, by level within the fair value hierarchy.\\n\\n\\n| |\\n| |\\n| | Fair Value Measurement at March 31, 2019 |\\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\\n| Notes payable | $ | 155,855 | $ | — | $ | — | $ | 159,871 | $ | 159,871 |\\n| Subordinated debt | 27,913 | — | — | 19,162 | 19,162 |\\n| | $ | 183,768 | $ | — | $ | — | $ | 179,033 | $ | 179,033 |\\n\\n\\n\\n| |\\n| |\\n| | Fair Value Measurement at December 31, 2018 |\\n| (Dollars in thousands) | CarryingValue(1) | Level 1 | Level 2 | Level 3 | Total |\\n| Notes payable | $ | 139,130 | $ | — | $ | — | $ | 143,564 | $ | 143,564 |\\n| Subordinated debt | 27,913 | — | — | 18,895 | 18,895 |\\n| | $ | 167,043 | $ | — | $ | — | $ | 162,459 | $ | 162,459 |\\n\\n\\n| (1) | These balances are presented before any deduction for deferred financing costs. |\\n\\n26\\n\\nFollowing is a description of the valuation methodologies used to estimate the fair value of our financial assets and liabilities. There have been no changes in the methodologies used at March 31, 2019 and December 31, 2018.\\n| · | Level 1 investments in marketable securities primarily consist of investments associated with the ownership of marketable securities in U.S. and New Zealand. These investments are valued based on observable market quotes on the last trading date of the reporting period. |\\n\\n| · | Level 2 derivative financial instruments are valued based on discounted cash flow models that incorporate observable inputs such as interest rates and yield curves from the derivative counterparties. The credit valuation adjustments associated with our non-performance risk and counterparty credit risk are incorporated in the fair value estimates of our derivatives. As of March 31, 2019 and December 31, 2018, we concluded that the credit valuation adjustments were not significant to the overall valuation of our derivatives. |\\n\\n| · | Level 3 borrowings include our secured and unsecured notes payable, trust preferred securities and other debt instruments. The borrowings are valued based on discounted cash flow models that incorporate appropriate market discount rates. We calculated the market discount rate by obtaining period-end treasury rates for fixed-rate debt, or LIBOR for variable-rate debt, for maturities that correspond to the maturities of our debt, adding appropriate credit spreads derived from information obtained from third-party financial institutions. These credit spreads take into account factors such as our credit rate, debt maturity, types of borrowings, and the loan-to-value ratios of the debt. |\\n\\n\\nThe Company’s financial instruments also include cash, cash equivalents, receivables and accounts payable. The carrying values of these financial instruments approximate the fair values due to their short maturities. Additionally, there were no transfers of assets and liabilities between levels 1, 2, or 3 during the quarter ended March 31, 2019 and March 31, 2018.\\nNote 19 – Business Combination\\n\\nOn January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019.\\n\\nThe total purchase price was allocated to the identifiable assets acquired based on our preliminary estimates of their fair values on the acquisition date. There were no liabilities assumed. As of March 31, 2019, the Company is still finalizing its allocation and this may result in potential adjustments within the one-year measurement period from acquisition date. The determination of the fair values of the acquired assets (and the related determination of their estimated lives) requires significant judgment.\\n\\nOur preliminary purchase price allocation is as follows:\\n\\n\\n| |\\n| | Preliminary Purchase Price |\\n| | Allocation |\\n| (Dollars in thousands) | US Dollars(1) | AU dollars |\\n| Tangible Assets |\\n| Operating property: |\\n| Fixtures and equipment | $ | 153 | $ | 213 |\\n| Intangible Assets |\\n| Goodwill | 1,248 | 1,734 |\\n| Total assets acquired | 1,401 | 1,947 |\\n| |\\n| Net assets acquired | $ | 1,401 | $ | 1,947 |\\n\\n\\n| (1) | The balances were translated into U.S. Dollars based on the applicable exchange rate as of the date of acquisition, January 30, 2019. |\\n\\n\\n\\n\\n\\n27\\nThis MD&A should be read in conjunction with the accompanying unaudited consolidated financial statements included in Part I, Item 1 (Financial Statements). The foregoing discussions and analyses contain certain forward-looking statements. Please refer to the “Forward Looking Statements” included at the conclusion of this section and our “Risk Factors” set forth in our 2018 Form 10-K, Part 1, Item 1A and the Risk Factors set out below.\\n\\n\\nItem 2 – Management’s Discussions and Analysis (“MD&A”) of Financial Condition and Results of Operations\\n\\nBUSINESS OVERVIEW\\n\\nWe are an internationally diversified company principally focused on the development, lease or ownership, and operation of entertainment and real estate assets in the United States, Australia, and New Zealand. As of March 31, 2019, we operate in two business segments:\\n| · | Cinema exhibition, through our 60 multiplex cinemas; and, |\\n\\n| · | Real estate, including real estate development and the rental of retail, commercial and live theatre assets. |\\n\\n\\nWe believe that these two business segments complement one another, as we can use the comparatively consistent cash flows generated by our cinema operations to fund the front-end cash demands of our real estate development business.\\n\\nCinema Exhibition\\nWe manage our worldwide cinema exhibition businesses under various brands:\\n| · | in the U.S., under the following brands: Reading Cinemas, Angelika Film Centers, Consolidated Theatres, and City Cinemas; |\\n\\n| · | in Australia, under the Reading Cinemas brand; and, |\\n\\n| · | in New Zealand, under the Reading Cinemas and Rialto Cinemas brands. |\\n\\n\\nShown in the following table are the number of locations and theater screens in our theater circuit in each country, by state/territory/ region and indicating our cinema brands and our interest in the underlying assets as of March 31, 2019:\\n\\n\\n| |\\n| |\\n| | State / Territory / | Location | Screen | Interest in AssetUnderlying the Cinema |\\n| Country | Region | Count | Count | Leased | Owned | Operating Brands |\\n| United States | Hawaii | 9 | 98 | 9 | Consolidated Theatres |\\n| | California | 7 | 88 | 7 | Reading Cinemas, Angelika Film Center |\\n| | New York(3) | 6 | 23 | 5 | 1 | Angelika Film Center, City Cinemas |\\n| | Texas | 2 | 13 | 2 | Angelika Film Center |\\n| | New Jersey | 1 | 12 | 1 | Reading Cinemas |\\n| | Virginia | 1 | 8 | 1 | Angelika Film Center |\\n| | Washington DC | 1 | 3 | 1 | Angelika Film Center |\\n| | U.S. Total | 27 | 245 | 26 | 1 |\\n| Australia | New South Wales | 6 | 44 | 4 | 2 | Reading Cinemas |\\n| | Victoria | 6 | 43 | 6 | Reading Cinemas |\\n| | Queensland | 5 | 50 | 2 | 3 | Reading Cinemas, Event Cinemas(1) |\\n| | Western Australia | 2 | 16 | 1 | 1 | Reading Cinemas |\\n| | South Australia | 2 | 15 | 2 | Reading Cinemas |\\n| | Tasmania | 1 | 4 | 1 | Reading Cinemas |\\n| | Australia Total | 22 | 172 | 16 | 6 |\\n| New Zealand | Wellington | 2 | 15 | 1 | 1 | Reading Cinemas |\\n| | Otago | 3 | 15 | 2 | 1 | Reading Cinemas, Rialto Cinemas(2) |\\n| | Auckland | 2 | 15 | 2 | Reading Cinemas, Rialto Cinemas(2) |\\n| | Canterbury | 1 | 8 | 1 | Reading Cinemas |\\n| | Southland | 1 | 5 | 1 | Reading Cinemas |\\n| | Bay of Plenty | 1 | 5 | 1 | Reading Cinemas |\\n| | Hawke's Bay | 1 | 4 | 1 | Reading Cinemas |\\n| | New Zealand Total | 11 | 67 | 6 | 5 |\\n| GRAND TOTAL | 60 | 484 | 48 | 12 |\\n\\n\\n| (1) | The Company has a 33.3% unincorporated joint venture interest in a 16-screen cinema located in Mt. Gravatt, Queensland managed by Event Cinemas. |\\n\\n| (2) | The Company is a 50% joint venture partner in two (2) New Zealand Rialto cinemas. We are responsible for the booking of these cinemas and our joint venture partner, Event Cinemas, manages their day-to-day operations. |\\n\\n| (3) | Our New York statistics include one (1) managed cinema, with a four-screen total. |\\n\\n\\n28\\nReal Estate\\nWe engage in real estate development and the ownership, and rental or licensing to third parties of retail, commercial and live theater assets. We own the fee interests in all three of our live theaters, and in 12 of our cinemas (as presented in the preceding table). Our real estate business creates long-term value for our stockholders through the continuous improvement and development of our investment and operating properties, including our entertainment-themed centers (“ETCs”).\\n\\nOur real estate activities have historically consisted principally of:\\n| · | the ownership of fee or long-term leasehold interests in properties used in our cinema exhibition activities or which were acquired for the development of cinemas or cinema-based real estate development projects; |\\n\\n| · | the acquisition and development of fee interests in land; |\\n\\n| · | the licensing to production companies of the use of our live theatres; and, |\\n\\n| · | the redevelopment of our existing fee-owned cinema or live theatre sites to their highest and best use. |\\n\\n\\nCinema Exhibition\\nOur cinema revenue consists primarily of admissions, Food & Beverage (“F&B”), advertising and theater rentals. Cinema operating expense consists of the costs directly attributable to the operation of the cinemas, including film rent expense, operating costs, and occupancy costs. Cinema revenue and expense fluctuate with the availability of quality first run films and the numbers of weeks such first run films stay in the market. For a breakdown of our current cinema assets that we own and/or manage, please see Part I, Item 1 – Our Business of our 2018 Form 10-K.\\n\\nWhile our capital projects in recent years have been focused in growing our real estate segment, we have over the past two years placed special emphasis on the expansion and upgrading of our cinema exhibition portfolio, as discussed below:\\n\\nCinema Additions (including re-openings)\\nThe latest additions and enhancements to our cinema portfolio are as follows:\\n| · | Opening our first dine-in concept, “Spotlight” in the United States: On March 30, 2018 we finished the conversion of one wing (six auditoriums) at our Reading Cinema in Murrieta, California (Cal Oaks) to our dine-in concept brand, “Spotlight”. |\\n\\n| · | AU and NZ Additions/Refurbishments On January 30, 2019, we purchased the tenant’s interest and other operating assets of an established four-screen cinema in Devonport, Tasmania, Australia, for $1.4 million (AU$1.95 million). We commenced trading from this new cinema site on January 30, 2019. For the first quarter of 2019, we invested in two additional Gold Lounge auditoriums at our Harbour Town cinema. In 2017 and 2018, we improved eight theaters: Belmont, Rouse Hill, Courtenay Central, Napier, Charlestown, Elizabeth, Auburn and Rotorua. |\\n\\n| · | U.S. Refurbishments For the first quarter of 2019, we continued investing in refurbishments primarily at our Mililani cinema. During 2017 and 2018, we continued to invest in the refurbishment and enhancements of our existing cinemas, as contemplated by our strategic plan. During this period, seven locations had significant refurbishment work performed: our Cal Oaks, Valley Plaza and Grossmont locations in California; our Ward, Pearlridge and Mililani locations in Hawaii; and our Manville location in New Jersey. Continuing with our strategic plan, since 2017, we converted (or are in the process of conversion), 74 of our 245 U.S. auditoriums to luxury recliner seating. |\\n\\nCinema Pipeline\\nDuring 2019, we currently plan to upgrade or begin the upgrade of 11 cinemas in the U.S., Australia, and New Zealand.\\n\\nWe have entered into lease agreements for four new cinemas in Australia (25 screens), which we anticipate will come on line in 2019 - 2021.\\n\\nOur focus with respect to new cinemas is on featuring state-of-the-art projection and sound, luxury recliner seating, enhanced F&B (typically including alcohol service) and typically at least one major TITAN type presentation screen. Our focus is on providing best in class services and amenities that will differentiate us from in-home and mobile viewing options. We believe that a night at the movies should be a special and premium experience and, indeed, that it must be in order to compete with the variety of options being offered to consumers through other platforms.\\n\\nThroughout 2019, we will also be focusing on the rollout and enhancement of our proprietary on-line ticketing capabilities and social media interfaces. These are intended to enhance the convenience of our offering and to promote customer affinity with the experience and product that we are offering.\\n\\n29\\nCinema Closures\\nWe evaluate the performance of each of our cinemas and, in some instances, we may decide to close an operation when it is not economically viable to continue to operate from the location. We did not close any theaters leased from third parties in 2018 or to date in 2019. While some of our theaters have encountered new competition, and while we believe that others will benefit from planned refurbishment and upgrading, none of our leased theaters are currently slated for closure.\\n\\nDuring January 2019, we closed our Courtenay Central cinema in Wellington, New Zealand due to seismic concerns. We are currently assessing the redevelopment of that property. It is currently anticipated that the cinema component will be upgraded and restored in connection with any such redevelopment.\\n\\nUpgrades to our Film Exhibition Technology and Theatre Amenities\\nWe continue to focus in areas of the matured cinema business where we believe we have growth potential and ultimately, provide long-term value to our stockholders. These are (i) upgrading of our existing cinemas and (ii) developing new cinemas to provide our customers with premium offerings, including state-of-the-art presentation (including sound, lounges and bar service) and luxury seating. As of March 31, 2019, the upgrades to our theater circuits’ film exhibition technology and amenities are summarized in the following table:\\n\\n| |\\n| |\\n| | LocationCount | ScreenCount |\\n| Screen Format |\\n| Digital (all cinemas in our theatre circuit) | 60 | 484 |\\n| IMAX | 1 | 1 |\\n| TITAN XC and LUXE | 18 | 20 |\\n| Dine-in Service |\\n| Gold Lounge (AU/NZ)(1) | 10 | 27 |\\n| Premium (AU/NZ)(2) | 11 | 21 |\\n| Spotlight (U.S.)(3) | 1 | 6 |\\n| Upgraded Food & Beverage menu (U.S.)(4) | 14 | n/a |\\n| Premium Seating (recliner seating features) | 22 | 142 |\\n| Liquor Licenses Obtained(5) | 28 | n/a |\\n\\n| (1) | Gold Lounge: This is our \\\"First Class Full Dine-in Service\\\" in our Australian and New Zealand cinemas, which includes upgraded F&B menu (with alcoholic beverages), luxury recliner seating features (intimate 25-50 seat cinemas) and waiter service. |\\n\\n| (2) | Premium Service: This is our \\\"Business Class Dine-in Service\\\" in our Australian and New Zealand cinemas, which typically includes upgraded F&B menu (some with alcoholic beverages) and may include luxury recliner seating features (less intimate 80-seat cinemas), but no waiter service. |\\n\\n| (3) | Spotlight Service: On March 30, 2018 we opened “Spotlight” our first dine-in cinema concept in the United States at Cal Oaks. Six of our 17 auditoriums at this theater feature this dine-in concept. |\\n\\n| (4) | Upgraded Food & Beverage Menu: Fourteen of our US theaters feature an elevated food and beverage menu served from a common counter, which includes, without limitation, beer, wine and/or spirits and a food menu beyond traditional concessions. We have worked with former Food Network executives to create a menu of locally inspired and freshly prepared items. |\\n\\n| (5) | Liquor Licenses: Licenses are applicable at each cinema location, rather than each theatre auditorium. For accounting purposes, we capitalize the cost of successfully purchasing or applying for liquor licenses meeting certain thresholds as an intangible asset due to long-term economic benefits derived on future sales of alcoholic beverages. |\\n\\n\\nReal Estate\\nOur operating properties currently consists of the following assets:\\n| · | our Newmarket, Queensland ETC, our Belmont, Western Australia ETC, our Auburn, New South Wales ETC, our Townsville, Queensland ETC and our Wellington, New Zealand ETC; and, |\\n\\n| · | two (2) single-auditorium live theatres in Manhattan (Minetta Lane and Orpheum) and a four-auditorium live theater complex (including the accompanying ancillary retail and commercial tenants) in Chicago (The Royal George); and, |\\n\\n| · | our US Headquarters building in Culver City, California and our Australia corporate office building in Melbourne, Australia; and, |\\n\\n| · | the ancillary retail and commercial space at some of our non-ETC cinema properties. |\\n\\n\\nIn February 2018, we entered into a one-year license agreement with Audible, Inc. a subsidiary of Amazon, at the Minetta Lane Theatre. This agreement was extended through March 2020, with an option to extend for one additional year through March 2021. Audible intends to continue to produce one to two character plays and special engagements for live performance, to record those productions making them available through Audible streaming service.\\n\\nIn addition, we have various parcels of unimproved real estate held for development in Australia and New Zealand and certain unimproved land in the United States, including some that was used in our legacy activities.\\n30\\n\\nOur key real estate transactions in recent years are as follows:\\n\\nStrategic Acquisitions\\n| · | Purchase of Land at Cannon Park, Australia. On June 13, 2018, we acquired a 163,000 square foot (15,150 square meter) parcel at our Cannon Park ETC, in connection with the restructuring of our relationship with the adjacent land owner. Prior to the restructuring, this parcel was commonly owned by us and the adjoining land owner. In the restructuring, the adjoining land owner conveyed to us its interest in the parcel for AU$1. We granted the adjoining land owner certain access rights. |\\n\\n| · | Purchase of Property in Auburn, Australia – On June 29, 2018, we added 20,870 square feet of land, improved with a 16,830 office building, to our Auburn/Redyard ETC. The property was acquired at auction for $3.5 million (AU$4.5 million) and is bordered by our existing ETC on three sides. The property is leased to Telstra through July 2022. This will allow us time to plan for the efficient integration of the property into our ETC. The final settlement payment was made in early October 2018. |\\n\\n\\nValue-creating Opportunities\\nWe are engaged in several real estate development projects to take our properties to their highest and best use. The most notable of these value-creating projects are as follows:\\n| · | Redevelopment of 44 Union Square Property in New York, USA. We secured construction financing for our 44 Union Square property in December 2016 and have entered into a guaranteed maximum price construction management agreement with an affiliate of CNY. We anticipate that the project will be ready for the commencement of tenant fit-out in the second quarter of 2019. Retail and office leasing interest to date has been strong and, while no assurances can be given, we are currently in exclusive negotiations with respect to long-term leases covering approximately 90% of the net rentable area of the building. This redevelopment will add approximately 23,000 square footage of rentable space to the current square footage of the building for an approximate total of 73,322 square feet of rentable space, inclusive of anticipated BOMA (Building Owners and Managers Association) adjustments and subject to lease negotiations and the final tenant mix. |\\n\\n| · | Expansion Project for our Newmarket Shopping Center at an affluent suburb of Brisbane, Australia. In December 2017 we opened our eight-screen Reading Cinema with TITAN LUXE, including 10,355 square feet of additional retail space and 124 parking spaces. As of March 31, 2019, approximately 80% of this new retail space has been leased. |\\n\\n| · | Courtenay Central Re-Development in Wellington, New Zealand. – Located in the heart of Wellington - New Zealand’s capital city – this center is comprised of 161,071 square feet of land situated proximate to the Te Papa Tongarewa Museum (attracting over 1.5 million visitors annually), across the street from the site of Wellington’s newly announced convention center (estimated to open its doors in 2022) and at a major public transit hub. Damage from the 2016 earthquake necessitated demolition of our nine-story parking garage at the site. Further, unrelated seismic issues have caused us to close the existing cinema and significant portions of the retail structure while we reevaluate the property for redevelopment as an entertainment themed urban center with a major food and grocery component. Wellington continues to be rated as one of the top cities in the world in which to live, and we continue to believe that the Courtenay Central site is located in one of the most vibrant and growing commercial and entertainment precincts of Wellington. |\\n\\n\\n31\\n\\n| § | Cinema 1,2,3 Redevelopment – In June 2017, we entered into an exclusive dealing and pre-development agreement with our adjoining neighbors, 260-264 LLC, to jointly develop the properties, currently home to Cinemas 1,2,3 and Anassa Taverna. Under the terms of the agreement, Reading and 260-264 LLC worked together on a comprehensive mixed-use plan to co-develop the properties located on 3rd Avenue, between 59th Street and 60th Streets, in New York City. The parties completed an initial feasibility study, analyzing various retail, entertainment and residential uses for the site and during 2018 continued to work on the terms of a final agreement for the development of the combined property. We do not presently believe that we will be able to come to an agreement with our neighbors for a joint development of our properties and, have, accordingly, begun developing plans for an approximately 96,000 square foot mixed use stand-alone development. Our Cinemas 1,2,3, property is located on Third Avenue in New York City, between 59th and 60th Streets across from Bloomingdales. |\\n\\n| · | Manukau Land Rezoning – In August 2016, the Auckland City Council up-zoned 64.0 acres of our property in Manukau from agricultural to light industrial use. The remaining 6.4 acres were already zoned for heavy industrial use. Our zoning enhancement goal having been achieved, in 2018, we worked with adjoining landholders to jointly advance necessary infrastructure improvement issues. We estimate that our property will support approximately 1.6 million square feet of improvements. We see this property as a future value realization opportunity for us. This tract is adjacent to the Auckland Airport, which is currently undergoing a major improvement and expansion project. |\\n\\n\\nCorporate Matters\\n\\n| § | Stock Repurchase Program – Our Board approved a $25-million repurchase program approved on March 2, 2017, and extended on March 14, 2019, and extended it on March 14, 2019. Under this authorization Reading may repurchase its Class A Common Stock from time to time in accordance with the requirements of the Securities and Exchange Commission on the open market, in block trades and in privately negotiated transactions, depending on market conditions and other factors. The new authorization continues through March 2, 2021. To date we have repurchased 559,627 shares of Class A Common Stock for $8.8 million at an average price of $15.81 per share (excluding transaction costs). 566 shares were purchased during the quarter ended March 31, 2019 at an average price of $16.08 per share. This leaves $16.2 million available under the March 2, 2017 program, as extended, for repurchase as of March 31, 2019. |\\n\\n\\nOur Financing Strategy\\n\\nOur treasury management is focused on cash management using cash balances to reduce debt. We have used cash generated from operations and other excess cash, to the extent not needed for capital expenditures, to pay down our loans and credit facilities providing us flexibility on our available loan facilities for future use and, thereby, reducing interest charges. On a periodic basis, we review the maturities of our borrowing arrangements and negotiate for renewals and extensions where necessary in the current circumstances.\\n\\nOn March 15, 2019, we amended our Revolving Corporate Markets Loan Facility with National Australia Bank (“NAB”) from a facility comprised of (i) a AU$66.5 million loan facility with an interest rate of 0.95% above the Bank Bill Swap Bid Rate (“BBSY”) and a maturity date of June 30, 2019 and (ii) a bank guarantee of AU$5.0 million at a rate of 1.90% per annum into a (i) AU$120.0 million corporate loan facility at rates of 0.85%-1.30% above BBSY depending on certain ratios with a due date of December 31, 2023, of which AU$80.0 million is revolving and AU$40.0 million is core and (ii) a bank guarantee facility of AU$5.0 million at a rate of 1.85% per annum. Prior to this, on June 12, 2018, we had extended the maturity of these facilities from June 30, 2019, to December 31, 2019. Such modifications of this particular term loan were not considered to be substantial under US GAAP.\\n\\nOn December 20, 2018, we restructured our Westpac Corporate Credit Facilities. The maturity of the 1st tranche (general/non-construction credit line) was extended to December 31, 2023, with the available facility being reduced from NZ$35.0 million to NZ$32.0 million. The facility bears an interest rate of 1.75% above the Bank Bill Bid Rate on the drawn down balance and a 1.1% line of credit charge on the entire facility. The 2nd tranche (construction line) with a facility of NZ$18.0 million was removed.\\n\\nOn March 5, 2019, we extended our current Bank of America credit facilities until May 1, 2020 (the $55.0 million credit line). We anticipate refinancing this credit line during the second quarter of 2019.\\n\\nRefer to our 2018 Form 10-K for more details on our cinema and real estate segments.\\n32\\nRESULTS OF OPERATIONS\\n\\nThe table below summarizes the results of operations for each of our principal business segments along with the non-segment information for the three months ended March 31, 2019 and March 31, 2018:\\n\\n\\n| |\\n| | Three Months Ended | % Change |\\n| (Dollars in thousands) | March 31,2019 | March 31,2018 | Fav/(Unfav) |\\n| SEGMENT RESULTS |\\n| | Revenue |\\n| | Cinema exhibition | $ | 57,986 | $ | 72,255 | (20) | % |\\n| | Real estate | 5,431 | 6,008 | (10) | % |\\n| | Inter-segment elimination | (1,866) | (2,391) | 22 | % |\\n| | Total revenue | 61,551 | 75,872 | (19) | % |\\n| | Operating expense |\\n| | Cinema exhibition | (50,195) | (57,339) | 12 | % |\\n| | Real estate | (2,445) | (2,384) | (3) | % |\\n| | Inter-segment elimination | 1,866 | 2,391 | (22) | % |\\n| | Total operating expense | (50,774) | (57,332) | 11 | % |\\n| | Depreciation and amortization |\\n| | Cinema exhibition | (4,157) | (3,765) | (10) | % |\\n| | Real estate | (1,376) | (1,369) | (1) | % |\\n| | Total depreciation and amortization | (5,533) | (5,134) | (8) | % |\\n| | General and administrative expense |\\n| | Cinema exhibition | (992) | (866) | (15) | % |\\n| | Real estate | (451) | (574) | 21 | % |\\n| | Total general and administrative expense | (1,443) | (1,440) | - | % |\\n| | Segment operating income |\\n| | Cinema exhibition | 2,642 | 10,285 | (74) | % |\\n| | Real estate | 1,159 | 1,681 | (31) | % |\\n| | Total segment operating income | $ | 3,801 | $ | 11,966 | (68) | % |\\n| NON-SEGMENT RESULTS |\\n| | Depreciation and amortization expense | (61) | (117) | 48 | % |\\n| | General and administrative expense | (5,041) | (6,156) | 18 | % |\\n| | Interest expense, net | (1,852) | (1,594) | (16) | % |\\n| | Equity earnings of unconsolidated joint ventures | 34 | 257 | (87) | % |\\n| | Other income (expense) | (20) | (82) | 76 | % |\\n| | Income before income taxes | (3,139) | 4,274 | (> 100) | % |\\n| | Income tax benefit (expense) | 1,042 | (1,170) | > 100 | % |\\n| Net income (loss) | (2,097) | 3,104 | (> 100) | % |\\n| | Less: net (income) loss attributable to noncontrolling interests | (16) | 22 | (> 100) | % |\\n| Net income (loss) attributable to RDI common stockholders | $ | (2,081) | $ | 3,082 | (> 100) | % |\\n| Basic EPS | $ | (0.09) | $ | 0.13 | (> 100) | % |\\n\\n“nm – not meaningful”\\nConsolidated and Non-Segment Results:\\n\\n1st Quarter Net Results\\n\\nNet income attributable to RDI common stockholders decreased by $5.2 million to a $(2.1) million loss. Basic EPS for the quarter ended March 31, 2019 decreased by $0.22 to $(0.09) from the prior-year quarter, mainly attributable to decreases in revenue in both the Cinema and Real Estate business segments.\\n\\nRevenue for the three months ended March 31, 2019 decreased by 19%or $14.3 million, to $61.6 million compared to the same period prior year. The revenue decrease was due to a decrease in revenues from our cinema business primarily due to the weak film slate experienced by the Cinema business segment worldwide, the closure of our cinema in Courtenay Central due to seismic concerns, and a decrease in revenues from the Real Estate business segment primarily due to the closure of most of the net rentable area of Courtenay Central due to seismic concerns. Overseas revenues were also adversely impacted by the continued weakness of the Australian and New Zealand Dollar compared to the U.S. dollar.\\n\\nU.S. admissions for the first quarter 2019 were down 19% falling from $24.7 million to $19.9 million for the same period in the prior year. According to industry sources, U.S. box office for the period was down 16%, falling from $2.5 billion to $2.1 billion. Australia and New Zealand Box Office saw similar declines. Again, in the case of New Zealand, the situation was exacerbated by the closure of our cinema at Courtenay Central. Due to the fact that our occupancy costs with respect to our cinema operations are fixed, the decrease in revenues disproportionally impacts the earnings from these operations, even though our film rent, cinema level labor and costs of goods sold are largely variable.\\n\\n33\\nLooking forward, The Avengers: Endgame has been setting box office records, having grossed more than $620 million in North America and more than $2.2 billion worldwide since its opening weekend of April 25, 2019.\\n\\nNon-Segment General & Administrative Expenses\\nNon-segment general and administrative expense for the quarter ended March 31, 2019 decreased by 18%, or $1.1 million, to $5.0 million compared to the same period of the prior year, respectively. This decrease mainly relates to lower legal expenses, offset by an increase in administrative occupancy cost in New Zealand attributable to the temporary closure of our administrative offices at Courtenay Central and need to lease replacement office space in Wellington.\\n\\nIncome Tax Expense\\nIncome tax expense for the quarter ended March 31, 2019, decreased 189%, or $2.2 million compared to the same quarter prior year. The change between 2019 and 2018 is primarily related to the pretax loss in the first quarter of 2019.\\nBusiness Segment Results\\n\\nAt March 31, 2019, we leased or owned and operated 60 cinemas with 484 screens, which includes (i) one managed cinema with 4 (four) screens and (ii) our interests in certain unconsolidated joint ventures that total 3 (three) cinemas with 29 screens. In the first quarter of 2019, we acquired a proven 4-screen cinema in Devonport, Tasmania, Australia, increasing our cinema count to 60 and our screen count to 484. We also (i) owned and operated 5 (five) ETCs located in Newmarket Village (a suburb of Brisbane), Belmont (a suburb of Perth), Auburn (a suburb of Sydney) and Townsville (a suburb of Cannon Park) in Australia and Wellington in New Zealand, (ii) owned and operated our headquarters office buildings in Culver City (an emerging high-tech and communications hub in Los Angeles County) and Melbourne, Australia, (iii) owned and operated the fee interests in three developed commercial properties in Manhattan and Chicago improved with live theaters comprising 6 (six) stages and ancillary retail and commercial space (our fourth live theatre was closed at the end of 2015 as part of the redevelopment of 44 Union Square in New York City), (iv) owned a 75% managing member interest in a limited liability company, which in turn owns the fee interest in Cinemas 1,2,3, (v) held for development approximately 70.4 acres of developable industrial land located next to the Auckland Airport in New Zealand, (vi) owned a 50% managing member interest in a limited liability company, which in turn owns a 202-acre property in Coachella, California that is zoned approximately 150 acres for single-family residential use (maximum 550 homes) and approximately 50 acres for high density mixed use in the U.S., that is held for development, and, (vii) owned 197 acres principally in Pennsylvania from our legacy railroad business, including the Reading Viaduct in downtown Philadelphia.\\n\\nThe Company transacts business in Australia and New Zealand and is subject to risks associated with changing foreign currency exchange rates. The Australian and New Zealand dollars based on the spot rate weakened versus prior three month period against the U.S. dollar slightly negatively impacting the value of our assets and liabilities. The average rate for the three months ended March 31, 2019 and 2018 has also weakened by 9.4% and 6.3% respectively. This has decreased the value of our Australian and New Zealand revenues and expenses. Refer to Note 3 – Operations in Foreign Currency for further information.\\n\\n34\\nCinema Exhibition\\n\\nThe following table details our cinema exhibition segment operating results for the three months ended March 31, 2019 and March 31, 2018, respectively:\\n\\n\\n| |\\n| | % Change |\\n| | Three Months Ended | Fav/(Unfav) |\\n| (Dollars in thousands) | March 31,2019 | % of Revenue | March 31,2018 | % of Revenue | Three Months Ended |\\n| REVENUE |\\n| | United States | Admissions revenue | $ | 19,913 | 34% | $ | 24,706 | 34% | (19) | % |\\n| | Food & beverage revenue | 9,575 | 17% | 10,765 | 15% | (11) | % |\\n| | Advertising and other revenue | 2,545 | 4% | 2,516 | 3% | 1 | % |\\n| | $ | 32,033 | 55% | $ | 37,987 | 53% | (16) | % |\\n| | Australia | Admissions revenue | $ | 14,037 | 24% | $ | 17,051 | 24% | (18) | % |\\n| | Food & beverage revenue | 6,061 | 10% | 7,837 | 11% | (23) | % |\\n| | Advertising and other revenue | 1,343 | 2% | 1,829 | 3% | (27) | % |\\n| | $ | 21,441 | 37% | $ | 26,717 | 37% | (20) | % |\\n| | New Zealand | Admissions revenue | $ | 2,991 | 5% | $ | 4,934 | 7% | (39) | % |\\n| | Food & beverage revenue | 1,309 | 3% | 2,266 | 3% | (42) | % |\\n| | Advertising and other revenue | 212 | 0% | 351 | 0% | (40) | % |\\n| | $ | 4,512 | 8% | $ | 7,551 | 10% | (40) | % |\\n| |\\n| | Total revenue | $ | 57,986 | 100% | $ | 72,255 | 100% | (20) | % |\\n| OPERATING EXPENSE |\\n| | United States | Film rent and advertising cost | $ | (10,127) | 17% | $ | (12,875) | 18% | 21 | % |\\n| | Food & beverage cost | (2,322) | 4% | (2,302) | 3% | (1) | % |\\n| | Occupancy expense | (6,945) | 12% | (7,202) | 10% | 4 | % |\\n| | Other operating expense | (10,174) | 18% | (9,942) | 14% | (2) | % |\\n| | $ | (29,568) | 51% | $ | (32,321) | 45% | 9 | % |\\n| | Australia | Film rent and advertising cost | $ | (6,279) | 11% | $ | (7,699) | 11% | 18 | % |\\n| | Food & beverage cost | (1,115) | 2% | (1,594) | 2% | 30 | % |\\n| | Occupancy expense | (3,962) | 7% | (4,251) | 6% | 7 | % |\\n| | Other operating expense | (5,415) | 9% | (5,754) | 8% | 6 | % |\\n| | $ | (16,771) | 29% | $ | (19,298) | 27% | 13 | % |\\n| | New Zealand | Film rent and advertising cost | $ | (1,336) | 3% | $ | (2,232) | 3% | 40 | % |\\n| | Food & beverage cost | (292) | 1% | (491) | 1% | 41 | % |\\n| | Occupancy expense | (803) | 1% | (1,344) | 2% | 40 | % |\\n| | Other operating expense | (1,425) | 2% | (1,653) | 2% | 14 | % |\\n| | $ | (3,856) | 7% | $ | (5,720) | 8% | 33 | % |\\n| |\\n| | Total operating expense | $ | (50,195) | 87% | $ | (57,339) | 79% | 12 | % |\\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\\n| | United States | Depreciation and amortization | $ | (2,626) | 5% | $ | (2,121) | 3% | (24) | % |\\n| | General and administrative expense | (604) | 1% | (545) | 1% | (11) | % |\\n| | $ | (3,230) | 6% | $ | (2,666) | 4% | (21) | % |\\n| | Australia | Depreciation and amortization | $ | (1,181) | 2% | $ | (1,204) | 2% | 2 | % |\\n| | General and administrative expense | (387) | 1% | (299) | 0% | (29) | % |\\n| | $ | (1,568) | 3% | $ | (1,503) | 2% | (4) | % |\\n| | New Zealand | Depreciation and amortization | $ | (350) | 1% | $ | (440) | 1% | 20 | % |\\n| | General and administrative expense | (1) | 0% | (22) | 0% | 95 | % |\\n| | $ | (351) | 1% | $ | (462) | 1% | 24 | % |\\n| |\\n| | Total depreciation, amortization, general and administrative expense | $ | (5,149) | 10% | $ | (4,631) | 6% | (11) | % |\\n| OPERATING INCOME – CINEMA |\\n| | United States | $ | (765) | (1)% | $ | 3,000 | 4% | (126) | % |\\n| | Australia | 3,102 | 5% | 5,916 | 8% | (48) | % |\\n| | New Zealand | 305 | 1% | 1,369 | 2% | (78) | % |\\n| | Total Cinema operating income | $ | 2,642 | 5% | $ | 10,285 | 14% | (74) | % |\\n\\n\\n“nm – not meaningful”\\n\\n35\\n1st Quarter Results\\n\\nCinema Segment operating income\\nCinema segment operating income decreased by 74%, or $7.6 million, to $2.6 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily driven by decreased operating income in the U.S., Australia, and New Zealand, which was due to a decrease in attendance worldwide, and fluctuations in average ticket price (“ATP”), and spend per patron (“SPP”) as outlined below.\\n\\nRevenue\\nCinema revenue decreased by 20%, or $14.3 million, to $58.0 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily attributable to a weak foreign currency exchange rate, and a weak film slate worldwide.\\n\\nThe top box office performers for the first quarter of 2019 included “Captain Marvel”, ($5.1 million), “Aquaman,” ($2.9 million) and “How to Train Your Dragon: The Hidden World,” ($2.7 million), did not stack up well against the top films for the same period 2018, which included major films such as “Black Panther,” “Jumanji: Welcome to the Jungle,” and “The Greatest Showman,” (which combined totaled $15.0 million). We believe that the first quarter of 2019 results are principally the product of the film available for cinema exhibition, and not a reflection of declining consumer interest in cinema as a beyond-the-home source of entertainment.\\n\\nBelow are the changes in our cinema revenue by market:\\n| · | U.S. cinema revenue decreased by 16%, or $6.0 million, to $32.0 million, due to a 22% decrease in attendance, offset by a 12% increase SPP, and a 4% increase in ATP. |\\n\\n| · | Australia cinema revenue decreased by 20%, or $5.3 million, to $21.4 million, primarily due to a 15% decrease in attendance, a 9% decrease in SPP, and a 4% decrease in ATP. |\\n\\n| · | New Zealand cinema revenue decreased by 40%, or $3.0 million, to $4.5 million versus the same period in 2018, due to a decrease of 40% in attendance, while ATP and SPP remained relatively flat. The decrease in New Zealand was materially greater than that in the U.S. and Australia due to the closure of our Courtenay Central cinema in January. |\\n\\n\\nMore recently “Avengers:Endgame” had the biggest box office opening of any film since the opening weekend of April 25, 2019 with $620 million in North America box office and $2.2 billion in worldwide box office. Slated for release this spring and summer are a number of potentially strong box office performers, including “John Wick Chapter 3,” “Aladdin”, “Godzilla: King of the Monsters”, “Men in Black: International,” “Toy Story 4,” and “Spider-Man: Far From Home.”\\n\\nOperating expense\\nOperating expense for the quarter ended March 31, 2019 decreased by 12%, to $50.2 million primarily attributable to (i) lower film rent expense driven by lower admissions revenue, and (ii) lower F&B costs due to lower F&B revenue primarily in Australia and New Zealand.\\n\\nOperating expense as a percentage of gross revenue has increased to 87% for the first quarter of 2019, compared to 79% for the same period in 2018, due to the lower than anticipated revenue in our box office and the fact that our occupancy costs are generally fixed, and cannot be adjusted to reflect such lower admission levels.\\n\\nDepreciation, amortization, general and administrative expense\\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 increased by 11%, or $0.5 million, to $5.1 million mainly due to the depreciation related to the completion of our capital improvements placed into service in the U.S.\\n36\\nReal Estate\\nThe following table details our real estate segment operating results for the three months ended March 31, 2019 and 2018, respectively:\\n\\n\\n\\n| |\\n| | % Change |\\n| | Three Months Ended | Fav/(Unfav) |\\n| (Dollars in thousands) | March 31,2019 | % ofRevenue | March 31,2018 | % ofRevenue | Three Months Ended |\\n| REVENUE |\\n| | United States | Live theater rental and ancillary income | $ | 936 | 17% | $ | 599 | 10% | 56 | % |\\n| | Property rental income | 52 | 1% | 56 | 1% | (7) | % |\\n| | 988 | 18% | 655 | 11% | 51 | % |\\n| | Australia | Property rental income | 3,916 | 72% | 4,154 | 69% | (6) | % |\\n| | New Zealand | Property rental income | 527 | 10% | 1,199 | 20% | (56) | % |\\n| |\\n| | Total revenue | $ | 5,431 | 100% | $ | 6,008 | 100% | (10) | % |\\n| OPERATING EXPENSE |\\n| | United States | Live theater cost | $ | (298) | 5% | $ | (296) | 5% | (1) | % |\\n| | Property cost | (158) | 3% | (134) | 2% | (18) | % |\\n| | Occupancy expense | (151) | 3% | (163) | 3% | 7 | % |\\n| | (607) | 11% | (593) | 10% | (2) | % |\\n| | Australia | Property cost | (701) | 13% | (752) | 13% | 7 | % |\\n| | Occupancy expense | (692) | 13% | (567) | 9% | (22) | % |\\n| | (1,393) | 26% | (1,319) | 22% | (6) | % |\\n| | New Zealand | Property cost | (298) | 5% | (321) | 5% | 7 | % |\\n| | Occupancy expense | (147) | 3% | (150) | 2% | 2 | % |\\n| | (445) | 8% | (471) | 8% | 6 | % |\\n| |\\n| | Total operating expense | $ | (2,445) | 45% | $ | (2,383) | 40% | (3) | % |\\n| DEPRECIATION, AMORTIZATION, GENERAL AND ADMINISTRATIVE EXPENSE |\\n| | United States | Depreciation and amortization | $ | (195) | 4% | $ | (192) | 3% | (2) | % |\\n| | General and administrative expense | (159) | 3% | (163) | 3% | 2 | % |\\n| | (354) | 7% | (355) | 6% | - | % |\\n| | Australia | Depreciation and amortization | $ | (926) | 17% | $ | (909) | 15% | (2) | % |\\n| | General and administrative expense | (292) | 5% | (411) | 7% | 29 | % |\\n| | (1,218) | 22% | (1,320) | 22% | 8 | % |\\n| | New Zealand | Depreciation and amortization | (256) | 5% | (269) | 4% | 5 | % |\\n| | General and administrative expense | — | 0% | — | 0% | - | % |\\n| | (256) | 5% | (269) | 4% | 5 | % |\\n| |\\n| | Total depreciation, amortization, general and administrative expense | $ | (1,828) | 34% | $ | (1,944) | 32% | 6 | % |\\n| OPERATING INCOME - REAL ESTATE |\\n| | United States | $ | 27 | 0% | $ | (293) | (5)% | 109 | % |\\n| | Australia | 1,305 | 24% | 1,515 | 25% | (14) | % |\\n| | New Zealand | (174) | (3)% | 459 | 8% | (138) | % |\\n| | Total real estate operating income | $ | 1,158 | 21% | $ | 1,681 | 28% | (31) | % |\\n\\n\\n1st Quarter Results\\n\\nReal Estate Segment income\\nReal estate segment operating income decreased by 31%, or $0.5 million, to $1.2 million for the quarter ended March 31, 2019 compared to March 31, 2018, primarily due to the closure of most of the net rentable area of Courtenay Central; offset by an increase in Live Theatre segment revenue of 56%, or $0.3 million, to $0.9 million.\\n\\nRevenue\\nReal estate revenue for the quarter decreased by 10%, or $0.6 million, to $5.4 million primarily due to a weak foreign currency exchange rate and a decrease in revenues from our New Zealand segment, principally related to the closure of portions of Courtenay Central.\\n\\nOperating expense\\nOperating expense for the quarter ended March 31, 2019 remained flat at $2.4 million.\\n\\nDepreciation, amortization, general and administrative expense\\nDepreciation, amortization, general and administrative expense for the quarter ended March 31, 2019 decreased by 6%, or $0.1 million, to $1.8 million primarily driven by a weak foreign currency exchange rate and a decrease in general and administrative expenses in Australia.\\n\\nLIQUIDITY AND CAPITAL RESOURCES\\n\\nOur cinema exhibition business plan is to enhance our current cinemas where it is financially reasonable to do so; develop our specialty cinemas in select markets; expand our food and beverage offering, and continue on an opportunistic basis, to identify, develop, and acquire cinema properties that allow us to leverage our cinema expertise over a larger operating base.\\n37\\n\\nOur real estate business is to complete the redevelopment of 44 Union Square in New York City; to reassess and master-plan the Cinemas 1,2,3 property for redevelopment as a stand-alone 96,000 square foot mixed use property and in the interim to continue to use it as a cinema; to continue the build-out of our Newmarket Village and Auburn ETCs and the master planning of the expansion of our Townsville ETC in Australia; to master plan and consider the redevelopment of our Courtenay Central site in New Zealand into an urban entertainment center with a focus on cinema exhibition, food and beverage, and grocery store uses; and in Manukau, New Zealand, to develop in concert with other major land owners, of plans for the development of the infrastructure needed to support the construction of income-producing improvements; and to continue to be sensitive to opportunities to convert our entertainment assets to higher and better uses, or, where appropriate, to dispose of such assets. We will also continue to explore potential synergistic acquisitions that may not readily fall into either our cinema or real estate segment.\\nThe success of our Company is dependent on our ability to execute these business plans effectively through our available resources (both cash and available borrowing facilities) while still timely addressing our liquidity risk. Liquidity risk is the risk relating to our ability to meet our financial obligations when they come due. At the present, our financial obligations arise mainly from capital expenditure needs, working capital requirements, and debt servicing requirements. We manage the liquidity risk by ensuring our ability to generate sufficient cash flows from operating activities and to obtain adequate, reasonable financing or extension of maturity dates under reasonable arrangements, and/or to convert non-performing or non-strategic assets into cash.\\n\\nAt March 31, 2019, our consolidated cash and cash equivalents totaled $12.6 million. Of this amount, $3.2 million and $0.7 million were held by our Australian and New Zealand subsidiaries, respectively. Our intention is to indefinitely reinvest Australian earnings locally, but not indefinitely reinvest New Zealand earnings. If the Australian earnings were used to fund U.S. operations, they would be subject to additional state income taxes upon repatriation.\\n\\nThe changes in cash and cash equivalents for the three months ended March 31, 2019 and 2018 are discussed as follows:\\n\\n\\n| |\\n| |\\n| | Three Months Ended |\\n| | March 31, |\\n| (Dollars in thousands) | 2019 | 2018 | % Change |\\n| Net cash provided by (used in) operating activities | $ | (3,841) | $ | 2,452 | (257) | % |\\n| Net cash provided by (used in) investing activities | (12,613) | (23,491) | (46) | % |\\n| Net cash provided by (used in) financing activities | 15,918 | 16,161 | 2 | % |\\n| Effect of exchange rate changes on cash and cash equivalents | 57 | (122) | 147 | % |\\n| Increase (decrease) in cash and cash equivalents | $ | (479) | $ | (5,000) | 90 | % |\\n\\n\\nOperating activities\\nCash provided by (used in) operating activities for the first three months of 2019 decreased by $6.3 million, to ($3.8) million primarily driven by $4.7 million lower cash inflows from operating activities as well as a $1.5 million decrease in net operating assets.\\n\\nInvesting activities\\nCash used in investing activities during the three months ended March 31, 2019 decreased by $10.9 million compared to the same period in 2018, to net cash used of $12.6 million, primarily due to a decrease in our cinema refurbishment activities compared to the 2018 quarter and the substantial completion of the upgrading and expansion of our Newmarket and Auburn/Redyard ETCs in 2018. It is anticipated that spending on our cinema activities will pick up over the remainder of the year.\\n\\nFinancing Activities\\nThe $15.9 million net cash provided by financing activities during the three months ended March 31, 2019 was primarily related to $22.3 million of new borrowings, offset by $6.1 million of loan repayments. Proceeds from these new borrowings related principally to the ongoing construction of our 44 Union Square project in Manhattan of $6.7 million and to fund the capital improvements in our cinemas and real estate segments.\\n\\nOn March 2, 2017, the Board of Directors authorized a stock repurchase program to repurchase up to $25.0 million of Reading’s Class A Common Stock. The Board on March 14, 2019, extended that program to March 2, 2021. At March 31, 2019, there was $16.2 million of capacity remaining in that authorization.\\n38\\n\\nWe manage our cash, investments and capital structure so we are able to meet the short-term and long-term obligations of our business, while maintaining financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable investment and financing within the overall constraints of our financial strategy. In recent years, our treasury management has been focused on more aggressive cash management using cash balances to reduce debt. In earlier years, we maintained significant cash balances in our bank accounts. We have used cash generated from operations and other excess cash, to the extent not needed for any capital expenditures, to pay down our loans and credit facilities providing us some flexibility on our available loan facilities for future use and thereby, reducing interest charges.\\n\\n\\nThe table below presents the changes in our total available resources (cash and borrowings), debt-to-equity ratio, working capital and other relevant information addressing our liquidity for the three months ended March 31, 2019 and preceding four years:\\n\\n\\n| |\\n| |\\n| | As of andfor the3-MonthsEnded | Year Ended December 31 |\\n| ($ in thousands) | 3/31/2019 | 2018 | 2017 | 2016 | 2015 (2) |\\n| Total Resources (cash and borrowings) |\\n| Cash and cash equivalents (unrestricted) | $ | 12,648 | $ | 13,127 | $ | 13,668 | $ | 19,017 | $ | 19,702 |\\n| Unused borrowing facility | 107,111 | 85,886 | 137,231 | 117,599 | 70,134 |\\n| Restricted for capital projects (1) | 23,566 | 30,318 | 62,280 | 62,024 | 10,263 |\\n| Unrestricted capacity | 83,545 | 55,568 | 74,951 | 55,575 | 59,871 |\\n| Total resources at period end | 119,759 | 99,013 | 150,899 | 136,616 | 89,836 |\\n| Total unrestricted resources at period end | 96,193 | 68,695 | 88,619 | 74,592 | 79,573 |\\n| Debt-to-Equity Ratio |\\n| Total contractual facility | $ | 290,879 | $ | 252,929 | $ | 271,732 | $ | 266,134 | $ | 207,075 |\\n| Total debt (gross of deferred financing costs) | 184,099 | 167,043 | 134,501 | 148,535 | 130,941 |\\n| Current | 40,077 | 30,393 | 8,109 | 567 | 15,000 |\\n| Non-current | 143,691 | 136,650 | 126,392 | 147,968 | 115,941 |\\n| Finance lease liabilities | 331 | — | — | — | — |\\n| Total book equity(2) | 179,946 | 180,547 | 181,618 | 146,890 | 138,951 |\\n| Debt-to-equity ratio | 1.02 | 0.93 | 0.74 | 1.01 | 0.94 |\\n| Changes in Working Capital |\\n| Working capital (deficit) (3) | $ | (77,236) | $ | (55,270) | $ | (46,971) | $ | 6,655 | $ | (35,581) |\\n| Current ratio | 0.28 | 0.35 | 0.42 | 1.10 | 0.51 |\\n| Capital Expenditures (including acquisitions) | $ | 11,476 | $ | 56,827 | $ | 76,708 | $ | 49,166 | $ | 53,119 |\\n\\n\\n| (1) | This relates to the construction facilities specifically negotiated for: (i) Union Square redevelopment project, obtained in December 2016, and (ii) New Zealand construction projects, obtained in May 2015. The New Zealand construction loan expired December 31, 2018. |\\n\\n| (2) | Certain 2015 balances included the restatement impact as a result of a change in accounting principle (see Note 2 – Summary of Significant Accounting Policies – Accounting Changes). Certain 2017 and 2016 balances included the restatement impact as a result of a prior period financial statement correction of immaterial errors (see Note 2 – Summary of Significant Accounting Policies – Prior Period Financial Statement Correction of Immaterial Errors). |\\n\\n| (3) | Typically our working capital (deficit) is negative as we receive revenue from our cinema business ahead of the time that we have to pay our associated liabilities. We use the money we receive to pay down our borrowings in the first instance |\\n\\n\\nCONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES\\n\\nThe following table provides information with respect to the maturities and scheduled principal repayments of our recorded contractual obligations and certain of our commitments and contingencies, either recorded or off-balance sheet, as of March 31, 2019:\\n\\n\\n| |\\n| |\\n| (Dollars in thousands) | 2019 | 2020 | 2021 | 2022 | 2023 | Thereafter | Total |\\n| Debt(1) | $ | 40,016 | $ | 48,799 | $ | 258 | $ | 270 | $ | 58,309 | $ | 8,204 | $ | 155,856 |\\n| Operating leases, including imputed interest | 23,566 | 31,434 | 31,717 | 31,901 | 31,018 | 169,221 | 318,857 |\\n| Finance leases, including imputed interest | 131 | 101 | 53 | 43 | 30 | — | 358 |\\n| Subordinated debt(1) | — | — | — | — | — | 27,913 | 27,913 |\\n| Pension liability | 513 | 684 | 684 | 684 | 684 | 1,979 | 5,228 |\\n| Village East purchase option(3) | 5,900 | — | — | — | — | — | 5,900 |\\n| Estimated interest on debt (2) | 7,717 | 6,098 | 5,156 | 5,157 | 5,134 | 7,498 | 36,761 |\\n| Total | $ | 77,844 | $ | 87,116 | $ | 37,868 | $ | 38,055 | $ | 95,175 | $ | 214,815 | $ | 550,873 |\\n\\n\\n| (1) | Information is presented gross of deferred financing costs. |\\n\\n| (2) | Estimated interest on debt is based on the anticipated loan balances for future periods and current applicable interest rates. |\\n\\n| (3) | Represents the lease liability of the option associated with the ground lease purchase of the Village East Cinema. |\\n\\n\\nRefer to Note 13 – Commitments and Contingencies for additional information.\\n\\n\\n\\n39\\nLitigation\\nWe are currently involved in certain legal proceedings and, as required, have accrued estimates of probable and estimable losses for the resolution of these claims.\\n\\nWhere we are the plaintiffs, we expense all legal fees on an on-going basis and make no provision for any potential settlement amounts until received. In Australia, the prevailing party is usually entitled to recover its attorneys’ fees, which typically work out to be approximately 60% of the amounts actually spent where first class legal counsel is engaged at customary rates. Where we are a plaintiff, we have likewise made no provision for the liability for the defendant’s attorneys' fees in the event we are determined not to be the prevailing party.\\n\\nWhere we are the defendants, we accrue for probable damages that insurance may not cover as they become known and can be reasonably estimated. In our opinion, any claims and litigation in which we are currently involved are not reasonably likely to have a material adverse effect on our business, results of operations, financial position, or liquidity. It is possible, however, that future results of the operations for any particular quarterly or annual period could be materially affected by the ultimate outcome of the legal proceedings. Please refer to Item 3 – Legal Proceedings in our 2018 Form 10-K for more information. There have been no material changes to our litigation since our 2018 Form 10-K, except as set forth in Note 13 – Commitments and Contingencies in the accompanying consolidated financial statements included in this Form 10-Q.\\n\\nOff-Balance Sheet Arrangements\\n\\nSee Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein on this report, there are no off-balance sheet arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in the financial condition, revenue or expense, results of operations, liquidity, capital expenditures or capital resources.\\n\\nCRITICAL ACCOUNTING POLICIES\\n\\nWe believe that the application of the following accounting policies requires significant judgments and estimates in the preparation of our Consolidated Financial Statements and hence, are critical to our business operations and the understanding of our financial results:\\n\\n(i) Impairment of Long-lived Assets (other than Goodwill and Intangible Assets with indefinite lives) – we evaluate our long-lived assets and finite-lived intangible assets using historical and projected data of cash flows as our primary indicator of potential impairment and we take into consideration the seasonality of our business. If the sum of the estimated, undiscounted future cash flows is less than the carrying amount of the asset, then an impairment is recognized for the amount by which the carrying value of the asset exceeds its estimated fair value based on an appraisal or a discounted cash flow calculation. For certain non-income producing properties or for those assets with no consistent historical or projected cash flows, we obtain appraisals or other evidence to evaluate whether there are impairment indicators for these assets.\\n\\nBesides the write-down of the carrying amount of our parking structure adjacent to our Courtenay Central ETC in Wellington, New Zealand due to earthquake damage during the 4th quarter of 2016, no other impairment losses were recorded for long-lived and finite-lived intangible assets for the three years ended December 31, 2018. Refer to Note 20 – Insurance Recoveries on Impairment and Related Losses due to Earthquake in the 2018 Form 10-K for further details.\\n\\n(ii) Impairment of Goodwill and Intangible Assets with indefinite lives – goodwill and intangible assets with indefinite useful lives are not amortized, but instead, tested for impairment at least annually on a reporting unit basis. The impairment evaluation is based on the present value of estimated future cash flows of each reporting unit plus the expected terminal value. There are significant assumptions and estimates used in determining the future cash flows and terminal value. The most significant assumptions include our cost of debt and cost of equity assumptions that comprise the weighted average cost of capital for each reporting unit. Accordingly, actual results could vary materially from such estimates.\\n\\nNo impairment losses were recorded for goodwill and indefinite-lived intangible assets for the three months ended March 31, 2019.\\n\\nFINANCIAL RISK MANAGEMENT\\n\\nInternational Business Risks\\nOur international operations are subject to a variety of risks, including the following:\\n\\n| · | Currency Risk: while we report our earnings and net assets in U.S. dollars, substantial portions of our revenue and of our obligations are denominated in either Australian or New Zealand dollars. The value of these currencies can vary significantly compared to the U.S. dollar and compared to each other. We do not hedge the currency risk, but rather have relied upon the 40 |\\n| natural hedges that exist as a result of the fact that our film costs are typically fixed as a percentage of the box office, and our local operating costs and obligations are likewise typically denominated in local currencies. However, we do have intercompany debt and our ability to service this debt could be adversely impacted by declines in the relative value of the Australian and New Zealand dollar compared to the U.S. dollar. Also, our use of local borrowings to mitigate the business risk of currency fluctuations has reduced our flexibility to move cash between jurisdictions. Set forth below is a chart of the exchange ratios between these three currencies since 1996: |\\n\\n\\n\\n\\nIn recent periods, we have repaid intercompany debt and used the proceeds to fund capital investment in the United States. Accordingly, our debt levels in Australia are higher than they would have been if funds had not been returned for such purposes. On a company wide basis, this means that a reduction in the relative strength of the U.S. dollar versus the Australian dollar and/or the New Zealand dollar will effectively raise the overall cost of our borrowing and capital and make it more expensive to return funds from the United States to Australia and New Zealand.\\n\\nOur exposure to interest rate risk arises out of our intermediate term floating-rate borrowings. To manage the risk, we utilize interest rate derivative contracts to convert certain floating-rate borrowings into fixed-rate borrowings. It is the Company’s policy to enter into interest rate derivative transactions only to the extent considered necessary to meet its objectives as stated above. The Company does not enter into these transactions or any other hedging transactions for speculative purposes.\\n\\nInflation\\n\\nWe continually monitor inflation and the effects of changing prices. Inflation increases the cost of goods and services used. Competitive conditions in many of our markets restrict our ability to recover fully the higher costs of acquired goods and services through price increases. We attempt to mitigate the impact of inflation by implementing continuous process improvement solutions to enhance productivity and efficiency and, as a result, lower costs and operating expenses. The effects of inflation have not had a material impact on our operations and the resulting financial position or liquidity.\\n\\n\\n\\n41\\n\\nFORWARD LOOKING STATEMENTS\\n\\nOur statements in this interim quarterly report contain a variety of forward-looking statements as defined by the Securities Litigation Reform Act of 1995. Forward-looking statements reflect only our expectations regarding future events and operating performance and necessarily speak only as of the date the information was prepared. No guarantees can be given that our expectation will in fact be realized, in whole or in part. You can recognize these statements by our use of words such as, by way of example, “may”, “will”, “expect”, “believe”, and “anticipate” or other similar terminology.\\n\\nThese forward-looking statements reflect our expectation after having considered a variety of risks and uncertainties. However, they are necessarily the product of internal discussion and do not necessarily completely reflect the views of individual members of our Board of Directors or of our management team. Individual Board members and individual members of our management team may have a different view as to the risks and uncertainties involved, and may have different views as to future events or our operating performance.\\n\\nAmong the factors that could cause actual results to differ materially from those expressed in or underlying our forward-looking statements are the following:\\n| · | with respect to our cinema operations: |\\n\\n| o | the number and attractiveness to moviegoers of the films released in future periods; |\\n\\n| o | the amount of money spent by film distributors to promote their motion pictures; |\\n\\n| o | the licensing fees and terms required by film distributors from motion picture exhibitors in order to exhibit their films; |\\n\\n| o | the comparative attractiveness of motion pictures as a source of entertainment and willingness and/or ability of consumers (i) to spend their dollars on entertainment and (ii) to spend their entertainment dollars on movies in and outside the home environment; |\\n\\n| o | the extent to which we encounter competition from other cinema exhibitors, from other sources of outside-the-home entertainment, and from inside-the-home entertainment options, such as “home theaters” and competitive film product distribution technology, such as, by way of example, cable, satellite broadcast and Blu-ray/DVD rentals and sales, and so called “movies on demand;” |\\n\\n| o | the cost and impact of improvements to our cinemas, such as improved seating, enhanced food and beverage offerings and other improvements; |\\n\\n| o | disruptions from theater improvements; and |\\n\\n| o | the extent to and the efficiency with which we are able to integrate acquisitions of cinema circuits with our existing operations. |\\n\\n| · | with respect to our real estate development and operation activities: |\\n\\n| o | the rental rates and capitalization rates applicable to the markets in which we operate and the quality of properties that we own; |\\n\\n| o | the extent to which we can obtain on a timely basis the various land use approvals and entitlements needed to develop our properties; |\\n\\n| o | the risks and uncertainties associated with real estate development; |\\n\\n| o | the availability and cost of labor and materials; |\\n\\n| o | the ability to obtain all permits to construct improvements; |\\n\\n| o | the ability to finance improvements; |\\n\\n| o | the disruptions from construction; |\\n\\n| o | the possibility of construction delays, work stoppage and material shortage; |\\n\\n| o | competition for development sites and tenants; |\\n\\n| o | environmental remediation issues; |\\n\\n| o | the extent to which our cinemas can continue to serve as an anchor tenant that will, in turn, be influenced by the same factors as will influence generally the results of our cinema operations; |\\n\\n| o | the increased depreciation and amortization expenses as construction projects transition to leased real property; |\\n\\n| o | the ability to negotiate and execute joint venture opportunities and relationships; and |\\n\\n| o | certain of our activities are in geologically active areas, creating a risk of damage and/or disruption of real estate and/or cinema businesses from earthquakes. |\\n\\n42\\n\\n| · | with respect to our operations generally as an international company involved in both the development and operation of cinemas and the development and operation of real estate and previously engaged for many years in the railroad business in the United States: |\\n\\n| o | our ability to renew, extend or renegotiate our loans that mature in 2019; |\\n\\n| o | our ability to grow our Company and provide value to our stockholders; |\\n\\n| o | our ongoing access to borrowed funds and capital and the interest that must be paid on that debt and the returns that must be paid on such capital; |\\n\\n| o | expenses, management and Board distraction and other effects of the litigation efforts mounted by James Cotter, Jr. against the Company, including his efforts to cause a sale of voting control of the Company; |\\n\\n| o | the relative values of the currency used in the countries in which we operate; |\\n\\n| o | changes in government regulation, including by way of example, the costs resulting from the implementation of the requirements of Sarbanes-Oxley; |\\n\\n| o | our labor relations and costs of labor (including future government requirements with respect to pension liabilities, disability insurance and health coverage, and vacations and leave); |\\n\\n| o | our exposure from time to time to legal claims and to uninsurable risks such as those related to our historic railroad operations, including potential environmental claims and health-related claims relating to alleged exposure to asbestos or other substances now or in the future recognized as being possible causes of cancer or other health related problems; |\\n\\n| o | our exposure to cyber-security risks, including misappropriation of customer information or other breaches of information security; |\\n\\n| o | changes in future effective tax rates and the results of currently ongoing and future potential audits by taxing authorities having jurisdiction over our various companies; and |\\n\\n| o | changes in applicable accounting policies and practices. |\\n\\n\\nThe above list is not necessarily exhaustive, as business is by definition unpredictable and risky, and subject to influence by numerous factors outside of our control, such as changes in government regulation or policy, competition, interest rates, supply, technological innovation, changes in consumer taste, the weather, and the extent to which consumers in our markets have the economic wherewithal to spend money on beyond-the-home entertainment. Refer to Item 1A Risk factors in the 2018 Form 10-K annual report for more information.\\n\\nGiven the variety and unpredictability of the factors that will ultimately influence our businesses and our results of operation, it naturally follows that no guarantees can be given that any of our forward-looking statements will ultimately prove to be correct. Actual results will undoubtedly vary and there is no guarantee as to how our securities will perform either when considered in isolation or when compared to other securities or investment opportunities.\\n\\nFinally, we undertake no obligation to update publicly or to revise any of our forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable law. Accordingly, you should always note the date to which our forward-looking statements speak.\\n\\nAdditionally, certain of the presentations included in this interim quarterly report may contain “non-GAAP financial measures.” In such case, a reconciliation of this information to our GAAP financial statements will be made available in connection with such statements.\\n43\\n\\nItem 3 –\\nQuantitative and Qualitative Disclosure about Market Risk\\n\\nThe SEC requires that registrants include information about potential effects of changes in currency exchange and interest rates in their filings. Several alternatives, all with some limitations, have been offered. We base the following discussion on a sensitivity analysis that models the effects of fluctuations in currency exchange rates and interest rates. This analysis is constrained by several factors, including the following:\\n| · | It is based on a single point in time; and |\\n\\n| · | It does not include the effects of other complex market reactions that would arise from the changes modeled. |\\n\\nAlthough the results of such an analysis may be useful as a benchmark, they should not be viewed as forecasts.\\nAt March 31, 2019, approximately 33% and 11% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), respectively, including approximately $3.9 million in cash and cash equivalents. At December 31, 2018, approximately 36% and 14% of our assets were invested in assets denominated in Australian dollars (Reading Australia) and New Zealand dollars (Reading New Zealand), including approximately $5.5 million in cash and cash equivalents.\\n\\nOur policy in Australia and New Zealand is to match revenues and expenses, whenever possible, in local currencies. As a result, we have procured a majority of our expenses in Australia and New Zealand in local currencies. Despite this natural hedge, recent movements in foreign currencies have had an effect on our current earnings. Although foreign currency has had an effect on our current earnings, the effect of the translation adjustment on our assets and liabilities noted in our other comprehensive income was an increase of $1.5 million for the three months ended March 31, 2019. As we continue to progress our acquisition and development activities in Australia and New Zealand, we cannot assure you that the foreign currency effect on our earnings will not be material in the future.\\n\\nHistorically, our policy has been to borrow in local currencies to finance the development and construction of our long-term assets in Australia and New Zealand whenever possible. As a result, the borrowings in local currencies have provided somewhat of a natural hedge against the foreign currency exchange exposure. Even so, and as a result of our issuance of subordinated Trust Preferred Securities in 2007, and their subsequent partial repayment, approximately 44% and 64% of our Australian and New Zealand assets, respectively, remain subject to such exposure, unless we elect to hedge our foreign currency exchange between the US and Australian and New Zealand dollars. If the foreign currency rates were to fluctuate by 10%, the resulting change in Australian and New Zealand assets would be $9.9 million and $4.6 million, respectively, and the change in our quarterly net income (loss) would be $0.2 million and ($0.1) million, respectively. Presently, we have no plan to hedge such exposure.\\n\\nWe record unrealized foreign currency translation gains or losses that could materially affect our financial position. As of March 31, 2019 and December 31, 2018, the balance of cumulative foreign currency translation adjustments was approximately $10.2 million gain and $8.7 million gain, respectively.\\n\\nHistorically, we maintain most of our cash and cash equivalent balances in short-term money market instruments with original maturities of three months or less. Due to the short-term nature of such investments, a change of 1% in short-term interest rates would not have a material effect on our financial condition.\\n\\nWe have a combination of fixed and variable interest rate loans. In connection with our variable interest rate loans, a change of approximately 1% in short-term interest rates would have resulted in approximately $239,000 increase or decrease in our quarterly interest expense.\\n\\nFor further discussion on market risks, please refer to International Business Risks included in Item 2, Part 1 of this Form 10-Q.\\n44\\n\\nItem 4 –\\nControls and Procedures\\n\\nWe maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.\\n\\nUnder the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such, term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based upon that evaluation, we concluded that, as of March 31, 2019, our disclosure controls and procedures were effective.\\n\\nChanges in Internal Control over Financial Reporting\\n\\nThere were no other changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended March 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n45\\nPART II – Other Information\\n\\n\\nItem 1 – Legal Proceedings\\n\\nThe information required under Part II, Item 1 (Legal Proceedings) is incorporated by reference to the information contained in Note 13 – Commitments and Contingencies to the Consolidated Financial Statements included herein in Part I, Item 1 (Financial Statements) on this Quarterly Report on Form 10-Q.\\n\\nIn the quarter ended March 31, 2019, the arbitration relating to the termination of Cotter, Jr.’s employment with our Company (Reading International, Inc. v. James J. Cotter, AAA Case No. 01-15-0004-2384, filed July 2015) was resolved. While our Company was the named claimant, this matter relates essentially to Cotter, Jr.’s claims for compensation and damages related to his termination as our Company’s president and chief executive officer which were originally included in the Derivative Action described in Note 13, above. The Arbitrator has determined that, while Cotter, Jr. did breach his obligations under his Employment Agreement with our Company, Cotter, Jr’s breaches were not sufficiently material to allow our Company relief from its obligations under the Employment Agreement to pay certain specified separation amounts, totaling $313,000 (the “Separation Payment Amount”). The arbitrator awarded this amount, plus interest at the rate of 10% from June 12, 2016, until the award was paid in full on March 6, 2019. The reserve set up by the Company in 2015 with respect to this claim has been reversed. The Arbitrator denied on substantive grounds Cotter, Jr’s claims for consequential damages and for damages based on various tort theories (including defamation) and/or upon wrongful termination claims and denied, on jurisdictional grounds, Cotter Jr’s claims that the unvested stock options granted to him under his Employment Agreement did not expire upon his termination and continued to be exercisable by him so long as he continued as a director of our Company. In total, Cotter, Jr., claimed specified damages in excess of $1,000,000 plus unspecified tort damages. While the award was less than half of the amount claimed by Cotter, Jr., and while finding that Cotter, Jr., was in breach of his agreement with our Company, the Arbitrator nevertheless determined that Cotter, Jr. was the prevailing party and awarded Cotter, Jr. $443,000 of his requested $787,769 in attorney’s fees and costs. The Arbitrator also assessed the costs of the arbitration against our Company and ordered a reimbursement of such costs paid to date by Cotter Jr. in the amount of $14,250. This amount is reflected in our Company’s financial statements. The determinations of the Arbitrator are final and binding on the parties, and not subject to appeal.\\n\\nFor further details on our legal proceedings, please refer to Item 3, Legal Proceedings, contained in our 2018 Form 10-K.\\n\\n\\nItem 1A – Risk Factors\\n\\nThere have been no material changes in risk factors as previously disclosed in our 2018 Form 10-K.\\n\\n\\nItem 2 – Unregistered Sales of Equity Securities and Use of Proceeds\\n\\nThere were no unregistered sales of equity securities during the periods covered by this report.\\n\\nThe following table summarizes our repurchases under the March 2, 2017, stock repurchase program up until March 31, 2019:\\n\\n| |\\n| |\\n| Period | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as part of our Stock Buy-Back Program | Approximate Dollar Value of Shares that may yet be Purchased under the Stock Buy-Back Program |\\n| March 2017 | 41,899 | $ | 15.99 | 41,899 | $ | 24,330,149 |\\n| May 2017 | 98,816 | $ | 15.78 | 98,816 | $ | 22,771,316 |\\n| June 2017 | 70,234 | $ | 16.39 | 70,234 | $ | 21,620,212 |\\n| August 2017 | 160,489 | $ | 15.82 | 160,489 | $ | 19,081,288 |\\n| September 2017 | 31,718 | $ | 15.77 | 31,718 | $ | 18,581,038 |\\n| December 2017 | 6,567 | $ | 16.01 | 6,567 | $ | 18,475,900 |\\n| February 2018 | 8,500 | $ | 16.98 | 8,500 | $ | 18,331,570 |\\n| March 2018 | 10,138 | $ | 16.99 | 10,138 | $ | 18,159,364 |\\n| April 2018 | 5,000 | $ | 16.12 | 5,000 | $ | 18,078,764 |\\n| December 2018 | 125,700 | $ | 15.24 | 125,700 | $ | 16,162,529 |\\n| March 2019 | 566 | $ | 16.08 | 566 | $ | 16,153,428 |\\n| Total | 559,627 | $ | 15.81 | 559,627 | $ | 16,153,428 |\\n\\n\\nFor a description of grants of stock to certain executives, see the Stock Based Compensation section under see Note 15 – Equity and Stock-Based Compensation to our Consolidated Financial Statements.\\n46\\n\\n\\nItem 3 – Defaults upon Senior Securities\\n\\nNone.\\n\\n\\nItem 4 – Mine Safety Disclosure\\n\\nNot applicable.\\n\\n\\n47\\n\\nItem 5 –\\nOther Information\\nNone\\n\\n\\nItem 6 –\\nExhibits\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n\\n| |\\n| 31.1 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\\n| 31.2 | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |\\n| 32 | Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith. |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema |\\n| 101.CAL | XBRL Taxonomy Extension Calculation |\\n| 101.DEF | XBRL Taxonomy Extension Definition |\\n| 101.LAB | XBRL Taxonomy Extension Labels |\\n| 101.PRE | XBRL Taxonomy Extension Presentation |\\n\\n\\n48\\nSIGNATURES\\n\\nPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.\\n\\nREADING INTERNATIONAL, INC.\\n\\nDate: May 10, 2019\\n\\nBy: /s/ Ellen M. Cotter\\nEllen M. Cotter\\nChief Executive Officer\\n\\nDate: May 10, 2019\\n\\nBy: /s/ Gilbert Avanes\\nGilbert Avanes\\nInterim Chief Financial Officer\\n\\n\\n\\n\\n\\n\\n49\\n</text>\\n\\nWhat is the increase or decrease in the percentage of net income to net cash provided by operating activities from 2018 to 2019?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -56.872639749635646.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 57,\n \"input_length\": 45380\n}"}}},{"rowIdx":58,"cells":{"data_source":{"kind":"string","value":"docmath_0_20000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements\niShares®Gold Trust Micro\nStatements of Assets and Liabilities (Unaudited)\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\n\n| September 30, 2021 | June 15, 2021 |\n| Assets |\n| Investment in gold bullion, at fair value(a) | $ | 607,260,237 | $ | 9,325,500 |\n| Total Assets | 607,260,237 | 9,325,500 |\n| Liabilities |\n| Sponsor’s fees payable | 34,807 | — |\n| Total Liabilities | 34,807 | — |\n| Commitments and contingent liabilities (Note 6) | — | — |\n| Net Assets | $ | 607,225,430 | $ | 9,325,500 |\n| Shares issued and outstanding(b) | 34,850,000 | 500,000 |\n| Net asset value per Share (Note 2C) | $ | 17.42 | $ | 18.65 |\n\n\n| (a) | Cost of investment in gold bullion: $626,373,040 and $9,325,500, respectively. |\n| (b) | No par value, unlimited amount authorized. |\n\nSee notes to financial statements.\n1\niShares®Gold Trust Micro\nStatements of Operations (Unaudited)\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Expenses |\n| Sponsor’s fees | $ | 200,617 | $ | 201,169 |\n| Sponsor’s fees waived | ( 107,095 | ) | ( 107,134 | ) |\n| Total expenses | 93,522 | 94,035 |\n| Net investment loss | ( 93,522 | ) | ( 94,035 | ) |\n| Net Realized and Unrealized Gain (Loss) |\n| Net realized gain (loss) from: |\n| Gold bullion sold to pay expenses | 422 | 422 |\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) | ( 19,112,803 | ) |\n| Net realized and unrealized loss | ( 18,602,631 | ) | ( 19,112,381 | ) |\n| Net decrease in net assets resulting from operations | $ | ( 18,696,153 | ) | $ | ( 19,206,416 | ) |\n| Net decrease in net assets per Share | $ | ( 0.61 | ) | $ | ( 0.74 | ) |\n\nSee notes to financial statements.\n2\niShares®Gold Trust Micro\nStatements of Changes in Net Assets (Unaudited)\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Net Assets at June 15, 2021 | $ | 9,325,500 |\n| Operations: |\n| Net investment loss | ( 513 | ) |\n| Net change in unrealized appreciation/depreciation | ( 509,750 | ) |\n| Net decrease in net assets resulting from operations | ( 510,263 | ) |\n| Decrease in net assets | ( 510,263 | ) |\n| Net Assets at June 30, 2021 | $ | 8,815,237 |\n| Operations: |\n| Net investment loss | ( 93,522 | ) |\n| Net realized gain | 422 |\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) |\n| Net decrease in net assets resulting from operations | ( 18,696,153 | ) |\n| Capital Share Transactions: |\n| Contributions for Shares issued | 617,106,346 |\n| Net increase in net assets from capital share transactions | 617,106,346 |\n| Increase in net assets | 598,410,193 |\n| Net Assets at September 30, 2021 | $ | 607,225,430 |\n| Shares issued and redeemed |\n| Shares issued | 34,350,000 |\n| Net increase in Shares issued and outstanding | 34,350,000 |\n\nSee notes to financial statements.\n3\niShares®Gold Trust Micro\nStatement of Cash Flows (Unaudited)\nFor the period from June 15, 2021 (Date of Inception) to September 30, 2021\n\n| June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Cash Flows from Operating Activities |\n| Proceeds from gold bullion sold to pay expenses | $ | 59,228 |\n| Expenses – Sponsor’s fees paid | ( 59,228 | ) |\n| Net cash provided by operating activities | — |\n| Increase (decrease) in cash | — |\n| Cash, beginning of period | — |\n| Cash, end of period | $ | — |\n| Reconciliation of Net Increase (Decrease) in Net Assets Resulting from Operations to Net Cash Provided by (Used in) Operating Activities |\n| Net decrease in net assets resulting from operations | $ | ( 19,206,416 | ) |\n| Adjustments to reconcile net increase (decrease) in net assets resulting from operations to net cash provided by (used in) operating activities: |\n| Proceeds from gold bullion sold to pay expenses | 59,228 |\n| Net realized (gain) loss | ( 422 | ) |\n| Net change in unrealized appreciation/depreciation | 19,112,803 |\n| Change in operating assets and liabilities: |\n| Sponsor’s fees payable | 34,807 |\n| Net cash provided by (used in) operating activities | $ | — |\n| Supplemental disclosure of non-cash information: |\n| Gold bullion contributed for Shares issued | $ | 617,106,346 |\n\nSee notes to financial statements.\n4\niShares®Gold Trust Micro\nSchedules of Investments (Unaudited)\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\n\n| September 30, 2021 |\n\n\n| Description | Ounces | Cost | Fair Value |\n| Gold bullion | 348,439 | $ | 626,373,040 | $ | 607,260,237 |\n| Total Investments – 100.01% | 607,260,237 |\n| Less Liabilities – (0.01)% | ( 34,807 | ) |\n| Net Assets – 100.00% | $ | 607,225,430 |\n\n\n| June 15, 2021 (Date of Inception) |\n\n\n| Description | Ounces | Cost | Fair Value |\n| Gold bullion | 5,000 | $ | 9,325,500 | $ | 9,325,500 |\n| Total Investments – 100.00% | 9,325,500 |\n| Less Liabilities – (0.00)% | — |\n| Net Assets – 100.00% | $ | 9,325,500 |\n\nSee notes to financial statements.\n5\niShares®Gold Trust Micro\nNotes to Financial Statements (Unaudited)\nSeptember 30, 2021\n\n| 1 - | Organization |\n\nThe iShares Gold Trust Micro (the “Trust”) was organized on June 15, 2021 as a New York trust. The trustee is The Bank of New York Mellon (the “Trustee”), which is responsible for the day-to-day administration of the Trust. The Trust’s sponsor is iShares Delaware Trust Sponsor LLC, a Delaware limited liability company (the “Sponsor”). The Trust is governed by the provisions of the Depositary Trust Agreement (the “Trust Agreement”) executed by the Trustee and the Sponsor as of June 15, 2021. The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets.\nBlackRock Financial Management, Inc. (the “Seed Capital Investor”), contributed 5,000 ounces of Gold in exchange for 500,000 shares (the “Seed Creation Baskets”) on June 15, 2021 for the benefit of BlackRock Financial Management, Inc. At contribution, the value of the gold deposited with the Trust was based on the price of an ounce of gold of $ 1,865.10 . The Seed Capital Investor is an affiliate of the Sponsor. The Seed Capital Investor did not and will not receive from the Trust, the Sponsor or any of their affiliates any fee or other compensation in connection with the sale of the Seed Creation Baskets.\nThe Trust seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust is designed to provide a vehicle for investors to make an investment similar to an investment in gold.\nThe accompanying unaudited financial statements were prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions for Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). In the opinion of management, all material adjustments, consisting only of normal recurring adjustments considered necessary for a fair statement of the interim period financial statements, have been made. Interim period results are not necessarily indicative of results for a full-year period. These financial statements and the notes thereto should be read in conjunction with the Trust’s financial statements included in the registration statement on Form S-1 as filed with the SEC on June 23, 2021.\nThe Trust qualifies as an investment company solely for accounting purposes and not for any other purpose and follows the accounting and reporting guidance under the Financial Accounting Standards Board Accounting Standards Codification Topic 946, Financial Services - Investment Companies, but is not registered, and is not required to be registered, as an investment company under the Investment Company Act of 1940, as amended.\n\n| 2 - | Significant Accounting Policies |\n\n\n\n| A. | Basis of Accounting |\n\nThe following significant accounting policies are consistently followed by the Trust in the preparation of its financial statements in conformity with U.S. GAAP. The preparation of financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.\n\n\n| B. | Gold Bullion |\n\nJPMorgan Chase Bank N.A., London branch (the “Custodian”), is responsible for the safekeeping of gold bullion owned by the Trust.\nFair value of the gold bullion held by the Trust is based on that day’s London Bullion Market Association (“LBMA”) Gold Price PM. “LBMA Gold Price PM” is the price per fine troy ounce of gold, stated in U.S. dollars, determined by ICE Benchmark Administration (“IBA”) following an electronic auction consisting of one or more 30-second rounds starting at 3:00 p.m. (London time), on each day that the London gold market is open for business and published shortly thereafter. If there is no LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (“LBMA Gold Price AM”) unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation.\nGain or loss on sales of gold bullion is calculated on a trade date basis using the average cost method.\n6\nThe following tables summarize activity in gold bullion for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021:\n\n| Three Months Ended September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 8,815,750 | $ | — |\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\n| Gold bullion distributed | — | — | — | — |\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\n| Net realized gain | — | — | 422 | — |\n| Net change in unrealized appreciation/depreciation | — | — | ( 18,603,053 | ) | — |\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\n\n\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 9,325,500 | $ | — |\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\n| Gold bullion distributed | — | — | — | — |\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\n| Net realized gain | — | — | 422 | — |\n| Net change in unrealized appreciation/depreciation | — | — | ( 19,112,803 | ) | — |\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\n\n\n\n| C. | Calculation of Net Asset Value |\n\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the net asset value of the Trust is obtained by subtracting all accrued fees, expenses and other liabilities of the Trust from the fair value of the gold and other assets held by the Trust. The Trustee computes the net asset value per Share by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\n\n\n| D. | Offering of the Shares |\n\nTrust Shares are issued and redeemed continuously in aggregations of 50,000 Shares in exchange for gold bullion rather than cash. Individual investors cannot purchase or redeem Shares in direct transactions with the Trust. The Trust only transacts with registered broker-dealers that are eligible to settle securities transactions through the book-entry facilities of the Depository Trust Company and that have entered into a contractual arrangement with the Trustee and the Sponsor governing, among other matters, the creation and redemption of Shares (such broker-dealers, the “Authorized Participants”). Holders of Shares of the Trust may redeem their Shares at any time acting through an Authorized Participant and in the prescribed aggregations of 50,000 Shares; provided, that redemptions of Shares may be suspended during any period while regular trading on NYSE Arca, Inc. (“NYSE Arca”) is suspended or restricted, or in which an emergency exists as a result of which delivery, disposal or evaluation of gold is not reasonably practicable.\nThe per Share amount of gold exchanged for a purchase or redemption represents the per Share amount of gold held by the Trust, after giving effect to its liabilities.\nWhen gold bullion is exchanged in settlement of a redemption, it is considered a sale of gold bullion for accounting purposes.\n\n\n| E. | Federal Income Taxes |\n\nThe Trust is treated as a grantor trust for federal income tax purposes and, therefore, no provision for federal income taxes is required. Any interest, expenses, gains and losses are passed through to the holders of Shares of the Trust.\nThe Sponsor has analyzed applicable tax laws and regulations and their application to the Trust as of September 30, 2021 and does not believe that there are any uncertain tax positions that require recognition of a tax liability.\n\n| 3 - | Trust Expenses |\n\nThe Trust pays to the Sponsor a Sponsor’s fee that accrues daily at an annualized rate equal to 0.15 % of the net asset value of the Trust, paid monthly in arrears. Effective June 29, 2021, the Sponsor has voluntarily agreed to waive a portion of the Sponsor’s Fee so that the Sponsor’s Fee after the fee waiver will not exceed 0.07 % through June 30, 2024. Although the Sponsor has no current intention of doing so, because the fee waiver is voluntary, the Sponsor may revert to the 0.15 % fee prior to June 30, 2024. Should the Sponsor choose to revert to the 0.15 % fee (or an amount higher than 0.07 % but no greater than 0.15 % annualized), prior to June 30, 2024, it will provide shareholders with at least 30 days’ prior written notice of such change through either a prospectus supplement to its registration statement or through a report furnished on Form 8-K. The Sponsor has agreed to assume the following administrative and marketing expenses incurred by the Trust: the Trustee’s fee and reimbursement for its reasonable out-of-pocket expenses, the Custodian’s fee, NYSE Arca listing fees, SEC registration fees, printing and mailing costs, audit fees and expenses, and up to $ 100,000 per annum in legal fees and expenses. The amount waived is included in Sponsor’s fees waived in the Statement of Operations. For the quarter ended September 30, 2021, the amount waived was $ 107,095 .\n7\n\n| 4 - | Related Parties |\n\nThe Sponsor and the Trustee are considered to be related parties to the Trust. The Trustee’s fee is paid by the Sponsor and is not a separate expense of the Trust.\nAs of September 30, 2021 BlackRock Financial Management, Inc., an affiliate of the Sponsor, owned 500,000 Shares of the Trust.\n\n| 5 - | Indemnification |\n\nThe Trust Agreement provides that the Trustee shall indemnify the Sponsor, its directors, officers, employees and agents against, and hold each of them harmless from, any loss, liability, cost, expense or judgment (including reasonable fees and expenses of counsel) (i) caused by the negligence or bad faith of the Trustee or (ii) arising out of any information furnished in writing to the Sponsor by the Trustee expressly for use in the registration statement, or any amendment thereto or periodic or other report filed with the SEC relating to the Shares that is not materially altered by the Sponsor.\nThe Trust Agreement provides that the Sponsor and its shareholders, directors, officers, employees, affiliates (as such term is defined under the Securities Act of 1933, as amended) and subsidiaries shall be indemnified from the Trust and held harmless against any loss, liability or expense incurred without their (1) negligence, bad faith, willful misconduct or willful malfeasance arising out of or in connection with the performance of their obligations under the Trust Agreement or any actions taken in accordance with the provisions of the Trust Agreement or (2) reckless disregard of their obligations and duties under the Trust Agreement.\nThe Trust has agreed that the Custodian will only be responsible for any loss or damage suffered by the Trust as a direct result of the Custodian’s negligence, fraud or willful default in the performance of its duties.\n\n| 6 - | Commitments and Contingent Liabilities |\n\nIn the normal course of business, the Trust may enter into contracts with service providers that contain general indemnification clauses. The Trust’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Trust that have not yet occurred.\n\n| 7 - | Concentration Risk |\n\nSubstantially all of the Trust’s assets are holdings of gold bullion, which creates a concentration risk associated with fluctuations in the price of gold. Accordingly, a decline in the price of gold will have an adverse effect on the value of the Shares of the Trust. Factors that may have the effect of causing a decline in the price of gold include large sales by the official sector (governments, central banks, and related institutions); a significant increase in the hedging activities of gold producers; significant changes in the attitude of speculators, investors and other market participants towards gold; global gold supply and demand; global or regional political, economic or financial events and situations; investors’ expectations with respect to the rate of inflation; interest rates; investment and trading activities of hedge funds and commodity funds; other economic variables such as income growth, economic output, and monetary policies; and investor confidence.\n8\n\n| 8 - | Financial Highlights |\n\nThe following financial highlights relate to investment performance and operations for a Share outstanding for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021.\n\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\n| Net asset value per Share, beginning of period | $ | 17.63 | $ | 18.65 |\n| Net investment loss(a) | ( 0.00 | )(b) | ( 0.00 | )(b) |\n| Net realized and unrealized gain (loss)(c) | ( 0.21 | ) | ( 1.23 | ) |\n| Net decrease in net assets from operations | ( 0.21 | ) | ( 1.23 | ) |\n| Net asset value per Share, end of period | $ | 17.42 | $ | 17.42 |\n| Total return, at net asset value(d)(e) | ( 1.19 | )% | ( 6.60 | )% |\n| Ratio to average net assets: |\n| Net investment loss(f) | ( 0.07 | )% | ( 0.07 | )% |\n| Total Expenses(f) | 0.15 | % | 0.15 | % |\n| Total expenses after fees waived(f) | 0.07 | % | 0.07 | % |\n\n\n| (a) | Based on average Shares outstanding during the period. |\n| (b) | Amount is greater than $( 0.005 ) per share |\n| (c) | The amounts reported for a Share outstanding may not accord with the change in aggregate gains and losses on investment for the period due to the timing of Trust Share transactions in relation to the fluctuating fair values of the Trust’s underlying investment. |\n| (d) | Based on the change in net asset value of a Share during the period. |\n| (e) | Percentage is not annualized. |\n| (f) | Percentage is annualized. |\n\n\n| 9 - | Investment Valuation |\n\nU.S. GAAP defines fair value as the price the Trust would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. The Trust’s policy is to value its investment at fair value.\nVarious inputs are used in determining the fair value of assets and liabilities. Inputs may be based on independent market data (“observable inputs”) or they may be internally developed (“unobservable inputs”). These inputs are categorized into a disclosure hierarchy consisting of three broad levels for financial reporting purposes. The level of a value determined for an asset or liability within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are as follows:\n\n| Level 1 − | Unadjusted quoted prices in active markets for identical assets or liabilities; |\n\n\n| Level 2 − | Inputs other than quoted prices included within Level 1 that are observable for the asset or liability either directly or indirectly, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not considered to be active, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived principally from or corroborated by observable market data by correlation or other means; and |\n\n\n| Level 3 − | Unobservable inputs that are unobservable for the asset or liability, including the Trust’s assumptions used in determining the fair value of investments. |\n\nAt September 30, 2021, the value of the gold bullion held by the Trust is categorized as Level 1.\n9\n\ns Discussion and Analysis of Financial Condition and Results of Operations.\nThis information should be read in conjunction with the financial statements and notes to financial statements included in Item 1 of Part I of this Form 10‑Q. The discussion and analysis that follows may contain statements that relate to future events or future performance. In some cases, such forward-looking statements can be identified by terminology such as “may,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. These statements are based upon certain assumptions and analyses made by the Sponsor on the basis of its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate in the circumstances. Whether or not actual results and developments will conform to the Sponsor’s expectations and predictions, however, is subject to a number of risks and uncertainties, including the special considerations discussed below, general economic, market and business conditions, changes in laws or regulations, including those concerning taxes, made by governmental authorities or regulatory bodies, and other world economic and political developments. Although the Sponsor does not make forward-looking statements unless it believes it has a reasonable basis for doing so, the Sponsor cannot guarantee their accuracy. Except as required by applicable disclosure laws, neither the Trust nor the Sponsor is under a duty to update any of the forward-looking statements to conform such statements to actual results or to a change in the Sponsor’s expectations or predictions.\nIntroduction\nThe iShares Gold Trust Micro (the “Trust”) is a grantor trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and iShares Delaware Trust Sponsor LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist primarily of gold bullion held by a custodian as an agent of the Trust responsible only to the Trustee.\nThe Trust is a passive investment vehicle and seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold.\nThe Trust issues and redeems Shares only in exchange for gold, only in aggregations of 50,000 Shares (a “Basket”) or integral multiples thereof, and only in transactions with registered broker-dealers that have previously entered into an agreement with the Sponsor and the Trustee governing the terms and conditions of such issuance (such broker-dealers, the “Authorized Participants”). A list of the current Authorized Participants is available from the Sponsor or the Trustee.\nShares of the Trust trade on NYSE Arca, Inc. under the ticker symbol IAUM.\nValuation of Gold Bullion; Computation of Net Asset Value\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the Trustee evaluates the gold held by the Trust and determines the net asset value of the Trust and the net asset value per Share (“NAV”). The Trustee values the gold held by the Trust using the price per fine troy ounce of gold determined in an electronic auction hosted by ICE Benchmark Administration (“IBA”) that begins at 3:00 p.m. (London time) and published shortly thereafter, on the day the valuation takes place (such price, the “LBMA Gold Price PM”). If there is no announced LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (such price, the “LBMA Gold Price AM”), unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation. The LBMA Gold Price AM and LBMA Gold Price PM are used by the Trust because they are commonly used by the U.S. gold market as indicators of the value of gold and are permitted to be used under the Trust Agreement. The use of indicators of the value of gold bullion other than the LBMA Gold Price AM and LBMA Gold Price PM could result in materially different fair value pricing of the gold held by the Trust, and as such, could result in different cost or market adjustments or in different redemption value adjustments of the outstanding redeemable capital Shares. Having valued the gold held by the Trust, the Trustee then subtracts all accrued fees, expenses and other liabilities of the Trust from the total value of the gold held by the Trust and other assets held by the Trust. The result is the net asset value of the Trust. The Trustee computes NAV by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\nLiquidity\nThe Trust is not aware of any trends, demands, conditions or events that are reasonably likely to result in material changes to its liquidity needs. In exchange for a fee, the Sponsor has agreed to assume most of the expenses incurred by the Trust. As a result, the only ordinary expense of the Trust during the period covered by this report was the Sponsor’s fee. The Trust’s only source of liquidity is its sales of gold.\nCritical Accounting Policies\nThe financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below is a description of the valuation of gold bullion, a critical accounting policy that the Trust believes is important to understanding its results of operations and financial position, is provided in the section entitled “Valuation of Gold Bullion; Computation of Net Asset Value” above. In addition, please refer to Note 2 to the financial statements included in this report for further discussion of the Trust’s accounting policies.\n10\nResults of Operations\nThe Quarter Ended September 30, 2021\nThe Trust’s net asset value increased from $8,815,237 at June 30, 2021 to $607,225,430 at September 30, 2021, a 6,788.36% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 30, 2021 to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the quarter. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 1.15% from $1,763.15 at June 30, 2021 to $1,742.80 at September 30, 2021.\nThe 1.19% decrease in the NAV from $17.63 at June 30, 2021 to $17.42 at September 30, 2021 is directly related to the 1.15% decrease in the price of gold.\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $93,522 for the quarter, or 0.02% of the Trust’s average weighted assets of $537,613,742 during the quarter. The NAV of $18.29 on July 29, 2021 was the highest during the quarter, compared with a low during the quarter of $17.23 on August 10, 2021.\nNet decrease in net assets resulting from operations for the quarter ended September 30, 2021 was $18,696,153, resulting from an unrealized loss on investment in gold bullion of $18,603,053, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $93,522. Other than the Sponsor’s fees of $93,522, the Trust had no expenses during the quarter.\nThe Period from June 15, 2021 (Date of Inception) to September 30, 2021\nThe Trust’s net asset value increased from $9,325,500 at June 15, 2021 (Date of Inception) to $607,225,430 at September 30, 2021, a 6,411.45% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 15, 2021 (Date of Inception) to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the period. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 6.56% from $1,865.10 at June 15, 2021 (Date of Inception) to $1,742.80 at September 30, 2021.\nThe 6.60% decrease in the NAV from $18.65 at June 15, 2021 (Date of Inception) to $17.42 at September 30, 2021 is directly related to the 6.56% decrease in the price of gold.\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $94,035 for the period, or 0.02% of the Trust’s average weighted assets of $459,291,726 during the period. The NAV of $18.65 on June 15, 2021 was the highest during the period, compared with a low during the period of $17.23 on August 10, 2021.\nNet decrease in net assets resulting from operations for the period ended September 30, 2021 was $19,206,416, resulting from an unrealized loss on investment in gold bullion of $19,112,803, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $94,035. Other than the Sponsor’s fees of $94,035, the Trust had no expenses during the period.\n\nNot applicable.\n\nThe duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, with the participation of the Trustee, have evaluated the effectiveness of the Trust’s disclosure controls and procedures, and have concluded that the disclosure controls and procedures of the Trust were effective as of the end of the period covered by this report to provide reasonable assurance that information required to be disclosed in the reports that the Trust files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to the duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, as appropriate to allow timely decisions regarding required disclosure.\nThere are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures.\n11\nPART II – OTHER INFORMATION\n\nNone.\n\nThere have been no material changes to the Risk Factors in the registration statement on Form S-1, initially filed with the Securities and Exchange Commission on February 26, 2021 and declared effective on June 28, 2021.\n\na) None.\nb) Not applicable.\nc) There were no Shares redeemed during the period from June 15, 2021 (Date of Inception) to September 30, 2021.\n\nNone.\n\nNot applicable.\n\nNot applicable.\n12\n\n\n| Exhibit No. | Description |\n| 4.1 | Depositary Trust Agreement is incorporated by reference to Exhibit 4.1 of the Registration Statement on Form S‑1 (File No. 333‑253614) filed by the Registrant on June 21, 2021 |\n| 4.2 | Standard Terms for Authorized Participant Agreements is incorporated by reference to Exhibit 4.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 10.1 | Custodian Agreement between The Bank of New York Mellon and JP Morgan Chase Bank N.A., London branch is incorporated by reference to Exhibit 10.1 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 10.2 | Sub-license Agreement is incorporated by reference to Exhibit 10.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\n| 31.1 | Certification by Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2 | Certification by Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1 | Certification by Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\n| 32.2 | Certification by Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\n| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104 | Cover Page Interactive Data File included as Exhibit 101 (embedded within the Inline XBRL document) |\n\n13\nSIGNATURES\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned in the capacities* indicated thereunto duly authorized.\niShares Delaware Trust Sponsor LLC, Sponsor of the iShares Gold Trust Micro (registrant)\n\n| /s/ Paul Lohrey |\n| Paul Lohrey |\n| Director, President and Chief Executive Officer |\n| (Principal executive officer) |\n\n\n| Date: | November 3, 2021 |\n\n\n| /s/ Trent Walker |\n| Trent Walker |\n| Chief Financial Officer |\n| (Principal financial and accounting officer) |\n\n\n| Date: | November 3, 2021 |\n\n\n| * | The registrant is a trust and the persons are signing in their respective capacities as officers of iShares Delaware Trust Sponsor LLC, the Sponsor of the registrant. |\n\n14\n</text>\n\nWhat is the percentage increase in the value of gold bullion from the date of inception until September 30, 2021?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1. Financial Statements\\niShares®Gold Trust Micro\\nStatements of Assets and Liabilities (Unaudited)\\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\\n\\n| September 30, 2021 | June 15, 2021 |\\n| Assets |\\n| Investment in gold bullion, at fair value(a) | $ | 607,260,237 | $ | 9,325,500 |\\n| Total Assets | 607,260,237 | 9,325,500 |\\n| Liabilities |\\n| Sponsor’s fees payable | 34,807 | — |\\n| Total Liabilities | 34,807 | — |\\n| Commitments and contingent liabilities (Note 6) | — | — |\\n| Net Assets | $ | 607,225,430 | $ | 9,325,500 |\\n| Shares issued and outstanding(b) | 34,850,000 | 500,000 |\\n| Net asset value per Share (Note 2C) | $ | 17.42 | $ | 18.65 |\\n\\n\\n| (a) | Cost of investment in gold bullion: $626,373,040 and $9,325,500, respectively. |\\n| (b) | No par value, unlimited amount authorized. |\\n\\nSee notes to financial statements.\\n1\\niShares®Gold Trust Micro\\nStatements of Operations (Unaudited)\\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\\n\\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\\n| Expenses |\\n| Sponsor’s fees | $ | 200,617 | $ | 201,169 |\\n| Sponsor’s fees waived | ( 107,095 | ) | ( 107,134 | ) |\\n| Total expenses | 93,522 | 94,035 |\\n| Net investment loss | ( 93,522 | ) | ( 94,035 | ) |\\n| Net Realized and Unrealized Gain (Loss) |\\n| Net realized gain (loss) from: |\\n| Gold bullion sold to pay expenses | 422 | 422 |\\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) | ( 19,112,803 | ) |\\n| Net realized and unrealized loss | ( 18,602,631 | ) | ( 19,112,381 | ) |\\n| Net decrease in net assets resulting from operations | $ | ( 18,696,153 | ) | $ | ( 19,206,416 | ) |\\n| Net decrease in net assets per Share | $ | ( 0.61 | ) | $ | ( 0.74 | ) |\\n\\nSee notes to financial statements.\\n2\\niShares®Gold Trust Micro\\nStatements of Changes in Net Assets (Unaudited)\\nFor the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021\\n\\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\\n| Net Assets at June 15, 2021 | $ | 9,325,500 |\\n| Operations: |\\n| Net investment loss | ( 513 | ) |\\n| Net change in unrealized appreciation/depreciation | ( 509,750 | ) |\\n| Net decrease in net assets resulting from operations | ( 510,263 | ) |\\n| Decrease in net assets | ( 510,263 | ) |\\n| Net Assets at June 30, 2021 | $ | 8,815,237 |\\n| Operations: |\\n| Net investment loss | ( 93,522 | ) |\\n| Net realized gain | 422 |\\n| Net change in unrealized appreciation/depreciation | ( 18,603,053 | ) |\\n| Net decrease in net assets resulting from operations | ( 18,696,153 | ) |\\n| Capital Share Transactions: |\\n| Contributions for Shares issued | 617,106,346 |\\n| Net increase in net assets from capital share transactions | 617,106,346 |\\n| Increase in net assets | 598,410,193 |\\n| Net Assets at September 30, 2021 | $ | 607,225,430 |\\n| Shares issued and redeemed |\\n| Shares issued | 34,350,000 |\\n| Net increase in Shares issued and outstanding | 34,350,000 |\\n\\nSee notes to financial statements.\\n3\\niShares®Gold Trust Micro\\nStatement of Cash Flows (Unaudited)\\nFor the period from June 15, 2021 (Date of Inception) to September 30, 2021\\n\\n| June 15, 2021 (Date of Inception) to September 30, 2021 |\\n| Cash Flows from Operating Activities |\\n| Proceeds from gold bullion sold to pay expenses | $ | 59,228 |\\n| Expenses – Sponsor’s fees paid | ( 59,228 | ) |\\n| Net cash provided by operating activities | — |\\n| Increase (decrease) in cash | — |\\n| Cash, beginning of period | — |\\n| Cash, end of period | $ | — |\\n| Reconciliation of Net Increase (Decrease) in Net Assets Resulting from Operations to Net Cash Provided by (Used in) Operating Activities |\\n| Net decrease in net assets resulting from operations | $ | ( 19,206,416 | ) |\\n| Adjustments to reconcile net increase (decrease) in net assets resulting from operations to net cash provided by (used in) operating activities: |\\n| Proceeds from gold bullion sold to pay expenses | 59,228 |\\n| Net realized (gain) loss | ( 422 | ) |\\n| Net change in unrealized appreciation/depreciation | 19,112,803 |\\n| Change in operating assets and liabilities: |\\n| Sponsor’s fees payable | 34,807 |\\n| Net cash provided by (used in) operating activities | $ | — |\\n| Supplemental disclosure of non-cash information: |\\n| Gold bullion contributed for Shares issued | $ | 617,106,346 |\\n\\nSee notes to financial statements.\\n4\\niShares®Gold Trust Micro\\nSchedules of Investments (Unaudited)\\nAt September 30, 2021 and June 15, 2021 (Date of Inception)\\n\\n| September 30, 2021 |\\n\\n\\n| Description | Ounces | Cost | Fair Value |\\n| Gold bullion | 348,439 | $ | 626,373,040 | $ | 607,260,237 |\\n| Total Investments – 100.01% | 607,260,237 |\\n| Less Liabilities – (0.01)% | ( 34,807 | ) |\\n| Net Assets – 100.00% | $ | 607,225,430 |\\n\\n\\n| June 15, 2021 (Date of Inception) |\\n\\n\\n| Description | Ounces | Cost | Fair Value |\\n| Gold bullion | 5,000 | $ | 9,325,500 | $ | 9,325,500 |\\n| Total Investments – 100.00% | 9,325,500 |\\n| Less Liabilities – (0.00)% | — |\\n| Net Assets – 100.00% | $ | 9,325,500 |\\n\\nSee notes to financial statements.\\n5\\niShares®Gold Trust Micro\\nNotes to Financial Statements (Unaudited)\\nSeptember 30, 2021\\n\\n| 1 - | Organization |\\n\\nThe iShares Gold Trust Micro (the “Trust”) was organized on June 15, 2021 as a New York trust. The trustee is The Bank of New York Mellon (the “Trustee”), which is responsible for the day-to-day administration of the Trust. The Trust’s sponsor is iShares Delaware Trust Sponsor LLC, a Delaware limited liability company (the “Sponsor”). The Trust is governed by the provisions of the Depositary Trust Agreement (the “Trust Agreement”) executed by the Trustee and the Sponsor as of June 15, 2021. The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets.\\nBlackRock Financial Management, Inc. (the “Seed Capital Investor”), contributed 5,000 ounces of Gold in exchange for 500,000 shares (the “Seed Creation Baskets”) on June 15, 2021 for the benefit of BlackRock Financial Management, Inc. At contribution, the value of the gold deposited with the Trust was based on the price of an ounce of gold of $ 1,865.10 . The Seed Capital Investor is an affiliate of the Sponsor. The Seed Capital Investor did not and will not receive from the Trust, the Sponsor or any of their affiliates any fee or other compensation in connection with the sale of the Seed Creation Baskets.\\nThe Trust seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust is designed to provide a vehicle for investors to make an investment similar to an investment in gold.\\nThe accompanying unaudited financial statements were prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions for Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). In the opinion of management, all material adjustments, consisting only of normal recurring adjustments considered necessary for a fair statement of the interim period financial statements, have been made. Interim period results are not necessarily indicative of results for a full-year period. These financial statements and the notes thereto should be read in conjunction with the Trust’s financial statements included in the registration statement on Form S-1 as filed with the SEC on June 23, 2021.\\nThe Trust qualifies as an investment company solely for accounting purposes and not for any other purpose and follows the accounting and reporting guidance under the Financial Accounting Standards Board Accounting Standards Codification Topic 946, Financial Services - Investment Companies, but is not registered, and is not required to be registered, as an investment company under the Investment Company Act of 1940, as amended.\\n\\n| 2 - | Significant Accounting Policies |\\n\\n\\n\\n| A. | Basis of Accounting |\\n\\nThe following significant accounting policies are consistently followed by the Trust in the preparation of its financial statements in conformity with U.S. GAAP. The preparation of financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.\\n\\n\\n| B. | Gold Bullion |\\n\\nJPMorgan Chase Bank N.A., London branch (the “Custodian”), is responsible for the safekeeping of gold bullion owned by the Trust.\\nFair value of the gold bullion held by the Trust is based on that day’s London Bullion Market Association (“LBMA”) Gold Price PM. “LBMA Gold Price PM” is the price per fine troy ounce of gold, stated in U.S. dollars, determined by ICE Benchmark Administration (“IBA”) following an electronic auction consisting of one or more 30-second rounds starting at 3:00 p.m. (London time), on each day that the London gold market is open for business and published shortly thereafter. If there is no LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (“LBMA Gold Price AM”) unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation.\\nGain or loss on sales of gold bullion is calculated on a trade date basis using the average cost method.\\n6\\nThe following tables summarize activity in gold bullion for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021:\\n\\n| Three Months Ended September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 8,815,750 | $ | — |\\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\\n| Gold bullion distributed | — | — | — | — |\\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\\n| Net realized gain | — | — | 422 | — |\\n| Net change in unrealized appreciation/depreciation | — | — | ( 18,603,053 | ) | — |\\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\\n\\n\\n| Period from June 15, 2021 (Date of Inception) to September 30, 2021 | Ounces | Cost | Fair Value | Realized Gain (Loss) |\\n| Beginning balance | 5,000 | $ | 9,325,500 | $ | 9,325,500 | $ | — |\\n| Gold bullion contributed | 343,472 | 617,106,346 | 617,106,346 | — |\\n| Gold bullion distributed | — | — | — | — |\\n| Gold bullion sold to pay expenses | ( 33 | ) | ( 58,806 | ) | ( 59,228 | ) | 422 |\\n| Net realized gain | — | — | 422 | — |\\n| Net change in unrealized appreciation/depreciation | — | — | ( 19,112,803 | ) | — |\\n| Ending balance | 348,439 | $ | 626,373,040 | $ | 607,260,237 | $ | 422 |\\n\\n\\n\\n| C. | Calculation of Net Asset Value |\\n\\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the net asset value of the Trust is obtained by subtracting all accrued fees, expenses and other liabilities of the Trust from the fair value of the gold and other assets held by the Trust. The Trustee computes the net asset value per Share by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\\n\\n\\n| D. | Offering of the Shares |\\n\\nTrust Shares are issued and redeemed continuously in aggregations of 50,000 Shares in exchange for gold bullion rather than cash. Individual investors cannot purchase or redeem Shares in direct transactions with the Trust. The Trust only transacts with registered broker-dealers that are eligible to settle securities transactions through the book-entry facilities of the Depository Trust Company and that have entered into a contractual arrangement with the Trustee and the Sponsor governing, among other matters, the creation and redemption of Shares (such broker-dealers, the “Authorized Participants”). Holders of Shares of the Trust may redeem their Shares at any time acting through an Authorized Participant and in the prescribed aggregations of 50,000 Shares; provided, that redemptions of Shares may be suspended during any period while regular trading on NYSE Arca, Inc. (“NYSE Arca”) is suspended or restricted, or in which an emergency exists as a result of which delivery, disposal or evaluation of gold is not reasonably practicable.\\nThe per Share amount of gold exchanged for a purchase or redemption represents the per Share amount of gold held by the Trust, after giving effect to its liabilities.\\nWhen gold bullion is exchanged in settlement of a redemption, it is considered a sale of gold bullion for accounting purposes.\\n\\n\\n| E. | Federal Income Taxes |\\n\\nThe Trust is treated as a grantor trust for federal income tax purposes and, therefore, no provision for federal income taxes is required. Any interest, expenses, gains and losses are passed through to the holders of Shares of the Trust.\\nThe Sponsor has analyzed applicable tax laws and regulations and their application to the Trust as of September 30, 2021 and does not believe that there are any uncertain tax positions that require recognition of a tax liability.\\n\\n| 3 - | Trust Expenses |\\n\\nThe Trust pays to the Sponsor a Sponsor’s fee that accrues daily at an annualized rate equal to 0.15 % of the net asset value of the Trust, paid monthly in arrears. Effective June 29, 2021, the Sponsor has voluntarily agreed to waive a portion of the Sponsor’s Fee so that the Sponsor’s Fee after the fee waiver will not exceed 0.07 % through June 30, 2024. Although the Sponsor has no current intention of doing so, because the fee waiver is voluntary, the Sponsor may revert to the 0.15 % fee prior to June 30, 2024. Should the Sponsor choose to revert to the 0.15 % fee (or an amount higher than 0.07 % but no greater than 0.15 % annualized), prior to June 30, 2024, it will provide shareholders with at least 30 days’ prior written notice of such change through either a prospectus supplement to its registration statement or through a report furnished on Form 8-K. The Sponsor has agreed to assume the following administrative and marketing expenses incurred by the Trust: the Trustee’s fee and reimbursement for its reasonable out-of-pocket expenses, the Custodian’s fee, NYSE Arca listing fees, SEC registration fees, printing and mailing costs, audit fees and expenses, and up to $ 100,000 per annum in legal fees and expenses. The amount waived is included in Sponsor’s fees waived in the Statement of Operations. For the quarter ended September 30, 2021, the amount waived was $ 107,095 .\\n7\\n\\n| 4 - | Related Parties |\\n\\nThe Sponsor and the Trustee are considered to be related parties to the Trust. The Trustee’s fee is paid by the Sponsor and is not a separate expense of the Trust.\\nAs of September 30, 2021 BlackRock Financial Management, Inc., an affiliate of the Sponsor, owned 500,000 Shares of the Trust.\\n\\n| 5 - | Indemnification |\\n\\nThe Trust Agreement provides that the Trustee shall indemnify the Sponsor, its directors, officers, employees and agents against, and hold each of them harmless from, any loss, liability, cost, expense or judgment (including reasonable fees and expenses of counsel) (i) caused by the negligence or bad faith of the Trustee or (ii) arising out of any information furnished in writing to the Sponsor by the Trustee expressly for use in the registration statement, or any amendment thereto or periodic or other report filed with the SEC relating to the Shares that is not materially altered by the Sponsor.\\nThe Trust Agreement provides that the Sponsor and its shareholders, directors, officers, employees, affiliates (as such term is defined under the Securities Act of 1933, as amended) and subsidiaries shall be indemnified from the Trust and held harmless against any loss, liability or expense incurred without their (1) negligence, bad faith, willful misconduct or willful malfeasance arising out of or in connection with the performance of their obligations under the Trust Agreement or any actions taken in accordance with the provisions of the Trust Agreement or (2) reckless disregard of their obligations and duties under the Trust Agreement.\\nThe Trust has agreed that the Custodian will only be responsible for any loss or damage suffered by the Trust as a direct result of the Custodian’s negligence, fraud or willful default in the performance of its duties.\\n\\n| 6 - | Commitments and Contingent Liabilities |\\n\\nIn the normal course of business, the Trust may enter into contracts with service providers that contain general indemnification clauses. The Trust’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Trust that have not yet occurred.\\n\\n| 7 - | Concentration Risk |\\n\\nSubstantially all of the Trust’s assets are holdings of gold bullion, which creates a concentration risk associated with fluctuations in the price of gold. Accordingly, a decline in the price of gold will have an adverse effect on the value of the Shares of the Trust. Factors that may have the effect of causing a decline in the price of gold include large sales by the official sector (governments, central banks, and related institutions); a significant increase in the hedging activities of gold producers; significant changes in the attitude of speculators, investors and other market participants towards gold; global gold supply and demand; global or regional political, economic or financial events and situations; investors’ expectations with respect to the rate of inflation; interest rates; investment and trading activities of hedge funds and commodity funds; other economic variables such as income growth, economic output, and monetary policies; and investor confidence.\\n8\\n\\n| 8 - | Financial Highlights |\\n\\nThe following financial highlights relate to investment performance and operations for a Share outstanding for the three months ended September 30, 2021 and the period from June 15, 2021 (Date of Inception) to September 30, 2021.\\n\\n| Three Months Ended September 30, 2021 | Period from June 15, 2021 (Date of Inception) to September 30, 2021 |\\n| Net asset value per Share, beginning of period | $ | 17.63 | $ | 18.65 |\\n| Net investment loss(a) | ( 0.00 | )(b) | ( 0.00 | )(b) |\\n| Net realized and unrealized gain (loss)(c) | ( 0.21 | ) | ( 1.23 | ) |\\n| Net decrease in net assets from operations | ( 0.21 | ) | ( 1.23 | ) |\\n| Net asset value per Share, end of period | $ | 17.42 | $ | 17.42 |\\n| Total return, at net asset value(d)(e) | ( 1.19 | )% | ( 6.60 | )% |\\n| Ratio to average net assets: |\\n| Net investment loss(f) | ( 0.07 | )% | ( 0.07 | )% |\\n| Total Expenses(f) | 0.15 | % | 0.15 | % |\\n| Total expenses after fees waived(f) | 0.07 | % | 0.07 | % |\\n\\n\\n| (a) | Based on average Shares outstanding during the period. |\\n| (b) | Amount is greater than $( 0.005 ) per share |\\n| (c) | The amounts reported for a Share outstanding may not accord with the change in aggregate gains and losses on investment for the period due to the timing of Trust Share transactions in relation to the fluctuating fair values of the Trust’s underlying investment. |\\n| (d) | Based on the change in net asset value of a Share during the period. |\\n| (e) | Percentage is not annualized. |\\n| (f) | Percentage is annualized. |\\n\\n\\n| 9 - | Investment Valuation |\\n\\nU.S. GAAP defines fair value as the price the Trust would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. The Trust’s policy is to value its investment at fair value.\\nVarious inputs are used in determining the fair value of assets and liabilities. Inputs may be based on independent market data (“observable inputs”) or they may be internally developed (“unobservable inputs”). These inputs are categorized into a disclosure hierarchy consisting of three broad levels for financial reporting purposes. The level of a value determined for an asset or liability within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are as follows:\\n\\n| Level 1 − | Unadjusted quoted prices in active markets for identical assets or liabilities; |\\n\\n\\n| Level 2 − | Inputs other than quoted prices included within Level 1 that are observable for the asset or liability either directly or indirectly, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not considered to be active, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived principally from or corroborated by observable market data by correlation or other means; and |\\n\\n\\n| Level 3 − | Unobservable inputs that are unobservable for the asset or liability, including the Trust’s assumptions used in determining the fair value of investments. |\\n\\nAt September 30, 2021, the value of the gold bullion held by the Trust is categorized as Level 1.\\n9\\n\\ns Discussion and Analysis of Financial Condition and Results of Operations.\\nThis information should be read in conjunction with the financial statements and notes to financial statements included in Item 1 of Part I of this Form 10‑Q. The discussion and analysis that follows may contain statements that relate to future events or future performance. In some cases, such forward-looking statements can be identified by terminology such as “may,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. These statements are based upon certain assumptions and analyses made by the Sponsor on the basis of its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate in the circumstances. Whether or not actual results and developments will conform to the Sponsor’s expectations and predictions, however, is subject to a number of risks and uncertainties, including the special considerations discussed below, general economic, market and business conditions, changes in laws or regulations, including those concerning taxes, made by governmental authorities or regulatory bodies, and other world economic and political developments. Although the Sponsor does not make forward-looking statements unless it believes it has a reasonable basis for doing so, the Sponsor cannot guarantee their accuracy. Except as required by applicable disclosure laws, neither the Trust nor the Sponsor is under a duty to update any of the forward-looking statements to conform such statements to actual results or to a change in the Sponsor’s expectations or predictions.\\nIntroduction\\nThe iShares Gold Trust Micro (the “Trust”) is a grantor trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and iShares Delaware Trust Sponsor LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues units of beneficial interest (“Shares”) representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist primarily of gold bullion held by a custodian as an agent of the Trust responsible only to the Trustee.\\nThe Trust is a passive investment vehicle and seeks to reflect generally the performance of the price of gold. The Trust seeks to reflect such performance before payment of the Trust’s expenses and liabilities. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold.\\nThe Trust issues and redeems Shares only in exchange for gold, only in aggregations of 50,000 Shares (a “Basket”) or integral multiples thereof, and only in transactions with registered broker-dealers that have previously entered into an agreement with the Sponsor and the Trustee governing the terms and conditions of such issuance (such broker-dealers, the “Authorized Participants”). A list of the current Authorized Participants is available from the Sponsor or the Trustee.\\nShares of the Trust trade on NYSE Arca, Inc. under the ticker symbol IAUM.\\nValuation of Gold Bullion; Computation of Net Asset Value\\nOn each business day, as soon as practicable after 4:00 p.m. (New York time), the Trustee evaluates the gold held by the Trust and determines the net asset value of the Trust and the net asset value per Share (“NAV”). The Trustee values the gold held by the Trust using the price per fine troy ounce of gold determined in an electronic auction hosted by ICE Benchmark Administration (“IBA”) that begins at 3:00 p.m. (London time) and published shortly thereafter, on the day the valuation takes place (such price, the “LBMA Gold Price PM”). If there is no announced LBMA Gold Price PM on any day, the Trustee is authorized to use the most recently announced price of gold determined in an electronic auction hosted by IBA that begins at 10:30 a.m. (London time) (such price, the “LBMA Gold Price AM”), unless the Trustee, in consultation with the Sponsor, determines that such price is inappropriate as a basis for evaluation. The LBMA Gold Price AM and LBMA Gold Price PM are used by the Trust because they are commonly used by the U.S. gold market as indicators of the value of gold and are permitted to be used under the Trust Agreement. The use of indicators of the value of gold bullion other than the LBMA Gold Price AM and LBMA Gold Price PM could result in materially different fair value pricing of the gold held by the Trust, and as such, could result in different cost or market adjustments or in different redemption value adjustments of the outstanding redeemable capital Shares. Having valued the gold held by the Trust, the Trustee then subtracts all accrued fees, expenses and other liabilities of the Trust from the total value of the gold held by the Trust and other assets held by the Trust. The result is the net asset value of the Trust. The Trustee computes NAV by dividing the net asset value of the Trust by the number of Shares outstanding on the date the computation is made.\\nLiquidity\\nThe Trust is not aware of any trends, demands, conditions or events that are reasonably likely to result in material changes to its liquidity needs. In exchange for a fee, the Sponsor has agreed to assume most of the expenses incurred by the Trust. As a result, the only ordinary expense of the Trust during the period covered by this report was the Sponsor’s fee. The Trust’s only source of liquidity is its sales of gold.\\nCritical Accounting Policies\\nThe financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below is a description of the valuation of gold bullion, a critical accounting policy that the Trust believes is important to understanding its results of operations and financial position, is provided in the section entitled “Valuation of Gold Bullion; Computation of Net Asset Value” above. In addition, please refer to Note 2 to the financial statements included in this report for further discussion of the Trust’s accounting policies.\\n10\\nResults of Operations\\nThe Quarter Ended September 30, 2021\\nThe Trust’s net asset value increased from $8,815,237 at June 30, 2021 to $607,225,430 at September 30, 2021, a 6,788.36% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 30, 2021 to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the quarter. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 1.15% from $1,763.15 at June 30, 2021 to $1,742.80 at September 30, 2021.\\nThe 1.19% decrease in the NAV from $17.63 at June 30, 2021 to $17.42 at September 30, 2021 is directly related to the 1.15% decrease in the price of gold.\\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $93,522 for the quarter, or 0.02% of the Trust’s average weighted assets of $537,613,742 during the quarter. The NAV of $18.29 on July 29, 2021 was the highest during the quarter, compared with a low during the quarter of $17.23 on August 10, 2021.\\nNet decrease in net assets resulting from operations for the quarter ended September 30, 2021 was $18,696,153, resulting from an unrealized loss on investment in gold bullion of $18,603,053, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $93,522. Other than the Sponsor’s fees of $93,522, the Trust had no expenses during the quarter.\\nThe Period from June 15, 2021 (Date of Inception) to September 30, 2021\\nThe Trust’s net asset value increased from $9,325,500 at June 15, 2021 (Date of Inception) to $607,225,430 at September 30, 2021, a 6,411.45% increase. The increase in the Trust’s net asset value resulted primarily from an increase in the number of outstanding shares, which rose from 500,000 Shares at June 15, 2021 (Date of Inception) to 34,850,000 Shares at September 30, 2021, a consequence of 34,350,000 Shares (687 Baskets) being created during the period. The increase in the Trust’s net asset value was partially offset by a decrease in the LMBA Gold Price, which fell 6.56% from $1,865.10 at June 15, 2021 (Date of Inception) to $1,742.80 at September 30, 2021.\\nThe 6.60% decrease in the NAV from $18.65 at June 15, 2021 (Date of Inception) to $17.42 at September 30, 2021 is directly related to the 6.56% decrease in the price of gold.\\nThe NAV decreased slightly more than the price of gold on a percentage basis due to the Sponsor’s fees, which were $94,035 for the period, or 0.02% of the Trust’s average weighted assets of $459,291,726 during the period. The NAV of $18.65 on June 15, 2021 was the highest during the period, compared with a low during the period of $17.23 on August 10, 2021.\\nNet decrease in net assets resulting from operations for the period ended September 30, 2021 was $19,206,416, resulting from an unrealized loss on investment in gold bullion of $19,112,803, a net realized gain of $422 from gold bullion sold to pay expenses during the quarter, and a net investment loss of $94,035. Other than the Sponsor’s fees of $94,035, the Trust had no expenses during the period.\\n\\nNot applicable.\\n\\nThe duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, with the participation of the Trustee, have evaluated the effectiveness of the Trust’s disclosure controls and procedures, and have concluded that the disclosure controls and procedures of the Trust were effective as of the end of the period covered by this report to provide reasonable assurance that information required to be disclosed in the reports that the Trust files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to the duly authorized officers of the Sponsor performing functions equivalent to those a principal executive officer and principal financial officer of the Trust would perform if the Trust had any officers, as appropriate to allow timely decisions regarding required disclosure.\\nThere are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures.\\n11\\nPART II – OTHER INFORMATION\\n\\nNone.\\n\\nThere have been no material changes to the Risk Factors in the registration statement on Form S-1, initially filed with the Securities and Exchange Commission on February 26, 2021 and declared effective on June 28, 2021.\\n\\na) None.\\nb) Not applicable.\\nc) There were no Shares redeemed during the period from June 15, 2021 (Date of Inception) to September 30, 2021.\\n\\nNone.\\n\\nNot applicable.\\n\\nNot applicable.\\n12\\n\\n\\n| Exhibit No. | Description |\\n| 4.1 | Depositary Trust Agreement is incorporated by reference to Exhibit 4.1 of the Registration Statement on Form S‑1 (File No. 333‑253614) filed by the Registrant on June 21, 2021 |\\n| 4.2 | Standard Terms for Authorized Participant Agreements is incorporated by reference to Exhibit 4.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\\n| 10.1 | Custodian Agreement between The Bank of New York Mellon and JP Morgan Chase Bank N.A., London branch is incorporated by reference to Exhibit 10.1 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\\n| 10.2 | Sub-license Agreement is incorporated by reference to Exhibit 10.2 of the Registration Statement on Form S-1 (File No. 333-253614) filed by the Registrant on June 21, 2021 |\\n| 31.1 | Certification by Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2 | Certification by Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1 | Certification by Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\\n| 32.2 | Certification by Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑Oxley Act of 2002 |\\n| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |\\n| 101.SCH | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104 | Cover Page Interactive Data File included as Exhibit 101 (embedded within the Inline XBRL document) |\\n\\n13\\nSIGNATURES\\nPursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned in the capacities* indicated thereunto duly authorized.\\niShares Delaware Trust Sponsor LLC, Sponsor of the iShares Gold Trust Micro (registrant)\\n\\n| /s/ Paul Lohrey |\\n| Paul Lohrey |\\n| Director, President and Chief Executive Officer |\\n| (Principal executive officer) |\\n\\n\\n| Date: | November 3, 2021 |\\n\\n\\n| /s/ Trent Walker |\\n| Trent Walker |\\n| Chief Financial Officer |\\n| (Principal financial and accounting officer) |\\n\\n\\n| Date: | November 3, 2021 |\\n\\n\\n| * | The registrant is a trust and the persons are signing in their respective capacities as officers of iShares Delaware Trust Sponsor LLC, the Sponsor of the registrant. |\\n\\n14\\n</text>\\n\\nWhat is the percentage increase in the value of gold bullion from the date of inception until September 30, 2021?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 6411.824963808911.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 58,\n \"input_length\": 9592\n}"}}},{"rowIdx":59,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nItem 1. Financial Statements.\nBETTER WORLD ACQUISITION CORP.\nCONDENSED BALANCE SHEETS\n\n| September 30, 2022 | December 31, 2021 |\n| (Unaudited) |\n| ASSETS |\n| Current assets |\n| Cash | $ | 83,760 | $ | 278,197 |\n| Prepaid expenses and other current assets | 48,251 | 30,805 |\n| Total Current Assets | 132,011 | 309,002 |\n| Cash and marketable securities held in Trust Account | 44,203,481 | 128,790,008 |\n| TOTAL ASSETS | $ | 44,335,492 | $ | 129,099,010 |\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\n| Current liabilities - Accounts payable and accrued expenses | $ | 560,689 | $ | 430,800 |\n| Deferred legal fees | 1,371,549 | 1,009,868 |\n| Convertible promissory note – related party, at fair value | 913,900 | 958,400 |\n| Warrant Liabilities | 422,846 | 2,641,204 |\n| Income taxes payable | 27,528 | — |\n| Total Liabilities | 3,296,512 | 5,040,272 |\n| Commitments and Contingencies (Note 6) |\n| Common stock subject to possible redemption; $ 0.0001 par value; 4,213,453 shares at $ 10.49 per share redemption value as of September 30, 2022 and 12,618,600 shares at $ 10.20 per share redemption value as of December 31, 2021 | 44,203,481 | 128,709,720 |\n| Stockholders’ Deficit |\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued or outstanding | — | — |\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 3,487,070 shares issued and outstanding (excluding 4,213,453 and 12,618,600 shares subject to possible redemption) at September 30, 2022 and December 31, 2021, respectively | 348 | 348 |\n| Accumulated deficit | ( 3,164,849 | ) | ( 4,651,330 | ) |\n| Total Stockholders’ Deficit | ( 3,164,501 | ) | ( 4,650,982 | ) |\n| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT | $ | 44,335,492 | $ | 129,099,010 |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n1\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n\n| Three Months Ended September 30, | Nine Months Ended September 30, |\n| 2022 | 2021 | 2022 | 2021 |\n| Operational costs | $ | 396,066 | $ | 735,695 | $ | 1,327,272 | $ | 1,148,802 |\n| Loss from operations | ( 396,066 | ) | ( 735,695 | ) | ( 1,327,272 | ) | ( 1,148,802 | ) |\n| Other income (expense): |\n| Interest earned on marketable securities held in Trust Account | 254,709 | 23,138 | 423,734 | 58,976 |\n| Unrealized gain (loss) on marketable securities held in Trust Account | 1,078 | ( 4,654 | ) | — | ( 5,829 | ) |\n| Change in fair value of Private Warrants liabilities | ( 106,018 | ) | 2,192,941 | 2,218,358 | 3,302,913 |\n| Change in fair value of convertible promissory note – related party | 1,113,700 | — | 2,119,960 | — |\n| Other income, net | 1,263,469 | 2,211,425 | 4,762,052 | 3,356,060 |\n| Income before provision for income taxes | 867,403 | 1,475,730 | 3,434,780 | 2,207,258 |\n| Provision for income taxes | ( 23,249 | ) | — | ( 27,528 | ) | — |\n| Net income | $ | 844,154 | $ | 1,475,730 | $ | 3,407,252 | $ | 2,207,258 |\n| Basic and diluted weighted average shares outstanding, redeemable common stock | 5,591,938 | 12,618,600 | 9,268,327 | 12,618,600 |\n| Basic and diluted net income per share, redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\n| Basic and diluted weighted average shares outstanding, non-redeemable common stock | 3,487,070 | 3,487,070 | 3,487,070 | 3,487,070 |\n| Basic and diluted net income per share, non-redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n2\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT\n(UNAUDITED)\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2022\n\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\n| Shares | Amount | in Capital | Deficit | Deficit |\n| Balance – January 1, 2022 | 3,487,070 | $ | 348 | $ | — | $ | ( 4,651,330 | ) | $ | ( 4,650,982 | ) |\n| Accretion for common stock to redemption amount | — | — | — | ( 1,261,860 | ) | ( 1,261,860 | ) |\n| Net income | — | — | — | 1,647,395 | 1,647,395 |\n| Balance – March 31, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,265,795 | ) | $ | ( 4,265,447 | ) |\n| Accretion for common stock to redemption amount | — | — | — | ( 500,000 | ) | ( 500,000 | ) |\n| Net income | — | — | — | 915,703 | 915,703 |\n| Balance – June 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,850,092 | ) | $ | ( 3,849,744 | ) |\n| Accretion for common stock to redemption amount | — | — | ( 346,400 | ) | ( 158,911 | ) | ( 505,311 | ) |\n| Promissory note proceeds in excess of initial fair value | — | — | 346,400 | — | 346,400 |\n| Net income | — | — | — | 844,154 | 844,154 |\n| Balance – September 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,164,849 | ) | $ | ( 3,164,501 | ) |\n\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021\n\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\n| Shares | Amount | in Capital | Deficit | Deficit |\n| Balance – January 1, 2021 | 3,487,070 | $ | 348 | $ | — | $ | ( 5,489,693 | ) | $ | ( 5,489,345 | ) |\n| Net income | — | — | — | 832,646 | 832,646 |\n| Balance – March 31, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,657,047 | ) | $ | ( 4,656,699 | ) |\n| Net loss | — | — | — | ( 101,118 | ) | ( 101,118 | ) |\n| Balance – June 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,758,165 | ) | $ | ( 4,757,817 | ) |\n| Net income | — | — | — | 1,475,730 | 1,475,730 |\n| Balance – September 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,282,435 | ) | $ | ( 3,282,087 | ) |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n3\nBETTER WORLD ACQUISITION CORP.\nCONDENSED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n\n| Nine Months Ended September 30, |\n| 2022 | 2021 |\n| Cash Flows from Operating Activities: |\n| Net income | $ | 3,407,252 | $ | 2,207,258 |\n| Adjustments to reconcile net income to net cash used in operating activities: |\n| Interest earned on marketable securities held in Trust Account | ( 423,734 | ) | ( 58,976 | ) |\n| Unrealized gain on marketable securities held in Trust Account | — | 5,829 |\n| Change in fair value of convertible promissory note – related party | ( 2,119,960 | ) | — |\n| Change in fair value of Private Warrant liabilities | ( 2,218,358 | ) | ( 3,302,913 | ) |\n| Changes in operating assets and liabilities: |\n| Prepaid expenses and other current assets | ( 17,446 | ) | 45,890 |\n| Accounts payable and accrued expenses | 129,889 | 574,639 |\n| Income taxes payable | 27,528 | — |\n| Deferred legal fees payable | 361,681 | — |\n| Net cash used in operating activities | ( 853,148 | ) | ( 528,273 | ) |\n| Cash Flows from Investing Activities: |\n| Investment of cash into Trust Account | ( 2,121,860 | ) | — |\n| Cash withdrawn from Trust Account to pay franchise taxes | 358,711 | — |\n| Cash withdrawn from Trust Account in connection with redemption | 86,773,410 | — |\n| Net cash provided by investing activities | 85,010,261 | — |\n| Cash Flows from Financing Activities: |\n| Advances from related party | 100,000 | — |\n| Proceeds from promissory note – related party | — | 107,639 |\n| Repayment of promissory note – related party | — | ( 107,639 | ) |\n| Proceeds from convertible promissory note – related party | 2,321,860 | — |\n| Redemption of common stock | ( 86,773,410 | ) | — |\n| Net cash used in financing activities | ( 84,351,550 | ) | — |\n| Net Change in Cash | ( 194,437 | ) | ( 528,273 | ) |\n| Cash – Beginning of period | 278,197 | 1,023,178 |\n| Cash – End of period | $ | 83,760 | $ | 494,905 |\n| Non-Cash investing and financing activities: |\n| Conversion of advance to convertible promissory note – related party | $ | 100,000 | $ | — |\n| Accretion for common stock to redemption amount | $ | 1,928,271 | $ | — |\n| Promissory note proceeds in excess of initial fair value | $ | ( 338,900 | ) | $ | — |\n\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\n4\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nNOTE 1. DESCRIPTION OF ORGANIZATION, BUSINESS OPERATIONS, LIQUIDITY AND GOING CONCERN\nBetter World Acquisition Corp. (the “Company”) was incorporated in Delaware on August 5, 2020. The Company is a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (the “Business Combination”).\nAlthough the Company is not limited to a particular industry or sector for purposes of consummating a Business Combination, the Company is focused on target businesses in the healthy living industries that benefit from strong Environmental, Social and Governance (“ESG”) profiles. The Company is an early stage and emerging growth company and, as such, the Company is subject to all the risks associated with early stage and emerging growth companies.\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from August 5, 2020 (inception) through September 30, 2022 relates to the Company’s formation, the initial public offering (“Initial Public Offering”), which is described below, and identifying a target company for a Business Combination. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company generates non-operating income in the form of interest income from the marketable securities held in the Trust Account (as defined below).\nThe registration statement for the Company’s Initial Public Offering was declared effective on November 12, 2020. On November 17, 2020, the Company consummated the Initial Public Offering of 11,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units sold, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 110,000,000 , which is described in Note 3.\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 4,800,000 warrants (the “Private Warrants”) at a price of $ 1.00 per Private Warrant in a private placement to BWA Holdings LLC (the “Sponsor”) and EarlyBirdCapital, Inc. (“EarlyBirdCapital”), generating gross proceeds of $ 4,800,000 , which is described in Note 4.\nFollowing the closing of the Initial Public Offering on November 17, 2020, an amount of $ 111,100,000 ($ 10.10 per Unit) from the net proceeds of the sale of the Units in the Initial Public Offering and the sale of the Private Warrants was placed in a trust account (the “Trust Account”) located in the United States and invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds in the Trust Account, as described below.\nOn November 17, 2020, the underwriters notified the Company of their intention to partially exercise their over-allotment option on November 19, 2020. As such, on November 19, 2020, the Company consummated the sale of an additional 1,618,600 Units, at $ 10.00 per Unit, generating gross proceeds of $ 16,186,000 , and the sale of an additional 485,580 Private Warrants, at $ 1.00 per Private Warrant, generating gross proceeds of $ 485,580 . A total of $ 16,347,860 of the net proceeds was deposited into the Trust Account on November 20, 2020, bringing the aggregate proceeds held in the Trust Account to $ 127,447,860 . On November 9, 2021, in connection with the first extension of the date by which the Company has to consummate a Business Combination, a total of $ 1,261,860 was deposited into the Trust Account. On February 17, 2022, a total of $ 1,261,860 was deposited in the Trust Account in connection with the second extension of the date by which the Company has to consummate a Business Combination to May 17, 2022. On May 18, 2022, a total of $ 500,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to August 17, 2022. On August 17, 2022, a total of $ 360,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to February 17, 2023.\nTransaction costs amounted to $ 2,880,354 consisting of $ 2,523,720 of underwriting fees and $ 356,634 of other offering costs.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward completing a Business Combination. The Company must complete a Business Combination having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (excluding taxes payable on income earned on the Trust Account) at the time of the agreement to enter into an initial Business Combination. The Company will only complete a Business Combination if the post Business Combination company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to complete a Business Combination successfully.\n5\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nThe Company will provide its holders of the outstanding Public Shares (the “public stockholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The public stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account ($ 10.46 per Public Share as of September 30, 2022 and $ 10.20 per Public Share as of December 31, 2021, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s warrants.\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 immediately prior to or upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the shares voted are voted in favor of the Business Combination. If a stockholder vote is not required by law and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation (the “Amended and Restated Certificate of Incorporation”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC containing substantially the same information as would be included in a proxy statement prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by law, or the Company decides to obtain stockholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, the Sponsor has agreed to vote its Founder Shares (as defined in Note 5), Representative Shares (as defined in Note 8) and any Public Shares purchased during or after the Initial Public Offering (a) in favor of approving a Business Combination and (b) not to redeem any shares in connection with a stockholder vote to approve a Business Combination or sell any shares to the Company in a tender offer in connection with a Business Combination. Additionally, each public stockholder may elect to redeem their Public Shares, irrespective of whether they vote for or against the proposed Business Combination.\nThe Sponsor has agreed (a) to waive its redemption rights with respect to the Founder Shares and Public Shares held by it in connection with the completion of a Business Combination and (b) not to propose an amendment to the Amended and Restated Certificate of Incorporation that would affect a public stockholders’ ability to convert or sell their shares to the Company in connection with a Business Combination or affect the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment.\nOn November 9, 2021, the Company’s board of directors approved the first extension of the date by which the Company has to consummate a Business Combination from November 17, 2021 to February 17, 2022. In connection with the extension, the Sponsor deposited into the Trust Account $ 0.10 for each of the 12,618,600 shares issued in the Initial Public Offering, for a total of $ 1,261,860 . The Company issued the Sponsor a non-interest bearing unsecured promissory note in the principal amount of $ 1,261,860 which is payable by the Company upon the earlier of the consummation of the Business Combination or the liquidation of the Company. The Note may be repaid in cash or convertible into Private Warrants at a price of $ 1.00 per Private Warrant. On February 16, 2022, the Company’s board of directors approved the second extension of the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022. In connection with the second extension, the Sponsor deposited into the Trust Account an additional $ 1,261,860 ($ 0.10 per Public Share) on February 17, 2022, and the Company amended and restated the promissory note in its entirety solely to increase the principal amount thereunder from $ 1,261,860 to $ 2,523,720 . On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 (the “Combination Period”) was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. The Company amended and restated the promissory note to increase the principal amount thereunder from $ 2,523,720 to $ 3,223,720 , which included a drawdown of $ 500,000 for the extension and a drawdown of $ 200,000 for working capital needs. On August 17, 2022, the Company held a special meeting of stockholders in which the Company’s stockholders approved a second amendment to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023. On August 17, 2022, the Company amended and restated the promissory note to increase the principal amount thereunder from $ 3,223,720 to $ 3,683,720 , which included a drawdown of $ 360,000 for the extension and $ 100,000 for working capital purposes.\n6\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nIf the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to the Company to pay taxes, divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\nThe Sponsor has agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Sponsor acquires Public Shares in or after the Initial Public Offering, such Public Shares will be entitled to liquidating distributions from the Trust Account if the Company fails to complete a Business Combination within the Combination Period. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the amount of funds initially deposited into the Trust Account (initially $ 10.10 per share, subsequently increased to $ 10.46 per share as of September 30, 2022 following extensions).\nIn order to protect the amounts held in the Trust Account, the Sponsor has agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below $ 10.10 per Public Share, except as to any claims by a third party who executed a valid and enforceable agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the insiders will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the insiders will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\nRisks and Uncertainties\nManagement continues to evaluate the impact of the COVID-19 pandemic and the military conflict in the Ukraine and has concluded that while it is reasonably possible that the virus and the military conflict could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impacts are not readily determinable as of the date of these financial statements. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.\nInflation Reduction Act of 2022\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1 % excise tax on certain repurchases of stock by publicly traded U.S. domestic corporations and certain U.S. domestic subsidiaries of publicly traded foreign corporations occurring on or after January 1, 2023. The excise tax is imposed on the repurchasing corporation itself, not its shareholders from which shares are repurchased. The amount of the excise tax is generally 1 % of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax.\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Business Combination, extension vote or otherwise, may be subject to the excise tax. Whether and to what extent the Company would be subject to the excise tax in connection with a Business Combination, extension vote or otherwise would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Business Combination, extension or otherwise, (ii) the structure of a Business Combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with a Business Combination (or otherwise issued not in connection with a Business Combination but issued within the same taxable year of a Business Combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by the Company and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a Business Combination and in the Company’s ability to complete a Business Combination.\n7\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nLiquidity and Going Concern\nAs of September 30, 2022, the Company had $ 83,760 in its operating bank accounts and $ 44,203,481 in securities held in the Trust Account to be used for a Business Combination or to repurchase or redeem its common stock in connection therewith. As of September 30, 2022, $ 145,311 of the amount on deposit in the Trust Account represented accrued interest income, which can be withdrawn to pay the Company’s tax obligations.\nOn May 13, 2022, July 1, 2022 and August 16, 2022, the Company withdrew $ 178,564 , $ 66,751 and $ 113,396 , respectively, of accrued interest from the Trust Account to pay certain tax obligations.\nUntil the consummation of a Business Combination, the Company will use the funds not held in the Trust Account for identifying and evaluating prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to acquire, and structuring, negotiating and consummating the Business Combination.\nThe Company expects it will need to raise additional capital through loans or additional investments from its Sponsor, stockholders, officers, directors, or third parties. The Company’s officers, directors and the Sponsor may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all.\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\nNOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the period ended December 31, 2021, as filed with the SEC on March 31, 2022. The interim results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected for the year ending December 31, 2022 or for any future periods.\n8\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nReclassification of Prior Year Presentation\nCertain prior year amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on the reported results of operations. An adjustment has been made to the balance sheet for December 31, 2021 to reclassify the deferred legal fees balance from accrued expenses to a separate deferred legal fees line.\nEmerging Growth Company\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements.\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Two of the more significant accounting estimates included in these financial statements is the determination of the fair value of the warrant liabilities as well as the fair value of the convertible promissory note. Such estimates may be subject to change as more current information becomes available and accordingly the actual results could differ significantly from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of September 30, 2022 and December 31, 2021.\n9\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nCash and Marketable Securities Held in Trust Account\nAt September 30, 2022, substantially all of the assets held in the Trust Account were held in money market funds which are invested primarily in U.S Treasury securities. At December 31, 2021, substantially all of the assets held in the Trust Account were held in U.S. Treasury Securities. All of the Company’s investments held in the Trust Account are classified as trading securities. Trading securities are presented on the balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of investments held in the Trust Account are included in interest earned on marketable securities held in the Trust Account in the accompanying condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information. As of September 30, 2022, the Company has withdrawn $ 358,711 of interest income from the Trust Account to pay certain tax obligations.\nCommon Stock Subject to Possible Redemption\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that is either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, as of September 30, 2022 and December 31, 2021, respectively, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of the Company’s condensed balance sheets.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable common stock to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock are affected by charges against additional paid in capital and accumulated deficit.\nAt September 30, 2022 and December 31, 2021, the common stock reflected in the condensed balance sheets are reconciled in the following table:\n\n| Gross proceeds | $ | 126,186,000 |\n| Less: |\n| Common stock issuance costs | ( 2,868,790 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value | 5,392,510 |\n| Common stock subject to possible redemption – December 31, 2021 | $ | 128,709,720 |\n| Less: |\n| Redemption of shares | ( 86,773,410 | ) |\n| Plus: |\n| Accretion of carrying value to redemption value | 2,267,171 |\n| Common stock subject to possible redemption – September 30, 2022 | $ | 44,203,481 |\n\nWarrant Liabilities\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\n10\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nThe Company accounts for its convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. The Company has made such election for its convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nIncome Taxes\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” ASC 740, Income Taxes, requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the unaudited condensed financial statements and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. As of September 30, 2022 and December 31, 2021, the Company’s deferred tax asset had a full valuation allowance recorded against it.\nThe Company’s effective tax rate was 2.68 % and 0.00 % for the three months ended September 30, 2022 and 2021, respectively, and 0.80 % and 0.00 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate differs from the statutory tax rate of 21 % for the three months and nine months ended September 30, 2022 and 2021, due to changes in fair value in warrant liability, changes in the fair value of the convertible promissory note and the valuation allowance on the deferred tax assets.\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\nWhile ASC 740 identifies usage of an effective annual tax rate for purposes of an interim provision, it does allow for estimating individual elements in the current period if they are significant, unusual, or infrequent. Computing the effective tax rate for the Company is complicated due to the potential impact of the timing of any Business Combination expenses and the actual interest income that will be recognized during the year. The Company has taken a position as to the calculation of income tax expense in a current period based on ASC 740-270-25-3 which states, “If an entity is unable to estimate part of its ordinary income (or loss) or the related tax (benefit) but is otherwise able to make a reasonable estimate, the tax (or benefit) applicable to the item that cannot be estimated shall be reported in the interim period in which the item is reported.” The Company believes its calculation to be a reliable estimate and allows it to properly take into account the usual elements that can impact its annualized book income and its impact on the effective tax rate. As such, the Company is computing its taxable income (loss) and associated income tax provision based on actual results through September 30, 2022.\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company has identified the United States as its only “major” tax jurisdiction. The Company is subject to income taxation by major taxing authorities since inception. These examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\nNet Income Per Common Share\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share”. Net income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from income per common share as the redemption value approximates fair value.\nThe calculation of diluted income per share does not consider the effect of the warrants issued in connection with the (i) Initial Public Offering, and (ii) the private placement since the exercise of the warrants is contingent upon the occurrence of future events. The warrants are exercisable to purchase 17,904,180 shares of common stock in the aggregate. As of September 30, 2022 and 2021, the Company did not have any dilutive securities or other contracts that could, potentially, be exercised or converted into common stock and then participate in the earnings of the Company. As a result, diluted net income per common share is the same as basic net income per common share for the periods presented.\n11\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nReconciliation of Net Income per Common Share\nThe Company’s net income is adjusted for the portion of income that is attributable to common stock subject to possible redemption, as these shares only participate in the earnings of the Trust Account and not the income or losses of the Company. Accordingly, basic and diluted net income per common share is calculated as follows:\n\n| Three Months Ended September 30, 2022 | Three Months Ended September 30, 2021 | Nine Months Ended September 30, 2022 | Nine Months Ended September 30, 2021 |\n| Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock |\n| Basic and diluted net income per common share |\n| Numerator: |\n| Allocation of net income, as adjusted | $ | 519,931 | $ | 324,223 | $ | 1,156,217 | 319,513 | $ | 2,475,778 | $ | 931,474 | $ | 1,729,360 | $ | 477,898 |\n| Denominator: |\n| Basic and diluted weighted average shares outstanding | 5,591,938 | 3,487,070 | 12,618,600 | 3,487,070 | 9,268,327 | 3,487,070 | 12,618,600 | 3,487,070 |\n| Basic and diluted net income per common share | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.27 | $ | 0.14 | $ | 0.14 |\n\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, at times may exceed the Federal Deposit Insurance Corporation maximum coverage of $ 250,000 . The Company has not experienced losses on these accounts.\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC Topic 820, “Fair Value Measurement,” approximates the carrying amounts represented in the accompanying condensed balance sheets, primarily due to their short-term nature, except for warrant liabilities (see Note 9).\nFair Value Measurements\nFair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\n12\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nRecent Accounting Standards\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined it would not have a material impact on the condensed financial statements as presented.\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the Company’s condensed financial statements.\nNOTE 3. PUBLIC OFFERING\nPursuant to the Initial Public Offering, the Company sold 11,000,000 Units at a price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one redeemable warrant (“Public Warrant”). In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Company sold an additional 1,618,600 Units, at a purchase price of $ 10.00 per Unit. Each Public Warrant entitles the holder to purchase one share of common stock at an exercise price of $11.50 per share (see Note 8).\nNOTE 4. PRIVATE PLACEMENT\nSimultaneously with the closing of the Initial Public Offering, the Sponsor and EarlyBirdCapital purchased an aggregate of 4,800,000 Private Warrants at a price of $ 1.00 per Private Warrant for an aggregate purchase price of $ 4,800,000 . The Sponsor purchased 3,975,000 Private Warrants and EarlyBirdCapital purchased 825,000 Private Warrants. In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Sponsor and EarlyBirdCapital purchased an additional 485,580 Private Warrants, at a purchase price of $ 1.00 per Private Warrant, for an aggregate purchase price of $ 485,580 . Each Private Warrant entitles the holder to purchase one share of common stock at a price of $11.50 per full share, subject to adjustment (see Note 8). The proceeds from the Private Warrants were added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law).\nNOTE 5. RELATED PARTY TRANSACTIONS\nFounder Shares\nOn August 5, 2020, the Sponsor paid $ 25,000 to cover certain offering costs of the Company in consideration for 3,593,750 shares of common stock (the “Founder Shares”). On November 9, 2020, the Sponsor returned to the Company for cancellation, at no cost, an aggregate of 718,750 Founder Shares, resulting in an aggregate of 2,875,000 Founder Shares outstanding and held by the Sponsor. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in an aggregate of 3,162,500 Founder Shares outstanding and held by the Sponsor. The Founder Shares included, after giving retroactive effect to the share surrender and stock dividend, an aggregate of up to 412,500 shares subject to forfeiture to the extent that the underwriters’ over-allotment was not exercised in full or in part, so that the Sponsor would collectively own 20 % of the Company’s issued and outstanding shares after the Initial Public Offering (assuming the Sponsor did not purchase any Public Shares in the Initial Public Offering). In connection with the underwriters’ partial exercise of the over-allotment option and the forfeiture of the remaining over-allotment option, 7,850 Founder Shares were forfeited, and 404,650 Founder Shares are no longer subject to forfeiture resulting in an aggregate of 3,154,650 Founder Shares outstanding at September 30, 2022.\nThe Sponsor has agreed, subject to certain limited exceptions, not to transfer, assign or sell any of the Founder Shares until (1) with respect to 50% of the Founder Shares, the earlier of one year after the completion of a Business Combination and the date on which the closing price of the common stock equals or exceeds $12.50 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing after a Business Combination and (2) with respect to the remaining 50% of the Founder Shares, one year after the completion of a Business Combination, or earlier, in either case, if, subsequent to a Business Combination, the Company completes a liquidation, merger, stock exchange or other similar transaction which results in all of the Company’s stockholders having the right to exchange their shares of common stock for cash, securities or other property.\n13\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nDue from Sponsor\nAt the closing of the Initial Public Offering on November 17, 2020, an aggregate amount of $ 25,038 was due to the Company. Such amount was paid by the Company to the Sponsor and was included in the prepaid expenses and other current assets on the balance sheet at December 31, 2020. No balance remains outstanding as of September 30, 2022.\nAdministrative Support Agreement\nThe Company has agreed, commencing on November 12, 2020 through the earlier of the Company’s consummation of a Business Combination and its liquidation, to pay an affiliate of the Company’s management a total of $ 10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred $ 30,000 and $ 90,000 , respectively, in fees for these services, of which such amounts are included in accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $ 30,000 and $ 90,000 , respectively, in fees for these services.\nPromissory Note — Related Party\nOn August 5, 2020, the Company issued an unsecured promissory note to the Sponsor (the “Promissory Note”), pursuant to which the Company could borrow up to an aggregate principal amount of $ 300,000 . The Promissory Note was non-interest bearing and payable on the earlier of (i) March 31, 2021, (ii) the consummation of the Initial Public Offering or (iii) the date on which the Company determined not to proceed with the Initial Public Offering. The outstanding balance under the Promissory Note was repaid subsequent to the Initial Public Offering. As of September 30, 2022 and December 31, 2021, respectively, no balance is outstanding under the Promissory Note. Borrowings under the Promissory Note are no longer available.\nRelated Party Loans\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or certain of the Company’s officers and directors or their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). Each loan would be evidenced by promissory note. The notes may be repaid upon completion of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1,500,000 of notes may be converted upon completion of a Business Combination into warrants at a price of $ 1.00 per warrant. Such warrants would be identical to the Private Warrants. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\nOn April 14, 2022 the Sponsor advanced to the Company $ 100,000 to be used for working capital purposes. On August 17, 2022, the Company transferred the advance from the Sponsor to the second amended and restated promissory note (see Convertible Promissory Note – Related Party below). On October 13, 2022, the Sponsor advanced to the Company $ 200,000 to be used for working capital purposes.\nRelated Party Extension Loans\nAs discussed in Note 1, the Company previously extended the period of time to consummate a Business Combination two times, each by an additional three months (to May 17, 2022 to complete a Business Combination). In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $1,261,860 ($0.10 per Public Share), on or prior to the date of the applicable deadline, for each three-month extension. Payments were made in the form of a non-interest bearing, unsecured promissory note to be paid upon consummation of a Business Combination, or, at the relevant insider’s discretion, converted upon consummation of a Business Combination into additional Private Warrants at a price of $ 1.00 per Private Warrant. The Sponsor and its affiliates or designees are not obligated to fund the Trust Account to extend the time for the Company to complete a Business Combination. On May 12, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 500,000 . On August 15, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation, as amended to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 360,000 .\n14\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nOn November 9, 2021, the Company issued a promissory note in the principal amount of $ 1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022 and May 18, 2022, the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,223,720. On August 17, 2022 the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $3,223,720 to $3,683,720, which included $100,000 advanced by the Sponsor to the Company on April 14, 2022 and the payment of $360,000 for the extension from August 17, 2022 to November 17, 2022. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. At the election of the Sponsor, up to $ 1,500,000 of the unpaid principal amount of the Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $ 1.00 , rounded up to the nearest whole number of warrants. As of September 30, 2022, there was a $ 3,683,720 balance outstanding under the Convertible Promissory Note. The Convertible Promissory Note was valued using the fair value method. The fair value of the note as of September 30, 2022, was $ 913,900 , which resulted in a change in fair value of the convertible promissory note of $ 1,113,700 and $ 2,119,960 which was recorded in the statements of operations for the three and nine months ended September 30, 2022, respectively (see Note 9).\nNOTE 6. COMMITMENTS AND CONTINGENCIES\nRegistration Rights\nPursuant to a registration rights agreement entered into on November 12, 2020, the holders of the Founder Shares and Representative Shares (as defined in Notes 5 and 8, respectively), as well as the holders of the Private Warrants (and underlying securities) and any warrants issued in payment of Working Capital Loans made to Company (and underlying securities) will be entitled to registration rights. The holders of a majority of these securities are entitled to make up to two demands that the Company register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Representative Shares, Private Warrants and warrants issued in payment of working capital loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the effective date of the registration statement of which this prospectus forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggy-back” registration only during the seven-year period beginning on the effective date of the registration statement of which this prospectus forms a part. The registration rights agreement does not contain liquidating damages or other cash settlement provisions resulting from delays in registering the Company’s securities. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\nUnderwriting Agreement\nThe Company granted the underwriters a 45-day option from the date of the Initial Public Offering to purchase up to 1,650,000 additional Units to cover over-allotments, if any, at the Initial Public Offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 Units at $ 10.00 per Unit and forfeited the remaining over-allotment option.\n15\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nBusiness Combination Marketing Agreement\nThe Company has engaged EarlyBirdCapital as an advisor in connection with a Business Combination to assist the Company in holding meetings with its stockholders to discuss the potential Business Combination and the target business’ attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with a Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay EarlyBirdCapital a cash fee for such services upon the consummation of a Business Combination in an amount equal to 3.5% of the gross proceeds of the Initial Public Offering, or $4,416,510, (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at the Company’s sole discretion to other FINRA members that assist the Company in identifying and consummating a Business Combination.\nAdditionally, the Company will pay EarlyBirdCapital a cash fee equal to 1.0 % of the total consideration payable in a Business Combination if EarlyBirdCapital introduces the Company to the target business with which the Company completes a Business Combination.\nLegal Fee Agreements\nThe Company has engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any Business Combination. The law firms will not be entitled to any contingent fees or expense reimbursement if the Company does not consummate a Business Combination within its deadline. Deferred fees of $ 1,371,549 and $ 1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\nTrust Extension\nOn February 16, 2022, the Company issued a press release announcing that its Sponsor has requested that the Company extend the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022 (the “Extension”). The Extension is the second of two three-month extensions permitted under the Company’s governing documents and provides the Company with additional time to complete its Business Combination. On February 18, 2022, the Company issued a press release announcing that the Sponsor had deposited an additional $ 1,261,860 (representing $ 0.10 per public share) into the Trust Account for its public stockholders. On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. In connection with the extension amendment, stockholders holding approximately 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by the stockholders. In connection with this extension, the Company deposited $ 360,000 into the Trust Account on August 17, 2022. In connection with the extension amendment, stockholders holding approximately 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\nOn November 16, 2021, the Company had previously issued a promissory note (the “Note”) in the principal amount of $ 1,261,860 to the Company’s Sponsor. On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, the Company amended and restated the Note in its entirety to increase the principal amount thereunder from $1,262,860 to $3,683,720.\nNOTE 7. STOCKHOLDERS’ DEFICIT\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. At September 30, 2022 and December 31, 2021, respectively, there were no shares of preferred stock issued or outstanding.\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. At September 30, 2022 and December 31, 2021, there were 3,487,070 shares of common stock issued and outstanding, excluding 4,213,453 and 12,618,600 shares of common stock subject to possible redemption, respectively, which are presented as temporary equity. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. In connection with the extension on August 17, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\n16\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nNOTE 8. WARRANTS\nThe Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering. No warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the Public Warrants is not effective within a specified period following the consummation of a Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. The Public Warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation.\nThe Company may redeem the Public Warrants (excluding the Private Warrants and any warrants underlying units issued upon conversion of the Working Capital Loans):\n\n| ● | in whole and not in part; |\n| ● | at a price of $0.01 per warrant; |\n| ● | upon not less than 30 days’ prior written notice of redemption to each warrant holder; and |\n| ● | if, and only if, the last reported sale price of the common stock equals or exceeds $18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like), for any 20 trading days within a 30 trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of shares of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a stock dividend, or recapitalization, reorganization, merger or consolidation. However, except as described below, the warrants will not be adjusted for issuance of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\nIn addition, if (x) the Company issues additional common stock or equity-linked securities for capital raising purposes in connection with the closing of a Business Combination at an issue price or effective issue price of less than $9.20 per common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of a Business Combination on the date of the consummation of a Business Combination (net of redemptions), and (z) the volume weighted average trading price of its common stock during the 20 trading day period starting on the trading day prior to the day on which the Company consummates its Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) Market Value or (ii) the price at which the Company issue the additional shares of common stock or equity-linked securities.\nThe Private Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Warrants and the shares of common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or saleable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable for cash or on a cashless basis, at the holder’s option, and be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\n17\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nRepresentative Shares\nOn August 5, 2020, the Company issued to EarlyBirdCapital 377,750 shares of common stock (the “Representative Shares”). On November 9, 2020, EarlyBirdCapital returned to the Company for cancellation, at no cost, an aggregate of 75,550 Representative Shares, resulting in an aggregate of 302,200 Representative Shares outstanding and held by EarlyBirdCapital. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in EarlyBirdCapital holding an aggregate of 332,420 Representative Shares. The Company accounted for the Representative Shares as an offering cost of the Initial Public Offering, with a corresponding credit to stockholders’ equity. The Company estimated the fair value of Representative Shares to be $ 2,666 based upon the price of the Founder Shares issued to the Sponsor. The holders of the Representative Shares have agreed not to transfer, assign or sell any such shares until the completion of a Business Combination. In addition, the holders have agreed (i) to waive their redemption rights with respect to such shares in connection with the completion of a Business Combination and (ii) to waive their rights to liquidating distributions from the Trust Account with respect to such shares if the Company fails to complete a Business Combination within the Combination Period.\nThe Representative Shares have been deemed compensation by FINRA and are therefore subject to a lock-up for a period of 180 days immediately following the effective date of the registration statement related to the Initial Public Offering pursuant to Rule 5110(g)(1) of FINRA’s NASD Conduct Rules. Pursuant to FINRA Rule 5110(g)(1), these securities will not be sold during the Initial Public Offering, or sold, transferred, assigned, pledged, or hypothecated, or be the subject of any hedging, short sale, derivative, put or call transaction that would result in the economic disposition of the securities by any person for a period of 180 days immediately following the effective date of the Initial Public Offering, except to any underwriter and selected dealer participating in the Initial Public Offering and their bona fide officers or partners, provided that all securities so transferred remain subject to the lockup restriction above for the remainder of the time period.\nNOTE 9. FAIR VALUE MEASUREMENTS\nThe Company follows the guidance in ASC 820 for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\n\n| Level 1: | Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. |\n| Level 2: | Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active. |\n| Level 3: | Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability. |\n\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis at September 30, 2022 and December 31, 2021, respectively, and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value:\n\n| Description | Level | September, 2022 | December 31, 2021 |\n| Assets: |\n| Marketable securities held in Trust Account | 1 | $ | 44,203,481 | $ | 128,790,008 |\n| Liabilities: |\n| Warrant liabilities – Private Warrants | 3 | $ | 422,846 | $ | 2,641,204 |\n| Convertible promissory note – related party | 3 | $ | 913,900 | $ | 958,400 |\n\n18\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nWarrant Liabilities\nThe Private Warrants were accounted for as liabilities in accordance with ASC 815-40 and are presented within warrant liabilities on the condensed balance sheets. The warrant liabilities are measured at fair value at inception and on a recurring basis, with changes in fair value presented within change in fair value of warrant liabilities in the condensed statements of operations.\nThe Private Warrants were valued using a binomial lattice model. The Company allocated the proceeds received from (i) the sale of Units (which is inclusive of one share of common stock and one Public Warrant) and (ii) the sale of Private Warrants, first to the warrants based on their fair values as determined at initial measurement, with the remaining proceeds allocated to common stock subject to possible redemption. The Private Warrants were classified as Level 3 at the initial measurement date due to the use of unobservable inputs.\nThe following are the inputs used by the Company in establishing the fair value of its Private Warrants at September 30, 2022 and December 31, 2021.\n\n| Input | September 30, 2022 | December 31, 2021 |\n| Risk-free interest rate | 4.07 | % | 1.15 | % |\n| Trading days per year | 252 | 252 |\n| Expected volatility | 5.3 | % | 9.6 | % |\n| Exercise price | $ | 11.50 | $ | 11.50 |\n| Stock Price | $ | 10.35 | $ | 10.17 |\n\nOn December 31, 2021 and September 30, 2022, the Private Warrants were determined to be $ 0.50 per warrant and $ 0.08 per warrant, respectively, for an aggregate value of $ 2.64 million and $ 0.4 million, respectively.\nThe following table presents the changes in the fair value of the warrant liabilities:\n\n| Private Placement |\n| Fair value as of December 31, 2021 | $ | 2,641,204 |\n| Change in valuation inputs or other assumptions | ( 1,744,591 | ) |\n| Fair value as of March 31, 2022 | $ | 896,613 |\n| Change in valuation inputs or other assumptions | ( 579,785 | ) |\n| Fair value as of June 30, 2022 | $ | 316,828 |\n| Change in valuation inputs or other assumptions | 106,018 |\n| Fair value as of September 30, 2022 | $ | 422,846 |\n\n19\nBETTER WORLD ACQUISITION CORP.\nNOTES TO CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\n(Unaudited)\nConvertible Promissory Note – Related Party\nThe fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nThe estimated fair value of the convertible promissory note was based on the following significant inputs:\n\n| September 30, 2022 |\n| Risk-free interest rate | 0.00 | % |\n| Time to Expiration (in years) | 1.38 |\n| Expected volatility | 5.3 | % |\n| Exercise price | $ | 11.50 |\n| Dividend yield | 0.00 | % |\n| Stock Price | $ | 10.35 |\n| Probability of transaction | 25.00 | % |\n\nThe following table presents the changes in the fair value of the Level 3 convertible promissory note:\n\n| Fair value as of January 1, 2021 | $ | 958,400 |\n| Proceeds received through Convertible Promissory Note | 1,261,860 |\n| Change in fair value | ( 337,260 | ) |\n| Fair value as of March 31, 2022 | $ | 1,883,000 |\n| Proceeds received through Convertible Promissory Note | 700,000 |\n| Change in fair value | ( 669,000 | ) |\n| Fair value as of June 30, 2022 | $ | 1,914,000 |\n| Conversion of Sponsor advance to Convertible Promissory Note | 100,000 |\n| Proceeds received through Convertible Promissory Note | 360,000 |\n| Change in fair value | ( 1,460,100 | ) |\n| Fair value as of September 30, 2022 | 913,900 |\n\nThere were no transfers in or out of Level 3 from other levels in the fair value hierarchy during the three and nine months ended September 30, 2022 for the convertible promissory note.\nNOTE 10. SUBSEQUENT EVENTS\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the financial statements were issued. Based upon this review the Company did not identify any subsequent events that would have required adjustment or disclosure in the condensed financial statements.\n20\n\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\nReferences in this report (the “Quarterly Report”) to “we,” “us,” “our” or the “Company” refer to Better World Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to BWA Holdings LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act that are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively.\nOverview\nWe are a blank check company formed under the laws of the State of Delaware on August 5, 2020 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (an “initial business combination”). We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful.\n21\nResults of Operations\nWe have neither engaged in any operations nor generated any revenues to date. Our only activities from August 5, 2020 (inception) through September 30, 2022 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence and transaction expenses.\nFor the three months ended September 30, 2022, we had net income of $844,154 which consists of the change in fair value of convertible promissory note – related party of $1,113,700, interest earned on marketable securities held in the Trust Account of $254,709 and unrealized gain on marketable securities held in the Trust Account of $1,078, offset by change in fair value of warrant liability of $106,018, a provision for income taxes of $23,249 and operational costs of $396,066.\nFor the nine months ended September 30, 2022, we had net income of $3,407,252 which consists of the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960, and interest earned on marketable securities held in the Trust Account of $423,734, offset by provision for income taxes of $27,528 and operational costs of $1,327,272.\nFor the three months ended September 30, 2021, we had net income of $1,475,730 which consists of the change in fair value of warrant liability of $2,192,941 and interest earned on marketable securities held in the Trust Account of $23,138, and unrealized loss on marketable securities held in the Trust Account of $4,654, offset by formation and operational costs of $735,695.\nFor the nine months ended September 30, 2021, we had net income of $2,207,258, which consists of the change in fair value of warrant liability of $3,302,913 and interest earned on marketable securities held in the Trust Account of $58,976, and unrealized loss on marketable securities held in the Trust Account of $5,829, offset by formation and operational costs of $1,148,802.\nLiquidity and Capital Resources\nOn November 17, 2020, we consummated the Initial Public Offering of 11,000,000 units, at $10.00 per Unit, generating gross proceeds of $110,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,800,000 Private Warrants at a price of $1.00 per Private Warrant in a private placement to our Sponsor and EarlyBirdCapital, Inc. generating gross proceeds of $4,800,000.\nOn November 19, 2020, in connection with the underwriters’ partial exercise of their over-allotment option, we consummated the sale of an additional 1,618,600 units at a price of $10.00 per unit, generating total gross proceeds of $16,186,000. In addition, we also consummated the sale of an additional 485,580 private placement warrants at $1.00 per private placement warrant, generating total gross proceeds of $485,580.\nFollowing the initial public offering, the partial exercise of the over-allotment option, and the sale of the private placement warrants, $111,100,000 was placed in the trust account on November 18, 2020 and $16,347,860 was placed in the Trust Account on November 20, 2020, respectively, for a total of $127,447,860. We incurred $2,880,354 in the initial public offering related costs, including $2,523,720 of underwriting fees and $356,634 of other costs.\nFor the nine months ended September 30, 2022, cash used in operating activities was $853,148. Net income of $3,407,252 was affected by the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960 and interest earned on marketable securities held in the Trust Account of $423,734. Changes in operating assets and liabilities provided $501,652 of cash for operating activities.\nFor the nine months ended September 30, 2021, cash used in operating activities was $528,273. Net income of $2,207,258 was affected by the change in fair value of warrant liability of $3,302,913, interest earned on marketable securities held in the Trust Account of $58,976, and an unrealized loss on marketable securities held in our Trust Account of $5,829. Changes in operating assets and liabilities provided $620,529 of cash for operating activities.\nAs of September 30, 2022, in the U.S.-based trust account maintained by Continental Stock Transfer & Trust Company, acting as trustee, we had cash held of $947 and marketable securities held in the Trust Account of $44,202,534 (including approximately $145,311 of interest income) consisting of securities held in a money market fund that invests in U.S. Treasury securities with a maturity of 180 days or less. Interest income on the balance in the trust account may be used by us to pay taxes. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $10.30 per share. In connection with the extension on August 15, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds on the Trust Account at a redemption price of approximately $10.37 per share. Through September 30, 2022, we have withdrawn $358,711 of interest earned on the trust account to pay our taxes.\n22\nWe intend to use substantially all of the funds held in the trust account, to acquire a target business and to pay our expenses relating thereto upon consummation of our initial business combination for assisting us in connection with our initial business combination. To the extent that our capital stock is used in whole or in part as consideration to effect an initial business combination, the remaining funds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our initial business combination if the funds available to us outside of the trust account were insufficient to cover such expenses.\nAs of September 30, 2022, we had cash of $83,760 held outside the trust account. We intend to use the funds held outside the trust account for identifying and evaluating prospective acquisition candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to acquire and structuring, negotiating and consummating the initial business combination.\nIn order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, the insiders, or certain of our officers and directors or their affiliates may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant, at the option of the lender. The units would be identical to the private placement warrants. On November 9, 2021, we issued a promissory note in the principal amount of $1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, we amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,683,720. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. At the election of the Sponsor, up to $1,500,000 of the unpaid principal amount of the Convertible Promissory Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $1.00, rounded up to the nearest whole number of warrants.\nWe expect that we will need to raise additional capital through loans or additional investments from our sponsor, stockholders, officers, directors, or third parties. Our officers, directors and sponsor may, but are not obligated to, loan us funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all.\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\nOff-Balance Sheet Financing Arrangements\nWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\n23\nContractual Obligations\nWe have agreed, commencing on November 12, 2020 through the earlier of our consummation of an initial business combination and our liquidation, to pay an affiliate of our management a total of $10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred and accrued $30,000 and $90,000 in fees for these services, respectively, and those fees are included in accounts payable and accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $30,000 and $90,000 in fees for these services.\nWe granted the underwriters a 45-day option from the date of the initial public offering to purchase up to 1,650,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 units at $10.00 per unit and forfeited the remaining over-allotment option.\nWe have engaged EarlyBirdCapital as an advisor in connection with an initial business combination to assist us in holding meetings with its stockholders to discuss the potential initial business combination and the target business’ attributes, introduce us to potential investors that are interested in purchasing our securities in connection with an initial business combination, assist us in obtaining stockholder approval for the initial business combination and assist us with our press releases and public filings in connection with the initial business combination. We will pay EarlyBirdCapital a cash fee for such services upon the consummation of an initial business combination in an amount equal to 3.5% of the gross proceeds of the initial public offering, or $4,416,510 (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at our sole discretion to other FINRA members that assist us in identifying and consummating an initial business combination.\nAdditionally, we will pay EarlyBirdCapital a cash fee equal to 1.0% of the total consideration payable in an initial business combination if EarlyBirdCapital introduces us to the target business with which we complete an initial business combination.\nWe have engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any business combination. The law firms will not be entitled to any contingent fees or expense reimbursement if we do not consummate an initial business combination within our deadline. Deferred fees of $1,371,549 and $1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\nCritical Accounting Policies\nThe preparation of condensed financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies:\nWarrant Liability\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\n24\nConvertible Promissory Note\nWe account for our convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. We have made such election for our convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into private placement warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\nCommon Stock Subject to Possible Redemption\nWe account for our common stock subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of our condensed balance sheets.\nNet Income per Common Share\nNet income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from net income per common share as the redemption value approximates fair value.\nRecent Accounting Standards\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined that it would not have a material impact on the condensed financial statements as presented.\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements.\nFactors That May Adversely Affect Our Results of Operations\nOur results of operation and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, volatility in the financial markets or economic conditions, increase of oil price and interest rate, inflation, supply chain disruption, decline in consumer confidence and spending, the on-going effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict one or more of the above events, their duration or magnitude of, or the extent to, which they may negatively impact our business and our ability to complete an initial business combination.\n25\n\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\nNot required for smaller reporting companies.\n\nItem 4. Controls and Procedures\nEvaluation of Disclosure Controls and Procedures\nDisclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized, and reported within the time period specified in the SEC’s rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\nAs required by Rule 13a-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective, due solely to the material weakness in our internal control over financial reporting related to our accounting for complex financial instruments. As a result, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the financial statements included in this Report present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\nManagement has identified a material weakness in our internal controls related to the accounting for complex financial instruments. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to continue to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for complex securities and related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\nChanges in Internal Control over Financial Reporting\nThere were no changes in our internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\n26\nPART II - OTHER INFORMATION\n\nItem 1. Legal Proceedings.\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\n\nItem 1A. Risk Factors\nAs of the date of this Quarterly Report on Form 10-Q, except as disclosed below, there have been no material changes to the risk factors previously disclosed in our final prospectus filed with the SEC on November 17, 2020 , in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the SEC on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\nA new 1% U.S. federal excise tax could be imposed on us in connection with redemptions of our shares in connection with a business combination or other stockholder vote pursuant to which stockholders would have a right to submit their shares for redemption (a “Redemption Event”).\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1% excise tax on certain repurchases (including redemptions) of stock by publicly traded domestic corporations and certain domestic subsidiaries of publicly traded foreign corporations. The excise tax is imposed on the repurchasing corporation itself, not its stockholders from whom shares are repurchased. The amount of the excise tax is generally 1% of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax. The IR Act applies only to repurchases that occur after December 31, 2022.\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Redemption Event may be subject to the excise tax. Whether and to what extent we would be subject to the excise tax in connection with a Redemption Event would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Redemption Event, (ii) the structure of the business combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with the business combination (or otherwise issued not in connection with the Redemption Event but issued within the same taxable year of the business combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by us, and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a business combination and in our ability to complete a business combination.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we expect to instruct the trustee to liquidate the securities held in our trust account and instead to hold the funds in our trust account in cash items until the earlier of the consummation of our initial business combination or our liquidation. As a result, we will likely receive minimal interest, if any, on the funds held in the trust account, which will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company.\nThe funds in our trust account have, since our initial public offering, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we expect to instruct Continental Stock Transfer & Trust Company, the trustee with respect to our trust account, to liquidate the U.S. government treasury obligations and money market funds held in the trust account and to hold all funds in the trust account as cash items until the earlier of the consummation of our initial business combination or the liquidation of the Company. Following such liquidation, we will likely receive minimal interest, if any, on the funds held in the trust account. However, interest previously earned on the funds held in the trust account still may be released to us to pay our taxes, if any. This will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company. In the event that we may be deemed to be an investment company, we may be required to liquidate the Company.\n27\n\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\nNone.\n\nItem 3. Defaults Upon Senior Securities\nNone.\n\nItem 4. Mine Safety Disclosures\nNone.\n\nItem 5. Other Information\nNone.\n28\n\nItem 6. Exhibits\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\n\n| No. | Description of Exhibit |\n| 3.1 | Second Amendment to the Amended and Restated Certificate of Incorporation, as amended (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\n| 10.1 | Third Amended and Restated Promissory Note, dated August 17, 2022 (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\n| 101.INS* | Inline XBRL Instance Document |\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\n| 104* | Cover Page Interactive Data File |\n\n\n| * | Filed herewith. |\n| ** | Furnished herewith. |\n\n29\nSIGNATURES\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| BETTER WORLD ACQUISITION CORP. |\n| Date: November 14, 2022 | By: | /s/ Rosemary L. Ripley |\n| Name: | Rosemary L. Ripley |\n| Title: | Chief Executive Officer |\n| (Principal Executive Officer) |\n| Date: November 14, 2022 | By: | /s/ Peter S.H. Grubstein |\n| Name: | Peter S.H. Grubstein |\n| Title: | Chief Financial Officer |\n| (Principal Financial Officer) |\n\n30\n\n</text>\n\nWhat's the estimated worth of the company Better World Acquisition Corp. at the end of Q4 in 2022 if the company continues to follow the same trend as it did in the first three quarters of 2022, in millions of dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nItem 1. Financial Statements.\\nBETTER WORLD ACQUISITION CORP.\\nCONDENSED BALANCE SHEETS\\n\\n| September 30, 2022 | December 31, 2021 |\\n| (Unaudited) |\\n| ASSETS |\\n| Current assets |\\n| Cash | $ | 83,760 | $ | 278,197 |\\n| Prepaid expenses and other current assets | 48,251 | 30,805 |\\n| Total Current Assets | 132,011 | 309,002 |\\n| Cash and marketable securities held in Trust Account | 44,203,481 | 128,790,008 |\\n| TOTAL ASSETS | $ | 44,335,492 | $ | 129,099,010 |\\n| LIABILITIES AND STOCKHOLDERS’ DEFICIT |\\n| Current liabilities - Accounts payable and accrued expenses | $ | 560,689 | $ | 430,800 |\\n| Deferred legal fees | 1,371,549 | 1,009,868 |\\n| Convertible promissory note – related party, at fair value | 913,900 | 958,400 |\\n| Warrant Liabilities | 422,846 | 2,641,204 |\\n| Income taxes payable | 27,528 | — |\\n| Total Liabilities | 3,296,512 | 5,040,272 |\\n| Commitments and Contingencies (Note 6) |\\n| Common stock subject to possible redemption; $ 0.0001 par value; 4,213,453 shares at $ 10.49 per share redemption value as of September 30, 2022 and 12,618,600 shares at $ 10.20 per share redemption value as of December 31, 2021 | 44,203,481 | 128,709,720 |\\n| Stockholders’ Deficit |\\n| Preferred stock, $ 0.0001 par value; 1,000,000 shares authorized; none issued or outstanding | — | — |\\n| Common stock, $ 0.0001 par value; 50,000,000 shares authorized; 3,487,070 shares issued and outstanding (excluding 4,213,453 and 12,618,600 shares subject to possible redemption) at September 30, 2022 and December 31, 2021, respectively | 348 | 348 |\\n| Accumulated deficit | ( 3,164,849 | ) | ( 4,651,330 | ) |\\n| Total Stockholders’ Deficit | ( 3,164,501 | ) | ( 4,650,982 | ) |\\n| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT | $ | 44,335,492 | $ | 129,099,010 |\\n\\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\\n1\\nBETTER WORLD ACQUISITION CORP.\\nCONDENSED STATEMENTS OF OPERATIONS\\n(UNAUDITED)\\n\\n| Three Months Ended September 30, | Nine Months Ended September 30, |\\n| 2022 | 2021 | 2022 | 2021 |\\n| Operational costs | $ | 396,066 | $ | 735,695 | $ | 1,327,272 | $ | 1,148,802 |\\n| Loss from operations | ( 396,066 | ) | ( 735,695 | ) | ( 1,327,272 | ) | ( 1,148,802 | ) |\\n| Other income (expense): |\\n| Interest earned on marketable securities held in Trust Account | 254,709 | 23,138 | 423,734 | 58,976 |\\n| Unrealized gain (loss) on marketable securities held in Trust Account | 1,078 | ( 4,654 | ) | — | ( 5,829 | ) |\\n| Change in fair value of Private Warrants liabilities | ( 106,018 | ) | 2,192,941 | 2,218,358 | 3,302,913 |\\n| Change in fair value of convertible promissory note – related party | 1,113,700 | — | 2,119,960 | — |\\n| Other income, net | 1,263,469 | 2,211,425 | 4,762,052 | 3,356,060 |\\n| Income before provision for income taxes | 867,403 | 1,475,730 | 3,434,780 | 2,207,258 |\\n| Provision for income taxes | ( 23,249 | ) | — | ( 27,528 | ) | — |\\n| Net income | $ | 844,154 | $ | 1,475,730 | $ | 3,407,252 | $ | 2,207,258 |\\n| Basic and diluted weighted average shares outstanding, redeemable common stock | 5,591,938 | 12,618,600 | 9,268,327 | 12,618,600 |\\n| Basic and diluted net income per share, redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\\n| Basic and diluted weighted average shares outstanding, non-redeemable common stock | 3,487,070 | 3,487,070 | 3,487,070 | 3,487,070 |\\n| Basic and diluted net income per share, non-redeemable common stock | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.14 |\\n\\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\\n2\\nBETTER WORLD ACQUISITION CORP.\\nCONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT\\n(UNAUDITED)\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2022\\n\\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\\n| Shares | Amount | in Capital | Deficit | Deficit |\\n| Balance – January 1, 2022 | 3,487,070 | $ | 348 | $ | — | $ | ( 4,651,330 | ) | $ | ( 4,650,982 | ) |\\n| Accretion for common stock to redemption amount | — | — | — | ( 1,261,860 | ) | ( 1,261,860 | ) |\\n| Net income | — | — | — | 1,647,395 | 1,647,395 |\\n| Balance – March 31, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,265,795 | ) | $ | ( 4,265,447 | ) |\\n| Accretion for common stock to redemption amount | — | — | — | ( 500,000 | ) | ( 500,000 | ) |\\n| Net income | — | — | — | 915,703 | 915,703 |\\n| Balance – June 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,850,092 | ) | $ | ( 3,849,744 | ) |\\n| Accretion for common stock to redemption amount | — | — | ( 346,400 | ) | ( 158,911 | ) | ( 505,311 | ) |\\n| Promissory note proceeds in excess of initial fair value | — | — | 346,400 | — | 346,400 |\\n| Net income | — | — | — | 844,154 | 844,154 |\\n| Balance – September 30, 2022 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,164,849 | ) | $ | ( 3,164,501 | ) |\\n\\nFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021\\n\\n| Common Stock | Additional Paid | Accumulated | Total Stockholders’ |\\n| Shares | Amount | in Capital | Deficit | Deficit |\\n| Balance – January 1, 2021 | 3,487,070 | $ | 348 | $ | — | $ | ( 5,489,693 | ) | $ | ( 5,489,345 | ) |\\n| Net income | — | — | — | 832,646 | 832,646 |\\n| Balance – March 31, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,657,047 | ) | $ | ( 4,656,699 | ) |\\n| Net loss | — | — | — | ( 101,118 | ) | ( 101,118 | ) |\\n| Balance – June 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 4,758,165 | ) | $ | ( 4,757,817 | ) |\\n| Net income | — | — | — | 1,475,730 | 1,475,730 |\\n| Balance – September 30, 2021 (unaudited) | 3,487,070 | $ | 348 | — | $ | ( 3,282,435 | ) | $ | ( 3,282,087 | ) |\\n\\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\\n3\\nBETTER WORLD ACQUISITION CORP.\\nCONDENSED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n\\n| Nine Months Ended September 30, |\\n| 2022 | 2021 |\\n| Cash Flows from Operating Activities: |\\n| Net income | $ | 3,407,252 | $ | 2,207,258 |\\n| Adjustments to reconcile net income to net cash used in operating activities: |\\n| Interest earned on marketable securities held in Trust Account | ( 423,734 | ) | ( 58,976 | ) |\\n| Unrealized gain on marketable securities held in Trust Account | — | 5,829 |\\n| Change in fair value of convertible promissory note – related party | ( 2,119,960 | ) | — |\\n| Change in fair value of Private Warrant liabilities | ( 2,218,358 | ) | ( 3,302,913 | ) |\\n| Changes in operating assets and liabilities: |\\n| Prepaid expenses and other current assets | ( 17,446 | ) | 45,890 |\\n| Accounts payable and accrued expenses | 129,889 | 574,639 |\\n| Income taxes payable | 27,528 | — |\\n| Deferred legal fees payable | 361,681 | — |\\n| Net cash used in operating activities | ( 853,148 | ) | ( 528,273 | ) |\\n| Cash Flows from Investing Activities: |\\n| Investment of cash into Trust Account | ( 2,121,860 | ) | — |\\n| Cash withdrawn from Trust Account to pay franchise taxes | 358,711 | — |\\n| Cash withdrawn from Trust Account in connection with redemption | 86,773,410 | — |\\n| Net cash provided by investing activities | 85,010,261 | — |\\n| Cash Flows from Financing Activities: |\\n| Advances from related party | 100,000 | — |\\n| Proceeds from promissory note – related party | — | 107,639 |\\n| Repayment of promissory note – related party | — | ( 107,639 | ) |\\n| Proceeds from convertible promissory note – related party | 2,321,860 | — |\\n| Redemption of common stock | ( 86,773,410 | ) | — |\\n| Net cash used in financing activities | ( 84,351,550 | ) | — |\\n| Net Change in Cash | ( 194,437 | ) | ( 528,273 | ) |\\n| Cash – Beginning of period | 278,197 | 1,023,178 |\\n| Cash – End of period | $ | 83,760 | $ | 494,905 |\\n| Non-Cash investing and financing activities: |\\n| Conversion of advance to convertible promissory note – related party | $ | 100,000 | $ | — |\\n| Accretion for common stock to redemption amount | $ | 1,928,271 | $ | — |\\n| Promissory note proceeds in excess of initial fair value | $ | ( 338,900 | ) | $ | — |\\n\\nThe accompanying notes are an integral part of the unaudited condensed financial statements.\\n4\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nNOTE 1. DESCRIPTION OF ORGANIZATION, BUSINESS OPERATIONS, LIQUIDITY AND GOING CONCERN\\nBetter World Acquisition Corp. (the “Company”) was incorporated in Delaware on August 5, 2020. The Company is a blank check company formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (the “Business Combination”).\\nAlthough the Company is not limited to a particular industry or sector for purposes of consummating a Business Combination, the Company is focused on target businesses in the healthy living industries that benefit from strong Environmental, Social and Governance (“ESG”) profiles. The Company is an early stage and emerging growth company and, as such, the Company is subject to all the risks associated with early stage and emerging growth companies.\\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from August 5, 2020 (inception) through September 30, 2022 relates to the Company’s formation, the initial public offering (“Initial Public Offering”), which is described below, and identifying a target company for a Business Combination. The Company will not generate any operating revenues until after the completion of a Business Combination, at the earliest. The Company generates non-operating income in the form of interest income from the marketable securities held in the Trust Account (as defined below).\\nThe registration statement for the Company’s Initial Public Offering was declared effective on November 12, 2020. On November 17, 2020, the Company consummated the Initial Public Offering of 11,000,000 units (the “Units” and, with respect to the shares of common stock included in the Units sold, the “Public Shares”), at $ 10.00 per Unit, generating gross proceeds of $ 110,000,000 , which is described in Note 3.\\nSimultaneously with the closing of the Initial Public Offering, the Company consummated the sale of 4,800,000 warrants (the “Private Warrants”) at a price of $ 1.00 per Private Warrant in a private placement to BWA Holdings LLC (the “Sponsor”) and EarlyBirdCapital, Inc. (“EarlyBirdCapital”), generating gross proceeds of $ 4,800,000 , which is described in Note 4.\\nFollowing the closing of the Initial Public Offering on November 17, 2020, an amount of $ 111,100,000 ($ 10.10 per Unit) from the net proceeds of the sale of the Units in the Initial Public Offering and the sale of the Private Warrants was placed in a trust account (the “Trust Account”) located in the United States and invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less or in any open-ended investment company that holds itself out as a money market fund selected by the Company meeting the conditions of Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of the funds in the Trust Account, as described below.\\nOn November 17, 2020, the underwriters notified the Company of their intention to partially exercise their over-allotment option on November 19, 2020. As such, on November 19, 2020, the Company consummated the sale of an additional 1,618,600 Units, at $ 10.00 per Unit, generating gross proceeds of $ 16,186,000 , and the sale of an additional 485,580 Private Warrants, at $ 1.00 per Private Warrant, generating gross proceeds of $ 485,580 . A total of $ 16,347,860 of the net proceeds was deposited into the Trust Account on November 20, 2020, bringing the aggregate proceeds held in the Trust Account to $ 127,447,860 . On November 9, 2021, in connection with the first extension of the date by which the Company has to consummate a Business Combination, a total of $ 1,261,860 was deposited into the Trust Account. On February 17, 2022, a total of $ 1,261,860 was deposited in the Trust Account in connection with the second extension of the date by which the Company has to consummate a Business Combination to May 17, 2022. On May 18, 2022, a total of $ 500,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to August 17, 2022. On August 17, 2022, a total of $ 360,000 was deposited into the Trust Account in connection with a further extension of the date by which the Company has to consummate a Business Combination to February 17, 2023.\\nTransaction costs amounted to $ 2,880,354 consisting of $ 2,523,720 of underwriting fees and $ 356,634 of other offering costs.\\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the Initial Public Offering and the sale of the Private Warrants, although substantially all of the net proceeds are intended to be applied generally toward completing a Business Combination. The Company must complete a Business Combination having an aggregate fair market value of at least 80 % of the assets held in the Trust Account (excluding taxes payable on income earned on the Trust Account) at the time of the agreement to enter into an initial Business Combination. The Company will only complete a Business Combination if the post Business Combination company owns or acquires 50 % or more of the outstanding voting securities of the target or otherwise acquires a controlling interest in the target sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to complete a Business Combination successfully.\\n5\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nThe Company will provide its holders of the outstanding Public Shares (the “public stockholders”) with the opportunity to redeem all or a portion of their Public Shares upon the completion of a Business Combination either (i) in connection with a stockholder meeting called to approve the Business Combination or (ii) by means of a tender offer. The decision as to whether the Company will seek stockholder approval of a Business Combination or conduct a tender offer will be made by the Company, solely in its discretion. The public stockholders will be entitled to redeem their Public Shares for a pro rata portion of the amount then in the Trust Account ($ 10.46 per Public Share as of September 30, 2022 and $ 10.20 per Public Share as of December 31, 2021, plus any pro rata interest earned on the funds held in the Trust Account and not previously released to the Company to pay its tax obligations). There will be no redemption rights upon the completion of a Business Combination with respect to the Company’s warrants.\\nThe Company will proceed with a Business Combination if the Company has net tangible assets of at least $ 5,000,001 immediately prior to or upon such consummation of a Business Combination and, if the Company seeks stockholder approval, a majority of the shares voted are voted in favor of the Business Combination. If a stockholder vote is not required by law and the Company does not decide to hold a stockholder vote for business or other legal reasons, the Company will, pursuant to its Amended and Restated Certificate of Incorporation (the “Amended and Restated Certificate of Incorporation”), conduct the redemptions pursuant to the tender offer rules of the U.S. Securities and Exchange Commission (“SEC”) and file tender offer documents with the SEC containing substantially the same information as would be included in a proxy statement prior to completing a Business Combination. If, however, stockholder approval of the transaction is required by law, or the Company decides to obtain stockholder approval for business or legal reasons, the Company will offer to redeem shares in conjunction with a proxy solicitation pursuant to the proxy rules and not pursuant to the tender offer rules. If the Company seeks stockholder approval in connection with a Business Combination, the Sponsor has agreed to vote its Founder Shares (as defined in Note 5), Representative Shares (as defined in Note 8) and any Public Shares purchased during or after the Initial Public Offering (a) in favor of approving a Business Combination and (b) not to redeem any shares in connection with a stockholder vote to approve a Business Combination or sell any shares to the Company in a tender offer in connection with a Business Combination. Additionally, each public stockholder may elect to redeem their Public Shares, irrespective of whether they vote for or against the proposed Business Combination.\\nThe Sponsor has agreed (a) to waive its redemption rights with respect to the Founder Shares and Public Shares held by it in connection with the completion of a Business Combination and (b) not to propose an amendment to the Amended and Restated Certificate of Incorporation that would affect a public stockholders’ ability to convert or sell their shares to the Company in connection with a Business Combination or affect the substance or timing of the Company’s obligation to redeem 100 % of its Public Shares if the Company does not complete a Business Combination, unless the Company provides the public stockholders with the opportunity to redeem their Public Shares in conjunction with any such amendment.\\nOn November 9, 2021, the Company’s board of directors approved the first extension of the date by which the Company has to consummate a Business Combination from November 17, 2021 to February 17, 2022. In connection with the extension, the Sponsor deposited into the Trust Account $ 0.10 for each of the 12,618,600 shares issued in the Initial Public Offering, for a total of $ 1,261,860 . The Company issued the Sponsor a non-interest bearing unsecured promissory note in the principal amount of $ 1,261,860 which is payable by the Company upon the earlier of the consummation of the Business Combination or the liquidation of the Company. The Note may be repaid in cash or convertible into Private Warrants at a price of $ 1.00 per Private Warrant. On February 16, 2022, the Company’s board of directors approved the second extension of the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022. In connection with the second extension, the Sponsor deposited into the Trust Account an additional $ 1,261,860 ($ 0.10 per Public Share) on February 17, 2022, and the Company amended and restated the promissory note in its entirety solely to increase the principal amount thereunder from $ 1,261,860 to $ 2,523,720 . On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 (the “Combination Period”) was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. The Company amended and restated the promissory note to increase the principal amount thereunder from $ 2,523,720 to $ 3,223,720 , which included a drawdown of $ 500,000 for the extension and a drawdown of $ 200,000 for working capital needs. On August 17, 2022, the Company held a special meeting of stockholders in which the Company’s stockholders approved a second amendment to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023. On August 17, 2022, the Company amended and restated the promissory note to increase the principal amount thereunder from $ 3,223,720 to $ 3,683,720 , which included a drawdown of $ 360,000 for the extension and $ 100,000 for working capital purposes.\\n6\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nIf the Company is unable to complete a Business Combination within the Combination Period, the Company will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account including interest earned on the funds held in the Trust Account and not previously released to the Company to pay taxes, divided by the number of then outstanding Public Shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining stockholders and the Company’s board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law.\\nThe Sponsor has agreed to waive its liquidation rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the Combination Period. However, if the Sponsor acquires Public Shares in or after the Initial Public Offering, such Public Shares will be entitled to liquidating distributions from the Trust Account if the Company fails to complete a Business Combination within the Combination Period. In the event of such distribution, it is possible that the per share value of the assets remaining available for distribution will be less than the amount of funds initially deposited into the Trust Account (initially $ 10.10 per share, subsequently increased to $ 10.46 per share as of September 30, 2022 following extensions).\\nIn order to protect the amounts held in the Trust Account, the Sponsor has agreed to be liable to the Company if and to the extent any claims by a vendor for services rendered or products sold to the Company, or a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below $ 10.10 per Public Share, except as to any claims by a third party who executed a valid and enforceable agreement with the Company waiving any right, title, interest or claim of any kind they may have in or to any monies held in the Trust Account and except as to any claims under the Company’s indemnity of the underwriters of Initial Public Offering against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the insiders will not be responsible to the extent of any liability for such third-party claims. The Company will seek to reduce the possibility that the insiders will have to indemnify the Trust Account due to claims of creditors by endeavoring to have all vendors, service providers (except the Company’s independent registered public accounting firm), prospective target businesses or other entities with which the Company does business, execute agreements with the Company waiving any right, title, interest or claim of any kind in or to monies held in the Trust Account.\\nRisks and Uncertainties\\nManagement continues to evaluate the impact of the COVID-19 pandemic and the military conflict in the Ukraine and has concluded that while it is reasonably possible that the virus and the military conflict could have a negative effect on the Company’s financial position, results of its operations and/or search for a target company, the specific impacts are not readily determinable as of the date of these financial statements. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.\\nInflation Reduction Act of 2022\\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1 % excise tax on certain repurchases of stock by publicly traded U.S. domestic corporations and certain U.S. domestic subsidiaries of publicly traded foreign corporations occurring on or after January 1, 2023. The excise tax is imposed on the repurchasing corporation itself, not its shareholders from which shares are repurchased. The amount of the excise tax is generally 1 % of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax.\\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Business Combination, extension vote or otherwise, may be subject to the excise tax. Whether and to what extent the Company would be subject to the excise tax in connection with a Business Combination, extension vote or otherwise would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Business Combination, extension or otherwise, (ii) the structure of a Business Combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with a Business Combination (or otherwise issued not in connection with a Business Combination but issued within the same taxable year of a Business Combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by the Company and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a Business Combination and in the Company’s ability to complete a Business Combination.\\n7\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nLiquidity and Going Concern\\nAs of September 30, 2022, the Company had $ 83,760 in its operating bank accounts and $ 44,203,481 in securities held in the Trust Account to be used for a Business Combination or to repurchase or redeem its common stock in connection therewith. As of September 30, 2022, $ 145,311 of the amount on deposit in the Trust Account represented accrued interest income, which can be withdrawn to pay the Company’s tax obligations.\\nOn May 13, 2022, July 1, 2022 and August 16, 2022, the Company withdrew $ 178,564 , $ 66,751 and $ 113,396 , respectively, of accrued interest from the Trust Account to pay certain tax obligations.\\nUntil the consummation of a Business Combination, the Company will use the funds not held in the Trust Account for identifying and evaluating prospective acquisition candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to acquire, and structuring, negotiating and consummating the Business Combination.\\nThe Company expects it will need to raise additional capital through loans or additional investments from its Sponsor, stockholders, officers, directors, or third parties. The Company’s officers, directors and the Sponsor may, but are not obligated to, loan the Company funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet the Company’s working capital needs. Accordingly, the Company may not be able to obtain additional financing. If the Company is unable to raise additional capital, it may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. The Company cannot provide any assurance that new financing will be available to it on commercially acceptable terms, if at all.\\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\\nNOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\\nBasis of Presentation\\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the period ended December 31, 2021, as filed with the SEC on March 31, 2022. The interim results for the three and nine months ended September 30, 2022 are not necessarily indicative of the results to be expected for the year ending December 31, 2022 or for any future periods.\\n8\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nReclassification of Prior Year Presentation\\nCertain prior year amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on the reported results of operations. An adjustment has been made to the balance sheet for December 31, 2021 to reclassify the deferred legal fees balance from accrued expenses to a separate deferred legal fees line.\\nEmerging Growth Company\\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the independent registered public accounting firm attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.\\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\\nUse of Estimates\\nThe preparation of the condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements.\\nMaking estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Two of the more significant accounting estimates included in these financial statements is the determination of the fair value of the warrant liabilities as well as the fair value of the convertible promissory note. Such estimates may be subject to change as more current information becomes available and accordingly the actual results could differ significantly from those estimates.\\nCash and Cash Equivalents\\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of September 30, 2022 and December 31, 2021.\\n9\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nCash and Marketable Securities Held in Trust Account\\nAt September 30, 2022, substantially all of the assets held in the Trust Account were held in money market funds which are invested primarily in U.S Treasury securities. At December 31, 2021, substantially all of the assets held in the Trust Account were held in U.S. Treasury Securities. All of the Company’s investments held in the Trust Account are classified as trading securities. Trading securities are presented on the balance sheets at fair value at the end of each reporting period. Gains and losses resulting from the change in fair value of investments held in the Trust Account are included in interest earned on marketable securities held in the Trust Account in the accompanying condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information. As of September 30, 2022, the Company has withdrawn $ 358,711 of interest income from the Trust Account to pay certain tax obligations.\\nCommon Stock Subject to Possible Redemption\\nThe Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that is either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, as of September 30, 2022 and December 31, 2021, respectively, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of the Company’s condensed balance sheets.\\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable common stock to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock are affected by charges against additional paid in capital and accumulated deficit.\\nAt September 30, 2022 and December 31, 2021, the common stock reflected in the condensed balance sheets are reconciled in the following table:\\n\\n| Gross proceeds | $ | 126,186,000 |\\n| Less: |\\n| Common stock issuance costs | ( 2,868,790 | ) |\\n| Plus: |\\n| Accretion of carrying value to redemption value | 5,392,510 |\\n| Common stock subject to possible redemption – December 31, 2021 | $ | 128,709,720 |\\n| Less: |\\n| Redemption of shares | ( 86,773,410 | ) |\\n| Plus: |\\n| Accretion of carrying value to redemption value | 2,267,171 |\\n| Common stock subject to possible redemption – September 30, 2022 | $ | 44,203,481 |\\n\\nWarrant Liabilities\\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\\n10\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nConvertible Promissory Note – Related Party\\nThe Company accounts for its convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. The Company has made such election for its convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\\nIncome Taxes\\nThe Company accounts for income taxes under ASC 740, “Income Taxes.” ASC 740, Income Taxes, requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the unaudited condensed financial statements and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. As of September 30, 2022 and December 31, 2021, the Company’s deferred tax asset had a full valuation allowance recorded against it.\\nThe Company’s effective tax rate was 2.68 % and 0.00 % for the three months ended September 30, 2022 and 2021, respectively, and 0.80 % and 0.00 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate differs from the statutory tax rate of 21 % for the three months and nine months ended September 30, 2022 and 2021, due to changes in fair value in warrant liability, changes in the fair value of the convertible promissory note and the valuation allowance on the deferred tax assets.\\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\\nWhile ASC 740 identifies usage of an effective annual tax rate for purposes of an interim provision, it does allow for estimating individual elements in the current period if they are significant, unusual, or infrequent. Computing the effective tax rate for the Company is complicated due to the potential impact of the timing of any Business Combination expenses and the actual interest income that will be recognized during the year. The Company has taken a position as to the calculation of income tax expense in a current period based on ASC 740-270-25-3 which states, “If an entity is unable to estimate part of its ordinary income (or loss) or the related tax (benefit) but is otherwise able to make a reasonable estimate, the tax (or benefit) applicable to the item that cannot be estimated shall be reported in the interim period in which the item is reported.” The Company believes its calculation to be a reliable estimate and allows it to properly take into account the usual elements that can impact its annualized book income and its impact on the effective tax rate. As such, the Company is computing its taxable income (loss) and associated income tax provision based on actual results through September 30, 2022.\\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\\nThe Company has identified the United States as its only “major” tax jurisdiction. The Company is subject to income taxation by major taxing authorities since inception. These examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months.\\nNet Income Per Common Share\\nThe Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share”. Net income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from income per common share as the redemption value approximates fair value.\\nThe calculation of diluted income per share does not consider the effect of the warrants issued in connection with the (i) Initial Public Offering, and (ii) the private placement since the exercise of the warrants is contingent upon the occurrence of future events. The warrants are exercisable to purchase 17,904,180 shares of common stock in the aggregate. As of September 30, 2022 and 2021, the Company did not have any dilutive securities or other contracts that could, potentially, be exercised or converted into common stock and then participate in the earnings of the Company. As a result, diluted net income per common share is the same as basic net income per common share for the periods presented.\\n11\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nReconciliation of Net Income per Common Share\\nThe Company’s net income is adjusted for the portion of income that is attributable to common stock subject to possible redemption, as these shares only participate in the earnings of the Trust Account and not the income or losses of the Company. Accordingly, basic and diluted net income per common share is calculated as follows:\\n\\n| Three Months Ended September 30, 2022 | Three Months Ended September 30, 2021 | Nine Months Ended September 30, 2022 | Nine Months Ended September 30, 2021 |\\n| Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock | Redeemable Common Stock | Non-Redeemable Common Stock |\\n| Basic and diluted net income per common share |\\n| Numerator: |\\n| Allocation of net income, as adjusted | $ | 519,931 | $ | 324,223 | $ | 1,156,217 | 319,513 | $ | 2,475,778 | $ | 931,474 | $ | 1,729,360 | $ | 477,898 |\\n| Denominator: |\\n| Basic and diluted weighted average shares outstanding | 5,591,938 | 3,487,070 | 12,618,600 | 3,487,070 | 9,268,327 | 3,487,070 | 12,618,600 | 3,487,070 |\\n| Basic and diluted net income per common share | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.09 | $ | 0.27 | $ | 0.27 | $ | 0.14 | $ | 0.14 |\\n\\nConcentration of Credit Risk\\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution, which, at times may exceed the Federal Deposit Insurance Corporation maximum coverage of $ 250,000 . The Company has not experienced losses on these accounts.\\nFair Value of Financial Instruments\\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC Topic 820, “Fair Value Measurement,” approximates the carrying amounts represented in the accompanying condensed balance sheets, primarily due to their short-term nature, except for warrant liabilities (see Note 9).\\nFair Value Measurements\\nFair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).\\nIn some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.\\n12\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nRecent Accounting Standards\\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined it would not have a material impact on the condensed financial statements as presented.\\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the Company’s condensed financial statements.\\nNOTE 3. PUBLIC OFFERING\\nPursuant to the Initial Public Offering, the Company sold 11,000,000 Units at a price of $ 10.00 per Unit. Each Unit consists of one share of common stock and one redeemable warrant (“Public Warrant”). In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Company sold an additional 1,618,600 Units, at a purchase price of $ 10.00 per Unit. Each Public Warrant entitles the holder to purchase one share of common stock at an exercise price of $11.50 per share (see Note 8).\\nNOTE 4. PRIVATE PLACEMENT\\nSimultaneously with the closing of the Initial Public Offering, the Sponsor and EarlyBirdCapital purchased an aggregate of 4,800,000 Private Warrants at a price of $ 1.00 per Private Warrant for an aggregate purchase price of $ 4,800,000 . The Sponsor purchased 3,975,000 Private Warrants and EarlyBirdCapital purchased 825,000 Private Warrants. In connection with the underwriters’ partial exercise of the over-allotment option on November 19, 2020, the Sponsor and EarlyBirdCapital purchased an additional 485,580 Private Warrants, at a purchase price of $ 1.00 per Private Warrant, for an aggregate purchase price of $ 485,580 . Each Private Warrant entitles the holder to purchase one share of common stock at a price of $11.50 per full share, subject to adjustment (see Note 8). The proceeds from the Private Warrants were added to the proceeds from the Initial Public Offering held in the Trust Account. If the Company does not complete a Business Combination within the Combination Period, the proceeds from the sale of the Private Warrants will be used to fund the redemption of the Public Shares (subject to the requirements of applicable law).\\nNOTE 5. RELATED PARTY TRANSACTIONS\\nFounder Shares\\nOn August 5, 2020, the Sponsor paid $ 25,000 to cover certain offering costs of the Company in consideration for 3,593,750 shares of common stock (the “Founder Shares”). On November 9, 2020, the Sponsor returned to the Company for cancellation, at no cost, an aggregate of 718,750 Founder Shares, resulting in an aggregate of 2,875,000 Founder Shares outstanding and held by the Sponsor. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in an aggregate of 3,162,500 Founder Shares outstanding and held by the Sponsor. The Founder Shares included, after giving retroactive effect to the share surrender and stock dividend, an aggregate of up to 412,500 shares subject to forfeiture to the extent that the underwriters’ over-allotment was not exercised in full or in part, so that the Sponsor would collectively own 20 % of the Company’s issued and outstanding shares after the Initial Public Offering (assuming the Sponsor did not purchase any Public Shares in the Initial Public Offering). In connection with the underwriters’ partial exercise of the over-allotment option and the forfeiture of the remaining over-allotment option, 7,850 Founder Shares were forfeited, and 404,650 Founder Shares are no longer subject to forfeiture resulting in an aggregate of 3,154,650 Founder Shares outstanding at September 30, 2022.\\nThe Sponsor has agreed, subject to certain limited exceptions, not to transfer, assign or sell any of the Founder Shares until (1) with respect to 50% of the Founder Shares, the earlier of one year after the completion of a Business Combination and the date on which the closing price of the common stock equals or exceeds $12.50 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing after a Business Combination and (2) with respect to the remaining 50% of the Founder Shares, one year after the completion of a Business Combination, or earlier, in either case, if, subsequent to a Business Combination, the Company completes a liquidation, merger, stock exchange or other similar transaction which results in all of the Company’s stockholders having the right to exchange their shares of common stock for cash, securities or other property.\\n13\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nDue from Sponsor\\nAt the closing of the Initial Public Offering on November 17, 2020, an aggregate amount of $ 25,038 was due to the Company. Such amount was paid by the Company to the Sponsor and was included in the prepaid expenses and other current assets on the balance sheet at December 31, 2020. No balance remains outstanding as of September 30, 2022.\\nAdministrative Support Agreement\\nThe Company has agreed, commencing on November 12, 2020 through the earlier of the Company’s consummation of a Business Combination and its liquidation, to pay an affiliate of the Company’s management a total of $ 10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred $ 30,000 and $ 90,000 , respectively, in fees for these services, of which such amounts are included in accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $ 30,000 and $ 90,000 , respectively, in fees for these services.\\nPromissory Note — Related Party\\nOn August 5, 2020, the Company issued an unsecured promissory note to the Sponsor (the “Promissory Note”), pursuant to which the Company could borrow up to an aggregate principal amount of $ 300,000 . The Promissory Note was non-interest bearing and payable on the earlier of (i) March 31, 2021, (ii) the consummation of the Initial Public Offering or (iii) the date on which the Company determined not to proceed with the Initial Public Offering. The outstanding balance under the Promissory Note was repaid subsequent to the Initial Public Offering. As of September 30, 2022 and December 31, 2021, respectively, no balance is outstanding under the Promissory Note. Borrowings under the Promissory Note are no longer available.\\nRelated Party Loans\\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Sponsor or certain of the Company’s officers and directors or their affiliates may, but are not obligated to, loan the Company funds as may be required (“Working Capital Loans”). Each loan would be evidenced by promissory note. The notes may be repaid upon completion of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1,500,000 of notes may be converted upon completion of a Business Combination into warrants at a price of $ 1.00 per warrant. Such warrants would be identical to the Private Warrants. In the event that a Business Combination does not close, the Company may use a portion of proceeds held outside the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\\nOn April 14, 2022 the Sponsor advanced to the Company $ 100,000 to be used for working capital purposes. On August 17, 2022, the Company transferred the advance from the Sponsor to the second amended and restated promissory note (see Convertible Promissory Note – Related Party below). On October 13, 2022, the Sponsor advanced to the Company $ 200,000 to be used for working capital purposes.\\nRelated Party Extension Loans\\nAs discussed in Note 1, the Company previously extended the period of time to consummate a Business Combination two times, each by an additional three months (to May 17, 2022 to complete a Business Combination). In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $1,261,860 ($0.10 per Public Share), on or prior to the date of the applicable deadline, for each three-month extension. Payments were made in the form of a non-interest bearing, unsecured promissory note to be paid upon consummation of a Business Combination, or, at the relevant insider’s discretion, converted upon consummation of a Business Combination into additional Private Warrants at a price of $ 1.00 per Private Warrant. The Sponsor and its affiliates or designees are not obligated to fund the Trust Account to extend the time for the Company to complete a Business Combination. On May 12, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 500,000 . On August 15, 2022, the Company held a special meeting of stockholders at which a proposal to amend the Company’s amended and restated certificate of incorporation, as amended to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. In order to extend the time available for the Company to consummate a Business Combination, the Sponsor or its affiliates or designees deposited into the Trust Account $ 360,000 .\\n14\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nConvertible Promissory Note – Related Party\\nOn November 9, 2021, the Company issued a promissory note in the principal amount of $ 1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022 and May 18, 2022, the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,223,720. On August 17, 2022 the Company amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $3,223,720 to $3,683,720, which included $100,000 advanced by the Sponsor to the Company on April 14, 2022 and the payment of $360,000 for the extension from August 17, 2022 to November 17, 2022. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by stockholders. At the election of the Sponsor, up to $ 1,500,000 of the unpaid principal amount of the Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $ 1.00 , rounded up to the nearest whole number of warrants. As of September 30, 2022, there was a $ 3,683,720 balance outstanding under the Convertible Promissory Note. The Convertible Promissory Note was valued using the fair value method. The fair value of the note as of September 30, 2022, was $ 913,900 , which resulted in a change in fair value of the convertible promissory note of $ 1,113,700 and $ 2,119,960 which was recorded in the statements of operations for the three and nine months ended September 30, 2022, respectively (see Note 9).\\nNOTE 6. COMMITMENTS AND CONTINGENCIES\\nRegistration Rights\\nPursuant to a registration rights agreement entered into on November 12, 2020, the holders of the Founder Shares and Representative Shares (as defined in Notes 5 and 8, respectively), as well as the holders of the Private Warrants (and underlying securities) and any warrants issued in payment of Working Capital Loans made to Company (and underlying securities) will be entitled to registration rights. The holders of a majority of these securities are entitled to make up to two demands that the Company register such securities. The holders of the majority of the Founder Shares can elect to exercise these registration rights at any time commencing three months prior to the date on which these shares of common stock are to be released from escrow. The holders of a majority of the Representative Shares, Private Warrants and warrants issued in payment of working capital loans made to the Company (or underlying securities) can elect to exercise these registration rights at any time after the Company consummates a Business Combination. Notwithstanding anything to the contrary, EarlyBirdCapital may only make a demand on one occasion and only during the five-year period beginning on the effective date of the registration statement of which this prospectus forms a part. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to consummation of a Business Combination; provided, however, that EarlyBirdCapital may participate in a “piggy-back” registration only during the seven-year period beginning on the effective date of the registration statement of which this prospectus forms a part. The registration rights agreement does not contain liquidating damages or other cash settlement provisions resulting from delays in registering the Company’s securities. The Company will bear the expenses incurred in connection with the filing of any such registration statements.\\nUnderwriting Agreement\\nThe Company granted the underwriters a 45-day option from the date of the Initial Public Offering to purchase up to 1,650,000 additional Units to cover over-allotments, if any, at the Initial Public Offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 Units at $ 10.00 per Unit and forfeited the remaining over-allotment option.\\n15\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nBusiness Combination Marketing Agreement\\nThe Company has engaged EarlyBirdCapital as an advisor in connection with a Business Combination to assist the Company in holding meetings with its stockholders to discuss the potential Business Combination and the target business’ attributes, introduce the Company to potential investors that are interested in purchasing the Company’s securities in connection with a Business Combination, assist the Company in obtaining stockholder approval for the Business Combination and assist the Company with its press releases and public filings in connection with the Business Combination. The Company will pay EarlyBirdCapital a cash fee for such services upon the consummation of a Business Combination in an amount equal to 3.5% of the gross proceeds of the Initial Public Offering, or $4,416,510, (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at the Company’s sole discretion to other FINRA members that assist the Company in identifying and consummating a Business Combination.\\nAdditionally, the Company will pay EarlyBirdCapital a cash fee equal to 1.0 % of the total consideration payable in a Business Combination if EarlyBirdCapital introduces the Company to the target business with which the Company completes a Business Combination.\\nLegal Fee Agreements\\nThe Company has engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any Business Combination. The law firms will not be entitled to any contingent fees or expense reimbursement if the Company does not consummate a Business Combination within its deadline. Deferred fees of $ 1,371,549 and $ 1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\\nTrust Extension\\nOn February 16, 2022, the Company issued a press release announcing that its Sponsor has requested that the Company extend the date by which the Company has to consummate a Business Combination from February 17, 2022 to May 17, 2022 (the “Extension”). The Extension is the second of two three-month extensions permitted under the Company’s governing documents and provides the Company with additional time to complete its Business Combination. On February 18, 2022, the Company issued a press release announcing that the Sponsor had deposited an additional $ 1,261,860 (representing $ 0.10 per public share) into the Trust Account for its public stockholders. On May 12, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from May 17, 2022 to August 17, 2022 was approved by the stockholders. In connection with this extension, the Company deposited $ 500,000 into the Trust Account on May 18, 2022. In connection with the extension amendment, stockholders holding approximately 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. On August 15, 2022, the Company held a special meeting of stockholders in which a proposal to amend the Company’s amended and restated certificate of incorporation to extend the date by which the Company must consummate a Business Combination from August 17, 2022 to February 17, 2023 was approved by the stockholders. In connection with this extension, the Company deposited $ 360,000 into the Trust Account on August 17, 2022. In connection with the extension amendment, stockholders holding approximately 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\\nOn November 16, 2021, the Company had previously issued a promissory note (the “Note”) in the principal amount of $ 1,261,860 to the Company’s Sponsor. On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, the Company amended and restated the Note in its entirety to increase the principal amount thereunder from $1,262,860 to $3,683,720.\\nNOTE 7. STOCKHOLDERS’ DEFICIT\\nPreferred Stock — The Company is authorized to issue 1,000,000 shares of preferred stock with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. At September 30, 2022 and December 31, 2021, respectively, there were no shares of preferred stock issued or outstanding.\\nCommon Stock — The Company is authorized to issue 50,000,000 shares of common stock with a par value of $ 0.0001 per share. At September 30, 2022 and December 31, 2021, there were 3,487,070 shares of common stock issued and outstanding, excluding 4,213,453 and 12,618,600 shares of common stock subject to possible redemption, respectively, which are presented as temporary equity. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.30 per share. In connection with the extension on August 17, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $ 10.37 per share.\\n16\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nNOTE 8. WARRANTS\\nThe Public Warrants will become exercisable on the later of (a) 30 days after the completion of a Business Combination or (b) 12 months from the closing of the Initial Public Offering. No warrants will be exercisable for cash unless the Company has an effective and current registration statement covering the shares of common stock issuable upon exercise of the warrants and a current prospectus relating to such shares of common stock. Notwithstanding the foregoing, if a registration statement covering the shares of common stock issuable upon exercise of the Public Warrants is not effective within a specified period following the consummation of a Business Combination, warrant holders may, until such time as there is an effective registration statement and during any period when the Company shall have failed to maintain an effective registration statement, exercise warrants on a cashless basis pursuant to the exemption provided by Section 3(a)(9) of the Securities Act, provided that such exemption is available. If that exemption, or another exemption, is not available, holders will not be able to exercise their warrants on a cashless basis. The Public Warrants will expire five years after the completion of a Business Combination or earlier upon redemption or liquidation.\\nThe Company may redeem the Public Warrants (excluding the Private Warrants and any warrants underlying units issued upon conversion of the Working Capital Loans):\\n\\n| ● | in whole and not in part; |\\n| ● | at a price of $0.01 per warrant; |\\n| ● | upon not less than 30 days’ prior written notice of redemption to each warrant holder; and |\\n| ● | if, and only if, the last reported sale price of the common stock equals or exceeds $18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like), for any 20 trading days within a 30 trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\\n\\nIf the Company calls the Public Warrants for redemption, management will have the option to require all holders that wish to exercise the Public Warrants to do so on a “cashless basis,” as described in the warrant agreement. The exercise price and number of shares of common stock issuable upon exercise of the warrants may be adjusted in certain circumstances including in the event of a stock dividend, or recapitalization, reorganization, merger or consolidation. However, except as described below, the warrants will not be adjusted for issuance of common stock at a price below its exercise price. Additionally, in no event will the Company be required to net cash settle the warrants. If the Company is unable to complete a Business Combination within the Combination Period and the Company liquidates the funds held in the Trust Account, holders of warrants will not receive any of such funds with respect to their warrants, nor will they receive any distribution from the Company’s assets held outside of the Trust Account with the respect to such warrants. Accordingly, the warrants may expire worthless.\\nIn addition, if (x) the Company issues additional common stock or equity-linked securities for capital raising purposes in connection with the closing of a Business Combination at an issue price or effective issue price of less than $9.20 per common stock (with such issue price or effective issue price to be determined in good faith by the Company’s board of directors and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance), (y) the aggregate gross proceeds from such issuances represent more than 60% of the total equity proceeds, and interest thereon, available for the funding of a Business Combination on the date of the consummation of a Business Combination (net of redemptions), and (z) the volume weighted average trading price of its common stock during the 20 trading day period starting on the trading day prior to the day on which the Company consummates its Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115% of the greater of (i) Market Value or (ii) the price at which the Company issue the additional shares of common stock or equity-linked securities.\\nThe Private Warrants are identical to the Public Warrants underlying the Units sold in the Initial Public Offering, except that the Private Warrants and the shares of common stock issuable upon the exercise of the Private Warrants will not be transferable, assignable or saleable until after the completion of a Business Combination, subject to certain limited exceptions. Additionally, the Private Warrants will be exercisable for cash or on a cashless basis, at the holder’s option, and be non-redeemable so long as they are held by the initial purchasers or their permitted transferees. If the Private Warrants are held by someone other than the initial purchasers or their permitted transferees, the Private Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants.\\n17\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nRepresentative Shares\\nOn August 5, 2020, the Company issued to EarlyBirdCapital 377,750 shares of common stock (the “Representative Shares”). On November 9, 2020, EarlyBirdCapital returned to the Company for cancellation, at no cost, an aggregate of 75,550 Representative Shares, resulting in an aggregate of 302,200 Representative Shares outstanding and held by EarlyBirdCapital. On November 12, 2020, the Company effected a stock dividend of 0.1 shares for each share of common stock outstanding, resulting in EarlyBirdCapital holding an aggregate of 332,420 Representative Shares. The Company accounted for the Representative Shares as an offering cost of the Initial Public Offering, with a corresponding credit to stockholders’ equity. The Company estimated the fair value of Representative Shares to be $ 2,666 based upon the price of the Founder Shares issued to the Sponsor. The holders of the Representative Shares have agreed not to transfer, assign or sell any such shares until the completion of a Business Combination. In addition, the holders have agreed (i) to waive their redemption rights with respect to such shares in connection with the completion of a Business Combination and (ii) to waive their rights to liquidating distributions from the Trust Account with respect to such shares if the Company fails to complete a Business Combination within the Combination Period.\\nThe Representative Shares have been deemed compensation by FINRA and are therefore subject to a lock-up for a period of 180 days immediately following the effective date of the registration statement related to the Initial Public Offering pursuant to Rule 5110(g)(1) of FINRA’s NASD Conduct Rules. Pursuant to FINRA Rule 5110(g)(1), these securities will not be sold during the Initial Public Offering, or sold, transferred, assigned, pledged, or hypothecated, or be the subject of any hedging, short sale, derivative, put or call transaction that would result in the economic disposition of the securities by any person for a period of 180 days immediately following the effective date of the Initial Public Offering, except to any underwriter and selected dealer participating in the Initial Public Offering and their bona fide officers or partners, provided that all securities so transferred remain subject to the lockup restriction above for the remainder of the time period.\\nNOTE 9. FAIR VALUE MEASUREMENTS\\nThe Company follows the guidance in ASC 820 for its financial assets and liabilities that are re-measured and reported at fair value at each reporting period, and non-financial assets and liabilities that are re-measured and reported at fair value at least annually.\\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\\n\\n| Level 1: | Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. |\\n| Level 2: | Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active. |\\n| Level 3: | Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability. |\\n\\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis at September 30, 2022 and December 31, 2021, respectively, and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value:\\n\\n| Description | Level | September, 2022 | December 31, 2021 |\\n| Assets: |\\n| Marketable securities held in Trust Account | 1 | $ | 44,203,481 | $ | 128,790,008 |\\n| Liabilities: |\\n| Warrant liabilities – Private Warrants | 3 | $ | 422,846 | $ | 2,641,204 |\\n| Convertible promissory note – related party | 3 | $ | 913,900 | $ | 958,400 |\\n\\n18\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nWarrant Liabilities\\nThe Private Warrants were accounted for as liabilities in accordance with ASC 815-40 and are presented within warrant liabilities on the condensed balance sheets. The warrant liabilities are measured at fair value at inception and on a recurring basis, with changes in fair value presented within change in fair value of warrant liabilities in the condensed statements of operations.\\nThe Private Warrants were valued using a binomial lattice model. The Company allocated the proceeds received from (i) the sale of Units (which is inclusive of one share of common stock and one Public Warrant) and (ii) the sale of Private Warrants, first to the warrants based on their fair values as determined at initial measurement, with the remaining proceeds allocated to common stock subject to possible redemption. The Private Warrants were classified as Level 3 at the initial measurement date due to the use of unobservable inputs.\\nThe following are the inputs used by the Company in establishing the fair value of its Private Warrants at September 30, 2022 and December 31, 2021.\\n\\n| Input | September 30, 2022 | December 31, 2021 |\\n| Risk-free interest rate | 4.07 | % | 1.15 | % |\\n| Trading days per year | 252 | 252 |\\n| Expected volatility | 5.3 | % | 9.6 | % |\\n| Exercise price | $ | 11.50 | $ | 11.50 |\\n| Stock Price | $ | 10.35 | $ | 10.17 |\\n\\nOn December 31, 2021 and September 30, 2022, the Private Warrants were determined to be $ 0.50 per warrant and $ 0.08 per warrant, respectively, for an aggregate value of $ 2.64 million and $ 0.4 million, respectively.\\nThe following table presents the changes in the fair value of the warrant liabilities:\\n\\n| Private Placement |\\n| Fair value as of December 31, 2021 | $ | 2,641,204 |\\n| Change in valuation inputs or other assumptions | ( 1,744,591 | ) |\\n| Fair value as of March 31, 2022 | $ | 896,613 |\\n| Change in valuation inputs or other assumptions | ( 579,785 | ) |\\n| Fair value as of June 30, 2022 | $ | 316,828 |\\n| Change in valuation inputs or other assumptions | 106,018 |\\n| Fair value as of September 30, 2022 | $ | 422,846 |\\n\\n19\\nBETTER WORLD ACQUISITION CORP.\\nNOTES TO CONDENSED FINANCIAL STATEMENTS\\nSEPTEMBER 30, 2022\\n(Unaudited)\\nConvertible Promissory Note – Related Party\\nThe fair value of the option to convert the convertible promissory note into Private Warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\\nThe estimated fair value of the convertible promissory note was based on the following significant inputs:\\n\\n| September 30, 2022 |\\n| Risk-free interest rate | 0.00 | % |\\n| Time to Expiration (in years) | 1.38 |\\n| Expected volatility | 5.3 | % |\\n| Exercise price | $ | 11.50 |\\n| Dividend yield | 0.00 | % |\\n| Stock Price | $ | 10.35 |\\n| Probability of transaction | 25.00 | % |\\n\\nThe following table presents the changes in the fair value of the Level 3 convertible promissory note:\\n\\n| Fair value as of January 1, 2021 | $ | 958,400 |\\n| Proceeds received through Convertible Promissory Note | 1,261,860 |\\n| Change in fair value | ( 337,260 | ) |\\n| Fair value as of March 31, 2022 | $ | 1,883,000 |\\n| Proceeds received through Convertible Promissory Note | 700,000 |\\n| Change in fair value | ( 669,000 | ) |\\n| Fair value as of June 30, 2022 | $ | 1,914,000 |\\n| Conversion of Sponsor advance to Convertible Promissory Note | 100,000 |\\n| Proceeds received through Convertible Promissory Note | 360,000 |\\n| Change in fair value | ( 1,460,100 | ) |\\n| Fair value as of September 30, 2022 | 913,900 |\\n\\nThere were no transfers in or out of Level 3 from other levels in the fair value hierarchy during the three and nine months ended September 30, 2022 for the convertible promissory note.\\nNOTE 10. SUBSEQUENT EVENTS\\nThe Company evaluated subsequent events and transactions that occurred after the balance sheet date up to the date that the financial statements were issued. Based upon this review the Company did not identify any subsequent events that would have required adjustment or disclosure in the condensed financial statements.\\n20\\n\\nItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations\\nReferences in this report (the “Quarterly Report”) to “we,” “us,” “our” or the “Company” refer to Better World Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to BWA Holdings LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\\nSpecial Note Regarding Forward-Looking Statements\\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act that are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10-Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively.\\nOverview\\nWe are a blank check company formed under the laws of the State of Delaware on August 5, 2020 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities (an “initial business combination”). We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Warrants, our capital stock, debt or a combination of cash, stock and debt.\\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a business combination will be successful.\\n21\\nResults of Operations\\nWe have neither engaged in any operations nor generated any revenues to date. Our only activities from August 5, 2020 (inception) through September 30, 2022 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and identifying a target company for a business combination. We do not expect to generate any operating revenues until after the completion of our business combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence and transaction expenses.\\nFor the three months ended September 30, 2022, we had net income of $844,154 which consists of the change in fair value of convertible promissory note – related party of $1,113,700, interest earned on marketable securities held in the Trust Account of $254,709 and unrealized gain on marketable securities held in the Trust Account of $1,078, offset by change in fair value of warrant liability of $106,018, a provision for income taxes of $23,249 and operational costs of $396,066.\\nFor the nine months ended September 30, 2022, we had net income of $3,407,252 which consists of the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960, and interest earned on marketable securities held in the Trust Account of $423,734, offset by provision for income taxes of $27,528 and operational costs of $1,327,272.\\nFor the three months ended September 30, 2021, we had net income of $1,475,730 which consists of the change in fair value of warrant liability of $2,192,941 and interest earned on marketable securities held in the Trust Account of $23,138, and unrealized loss on marketable securities held in the Trust Account of $4,654, offset by formation and operational costs of $735,695.\\nFor the nine months ended September 30, 2021, we had net income of $2,207,258, which consists of the change in fair value of warrant liability of $3,302,913 and interest earned on marketable securities held in the Trust Account of $58,976, and unrealized loss on marketable securities held in the Trust Account of $5,829, offset by formation and operational costs of $1,148,802.\\nLiquidity and Capital Resources\\nOn November 17, 2020, we consummated the Initial Public Offering of 11,000,000 units, at $10.00 per Unit, generating gross proceeds of $110,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,800,000 Private Warrants at a price of $1.00 per Private Warrant in a private placement to our Sponsor and EarlyBirdCapital, Inc. generating gross proceeds of $4,800,000.\\nOn November 19, 2020, in connection with the underwriters’ partial exercise of their over-allotment option, we consummated the sale of an additional 1,618,600 units at a price of $10.00 per unit, generating total gross proceeds of $16,186,000. In addition, we also consummated the sale of an additional 485,580 private placement warrants at $1.00 per private placement warrant, generating total gross proceeds of $485,580.\\nFollowing the initial public offering, the partial exercise of the over-allotment option, and the sale of the private placement warrants, $111,100,000 was placed in the trust account on November 18, 2020 and $16,347,860 was placed in the Trust Account on November 20, 2020, respectively, for a total of $127,447,860. We incurred $2,880,354 in the initial public offering related costs, including $2,523,720 of underwriting fees and $356,634 of other costs.\\nFor the nine months ended September 30, 2022, cash used in operating activities was $853,148. Net income of $3,407,252 was affected by the change in fair value of warrant liability of $2,218,358, change in fair value of convertible promissory note – related party of $2,119,960 and interest earned on marketable securities held in the Trust Account of $423,734. Changes in operating assets and liabilities provided $501,652 of cash for operating activities.\\nFor the nine months ended September 30, 2021, cash used in operating activities was $528,273. Net income of $2,207,258 was affected by the change in fair value of warrant liability of $3,302,913, interest earned on marketable securities held in the Trust Account of $58,976, and an unrealized loss on marketable securities held in our Trust Account of $5,829. Changes in operating assets and liabilities provided $620,529 of cash for operating activities.\\nAs of September 30, 2022, in the U.S.-based trust account maintained by Continental Stock Transfer & Trust Company, acting as trustee, we had cash held of $947 and marketable securities held in the Trust Account of $44,202,534 (including approximately $145,311 of interest income) consisting of securities held in a money market fund that invests in U.S. Treasury securities with a maturity of 180 days or less. Interest income on the balance in the trust account may be used by us to pay taxes. In connection with the extension on May 12, 2022, stockholders holding 5,586,910 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds in the Trust Account at a redemption price of approximately $10.30 per share. In connection with the extension on August 15, 2022, stockholders holding 2,818,237 shares of the Company’s redeemable common stock exercised their right to redeem such shares for a pro rata portion of the funds on the Trust Account at a redemption price of approximately $10.37 per share. Through September 30, 2022, we have withdrawn $358,711 of interest earned on the trust account to pay our taxes.\\n22\\nWe intend to use substantially all of the funds held in the trust account, to acquire a target business and to pay our expenses relating thereto upon consummation of our initial business combination for assisting us in connection with our initial business combination. To the extent that our capital stock is used in whole or in part as consideration to effect an initial business combination, the remaining funds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our initial business combination if the funds available to us outside of the trust account were insufficient to cover such expenses.\\nAs of September 30, 2022, we had cash of $83,760 held outside the trust account. We intend to use the funds held outside the trust account for identifying and evaluating prospective acquisition candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to acquire and structuring, negotiating and consummating the initial business combination.\\nIn order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, the insiders, or certain of our officers and directors or their affiliates may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant, at the option of the lender. The units would be identical to the private placement warrants. On November 9, 2021, we issued a promissory note in the principal amount of $1,261,860 to the Sponsor in connection with the Extension (“Convertible Promissory Note”) (as defined below). On February 17, 2022, April 14, 2022, May 18, 2022, and August 17, 2022, we amended and restated the Convertible Promissory Note to increase the principal amount thereunder from $1,261,860 to $3,683,720. The Note bears no interest and is due and payable upon the earlier to occur of (i) the date on which the Company’s Business Combination is consummated and (ii) the liquidation of the Company on or before February 17, 2023 or such later liquidation date as may be approved by the Company’s stockholders. At the election of the Sponsor, up to $1,500,000 of the unpaid principal amount of the Convertible Promissory Note may be converted into warrants of the Company, each warrant exercisable for one share of common stock of the Company upon the consummation of its Business Combination, equal to: (x) the portion of the principal amount of the Note being converted, divided by (y) $1.00, rounded up to the nearest whole number of warrants.\\nWe expect that we will need to raise additional capital through loans or additional investments from our sponsor, stockholders, officers, directors, or third parties. Our officers, directors and sponsor may, but are not obligated to, loan us funds, from time to time or at any time, in whatever amount they deem reasonable in their sole discretion, to meet our working capital needs. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all.\\nIn connection with the Company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” the Company has until February 17, 2023 to consummate a Business Combination. It is uncertain that the Company will be able to consummate a Business Combination by this time. If a Business Combination is not consummated by this date and an extension has not been requested by the Sponsor and approved by the Company’s stockholders, there will be a mandatory liquidation and subsequent dissolution of the Company. Management has determined that the liquidity condition and the mandatory liquidation and potential subsequent dissolution raises substantial doubt about the Company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 17, 2023. The Company intends to continue to search for and seek to complete a Business Combination before the mandatory liquidation date. The Company is within 12 months of its mandatory liquidation date as of the time of filing of this Quarterly Report on Form 10-Q.\\nOff-Balance Sheet Financing Arrangements\\nWe have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\\n23\\nContractual Obligations\\nWe have agreed, commencing on November 12, 2020 through the earlier of our consummation of an initial business combination and our liquidation, to pay an affiliate of our management a total of $10,000 per month for office space, utilities and secretarial support. For the three and nine months ended September 30, 2022, the Company incurred and accrued $30,000 and $90,000 in fees for these services, respectively, and those fees are included in accounts payable and accrued expenses in the accompanying condensed balance sheets. For the three and nine months ended September 30, 2021, the Company incurred and paid $30,000 and $90,000 in fees for these services.\\nWe granted the underwriters a 45-day option from the date of the initial public offering to purchase up to 1,650,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. On November 19, 2020, the underwriters partially exercised their over-allotment option to purchase an additional 1,618,600 units at $10.00 per unit and forfeited the remaining over-allotment option.\\nWe have engaged EarlyBirdCapital as an advisor in connection with an initial business combination to assist us in holding meetings with its stockholders to discuss the potential initial business combination and the target business’ attributes, introduce us to potential investors that are interested in purchasing our securities in connection with an initial business combination, assist us in obtaining stockholder approval for the initial business combination and assist us with our press releases and public filings in connection with the initial business combination. We will pay EarlyBirdCapital a cash fee for such services upon the consummation of an initial business combination in an amount equal to 3.5% of the gross proceeds of the initial public offering, or $4,416,510 (exclusive of any applicable finders’ fees which might become payable); provided that up to 30% of the fee may be allocated at our sole discretion to other FINRA members that assist us in identifying and consummating an initial business combination.\\nAdditionally, we will pay EarlyBirdCapital a cash fee equal to 1.0% of the total consideration payable in an initial business combination if EarlyBirdCapital introduces us to the target business with which we complete an initial business combination.\\nWe have engaged various law firms to provide legal due diligence services and business combination services related to potential target companies. All fees and expenses related to the various engagements will be deferred and are to be paid fully upon the closing of any business combination. The law firms will not be entitled to any contingent fees or expense reimbursement if we do not consummate an initial business combination within our deadline. Deferred fees of $1,371,549 and $1,009,868 related to these legal services have been accrued as of September 30, 2022 and December 31, 2021, respectively.\\nCritical Accounting Policies\\nThe preparation of condensed financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies:\\nWarrant Liability\\nThe Company accounts for the Private Warrants in accordance with the guidance contained in ASC 815-40-15-7D and 7F under which the Private Warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the Private Warrants as liabilities at their fair value and adjusts the Private Warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in our statements of operations. The Private Warrants for periods where no observable traded price was available are valued using a binomial lattice simulation model.\\n24\\nConvertible Promissory Note\\nWe account for our convertible promissory note under ASC 815, Derivatives and Hedging (“ASC 815”). Under 815-15-25, the election can be at the inception of a financial instrument to account for the instrument under the fair value option under ASC 825. We have made such election for our convertible promissory note. Using fair value option, the convertible promissory note is required to be recorded at its initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the note are recognized as non-cash change in the fair value of the convertible promissory note in the statements of operations. The fair value of the option to convert the convertible promissory note into private placement warrants was valued by utilizing a binomial lattice model incorporating the Cox-Ross-Rubenstein methodology.\\nCommon Stock Subject to Possible Redemption\\nWe account for our common stock subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ deficit section of our condensed balance sheets.\\nNet Income per Common Share\\nNet income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Accretion associated with the redeemable shares of common stock is excluded from net income per common share as the redemption value approximates fair value.\\nRecent Accounting Standards\\nIn August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The Company assessed the potential impact of ASU 2020-06 and determined that it would not have a material impact on the condensed financial statements as presented.\\nManagement does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our condensed financial statements.\\nFactors That May Adversely Affect Our Results of Operations\\nOur results of operation and our ability to complete an initial business combination may be adversely affected by various factors that could cause economic uncertainty and volatility in the financial markets, many of which are beyond our control. Our business could be impacted by, among other things, volatility in the financial markets or economic conditions, increase of oil price and interest rate, inflation, supply chain disruption, decline in consumer confidence and spending, the on-going effects of the COVID-19 pandemic, including resurgences and the emergence of new variants, and geopolitical instability, such as the military conflict in Ukraine. We cannot at this time fully predict one or more of the above events, their duration or magnitude of, or the extent to, which they may negatively impact our business and our ability to complete an initial business combination.\\n25\\n\\nItem 3. Quantitative and Qualitative Disclosures About Market Risk\\nNot required for smaller reporting companies.\\n\\nItem 4. Controls and Procedures\\nEvaluation of Disclosure Controls and Procedures\\nDisclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized, and reported within the time period specified in the SEC’s rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.\\nAs required by Rule 13a-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective, due solely to the material weakness in our internal control over financial reporting related to our accounting for complex financial instruments. As a result, we performed additional analysis as deemed necessary to ensure that our financial statements were prepared in accordance with GAAP. Accordingly, management believes that the financial statements included in this Report present fairly in all material respects our financial position, results of operations and cash flows for the period presented.\\nManagement has identified a material weakness in our internal controls related to the accounting for complex financial instruments. While we have processes to identify and appropriately apply applicable accounting requirements, we plan to continue to enhance our system of evaluating and implementing the accounting standards that apply to our financial statements, including through enhanced analyses by our personnel and third-party professionals with whom we consult regarding complex accounting applications. The elements of our remediation plan can only be accomplished over time, and we can offer no assurance that these initiatives will ultimately have the intended effects.\\nManagement has implemented remediation steps to improve our internal control over financial reporting. Specifically, we expanded and improved our review process for complex securities and related accounting standards. We plan to further improve this process by enhancing access to accounting literature, identification of third-party professionals with whom to consult regarding complex accounting applications and consideration of additional staff with the requisite experience and training to supplement existing accounting professionals.\\nChanges in Internal Control over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.\\n26\\nPART II - OTHER INFORMATION\\n\\nItem 1. Legal Proceedings.\\nTo the knowledge of our management team, there is no litigation currently pending or contemplated against us, any of our officers or directors in their capacity as such or against any of our property.\\n\\nItem 1A. Risk Factors\\nAs of the date of this Quarterly Report on Form 10-Q, except as disclosed below, there have been no material changes to the risk factors previously disclosed in our final prospectus filed with the SEC on November 17, 2020 , in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the SEC on March 31, 2022 and in our Quarterly Reports on Form 10-Q for the period ended March 31, 2022 and June 30, 2022, filed with the SEC on May 13, 2022 and August 3, 2022, respectively. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results of operations. We may disclose changes to such risk factors or disclose additional risk factors from time to time in our future filings with the SEC.\\nA new 1% U.S. federal excise tax could be imposed on us in connection with redemptions of our shares in connection with a business combination or other stockholder vote pursuant to which stockholders would have a right to submit their shares for redemption (a “Redemption Event”).\\nOn August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for, among other things, a new U.S. federal 1% excise tax on certain repurchases (including redemptions) of stock by publicly traded domestic corporations and certain domestic subsidiaries of publicly traded foreign corporations. The excise tax is imposed on the repurchasing corporation itself, not its stockholders from whom shares are repurchased. The amount of the excise tax is generally 1% of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax. The U.S. Department of the Treasury has been given authority to provide regulations and other guidance to carry out and prevent the abuse or avoidance of the excise tax. The IR Act applies only to repurchases that occur after December 31, 2022.\\nAny redemption or other repurchase that occurs after December 31, 2022, in connection with a Redemption Event may be subject to the excise tax. Whether and to what extent we would be subject to the excise tax in connection with a Redemption Event would depend on a number of factors, including (i) the fair market value of the redemptions and repurchases in connection with the Redemption Event, (ii) the structure of the business combination, (iii) the nature and amount of any “PIPE” or other equity issuances in connection with the business combination (or otherwise issued not in connection with the Redemption Event but issued within the same taxable year of the business combination) and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury. In addition, because the excise tax would be payable by us, and not by the redeeming holder, the mechanics of any required payment of the excise tax have not been determined. The foregoing could cause a reduction in the cash available on hand to complete a business combination and in our ability to complete a business combination.\\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we expect to instruct the trustee to liquidate the securities held in our trust account and instead to hold the funds in our trust account in cash items until the earlier of the consummation of our initial business combination or our liquidation. As a result, we will likely receive minimal interest, if any, on the funds held in the trust account, which will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company.\\nThe funds in our trust account have, since our initial public offering, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we expect to instruct Continental Stock Transfer & Trust Company, the trustee with respect to our trust account, to liquidate the U.S. government treasury obligations and money market funds held in the trust account and to hold all funds in the trust account as cash items until the earlier of the consummation of our initial business combination or the liquidation of the Company. Following such liquidation, we will likely receive minimal interest, if any, on the funds held in the trust account. However, interest previously earned on the funds held in the trust account still may be released to us to pay our taxes, if any. This will likely reduce the dollar amount our public stockholders would receive upon any redemption or liquidation of the Company. In the event that we may be deemed to be an investment company, we may be required to liquidate the Company.\\n27\\n\\nItem 2. Unregistered Sales of Equity Securities and Use of Proceeds.\\nNone.\\n\\nItem 3. Defaults Upon Senior Securities\\nNone.\\n\\nItem 4. Mine Safety Disclosures\\nNone.\\n\\nItem 5. Other Information\\nNone.\\n28\\n\\nItem 6. Exhibits\\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.\\n\\n| No. | Description of Exhibit |\\n| 3.1 | Second Amendment to the Amended and Restated Certificate of Incorporation, as amended (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\\n| 10.1 | Third Amended and Restated Promissory Note, dated August 17, 2022 (Incorporated by reference to the Company’s Form 8-K filed on August 17, 2022) |\\n| 31.1* | Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 31.2* | Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |\\n| 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |\\n| 101.INS* | Inline XBRL Instance Document |\\n| 101.SCH* | Inline XBRL Taxonomy Extension Schema Document |\\n| 101.CAL* | Inline XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF* | Inline XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB* | Inline XBRL Taxonomy Extension Labels Linkbase Document |\\n| 101.PRE* | Inline XBRL Taxonomy Extension Presentation Linkbase Document |\\n| 104* | Cover Page Interactive Data File |\\n\\n\\n| * | Filed herewith. |\\n| ** | Furnished herewith. |\\n\\n29\\nSIGNATURES\\nIn accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\\n\\n| BETTER WORLD ACQUISITION CORP. |\\n| Date: November 14, 2022 | By: | /s/ Rosemary L. Ripley |\\n| Name: | Rosemary L. Ripley |\\n| Title: | Chief Executive Officer |\\n| (Principal Executive Officer) |\\n| Date: November 14, 2022 | By: | /s/ Peter S.H. Grubstein |\\n| Name: | Peter S.H. Grubstein |\\n| Title: | Chief Financial Officer |\\n| (Principal Financial Officer) |\\n\\n30\\n\\n</text>\\n\\nWhat's the estimated worth of the company Better World Acquisition Corp. at the end of Q4 in 2022 if the company continues to follow the same trend as it did in the first three quarters of 2022, in millions of dollars?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is -0.10797933333333326.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 59,\n \"input_length\": 29244\n}"}}},{"rowIdx":60,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nBusiness\nOrganization\nSotherly Hotels Inc. (the “Company”) is a self-managed and self-administered lodging real estate investment trust, or REIT, that was formed in August 2004 to own, acquire, renovate and reposition full-service, primarily upscale and upper-upscale hotel properties located in primary markets in the mid-Atlantic and southern United States. On December 21, 2004, the Company successfully completed its initial public offering and elected to be treated as a self-advised REIT for federal income tax purposes. The Company conducts its business through Sotherly Hotels LP, its operating partnership (the “Operating Partnership”), of which the Company is the general partner. The Company owns approximately 89.1% of the partnership units in the Operating Partnership. Limited partners (including certain of the Company’s officers and directors) own the remaining Operating Partnership units.\nAs of December 31, 2016, our portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels located in eight states with an aggregate total of 3,011 rooms and approximately 160,928 square feet of meeting space. All of our hotels are wholly-owned by subsidiaries of the Operating Partnership, and all are managed on a day to day basis by MHI Hotels Services, LLC, which does business as Chesapeake Hospitality (“Chesapeake Hospitality”).\nIn order for the Company to qualify as a REIT, it cannot directly manage or operate our wholly-owned hotels. Therefore, we lease our wholly-owned hotel properties to entities that we refer to as our TRS Lessees, which in turn have engaged Chesapeake Hospitality, an eligible independent management company, to manage our hotels. Our TRS Lessees are wholly-owned subsidiaries of MHI Hospitality TRS Holding, Inc. (“MHI Holding”, and collectively, “MHI TRS”). MHI TRS is a taxable REIT subsidiary for federal income tax purposes.\nOur corporate office is located at 410 West Francis Street, Williamsburg, Virginia 23185. Our telephone number is (757) 229-5648.\nOur Properties\nAs of December 31, 2016, our hotels were located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, Texas, and Virginia. Ten of these hotels operate under franchise agreements with major hotel brands, and two are independent hotels. Developments at our properties for the five years ended December 31, 2016 included the following:\n| • | In 2013 we acquired the Crowne Plaza Houston Downtown located in Houston, Texas at an aggregate value of approximately $30.9 million, including certain closing costs. |\n\n| • | In 2014, we acquired the Georgian Terrace located in Atlanta, Georgia at an aggregate value of approximately $61.1 million, including certain closing costs. We also, after extensive renovations, re-branded and renamed the Hilton Philadelphia Airport to the DoubleTree by Hilton Philadelphia Airport. |\n\n| • | In 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. We also, after extensive renovations, re-branded and renamed the Crowne Plaza Jacksonville Riverfront to the DoubleTree by Hilton Jacksonville Riverfront, and re-branded and renamed the Holiday Inn Laurel West to the DoubleTree by Hilton Laurel. |\n\n| • | In 2016, after extensive renovations, we re-branded and renamed the Crowne Plaza Houston Downtown to The Whitehall. |\n\nSee Items 2 and 7 of this Form 10-K for additional detail on our properties.\nOur Strategy and Investment Criteria\nOur strategy is to grow through acquisitions of full-service, upscale and upper-upscale hotel properties located in the primary markets of the southern United States. We intend to grow our portfolio through disciplined acquisitions of hotel properties and believe that we will be able to source significant external growth opportunities through our management team’s extensive network of industry, corporate and institutional relationships.\n5\nOur investment criteria are further detailed below:\n| • | Geographic Growth Markets: We are focusing our growth strategy on the major markets in the Southern region of the United States. Our management team remains confident in the long-term growth potential associated with this part of the United States. We believe these markets have, during the Company’s and our predecessors’ existence, been characterized by population growth, economic expansion, growth in new businesses and growth in the resort, recreation and leisure segments. We will continue to focus on these markets, including coastal locations, and will investigate other markets for acquisitions only if we believe these new markets will provide similar long-term growth prospects. |\n\n| • | Full-Service Hotels: We focus our acquisition strategy on the full-service hotel segment. Our full-service hotels fall primarily under the upscale to upper-upscale categories and include such brands as Hilton, Doubletree by Hilton, Sheraton and Crowne Plaza, as well as independent hotels affiliated with Preferred Hotels & Resorts. We may also acquire commercial unit(s) within upscale to upper-upscale condominium hotel projects, allowing us to establish and operate unit rental programs. We do not own economy hotels. We believe that full-service hotels, in the upscale to upper-upscale categories, will outperform the broader U.S. hotel industry, and thus offer the highest returns on invested capital. |\n\n| • | Significant Barriers to Entry: We intend to execute a strategy that entails the acquisition of hotels in prime locations with significant barriers to entry. |\n\n| • | Proximity to Demand Generators: We seek to acquire hotel properties located in central business districts for both leisure and business travelers within the respective markets, including large state universities, airports, convention centers, corporate headquarters, sports venues and office buildings. We seek to be in walking locations that are proximate to the markets’ major demand generators. |\n\nWe typically define underperforming hotels as those that are poorly managed, suffer from significant deferred maintenance and capital investment and that are not properly positioned in their respective markets. In pursuing these opportunities, we hope to improve revenue and cash flow and increase the long-term value of the underperforming hotels we acquire. Our ultimate goal is to achieve a total investment that is substantially less than replacement cost of a hotel or the acquisition cost of a market performing hotel. In analyzing a potential investment in an underperforming hotel property, we typically characterize the investment opportunity as one of the following:\n| • | Branding Opportunity: The acquisition of properties that includes a repositioning of the property through a change in brand affiliation, which may include positioning the property as an independent hotel. Branding opportunities typically include physical upgrades and enhanced efficiencies brought about by changes in operations. |\n\n| • | Shallow-Turn Opportunity: The acquisition of an underperforming but structurally sound hotel that requires moderate renovation to re-establish the hotel in its market. |\n\n| • | Deep-Turn Opportunity: The acquisition of a hotel that is closed or functionally obsolete and requires a restructuring of both the business components of the operations as well as the physical plant of the hotel, including extensive renovation of the building, furniture, fixtures and equipment. |\n\nTypically, in our experience, a deep turn opportunity takes a total of approximately four years from the initial acquisition of a property to achieving full post-renovation stabilization. Therefore, when evaluating future opportunities in underperforming hotels, we intend to focus on up-branding and shallow-turn opportunities, and to pursue deep-turn opportunities on a more limited basis and in joint venture partnerships, if possible.\nInvestment Vehicles. In pursuit of our investment strategy, we may employ various traditional and non-traditional investment vehicles:\n| • | Direct Purchase Opportunity: Our traditional investment strategy is to acquire direct ownership interests via our Operating Partnership in properties that meet our investment criteria, including opportunities that involve full-service, upscale and upper-upscale properties in identified geographic growth markets that have significant barriers to entry for new product delivery. Such properties, or portfolio of properties, may or may not be acquired subject to a mortgage, or other financing or lending instruments, by the seller or third-party. |\n\n| • | Joint Venture/Mezzanine Lending Opportunities: We may, from time to time, undertake a significant renovation and rehabilitation project that we characterize as a deep-turn opportunity. In such cases, we may acquire a functionally obsolete hotel whose renovation may be very lengthy and require significant capital. In these projects, we may choose to structure such acquisitions as a joint venture, or mezzanine lending program, in order to avoid severe short-term dilution and loss of current income commonly referred to as the “negative carry” associated with such extensive renovation programs. We will not pursue joint venture or mezzanine programs in which we would become a “de facto” lender to the real estate community. |\n\n6\nPortfolio and Asset Management Strategy\nWe intend to ensure that the management of our hotel properties maximizes market share, as evidenced by revenue per available room (“RevPAR”) penetration indices, and that our market share yields the optimum level of revenues for our hotels in their respective markets. Our strategy is designed to actively manage our hotels’ operating expenses in an effort to maximize hotel earnings before interest, taxes, depreciation and amortization (“Hotel EBITDA”).\nOver our long history in the lodging industry we have refined many portfolio and asset management techniques that we believe provide for exceptional cash returns at our hotels. We undertake extensive budgeting due diligence wherein we examine market trends, one-time or exceptional revenue opportunities, and/or changes in the regulatory climate that may impact costs. We review daily revenue results and revenue management strategies at the hotels, and we focus on our manager’s ability to produce high quality revenues that translate to higher profit margins. We look for ancillary forms of revenues, such as leasing roof-top space for cellular towers and other communication devices and also look to lease space to third parties in our hotels, which may include, but are not limited to, gift shops or restaurants. We have and will continue to engage parking management companies to maximize parking revenue. Our efforts further include periodic review of property insurance costs and coverage, and the cost of real and personal property taxes. We generally appeal tax increases in an effort to secure lower tax payments and routinely pursue strategies that allow for lower overall insurance costs, such as purchasing re-insurance and participating in state-sponsored insurance pools.\nWe also require detailed and refined reporting data from Chesapeake Hospitality, which includes detailed accounts of revenues, revenue segments, expenses and forecasts based on current and historic booking patterns. We also believe we optimize and successfully manage capital costs at our hotels while ensuring that adequate product standards are maintained to provide a positive guest experience.\nNone of our hotels are managed by a major national or global hotel franchise company. Through our long history in the lodging industry, we have found that management of our hotels by management companies other than franchisors is preferable to and more profitable than management services provided by the major franchise companies, specifically with respect to optimization of operating expenses and the delivery of guest service.\nOur portfolio management strategy includes our effort to optimize labor costs. The labor force in our hotels is predominately non-unionized, with only one property, the DoubleTree by Hilton Jacksonville Riverfront, having a total of approximately 26 employees electing to participate under a collective bargaining arrangement. Further, the labor force at our hotels is eligible to receive health and other insurance coverage through Chesapeake Hospitality, which self-insures. Self-insuring has, in our opinion and experience, provided significant savings over traditional insurance company sponsored plans.\nAsset Disposition Strategy. When a property no longer fits with our investment objectives, we will pursue a direct sale of the property for cash so that our investment capital can be redeployed according to the investment strategies outlined above. Where possible, we will seek to subsequently purchase a hotel in connection with the requirements of a tax-free exchange. Such a strategy may be deployed in order to mitigate the tax consequence that a direct sale may cause.\nOur Principal Agreements\nManagement Agreements\nChesapeake Hospitality is currently the management company for each of our hotels. Andrew M. Sims, our chairman and chief executive officer owns an equity interest in Chesapeake Hospitality. Immediately prior to March 1, 2017, our chairman and chief executive officer, and another of our directors were also directors of Chesapeake Hospitality.\nOn December 15, 2014, we entered into a master agreement (the “Master Agreement”) and a series of individual hotel management agreements (each a “Hotel Management Agreement” and, together, the “Hotel Management Agreements”) between the Company, the Operating Partnership, and MHI Hospitality TRS, LLC (and other TRS Lessees) on the one hand and Chesapeake Hospitality on the other hand, to address the scheduled expiration of the then existing master management agreement (the “MMA”) and the strategic alliance agreement (the “SA Agreement”) and to provide for ongoing management of the Company’s hotels. The Master Agreement and Hotel Management Agreements terminated and replaced the then existing MMA and individual management agreements.\nThe Master Agreement:\n| • | expires on December 31, 2019, or earlier if all of the Hotel Management Agreements expire or are terminated prior to that date. The Master Agreement will be extended beyond 2019 for such additional periods as a Hotel Management Agreement remains in effect; |\n\n7\n\n| • | terminated the then existing SA Agreement as of December 15, 2014; |\n\n| • | extended the term of the then existing MMA until December 31, 2014 and terminated the MMA and other individual management agreements for Tampa, Houston, and Atlanta as of such date; |\n\n| • | caused the Hotel Management Agreements to come into effect coincident with the termination of the MMA and other individual management agreements on December 31, 2014; |\n\n| • | requires Chesapeake Hospitality to provide dedicated executive level support for our managed hotels pursuant to certain criteria; |\n\n| • | provides a mechanism and established conditions on which the Company will offer Chesapeake Hospitality the opportunity to manage hotels acquired by the Company in the future, pursuant to a negotiated form of single facility management agreement, with the caveat that the Company is not required to offer the management of future hotels to Chesapeake Hospitality; and |\n\n| • | sets an incentive management fee for each of the hotels to be managed by Chesapeake Hospitality equal to 10% of the amount by which gross operating profit, as defined in the Hotel Management Agreement, for a given year exceeds the budgeted gross operating profit for such year; provided, however, that the incentive management fee payable in respect of any such year shall not exceed 0.25% of the gross revenues of the hotel included in such calculation. |\n\nEach of the Hotel Management Agreements has a term of five years commencing January 1, 2015, with the exception of the Hotel Management Agreement for the management of the Crowne Plaza Hollywood Beach Resort, which has a term of five years commencing July 31, 2015. Each of the Hotel Management Agreements may be extended for up to two additional periods of five years subject to the approval of both parties with respect to any such extension. The agreements provide that Chesapeake Hospitality will be the sole and exclusive manager of the hotels as the agent of the respective TRS Lessee and at the sole cost and expense of the TRS Lessee and subject to certain operating standards. Each agreement may be terminated in connection with a sale of the related hotel. In connection with a termination upon the sale of the hotel, Chesapeake Hospitality will be entitled to receive a termination fee equal to the lesser of the management fee paid with respect to the prior twelve months or the management fees paid for that number of months prior to the closing date of the hotel sale equal to the number of months remaining on the current term of the Hotel Management Agreement. No sale termination fee will be payable in the event the Company elects to provide Chesapeake Hospitality with the opportunity to manage another comparable hotel and Chesapeake Hospitality is not precluded from accepting such opportunity. Chesapeake Hospitality is required to qualify as an eligible independent contractor in order to permit the Company to continue to operate as a real estate investment trust.\nAmounts Payable under the Management Agreements. Chesapeake Hospitality receives a base management fee, and, if the hotels exceed certain financial thresholds, an additional incentive management fee for the management of our hotels.\nThe base management fee for our hotels will be a percentage of the gross revenues of the hotel and will be due monthly. The applicable percentage of gross revenue for the base management fee for each of our wholly-owned hotels is as follows (1):\n\n| 2019 | 2018 | 2017 | 2016 | 2015 | 2014 |\n| Crowne Plaza Hampton Marina (2) | N/A | N/A | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Crowne Plaza Hollywood Beach Resort | 2.50 | % | 2.50 | % | (3) | (3) | 2.00 | % | N/A |\n| Crowne Plaza Tampa Westshore (4) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Jacksonville Riverfront | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Laurel | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Philadelphia Airport | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| DoubleTree by Hilton Raleigh Brownstone – University | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Georgian Terrace (5) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\n| Hilton Savannah DeSoto | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Hilton Wilmington Riverside | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| Sheraton Louisville Riverside (6) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\n| The Whitehall (7) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\n\n\n| (1) | The fees for 2014 were set by the MMA, and the individual management agreements for Tampa, Houston, and Atlanta. The fees for 2015-2019 are set by the Master Agreement and the Hotel Management Agreements. |\n\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017; therefore, the base management fee no longer applies after February 7, 2017. |\n\n8\n\n| (3) | Upon acquiring the Crowne Plaza Hollywood Beach Resort in July 2015, we entered into a single facility management agreement with Chesapeake Hospitality for the management of the hotel. The terms of the agreement provide for a base management fee of 2.00% through July 2016, 2.25% through July 2017, and 2.50% thereafter. |\n\n| (4) | In January 2009, we entered a separate management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Tampa Westshore. The provisions of the new agreement related to base management fee were the same as those contained in the MMA. The provisions of the agreement related to the incentive management fee were the same as those contained in the MMA except that it was calculated separately and not aggregated with the other properties covered by the MMA. |\n\n| (5) | In March 2014, we entered into the Atlanta Agreement with Chesapeake Hospitality for the management of the Georgian Terrace. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. The Atlanta Agreement was terminated in connection with the entry into the Master Agreement and Hotel Management Agreements. |\n\n| (6) | Pursuant to the MMA, the term for each of the initial properties, which included the Holiday Inn Downtown Williamsburg, was 10 years. The management company agreed to substitute the Sheraton Louisville Riverside for the Holiday Inn Downtown Williamsburg for remainder of the term of the agreement. |\n\n| (7) | In November 2013, we assumed the existing management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Houston Downtown. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. |\n\nThe base management fee for a hotel acquired in the future which is first leased by our TRS Lessees, other than on the first day of a fiscal year, will be 2.0% for the partial year such hotel is first leased and for the first full year such hotel is managed. There is no fee cap on the base management fee.\nSubsequently Acquired Hotel Properties\n\n| First year | 2.00 | % |\n| Second year | 2.25 | % |\n| Third year and thereafter | 2.50 | % |\n\nTerminated Strategic Alliance Agreement and Management Agreements\nOn December 21, 2004, we entered into the now terminated ten-year SA Agreement with Chesapeake Hospitality pursuant to which (i) Chesapeake Hospitality agreed to refer to us (on an exclusive basis) hotel acquisition opportunities in the United States presented to Chesapeake Hospitality, and (ii) unless a majority of the Company’s independent directors in good faith concluded for valid business reasons that another management company should manage a hotel owned by us, we agreed to offer Chesapeake Hospitality or its subsidiaries the right to manage hotel properties that we acquired in the United States. The SA Agreement was terminated effective as of December 15, 2014, pursuant to the terms of the Master Agreement.\nPursuant to the terms of the now terminated MMA and other individual management agreements for Tampa, Houston and Atlanta, we engaged Chesapeake Hospitality as the property manager for each of our wholly-owned hotels through December 2015. The MMA had a term of ten (10) years for each initial hotel and a term of ten (10) years for each subsequently acquired hotel that became subject to the MMA. Chesapeake Hospitality benefited from the payment of management fees by us pursuant to the MMA. Chesapeake Hospitality received a base management fee equal to a percentage of each hotel’s revenues (2.0% for the first year, 2.5% for the second year and 3.0% thereafter). Additionally, pursuant to the MMA, Chesapeake Hospitality was entitled to receive certain incentive fees and project management fees. For Tampa, the base management and incentive management fees were the same as those contained in the MMA. For Houston and Atlanta, the base management fee was equal to 2% of the respective hotels’ revenues, and there was no incentive management fee. The MMA and the individual management agreements for Tampa, Houston, and Atlanta were terminated on December 31, 2014, pursuant to the terms of the Master Agreement.\nFranchise Agreements\nAs of December 31, 2016, all but two of our wholly-owned hotels operate under franchise licenses from national hotel companies. On March 27, 2014, we purchased an independent full-service hotel in Atlanta, Georgia, which does not operate under a franchise license. On April 12, 2016, we allowed the Crowne Plaza Houston Downtown’s franchise agreement to expire and rebranded it as The Whitehall, an independent full-service hotel.\nOur TRS Lessees hold the franchise licenses for our wholly-owned hotels. Chesapeake Hospitality must operate each of our hotels it manages in accordance with and pursuant to the terms of the franchise agreement for the hotel.\n9\nThe franchise licenses generally specify certain management, operational, record keeping, accounting, reporting and marketing standards and procedures with which the franchisee must comply. Under the franchise licenses, the franchisee must comply with the franchisors’ standards and requirements with respect to:\n| • | training of operational personnel; |\n\n| • | safety; |\n\n| • | maintaining specified insurance; |\n\n| • | the types of services and products ancillary to guest room services that may be provided; |\n\n| • | display of signage; |\n\n| • | marketing techniques including print media, billboards, and promotions standards; and |\n\n| • | the type, quality and age of furniture, fixtures and equipment included in guest rooms, lobbies and other common areas. |\n\nAdditionally, as the franchisee, our TRS Lessees are required to pay the franchise fees described below.\nThe following table sets forth certain information for the franchise licenses of our wholly-owned hotel properties as of December 31, 2016:\n\n| Marketing/ |\n| Franchise | Reservation | Expiration |\n| Fee (1) | Fee (1) | Date |\n| Crowne Plaza Hampton Marina (2) | 5.0 | % | 3.5 | % | 2/7/2017 |\n| Crowne Plaza Hollywood Beach Resort (3) | 5.0 | % | 3.5 | % | 10/31/2017 |\n| Crowne Plaza Tampa Westshore | 5.0 | % | 3.5 | % | 3/6/2019 |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 5.0 | % | 4.0 | % | 9/30/2025 |\n| DoubleTree by Hilton Laurel | 5.0 | % | 4.0 | % | 10/31/2030 |\n| DoubleTree by Hilton Philadelphia – Airport (5) | 5.0 | % | 4.0 | % | 10/31/2024 |\n| DoubleTree by Hilton Raleigh Brownstone – University (4) | 5.0 | % | 4.0 | % | 11/30/2021 |\n| Hilton Savannah DeSoto (6) | 5.0 | % | 4.0 | % | 7/31/2017 |\n| Hilton Wilmington Riverside | 5.0 | % | 4.0 | % | 3/31/2018 |\n| Sheraton Louisville Riverside | 5.0 | % | 3.5 | % | 4/25/2023 |\n\n\n| (1) | Percentage of room revenues payable to the franchisor. |\n\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017, and the franchise license was transferred to the new owners. |\n\n| (3) | We have entered into a franchise agreement with Hilton to rebrand the Hollywood hotel as a DoubleTree by Hilton. |\n\n| (4) | The Franchise Fee is 3.0% for operating year 1, 4.0% for operating year 2, and 5.0% thereafter. |\n\n| (5) | The Franchise Fee is 4.0% for operating years 1 and 2, and 5.0% thereafter. |\n\n| (6) | We intend to convert the Savannah hotel to an independent hotel. |\n\nLease Agreements\nIn order for the Company to maintain qualification as a REIT, neither the Company nor the Operating Partnership or its subsidiaries can operate our hotels directly. Our wholly-owned hotels are leased to our TRS Lessees, which have engaged Chesapeake Hospitality to manage the hotels. Each lease has a non-cancelable term of three to thirty years, subject to earlier termination upon the occurrence of certain contingencies described in the lease.\nDuring the term of each lease, our TRS Lessees are obligated to pay a fixed annual base rent plus a percentage rent and certain other additional charges. Base rent accrues and is paid monthly. Percentage rent is calculated by multiplying fixed percentages by gross room revenues, in excess of certain threshold amounts and is paid monthly or quarterly, according to the terms of the agreement.\nTax Status\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”), commencing with its taxable year ended December 31, 2004. In order to maintain its qualification as a REIT, the Company must meet a number of organizational and operational requirements, including a requirement that it currently distribute, as “qualifying distributions,” at least 90.0% of its taxable income (determined without regard to the deduction for dividends paid and by\n10\nexcluding its net capital gains and reduced by certain non-cash items) to its stockholders. The Company has adhered to these requirements each taxable year since its formation in 2004 and intends to continue to adhere to these requirements and maintain its qualification for taxation as a REIT. As a REIT, the Company generally will not be subject to federal corporate income tax on that portion of its taxable income (including its net capital gain) that is distributed to its stockholders. If the Company fails to qualify for taxation as a REIT in any taxable year, and no relief provision applies, it will be subject to federal income taxes at regular corporate rates (as well as any applicable alternative minimum tax) and it would be disqualified from re-electing treatment as a REIT until the fifth taxable year after the year in which it failed to qualify as a REIT. Even if the Company qualifies for taxation as a REIT, it may be subject to certain state and local taxes on its income and property, and to federal income and excise taxes on its undistributed taxable income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes.\nWhile the Operating Partnership is generally not subject to federal and state income taxes, the unit holders of the Operating Partnership, including the Company, are subject to tax on their respective allocable shares of the Operating Partnership’s taxable income.\nThe Company has one taxable REIT subsidiary, MHI Holding, in which it owns an interest through the Operating Partnership. MHI Holding is subject to federal, state and local income taxes. MHI Holding has operated at a cumulative taxable loss, through December 31, 2016, of approximately $15.9 million and in addition had deferred timing differences of approximately $0.2 million attributable to start-up expenses related to the opening of several of its hotels, which was not deductible when incurred and is being amortized over 15 years and deferred timing differences of approximately $0.5 million attributable to accrued, but not deductible, vacation and sick pay amounts. The Company has not incurred federal income taxes since its formation. The cumulative taxable loss and combined timing differences result in a net deferred tax asset of approximately $6.9 million for these cumulative deferred tax loss carryforwards.\nEnvironmental Matters\nIn connection with the ownership and operation of the hotels, we are subject to various federal, state and local laws, ordinances and regulations relating to environmental protection. Under these laws, a current or previous owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on, under, or in such property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances. In addition, the presence of contamination from hazardous or toxic substances, or the failure to remediate such contaminated property properly, may adversely affect the owner’s ability to borrow using such property as collateral. Furthermore, a person who arranges for the disposal or treatment of a hazardous or toxic substance at a property owned by another, or who transports such substance to or from such property, may be liable for the costs of removal or remediation of such substance released into the environment at the disposal or treatment facility. The costs of remediation or removal of such substances may be substantial, and the presence of such substances may adversely affect the owner’s ability to sell such real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of the hotels, we may be potentially liable for such costs.\nWe believe that our hotels are in compliance, in all material respects, with all federal, state and local environmental ordinances and regulations regarding hazardous or toxic substances and other environmental matters, the violation of which would have a material adverse effect on us. We have not received written notice from any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental matters in connection with any of our present hotel properties.\nEmployees\nAs of December 31, 2016, we employed twelve full-time persons, all of whom work at our corporate office in Williamsburg, Virginia. All persons employed in the day-to-day operations of the hotels are employees of Chesapeake Hospitality, the management company engaged by our TRS Lessees to operate such hotels.\nSubsequent Events\nHyde Resort & Residences\nOn January 30, 2017, we purchased the commercial unit of the Hyde Resort & ResidencesTM, a condominium hotel located in the Hollywood, Florida market, for an aggregate price of approximately $4.8 million, including inventory and closing fees. The trademarked Hyde Resort & Residences is operated under license from SBE Hotel Licensing, LLC.\n11\nWe have entered into several agreements related to the Hyde Resort & Residences, which is zoned and operated as a condominium hotel with individual condominium units owned by third parties. In addition to our ownership of the commercial condominium unit, consisting of the designated lobby and front desk areas, we entered into a 20-year Lease Agreement with the condominium association responsible for the operation of the condominium, whereby we lease other common areas, including meeting rooms, office spaces, and 400 parking spaces, and also manage the parking garage. We have also entered into a 20-year Association Management Agreement with the condominium association, whereby we are engaged to manage the condominium association and to operate the Hyde Resort & Residences as a condominium hotel. Individual condominium unit owners may elect for their condominium units to be rented to condominium hotel guests pursuant to a rental management program managed for us by Chesapeake Hospitality pursuant to the Hyde Management Agreement, described below. As part of the rental management program, we have entered into individual rental agreements with condominium unit owners who have chosen to participate in our rental program, and may enter into rental agreements with unit owners in the future. We expect the number of individual condominium unit owners who elect to participate in our rental program to vary, and the number of units available for rental to condominium hotel guests at any given time will fluctuate pursuant to that participation and due to owner occupation of the condominium hotel units.\nOn February 3, 2017, we entered into a Condominium Hotel Management Agreement (the “Hyde Management Agreement”) with Chesapeake Hospitality for the management of the Hyde Resort & Residences condominium hotel. In accordance with the Master Agreement, the Hyde Management Agreement has an initial term of five years commencing January 30, 2017 and mirrors the material terms of the other Hotel Management Agreements. The terms of the Hyde Management Agreement provide for a base management fee equal to a percentage of gross revenues of the rental of condominium units participating in our rental program in the amount of 2.00% through January 2018, 2.25% through January 2019, and 2.50% thereafter. Pursuant to the Hyde Management Agreement, Chesapeake Hospitality will manage for us the rental of individually owned condominium units pursuant to rental agreements entered into with individual condominium unit owners. We also entered into an Association Sub Management and Assignment Agreement with Chesapeake Hospitality for the management and operation of the condominium association responsible for the operation of the Hyde Resort & Residences, and a Rental Management Agreement pursuant to which Chesapeake Hospitality agreed to manage the marketing and negotiation of rental agreements with individual condominium unit owners.\nCrowne Plaza Hampton Marina Disposition\nOn February 7, 2017, we sold the Crowne Plaza Hampton Marina for a price of approximately $5.6 million. Following the sale, our portfolio consisted of eleven wholly-owned hotels located in seven states with an aggregate total of 2,838 rooms and approximately 149,435 square feet of meeting space, as well as our interests in the Hyde Resort & Residences.\nEmployee Stock Ownership Plan\nBetween January 3, 2017 and February 23, 2017, the Company’s Employee Stock Ownership Plan (“ESOP”) purchased 682,500 shares of the Company’s common stock. The Company sponsors and maintains the ESOP and related trust for the benefit of its eligible employees. The ESOP, which was established January 1, 2016, is funded by a loan from the Company, pursuant to which the ESOP may borrow up to $5,000,000 to purchase shares of the Company’s common stock, which serve as collateral for the loan.\nDirector and Officer Changes\nOn March 1, 2017, Kim E. Sims resigned as a member of the board of directors of the Company.\nAvailable Information\nWe maintain an Internet site, http://www.sotherlyhotels.com, which contains additional information concerning Sotherly Hotels Inc. We make available free of charge through our Internet site all our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, definitive proxy statements and other reports filed with the Securities and Exchange Commission as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We have also posted on this website the Company’s Code of Business Conduct and the charters of the Company’s Nominating, Corporate Governance and Compensation (“NCGC”) and Audit Committees of the Company’s board of directors. We intend to disclose on our website any changes to, or waivers from, the Company’s Code of Business Conduct. Information on the Company’s Internet site is neither part of nor incorporated into this Form 10-K.\n12\n\nItem 1A.\nRi\nsk Factors\nThe following are the material risks that may affect us. Any of the risks discussed herein can materially adversely affect our business, liquidity, operations, industry or financial position or our future financial performance.\nRisks Related to Our Debt\nWe have substantial financial leverage.\nAs of December 31, 2016, the principal balance of our debt was approximately $309.8 million, which is comprised of approximately $284.5 million secured debt and approximately $25.3 million unsecured debt related to the 7.0% senior unsecured notes due November 20, 2019 (the “7% Notes”) (not accounting for reductions of unamortized premiums or deferred financing costs as shown on our balance sheet). Historically, we have incurred debt for acquisitions and to fund our renovation, redevelopment and rebranding programs. Limitations upon our access to additional debt could adversely affect our ability to fund these programs or acquire hotels in the future.\nOur financial leverage could negatively affect our business and financial results, including the following:\n| • | require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for operations, working capital, capital expenditures, future business opportunities, paying dividends or other purposes; |\n\n| • | limit our ability to obtain additional financing for working capital, renovation, redevelopment and rebranding plans, acquisitions, debt service requirements and other purposes; |\n\n| • | adversely affect our ability to satisfy our financial obligations, including those related to the 7% Notes; |\n\n| • | limit our ability to refinance existing debt; |\n\n| • | require us to agree to additional restrictions and limitations on our business operations and capital structure to obtain financing; |\n\n| • | force us to dispose of one or more of our properties, possibly on unfavorable terms; |\n\n| • | increase our vulnerability to adverse economic and industry conditions, and to interest rate fluctuations; |\n\n| • | force us to issue additional equity, possibly on terms unfavorable to existing shareholders; |\n\n| • | limit our flexibility to make, or react to, changes in our business and our industry; and |\n\n| • | place us at a competitive disadvantage, compared to our competitors that have less debt. |\n\nWe must comply with financial covenants in our mortgage loan agreements and in the indenture.\nOur mortgage loan agreements and indenture contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\nIf we violate the financial covenants contained in our mortgage loan agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\nIf we violate the financial covenants in the indenture, we may attempt to cure that violation by engaging in one or more transactions pursuant to the cure provision in the indenture.\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through debt financing, private or public offerings of debt securities, additional equity financing, or by disposing of an asset. We are uncertain whether we will be able to refinance these obligations or if refinancing terms will be favorable.\n13\nWe have one mortgage debt obligation maturing in 2018, and if we are not successful in extending the term of this indebtedness or in refinancing this debt on acceptable economic terms or at all, our overall financial condition could be materially and adversely affected.\nWe will be required to seek additional capital in the near future to refinance or replace existing long-term mortgage debt that is maturing. Based on current market conditions, the availability of financing is, and may continue to be, limited. There can be no assurance that we will be able to obtain future financings on acceptable terms, if at all.\nIn August 2018, the mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures, and we have additional significant obligations maturing in subsequent years.\nWe have no material debt obligations maturing in 2017. The total aggregate amount of our debt obligations scheduled to mature in 2018, inclusive of monthly amortization of all our indebtedness, is approximately $24.6 million, which represents approximately 7.9% of our total debt obligation outstanding as of December 31, 2016.\nWe will need to, and plan to, renew, replace or extend our long-term indebtedness prior to the respective maturity date. If we are unable to extend this loan, we may be required to repay the outstanding principal amount at maturity or a portion of such indebtedness upon refinance. If we do not have sufficient funds to repay any portion of the indebtedness, it may be necessary to raise capital through debt financing, private or public offerings of debt securities or equity financings. We are uncertain whether we will be able to refinance this obligation or if refinancing terms will be favorable. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on refinancing, increases in interest expense would lower our cash flow, and, consequently, cash available to meet our financial obligations. If we are unable to obtain alternative or additional financing arrangements in the future, or if we cannot obtain financing on acceptable terms, we may not be able to execute our business strategies or we may be forced to dispose of hotel properties on disadvantageous terms, potentially resulting in losses and potentially reducing cash flow from operating activities if the sale proceeds in excess of the amount required to satisfy the indebtedness could not be reinvested in equally profitable real property investments. Moreover, the terms of any additional financing may restrict our financial flexibility, including the debt we may incur in the future, or may restrict our ability to manage our business as we had intended. To the extent we cannot repay our outstanding debt, we risk losing some or all of our hotel properties to foreclosure and we could be required to invoke insolvency proceedings including, but not limited to, commencing a voluntary case under the U.S. Bankruptcy Code.\nFor tax purposes, a foreclosure of any of our hotels would be treated as a sale of the hotel for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the hotel, we would recognize taxable income on foreclosure, but we would not receive any cash proceeds, which could hinder the Company’s ability to meet the REIT distribution requirements imposed by the Code. In addition, we may give full or partial guarantees to lenders of mortgage debt on behalf of the entities that own our hotels. When we give a guarantee on behalf of an entity that owns one of our hotels, we will be responsible to the lender for satisfaction of the debt if it is not paid by such entity.\nOur borrowing costs are sensitive to fluctuations in interest rates.\nHigher interest rates could increase our debt service requirements and interest expense. Currently, our floating rate debt is limited to the mortgages on the DoubleTree by Hilton Philadelphia Airport, the DoubleTree by Hilton Jacksonville Riverfront, the Crowne Plaza Tampa Westshore and The Whitehall. Each of these mortgages bears interest at rates tied to the 1-month London Interbank Offered Rate (“LIBOR”) and provide for minimum rates of interest. To the extent that increases in the LIBOR rate of interest cause the interest on the mortgages to exceed the minimum rates of interest, we are exposed to rising interest rates.\nShould we obtain new debt financing or refinance existing indebtedness, we may increase the amount of floating rate debt that currently exists. In addition, adverse economic conditions could also cause the terms on which we borrow to be unfavorable.\nRisks Related to Our Business and Properties\nIf the economy falls back into a recessionary period or fails to maintain positive growth, our operating performance and financial results may be harmed by declines in occupancy, average daily room rates and/or other operating revenues.\nThe performance of the lodging industry and the general economy historically have been closely linked. In an economic downturn, business and leisure travelers may seek to reduce costs by limiting travel and/or reducing costs on their trips. Our hotels, which are all full-service hotels, may be more susceptible to a decrease in revenue, as compared to hotels in other categories that have lower room rates. A decrease in demand for hotel stays and hotel services will negatively affect our operating revenues, which will lower our cash flow and may affect our ability to make distributions to stockholders and to maintain compliance with our loan obligations. We had net loss attributable to the common shareholders of approximately $0.2 million for the 2016 fiscal year. A renewed economic downturn may increase our losses or reduce our income in the future. A weakening of the economy may adversely and materially affect our industry, business and results of operations and we cannot predict the likelihood, severity or duration of any such downturn. Moreover, reduced revenues as a result of a weakening economy may also reduce our working capital and impact our long-term business strategy.\n14\nWe own a limited number of hotels and significant adverse changes at one hotel could have a material adverse effect on our financial performance and may limit our ability to make distributions to stockholders.\nAs of December 31, 2016, our portfolio consisted of twelve wholly-owned hotels with a total of 3,011 rooms. Significant adverse changes in the operations of any one hotel could have a material adverse effect on our financial performance and, accordingly, on our ability to make distributions to stockholders. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences.\nWe are subject to risks of increased hotel operating expenses and decreased hotel revenues.\nOur leases with our TRS Lessees provide for the payment of rent based in part on gross revenues from our hotels. Our TRS Lessees are subject to hotel operating risks including decreased hotel revenues and increased hotel operating expenses, including but not limited to the following:\n| • | wage and benefit costs; |\n\n| • | repair and maintenance expenses; |\n\n| • | energy costs; |\n\n| • | property taxes; |\n\n| • | insurance costs; and |\n\n| • | other operating expenses. |\n\nAny increases in these operating expenses can have a significant adverse impact on our TRS Lessees’ ability to pay rent and other operating expenses and, consequently, our earnings and cash flow.\nIn keeping with our investment strategy, we may acquire, renovate and/or re-brand hotels in new or existing geographic markets as part of our repositioning strategy. Unanticipated expenses and insufficient demand for newly repositioned hotels could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\nWe have in the past, and may in the future, develop or acquire hotels in geographic areas in which our management may have little or no operating experience. Additionally, those properties may also be renovated and re-branded as part of a repositioning strategy. Potential customers may not be familiar with our newly renovated hotel or be aware of the brand change. As a result, we may have to incur costs relating to the opening, operation and promotion of those new hotel properties that are substantially greater than those incurred in other geographic areas. These hotels may attract fewer customers than expected and we may choose to increase spending on advertising and marketing to promote the hotel and increase customer demand. Unanticipated expenses and insufficient demand at new hotel properties, therefore, could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\nWe do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel and as a result, our returns are dependent on the management of our hotels by Chesapeake Hospitality.\nSince federal income tax laws restrict REITs and their subsidiaries from operating or managing hotels, we do not operate or manage our hotels. Instead, we lease all of our hotels to our TRS Lessees, and our TRS Lessees retain third-party managers to operate our hotels pursuant to management agreements.\nUnder the terms of our management agreements with Chesapeake Hospitality and the REIT qualification rules, our ability to participate in operating decisions regarding the hotels is limited. We will depend on Chesapeake Hospitality to operate our hotels as provided in the management agreements. We do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel. Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, RevPAR, and average daily rates (“ADR”), we may not be able to force Chesapeake Hospitality to change its method of operating our hotels. Additionally, in the event that we need to replace Chesapeake Hospitality or any other management companies in the future, we may be required by the terms of the applicable management agreement to pay substantial termination fees and may experience significant disruptions at the affected hotels.\n15\nOur ability to make distributions to the Company’s stockholders is subject to fluctuations in our financial performance, operating results and capital improvement requirements.\nAs a REIT, the Company is required to distribute, as “qualifying distributions,” at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items), each year to the Company’s stockholders. However, several factors may make us unable to declare or pay distributions to the Company’s stockholders, including poor operating results and financial performance or unanticipated capital improvements to our hotels, including capital improvements that may be required by our franchisors.\nWe lease all of our hotels to our TRS Lessees. Our TRS Lessees are subject to hotel operating risks, including risks of sustaining operating losses after payment of hotel operating expenses, including management fees. Among the factors which could cause our TRS Lessees to fail to make required rent payments are reduced net operating profits or operating losses, increased debt service requirements and capital expenditures at our hotels, including capital expenditures required by the franchisors of our hotels. Among the factors that could reduce the net operating profits of our TRS Lessees are decreases in hotel revenues and increases in hotel operating expenses. Hotel revenue can decrease for a number of reasons, including increased competition from a new supply of hotel rooms and decreased demand for hotel rooms. These factors can reduce both occupancy and room rates at our hotels.\nThe amount of any dividend distributions to holders of the Company’s common stock is in the sole discretion of the Company’s board of directors, which will consider, among other factors, our financial performance, debt service obligations, debt covenants and capital expenditure requirements. We cannot assure you that we will continue to generate sufficient cash to fund distributions.\nGeographic concentration of our hotels makes our business vulnerable to economic downturns in the mid-Atlantic and southern United States.\nOur hotels are located in the mid-Atlantic and southern United States. As a result, economic conditions in the mid-Atlantic and southern United States significantly affect our revenues and the value of our hotels to a greater extent than if we had a more geographically diversified portfolio. Business layoffs or downsizing, industry slowdowns, changing demographics and other similar factors that may adversely affect the economic climate in these areas could have a significant adverse impact on our business. Any resulting oversupply or reduced demand for hotels in the mid-Atlantic and southern United States and in our markets in particular would therefore have a disproportionate negative impact on our revenues and limit our ability to make distributions to stockholders.\nA substantial number of our hotels operate under a brand owned by Hilton Worldwide (Hilton), InterContinental Hotels Group (IHG) and Marriott International, Inc. (Marriott) brands; therefore, we are subject to risks associated with concentrating our portfolio in three brands.\nIn our portfolio, the majority of the hotels that we owned as of December 31, 2016 utilize brands owned by IHG, Marriott or Hilton. As a result, our success is dependent in part on the continued success of IHG, Marriott or Hilton and their respective brands. If market recognition or the positive perception of IHG, Marriott and/or Hilton is reduced or compromised, the goodwill associated with the IHG, Marriott and Hilton branded hotels in our portfolio may be adversely affected, which may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders.\nHedging against interest rate exposure may adversely affect us and our hedges may fail to protect us from the losses that the hedges were designed to offset.\nSubject to maintaining the Company’s qualification as a REIT, we may elect to manage our exposure to interest rate volatility by using interest rate hedging arrangements, such as cap agreements and swap agreements. These agreements involve the risks that these arrangements may fail to protect or adversely affect us because, among other things:\n| • | interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; |\n\n| • | available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought; |\n\n| • | the financial instruments we select may not have the effect of reducing our interest rate risk; |\n\n| • | the duration of the hedge may not match the duration of the related liability; |\n\n| • | the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and |\n\n| • | the hedging counterparty owing money in the hedging transaction may default on its obligation to pay. |\n\n16\nAs a result of any of the foregoing, our hedging transactions, which are intended to limit losses, may fail to protect us from the losses that the hedges were designed to offset and could have a material adverse effect on us.\nOur investment opportunities and growth prospects may be affected by competition for acquisitions.\nWe compete for investment opportunities with other entities, some of which have substantially greater financial resources than we do. This competition may generally limit the number of suitable investment opportunities offered to us, which may limit our ability to grow. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms, or at all.\nIf we fail to maintain an effective system of internal controls, we may not be able to accurately determine our financial results or prevent fraud. As a result, the Company’s stockholders could lose confidence in our financial results, which could harm our business and the value of the Company’s shares.\nEffective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate and report on our internal controls over financial reporting. Our internal controls and financial reporting are not subject to attestation by our independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. While we have undertaken substantial work to comply with Section 404, we cannot be certain that we will be successful in maintaining adequate internal controls over our financial reporting and financial processes in the future. We may in the future discover areas of our internal controls that need improvement. Furthermore, as we grow our business, our internal controls will become more complex, and we will require significantly more resources to ensure our internal controls remain effective. If we or our independent auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could reduce the market value of the Company’s shares. Additionally, the existence of any material weakness or significant deficiency would require management to devote significant time and incur significant expense to remediate any such material weaknesses or significant deficiencies and management may not be able to remediate any such material weaknesses or significant deficiencies in a timely manner. In 2014, we identified a material weakness in our internal control over financial reporting which has been remediated.\nWe are subject to cyber-security risks related to breaches of security pertaining to sensitive company, customer, employee and vendor information as well as breaches in the technology that manages operations and other business processes.\nOur business operations rely upon secure information technology systems for data capture, processing, storage and reporting. Despite careful security and controls design, implementation, updating and independent third party verification, our information technology systems, and those of our third party providers, could become subject to cyber-attacks. Network, system, application and data breaches could result in operational disruptions or information misappropriation including, but not limited to interruption to systems availability, denial of access to and misuse of applications required by our customers. Access to internal applications required to plan our operations could be denied or misused. Inappropriate disclosure of confidential company, employee, customer or vendor information, could stem from such incidents. Any of these operational disruptions and/or misappropriation of information could result in lost sales, business delays, and negative publicity and could have a material effect on our business.\nRisks Related to Conflicts of Interest of Our Officers and Directors\nConflicts of interest could result in our executive officers and certain of our directors acting in a manner other than in the Company’s stockholders’ best interest.\nConflicts of interest relating to Chesapeake Hospitality, the entity that manages the properties, and the terms of its management agreements may lead to management decisions that are not in the stockholders’ best interest.\nConflicts of interest relating to Chesapeake Hospitality may lead to management decisions that are not in the stockholders’ best interest. Andrew M. Sims, our chairman and chief executive officer, and Kim E. Sims, a former member of our board of directors, together own a substantial interest in Chesapeake Hospitality which manages our hotel properties.\nOur management agreements establish the terms of Chesapeake Hospitality’s management of our hotels. The new Master Agreement provides that in the event the agreement is terminated in connection with the sale of a hotel, and Chesapeake Hospitality accepts an offer to manage another hotel which is reasonable comparable to the hotel that was sold, we will not be liable for any termination fee. If we do not offer Chesapeake Hospitality such opportunity or Chesapeake Hospitality declines such opportunity, then a termination fee equivalent to the lesser of the management fees paid for the prior twelve-month period or the management fees for the period prior to the sale that is equal to the number of months remaining under the term of the agreement will be due. If we terminate the agreement at the end of any renewable five-year term, Chesapeake Hospitality is due a termination fee equivalent to one month’s management fees, as determined under the agreement.\n17\nAs a significant owner of Chesapeake Hospitality, which would receive any management and management termination fees payable by us under the management agreement, Andrew M. Sims may influence our decisions to sell a hotel or acquire or develop a hotel when it is not in the best interests of the Company’s stockholders to do so. In addition, Andrew M. Sims will have conflicts of interest with respect to decisions to enforce provisions of the management agreement, including any termination thereof.\nThere can be no assurance that provisions in our bylaws will always be successful in mitigating conflicts of interest.\nUnder our bylaws, a committee consisting of only independent directors must approve any transaction between us and Chesapeake Hospitality or its affiliates or any interested director. However, there can be no assurance that these policies always will be successful in mitigating such conflicts, and decisions could be made that might not fully reflect the interests of all of the Company’s stockholders.\nCertain of our officers and directors control trusts that hold units in our Operating Partnership and may seek to avoid adverse tax consequences, which could result from transactions that would otherwise benefit the Company’s stockholders.\nHolders of units in our Operating Partnership, including trusts controlled in whole or part by members of our management team, may suffer adverse tax consequences upon our sale or refinancing of certain properties. Therefore, holders of units, including a trust controlled by Andrew M. Sims and two former members of our board of directors, and a charitable trust controlled by Edward S. Stein, may have different objectives than holders of the Company’s stock regarding the appropriate pricing and timing of a property’s sale, or the timing and amount of a property’s refinancing. As of December 31, 2016, these trusts owned approximately 1.0% of the outstanding units in our Operating Partnership. Although the individuals controlling the trusts do not have any beneficial interest in the trusts, they may influence us not to sell or refinance certain properties, even if such sale or refinancing might be financially advantageous to the Company’s stockholders, or may influence us to enter into tax-deferred exchanges with the proceeds of such sales when such a reinvestment might not otherwise be in our best interest.\nOur agreements with Chesapeake Hospitality and its affiliates, including the contribution agreements and the partnership agreement of our Operating Partnership, were not negotiated on an arms’ length basis and may be less favorable to us than we could have obtained from third parties.\nIn connection with the Company’s initial public offering, we entered into various agreements with Chesapeake Hospitality and its affiliates, including contribution agreements, a master management agreement, a strategic alliance agreement, subleases, the partnership agreement of our Operating Partnership and employment agreements – of which only the contribution agreements and the partnership agreement of our Operating Partnership have not expired. In addition, we entered into various separate management agreements with Chesapeake Hospitality which have all been superseded by the new master management agreement and new individual hotel agreements executed in December 2014. The terms of all of these agreements were determined by our management team, who had conflicts of interest as described above and ownership interests in Chesapeake Hospitality and its affiliates. The terms of all of these agreements may be less favorable to us than we could have obtained from third parties.\nRisks Related to the Lodging Industry\nOur ability to comply with the terms of the indenture, our ability to make distributions to the Company’s stockholders and the value of our hotels in general, may be adversely affected by factors in the lodging industry.\nOperating Risks\nOur hotel properties are subject to various operating risks common to the lodging industry, many of which are beyond our control, including the following:\n| • | competition from other hotel properties in our markets; |\n\n| • | over-building of hotels in our markets, which adversely affects occupancy and revenues at our hotels; |\n\n| • | dependence on business and commercial travelers and tourism; |\n\n| • | increases in energy costs and other expenses affecting travel, which may affect travel patterns and reduce the number of business and commercial travelers and tourists; |\n\n| • | increases in operating costs due to inflation and other factors, including increases in labor costs, that may not be offset by increased room rates; |\n\n| • | changes in interest rates and in the availability, cost and terms of debt financing; |\n\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\n\n18\n\n| • | adverse effects of international, national, regional and local economic and market conditions; |\n\n| • | adverse effects of a downturn in the lodging industry; and |\n\n| • | risks generally associated with the ownership of hotel properties and real estate, as we discuss in detail below. |\n\nThese factors could reduce the net income of our TRS Lessees, which in turn could adversely affect the value of our hotels and our ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders.\nCompetition for Acquisitions\nWe may compete for investment opportunities with entities that may have substantially greater financial resources than we do. These entities generally may be able to accept more risk than we choose to prudently manage. This competition may generally limit the number of suitable investment opportunities offered to us. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms.\nSeasonality of the Hotel Business\nThe lodging industry is seasonal in nature, which can be expected to cause quarterly fluctuations in our revenues. Our quarterly earnings may be adversely affected by factors outside our control, including weather conditions and poor economic factors. As a result, we may have to enter into short-term borrowings in certain quarters in order to offset these fluctuations in revenues and to make distributions to the Company’s stockholders.\nInvestment Concentration in Particular Segments of a Single Industry\nOur entire business is lodging-related. Therefore, a downturn in the lodging industry, in general, and the full-service, upscale and upper-upscale segments in which we operate, in particular, will have a material adverse effect on the value of our hotels, our financial condition and the extent to which cash may be available for distribution to the Company’s stockholders.\nCapital Expenditures\nOur hotel properties have an ongoing need for renovations and other capital improvements, including replacements, from time to time, of furniture, fixtures and equipment. The franchisors of our hotels also require us to make periodic capital improvements as a condition of keeping the franchise licenses. In addition, several of our mortgage lenders require that we set aside amounts for capital improvements to the secured properties on a monthly basis. For the years ended December 31, 2016 and 2015, we spent approximately $14.8 million and approximately $20.1 million, respectively, on capital improvements to our hotels. Capital improvements and renovation projects may give rise to the following risks:\n| • | possible environmental problems; |\n\n| • | construction cost overruns and delays; |\n\n| • | a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available to us on affordable terms; and |\n\n| • | uncertainties as to market demand or a loss of market demand after capital improvements have begun. |\n\nThe costs of all these capital improvements as well as future capital improvements could adversely affect our financial condition and amounts available for distribution to the Company’s stockholders.\nOperating our hotels under franchise agreements could increase our operating costs and lower our net income.\nMost of our hotels operate under franchise agreements which subject us to risks in the event of negative publicity related to one of our franchisors.\nThe maintenance of the franchise licenses for our hotels is subject to our franchisors’ operating standards and other terms and conditions. Our franchisors periodically inspect our hotels to ensure that we, our TRS Lessees, and the management company follow their standards. Failure by us, our TRS Lessees or the management company to maintain these standards or other terms and conditions could result in a franchise license being canceled. If a franchise license terminates due to our failure to make required improvements or to otherwise comply with its terms, we may also be liable to the franchisor for a termination payment, which varies by franchisor and by hotel. As a condition of continuing a franchise license, a franchisor may require us to make capital expenditures, even if we do not believe the capital improvements are necessary or desirable or will result in an acceptable return on our investment. Nonetheless, we may risk losing a franchise license if we do not make franchisor-required capital expenditures.\n19\nIf a franchisor terminates the franchise license, we may try either to obtain a suitable replacement franchise license or to operate the hotel without a franchise license. The loss of a franchise license could significantly decrease the revenues at the hotel and reduce the underlying value of the hotel because of the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchisor. A loss of a franchise license for one or more hotels could materially and adversely affect our revenues. This loss of revenues could, therefore, also adversely affect our financial condition and results of operations, our ability to comply with the terms of the indenture and reduce our cash available for distribution to stockholders.\nRestrictive covenants in certain of our franchise agreements contain provisions that may operate to limit our ability to sell or refinance our hotels, which could have a material adverse effect on us.\nFranchise agreements typically contain covenants that may affect our ability to sell or refinance a hotel, including requirements to obtain the consent of the franchisor in the event of such a sale or refinancing transaction. In the event that a franchisor’s consent is not forthcoming, the terms of a sale or refinancing may be less favorable to us than would otherwise be the case. Some of our franchise agreements provide the franchisor with a right of first offer in the event of certain sales or transfers of a hotel and provide that the franchisor has the right to approve any change in the hotel management company engaged to manage the hotel. Generally, we may be limited in our ability to sell, lease or otherwise transfer hotels unless the transferee is not a competitor of the franchisor and the transferee agrees to assume the related franchise agreements. If the franchisor does not consent to the sale or financing of our hotels, we may be unable to consummate transactions that are in our best interests or the terms of those transactions may be less favorable to us, which could have a material adverse effect on our financial condition and the execution of our strategies.\nHotel re-development is subject to timing, budgeting and other risks that would increase our operating costs and limit our ability to make distributions to stockholders.\nWe intend to acquire hotel properties from time to time as suitable opportunities arise, taking into consideration general economic conditions, and seek to re-develop or reposition these hotels. Redevelopment of hotel properties involves a number of risks, including risks associated with:\n| • | construction delays or cost overruns that may increase project costs; |\n\n| • | receipt of zoning, occupancy and other required governmental permits and authorizations; |\n\n| • | development costs incurred for projects that are not pursued to completion; |\n\n| • | acts of God such as earthquakes, hurricanes, floods or fires that could adversely impact a project; |\n\n| • | financing; and |\n\n| • | governmental restrictions on the nature or size of a project. |\n\nWe cannot assure you that any re-development project will be completed on time or within budget. Our inability to complete a project on time or within budget would increase our operating costs and reduce our net income.\nThe hotel business is capital intensive and our inability to obtain financing could limit our growth.\nOur hotel properties will require periodic capital expenditures and renovation to remain competitive. Acquisitions or development of additional hotel properties will require significant capital expenditures. In addition, several of our mortgage lenders require that we set aside annual amounts for capital improvements to the secured property. We may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we must distribute at least 90.0% of our REIT taxable income, excluding net capital gains, each year to maintain our REIT tax status. As a result, our ability to fund significant capital expenditures, acquisitions or hotel development through retained earnings is very limited. Consequently, we rely upon the availability of debt or equity capital to fund any significant investments or capital improvements. Our ability to grow through acquisitions or development of hotels will be limited if we cannot obtain satisfactory debt or equity financing which will depend on market conditions. Neither our charter nor our bylaws limit the amount of debt that we can incur. However, we cannot assure you that we will be able to obtain additional equity or debt financing or that we will be able to obtain such financing on favorable terms.\n20\nUninsured and underinsured losses could adversely affect our operating results and our ability to make distributions to the Company’s stockholders.\nWe maintain comprehensive insurance on each of our hotel properties, including liability, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel owners. There are no assurances that current coverage will continue to be available at reasonable rates. Various types of catastrophic losses, like hurricanes, earthquakes and floods, such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, losses from foreign terrorist activities, such as those on September 11, 2001, or losses from domestic terrorist activities, such as the Oklahoma City bombing on April 19, 1995, may not be insurable or may not be economically insurable. Currently, our insurers provide terrorism coverage in conjunction with the Terrorism Risk Insurance Program sponsored by the federal government through which insurers are able to receive compensation for insured losses resulting from acts of terrorism.\nIn the event of a substantial loss, our insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a hotel, as well as the anticipated future revenue from the hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position on the damaged or destroyed property.\nNoncompliance with governmental regulations could adversely affect our operating results.\nEnvironmental Matters\nOur hotels may be subject to environmental liabilities. An owner of real property can face liability for environmental contamination created by the presence or discharge of hazardous substances on the property. We may face liability regardless of:\n| • | our knowledge of the contamination; |\n\n| • | the timing of the contamination; |\n\n| • | the cause of the contamination; or |\n\n| • | the party responsible for the contamination of the property. |\n\nThere may be unknown environmental problems associated with our properties. If environmental contamination exists on our properties, we could become subject to strict, joint and several liability for the contamination by virtue of our ownership interest.\nThe presence of hazardous substances on a property may adversely affect our ability to sell the property and we may incur substantial remediation costs. The discovery of environmental liabilities attached to our properties could have a material adverse effect on our results of operations and financial condition and our ability to comply with our covenants and to pay distributions to stockholders.\nAmericans with Disabilities Act and Other Changes in Governmental Rules and Regulations\nUnder the Americans with Disabilities Act of 1990, or the ADA, all public accommodations must meet various federal requirements related to access and use by disabled persons. Compliance with the ADA’s requirements could require removal of access barriers, and non-compliance could result in the U.S. government imposing fines or in private litigants winning damages. If we are required to make substantial modifications to our hotels, whether to comply with the ADA or other changes in governmental rules and regulations, our financial condition, results of operations and ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders could be adversely affected.\nOur hotels may be subject to unknown or contingent liabilities which could cause us to incur substantial costs.\nThe hotel properties that we acquire may be subject to unknown or contingent liabilities for which we may have no recourse, or only limited recourse, against the sellers. Contingent or unknown liabilities with respect to entities or properties acquired might include:\n| • | liabilities for environmental conditions; |\n\n| • | losses in excess of our insured coverage; |\n\n| • | accrued but unpaid liabilities incurred in the ordinary course of business; |\n\n21\n\n| • | tax, legal and regulatory liabilities; |\n\n| • | claims of customers, vendors or other persons dealing with the Company’s predecessors prior to our formation or acquisition transactions that had not been asserted or were unknown prior to the Company’s formation or acquisition transactions; and |\n\n| • | claims for indemnification by the general partners, officers and directors and others indemnified by the former owners of our properties. |\n\nIn general, the representations and warranties provided under the transaction agreements related to the sales of the hotel properties may not survive the closing of the transactions. While we will likely seek to require the sellers to indemnify us with respect to breaches of representations and warranties that survive, such indemnification may be limited and subject to various materiality thresholds, a significant deductible or an aggregate cap on losses. As a result, there is no guarantee that we will recover any amounts with respect to losses due to breaches by the sellers of their representations and warranties. In addition, the total amount of costs and expenses that may be incurred with respect to liabilities associated with these hotels may exceed our expectations, and we may experience other unanticipated adverse effects, all of which may adversely affect our financial condition, results of operations and our ability to make distributions to the Company’s stockholders.\nFuture terrorist activities may adversely affect, and create uncertainty in, our business.\nTerrorism in the United States or elsewhere could have an adverse effect on our business, although the degree of impact will depend on a number of factors, including the U.S. and global economies and global financial markets. Previous terrorist attacks in the United States and subsequent terrorism alerts have adversely affected the travel and hospitality industries over the past several years. Such attacks, or the threat of such attacks, could have a material adverse effect on our business, our ability to finance our business, our ability to insure our properties and/or our results of operations and financial condition, as a whole.\nWe face risks related to pandemic diseases, which could materially and adversely affect travel and result in reduced demand for our hotels.\nOur business could be materially and adversely affected by the effect of a pandemic disease on the travel industry. For example, the outbreaks of SARS and avian flu in 2003 had a severe impact on the travel industry, the outbreaks of H1N1 flu in 2009 threatened to have a similar impact, and the perceived threat of a Zika virus outbreak in 2016 had an impact on the south Florida market. A prolonged recurrence of SARS, avian flu, H1N1 flu, Ebola virus, Zika virus or another pandemic disease also may result in health or other government authorities imposing restrictions on travel. Any of these events could result in a significant drop in demand for our hotels and adversely affect our financial conditions and results of operations.\nGeneral Risks Related to the Real Estate Industry\nIlliquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties and harm our financial condition.\nBecause real estate investments are relatively illiquid, our ability to promptly sell one or more hotel properties in our portfolio in response to changing economic, financial and investment conditions is limited.\nThe real estate market is affected by many factors that are beyond our control, including:\n| • | adverse changes in international, national, regional and local economic and market conditions; |\n\n| • | changes in interest rates and in the cost and terms of debt financing; |\n\n| • | absence of liquidity in credit markets which limits the availability and amount of debt financing; |\n\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\n\n| • | the ongoing need for capital improvements, particularly in older structures; |\n\n| • | changes in operating expenses; and |\n\n| • | civil unrest, acts of God, including earthquakes, floods and other natural disasters such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, which may result in uninsured losses, and acts of war or terrorism, including the consequences of terrorist acts, such as those that occurred on September 11, 2001. |\n\n22\nWe may decide to sell our hotels in the future. We cannot predict whether we will be able to sell any hotel property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a hotel property.\nWe may be required to expend funds to correct defects or to make improvements before a hotel property can be sold. We cannot assure you that we will have funds available to correct those defects or to make those improvements. In acquiring a hotel property, we may agree to lock-out provisions that materially restrict us from selling that property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that property. These factors and any others that would impede our ability to respond to adverse changes in the performance of our properties could have a material adverse effect on our operating results and financial condition, as well as our ability to comply with the terms of the indenture and to pay distributions to stockholders.\nFuture acquisitions may not yield the returns expected, may result in disruptions to our business, may strain management resources and may result in stockholder dilution.\nOur business strategy may not ultimately be successful and may not provide positive returns on our investments. Acquisitions may cause disruptions in our operations and divert management’s attention away from day-to-day operations. The issuance of equity securities in connection with any acquisition could be substantially dilutive to the Company’s stockholders.\nOur hotels may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem.\nWhen excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing, as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property, which would reduce our cash available for distribution. In addition, the presence of significant mold could expose us to liability from our guests, employees or the management company and others if property damage or health concerns arise and could harm our reputation.\nIncreases in property taxes would increase our operating costs, reduce our income and adversely affect our ability to make distributions to the Company’s stockholders.\nEach of our hotel properties is subject to real and personal property taxes. These taxes may increase as tax rates change and as the properties are assessed or reassessed by taxing authorities. If property taxes increase, our financial condition, results of operations and our ability to make distributions to the Company’s stockholders could be materially and adversely affected and the market price of the Company’s shares could decline.\nRisks Related to Our Organization and Structure\nOur ability to effect a merger or other business combination transaction may be restricted by our Operating Partnership agreement.\nIn the event of a change of control of the Company, the limited partners of our Operating Partnership will have the right, for a period of 30 days following the change of control event, to cause the Operating Partnership to redeem all of the units held by the limited partners for a cash amount equal to the cash redemption amount otherwise payable upon redemption pursuant to the partnership agreement. This cash redemption right may make it more unlikely or difficult for a third party to propose or consummate a change of control transaction, even if such transaction were in the best interests of the Company’s stockholders.\nProvisions of the Company’s charter may limit the ability of a third party to acquire control of the Company.\nAggregate Share and Common Share Ownership Limits\nThe Company’s charter provides that no person may directly or indirectly own more than 9.9% of the value of the Company’s outstanding shares of capital stock or more than 9.9% of the number of the Company’s outstanding shares of common stock. These ownership limitations may prevent an acquisition of control of the Company by a third party without the Company’s board of directors’ approval, even if the Company’s stockholders believe the change of control is in their interest. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\n23\nAuthority to Issue Stock\nThe Company’s amended and restated charter authorizes our board of directors to issue up to 49,000,000 shares of common stock and up to 11,000,000 shares of preferred stock, to classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares. Issuances of additional shares of stock may have the effect of delaying or preventing a change in control of the Company, including transactions at a premium over the market price of the Company’s stock, even if stockholders believe that a change of control is in their interest. The Company will be able to issue additional shares of common or preferred stock without stockholder approval, unless stockholder approval is required by applicable law or the rules of any stock exchange or automated quotation system on which the Company’s securities may be listed or traded.\nProvisions of Maryland law may limit the ability of a third party to acquire control of the Company.\nCertain provisions of the Maryland General Corporation Law, or the MGCL, may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change of control under circumstances that otherwise could provide the holders of shares of the Company’s common stock with the opportunity to realize a premium over the then-prevailing market price of such shares, including:\n| • | “business combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10.0% or more of the voting power of our shares or an affiliate thereof) for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes special appraisal rights and special stockholder voting requirements on these combinations; and |\n\n| • | “control share” provisions that provide that “control shares” of the Company (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by the Company’s stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares. |\n\nThe Company has opted out of these provisions of the MGCL, in the case of the business combination provisions of the MGCL by resolution of the Company’s board of directors, and in the case of the control share provisions of the MGCL pursuant to a provision in the Company’s bylaws. However, the Company’s board of directors may by resolution elect to opt in to the business combination provisions of the MGCL and the Company may, by amendment to its bylaws, opt in to the control share provisions of the MGCL in the future. The Company’s board of directors has the exclusive power to amend the Company’s bylaws.\nAdditionally, Title 8, Subtitle 3 of the MGCL permits the Company’s board of directors, without stockholder approval and regardless of what is currently provided in the Company’s charter or bylaws, to implement takeover defenses, some of which (for example, a classified board) the Company does not currently have. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for the Company or of delaying, deferring or preventing a change in control of the Company under the circumstances that otherwise could provide the holders of the Company’s common stock with the opportunity to realize a premium over the then current market price.\nProvisions in the Company’s executive officers’ employment agreements may make a change of control of the Company more costly or difficult.\nThe Company’s employment agreements with Andrew M. Sims, its chief executive officer, David R. Folsom, its president and chief operating officer, and Anthony E. Domalski, its chief financial officer, contain provisions providing for substantial payments to these officers in the event of a change of control of the Company. Specifically, if the Company terminates these executive’s employment without cause or the executive resigns with good reason, which includes a failure to nominate Andrew M. Sims to the Company’s board of directors or his involuntary removal from the Company’s board of directors, unless for cause or by vote of the stockholders, or if there is a change of control, each of these executives is entitled to the following:\n| • | any accrued but unpaid salary and bonuses; |\n\n| • | vesting of any previously issued stock options and restricted stock; |\n\n| • | payment of the executive’s life, health and disability insurance coverage for a period of five years following termination; |\n\n| • | any unreimbursed expenses; and |\n\n| • | a severance payment equal to three times for Andrew M. Sims’, David R. Folsom’s and Anthony E. Domalski’s respective combined salary and actual bonus compensation for the preceding fiscal year. |\n\n24\nIn addition, these executives will receive additional payments to compensate them for the additional taxes, if any, imposed on them under Section 4999 of the Code by reason of receipt of excess parachute payments. We will not be able to deduct any of the above amounts paid to the executives for tax purposes.\nThese provisions may make a change of control of the Company, even if it is in the best interests of the Company’s stockholders, more costly and difficult and may reduce the amounts the Company’s stockholders would receive in a change of control transaction.\nOur ownership limitations may restrict or prevent you from engaging in certain transfers of the Company’s common stock or preferred stock.\nIn order to maintain the Company’s REIT qualification, it cannot be closely held (i.e., more than 50.0% in value of our outstanding stock cannot be owned, directly or indirectly, by five or fewer individuals during the last half of any taxable year). To preserve the Company’s REIT qualification, the Company’s charter contains a 9.9% aggregate share ownership limit and a 9.9% common share ownership limit. Generally, any shares of the Company’s stock owned by affiliated persons will be added together for purposes of the aggregate share ownership limit, and any shares of common stock owned by affiliated owners will be added together for purposes of the common share ownership limit.\nIf anyone transfers shares in a way that would violate the aggregate share ownership limit or the common share ownership limit, or prevent the Company from continuing to qualify as a REIT under the federal income tax laws, those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate the aggregate share ownership limit or the common share ownership limit. If this transfer to a trust fails to prevent such a violation or fails to preserve the Company’s continued qualification as a REIT, then the Company will consider the initial intended transfer to be null and void from the outset. The intended transferee of those shares will be deemed never to have owned the shares. Anyone who acquires shares in violation of the aggregate share ownership limit, the common share ownership limit or the other restrictions on transfer in the Company’s charter bears the risk of suffering a financial loss when the shares are redeemed or sold if the market price of the Company’s stock falls between the date of purchase and the date of redemption or sale.\nThe Company’s articles supplementary establishing and fixing the rights and preferences of Series B preferred stock provide that no person may directly or indirectly own more than 9.9% of the aggregate number of outstanding shares of Series B preferred stock, excluding any outstanding shares of Series B preferred stock not treated as outstanding for federal income tax purposes. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\nHolders of our outstanding preferred shares have dividend, liquidation and other rights that are senior to the rights of the holders of our common shares.\nOur board of directors has the authority to designate and issue preferred shares with liquidation, dividend and other rights that are senior to those of our common shares. As of December 31, 2016, 1,610,000 shares of our 8.0% Series B Cumulative Redeemable Preferred Stock were issued and outstanding. The aggregate liquidation preference with respect to the outstanding preferred shares is approximately $40.3 million, and annual dividends on our outstanding preferred shares are approximately $3.2 million. Holders of our Series B Preferred Stock are entitled to cumulative dividends before any dividends may be declared or set aside on our common shares. Upon our voluntary or involuntary liquidation, dissolution or winding up, before any payment is made to holders of our common shares, holders of these preferred shares are entitled to receive a liquidation preference of $25.00 per share plus any accrued and unpaid distributions. This will reduce the remaining amount of our assets, if any, available to distribute to holders of our common shares. In addition, holders of these preferred shares have the right to elect two additional directors to our board of directors whenever dividends on the preferred shares are in arrears in an aggregate amount equivalent to six or more quarterly dividends (whether or not consecutive). Because our decision to issue securities will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of any future preferred offerings. Thus, our stockholders bear the risk of our future securities issuances reducing the market price of our common shares and diluting their interest.\nThe change of control conversion and redemption features of the Series B Preferred Stock may make it more difficult for a party to take over our Company or discourage a party from taking over our Company.\nUpon a change of control (as defined in our charter), holders of our Series B Preferred Stock will have the right (unless, as provided in our charter, we have provided or provide notice of our election to exercise our special optional redemption right before the relevant date) to convert some or all of their shares of our Series B Preferred Stock into shares of our common stock (or equivalent value of alternative consideration). Upon such a conversion, holders will be limited to a maximum number of shares equal to the share cap, subject to adjustments. If the common stock price is less than $3.015, subject to adjustment, holders will receive a maximum of\n25\n8.29187 shares of our common stock per share of Series B Preferred Stock, which may result in a holder receiving value that is less than the liquidation preference of the Series B Preferred Stock. In addition, those features of our Series B Preferred Stock may have the effect of inhibiting or discouraging a third party from making an acquisition proposal for our Company or of delaying, deferring or preventing a change in control of our Company under circumstances that otherwise could provide the holders of shares of our common stock and shares of our Series B Preferred Stock with the opportunity to realize a premium over the then current market price or that stockholders may otherwise believe is in their best interests.\nThe board of directors’ revocation of the Company’s REIT status without stockholder approval may decrease the Company’s stockholders’ total return.\nThe Company’s charter provides that the Company’s board of directors may revoke or otherwise terminate the Company’s REIT election, without the approval of the Company’s stockholders, if the Company’s board of directors determines that it is no longer in the Company’s best interest to continue to qualify as a REIT. If the Company ceases to be a REIT, it would become subject to federal income tax on its taxable income and would no longer be required to distribute most of its taxable income to the Company’s stockholders, which may have adverse consequences on our total return to the Company’s stockholders.\nThe ability of the Company’s board of directors to change the Company’s major corporate policies may not be in your best interest.\nThe Company’s board of directors determines the Company’s major corporate policies, including its acquisition, financing, growth, operations and distribution policies. The Company’s board of directors may amend or revise these and other policies from time to time without the vote or consent of the Company’s stockholders.\nOur success depends on key personnel whose continued service is not guaranteed.\nWe depend on the efforts and expertise of our chairman and chief executive officer, Andrew M. Sims; our president and chief operating officer, David R. Folsom; and our chief financial officer, Anthony E. Domalski, to manage our day-to-day operations and strategic business direction. The loss of any of their services could have an adverse effect on our operations.\nFederal Income Tax Risks Related to the Company’s Status as a REIT\nThe federal income tax laws governing REITs are complex.\nThe Company intends to operate in a manner that will maintain its qualification as a REIT under the federal income tax laws. The REIT qualification requirements are extremely complex, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited. The Company has not requested or obtained a ruling from the Internal Revenue Service, or the IRS, that it qualifies as a REIT. Accordingly, we cannot be certain that the Company will be successful in operating in a manner that will permit it to qualify as a REIT. At any time, new laws, interpretations or court decisions may change the federal tax laws or the federal income tax consequences of the Company’s qualification as a REIT. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. The Company and its stockholders could be adversely affected by any such change in, or any new, federal income tax law, regulation or administrative interpretation. We are not aware, however, of any pending tax legislation that would adversely affect the Company’s ability to qualify as a REIT.\nFailure to make distributions could subject the Company to tax.\nIn order to maintain its qualification as a REIT, each year the Company must pay out to its stockholders in distributions, as “qualifying distributions,” at least 90.0% of its REIT taxable income, computed without regard to the deductions for dividends paid and excluding net capital gains and reduced by certain non-cash items. To the extent that the Company satisfies this distribution requirement, but distributes less than 100.0% of its taxable income (including its net capital gain), it will be subject to federal corporate income tax on its undistributed taxable income. In addition, the Company will be subject to a 4.0% nondeductible excise tax if the actual amount that it pays out to its stockholders as a “qualifying distribution” for a calendar year is less than the sum of: (A) 85.0% of our ordinary income for such calendar year, plus (B) 95.0% of our capital gain net income for such calendar year. The Company’s only recurring source of funds to make these distributions comes from rent received from its TRS Lessees whose only recurring source of funds with which to make these payments and distributions is the net cash flow (after payment of operating and other costs and expenses and management fees) from hotel operations, and any dividend and other distributions that we may receive from MHI Holding. Accordingly, the Company may be required to borrow money or sell assets to make distributions sufficient to enable it to pay out enough of its taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4.0% nondeductible excise tax in a particular year.\n26\nFailure to qualify as a REIT would subject the Company to federal income tax.\nIf the Company fails to qualify as a REIT in any taxable year, it will be required to pay federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. The resulting tax liability might cause the Company to borrow funds, liquidate some of its investments or take other steps that could negatively affect its operating results in order to pay any such tax. Unless it is entitled to relief under certain statutory provisions, the Company would be disqualified from treatment as a REIT for the four taxable years following the year in which it lost its qualification. If the Company lost its REIT status, its net earnings available for investment or distribution to stockholders would be significantly reduced for each of the years involved. In addition, the Company would no longer be required to make distributions to its stockholders, and it would not be able to deduct any stockholder distributions in computing its taxable income. This would substantially reduce the Company’s earnings, cash available to pay distributions, and the value of common stock.\nFailure to qualify as a REIT may cause the Company to reduce or eliminate distributions to its stockholders, and the Company may face increased difficulty in raising capital or obtaining financing.\nIf the Company fails to remain qualified as a REIT, it may have to reduce or eliminate any distributions to its stockholders in order to satisfy its income tax liabilities. Any distributions that the Company does make to its stockholders would be treated as taxable dividends to the extent of its current and accumulated earnings and profits. This may result in negative investor and market perception regarding the market value of the Company’s stock, and the value of its stock may be reduced. In addition, the Company and the Operating Partnership may face increased difficulty in raising capital or obtaining financing if the Company fails to qualify or remain qualified as a REIT because of the resulting tax liability and potential reduction of its market valuation.\nIf MHI Holding exceeds certain value thresholds, this could cause the Company to fail to qualify as a REIT.\nFor taxable years of the Company ending on or before December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 25.0% of the value of the Company’s total assets may consist of securities of one or more taxable REIT subsidiaries (“TRSs”). For taxable years of the Company ending after December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 20.0% of the value of the Company’s total assets may consist of securities of one or more TRSs. MHI Holding is a TRS and the Company may form other TRSs in the future. The Company plans to monitor the value of its shares of MHI Holding and of any other TRS the Company may form. However, there can be no assurance that the Internal Revenue Service will not attempt to attribute additional value to the shares of MHI Holding or to the shares of any other TRS that the Company may form. If the Company is treated as owning securities of one or more TRSs with an aggregate value that is in excess of the thresholds outlined above, the Company could lose its status as a REIT or become subject to penalties.\nEven if the Company remains qualified as a REIT, it may face other tax liabilities that reduce its cash flow.\nEven if the Company remains qualified for taxation as a REIT, it may be subject to certain federal, state and local taxes on its income and assets. For example:\n| • | it will be required to pay tax on undistributed REIT taxable income (including net capital gain); |\n\n| • | it may be required to pay “alternative minimum tax” on its items of tax preference; |\n\n| • | if it has net income from the disposition of foreclosure property held primarily for sale to customers in the ordinary course of business or other non-qualifying income from foreclosure property, it must pay tax on that income at the highest corporate rate; |\n\n| • | if it (or the Operating Partnership or any subsidiary of the Operating Partnership other than MHI Holding) sells a property in a “prohibited transaction,” its gain, or its share of such gain, from the sale would be subject to a 100.0% penalty tax. A “prohibited transaction” would be a sale of property, other than a foreclosure property, held primarily for sale to customers in the ordinary course of business; |\n\n| • | MHI Holding is a fully taxable corporation and is required to pay federal and state taxes on its taxable income; and |\n\n| • | it may experience increases in its state and/or local income tax burdens as states and localities continue to look to modify their tax laws in order to raise revenues, including by (among other things) changing from a net taxable income-based regime to a gross receipts-based regime, suspending and/or limiting the use of net operating losses, increasing tax rates and fees, imposing surcharges and subjecting partnerships to an entity-level tax, and limiting or disallowing certain U.S. federal deductions such as the dividends-paid deduction. |\n\n27\nComplying with REIT requirements may cause the Company to forgo attractive opportunities that could otherwise generate strong risk-adjusted returns and instead pursue less attractive opportunities, or none at all.\nTo qualify as a REIT for federal income tax purposes, the Company must continually satisfy tests concerning, among other things, the sources of its income, the nature and diversification of its assets, the amounts it distributes to its stockholders and the ownership of its stock.\nIn general, when applying these tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which share is determined in accordance with the Company’s capital interest in the Operating Partnership) and as being entitled to the Operating Partnership’s income attributable to such share. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of generating strong risk-adjusted returns on invested capital for our stockholders.\nComplying with REIT requirements may force the Company to liquidate otherwise attractive investments, which could result in an overall loss on its investments.\nTo maintain qualification as a REIT, the Company must ensure that at the end of each calendar quarter at least 75.0% of the value of its assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of the Company’s assets (other than securities of one or more taxable REIT subsidiaries) generally cannot include more than 10.0% of the outstanding voting securities of any one issuer or more than 10.0% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5.0% of the value of the Company’s assets (other than government securities, qualified real estate assets and securities of one or more taxable REIT subsidiaries) can consist of the securities of any one issuer, and no more than 25.0% (20.0% for taxable years beginning after December 31, 2017) of the value of the Company’s total assets can be represented by securities of one or more taxable REIT subsidiaries.\nWhen applying these asset tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which is determined in accordance with the Company’s capital interest in the Operating Partnership). If the Company fails to comply with these requirements at the end of any calendar quarter, it must correct such failure within 30 days after the end of the calendar quarter to avoid losing its REIT status and suffering adverse tax consequences. If the Company fails to comply with these requirements at the end of any calendar quarter, and the failure exceeds a de-minimis threshold, the Company may be able to preserve its REIT status if the failure was due to reasonable cause and not to willful neglect. In this case, we will be required to dispose of the assets causing the failure within six months after the last day of the quarter in which the failure occurred, and we will be required to pay an additional tax of the greater of $50,000 or the product of the highest applicable tax rate multiplied by the net income generated on those assets.\nAs a result, we may be required to liquidate otherwise attractive investments.\nIf the Operating Partnership fails to qualify as a partnership for federal income tax purposes, the Company could cease to qualify as a REIT and suffer other adverse consequences.\nWe believe that the Operating Partnership will continue to qualify to be treated as a partnership for U.S. federal income tax purposes. As a partnership, the Operating Partnership is not subject to federal income tax on its income. Instead, each of its partners, including the Company, will be required to pay tax on its allocable share of the Operating Partnership’s income. We cannot assure you, however, that the IRS will not challenge the Operating Partnership’s status as a partnership for U.S. federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in treating the Operating Partnership as a corporation for federal income tax purposes, the Company could fail to meet the gross income tests and certain of the asset tests applicable to REITs and, accordingly, cease to qualify as a REIT. Also, the failure of the Operating Partnership to qualify as a partnership would cause the Operating Partnership to become subject to federal and state corporate income tax, which would reduce significantly the amount of cash available for debt service and for distribution to its partners, including the Company.\nThe Company’s failure to qualify as a REIT would have serious adverse consequences to its stockholders.\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Code, commencing with its taxable year ended December 31, 2004. The Company believes it has operated so as to qualify as a REIT under the Code and believes that its current organization and method of operation comply with the rules and regulations promulgated under the Code to enable the Company to continue to qualify as a REIT. However, it is possible that the Company has been organized or has operated in a manner that would not allow it to qualify as a REIT, or that its future operations could cause it to fail to qualify. Qualification as a REIT requires the Company to satisfy numerous requirements (some on an annual and others on a quarterly basis) established under highly technical and complex sections of the Code for which there are only limited judicial and administrative interpretations, and involves the determination of various factual matters and circumstances not entirely within its control. For example, in order to qualify as a\n28\nREIT, the Company must satisfy a 75.0% gross income test pursuant to Code Section 856(c)(3) and a 95.0% gross income test pursuant to Code Section 856(c)(2) each taxable year. In addition, the Company must pay dividends, as “qualifying distributions,” to its stockholders aggregating annually at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding capital gains, and reduced by certain non-cash items) and must satisfy specified asset tests on a quarterly basis. While historically the Company has satisfied the distribution requirement discussed above by making cash distributions to its stockholders, the Company may choose to satisfy this requirement by making distributions of cash or other property, including, in limited circumstances, its stock. The provisions of the Code and applicable Treasury regulations regarding qualification as a REIT are more complicated in the Company’s case because its holds its assets through the Operating Partnership.\nIf MHI Holding does not qualify as a taxable REIT subsidiary, or if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT and would be subject to higher taxes and have less cash available for distribution to its shareholders.\nRent paid by a lessee that is a “related party tenant” of ours will not be qualifying income for purposes of the two gross income tests applicable to REITs. The Company currently leases substantially all of its hotels to the TRS Lessees, which are disregarded entities for U.S. federal income tax purposes and are wholly-owned by MHI Holding, a taxable REIT subsidiary, and expects to continue to do so. So long as MHI Holding qualifies as a taxable REIT subsidiary, it will not be treated as a “related party tenant” with respect to the Company’s properties that are managed by an independent hotel management company that qualifies as an “eligible independent contractor.” The Company believes that MHI Holding will continue to qualify to be treated as a taxable REIT subsidiary for federal income tax purposes, but there can be no assurance that the IRS will not challenge this status or that a court would not sustain such a challenge. If the IRS were successful in such challenge, it is possible that the Company would fail to meet the asset tests applicable to REITs and substantially all of its income would fail to be qualifying income for purposes of the two gross income tests. If the Company failed to meet any of the asset or gross income tests, it would likely lose its REIT qualification for federal income tax purposes.\nAdditionally, if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT. Each hotel manager that enters into a management contract with the TRS Lessees must qualify as an “eligible independent contractor” under the REIT rules in order for the rent paid by the TRS Lessees to be qualifying income for purposes of the REIT gross income tests. Among other requirements, in order to qualify as an eligible independent contractor, a hotel manager must not own, directly or through its shareholders, more than 35.0% of the Company’s outstanding shares, taking into account certain ownership attribution rules. The ownership attribution rules that apply for purposes of these 35.0% thresholds are complex. Although the Company intends to monitor ownership of its shares by its hotel manager and its owners, there can be no assurance that these ownership levels will not be exceeded.\nForeign investors may be subject to U.S. tax on the disposition of the Company’s stock if the Company does not qualify as a “domestically controlled” REIT.\nA foreign person disposing of a “U.S. real property interest,” which includes stock of a U.S. corporation whose assets consist principally of U.S. real property interests, is generally subject to U.S. federal income tax under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) on the gain recognized on the disposition, unless such foreign person is a “qualified foreign pension fund” or one of the certain publicly traded non-U.S. “qualified collective investment vehicles”. Additionally, the transferee will be required to withhold 15.0% on the amount realized on the disposition if the foreign transferor is subject to U.S. federal income tax under FIRPTA. This 15.0% is creditable against the U.S. federal income tax liability of the foreign transferor in connection with such transferor’s disposition of the Company’s stock. FIRPTA does not apply, however, to the disposition of stock in a REIT if the REIT is “domestically controlled” (i.e., less than 50.0% of the REIT’s capital stock, by value, has been owned directly or indirectly by persons who are not qualifying U.S. persons during a continuous five-year period ending on the date of disposition or, if shorter, during the entire period of the REIT’s existence). We cannot be sure that the Company will qualify as a “domestically controlled” REIT. If the Company does not so qualify, gain realized by foreign investors on a sale of the Company’s stock would be subject to U.S. income and withholding tax under FIRPTA, unless the Company’s stock were traded on an established securities market and a foreign investor did not at any time during a specified testing period directly or indirectly own more than 10.0% of the value of the Company’s outstanding stock.\nMHI Holding increases our overall tax liability.\nOur TRS Lessees are single-member limited liability companies that are wholly-owned, directly or indirectly, by MHI Holding, a taxable REIT subsidiary that is wholly-owned by the Operating Partnership. Each of our TRS Lessees is disregarded as an entity separate from MHI Holding for U.S. federal income tax purposes, such that the assets, liabilities, income, gains, losses, credits and deductions of our TRS Lessees are treated as the assets, liabilities, income, gains, losses, credits and deductions of MHI Holding for U.S. federal income tax purposes. MHI Holding is subject to federal and state income tax on its taxable income, which will consist of\n29\nthe revenues from the hotels leased by the Company’s TRS Lessees, net of the operating expenses for such hotels and rent payments. Accordingly, although the Company’s ownership of MHI Holding and the TRS Lessees will allow it to participate in the operating income from its hotels in addition to receiving rent, that operating income will be fully subject to income tax. The after-tax net income of MHI Holding, if any, will be available for distribution to the Company.\nThe Company will incur a 100.0% excise tax on its transactions with MHI Holding and the TRS Lessees that are not conducted on an arm’s-length basis. For example, to the extent that the rent paid by the TRS Lessees exceeds an arm’s-length rental amount, such amount potentially will be subject to this excise tax. The Company intends that all transactions among itself, MHI Holding and the TRS Lessees will be conducted on an arm’s-length basis and, therefore, that the rent paid by the TRS Lessees will not be subject to this excise tax.\nOur ability to use net operating loss carryforwards to reduce future tax payments may be limited or restricted or may not exist at all, and if we do not sustain our profitability, we may be required to put up a valuation allowance against our deferred tax assets.\nAt December 31, 2016, our financial statements reflected deferred tax assets totaling approximately $6.9 million, of which approximately $6.0 million relates to significant federal and state net operating losses (“NOLs”) generated by our TRS Lessee over the past three years. We are generally able to carry NOLs forward to reduce taxable income in future years. Our ability to use our NOLs to reduce future tax payments is dependent upon our ability to sustain profitability during the time period over which these NOLs may be used under applicable tax law. A valuation allowance is required for deferred tax assets if, based on all available evidence, it is “more-likely-than-not” (defined as a likelihood of more than 50%) that all or a portion of the deferred tax assets will not be realized due to the inability to generate sufficient taxable income in certain financial statement periods. The net amount of deferred tax assets that are recorded on the financial statements must reflect the tax benefits that are expected to be realized using these criteria. We perform this analysis by evaluating a number of factors, including a demonstrated track record of past profitability, reasonable forecasts of future taxable income, and anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. At December 31, 2016, we determined based on all available positive and negative evidence that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We made this determination considering reasonable tax strategies available to us capable of ensuring the realization of our deferred tax assets, anticipated changes in the lease rental payments and one time losses that generated some of our net operating losses. However, there is no assurance that the TRS Lessee will be able to achieve profitability. The TRS Lessee’s ability to generate sustained profitability in the amounts necessary to realize our deferred tax assets against future taxable income depends upon general economic and market conditions, interest rates, and the TRS Lessee’s ability to meet our strategic plans. If the TRS Lessee is unable to generate adequate sustained profitability, we may be required to record a valuation allowance against some or all of our deferred tax assets, which would negatively impact our financial results.\nTaxation of dividend income could make the Company’s stock less attractive to investors and reduce the market price of its stock.\nThe federal income tax laws governing REITs, or the administrative interpretations of those laws, may be amended at any time. Any new laws or interpretations may take effect retroactively and could adversely affect the Company or could adversely affect its stockholders. Currently, “qualified dividends,” which include dividends from domestic C corporations that are paid to non-corporate stockholders, are subject to a reduced maximum U.S. federal income tax rate of 20.0%. Because REITs generally do not pay corporate-level taxes as a result of the dividends-paid deduction to which they are entitled, dividends from REITs generally are not treated as qualified dividends and thus do not qualify for a reduced tax rate. Non-corporate investors could view an investment in non-REIT corporations as more attractive than an investment in REITs because the dividends they would receive from non-REIT corporations would be subject to lower tax rates.\nInvestors may be subject to a 3.8% Medicare tax in connection with an investment in the Company’s stock or the 7% Notes.\nThe U.S. tax laws impose a 3.8% “Medicare tax” on the “net investment income” (i.e., interest, dividends, capital gains, annuities, and rents that are not derived in the ordinary course of a trade or business) of individuals with income exceeding $200,000 ($250,000 if married filing jointly or $125,000 if married filing separately), and of estates and trusts. Dividends on the Company’s stock and interest on the 7% Notes as well as gains from the disposition of the Company’s stock or the 7% Notes may be subject to the Medicare tax. Prospective investors should consult with their independent advisors as to the applicability of the Medicare tax to an investment in the Company’s stock or the 7% Notes in light of such investors’ particular circumstances.\n30\nInvestors may be subject to U.S. withholding tax under the “Foreign Account Tax Compliance Act.”\nOn March 18, 2010, the Hiring Incentives to Restore Employment Act, or the HIRE Act, was enacted in the United States. The HIRE Act includes provisions known as the Foreign Account Tax Compliance Act, or FATCA, that generally impose a 30.0% U.S. withholding tax on “withholdable payments,” which consist of (i) U.S.-source dividends, interest, rents and other “fixed or determinable annual or periodical income” paid after June 30, 2014 and (ii) certain U.S.-source gross proceeds paid after December 31, 2018 to (a) “foreign financial institutions” unless (x) they enter into an agreement with the IRS to collect and disclose to the IRS information regarding their direct and indirect U.S. owners or (y) they comply with the terms of any FATCA intergovernmental agreement executed between the authorities in their jurisdiction and the U.S., and (b) “non-financial foreign entities” (i.e., foreign entities that are not foreign financial institutions) unless they certify certain information regarding their direct and indirect U.S. owners. Final regulations under FATCA were issued by the IRS on January 17, 2013, and have been subsequently supplemented by additional regulations and guidance. FATCA does not replace the existing U.S. withholding tax regime. However, the FATCA regulations contain coordination provisions to avoid double withholding on U.S.-source income.\nA foreign investor that receives dividends on the Company’s stock or gross proceeds from a disposition of shares of the Company’s stock may be subject to FATCA withholding tax with respect to such dividends or gross proceeds.\nForeign investors will be subject to U.S. withholding tax on the receipt of ordinary dividends on the Company’s stock.\nThe portion of dividends received by a foreign investor payable out of the Company’s current and accumulated earnings and profits which are not attributable to capital gains and which are not effectively connected with a U.S. trade or business of the foreign investor will generally be subject to U.S. withholding tax at a statutory rate of 30.0%. This 30.0% withholding tax may be reduced by an applicable income tax treaty. The FATCA and nonresident withholding regulations are complex. Even if the 30.0% withholding is reduced or eliminated by treaty for payments made to a foreign investor, FATCA withholding of 30.0% could apply depending upon the foreign investor’s FATCA status. Foreign investors should consult with their independent advisors as to the U.S. withholding tax consequences to such investors with respect to their investment in the Company’s stock in light of their particular circumstances, as well as determining the appropriate documentation required to reduce or eliminate U.S. withholding tax.\nForeign investors will be subject to U.S. income tax on the receipt of capital gain dividends on the Company’s stock.\nUnder FIRPTA, distributions that we make to a foreign investor that are attributable to gains from our dispositions of U.S. real property interests (“capital gain dividends”) will be treated as income that is effectively connected with a U.S. trade or business, and therefore subject to U.S. federal income tax, in the hands of the foreign investor, unless such foreign person is a “qualified foreign pension fund” or one of certain publicly traded non-U.S. “qualified collective investment vehicles”. A foreign investor who is subject to tax under FIRPTA will be subject to U.S. federal income tax (at the rates applicable to U.S. investors) on any capital gain dividends, and will also be required to file U.S. federal income tax returns to report such capital gain dividends. Furthermore, capital gain dividends are subject to an additional 30.0% “branch profits tax” (which may be reduced by an applicable income tax treaty) in the hands of a foreign investor who is subject to tax under FIRPTA if such foreign investor is treated as a corporation for U.S. federal income tax purposes.\nLegislative or regulatory action could adversely affect you.\nBecause our operations are governed to a significant extent by the federal tax laws, new legislative or regulatory action could adversely affect our investors. You are strongly encouraged to consult with your own tax advisor with respect to the status of any legislative, regulatory or administrative developments, announcements and proposals and their potential impact on your investment in the Company’s stock.\n\nUnresolved Staff Comments\nNot applicable.\n31\n\nItem 2.\nP\nroperties\nAs of December 31, 2016, our portfolio consisted of the following properties (see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Key Operating Metrics, for definitions of Occupancy, ADR, and RevPAR):\n\n| Number of | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR |\n| Wholly-Owned Properties | Rooms | 2016 | 2016 | 2016 | 2015 | 2015 | 2015 | 2014 | 2014 | 2014 |\n| Crowne Plaza Hampton Marina, Hampton, Virginia (1) | 173 | 55.2 | % | $ | 96.81 | $ | 53.40 | 55.2 | % | $ | 93.59 | $ | 51.64 | 50.8 | % | $ | 93.17 | $ | 48.27 |\n| Crowne Plaza Hollywood Beach Resort, Hollywood, Florida (2) | 311 | 79.6 | % | $ | 170.57 | $ | 135.74 | 83.1 | % | $ | 174.35 | $ | 144.86 | 83.1 | % | $ | 163.13 | $ | 135.55 |\n| Crowne Plaza Tampa Westshore, Tampa, Florida | 222 | 74.6 | % | $ | 116.15 | $ | 86.69 | 72.5 | % | $ | 111.08 | $ | 80.53 | 72.5 | % | $ | 104.90 | $ | 76.09 |\n| DoubleTree by Hilton Jacksonville Riverfront, Jacksonville, Florida | 293 | 77.4 | % | $ | 126.67 | $ | 98.06 | 67.4 | % | $ | 109.20 | $ | 73.60 | 65.8 | % | $ | 99.20 | $ | 65.24 |\n| DoubleTree by Hilton Laurel, Laurel, Maryland | 208 | 60.5 | % | $ | 104.35 | $ | 63.16 | 48.2 | % | $ | 95.19 | $ | 45.86 | 60.8 | % | $ | 89.08 | $ | 54.19 |\n| DoubleTree by Hilton Philadelphia Airport, Philadelphia, Pennsylvania | 331 | 77.0 | % | $ | 144.92 | $ | 111.66 | 79.3 | % | $ | 136.32 | $ | 108.13 | 75.9 | % | $ | 133.78 | $ | 101.58 |\n| DoubleTree by Hilton Raleigh Brownstone – University, Raleigh, North Carolina | 190 | 70.0 | % | $ | 134.74 | $ | 94.33 | 71.5 | % | $ | 131.61 | $ | 94.16 | 73.4 | % | $ | 122.60 | $ | 90.04 |\n| Georgian Terrace, Atlanta, Georgia (3) | 326 | 70.8 | % | $ | 160.89 | $ | 113.88 | 69.9 | % | $ | 155.56 | $ | 108.70 | 76.2 | % | $ | 137.65 | $ | 104.88 |\n| Hilton Savannah DeSoto, Savannah, Georgia | 246 | 71.5 | % | $ | 155.87 | $ | 111.48 | 76.9 | % | $ | 154.52 | $ | 118.89 | 75.7 | % | $ | 146.75 | $ | 111.14 |\n| Hilton Wilmington Riverside, Wilmington, North Carolina | 272 | 70.5 | % | $ | 147.14 | $ | 103.72 | 71.6 | % | $ | 138.36 | $ | 99.07 | 69.7 | % | $ | 139.09 | $ | 96.90 |\n| Sheraton Louisville Riverside, Jeffersonville, Indiana | 180 | 63.1 | % | $ | 137.34 | $ | 86.60 | 69.5 | % | $ | 131.74 | $ | 111.87 | 66.8 | % | $ | 150.20 | $ | 100.31 |\n| The Whitehall, Houston, Texas | 259 | 54.4 | % | $ | 140.70 | $ | 76.56 | 70.9 | % | $ | 142.05 | $ | 100.66 | 76.1 | % | $ | 138.93 | $ | 105.66 |\n| Total | 3,011 |\n\n\n| (1) | On February 7, 2017, the Company sold the Crowne Plaza Hampton Marina. |\n\n| (2) | The operating statistics for the Crowne Plaza Hollywood Beach Resort rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\n\n| (3) | The operating statistics for the Georgian Terrace rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\n\n\nLegal Proceedings\nWe are not involved in any material litigation, nor to our knowledge, is any material litigation threatened against us. We have settled, during the period covered by this report, all significant claims made during the same period. We are involved in routine litigation arising out of the ordinary course of business, all of which is expected to be covered by insurance, and none of which is expected to have a material impact on our financial condition or results of operations.\nMine Safety Disclosure\nNot applicable.\n32\nPART II\nMarket for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\nSotherly Hotels Inc.\nMarket Information\nThe Company’s common stock trades on the NASDAQ ® Global Market under the symbol “SOHO”. The following table sets forth, for the indicated period, the intraday high and low prices for the common stock, as reported on NASDAQ ®:\n\n| Price Range |\n| High | Low |\n| Year Ended December 31, 2016 |\n| First Quarter | $ | 6.59 | $ | 4.59 |\n| Second Quarter | $ | 5.99 | $ | 5.00 |\n| Third Quarter | $ | 6.35 | $ | 5.22 |\n| Fourth Quarter | $ | 7.11 | $ | 4.65 |\n| Year Ended December 31, 2015 |\n| First Quarter | $ | 7.87 | $ | 6.26 |\n| Second Quarter | $ | 8.71 | $ | 6.94 |\n| Third Quarter | $ | 7.63 | $ | 5.83 |\n| Fourth Quarter | $ | 6.94 | $ | 4.50 |\n\nThe closing price of the Company’s common stock on the NASDAQ ® Global Market on March 1, 2017 was $6.97 per share.\nStockholder Information\nAs of March 1, 2017, there were 80 holders of record of the Company’s common stock and as of March 1, 2017, there were approximately 3,772 beneficial owners of the Company’s common stock.\nIn order to comply with certain requirements related to the Company’s qualification as a REIT, the Company’s charter, subject to certain exceptions, limits the number of common shares that may be owned by any single person or affiliated group to 9.9% of the outstanding common shares.\nRecent Sales of Unregistered Securities\nOn February 1, 2016, two holders of units in the Operating Partnership redeemed a total of 422,687 units for an equivalent number of shares of the Company’s common stock. The shares of common stock were issued to the unitholder pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933, as amended.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company has used and expects to continue to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016 the Company repurchased the following amounts of common stock and the repurchased shares have been returned to the status of authorized but unissued shares of common stock:\n\n| Period | Total Number of Shares Repurchased | Average Price Paid Per Share | Total Number of Shares Purchased As Part of PubliclyAnnounced Program | Maximum Number (or Approximate Dollar Value) of Shares ThatMay Yet Be Purchased Under the Program |\n| December 1- December 31, 2016 | 481,100 | $ | 6.53 | 481,100 | $ | 6,835,464 |\n\n33\nUse of Proceeds from Registered Securities\nOn August 23, 2016, the Company sold 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock pursuant to a registration statement on Form S-3 (file no. 333-199256) for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units. The Operating Partnership used the net proceeds to redeem the entire $27.6 million aggregate principal amount of its outstanding 8.0% senior unsecured notes (the “8% Notes”), to acquire the commercial condominium unit and related inventories of the Hyde Resort & Residences for approximately $4.8 million, and will use the remainder of the proceeds for general corporate purposes.\nSotherly Hotels LP\nMarket Information\nThere is no established trading market for partnership units of the Operating Partnership. The Operating Partnership does not currently propose to offer partnership units to the public, and does not currently expect that a public market for those units will develop.\nPartnership Unitholder Information\nAs of March 1, 2017, there were 12 holders of the Operating Partnership’s partnership units, including Sotherly Hotels Inc.\nRecent Sales of Unregistered Securities\nFrom time to time, the Operating Partnership issues limited partnership units (common and/or preferred) to the Company, as required by the Amended and Restated Agreement of Limited Partnership of the Operating Partnership, to mirror the capital structure of the Company to reflect additional issuances by the Company and to preserve equitable ownership ratios.\nThere were no sales of unregistered securities in the Operating Partnership during 2016.\nUse of Proceeds from Registered Securities\nThere were no sales of registered securities in the Operating Partnership during 2016.\nSotherly Hotels Inc. and Sotherly Hotels LP\nDividend and Distribution Information\nThe Company elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, we are required to make annual distributions to the Company’s stockholders of at least 90.0% of our REIT taxable income, excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles. Our ability to pay distributions to the Company’s stockholders will depend, in part, upon our receipt of distributions from our Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, our TRS Lessees may retain any after-tax earnings.\nIn order to maintain our qualification as a REIT, we must make distributions to our stockholders each year in an amount equal to at least:\n| • | 90% of our REIT taxable income determined without regard to the dividends paid deduction and excluding net capital gains; plus |\n\n| • | 90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code; minus |\n\n| • | Any excess noncash income (as defined in the Code). |\n\n34\nThe following tables set forth information regarding the declaration, payment and income tax characterization of distributions by the Company on its common and preferred shares to Company’s stockholders for fiscal year 2015 to 2016. The same table sets forth the Operating Partnership’s distributions per common and preferred partnership units for fiscal year 2015 to 2016:\n\n| Dividend (Distribution) Payments - Common |\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\n| January 2015 | March 31, 2015 | April 10, 2015 | $ | 0.070 | 82.6% | 17.4% |\n| April 2015 | June 30, 2015 | July 10, 2015 | $ | 0.075 | 82.6% | 17.4% |\n| July 2015 | September 30, 2015 | October 9, 2015 | $ | 0.080 | 82.6% | 17.4% |\n| October 2015 | December 31, 2015 | January 11, 2016 | $ | 0.080 | 82.6% | 17.4% |\n| January 2016 | March 31, 2016 | April 11, 2016 | $ | 0.085 | 73.5% | 26.5% |\n| April 2016 | June 30, 2016 | July 11, 2016 | $ | 0.090 | 73.5% | 26.5% |\n| July 2016 | September 30, 2016 | October 11, 2016 | $ | 0.095 | 73.5% | 26.5% |\n| October 2016 | December 31, 2016 | January 11, 2017 | $ | 0.095 | 73.5% | 26.5% |\n\n\n| Dividend (Distribution) Payments - Preferred |\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\n| August 2016 | September 30, 2016 | October 17, 2016 | $ | 0.2111 | 73.5% | 26.5% |\n| October 2016 | December 31, 2016 | January 17, 2017 | $ | 0.500 | 73.5% | 26.5% |\n\nThe amount of future common stock distributions will be based upon quarterly operating results, general economic conditions, requirements for capital improvements, the availability of debt and equity capital, the Code’s annual distribution requirements, and other factors, which the Company’s board of directors deems relevant. The amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future.\n\nSelected Financial Data\nThe following table sets forth selected historical financial data for Sotherly Hotels Inc. and Sotherly Hotels LP for the years ended December 31, 2016, 2015, 2014, 2013, and 2012. The financial results for the Crowne Plaza Hollywood Beach Resort, in which we had a 25.0% indirect interest, are not consolidated through July 31, 2015, as we accounted for our investment under the equity method of accounting. However, from August 1, 2015 through December 31, 2015 we did consolidate the financial results for the Crowne Plaza Hollywood Beach Resort, as a result of our acquisition of the remaining 75.0% interest in the hotel. The following selected historical financial data was derived from audited consolidated financial statements contained elsewhere in this Annual Report on Form 10-K and in prior filings. The Company’s financial statements: for the year ended December 31, 2016, have been audited by Dixon Hughes Goodman LLP; for the years ended December 31, 2015 and 2014, have been audited by Grant Thornton LLP; and for the years ended December 31, 2013 and 2012, have been audited by PBMares, LLP (formerly Witt Mares, PLC), our independent registered public accounting firms, for such periods. The audited historical financial statements include reclassifications and all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of our financial condition and the results of operations as of those dates and for those periods under accounting principles generally accepted in the United States of America.\nThe information presented below is only a summary and does not provide all of the information contained in our consolidated financial statements, including notes thereto, and should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.\n35\nSOTHERLY HOTELS INC.\nSOTHERLY HOTELS LP\nSELECTED HISTORICAL FINANCIAL DATA\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Statement of Operations |\n| Total Revenues | $ | 152,845,752 | $ | 138,533,476 | $ | 122,939,919 | $ | 89,374,527 | $ | 87,343,220 |\n| Total Operating Expenses excluding Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (118,854,236 | ) | (109,153,366 | ) | (95,290,304 | ) | (69,888,820 | ) | (68,519,401 | ) |\n| Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (15,384,390 | ) | (14,050,060 | ) | (15,144,284 | ) | (9,078,228 | ) | (8,661,769 | ) |\n| Net Operating Income | 18,607,126 | 15,330,050 | 12,505,331 | 10,407,479 | 10,162,050 |\n| Interest Income | 115,785 | 50,461 | 19,865 | 17,914 | 16,158 |\n| Interest Expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) | (9,606,479 | ) | (10,399,962 | ) |\n| Other Income (Expense) – net | (1,455,289 | ) | 6,196,936 | (354,558 | ) | (3,796,410 | ) | (3,941,594 | ) |\n| Income Tax Benefit (Provision) | 1,367,634 | 1,336,033 | 1,727,723 | (1,496,096 | ) | (1,246,397 | ) |\n| Net Income (Loss) | 900,149 | 6,397,653 | (738,509 | ) | (4,473,592 | ) | (5,409,745 | ) |\n| Net (Income) Loss Attributable to Noncontrolling Interest | 26,567 | (1,040,987 | ) | 153,838 | 989,623 | 1,241,868 |\n| Net Income (Loss) Attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) | (3,483,969 | ) | (4,167,877 | ) |\n| Distributions to Preferred Stockholders | (1,144,889 | ) | — | — | — | — |\n| Net Income/(Loss) Attributable to Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,167,877 | ) |\n| Statement of Cash Flows |\n| Cash provided by Operations – net | $ | 17,139,409 | $ | 11,377,374 | $ | 14,851,255 | $ | 9,594,751 | $ | 9,011,957 |\n| Cash used in Investing – net | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) | (29,527,589 | ) | (3,156,121 | ) |\n| Cash provided by (used in) Financing – net | 16,074,218 | 24,614,643 | 63,503,194 | 22,133,750 | (3,090,079 | ) |\n| Net Increase (Decrease) in Cash and Cash Equivalents | $ | 20,272,861 | $ | (5,140,585 | ) | $ | 7,257,871 | $ | 2,200,912 | $ | 2,765,757 |\n| Balance Sheet |\n| Investments in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 | $ | 260,192,153 | $ | 202,645,633 | $ | 176,427,904 |\n| Investment in Hotel Properties Held for Sale, Net | 5,333,000 | — | — | — | — |\n| Total Assets (1) | 406,019,564 | 393,058,353 | 299,820,043 | 228,169,081 | 204,223,074 |\n| Mortgage Loans | 282,708,289 | 271,977,944 | 205,291,657 | 160,363,549 | 135,674,432 |\n| Unsecured Notes | 24,308,713 | 52,900,000 | 52,900,000 | 27,600,000 | — |\n| Redeemable Preferred Stock | — | — | — | — | 14,227,650 |\n| Total Liabilities | 324,680,276 | 340,199,985 | 272,310,186 | 197,314,286 | 167,179,121 |\n| Noncontrolling Interest (1) | 2,329,175 | 3,855,237 | 4,132,662 | 5,669,386 | 7,322,314 |\n| Total Sotherly Hotels Inc. Stockholders’ Equity (1) | $ | 79,010,113 | $ | 49,003,131 | $ | 23,377,195 | $ | 25,185,409 | $ | 29,721,639 |\n| Operating Data |\n| Average Number of Available Rooms | 3,011 | 2,828 | 2,622 | 2,148 | 2,113 |\n| Total Number of Available Room Nights | 1,102,026 | 1,032,353 | 957,060 | 783,936 | 773,358 |\n| Occupancy Percentage (2) | 69.8 | % | 69.9 | % | 70.3 | % | 67.4 | % | 68.9 | % |\n| Average Daily Rate (ADR) (2) | $ | 140.63 | $ | 134.21 | $ | 125.77 | $ | 118.91 | $ | 114.22 |\n| RevPAR (2) | $ | 98.18 | $ | 93.80 | $ | 88.42 | $ | 80.16 | $ | 78.65 |\n| Additional Financial Data |\n| FFO (3) | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\n| Adjusted FFO (3) | 15,100,188 | 14,904,608 | 14,142,080 | 10,766,147 | 9,218,032 |\n| Hotel EBITDA (4) | 40,012,581 | 36,447,390 | 32,084,957 | 23,220,515 | 22,296,938 |\n| Income (Loss) Per Basic Share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) | $ | (0.34 | ) | $ | (0.42 | ) |\n\n\n| (1) | As of the period end. |\n\n| (2) | Occupancy Percent is calculated by dividing the total daily number of rooms sold by the total daily number of rooms available. ADR is calculated by dividing the total daily room revenue by the total daily number of rooms sold. RevPAR is calculated by dividing the total daily room revenue by the total daily number of rooms available. |\n\n36\n\n| (3) | Industry analysts and investors use Funds from Operations (“FFO”) as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with generally accepted accounting principles (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. |\n\nAdjusted FFO accounts for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on its hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, franchise termination costs, loan modification fees, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs.\n| (4) | Hotel EBITDA represents the portion of net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. |\n\nThe following is a reconciliation of net loss to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\n| Equity in Depreciation and Amortization of Joint Venture | — | 259,279 | 529,053 | 545,667 | 590,675 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\n| (Increase) Decrease in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) | 1,370,189 | 1,241,848 |\n| Acquisition Costs | — | 634,376 | 155,187 | 89,743 | — |\n| Loss on Starwood Settlement | — | 324,271 | — | — | — |\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — | — | — |\n| Loan Modification Fees | 64,215 | 243,229 | — | — | — |\n| Franchise Termination Fee | — | — | 351,800 | — | — |\n| Realized and Unrealized (Gain) Loss on Hedging Activities (A) | 37,384 | 108,819 | — | (89,998 | ) | 13,752 |\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 | $ | 10,766,147 | $ | 9,218,031 |\n\n\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\n\n37\nThe following is a reconciliation of net income/(loss) to Hotel EBITDA for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\n\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 | 2013 | 2012 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 | 9,606,479 | 10,399,962 |\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) | (17,914 | ) | (16,158 | ) |\n| Distributions to Preferred Stockholders | 1,144,889 | — | — | — | — |\n| Income Tax Provision (Benefit) | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) | 1,496,096 | 1,246,397 |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\n| Equity in (Earnings) Loss of Joint Venture | — | (475,514 | ) | (307,370 | ) | (449,500 | ) | (178,138 | ) |\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\n| Realized and Unrealized Loss (Gain) on Hedging Activities | 37,384 | 108,819 | — | — | — |\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\n| Loss on Early Debt Extinguishment | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 | 4,360,582 | 4,078,826 |\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\n| Net Lease Rental Income | — | — | (350,000 | ) | (350,000 | ) | (350,000 | ) |\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) | (275,774 | ) | (255,707 | ) |\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 | $ | 23,220,515 | $ | 22,296,938 |\n\n38\n\nItem 7.\nManagement’s Discussion and Analysis of\nFinancial Condition and Results of Operations\nOverview\nThe Company is a self-managed and self-administered lodging REIT incorporated in Maryland in August 2004 to pursue opportunities in the full-service, primarily upscale and upper-upscale segments of the hotel industry located in primary and secondary markets in the mid-Atlantic and southern United States. We commenced operations in December 2004 when the Company completed its initial public offering and thereafter consummated the acquisition of six initial hotel properties. Since the Company’s initial public offering, we have engaged in the following acquisitions and dispositions:\n| • | On July 22, 2005, we acquired the Crowne Plaza Jacksonville Riverfront (formerly, the Hilton Jacksonville Riverfront). During September 2015, after extensive renovations, we re-branded and renamed the hotel the DoubleTree by Hilton Jacksonville Riverfront. |\n\n| • | On August 10, 2006, we sold the Holiday Inn Downtown Williamsburg. |\n\n| • | On September 20, 2006, we acquired the Louisville Ramada Riverfront Inn, which went through an extensive renovation and re-opened in May 2008 as the Sheraton Riverside Louisville. |\n\n| • | On August 8, 2007, through our joint venture with Carlyle, we acquired a 25.0% indirect noncontrolling interest in the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida. |\n\n| • | On October 29, 2007, we acquired a hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel, which went through an extensive renovation and re-opened in March 2009 as the Crowne Plaza Tampa Westshore. |\n\n| • | On April 24, 2008, we acquired the Hampton Marina Hotel in Hampton, Virginia, which has been renovated and was converted to the Crowne Plaza Hampton Marina in October 2008. |\n\n| • | On November 13, 2013, we acquired the Crowne Plaza Houston Downtown in Houston, Texas. |\n\n| • | On March 27, 2014, we acquired the Georgian Terrace in Atlanta, Georgia. |\n\n| • | On July 31, 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. |\n\n| • | On January 30, 2017, we closed on the purchase of the hotel commercial unit of the Hyde Resort & Residences, a 400-unit condominium-hotel located in the Hollywood, Florida market. |\n\n| • | On February 7, 2017, we closed on the sale of the Crowne Plaza Hampton Marina. |\n\n39\nAs of December 31, 2016, our hotel portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels with 3,011 rooms, ten of which operate under well-known brands such as Hilton, Crowne Plaza, DoubleTree and Sheraton, and two of which are independent hotels. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences. As of December 31, 2016, we owned the following hotel properties:\n\n| Number |\n| Property | of Rooms | Location | Date of Acquisition | Chain Designation |\n| Wholly-owned |\n| Crowne Plaza Hampton Marina (1) | 173 | Hampton, VA | April 24, 2008 | Upscale |\n| Crowne Plaza Hollywood Beach Resort | 311 | Hollywood, FL | August 9, 2007 | Upscale |\n| Crowne Plaza Tampa Westshore | 222 | Tampa, FL | October 29, 2007 | Upscale |\n| DoubleTree by Hilton Jacksonville Riverfront | 293 | Jacksonville, FL | July 22, 2005 | Upscale |\n| DoubleTree by Hilton Laurel | 208 | Laurel, MD | December 21, 2004 | Upscale |\n| DoubleTree by Hilton Philadelphia Airport | 331 | Philadelphia, PA | December 21, 2004 | Upscale |\n| DoubleTree by Hilton Raleigh Brownstone-University | 190 | Raleigh, NC | December 21, 2004 | Upscale |\n| The Georgian Terrace | 326 | Atlanta, GA | March 27, 2014 | Independent(2) |\n| Hilton Savannah DeSoto | 246 | Savannah, GA | December 21, 2004 | Upper Upscale |\n| Hilton Wilmington Riverside | 272 | Wilmington, NC | December 21, 2004 | Upper Upscale |\n| Sheraton Louisville Riverside | 180 | Jeffersonville, IN | September 20, 2006 | Upper Upscale |\n| The Whitehall | 259 | Houston, TX | November 13, 2013 | Independent(2) |\n| Total | 3,011 |\n\n\n| (1) | On February 7, 2017, we closed on the sale of this hotel. |\n\n| (2) | We believe that the Georgian Terrace and The Whitehall would carry a chain scale designation of upper upscale if they were branded hotels. |\n\nWe conduct substantially all our business through the Operating Partnership, Sotherly Hotels LP. The Company is the sole general partner of the Operating Partnership and owns an approximate 89.1% interest in the Operating Partnership, with the remaining interest being held by limited partners who were contributors of our initial hotel properties and related assets.\nTo qualify as a REIT, neither the Company nor the Operating Partnership can operate our hotels. Therefore, our wholly-owned hotel properties are leased to our TRS Lessees that are wholly-owned subsidiaries of the Operating Partnership, which then engage a hotel management company to operate the hotels under a management agreement. Our TRS Lessees have engaged Chesapeake Hospitality to manage our hotels. Our TRS Lessees, and their parent, MHI Hospitality TRS Holding, Inc., are consolidated into each of our financial statements for accounting purposes. The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.\nKey Operating Metrics\nIn the hotel industry, room revenue is considered the most important category of revenue and drives other revenue categories such as food, beverage, catering, parking and telephone. There are three key performance indicators used in the hotel industry to measure room revenues:\n| • | Occupancy, or the number of rooms sold, usually expressed as a percentage of total rooms available; |\n\n| • | Average daily rate, or ADR, which is total room revenue divided by the number of rooms sold; and |\n\n| • | Revenue per available room, or RevPAR, which is total room revenue divided by the total number of available rooms. |\n\nRevPAR changes that are primarily driven by changes in occupancy have different implications for overall revenues and profitability than changes that are driven primarily by changes in ADR. For example, an increase in occupancy at a hotel would lead to additional variable operating costs (such as housekeeping services, laundry, utilities, room supplies, franchise fees, management fees, credit card commissions and reservations expense), but could also result in increased non-room revenue from the hotel’s restaurant, banquet or parking facilities. Changes in RevPAR that are primarily driven by changes in ADR typically have a greater impact on operating margins and profitability as they do not generate all the additional variable operating costs associated with higher occupancy.\n40\nWe also use FFO, Adjusted FFO and Hotel EBITDA as measures of our operating performance. See “Non-GAAP Financial Measures”.\nResults of Operations\nComparison of Year Ended December 31, 2016 to Year Ended December 31, 2015\nThe following table illustrates the key operating metrics for the years ended December 31, 2016 and 2015 for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the eleven wholly-owned properties that were under our control during all of 2015 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter.\n\n| Year Ended December 31, 2016 | Year Ended December 31, 2015 |\n| Actual | Same-Store | Actual | Same-Store |\n| Occupancy % | 69.8 | % | 68.7 | % | 69.9 | % | 65.7 | % |\n| ADR | $ | 140.63 | $ | 136.63 | $ | 134.21 | $ | 130.09 |\n| RevPAR | $ | 98.18 | $ | 93.86 | $ | 93.80 | $ | 85.47 |\n\nRevenue. Total revenue for the year ended December 31, 2016 was approximately $152.8 million, an increase of approximately $14.3 million, or 10.3%, from total revenue for the year ended December 31, 2015 of approximately $138.5 million. Approximately $11.9 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; and Atlanta, Georgia of approximately $7.1 million, were offset by decreases in revenue at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas of approximately $3.3 million, as well as the remaining properties revenue decreases of $1.6 million.\nRoom revenues at our properties for the year ended December 31, 2016 increased approximately $11.4 million, or 11.7%, to approximately $108.2 million compared to room revenues for the year ended December 31, 2015 of approximately $96.8 million. The increase in room revenues for the year ended December 31, 2016 resulted mainly from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.6 million for the period. Our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenues, offset by decreases at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas. We continue to expect occupancy and ADR to increase in 2017 as a result of continuing strong demand and the completion in 2016 of renovations at our properties in Houston, Texas and Atlanta, Georgia.\nFood and beverage revenues at our properties for the year ended December 31, 2016 increased approximately $2.1 million, or 6.3%, to approximately $35.4 million compared to food and beverage revenues of approximately $33.3 million for the year ended December 31, 2015. The increase in food and beverage revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.6 million for the period. Additional increases in food and beverage revenues at our properties in Savannah, Georgia; Raleigh, North Carolina; Laurel, Maryland: Jacksonville, Florida; and Tampa, Florida of approximately $1.5 million, were offset by decreases of approximately $1.0 million in food and beverage revenues at our other properties.\nOther operating revenues for the year ended December 31, 2016 increased approximately $0.8 million, or 10.0%, to approximately $9.3 million compared to other operating revenues for the year ended December 31, 2015 of approximately $8.4 million. The increase in other operating department revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.6 million for the period. Additional increases in other operating revenues at our properties in Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Jeffersonville, Indiana and Hampton, Virginia of approximately $0.5 million, were offset by decreases of approximately $0.5 million in other operating revenues at our other properties.\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $10.9 million, or 10.7%, for the year ended December 31, 2016 to approximately $112.8 million compared to hotel operating expenses for the year ended December 31, 2015 of approximately $101.9 million. The increase in hotel operating expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.0 million for the period, coupled with an increase in hotel operating expenses at our same-store properties of approximately $1.1 million, mainly from increased occupancy by 4.6%, offset with decreases in expenses at our properties in Wilmington, North Carolina; Philadelphia, Pennsylvania; Jeffersonville, Indiana; Hampton, Virginia and Houston, Texas.\n41\nRooms expense at our properties for the year ended December 31, 2016 increased approximately $3.1 million, or 12.1%, to approximately $28.9 million compared to rooms expense of approximately $25.8 million for the year ended December 31, 2015. The increase in rooms expense for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.3 million for the period.\nFood and beverage expenses at our properties for the year ended December 31, 2016 increased approximately $1.4 million, or 5.9%, to approximately $24.4 million compared to food and beverage expense of approximately $23.0 million for the year ended December 31, 2015. The increase in food and beverage expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period.\nIndirect expenses at our properties for the year ended December 31, 2016 increased approximately $5.8 million, or 11.4%, to approximately $57.1 million compared to indirect expenses of approximately $51.3 million for the year ended December 31, 2015. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our recently acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $5.1 million for the period, compared to the year ended December 31, 2015.\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2016 increased approximately $1.4 million, or 10.5%, to approximately $15.0 million compared to depreciation and amortization expense of approximately $13.6 million for the year ended December 31, 2015. The increase was mostly attributable to depreciation and amortization related to our recently acquired property in Hollywood Beach, Florida and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2015 and for the year 2016, offset by reductions of intangible asset amortization during the year ended December 31, 2016 compared to the year ended December 31, 2015.\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2016 and 2015 was $0 and $0.5 million, respectively. Our review of possible impairment of our hotel properties revealed no excess of current carrying cost over the estimated undiscounted future cash flows, as of December 31, 2016.\nGain / Loss on Disposal of Assets. During the year ended December 31, 2016, we recorded a net loss on disposal of assets of $365,319, comprised of disposals of furniture, fixtures, and equipment of $565,319, offset by a gain on sale of $200,000, compared to a $41,435 net gain on disposal of assets for the year ended December 31, 2015, comprised of a net gain on the sale of development parcel rights and the development parcel for approximately $710,250, offset by losses on disposals of furniture, fixtures and equipment of $668,815.\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2016 decreased approximately $1.2 million, or 17.2%, to approximately $6.0 million compared to corporate general and administrative expenses of approximately $7.3 million for the year ended December 31, 2015. The decrease in corporate general and administrative expenses was mainly due to decreases in acquisition costs of approximately $0.6 million, the absence of a one-time tax penalty of $0.4 million in 2016, reduced professional fees of approximately $0.2 million, reduced loan modification costs of $0.2 million and reduced audit fees of approximately $0.2 million partially offset by additional staffing and related salary increase of approximately $0.3 million, an increase in legal fees of approximately $0.4 million and increased marketing support costs of $0.2 million.\nInterest Expense. Interest expense for the year ended December 31, 2016 increased approximately $1.2 million, or 7.4%, to approximately $17.7 million compared to approximately $16.5 million of interest expense for the year ended December 31, 2015. The increase in interest expense for the year ended December 31, 2016, was substantially related to the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.8 million. This increase was mainly offset by a decrease in interest from the redemption of the 8% Notes with an approximate decrease of $0.5 million.\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture decreased approximately $0.5 million, or 100.0%, to $0 for the year ended December 31, 2016 compared to equity in the income of the joint venture of approximately $0.5 million for the year ended December 31, 2015, due the acquisition of the Crowne Plaza Hollywood Beach Resort in July 2015.\n42\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2016 increased approximately $0.6 million, or 83.5%, to approximately $1.4 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2015. During the year ended December 31, 2016, we refinanced mortgage loans at our properties in Wilmington, North Carolina; Savannah, Georgia; Jeffersonville, Indiana; Tampa, Florida and Houston, Texas with an increase in loss on early debt extinguishments of approximately $0.3 million. We also redeemed our 8% unsecured notes with the majority of the loss on early debt extinguishment of approximately $1.1 million.\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2016, the fair market value of the interest rate cap is $33,597 compared to the fair market value of $70,981, as of December 31, 2015. The unrealized loss on hedging activities during the year ended December 31, 2016 and 2015, was $37,384 and $108,818, respectively.\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015, was approximately $6.6 million while no such gain was recorded in 2016.\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2016 increased approximately $32,000, or 2.4%, to approximately $1.4 million compared to an income tax provision of approximately $1.3 million for the year ended December 31, 2015. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized higher operating loss for the year ended December 31, 2016 compared to the year ended December 31, 2015. At December 31, 2016, deferred tax assets total approximately $6.9 million, of which approximately $6.0 million relate to net operating losses of our TRS Lessee. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We will continue to regularly evaluate the likelihood that we will be able to realize our deferred tax assets and the need for a valuation allowance for the deferred tax assets.\nNet Income. Net income for the year ended December 31, 2016 decreased approximately $5.5 million, or 85.9%, to approximately $0.9 million compared to net income of approximately $6.4 million for the year ended December 31, 2015, as a result of the operating results discussed above.\nDistributions to Preferred Stockholders. During the year ended December 31, 2016, we recorded distributions to preferred stockholders of approximately $1.1 million, compared to no distributions to preferred stockholders for the year ended December 31, 2015. As of December 31, 2016 and 2015, we accrued $805,000 and $0, as dividends on the preferred stock, respectively.\nComparison of Year Ended December 31, 2015 to Year Ended December 31, 2014\nThe following table illustrates the key operating metrics for the years ended December 31, 2015 and 2014, for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the ten wholly-owned properties that were under our control during all of 2014 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Georgian Terrace, which was acquired in March 2014. Each table excludes performance data for the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter through December 31, 2015.\n\n| Year Ended December 31, 2015 | Year Ended December 31, 2014 |\n| Actual | Same-Store | Actual | Same-Store |\n| Occupancy % | 69.9 | % | 65.7 | % | 70.3 | % | 69.7 | % |\n| ADR | $ | 134.21 | $ | 130.09 | $ | 15.77 | $ | 124.27 |\n| RevPAR | $ | 93.80 | $ | 85.47 | $ | 88.42 | $ | 86.57 |\n\nRevenue. Total revenue for the year ended December 31, 2015 was approximately $138.5 million, an increase of approximately $15.6 million, or 12.7%, from total revenue for the year ended December 31, 2014 of approximately $122.9 million. Approximately $6.2 million of the increase relates to the acquisition of our property in Atlanta, Georgia in March 2014. Approximately $7.5 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Jeffersonville, Indiana; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia were offset by decreases in revenue at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas, as well as by the loss of rental income associated with Shell Island which expired in December 2014.\n43\nRoom revenues at our properties for the year ended December 31, 2015 increased approximately $12.2 million, or 14.4%, to approximately $96.8 million compared to room revenues for the year ended December 31, 2014 of approximately $84.6 million. The increase in room revenue for the year ended December 31, 2015 resulted mainly from the acquired property in Atlanta, Georgia, accounting for an increase of approximately $3.3 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.4 million for the period. Our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; and Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenue, offset by decreases at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\nFood and beverage revenues at our properties for the year ended December 31, 2015 increased approximately $1.8 million, or 5.8%, to approximately $33.3 million compared to food and beverage revenue of approximately $31.4 million for the year ended December 31, 2014. The increase in food and beverage revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $2.1 million for the period, and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period. Additional increases in food and beverage revenue at our properties in Wilmington, North Carolina; Raleigh, North Carolina and Jeffersonville, Indiana of approximately $0.3 million, were offset by decreases of approximately $1.6 million in banqueting revenue at our other properties.\nOther operating revenues for the year ended December 31, 2015 increased approximately $1.5 million, or 22.5%, to approximately $8.4 million compared to other operating revenues for the year ended December 31, 2014 of approximately $6.9 million. The increase in other operating departments revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $0.8 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.5 million for the period.\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $11.7 million, or 12.9%, for the year ended December 31, 2015, to approximately $101.9 million compared to hotel operating expenses for the year ended December 31, 2014 of approximately $90.2 million. The increase in hotel operating expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $6.7 million of the increase in expenses for the year ended December 31, 2015 and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.2 million for the period, coupled by a decrease in hotel operating expenses at our same-store properties of approximately $1.0 million, mainly from reduced occupancy by 5.7% and RevPAR by 1.3% combined with decreases in expenses at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\nRooms expense at our properties for the year ended December 31, 2015 increased approximately $2.9 million, or 12.5%, to approximately $25.8 million compared to rooms expense of approximately $22.9 million for the year ended December 31, 2014. The increase in rooms expense for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.0 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.3 million for the period.\nFood and beverage expenses at our properties for the year ended December 31, 2015 increased approximately $2.0 million, or 9.4%, to approximately $23.0 million compared to food and beverage expense of approximately $21.0 million for the year ended December 31, 2014. The increase in food and beverage expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.5 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.9 million for the period, offset by decreases in food and beverage expenses mainly from reduced occupancy and decreases in expenses at our property impacted by renovation activities in Houston, Texas.\nIndirect expenses at our properties for the year ended December 31, 2015 increased approximately $6.2 million, or 13.8%, to approximately $51.3 million compared to indirect expenses of approximately $45.1 million for the year ended December 31, 2014. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $2.1 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.8 million for the period, compared to the year ended December 31, 2014.\n44\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2015 increased approximately $1.6 million, or 13.6%, to approximately $13.6 million compared to depreciation and amortization expense of approximately $12.0 million for the year ended December 31, 2014. The increase was mostly attributable to depreciation and amortization related to our acquired property in Atlanta, Georgia and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2014 and the year of 2015, offset by reductions of intangible asset amortization during the year ended December 31, 2015 compared to the year ended December 31, 2014.\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2015 and 2014, was approximately $0.5 million and $3.2 million, respectively. Our review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which was triggered by a combination of a change in anticipated use and future branding of the property; and a re-evaluation of future revenues based on anticipated market conditions, market penetration and costs necessary to achieve such market penetration, resulting in an impairment to fair market value of $0.5 million, as of December 31, 2015.\nGain on Disposal of Assets. During the year ended December 31, 2015, we recorded a gain on disposal of assets of $41,435, compared to no gain or loss on disposal of assets for the year ended December 31, 2014.\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2015 increased approximately $2.2 million, or 42.9%, to approximately $7.3 million compared to corporate general and administrative expenses of approximately $5.1 million for the year ended December 31, 2014. The increase in corporate general and administrative expenses was mainly due to an increase in acquisition costs of approximately $0.5 million, a one-time tax penalty of $0.4 million, additional staffing and related salary increase of approximately $0.3 million, increased professional fees of approximately $0.5 million, loan costs of $0.2 million on the loan modifications of the Crowne Plaza Hollywood Beach Resort mortgage and the DoubleTree by Hilton Laurel mortgage, and increased audit fees of approximately $0.1 million partially offset by a reduction in legal fees of approximately $0.1 million.\nInterest Expense. Interest expense for the year ended December 31, 2015 increased approximately $1.9 million, or 12.8%, to approximately $16.5 million compared to approximately $14.6 million of interest expense for the year ended December 31, 2014. The increase in interest expense for the year ended December 31, 2015 was substantially related to the additional mortgage on our acquired property in Atlanta, Georgia of $0.7 million, the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.4 million, the issuance of the 7% Notes due in 2019, accounting for an increase of approximately $1.6 million. These increases were offset by a decrease in interest from the reduction of the bridge loan with Richmond Hill Capital Partners, LP during the year ending December 31, 2015 of $1.3 million.\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture increased approximately $0.2 million, or 54.7%, to approximately $0.5 million for the year ended December 31, 2015 compared to equity in the income of the joint venture of approximately $0.3 million for the year ended December 31, 2014 and represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort through July 31, 2015. For the year ended December 31, 2015, the Crowne Plaza Hollywood Beach Resort reported occupancy of 83.1%, ADR of $174.35 and RevPAR of $144.86. This compares with results reported by the hotel for the year ended December 31, 2014 of occupancy of 83.1%, ADR of $163.13 and RevPAR of $135.55.\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2015 decreased approximately $0.1 million, or 7.0%, to approximately $0.7 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2014. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with the Bank of the Ozarks on the Georgian Terrace, with a new fixed rate loan from Bank of America. The amount of accumulated un-amortized loan costs of $697,582 was written off during 2015. In addition, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. The amount of accumulated un-amortized loan costs of $75,324 was written off during 2015.\nGain on Involuntary Conversion of Asset. Gain on involuntary conversion of asset for the year ended December 31, 2015 decreased approximately $0.2 million, or 100.0%, to $0 compared to approximately $0.2 million of gain on involuntary conversion of asset for the year ended December 31, 2014. During 2014, we had a one-time involuntary conversion of equipment at our Hilton Wilmington Riverside property for replacement of a water chiller in the amount of approximately $0.2 million.\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2015, the fair market value of the interest rate cap was $70,981. The unrealized loss on hedging activities during the years ended December 31, 2015 and 2014, was approximately $0.1 million and $0, respectively.\n45\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015 was approximately $6.6 million while no such gain was recorded in 2014.\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2015 decreased approximately $0.4 million, or 22.7%, to approximately $1.3 million compared to an income tax benefit of approximately $1.7 million for the year ended December 31, 2014. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized lower operating loss for the year ended December 31, 2015 compared to the year ended December 31, 2014.\nNet Income (Loss). Net income for the year ended December 31, 2015 increased approximately $7.1 million, or 966.3%, to approximately $6.4 million compared to net loss of approximately $0.7 million for the year ended December 31, 2014 as a result of the operating results discussed above.\nSources and Uses of Cash\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2016.\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2016 was approximately $17.1 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\nInvesting Activities. During the year ended December 31, 2016, we spent approximately $14.9 million on capital expenditures, of which, approximately $5.3 million related to the routine replacement of furniture, fixtures and equipment; approximately $1.8 million related to the renovation of our property in Houston, Texas in anticipation of our newly independent hotel The Whitehall which opened in May 2016; approximately $4.9 million related to the renovation of our property in Savannah, Georgia; approximately $1.5 million related to the renovation of our property in Atlanta, Georgia; approximately $0.6 million related to the renovation of our property in Wilmington, North Carolina; approximately $0.4 million related to the renovation of our property in Laurel, Maryland and approximately $0.4 million related to the renovation of our property in Hollywood Beach, Florida.\nWe also contributed approximately $5.3 million during 2016 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2016, we received reimbursements from those reserves of approximately $7.0 million for capital expenditures related to those properties for periods ending on or before December 31, 2016.\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2016 was approximately $16.1 million. This inflow was principally from proceeds from the sale of preferred stock of approximately $37.8 million and net mortgage proceeds of approximately $14.2 million, offset by redemption of the 8% Notes for $27.6 million, repurchase of common stock for approximately $2.1 million, dividend and distribution payments of approximately $6.2 million and payments of deferred financing costs of approximately $1.5 million.\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company.\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank.\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\n46\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions.\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan provides proceeds of $12.0 million.\nOn November 3, 2016, we entered into a loan agreement to modify and extend the $2.6 million mortgage on the Crowne Plaza Hampton Marina with TowneBank.\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2015.\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2015 was approximately $11.4 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\nInvesting Activities. During the year ended December 31, 2015, we used approximately $25.5 million to acquire the remaining 75.0% ownership interest in the Crowne Plaza Hollywood Beach Resort. We also spent approximately $20.1 million on capital expenditures, of which, approximately $5.1 million related to the routine replacement of furniture, fixtures and equipment; approximately $4.6 million related to the renovation of our property in Laurel, Maryland in anticipation of a new franchise agreement which commenced in October 2015; approximately $3.4 million related to the renovation of our property in Jacksonville, Florida in anticipation of a new franchise license which commenced in September 2015; approximately $3.1 million related to guestroom renovations at the Georgian Terrace; approximately $3.0 million in renovations at our property in Houston, Texas; and approximately $0.9 related to the renovation of our property in Philadelphia, Pennsylvania.\nWe also contributed approximately $5.0 million during 2015 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2015, we received reimbursements from those reserves of approximately $6.4 million for capital expenditures related to those properties for periods ending on or before December 31, 2015 and we received net proceeds of approximately $2.4 million from the sale of a 0.3-acre parcel of excess land located adjacent to our property in Atlanta, Georgia and related development rights.\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2015 was approximately $24.6 million. This inflow was principally from proceeds from the sale of common stock of approximately $23.3 million and net mortgage proceeds of approximately $6.8 million, offset by dividend and distribution payments of approximately $4.1 million and payments of deferred financing costs of approximately $1.4 million.\nOn October 20, 2015, we secured $2.0 million of additional proceeds on the mortgage loan on the DoubleTree by Hilton Jacksonville Riverfront as part of an earn-out pursuant to the terms of the loan agreement.\nOn September 28, 2015, we entered into a loan agreement to secure a $60.0 million mortgage on the Crowne Plaza Hollywood Beach Resort with Bank of America, N.A.\n47\nOn July 17, 2015, the Company sold 435,000 shares of common stock for net proceeds of approximately $2.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\nOn July 7, 2015, we entered into a loan agreement and other loan documents to secure an $18.5 million mortgage with Bank of the Ozarks collateralized by a first mortgage on the DoubleTree by Hilton Jacksonville Riverfront. The $18.5 million mortgage was received in two parts. We received $18.0 million on July 7, 2015 and the remainder of $0.5 million on October 20, 2015. The $0.5 million was included with the additional earn-out provision of $1.5 million, for a total of $2.0 million additional proceeds.\nOn July 1, 2015, the Company sold 3,000,000 shares of common stock, for net proceeds of approximately $19.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\nDuring June 2015, the Company sold 98,682 shares of common stock for net proceeds of approximately $0.7 million, which it contributed to the Operating Partnership for an equivalent number of units.\nOn May 5, 2015, the Company obtained a $47.0 million mortgage with Bank of America, N.A. on the Georgian Terrace in Atlanta, Georgia.\nCapital Expenditures\nWe anticipate that our need for recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment over the next 12 to 24 months will be at historical norms for our properties and the industry. Historically, we have aimed to maintain overall capital expenditures, except for those required by our franchisors as a condition to a franchise license or license renewal, at 4.0% of gross revenue. In addition, during fiscal years 2017 and 2018 we expect total renovation capital expenditures of approximately $23.5 million related to our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida.\nGiven our desire to proceed with the renovation activities at our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida, we aim to restrict all other capital expenditures to the replacement of broken or damaged furniture and equipment and the acquisition of items mandated by our licensors that are necessary to maintain our brand affiliations. We anticipate that capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment that are not related to these renovation activities to total 3.50% of gross revenues in 2017.\nWe expect capital expenditures for the recurring replacement or refurbishment of furniture, fixtures and equipment at our properties will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors. Reserve accounts are escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures with respect to all of our hotels. We currently deposit an amount equal to 4.0% of gross revenue for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside, the Crowne Plaza Hollywood Beach Resort, The DoubleTree by Hilton Jacksonville Riverside, the DoubleTree by Hilton Raleigh Brownstone-University, the Whitehall and the Georgian Terrace as well as 4.0% of room revenues for the DoubleTree by Hilton Philadelphia Airport on a monthly basis.\nLiquidity and Capital Resources\nAs of December 31, 2016, we had cash and cash equivalents of approximately $36.4 million, of which approximately $4.6 million was in restricted reserve accounts for capital improvements, real estate tax and insurance escrows. We expect that our cash on hand combined with our cash flow from our hotels should be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment, and monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of the indentures or mortgage debt).\nWe intend to continue to invest in hotel properties as suitable opportunities arise. The success of our acquisition strategy depends, in part, on our ability to access additional capital through other sources. There can be no assurance that we will continue to make investments in properties that meet our investment criteria. Additionally, we may choose to dispose of certain hotels as a means to provide liquidity.\nWe expect to meet our liquidity requirements for hotel property acquisitions, property redevelopment, investments in new joint ventures and debt maturities, which include the repayment of the 7% Notes (which are callable after November 15, 2017) and the retirement of maturing mortgage debt, through net proceeds from additional issuances of common shares, additional issuances of preferred shares, issuances of units of limited partnership interest in our Operating Partnership, secured and unsecured borrowings, the selective disposition of non-core assets, and cash on hand. We remain committed to a flexible capital structure and strive to maintain prudent debt leverage.\n48\nWe do not have any debt obligations maturing until August 2018. In August 2018, the approximate $14.5 mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures. We have approximately $87.6 million in debt obligations maturing in 2019, including $25.3 million of the Operating Partnership’s 7% Notes and approximately $62.3 million in mortgage debt, including reductions for future monthly principal payments on the mortgages.\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company. The loan has a maturity date of July 1, 2026.\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank. The loan has an initial term of three years with a maturity on July 1, 2019, and may be extended for two additional periods of one year each, subject to certain conditions.\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan: provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions, has a term of five years, bears a floating interest rate of the one month LIBOR plus 3.5%, subject to a floor rate of 4.0%, amortizes on an 18-year schedule after a 2-year interest only period, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP.\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan: provides proceeds of $12.0 million, has a maturity date of December 1, 2026, bears a fixed interest rate of 4.27% for the first 5 years of the loan with an option for the lender to reset that rate after 5 years, amortizes on a 25-year schedule, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP at 50% of the unpaid principal balance, interest, and other amounts owed.\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan: provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; has a term of 10 years; bears a fixed interest rate of 4.25%; amortizes on a 25-year schedule after a 1-year interest-only period and is subject to a prepayment premium.\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for approximately $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\nFinancial Covenants\nMortgage Loans\nOur mortgage loan agreements contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\n49\nIf we violate the financial covenants contained in these agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through additional debt financing, private or public offerings of debt securities, or additional equity financing.\nUnder the terms of our non-recourse secured mortgage loan agreements, failure to comply with the financial covenants in the loan agreement triggers cash flows from the property to be directed to the lender, which may limit our overall liquidity as that cash flow would not be available to us.\nAt December 31, 2016, we were in compliance with all debt covenants, current on all loan payments and not otherwise in default under any of our mortgage loans.\nUnsecured Notes\nThe indenture for the 7% Notes contains certain covenants and restrictions that require us to meet certain financial ratios. We are not permitted to incur any Debt (other than intercompany Debt), as defined in the indenture, if, immediately after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, the ratio of the aggregate principal amount of all outstanding Debt to Adjusted Total Asset Value, as defined in the indenture, would be greater than 0.65 to 1.0. In addition, we are not permitted to incur any Debt if the ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense, both as defined in the indenture, on the date on which such additional Debt is to be incurred, on a pro-forma basis, after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, would be less than 1.50 to 1.0.\n50\nThese financial measures are not calculated in accordance with GAAP and are presented below for the sole purpose of evaluating our compliance with the key financial covenants as they were or would have been applicable at December 31, 2016 and December 31, 2015, respectively.\n\n| December 31, | December 31, |\n| 2016 | 2015 |\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense |\n| Net income(1) | $ | 900,149 | $ | 6,397,653 |\n| Interest expense(1) | 17,735,107 | 16,515,827 |\n| Loss on early debt extinguishment | 1,417,905 | 772,907 |\n| Unrealized loss on hedging activities | 37,384 | 108,819 |\n| Gain on change in control | — | (6,603,148 | ) |\n| Loss (Gain) on disposal of assets | 365,319 | (41,435 | ) |\n| Income tax benefit(1) | (1,367,634 | ) | (1,336,033 | ) |\n| Equity in income of joint venture(1) | — | (475,514 | ) |\n| Impairment of investment in hotel properties, net(1) | — | 500,000 |\n| Depreciation and amortization(1) | 15,019,071 | 13,591,495 |\n| Corporate general and administrative expenses(1) | 6,021,065 | 7,268,256 |\n| Consolidated income available for debt service(1) | 40,128,366 | 36,698,827 |\n| Less: income of non-stabilized assets(1) | (10,203,893 | ) | (16,284,975 | ) |\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\n| Interest expense(1) (2) | $ | 18,011,107 | $ | 16,515,827 |\n| Amortization of issuance costs(1) | (1,147,864 | ) | (1,300,032 | ) |\n| Consolidated interest expense(1) | 16,863,243 | 15,215,795 |\n| Less: interest expense of non-stabilized assets(1) | (3,417,412 | ) | (5,295,224 | ) |\n| Stabilized Consolidated Interest Expense(1) | $ | 13,445,831 | $ | 9,920,571 |\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense | 2.23 | 2.06 |\n| Threshold Ratio Minimum | 1.50 | 1.50 |\n| Ratio of Debt to Adjusted Total Asset Value: |\n| Mortgage loans | $ | 284,757,698 | $ | 271,977,944 |\n| Unsecured notes | 25,300,000 | 52,900,000 |\n| Total debt | $ | 310,057,698 | $ | 324,877,944 |\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\n| Capitalization rate | 7.5 | % | 7.5 | % |\n| 398,992,973 | 272,184,693 |\n| Non-stabilized assets | 145,400,000 | 305,255,698 |\n| Total cash | 36,362,920 | 17,287,754 |\n| Adjusted Total Asset Value | $ | 580,755,893 | $ | 594,728,145 |\n| Ratio of Debt to Adjusted Total Asset Value | 0.53 | 0.55 |\n| Threshold Ratio Maximum | 0.65 | 0.65 |\n\n\n| (1) | As permitted by the indenture, the Hilton Savannah DeSoto, DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and The Whitehall, for the period ended December 31, 2016, and the DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and Crowne Plaza Hollywood Beach Resort, for the period ended December 31, 2015, are considered non-stabilized assets for purposes of the financial covenants. |\n\n| (2) | Includes losses on debt extinguishment paid for in cash of $276,000 in fiscal year 2016. |\n\n51\nMortgage Debt\nAs of December 31, 2016, we had a principal mortgage debt balance of approximately $284.5 million. The following table sets forth our mortgage debt obligations on our hotels.\n\n| December 31, | Prepayment | Maturity | Amortization |\n| Property | 2016 | Penalties | Date | Provisions | Interest Rate |\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | None | 11/1/2019 | $ | 3 years | 5.00% |\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | N/A | 10/1/2025 | 30 years | 4.913% |\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | Yes | 8/5/2021 | 25 years | 5.25% |\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | N/A | 8/1/2018 | 30 years | 4.78% |\n| The Georgian Terrace (8) | 45,826,038 | N/A | 6/1/2025 | 30 years | 4.42% |\n| Hilton Savannah DeSoto (9) | 30,000,000 | Yes | 7/1/2026 | 25 years | 4.25% |\n| Hilton Wilmington Riverside (10) | 30,000,000 | Yes | 1/1/2027 | 25 years | 4.25% |\n| Sheraton Louisville Riverside (11) | 11,977,557 | Yes | 12/1/2026 | 25 years | 4.27% |\n| The Whitehall (12) | 15,000,000 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\n| Total Mortgage Principal Balance | 284,542,043 |\n| Deferred financing costs, net | (2,049,409) |\n| Unamortized premium on loan | 215,655 |\n| Total Mortgage Loans | $ | 282,708,289 |\n\n\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\n\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\n\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\n\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\n\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\n\n| (6) | The note bears a minimum interest rate of 3.50%. |\n\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\n\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\n\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project. The note amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\n\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0%; and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\n\n52\nContractual Obligations\nThe following table outlines our contractual obligations as of December 31, 2016, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands).\n\n| Payments due by period (in thousands) |\n| Less than | More than |\n| Contractual Obligations | Total | 1 year | 1-3 years | 3-5 years | 5 years |\n| Mortgage loans, including interest | $ | 355,927 | $ | 18,895 | $ | 119,609 | $ | 55,911 | $ | 161,512 |\n| Unsecured notes, including interest | 30,416 | 1,771 | 28,645 | — | — |\n| Ground, building, office and equipment leases | 1,137 | 224 | 276 | 191 | 446 |\n| Purchase commitment | 4,250 | 4,250 | — | — | — |\n| Totals | $ | 391,730 | $ | 25,140 | $ | 148,530 | $ | 56,102 | $ | 161,958 |\n\nIn connection with the acquisition of our six initial hotel properties, we entered into tax indemnity agreements that required us to indemnify the contributors of our initial properties against tax liabilities in the event we sold any of those properties in a taxable transaction during a 10-year period. The tax indemnity agreements expired on or about December 22, 2014. Our obligations under the contribution agreements may effectively preclude us from reducing our consolidated indebtedness below approximately $11.0 million.\nOff Balance Sheet Arrangements. Through a joint venture with a Carlyle subsidiary, we owned a 25.0% indirect, noncontrolling interest in an entity (the “JV Owner”) that acquired the 311-room Crowne Plaza Hollywood Beach Resort in Hollywood, Florida. We had the right to receive a pro rata share of operating surpluses and we had an obligation to fund our pro rata share of operating shortfalls. We also had the opportunity to earn an incentive participation in the net proceeds realized from the sale of the hotel based upon the achievement of certain overall investment returns, in addition to our pro rata share of net sale proceeds. The Crowne Plaza Hollywood Beach Resort was leased to another entity (the “Joint Venture Lessee”) in which we also owned a 25.0% indirect, noncontrolling interest.\nCarlyle owned a 75.0% controlling interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Carlyle had the right to dispose of the Crowne Plaza Hollywood Beach Resort without our consent. We accounted for our noncontrolling 25.0% interest in all of these entities under the equity method of accounting.\nOn July 31, 2015, indirect subsidiaries of the Operating Partnership acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. The property was refinanced on September 28, 2015 and is encumbered by a $60.0 million mortgage which matures in September 2025 and requires monthly payments of interest at a rate of 4.913%. The Crowne Plaza Hollywood Beach Resort secures the mortgage.\nDistributions to Stockholders and Holders of Units in the Operating Partnership. The Company has elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, the Company is required to make annual distributions to its stockholders of at least 90.0% of our REIT taxable income, (excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). The Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\nDistributions to Preferred Stockholders and Holder of Preferred partnership units in the Operating Partnership. The Company is obligated to pay distributions to its preferred stockholders of the Company’s preferred stock and the Operating Partnership is obligated to pay its preferred unit holder, the Company. Holders of the Company’s 8% Series B Cumulative Redeemable Preferred Stock are entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions. The amount of annual dividends on our outstanding preferred shares is approximately $3.2 million and the aggregate liquidation preference with respect to our outstanding preferred shares is approximately $40.3 million. The preferred stock is not redeemable by the holders, has no maturity date and is not convertible into any other security of the Company or its affiliates, except in the event of a change of control.\n53\nThe Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\nThe amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by the Company based upon a variety of factors deemed relevant by its directors, and no assurance can be given that the distribution policy will not change in the future.\nInflation\nWe generate revenues primarily from lease payments from our TRS Lessees and net income from the operations of our TRS Lessees. Therefore, we rely primarily on the performance of the individual properties and the ability of the management company to increase revenues and to keep pace with inflation. Operators of hotels, in general, possess the ability to adjust room rates daily to keep pace with inflation. However, competitive pressures at some or all of our hotels may limit the ability of the management company to raise room rates.\nOur expenses, including hotel operating expenses, administrative expenses, real estate taxes and property and casualty insurance are subject to inflation. These expenses are expected to grow with the general rate of inflation, except for energy, liability insurance, property and casualty insurance, property tax rates, employee benefits, and some wages, which are expected to increase at rates higher than inflation.\nGeographic Concentration and Seasonality\nOur hotels are located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, and Texas. As a result, we are particularly susceptible to adverse market conditions in these geographic areas, including industry downturns, relocation of businesses and any oversupply of hotel rooms or a reduction in lodging demand. Adverse economic developments in the markets in which we have a concentration of hotels, or in any of the other markets in which we operate, or any increase in hotel supply or decrease in lodging demand resulting from the local, regional or national business climate, could materially and adversely affect us.\nThe operations of our hotel properties have historically been seasonal. The months of April and May are traditionally strong, as is October. The periods from mid-November through mid-February are traditionally slow with the exception of hotels located in certain markets, namely Florida and Texas, which experience significant room demand during this period.\nCompetition\nThe hotel industry is highly competitive with various participants competing on the basis of price, level of service and geographic location. Each of our hotels is located in a developed area that includes other hotel properties. The number of competitive hotel properties in a particular area could have a material adverse effect on occupancy, ADR and RevPAR of our hotels or at hotel properties acquired in the future. We believe that brand recognition, location, the quality of the hotel, consistency of services provided, and price, are the principal competitive factors affecting our hotels.\nCritical Accounting Policies\nThe critical accounting policies are described below. We consider these policies critical because they involve difficult management judgments and assumptions, are subject to material change from external factors or are pervasive, and are significant to fully understand and evaluate our reported financial results.\nInvestment in Hotel Properties. Hotel properties are stated at cost, net of any impairment charges, and are depreciated using the straight-line method over an estimated useful life of 7-39 years for buildings and improvements and 3-10 years for furniture and equipment. In accordance with generally accepted accounting principles, the controlling interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and noncontrolling interests held by the controlling holders of our accounting predecessor in hotels, which were acquired from third parties contributed to us in connection with the Company’s initial public offering, are recorded at historical cost basis. Noncontrolling interests in those entities that comprise our accounting predecessor and the interests in hotels, other than those held by the controlling members of our accounting predecessor, acquired from third parties are recorded at fair value at the time of acquisition.\n54\nWe review our hotel properties for impairment whenever events or changes in circumstances indicate the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause us to perform our review include, but are not limited to, adverse permanent changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs a recoverability analysis to determine if the estimated undiscounted future cash flows from operating activities and the estimated proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are found to be less than the carrying amount of the hotel property, an adjustment to reduce the carrying value to the related hotel property’s estimated fair market value would be recorded and an impairment loss recognized.\nOur review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which resulted in an impairment to fair market value by an approximate amounts of $0.5 million and $3.2 million, as of December 31, 2015 and 2014, respectively.\nIn performing the recoverability analysis, we project future operating cash flows based upon significant assumptions regarding growth rates, occupancy, room rates, economic trends, property-specific operating costs and future capital expenditures required to maintain the hotel in its current operating condition. We also project cash flows from the eventual disposition of the hotel based upon various factors including property-specific capitalization rates, ratio of selling price to gross hotel revenues and the selling price per room.\nRevenue Recognition. Hotel revenues, including room, food, beverage and other hotel revenues, are recognized as the related services are delivered. We generally consider accounts receivable to be fully collectible; accordingly, no allowance for doubtful accounts is required. If we determine that amounts are uncollectible, which would generally be the result of a customer’s bankruptcy or other economic downturn, such amounts will be charged against operations when that determination is made.\nIncome Taxes. We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS Lessee, we have not recorded a valuation allowance to reduce our net deferred tax asset as of December 31, 2016. We regularly evaluate the likelihood that our TRS Lessee will be able to realize its deferred tax assets and the continuing need for a valuation allowance. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. A number of factors played a critical role in this determination, including:\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\n\n| • | reasonable forecasts of future taxable income, and |\n\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\n\nShould unanticipated adverse financial trends occur, or other negative evidence develop, a valuation allowance may be necessary in the future against some or all of our deferred tax assets.\nRecent Accounting Pronouncements\nFor a summary of recently adopted and newly issued accounting pronouncements, please refer to the Recent Accounting Pronouncements section of Note 2, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.\nNon-GAAP Financial Measures\nWe consider FFO, Adjusted FFO and Hotel EBITDA, all of which are non-GAAP financial measures, to be key supplemental measures of our performance and could be considered along with, not alternatives to, net income (loss) as a measure of our performance. These measures do not represent cash generated from operating activities determined by generally accepted accounting principles (“GAAP”) or amounts available for our discretionary use and should not be considered alternative measures of net income, cash flows from operations or any other operating performance measure prescribed by GAAP.\nFFO and Adjusted FFO. Industry analysts and investors use Funds from Operations (“FFO”), as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization,\n55\nand after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by itself.\nWe consider FFO to be a useful measure of adjusted net income (loss) for reviewing comparative operating and financial performance because we believe FFO is most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.\nWe further adjust FFO for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, loan modification fees, franchise termination costs, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs. We exclude these items as we believe it allows for meaningful comparisons between periods and among other REITs and is more indicative than FFO of the on-going performance of our business and assets. Our calculation of Adjusted FFO may be different from similar measures calculated by other REITs.\nThe following is a reconciliation of net income (loss) to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, and 2014.\n\n| Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\n| Equity in Depreciation on Joint Venture | — | 259,279 | 529,053 |\n| Gain on Change in Control | — | (6,603,148 | ) | — |\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 |\n| Increase in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Acquisition Costs | — | 634,376 | 155,187 |\n| Loss on Starwood Settlement | — | 324,271 | — |\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — |\n| Loan Modification Fees | 64,215 | 243,229 | — |\n| Franchise Termination Fee | — | — | 351,800 |\n| Realized and Unrealized Loss on Hedging Activities (A) | 37,384 | 108,819 | — |\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 |\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 |\n\n\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\n\nHotel EBITDA. We define Hotel EBITDA as net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. We believe this provides a more\n56\ncomplete understanding of the operating results over which our wholly-owned hotels and its operators have direct control. We believe Hotel EBITDA provides investors with supplemental information on the on-going operational performance of our hotels and the effectiveness of third-party management companies operating our business on a property-level basis.\nOur calculation of Hotel EBITDA may be different from similar measures calculated by other REITs.\nThe following is a reconciliation of net loss to Hotel EBITDA for the years ended December 31, 2016, 2015, and 2014.\n\n| Year Ended | Year Ended | Year Ended |\n| December 31, | December 31, | December 31, |\n| 2016 | 2015 | 2014 |\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 |\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) |\n| Distributions to Preferred Stockholders | 1,144,889 | — | — |\n| Income Tax Benefit | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) |\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Equity in Earnings of Joint Venture | — | (475,514 | ) | (307,370 | ) |\n| Unrealized Loss on Hedging Activities | 37,384 | 108,819 | — |\n| Gain on Change in Control | — | (6,603,148 | ) | — |\n| Loss on Debt Extinguishment | 1,417,905 | 772,907 | 831,079 |\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 |\n| Net Lease Rental Income | — | — | (350,000 | ) |\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) |\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 |\n\n\nQuantitative and Qualitative Disclosures about Market Risk\nThe effects of potential changes in interest rates are discussed below. Our market risk discussion includes “forward-looking statements” and represents an estimate of possible changes in fair value or future earnings that could occur assuming hypothetical future movements in interest rates. These disclosures are not precise indicators of expected future losses, but only indicators of reasonably possible losses. As a result, actual future results may differ materially from those presented. The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market interest rates.\nTo meet in part our long-term liquidity requirements, we will borrow funds at a combination of fixed and variable rates. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. From time to time we may enter into interest rate hedge contracts such as collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not intend to hold or issue derivative contracts for trading or speculative purposes.\nAs of December 31, 2016, we had approximately $228.7 million of fixed-rate debt and approximately $81.1 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 4.84%. A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgages on the Crowne Plaza Tampa Westshore, DoubleTree by Hilton Philadelphia Airport, DoubleTree by Hilton Jacksonville Riverfront and the mortgage on The Whitehall remains at approximately $81.1 million, the balance at December 31, 2016, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR would be approximately $0.8 million.\nAs of December 31, 2015, we had approximately $272.6 million of fixed-rate debt and approximately $52.3 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 5.58%. A change in market interest rates on the fixed portion\n57\nof our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month and 3-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgage on the DoubleTree by Hilton Philadelphia Airport and the mortgage on the DoubleTree by Hilton Jacksonville Riverfront remains at approximately $52.2 million, the balance at December 31, 2015, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR and 3-month LIBOR would be approximately $0.5 million.\nFinancial Statements and Supplementary Data\nSee Index to Financial Statements and Financial Statement Schedules on page F-1.\nChanges in and Disagreements with Accountants on Accounting and Financial Disclosure\nNone.\nControls and Procedures\nSotherly Hotels Inc.\nDisclosure Controls and Procedures\nThe Company’s management, under the supervision and participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, its disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in its reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\nThe Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures or its internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels Inc. have been detected.\nManagement’s Report on Internal Control over Financial Reporting\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). The Company’s management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) 2013 Internal Control-Integrated Framework. The Company’s management has concluded that, as of December 31, 2016, its internal control over financial reporting is effective based on these criteria.\nThis annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\n58\nChanges in Internal Control over Financial Reporting\nThere was no change in Sotherly Hotels Inc.’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels Inc.’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels Inc.’s internal control over financial reporting.\nSotherly Hotels LP\nDisclosure Controls and Procedures\nThe Operating Partnership’s management, under the supervision and participation of the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, has evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, the disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in the reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\nThe Operating Partnership’s management, including the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, does not expect that the disclosure controls and procedures or the internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels LP have been detected.\nManagement’s Report on Internal Control over Financial Reporting\nThe Operating Partnership’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). Management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in 2013 Internal Control-Integrated Framework. Management has concluded that, as of December 31, 2016, the Operating Partnership’s internal control over financial reporting is effective based on these criteria.\nThis annual report does not include an attestation report of the Operating Partnership’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Operating Partnership’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\nChanges in Internal Control over Financial Reporting\nThere was no change in Sotherly Hotels LP’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels LP’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels LP’s internal control over financial reporting.\nOther Information\nNone.\n59\nPART III\nThe information required by Items 10-14 is incorporated by reference to the Company’s proxy statement for the 2017 annual meeting of stockholders (to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report).\nDirectors, Executive Officers and Corporate Governance\nThe Company has adopted a code of business conduct and ethics, including a conflicts of interest policy that applies to its principal executive officer, principal financial officer, principal accounting officer or controller performing similar functions. We intend to maintain the highest standards of ethical business practices and compliance with all laws and regulations applicable to our business. A copy of the Company’s Code of Business Conduct is posted on the Company’s external website at www.sotherlyhotels.com. The Company and the Operating Partnership intend to post to its website any amendments to or waivers of its code. The Operating Partnership is managed by the Company, its sole general partner and parent company. Consequently, the Operating Partnership does not have its own separate directors or executive officers.\nInformation on the Company’s directors is incorporated by reference to the sections captioned “Proposal I – Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Company’s 2017 Proxy Statement.\n. Executive Compensation\nThe information required by this item is incorporated by reference to the section captioned “Director and Executive Compensation” contained in the Company’s 2017 Proxy Statement.\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\n(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\n(b) SECURITY OWNERSHIP OF MANAGEMENT\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\n(c) CHANGES IN CONTROL\nManagement of the Company knows of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company.\n(d) SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS\nSet forth below is information as of December 31, 2016 with respect to compensation plans under which equity securities of the Company are authorized for issuance.\n60\nEQUITY COMPENSATION PLAN INFORMATION\n\n| NUMBER OF SECURITIES TO BE ISSUED UPON EXERCISE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | WEIGHTED-AVERAGE EXERCISE PRICE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | NUMBER OF SECURITIES REMAINING AVAILABLE FOR FUTURE ISSUANCE |\n| Equity compensation plans approved by security holders: |\n| 2013 Plan (1) | N/A | N/A | 640,900 |\n| Equity compensation plans not approved by security holders: |\n| None | N/A | N/A | N/A |\n| Total | N/A | N/A | 640,900 |\n\n\n| (1) | On February 2, 2016, we granted 8,000 shares of stock to Andrew M. Sims, 6,000 shares of stock to Anthony E. Domalski, 7,000 shares of stock to David R. Folsom, and 1,000 shares of stock to other employees of the Company. |\n\nOn February 2, 2016, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that vested on December 31, 2016. Also on February 2, 2016, we granted an additional 2,250 shares of unrestricted stock to director Herschel J. Walker in consideration for his service during 2015.\nOn February 15, 2017, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that will vest on December 31, 2017. These shares are included in the number of securities remaining available for future issuance at December 31, 2016.\nCertain Relationships and Related Transactions, and Director Independence\nThe information required by this item is incorporated by reference to the sections captioned “Certain Relationships and Related Transactions” and “Proposal I – Election of Directors” in the Company’s 2017 Proxy Statement.\nPrincipal Accountant Fees and Services\nThe information required by this item is incorporated by reference to the section captioned “Proposal II –Ratification of Appointment of Accountants” in the Company’s 2017 Proxy Statement.\n61\nPART IV\nExhibits and Financial Statement Schedules\n\n| 1. Financial Statements |\n| Index to Financial Statements and Financial Statement Schedules | F-1 |\n| Sotherly Hotels Inc. |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\n| Sotherly Hotels LP |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\n| Notes to Consolidated Financial Statements | F-14 |\n| 2. Financial Statement Schedules |\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\n\nAll other schedules for which provision is made in Regulation S-X are either not required to be included herein under the related instructions or are inapplicable or the related information is included in the footnotes to the applicable financial statement and, therefore, have been omitted.\nThe following exhibits are filed as part of this Form 10-K:\n\n| Exhibits |\n| 3.1 | Articles of Amendment and Restatement of the Company (incorporated by reference to the document previously filed as Exhibit 3.1 to the Company’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on October 20, 2004 (File No. 333-118873)). |\n| 3.1A | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.7 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\n| 3.1B | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of August 12, 2016 (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 15, 2016). |\n| 3.2 | Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 3.2A | Amendment No. 1 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.6 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\n\n62\n\n| Exhibits |\n| 3.2B | Amendment No. 2 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Operating Partnership’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on August 9, 2013 (File No. 333-189821)). |\n| 3.2C | Amendment No. 3 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 23, 2016). |\n| 3.3 | Articles Supplementary of Sotherly Hotels Inc. (incorporated by reference to the document previously filed as Exhibit 3.4 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\n| 3.4 | Second Amended and Restated Bylaws of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.8 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\n| 3.5 | Articles Supplementary designating the Series B Preferred Stock of the Company, effective as of August 19, 2016 (incorporated by reference to the document previously filed as Exhibit 3.5 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\n| 4.0 | Form of Common Stock Certificate. |\n| 4.1 | Senior Unsecured Note issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.6 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\n| 4.2 | Indenture by and among Sotherly Hotels LP and Wilmington Trust, National Association, as trustee (incorporated by reference to the document previously filed as Exhibit 4.7 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\n| 4.3 | Indenture by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.8 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\n| 4.4 | First Supplemental Indenture, by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.9 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\n| 4.5 | 7.00% Senior Unsecured Note due 2019, issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.10 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, filed with the Securities and Exchange Commission on April 14, 2015). |\n| 4.6 | Form of Specimen Certificate of Series B Preferred Stock of the Company (incorporated by reference to the document previously filed as Exhibit 4.1 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\n| 10.1 | Sotherly Hotels Inc. 2004 Long-Term Incentive Plan (incorporated by reference to the document previously filed as Exhibit 10.1 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). * |\n| 10.1A | Form of Restricted Stock Award Agreement between Sotherly Hotels Inc. and Participant (incorporated by reference to the document previously filed as Exhibit 10.1A to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008, filed with the Securities and Exchange Commission on March 25, 2009). * |\n| 10.2 | Executive Employment Agreement between Sotherly Hotels Inc. and Andrew M. Sims, dated January 12, 2015 (incorporated by reference to the document previously filed as Exhibit 10.2A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 13, 2015). * |\n| 10.3 | Executive Employment Agreement between Sotherly Hotels Inc. and Anthony E. Domalski (incorporated by reference to the document previously filed as Exhibit 10.2A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on January 3, 2013). * |\n\n63\n\n| Exhibits |\n| 10.4 | Contribution Agreement dated August 23, 2004 by and between the owners of Capitol Hotel Associates L.P., L.L.P. and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.6 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\n| 10.5 | Contribution Agreement dated August 23, 2004 by and between the owners of Savannah Hotel Associates LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.7 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\n| 10.6 | Contribution Agreement dated August 23, 2004 by and between KDCA Partnership, MAVAS LLC, and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.8 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.7 | Contribution Agreement dated September 8, 2004 by and between Elpizo Limited Partnership, Phileo Land Corporation and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.9 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.8 | Asset Purchase Agreement dated August 19, 2004 by and between Accord LLC, West Laurel Corporation and MHI Hotels Services, LLC (incorporated by reference to the document previously filed as Exhibit 10.10 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\n| 10.9 | Agreement to Assign and Sublease Common Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels, LLC (incorporated by reference to the document previously filed as Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.10 | Agreement to Assign and Sublease Commercial Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.11 | Lease Agreement by and between Philadelphia Hotel Associates, LP and MHI Hospitality TRS, LLC (with a schedule of eight additional agreements that are substantially identical in all material respects to the Lease agreement, except as identified in such schedule, and are not being filed herewith per Instruction 2 to Item 601 of Regulation S-K (incorporated by reference to the document previously filed as Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.12 | Management Restructuring Agreement by and between MHI Hospitality TRS, LLC, MHI Hotels Services, LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.14 to the Company’s Pre-Effective Amendment No. 3 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on November 15, 2004 (File No. 333-118873)). |\n| 10.13 | Contribution Agreement by and between MHI Hotels Services, LLC, MHI Hotels, LLC and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.15 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\n| 10.14 | Executive Employment Agreement, dated as of January 1, 2016, between Sotherly Hotels Inc. and David R. Folsom (incorporated by reference to the document previously filed as Exhibit 10.20A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 4, 2016). * |\n| 10.15 | Promissory Note dated March 29, 2007, made by Capitol Hotel Associates, L.P., L.L.P. and MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.25 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 2, 2007). |\n| Exhibits |\n| 10.16 | Limited Liability Company Agreement of MHI/Carlyle Hotel Investment Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\n| 10.17 | Limited Liability Company Agreement of MHI/Carlyle Hotel Lessee Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26B to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\n| 10.18 | Promissory Note dated August 2, 2007 made by Savannah Hotel Associates L.L.C., to the order of MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.29 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 3, 2007). |\n| 10.19 | Sotherly Hotels Inc. 2013 Long-Term Incentive Plan (incorporated by reference to Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 20, 2013). * |\n| 10.20 | Sales Agency Agreement, dated July 9, 2014, among Sotherly Hotels Inc., Sotherly Hotels LP and Sandler O’Neill & Partners, L.P. (incorporated by reference to the document previously filed as Exhibit 10.51 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on July 9, 2014). |\n| 10.21 | Master Agreement by and among Sotherly Hotels Inc., Sotherly Hotels LP, MHI Hospitality TRS, LLC and MHI Hotels Services LLC (incorporated by reference to the document previously filed as Exhibit 10.52 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 19, 2014). |\n| 10.22 | Purchase and Sale Agreement by and between MHI Hospitality TRS II, LLC, MHI Hotel Investments Holdings LLC and CRP/MHI Holdings, L.L.C., dated as of June 19, 2015 (incorporated by reference to the document previously filed as Exhibit 10.53 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on June 22, 2015). |\n| 10.23 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of April 29, 2016 (incorporated by reference to the document previously filed as Exhibit 10.54 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\n| 10.24 | Amendment to the Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of June 10, 2016 (incorporated by reference to the document previously filed as Exhibit 10.55 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\n| 10.25 | Commercial Unit Purchase Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.56 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\n| 10.26 | Addendum to Commercial Unit Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.57 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\n| 10.27 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of October 6, 2016 (incorporated by reference to the document previously filed as Exhibit 10.58 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\n| 10.28 | Amendment to Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of February 7, 2017 (incorporated by reference to the document previously filed as Exhibit 10.59 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\n| 16.1 | Letter from Grant Thornton LLP, dated April 6, 2016 (incorporated by reference to the document previously filed as Exhibit 16.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on April 6, 2016). |\n| 21.1 | List of Subsidiaries of Sotherly Hotels Inc. |\n| 21.2 | List of Subsidiaries of Sotherly Hotels LP. |\n| Exhibits |\n| 23.1 | Consent of Dixon Hughes Goodman LLP. |\n| 23.2 | Consent of Grant Thornton LLP. |\n| 23.3 | Consent of Dixon Hughes Goodman LLP. |\n| 23.4 | Consent of Grant Thornton LLP. |\n| 31.1 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.3 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.4 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.3 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 32.4 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS | XBRL Instance Document |\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\n| * | Denotes management contract and/or compensatory plan/arrangement. |\n| SOTHERLY HOTELS INC. |\n| By: | /s/ ANDREW M. SIMS |\n| Andrew M. Sims Chief Executive Officer |\n| Signature | Title | Date |\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors | March 22, 2017 |\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director | March 22, 2017 |\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer | March 22, 2017 |\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director | March 22, 2017 |\n| /s/ DAVID J. BEATTY David J. Beatty | Director | March 22, 2017 |\n| /s/ EDWARD S. STEIN Edward S. Stein | Director | March 22, 2017 |\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director | March 22, 2017 |\n| SOTHERLY HOTELS LP, |\n| by its General Partner, |\n| SOTHERLY HOTELS INC. |\n| By: | /s/ ANDREW M. SIMS |\n| Andrew M. Sims Chief Executive Officer |\n| Signature | Title | Date |\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors of the General Partner | March 22, 2017 |\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director of the General Partner | March 22, 2017 |\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer of the General Partner | March 22, 2017 |\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director of the General Partner | March 22, 2017 |\n| /s/ DAVID J. BEATTY David J. Beatty | Director of the General Partner | March 22, 2017 |\n| /s/ EDWARD S. STEIN Edward S. Stein | Director of the General Partner | March 22, 2017 |\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director of the General Partner | March 22, 2017 |\n| Sotherly Hotels Inc. |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\n| Sotherly Hotels LP |\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\n| Notes to Consolidated Financial Statements | F-14 |\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\n| Investment in hotel properties held for sale, net | 5,333,000 | — |\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\n| Restricted cash | 4,596,145 | 5,793,840 |\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\n| Accounts receivable-affiliate | 4,175 | 226,552 |\n| Loan proceeds receivable | — | 2,600,711 |\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\n| Deferred income taxes | 6,949,340 | 5,390,374 |\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\n| LIABILITIES |\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\n| Accounts payable and accrued expenses | 12,970,960 | 12,334,878 |\n| Advance deposits | 2,315,787 | 1,651,840 |\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\n| Commitments and contingencies (See Note 6) | — | — |\n| EQUITY |\n| Sotherly Hotels Inc. stockholders’ equity |\n| 8% Series B Cumulative Redeemable Perpetual Preferred stock, par value $0.01, 11,000,000 shares authorized, liquidation preference $25 per share, 1,610,000 shares and 0 shares issued and outstanding at December 31, 2016 and 2015, respectively | 16,100 | — |\n| Common stock, par value $0.01, 49,000,000 shares authorized, 14,468,551 shares and 14,490,714 shares issued and outstanding at December 31, 2016 and 2015, respectively | 144,685 | 144,907 |\n| Additional paid in capital | 118,395,082 | 82,749,058 |\n| Distributions in excess of retained earnings | (39,545,754 | ) | (33,890,834 | ) |\n| Total Sotherly Hotels Inc. stockholders’ equity | 79,010,113 | 49,003,131 |\n| Noncontrolling interest | 2,329,175 | 3,855,237 |\n| TOTAL EQUITY | 81,339,288 | 52,858,368 |\n| TOTAL LIABILITIES AND EQUITY | $ | 406,019,564 | $ | 388,972,239 |\n| 2016 | 2015 | 2014 |\n| REVENUE |\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\n| EXPENSES |\n| Hotel operating expenses |\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\n| Other income (expense) |\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\n| Interest income | 115,785 | 50,461 | 19,865 |\n| Equity income in joint venture | — | 475,514 | 307,370 |\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\n| Gain on change in control | — | 6,603,148 | — |\n| Gain on involuntary conversion of asset | — | — | 169,151 |\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\n| Less: Net (income)/loss attributable to the noncontrolling interest | 26,567 | (1,040,987 | ) | 153,838 |\n| Net income/(loss) attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) |\n| Distributions to preferred stockholders | (1,144,889 | ) | — | — |\n| Net income/(loss) attributable to common stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Net income/(loss) per share attributable to the common stockholders |\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Weighted average number of common shares outstanding |\n| Basic and diluted | 14,896,994 | 12,541,117 | 10,377,125 |\n| Additional | Distributions |\n| Preferred Stock | Common Stock | Paid- | in Excess of | Noncontrolling |\n| Shares | Par Value | Shares | Par Value | In Capital | Retained Earnings | Interest | Total |\n| Balances at December 31, 2013 | — | $ | — | 10,206,927 | $ | 102,069 | $ | 57,534,113 | $ | (32,450,773 | ) | $ | 5,669,386 | $ | 30,854,795 |\n| Net loss | — | — | — | — | — | (584,671 | ) | (153,838 | ) | (738,509 | ) |\n| Conversion of units in Operating Partnership to shares of common stock | — | — | 310,000 | 3,100 | 755,750 | — | (758,850 | ) | — |\n| Redemption of units in Operating Partnership | — | — | — | — | — | — | (25,621 | ) | (25,621 | ) |\n| Issuance of unrestricted common stock awards | — | — | 24,750 | 248 | 147,112 | — | — | 147,360 |\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 78,165 | — | — | 78,285 |\n| Issuance of common stock through ATM offering, net | — | — | 17,255 | 172 | 124,739 | — | — | 124,911 |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Dividends and distributions declared | — | — | — | — | (2,352,869 | ) | (598,415 | ) | (2,951,284 | ) |\n| Balances at December 31, 2014 | — | $ | — | 10,570,932 | $ | 105,709 | $ | 58,659,799 | $ | (35,388,313 | ) | $ | 4,132,662 | $ | 27,509,857 |\n| Net income | — | — | — | — | — | 5,356,666 | 1,040,987 | 6,397,653 |\n| Issuance of unrestricted common stock awards | — | — | 26,350 | 264 | 193,936 | — | — | 194,200 |\n| Issuance of restricted common stock awards | — | — | 9,750 | 98 | 71,760 | — | — | 71,858 |\n| Issuance of common stock from ATM sales | — | — | 98,682 | 986 | 681,222 | — | — | 682,208 |\n| Issuance of common stock from equity offering | — | — | 3,435,000 | 34,350 | 22,534,259 | — | — | 22,568,609 |\n| Conversion of Operating Partnership units into shares of common stock | — | — | 350,000 | 3,500 | 588,162 | — | (591,662 | ) | — |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Dividends and distributions declared | — | — | — | — | — | (3,859,187 | ) | (726,750 | ) | (4,585,937 | ) |\n| Balances at December 31, 2015 | — | $ | — | 14,490,714 | $ | 144,907 | $ | 82,749,058 | $ | (33,890,834 | ) | $ | 3,855,237 | $ | 52,858,368 |\n| Net income (loss) | — | — | — | — | — | 926,716 | (26,567 | ) | 900,149 |\n| Issuance of Series B Preferred Stock | 1,610,000 | 16,100 | — | — | 37,750,431 | — | — | 37,766,531 |\n| Issuance of unrestricted common stock awards | — | — | 24,250 | 242 | 128,040 | — | — | 128,282 |\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 63,360 | — | — | 63,480 |\n| Repurchase of common stock | — | — | (481,100 | ) | (4,811 | ) | (3,159,725 | ) | — | — | (3,164,536 | ) |\n| Conversion of Operating Partnership units into shares of common stock | — | — | 422,687 | 4,227 | 843,998 | — | (848,225 | ) | — |\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\n| Preferred stock dividends declared | — | — | — | — | — | (1,144,889 | ) | — | (1,144,889 | ) |\n| Common stockholders' dividends and distributions declared | — | — | — | — | — | (5,436,747 | ) | (651,270 | ) | (6,088,017 | ) |\n| Balances at December 31, 2016 | 1,610,000 | $ | 16,100 | 14,468,551 | $ | 144,685 | $ | 118,395,082 | $ | (39,545,754 | ) | $ | 2,329,175 | $ | 81,339,288 |\n| 2016 | 2015 | 2014 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Gain on change in control | — | (6,603,148 | ) | — |\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\n| Changes in assets and liabilities: |\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\n| Advance deposits | 663,947 | 431,111 | 89,099 |\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\n| Cash flows from investing activities: |\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\n| Payments on involuntary insurance conversions | — | — | — |\n| Distributions from joint venture | — | 600,000 | 750,000 |\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\n| Proceeds from the sale of assets | 213,400 | 2,402,113 | — |\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\n| Cash flows from financing activities: |\n| Proceeds of unsecured debt | — | — | 25,300,000 |\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\n| Proceeds from loans | — | — | 19,000,000 |\n| Proceeds from sale of common stock, net | — | 23,250,818 | 124,911 |\n| Proceeds from sale of preferred stock, net | 37,766,531 | — | — |\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\n| Redemption of unsecured notes | (27,600,000 | ) | — | — |\n| Repurchase of common stock | (2,061,407 | ) | — | — |\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\n| Dividends and distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\n| Preferred dividends paid | (339,889 | ) | — | — |\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\n| Supplemental disclosures: |\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\n| Non-cash investing and financing activities: |\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\n| December 31, 2016 | December 31, 2015 |\n| ASSETS |\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\n| Investment in hotel property held for sale, net | 5,333,000 | — |\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\n| Restricted cash | 4,596,145 | 5,793,840 |\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\n| Accounts receivable-affiliate | 4,175 | 226,552 |\n| Loan proceeds receivable | — | 2,600,711 |\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\n| Deferred income taxes | 6,949,340 | 5,390,374 |\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\n| LIABILITIES |\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\n| Accounts payable and other accrued liabilities | 12,970,960 | 12,334,878 |\n| Advance deposits | 2,315,787 | 1,651,840 |\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\n| Commitments and contingencies (see Note 6) | — | — |\n| PARTNERS’ CAPITAL |\n| 8% Series B Cumulative Redeemable Perpetual Preferred partnership units, liquidation preference $25 per unit, 1,610,000 units and 0 units issued and outstanding at December 31, 2016 and 2015, respectively | 37,766,531 | — |\n| General Partner: 162,467 units and 166,915 units issued and outstanding as of December 31, 2016 and 2015, respectively | 681,389 | 774,295 |\n| Limited Partners: 16,084,224 units and 16,524,626 units issued and outstanding as of December 31, 2016 and 2015, respectively | 42,891,368 | 52,084,073 |\n| TOTAL PARTNERS’ CAPITAL | 81,339,288 | 52,858,368 |\n| TOTAL LIABILITIES AND PARTNERS’ CAPITAL | $ | 406,019,564 | $ | 388,972,239 |\n| 2016 | 2015 | 2014 |\n| REVENUE |\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\n| EXPENSES |\n| Hotel operating expenses |\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\n| Loss on disposal of assets | 365,319 | (41,435 | ) | — |\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\n| Other income (expense) |\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\n| Interest income | 115,785 | 50,461 | 19,865 |\n| Equity income in joint venture | — | 475,514 | 307,370 |\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\n| Gain on change in control | — | 6,603,148 | — |\n| Gain on involuntary conversion of asset | — | — | 169,151 |\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\n| Distributions to preferred unit holders | (1,144,889 | ) | — | — |\n| Net income/(loss) attributable to operating partnership unit holders | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\n| Net income/(loss) attributable per operating partner unit |\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Weighted average number of operating partner units outstanding |\n| Basic and diluted | 16,710,935 | 14,924,410 | 13,107,413 |\n| Preferred Units | General Partner | Limited Partner |\n| Units | Amount | Units | Amount | Units | Amounts | Total |\n| Balances at December 31, 2013 | — | $ | — | 130,711 | $ | 554,316 | 12,940,343 | $ | 30,300,479 | $ | 30,854,795 |\n| Issuance of partnership units | — | — | 540 | 3,534 | 53,465 | 347,022 | 350,556 |\n| Amortization of restricted units award | — | — | — | 199 | — | 19,721 | 19,920 |\n| Distributions declared | — | — | — | (29,644 | ) | — | (2,921,640 | ) | (2,951,284 | ) |\n| Redemption of limited partnership units | — | — | (33 | ) | (228 | ) | (3,267 | ) | (25,393 | ) | (25,621 | ) |\n| Net loss | — | — | — | (7,386 | ) | — | (731,123 | ) | (738,509 | ) |\n| Balances at December 31, 2014 | — | $ | — | 131,218 | $ | 520,791 | 12,990,541 | $ | 26,989,066 | $ | 27,509,857 |\n| Issuance of partnership units | — | — | 35,697 | 235,237 | 3,534,085 | 23,281,638 | 23,516,875 |\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\n| Distributions declared | — | — | — | (45,859 | ) | — | (4,540,078 | ) | (4,585,937 | ) |\n| Net income | — | — | — | 63,977 | — | 6,333,676 | 6,397,653 |\n| Balances at December 31, 2015 | — | $ | — | 166,915 | $ | 774,295 | 16,524,626 | $ | 52,084,073 | $ | 52,858,368 |\n| Issuance of common partnership units | — | — | 363 | 1,918 | 35,887 | 189,844 | 191,762 |\n| Issuance of preferred partnership units | 1,610,000 | 37,766,531 | — | — | — | — | 37,766,531 |\n| Repurchased common units | — | — | (4,811 | ) | (31,645 | ) | (476,289 | ) | (3,132,891 | ) | (3,164,536 | ) |\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\n| Preferred partnership units distributions declared | — | (1,144,889 | ) | — | — | — | — | (1,144,889 | ) |\n| Partnership units distributions declared | — | — | — | (60,880 | ) | — | (6,027,137 | ) | (6,088,017 | ) |\n| Net income | — | 1,144,889 | — | (2,447 | ) | — | (242,293 | ) | 900,149 |\n| Balances at December 31, 2016 | 1,610,000 | $ | 37,766,531 | 162,467 | $ | 681,389 | 16,084,224 | $ | 42,891,368 | $ | 81,339,288 |\n| 2016 | 2015 | 2014 |\n| Cash flows from operating activities: |\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\n| Gain on change in control | — | (6,603,148 | ) | — |\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\n| Changes in assets and liabilities: |\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\n| Advance deposits | 663,947 | 431,111 | 89,099 |\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\n| Cash flows from investing activities: |\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\n| Payments on involuntary insurance conversions | — | — | — |\n| Distributions from joint venture | — | 600,000 | 750,000 |\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\n| Proceeds from the sale of assets | 213,400 | 2,402,113 |\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\n| Cash flows from financing activities: |\n| Proceeds of unsecured debt | — | — | 25,300,000 |\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\n| Proceeds from loans | — | — | 19,000,000 |\n| Proceeds from sale of operating units | — | 23,250,818 | 124,911 |\n| Proceeds from sale of preferred operating units | 37,766,531 | — | — |\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\n| Redemption of unsecured notes | (27,600,000 | ) |\n| Repurchase of common units | (2,061,407 | ) | — | — |\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\n| Distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\n| Preferred dividends paid | (339,889 | ) | — | — |\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\n| Supplemental disclosures: |\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\n| Non-cash investing and financing activities: |\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\n| Level 1 | Unadjusted quoted prices in active markets for identical assets or liabilities. |\n| Level 2 | Unadjusted quoted prices in active markets for similar assets or liabilities, or Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or Inputs other than quoted prices that are observable for the asset or liability. |\n| Level 3 | Unobservable inputs for the asset or liability. |\n| Level 1 | Level 2 | Level 3 |\n| December 31, 2015 |\n| Investment in hotel property, net (1) | $ | — | $ | — | $ | 5,700,762 |\n| Interest Rate Cap (4) | $ | — | $ | 70,981 | $ | — |\n| Mortgage loans (2) | $ | — | $ | (272,933,327 | ) | $ | — |\n| Unsecured notes (3) | $ | (54,238,600 | ) | $ | — | $ | — |\n| December 31, 2016 |\n| Interest Rate Cap (4) | $ | — | $ | 33,597 | $ | — |\n| Mortgage loans (2) | $ | — | $ | (281,840,780 | ) | $ | — |\n| Unsecured notes (3) | $ | (26,241,160 | ) | $ | — | $ | — |\n| (1) | A non-recurring fair value measurement was conducted in 2015 for our investment in hotel property, which resulted in a recorded impairment charge for the year ended December 31, 2015, which represent the amounts by which the carrying value of the asset group exceeded its fair value. |\n| (2) | Mortgage loans are reflected at carrying value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| (3) | Unsecured notes are recorded at historical cost on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| (4) | An interest rate cap on the DoubleTree by Hilton Jacksonville Riverfront mortgage with the Bank of the Ozarks is recorded at fair value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\n| December 31, 2017 | $ | 1,105,165 |\n| December 31, 2018 | 632,365 |\n| December 31, 2019 | 544,920 |\n| December 31, 2020 | 499,294 |\n| December 31, 2021 | 246,388 |\n| December 31, 2022 and thereafter | 1,661,913 |\n| Total | $ | 4,690,045 |\n| Georgian Terrace | Crowne Plaza Hollywood Beach Resort |\n| Land and land improvements | $ | 10,127,687 | $ | 24,008,289 |\n| Buildings and improvements | 45,385,939 | 64,854,787 |\n| Furniture, fixtures and equipment | 5,163,135 | 2,802,135 |\n| Investment in hotel properties | 60,676,761 | 91,665,211 |\n| Restricted cash | 124,658 | 1,159,759 |\n| Accounts receivable | 465,287 | 140,588 |\n| Prepaid expenses, inventory and other assets | 430,997 | 797,505 |\n| Assumed mortgage | — | (57,259,159 | ) |\n| Accounts payable and accrued liabilities | (591,618 | ) | (2,485,442 | ) |\n| Equity investment | — | (1,889,560 | ) |\n| Gain on change in control | — | (6,603,148 | ) |\n| Net cash | $ | 61,106,085 | $ | 25,525,754 |\n| December 31, 2015 | December 31, 2014 |\n| (unaudited) | (unaudited) |\n| Pro forma revenues | $ | 151,931,931 | $ | 147,451,042 |\n| Pro forma operating expenses | $ | 133,346,497 | $ | 129,961,867 |\n| Pro forma operating income | $ | 18,585,434 | $ | 17,489,175 |\n| Pro forma net income (loss) | $ | 1,017,180 | $ | (1,671,774 | ) |\n| Pro forma earnings (loss) per basic and diluted share | $ | 0.07 | $ | (0.10 | ) |\n| Pro forma earnings (loss) per basic and diluted units | $ | 0.07 | $ | (0.10 | ) |\n| Pro forma basic and diluted common shares | 12,541,117 | 13,812,125 |\n| Pro forma basic and diluted units | 14,924,410 | 16,542,413 |\n| December 31, 2016 | December 31, 2015 |\n| Land and land improvements | $ | 57,851,380 | $ | 59,910,212 |\n| Buildings and improvements | 336,996,876 | 333,720,421 |\n| Furniture, fixtures and equipment | 43,458,781 | 42,245,334 |\n| 438,307,037 | 435,875,967 |\n| Less: accumulated depreciation and impairment | (89,713,125 | ) | (80,912,725 | ) |\n| Investment in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 |\n| December 31, 2016 | December 31, 2015 |\n| Land and land improvements | $ | 1,097,096 | $ | — |\n| Buildings and improvements | 6,242,504 | — |\n| Furniture, fixtures and equipment | 2,289,008 | — |\n| 9,628,608 | — |\n| Less: accumulated depreciation and impairment | (4,295,608 | ) | — |\n| Investment in Hotel Properties Held for Sale, Net | $ | 5,333,000 | $ | — |\n| Balance Outstanding as of |\n| December 31, | December 31, | Prepayment | Maturity | Amortization | Interest |\n| Property | 2016 | 2015 | Penalties | Date | Provisions | Rate |\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | $ | 3,512,586 | None | 11/1/2019 | 3 years | 5.00% |\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | 59,795,743 | n/a | 10/1/2025 | 30 years | 4.913% |\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | 13,016,045 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | 19,774,577 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | 9,500,000 | Yes | 8/5/2021 | 25 years | 5.25% |\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | 32,376,795 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | 15,029,121 | n/a | 8/1/2018 | 30 years | 4.78% |\n| The Georgian Terrace (8) | 45,826,038 | 46,579,011 | n/a | 6/1/2025 | 30 years | 4.42% |\n| Hilton Savannah DeSoto (9) | 30,000,000 | 20,522,836 | Yes | 7/1/2026 | 25 years | 4.25% |\n| Hilton Wilmington Riverside (10) | 30,000,000 | 19,825,772 | Yes | 1/1/2027 | 25 years | 4.25% |\n| Sheraton Louisville Riverside (11) | 11,977,557 | 11,345,866 | Yes | 12/1/2026 | 25 years | 4.27% |\n| The Whitehall (12) | 15,000,000 | 20,459,256 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\n| Total Mortgage Principal Balance | $ | 284,542,043 | $ | 271,737,608 |\n| Deferred financing costs, net | (2,049,409 | ) | (1,646,220 | ) |\n| Unamortized premium on loan | 215,655 | 240,336 |\n| Total Mortgage Loans, Net | $ | 282,708,289 | $ | 270,331,724 |\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 30-day LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\n| (6) | The note bears a minimum interest rate of 3.50%. |\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0% and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\n| For the year ending: December 31, 2017 | $ | 6,363,323 |\n| December 31, 2018 | 24,626,923 |\n| December 31, 2019 | 73,423,203 |\n| December 31, 2020 | 9,248,750 |\n| December 31, 2021 | 31,008,186 |\n| December 31, 2022 and thereafter | 139,871,658 |\n| Total future maturities | $ | 284,542,043 |\n| For the year ending: December 31, 2017 | $ | 223,682 |\n| December 31, 2018 | 176,740 |\n| December 31, 2019 | 100,480 |\n| December 31, 2020 | 95,482 |\n| December 31, 2021 | 95,482 |\n| December 31, 2022 and thereafter | 445,583 |\n| Total | $ | 1,137,449 |\n| Quarter Ended | 2014 | 2015 | 2016 |\n| March 31, | $ | 0.045 | $ | 0.070 | $ | 0.085 |\n| June 30, | $ | 0.050 | $ | 0.075 | $ | 0.090 |\n| September 30, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\n| December 31, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\n| Seven Months Ended | Year Ended |\n| July 31, 2015 | December 31, 2014 |\n| Revenue |\n| Rooms department | $ | 10,605,941 | $ | 15,386,595 |\n| Food and beverage department | 1,911,950 | 2,968,395 |\n| Other operating departments | 880,564 | 1,385,469 |\n| Total revenue | 13,398,455 | 19,740,459 |\n| Expenses |\n| Hotel operating expenses |\n| Rooms department | 2,062,515 | 3,270,930 |\n| Food and beverage department | 1,442,139 | 2,270,918 |\n| Other operating departments | 388,087 | 655,818 |\n| Indirect | 4,774,322 | 7,436,198 |\n| Total hotel operating expenses | 8,667,063 | 13,633,864 |\n| Depreciation and amortization | 1,060,339 | 2,116,211 |\n| General and administrative | 252,565 | 148,873 |\n| Total operating expenses | 9,979,967 | 15,898,948 |\n| Operating income | 3,418,488 | 3,841,511 |\n| Interest expense | (1,516,433 | ) | (2,612,032 | ) |\n| Net income | $ | 1,902,055 | $ | 1,229,479 |\n| 2016 | 2015 | 2014 |\n| General and administrative | $ | 12,419,221 | $ | 11,595,819 | $ | 9,823,853 |\n| Sales and marketing | 13,754,600 | 11,426,637 | 9,788,079 |\n| Repairs and maintenance | 7,401,755 | 6,948,699 | 6,278,411 |\n| Utilities | 6,429,686 | 6,124,459 | 5,763,990 |\n| Franchise fees | 4,091,729 | 4,016,083 | 4,122,726 |\n| Management fees, including incentive | 3,865,362 | 3,490,586 | 3,439,807 |\n| Property taxes | 5,983,280 | 5,110,659 | 3,664,022 |\n| Insurance | 2,594,783 | 2,305,966 | 1,927,935 |\n| Other | 601,276 | 291,383 | 263,668 |\n| Total indirect hotel operating expenses | $ | 57,141,692 | $ | 51,310,292 | $ | 45,072,491 |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Current: |\n| Federal | $ | — | $ | — | $ | — |\n| State | 191,332 | 444,538 | 233,940 |\n| 191,332 | 444,538 | 233,940 |\n| Deferred: |\n| Federal | (1,294,408 | ) | (1,510,726 | ) | (1,718,351 | ) |\n| State | (264,558 | ) | (269,845 | ) | (243,312 | ) |\n| (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Statutory federal income tax expense | $ | (158,859 | ) | $ | 1,705,610 | $ | (838,519 | ) |\n| Effect of non-taxable REIT income | (1,135,549 | ) | (2,866,950 | ) | (898,576 | ) |\n| State income tax benefit | (73,226 | ) | (174,693 | ) | 9,372 |\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\n| • | reasonable forecasts of future taxable income, and |\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Numerator |\n| Net income/(loss) attributable to the common shareholders for basic computation | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\n| Denominator |\n| Weighted average number of common shares outstanding for basic computation | 14,896,994 | 12,541,117 | 10,377,125 |\n| Basic and diluted net income (loss) per share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Year Ended | Year Ended | Year Ended |\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\n| Numerator |\n| Net income/(loss) attributable to the common unitholders for basic computation | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\n| Denominator |\n| Weighted average number of units outstanding | 16,710,935 | 14,924,410 | 13,107,413 |\n| Basic and diluted net income (loss) per unit | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\n| Quarters Ended 2016 |\n| March 31 | June 30 | September 30 | December 31 |\n| Total revenue | $ | 37,810,144 | $ | 41,824,954 | $ | 37,275,312 | $ | 35,935,342 |\n| Total operating expenses | 33,025,990 | 34,645,809 | 33,539,913 | 33,026,914 |\n| Net operating income | 4,784,154 | 7,179,145 | 3,735,399 | 2,908,428 |\n| Net income(loss) | 545,874 | 1,977,550 | (1,549,191 | ) | (74,084 | ) |\n| Net income (loss) attributable to common shareholders | 483,095 | 1,761,106 | (1,716,234 | ) | (746,140 | ) |\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.03 | $ | 0.12 | $ | (0.11 | ) | $ | (0.05 | ) |\n| Quarters Ended 2015 |\n| March 31 | June 30 | September 30 | December 31 |\n| Total revenue | $ | 30,975,630 | $ | 36,865,108 | $ | 33,941,875 | $ | 36,750,863 |\n| Total operating expenses | 27,410,462 | 29,689,455 | 31,976,036 | 34,127,473 |\n| Net operating income | 3,565,168 | 7,175,653 | 1,965,839 | 2,623,390 |\n| Net income(loss) | 713,859 | 1,759,109 | 4,636,644 | (711,959 | ) |\n| Net income (loss) attributable to common shareholders | 575,336 | 1,431,110 | 3,872,394 | (522,174 | ) |\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.05 | $ | 0.13 | $ | 0.27 | $ | (0.04 | ) |\n| Costs Capitalized | Life on |\n| Initial Costs | Subsequent to Acquisition | Gross Amount At End of Year | Accumulated | Which |\n| Building & | Building & | Building & | Depreciation | Date of | Date | Depreciation |\n| Description | Encumbrances | Land | Improvements | Land | Improvements | Land | Improvements | Total | & Impairment | Construction | Acquired | is Computed |\n| Crowne Plaza Hampton Marina – Hampton, Virginia | $ | 2,585 | $ | 1,061 | $ | 6,733 | $ | 36 | 3,796 | $ | 1,097 | $ | 10,529 | $ | 11,626 | $ | (4,296 | ) | 1988 | 2008 | 3-39 years |\n| Crowne Plaza Hollywood Beach Resort - Hollywood Beach, Florida | 58,936 | 22,865 | 67,660 | — | (124 | ) | 22,865 | 67,536 | 90,401 | (2,646 | ) | 1972 | 2015 | 3-39 years |\n| Crowne Plaza Tampa Westshore – Tampa, Florida | 15,561 | 4,153 | 9,670 | 297 | 22,259 | 4,450 | 31,929 | 36,379 | (7,707 | ) | 1973 | 2007 | 3-39 years |\n| DoubleTree by Hilton Jacksonville Riverfront – Jacksonville, Florida | 19,292 | 7,090 | 14,604 | 89 | 7,113 | 7,179 | 21,717 | 28,896 | (5,881 | ) | 1970 | 2005 | 3-39 years |\n| DoubleTree by Hilton Laurel – Laurel, Maryland | 9,329 | 900 | 9,443 | 175 | 5,679 | 1,075 | 15,122 | 16,197 | (3,913 | ) | 1985 | 2004 | 3-39 years |\n| DoubleTree by Hilton Philadelphia Airport – Philadelphia, Pennsylvania | 31,262 | 2,100 | 22,031 | 260 | 5,478 | 2,360 | 27,509 | 29,869 | (8,281 | ) | 1972 | 2004 | 3-39 years |\n| DoubleTree by Hilton Raleigh Brownstone – University – Raleigh, North Carolina | 14,774 | 815 | 7,416 | 213 | 5,761 | 1,028 | 13,177 | 14,205 | (4,831 | ) | 1971 | 2004 | 3-39 years |\n| Georgian Terrace – Atlanta, Georgia | 45,826 | 10,128 | 45,386 | (1,332 | ) | 4,811 | 8,796 | 50,197 | 58,993 | (3,715 | ) | 1911 | 2014 | 3-39 years |\n| Hilton Savannah DeSoto – Savannah, Georgia | 30,000 | 600 | 13,562 | 31 | 14,545 | 631 | 28,107 | 28,738 | (8,640 | ) | 1968 | 2004 | 3-39 years |\n| Hilton Wilmington Riverside – Wilmington, North Carolina | 30,000 | 785 | 16,829 | 228 | 12,514 | 1,013 | 29,343 | 30,356 | (11,283 | ) | 1970 | 2004 | 3-39 years |\n| Sheraton Louisville Riverside – Jeffersonville, Indiana | 11,977 | 782 | 6,891 | 222 | 14,566 | 1,004 | 21,457 | 22,461 | (5,074 | ) | 1972 | 2006 | 3-39 years |\n| The Whitehall – Houston, Texas | 15,000 | 7,374 | 22,185 | 78 | 4,431 | 7,452 | 26,616 | 34,068 | (2,239 | ) | 1963 | 2013 | 3-39 years |\n| $ | 284,542 | $ | 58,653 | $ | 242,410 | $ | 297 | $ | 100,829 | $ | 58,950 | $ | 343,239 | $ | 402,189 | $ | (68,506 | ) |\n| (1) | For the year ending December 31, 2016, the aggregate cost of our real estate assets for federal income tax purposes was approximately $398.6 million. |\n| Balance at December 31, 2014 | $ | 294,827 |\n| Acquisitions | 91,669 |\n| Improvements | 11,105 |\n| Disposal of Assets | (3,971 | ) |\n| Balance at December 31, 2015 | $ | 393,630 |\n| Acquisitions | — |\n| Improvements | 9,473 |\n| Disposal of Assets | (914 | ) |\n| Balance at December 31, 2016 | $ | 402,189 |\n| Balance at December 31, 2014 | $ | 53,233 |\n| Current Expense | 8,790 |\n| Impairment | 500 |\n| Disposal of Assets | (482 | ) |\n| Balance at December 31, 2015 | $ | 62,041 |\n| Current Expense | 7,018 |\n| Impairment | — |\n| Disposal of Assets | (553 | ) |\n| Balance at December 31, 2016 | $ | 68,506 |\n\n</text>\n\nWhat is the average annual franchise fee, in percentage, if the company operates the franchise for a period of 5 years based on the franchise fee for operating year 1, 2 and thereafter?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nBusiness\\nOrganization\\nSotherly Hotels Inc. (the “Company”) is a self-managed and self-administered lodging real estate investment trust, or REIT, that was formed in August 2004 to own, acquire, renovate and reposition full-service, primarily upscale and upper-upscale hotel properties located in primary markets in the mid-Atlantic and southern United States. On December 21, 2004, the Company successfully completed its initial public offering and elected to be treated as a self-advised REIT for federal income tax purposes. The Company conducts its business through Sotherly Hotels LP, its operating partnership (the “Operating Partnership”), of which the Company is the general partner. The Company owns approximately 89.1% of the partnership units in the Operating Partnership. Limited partners (including certain of the Company’s officers and directors) own the remaining Operating Partnership units.\\nAs of December 31, 2016, our portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels located in eight states with an aggregate total of 3,011 rooms and approximately 160,928 square feet of meeting space. All of our hotels are wholly-owned by subsidiaries of the Operating Partnership, and all are managed on a day to day basis by MHI Hotels Services, LLC, which does business as Chesapeake Hospitality (“Chesapeake Hospitality”).\\nIn order for the Company to qualify as a REIT, it cannot directly manage or operate our wholly-owned hotels. Therefore, we lease our wholly-owned hotel properties to entities that we refer to as our TRS Lessees, which in turn have engaged Chesapeake Hospitality, an eligible independent management company, to manage our hotels. Our TRS Lessees are wholly-owned subsidiaries of MHI Hospitality TRS Holding, Inc. (“MHI Holding”, and collectively, “MHI TRS”). MHI TRS is a taxable REIT subsidiary for federal income tax purposes.\\nOur corporate office is located at 410 West Francis Street, Williamsburg, Virginia 23185. Our telephone number is (757) 229-5648.\\nOur Properties\\nAs of December 31, 2016, our hotels were located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, Texas, and Virginia. Ten of these hotels operate under franchise agreements with major hotel brands, and two are independent hotels. Developments at our properties for the five years ended December 31, 2016 included the following:\\n| • | In 2013 we acquired the Crowne Plaza Houston Downtown located in Houston, Texas at an aggregate value of approximately $30.9 million, including certain closing costs. |\\n\\n| • | In 2014, we acquired the Georgian Terrace located in Atlanta, Georgia at an aggregate value of approximately $61.1 million, including certain closing costs. We also, after extensive renovations, re-branded and renamed the Hilton Philadelphia Airport to the DoubleTree by Hilton Philadelphia Airport. |\\n\\n| • | In 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. We also, after extensive renovations, re-branded and renamed the Crowne Plaza Jacksonville Riverfront to the DoubleTree by Hilton Jacksonville Riverfront, and re-branded and renamed the Holiday Inn Laurel West to the DoubleTree by Hilton Laurel. |\\n\\n| • | In 2016, after extensive renovations, we re-branded and renamed the Crowne Plaza Houston Downtown to The Whitehall. |\\n\\nSee Items 2 and 7 of this Form 10-K for additional detail on our properties.\\nOur Strategy and Investment Criteria\\nOur strategy is to grow through acquisitions of full-service, upscale and upper-upscale hotel properties located in the primary markets of the southern United States. We intend to grow our portfolio through disciplined acquisitions of hotel properties and believe that we will be able to source significant external growth opportunities through our management team’s extensive network of industry, corporate and institutional relationships.\\n5\\nOur investment criteria are further detailed below:\\n| • | Geographic Growth Markets: We are focusing our growth strategy on the major markets in the Southern region of the United States. Our management team remains confident in the long-term growth potential associated with this part of the United States. We believe these markets have, during the Company’s and our predecessors’ existence, been characterized by population growth, economic expansion, growth in new businesses and growth in the resort, recreation and leisure segments. We will continue to focus on these markets, including coastal locations, and will investigate other markets for acquisitions only if we believe these new markets will provide similar long-term growth prospects. |\\n\\n| • | Full-Service Hotels: We focus our acquisition strategy on the full-service hotel segment. Our full-service hotels fall primarily under the upscale to upper-upscale categories and include such brands as Hilton, Doubletree by Hilton, Sheraton and Crowne Plaza, as well as independent hotels affiliated with Preferred Hotels & Resorts. We may also acquire commercial unit(s) within upscale to upper-upscale condominium hotel projects, allowing us to establish and operate unit rental programs. We do not own economy hotels. We believe that full-service hotels, in the upscale to upper-upscale categories, will outperform the broader U.S. hotel industry, and thus offer the highest returns on invested capital. |\\n\\n| • | Significant Barriers to Entry: We intend to execute a strategy that entails the acquisition of hotels in prime locations with significant barriers to entry. |\\n\\n| • | Proximity to Demand Generators: We seek to acquire hotel properties located in central business districts for both leisure and business travelers within the respective markets, including large state universities, airports, convention centers, corporate headquarters, sports venues and office buildings. We seek to be in walking locations that are proximate to the markets’ major demand generators. |\\n\\nWe typically define underperforming hotels as those that are poorly managed, suffer from significant deferred maintenance and capital investment and that are not properly positioned in their respective markets. In pursuing these opportunities, we hope to improve revenue and cash flow and increase the long-term value of the underperforming hotels we acquire. Our ultimate goal is to achieve a total investment that is substantially less than replacement cost of a hotel or the acquisition cost of a market performing hotel. In analyzing a potential investment in an underperforming hotel property, we typically characterize the investment opportunity as one of the following:\\n| • | Branding Opportunity: The acquisition of properties that includes a repositioning of the property through a change in brand affiliation, which may include positioning the property as an independent hotel. Branding opportunities typically include physical upgrades and enhanced efficiencies brought about by changes in operations. |\\n\\n| • | Shallow-Turn Opportunity: The acquisition of an underperforming but structurally sound hotel that requires moderate renovation to re-establish the hotel in its market. |\\n\\n| • | Deep-Turn Opportunity: The acquisition of a hotel that is closed or functionally obsolete and requires a restructuring of both the business components of the operations as well as the physical plant of the hotel, including extensive renovation of the building, furniture, fixtures and equipment. |\\n\\nTypically, in our experience, a deep turn opportunity takes a total of approximately four years from the initial acquisition of a property to achieving full post-renovation stabilization. Therefore, when evaluating future opportunities in underperforming hotels, we intend to focus on up-branding and shallow-turn opportunities, and to pursue deep-turn opportunities on a more limited basis and in joint venture partnerships, if possible.\\nInvestment Vehicles. In pursuit of our investment strategy, we may employ various traditional and non-traditional investment vehicles:\\n| • | Direct Purchase Opportunity: Our traditional investment strategy is to acquire direct ownership interests via our Operating Partnership in properties that meet our investment criteria, including opportunities that involve full-service, upscale and upper-upscale properties in identified geographic growth markets that have significant barriers to entry for new product delivery. Such properties, or portfolio of properties, may or may not be acquired subject to a mortgage, or other financing or lending instruments, by the seller or third-party. |\\n\\n| • | Joint Venture/Mezzanine Lending Opportunities: We may, from time to time, undertake a significant renovation and rehabilitation project that we characterize as a deep-turn opportunity. In such cases, we may acquire a functionally obsolete hotel whose renovation may be very lengthy and require significant capital. In these projects, we may choose to structure such acquisitions as a joint venture, or mezzanine lending program, in order to avoid severe short-term dilution and loss of current income commonly referred to as the “negative carry” associated with such extensive renovation programs. We will not pursue joint venture or mezzanine programs in which we would become a “de facto” lender to the real estate community. |\\n\\n6\\nPortfolio and Asset Management Strategy\\nWe intend to ensure that the management of our hotel properties maximizes market share, as evidenced by revenue per available room (“RevPAR”) penetration indices, and that our market share yields the optimum level of revenues for our hotels in their respective markets. Our strategy is designed to actively manage our hotels’ operating expenses in an effort to maximize hotel earnings before interest, taxes, depreciation and amortization (“Hotel EBITDA”).\\nOver our long history in the lodging industry we have refined many portfolio and asset management techniques that we believe provide for exceptional cash returns at our hotels. We undertake extensive budgeting due diligence wherein we examine market trends, one-time or exceptional revenue opportunities, and/or changes in the regulatory climate that may impact costs. We review daily revenue results and revenue management strategies at the hotels, and we focus on our manager’s ability to produce high quality revenues that translate to higher profit margins. We look for ancillary forms of revenues, such as leasing roof-top space for cellular towers and other communication devices and also look to lease space to third parties in our hotels, which may include, but are not limited to, gift shops or restaurants. We have and will continue to engage parking management companies to maximize parking revenue. Our efforts further include periodic review of property insurance costs and coverage, and the cost of real and personal property taxes. We generally appeal tax increases in an effort to secure lower tax payments and routinely pursue strategies that allow for lower overall insurance costs, such as purchasing re-insurance and participating in state-sponsored insurance pools.\\nWe also require detailed and refined reporting data from Chesapeake Hospitality, which includes detailed accounts of revenues, revenue segments, expenses and forecasts based on current and historic booking patterns. We also believe we optimize and successfully manage capital costs at our hotels while ensuring that adequate product standards are maintained to provide a positive guest experience.\\nNone of our hotels are managed by a major national or global hotel franchise company. Through our long history in the lodging industry, we have found that management of our hotels by management companies other than franchisors is preferable to and more profitable than management services provided by the major franchise companies, specifically with respect to optimization of operating expenses and the delivery of guest service.\\nOur portfolio management strategy includes our effort to optimize labor costs. The labor force in our hotels is predominately non-unionized, with only one property, the DoubleTree by Hilton Jacksonville Riverfront, having a total of approximately 26 employees electing to participate under a collective bargaining arrangement. Further, the labor force at our hotels is eligible to receive health and other insurance coverage through Chesapeake Hospitality, which self-insures. Self-insuring has, in our opinion and experience, provided significant savings over traditional insurance company sponsored plans.\\nAsset Disposition Strategy. When a property no longer fits with our investment objectives, we will pursue a direct sale of the property for cash so that our investment capital can be redeployed according to the investment strategies outlined above. Where possible, we will seek to subsequently purchase a hotel in connection with the requirements of a tax-free exchange. Such a strategy may be deployed in order to mitigate the tax consequence that a direct sale may cause.\\nOur Principal Agreements\\nManagement Agreements\\nChesapeake Hospitality is currently the management company for each of our hotels. Andrew M. Sims, our chairman and chief executive officer owns an equity interest in Chesapeake Hospitality. Immediately prior to March 1, 2017, our chairman and chief executive officer, and another of our directors were also directors of Chesapeake Hospitality.\\nOn December 15, 2014, we entered into a master agreement (the “Master Agreement”) and a series of individual hotel management agreements (each a “Hotel Management Agreement” and, together, the “Hotel Management Agreements”) between the Company, the Operating Partnership, and MHI Hospitality TRS, LLC (and other TRS Lessees) on the one hand and Chesapeake Hospitality on the other hand, to address the scheduled expiration of the then existing master management agreement (the “MMA”) and the strategic alliance agreement (the “SA Agreement”) and to provide for ongoing management of the Company’s hotels. The Master Agreement and Hotel Management Agreements terminated and replaced the then existing MMA and individual management agreements.\\nThe Master Agreement:\\n| • | expires on December 31, 2019, or earlier if all of the Hotel Management Agreements expire or are terminated prior to that date. The Master Agreement will be extended beyond 2019 for such additional periods as a Hotel Management Agreement remains in effect; |\\n\\n7\\n\\n| • | terminated the then existing SA Agreement as of December 15, 2014; |\\n\\n| • | extended the term of the then existing MMA until December 31, 2014 and terminated the MMA and other individual management agreements for Tampa, Houston, and Atlanta as of such date; |\\n\\n| • | caused the Hotel Management Agreements to come into effect coincident with the termination of the MMA and other individual management agreements on December 31, 2014; |\\n\\n| • | requires Chesapeake Hospitality to provide dedicated executive level support for our managed hotels pursuant to certain criteria; |\\n\\n| • | provides a mechanism and established conditions on which the Company will offer Chesapeake Hospitality the opportunity to manage hotels acquired by the Company in the future, pursuant to a negotiated form of single facility management agreement, with the caveat that the Company is not required to offer the management of future hotels to Chesapeake Hospitality; and |\\n\\n| • | sets an incentive management fee for each of the hotels to be managed by Chesapeake Hospitality equal to 10% of the amount by which gross operating profit, as defined in the Hotel Management Agreement, for a given year exceeds the budgeted gross operating profit for such year; provided, however, that the incentive management fee payable in respect of any such year shall not exceed 0.25% of the gross revenues of the hotel included in such calculation. |\\n\\nEach of the Hotel Management Agreements has a term of five years commencing January 1, 2015, with the exception of the Hotel Management Agreement for the management of the Crowne Plaza Hollywood Beach Resort, which has a term of five years commencing July 31, 2015. Each of the Hotel Management Agreements may be extended for up to two additional periods of five years subject to the approval of both parties with respect to any such extension. The agreements provide that Chesapeake Hospitality will be the sole and exclusive manager of the hotels as the agent of the respective TRS Lessee and at the sole cost and expense of the TRS Lessee and subject to certain operating standards. Each agreement may be terminated in connection with a sale of the related hotel. In connection with a termination upon the sale of the hotel, Chesapeake Hospitality will be entitled to receive a termination fee equal to the lesser of the management fee paid with respect to the prior twelve months or the management fees paid for that number of months prior to the closing date of the hotel sale equal to the number of months remaining on the current term of the Hotel Management Agreement. No sale termination fee will be payable in the event the Company elects to provide Chesapeake Hospitality with the opportunity to manage another comparable hotel and Chesapeake Hospitality is not precluded from accepting such opportunity. Chesapeake Hospitality is required to qualify as an eligible independent contractor in order to permit the Company to continue to operate as a real estate investment trust.\\nAmounts Payable under the Management Agreements. Chesapeake Hospitality receives a base management fee, and, if the hotels exceed certain financial thresholds, an additional incentive management fee for the management of our hotels.\\nThe base management fee for our hotels will be a percentage of the gross revenues of the hotel and will be due monthly. The applicable percentage of gross revenue for the base management fee for each of our wholly-owned hotels is as follows (1):\\n\\n| 2019 | 2018 | 2017 | 2016 | 2015 | 2014 |\\n| Crowne Plaza Hampton Marina (2) | N/A | N/A | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| Crowne Plaza Hollywood Beach Resort | 2.50 | % | 2.50 | % | (3) | (3) | 2.00 | % | N/A |\\n| Crowne Plaza Tampa Westshore (4) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| DoubleTree by Hilton Jacksonville Riverfront | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| DoubleTree by Hilton Laurel | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| DoubleTree by Hilton Philadelphia Airport | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| DoubleTree by Hilton Raleigh Brownstone – University | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| Georgian Terrace (5) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\\n| Hilton Savannah DeSoto | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| Hilton Wilmington Riverside | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| Sheraton Louisville Riverside (6) | 2.50 | % | 2.50 | % | 2.65 | % | 2.65 | % | 2.65 | % | 3.00 | % |\\n| The Whitehall (7) | 2.50 | % | 2.50 | % | 2.50 | % | 2.25 | % | 2.00 | % | 2.00 | % |\\n\\n\\n| (1) | The fees for 2014 were set by the MMA, and the individual management agreements for Tampa, Houston, and Atlanta. The fees for 2015-2019 are set by the Master Agreement and the Hotel Management Agreements. |\\n\\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017; therefore, the base management fee no longer applies after February 7, 2017. |\\n\\n8\\n\\n| (3) | Upon acquiring the Crowne Plaza Hollywood Beach Resort in July 2015, we entered into a single facility management agreement with Chesapeake Hospitality for the management of the hotel. The terms of the agreement provide for a base management fee of 2.00% through July 2016, 2.25% through July 2017, and 2.50% thereafter. |\\n\\n| (4) | In January 2009, we entered a separate management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Tampa Westshore. The provisions of the new agreement related to base management fee were the same as those contained in the MMA. The provisions of the agreement related to the incentive management fee were the same as those contained in the MMA except that it was calculated separately and not aggregated with the other properties covered by the MMA. |\\n\\n| (5) | In March 2014, we entered into the Atlanta Agreement with Chesapeake Hospitality for the management of the Georgian Terrace. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. The Atlanta Agreement was terminated in connection with the entry into the Master Agreement and Hotel Management Agreements. |\\n\\n| (6) | Pursuant to the MMA, the term for each of the initial properties, which included the Holiday Inn Downtown Williamsburg, was 10 years. The management company agreed to substitute the Sheraton Louisville Riverside for the Holiday Inn Downtown Williamsburg for remainder of the term of the agreement. |\\n\\n| (7) | In November 2013, we assumed the existing management agreement with Chesapeake Hospitality for the management of the Crowne Plaza Houston Downtown. The terms of the agreement provided for a base management fee of 2.0% and no incentive management fee. |\\n\\nThe base management fee for a hotel acquired in the future which is first leased by our TRS Lessees, other than on the first day of a fiscal year, will be 2.0% for the partial year such hotel is first leased and for the first full year such hotel is managed. There is no fee cap on the base management fee.\\nSubsequently Acquired Hotel Properties\\n\\n| First year | 2.00 | % |\\n| Second year | 2.25 | % |\\n| Third year and thereafter | 2.50 | % |\\n\\nTerminated Strategic Alliance Agreement and Management Agreements\\nOn December 21, 2004, we entered into the now terminated ten-year SA Agreement with Chesapeake Hospitality pursuant to which (i) Chesapeake Hospitality agreed to refer to us (on an exclusive basis) hotel acquisition opportunities in the United States presented to Chesapeake Hospitality, and (ii) unless a majority of the Company’s independent directors in good faith concluded for valid business reasons that another management company should manage a hotel owned by us, we agreed to offer Chesapeake Hospitality or its subsidiaries the right to manage hotel properties that we acquired in the United States. The SA Agreement was terminated effective as of December 15, 2014, pursuant to the terms of the Master Agreement.\\nPursuant to the terms of the now terminated MMA and other individual management agreements for Tampa, Houston and Atlanta, we engaged Chesapeake Hospitality as the property manager for each of our wholly-owned hotels through December 2015. The MMA had a term of ten (10) years for each initial hotel and a term of ten (10) years for each subsequently acquired hotel that became subject to the MMA. Chesapeake Hospitality benefited from the payment of management fees by us pursuant to the MMA. Chesapeake Hospitality received a base management fee equal to a percentage of each hotel’s revenues (2.0% for the first year, 2.5% for the second year and 3.0% thereafter). Additionally, pursuant to the MMA, Chesapeake Hospitality was entitled to receive certain incentive fees and project management fees. For Tampa, the base management and incentive management fees were the same as those contained in the MMA. For Houston and Atlanta, the base management fee was equal to 2% of the respective hotels’ revenues, and there was no incentive management fee. The MMA and the individual management agreements for Tampa, Houston, and Atlanta were terminated on December 31, 2014, pursuant to the terms of the Master Agreement.\\nFranchise Agreements\\nAs of December 31, 2016, all but two of our wholly-owned hotels operate under franchise licenses from national hotel companies. On March 27, 2014, we purchased an independent full-service hotel in Atlanta, Georgia, which does not operate under a franchise license. On April 12, 2016, we allowed the Crowne Plaza Houston Downtown’s franchise agreement to expire and rebranded it as The Whitehall, an independent full-service hotel.\\nOur TRS Lessees hold the franchise licenses for our wholly-owned hotels. Chesapeake Hospitality must operate each of our hotels it manages in accordance with and pursuant to the terms of the franchise agreement for the hotel.\\n9\\nThe franchise licenses generally specify certain management, operational, record keeping, accounting, reporting and marketing standards and procedures with which the franchisee must comply. Under the franchise licenses, the franchisee must comply with the franchisors’ standards and requirements with respect to:\\n| • | training of operational personnel; |\\n\\n| • | safety; |\\n\\n| • | maintaining specified insurance; |\\n\\n| • | the types of services and products ancillary to guest room services that may be provided; |\\n\\n| • | display of signage; |\\n\\n| • | marketing techniques including print media, billboards, and promotions standards; and |\\n\\n| • | the type, quality and age of furniture, fixtures and equipment included in guest rooms, lobbies and other common areas. |\\n\\nAdditionally, as the franchisee, our TRS Lessees are required to pay the franchise fees described below.\\nThe following table sets forth certain information for the franchise licenses of our wholly-owned hotel properties as of December 31, 2016:\\n\\n| Marketing/ |\\n| Franchise | Reservation | Expiration |\\n| Fee (1) | Fee (1) | Date |\\n| Crowne Plaza Hampton Marina (2) | 5.0 | % | 3.5 | % | 2/7/2017 |\\n| Crowne Plaza Hollywood Beach Resort (3) | 5.0 | % | 3.5 | % | 10/31/2017 |\\n| Crowne Plaza Tampa Westshore | 5.0 | % | 3.5 | % | 3/6/2019 |\\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 5.0 | % | 4.0 | % | 9/30/2025 |\\n| DoubleTree by Hilton Laurel | 5.0 | % | 4.0 | % | 10/31/2030 |\\n| DoubleTree by Hilton Philadelphia – Airport (5) | 5.0 | % | 4.0 | % | 10/31/2024 |\\n| DoubleTree by Hilton Raleigh Brownstone – University (4) | 5.0 | % | 4.0 | % | 11/30/2021 |\\n| Hilton Savannah DeSoto (6) | 5.0 | % | 4.0 | % | 7/31/2017 |\\n| Hilton Wilmington Riverside | 5.0 | % | 4.0 | % | 3/31/2018 |\\n| Sheraton Louisville Riverside | 5.0 | % | 3.5 | % | 4/25/2023 |\\n\\n\\n| (1) | Percentage of room revenues payable to the franchisor. |\\n\\n| (2) | The Crowne Plaza Hampton Marina was sold on February 7, 2017, and the franchise license was transferred to the new owners. |\\n\\n| (3) | We have entered into a franchise agreement with Hilton to rebrand the Hollywood hotel as a DoubleTree by Hilton. |\\n\\n| (4) | The Franchise Fee is 3.0% for operating year 1, 4.0% for operating year 2, and 5.0% thereafter. |\\n\\n| (5) | The Franchise Fee is 4.0% for operating years 1 and 2, and 5.0% thereafter. |\\n\\n| (6) | We intend to convert the Savannah hotel to an independent hotel. |\\n\\nLease Agreements\\nIn order for the Company to maintain qualification as a REIT, neither the Company nor the Operating Partnership or its subsidiaries can operate our hotels directly. Our wholly-owned hotels are leased to our TRS Lessees, which have engaged Chesapeake Hospitality to manage the hotels. Each lease has a non-cancelable term of three to thirty years, subject to earlier termination upon the occurrence of certain contingencies described in the lease.\\nDuring the term of each lease, our TRS Lessees are obligated to pay a fixed annual base rent plus a percentage rent and certain other additional charges. Base rent accrues and is paid monthly. Percentage rent is calculated by multiplying fixed percentages by gross room revenues, in excess of certain threshold amounts and is paid monthly or quarterly, according to the terms of the agreement.\\nTax Status\\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”), commencing with its taxable year ended December 31, 2004. In order to maintain its qualification as a REIT, the Company must meet a number of organizational and operational requirements, including a requirement that it currently distribute, as “qualifying distributions,” at least 90.0% of its taxable income (determined without regard to the deduction for dividends paid and by\\n10\\nexcluding its net capital gains and reduced by certain non-cash items) to its stockholders. The Company has adhered to these requirements each taxable year since its formation in 2004 and intends to continue to adhere to these requirements and maintain its qualification for taxation as a REIT. As a REIT, the Company generally will not be subject to federal corporate income tax on that portion of its taxable income (including its net capital gain) that is distributed to its stockholders. If the Company fails to qualify for taxation as a REIT in any taxable year, and no relief provision applies, it will be subject to federal income taxes at regular corporate rates (as well as any applicable alternative minimum tax) and it would be disqualified from re-electing treatment as a REIT until the fifth taxable year after the year in which it failed to qualify as a REIT. Even if the Company qualifies for taxation as a REIT, it may be subject to certain state and local taxes on its income and property, and to federal income and excise taxes on its undistributed taxable income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes.\\nWhile the Operating Partnership is generally not subject to federal and state income taxes, the unit holders of the Operating Partnership, including the Company, are subject to tax on their respective allocable shares of the Operating Partnership’s taxable income.\\nThe Company has one taxable REIT subsidiary, MHI Holding, in which it owns an interest through the Operating Partnership. MHI Holding is subject to federal, state and local income taxes. MHI Holding has operated at a cumulative taxable loss, through December 31, 2016, of approximately $15.9 million and in addition had deferred timing differences of approximately $0.2 million attributable to start-up expenses related to the opening of several of its hotels, which was not deductible when incurred and is being amortized over 15 years and deferred timing differences of approximately $0.5 million attributable to accrued, but not deductible, vacation and sick pay amounts. The Company has not incurred federal income taxes since its formation. The cumulative taxable loss and combined timing differences result in a net deferred tax asset of approximately $6.9 million for these cumulative deferred tax loss carryforwards.\\nEnvironmental Matters\\nIn connection with the ownership and operation of the hotels, we are subject to various federal, state and local laws, ordinances and regulations relating to environmental protection. Under these laws, a current or previous owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on, under, or in such property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances. In addition, the presence of contamination from hazardous or toxic substances, or the failure to remediate such contaminated property properly, may adversely affect the owner’s ability to borrow using such property as collateral. Furthermore, a person who arranges for the disposal or treatment of a hazardous or toxic substance at a property owned by another, or who transports such substance to or from such property, may be liable for the costs of removal or remediation of such substance released into the environment at the disposal or treatment facility. The costs of remediation or removal of such substances may be substantial, and the presence of such substances may adversely affect the owner’s ability to sell such real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of the hotels, we may be potentially liable for such costs.\\nWe believe that our hotels are in compliance, in all material respects, with all federal, state and local environmental ordinances and regulations regarding hazardous or toxic substances and other environmental matters, the violation of which would have a material adverse effect on us. We have not received written notice from any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental matters in connection with any of our present hotel properties.\\nEmployees\\nAs of December 31, 2016, we employed twelve full-time persons, all of whom work at our corporate office in Williamsburg, Virginia. All persons employed in the day-to-day operations of the hotels are employees of Chesapeake Hospitality, the management company engaged by our TRS Lessees to operate such hotels.\\nSubsequent Events\\nHyde Resort & Residences\\nOn January 30, 2017, we purchased the commercial unit of the Hyde Resort & ResidencesTM, a condominium hotel located in the Hollywood, Florida market, for an aggregate price of approximately $4.8 million, including inventory and closing fees. The trademarked Hyde Resort & Residences is operated under license from SBE Hotel Licensing, LLC.\\n11\\nWe have entered into several agreements related to the Hyde Resort & Residences, which is zoned and operated as a condominium hotel with individual condominium units owned by third parties. In addition to our ownership of the commercial condominium unit, consisting of the designated lobby and front desk areas, we entered into a 20-year Lease Agreement with the condominium association responsible for the operation of the condominium, whereby we lease other common areas, including meeting rooms, office spaces, and 400 parking spaces, and also manage the parking garage. We have also entered into a 20-year Association Management Agreement with the condominium association, whereby we are engaged to manage the condominium association and to operate the Hyde Resort & Residences as a condominium hotel. Individual condominium unit owners may elect for their condominium units to be rented to condominium hotel guests pursuant to a rental management program managed for us by Chesapeake Hospitality pursuant to the Hyde Management Agreement, described below. As part of the rental management program, we have entered into individual rental agreements with condominium unit owners who have chosen to participate in our rental program, and may enter into rental agreements with unit owners in the future. We expect the number of individual condominium unit owners who elect to participate in our rental program to vary, and the number of units available for rental to condominium hotel guests at any given time will fluctuate pursuant to that participation and due to owner occupation of the condominium hotel units.\\nOn February 3, 2017, we entered into a Condominium Hotel Management Agreement (the “Hyde Management Agreement”) with Chesapeake Hospitality for the management of the Hyde Resort & Residences condominium hotel. In accordance with the Master Agreement, the Hyde Management Agreement has an initial term of five years commencing January 30, 2017 and mirrors the material terms of the other Hotel Management Agreements. The terms of the Hyde Management Agreement provide for a base management fee equal to a percentage of gross revenues of the rental of condominium units participating in our rental program in the amount of 2.00% through January 2018, 2.25% through January 2019, and 2.50% thereafter. Pursuant to the Hyde Management Agreement, Chesapeake Hospitality will manage for us the rental of individually owned condominium units pursuant to rental agreements entered into with individual condominium unit owners. We also entered into an Association Sub Management and Assignment Agreement with Chesapeake Hospitality for the management and operation of the condominium association responsible for the operation of the Hyde Resort & Residences, and a Rental Management Agreement pursuant to which Chesapeake Hospitality agreed to manage the marketing and negotiation of rental agreements with individual condominium unit owners.\\nCrowne Plaza Hampton Marina Disposition\\nOn February 7, 2017, we sold the Crowne Plaza Hampton Marina for a price of approximately $5.6 million. Following the sale, our portfolio consisted of eleven wholly-owned hotels located in seven states with an aggregate total of 2,838 rooms and approximately 149,435 square feet of meeting space, as well as our interests in the Hyde Resort & Residences.\\nEmployee Stock Ownership Plan\\nBetween January 3, 2017 and February 23, 2017, the Company’s Employee Stock Ownership Plan (“ESOP”) purchased 682,500 shares of the Company’s common stock. The Company sponsors and maintains the ESOP and related trust for the benefit of its eligible employees. The ESOP, which was established January 1, 2016, is funded by a loan from the Company, pursuant to which the ESOP may borrow up to $5,000,000 to purchase shares of the Company’s common stock, which serve as collateral for the loan.\\nDirector and Officer Changes\\nOn March 1, 2017, Kim E. Sims resigned as a member of the board of directors of the Company.\\nAvailable Information\\nWe maintain an Internet site, http://www.sotherlyhotels.com, which contains additional information concerning Sotherly Hotels Inc. We make available free of charge through our Internet site all our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, definitive proxy statements and other reports filed with the Securities and Exchange Commission as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We have also posted on this website the Company’s Code of Business Conduct and the charters of the Company’s Nominating, Corporate Governance and Compensation (“NCGC”) and Audit Committees of the Company’s board of directors. We intend to disclose on our website any changes to, or waivers from, the Company’s Code of Business Conduct. Information on the Company’s Internet site is neither part of nor incorporated into this Form 10-K.\\n12\\n\\nItem 1A.\\nRi\\nsk Factors\\nThe following are the material risks that may affect us. Any of the risks discussed herein can materially adversely affect our business, liquidity, operations, industry or financial position or our future financial performance.\\nRisks Related to Our Debt\\nWe have substantial financial leverage.\\nAs of December 31, 2016, the principal balance of our debt was approximately $309.8 million, which is comprised of approximately $284.5 million secured debt and approximately $25.3 million unsecured debt related to the 7.0% senior unsecured notes due November 20, 2019 (the “7% Notes”) (not accounting for reductions of unamortized premiums or deferred financing costs as shown on our balance sheet). Historically, we have incurred debt for acquisitions and to fund our renovation, redevelopment and rebranding programs. Limitations upon our access to additional debt could adversely affect our ability to fund these programs or acquire hotels in the future.\\nOur financial leverage could negatively affect our business and financial results, including the following:\\n| • | require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for operations, working capital, capital expenditures, future business opportunities, paying dividends or other purposes; |\\n\\n| • | limit our ability to obtain additional financing for working capital, renovation, redevelopment and rebranding plans, acquisitions, debt service requirements and other purposes; |\\n\\n| • | adversely affect our ability to satisfy our financial obligations, including those related to the 7% Notes; |\\n\\n| • | limit our ability to refinance existing debt; |\\n\\n| • | require us to agree to additional restrictions and limitations on our business operations and capital structure to obtain financing; |\\n\\n| • | force us to dispose of one or more of our properties, possibly on unfavorable terms; |\\n\\n| • | increase our vulnerability to adverse economic and industry conditions, and to interest rate fluctuations; |\\n\\n| • | force us to issue additional equity, possibly on terms unfavorable to existing shareholders; |\\n\\n| • | limit our flexibility to make, or react to, changes in our business and our industry; and |\\n\\n| • | place us at a competitive disadvantage, compared to our competitors that have less debt. |\\n\\nWe must comply with financial covenants in our mortgage loan agreements and in the indenture.\\nOur mortgage loan agreements and indenture contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\\nIf we violate the financial covenants contained in our mortgage loan agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\\nIf we violate the financial covenants in the indenture, we may attempt to cure that violation by engaging in one or more transactions pursuant to the cure provision in the indenture.\\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through debt financing, private or public offerings of debt securities, additional equity financing, or by disposing of an asset. We are uncertain whether we will be able to refinance these obligations or if refinancing terms will be favorable.\\n13\\nWe have one mortgage debt obligation maturing in 2018, and if we are not successful in extending the term of this indebtedness or in refinancing this debt on acceptable economic terms or at all, our overall financial condition could be materially and adversely affected.\\nWe will be required to seek additional capital in the near future to refinance or replace existing long-term mortgage debt that is maturing. Based on current market conditions, the availability of financing is, and may continue to be, limited. There can be no assurance that we will be able to obtain future financings on acceptable terms, if at all.\\nIn August 2018, the mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures, and we have additional significant obligations maturing in subsequent years.\\nWe have no material debt obligations maturing in 2017. The total aggregate amount of our debt obligations scheduled to mature in 2018, inclusive of monthly amortization of all our indebtedness, is approximately $24.6 million, which represents approximately 7.9% of our total debt obligation outstanding as of December 31, 2016.\\nWe will need to, and plan to, renew, replace or extend our long-term indebtedness prior to the respective maturity date. If we are unable to extend this loan, we may be required to repay the outstanding principal amount at maturity or a portion of such indebtedness upon refinance. If we do not have sufficient funds to repay any portion of the indebtedness, it may be necessary to raise capital through debt financing, private or public offerings of debt securities or equity financings. We are uncertain whether we will be able to refinance this obligation or if refinancing terms will be favorable. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on refinancing, increases in interest expense would lower our cash flow, and, consequently, cash available to meet our financial obligations. If we are unable to obtain alternative or additional financing arrangements in the future, or if we cannot obtain financing on acceptable terms, we may not be able to execute our business strategies or we may be forced to dispose of hotel properties on disadvantageous terms, potentially resulting in losses and potentially reducing cash flow from operating activities if the sale proceeds in excess of the amount required to satisfy the indebtedness could not be reinvested in equally profitable real property investments. Moreover, the terms of any additional financing may restrict our financial flexibility, including the debt we may incur in the future, or may restrict our ability to manage our business as we had intended. To the extent we cannot repay our outstanding debt, we risk losing some or all of our hotel properties to foreclosure and we could be required to invoke insolvency proceedings including, but not limited to, commencing a voluntary case under the U.S. Bankruptcy Code.\\nFor tax purposes, a foreclosure of any of our hotels would be treated as a sale of the hotel for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the hotel, we would recognize taxable income on foreclosure, but we would not receive any cash proceeds, which could hinder the Company’s ability to meet the REIT distribution requirements imposed by the Code. In addition, we may give full or partial guarantees to lenders of mortgage debt on behalf of the entities that own our hotels. When we give a guarantee on behalf of an entity that owns one of our hotels, we will be responsible to the lender for satisfaction of the debt if it is not paid by such entity.\\nOur borrowing costs are sensitive to fluctuations in interest rates.\\nHigher interest rates could increase our debt service requirements and interest expense. Currently, our floating rate debt is limited to the mortgages on the DoubleTree by Hilton Philadelphia Airport, the DoubleTree by Hilton Jacksonville Riverfront, the Crowne Plaza Tampa Westshore and The Whitehall. Each of these mortgages bears interest at rates tied to the 1-month London Interbank Offered Rate (“LIBOR”) and provide for minimum rates of interest. To the extent that increases in the LIBOR rate of interest cause the interest on the mortgages to exceed the minimum rates of interest, we are exposed to rising interest rates.\\nShould we obtain new debt financing or refinance existing indebtedness, we may increase the amount of floating rate debt that currently exists. In addition, adverse economic conditions could also cause the terms on which we borrow to be unfavorable.\\nRisks Related to Our Business and Properties\\nIf the economy falls back into a recessionary period or fails to maintain positive growth, our operating performance and financial results may be harmed by declines in occupancy, average daily room rates and/or other operating revenues.\\nThe performance of the lodging industry and the general economy historically have been closely linked. In an economic downturn, business and leisure travelers may seek to reduce costs by limiting travel and/or reducing costs on their trips. Our hotels, which are all full-service hotels, may be more susceptible to a decrease in revenue, as compared to hotels in other categories that have lower room rates. A decrease in demand for hotel stays and hotel services will negatively affect our operating revenues, which will lower our cash flow and may affect our ability to make distributions to stockholders and to maintain compliance with our loan obligations. We had net loss attributable to the common shareholders of approximately $0.2 million for the 2016 fiscal year. A renewed economic downturn may increase our losses or reduce our income in the future. A weakening of the economy may adversely and materially affect our industry, business and results of operations and we cannot predict the likelihood, severity or duration of any such downturn. Moreover, reduced revenues as a result of a weakening economy may also reduce our working capital and impact our long-term business strategy.\\n14\\nWe own a limited number of hotels and significant adverse changes at one hotel could have a material adverse effect on our financial performance and may limit our ability to make distributions to stockholders.\\nAs of December 31, 2016, our portfolio consisted of twelve wholly-owned hotels with a total of 3,011 rooms. Significant adverse changes in the operations of any one hotel could have a material adverse effect on our financial performance and, accordingly, on our ability to make distributions to stockholders. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences.\\nWe are subject to risks of increased hotel operating expenses and decreased hotel revenues.\\nOur leases with our TRS Lessees provide for the payment of rent based in part on gross revenues from our hotels. Our TRS Lessees are subject to hotel operating risks including decreased hotel revenues and increased hotel operating expenses, including but not limited to the following:\\n| • | wage and benefit costs; |\\n\\n| • | repair and maintenance expenses; |\\n\\n| • | energy costs; |\\n\\n| • | property taxes; |\\n\\n| • | insurance costs; and |\\n\\n| • | other operating expenses. |\\n\\nAny increases in these operating expenses can have a significant adverse impact on our TRS Lessees’ ability to pay rent and other operating expenses and, consequently, our earnings and cash flow.\\nIn keeping with our investment strategy, we may acquire, renovate and/or re-brand hotels in new or existing geographic markets as part of our repositioning strategy. Unanticipated expenses and insufficient demand for newly repositioned hotels could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\\nWe have in the past, and may in the future, develop or acquire hotels in geographic areas in which our management may have little or no operating experience. Additionally, those properties may also be renovated and re-branded as part of a repositioning strategy. Potential customers may not be familiar with our newly renovated hotel or be aware of the brand change. As a result, we may have to incur costs relating to the opening, operation and promotion of those new hotel properties that are substantially greater than those incurred in other geographic areas. These hotels may attract fewer customers than expected and we may choose to increase spending on advertising and marketing to promote the hotel and increase customer demand. Unanticipated expenses and insufficient demand at new hotel properties, therefore, could adversely affect our financial performance and our ability to comply with covenants in the indenture and to make distributions to the Company’s stockholders.\\nWe do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel and as a result, our returns are dependent on the management of our hotels by Chesapeake Hospitality.\\nSince federal income tax laws restrict REITs and their subsidiaries from operating or managing hotels, we do not operate or manage our hotels. Instead, we lease all of our hotels to our TRS Lessees, and our TRS Lessees retain third-party managers to operate our hotels pursuant to management agreements.\\nUnder the terms of our management agreements with Chesapeake Hospitality and the REIT qualification rules, our ability to participate in operating decisions regarding the hotels is limited. We will depend on Chesapeake Hospitality to operate our hotels as provided in the management agreements. We do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel. Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, RevPAR, and average daily rates (“ADR”), we may not be able to force Chesapeake Hospitality to change its method of operating our hotels. Additionally, in the event that we need to replace Chesapeake Hospitality or any other management companies in the future, we may be required by the terms of the applicable management agreement to pay substantial termination fees and may experience significant disruptions at the affected hotels.\\n15\\nOur ability to make distributions to the Company’s stockholders is subject to fluctuations in our financial performance, operating results and capital improvement requirements.\\nAs a REIT, the Company is required to distribute, as “qualifying distributions,” at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items), each year to the Company’s stockholders. However, several factors may make us unable to declare or pay distributions to the Company’s stockholders, including poor operating results and financial performance or unanticipated capital improvements to our hotels, including capital improvements that may be required by our franchisors.\\nWe lease all of our hotels to our TRS Lessees. Our TRS Lessees are subject to hotel operating risks, including risks of sustaining operating losses after payment of hotel operating expenses, including management fees. Among the factors which could cause our TRS Lessees to fail to make required rent payments are reduced net operating profits or operating losses, increased debt service requirements and capital expenditures at our hotels, including capital expenditures required by the franchisors of our hotels. Among the factors that could reduce the net operating profits of our TRS Lessees are decreases in hotel revenues and increases in hotel operating expenses. Hotel revenue can decrease for a number of reasons, including increased competition from a new supply of hotel rooms and decreased demand for hotel rooms. These factors can reduce both occupancy and room rates at our hotels.\\nThe amount of any dividend distributions to holders of the Company’s common stock is in the sole discretion of the Company’s board of directors, which will consider, among other factors, our financial performance, debt service obligations, debt covenants and capital expenditure requirements. We cannot assure you that we will continue to generate sufficient cash to fund distributions.\\nGeographic concentration of our hotels makes our business vulnerable to economic downturns in the mid-Atlantic and southern United States.\\nOur hotels are located in the mid-Atlantic and southern United States. As a result, economic conditions in the mid-Atlantic and southern United States significantly affect our revenues and the value of our hotels to a greater extent than if we had a more geographically diversified portfolio. Business layoffs or downsizing, industry slowdowns, changing demographics and other similar factors that may adversely affect the economic climate in these areas could have a significant adverse impact on our business. Any resulting oversupply or reduced demand for hotels in the mid-Atlantic and southern United States and in our markets in particular would therefore have a disproportionate negative impact on our revenues and limit our ability to make distributions to stockholders.\\nA substantial number of our hotels operate under a brand owned by Hilton Worldwide (Hilton), InterContinental Hotels Group (IHG) and Marriott International, Inc. (Marriott) brands; therefore, we are subject to risks associated with concentrating our portfolio in three brands.\\nIn our portfolio, the majority of the hotels that we owned as of December 31, 2016 utilize brands owned by IHG, Marriott or Hilton. As a result, our success is dependent in part on the continued success of IHG, Marriott or Hilton and their respective brands. If market recognition or the positive perception of IHG, Marriott and/or Hilton is reduced or compromised, the goodwill associated with the IHG, Marriott and Hilton branded hotels in our portfolio may be adversely affected, which may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders.\\nHedging against interest rate exposure may adversely affect us and our hedges may fail to protect us from the losses that the hedges were designed to offset.\\nSubject to maintaining the Company’s qualification as a REIT, we may elect to manage our exposure to interest rate volatility by using interest rate hedging arrangements, such as cap agreements and swap agreements. These agreements involve the risks that these arrangements may fail to protect or adversely affect us because, among other things:\\n| • | interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; |\\n\\n| • | available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought; |\\n\\n| • | the financial instruments we select may not have the effect of reducing our interest rate risk; |\\n\\n| • | the duration of the hedge may not match the duration of the related liability; |\\n\\n| • | the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and |\\n\\n| • | the hedging counterparty owing money in the hedging transaction may default on its obligation to pay. |\\n\\n16\\nAs a result of any of the foregoing, our hedging transactions, which are intended to limit losses, may fail to protect us from the losses that the hedges were designed to offset and could have a material adverse effect on us.\\nOur investment opportunities and growth prospects may be affected by competition for acquisitions.\\nWe compete for investment opportunities with other entities, some of which have substantially greater financial resources than we do. This competition may generally limit the number of suitable investment opportunities offered to us, which may limit our ability to grow. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms, or at all.\\nIf we fail to maintain an effective system of internal controls, we may not be able to accurately determine our financial results or prevent fraud. As a result, the Company’s stockholders could lose confidence in our financial results, which could harm our business and the value of the Company’s shares.\\nEffective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate and report on our internal controls over financial reporting. Our internal controls and financial reporting are not subject to attestation by our independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. While we have undertaken substantial work to comply with Section 404, we cannot be certain that we will be successful in maintaining adequate internal controls over our financial reporting and financial processes in the future. We may in the future discover areas of our internal controls that need improvement. Furthermore, as we grow our business, our internal controls will become more complex, and we will require significantly more resources to ensure our internal controls remain effective. If we or our independent auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could reduce the market value of the Company’s shares. Additionally, the existence of any material weakness or significant deficiency would require management to devote significant time and incur significant expense to remediate any such material weaknesses or significant deficiencies and management may not be able to remediate any such material weaknesses or significant deficiencies in a timely manner. In 2014, we identified a material weakness in our internal control over financial reporting which has been remediated.\\nWe are subject to cyber-security risks related to breaches of security pertaining to sensitive company, customer, employee and vendor information as well as breaches in the technology that manages operations and other business processes.\\nOur business operations rely upon secure information technology systems for data capture, processing, storage and reporting. Despite careful security and controls design, implementation, updating and independent third party verification, our information technology systems, and those of our third party providers, could become subject to cyber-attacks. Network, system, application and data breaches could result in operational disruptions or information misappropriation including, but not limited to interruption to systems availability, denial of access to and misuse of applications required by our customers. Access to internal applications required to plan our operations could be denied or misused. Inappropriate disclosure of confidential company, employee, customer or vendor information, could stem from such incidents. Any of these operational disruptions and/or misappropriation of information could result in lost sales, business delays, and negative publicity and could have a material effect on our business.\\nRisks Related to Conflicts of Interest of Our Officers and Directors\\nConflicts of interest could result in our executive officers and certain of our directors acting in a manner other than in the Company’s stockholders’ best interest.\\nConflicts of interest relating to Chesapeake Hospitality, the entity that manages the properties, and the terms of its management agreements may lead to management decisions that are not in the stockholders’ best interest.\\nConflicts of interest relating to Chesapeake Hospitality may lead to management decisions that are not in the stockholders’ best interest. Andrew M. Sims, our chairman and chief executive officer, and Kim E. Sims, a former member of our board of directors, together own a substantial interest in Chesapeake Hospitality which manages our hotel properties.\\nOur management agreements establish the terms of Chesapeake Hospitality’s management of our hotels. The new Master Agreement provides that in the event the agreement is terminated in connection with the sale of a hotel, and Chesapeake Hospitality accepts an offer to manage another hotel which is reasonable comparable to the hotel that was sold, we will not be liable for any termination fee. If we do not offer Chesapeake Hospitality such opportunity or Chesapeake Hospitality declines such opportunity, then a termination fee equivalent to the lesser of the management fees paid for the prior twelve-month period or the management fees for the period prior to the sale that is equal to the number of months remaining under the term of the agreement will be due. If we terminate the agreement at the end of any renewable five-year term, Chesapeake Hospitality is due a termination fee equivalent to one month’s management fees, as determined under the agreement.\\n17\\nAs a significant owner of Chesapeake Hospitality, which would receive any management and management termination fees payable by us under the management agreement, Andrew M. Sims may influence our decisions to sell a hotel or acquire or develop a hotel when it is not in the best interests of the Company’s stockholders to do so. In addition, Andrew M. Sims will have conflicts of interest with respect to decisions to enforce provisions of the management agreement, including any termination thereof.\\nThere can be no assurance that provisions in our bylaws will always be successful in mitigating conflicts of interest.\\nUnder our bylaws, a committee consisting of only independent directors must approve any transaction between us and Chesapeake Hospitality or its affiliates or any interested director. However, there can be no assurance that these policies always will be successful in mitigating such conflicts, and decisions could be made that might not fully reflect the interests of all of the Company’s stockholders.\\nCertain of our officers and directors control trusts that hold units in our Operating Partnership and may seek to avoid adverse tax consequences, which could result from transactions that would otherwise benefit the Company’s stockholders.\\nHolders of units in our Operating Partnership, including trusts controlled in whole or part by members of our management team, may suffer adverse tax consequences upon our sale or refinancing of certain properties. Therefore, holders of units, including a trust controlled by Andrew M. Sims and two former members of our board of directors, and a charitable trust controlled by Edward S. Stein, may have different objectives than holders of the Company’s stock regarding the appropriate pricing and timing of a property’s sale, or the timing and amount of a property’s refinancing. As of December 31, 2016, these trusts owned approximately 1.0% of the outstanding units in our Operating Partnership. Although the individuals controlling the trusts do not have any beneficial interest in the trusts, they may influence us not to sell or refinance certain properties, even if such sale or refinancing might be financially advantageous to the Company’s stockholders, or may influence us to enter into tax-deferred exchanges with the proceeds of such sales when such a reinvestment might not otherwise be in our best interest.\\nOur agreements with Chesapeake Hospitality and its affiliates, including the contribution agreements and the partnership agreement of our Operating Partnership, were not negotiated on an arms’ length basis and may be less favorable to us than we could have obtained from third parties.\\nIn connection with the Company’s initial public offering, we entered into various agreements with Chesapeake Hospitality and its affiliates, including contribution agreements, a master management agreement, a strategic alliance agreement, subleases, the partnership agreement of our Operating Partnership and employment agreements – of which only the contribution agreements and the partnership agreement of our Operating Partnership have not expired. In addition, we entered into various separate management agreements with Chesapeake Hospitality which have all been superseded by the new master management agreement and new individual hotel agreements executed in December 2014. The terms of all of these agreements were determined by our management team, who had conflicts of interest as described above and ownership interests in Chesapeake Hospitality and its affiliates. The terms of all of these agreements may be less favorable to us than we could have obtained from third parties.\\nRisks Related to the Lodging Industry\\nOur ability to comply with the terms of the indenture, our ability to make distributions to the Company’s stockholders and the value of our hotels in general, may be adversely affected by factors in the lodging industry.\\nOperating Risks\\nOur hotel properties are subject to various operating risks common to the lodging industry, many of which are beyond our control, including the following:\\n| • | competition from other hotel properties in our markets; |\\n\\n| • | over-building of hotels in our markets, which adversely affects occupancy and revenues at our hotels; |\\n\\n| • | dependence on business and commercial travelers and tourism; |\\n\\n| • | increases in energy costs and other expenses affecting travel, which may affect travel patterns and reduce the number of business and commercial travelers and tourists; |\\n\\n| • | increases in operating costs due to inflation and other factors, including increases in labor costs, that may not be offset by increased room rates; |\\n\\n| • | changes in interest rates and in the availability, cost and terms of debt financing; |\\n\\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\\n\\n18\\n\\n| • | adverse effects of international, national, regional and local economic and market conditions; |\\n\\n| • | adverse effects of a downturn in the lodging industry; and |\\n\\n| • | risks generally associated with the ownership of hotel properties and real estate, as we discuss in detail below. |\\n\\nThese factors could reduce the net income of our TRS Lessees, which in turn could adversely affect the value of our hotels and our ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders.\\nCompetition for Acquisitions\\nWe may compete for investment opportunities with entities that may have substantially greater financial resources than we do. These entities generally may be able to accept more risk than we choose to prudently manage. This competition may generally limit the number of suitable investment opportunities offered to us. This competition may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new properties on attractive terms.\\nSeasonality of the Hotel Business\\nThe lodging industry is seasonal in nature, which can be expected to cause quarterly fluctuations in our revenues. Our quarterly earnings may be adversely affected by factors outside our control, including weather conditions and poor economic factors. As a result, we may have to enter into short-term borrowings in certain quarters in order to offset these fluctuations in revenues and to make distributions to the Company’s stockholders.\\nInvestment Concentration in Particular Segments of a Single Industry\\nOur entire business is lodging-related. Therefore, a downturn in the lodging industry, in general, and the full-service, upscale and upper-upscale segments in which we operate, in particular, will have a material adverse effect on the value of our hotels, our financial condition and the extent to which cash may be available for distribution to the Company’s stockholders.\\nCapital Expenditures\\nOur hotel properties have an ongoing need for renovations and other capital improvements, including replacements, from time to time, of furniture, fixtures and equipment. The franchisors of our hotels also require us to make periodic capital improvements as a condition of keeping the franchise licenses. In addition, several of our mortgage lenders require that we set aside amounts for capital improvements to the secured properties on a monthly basis. For the years ended December 31, 2016 and 2015, we spent approximately $14.8 million and approximately $20.1 million, respectively, on capital improvements to our hotels. Capital improvements and renovation projects may give rise to the following risks:\\n| • | possible environmental problems; |\\n\\n| • | construction cost overruns and delays; |\\n\\n| • | a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available to us on affordable terms; and |\\n\\n| • | uncertainties as to market demand or a loss of market demand after capital improvements have begun. |\\n\\nThe costs of all these capital improvements as well as future capital improvements could adversely affect our financial condition and amounts available for distribution to the Company’s stockholders.\\nOperating our hotels under franchise agreements could increase our operating costs and lower our net income.\\nMost of our hotels operate under franchise agreements which subject us to risks in the event of negative publicity related to one of our franchisors.\\nThe maintenance of the franchise licenses for our hotels is subject to our franchisors’ operating standards and other terms and conditions. Our franchisors periodically inspect our hotels to ensure that we, our TRS Lessees, and the management company follow their standards. Failure by us, our TRS Lessees or the management company to maintain these standards or other terms and conditions could result in a franchise license being canceled. If a franchise license terminates due to our failure to make required improvements or to otherwise comply with its terms, we may also be liable to the franchisor for a termination payment, which varies by franchisor and by hotel. As a condition of continuing a franchise license, a franchisor may require us to make capital expenditures, even if we do not believe the capital improvements are necessary or desirable or will result in an acceptable return on our investment. Nonetheless, we may risk losing a franchise license if we do not make franchisor-required capital expenditures.\\n19\\nIf a franchisor terminates the franchise license, we may try either to obtain a suitable replacement franchise license or to operate the hotel without a franchise license. The loss of a franchise license could significantly decrease the revenues at the hotel and reduce the underlying value of the hotel because of the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchisor. A loss of a franchise license for one or more hotels could materially and adversely affect our revenues. This loss of revenues could, therefore, also adversely affect our financial condition and results of operations, our ability to comply with the terms of the indenture and reduce our cash available for distribution to stockholders.\\nRestrictive covenants in certain of our franchise agreements contain provisions that may operate to limit our ability to sell or refinance our hotels, which could have a material adverse effect on us.\\nFranchise agreements typically contain covenants that may affect our ability to sell or refinance a hotel, including requirements to obtain the consent of the franchisor in the event of such a sale or refinancing transaction. In the event that a franchisor’s consent is not forthcoming, the terms of a sale or refinancing may be less favorable to us than would otherwise be the case. Some of our franchise agreements provide the franchisor with a right of first offer in the event of certain sales or transfers of a hotel and provide that the franchisor has the right to approve any change in the hotel management company engaged to manage the hotel. Generally, we may be limited in our ability to sell, lease or otherwise transfer hotels unless the transferee is not a competitor of the franchisor and the transferee agrees to assume the related franchise agreements. If the franchisor does not consent to the sale or financing of our hotels, we may be unable to consummate transactions that are in our best interests or the terms of those transactions may be less favorable to us, which could have a material adverse effect on our financial condition and the execution of our strategies.\\nHotel re-development is subject to timing, budgeting and other risks that would increase our operating costs and limit our ability to make distributions to stockholders.\\nWe intend to acquire hotel properties from time to time as suitable opportunities arise, taking into consideration general economic conditions, and seek to re-develop or reposition these hotels. Redevelopment of hotel properties involves a number of risks, including risks associated with:\\n| • | construction delays or cost overruns that may increase project costs; |\\n\\n| • | receipt of zoning, occupancy and other required governmental permits and authorizations; |\\n\\n| • | development costs incurred for projects that are not pursued to completion; |\\n\\n| • | acts of God such as earthquakes, hurricanes, floods or fires that could adversely impact a project; |\\n\\n| • | financing; and |\\n\\n| • | governmental restrictions on the nature or size of a project. |\\n\\nWe cannot assure you that any re-development project will be completed on time or within budget. Our inability to complete a project on time or within budget would increase our operating costs and reduce our net income.\\nThe hotel business is capital intensive and our inability to obtain financing could limit our growth.\\nOur hotel properties will require periodic capital expenditures and renovation to remain competitive. Acquisitions or development of additional hotel properties will require significant capital expenditures. In addition, several of our mortgage lenders require that we set aside annual amounts for capital improvements to the secured property. We may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we must distribute at least 90.0% of our REIT taxable income, excluding net capital gains, each year to maintain our REIT tax status. As a result, our ability to fund significant capital expenditures, acquisitions or hotel development through retained earnings is very limited. Consequently, we rely upon the availability of debt or equity capital to fund any significant investments or capital improvements. Our ability to grow through acquisitions or development of hotels will be limited if we cannot obtain satisfactory debt or equity financing which will depend on market conditions. Neither our charter nor our bylaws limit the amount of debt that we can incur. However, we cannot assure you that we will be able to obtain additional equity or debt financing or that we will be able to obtain such financing on favorable terms.\\n20\\nUninsured and underinsured losses could adversely affect our operating results and our ability to make distributions to the Company’s stockholders.\\nWe maintain comprehensive insurance on each of our hotel properties, including liability, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel owners. There are no assurances that current coverage will continue to be available at reasonable rates. Various types of catastrophic losses, like hurricanes, earthquakes and floods, such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, losses from foreign terrorist activities, such as those on September 11, 2001, or losses from domestic terrorist activities, such as the Oklahoma City bombing on April 19, 1995, may not be insurable or may not be economically insurable. Currently, our insurers provide terrorism coverage in conjunction with the Terrorism Risk Insurance Program sponsored by the federal government through which insurers are able to receive compensation for insured losses resulting from acts of terrorism.\\nIn the event of a substantial loss, our insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a hotel, as well as the anticipated future revenue from the hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position on the damaged or destroyed property.\\nNoncompliance with governmental regulations could adversely affect our operating results.\\nEnvironmental Matters\\nOur hotels may be subject to environmental liabilities. An owner of real property can face liability for environmental contamination created by the presence or discharge of hazardous substances on the property. We may face liability regardless of:\\n| • | our knowledge of the contamination; |\\n\\n| • | the timing of the contamination; |\\n\\n| • | the cause of the contamination; or |\\n\\n| • | the party responsible for the contamination of the property. |\\n\\nThere may be unknown environmental problems associated with our properties. If environmental contamination exists on our properties, we could become subject to strict, joint and several liability for the contamination by virtue of our ownership interest.\\nThe presence of hazardous substances on a property may adversely affect our ability to sell the property and we may incur substantial remediation costs. The discovery of environmental liabilities attached to our properties could have a material adverse effect on our results of operations and financial condition and our ability to comply with our covenants and to pay distributions to stockholders.\\nAmericans with Disabilities Act and Other Changes in Governmental Rules and Regulations\\nUnder the Americans with Disabilities Act of 1990, or the ADA, all public accommodations must meet various federal requirements related to access and use by disabled persons. Compliance with the ADA’s requirements could require removal of access barriers, and non-compliance could result in the U.S. government imposing fines or in private litigants winning damages. If we are required to make substantial modifications to our hotels, whether to comply with the ADA or other changes in governmental rules and regulations, our financial condition, results of operations and ability to comply with the terms of the indenture and to make distributions to the Company’s stockholders could be adversely affected.\\nOur hotels may be subject to unknown or contingent liabilities which could cause us to incur substantial costs.\\nThe hotel properties that we acquire may be subject to unknown or contingent liabilities for which we may have no recourse, or only limited recourse, against the sellers. Contingent or unknown liabilities with respect to entities or properties acquired might include:\\n| • | liabilities for environmental conditions; |\\n\\n| • | losses in excess of our insured coverage; |\\n\\n| • | accrued but unpaid liabilities incurred in the ordinary course of business; |\\n\\n21\\n\\n| • | tax, legal and regulatory liabilities; |\\n\\n| • | claims of customers, vendors or other persons dealing with the Company’s predecessors prior to our formation or acquisition transactions that had not been asserted or were unknown prior to the Company’s formation or acquisition transactions; and |\\n\\n| • | claims for indemnification by the general partners, officers and directors and others indemnified by the former owners of our properties. |\\n\\nIn general, the representations and warranties provided under the transaction agreements related to the sales of the hotel properties may not survive the closing of the transactions. While we will likely seek to require the sellers to indemnify us with respect to breaches of representations and warranties that survive, such indemnification may be limited and subject to various materiality thresholds, a significant deductible or an aggregate cap on losses. As a result, there is no guarantee that we will recover any amounts with respect to losses due to breaches by the sellers of their representations and warranties. In addition, the total amount of costs and expenses that may be incurred with respect to liabilities associated with these hotels may exceed our expectations, and we may experience other unanticipated adverse effects, all of which may adversely affect our financial condition, results of operations and our ability to make distributions to the Company’s stockholders.\\nFuture terrorist activities may adversely affect, and create uncertainty in, our business.\\nTerrorism in the United States or elsewhere could have an adverse effect on our business, although the degree of impact will depend on a number of factors, including the U.S. and global economies and global financial markets. Previous terrorist attacks in the United States and subsequent terrorism alerts have adversely affected the travel and hospitality industries over the past several years. Such attacks, or the threat of such attacks, could have a material adverse effect on our business, our ability to finance our business, our ability to insure our properties and/or our results of operations and financial condition, as a whole.\\nWe face risks related to pandemic diseases, which could materially and adversely affect travel and result in reduced demand for our hotels.\\nOur business could be materially and adversely affected by the effect of a pandemic disease on the travel industry. For example, the outbreaks of SARS and avian flu in 2003 had a severe impact on the travel industry, the outbreaks of H1N1 flu in 2009 threatened to have a similar impact, and the perceived threat of a Zika virus outbreak in 2016 had an impact on the south Florida market. A prolonged recurrence of SARS, avian flu, H1N1 flu, Ebola virus, Zika virus or another pandemic disease also may result in health or other government authorities imposing restrictions on travel. Any of these events could result in a significant drop in demand for our hotels and adversely affect our financial conditions and results of operations.\\nGeneral Risks Related to the Real Estate Industry\\nIlliquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties and harm our financial condition.\\nBecause real estate investments are relatively illiquid, our ability to promptly sell one or more hotel properties in our portfolio in response to changing economic, financial and investment conditions is limited.\\nThe real estate market is affected by many factors that are beyond our control, including:\\n| • | adverse changes in international, national, regional and local economic and market conditions; |\\n\\n| • | changes in interest rates and in the cost and terms of debt financing; |\\n\\n| • | absence of liquidity in credit markets which limits the availability and amount of debt financing; |\\n\\n| • | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; |\\n\\n| • | the ongoing need for capital improvements, particularly in older structures; |\\n\\n| • | changes in operating expenses; and |\\n\\n| • | civil unrest, acts of God, including earthquakes, floods and other natural disasters such as Hurricane Matthew in October 2016 and Hurricane Sandy in October 2012, which may result in uninsured losses, and acts of war or terrorism, including the consequences of terrorist acts, such as those that occurred on September 11, 2001. |\\n\\n22\\nWe may decide to sell our hotels in the future. We cannot predict whether we will be able to sell any hotel property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a hotel property.\\nWe may be required to expend funds to correct defects or to make improvements before a hotel property can be sold. We cannot assure you that we will have funds available to correct those defects or to make those improvements. In acquiring a hotel property, we may agree to lock-out provisions that materially restrict us from selling that property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that property. These factors and any others that would impede our ability to respond to adverse changes in the performance of our properties could have a material adverse effect on our operating results and financial condition, as well as our ability to comply with the terms of the indenture and to pay distributions to stockholders.\\nFuture acquisitions may not yield the returns expected, may result in disruptions to our business, may strain management resources and may result in stockholder dilution.\\nOur business strategy may not ultimately be successful and may not provide positive returns on our investments. Acquisitions may cause disruptions in our operations and divert management’s attention away from day-to-day operations. The issuance of equity securities in connection with any acquisition could be substantially dilutive to the Company’s stockholders.\\nOur hotels may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem.\\nWhen excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing, as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property, which would reduce our cash available for distribution. In addition, the presence of significant mold could expose us to liability from our guests, employees or the management company and others if property damage or health concerns arise and could harm our reputation.\\nIncreases in property taxes would increase our operating costs, reduce our income and adversely affect our ability to make distributions to the Company’s stockholders.\\nEach of our hotel properties is subject to real and personal property taxes. These taxes may increase as tax rates change and as the properties are assessed or reassessed by taxing authorities. If property taxes increase, our financial condition, results of operations and our ability to make distributions to the Company’s stockholders could be materially and adversely affected and the market price of the Company’s shares could decline.\\nRisks Related to Our Organization and Structure\\nOur ability to effect a merger or other business combination transaction may be restricted by our Operating Partnership agreement.\\nIn the event of a change of control of the Company, the limited partners of our Operating Partnership will have the right, for a period of 30 days following the change of control event, to cause the Operating Partnership to redeem all of the units held by the limited partners for a cash amount equal to the cash redemption amount otherwise payable upon redemption pursuant to the partnership agreement. This cash redemption right may make it more unlikely or difficult for a third party to propose or consummate a change of control transaction, even if such transaction were in the best interests of the Company’s stockholders.\\nProvisions of the Company’s charter may limit the ability of a third party to acquire control of the Company.\\nAggregate Share and Common Share Ownership Limits\\nThe Company’s charter provides that no person may directly or indirectly own more than 9.9% of the value of the Company’s outstanding shares of capital stock or more than 9.9% of the number of the Company’s outstanding shares of common stock. These ownership limitations may prevent an acquisition of control of the Company by a third party without the Company’s board of directors’ approval, even if the Company’s stockholders believe the change of control is in their interest. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\\n23\\nAuthority to Issue Stock\\nThe Company’s amended and restated charter authorizes our board of directors to issue up to 49,000,000 shares of common stock and up to 11,000,000 shares of preferred stock, to classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares. Issuances of additional shares of stock may have the effect of delaying or preventing a change in control of the Company, including transactions at a premium over the market price of the Company’s stock, even if stockholders believe that a change of control is in their interest. The Company will be able to issue additional shares of common or preferred stock without stockholder approval, unless stockholder approval is required by applicable law or the rules of any stock exchange or automated quotation system on which the Company’s securities may be listed or traded.\\nProvisions of Maryland law may limit the ability of a third party to acquire control of the Company.\\nCertain provisions of the Maryland General Corporation Law, or the MGCL, may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change of control under circumstances that otherwise could provide the holders of shares of the Company’s common stock with the opportunity to realize a premium over the then-prevailing market price of such shares, including:\\n| • | “business combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10.0% or more of the voting power of our shares or an affiliate thereof) for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes special appraisal rights and special stockholder voting requirements on these combinations; and |\\n\\n| • | “control share” provisions that provide that “control shares” of the Company (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by the Company’s stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares. |\\n\\nThe Company has opted out of these provisions of the MGCL, in the case of the business combination provisions of the MGCL by resolution of the Company’s board of directors, and in the case of the control share provisions of the MGCL pursuant to a provision in the Company’s bylaws. However, the Company’s board of directors may by resolution elect to opt in to the business combination provisions of the MGCL and the Company may, by amendment to its bylaws, opt in to the control share provisions of the MGCL in the future. The Company’s board of directors has the exclusive power to amend the Company’s bylaws.\\nAdditionally, Title 8, Subtitle 3 of the MGCL permits the Company’s board of directors, without stockholder approval and regardless of what is currently provided in the Company’s charter or bylaws, to implement takeover defenses, some of which (for example, a classified board) the Company does not currently have. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for the Company or of delaying, deferring or preventing a change in control of the Company under the circumstances that otherwise could provide the holders of the Company’s common stock with the opportunity to realize a premium over the then current market price.\\nProvisions in the Company’s executive officers’ employment agreements may make a change of control of the Company more costly or difficult.\\nThe Company’s employment agreements with Andrew M. Sims, its chief executive officer, David R. Folsom, its president and chief operating officer, and Anthony E. Domalski, its chief financial officer, contain provisions providing for substantial payments to these officers in the event of a change of control of the Company. Specifically, if the Company terminates these executive’s employment without cause or the executive resigns with good reason, which includes a failure to nominate Andrew M. Sims to the Company’s board of directors or his involuntary removal from the Company’s board of directors, unless for cause or by vote of the stockholders, or if there is a change of control, each of these executives is entitled to the following:\\n| • | any accrued but unpaid salary and bonuses; |\\n\\n| • | vesting of any previously issued stock options and restricted stock; |\\n\\n| • | payment of the executive’s life, health and disability insurance coverage for a period of five years following termination; |\\n\\n| • | any unreimbursed expenses; and |\\n\\n| • | a severance payment equal to three times for Andrew M. Sims’, David R. Folsom’s and Anthony E. Domalski’s respective combined salary and actual bonus compensation for the preceding fiscal year. |\\n\\n24\\nIn addition, these executives will receive additional payments to compensate them for the additional taxes, if any, imposed on them under Section 4999 of the Code by reason of receipt of excess parachute payments. We will not be able to deduct any of the above amounts paid to the executives for tax purposes.\\nThese provisions may make a change of control of the Company, even if it is in the best interests of the Company’s stockholders, more costly and difficult and may reduce the amounts the Company’s stockholders would receive in a change of control transaction.\\nOur ownership limitations may restrict or prevent you from engaging in certain transfers of the Company’s common stock or preferred stock.\\nIn order to maintain the Company’s REIT qualification, it cannot be closely held (i.e., more than 50.0% in value of our outstanding stock cannot be owned, directly or indirectly, by five or fewer individuals during the last half of any taxable year). To preserve the Company’s REIT qualification, the Company’s charter contains a 9.9% aggregate share ownership limit and a 9.9% common share ownership limit. Generally, any shares of the Company’s stock owned by affiliated persons will be added together for purposes of the aggregate share ownership limit, and any shares of common stock owned by affiliated owners will be added together for purposes of the common share ownership limit.\\nIf anyone transfers shares in a way that would violate the aggregate share ownership limit or the common share ownership limit, or prevent the Company from continuing to qualify as a REIT under the federal income tax laws, those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate the aggregate share ownership limit or the common share ownership limit. If this transfer to a trust fails to prevent such a violation or fails to preserve the Company’s continued qualification as a REIT, then the Company will consider the initial intended transfer to be null and void from the outset. The intended transferee of those shares will be deemed never to have owned the shares. Anyone who acquires shares in violation of the aggregate share ownership limit, the common share ownership limit or the other restrictions on transfer in the Company’s charter bears the risk of suffering a financial loss when the shares are redeemed or sold if the market price of the Company’s stock falls between the date of purchase and the date of redemption or sale.\\nThe Company’s articles supplementary establishing and fixing the rights and preferences of Series B preferred stock provide that no person may directly or indirectly own more than 9.9% of the aggregate number of outstanding shares of Series B preferred stock, excluding any outstanding shares of Series B preferred stock not treated as outstanding for federal income tax purposes. The Company’s board of directors has discretion to waive that ownership limit if, including other considerations, the board receives evidence that ownership in excess of the limit will not jeopardize the Company’s REIT status.\\nHolders of our outstanding preferred shares have dividend, liquidation and other rights that are senior to the rights of the holders of our common shares.\\nOur board of directors has the authority to designate and issue preferred shares with liquidation, dividend and other rights that are senior to those of our common shares. As of December 31, 2016, 1,610,000 shares of our 8.0% Series B Cumulative Redeemable Preferred Stock were issued and outstanding. The aggregate liquidation preference with respect to the outstanding preferred shares is approximately $40.3 million, and annual dividends on our outstanding preferred shares are approximately $3.2 million. Holders of our Series B Preferred Stock are entitled to cumulative dividends before any dividends may be declared or set aside on our common shares. Upon our voluntary or involuntary liquidation, dissolution or winding up, before any payment is made to holders of our common shares, holders of these preferred shares are entitled to receive a liquidation preference of $25.00 per share plus any accrued and unpaid distributions. This will reduce the remaining amount of our assets, if any, available to distribute to holders of our common shares. In addition, holders of these preferred shares have the right to elect two additional directors to our board of directors whenever dividends on the preferred shares are in arrears in an aggregate amount equivalent to six or more quarterly dividends (whether or not consecutive). Because our decision to issue securities will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of any future preferred offerings. Thus, our stockholders bear the risk of our future securities issuances reducing the market price of our common shares and diluting their interest.\\nThe change of control conversion and redemption features of the Series B Preferred Stock may make it more difficult for a party to take over our Company or discourage a party from taking over our Company.\\nUpon a change of control (as defined in our charter), holders of our Series B Preferred Stock will have the right (unless, as provided in our charter, we have provided or provide notice of our election to exercise our special optional redemption right before the relevant date) to convert some or all of their shares of our Series B Preferred Stock into shares of our common stock (or equivalent value of alternative consideration). Upon such a conversion, holders will be limited to a maximum number of shares equal to the share cap, subject to adjustments. If the common stock price is less than $3.015, subject to adjustment, holders will receive a maximum of\\n25\\n8.29187 shares of our common stock per share of Series B Preferred Stock, which may result in a holder receiving value that is less than the liquidation preference of the Series B Preferred Stock. In addition, those features of our Series B Preferred Stock may have the effect of inhibiting or discouraging a third party from making an acquisition proposal for our Company or of delaying, deferring or preventing a change in control of our Company under circumstances that otherwise could provide the holders of shares of our common stock and shares of our Series B Preferred Stock with the opportunity to realize a premium over the then current market price or that stockholders may otherwise believe is in their best interests.\\nThe board of directors’ revocation of the Company’s REIT status without stockholder approval may decrease the Company’s stockholders’ total return.\\nThe Company’s charter provides that the Company’s board of directors may revoke or otherwise terminate the Company’s REIT election, without the approval of the Company’s stockholders, if the Company’s board of directors determines that it is no longer in the Company’s best interest to continue to qualify as a REIT. If the Company ceases to be a REIT, it would become subject to federal income tax on its taxable income and would no longer be required to distribute most of its taxable income to the Company’s stockholders, which may have adverse consequences on our total return to the Company’s stockholders.\\nThe ability of the Company’s board of directors to change the Company’s major corporate policies may not be in your best interest.\\nThe Company’s board of directors determines the Company’s major corporate policies, including its acquisition, financing, growth, operations and distribution policies. The Company’s board of directors may amend or revise these and other policies from time to time without the vote or consent of the Company’s stockholders.\\nOur success depends on key personnel whose continued service is not guaranteed.\\nWe depend on the efforts and expertise of our chairman and chief executive officer, Andrew M. Sims; our president and chief operating officer, David R. Folsom; and our chief financial officer, Anthony E. Domalski, to manage our day-to-day operations and strategic business direction. The loss of any of their services could have an adverse effect on our operations.\\nFederal Income Tax Risks Related to the Company’s Status as a REIT\\nThe federal income tax laws governing REITs are complex.\\nThe Company intends to operate in a manner that will maintain its qualification as a REIT under the federal income tax laws. The REIT qualification requirements are extremely complex, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited. The Company has not requested or obtained a ruling from the Internal Revenue Service, or the IRS, that it qualifies as a REIT. Accordingly, we cannot be certain that the Company will be successful in operating in a manner that will permit it to qualify as a REIT. At any time, new laws, interpretations or court decisions may change the federal tax laws or the federal income tax consequences of the Company’s qualification as a REIT. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. The Company and its stockholders could be adversely affected by any such change in, or any new, federal income tax law, regulation or administrative interpretation. We are not aware, however, of any pending tax legislation that would adversely affect the Company’s ability to qualify as a REIT.\\nFailure to make distributions could subject the Company to tax.\\nIn order to maintain its qualification as a REIT, each year the Company must pay out to its stockholders in distributions, as “qualifying distributions,” at least 90.0% of its REIT taxable income, computed without regard to the deductions for dividends paid and excluding net capital gains and reduced by certain non-cash items. To the extent that the Company satisfies this distribution requirement, but distributes less than 100.0% of its taxable income (including its net capital gain), it will be subject to federal corporate income tax on its undistributed taxable income. In addition, the Company will be subject to a 4.0% nondeductible excise tax if the actual amount that it pays out to its stockholders as a “qualifying distribution” for a calendar year is less than the sum of: (A) 85.0% of our ordinary income for such calendar year, plus (B) 95.0% of our capital gain net income for such calendar year. The Company’s only recurring source of funds to make these distributions comes from rent received from its TRS Lessees whose only recurring source of funds with which to make these payments and distributions is the net cash flow (after payment of operating and other costs and expenses and management fees) from hotel operations, and any dividend and other distributions that we may receive from MHI Holding. Accordingly, the Company may be required to borrow money or sell assets to make distributions sufficient to enable it to pay out enough of its taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4.0% nondeductible excise tax in a particular year.\\n26\\nFailure to qualify as a REIT would subject the Company to federal income tax.\\nIf the Company fails to qualify as a REIT in any taxable year, it will be required to pay federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. The resulting tax liability might cause the Company to borrow funds, liquidate some of its investments or take other steps that could negatively affect its operating results in order to pay any such tax. Unless it is entitled to relief under certain statutory provisions, the Company would be disqualified from treatment as a REIT for the four taxable years following the year in which it lost its qualification. If the Company lost its REIT status, its net earnings available for investment or distribution to stockholders would be significantly reduced for each of the years involved. In addition, the Company would no longer be required to make distributions to its stockholders, and it would not be able to deduct any stockholder distributions in computing its taxable income. This would substantially reduce the Company’s earnings, cash available to pay distributions, and the value of common stock.\\nFailure to qualify as a REIT may cause the Company to reduce or eliminate distributions to its stockholders, and the Company may face increased difficulty in raising capital or obtaining financing.\\nIf the Company fails to remain qualified as a REIT, it may have to reduce or eliminate any distributions to its stockholders in order to satisfy its income tax liabilities. Any distributions that the Company does make to its stockholders would be treated as taxable dividends to the extent of its current and accumulated earnings and profits. This may result in negative investor and market perception regarding the market value of the Company’s stock, and the value of its stock may be reduced. In addition, the Company and the Operating Partnership may face increased difficulty in raising capital or obtaining financing if the Company fails to qualify or remain qualified as a REIT because of the resulting tax liability and potential reduction of its market valuation.\\nIf MHI Holding exceeds certain value thresholds, this could cause the Company to fail to qualify as a REIT.\\nFor taxable years of the Company ending on or before December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 25.0% of the value of the Company’s total assets may consist of securities of one or more taxable REIT subsidiaries (“TRSs”). For taxable years of the Company ending after December 31, 2017, at the end of each quarter of each taxable year of the Company, no more than 20.0% of the value of the Company’s total assets may consist of securities of one or more TRSs. MHI Holding is a TRS and the Company may form other TRSs in the future. The Company plans to monitor the value of its shares of MHI Holding and of any other TRS the Company may form. However, there can be no assurance that the Internal Revenue Service will not attempt to attribute additional value to the shares of MHI Holding or to the shares of any other TRS that the Company may form. If the Company is treated as owning securities of one or more TRSs with an aggregate value that is in excess of the thresholds outlined above, the Company could lose its status as a REIT or become subject to penalties.\\nEven if the Company remains qualified as a REIT, it may face other tax liabilities that reduce its cash flow.\\nEven if the Company remains qualified for taxation as a REIT, it may be subject to certain federal, state and local taxes on its income and assets. For example:\\n| • | it will be required to pay tax on undistributed REIT taxable income (including net capital gain); |\\n\\n| • | it may be required to pay “alternative minimum tax” on its items of tax preference; |\\n\\n| • | if it has net income from the disposition of foreclosure property held primarily for sale to customers in the ordinary course of business or other non-qualifying income from foreclosure property, it must pay tax on that income at the highest corporate rate; |\\n\\n| • | if it (or the Operating Partnership or any subsidiary of the Operating Partnership other than MHI Holding) sells a property in a “prohibited transaction,” its gain, or its share of such gain, from the sale would be subject to a 100.0% penalty tax. A “prohibited transaction” would be a sale of property, other than a foreclosure property, held primarily for sale to customers in the ordinary course of business; |\\n\\n| • | MHI Holding is a fully taxable corporation and is required to pay federal and state taxes on its taxable income; and |\\n\\n| • | it may experience increases in its state and/or local income tax burdens as states and localities continue to look to modify their tax laws in order to raise revenues, including by (among other things) changing from a net taxable income-based regime to a gross receipts-based regime, suspending and/or limiting the use of net operating losses, increasing tax rates and fees, imposing surcharges and subjecting partnerships to an entity-level tax, and limiting or disallowing certain U.S. federal deductions such as the dividends-paid deduction. |\\n\\n27\\nComplying with REIT requirements may cause the Company to forgo attractive opportunities that could otherwise generate strong risk-adjusted returns and instead pursue less attractive opportunities, or none at all.\\nTo qualify as a REIT for federal income tax purposes, the Company must continually satisfy tests concerning, among other things, the sources of its income, the nature and diversification of its assets, the amounts it distributes to its stockholders and the ownership of its stock.\\nIn general, when applying these tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which share is determined in accordance with the Company’s capital interest in the Operating Partnership) and as being entitled to the Operating Partnership’s income attributable to such share. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of generating strong risk-adjusted returns on invested capital for our stockholders.\\nComplying with REIT requirements may force the Company to liquidate otherwise attractive investments, which could result in an overall loss on its investments.\\nTo maintain qualification as a REIT, the Company must ensure that at the end of each calendar quarter at least 75.0% of the value of its assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of the Company’s assets (other than securities of one or more taxable REIT subsidiaries) generally cannot include more than 10.0% of the outstanding voting securities of any one issuer or more than 10.0% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5.0% of the value of the Company’s assets (other than government securities, qualified real estate assets and securities of one or more taxable REIT subsidiaries) can consist of the securities of any one issuer, and no more than 25.0% (20.0% for taxable years beginning after December 31, 2017) of the value of the Company’s total assets can be represented by securities of one or more taxable REIT subsidiaries.\\nWhen applying these asset tests, the Company is treated as owning its proportionate share of the Operating Partnership’s assets (which is determined in accordance with the Company’s capital interest in the Operating Partnership). If the Company fails to comply with these requirements at the end of any calendar quarter, it must correct such failure within 30 days after the end of the calendar quarter to avoid losing its REIT status and suffering adverse tax consequences. If the Company fails to comply with these requirements at the end of any calendar quarter, and the failure exceeds a de-minimis threshold, the Company may be able to preserve its REIT status if the failure was due to reasonable cause and not to willful neglect. In this case, we will be required to dispose of the assets causing the failure within six months after the last day of the quarter in which the failure occurred, and we will be required to pay an additional tax of the greater of $50,000 or the product of the highest applicable tax rate multiplied by the net income generated on those assets.\\nAs a result, we may be required to liquidate otherwise attractive investments.\\nIf the Operating Partnership fails to qualify as a partnership for federal income tax purposes, the Company could cease to qualify as a REIT and suffer other adverse consequences.\\nWe believe that the Operating Partnership will continue to qualify to be treated as a partnership for U.S. federal income tax purposes. As a partnership, the Operating Partnership is not subject to federal income tax on its income. Instead, each of its partners, including the Company, will be required to pay tax on its allocable share of the Operating Partnership’s income. We cannot assure you, however, that the IRS will not challenge the Operating Partnership’s status as a partnership for U.S. federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in treating the Operating Partnership as a corporation for federal income tax purposes, the Company could fail to meet the gross income tests and certain of the asset tests applicable to REITs and, accordingly, cease to qualify as a REIT. Also, the failure of the Operating Partnership to qualify as a partnership would cause the Operating Partnership to become subject to federal and state corporate income tax, which would reduce significantly the amount of cash available for debt service and for distribution to its partners, including the Company.\\nThe Company’s failure to qualify as a REIT would have serious adverse consequences to its stockholders.\\nThe Company elected to be taxed as a REIT under Sections 856 through 860 of the Code, commencing with its taxable year ended December 31, 2004. The Company believes it has operated so as to qualify as a REIT under the Code and believes that its current organization and method of operation comply with the rules and regulations promulgated under the Code to enable the Company to continue to qualify as a REIT. However, it is possible that the Company has been organized or has operated in a manner that would not allow it to qualify as a REIT, or that its future operations could cause it to fail to qualify. Qualification as a REIT requires the Company to satisfy numerous requirements (some on an annual and others on a quarterly basis) established under highly technical and complex sections of the Code for which there are only limited judicial and administrative interpretations, and involves the determination of various factual matters and circumstances not entirely within its control. For example, in order to qualify as a\\n28\\nREIT, the Company must satisfy a 75.0% gross income test pursuant to Code Section 856(c)(3) and a 95.0% gross income test pursuant to Code Section 856(c)(2) each taxable year. In addition, the Company must pay dividends, as “qualifying distributions,” to its stockholders aggregating annually at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding capital gains, and reduced by certain non-cash items) and must satisfy specified asset tests on a quarterly basis. While historically the Company has satisfied the distribution requirement discussed above by making cash distributions to its stockholders, the Company may choose to satisfy this requirement by making distributions of cash or other property, including, in limited circumstances, its stock. The provisions of the Code and applicable Treasury regulations regarding qualification as a REIT are more complicated in the Company’s case because its holds its assets through the Operating Partnership.\\nIf MHI Holding does not qualify as a taxable REIT subsidiary, or if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT and would be subject to higher taxes and have less cash available for distribution to its shareholders.\\nRent paid by a lessee that is a “related party tenant” of ours will not be qualifying income for purposes of the two gross income tests applicable to REITs. The Company currently leases substantially all of its hotels to the TRS Lessees, which are disregarded entities for U.S. federal income tax purposes and are wholly-owned by MHI Holding, a taxable REIT subsidiary, and expects to continue to do so. So long as MHI Holding qualifies as a taxable REIT subsidiary, it will not be treated as a “related party tenant” with respect to the Company’s properties that are managed by an independent hotel management company that qualifies as an “eligible independent contractor.” The Company believes that MHI Holding will continue to qualify to be treated as a taxable REIT subsidiary for federal income tax purposes, but there can be no assurance that the IRS will not challenge this status or that a court would not sustain such a challenge. If the IRS were successful in such challenge, it is possible that the Company would fail to meet the asset tests applicable to REITs and substantially all of its income would fail to be qualifying income for purposes of the two gross income tests. If the Company failed to meet any of the asset or gross income tests, it would likely lose its REIT qualification for federal income tax purposes.\\nAdditionally, if the Company’s hotel manager does not qualify as an “eligible independent contractor,” the Company would fail to qualify as a REIT. Each hotel manager that enters into a management contract with the TRS Lessees must qualify as an “eligible independent contractor” under the REIT rules in order for the rent paid by the TRS Lessees to be qualifying income for purposes of the REIT gross income tests. Among other requirements, in order to qualify as an eligible independent contractor, a hotel manager must not own, directly or through its shareholders, more than 35.0% of the Company’s outstanding shares, taking into account certain ownership attribution rules. The ownership attribution rules that apply for purposes of these 35.0% thresholds are complex. Although the Company intends to monitor ownership of its shares by its hotel manager and its owners, there can be no assurance that these ownership levels will not be exceeded.\\nForeign investors may be subject to U.S. tax on the disposition of the Company’s stock if the Company does not qualify as a “domestically controlled” REIT.\\nA foreign person disposing of a “U.S. real property interest,” which includes stock of a U.S. corporation whose assets consist principally of U.S. real property interests, is generally subject to U.S. federal income tax under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) on the gain recognized on the disposition, unless such foreign person is a “qualified foreign pension fund” or one of the certain publicly traded non-U.S. “qualified collective investment vehicles”. Additionally, the transferee will be required to withhold 15.0% on the amount realized on the disposition if the foreign transferor is subject to U.S. federal income tax under FIRPTA. This 15.0% is creditable against the U.S. federal income tax liability of the foreign transferor in connection with such transferor’s disposition of the Company’s stock. FIRPTA does not apply, however, to the disposition of stock in a REIT if the REIT is “domestically controlled” (i.e., less than 50.0% of the REIT’s capital stock, by value, has been owned directly or indirectly by persons who are not qualifying U.S. persons during a continuous five-year period ending on the date of disposition or, if shorter, during the entire period of the REIT’s existence). We cannot be sure that the Company will qualify as a “domestically controlled” REIT. If the Company does not so qualify, gain realized by foreign investors on a sale of the Company’s stock would be subject to U.S. income and withholding tax under FIRPTA, unless the Company’s stock were traded on an established securities market and a foreign investor did not at any time during a specified testing period directly or indirectly own more than 10.0% of the value of the Company’s outstanding stock.\\nMHI Holding increases our overall tax liability.\\nOur TRS Lessees are single-member limited liability companies that are wholly-owned, directly or indirectly, by MHI Holding, a taxable REIT subsidiary that is wholly-owned by the Operating Partnership. Each of our TRS Lessees is disregarded as an entity separate from MHI Holding for U.S. federal income tax purposes, such that the assets, liabilities, income, gains, losses, credits and deductions of our TRS Lessees are treated as the assets, liabilities, income, gains, losses, credits and deductions of MHI Holding for U.S. federal income tax purposes. MHI Holding is subject to federal and state income tax on its taxable income, which will consist of\\n29\\nthe revenues from the hotels leased by the Company’s TRS Lessees, net of the operating expenses for such hotels and rent payments. Accordingly, although the Company’s ownership of MHI Holding and the TRS Lessees will allow it to participate in the operating income from its hotels in addition to receiving rent, that operating income will be fully subject to income tax. The after-tax net income of MHI Holding, if any, will be available for distribution to the Company.\\nThe Company will incur a 100.0% excise tax on its transactions with MHI Holding and the TRS Lessees that are not conducted on an arm’s-length basis. For example, to the extent that the rent paid by the TRS Lessees exceeds an arm’s-length rental amount, such amount potentially will be subject to this excise tax. The Company intends that all transactions among itself, MHI Holding and the TRS Lessees will be conducted on an arm’s-length basis and, therefore, that the rent paid by the TRS Lessees will not be subject to this excise tax.\\nOur ability to use net operating loss carryforwards to reduce future tax payments may be limited or restricted or may not exist at all, and if we do not sustain our profitability, we may be required to put up a valuation allowance against our deferred tax assets.\\nAt December 31, 2016, our financial statements reflected deferred tax assets totaling approximately $6.9 million, of which approximately $6.0 million relates to significant federal and state net operating losses (“NOLs”) generated by our TRS Lessee over the past three years. We are generally able to carry NOLs forward to reduce taxable income in future years. Our ability to use our NOLs to reduce future tax payments is dependent upon our ability to sustain profitability during the time period over which these NOLs may be used under applicable tax law. A valuation allowance is required for deferred tax assets if, based on all available evidence, it is “more-likely-than-not” (defined as a likelihood of more than 50%) that all or a portion of the deferred tax assets will not be realized due to the inability to generate sufficient taxable income in certain financial statement periods. The net amount of deferred tax assets that are recorded on the financial statements must reflect the tax benefits that are expected to be realized using these criteria. We perform this analysis by evaluating a number of factors, including a demonstrated track record of past profitability, reasonable forecasts of future taxable income, and anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. At December 31, 2016, we determined based on all available positive and negative evidence that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We made this determination considering reasonable tax strategies available to us capable of ensuring the realization of our deferred tax assets, anticipated changes in the lease rental payments and one time losses that generated some of our net operating losses. However, there is no assurance that the TRS Lessee will be able to achieve profitability. The TRS Lessee’s ability to generate sustained profitability in the amounts necessary to realize our deferred tax assets against future taxable income depends upon general economic and market conditions, interest rates, and the TRS Lessee’s ability to meet our strategic plans. If the TRS Lessee is unable to generate adequate sustained profitability, we may be required to record a valuation allowance against some or all of our deferred tax assets, which would negatively impact our financial results.\\nTaxation of dividend income could make the Company’s stock less attractive to investors and reduce the market price of its stock.\\nThe federal income tax laws governing REITs, or the administrative interpretations of those laws, may be amended at any time. Any new laws or interpretations may take effect retroactively and could adversely affect the Company or could adversely affect its stockholders. Currently, “qualified dividends,” which include dividends from domestic C corporations that are paid to non-corporate stockholders, are subject to a reduced maximum U.S. federal income tax rate of 20.0%. Because REITs generally do not pay corporate-level taxes as a result of the dividends-paid deduction to which they are entitled, dividends from REITs generally are not treated as qualified dividends and thus do not qualify for a reduced tax rate. Non-corporate investors could view an investment in non-REIT corporations as more attractive than an investment in REITs because the dividends they would receive from non-REIT corporations would be subject to lower tax rates.\\nInvestors may be subject to a 3.8% Medicare tax in connection with an investment in the Company’s stock or the 7% Notes.\\nThe U.S. tax laws impose a 3.8% “Medicare tax” on the “net investment income” (i.e., interest, dividends, capital gains, annuities, and rents that are not derived in the ordinary course of a trade or business) of individuals with income exceeding $200,000 ($250,000 if married filing jointly or $125,000 if married filing separately), and of estates and trusts. Dividends on the Company’s stock and interest on the 7% Notes as well as gains from the disposition of the Company’s stock or the 7% Notes may be subject to the Medicare tax. Prospective investors should consult with their independent advisors as to the applicability of the Medicare tax to an investment in the Company’s stock or the 7% Notes in light of such investors’ particular circumstances.\\n30\\nInvestors may be subject to U.S. withholding tax under the “Foreign Account Tax Compliance Act.”\\nOn March 18, 2010, the Hiring Incentives to Restore Employment Act, or the HIRE Act, was enacted in the United States. The HIRE Act includes provisions known as the Foreign Account Tax Compliance Act, or FATCA, that generally impose a 30.0% U.S. withholding tax on “withholdable payments,” which consist of (i) U.S.-source dividends, interest, rents and other “fixed or determinable annual or periodical income” paid after June 30, 2014 and (ii) certain U.S.-source gross proceeds paid after December 31, 2018 to (a) “foreign financial institutions” unless (x) they enter into an agreement with the IRS to collect and disclose to the IRS information regarding their direct and indirect U.S. owners or (y) they comply with the terms of any FATCA intergovernmental agreement executed between the authorities in their jurisdiction and the U.S., and (b) “non-financial foreign entities” (i.e., foreign entities that are not foreign financial institutions) unless they certify certain information regarding their direct and indirect U.S. owners. Final regulations under FATCA were issued by the IRS on January 17, 2013, and have been subsequently supplemented by additional regulations and guidance. FATCA does not replace the existing U.S. withholding tax regime. However, the FATCA regulations contain coordination provisions to avoid double withholding on U.S.-source income.\\nA foreign investor that receives dividends on the Company’s stock or gross proceeds from a disposition of shares of the Company’s stock may be subject to FATCA withholding tax with respect to such dividends or gross proceeds.\\nForeign investors will be subject to U.S. withholding tax on the receipt of ordinary dividends on the Company’s stock.\\nThe portion of dividends received by a foreign investor payable out of the Company’s current and accumulated earnings and profits which are not attributable to capital gains and which are not effectively connected with a U.S. trade or business of the foreign investor will generally be subject to U.S. withholding tax at a statutory rate of 30.0%. This 30.0% withholding tax may be reduced by an applicable income tax treaty. The FATCA and nonresident withholding regulations are complex. Even if the 30.0% withholding is reduced or eliminated by treaty for payments made to a foreign investor, FATCA withholding of 30.0% could apply depending upon the foreign investor’s FATCA status. Foreign investors should consult with their independent advisors as to the U.S. withholding tax consequences to such investors with respect to their investment in the Company’s stock in light of their particular circumstances, as well as determining the appropriate documentation required to reduce or eliminate U.S. withholding tax.\\nForeign investors will be subject to U.S. income tax on the receipt of capital gain dividends on the Company’s stock.\\nUnder FIRPTA, distributions that we make to a foreign investor that are attributable to gains from our dispositions of U.S. real property interests (“capital gain dividends”) will be treated as income that is effectively connected with a U.S. trade or business, and therefore subject to U.S. federal income tax, in the hands of the foreign investor, unless such foreign person is a “qualified foreign pension fund” or one of certain publicly traded non-U.S. “qualified collective investment vehicles”. A foreign investor who is subject to tax under FIRPTA will be subject to U.S. federal income tax (at the rates applicable to U.S. investors) on any capital gain dividends, and will also be required to file U.S. federal income tax returns to report such capital gain dividends. Furthermore, capital gain dividends are subject to an additional 30.0% “branch profits tax” (which may be reduced by an applicable income tax treaty) in the hands of a foreign investor who is subject to tax under FIRPTA if such foreign investor is treated as a corporation for U.S. federal income tax purposes.\\nLegislative or regulatory action could adversely affect you.\\nBecause our operations are governed to a significant extent by the federal tax laws, new legislative or regulatory action could adversely affect our investors. You are strongly encouraged to consult with your own tax advisor with respect to the status of any legislative, regulatory or administrative developments, announcements and proposals and their potential impact on your investment in the Company’s stock.\\n\\nUnresolved Staff Comments\\nNot applicable.\\n31\\n\\nItem 2.\\nP\\nroperties\\nAs of December 31, 2016, our portfolio consisted of the following properties (see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Key Operating Metrics, for definitions of Occupancy, ADR, and RevPAR):\\n\\n| Number of | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR | Occupancy | ADR | RevPAR |\\n| Wholly-Owned Properties | Rooms | 2016 | 2016 | 2016 | 2015 | 2015 | 2015 | 2014 | 2014 | 2014 |\\n| Crowne Plaza Hampton Marina, Hampton, Virginia (1) | 173 | 55.2 | % | $ | 96.81 | $ | 53.40 | 55.2 | % | $ | 93.59 | $ | 51.64 | 50.8 | % | $ | 93.17 | $ | 48.27 |\\n| Crowne Plaza Hollywood Beach Resort, Hollywood, Florida (2) | 311 | 79.6 | % | $ | 170.57 | $ | 135.74 | 83.1 | % | $ | 174.35 | $ | 144.86 | 83.1 | % | $ | 163.13 | $ | 135.55 |\\n| Crowne Plaza Tampa Westshore, Tampa, Florida | 222 | 74.6 | % | $ | 116.15 | $ | 86.69 | 72.5 | % | $ | 111.08 | $ | 80.53 | 72.5 | % | $ | 104.90 | $ | 76.09 |\\n| DoubleTree by Hilton Jacksonville Riverfront, Jacksonville, Florida | 293 | 77.4 | % | $ | 126.67 | $ | 98.06 | 67.4 | % | $ | 109.20 | $ | 73.60 | 65.8 | % | $ | 99.20 | $ | 65.24 |\\n| DoubleTree by Hilton Laurel, Laurel, Maryland | 208 | 60.5 | % | $ | 104.35 | $ | 63.16 | 48.2 | % | $ | 95.19 | $ | 45.86 | 60.8 | % | $ | 89.08 | $ | 54.19 |\\n| DoubleTree by Hilton Philadelphia Airport, Philadelphia, Pennsylvania | 331 | 77.0 | % | $ | 144.92 | $ | 111.66 | 79.3 | % | $ | 136.32 | $ | 108.13 | 75.9 | % | $ | 133.78 | $ | 101.58 |\\n| DoubleTree by Hilton Raleigh Brownstone – University, Raleigh, North Carolina | 190 | 70.0 | % | $ | 134.74 | $ | 94.33 | 71.5 | % | $ | 131.61 | $ | 94.16 | 73.4 | % | $ | 122.60 | $ | 90.04 |\\n| Georgian Terrace, Atlanta, Georgia (3) | 326 | 70.8 | % | $ | 160.89 | $ | 113.88 | 69.9 | % | $ | 155.56 | $ | 108.70 | 76.2 | % | $ | 137.65 | $ | 104.88 |\\n| Hilton Savannah DeSoto, Savannah, Georgia | 246 | 71.5 | % | $ | 155.87 | $ | 111.48 | 76.9 | % | $ | 154.52 | $ | 118.89 | 75.7 | % | $ | 146.75 | $ | 111.14 |\\n| Hilton Wilmington Riverside, Wilmington, North Carolina | 272 | 70.5 | % | $ | 147.14 | $ | 103.72 | 71.6 | % | $ | 138.36 | $ | 99.07 | 69.7 | % | $ | 139.09 | $ | 96.90 |\\n| Sheraton Louisville Riverside, Jeffersonville, Indiana | 180 | 63.1 | % | $ | 137.34 | $ | 86.60 | 69.5 | % | $ | 131.74 | $ | 111.87 | 66.8 | % | $ | 150.20 | $ | 100.31 |\\n| The Whitehall, Houston, Texas | 259 | 54.4 | % | $ | 140.70 | $ | 76.56 | 70.9 | % | $ | 142.05 | $ | 100.66 | 76.1 | % | $ | 138.93 | $ | 105.66 |\\n| Total | 3,011 |\\n\\n\\n| (1) | On February 7, 2017, the Company sold the Crowne Plaza Hampton Marina. |\\n\\n| (2) | The operating statistics for the Crowne Plaza Hollywood Beach Resort rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\\n\\n| (3) | The operating statistics for the Georgian Terrace rely on information from both the period prior to, and the period subsequent to, the Company’s acquisition of the hotel. |\\n\\n\\nLegal Proceedings\\nWe are not involved in any material litigation, nor to our knowledge, is any material litigation threatened against us. We have settled, during the period covered by this report, all significant claims made during the same period. We are involved in routine litigation arising out of the ordinary course of business, all of which is expected to be covered by insurance, and none of which is expected to have a material impact on our financial condition or results of operations.\\nMine Safety Disclosure\\nNot applicable.\\n32\\nPART II\\nMarket for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities\\nSotherly Hotels Inc.\\nMarket Information\\nThe Company’s common stock trades on the NASDAQ ® Global Market under the symbol “SOHO”. The following table sets forth, for the indicated period, the intraday high and low prices for the common stock, as reported on NASDAQ ®:\\n\\n| Price Range |\\n| High | Low |\\n| Year Ended December 31, 2016 |\\n| First Quarter | $ | 6.59 | $ | 4.59 |\\n| Second Quarter | $ | 5.99 | $ | 5.00 |\\n| Third Quarter | $ | 6.35 | $ | 5.22 |\\n| Fourth Quarter | $ | 7.11 | $ | 4.65 |\\n| Year Ended December 31, 2015 |\\n| First Quarter | $ | 7.87 | $ | 6.26 |\\n| Second Quarter | $ | 8.71 | $ | 6.94 |\\n| Third Quarter | $ | 7.63 | $ | 5.83 |\\n| Fourth Quarter | $ | 6.94 | $ | 4.50 |\\n\\nThe closing price of the Company’s common stock on the NASDAQ ® Global Market on March 1, 2017 was $6.97 per share.\\nStockholder Information\\nAs of March 1, 2017, there were 80 holders of record of the Company’s common stock and as of March 1, 2017, there were approximately 3,772 beneficial owners of the Company’s common stock.\\nIn order to comply with certain requirements related to the Company’s qualification as a REIT, the Company’s charter, subject to certain exceptions, limits the number of common shares that may be owned by any single person or affiliated group to 9.9% of the outstanding common shares.\\nRecent Sales of Unregistered Securities\\nOn February 1, 2016, two holders of units in the Operating Partnership redeemed a total of 422,687 units for an equivalent number of shares of the Company’s common stock. The shares of common stock were issued to the unitholder pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933, as amended.\\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company has used and expects to continue to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016 the Company repurchased the following amounts of common stock and the repurchased shares have been returned to the status of authorized but unissued shares of common stock:\\n\\n| Period | Total Number of Shares Repurchased | Average Price Paid Per Share | Total Number of Shares Purchased As Part of PubliclyAnnounced Program | Maximum Number (or Approximate Dollar Value) of Shares ThatMay Yet Be Purchased Under the Program |\\n| December 1- December 31, 2016 | 481,100 | $ | 6.53 | 481,100 | $ | 6,835,464 |\\n\\n33\\nUse of Proceeds from Registered Securities\\nOn August 23, 2016, the Company sold 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock pursuant to a registration statement on Form S-3 (file no. 333-199256) for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units. The Operating Partnership used the net proceeds to redeem the entire $27.6 million aggregate principal amount of its outstanding 8.0% senior unsecured notes (the “8% Notes”), to acquire the commercial condominium unit and related inventories of the Hyde Resort & Residences for approximately $4.8 million, and will use the remainder of the proceeds for general corporate purposes.\\nSotherly Hotels LP\\nMarket Information\\nThere is no established trading market for partnership units of the Operating Partnership. The Operating Partnership does not currently propose to offer partnership units to the public, and does not currently expect that a public market for those units will develop.\\nPartnership Unitholder Information\\nAs of March 1, 2017, there were 12 holders of the Operating Partnership’s partnership units, including Sotherly Hotels Inc.\\nRecent Sales of Unregistered Securities\\nFrom time to time, the Operating Partnership issues limited partnership units (common and/or preferred) to the Company, as required by the Amended and Restated Agreement of Limited Partnership of the Operating Partnership, to mirror the capital structure of the Company to reflect additional issuances by the Company and to preserve equitable ownership ratios.\\nThere were no sales of unregistered securities in the Operating Partnership during 2016.\\nUse of Proceeds from Registered Securities\\nThere were no sales of registered securities in the Operating Partnership during 2016.\\nSotherly Hotels Inc. and Sotherly Hotels LP\\nDividend and Distribution Information\\nThe Company elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, we are required to make annual distributions to the Company’s stockholders of at least 90.0% of our REIT taxable income, excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles. Our ability to pay distributions to the Company’s stockholders will depend, in part, upon our receipt of distributions from our Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, our TRS Lessees may retain any after-tax earnings.\\nIn order to maintain our qualification as a REIT, we must make distributions to our stockholders each year in an amount equal to at least:\\n| • | 90% of our REIT taxable income determined without regard to the dividends paid deduction and excluding net capital gains; plus |\\n\\n| • | 90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code; minus |\\n\\n| • | Any excess noncash income (as defined in the Code). |\\n\\n34\\nThe following tables set forth information regarding the declaration, payment and income tax characterization of distributions by the Company on its common and preferred shares to Company’s stockholders for fiscal year 2015 to 2016. The same table sets forth the Operating Partnership’s distributions per common and preferred partnership units for fiscal year 2015 to 2016:\\n\\n| Dividend (Distribution) Payments - Common |\\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\\n| January 2015 | March 31, 2015 | April 10, 2015 | $ | 0.070 | 82.6% | 17.4% |\\n| April 2015 | June 30, 2015 | July 10, 2015 | $ | 0.075 | 82.6% | 17.4% |\\n| July 2015 | September 30, 2015 | October 9, 2015 | $ | 0.080 | 82.6% | 17.4% |\\n| October 2015 | December 31, 2015 | January 11, 2016 | $ | 0.080 | 82.6% | 17.4% |\\n| January 2016 | March 31, 2016 | April 11, 2016 | $ | 0.085 | 73.5% | 26.5% |\\n| April 2016 | June 30, 2016 | July 11, 2016 | $ | 0.090 | 73.5% | 26.5% |\\n| July 2016 | September 30, 2016 | October 11, 2016 | $ | 0.095 | 73.5% | 26.5% |\\n| October 2016 | December 31, 2016 | January 11, 2017 | $ | 0.095 | 73.5% | 26.5% |\\n\\n\\n| Dividend (Distribution) Payments - Preferred |\\n| Date Declared | For the Quarter Ended | Date Paid | Amount per Share and Unit | Ordinary Income | Return of Capital |\\n| August 2016 | September 30, 2016 | October 17, 2016 | $ | 0.2111 | 73.5% | 26.5% |\\n| October 2016 | December 31, 2016 | January 17, 2017 | $ | 0.500 | 73.5% | 26.5% |\\n\\nThe amount of future common stock distributions will be based upon quarterly operating results, general economic conditions, requirements for capital improvements, the availability of debt and equity capital, the Code’s annual distribution requirements, and other factors, which the Company’s board of directors deems relevant. The amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future.\\n\\nSelected Financial Data\\nThe following table sets forth selected historical financial data for Sotherly Hotels Inc. and Sotherly Hotels LP for the years ended December 31, 2016, 2015, 2014, 2013, and 2012. The financial results for the Crowne Plaza Hollywood Beach Resort, in which we had a 25.0% indirect interest, are not consolidated through July 31, 2015, as we accounted for our investment under the equity method of accounting. However, from August 1, 2015 through December 31, 2015 we did consolidate the financial results for the Crowne Plaza Hollywood Beach Resort, as a result of our acquisition of the remaining 75.0% interest in the hotel. The following selected historical financial data was derived from audited consolidated financial statements contained elsewhere in this Annual Report on Form 10-K and in prior filings. The Company’s financial statements: for the year ended December 31, 2016, have been audited by Dixon Hughes Goodman LLP; for the years ended December 31, 2015 and 2014, have been audited by Grant Thornton LLP; and for the years ended December 31, 2013 and 2012, have been audited by PBMares, LLP (formerly Witt Mares, PLC), our independent registered public accounting firms, for such periods. The audited historical financial statements include reclassifications and all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of our financial condition and the results of operations as of those dates and for those periods under accounting principles generally accepted in the United States of America.\\nThe information presented below is only a summary and does not provide all of the information contained in our consolidated financial statements, including notes thereto, and should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.\\n35\\nSOTHERLY HOTELS INC.\\nSOTHERLY HOTELS LP\\nSELECTED HISTORICAL FINANCIAL DATA\\n\\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 | 2013 | 2012 |\\n| Statement of Operations |\\n| Total Revenues | $ | 152,845,752 | $ | 138,533,476 | $ | 122,939,919 | $ | 89,374,527 | $ | 87,343,220 |\\n| Total Operating Expenses excluding Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (118,854,236 | ) | (109,153,366 | ) | (95,290,304 | ) | (69,888,820 | ) | (68,519,401 | ) |\\n| Depreciation, Amortization, Disposal Gain and Impairment of Investments in Hotel Properties, net | (15,384,390 | ) | (14,050,060 | ) | (15,144,284 | ) | (9,078,228 | ) | (8,661,769 | ) |\\n| Net Operating Income | 18,607,126 | 15,330,050 | 12,505,331 | 10,407,479 | 10,162,050 |\\n| Interest Income | 115,785 | 50,461 | 19,865 | 17,914 | 16,158 |\\n| Interest Expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) | (9,606,479 | ) | (10,399,962 | ) |\\n| Other Income (Expense) – net | (1,455,289 | ) | 6,196,936 | (354,558 | ) | (3,796,410 | ) | (3,941,594 | ) |\\n| Income Tax Benefit (Provision) | 1,367,634 | 1,336,033 | 1,727,723 | (1,496,096 | ) | (1,246,397 | ) |\\n| Net Income (Loss) | 900,149 | 6,397,653 | (738,509 | ) | (4,473,592 | ) | (5,409,745 | ) |\\n| Net (Income) Loss Attributable to Noncontrolling Interest | 26,567 | (1,040,987 | ) | 153,838 | 989,623 | 1,241,868 |\\n| Net Income (Loss) Attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) | (3,483,969 | ) | (4,167,877 | ) |\\n| Distributions to Preferred Stockholders | (1,144,889 | ) | — | — | — | — |\\n| Net Income/(Loss) Attributable to Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,167,877 | ) |\\n| Statement of Cash Flows |\\n| Cash provided by Operations – net | $ | 17,139,409 | $ | 11,377,374 | $ | 14,851,255 | $ | 9,594,751 | $ | 9,011,957 |\\n| Cash used in Investing – net | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) | (29,527,589 | ) | (3,156,121 | ) |\\n| Cash provided by (used in) Financing – net | 16,074,218 | 24,614,643 | 63,503,194 | 22,133,750 | (3,090,079 | ) |\\n| Net Increase (Decrease) in Cash and Cash Equivalents | $ | 20,272,861 | $ | (5,140,585 | ) | $ | 7,257,871 | $ | 2,200,912 | $ | 2,765,757 |\\n| Balance Sheet |\\n| Investments in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 | $ | 260,192,153 | $ | 202,645,633 | $ | 176,427,904 |\\n| Investment in Hotel Properties Held for Sale, Net | 5,333,000 | — | — | — | — |\\n| Total Assets (1) | 406,019,564 | 393,058,353 | 299,820,043 | 228,169,081 | 204,223,074 |\\n| Mortgage Loans | 282,708,289 | 271,977,944 | 205,291,657 | 160,363,549 | 135,674,432 |\\n| Unsecured Notes | 24,308,713 | 52,900,000 | 52,900,000 | 27,600,000 | — |\\n| Redeemable Preferred Stock | — | — | — | — | 14,227,650 |\\n| Total Liabilities | 324,680,276 | 340,199,985 | 272,310,186 | 197,314,286 | 167,179,121 |\\n| Noncontrolling Interest (1) | 2,329,175 | 3,855,237 | 4,132,662 | 5,669,386 | 7,322,314 |\\n| Total Sotherly Hotels Inc. Stockholders’ Equity (1) | $ | 79,010,113 | $ | 49,003,131 | $ | 23,377,195 | $ | 25,185,409 | $ | 29,721,639 |\\n| Operating Data |\\n| Average Number of Available Rooms | 3,011 | 2,828 | 2,622 | 2,148 | 2,113 |\\n| Total Number of Available Room Nights | 1,102,026 | 1,032,353 | 957,060 | 783,936 | 773,358 |\\n| Occupancy Percentage (2) | 69.8 | % | 69.9 | % | 70.3 | % | 67.4 | % | 68.9 | % |\\n| Average Daily Rate (ADR) (2) | $ | 140.63 | $ | 134.21 | $ | 125.77 | $ | 118.91 | $ | 114.22 |\\n| RevPAR (2) | $ | 98.18 | $ | 93.80 | $ | 88.42 | $ | 80.16 | $ | 78.65 |\\n| Additional Financial Data |\\n| FFO (3) | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\\n| Adjusted FFO (3) | 15,100,188 | 14,904,608 | 14,142,080 | 10,766,147 | 9,218,032 |\\n| Hotel EBITDA (4) | 40,012,581 | 36,447,390 | 32,084,957 | 23,220,515 | 22,296,938 |\\n| Income (Loss) Per Basic Share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) | $ | (0.34 | ) | $ | (0.42 | ) |\\n\\n\\n| (1) | As of the period end. |\\n\\n| (2) | Occupancy Percent is calculated by dividing the total daily number of rooms sold by the total daily number of rooms available. ADR is calculated by dividing the total daily room revenue by the total daily number of rooms sold. RevPAR is calculated by dividing the total daily room revenue by the total daily number of rooms available. |\\n\\n36\\n\\n| (3) | Industry analysts and investors use Funds from Operations (“FFO”) as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with generally accepted accounting principles (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. |\\n\\nAdjusted FFO accounts for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on its hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, franchise termination costs, loan modification fees, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs.\\n| (4) | Hotel EBITDA represents the portion of net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. |\\n\\nThe following is a reconciliation of net loss to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\\n\\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 | 2013 | 2012 |\\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\\n| Equity in Depreciation and Amortization of Joint Venture | — | 259,279 | 529,053 | 545,667 | 590,675 |\\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 | $ | 5,150,303 | $ | 3,842,699 |\\n| (Increase) Decrease in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) | 1,370,189 | 1,241,848 |\\n| Acquisition Costs | — | 634,376 | 155,187 | 89,743 | — |\\n| Loss on Starwood Settlement | — | 324,271 | — | — | — |\\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — | — | — |\\n| Loan Modification Fees | 64,215 | 243,229 | — | — | — |\\n| Franchise Termination Fee | — | — | 351,800 | — | — |\\n| Realized and Unrealized (Gain) Loss on Hedging Activities (A) | 37,384 | 108,819 | — | (89,998 | ) | 13,752 |\\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 | $ | 10,766,147 | $ | 9,218,031 |\\n\\n\\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\\n\\n37\\nThe following is a reconciliation of net income/(loss) to Hotel EBITDA for the years ended December 31, 2016, 2015, 2014, 2013, and 2012.\\n\\n| Year Ended | Year Ended | Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 | 2013 | 2012 |\\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) | $ | (3,483,969 | ) | $ | (4,186,709 | ) |\\n| Add: Net Income (Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) | (989,623 | ) | (1,223,036 | ) |\\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 | 9,606,479 | 10,399,962 |\\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) | (17,914 | ) | (16,158 | ) |\\n| Distributions to Preferred Stockholders | 1,144,889 | — | — | — | — |\\n| Income Tax Provision (Benefit) | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) | 1,496,096 | 1,246,397 |\\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 | 8,467,228 | 8,661,769 |\\n| Equity in (Earnings) Loss of Joint Venture | — | (475,514 | ) | (307,370 | ) | (449,500 | ) | (178,138 | ) |\\n| Loss (Gain) on Asset Disposal | 365,319 | (41,435 | ) | — | — | — |\\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) | — | — |\\n| Realized and Unrealized Loss (Gain) on Hedging Activities | 37,384 | 108,819 | — | — | — |\\n| Realized and Unrealized Loss on Warrant Derivative | — | — | — | 2,205,248 | 2,026,677 |\\n| Loss on Early Debt Extinguishment | 1,417,905 | 772,907 | 831,079 | 2,040,662 | 1,982,184 |\\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 | 611,000 | — |\\n| Impairment of Note Receivable | — | — | — | — | 110,871 |\\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 | 4,360,582 | 4,078,826 |\\n| Gain on Change in Control | — | (6,603,148 | ) | — | — | — |\\n| Net Lease Rental Income | — | — | (350,000 | ) | (350,000 | ) | (350,000 | ) |\\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) | (275,774 | ) | (255,707 | ) |\\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 | $ | 23,220,515 | $ | 22,296,938 |\\n\\n38\\n\\nItem 7.\\nManagement’s Discussion and Analysis of\\nFinancial Condition and Results of Operations\\nOverview\\nThe Company is a self-managed and self-administered lodging REIT incorporated in Maryland in August 2004 to pursue opportunities in the full-service, primarily upscale and upper-upscale segments of the hotel industry located in primary and secondary markets in the mid-Atlantic and southern United States. We commenced operations in December 2004 when the Company completed its initial public offering and thereafter consummated the acquisition of six initial hotel properties. Since the Company’s initial public offering, we have engaged in the following acquisitions and dispositions:\\n| • | On July 22, 2005, we acquired the Crowne Plaza Jacksonville Riverfront (formerly, the Hilton Jacksonville Riverfront). During September 2015, after extensive renovations, we re-branded and renamed the hotel the DoubleTree by Hilton Jacksonville Riverfront. |\\n\\n| • | On August 10, 2006, we sold the Holiday Inn Downtown Williamsburg. |\\n\\n| • | On September 20, 2006, we acquired the Louisville Ramada Riverfront Inn, which went through an extensive renovation and re-opened in May 2008 as the Sheraton Riverside Louisville. |\\n\\n| • | On August 8, 2007, through our joint venture with Carlyle, we acquired a 25.0% indirect noncontrolling interest in the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida. |\\n\\n| • | On October 29, 2007, we acquired a hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel, which went through an extensive renovation and re-opened in March 2009 as the Crowne Plaza Tampa Westshore. |\\n\\n| • | On April 24, 2008, we acquired the Hampton Marina Hotel in Hampton, Virginia, which has been renovated and was converted to the Crowne Plaza Hampton Marina in October 2008. |\\n\\n| • | On November 13, 2013, we acquired the Crowne Plaza Houston Downtown in Houston, Texas. |\\n\\n| • | On March 27, 2014, we acquired the Georgian Terrace in Atlanta, Georgia. |\\n\\n| • | On July 31, 2015, we acquired the remaining 75.0% interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort, and (ii) the entity that leases the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. |\\n\\n| • | On January 30, 2017, we closed on the purchase of the hotel commercial unit of the Hyde Resort & Residences, a 400-unit condominium-hotel located in the Hollywood, Florida market. |\\n\\n| • | On February 7, 2017, we closed on the sale of the Crowne Plaza Hampton Marina. |\\n\\n39\\nAs of December 31, 2016, our hotel portfolio consisted of twelve full-service, primarily upscale and upper-upscale hotels with 3,011 rooms, ten of which operate under well-known brands such as Hilton, Crowne Plaza, DoubleTree and Sheraton, and two of which are independent hotels. Following the sale of the Crowne Plaza Hampton Marina on February 7, 2017, our portfolio consisted of eleven wholly-owned hotels with a total of 2,838 rooms, as well as our interests in the Hyde Resort & Residences. As of December 31, 2016, we owned the following hotel properties:\\n\\n| Number |\\n| Property | of Rooms | Location | Date of Acquisition | Chain Designation |\\n| Wholly-owned |\\n| Crowne Plaza Hampton Marina (1) | 173 | Hampton, VA | April 24, 2008 | Upscale |\\n| Crowne Plaza Hollywood Beach Resort | 311 | Hollywood, FL | August 9, 2007 | Upscale |\\n| Crowne Plaza Tampa Westshore | 222 | Tampa, FL | October 29, 2007 | Upscale |\\n| DoubleTree by Hilton Jacksonville Riverfront | 293 | Jacksonville, FL | July 22, 2005 | Upscale |\\n| DoubleTree by Hilton Laurel | 208 | Laurel, MD | December 21, 2004 | Upscale |\\n| DoubleTree by Hilton Philadelphia Airport | 331 | Philadelphia, PA | December 21, 2004 | Upscale |\\n| DoubleTree by Hilton Raleigh Brownstone-University | 190 | Raleigh, NC | December 21, 2004 | Upscale |\\n| The Georgian Terrace | 326 | Atlanta, GA | March 27, 2014 | Independent(2) |\\n| Hilton Savannah DeSoto | 246 | Savannah, GA | December 21, 2004 | Upper Upscale |\\n| Hilton Wilmington Riverside | 272 | Wilmington, NC | December 21, 2004 | Upper Upscale |\\n| Sheraton Louisville Riverside | 180 | Jeffersonville, IN | September 20, 2006 | Upper Upscale |\\n| The Whitehall | 259 | Houston, TX | November 13, 2013 | Independent(2) |\\n| Total | 3,011 |\\n\\n\\n| (1) | On February 7, 2017, we closed on the sale of this hotel. |\\n\\n| (2) | We believe that the Georgian Terrace and The Whitehall would carry a chain scale designation of upper upscale if they were branded hotels. |\\n\\nWe conduct substantially all our business through the Operating Partnership, Sotherly Hotels LP. The Company is the sole general partner of the Operating Partnership and owns an approximate 89.1% interest in the Operating Partnership, with the remaining interest being held by limited partners who were contributors of our initial hotel properties and related assets.\\nTo qualify as a REIT, neither the Company nor the Operating Partnership can operate our hotels. Therefore, our wholly-owned hotel properties are leased to our TRS Lessees that are wholly-owned subsidiaries of the Operating Partnership, which then engage a hotel management company to operate the hotels under a management agreement. Our TRS Lessees have engaged Chesapeake Hospitality to manage our hotels. Our TRS Lessees, and their parent, MHI Hospitality TRS Holding, Inc., are consolidated into each of our financial statements for accounting purposes. The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.\\nKey Operating Metrics\\nIn the hotel industry, room revenue is considered the most important category of revenue and drives other revenue categories such as food, beverage, catering, parking and telephone. There are three key performance indicators used in the hotel industry to measure room revenues:\\n| • | Occupancy, or the number of rooms sold, usually expressed as a percentage of total rooms available; |\\n\\n| • | Average daily rate, or ADR, which is total room revenue divided by the number of rooms sold; and |\\n\\n| • | Revenue per available room, or RevPAR, which is total room revenue divided by the total number of available rooms. |\\n\\nRevPAR changes that are primarily driven by changes in occupancy have different implications for overall revenues and profitability than changes that are driven primarily by changes in ADR. For example, an increase in occupancy at a hotel would lead to additional variable operating costs (such as housekeeping services, laundry, utilities, room supplies, franchise fees, management fees, credit card commissions and reservations expense), but could also result in increased non-room revenue from the hotel’s restaurant, banquet or parking facilities. Changes in RevPAR that are primarily driven by changes in ADR typically have a greater impact on operating margins and profitability as they do not generate all the additional variable operating costs associated with higher occupancy.\\n40\\nWe also use FFO, Adjusted FFO and Hotel EBITDA as measures of our operating performance. See “Non-GAAP Financial Measures”.\\nResults of Operations\\nComparison of Year Ended December 31, 2016 to Year Ended December 31, 2015\\nThe following table illustrates the key operating metrics for the years ended December 31, 2016 and 2015 for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the eleven wholly-owned properties that were under our control during all of 2015 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter.\\n\\n| Year Ended December 31, 2016 | Year Ended December 31, 2015 |\\n| Actual | Same-Store | Actual | Same-Store |\\n| Occupancy % | 69.8 | % | 68.7 | % | 69.9 | % | 65.7 | % |\\n| ADR | $ | 140.63 | $ | 136.63 | $ | 134.21 | $ | 130.09 |\\n| RevPAR | $ | 98.18 | $ | 93.86 | $ | 93.80 | $ | 85.47 |\\n\\nRevenue. Total revenue for the year ended December 31, 2016 was approximately $152.8 million, an increase of approximately $14.3 million, or 10.3%, from total revenue for the year ended December 31, 2015 of approximately $138.5 million. Approximately $11.9 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; and Atlanta, Georgia of approximately $7.1 million, were offset by decreases in revenue at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas of approximately $3.3 million, as well as the remaining properties revenue decreases of $1.6 million.\\nRoom revenues at our properties for the year ended December 31, 2016 increased approximately $11.4 million, or 11.7%, to approximately $108.2 million compared to room revenues for the year ended December 31, 2015 of approximately $96.8 million. The increase in room revenues for the year ended December 31, 2016 resulted mainly from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.6 million for the period. Our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenues, offset by decreases at our properties impacted by renovation activities in Savannah, Georgia and Houston, Texas. We continue to expect occupancy and ADR to increase in 2017 as a result of continuing strong demand and the completion in 2016 of renovations at our properties in Houston, Texas and Atlanta, Georgia.\\nFood and beverage revenues at our properties for the year ended December 31, 2016 increased approximately $2.1 million, or 6.3%, to approximately $35.4 million compared to food and beverage revenues of approximately $33.3 million for the year ended December 31, 2015. The increase in food and beverage revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.6 million for the period. Additional increases in food and beverage revenues at our properties in Savannah, Georgia; Raleigh, North Carolina; Laurel, Maryland: Jacksonville, Florida; and Tampa, Florida of approximately $1.5 million, were offset by decreases of approximately $1.0 million in food and beverage revenues at our other properties.\\nOther operating revenues for the year ended December 31, 2016 increased approximately $0.8 million, or 10.0%, to approximately $9.3 million compared to other operating revenues for the year ended December 31, 2015 of approximately $8.4 million. The increase in other operating department revenues for the year ended December 31, 2016 resulted principally from our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.6 million for the period. Additional increases in other operating revenues at our properties in Philadelphia, Pennsylvania; Laurel, Maryland; Jacksonville, Florida; Jeffersonville, Indiana and Hampton, Virginia of approximately $0.5 million, were offset by decreases of approximately $0.5 million in other operating revenues at our other properties.\\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $10.9 million, or 10.7%, for the year ended December 31, 2016 to approximately $112.8 million compared to hotel operating expenses for the year ended December 31, 2015 of approximately $101.9 million. The increase in hotel operating expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.0 million for the period, coupled with an increase in hotel operating expenses at our same-store properties of approximately $1.1 million, mainly from increased occupancy by 4.6%, offset with decreases in expenses at our properties in Wilmington, North Carolina; Philadelphia, Pennsylvania; Jeffersonville, Indiana; Hampton, Virginia and Houston, Texas.\\n41\\nRooms expense at our properties for the year ended December 31, 2016 increased approximately $3.1 million, or 12.1%, to approximately $28.9 million compared to rooms expense of approximately $25.8 million for the year ended December 31, 2015. The increase in rooms expense for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.3 million for the period.\\nFood and beverage expenses at our properties for the year ended December 31, 2016 increased approximately $1.4 million, or 5.9%, to approximately $24.4 million compared to food and beverage expense of approximately $23.0 million for the year ended December 31, 2015. The increase in food and beverage expenses for the year ended December 31, 2016 was substantially related to our acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period.\\nIndirect expenses at our properties for the year ended December 31, 2016 increased approximately $5.8 million, or 11.4%, to approximately $57.1 million compared to indirect expenses of approximately $51.3 million for the year ended December 31, 2015. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our recently acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $5.1 million for the period, compared to the year ended December 31, 2015.\\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2016 increased approximately $1.4 million, or 10.5%, to approximately $15.0 million compared to depreciation and amortization expense of approximately $13.6 million for the year ended December 31, 2015. The increase was mostly attributable to depreciation and amortization related to our recently acquired property in Hollywood Beach, Florida and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2015 and for the year 2016, offset by reductions of intangible asset amortization during the year ended December 31, 2016 compared to the year ended December 31, 2015.\\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2016 and 2015 was $0 and $0.5 million, respectively. Our review of possible impairment of our hotel properties revealed no excess of current carrying cost over the estimated undiscounted future cash flows, as of December 31, 2016.\\nGain / Loss on Disposal of Assets. During the year ended December 31, 2016, we recorded a net loss on disposal of assets of $365,319, comprised of disposals of furniture, fixtures, and equipment of $565,319, offset by a gain on sale of $200,000, compared to a $41,435 net gain on disposal of assets for the year ended December 31, 2015, comprised of a net gain on the sale of development parcel rights and the development parcel for approximately $710,250, offset by losses on disposals of furniture, fixtures and equipment of $668,815.\\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2016 decreased approximately $1.2 million, or 17.2%, to approximately $6.0 million compared to corporate general and administrative expenses of approximately $7.3 million for the year ended December 31, 2015. The decrease in corporate general and administrative expenses was mainly due to decreases in acquisition costs of approximately $0.6 million, the absence of a one-time tax penalty of $0.4 million in 2016, reduced professional fees of approximately $0.2 million, reduced loan modification costs of $0.2 million and reduced audit fees of approximately $0.2 million partially offset by additional staffing and related salary increase of approximately $0.3 million, an increase in legal fees of approximately $0.4 million and increased marketing support costs of $0.2 million.\\nInterest Expense. Interest expense for the year ended December 31, 2016 increased approximately $1.2 million, or 7.4%, to approximately $17.7 million compared to approximately $16.5 million of interest expense for the year ended December 31, 2015. The increase in interest expense for the year ended December 31, 2016, was substantially related to the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.8 million. This increase was mainly offset by a decrease in interest from the redemption of the 8% Notes with an approximate decrease of $0.5 million.\\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture decreased approximately $0.5 million, or 100.0%, to $0 for the year ended December 31, 2016 compared to equity in the income of the joint venture of approximately $0.5 million for the year ended December 31, 2015, due the acquisition of the Crowne Plaza Hollywood Beach Resort in July 2015.\\n42\\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2016 increased approximately $0.6 million, or 83.5%, to approximately $1.4 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2015. During the year ended December 31, 2016, we refinanced mortgage loans at our properties in Wilmington, North Carolina; Savannah, Georgia; Jeffersonville, Indiana; Tampa, Florida and Houston, Texas with an increase in loss on early debt extinguishments of approximately $0.3 million. We also redeemed our 8% unsecured notes with the majority of the loss on early debt extinguishment of approximately $1.1 million.\\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2016, the fair market value of the interest rate cap is $33,597 compared to the fair market value of $70,981, as of December 31, 2015. The unrealized loss on hedging activities during the year ended December 31, 2016 and 2015, was $37,384 and $108,818, respectively.\\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015, was approximately $6.6 million while no such gain was recorded in 2016.\\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2016 increased approximately $32,000, or 2.4%, to approximately $1.4 million compared to an income tax provision of approximately $1.3 million for the year ended December 31, 2015. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized higher operating loss for the year ended December 31, 2016 compared to the year ended December 31, 2015. At December 31, 2016, deferred tax assets total approximately $6.9 million, of which approximately $6.0 million relate to net operating losses of our TRS Lessee. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. We will continue to regularly evaluate the likelihood that we will be able to realize our deferred tax assets and the need for a valuation allowance for the deferred tax assets.\\nNet Income. Net income for the year ended December 31, 2016 decreased approximately $5.5 million, or 85.9%, to approximately $0.9 million compared to net income of approximately $6.4 million for the year ended December 31, 2015, as a result of the operating results discussed above.\\nDistributions to Preferred Stockholders. During the year ended December 31, 2016, we recorded distributions to preferred stockholders of approximately $1.1 million, compared to no distributions to preferred stockholders for the year ended December 31, 2015. As of December 31, 2016 and 2015, we accrued $805,000 and $0, as dividends on the preferred stock, respectively.\\nComparison of Year Ended December 31, 2015 to Year Ended December 31, 2014\\nThe following table illustrates the key operating metrics for the years ended December 31, 2015 and 2014, for our wholly-owned properties during each respective reporting period (“actual” properties) as well as the key operating metrics for the ten wholly-owned properties that were under our control during all of 2014 (“same-store” properties). Accordingly, the same-store data does not reflect the performance of the Georgian Terrace, which was acquired in March 2014. Each table excludes performance data for the Crowne Plaza Hollywood Beach Resort, which was acquired through a joint venture and in which we had a 25.0% indirect interest through July 31, 2015 and a 100.0% interest thereafter through December 31, 2015.\\n\\n| Year Ended December 31, 2015 | Year Ended December 31, 2014 |\\n| Actual | Same-Store | Actual | Same-Store |\\n| Occupancy % | 69.9 | % | 65.7 | % | 70.3 | % | 69.7 | % |\\n| ADR | $ | 134.21 | $ | 130.09 | $ | 15.77 | $ | 124.27 |\\n| RevPAR | $ | 93.80 | $ | 85.47 | $ | 88.42 | $ | 86.57 |\\n\\nRevenue. Total revenue for the year ended December 31, 2015 was approximately $138.5 million, an increase of approximately $15.6 million, or 12.7%, from total revenue for the year ended December 31, 2014 of approximately $122.9 million. Approximately $6.2 million of the increase relates to the acquisition of our property in Atlanta, Georgia in March 2014. Approximately $7.5 million of the increase relates to the acquisition of the remaining 75.0% interest in our property in Hollywood Beach, Florida in July 2015. Increases in revenues at our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Jeffersonville, Indiana; Tampa, Florida; Hampton, Virginia and Atlanta, Georgia were offset by decreases in revenue at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas, as well as by the loss of rental income associated with Shell Island which expired in December 2014.\\n43\\nRoom revenues at our properties for the year ended December 31, 2015 increased approximately $12.2 million, or 14.4%, to approximately $96.8 million compared to room revenues for the year ended December 31, 2014 of approximately $84.6 million. The increase in room revenue for the year ended December 31, 2015 resulted mainly from the acquired property in Atlanta, Georgia, accounting for an increase of approximately $3.3 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.4 million for the period. Our properties in Wilmington, North Carolina; Savannah, Georgia; Raleigh, North Carolina; Philadelphia, Pennsylvania; Jacksonville, Florida; Tampa, Florida; and Hampton, Virginia and Atlanta, Georgia, experienced a significant increase in room revenue, offset by decreases at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\\nFood and beverage revenues at our properties for the year ended December 31, 2015 increased approximately $1.8 million, or 5.8%, to approximately $33.3 million compared to food and beverage revenue of approximately $31.4 million for the year ended December 31, 2014. The increase in food and beverage revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $2.1 million for the period, and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.2 million for the period. Additional increases in food and beverage revenue at our properties in Wilmington, North Carolina; Raleigh, North Carolina and Jeffersonville, Indiana of approximately $0.3 million, were offset by decreases of approximately $1.6 million in banqueting revenue at our other properties.\\nOther operating revenues for the year ended December 31, 2015 increased approximately $1.5 million, or 22.5%, to approximately $8.4 million compared to other operating revenues for the year ended December 31, 2014 of approximately $6.9 million. The increase in other operating departments revenues for the year ended December 31, 2015 resulted principally from our acquired property in Atlanta, Georgia, accounting for an increase of approximately $0.8 million for the period and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.5 million for the period.\\nHotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $11.7 million, or 12.9%, for the year ended December 31, 2015, to approximately $101.9 million compared to hotel operating expenses for the year ended December 31, 2014 of approximately $90.2 million. The increase in hotel operating expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $6.7 million of the increase in expenses for the year ended December 31, 2015 and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $9.2 million for the period, coupled by a decrease in hotel operating expenses at our same-store properties of approximately $1.0 million, mainly from reduced occupancy by 5.7% and RevPAR by 1.3% combined with decreases in expenses at our properties impacted by renovation activities in Laurel, Maryland and Houston, Texas.\\nRooms expense at our properties for the year ended December 31, 2015 increased approximately $2.9 million, or 12.5%, to approximately $25.8 million compared to rooms expense of approximately $22.9 million for the year ended December 31, 2014. The increase in rooms expense for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.0 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $1.3 million for the period.\\nFood and beverage expenses at our properties for the year ended December 31, 2015 increased approximately $2.0 million, or 9.4%, to approximately $23.0 million compared to food and beverage expense of approximately $21.0 million for the year ended December 31, 2014. The increase in food and beverage expenses for the year ended December 31, 2015 was substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $1.5 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $0.9 million for the period, offset by decreases in food and beverage expenses mainly from reduced occupancy and decreases in expenses at our property impacted by renovation activities in Houston, Texas.\\nIndirect expenses at our properties for the year ended December 31, 2015 increased approximately $6.2 million, or 13.8%, to approximately $51.3 million compared to indirect expenses of approximately $45.1 million for the year ended December 31, 2014. Sales and marketing costs, franchise fees, utilities, repairs and maintenance, insurance, management fees, real and personal property taxes as well as general and administrative costs at the property level are included in indirect expenses. Most of the increase in indirect expenses related to expenses that increase proportionally with increases in occupancy and/or revenue, including management fees and franchise fees. Specifically, increases in indirect expenses were substantially related to our acquired property in Atlanta, Georgia, accounting for approximately $2.1 million of the increase and from the acquired property in Hollywood Beach, Florida, accounting for an increase of approximately $2.8 million for the period, compared to the year ended December 31, 2014.\\n44\\nDepreciation and Amortization. Depreciation and amortization for the year ended December 31, 2015 increased approximately $1.6 million, or 13.6%, to approximately $13.6 million compared to depreciation and amortization expense of approximately $12.0 million for the year ended December 31, 2014. The increase was mostly attributable to depreciation and amortization related to our acquired property in Atlanta, Georgia and depreciation and amortization related to our capital assets acquired in the fourth quarter of 2014 and the year of 2015, offset by reductions of intangible asset amortization during the year ended December 31, 2015 compared to the year ended December 31, 2014.\\nImpairment of Investment in Hotel Properties, Net. The impairment of investment in hotel properties, net for the years ended December 31, 2015 and 2014, was approximately $0.5 million and $3.2 million, respectively. Our review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which was triggered by a combination of a change in anticipated use and future branding of the property; and a re-evaluation of future revenues based on anticipated market conditions, market penetration and costs necessary to achieve such market penetration, resulting in an impairment to fair market value of $0.5 million, as of December 31, 2015.\\nGain on Disposal of Assets. During the year ended December 31, 2015, we recorded a gain on disposal of assets of $41,435, compared to no gain or loss on disposal of assets for the year ended December 31, 2014.\\nCorporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2015 increased approximately $2.2 million, or 42.9%, to approximately $7.3 million compared to corporate general and administrative expenses of approximately $5.1 million for the year ended December 31, 2014. The increase in corporate general and administrative expenses was mainly due to an increase in acquisition costs of approximately $0.5 million, a one-time tax penalty of $0.4 million, additional staffing and related salary increase of approximately $0.3 million, increased professional fees of approximately $0.5 million, loan costs of $0.2 million on the loan modifications of the Crowne Plaza Hollywood Beach Resort mortgage and the DoubleTree by Hilton Laurel mortgage, and increased audit fees of approximately $0.1 million partially offset by a reduction in legal fees of approximately $0.1 million.\\nInterest Expense. Interest expense for the year ended December 31, 2015 increased approximately $1.9 million, or 12.8%, to approximately $16.5 million compared to approximately $14.6 million of interest expense for the year ended December 31, 2014. The increase in interest expense for the year ended December 31, 2015 was substantially related to the additional mortgage on our acquired property in Atlanta, Georgia of $0.7 million, the assumed mortgage loan for the acquired property in Hollywood Beach, Florida, accounting for an increase in interest expense of approximately $1.4 million, the issuance of the 7% Notes due in 2019, accounting for an increase of approximately $1.6 million. These increases were offset by a decrease in interest from the reduction of the bridge loan with Richmond Hill Capital Partners, LP during the year ending December 31, 2015 of $1.3 million.\\nEquity Income (Loss) in Joint Venture. Equity in the income of the joint venture increased approximately $0.2 million, or 54.7%, to approximately $0.5 million for the year ended December 31, 2015 compared to equity in the income of the joint venture of approximately $0.3 million for the year ended December 31, 2014 and represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort through July 31, 2015. For the year ended December 31, 2015, the Crowne Plaza Hollywood Beach Resort reported occupancy of 83.1%, ADR of $174.35 and RevPAR of $144.86. This compares with results reported by the hotel for the year ended December 31, 2014 of occupancy of 83.1%, ADR of $163.13 and RevPAR of $135.55.\\nLoss on Early Debt Extinguishment. The loss on early debt extinguishment for the year ended December 31, 2015 decreased approximately $0.1 million, or 7.0%, to approximately $0.7 million compared to a loss on debt extinguishment of approximately $0.8 million for the year ended December 31, 2014. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with the Bank of the Ozarks on the Georgian Terrace, with a new fixed rate loan from Bank of America. The amount of accumulated un-amortized loan costs of $697,582 was written off during 2015. In addition, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. The amount of accumulated un-amortized loan costs of $75,324 was written off during 2015.\\nGain on Involuntary Conversion of Asset. Gain on involuntary conversion of asset for the year ended December 31, 2015 decreased approximately $0.2 million, or 100.0%, to $0 compared to approximately $0.2 million of gain on involuntary conversion of asset for the year ended December 31, 2014. During 2014, we had a one-time involuntary conversion of equipment at our Hilton Wilmington Riverside property for replacement of a water chiller in the amount of approximately $0.2 million.\\nUnrealized Loss on Hedging Activities. During the year ended December 31, 2015, we refinanced a variable rate mortgage loan we had with Fifth Third Bank on the DoubleTree by Hilton Jacksonville Riverfront, with a new variable rate loan from Bank of the Ozarks. During August 2015, we purchased an interest rate cap for $179,800. As of December 31, 2015, the fair market value of the interest rate cap was $70,981. The unrealized loss on hedging activities during the years ended December 31, 2015 and 2014, was approximately $0.1 million and $0, respectively.\\n45\\nGain on Change in Control. On July 31, 2015, we acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Due to the increased fair market value of the property for our original 25.0% interest we recognized a discounted gain on change in control. The gain on change in control during the year ended December 31, 2015 was approximately $6.6 million while no such gain was recorded in 2014.\\nIncome Tax Benefit. The income tax benefit for the year ended December 31, 2015 decreased approximately $0.4 million, or 22.7%, to approximately $1.3 million compared to an income tax benefit of approximately $1.7 million for the year ended December 31, 2014. The income tax benefit was primarily derived from the operations of our TRS Lessees. Our TRS Lessees realized lower operating loss for the year ended December 31, 2015 compared to the year ended December 31, 2014.\\nNet Income (Loss). Net income for the year ended December 31, 2015 increased approximately $7.1 million, or 966.3%, to approximately $6.4 million compared to net loss of approximately $0.7 million for the year ended December 31, 2014 as a result of the operating results discussed above.\\nSources and Uses of Cash\\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2016.\\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2016 was approximately $17.1 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\\nInvesting Activities. During the year ended December 31, 2016, we spent approximately $14.9 million on capital expenditures, of which, approximately $5.3 million related to the routine replacement of furniture, fixtures and equipment; approximately $1.8 million related to the renovation of our property in Houston, Texas in anticipation of our newly independent hotel The Whitehall which opened in May 2016; approximately $4.9 million related to the renovation of our property in Savannah, Georgia; approximately $1.5 million related to the renovation of our property in Atlanta, Georgia; approximately $0.6 million related to the renovation of our property in Wilmington, North Carolina; approximately $0.4 million related to the renovation of our property in Laurel, Maryland and approximately $0.4 million related to the renovation of our property in Hollywood Beach, Florida.\\nWe also contributed approximately $5.3 million during 2016 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2016, we received reimbursements from those reserves of approximately $7.0 million for capital expenditures related to those properties for periods ending on or before December 31, 2016.\\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2016 was approximately $16.1 million. This inflow was principally from proceeds from the sale of preferred stock of approximately $37.8 million and net mortgage proceeds of approximately $14.2 million, offset by redemption of the 8% Notes for $27.6 million, repurchase of common stock for approximately $2.1 million, dividend and distribution payments of approximately $6.2 million and payments of deferred financing costs of approximately $1.5 million.\\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company.\\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank.\\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\\n46\\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions.\\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan provides proceeds of $12.0 million.\\nOn November 3, 2016, we entered into a loan agreement to modify and extend the $2.6 million mortgage on the Crowne Plaza Hampton Marina with TowneBank.\\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project.\\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\\nThe following narrative discusses our sources and uses of cash for the year ended December 31, 2015.\\nOperating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders of the Operating Partnership and stockholders of the Company as well as debt service (excluding debt maturities), is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2015 was approximately $11.4 million. We expect that cash on hand and the net cash provided by operations will be adequate to fund our operating requirements, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the stockholders of the Company (the unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90.0% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).\\nInvesting Activities. During the year ended December 31, 2015, we used approximately $25.5 million to acquire the remaining 75.0% ownership interest in the Crowne Plaza Hollywood Beach Resort. We also spent approximately $20.1 million on capital expenditures, of which, approximately $5.1 million related to the routine replacement of furniture, fixtures and equipment; approximately $4.6 million related to the renovation of our property in Laurel, Maryland in anticipation of a new franchise agreement which commenced in October 2015; approximately $3.4 million related to the renovation of our property in Jacksonville, Florida in anticipation of a new franchise license which commenced in September 2015; approximately $3.1 million related to guestroom renovations at the Georgian Terrace; approximately $3.0 million in renovations at our property in Houston, Texas; and approximately $0.9 related to the renovation of our property in Philadelphia, Pennsylvania.\\nWe also contributed approximately $5.0 million during 2015 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements. During 2015, we received reimbursements from those reserves of approximately $6.4 million for capital expenditures related to those properties for periods ending on or before December 31, 2015 and we received net proceeds of approximately $2.4 million from the sale of a 0.3-acre parcel of excess land located adjacent to our property in Atlanta, Georgia and related development rights.\\nFinancing Activities. Cash flow provided by financing activities for the year ended December 31, 2015 was approximately $24.6 million. This inflow was principally from proceeds from the sale of common stock of approximately $23.3 million and net mortgage proceeds of approximately $6.8 million, offset by dividend and distribution payments of approximately $4.1 million and payments of deferred financing costs of approximately $1.4 million.\\nOn October 20, 2015, we secured $2.0 million of additional proceeds on the mortgage loan on the DoubleTree by Hilton Jacksonville Riverfront as part of an earn-out pursuant to the terms of the loan agreement.\\nOn September 28, 2015, we entered into a loan agreement to secure a $60.0 million mortgage on the Crowne Plaza Hollywood Beach Resort with Bank of America, N.A.\\n47\\nOn July 17, 2015, the Company sold 435,000 shares of common stock for net proceeds of approximately $2.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\\nOn July 7, 2015, we entered into a loan agreement and other loan documents to secure an $18.5 million mortgage with Bank of the Ozarks collateralized by a first mortgage on the DoubleTree by Hilton Jacksonville Riverfront. The $18.5 million mortgage was received in two parts. We received $18.0 million on July 7, 2015 and the remainder of $0.5 million on October 20, 2015. The $0.5 million was included with the additional earn-out provision of $1.5 million, for a total of $2.0 million additional proceeds.\\nOn July 1, 2015, the Company sold 3,000,000 shares of common stock, for net proceeds of approximately $19.8 million, which it contributed to the Operating Partnership for an equivalent number of units.\\nDuring June 2015, the Company sold 98,682 shares of common stock for net proceeds of approximately $0.7 million, which it contributed to the Operating Partnership for an equivalent number of units.\\nOn May 5, 2015, the Company obtained a $47.0 million mortgage with Bank of America, N.A. on the Georgian Terrace in Atlanta, Georgia.\\nCapital Expenditures\\nWe anticipate that our need for recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment over the next 12 to 24 months will be at historical norms for our properties and the industry. Historically, we have aimed to maintain overall capital expenditures, except for those required by our franchisors as a condition to a franchise license or license renewal, at 4.0% of gross revenue. In addition, during fiscal years 2017 and 2018 we expect total renovation capital expenditures of approximately $23.5 million related to our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida.\\nGiven our desire to proceed with the renovation activities at our properties in Wilmington, North Carolina; Savannah, Georgia and Hollywood Beach, Florida, we aim to restrict all other capital expenditures to the replacement of broken or damaged furniture and equipment and the acquisition of items mandated by our licensors that are necessary to maintain our brand affiliations. We anticipate that capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment that are not related to these renovation activities to total 3.50% of gross revenues in 2017.\\nWe expect capital expenditures for the recurring replacement or refurbishment of furniture, fixtures and equipment at our properties will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors. Reserve accounts are escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures with respect to all of our hotels. We currently deposit an amount equal to 4.0% of gross revenue for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside, the Crowne Plaza Hollywood Beach Resort, The DoubleTree by Hilton Jacksonville Riverside, the DoubleTree by Hilton Raleigh Brownstone-University, the Whitehall and the Georgian Terrace as well as 4.0% of room revenues for the DoubleTree by Hilton Philadelphia Airport on a monthly basis.\\nLiquidity and Capital Resources\\nAs of December 31, 2016, we had cash and cash equivalents of approximately $36.4 million, of which approximately $4.6 million was in restricted reserve accounts for capital improvements, real estate tax and insurance escrows. We expect that our cash on hand combined with our cash flow from our hotels should be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment, and monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of the indentures or mortgage debt).\\nWe intend to continue to invest in hotel properties as suitable opportunities arise. The success of our acquisition strategy depends, in part, on our ability to access additional capital through other sources. There can be no assurance that we will continue to make investments in properties that meet our investment criteria. Additionally, we may choose to dispose of certain hotels as a means to provide liquidity.\\nWe expect to meet our liquidity requirements for hotel property acquisitions, property redevelopment, investments in new joint ventures and debt maturities, which include the repayment of the 7% Notes (which are callable after November 15, 2017) and the retirement of maturing mortgage debt, through net proceeds from additional issuances of common shares, additional issuances of preferred shares, issuances of units of limited partnership interest in our Operating Partnership, secured and unsecured borrowings, the selective disposition of non-core assets, and cash on hand. We remain committed to a flexible capital structure and strive to maintain prudent debt leverage.\\n48\\nWe do not have any debt obligations maturing until August 2018. In August 2018, the approximate $14.5 mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures. We have approximately $87.6 million in debt obligations maturing in 2019, including $25.3 million of the Operating Partnership’s 7% Notes and approximately $62.3 million in mortgage debt, including reductions for future monthly principal payments on the mortgages.\\nOn June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company. The loan has a maturity date of July 1, 2026.\\nOn June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank. The loan has an initial term of three years with a maturity on July 1, 2019, and may be extended for two additional periods of one year each, subject to certain conditions.\\nOn August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units.\\nOn September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.\\nOn October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with International Bank of Commerce. Pursuant to the loan documents, the loan: provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions, has a term of five years, bears a floating interest rate of the one month LIBOR plus 3.5%, subject to a floor rate of 4.0%, amortizes on an 18-year schedule after a 2-year interest only period, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP.\\nOn November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company. Pursuant to the loan documents, the loan: provides proceeds of $12.0 million, has a maturity date of December 1, 2026, bears a fixed interest rate of 4.27% for the first 5 years of the loan with an option for the lender to reset that rate after 5 years, amortizes on a 25-year schedule, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP at 50% of the unpaid principal balance, interest, and other amounts owed.\\nOn December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company. Pursuant to the loan documents, the loan: provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; has a term of 10 years; bears a fixed interest rate of 4.25%; amortizes on a 25-year schedule after a 1-year interest-only period and is subject to a prepayment premium.\\nOn December 2, 2016, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management. The Company expects to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the Board of Directors. Through December 31, 2016, the Company repurchased 481,100 shares of common stock for approximately $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.\\nFinancial Covenants\\nMortgage Loans\\nOur mortgage loan agreements contain various financial covenants. Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.\\n49\\nIf we violate the financial covenants contained in these agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms. Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral. Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.\\nIf we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through additional debt financing, private or public offerings of debt securities, or additional equity financing.\\nUnder the terms of our non-recourse secured mortgage loan agreements, failure to comply with the financial covenants in the loan agreement triggers cash flows from the property to be directed to the lender, which may limit our overall liquidity as that cash flow would not be available to us.\\nAt December 31, 2016, we were in compliance with all debt covenants, current on all loan payments and not otherwise in default under any of our mortgage loans.\\nUnsecured Notes\\nThe indenture for the 7% Notes contains certain covenants and restrictions that require us to meet certain financial ratios. We are not permitted to incur any Debt (other than intercompany Debt), as defined in the indenture, if, immediately after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, the ratio of the aggregate principal amount of all outstanding Debt to Adjusted Total Asset Value, as defined in the indenture, would be greater than 0.65 to 1.0. In addition, we are not permitted to incur any Debt if the ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense, both as defined in the indenture, on the date on which such additional Debt is to be incurred, on a pro-forma basis, after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, would be less than 1.50 to 1.0.\\n50\\nThese financial measures are not calculated in accordance with GAAP and are presented below for the sole purpose of evaluating our compliance with the key financial covenants as they were or would have been applicable at December 31, 2016 and December 31, 2015, respectively.\\n\\n| December 31, | December 31, |\\n| 2016 | 2015 |\\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense |\\n| Net income(1) | $ | 900,149 | $ | 6,397,653 |\\n| Interest expense(1) | 17,735,107 | 16,515,827 |\\n| Loss on early debt extinguishment | 1,417,905 | 772,907 |\\n| Unrealized loss on hedging activities | 37,384 | 108,819 |\\n| Gain on change in control | — | (6,603,148 | ) |\\n| Loss (Gain) on disposal of assets | 365,319 | (41,435 | ) |\\n| Income tax benefit(1) | (1,367,634 | ) | (1,336,033 | ) |\\n| Equity in income of joint venture(1) | — | (475,514 | ) |\\n| Impairment of investment in hotel properties, net(1) | — | 500,000 |\\n| Depreciation and amortization(1) | 15,019,071 | 13,591,495 |\\n| Corporate general and administrative expenses(1) | 6,021,065 | 7,268,256 |\\n| Consolidated income available for debt service(1) | 40,128,366 | 36,698,827 |\\n| Less: income of non-stabilized assets(1) | (10,203,893 | ) | (16,284,975 | ) |\\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\\n| Interest expense(1) (2) | $ | 18,011,107 | $ | 16,515,827 |\\n| Amortization of issuance costs(1) | (1,147,864 | ) | (1,300,032 | ) |\\n| Consolidated interest expense(1) | 16,863,243 | 15,215,795 |\\n| Less: interest expense of non-stabilized assets(1) | (3,417,412 | ) | (5,295,224 | ) |\\n| Stabilized Consolidated Interest Expense(1) | $ | 13,445,831 | $ | 9,920,571 |\\n| Ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense | 2.23 | 2.06 |\\n| Threshold Ratio Minimum | 1.50 | 1.50 |\\n| Ratio of Debt to Adjusted Total Asset Value: |\\n| Mortgage loans | $ | 284,757,698 | $ | 271,977,944 |\\n| Unsecured notes | 25,300,000 | 52,900,000 |\\n| Total debt | $ | 310,057,698 | $ | 324,877,944 |\\n| Stabilized Consolidated Income Available for Debt Service(1) | $ | 29,924,473 | $ | 20,413,852 |\\n| Capitalization rate | 7.5 | % | 7.5 | % |\\n| 398,992,973 | 272,184,693 |\\n| Non-stabilized assets | 145,400,000 | 305,255,698 |\\n| Total cash | 36,362,920 | 17,287,754 |\\n| Adjusted Total Asset Value | $ | 580,755,893 | $ | 594,728,145 |\\n| Ratio of Debt to Adjusted Total Asset Value | 0.53 | 0.55 |\\n| Threshold Ratio Maximum | 0.65 | 0.65 |\\n\\n\\n| (1) | As permitted by the indenture, the Hilton Savannah DeSoto, DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and The Whitehall, for the period ended December 31, 2016, and the DoubleTree by Hilton Laurel, DoubleTree by Hilton Jacksonville Riverfront and Crowne Plaza Hollywood Beach Resort, for the period ended December 31, 2015, are considered non-stabilized assets for purposes of the financial covenants. |\\n\\n| (2) | Includes losses on debt extinguishment paid for in cash of $276,000 in fiscal year 2016. |\\n\\n51\\nMortgage Debt\\nAs of December 31, 2016, we had a principal mortgage debt balance of approximately $284.5 million. The following table sets forth our mortgage debt obligations on our hotels.\\n\\n| December 31, | Prepayment | Maturity | Amortization |\\n| Property | 2016 | Penalties | Date | Provisions | Interest Rate |\\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | None | 11/1/2019 | $ | 3 years | 5.00% |\\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | N/A | 10/1/2025 | 30 years | 4.913% |\\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | Yes | 8/5/2021 | 25 years | 5.25% |\\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | N/A | 8/1/2018 | 30 years | 4.78% |\\n| The Georgian Terrace (8) | 45,826,038 | N/A | 6/1/2025 | 30 years | 4.42% |\\n| Hilton Savannah DeSoto (9) | 30,000,000 | Yes | 7/1/2026 | 25 years | 4.25% |\\n| Hilton Wilmington Riverside (10) | 30,000,000 | Yes | 1/1/2027 | 25 years | 4.25% |\\n| Sheraton Louisville Riverside (11) | 11,977,557 | Yes | 12/1/2026 | 25 years | 4.27% |\\n| The Whitehall (12) | 15,000,000 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\\n| Total Mortgage Principal Balance | 284,542,043 |\\n| Deferred financing costs, net | (2,049,409) |\\n| Unamortized premium on loan | 215,655 |\\n| Total Mortgage Loans | $ | 282,708,289 |\\n\\n\\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\\n\\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\\n\\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\\n\\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\\n\\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\\n\\n| (6) | The note bears a minimum interest rate of 3.50%. |\\n\\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\\n\\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\\n\\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\\n\\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project. The note amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\\n\\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\\n\\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0%; and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\\n\\n52\\nContractual Obligations\\nThe following table outlines our contractual obligations as of December 31, 2016, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands).\\n\\n| Payments due by period (in thousands) |\\n| Less than | More than |\\n| Contractual Obligations | Total | 1 year | 1-3 years | 3-5 years | 5 years |\\n| Mortgage loans, including interest | $ | 355,927 | $ | 18,895 | $ | 119,609 | $ | 55,911 | $ | 161,512 |\\n| Unsecured notes, including interest | 30,416 | 1,771 | 28,645 | — | — |\\n| Ground, building, office and equipment leases | 1,137 | 224 | 276 | 191 | 446 |\\n| Purchase commitment | 4,250 | 4,250 | — | — | — |\\n| Totals | $ | 391,730 | $ | 25,140 | $ | 148,530 | $ | 56,102 | $ | 161,958 |\\n\\nIn connection with the acquisition of our six initial hotel properties, we entered into tax indemnity agreements that required us to indemnify the contributors of our initial properties against tax liabilities in the event we sold any of those properties in a taxable transaction during a 10-year period. The tax indemnity agreements expired on or about December 22, 2014. Our obligations under the contribution agreements may effectively preclude us from reducing our consolidated indebtedness below approximately $11.0 million.\\nOff Balance Sheet Arrangements. Through a joint venture with a Carlyle subsidiary, we owned a 25.0% indirect, noncontrolling interest in an entity (the “JV Owner”) that acquired the 311-room Crowne Plaza Hollywood Beach Resort in Hollywood, Florida. We had the right to receive a pro rata share of operating surpluses and we had an obligation to fund our pro rata share of operating shortfalls. We also had the opportunity to earn an incentive participation in the net proceeds realized from the sale of the hotel based upon the achievement of certain overall investment returns, in addition to our pro rata share of net sale proceeds. The Crowne Plaza Hollywood Beach Resort was leased to another entity (the “Joint Venture Lessee”) in which we also owned a 25.0% indirect, noncontrolling interest.\\nCarlyle owned a 75.0% controlling interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. Carlyle had the right to dispose of the Crowne Plaza Hollywood Beach Resort without our consent. We accounted for our noncontrolling 25.0% interest in all of these entities under the equity method of accounting.\\nOn July 31, 2015, indirect subsidiaries of the Operating Partnership acquired from Carlyle the remaining 75.0% interest in the entities that own and lease the Crowne Plaza Hollywood Beach Resort. As a result, the Operating Partnership now has a 100% indirect ownership interest in the entities that own the Crowne Plaza Hollywood Beach Resort. The property was refinanced on September 28, 2015 and is encumbered by a $60.0 million mortgage which matures in September 2025 and requires monthly payments of interest at a rate of 4.913%. The Crowne Plaza Hollywood Beach Resort secures the mortgage.\\nDistributions to Stockholders and Holders of Units in the Operating Partnership. The Company has elected to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To maintain qualification as a REIT, the Company is required to make annual distributions to its stockholders of at least 90.0% of our REIT taxable income, (excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). The Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\\nDistributions to Preferred Stockholders and Holder of Preferred partnership units in the Operating Partnership. The Company is obligated to pay distributions to its preferred stockholders of the Company’s preferred stock and the Operating Partnership is obligated to pay its preferred unit holder, the Company. Holders of the Company’s 8% Series B Cumulative Redeemable Preferred Stock are entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions. The amount of annual dividends on our outstanding preferred shares is approximately $3.2 million and the aggregate liquidation preference with respect to our outstanding preferred shares is approximately $40.3 million. The preferred stock is not redeemable by the holders, has no maturity date and is not convertible into any other security of the Company or its affiliates, except in the event of a change of control.\\n53\\nThe Company’s ability to pay distributions to its stockholders will depend, in part, upon its receipt of distributions from the Operating Partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessees, and in turn, upon the management of our properties by our hotel manager. Distributions to the Company’s stockholders will generally be taxable to the Company’s stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a non-taxable return of capital. To the extent not inconsistent with maintaining the Company’s REIT status, our TRS Lessees may retain any after-tax earnings.\\nThe amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by the Company based upon a variety of factors deemed relevant by its directors, and no assurance can be given that the distribution policy will not change in the future.\\nInflation\\nWe generate revenues primarily from lease payments from our TRS Lessees and net income from the operations of our TRS Lessees. Therefore, we rely primarily on the performance of the individual properties and the ability of the management company to increase revenues and to keep pace with inflation. Operators of hotels, in general, possess the ability to adjust room rates daily to keep pace with inflation. However, competitive pressures at some or all of our hotels may limit the ability of the management company to raise room rates.\\nOur expenses, including hotel operating expenses, administrative expenses, real estate taxes and property and casualty insurance are subject to inflation. These expenses are expected to grow with the general rate of inflation, except for energy, liability insurance, property and casualty insurance, property tax rates, employee benefits, and some wages, which are expected to increase at rates higher than inflation.\\nGeographic Concentration and Seasonality\\nOur hotels are located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, and Texas. As a result, we are particularly susceptible to adverse market conditions in these geographic areas, including industry downturns, relocation of businesses and any oversupply of hotel rooms or a reduction in lodging demand. Adverse economic developments in the markets in which we have a concentration of hotels, or in any of the other markets in which we operate, or any increase in hotel supply or decrease in lodging demand resulting from the local, regional or national business climate, could materially and adversely affect us.\\nThe operations of our hotel properties have historically been seasonal. The months of April and May are traditionally strong, as is October. The periods from mid-November through mid-February are traditionally slow with the exception of hotels located in certain markets, namely Florida and Texas, which experience significant room demand during this period.\\nCompetition\\nThe hotel industry is highly competitive with various participants competing on the basis of price, level of service and geographic location. Each of our hotels is located in a developed area that includes other hotel properties. The number of competitive hotel properties in a particular area could have a material adverse effect on occupancy, ADR and RevPAR of our hotels or at hotel properties acquired in the future. We believe that brand recognition, location, the quality of the hotel, consistency of services provided, and price, are the principal competitive factors affecting our hotels.\\nCritical Accounting Policies\\nThe critical accounting policies are described below. We consider these policies critical because they involve difficult management judgments and assumptions, are subject to material change from external factors or are pervasive, and are significant to fully understand and evaluate our reported financial results.\\nInvestment in Hotel Properties. Hotel properties are stated at cost, net of any impairment charges, and are depreciated using the straight-line method over an estimated useful life of 7-39 years for buildings and improvements and 3-10 years for furniture and equipment. In accordance with generally accepted accounting principles, the controlling interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and noncontrolling interests held by the controlling holders of our accounting predecessor in hotels, which were acquired from third parties contributed to us in connection with the Company’s initial public offering, are recorded at historical cost basis. Noncontrolling interests in those entities that comprise our accounting predecessor and the interests in hotels, other than those held by the controlling members of our accounting predecessor, acquired from third parties are recorded at fair value at the time of acquisition.\\n54\\nWe review our hotel properties for impairment whenever events or changes in circumstances indicate the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause us to perform our review include, but are not limited to, adverse permanent changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs a recoverability analysis to determine if the estimated undiscounted future cash flows from operating activities and the estimated proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are found to be less than the carrying amount of the hotel property, an adjustment to reduce the carrying value to the related hotel property’s estimated fair market value would be recorded and an impairment loss recognized.\\nOur review of possible impairment at one of our hotel properties revealed an excess of current carrying cost over the estimated undiscounted future cash flows, which resulted in an impairment to fair market value by an approximate amounts of $0.5 million and $3.2 million, as of December 31, 2015 and 2014, respectively.\\nIn performing the recoverability analysis, we project future operating cash flows based upon significant assumptions regarding growth rates, occupancy, room rates, economic trends, property-specific operating costs and future capital expenditures required to maintain the hotel in its current operating condition. We also project cash flows from the eventual disposition of the hotel based upon various factors including property-specific capitalization rates, ratio of selling price to gross hotel revenues and the selling price per room.\\nRevenue Recognition. Hotel revenues, including room, food, beverage and other hotel revenues, are recognized as the related services are delivered. We generally consider accounts receivable to be fully collectible; accordingly, no allowance for doubtful accounts is required. If we determine that amounts are uncollectible, which would generally be the result of a customer’s bankruptcy or other economic downturn, such amounts will be charged against operations when that determination is made.\\nIncome Taxes. We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS Lessee, we have not recorded a valuation allowance to reduce our net deferred tax asset as of December 31, 2016. We regularly evaluate the likelihood that our TRS Lessee will be able to realize its deferred tax assets and the continuing need for a valuation allowance. At December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward. A number of factors played a critical role in this determination, including:\\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\\n\\n| • | reasonable forecasts of future taxable income, and |\\n\\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\\n\\nShould unanticipated adverse financial trends occur, or other negative evidence develop, a valuation allowance may be necessary in the future against some or all of our deferred tax assets.\\nRecent Accounting Pronouncements\\nFor a summary of recently adopted and newly issued accounting pronouncements, please refer to the Recent Accounting Pronouncements section of Note 2, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.\\nNon-GAAP Financial Measures\\nWe consider FFO, Adjusted FFO and Hotel EBITDA, all of which are non-GAAP financial measures, to be key supplemental measures of our performance and could be considered along with, not alternatives to, net income (loss) as a measure of our performance. These measures do not represent cash generated from operating activities determined by generally accepted accounting principles (“GAAP”) or amounts available for our discretionary use and should not be considered alternative measures of net income, cash flows from operations or any other operating performance measure prescribed by GAAP.\\nFFO and Adjusted FFO. Industry analysts and investors use Funds from Operations (“FFO”), as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization,\\n55\\nand after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by itself.\\nWe consider FFO to be a useful measure of adjusted net income (loss) for reviewing comparative operating and financial performance because we believe FFO is most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.\\nWe further adjust FFO for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, loan modification fees, franchise termination costs, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs. We exclude these items as we believe it allows for meaningful comparisons between periods and among other REITs and is more indicative than FFO of the on-going performance of our business and assets. Our calculation of Adjusted FFO may be different from similar measures calculated by other REITs.\\nThe following is a reconciliation of net income (loss) to FFO and Adjusted FFO for the years ended December 31, 2016, 2015, and 2014.\\n\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 |\\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\\n| Equity in Depreciation on Joint Venture | — | 259,279 | 529,053 |\\n| Gain on Change in Control | — | (6,603,148 | ) | — |\\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\\n| Funds From Operations | $ | 15,139,650 | $ | 14,103,844 | $ | 14,765,677 |\\n| Increase in Deferred Income Taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\\n| Acquisition Costs | — | 634,376 | 155,187 |\\n| Loss on Starwood Settlement | — | 324,271 | — |\\n| Over-Assessed Real Estate Taxes Under Appeal | — | 497,733 | — |\\n| Loan Modification Fees | 64,215 | 243,229 | — |\\n| Franchise Termination Fee | — | — | 351,800 |\\n| Realized and Unrealized Loss on Hedging Activities (A) | 37,384 | 108,819 | — |\\n| Loss on Early Debt Extinguishment (A) | 1,417,905 | 772,907 | 831,079 |\\n| Adjusted FFO | $ | 15,100,188 | $ | 14,904,608 | $ | 14,142,080 |\\n\\n\\n| (A) | Includes equity in unrealized (gain)/loss on hedging activities and loss on early extinguishment of debt of joint venture. |\\n\\nHotel EBITDA. We define Hotel EBITDA as net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio. We believe this provides a more\\n56\\ncomplete understanding of the operating results over which our wholly-owned hotels and its operators have direct control. We believe Hotel EBITDA provides investors with supplemental information on the on-going operational performance of our hotels and the effectiveness of third-party management companies operating our business on a property-level basis.\\nOur calculation of Hotel EBITDA may be different from similar measures calculated by other REITs.\\nThe following is a reconciliation of net loss to Hotel EBITDA for the years ended December 31, 2016, 2015, and 2014.\\n\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, | December 31, | December 31, |\\n| 2016 | 2015 | 2014 |\\n| Net Income/(Loss) Attributable to the Common Stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\\n| Add: Net Income/(Loss) Attributable to the Noncontrolling Interest | (26,567 | ) | 1,040,987 | (153,838 | ) |\\n| Interest Expense | 17,735,107 | 16,515,827 | 14,636,870 |\\n| Interest Income | (115,785 | ) | (50,461 | ) | (19,865 | ) |\\n| Distributions to Preferred Stockholders | 1,144,889 | — | — |\\n| Income Tax Benefit | (1,367,634 | ) | (1,336,033 | ) | (1,727,723 | ) |\\n| Depreciation and Amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Equity in Earnings of Joint Venture | — | (475,514 | ) | (307,370 | ) |\\n| Unrealized Loss on Hedging Activities | 37,384 | 108,819 | — |\\n| Gain on Change in Control | — | (6,603,148 | ) | — |\\n| Loss on Debt Extinguishment | 1,417,905 | 772,907 | 831,079 |\\n| Loss (Gain) on Disposal of Assets | 365,319 | (41,435 | ) | — |\\n| Gain on Involuntary Conversion of Asset | — | — | (169,151 | ) |\\n| Impairment of Investment in Hotel Properties, Net | — | 500,000 | 3,175,000 |\\n| Corporate General and Administrative Expenses | 6,021,065 | 7,268,256 | 5,085,949 |\\n| Net Lease Rental Income | — | — | (350,000 | ) |\\n| Other Fee Income | — | (200,976 | ) | (300,607 | ) |\\n| Hotel EBITDA | $ | 40,012,581 | $ | 36,447,390 | $ | 32,084,957 |\\n\\n\\nQuantitative and Qualitative Disclosures about Market Risk\\nThe effects of potential changes in interest rates are discussed below. Our market risk discussion includes “forward-looking statements” and represents an estimate of possible changes in fair value or future earnings that could occur assuming hypothetical future movements in interest rates. These disclosures are not precise indicators of expected future losses, but only indicators of reasonably possible losses. As a result, actual future results may differ materially from those presented. The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market interest rates.\\nTo meet in part our long-term liquidity requirements, we will borrow funds at a combination of fixed and variable rates. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. From time to time we may enter into interest rate hedge contracts such as collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not intend to hold or issue derivative contracts for trading or speculative purposes.\\nAs of December 31, 2016, we had approximately $228.7 million of fixed-rate debt and approximately $81.1 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 4.84%. A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgages on the Crowne Plaza Tampa Westshore, DoubleTree by Hilton Philadelphia Airport, DoubleTree by Hilton Jacksonville Riverfront and the mortgage on The Whitehall remains at approximately $81.1 million, the balance at December 31, 2016, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR would be approximately $0.8 million.\\nAs of December 31, 2015, we had approximately $272.6 million of fixed-rate debt and approximately $52.3 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 5.58%. A change in market interest rates on the fixed portion\\n57\\nof our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month and 3-month LIBOR. However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates. Assuming that the aggregate amount outstanding on the mortgage on the DoubleTree by Hilton Philadelphia Airport and the mortgage on the DoubleTree by Hilton Jacksonville Riverfront remains at approximately $52.2 million, the balance at December 31, 2015, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR and 3-month LIBOR would be approximately $0.5 million.\\nFinancial Statements and Supplementary Data\\nSee Index to Financial Statements and Financial Statement Schedules on page F-1.\\nChanges in and Disagreements with Accountants on Accounting and Financial Disclosure\\nNone.\\nControls and Procedures\\nSotherly Hotels Inc.\\nDisclosure Controls and Procedures\\nThe Company’s management, under the supervision and participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, its disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in its reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\\nThe Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures or its internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels Inc. have been detected.\\nManagement’s Report on Internal Control over Financial Reporting\\nThe Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). The Company’s management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) 2013 Internal Control-Integrated Framework. The Company’s management has concluded that, as of December 31, 2016, its internal control over financial reporting is effective based on these criteria.\\nThis annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\\n58\\nChanges in Internal Control over Financial Reporting\\nThere was no change in Sotherly Hotels Inc.’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels Inc.’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels Inc.’s internal control over financial reporting.\\nSotherly Hotels LP\\nDisclosure Controls and Procedures\\nThe Operating Partnership’s management, under the supervision and participation of the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, has evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of December 31, 2016. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2016, the disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in the reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.\\nThe Operating Partnership’s management, including the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, does not expect that the disclosure controls and procedures or the internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels LP have been detected.\\nManagement’s Report on Internal Control over Financial Reporting\\nThe Operating Partnership’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(e) under the Exchange Act). Management assessed the effectiveness over internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in 2013 Internal Control-Integrated Framework. Management has concluded that, as of December 31, 2016, the Operating Partnership’s internal control over financial reporting is effective based on these criteria.\\nThis annual report does not include an attestation report of the Operating Partnership’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Operating Partnership’s independent registered public accounting firm pursuant to the exemption provided to issuers that are not “large accelerated filers” or “accelerated filers” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\\nChanges in Internal Control over Financial Reporting\\nThere was no change in Sotherly Hotels LP’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels LP’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels LP’s internal control over financial reporting.\\nOther Information\\nNone.\\n59\\nPART III\\nThe information required by Items 10-14 is incorporated by reference to the Company’s proxy statement for the 2017 annual meeting of stockholders (to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report).\\nDirectors, Executive Officers and Corporate Governance\\nThe Company has adopted a code of business conduct and ethics, including a conflicts of interest policy that applies to its principal executive officer, principal financial officer, principal accounting officer or controller performing similar functions. We intend to maintain the highest standards of ethical business practices and compliance with all laws and regulations applicable to our business. A copy of the Company’s Code of Business Conduct is posted on the Company’s external website at www.sotherlyhotels.com. The Company and the Operating Partnership intend to post to its website any amendments to or waivers of its code. The Operating Partnership is managed by the Company, its sole general partner and parent company. Consequently, the Operating Partnership does not have its own separate directors or executive officers.\\nInformation on the Company’s directors is incorporated by reference to the sections captioned “Proposal I – Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Company’s 2017 Proxy Statement.\\n. Executive Compensation\\nThe information required by this item is incorporated by reference to the section captioned “Director and Executive Compensation” contained in the Company’s 2017 Proxy Statement.\\nSecurity Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters\\n(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS\\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\\n(b) SECURITY OWNERSHIP OF MANAGEMENT\\nInformation required by this item is incorporated herein by reference to the section captioned “Principal Holders” of the Company’s 2017 Proxy Statement.\\n(c) CHANGES IN CONTROL\\nManagement of the Company knows of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company.\\n(d) SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS\\nSet forth below is information as of December 31, 2016 with respect to compensation plans under which equity securities of the Company are authorized for issuance.\\n60\\nEQUITY COMPENSATION PLAN INFORMATION\\n\\n| NUMBER OF SECURITIES TO BE ISSUED UPON EXERCISE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | WEIGHTED-AVERAGE EXERCISE PRICE OF OUTSTANDING OPTIONS, WARRANTS AND RIGHTS | NUMBER OF SECURITIES REMAINING AVAILABLE FOR FUTURE ISSUANCE |\\n| Equity compensation plans approved by security holders: |\\n| 2013 Plan (1) | N/A | N/A | 640,900 |\\n| Equity compensation plans not approved by security holders: |\\n| None | N/A | N/A | N/A |\\n| Total | N/A | N/A | 640,900 |\\n\\n\\n| (1) | On February 2, 2016, we granted 8,000 shares of stock to Andrew M. Sims, 6,000 shares of stock to Anthony E. Domalski, 7,000 shares of stock to David R. Folsom, and 1,000 shares of stock to other employees of the Company. |\\n\\nOn February 2, 2016, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that vested on December 31, 2016. Also on February 2, 2016, we granted an additional 2,250 shares of unrestricted stock to director Herschel J. Walker in consideration for his service during 2015.\\nOn February 15, 2017, we granted 12,000 shares (3,000 each) of restricted stock to certain of our independent directors that will vest on December 31, 2017. These shares are included in the number of securities remaining available for future issuance at December 31, 2016.\\nCertain Relationships and Related Transactions, and Director Independence\\nThe information required by this item is incorporated by reference to the sections captioned “Certain Relationships and Related Transactions” and “Proposal I – Election of Directors” in the Company’s 2017 Proxy Statement.\\nPrincipal Accountant Fees and Services\\nThe information required by this item is incorporated by reference to the section captioned “Proposal II –Ratification of Appointment of Accountants” in the Company’s 2017 Proxy Statement.\\n61\\nPART IV\\nExhibits and Financial Statement Schedules\\n\\n| 1. Financial Statements |\\n| Index to Financial Statements and Financial Statement Schedules | F-1 |\\n| Sotherly Hotels Inc. |\\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\\n| Sotherly Hotels LP |\\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\\n| Notes to Consolidated Financial Statements | F-14 |\\n| 2. Financial Statement Schedules |\\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\\n\\nAll other schedules for which provision is made in Regulation S-X are either not required to be included herein under the related instructions or are inapplicable or the related information is included in the footnotes to the applicable financial statement and, therefore, have been omitted.\\nThe following exhibits are filed as part of this Form 10-K:\\n\\n| Exhibits |\\n| 3.1 | Articles of Amendment and Restatement of the Company (incorporated by reference to the document previously filed as Exhibit 3.1 to the Company’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on October 20, 2004 (File No. 333-118873)). |\\n| 3.1A | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.7 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\\n| 3.1B | Articles of Amendment to the Articles of Amendment and Restatement of the Company, effective as of August 12, 2016 (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 15, 2016). |\\n| 3.2 | Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\\n| 3.2A | Amendment No. 1 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.6 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\\n\\n62\\n\\n| Exhibits |\\n| 3.2B | Amendment No. 2 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.3 to the Operating Partnership’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on August 9, 2013 (File No. 333-189821)). |\\n| 3.2C | Amendment No. 3 to the Amended and Restated Agreement of Limited Partnership of Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 3.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 23, 2016). |\\n| 3.3 | Articles Supplementary of Sotherly Hotels Inc. (incorporated by reference to the document previously filed as Exhibit 3.4 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011). |\\n| 3.4 | Second Amended and Restated Bylaws of the Company, effective as of April 16, 2013 (incorporated by reference to the document previously filed as Exhibit 3.8 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 16, 2013). |\\n| 3.5 | Articles Supplementary designating the Series B Preferred Stock of the Company, effective as of August 19, 2016 (incorporated by reference to the document previously filed as Exhibit 3.5 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\\n| 4.0 | Form of Common Stock Certificate. |\\n| 4.1 | Senior Unsecured Note issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.6 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\\n| 4.2 | Indenture by and among Sotherly Hotels LP and Wilmington Trust, National Association, as trustee (incorporated by reference to the document previously filed as Exhibit 4.7 to our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013, filed with the Securities and Exchange Commission on November 7, 2013). |\\n| 4.3 | Indenture by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.8 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\\n| 4.4 | First Supplemental Indenture, by and among Sotherly Hotels Inc., Sotherly Hotels LP and Wilmington Trust, National Association, as trustee, dated November 21, 2014 (incorporated by reference to the document previously filed as Exhibit 4.9 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2014). |\\n| 4.5 | 7.00% Senior Unsecured Note due 2019, issued by Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 4.10 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, filed with the Securities and Exchange Commission on April 14, 2015). |\\n| 4.6 | Form of Specimen Certificate of Series B Preferred Stock of the Company (incorporated by reference to the document previously filed as Exhibit 4.1 to the Company’s Registration Statement on Form 8-A filed with the Securities and Exchange Commission on August 22, 2016). |\\n| 10.1 | Sotherly Hotels Inc. 2004 Long-Term Incentive Plan (incorporated by reference to the document previously filed as Exhibit 10.1 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). * |\\n| 10.1A | Form of Restricted Stock Award Agreement between Sotherly Hotels Inc. and Participant (incorporated by reference to the document previously filed as Exhibit 10.1A to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008, filed with the Securities and Exchange Commission on March 25, 2009). * |\\n| 10.2 | Executive Employment Agreement between Sotherly Hotels Inc. and Andrew M. Sims, dated January 12, 2015 (incorporated by reference to the document previously filed as Exhibit 10.2A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 13, 2015). * |\\n| 10.3 | Executive Employment Agreement between Sotherly Hotels Inc. and Anthony E. Domalski (incorporated by reference to the document previously filed as Exhibit 10.2A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on January 3, 2013). * |\\n\\n63\\n\\n| Exhibits |\\n| 10.4 | Contribution Agreement dated August 23, 2004 by and between the owners of Capitol Hotel Associates L.P., L.L.P. and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.6 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\\n| 10.5 | Contribution Agreement dated August 23, 2004 by and between the owners of Savannah Hotel Associates LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.7 to the Company’s Pre-Effective Amendment No. 6 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 15, 2004 (File No. 333-118873)). |\\n| 10.6 | Contribution Agreement dated August 23, 2004 by and between KDCA Partnership, MAVAS LLC, and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.8 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\\n| 10.7 | Contribution Agreement dated September 8, 2004 by and between Elpizo Limited Partnership, Phileo Land Corporation and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.9 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\\n| 10.8 | Asset Purchase Agreement dated August 19, 2004 by and between Accord LLC, West Laurel Corporation and MHI Hotels Services, LLC (incorporated by reference to the document previously filed as Exhibit 10.10 to the Company’s Pre-Effective Amendment No. 5 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on December 13, 2004 (File No. 333-118873)). |\\n| 10.9 | Agreement to Assign and Sublease Common Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels, LLC (incorporated by reference to the document previously filed as Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\\n| 10.10 | Agreement to Assign and Sublease Commercial Space Lease and Form of Sublease by and between MHI Hospitality L.P. and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\\n| 10.11 | Lease Agreement by and between Philadelphia Hotel Associates, LP and MHI Hospitality TRS, LLC (with a schedule of eight additional agreements that are substantially identical in all material respects to the Lease agreement, except as identified in such schedule, and are not being filed herewith per Instruction 2 to Item 601 of Regulation S-K (incorporated by reference to the document previously filed as Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\\n| 10.12 | Management Restructuring Agreement by and between MHI Hospitality TRS, LLC, MHI Hotels Services, LLC and Sotherly Hotels LP (incorporated by reference to the document previously filed as Exhibit 10.14 to the Company’s Pre-Effective Amendment No. 3 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on November 15, 2004 (File No. 333-118873)). |\\n| 10.13 | Contribution Agreement by and between MHI Hotels Services, LLC, MHI Hotels, LLC and MHI Hotels Two, Inc. (incorporated by reference to the document previously filed as Exhibit 10.15 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011, filed with the Securities and Exchange Commission on November 9, 2011). |\\n| 10.14 | Executive Employment Agreement, dated as of January 1, 2016, between Sotherly Hotels Inc. and David R. Folsom (incorporated by reference to the document previously filed as Exhibit 10.20A to our Current Report on Form 8-K filed with the Securities and Exchange Commission on January 4, 2016). * |\\n| 10.15 | Promissory Note dated March 29, 2007, made by Capitol Hotel Associates, L.P., L.L.P. and MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.25 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 2, 2007). |\\n| Exhibits |\\n| 10.16 | Limited Liability Company Agreement of MHI/Carlyle Hotel Investment Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26A to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\\n| 10.17 | Limited Liability Company Agreement of MHI/Carlyle Hotel Lessee Program I, L.L.C. dated April 26, 2007 (incorporated by reference to the document previously filed as Exhibit 10.26B to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 2, 2007). |\\n| 10.18 | Promissory Note dated August 2, 2007 made by Savannah Hotel Associates L.L.C., to the order of MONY Life Insurance Company (incorporated by reference to the document previously filed as Exhibit 10.29 to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 3, 2007). |\\n| 10.19 | Sotherly Hotels Inc. 2013 Long-Term Incentive Plan (incorporated by reference to Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 20, 2013). * |\\n| 10.20 | Sales Agency Agreement, dated July 9, 2014, among Sotherly Hotels Inc., Sotherly Hotels LP and Sandler O’Neill & Partners, L.P. (incorporated by reference to the document previously filed as Exhibit 10.51 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on July 9, 2014). |\\n| 10.21 | Master Agreement by and among Sotherly Hotels Inc., Sotherly Hotels LP, MHI Hospitality TRS, LLC and MHI Hotels Services LLC (incorporated by reference to the document previously filed as Exhibit 10.52 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 19, 2014). |\\n| 10.22 | Purchase and Sale Agreement by and between MHI Hospitality TRS II, LLC, MHI Hotel Investments Holdings LLC and CRP/MHI Holdings, L.L.C., dated as of June 19, 2015 (incorporated by reference to the document previously filed as Exhibit 10.53 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on June 22, 2015). |\\n| 10.23 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of April 29, 2016 (incorporated by reference to the document previously filed as Exhibit 10.54 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\\n| 10.24 | Amendment to the Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Three Capital Hotels, Inc., and Ajitkumar B. Patel, dated as of June 10, 2016 (incorporated by reference to the document previously filed as Exhibit 10.55 to our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2016, filed with the Securities and Exchange Commission on August 12, 2016). |\\n| 10.25 | Commercial Unit Purchase Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.56 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\\n| 10.26 | Addendum to Commercial Unit Agreement between Sotherly Hotels Inc. and 4111 South Ocean Drive, LLC, dated as of September 14, 2016 (incorporated by reference to the document previously filed as Exhibit 10.57 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2016). |\\n| 10.27 | Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of October 6, 2016 (incorporated by reference to the document previously filed as Exhibit 10.58 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\\n| 10.28 | Amendment to Agreement for Sale and Purchase of Property by and between Hampton Hotel Associates LLC, Marina Hotel, LLC, Neil Amin and Shamin Hotels, Inc., dated as of February 7, 2017 (incorporated by reference to the document previously filed as Exhibit 10.59 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2017). |\\n| 16.1 | Letter from Grant Thornton LLP, dated April 6, 2016 (incorporated by reference to the document previously filed as Exhibit 16.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on April 6, 2016). |\\n| 21.1 | List of Subsidiaries of Sotherly Hotels Inc. |\\n| 21.2 | List of Subsidiaries of Sotherly Hotels LP. |\\n| Exhibits |\\n| 23.1 | Consent of Dixon Hughes Goodman LLP. |\\n| 23.2 | Consent of Grant Thornton LLP. |\\n| 23.3 | Consent of Dixon Hughes Goodman LLP. |\\n| 23.4 | Consent of Grant Thornton LLP. |\\n| 31.1 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.3 | Certification of Chief Executive Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.4 | Certification of Chief Financial Officer pursuant to Exchange Act Rule 13(a)-14 and 15(d)-14, as adopted, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\\n| 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\\n| 32.3 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\\n| 32.4 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of the Sarbanes-Oxley Act of 2002. |\\n| 101.INS | XBRL Instance Document |\\n| 101.SCH | XBRL Taxonomy Extension Schema Document |\\n| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |\\n| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |\\n| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |\\n| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |\\n| * | Denotes management contract and/or compensatory plan/arrangement. |\\n| SOTHERLY HOTELS INC. |\\n| By: | /s/ ANDREW M. SIMS |\\n| Andrew M. Sims Chief Executive Officer |\\n| Signature | Title | Date |\\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors | March 22, 2017 |\\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director | March 22, 2017 |\\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer | March 22, 2017 |\\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director | March 22, 2017 |\\n| /s/ DAVID J. BEATTY David J. Beatty | Director | March 22, 2017 |\\n| /s/ EDWARD S. STEIN Edward S. Stein | Director | March 22, 2017 |\\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director | March 22, 2017 |\\n| SOTHERLY HOTELS LP, |\\n| by its General Partner, |\\n| SOTHERLY HOTELS INC. |\\n| By: | /s/ ANDREW M. SIMS |\\n| Andrew M. Sims Chief Executive Officer |\\n| Signature | Title | Date |\\n| /s/ ANDREW M. SIMS Andrew M. Sims | Chief Executive Officer and Chairman of the Board of Directors of the General Partner | March 22, 2017 |\\n| /s/ DAVID R. FOLSOM David R. Folsom | President, Chief Operating Officer and Director of the General Partner | March 22, 2017 |\\n| /s/ ANTHONY E. DOMALSKI Anthony E. Domalski | Chief Financial Officer of the General Partner | March 22, 2017 |\\n| /s/ HERSCHEL J. WALKER Herschel J. Walker | Director of the General Partner | March 22, 2017 |\\n| /s/ DAVID J. BEATTY David J. Beatty | Director of the General Partner | March 22, 2017 |\\n| /s/ EDWARD S. STEIN Edward S. Stein | Director of the General Partner | March 22, 2017 |\\n| /s/ ANTHONY C. ZINNI Anthony C. Zinni | Director of the General Partner | March 22, 2017 |\\n| Sotherly Hotels Inc. |\\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-2 |\\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-3 |\\n| Consolidated Balance Sheets for Sotherly Hotels Inc. as of December 31, 2016 and 2015 | F-4 |\\n| Consolidated Statements of Operations for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-5 |\\n| Consolidated Statements of Changes in Equity for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-6 |\\n| Consolidated Statements of Cash Flows for Sotherly Hotels Inc. for the years ended December 31, 2016, 2015 and 2014 | F-7 |\\n| Sotherly Hotels LP |\\n| Report of Independent Registered Public Accounting Firm, Dixon Hughes Goodman LLP | F-8 |\\n| Report of Independent Registered Public Accounting Firm, Grant Thornton LLP | F-9 |\\n| Consolidated Balance Sheets for Sotherly Hotels LP as of December 31, 2016 and 2015 | F-10 |\\n| Consolidated Statements of Operations for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-11 |\\n| Consolidated Statements of Changes in Partners’ Capital for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-12 |\\n| Consolidated Statements of Cash Flows for Sotherly Hotels LP for the years ended December 31, 2016, 2015 and 2014 | F-13 |\\n| Notes to Consolidated Financial Statements | F-14 |\\n| Schedule III – Real Estate and Accumulated Depreciation as of December 31, 2016 | F-35 |\\n| December 31, 2016 | December 31, 2015 |\\n| ASSETS |\\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\\n| Investment in hotel properties held for sale, net | 5,333,000 | — |\\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\\n| Restricted cash | 4,596,145 | 5,793,840 |\\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\\n| Accounts receivable-affiliate | 4,175 | 226,552 |\\n| Loan proceeds receivable | — | 2,600,711 |\\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\\n| Deferred income taxes | 6,949,340 | 5,390,374 |\\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\\n| LIABILITIES |\\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\\n| Accounts payable and accrued expenses | 12,970,960 | 12,334,878 |\\n| Advance deposits | 2,315,787 | 1,651,840 |\\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\\n| Commitments and contingencies (See Note 6) | — | — |\\n| EQUITY |\\n| Sotherly Hotels Inc. stockholders’ equity |\\n| 8% Series B Cumulative Redeemable Perpetual Preferred stock, par value $0.01, 11,000,000 shares authorized, liquidation preference $25 per share, 1,610,000 shares and 0 shares issued and outstanding at December 31, 2016 and 2015, respectively | 16,100 | — |\\n| Common stock, par value $0.01, 49,000,000 shares authorized, 14,468,551 shares and 14,490,714 shares issued and outstanding at December 31, 2016 and 2015, respectively | 144,685 | 144,907 |\\n| Additional paid in capital | 118,395,082 | 82,749,058 |\\n| Distributions in excess of retained earnings | (39,545,754 | ) | (33,890,834 | ) |\\n| Total Sotherly Hotels Inc. stockholders’ equity | 79,010,113 | 49,003,131 |\\n| Noncontrolling interest | 2,329,175 | 3,855,237 |\\n| TOTAL EQUITY | 81,339,288 | 52,858,368 |\\n| TOTAL LIABILITIES AND EQUITY | $ | 406,019,564 | $ | 388,972,239 |\\n| 2016 | 2015 | 2014 |\\n| REVENUE |\\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\\n| EXPENSES |\\n| Hotel operating expenses |\\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\\n| Other income (expense) |\\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\\n| Interest income | 115,785 | 50,461 | 19,865 |\\n| Equity income in joint venture | — | 475,514 | 307,370 |\\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\\n| Gain on change in control | — | 6,603,148 | — |\\n| Gain on involuntary conversion of asset | — | — | 169,151 |\\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\\n| Less: Net (income)/loss attributable to the noncontrolling interest | 26,567 | (1,040,987 | ) | 153,838 |\\n| Net income/(loss) attributable to the Company | 926,716 | 5,356,666 | (584,671 | ) |\\n| Distributions to preferred stockholders | (1,144,889 | ) | — | — |\\n| Net income/(loss) attributable to common stockholders | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\\n| Net income/(loss) per share attributable to the common stockholders |\\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\\n| Weighted average number of common shares outstanding |\\n| Basic and diluted | 14,896,994 | 12,541,117 | 10,377,125 |\\n| Additional | Distributions |\\n| Preferred Stock | Common Stock | Paid- | in Excess of | Noncontrolling |\\n| Shares | Par Value | Shares | Par Value | In Capital | Retained Earnings | Interest | Total |\\n| Balances at December 31, 2013 | — | $ | — | 10,206,927 | $ | 102,069 | $ | 57,534,113 | $ | (32,450,773 | ) | $ | 5,669,386 | $ | 30,854,795 |\\n| Net loss | — | — | — | — | — | (584,671 | ) | (153,838 | ) | (738,509 | ) |\\n| Conversion of units in Operating Partnership to shares of common stock | — | — | 310,000 | 3,100 | 755,750 | — | (758,850 | ) | — |\\n| Redemption of units in Operating Partnership | — | — | — | — | — | — | (25,621 | ) | (25,621 | ) |\\n| Issuance of unrestricted common stock awards | — | — | 24,750 | 248 | 147,112 | — | — | 147,360 |\\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 78,165 | — | — | 78,285 |\\n| Issuance of common stock through ATM offering, net | — | — | 17,255 | 172 | 124,739 | — | — | 124,911 |\\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\\n| Dividends and distributions declared | — | — | — | — | (2,352,869 | ) | (598,415 | ) | (2,951,284 | ) |\\n| Balances at December 31, 2014 | — | $ | — | 10,570,932 | $ | 105,709 | $ | 58,659,799 | $ | (35,388,313 | ) | $ | 4,132,662 | $ | 27,509,857 |\\n| Net income | — | — | — | — | — | 5,356,666 | 1,040,987 | 6,397,653 |\\n| Issuance of unrestricted common stock awards | — | — | 26,350 | 264 | 193,936 | — | — | 194,200 |\\n| Issuance of restricted common stock awards | — | — | 9,750 | 98 | 71,760 | — | — | 71,858 |\\n| Issuance of common stock from ATM sales | — | — | 98,682 | 986 | 681,222 | — | — | 682,208 |\\n| Issuance of common stock from equity offering | — | — | 3,435,000 | 34,350 | 22,534,259 | — | — | 22,568,609 |\\n| Conversion of Operating Partnership units into shares of common stock | — | — | 350,000 | 3,500 | 588,162 | — | (591,662 | ) | — |\\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\\n| Dividends and distributions declared | — | — | — | — | — | (3,859,187 | ) | (726,750 | ) | (4,585,937 | ) |\\n| Balances at December 31, 2015 | — | $ | — | 14,490,714 | $ | 144,907 | $ | 82,749,058 | $ | (33,890,834 | ) | $ | 3,855,237 | $ | 52,858,368 |\\n| Net income (loss) | — | — | — | — | — | 926,716 | (26,567 | ) | 900,149 |\\n| Issuance of Series B Preferred Stock | 1,610,000 | 16,100 | — | — | 37,750,431 | — | — | 37,766,531 |\\n| Issuance of unrestricted common stock awards | — | — | 24,250 | 242 | 128,040 | — | — | 128,282 |\\n| Issuance of restricted common stock awards | — | — | 12,000 | 120 | 63,360 | — | — | 63,480 |\\n| Repurchase of common stock | — | — | (481,100 | ) | (4,811 | ) | (3,159,725 | ) | — | — | (3,164,536 | ) |\\n| Conversion of Operating Partnership units into shares of common stock | — | — | 422,687 | 4,227 | 843,998 | — | (848,225 | ) | — |\\n| Amortization of restricted stock award | — | — | — | — | 19,920 | — | — | 19,920 |\\n| Preferred stock dividends declared | — | — | — | — | — | (1,144,889 | ) | — | (1,144,889 | ) |\\n| Common stockholders' dividends and distributions declared | — | — | — | — | — | (5,436,747 | ) | (651,270 | ) | (6,088,017 | ) |\\n| Balances at December 31, 2016 | 1,610,000 | $ | 16,100 | 14,468,551 | $ | 144,685 | $ | 118,395,082 | $ | (39,545,754 | ) | $ | 2,329,175 | $ | 81,339,288 |\\n| 2016 | 2015 | 2014 |\\n| Cash flows from operating activities: |\\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Gain on change in control | — | (6,603,148 | ) | — |\\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\\n| Changes in assets and liabilities: |\\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\\n| Advance deposits | 663,947 | 431,111 | 89,099 |\\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\\n| Cash flows from investing activities: |\\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\\n| Payments on involuntary insurance conversions | — | — | — |\\n| Distributions from joint venture | — | 600,000 | 750,000 |\\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\\n| Proceeds from the sale of assets | 213,400 | 2,402,113 | — |\\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds of unsecured debt | — | — | 25,300,000 |\\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\\n| Proceeds from loans | — | — | 19,000,000 |\\n| Proceeds from sale of common stock, net | — | 23,250,818 | 124,911 |\\n| Proceeds from sale of preferred stock, net | 37,766,531 | — | — |\\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\\n| Redemption of unsecured notes | (27,600,000 | ) | — | — |\\n| Repurchase of common stock | (2,061,407 | ) | — | — |\\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\\n| Dividends and distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\\n| Preferred dividends paid | (339,889 | ) | — | — |\\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\\n| Supplemental disclosures: |\\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\\n| Non-cash investing and financing activities: |\\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\\n| December 31, 2016 | December 31, 2015 |\\n| ASSETS |\\n| Investment in hotel properties, net | $ | 348,593,912 | $ | 354,963,242 |\\n| Investment in hotel property held for sale, net | 5,333,000 | — |\\n| Cash and cash equivalents | 31,766,775 | 11,493,914 |\\n| Restricted cash | 4,596,145 | 5,793,840 |\\n| Accounts receivable, net | 4,127,748 | 4,071,175 |\\n| Accounts receivable-affiliate | 4,175 | 226,552 |\\n| Loan proceeds receivable | — | 2,600,711 |\\n| Prepaid expenses, inventory and other assets | 4,648,469 | 4,432,431 |\\n| Deferred income taxes | 6,949,340 | 5,390,374 |\\n| TOTAL ASSETS | $ | 406,019,564 | $ | 388,972,239 |\\n| LIABILITIES |\\n| Mortgage loans, net | $ | 282,708,289 | $ | 270,331,724 |\\n| Unsecured notes, net | 24,308,713 | 50,460,106 |\\n| Accounts payable and other accrued liabilities | 12,970,960 | 12,334,878 |\\n| Advance deposits | 2,315,787 | 1,651,840 |\\n| Dividends and distributions payable | 2,376,527 | 1,335,323 |\\n| TOTAL LIABILITIES | $ | 324,680,276 | $ | 336,113,871 |\\n| Commitments and contingencies (see Note 6) | — | — |\\n| PARTNERS’ CAPITAL |\\n| 8% Series B Cumulative Redeemable Perpetual Preferred partnership units, liquidation preference $25 per unit, 1,610,000 units and 0 units issued and outstanding at December 31, 2016 and 2015, respectively | 37,766,531 | — |\\n| General Partner: 162,467 units and 166,915 units issued and outstanding as of December 31, 2016 and 2015, respectively | 681,389 | 774,295 |\\n| Limited Partners: 16,084,224 units and 16,524,626 units issued and outstanding as of December 31, 2016 and 2015, respectively | 42,891,368 | 52,084,073 |\\n| TOTAL PARTNERS’ CAPITAL | 81,339,288 | 52,858,368 |\\n| TOTAL LIABILITIES AND PARTNERS’ CAPITAL | $ | 406,019,564 | $ | 388,972,239 |\\n| 2016 | 2015 | 2014 |\\n| REVENUE |\\n| Rooms department | $ | 108,199,151 | $ | 96,837,386 | $ | 84,618,889 |\\n| Food and beverage department | 35,384,530 | 33,273,599 | 31,444,984 |\\n| Other operating departments | 9,262,071 | 8,422,491 | 6,876,046 |\\n| Total revenue | 152,845,752 | 138,533,476 | 122,939,919 |\\n| EXPENSES |\\n| Hotel operating expenses |\\n| Rooms department | 28,895,371 | 25,782,992 | 22,913,479 |\\n| Food and beverage department | 24,357,248 | 23,005,629 | 21,026,202 |\\n| Other operating departments | 2,438,860 | 1,786,197 | 1,192,183 |\\n| Indirect | 57,141,692 | 51,310,292 | 45,072,491 |\\n| Total hotel operating expenses | 112,833,171 | 101,885,110 | 90,204,355 |\\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Impairment of investment in hotel properties, net | — | 500,000 | 3,175,000 |\\n| Loss on disposal of assets | 365,319 | (41,435 | ) | — |\\n| Corporate general and administrative | 6,021,065 | 7,268,256 | 5,085,949 |\\n| Total operating expenses | 134,238,626 | 123,203,426 | 110,434,588 |\\n| NET OPERATING INCOME | 18,607,126 | 15,330,050 | 12,505,331 |\\n| Other income (expense) |\\n| Interest expense | (17,735,107 | ) | (16,515,827 | ) | (14,636,870 | ) |\\n| Interest income | 115,785 | 50,461 | 19,865 |\\n| Equity income in joint venture | — | 475,514 | 307,370 |\\n| Loss on early debt extinguishment | (1,417,905 | ) | (772,907 | ) | (831,079 | ) |\\n| Unrealized loss on hedging activities | (37,384 | ) | (108,819 | ) | — |\\n| Gain on change in control | — | 6,603,148 | — |\\n| Gain on involuntary conversion of asset | — | — | 169,151 |\\n| Net income/(loss) before income taxes | (467,485 | ) | 5,061,620 | (2,466,232 | ) |\\n| Income tax benefit | 1,367,634 | 1,336,033 | 1,727,723 |\\n| Net income/(loss) | 900,149 | 6,397,653 | (738,509 | ) |\\n| Distributions to preferred unit holders | (1,144,889 | ) | — | — |\\n| Net income/(loss) attributable to operating partnership unit holders | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\\n| Net income/(loss) attributable per operating partner unit |\\n| Basic and diluted | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\\n| Weighted average number of operating partner units outstanding |\\n| Basic and diluted | 16,710,935 | 14,924,410 | 13,107,413 |\\n| Preferred Units | General Partner | Limited Partner |\\n| Units | Amount | Units | Amount | Units | Amounts | Total |\\n| Balances at December 31, 2013 | — | $ | — | 130,711 | $ | 554,316 | 12,940,343 | $ | 30,300,479 | $ | 30,854,795 |\\n| Issuance of partnership units | — | — | 540 | 3,534 | 53,465 | 347,022 | 350,556 |\\n| Amortization of restricted units award | — | — | — | 199 | — | 19,721 | 19,920 |\\n| Distributions declared | — | — | — | (29,644 | ) | — | (2,921,640 | ) | (2,951,284 | ) |\\n| Redemption of limited partnership units | — | — | (33 | ) | (228 | ) | (3,267 | ) | (25,393 | ) | (25,621 | ) |\\n| Net loss | — | — | — | (7,386 | ) | — | (731,123 | ) | (738,509 | ) |\\n| Balances at December 31, 2014 | — | $ | — | 131,218 | $ | 520,791 | 12,990,541 | $ | 26,989,066 | $ | 27,509,857 |\\n| Issuance of partnership units | — | — | 35,697 | 235,237 | 3,534,085 | 23,281,638 | 23,516,875 |\\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\\n| Distributions declared | — | — | — | (45,859 | ) | — | (4,540,078 | ) | (4,585,937 | ) |\\n| Net income | — | — | — | 63,977 | — | 6,333,676 | 6,397,653 |\\n| Balances at December 31, 2015 | — | $ | — | 166,915 | $ | 774,295 | 16,524,626 | $ | 52,084,073 | $ | 52,858,368 |\\n| Issuance of common partnership units | — | — | 363 | 1,918 | 35,887 | 189,844 | 191,762 |\\n| Issuance of preferred partnership units | 1,610,000 | 37,766,531 | — | — | — | — | 37,766,531 |\\n| Repurchased common units | — | — | (4,811 | ) | (31,645 | ) | (476,289 | ) | (3,132,891 | ) | (3,164,536 | ) |\\n| Amortization of restricted units award | — | — | — | 149 | — | 19,771 | 19,920 |\\n| Preferred partnership units distributions declared | — | (1,144,889 | ) | — | — | — | — | (1,144,889 | ) |\\n| Partnership units distributions declared | — | — | — | (60,880 | ) | — | (6,027,137 | ) | (6,088,017 | ) |\\n| Net income | — | 1,144,889 | — | (2,447 | ) | — | (242,293 | ) | 900,149 |\\n| Balances at December 31, 2016 | 1,610,000 | $ | 37,766,531 | 162,467 | $ | 681,389 | 16,084,224 | $ | 42,891,368 | $ | 81,339,288 |\\n| 2016 | 2015 | 2014 |\\n| Cash flows from operating activities: |\\n| Net income (loss) | $ | 900,149 | $ | 6,397,653 | $ | (738,509 | ) |\\n| Adjustments to reconcile net income (loss) to net cash provided by operating activities: |\\n| Depreciation and amortization | 15,019,071 | 13,591,495 | 11,969,284 |\\n| Gain on change in control | — | (6,603,148 | ) | — |\\n| Equity income in joint venture | — | (475,514 | ) | (307,370 | ) |\\n| Impairment of investment in hotel properties | — | 500,000 | 3,175,000 |\\n| Amortization of deferred financing costs | 1,147,864 | 1,300,032 | 1,428,674 |\\n| Amortization of mortgage premium | (24,682 | ) | (18,820 | ) | — |\\n| Unrealized loss on derivative instrument | 37,384 | 108,819 | — |\\n| Loss (gain) on disposal of assets | 365,319 | (41,435 | ) | — |\\n| Loss on early debt extinguishment | 1,141,905 | 772,907 | — |\\n| Charges related to equity-based compensation | 211,682 | 285,978 | 245,565 |\\n| Changes in assets and liabilities: |\\n| Restricted cash | (560,817 | ) | 584,926 | (92,439 | ) |\\n| Accounts receivable | (56,573 | ) | (2,021,825 | ) | 369,685 |\\n| Prepaid expenses, inventory and other assets | (334,063 | ) | (623,980 | ) | (1,677,032 | ) |\\n| Deferred income taxes | (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\\n| Accounts payable and other accrued liabilities | (35,188 | ) | (1,001,376 | ) | 2,338,688 |\\n| Advance deposits | 663,947 | 431,111 | 89,099 |\\n| Accounts receivable - affiliate | 222,377 | (28,878 | ) | 12,273 |\\n| Net cash provided by operating activities | 17,139,409 | 11,377,374 | 14,851,255 |\\n| Cash flows from investing activities: |\\n| Acquisitions of hotel properties | — | (25,525,754 | ) | (61,106,085 | ) |\\n| Improvements and additions to hotel properties | (14,912,677 | ) | (20,136,427 | ) | (9,801,018 | ) |\\n| Payments on involuntary insurance conversions | — | — | — |\\n| Distributions from joint venture | — | 600,000 | 750,000 |\\n| Funding of restricted cash reserves | (5,276,518 | ) | (4,973,602 | ) | (3,692,045 | ) |\\n| Proceeds from involuntary conversion of assets | — | 124,609 | 169,151 |\\n| Proceeds of restricted cash reserves | 7,035,029 | 6,376,459 | 2,583,419 |\\n| Proceeds from the sale of assets | 213,400 | 2,402,113 |\\n| Net cash used in investing activities | (12,940,766 | ) | (41,132,602 | ) | (71,096,578 | ) |\\n| Cash flows from financing activities: |\\n| Proceeds of unsecured debt | — | — | 25,300,000 |\\n| Proceeds of mortgage debt | 102,700,000 | 127,000,000 | 48,600,000 |\\n| Proceeds from mortgage loan receivable | 2,600,711 | — | — |\\n| Proceeds from loans | — | — | 19,000,000 |\\n| Proceeds from sale of operating units | — | 23,250,818 | 124,911 |\\n| Proceeds from sale of preferred operating units | 37,766,531 | — | — |\\n| Payments on mortgage loans | (89,619,564 | ) | (120,154,764 | ) | (24,171,892 | ) |\\n| Redemption of unsecured notes | (27,600,000 | ) |\\n| Repurchase of common units | (2,061,407 | ) | — | — |\\n| Payment of deferred financing costs | (1,520,351 | ) | (1,377,882 | ) | (2,637,637 | ) |\\n| Distributions paid | (5,851,813 | ) | (4,103,529 | ) | (2,686,567 | ) |\\n| Preferred dividends paid | (339,889 | ) | — | — |\\n| Redemption of units in Operating Partnership | — | — | (25,621 | ) |\\n| Net cash provided by financing activities | 16,074,218 | 24,614,643 | 63,503,194 |\\n| Net increase (decrease) in cash and cash equivalents | 20,272,861 | (5,140,585 | ) | 7,257,871 |\\n| Cash and cash equivalents at the beginning of the period | 11,493,914 | 16,634,499 | 9,376,628 |\\n| Cash and cash equivalents at the end of the period | $ | 31,766,775 | $ | 11,493,914 | $ | 16,634,499 |\\n| Supplemental disclosures: |\\n| Cash paid during the period for interest | $ | 16,881,223 | $ | 15,415,695 | $ | 13,766,824 |\\n| Cash paid during the period for income taxes | $ | 192,965 | $ | 570,762 | $ | 263,621 |\\n| Non-cash investing and financing activities: |\\n| Mortgage debt proceeds receivable and related loan costs | $ | — | $ | 2,704,415 | $ | — |\\n| Assumption of mortgage loan on Crowne Plaza Hollywood Beach Resort acquisition | $ | — | $ | 57,000,000 | $ | — |\\n| Assumption of loan premium on the Crowne Plaza Hollywood Beach Resort assumed loan | $ | — | $ | 246,815 | $ | — |\\n| Change in amount of deferred financing and deferred offering cost in accounts payable and accrued liabilities | $ | — | $ | 624,117 | $ | 375,487 |\\n| Change in amount of hotel property improvements in accounts payable and accrued liabilities | $ | 431,858 | $ | 601,895 | $ | 1,108,182 |\\n| Level 1 | Unadjusted quoted prices in active markets for identical assets or liabilities. |\\n| Level 2 | Unadjusted quoted prices in active markets for similar assets or liabilities, or Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or Inputs other than quoted prices that are observable for the asset or liability. |\\n| Level 3 | Unobservable inputs for the asset or liability. |\\n| Level 1 | Level 2 | Level 3 |\\n| December 31, 2015 |\\n| Investment in hotel property, net (1) | $ | — | $ | — | $ | 5,700,762 |\\n| Interest Rate Cap (4) | $ | — | $ | 70,981 | $ | — |\\n| Mortgage loans (2) | $ | — | $ | (272,933,327 | ) | $ | — |\\n| Unsecured notes (3) | $ | (54,238,600 | ) | $ | — | $ | — |\\n| December 31, 2016 |\\n| Interest Rate Cap (4) | $ | — | $ | 33,597 | $ | — |\\n| Mortgage loans (2) | $ | — | $ | (281,840,780 | ) | $ | — |\\n| Unsecured notes (3) | $ | (26,241,160 | ) | $ | — | $ | — |\\n| (1) | A non-recurring fair value measurement was conducted in 2015 for our investment in hotel property, which resulted in a recorded impairment charge for the year ended December 31, 2015, which represent the amounts by which the carrying value of the asset group exceeded its fair value. |\\n| (2) | Mortgage loans are reflected at carrying value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\\n| (3) | Unsecured notes are recorded at historical cost on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\\n| (4) | An interest rate cap on the DoubleTree by Hilton Jacksonville Riverfront mortgage with the Bank of the Ozarks is recorded at fair value on our Consolidated Balance Sheet as of December 31, 2016 and December 31, 2015. |\\n| December 31, 2017 | $ | 1,105,165 |\\n| December 31, 2018 | 632,365 |\\n| December 31, 2019 | 544,920 |\\n| December 31, 2020 | 499,294 |\\n| December 31, 2021 | 246,388 |\\n| December 31, 2022 and thereafter | 1,661,913 |\\n| Total | $ | 4,690,045 |\\n| Georgian Terrace | Crowne Plaza Hollywood Beach Resort |\\n| Land and land improvements | $ | 10,127,687 | $ | 24,008,289 |\\n| Buildings and improvements | 45,385,939 | 64,854,787 |\\n| Furniture, fixtures and equipment | 5,163,135 | 2,802,135 |\\n| Investment in hotel properties | 60,676,761 | 91,665,211 |\\n| Restricted cash | 124,658 | 1,159,759 |\\n| Accounts receivable | 465,287 | 140,588 |\\n| Prepaid expenses, inventory and other assets | 430,997 | 797,505 |\\n| Assumed mortgage | — | (57,259,159 | ) |\\n| Accounts payable and accrued liabilities | (591,618 | ) | (2,485,442 | ) |\\n| Equity investment | — | (1,889,560 | ) |\\n| Gain on change in control | — | (6,603,148 | ) |\\n| Net cash | $ | 61,106,085 | $ | 25,525,754 |\\n| December 31, 2015 | December 31, 2014 |\\n| (unaudited) | (unaudited) |\\n| Pro forma revenues | $ | 151,931,931 | $ | 147,451,042 |\\n| Pro forma operating expenses | $ | 133,346,497 | $ | 129,961,867 |\\n| Pro forma operating income | $ | 18,585,434 | $ | 17,489,175 |\\n| Pro forma net income (loss) | $ | 1,017,180 | $ | (1,671,774 | ) |\\n| Pro forma earnings (loss) per basic and diluted share | $ | 0.07 | $ | (0.10 | ) |\\n| Pro forma earnings (loss) per basic and diluted units | $ | 0.07 | $ | (0.10 | ) |\\n| Pro forma basic and diluted common shares | 12,541,117 | 13,812,125 |\\n| Pro forma basic and diluted units | 14,924,410 | 16,542,413 |\\n| December 31, 2016 | December 31, 2015 |\\n| Land and land improvements | $ | 57,851,380 | $ | 59,910,212 |\\n| Buildings and improvements | 336,996,876 | 333,720,421 |\\n| Furniture, fixtures and equipment | 43,458,781 | 42,245,334 |\\n| 438,307,037 | 435,875,967 |\\n| Less: accumulated depreciation and impairment | (89,713,125 | ) | (80,912,725 | ) |\\n| Investment in Hotel Properties, Net | $ | 348,593,912 | $ | 354,963,242 |\\n| December 31, 2016 | December 31, 2015 |\\n| Land and land improvements | $ | 1,097,096 | $ | — |\\n| Buildings and improvements | 6,242,504 | — |\\n| Furniture, fixtures and equipment | 2,289,008 | — |\\n| 9,628,608 | — |\\n| Less: accumulated depreciation and impairment | (4,295,608 | ) | — |\\n| Investment in Hotel Properties Held for Sale, Net | $ | 5,333,000 | $ | — |\\n| Balance Outstanding as of |\\n| December 31, | December 31, | Prepayment | Maturity | Amortization | Interest |\\n| Property | 2016 | 2015 | Penalties | Date | Provisions | Rate |\\n| Crowne Plaza Hampton Marina (1) | $ | 2,584,633 | $ | 3,512,586 | None | 11/1/2019 | 3 years | 5.00% |\\n| Crowne Plaza Hollywood Beach Resort (2) | 58,935,818 | 59,795,743 | n/a | 10/1/2025 | 30 years | 4.913% |\\n| Crowne Plaza Tampa Westshore (3) | 15,561,400 | 13,016,045 | None | 6/30/2019 | 25 years | LIBOR plus 3.75 % |\\n| DoubleTree by Hilton Jacksonville Riverfront (4) | 19,291,716 | 19,774,577 | Yes | 7/7/2019 | 25 years | LIBOR plus 3.50 % |\\n| DoubleTree by Hilton Laurel (5) | 9,329,005 | 9,500,000 | Yes | 8/5/2021 | 25 years | 5.25% |\\n| DoubleTree by Hilton Philadelphia Airport (6) | 31,261,991 | 32,376,795 | None | 4/1/2019 | 25 years | LIBOR plus 3.00 % |\\n| DoubleTree by Hilton Raleigh Brownstone University (7) | 14,773,885 | 15,029,121 | n/a | 8/1/2018 | 30 years | 4.78% |\\n| The Georgian Terrace (8) | 45,826,038 | 46,579,011 | n/a | 6/1/2025 | 30 years | 4.42% |\\n| Hilton Savannah DeSoto (9) | 30,000,000 | 20,522,836 | Yes | 7/1/2026 | 25 years | 4.25% |\\n| Hilton Wilmington Riverside (10) | 30,000,000 | 19,825,772 | Yes | 1/1/2027 | 25 years | 4.25% |\\n| Sheraton Louisville Riverside (11) | 11,977,557 | 11,345,866 | Yes | 12/1/2026 | 25 years | 4.27% |\\n| The Whitehall (12) | 15,000,000 | 20,459,256 | Yes | 10/12/2021 | 18 years | LIBOR plus 3.50 % |\\n| Total Mortgage Principal Balance | $ | 284,542,043 | $ | 271,737,608 |\\n| Deferred financing costs, net | (2,049,409 | ) | (1,646,220 | ) |\\n| Unamortized premium on loan | 215,655 | 240,336 |\\n| Total Mortgage Loans, Net | $ | 282,708,289 | $ | 270,331,724 |\\n| (1) | The note was extended and modified in November 2016 for 3 years until November 1, 2019 and the Operating Partnership was required to make monthly principal payments of $15,367. The note rate was changed to a fixed rate of 5.00%, effective June 27, 2014. As of February 7, 2017, the note is no longer outstanding. |\\n| (2) | With limited exception, the note may not be prepaid until June 2025. |\\n| (3) | The note provides initial proceeds of $15.7 million, with an additional $3.3 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 30-day LIBOR plus 3.75%, subject to a floor rate of 3.75%; the note provides that the mortgage can be extended for two additional periods of one year each, subject to certain conditions. |\\n| (4) | The note is subject to a pre-payment penalty until July 2017. Prepayment can be made without penalty thereafter. The note provides that the mortgage can be extended until July 2020 if certain conditions have been satisfied. |\\n| (5) | The note is subject to a pre-payment penalty except for any pre-payments made either between April 2017 and August 2017, or from April 2021 through maturity of the note. The note provides that on January 5, 2018, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current five-year U.S. Treasury rate of interest, with a floor of 5.25%. |\\n| (6) | The note bears a minimum interest rate of 3.50%. |\\n| (7) | With limited exception, the note may not be prepaid until two months before maturity. |\\n| (8) | With limited exception, the note may not be prepaid until February 2025. |\\n| (9) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions, namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\\n| (10) | The note provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions namely, the completion of a renovation project; amortizes on a 25-year schedule after a 1-year interest-only period; and is subject to a pre-payment penalty except for any pre-payments made within 120 days of the maturity date. |\\n| (11) | The note bears a fixed interest rate of 4.27% for the first 5 years of the loan, with an option for the lender to reset the interest rate after 5 years. |\\n| (12) | The note was refinanced in October 2016, provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions; bears a floating interest rate of the 1-month LIBOR plus 3.5%, subject to a floor rate of 4.0% and is subject to prepayment penalties subject to a declining scale from 3.0% penalty on or before the first anniversary date, a 2.0% penalty during the second anniversary year and a 1.0% penalty after the third anniversary date. |\\n| For the year ending: December 31, 2017 | $ | 6,363,323 |\\n| December 31, 2018 | 24,626,923 |\\n| December 31, 2019 | 73,423,203 |\\n| December 31, 2020 | 9,248,750 |\\n| December 31, 2021 | 31,008,186 |\\n| December 31, 2022 and thereafter | 139,871,658 |\\n| Total future maturities | $ | 284,542,043 |\\n| For the year ending: December 31, 2017 | $ | 223,682 |\\n| December 31, 2018 | 176,740 |\\n| December 31, 2019 | 100,480 |\\n| December 31, 2020 | 95,482 |\\n| December 31, 2021 | 95,482 |\\n| December 31, 2022 and thereafter | 445,583 |\\n| Total | $ | 1,137,449 |\\n| Quarter Ended | 2014 | 2015 | 2016 |\\n| March 31, | $ | 0.045 | $ | 0.070 | $ | 0.085 |\\n| June 30, | $ | 0.050 | $ | 0.075 | $ | 0.090 |\\n| September 30, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\\n| December 31, | $ | 0.065 | $ | 0.080 | $ | 0.095 |\\n| Seven Months Ended | Year Ended |\\n| July 31, 2015 | December 31, 2014 |\\n| Revenue |\\n| Rooms department | $ | 10,605,941 | $ | 15,386,595 |\\n| Food and beverage department | 1,911,950 | 2,968,395 |\\n| Other operating departments | 880,564 | 1,385,469 |\\n| Total revenue | 13,398,455 | 19,740,459 |\\n| Expenses |\\n| Hotel operating expenses |\\n| Rooms department | 2,062,515 | 3,270,930 |\\n| Food and beverage department | 1,442,139 | 2,270,918 |\\n| Other operating departments | 388,087 | 655,818 |\\n| Indirect | 4,774,322 | 7,436,198 |\\n| Total hotel operating expenses | 8,667,063 | 13,633,864 |\\n| Depreciation and amortization | 1,060,339 | 2,116,211 |\\n| General and administrative | 252,565 | 148,873 |\\n| Total operating expenses | 9,979,967 | 15,898,948 |\\n| Operating income | 3,418,488 | 3,841,511 |\\n| Interest expense | (1,516,433 | ) | (2,612,032 | ) |\\n| Net income | $ | 1,902,055 | $ | 1,229,479 |\\n| 2016 | 2015 | 2014 |\\n| General and administrative | $ | 12,419,221 | $ | 11,595,819 | $ | 9,823,853 |\\n| Sales and marketing | 13,754,600 | 11,426,637 | 9,788,079 |\\n| Repairs and maintenance | 7,401,755 | 6,948,699 | 6,278,411 |\\n| Utilities | 6,429,686 | 6,124,459 | 5,763,990 |\\n| Franchise fees | 4,091,729 | 4,016,083 | 4,122,726 |\\n| Management fees, including incentive | 3,865,362 | 3,490,586 | 3,439,807 |\\n| Property taxes | 5,983,280 | 5,110,659 | 3,664,022 |\\n| Insurance | 2,594,783 | 2,305,966 | 1,927,935 |\\n| Other | 601,276 | 291,383 | 263,668 |\\n| Total indirect hotel operating expenses | $ | 57,141,692 | $ | 51,310,292 | $ | 45,072,491 |\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\\n| Current: |\\n| Federal | $ | — | $ | — | $ | — |\\n| State | 191,332 | 444,538 | 233,940 |\\n| 191,332 | 444,538 | 233,940 |\\n| Deferred: |\\n| Federal | (1,294,408 | ) | (1,510,726 | ) | (1,718,351 | ) |\\n| State | (264,558 | ) | (269,845 | ) | (243,312 | ) |\\n| (1,558,966 | ) | (1,780,571 | ) | (1,961,663 | ) |\\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\\n| Statutory federal income tax expense | $ | (158,859 | ) | $ | 1,705,610 | $ | (838,519 | ) |\\n| Effect of non-taxable REIT income | (1,135,549 | ) | (2,866,950 | ) | (898,576 | ) |\\n| State income tax benefit | (73,226 | ) | (174,693 | ) | 9,372 |\\n| $ | (1,367,634 | ) | $ | (1,336,033 | ) | $ | (1,727,723 | ) |\\n| • | a demonstrated track record of past profitability and utilization of past NOL carryforwards, |\\n| • | reasonable forecasts of future taxable income, and |\\n| • | anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. |\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\\n| Numerator |\\n| Net income/(loss) attributable to the common shareholders for basic computation | $ | (218,173 | ) | $ | 5,356,666 | $ | (584,671 | ) |\\n| Denominator |\\n| Weighted average number of common shares outstanding for basic computation | 14,896,994 | 12,541,117 | 10,377,125 |\\n| Basic and diluted net income (loss) per share | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\\n| Year Ended | Year Ended | Year Ended |\\n| December 31, 2016 | December 31, 2015 | December 31, 2014 |\\n| Numerator |\\n| Net income/(loss) attributable to the common unitholders for basic computation | $ | (244,740 | ) | $ | 6,397,653 | $ | (738,509 | ) |\\n| Denominator |\\n| Weighted average number of units outstanding | 16,710,935 | 14,924,410 | 13,107,413 |\\n| Basic and diluted net income (loss) per unit | $ | (0.01 | ) | $ | 0.43 | $ | (0.06 | ) |\\n| Quarters Ended 2016 |\\n| March 31 | June 30 | September 30 | December 31 |\\n| Total revenue | $ | 37,810,144 | $ | 41,824,954 | $ | 37,275,312 | $ | 35,935,342 |\\n| Total operating expenses | 33,025,990 | 34,645,809 | 33,539,913 | 33,026,914 |\\n| Net operating income | 4,784,154 | 7,179,145 | 3,735,399 | 2,908,428 |\\n| Net income(loss) | 545,874 | 1,977,550 | (1,549,191 | ) | (74,084 | ) |\\n| Net income (loss) attributable to common shareholders | 483,095 | 1,761,106 | (1,716,234 | ) | (746,140 | ) |\\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.03 | $ | 0.12 | $ | (0.11 | ) | $ | (0.05 | ) |\\n| Quarters Ended 2015 |\\n| March 31 | June 30 | September 30 | December 31 |\\n| Total revenue | $ | 30,975,630 | $ | 36,865,108 | $ | 33,941,875 | $ | 36,750,863 |\\n| Total operating expenses | 27,410,462 | 29,689,455 | 31,976,036 | 34,127,473 |\\n| Net operating income | 3,565,168 | 7,175,653 | 1,965,839 | 2,623,390 |\\n| Net income(loss) | 713,859 | 1,759,109 | 4,636,644 | (711,959 | ) |\\n| Net income (loss) attributable to common shareholders | 575,336 | 1,431,110 | 3,872,394 | (522,174 | ) |\\n| Earnings (loss) per share attributable to common shareholders– basic and diluted | $ | 0.05 | $ | 0.13 | $ | 0.27 | $ | (0.04 | ) |\\n| Costs Capitalized | Life on |\\n| Initial Costs | Subsequent to Acquisition | Gross Amount At End of Year | Accumulated | Which |\\n| Building & | Building & | Building & | Depreciation | Date of | Date | Depreciation |\\n| Description | Encumbrances | Land | Improvements | Land | Improvements | Land | Improvements | Total | & Impairment | Construction | Acquired | is Computed |\\n| Crowne Plaza Hampton Marina – Hampton, Virginia | $ | 2,585 | $ | 1,061 | $ | 6,733 | $ | 36 | 3,796 | $ | 1,097 | $ | 10,529 | $ | 11,626 | $ | (4,296 | ) | 1988 | 2008 | 3-39 years |\\n| Crowne Plaza Hollywood Beach Resort - Hollywood Beach, Florida | 58,936 | 22,865 | 67,660 | — | (124 | ) | 22,865 | 67,536 | 90,401 | (2,646 | ) | 1972 | 2015 | 3-39 years |\\n| Crowne Plaza Tampa Westshore – Tampa, Florida | 15,561 | 4,153 | 9,670 | 297 | 22,259 | 4,450 | 31,929 | 36,379 | (7,707 | ) | 1973 | 2007 | 3-39 years |\\n| DoubleTree by Hilton Jacksonville Riverfront – Jacksonville, Florida | 19,292 | 7,090 | 14,604 | 89 | 7,113 | 7,179 | 21,717 | 28,896 | (5,881 | ) | 1970 | 2005 | 3-39 years |\\n| DoubleTree by Hilton Laurel – Laurel, Maryland | 9,329 | 900 | 9,443 | 175 | 5,679 | 1,075 | 15,122 | 16,197 | (3,913 | ) | 1985 | 2004 | 3-39 years |\\n| DoubleTree by Hilton Philadelphia Airport – Philadelphia, Pennsylvania | 31,262 | 2,100 | 22,031 | 260 | 5,478 | 2,360 | 27,509 | 29,869 | (8,281 | ) | 1972 | 2004 | 3-39 years |\\n| DoubleTree by Hilton Raleigh Brownstone – University – Raleigh, North Carolina | 14,774 | 815 | 7,416 | 213 | 5,761 | 1,028 | 13,177 | 14,205 | (4,831 | ) | 1971 | 2004 | 3-39 years |\\n| Georgian Terrace – Atlanta, Georgia | 45,826 | 10,128 | 45,386 | (1,332 | ) | 4,811 | 8,796 | 50,197 | 58,993 | (3,715 | ) | 1911 | 2014 | 3-39 years |\\n| Hilton Savannah DeSoto – Savannah, Georgia | 30,000 | 600 | 13,562 | 31 | 14,545 | 631 | 28,107 | 28,738 | (8,640 | ) | 1968 | 2004 | 3-39 years |\\n| Hilton Wilmington Riverside – Wilmington, North Carolina | 30,000 | 785 | 16,829 | 228 | 12,514 | 1,013 | 29,343 | 30,356 | (11,283 | ) | 1970 | 2004 | 3-39 years |\\n| Sheraton Louisville Riverside – Jeffersonville, Indiana | 11,977 | 782 | 6,891 | 222 | 14,566 | 1,004 | 21,457 | 22,461 | (5,074 | ) | 1972 | 2006 | 3-39 years |\\n| The Whitehall – Houston, Texas | 15,000 | 7,374 | 22,185 | 78 | 4,431 | 7,452 | 26,616 | 34,068 | (2,239 | ) | 1963 | 2013 | 3-39 years |\\n| $ | 284,542 | $ | 58,653 | $ | 242,410 | $ | 297 | $ | 100,829 | $ | 58,950 | $ | 343,239 | $ | 402,189 | $ | (68,506 | ) |\\n| (1) | For the year ending December 31, 2016, the aggregate cost of our real estate assets for federal income tax purposes was approximately $398.6 million. |\\n| Balance at December 31, 2014 | $ | 294,827 |\\n| Acquisitions | 91,669 |\\n| Improvements | 11,105 |\\n| Disposal of Assets | (3,971 | ) |\\n| Balance at December 31, 2015 | $ | 393,630 |\\n| Acquisitions | — |\\n| Improvements | 9,473 |\\n| Disposal of Assets | (914 | ) |\\n| Balance at December 31, 2016 | $ | 402,189 |\\n| Balance at December 31, 2014 | $ | 53,233 |\\n| Current Expense | 8,790 |\\n| Impairment | 500 |\\n| Disposal of Assets | (482 | ) |\\n| Balance at December 31, 2015 | $ | 62,041 |\\n| Current Expense | 7,018 |\\n| Impairment | — |\\n| Disposal of Assets | (553 | ) |\\n| Balance at December 31, 2016 | $ | 68,506 |\\n\\n</text>\\n\\nWhat is the average annual franchise fee, in percentage, if the company operates the franchise for a period of 5 years based on the franchise fee for operating year 1, 2 and thereafter?\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 4.4.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 60,\n \"input_length\": 87912\n}"}}},{"rowIdx":61,"cells":{"data_source":{"kind":"string","value":"docmath_40000_plus"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nPART I—FINANCIAL INFORMATION\nITEM 1. FINANCIAL STATEMENTS\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF OPERATIONS\n(UNAUDITED)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| OPERATING REVENUES |\n| Operating revenues | $ | 1,573 | 1,618 | 3,172 | 3,254 |\n| Operating revenues - affiliates | 650 | 604 | 1,304 | 1,185 |\n| Total operating revenues | 2,223 | 2,222 | 4,476 | 4,439 |\n| OPERATING EXPENSES |\n| Cost of services and products (exclusive of depreciation and amortization) | 731 | 743 | 1,439 | 1,435 |\n| Selling, general and administrative | 235 | 256 | 485 | 526 |\n| Operating expenses - affiliates | 231 | 238 | 482 | 486 |\n| Depreciation and amortization | 424 | 464 | 843 | 926 |\n| Total operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\n| OPERATING INCOME | 602 | 521 | 1,227 | 1,066 |\n| OTHER (EXPENSE) INCOME |\n| Interest expense | (120 | ) | (119 | ) | (241 | ) | (237 | ) |\n| Interest expense - affiliates, net | (15 | ) | (13 | ) | (29 | ) | (26 | ) |\n| Other income, net | — | 1 | 2 | 1 |\n| Total other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\n| INCOME BEFORE INCOME TAX EXPENSE | 467 | 390 | 959 | 804 |\n| Income tax expense | 179 | 152 | 367 | 319 |\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\n\nSee accompanying notes to consolidated financial statements.\n3\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\n(UNAUDITED)\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\n| OTHER COMPREHENSIVE INCOME: |\n| Foreign currency translation adjustment, net of $—, $—, $— and $— tax | 3 | — | — | — |\n| Other comprehensive income | 3 | — | — | — |\n| COMPREHENSIVE INCOME | $ | 291 | 238 | 592 | 485 |\n\nSee accompanying notes to consolidated financial statements.\n4\nQWEST CORPORATION\nCONSOLIDATED BALANCE SHEETS\n(UNAUDITED)\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| ASSETS |\n| CURRENT ASSETS |\n| Cash and cash equivalents | $ | 4 | 3 |\n| Accounts receivable, less allowance of $48 and $47 | 688 | 688 |\n| Advances to affiliates | 811 | 788 |\n| Other | 148 | 123 |\n| Total current assets | 1,651 | 1,602 |\n| NET PROPERTY, PLANT AND EQUIPMENT |\n| Property, plant and equipment | 12,619 | 12,182 |\n| Accumulated depreciation | (5,182 | ) | (4,808 | ) |\n| Net property, plant and equipment | 7,437 | 7,374 |\n| GOODWILL AND OTHER ASSETS |\n| Goodwill | 9,354 | 9,354 |\n| Customer relationships, less accumulated amortization of $3,549 and $3,264 | 2,150 | 2,435 |\n| Other intangible assets, less accumulated amortization of $1,435 and $1,383 | 539 | 613 |\n| Other, net | 98 | 92 |\n| Total goodwill and other assets | 12,141 | 12,494 |\n| TOTAL ASSETS | $ | 21,229 | 21,470 |\n| LIABILITIES AND STOCKHOLDER'S EQUITY |\n| CURRENT LIABILITIES |\n| Current maturities of long-term debt | $ | 509 | 242 |\n| Accounts payable | 350 | 369 |\n| Note payable - affiliate | 884 | 855 |\n| Accrued expenses and other liabilities |\n| Salaries and benefits | 186 | 211 |\n| Income and other taxes | 165 | 189 |\n| Other | 146 | 135 |\n| Current affiliate obligations, net | 94 | 97 |\n| Advance billings and customer deposits | 322 | 324 |\n| Total current liabilities | 2,656 | 2,422 |\n| LONG-TERM DEBT | 6,726 | 6,997 |\n| DEFERRED CREDITS AND OTHER LIABILITIES |\n| Deferred revenues | 123 | 137 |\n| Deferred income taxes, net | 1,861 | 1,896 |\n| Affiliate obligations, net | 1,003 | 1,051 |\n| Other | 61 | 60 |\n| Total deferred credits and other liabilities | 3,048 | 3,144 |\n| COMMITMENTS AND CONTINGENCIES (Note 5) |\n| STOCKHOLDER'S EQUITY |\n| Common stock - one share without par value, owned by Qwest Services Corporation | 10,050 | 10,050 |\n| Accumulated deficit | (1,251 | ) | (1,143 | ) |\n| Total stockholder's equity | 8,799 | 8,907 |\n| TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY | $ | 21,229 | 21,470 |\n\nSee accompanying notes to consolidated financial statements.\n5\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF CASH FLOWS\n(UNAUDITED)\n| Six Months Ended June 30, |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| OPERATING ACTIVITIES |\n| Net income | $ | 592 | 485 |\n| Adjustments to reconcile net income to net cash provided by operating activities: |\n| Depreciation and amortization | 843 | 926 |\n| Deferred income taxes | (35 | ) | (180 | ) |\n| Provision for uncollectible accounts | 40 | 39 |\n| Net long-term debt issuance costs and premium amortization | (7 | ) | (11 | ) |\n| Accrued interest on affiliate note | 29 | 31 |\n| Changes in current assets and liabilities: |\n| Accounts receivable | (40 | ) | 8 |\n| Accounts payable | (20 | ) | 30 |\n| Accrued income and other taxes | (24 | ) | (14 | ) |\n| Other current assets and liabilities, net | (40 | ) | (34 | ) |\n| Other current assets and liabilities - affiliates, net | — | (4 | ) |\n| Changes in other noncurrent assets and liabilities, net | (11 | ) | (23 | ) |\n| Changes in affiliate obligations, net | (51 | ) | (4 | ) |\n| Other, net | 8 | 5 |\n| Net cash provided by operating activities | 1,284 | 1,254 |\n| INVESTING ACTIVITIES |\n| Payments for property, plant and equipment and capitalized software | (546 | ) | (564 | ) |\n| Changes in advances to affiliates | (23 | ) | (383 | ) |\n| Net cash used in investing activities | (569 | ) | (947 | ) |\n| FINANCING ACTIVITIES |\n| Net proceeds from issuance of long-term debt | 227 | 99 |\n| Payments of long-term debt | (241 | ) | (106 | ) |\n| Dividends paid to Qwest Services Corporation | (700 | ) | (300 | ) |\n| Net cash used in financing activities | (714 | ) | (307 | ) |\n| Net increase in cash and cash equivalents | 1 | — |\n| Cash and cash equivalents at beginning of period | 3 | 6 |\n| Cash and cash equivalents at end of period | $ | 4 | 6 |\n| Supplemental cash flow information: |\n| Income taxes paid, net | $ | (401 | ) | (379 | ) |\n| Interest paid (net of capitalized interest of $8 and $9) | $ | (249 | ) | (247 | ) |\n\nSee accompanying notes to consolidated financial statements.\n6\nQWEST CORPORATION\nCONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY\n(UNAUDITED)\n| Six Months Ended June 30, |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| COMMON STOCK |\n| Balance at beginning of period | $ | 10,050 | 10,050 |\n| Balance at end of period | 10,050 | 10,050 |\n| ACCUMULATED DEFICIT |\n| Balance at beginning of period | (1,143 | ) | (867 | ) |\n| Net income | 592 | 485 |\n| Dividends declared to Qwest Services Corporation | (700 | ) | (300 | ) |\n| Balance at end of period | (1,251 | ) | (682 | ) |\n| TOTAL STOCKHOLDER'S EQUITY | $ | 8,799 | 9,368 |\n\nSee accompanying notes to consolidated financial statements.\n7\nQWEST CORPORATION\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\n(UNAUDITED)\nUnless the context requires otherwise, references in this report to \"QC\" refer to Qwest Corporation, references to \"Qwest,\" \"we,\" \"us,\" and \"our\" refer to Qwest Corporation and its consolidated subsidiaries, references to \"QSC\" refer to our direct parent company, Qwest Services Corporation, and its consolidated subsidiaries, references to \"QCII\" refer to QSC's direct parent company and our indirect parent company, Qwest Communications International Inc., and its consolidated subsidiaries, and references to \"CenturyLink\" refer to QCII's direct parent company and our ultimate parent company, CenturyLink, Inc., and its consolidated subsidiaries.\n(1) Basis of Presentation\nGeneral\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers.\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\nOur consolidated balance sheet as of December 31, 2015, which was derived from our audited consolidated financial statements, and our unaudited interim consolidated financial statements provided herein have been prepared in accordance with the instructions for Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (\"SEC\"); however, in our opinion, the disclosures made are adequate to make the information presented not misleading. We believe that these consolidated financial statements include all normal recurring adjustments necessary to fairly present the results for the interim periods. The consolidated results of operations for the first six months of the year are not necessarily indicative of the consolidated results of operations that might be expected for the entire year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.\nThe accompanying consolidated financial statements include our accounts and the accounts of our subsidiaries. Intercompany amounts and transactions with our consolidated subsidiaries have been eliminated. Transactions with our non-consolidated affiliates (referred to herein as affiliates) have not been eliminated.\nWe reclassified certain prior period amounts to conform to the current period presentation, including the categorization of our revenues. See Note 4—Products and Services Revenues for additional information. These changes had no impact on total operating revenues, total operating expenses or net income for any period.\nConnect America Fund\nIn 2015, CenturyLink accepted funding from the Federal Communications Commission's (\"FCC\") Connect America Fund (\"CAF\") of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 high-cost support program. The funding from the CAF Phase 2 support program in these 33 states will substantially supplant funding from the interstate Universal Service Fund (\"USF\") high-cost program that we previously utilized to support voice services in high-cost rural markets. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. In late 2015, we began receiving these support payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than in the comparable periods for 2015 with respect to our 13 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our \"affiliate and other services\" revenues for the full year 2016 when compared to the full year 2015.\n8\nRecent Accounting Pronouncements\nFinancial Instruments\nOn June 16, 2016, the Financial Accounting Standards Board (\"FASB\") issued Accounting Standards Update (\"ASU\") 2016-13, “Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). The primary impact of ASU 2016-13 for us is a change in the model for the recognition of credit losses related to our financial instruments from an incurred loss model, which recognized credit losses only if it was probable that a loss had been incurred to an expected loss model, which requires our management team to estimate the total credit losses expected on the portfolio of financial instruments. We are currently reviewing the requirements of the standard and evaluating the impact on our consolidated financial statements.\nWe are required to adopt the provisions of ASU 2016-13 effective January 1, 2020, but could elect to early adopt the provisions as of January 1, 2019. We expect to recognize the impacts of adopting ASU 2016-13 through a cumulative adjustment to retained earnings as of the date of adoption.\nShare-based Compensation\nOn March 30, 2016, the FASB issued ASU 2016-09, “Improvement to Employee Share-Based Payment Accounting\" (“ASU 2016-09”). ASU 2016-09 modifies the accounting and associated income tax accounting for share-based compensation in order to reduce the cost and complexity associated with current generally accepted accounting principles. ASU 2016-09 is effective for us as of January 1, 2017, but early adoption may be elected. ASU 2016-09 includes different transition requirements for the different changes implemented, including some provisions which allow retrospective application. We have not determined when we will implement this standard or if we will retrospectively apply the requirements when allowed.\nThe primary provisions of ASU 2016-09 that we expect will affect our financial statements are: 1) a reclassification of the tax effect associated with the difference between the expense recognized for share-based payments and the associated tax deduction from additional paid-in capital to income tax expense; 2) a reclassification of the tax effect associated with the difference between compensation expense and associated deduction from financing cash flow to operating cash flow; and 3) an optional accounting policy election to account for forfeitures of share-based payment grants as they occur as opposed to our current policy of estimating the forfeitures on the grant date. These provisions would not have had a material impact on our previously issued financial statements; however, this is not necessarily representative of future impacts. Adoption of ASU 2016-09 may increase the volatility of income tax expense and cash flow from operating activities.\nLeases\nOn February 25, 2016, the FASB issued ASU 2016-02, “Leases” (“ASU 2016-02”). The core principle of ASU 2016-02 will require lessees to present right-of-use assets and lease liabilities on their balance sheets for operating leases, which are currently not reflected on their balance sheets.\nASU 2016-02 is effective for annual and interim periods beginning January 1, 2019. Early adoption of ASU 2016-02 is permitted. Upon adoption of ASU 2016-02, we are required to recognize and measure leases at the beginning of the earliest period presented in our consolidated financial statements using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that we may elect to apply. We have not yet decided when we will adopt ASU 2016-02 or which practical expedient options we will elect. We are currently evaluating and assessing the impact ASU 2016-02 will have on us and our consolidated financial statements. As of the date of this report, we cannot provide any estimate of the impact of adopting ASU 2016-02.\nRevenue Recognition\nOn May 28, 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”). ASU 2014-09 replaces virtually all existing generally accepted accounting principles (“GAAP”) on revenue recognition and replaces them with a principles-based approach for determining revenue recognition using a new five step model. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 also includes new accounting principles related to the deferral and amortization of contract acquisition and fulfillment costs. We currently do not defer any contract acquisition costs and we defer contract fulfillment costs only up to the extent of any revenue deferred.\n9\nOn July 9, 2015, the FASB approved the deferral of the effective date of ASU 2014-09 by one year until January 1, 2018, which is the date we plan to adopt this standard. ASU 2014-09 may be adopted by applying the provisions of this standard on a retrospective basis to the periods included in the financial statements or on a modified retrospective basis which would result in the recognition of a cumulative effect of adopting ASU 2014-09 in the first quarter of 2018. We have not yet decided which implementation method we will adopt. We are studying ASU 2014-09 and are assessing the impact this standard will have on us and our consolidated financial statements. We cannot at this time, however, provide any estimate of the impact of adopting ASU 2014-09.\n(2) Long-Term Debt and Revolving Promissory Note\nLong-term debt, including unamortized discounts and premiums, unamortized debt issuance costs and note payable - affiliate, were as follows:\n| Interest Rates | Maturities | As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Senior notes | 6.125% - 7.750% | 2017 - 2056 | $ | 7,229 | 7,229 |\n| Term loan | 2.220% | 2025 | 100 | 100 |\n| Capital lease and other obligations | Various | Various | 28 | 17 |\n| Unamortized premiums, net | 8 | 16 |\n| Unamortized debt issuance costs | (130 | ) | (123 | ) |\n| Total long-term debt | 7,235 | 7,239 |\n| Less current maturities | (509 | ) | (242 | ) |\n| Long-term debt, excluding current maturities | $ | 6,726 | 6,997 |\n| Note payable - affiliate | 6.795% | 2022 | $ | 884 | 855 |\n\nNew Issuance\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. All of the 7% Notes are unsecured obligations and may be redeemed by QC, in whole or in part, on or after February 1, 2021, at a redemption price equal to 100% of the principal amount redeemed plus accrued and unpaid interest to the redemption date.\nRepayment\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\nRevolving Promissory Note\nWe are currently indebted to an affiliate of our ultimate parent company, CenturyLink, under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet. In accordance with the note agreement, all accrued interest and unpaid interest is capitalized to the unpaid principal balance on June 1 and December 1 of each year.\nCovenants\nThe indentures governing our notes contain certain covenants including, but not limited to: (i) a prohibition on certain liens on our assets; and (ii) a limitation on mergers or sales of all, or substantially all, of our assets, which limitation requires that a successor assume the obligation with regard to these notes. These indentures do not contain any cross-default provisions.\nOur senior notes were issued under indentures dated April 15, 1990 and October 15, 1999. These indentures do not contain any financial covenants, but do include restrictions that limit our ability to (i) incur, issue or create liens upon our property and (ii) consolidate with or merge into, transfer or lease all or substantially all of our assets to any other party.\nAs of June 30, 2016, we believe we were in compliance with the provisions and covenants of our debt agreements.\n10\n(3) Fair Value Disclosure\nOur financial instruments consist of cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, note payable - affiliate and long-term debt, excluding capital lease and other obligations. Due to their short-term nature, the carrying amounts of our cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, and note payable - affiliate approximate their fair values.\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between independent and knowledgeable parties who are willing and able to transact for an asset or liability at the measurement date. We use valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs when determining fair value and then we rank the estimated values based on the reliability of the inputs used following the fair value hierarchy set forth by the FASB. We determined the fair values of our long-term debt, including the current portion, based on quoted market prices where available or, if not available, based on discounted future cash flows using current market interest rates.\n| Input Level | Description of Input |\n| Level 1 | Observable inputs such as quoted market prices in active markets. |\n| Level 2 | Inputs other than quoted prices in active markets that are either directly or indirectly observable. |\n| Level 3 | Unobservable inputs in which little or no market data exists. |\n\n| As of June 30, 2016 | As of December 31, 2015 |\n| InputLevel | CarryingAmount | FairValue | CarryingAmount | FairValue |\n| (Dollars in millions) |\n| Liabilities—Long-term debt, excluding capital lease and other obligations | 2 | $ | 7,207 | 7,579 | 7,222 | 7,456 |\n\n(4) Products and Services Revenues\nWe are an integrated communications company engaged primarily in providing an array of services, including local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As a result, we now reflect these operating revenues as legacy services, and we have reclassified certain prior period amounts to conform to this change. The revision resulted in a reduction of revenue from strategic services and a corresponding increase in revenue from legacy services of $209 million and $426 million (net of $1 million and $2 million of deferred revenue included in affiliate and other services) for the three and six months ended June 30, 2015, respectively.\n11\nWe now categorize our products, services and revenues among the following three categories:\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\n\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\"ISDN\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\"WAN\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\n\n| • | Affiliates and other services, which consist primarily of CAF support payments, USF support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the FCC's universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\n\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 674 | 650 | 1,345 | 1,291 |\n| Legacy services | 814 | 904 | 1,658 | 1,833 |\n| Affiliates and other services | 735 | 668 | 1,473 | 1,315 |\n| Total operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\n\nWe do not have any single external customer that provides more than 10% of our total consolidated operating revenues. Substantially all of our consolidated revenues come from customers located in the United States.\nWe recognize revenues in our consolidated statements of operations for certain USF surcharges and transaction taxes that we bill to our customers. Our consolidated statements of operations also reflect the related expense for the amounts we remit to the government agencies. The total amount of such surcharges and transaction taxes that we included in revenues aggregated approximately $38 million for each of the three months ended June 30, 2016 and 2015, respectively, and approximately $76 million and $75 million for the six months ended June 30, 2016 and 2015, respectively. These USF surcharges, where we record revenue, are included in \"affiliate and other services\" revenues and these transaction taxes are included in \"legacy services\" revenues. We also act as a collection agent for certain other USF and transaction taxes that we are required by government agencies to bill our customers, for which we do not record any revenue or expense because we only act as a pass-through agent.\nOur operations are integrated into and reported as part of the consolidated segment data of CenturyLink. CenturyLink's chief operating decision maker (\"CODM\") is our CODM, but reviews our financial information on an aggregate basis only in connection with our quarterly and annual reports that we file with the Securities and Exchange Commission. Consequently, we do not provide our discrete financial information to the CODM on a regular basis. As such, we believe we have one reportable segment.\n(5) Commitments and Contingencies\nPending Matters\nSubsidiaries of CenturyLink, Inc., including us, are among hundreds of companies in an industry-wide dispute, raised in nearly 100 federal lawsuits (filed between 2014 and 2016) that have been consolidated in the United States District Court for the District of Northern Texas for pretrial procedures. The disputes relate to switched access charges that local exchange carriers (\"LECs\") collect from interexchange carriers (\"IXCs\") for IXCs' use of LEC's access services. In the lawsuits, three IXCs, Sprint Communications Company L.P. (\"Sprint\"), affiliates of Verizon Communications Inc. (\"Verizon\") and affiliates of Level 3 Communications LLC (\"Level 3\"), assert that federal and state laws bar LECs from collecting access charges when IXCs exchange certain types of calls between mobile and wireline devices that are routed through an IXC. Some of these IXCs have asserted claims seeking refunds of payments for access charges previously paid and relief from future access charges. In addition, Level 3 has ceased paying switched access charges on these calls.\n12\nIn November 2015, the federal court agreed with the LECs and rejected the IXCs' contention that federal law prohibits these particular access charges, and also allowed the IXCs to refile state-law claims. Since then, many of the LECs and IXCs have filed revised pleadings and additional motions, which remain pending. Separately, some of the defendants, including us, have petitioned the Federal Communications Commission to address these issues on an industry-wide basis.\nThe outcome of these disputes and lawsuits, as well as any related regulatory proceedings that could ensue, are currently not predictable. If we are required to stop assessing these charges or to pay refunds of any such charges, our financial results could be negatively affected.\nOther Proceedings and Disputes\nFrom time to time, we are involved in other proceedings incidental to our business, including patent infringement allegations, administrative hearings of state public utility commissions relating primarily to our rates or services, actions relating to employee claims, various tax issues, environmental law issues, grievance hearings before labor regulatory agencies and miscellaneous third party tort actions.\nWe are currently defending several patent infringement lawsuits asserted against us by non-practicing entities, many of whom are seeking substantial recoveries. These cases have progressed to various stages and one or more may go to trial in the coming 24 months if they are not otherwise resolved. Where applicable, we are seeking full or partial indemnification from our vendors and suppliers. As with all litigation, we are vigorously defending these actions and, as a matter of course, are prepared to litigate these matters to judgment, as well as to evaluate and consider all reasonable settlement opportunities.\nWe are subject to various federal, state and local environmental protection and health and safety laws. From time to time, we are subject to judicial and administrative proceedings brought by various governmental authorities under these laws. Several such proceedings are currently pending, but none is reasonably expected to exceed $100,000 in fines and penalties.\nThe outcome of these other proceedings is not predictable. However, based on current circumstances, we do not believe that the ultimate resolution of these other proceedings, after considering available defenses and any insurance coverage or indemnification rights, will have a material adverse effect on our financial position, results of operations or cash flows.\nCenturyLink, Inc. and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As an indirect wholly-owned subsidiary of CenturyLink, Inc., our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink, Inc.'s quarterly and annual reports filed with the Securities and Exchange Commission. Because we are not a party to any of the matters, we have not accrued any liabilities for the matters.\n(6) Dividends\nDuring the six months ended June 30, 2016, we declared and paid dividends of $700 million to our direct parent company, Qwest Services Corporation. Dividends paid are reflected on our consolidated statements of cash flows as financing activities.\n(7) Other Financial Information\nOther Current Assets\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Prepaid expenses | $ | 70 | 46 |\n| Other | 78 | 77 |\n| Total other current assets | $ | 148 | 123 |\n\n13\nSelected Current Liabilities\n| As of June 30, 2016 | As of December 31, 2015 |\n| (Dollars in millions) |\n| Accounts payable | $ | 350 | 369 |\n\nIncluded in accounts payable at both June 30, 2016 and December 31, 2015, was $29 million associated with capital expenditures.\n14\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nUnless the context requires otherwise, references in this report to \"QC\" refer to Qwest Corporation, and references to \"Qwest,\" \"we,\" \"us\" and \"our\" refer to Qwest Corporation and its consolidated subsidiaries.\nAll references to \"Notes\" in this Item 2 of Part I refer to the Notes to Consolidated Financial Statements included in Item 1 of Part I of this report.\nCertain statements in this report constitute forward-looking statements. See the last paragraph of this Item 2 of Part I and \"Risk Factors\" in Item 1A of Part II of this report for a discussion of certain factors that could cause our actual results to differ from our anticipated results or otherwise impact our business, financial condition, results of operations, liquidity or prospects.\nOverview\nManagement's Discussion and Analysis of Financial Condition and Results of Operations (\"MD&A\") included herein should be read in conjunction with MD&A and the other information included in our Annual Report on Form 10-K for the year ended December 31, 2015, and with the consolidated financial statements and related notes in Item 1 of Part I of this report. The results of operations for the first six months of the year are not necessarily indicative of the results of operations that might be expected for the entire year.\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\nOur ultimate parent company, CenturyLink, Inc. (\"CenturyLink\"), has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to Qwest Services Corporation (\"QSC\"), our direct parent, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. We report the balance of these transfers on our consolidated balance sheet as advances to affiliates.\nFor the reasons noted in Note 4—Products and Services Revenues to our consolidated financial statements in Item 1 of Part I of this report, we believe we have one reportable segment.\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As described in greater detail in Note 4—Products and Services Revenues, these operating revenues are now reflected as legacy services.\nWe now categorize our products, services and revenues among the following three categories:\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\n\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\"ISDN\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\"WAN\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\n\n15\n| • | Affiliates and other services, which consist primarily of Connect America Fund (\"CAF\") support payments, Universal Service Fund (\"USF\") support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the Federal Communications Commission's (\"FCC\") universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\n\nAt June 30, 2016, we operated approximately 6.8 million access lines and served approximately 3.5 million broadband subscribers. Our methodology for counting access lines and broadband subscribers, which is described further in the operational metrics table below under \"Results of Operations\", may not be comparable to those of other companies.\nThe following analysis is organized to provide the information we believe will be useful for understanding material trends affecting our business.\nBusiness Trends\nOur financial results were impacted by several significant trends, which are described below. We expect that these trends will continue to affect our results of operations, cash flows or financial position.\n| • | Strategic services. We continue to see shifts in the makeup of our total revenues as customers move to lower margin strategic services, such as broadband and video services, from higher margin legacy services. Revenues from our strategic services represented 30% and 29% of our total revenues for both the three and six months ended June 30, 2016 and 2015, respectively. We continue to experienced price compression due to competition, which negatively impacted the growth of our strategic revenues. We continue to focus on increasing subscribers of our broadband services, particularly among consumer and small business customers. We believe that continually increasing the scope and connection speeds of our broadband services is important to remaining competitive in our industry. As a result, we continue to invest in our broadband network, which allows for the delivery of higher speed broadband services to a greater number of customers. We compete in a maturing broadband market in which most customers already have broadband services and growth rates in new subscribers have slowed. Moreover, as described further in \"Risk Factors\" in Item 1A of Part II of this report, demand for our broadband services could be adversely affected by competitors continuing to provide services at higher broadband speeds than ours or expanding their advanced wireless data service offerings. Our Ethernet-based services in the wholesale market face competition from cable companies and competitive fiber-based telecommunications providers; |\n\n| • | Legacy services. Revenues from our legacy services represented 37% and 41% of our total revenues for the three and six months ended June 30, 2016 and 2015, respectively. We expect these percentages to continue to decline. Our legacy services revenues have been, and we expect they will continue to be adversely affected by access line losses and price compression. Intense competition and product substitution continue to drive our access line losses. For example, many consumers are replacing traditional voice telecommunications service with substitute services, including (i) cable and wireless voice services and (ii) electronic mail, texting and social networking services. We expect that these factors will continue to negatively impact our business. As a result of the expected loss of revenue associated with access lines, we continue to offer our customers service bundling and other product promotions to help mitigate this trend, as described below. Demand for our private line services (including special access) continues to decline due to customers' optimization of their networks, industry consolidation and technological migration to higher-speed services; |\n\n| • | Service bundling and product promotions. We offer our customers the ability to bundle multiple products and services. These customers can bundle local services with other services such as broadband and video. While we believe our bundled service offerings can help retain customers, they also tend to lower our profit margins due to the related discounts; and |\n\n| • | Operating efficiencies. We continue to evaluate our operating structure and focus. This involves balancing our workforce in response to our workload requirements, productivity improvements and changes in industry, competitive, technological and regulatory conditions. |\n\nWhile these trends are important to understanding and evaluating our financial results, the other transactions, events, uncertainties and trends discussed in \"Risk Factors\" in Item 1A of Part II of this report may also materially impact our business operations and financial results.\n16\nResults of Operations\n| Three Months Ended June 30, | Six Months Ended June 30, |\n| 2016 | 2015 | 2016 | 2015 |\n| (Dollars in millions) |\n| Operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\n| Operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\n| Operating income | 602 | 521 | 1,227 | 1,066 |\n| Other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\n| Income tax expense | 179 | 152 | 367 | 319 |\n| Net income | $ | 288 | 238 | 592 | 485 |\n\n| As of June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (in thousands) |\n| Operational metrics: |\n| Total access lines (1) | 6,808 | 7,184 | (376 | ) | (5 | )% |\n| Total broadband subscribers (1) | 3,516 | 3,556 | (40 | ) | (1 | )% |\n| Total employees | 22.9 | 22.5 | 0.4 | 2 | % |\n\n(1) Access lines are lines reaching from the customers' premises to a connection with the public network and broadband subscribers are customers that purchase broadband connection service through their existing telephone lines, stand-alone telephone lines, or fiber-optic cables. Our methodology for counting our access lines and broadband subscribers includes only those lines that we use to provide services to external customers and excludes lines used solely by us and our affiliates. It also excludes unbundled loops and includes stand-alone broadband subscribers. We count lines when we install the service.\nOperating Revenues\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 674 | 650 | 24 | 4 | % |\n| Legacy services | 814 | 904 | (90 | ) | (10 | )% |\n| Affiliates and other services | 735 | 668 | 67 | 10 | % |\n| Total operating revenues | $ | 2,223 | 2,222 | 1 | — | % |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Strategic services | $ | 1,345 | 1,291 | 54 | 4 | % |\n| Legacy services | 1,658 | 1,833 | (175 | ) | (10 | )% |\n| Affiliates and other services | 1,473 | 1,315 | 158 | 12 | % |\n| Total operating revenues | $ | 4,476 | 4,439 | 37 | 1 | % |\n\n17\nStrategic Services\nStrategic services revenues increased by $24 million, or 4%, and increased by $54 million, or 4%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our strategic services revenues for both periods was primarily due to price increases for broadband services, volume increases in Ethernet services and price increases for other services.\nLegacy Services\nLegacy services revenues decreased by $90 million, or 10%, and decreased by $175 million, or 10%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decline in our legacy services revenues for both periods was primarily due to lower local voice services revenues due to access line loss and reduced access services usage related to customer migration, competitive pressures and product substitution and to reductions in the volumes of our private line (including special access) services.\nAffiliates and Other Services\nAffiliates and other services revenues increased by $67 million, or 10%, and increased by $158 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our affiliates and other services revenues for both periods was primarily due to increases in the volume and in the rates we charge for the support services we provided to affiliates and to the additional revenue recorded under the FCC's CAF Phase 2 support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than for the three and six months ended June 30, 2015, with respect to our 13 CAF Phase 2 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our other operating revenues for the full year 2016 when compared to the full year 2015.\nOperating Expenses\nThe following tables summarize our consolidated operating expenses:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 731 | 743 | (12 | ) | (2 | )% |\n| Selling, general and administrative | 235 | 256 | (21 | ) | (8 | )% |\n| Operating expenses - affiliates | 231 | 238 | (7 | ) | (3 | )% |\n| Depreciation and amortization | 424 | 464 | (40 | ) | (9 | )% |\n| Total operating expenses | $ | 1,621 | 1,701 | (80 | ) | (5 | )% |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 1,439 | 1,435 | 4 | — | % |\n| Selling, general and administrative | 485 | 526 | (41 | ) | (8 | )% |\n| Operating expenses - affiliates | 482 | 486 | (4 | ) | (1 | )% |\n| Depreciation and amortization | 843 | 926 | (83 | ) | (9 | )% |\n| Total operating expenses | $ | 3,249 | 3,373 | (124 | ) | (4 | )% |\n\n18\nCost of Services and Products (exclusive of depreciation and amortization)\nCost of services and products (exclusive of depreciation and amortization) are expenses incurred in providing products and services to our customers. These expenses include: employee-related expenses directly attributable to operating and maintaining our network (such as salaries, wages, benefits and professional fees); facilities expenses (which include third-party telecommunications expenses we incur for using other carriers' networks to provide services to our customers); rents and utilities expenses; equipment sales expenses (such as modem expenses); payments of universal service funds (which are federal and state funds that are established to promote the availability of telecommunications services to all consumers at reasonable and affordable rates, among other things, and to which we are often required to contribute); litigation expenses associated with our operations; and other expenses directly related to our operations.\nCost of services and products (exclusive of depreciation and amortization) decreased by $12 million, or 2%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our cost of services and products was primarily due to decreases in employee benefits expense, professional fees and contract labor costs, which were partially offset by increases in facility costs and network expense. Cost of services and products (exclusive of depreciation and amortization) increased by $4 million, or less than 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in our cost of services and products was primarily due to increases in facility costs and allocated corporate costs from affiliates, which were substantially offset by decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), professional fees and contract labor costs.\nSelling, General and Administrative\nSelling, general and administrative expenses are expenses incurred in selling products and services to our customers, corporate overhead and other operating expenses. These expenses include: employee-related expenses (such as salaries, wages, internal commissions, benefits and professional fees) directly attributable to selling products or services and employee-related expenses for administrative functions; marketing and advertising; property and other operating taxes and fees; external commissions; litigation expenses associated with general matters; bad debt expense; and other selling, general and administrative expenses.\nSelling, general and administrative expenses decreased by $21 million, or 8%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs and property and other taxes, which were partially offset by an increase in external commissions. Selling, general and administrative expenses decreased by $41 million, or 8%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs, property and other taxes and regulatory fines of $15 million associated with a 911 system outage in 2015, which were partially offset by an increase in external commissions.\nOperating Expenses - Affiliates\nSince CenturyLink's acquisition of us, we have incurred affiliates expenses related to our use of telecommunication services, marketing and employee related support services provided by CenturyLink and its subsidiaries.\nOperating expenses - affiliates decreased by $7 million, or 3%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and decreased by $4 million, or 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in operating expenses - affiliates for both periods was primarily due to decreases in level of services provided to us by our affiliates.\n19\nDepreciation and Amortization\nThe following tables provide detail of our depreciation and amortization expense:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Depreciation | $ | 230 | 244 | (14 | ) | (6 | )% |\n| Amortization | 194 | 220 | (26 | ) | (12 | )% |\n| Total depreciation and amortization | $ | 424 | 464 | (40 | ) | (9 | )% |\n\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Depreciation | $ | 452 | 484 | (32 | ) | (7 | )% |\n| Amortization | 391 | 442 | (51 | ) | (12 | )% |\n| Total depreciation and amortization | $ | 843 | 926 | (83 | ) | (9 | )% |\n\nDepreciation expense is impacted by several factors, including changes in our depreciable cost basis, changes in our estimates of the remaining economic life of certain network assets and the addition of new plant. Depreciation expense decreased by $14 million, or 6%, and decreased by $32 million, or 7%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The depreciation expense related to our plant for the six months ended June 30, 2016 was lower than the depreciation expense for the six months ended June 30, 2015 due to full depreciation and retirement of certain plant placed in service prior to 2016. This decrease was partially offset by an increase in depreciation expense attributable to new plant placed in service since June 30, 2015.\nAmortization expense decreased by $26 million, or 12%, and decreased by $51 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decrease in amortization expense for both periods was primarily due to software becoming fully amortized faster than new software was acquired or developed.\nOther Consolidated Results\nThe following tables summarize our total other expense, net and income tax expense:\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Interest expense | $ | (120 | ) | (119 | ) | 1 | 1 | % |\n| Interest expense - affiliate | (15 | ) | (13 | ) | 2 | 15 | % |\n| Other income, net | — | 1 | (1 | ) | 100 | % |\n| Total other expense, net | $ | (135 | ) | (131 | ) | 4 | 3 | % |\n| Income tax expense | $ | 179 | 152 | 27 | 18 | % |\n\n20\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Interest expense | $ | (241 | ) | (237 | ) | 4 | 2 | % |\n| Interest expense - affiliate | (29 | ) | (26 | ) | 3 | 12 | % |\n| Other income, net | 2 | 1 | 1 | 100 | % |\n| Total other expense, net | $ | (268 | ) | (262 | ) | 6 | 2 | % |\n| Income tax expense | $ | 367 | 319 | 48 | 15 | % |\n\nInterest Expense\nInterest expense increased by $1 million, or 1%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $4 million, or 2%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in interest expense for both periods was primarily due to a reduction in the amount of net premium amortization recorded at acquisition primarily due to the retirement of several issuances of debt during the period. See Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of Part I of this report and Liquidity and Capital Resources below for additional information about our debt.\nInterest Expense - Affiliates, Net\nAffiliate interest expense increased by $2 million, or 15%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $3 million, or 12%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in affiliate interest expense for both periods was primarily due to the increase in the average amount outstanding on our intercompany revolving indebtedness.\nIncome Tax Expense\nIncome tax expense for the three months ended June 30, 2016 was $179 million, or an effective tax rate of 38.3%, compared to $152 million, or an effective tax rate of 39.0%, for the three months ended June 30, 2015. Income tax expense for the six months ended June 30, 2016 was $367 million, or an effective tax rate of 38.3%, compared to $319 million, or an effective tax rate of 39.7%, for the six months ended June 30, 2015. The 2016 rates include the effect of changes in state apportionment factors and research and development credits. The 2015 rates include the effect of regulatory fines associated with a 911 system outage and state tax rate changes.\nLiquidity and Capital Resources\nOverview\nWe are an indirectly wholly-owned subsidiary of CenturyLink. As such, factors relating to, or affecting, CenturyLink's liquidity and capital resources could have material impacts on us, including impacts on our credit ratings, our access to capital markets and changes in the financial market's perception of us.\nCenturyLink has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate advances and obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to our stockholder, QSC, in excess of our earnings to the extent permitted by applicable law, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. Our debt covenants do not currently limit the amount of dividends we can pay to QSC. Given our cash management arrangement with our ultimate parent, CenturyLink, and the resulting amounts due to us from CenturyLink, a significant component of our liquidity is dependent upon CenturyLink's ability to repay its obligation to us.\n21\nAt June 30, 2016, we had a working capital deficit of $1.005 billion, reflecting current liabilities of $2.656 billion and current assets of $1.651 billion, compared to a working capital deficit of approximately $820 million as of December 31, 2015. We have historically operated with a working capital deficit due to our practice of declaring and paying regular cash dividends to QSC. As long as we continue declaring and paying cash dividends to QSC, it is likely that we will continue to operate with a working capital deficit in the future. We anticipate that our future liquidity needs will be met through (i) our cash provided by our operating activities, (ii) amounts due to us from CenturyLink and (iii) capital contributions, advances or loans from CenturyLink or its affiliates if and to the extent they have available funds or access to available funds that they are willing and able to contribute, advance or loan.\nCapital Expenditures\nWe incur capital expenditures on an ongoing basis in order to enhance and modernize our networks, compete effectively in our markets and expand our service offerings. CenturyLink evaluates capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and the expected return on investment. The amount of CenturyLink’s consolidated capital investment is influenced by, among other things, demand for CenturyLink’s services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations (such as our CAF Phase 2 infrastructure buildout requirements discussed below). Based on the type and volume of services we provide, approximately 38% to 43% of CenturyLink’s annual consolidated capital expenditures have been attributed over the last couple of years to us for use in our operations. For more information on CenturyLink’s total capital expenditures, please see its annual and quarterly reports filed with the SEC.\nOur capital expenditures continue to be focused on our strategic services. For more information on our capital spending, see Item 1of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nDebt and Other Financing Arrangements\nSubject to market conditions, and to the extent feasible, we expect to continue to issue debt securities from time to time in the future to refinance a substantial portion of our maturing debt. The availability, interest rate and other terms of any new borrowings will depend on the ratings assigned to us by credit rating agencies, among other factors. We have no debt maturities due during the remainder of 2016.\n| Agency | Credit Ratings |\n| Standard & Poor's | BBB- |\n| Moody's Investors Service, Inc. (1) | Ba1 |\n| Fitch Ratings | BBB- |\n\n| (1) | On March 15, 2016, Moody's Investors Service, Inc. downgraded CenturyLink's rating from Ba2 to Ba3 and downgraded Qwest Corporation's rating from Baa3 to Ba1. |\n\nOur credit ratings are reviewed and adjusted from time to time by the rating agencies, and downgrades could impact CenturyLink's and our access to debt capital or further raise CenturyLink's and our borrowing costs. Additional downgrades of CenturyLink's senior unsecured debt ratings could, under certain circumstances, incrementally increase the cost of CenturyLink's borrowing under its revolving credit facility, which could indirectly impact us. See \"Risk Factors—Risks Affecting our Liquidity and Capital Resources\" in Item 1A of Part II of this report.\nTerm Loan\nIn 2015, we entered into a term loan in the amount of $100 million with CoBank, ACB. The outstanding unpaid principal amount of this term loan plus any accrued and unpaid interest is due on February 20, 2025. Interest is paid monthly based upon either the London Interbank Offered Rate (“LIBOR”) or the base rate (as defined in the credit agreement) plus an applicable margin between 1.50% to 2.50% per annum for LIBOR loans and 0.50% to 1.50% per annum for base rate loans depending on our then current senior unsecured long-term debt rating. As of June 30, 2016, the outstanding principal balance on this term loan was $100 million.\n22\nRevolving Promissory Note\nWe are currently indebted to an affiliate of CenturyLink under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. The revolving promissory note is due on demand and ranks equally to our outstanding Senior Notes. Interest is accrued on the outstanding balance using a weighted average per annum interest rate of CenturyLink's outstanding borrowings for the interest period. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet.\nDividends\nWe periodically pay dividends to our direct parent company. See Note 6—Dividends and the discussion above under the heading \"Overview\".\nPension and Post-retirement Benefit Obligations\nCenturyLink is subject to material obligations under its existing defined benefit pension plans and post-retirement benefit plans. At December 31, 2015, the accounting unfunded status of CenturyLink's qualified and non-qualified defined benefit pension plans and post-retirement benefit plans was $2.277 billion and $3.374 billion, respectively. For additional information about CenturyLink's pension and post-retirement benefit arrangements, see \"Critical Accounting Policies and Estimates—Pensions and Post-Retirement Benefits\" in Item 7 of CenturyLink's Annual Report on Form 10-K for the year ended December 31, 2015, and see Note 7—Employee Benefits to the consolidated financial statements in Item 8 of Part II of the same report.\nA substantial portion of our active and retired employees participate in CenturyLink's qualified Combined Pension Plan and post-retirement benefit plans. On December 31, 2014, the Qwest Communications International Inc. (\"QCII\") pension plan and a pension plan of an affiliate were merged into the CenturyLink Retirement Plan, which was renamed the CenturyLink Combined Pension Plan. Our contributions to the trust are not segregated or restricted to pay amounts due to our employees and may be used to provide benefits to other employees of our affiliates. Prior to the pension plan merger, the above-noted employees participated in the QCII pension plan.\nThe affiliate obligations, net in current and noncurrent liabilities on our consolidated balance sheets represents the cumulative allocation of expense, net of payments, associated with QCII's pension plans and post-retirement benefits plans prior to the plan mergers. In 2015, we agreed to a plan to settle the outstanding pension and post-retirement affiliate obligations, net balance with QCII over a 30 year term. Payments will be made on a monthly basis. For the six months ended June 30, 2016, we made a settlement payment of $49 million to QCII on our affiliate obligations, net balance. Changes in the affiliate obligations, net are reflected in operating activities on our consolidated statements of cash flows. For the year ending December 31, 2016, we expect to make a settlement payment of $97 million to QCII on our affiliate obligations, net balance.\nFor 2016, CenturyLink's estimated annual long-term rate of return is 7.0% for both the pension plan trust assets and post-retirement plans trust assets, based on the assets currently held. However, actual returns could be substantially different.\nFor additional information, see “Risk Factors—Risks Affecting Our Liquidity and Capital Resources—Adverse changes in the value of assets or obligations associated with CenturyLink’s qualified pension plan could negatively impact CenturyLink’s liquidity, which may in turn affect our business and liquidity” in Item 1A of Part II of this report.\nConnect America Fund\nIn 2015, CenturyLink accepted CAF funding from the FCC of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 support program. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. The funding from the CAF Phase 2 support program is expected to substantially supplant the funding we previously received from the interstate USF program that we previously utilized to support voice services in high-cost rural markets in these 13 states. In late 2015, we began receiving these payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We received a substantial one-time cumulative catch-up payment from the FCC in the third quarter of 2015, and, as a result, we do not expect our funding from the CAF Phase 2 support program to materially change our operating revenues for the full year 2016 when compared to the full year 2015.\n23\nAs a result of accepting CAF Phase 2 support payments for 13 states, we will be obligated to make substantial capital expenditures to build infrastructure over the next several years. See \"Capital Expenditures\" above.\nFor additional information on the FCC's CAF order and the USF program, see \"Business—Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015 and see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources\" in Item 1A of Part II of this report.\nIn 2013, under the second round of the first phase of the CAF program, CenturyLink received $40 million in funding, $15 million attributed to our service areas, for deployment of broadband services in rural areas. For various reasons, we failed to meet certain broadband deployment requirements by specified deadlines, but we are currently developing alternate solutions, which may satisfy some or all of the requirements. If the FCC does not recognize our alternate deployment plans or grant us an extension of time to fulfill the deployment requirements, we anticipate that we will be requested to refund a substantial portion of the $15 million in funding we received. As of June 30, 2016, we have included approximately $8 million of CAF 1 Round 2 funding in other current liabilities and the remaining approximately $7 million of funding in other noncurrent liabilities on our consolidated balance sheet.\nFuture Contractual Obligations\nFor information regarding our estimated future contractual obligations, see the MD&A discussion included in our Annual Report on Form 10-K for the year ended December 31, 2015.\nHistorical Information\n| Six Months Ended June 30, | Increase / (Decrease) |\n| 2016 | 2015 |\n| (Dollars in millions) |\n| Cash Flows Provided By (Used In) |\n| Net cash provided by operating activities | $ | 1,284 | 1,254 | 30 |\n| Net cash used in investing activities | (569 | ) | (947 | ) | (378 | ) |\n| Net cash used in financing activities | (714 | ) | (307 | ) | 407 |\n\nNet cash provided by operating activities increased by $30 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in net income (which was directly impacted by the cash received from the CAF Phase 2 support program, which was $50 million greater than the cash we received in the first six months of 2015) adjusted for non-cash items, which was partially offset by negative variances in the changes in accounts receivable, accounts payable and affiliate obligations, net. For additional information about our operating results, see \"Results of Operations\" above.\nNet cash used in investing activities decreased by $378 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to a positive variance in the change in the amount of funds advanced to our affiliates.\nNet cash used in financing activities increased by $407 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in the amount of dividends paid to our direct parent company. For additional information regarding our financing activities, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. For additional information on the terms of QC's 7% Notes due in 2056, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\n24\nOther Matters\nIn February 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. In light of pending litigation, we believe it is premature for us to determine the ultimate impact of the new regulations on our operations; however, we currently expect that they will negatively impact our operations. For additional information, see “Risk Factors—Risks Relating to Legal and Regulatory Matters” in Item 1A of Part II of this report.\nCenturyLink and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As a wholly-owned subsidiary of CenturyLink, our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink's quarterly and annual reports filed with the Securities and Exchange Commission (\"SEC\"). Because we are not a party to any of the matters, we have not accrued any liabilities for these matters as of June 30, 2016.\nMarket Risk\nWe are exposed to market risk from changes in interest rates on our variable rate long-term debt obligations and revolving promissory note. We seek to maintain a favorable mix of fixed and variable rate debt in an effort to limit interest costs and cash flow volatility resulting from changes in rates.\nManagement periodically reviews our exposure to interest rate fluctuations and periodically implements strategies to manage the exposure. From time to time, we have used derivative instruments to (i) lock-in or swap our exposure to changing or variable interest rates for fixed interest rates or (ii) to swap obligations to pay fixed interest rates for variable interest rates. As of June 30, 2016, we had no such instruments outstanding. We have established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative instrument activities. We do not hold or issue derivative financial instruments for trading or speculative purposes.\nWe do not believe that there were any material changes to market risks arising from changes in interest rates for the six months ended June 30, 2016, when compared to the disclosures provided in our Annual Report on Form 10-K for the year ended December 31, 2015.\nCertain shortcomings are inherent in the method of analysis presented in the computation of exposures to market risks. Actual values may differ materially from those disclosed by us from time to time if market conditions vary from the assumptions used in the analyses performed. These analyses only incorporate the risk exposures that existed at June 30, 2016.\nOff-Balance Sheet Arrangements\nWe have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support and we do not engage in leasing, hedging or other similar activities that expose us to any significant liabilities that are not (i) reflected on the face of the consolidated financial statements, (ii) disclosed in Note 15—Commitments and Contingencies to our consolidated financial statements in Item 8 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015 or (iii) discussed under the heading \"Market Risk\" above.\n25\nOther Information\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \"Investor Relations\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \"Investor Relations\" section of our website (ir.centurylink.com) under the heading \"SEC Filings.\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\n26\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe have omitted this information pursuant to General Instruction H(2).\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\nITEM 1A. RISK FACTORS\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\nRisks Affecting Our Business\nWe may not be able to compete successfully against current or future competitors.\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \"Competition\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\n28\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\nRapid technological changes could significantly impact our competitive and financial position.\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \"long-term evolution\" or \"LTE\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\nFor additional information on the risks of increased expenditures, see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\"\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\n\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\n\n| • | greater use of service bundles. |\n\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\n29\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\nAdditional risks to our network, infrastructure and related systems include:\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\n\n30\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\n\n| • | theft or failure of our equipment; |\n\n| • | software or hardware obsolescence, defects or malfunctions; |\n\n| • | deficiencies in our processes or controls; |\n\n| • | programming, processing and other human error; and |\n\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\n\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\n\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\n\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\n\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\n\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\n\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\n\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\n\nWe could experience difficulties in expanding and updating our technical infrastructure.\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\n31\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\nOur operations, financial performance and liquidity are materially reliant on various third parties.\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\" included in Item 2 of Part I of this report.\n32\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\n| • | become bankrupt or experience substantial financial difficulties; |\n\n| • | suffer work stoppages or other labor strife; |\n\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\n\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\n\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \"Risk Factors—Risks Relating to Legal and Regulatory Matters.\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\nPortions of our property, plant and equipment are located on property owned by third parties.\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\n33\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\nOur business customers may seek to shift risk to us.\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Relating to Legal and Regulatory Matters\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\"VoIP\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\n34\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\"the 2011 order\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in Item 2 of Part I of this report.\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\"NPRM\") to consider changes in Business Data Services (\"BDS\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\n35\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\nOur participation in the FCC's Connect America Fund (\"CAF\") Phase 2 support program poses certain risks.\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\n\"Open Internet\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\nWe may be liable for the material that content providers distribute over our network.\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\n36\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\nFor a more thorough discussion of the regulatory issues that may affect our business, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Affecting Our Liquidity and Capital Resources\nCenturyLink's and our high debt levels expose us to a broad range of risks.\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\nOur significant levels of debt can adversely affect us in several other respects, including:\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\n\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\n\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\n\n| • | increasing our future borrowing costs; |\n\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\n\n37\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\n\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\n\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\n\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\n\nThe effects of each of these factors could be intensified if we increase our borrowings.\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\n38\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \"investment grade\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\n39\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\nOther Risks\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \"critical\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\n40\nTax audits or changes in tax laws could adversely affect us.\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\n41\n25\nOther Information\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \"Investor Relations\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \"Investor Relations\" section of our website (ir.centurylink.com) under the heading \"SEC Filings.\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\n26\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nWe have omitted this information pursuant to General Instruction H(2).\nITEM 4. CONTROLS AND PROCEDURES\nDisclosure Controls and Procedures\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\nChanges in Internal Control Over Financial Reporting\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\n27\nPART II—OTHER INFORMATION\nITEM 1. LEGAL PROCEEDINGS\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\nITEM 1A. RISK FACTORS\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\nRisks Affecting Our Business\nWe may not be able to compete successfully against current or future competitors.\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \"Competition\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\n28\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\nRapid technological changes could significantly impact our competitive and financial position.\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \"long-term evolution\" or \"LTE\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\nFor additional information on the risks of increased expenditures, see \"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\"\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\n\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\n\n| • | greater use of service bundles. |\n\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\n29\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\nAdditional risks to our network, infrastructure and related systems include:\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\n\n30\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\n\n| • | theft or failure of our equipment; |\n\n| • | software or hardware obsolescence, defects or malfunctions; |\n\n| • | deficiencies in our processes or controls; |\n\n| • | programming, processing and other human error; and |\n\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\n\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\n\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\n\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\n\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\n\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\n\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\n\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\n\nWe could experience difficulties in expanding and updating our technical infrastructure.\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\n31\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\nOur operations, financial performance and liquidity are materially reliant on various third parties.\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\" included in Item 2 of Part I of this report.\n32\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\n| • | become bankrupt or experience substantial financial difficulties; |\n\n| • | suffer work stoppages or other labor strife; |\n\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\n\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\n\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \"Risk Factors—Risks Relating to Legal and Regulatory Matters.\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\nPortions of our property, plant and equipment are located on property owned by third parties.\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\n33\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\nOur business customers may seek to shift risk to us.\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Relating to Legal and Regulatory Matters\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\"VoIP\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\n34\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\"the 2011 order\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \"Management's Discussion and Analysis of Financial Condition and Results of Operations\" in Item 2 of Part I of this report.\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\"NPRM\") to consider changes in Business Data Services (\"BDS\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\n35\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\nOur participation in the FCC's Connect America Fund (\"CAF\") Phase 2 support program poses certain risks.\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\n\"Open Internet\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\nWe may be liable for the material that content providers distribute over our network.\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\n36\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\nFor a more thorough discussion of the regulatory issues that may affect our business, see \"Regulation\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\nRisks Affecting Our Liquidity and Capital Resources\nCenturyLink's and our high debt levels expose us to a broad range of risks.\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\nOur significant levels of debt can adversely affect us in several other respects, including:\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\n\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\n\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\n\n| • | increasing our future borrowing costs; |\n\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\n\n37\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\n\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\n\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\n\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\n\nThe effects of each of these factors could be intensified if we increase our borrowings.\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\n38\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \"investment grade\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\n39\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\nOther Risks\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \"critical\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\n40\nTax audits or changes in tax laws could adversely affect us.\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\n41\nITEM 6. EXHIBITS\n| ExhibitNumber | Description |\n| 3.1 | Amended and restated Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended March 31, 2013 (File No. 001-03040) filed with the Securities and Exchange Commission on May 13, 2013). |\n| 3.2 | Articles of Amendment to the Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended June 30, 2000 (File No. 001-03040) filed with the Securities and Exchange Commission on August 11, 2000). |\n| 3.3 | Amended and Restated Bylaws of Qwest Corporation (incorporated by reference to Exhibit 3.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.1 | Indenture, dated as of April 15, 1990, by and between The Mountain States Telephone and Telegraph Company (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.2 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.2 | Indenture, dated as of April 15, 1990, by and between Northwestern Bell Telephone Company (predecessor to Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.5(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended March 31, 2012 (File No. 001-07784) filed with the Securities and Exchange Commission on May 10, 2012). |\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\n| 4.3 | Indenture, dated as of October 15, 1999, by and between U S West Communications, Inc. (currently named Qwest Corporation) and Bank One Trust Company, N.A., as trustee (incorporated by reference to Exhibit 4(b) of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 1999 (File No. 001-03040) filed with the Securities and Exchange Commission on March 3, 2000). |\n| a. | Fifth Supplemental Indenture, dated as of May 16, 2007, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on May 18, 2007). |\n| b. | Seventh Supplemental Indenture, dated as of June 8, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.8 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 7, 2011). |\n| c. | Eighth Supplemental Indenture, dated as of September 21, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.9 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 20, 2011). |\n| d. | Ninth Supplemental Indenture, dated as of October 4, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on October 4, 2011). |\n\n_______________________________________________________________________________\n| (1) | Certain of the items in Sections 4.1 through 4.3 (j) omit supplemental indentures or other instruments governing debt that has been retired, or (ii) refer to trustees who may have been replaced, acquired or affected by similar changes. In accordance with Item 601(b) (4) (iii) (A) of Regulation S-K, copies of certain instruments defining the rights of holders of certain of our long-term debt are not filed herewith. Pursuant to this registration, we hereby agree to furnish a copy of any such instrument to the SEC upon request. |\n\n42\n| ExhibitNumber | Description |\n| e | Tenth Supplemental Indenture, dated as of April 2, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on March 30, 2012). |\n| f. | Eleventh Supplemental Indenture, dated as of June 25, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 22, 2012). |\n| g | Twelfth Supplemental Indenture, dated as of May 23, 2013, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.13 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on May 22, 2013). |\n| h. | Thirteenth Supplemental Indenture, dated as of September 29, 2014, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.14 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 26, 2014). |\n| i. | Fourteenth Supplemental Indenture, dated as of September 21, 2015, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.15 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 21, 2015). |\n| j. | Fifteenth Supplemental Indenture, dated as of January 29, 2016, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.16 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on January 29, 2016). |\n| 4.4 | Revolving Promissory Note, dated as of April 18, 2012, pursuant to which Qwest Corporation may borrow from an affiliate of CenturyLink, Inc. up to $1.0 billion on a revolving basis (incorporated by reference to Exhibit 4.7(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended June 30, 2012 (File No 001-07784) filed with the Securities and Exchange Commission on August 9, 2012). |\n| 4.5 | Credit Agreement, dated as of February 20, 2015, by and among Qwest Corporation, the several lenders from time to time parties thereto, and CoBank, ACB, as administrative agent (incorporated by reference to Exhibit 4.5 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2014 (File No. 001-03040) filed with the Securities and Exchange Commission on February 27, 2015). |\n| 12* | Calculation of Ratio of Earnings to Fixed Charges. |\n| 31.1* | Certification of the Chief Executive Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2* | Certification of the Chief Financial Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32* | Certification of the Chief Executive Officer and Chief Financial Officer of CenturyLink, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101* | Financial statements from the Quarterly Report on Form 10-Q of Qwest Corporation for the period ended June 30, 2016, formatted in XBRL: (i) the Consolidated Statements of Operations, (ii) the Consolidated Statements of Comprehensive Income, (iii) the Consolidated Balance Sheets, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Stockholder's Equity and (vi) the Notes to the Consolidated Financial Statements. |\n\n_______________________________________________________________________________\n| * | Exhibit filed herewith. |\n\n43\nSIGNATURE\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 5, 2016.\n| QWEST CORPORATION |\n| By: | /s/ DAVID D. COLE |\n| David D. ColeExecutive Vice President, Controller and Operations Support (Chief Accounting Officer) |\n\n44\n</text>\n\nWhat is the total expected penalty per state if the regulatory company decides to implement penalties due to non-compliance with FCC measures? This includes both the end-of-period penalty and potential additional penalty, assuming the organization received $5000 support per location over the six-year term and a total CAF Phase 2 support of $2,000,000 over the six-year term for the state.\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<text>\\nPART I—FINANCIAL INFORMATION\\nITEM 1. FINANCIAL STATEMENTS\\nQWEST CORPORATION\\nCONSOLIDATED STATEMENTS OF OPERATIONS\\n(UNAUDITED)\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (Dollars in millions) |\\n| OPERATING REVENUES |\\n| Operating revenues | $ | 1,573 | 1,618 | 3,172 | 3,254 |\\n| Operating revenues - affiliates | 650 | 604 | 1,304 | 1,185 |\\n| Total operating revenues | 2,223 | 2,222 | 4,476 | 4,439 |\\n| OPERATING EXPENSES |\\n| Cost of services and products (exclusive of depreciation and amortization) | 731 | 743 | 1,439 | 1,435 |\\n| Selling, general and administrative | 235 | 256 | 485 | 526 |\\n| Operating expenses - affiliates | 231 | 238 | 482 | 486 |\\n| Depreciation and amortization | 424 | 464 | 843 | 926 |\\n| Total operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\\n| OPERATING INCOME | 602 | 521 | 1,227 | 1,066 |\\n| OTHER (EXPENSE) INCOME |\\n| Interest expense | (120 | ) | (119 | ) | (241 | ) | (237 | ) |\\n| Interest expense - affiliates, net | (15 | ) | (13 | ) | (29 | ) | (26 | ) |\\n| Other income, net | — | 1 | 2 | 1 |\\n| Total other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\\n| INCOME BEFORE INCOME TAX EXPENSE | 467 | 390 | 959 | 804 |\\n| Income tax expense | 179 | 152 | 367 | 319 |\\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\\n\\nSee accompanying notes to consolidated financial statements.\\n3\\nQWEST CORPORATION\\nCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME\\n(UNAUDITED)\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (Dollars in millions) |\\n| NET INCOME | $ | 288 | 238 | 592 | 485 |\\n| OTHER COMPREHENSIVE INCOME: |\\n| Foreign currency translation adjustment, net of $—, $—, $— and $— tax | 3 | — | — | — |\\n| Other comprehensive income | 3 | — | — | — |\\n| COMPREHENSIVE INCOME | $ | 291 | 238 | 592 | 485 |\\n\\nSee accompanying notes to consolidated financial statements.\\n4\\nQWEST CORPORATION\\nCONSOLIDATED BALANCE SHEETS\\n(UNAUDITED)\\n| As of June 30, 2016 | As of December 31, 2015 |\\n| (Dollars in millions) |\\n| ASSETS |\\n| CURRENT ASSETS |\\n| Cash and cash equivalents | $ | 4 | 3 |\\n| Accounts receivable, less allowance of $48 and $47 | 688 | 688 |\\n| Advances to affiliates | 811 | 788 |\\n| Other | 148 | 123 |\\n| Total current assets | 1,651 | 1,602 |\\n| NET PROPERTY, PLANT AND EQUIPMENT |\\n| Property, plant and equipment | 12,619 | 12,182 |\\n| Accumulated depreciation | (5,182 | ) | (4,808 | ) |\\n| Net property, plant and equipment | 7,437 | 7,374 |\\n| GOODWILL AND OTHER ASSETS |\\n| Goodwill | 9,354 | 9,354 |\\n| Customer relationships, less accumulated amortization of $3,549 and $3,264 | 2,150 | 2,435 |\\n| Other intangible assets, less accumulated amortization of $1,435 and $1,383 | 539 | 613 |\\n| Other, net | 98 | 92 |\\n| Total goodwill and other assets | 12,141 | 12,494 |\\n| TOTAL ASSETS | $ | 21,229 | 21,470 |\\n| LIABILITIES AND STOCKHOLDER'S EQUITY |\\n| CURRENT LIABILITIES |\\n| Current maturities of long-term debt | $ | 509 | 242 |\\n| Accounts payable | 350 | 369 |\\n| Note payable - affiliate | 884 | 855 |\\n| Accrued expenses and other liabilities |\\n| Salaries and benefits | 186 | 211 |\\n| Income and other taxes | 165 | 189 |\\n| Other | 146 | 135 |\\n| Current affiliate obligations, net | 94 | 97 |\\n| Advance billings and customer deposits | 322 | 324 |\\n| Total current liabilities | 2,656 | 2,422 |\\n| LONG-TERM DEBT | 6,726 | 6,997 |\\n| DEFERRED CREDITS AND OTHER LIABILITIES |\\n| Deferred revenues | 123 | 137 |\\n| Deferred income taxes, net | 1,861 | 1,896 |\\n| Affiliate obligations, net | 1,003 | 1,051 |\\n| Other | 61 | 60 |\\n| Total deferred credits and other liabilities | 3,048 | 3,144 |\\n| COMMITMENTS AND CONTINGENCIES (Note 5) |\\n| STOCKHOLDER'S EQUITY |\\n| Common stock - one share without par value, owned by Qwest Services Corporation | 10,050 | 10,050 |\\n| Accumulated deficit | (1,251 | ) | (1,143 | ) |\\n| Total stockholder's equity | 8,799 | 8,907 |\\n| TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY | $ | 21,229 | 21,470 |\\n\\nSee accompanying notes to consolidated financial statements.\\n5\\nQWEST CORPORATION\\nCONSOLIDATED STATEMENTS OF CASH FLOWS\\n(UNAUDITED)\\n| Six Months Ended June 30, |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| OPERATING ACTIVITIES |\\n| Net income | $ | 592 | 485 |\\n| Adjustments to reconcile net income to net cash provided by operating activities: |\\n| Depreciation and amortization | 843 | 926 |\\n| Deferred income taxes | (35 | ) | (180 | ) |\\n| Provision for uncollectible accounts | 40 | 39 |\\n| Net long-term debt issuance costs and premium amortization | (7 | ) | (11 | ) |\\n| Accrued interest on affiliate note | 29 | 31 |\\n| Changes in current assets and liabilities: |\\n| Accounts receivable | (40 | ) | 8 |\\n| Accounts payable | (20 | ) | 30 |\\n| Accrued income and other taxes | (24 | ) | (14 | ) |\\n| Other current assets and liabilities, net | (40 | ) | (34 | ) |\\n| Other current assets and liabilities - affiliates, net | — | (4 | ) |\\n| Changes in other noncurrent assets and liabilities, net | (11 | ) | (23 | ) |\\n| Changes in affiliate obligations, net | (51 | ) | (4 | ) |\\n| Other, net | 8 | 5 |\\n| Net cash provided by operating activities | 1,284 | 1,254 |\\n| INVESTING ACTIVITIES |\\n| Payments for property, plant and equipment and capitalized software | (546 | ) | (564 | ) |\\n| Changes in advances to affiliates | (23 | ) | (383 | ) |\\n| Net cash used in investing activities | (569 | ) | (947 | ) |\\n| FINANCING ACTIVITIES |\\n| Net proceeds from issuance of long-term debt | 227 | 99 |\\n| Payments of long-term debt | (241 | ) | (106 | ) |\\n| Dividends paid to Qwest Services Corporation | (700 | ) | (300 | ) |\\n| Net cash used in financing activities | (714 | ) | (307 | ) |\\n| Net increase in cash and cash equivalents | 1 | — |\\n| Cash and cash equivalents at beginning of period | 3 | 6 |\\n| Cash and cash equivalents at end of period | $ | 4 | 6 |\\n| Supplemental cash flow information: |\\n| Income taxes paid, net | $ | (401 | ) | (379 | ) |\\n| Interest paid (net of capitalized interest of $8 and $9) | $ | (249 | ) | (247 | ) |\\n\\nSee accompanying notes to consolidated financial statements.\\n6\\nQWEST CORPORATION\\nCONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY\\n(UNAUDITED)\\n| Six Months Ended June 30, |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| COMMON STOCK |\\n| Balance at beginning of period | $ | 10,050 | 10,050 |\\n| Balance at end of period | 10,050 | 10,050 |\\n| ACCUMULATED DEFICIT |\\n| Balance at beginning of period | (1,143 | ) | (867 | ) |\\n| Net income | 592 | 485 |\\n| Dividends declared to Qwest Services Corporation | (700 | ) | (300 | ) |\\n| Balance at end of period | (1,251 | ) | (682 | ) |\\n| TOTAL STOCKHOLDER'S EQUITY | $ | 8,799 | 9,368 |\\n\\nSee accompanying notes to consolidated financial statements.\\n7\\nQWEST CORPORATION\\nNOTES TO CONSOLIDATED FINANCIAL STATEMENTS\\n(UNAUDITED)\\nUnless the context requires otherwise, references in this report to \\\"QC\\\" refer to Qwest Corporation, references to \\\"Qwest,\\\" \\\"we,\\\" \\\"us,\\\" and \\\"our\\\" refer to Qwest Corporation and its consolidated subsidiaries, references to \\\"QSC\\\" refer to our direct parent company, Qwest Services Corporation, and its consolidated subsidiaries, references to \\\"QCII\\\" refer to QSC's direct parent company and our indirect parent company, Qwest Communications International Inc., and its consolidated subsidiaries, and references to \\\"CenturyLink\\\" refer to QCII's direct parent company and our ultimate parent company, CenturyLink, Inc., and its consolidated subsidiaries.\\n(1) Basis of Presentation\\nGeneral\\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers.\\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\\nOur consolidated balance sheet as of December 31, 2015, which was derived from our audited consolidated financial statements, and our unaudited interim consolidated financial statements provided herein have been prepared in accordance with the instructions for Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (\\\"SEC\\\"); however, in our opinion, the disclosures made are adequate to make the information presented not misleading. We believe that these consolidated financial statements include all normal recurring adjustments necessary to fairly present the results for the interim periods. The consolidated results of operations for the first six months of the year are not necessarily indicative of the consolidated results of operations that might be expected for the entire year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.\\nThe accompanying consolidated financial statements include our accounts and the accounts of our subsidiaries. Intercompany amounts and transactions with our consolidated subsidiaries have been eliminated. Transactions with our non-consolidated affiliates (referred to herein as affiliates) have not been eliminated.\\nWe reclassified certain prior period amounts to conform to the current period presentation, including the categorization of our revenues. See Note 4—Products and Services Revenues for additional information. These changes had no impact on total operating revenues, total operating expenses or net income for any period.\\nConnect America Fund\\nIn 2015, CenturyLink accepted funding from the Federal Communications Commission's (\\\"FCC\\\") Connect America Fund (\\\"CAF\\\") of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 high-cost support program. The funding from the CAF Phase 2 support program in these 33 states will substantially supplant funding from the interstate Universal Service Fund (\\\"USF\\\") high-cost program that we previously utilized to support voice services in high-cost rural markets. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. In late 2015, we began receiving these support payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than in the comparable periods for 2015 with respect to our 13 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our \\\"affiliate and other services\\\" revenues for the full year 2016 when compared to the full year 2015.\\n8\\nRecent Accounting Pronouncements\\nFinancial Instruments\\nOn June 16, 2016, the Financial Accounting Standards Board (\\\"FASB\\\") issued Accounting Standards Update (\\\"ASU\\\") 2016-13, “Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). The primary impact of ASU 2016-13 for us is a change in the model for the recognition of credit losses related to our financial instruments from an incurred loss model, which recognized credit losses only if it was probable that a loss had been incurred to an expected loss model, which requires our management team to estimate the total credit losses expected on the portfolio of financial instruments. We are currently reviewing the requirements of the standard and evaluating the impact on our consolidated financial statements.\\nWe are required to adopt the provisions of ASU 2016-13 effective January 1, 2020, but could elect to early adopt the provisions as of January 1, 2019. We expect to recognize the impacts of adopting ASU 2016-13 through a cumulative adjustment to retained earnings as of the date of adoption.\\nShare-based Compensation\\nOn March 30, 2016, the FASB issued ASU 2016-09, “Improvement to Employee Share-Based Payment Accounting\\\" (“ASU 2016-09”). ASU 2016-09 modifies the accounting and associated income tax accounting for share-based compensation in order to reduce the cost and complexity associated with current generally accepted accounting principles. ASU 2016-09 is effective for us as of January 1, 2017, but early adoption may be elected. ASU 2016-09 includes different transition requirements for the different changes implemented, including some provisions which allow retrospective application. We have not determined when we will implement this standard or if we will retrospectively apply the requirements when allowed.\\nThe primary provisions of ASU 2016-09 that we expect will affect our financial statements are: 1) a reclassification of the tax effect associated with the difference between the expense recognized for share-based payments and the associated tax deduction from additional paid-in capital to income tax expense; 2) a reclassification of the tax effect associated with the difference between compensation expense and associated deduction from financing cash flow to operating cash flow; and 3) an optional accounting policy election to account for forfeitures of share-based payment grants as they occur as opposed to our current policy of estimating the forfeitures on the grant date. These provisions would not have had a material impact on our previously issued financial statements; however, this is not necessarily representative of future impacts. Adoption of ASU 2016-09 may increase the volatility of income tax expense and cash flow from operating activities.\\nLeases\\nOn February 25, 2016, the FASB issued ASU 2016-02, “Leases” (“ASU 2016-02”). The core principle of ASU 2016-02 will require lessees to present right-of-use assets and lease liabilities on their balance sheets for operating leases, which are currently not reflected on their balance sheets.\\nASU 2016-02 is effective for annual and interim periods beginning January 1, 2019. Early adoption of ASU 2016-02 is permitted. Upon adoption of ASU 2016-02, we are required to recognize and measure leases at the beginning of the earliest period presented in our consolidated financial statements using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that we may elect to apply. We have not yet decided when we will adopt ASU 2016-02 or which practical expedient options we will elect. We are currently evaluating and assessing the impact ASU 2016-02 will have on us and our consolidated financial statements. As of the date of this report, we cannot provide any estimate of the impact of adopting ASU 2016-02.\\nRevenue Recognition\\nOn May 28, 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”). ASU 2014-09 replaces virtually all existing generally accepted accounting principles (“GAAP”) on revenue recognition and replaces them with a principles-based approach for determining revenue recognition using a new five step model. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 also includes new accounting principles related to the deferral and amortization of contract acquisition and fulfillment costs. We currently do not defer any contract acquisition costs and we defer contract fulfillment costs only up to the extent of any revenue deferred.\\n9\\nOn July 9, 2015, the FASB approved the deferral of the effective date of ASU 2014-09 by one year until January 1, 2018, which is the date we plan to adopt this standard. ASU 2014-09 may be adopted by applying the provisions of this standard on a retrospective basis to the periods included in the financial statements or on a modified retrospective basis which would result in the recognition of a cumulative effect of adopting ASU 2014-09 in the first quarter of 2018. We have not yet decided which implementation method we will adopt. We are studying ASU 2014-09 and are assessing the impact this standard will have on us and our consolidated financial statements. We cannot at this time, however, provide any estimate of the impact of adopting ASU 2014-09.\\n(2) Long-Term Debt and Revolving Promissory Note\\nLong-term debt, including unamortized discounts and premiums, unamortized debt issuance costs and note payable - affiliate, were as follows:\\n| Interest Rates | Maturities | As of June 30, 2016 | As of December 31, 2015 |\\n| (Dollars in millions) |\\n| Senior notes | 6.125% - 7.750% | 2017 - 2056 | $ | 7,229 | 7,229 |\\n| Term loan | 2.220% | 2025 | 100 | 100 |\\n| Capital lease and other obligations | Various | Various | 28 | 17 |\\n| Unamortized premiums, net | 8 | 16 |\\n| Unamortized debt issuance costs | (130 | ) | (123 | ) |\\n| Total long-term debt | 7,235 | 7,239 |\\n| Less current maturities | (509 | ) | (242 | ) |\\n| Long-term debt, excluding current maturities | $ | 6,726 | 6,997 |\\n| Note payable - affiliate | 6.795% | 2022 | $ | 884 | 855 |\\n\\nNew Issuance\\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. All of the 7% Notes are unsecured obligations and may be redeemed by QC, in whole or in part, on or after February 1, 2021, at a redemption price equal to 100% of the principal amount redeemed plus accrued and unpaid interest to the redemption date.\\nRepayment\\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\\nRevolving Promissory Note\\nWe are currently indebted to an affiliate of our ultimate parent company, CenturyLink, under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet. In accordance with the note agreement, all accrued interest and unpaid interest is capitalized to the unpaid principal balance on June 1 and December 1 of each year.\\nCovenants\\nThe indentures governing our notes contain certain covenants including, but not limited to: (i) a prohibition on certain liens on our assets; and (ii) a limitation on mergers or sales of all, or substantially all, of our assets, which limitation requires that a successor assume the obligation with regard to these notes. These indentures do not contain any cross-default provisions.\\nOur senior notes were issued under indentures dated April 15, 1990 and October 15, 1999. These indentures do not contain any financial covenants, but do include restrictions that limit our ability to (i) incur, issue or create liens upon our property and (ii) consolidate with or merge into, transfer or lease all or substantially all of our assets to any other party.\\nAs of June 30, 2016, we believe we were in compliance with the provisions and covenants of our debt agreements.\\n10\\n(3) Fair Value Disclosure\\nOur financial instruments consist of cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, note payable - affiliate and long-term debt, excluding capital lease and other obligations. Due to their short-term nature, the carrying amounts of our cash and cash equivalents, accounts receivable, advances to affiliates, accounts payable, and note payable - affiliate approximate their fair values.\\nFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between independent and knowledgeable parties who are willing and able to transact for an asset or liability at the measurement date. We use valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs when determining fair value and then we rank the estimated values based on the reliability of the inputs used following the fair value hierarchy set forth by the FASB. We determined the fair values of our long-term debt, including the current portion, based on quoted market prices where available or, if not available, based on discounted future cash flows using current market interest rates.\\n| Input Level | Description of Input |\\n| Level 1 | Observable inputs such as quoted market prices in active markets. |\\n| Level 2 | Inputs other than quoted prices in active markets that are either directly or indirectly observable. |\\n| Level 3 | Unobservable inputs in which little or no market data exists. |\\n\\n| As of June 30, 2016 | As of December 31, 2015 |\\n| InputLevel | CarryingAmount | FairValue | CarryingAmount | FairValue |\\n| (Dollars in millions) |\\n| Liabilities—Long-term debt, excluding capital lease and other obligations | 2 | $ | 7,207 | 7,579 | 7,222 | 7,456 |\\n\\n(4) Products and Services Revenues\\nWe are an integrated communications company engaged primarily in providing an array of services, including local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As a result, we now reflect these operating revenues as legacy services, and we have reclassified certain prior period amounts to conform to this change. The revision resulted in a reduction of revenue from strategic services and a corresponding increase in revenue from legacy services of $209 million and $426 million (net of $1 million and $2 million of deferred revenue included in affiliate and other services) for the three and six months ended June 30, 2015, respectively.\\n11\\nWe now categorize our products, services and revenues among the following three categories:\\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\\n\\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\\\"ISDN\\\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\\\"WAN\\\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\\n\\n| • | Affiliates and other services, which consist primarily of CAF support payments, USF support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the FCC's universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\\n\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (Dollars in millions) |\\n| Strategic services | $ | 674 | 650 | 1,345 | 1,291 |\\n| Legacy services | 814 | 904 | 1,658 | 1,833 |\\n| Affiliates and other services | 735 | 668 | 1,473 | 1,315 |\\n| Total operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\\n\\nWe do not have any single external customer that provides more than 10% of our total consolidated operating revenues. Substantially all of our consolidated revenues come from customers located in the United States.\\nWe recognize revenues in our consolidated statements of operations for certain USF surcharges and transaction taxes that we bill to our customers. Our consolidated statements of operations also reflect the related expense for the amounts we remit to the government agencies. The total amount of such surcharges and transaction taxes that we included in revenues aggregated approximately $38 million for each of the three months ended June 30, 2016 and 2015, respectively, and approximately $76 million and $75 million for the six months ended June 30, 2016 and 2015, respectively. These USF surcharges, where we record revenue, are included in \\\"affiliate and other services\\\" revenues and these transaction taxes are included in \\\"legacy services\\\" revenues. We also act as a collection agent for certain other USF and transaction taxes that we are required by government agencies to bill our customers, for which we do not record any revenue or expense because we only act as a pass-through agent.\\nOur operations are integrated into and reported as part of the consolidated segment data of CenturyLink. CenturyLink's chief operating decision maker (\\\"CODM\\\") is our CODM, but reviews our financial information on an aggregate basis only in connection with our quarterly and annual reports that we file with the Securities and Exchange Commission. Consequently, we do not provide our discrete financial information to the CODM on a regular basis. As such, we believe we have one reportable segment.\\n(5) Commitments and Contingencies\\nPending Matters\\nSubsidiaries of CenturyLink, Inc., including us, are among hundreds of companies in an industry-wide dispute, raised in nearly 100 federal lawsuits (filed between 2014 and 2016) that have been consolidated in the United States District Court for the District of Northern Texas for pretrial procedures. The disputes relate to switched access charges that local exchange carriers (\\\"LECs\\\") collect from interexchange carriers (\\\"IXCs\\\") for IXCs' use of LEC's access services. In the lawsuits, three IXCs, Sprint Communications Company L.P. (\\\"Sprint\\\"), affiliates of Verizon Communications Inc. (\\\"Verizon\\\") and affiliates of Level 3 Communications LLC (\\\"Level 3\\\"), assert that federal and state laws bar LECs from collecting access charges when IXCs exchange certain types of calls between mobile and wireline devices that are routed through an IXC. Some of these IXCs have asserted claims seeking refunds of payments for access charges previously paid and relief from future access charges. In addition, Level 3 has ceased paying switched access charges on these calls.\\n12\\nIn November 2015, the federal court agreed with the LECs and rejected the IXCs' contention that federal law prohibits these particular access charges, and also allowed the IXCs to refile state-law claims. Since then, many of the LECs and IXCs have filed revised pleadings and additional motions, which remain pending. Separately, some of the defendants, including us, have petitioned the Federal Communications Commission to address these issues on an industry-wide basis.\\nThe outcome of these disputes and lawsuits, as well as any related regulatory proceedings that could ensue, are currently not predictable. If we are required to stop assessing these charges or to pay refunds of any such charges, our financial results could be negatively affected.\\nOther Proceedings and Disputes\\nFrom time to time, we are involved in other proceedings incidental to our business, including patent infringement allegations, administrative hearings of state public utility commissions relating primarily to our rates or services, actions relating to employee claims, various tax issues, environmental law issues, grievance hearings before labor regulatory agencies and miscellaneous third party tort actions.\\nWe are currently defending several patent infringement lawsuits asserted against us by non-practicing entities, many of whom are seeking substantial recoveries. These cases have progressed to various stages and one or more may go to trial in the coming 24 months if they are not otherwise resolved. Where applicable, we are seeking full or partial indemnification from our vendors and suppliers. As with all litigation, we are vigorously defending these actions and, as a matter of course, are prepared to litigate these matters to judgment, as well as to evaluate and consider all reasonable settlement opportunities.\\nWe are subject to various federal, state and local environmental protection and health and safety laws. From time to time, we are subject to judicial and administrative proceedings brought by various governmental authorities under these laws. Several such proceedings are currently pending, but none is reasonably expected to exceed $100,000 in fines and penalties.\\nThe outcome of these other proceedings is not predictable. However, based on current circumstances, we do not believe that the ultimate resolution of these other proceedings, after considering available defenses and any insurance coverage or indemnification rights, will have a material adverse effect on our financial position, results of operations or cash flows.\\nCenturyLink, Inc. and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As an indirect wholly-owned subsidiary of CenturyLink, Inc., our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink, Inc.'s quarterly and annual reports filed with the Securities and Exchange Commission. Because we are not a party to any of the matters, we have not accrued any liabilities for the matters.\\n(6) Dividends\\nDuring the six months ended June 30, 2016, we declared and paid dividends of $700 million to our direct parent company, Qwest Services Corporation. Dividends paid are reflected on our consolidated statements of cash flows as financing activities.\\n(7) Other Financial Information\\nOther Current Assets\\n| As of June 30, 2016 | As of December 31, 2015 |\\n| (Dollars in millions) |\\n| Prepaid expenses | $ | 70 | 46 |\\n| Other | 78 | 77 |\\n| Total other current assets | $ | 148 | 123 |\\n\\n13\\nSelected Current Liabilities\\n| As of June 30, 2016 | As of December 31, 2015 |\\n| (Dollars in millions) |\\n| Accounts payable | $ | 350 | 369 |\\n\\nIncluded in accounts payable at both June 30, 2016 and December 31, 2015, was $29 million associated with capital expenditures.\\n14\\nITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\\nUnless the context requires otherwise, references in this report to \\\"QC\\\" refer to Qwest Corporation, and references to \\\"Qwest,\\\" \\\"we,\\\" \\\"us\\\" and \\\"our\\\" refer to Qwest Corporation and its consolidated subsidiaries.\\nAll references to \\\"Notes\\\" in this Item 2 of Part I refer to the Notes to Consolidated Financial Statements included in Item 1 of Part I of this report.\\nCertain statements in this report constitute forward-looking statements. See the last paragraph of this Item 2 of Part I and \\\"Risk Factors\\\" in Item 1A of Part II of this report for a discussion of certain factors that could cause our actual results to differ from our anticipated results or otherwise impact our business, financial condition, results of operations, liquidity or prospects.\\nOverview\\nManagement's Discussion and Analysis of Financial Condition and Results of Operations (\\\"MD&A\\\") included herein should be read in conjunction with MD&A and the other information included in our Annual Report on Form 10-K for the year ended December 31, 2015, and with the consolidated financial statements and related notes in Item 1 of Part I of this report. The results of operations for the first six months of the year are not necessarily indicative of the results of operations that might be expected for the entire year.\\nWe are an integrated communications company engaged primarily in providing an array of services to our residential and business customers. Our communications services include local voice, broadband, private line (including special access), network access, Ethernet, information technology, video and other ancillary services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.\\nWe generate the majority of our total consolidated operating revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.\\nOur ultimate parent company, CenturyLink, Inc. (\\\"CenturyLink\\\"), has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to Qwest Services Corporation (\\\"QSC\\\"), our direct parent, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. We report the balance of these transfers on our consolidated balance sheet as advances to affiliates.\\nFor the reasons noted in Note 4—Products and Services Revenues to our consolidated financial statements in Item 1 of Part I of this report, we believe we have one reportable segment.\\nFrom time to time, we may change the categorization of our products and services. During the second quarter of 2016, we determined that because of declines due to customer migration to other strategic products and services, certain of our services, specifically our private line (including special access) services, are now more closely aligned with our legacy services than with our strategic services. As described in greater detail in Note 4—Products and Services Revenues, these operating revenues are now reflected as legacy services.\\nWe now categorize our products, services and revenues among the following three categories:\\n| • | Strategic services, which include primarily broadband, Ethernet, video and other ancillary services; |\\n\\n| • | Legacy services, which include primarily local voice, private line (including special access), Integrated Services Digital Network (\\\"ISDN\\\") (which use regular telephone lines to support voice, video and data applications), switched access, traditional wide area network (\\\"WAN\\\") (which allow a local communications network to link to networks in remote locations) and other ancillary services; and |\\n\\n15\\n| • | Affiliates and other services, which consist primarily of Connect America Fund (\\\"CAF\\\") support payments, Universal Service Fund (\\\"USF\\\") support payments, USF surcharges and services we provide to our affiliates. We receive federal support payments from both CAF Phase 1 and CAF Phase 2 programs, and support payments from both federal and state USF programs. These support payments are government subsidies designed to reimburse us for various costs related to certain telecommunications services, including the costs of deploying, maintaining and operating voice and broadband infrastructure in high-cost rural areas where we are not able to fully recover our costs from our customers. USF surcharges are the amounts we collect based on specific items we list on our customers' invoices to fund the Federal Communications Commission's (\\\"FCC\\\") universal service programs. We provide to our affiliates, telecommunication services that we also provide to external customers. In addition, we provide to our affiliates, computer system development and support services, network support and technical services. |\\n\\nAt June 30, 2016, we operated approximately 6.8 million access lines and served approximately 3.5 million broadband subscribers. Our methodology for counting access lines and broadband subscribers, which is described further in the operational metrics table below under \\\"Results of Operations\\\", may not be comparable to those of other companies.\\nThe following analysis is organized to provide the information we believe will be useful for understanding material trends affecting our business.\\nBusiness Trends\\nOur financial results were impacted by several significant trends, which are described below. We expect that these trends will continue to affect our results of operations, cash flows or financial position.\\n| • | Strategic services. We continue to see shifts in the makeup of our total revenues as customers move to lower margin strategic services, such as broadband and video services, from higher margin legacy services. Revenues from our strategic services represented 30% and 29% of our total revenues for both the three and six months ended June 30, 2016 and 2015, respectively. We continue to experienced price compression due to competition, which negatively impacted the growth of our strategic revenues. We continue to focus on increasing subscribers of our broadband services, particularly among consumer and small business customers. We believe that continually increasing the scope and connection speeds of our broadband services is important to remaining competitive in our industry. As a result, we continue to invest in our broadband network, which allows for the delivery of higher speed broadband services to a greater number of customers. We compete in a maturing broadband market in which most customers already have broadband services and growth rates in new subscribers have slowed. Moreover, as described further in \\\"Risk Factors\\\" in Item 1A of Part II of this report, demand for our broadband services could be adversely affected by competitors continuing to provide services at higher broadband speeds than ours or expanding their advanced wireless data service offerings. Our Ethernet-based services in the wholesale market face competition from cable companies and competitive fiber-based telecommunications providers; |\\n\\n| • | Legacy services. Revenues from our legacy services represented 37% and 41% of our total revenues for the three and six months ended June 30, 2016 and 2015, respectively. We expect these percentages to continue to decline. Our legacy services revenues have been, and we expect they will continue to be adversely affected by access line losses and price compression. Intense competition and product substitution continue to drive our access line losses. For example, many consumers are replacing traditional voice telecommunications service with substitute services, including (i) cable and wireless voice services and (ii) electronic mail, texting and social networking services. We expect that these factors will continue to negatively impact our business. As a result of the expected loss of revenue associated with access lines, we continue to offer our customers service bundling and other product promotions to help mitigate this trend, as described below. Demand for our private line services (including special access) continues to decline due to customers' optimization of their networks, industry consolidation and technological migration to higher-speed services; |\\n\\n| • | Service bundling and product promotions. We offer our customers the ability to bundle multiple products and services. These customers can bundle local services with other services such as broadband and video. While we believe our bundled service offerings can help retain customers, they also tend to lower our profit margins due to the related discounts; and |\\n\\n| • | Operating efficiencies. We continue to evaluate our operating structure and focus. This involves balancing our workforce in response to our workload requirements, productivity improvements and changes in industry, competitive, technological and regulatory conditions. |\\n\\nWhile these trends are important to understanding and evaluating our financial results, the other transactions, events, uncertainties and trends discussed in \\\"Risk Factors\\\" in Item 1A of Part II of this report may also materially impact our business operations and financial results.\\n16\\nResults of Operations\\n| Three Months Ended June 30, | Six Months Ended June 30, |\\n| 2016 | 2015 | 2016 | 2015 |\\n| (Dollars in millions) |\\n| Operating revenues | $ | 2,223 | 2,222 | 4,476 | 4,439 |\\n| Operating expenses | 1,621 | 1,701 | 3,249 | 3,373 |\\n| Operating income | 602 | 521 | 1,227 | 1,066 |\\n| Other expense, net | (135 | ) | (131 | ) | (268 | ) | (262 | ) |\\n| Income tax expense | 179 | 152 | 367 | 319 |\\n| Net income | $ | 288 | 238 | 592 | 485 |\\n\\n| As of June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (in thousands) |\\n| Operational metrics: |\\n| Total access lines (1) | 6,808 | 7,184 | (376 | ) | (5 | )% |\\n| Total broadband subscribers (1) | 3,516 | 3,556 | (40 | ) | (1 | )% |\\n| Total employees | 22.9 | 22.5 | 0.4 | 2 | % |\\n\\n(1) Access lines are lines reaching from the customers' premises to a connection with the public network and broadband subscribers are customers that purchase broadband connection service through their existing telephone lines, stand-alone telephone lines, or fiber-optic cables. Our methodology for counting our access lines and broadband subscribers includes only those lines that we use to provide services to external customers and excludes lines used solely by us and our affiliates. It also excludes unbundled loops and includes stand-alone broadband subscribers. We count lines when we install the service.\\nOperating Revenues\\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Strategic services | $ | 674 | 650 | 24 | 4 | % |\\n| Legacy services | 814 | 904 | (90 | ) | (10 | )% |\\n| Affiliates and other services | 735 | 668 | 67 | 10 | % |\\n| Total operating revenues | $ | 2,223 | 2,222 | 1 | — | % |\\n\\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Strategic services | $ | 1,345 | 1,291 | 54 | 4 | % |\\n| Legacy services | 1,658 | 1,833 | (175 | ) | (10 | )% |\\n| Affiliates and other services | 1,473 | 1,315 | 158 | 12 | % |\\n| Total operating revenues | $ | 4,476 | 4,439 | 37 | 1 | % |\\n\\n17\\nStrategic Services\\nStrategic services revenues increased by $24 million, or 4%, and increased by $54 million, or 4%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our strategic services revenues for both periods was primarily due to price increases for broadband services, volume increases in Ethernet services and price increases for other services.\\nLegacy Services\\nLegacy services revenues decreased by $90 million, or 10%, and decreased by $175 million, or 10%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decline in our legacy services revenues for both periods was primarily due to lower local voice services revenues due to access line loss and reduced access services usage related to customer migration, competitive pressures and product substitution and to reductions in the volumes of our private line (including special access) services.\\nAffiliates and Other Services\\nAffiliates and other services revenues increased by $67 million, or 10%, and increased by $158 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The increase in our affiliates and other services revenues for both periods was primarily due to increases in the volume and in the rates we charge for the support services we provided to affiliates and to the additional revenue recorded under the FCC's CAF Phase 2 support program. We recorded $24 million and $48 million more in revenue for the three and six months ended June 30, 2016, respectively, than for the three and six months ended June 30, 2015, with respect to our 13 CAF Phase 2 states. We received a substantial one-time cumulative catch-up payment related to the first half of 2015 from the FCC in the third quarter of 2015, and, as a result, we do not expect funding from the CAF Phase 2 support program to materially change our other operating revenues for the full year 2016 when compared to the full year 2015.\\nOperating Expenses\\nThe following tables summarize our consolidated operating expenses:\\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 731 | 743 | (12 | ) | (2 | )% |\\n| Selling, general and administrative | 235 | 256 | (21 | ) | (8 | )% |\\n| Operating expenses - affiliates | 231 | 238 | (7 | ) | (3 | )% |\\n| Depreciation and amortization | 424 | 464 | (40 | ) | (9 | )% |\\n| Total operating expenses | $ | 1,621 | 1,701 | (80 | ) | (5 | )% |\\n\\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Cost of services and products (exclusive of depreciation and amortization) | $ | 1,439 | 1,435 | 4 | — | % |\\n| Selling, general and administrative | 485 | 526 | (41 | ) | (8 | )% |\\n| Operating expenses - affiliates | 482 | 486 | (4 | ) | (1 | )% |\\n| Depreciation and amortization | 843 | 926 | (83 | ) | (9 | )% |\\n| Total operating expenses | $ | 3,249 | 3,373 | (124 | ) | (4 | )% |\\n\\n18\\nCost of Services and Products (exclusive of depreciation and amortization)\\nCost of services and products (exclusive of depreciation and amortization) are expenses incurred in providing products and services to our customers. These expenses include: employee-related expenses directly attributable to operating and maintaining our network (such as salaries, wages, benefits and professional fees); facilities expenses (which include third-party telecommunications expenses we incur for using other carriers' networks to provide services to our customers); rents and utilities expenses; equipment sales expenses (such as modem expenses); payments of universal service funds (which are federal and state funds that are established to promote the availability of telecommunications services to all consumers at reasonable and affordable rates, among other things, and to which we are often required to contribute); litigation expenses associated with our operations; and other expenses directly related to our operations.\\nCost of services and products (exclusive of depreciation and amortization) decreased by $12 million, or 2%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our cost of services and products was primarily due to decreases in employee benefits expense, professional fees and contract labor costs, which were partially offset by increases in facility costs and network expense. Cost of services and products (exclusive of depreciation and amortization) increased by $4 million, or less than 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in our cost of services and products was primarily due to increases in facility costs and allocated corporate costs from affiliates, which were substantially offset by decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), professional fees and contract labor costs.\\nSelling, General and Administrative\\nSelling, general and administrative expenses are expenses incurred in selling products and services to our customers, corporate overhead and other operating expenses. These expenses include: employee-related expenses (such as salaries, wages, internal commissions, benefits and professional fees) directly attributable to selling products or services and employee-related expenses for administrative functions; marketing and advertising; property and other operating taxes and fees; external commissions; litigation expenses associated with general matters; bad debt expense; and other selling, general and administrative expenses.\\nSelling, general and administrative expenses decreased by $21 million, or 8%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs and property and other taxes, which were partially offset by an increase in external commissions. Selling, general and administrative expenses decreased by $41 million, or 8%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in our selling, general and administrative expenses was primarily due to decreases in salaries and wages and related employee benefits expense (driven by increases in the amount of labor capitalized and allocated to our affiliates), contract labor costs, property and other taxes and regulatory fines of $15 million associated with a 911 system outage in 2015, which were partially offset by an increase in external commissions.\\nOperating Expenses - Affiliates\\nSince CenturyLink's acquisition of us, we have incurred affiliates expenses related to our use of telecommunication services, marketing and employee related support services provided by CenturyLink and its subsidiaries.\\nOperating expenses - affiliates decreased by $7 million, or 3%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and decreased by $4 million, or 1%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The decrease in operating expenses - affiliates for both periods was primarily due to decreases in level of services provided to us by our affiliates.\\n19\\nDepreciation and Amortization\\nThe following tables provide detail of our depreciation and amortization expense:\\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Depreciation | $ | 230 | 244 | (14 | ) | (6 | )% |\\n| Amortization | 194 | 220 | (26 | ) | (12 | )% |\\n| Total depreciation and amortization | $ | 424 | 464 | (40 | ) | (9 | )% |\\n\\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Depreciation | $ | 452 | 484 | (32 | ) | (7 | )% |\\n| Amortization | 391 | 442 | (51 | ) | (12 | )% |\\n| Total depreciation and amortization | $ | 843 | 926 | (83 | ) | (9 | )% |\\n\\nDepreciation expense is impacted by several factors, including changes in our depreciable cost basis, changes in our estimates of the remaining economic life of certain network assets and the addition of new plant. Depreciation expense decreased by $14 million, or 6%, and decreased by $32 million, or 7%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The depreciation expense related to our plant for the six months ended June 30, 2016 was lower than the depreciation expense for the six months ended June 30, 2015 due to full depreciation and retirement of certain plant placed in service prior to 2016. This decrease was partially offset by an increase in depreciation expense attributable to new plant placed in service since June 30, 2015.\\nAmortization expense decreased by $26 million, or 12%, and decreased by $51 million, or 12%, for the three and six months ended June 30, 2016, respectively, as compared to the three and six months ended June 30, 2015. The decrease in amortization expense for both periods was primarily due to software becoming fully amortized faster than new software was acquired or developed.\\nOther Consolidated Results\\nThe following tables summarize our total other expense, net and income tax expense:\\n| Three Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Interest expense | $ | (120 | ) | (119 | ) | 1 | 1 | % |\\n| Interest expense - affiliate | (15 | ) | (13 | ) | 2 | 15 | % |\\n| Other income, net | — | 1 | (1 | ) | 100 | % |\\n| Total other expense, net | $ | (135 | ) | (131 | ) | 4 | 3 | % |\\n| Income tax expense | $ | 179 | 152 | 27 | 18 | % |\\n\\n20\\n| Six Months Ended June 30, | Increase/(Decrease) | % Change |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Interest expense | $ | (241 | ) | (237 | ) | 4 | 2 | % |\\n| Interest expense - affiliate | (29 | ) | (26 | ) | 3 | 12 | % |\\n| Other income, net | 2 | 1 | 1 | 100 | % |\\n| Total other expense, net | $ | (268 | ) | (262 | ) | 6 | 2 | % |\\n| Income tax expense | $ | 367 | 319 | 48 | 15 | % |\\n\\nInterest Expense\\nInterest expense increased by $1 million, or 1%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $4 million, or 2%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in interest expense for both periods was primarily due to a reduction in the amount of net premium amortization recorded at acquisition primarily due to the retirement of several issuances of debt during the period. See Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of Part I of this report and Liquidity and Capital Resources below for additional information about our debt.\\nInterest Expense - Affiliates, Net\\nAffiliate interest expense increased by $2 million, or 15%, for the three months ended June 30, 2016 as compared to the three months ended June 30, 2015 and increased by $3 million, or 12%, for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015. The increase in affiliate interest expense for both periods was primarily due to the increase in the average amount outstanding on our intercompany revolving indebtedness.\\nIncome Tax Expense\\nIncome tax expense for the three months ended June 30, 2016 was $179 million, or an effective tax rate of 38.3%, compared to $152 million, or an effective tax rate of 39.0%, for the three months ended June 30, 2015. Income tax expense for the six months ended June 30, 2016 was $367 million, or an effective tax rate of 38.3%, compared to $319 million, or an effective tax rate of 39.7%, for the six months ended June 30, 2015. The 2016 rates include the effect of changes in state apportionment factors and research and development credits. The 2015 rates include the effect of regulatory fines associated with a 911 system outage and state tax rate changes.\\nLiquidity and Capital Resources\\nOverview\\nWe are an indirectly wholly-owned subsidiary of CenturyLink. As such, factors relating to, or affecting, CenturyLink's liquidity and capital resources could have material impacts on us, including impacts on our credit ratings, our access to capital markets and changes in the financial market's perception of us.\\nCenturyLink has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate advances and obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to our stockholder, QSC, in excess of our earnings to the extent permitted by applicable law, using cash owed to us under these advances, which has the net effect of reducing the amount of these advances. Our debt covenants do not currently limit the amount of dividends we can pay to QSC. Given our cash management arrangement with our ultimate parent, CenturyLink, and the resulting amounts due to us from CenturyLink, a significant component of our liquidity is dependent upon CenturyLink's ability to repay its obligation to us.\\n21\\nAt June 30, 2016, we had a working capital deficit of $1.005 billion, reflecting current liabilities of $2.656 billion and current assets of $1.651 billion, compared to a working capital deficit of approximately $820 million as of December 31, 2015. We have historically operated with a working capital deficit due to our practice of declaring and paying regular cash dividends to QSC. As long as we continue declaring and paying cash dividends to QSC, it is likely that we will continue to operate with a working capital deficit in the future. We anticipate that our future liquidity needs will be met through (i) our cash provided by our operating activities, (ii) amounts due to us from CenturyLink and (iii) capital contributions, advances or loans from CenturyLink or its affiliates if and to the extent they have available funds or access to available funds that they are willing and able to contribute, advance or loan.\\nCapital Expenditures\\nWe incur capital expenditures on an ongoing basis in order to enhance and modernize our networks, compete effectively in our markets and expand our service offerings. CenturyLink evaluates capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and the expected return on investment. The amount of CenturyLink’s consolidated capital investment is influenced by, among other things, demand for CenturyLink’s services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations (such as our CAF Phase 2 infrastructure buildout requirements discussed below). Based on the type and volume of services we provide, approximately 38% to 43% of CenturyLink’s annual consolidated capital expenditures have been attributed over the last couple of years to us for use in our operations. For more information on CenturyLink’s total capital expenditures, please see its annual and quarterly reports filed with the SEC.\\nOur capital expenditures continue to be focused on our strategic services. For more information on our capital spending, see Item 1of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nDebt and Other Financing Arrangements\\nSubject to market conditions, and to the extent feasible, we expect to continue to issue debt securities from time to time in the future to refinance a substantial portion of our maturing debt. The availability, interest rate and other terms of any new borrowings will depend on the ratings assigned to us by credit rating agencies, among other factors. We have no debt maturities due during the remainder of 2016.\\n| Agency | Credit Ratings |\\n| Standard & Poor's | BBB- |\\n| Moody's Investors Service, Inc. (1) | Ba1 |\\n| Fitch Ratings | BBB- |\\n\\n| (1) | On March 15, 2016, Moody's Investors Service, Inc. downgraded CenturyLink's rating from Ba2 to Ba3 and downgraded Qwest Corporation's rating from Baa3 to Ba1. |\\n\\nOur credit ratings are reviewed and adjusted from time to time by the rating agencies, and downgrades could impact CenturyLink's and our access to debt capital or further raise CenturyLink's and our borrowing costs. Additional downgrades of CenturyLink's senior unsecured debt ratings could, under certain circumstances, incrementally increase the cost of CenturyLink's borrowing under its revolving credit facility, which could indirectly impact us. See \\\"Risk Factors—Risks Affecting our Liquidity and Capital Resources\\\" in Item 1A of Part II of this report.\\nTerm Loan\\nIn 2015, we entered into a term loan in the amount of $100 million with CoBank, ACB. The outstanding unpaid principal amount of this term loan plus any accrued and unpaid interest is due on February 20, 2025. Interest is paid monthly based upon either the London Interbank Offered Rate (“LIBOR”) or the base rate (as defined in the credit agreement) plus an applicable margin between 1.50% to 2.50% per annum for LIBOR loans and 0.50% to 1.50% per annum for base rate loans depending on our then current senior unsecured long-term debt rating. As of June 30, 2016, the outstanding principal balance on this term loan was $100 million.\\n22\\nRevolving Promissory Note\\nWe are currently indebted to an affiliate of CenturyLink under a revolving promissory note that provides us with a funding commitment of up to $1.0 billion aggregate principal amount through June 30, 2022, of which $884 million was outstanding as of June 30, 2016. The revolving promissory note is due on demand and ranks equally to our outstanding Senior Notes. Interest is accrued on the outstanding balance using a weighted average per annum interest rate of CenturyLink's outstanding borrowings for the interest period. As of June 30, 2016, the weighted average interest rate was 6.795%. As of June 30, 2016 and December 31, 2015, this revolving promissory note is reflected on our consolidated balance sheets as a current liability under note payable - affiliate. As of June 30, 2016, $5 million of accrued interest is reflected in other current liabilities on our consolidated balance sheet.\\nDividends\\nWe periodically pay dividends to our direct parent company. See Note 6—Dividends and the discussion above under the heading \\\"Overview\\\".\\nPension and Post-retirement Benefit Obligations\\nCenturyLink is subject to material obligations under its existing defined benefit pension plans and post-retirement benefit plans. At December 31, 2015, the accounting unfunded status of CenturyLink's qualified and non-qualified defined benefit pension plans and post-retirement benefit plans was $2.277 billion and $3.374 billion, respectively. For additional information about CenturyLink's pension and post-retirement benefit arrangements, see \\\"Critical Accounting Policies and Estimates—Pensions and Post-Retirement Benefits\\\" in Item 7 of CenturyLink's Annual Report on Form 10-K for the year ended December 31, 2015, and see Note 7—Employee Benefits to the consolidated financial statements in Item 8 of Part II of the same report.\\nA substantial portion of our active and retired employees participate in CenturyLink's qualified Combined Pension Plan and post-retirement benefit plans. On December 31, 2014, the Qwest Communications International Inc. (\\\"QCII\\\") pension plan and a pension plan of an affiliate were merged into the CenturyLink Retirement Plan, which was renamed the CenturyLink Combined Pension Plan. Our contributions to the trust are not segregated or restricted to pay amounts due to our employees and may be used to provide benefits to other employees of our affiliates. Prior to the pension plan merger, the above-noted employees participated in the QCII pension plan.\\nThe affiliate obligations, net in current and noncurrent liabilities on our consolidated balance sheets represents the cumulative allocation of expense, net of payments, associated with QCII's pension plans and post-retirement benefits plans prior to the plan mergers. In 2015, we agreed to a plan to settle the outstanding pension and post-retirement affiliate obligations, net balance with QCII over a 30 year term. Payments will be made on a monthly basis. For the six months ended June 30, 2016, we made a settlement payment of $49 million to QCII on our affiliate obligations, net balance. Changes in the affiliate obligations, net are reflected in operating activities on our consolidated statements of cash flows. For the year ending December 31, 2016, we expect to make a settlement payment of $97 million to QCII on our affiliate obligations, net balance.\\nFor 2016, CenturyLink's estimated annual long-term rate of return is 7.0% for both the pension plan trust assets and post-retirement plans trust assets, based on the assets currently held. However, actual returns could be substantially different.\\nFor additional information, see “Risk Factors—Risks Affecting Our Liquidity and Capital Resources—Adverse changes in the value of assets or obligations associated with CenturyLink’s qualified pension plan could negatively impact CenturyLink’s liquidity, which may in turn affect our business and liquidity” in Item 1A of Part II of this report.\\nConnect America Fund\\nIn 2015, CenturyLink accepted CAF funding from the FCC of approximately $500 million per year for six years to fund the deployment of voice and broadband capable infrastructure for approximately 1.2 million rural households and businesses in 33 states under the CAF Phase 2 support program. Of these amounts, approximately $150 million per year is attributable to our service area, to provide service to approximately 0.3 million rural households and businesses in 13 states. The funding from the CAF Phase 2 support program is expected to substantially supplant the funding we previously received from the interstate USF program that we previously utilized to support voice services in high-cost rural markets in these 13 states. In late 2015, we began receiving these payments from the FCC under the new CAF Phase 2 support program, which included monthly support payments at a higher rate than under the interstate USF support program. We received a substantial one-time cumulative catch-up payment from the FCC in the third quarter of 2015, and, as a result, we do not expect our funding from the CAF Phase 2 support program to materially change our operating revenues for the full year 2016 when compared to the full year 2015.\\n23\\nAs a result of accepting CAF Phase 2 support payments for 13 states, we will be obligated to make substantial capital expenditures to build infrastructure over the next several years. See \\\"Capital Expenditures\\\" above.\\nFor additional information on the FCC's CAF order and the USF program, see \\\"Business—Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015 and see \\\"Risk Factors—Risks Affecting our Liquidity and Capital Resources\\\" in Item 1A of Part II of this report.\\nIn 2013, under the second round of the first phase of the CAF program, CenturyLink received $40 million in funding, $15 million attributed to our service areas, for deployment of broadband services in rural areas. For various reasons, we failed to meet certain broadband deployment requirements by specified deadlines, but we are currently developing alternate solutions, which may satisfy some or all of the requirements. If the FCC does not recognize our alternate deployment plans or grant us an extension of time to fulfill the deployment requirements, we anticipate that we will be requested to refund a substantial portion of the $15 million in funding we received. As of June 30, 2016, we have included approximately $8 million of CAF 1 Round 2 funding in other current liabilities and the remaining approximately $7 million of funding in other noncurrent liabilities on our consolidated balance sheet.\\nFuture Contractual Obligations\\nFor information regarding our estimated future contractual obligations, see the MD&A discussion included in our Annual Report on Form 10-K for the year ended December 31, 2015.\\nHistorical Information\\n| Six Months Ended June 30, | Increase / (Decrease) |\\n| 2016 | 2015 |\\n| (Dollars in millions) |\\n| Cash Flows Provided By (Used In) |\\n| Net cash provided by operating activities | $ | 1,284 | 1,254 | 30 |\\n| Net cash used in investing activities | (569 | ) | (947 | ) | (378 | ) |\\n| Net cash used in financing activities | (714 | ) | (307 | ) | 407 |\\n\\nNet cash provided by operating activities increased by $30 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in net income (which was directly impacted by the cash received from the CAF Phase 2 support program, which was $50 million greater than the cash we received in the first six months of 2015) adjusted for non-cash items, which was partially offset by negative variances in the changes in accounts receivable, accounts payable and affiliate obligations, net. For additional information about our operating results, see \\\"Results of Operations\\\" above.\\nNet cash used in investing activities decreased by $378 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to a positive variance in the change in the amount of funds advanced to our affiliates.\\nNet cash used in financing activities increased by $407 million for the six months ended June 30, 2016 as compared to the six months ended June 30, 2015 primarily due to an increase in the amount of dividends paid to our direct parent company. For additional information regarding our financing activities, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\\nOn May 2, 2016, QC paid at maturity the $235 million principal amount and accrued and unpaid interest due under its 8.375% Notes.\\nIn January 2016, QC issued $235 million aggregate principal amount of 7% Notes due 2056, in exchange for net proceeds, after deducting underwriting discounts and other expenses, of approximately $227 million. For additional information on the terms of QC's 7% Notes due in 2056, see Note 2—Long-Term Debt and Revolving Promissory Note to our consolidated financial statements in Item 1 of this report.\\n24\\nOther Matters\\nIn February 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. In light of pending litigation, we believe it is premature for us to determine the ultimate impact of the new regulations on our operations; however, we currently expect that they will negatively impact our operations. For additional information, see “Risk Factors—Risks Relating to Legal and Regulatory Matters” in Item 1A of Part II of this report.\\nCenturyLink and its affiliates are involved in several legal proceedings to which we are not a party that, if resolved against them, could have a material adverse effect on their business and financial condition. As a wholly-owned subsidiary of CenturyLink, our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink's quarterly and annual reports filed with the Securities and Exchange Commission (\\\"SEC\\\"). Because we are not a party to any of the matters, we have not accrued any liabilities for these matters as of June 30, 2016.\\nMarket Risk\\nWe are exposed to market risk from changes in interest rates on our variable rate long-term debt obligations and revolving promissory note. We seek to maintain a favorable mix of fixed and variable rate debt in an effort to limit interest costs and cash flow volatility resulting from changes in rates.\\nManagement periodically reviews our exposure to interest rate fluctuations and periodically implements strategies to manage the exposure. From time to time, we have used derivative instruments to (i) lock-in or swap our exposure to changing or variable interest rates for fixed interest rates or (ii) to swap obligations to pay fixed interest rates for variable interest rates. As of June 30, 2016, we had no such instruments outstanding. We have established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative instrument activities. We do not hold or issue derivative financial instruments for trading or speculative purposes.\\nWe do not believe that there were any material changes to market risks arising from changes in interest rates for the six months ended June 30, 2016, when compared to the disclosures provided in our Annual Report on Form 10-K for the year ended December 31, 2015.\\nCertain shortcomings are inherent in the method of analysis presented in the computation of exposures to market risks. Actual values may differ materially from those disclosed by us from time to time if market conditions vary from the assumptions used in the analyses performed. These analyses only incorporate the risk exposures that existed at June 30, 2016.\\nOff-Balance Sheet Arrangements\\nWe have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support and we do not engage in leasing, hedging or other similar activities that expose us to any significant liabilities that are not (i) reflected on the face of the consolidated financial statements, (ii) disclosed in Note 15—Commitments and Contingencies to our consolidated financial statements in Item 8 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015 or (iii) discussed under the heading \\\"Market Risk\\\" above.\\n25\\nOther Information\\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \\\"Investor Relations\\\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \\\"Investor Relations\\\" section of our website (ir.centurylink.com) under the heading \\\"SEC Filings.\\\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\\n26\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nWe have omitted this information pursuant to General Instruction H(2).\\nITEM 4. CONTROLS AND PROCEDURES\\nDisclosure Controls and Procedures\\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\\nChanges in Internal Control Over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\\n27\\nPART II—OTHER INFORMATION\\nITEM 1. LEGAL PROCEEDINGS\\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\\nITEM 1A. RISK FACTORS\\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\\nRisks Affecting Our Business\\nWe may not be able to compete successfully against current or future competitors.\\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \\\"Competition\\\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\\n28\\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\\nRapid technological changes could significantly impact our competitive and financial position.\\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \\\"long-term evolution\\\" or \\\"LTE\\\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\\nFor additional information on the risks of increased expenditures, see \\\"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\\\"\\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\\n\\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\\n\\n| • | greater use of service bundles. |\\n\\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\\n29\\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\\nAdditional risks to our network, infrastructure and related systems include:\\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\\n\\n30\\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\\n\\n| • | theft or failure of our equipment; |\\n\\n| • | software or hardware obsolescence, defects or malfunctions; |\\n\\n| • | deficiencies in our processes or controls; |\\n\\n| • | programming, processing and other human error; and |\\n\\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\\n\\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\\n\\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\\n\\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\\n\\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\\n\\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\\n\\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\\n\\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\\n\\nWe could experience difficulties in expanding and updating our technical infrastructure.\\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\\n31\\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\\nOur operations, financial performance and liquidity are materially reliant on various third parties.\\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\\\" included in Item 2 of Part I of this report.\\n32\\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\\n| • | become bankrupt or experience substantial financial difficulties; |\\n\\n| • | suffer work stoppages or other labor strife; |\\n\\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\\n\\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\\n\\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \\\"Risk Factors—Risks Relating to Legal and Regulatory Matters.\\\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\\nPortions of our property, plant and equipment are located on property owned by third parties.\\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\\n33\\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\\nOur business customers may seek to shift risk to us.\\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nRisks Relating to Legal and Regulatory Matters\\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\\\"VoIP\\\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\\n34\\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\\\"the 2011 order\\\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \\\"Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in Item 2 of Part I of this report.\\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\\\"NPRM\\\") to consider changes in Business Data Services (\\\"BDS\\\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\\n35\\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\\nOur participation in the FCC's Connect America Fund (\\\"CAF\\\") Phase 2 support program poses certain risks.\\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\\n\\\"Open Internet\\\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\\nWe may be liable for the material that content providers distribute over our network.\\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\\n36\\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\\nFor a more thorough discussion of the regulatory issues that may affect our business, see \\\"Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nRisks Affecting Our Liquidity and Capital Resources\\nCenturyLink's and our high debt levels expose us to a broad range of risks.\\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\\nOur significant levels of debt can adversely affect us in several other respects, including:\\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\\n\\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\\n\\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\\n\\n| • | increasing our future borrowing costs; |\\n\\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\\n\\n37\\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\\n\\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\\n\\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\\n\\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\\n\\nThe effects of each of these factors could be intensified if we increase our borrowings.\\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\\\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\\n38\\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \\\"investment grade\\\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \\\"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\\\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\\n39\\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\\nOther Risks\\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\\\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \\\"critical\\\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\\n40\\nTax audits or changes in tax laws could adversely affect us.\\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\\n41\\n25\\nOther Information\\nCenturyLink's and our website is www.centurylink.com. We routinely post important investor information in the \\\"Investor Relations\\\" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the \\\"Investor Relations\\\" section of our website (ir.centurylink.com) under the heading \\\"SEC Filings.\\\" These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.\\nIn addition to historical information, this quarterly report includes certain forward-looking statements that are based upon our judgment and assumptions as of the date of this report concerning future developments and events, many of which are beyond our control. These forward-looking statements, and the assumptions upon which they are based, are not guarantees of future results, are inherently speculative and are subject to a number of risks and uncertainties. Actual events and results may differ materially from those anticipated, estimated, projected or implied by us in those statements if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the effects of competition from a wide variety of competitive providers, including lower demand for our legacy offerings; the effects of new, emerging or competing technologies, including those that could make our products less desirable or obsolete; the effects of ongoing changes in the regulation of the communications industry, including the outcome of regulatory or judicial proceedings relating to intercarrier compensation, interconnection obligations, access charges, universal service, broadband deployment, data protection and net neutrality; our ability to effectively adjust to changes in the communications industry, and changes in the composition of our markets and product mix; possible changes in the demand for, or pricing of, our products and services, including our ability to effectively respond to increased demand for high-speed broadband service; our ability to successfully maintain the quality and profitability of our existing product and service offerings and to introduce new offerings on a timely and cost-effective basis; the adverse impact on our business and network from possible equipment failures, service outages, security breaches or similar events impacting our network; our ability to generate cash flows sufficient to fund our financial commitments and objectives, including our capital expenditures, operating costs, dividends, pension contributions and debt payments; changes in our operating plans, corporate strategies, dividend payment plans or other capital allocation plans, whether based upon changes in our cash flows, cash requirements, financial performance, financial position, or otherwise; our ability to effectively retain and hire key personnel and to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; increases in the costs of CenturyLink's pension, health, post-employment or other benefits, including those caused by changes in markets, interest rates, mortality rates, demographics or regulations, which may in turn affect our business and liquidity; adverse changes in our access to credit markets on favorable terms, whether caused by changes in our financial position, lower debt credit ratings, unstable markets or otherwise; our ability to maintain favorable relations with our key business partners, suppliers, vendors, landlords and financial institutions; our ability to effectively manage our network buildout project and other expansion opportunities; our ability to collect our receivables from financially troubled customers; any adverse developments in legal or regulatory proceedings involving us or our affiliates (including CenturyLink); changes in tax, communications, pension, healthcare or other laws or regulations, in governmental support programs, or in general government funding levels; the effects of changes in accounting policies or practices, including potential future impairment charges; the effects of terrorism, adverse weather or other natural or man-made disasters; the effects of more general factors such as changes in interest rates, in operating costs, in general market, labor, economic or geo-political conditions, or in public policy; and other risks referenced in Item 1A or elsewhere in this Quarterly Report or other of our filings with the SEC. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. Given these uncertainties, we caution investors not to unduly rely upon our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements for any reason, whether as a result of new information, future events or developments, changed circumstances, or otherwise. Furthermore, any information about our intentions contained in any of our forward-looking statements reflects our intentions as of the date of this report, and is based upon, among other things, existing regulatory, technological, industry, competitive, economic and market conditions, and our assumptions as of such date. We may change our intentions, strategies or plans at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.\\n26\\nITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\\nWe have omitted this information pursuant to General Instruction H(2).\\nITEM 4. CONTROLS AND PROCEDURES\\nDisclosure Controls and Procedures\\nThe Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management, with the participation of our Chief Executive Officer, Glen F. Post, III, and our Chief Financial Officer, R. Stewart Ewing, Jr., evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2016. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2016, in providing reasonable assurance that the information required to be disclosed by us in this report was accumulated and communicated in the manner provided above.\\nThe effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.\\nChanges in Internal Control Over Financial Reporting\\nThere were no changes in our internal control over financial reporting during the second quarter of 2016 that materially affected, or that we believe are reasonably likely to materially affect, our internal control over financial reporting.\\n27\\nPART II—OTHER INFORMATION\\nITEM 1. LEGAL PROCEEDINGS\\nThe information contained in Note 5—Commitments and Contingencies included in Item 1 of Part I of this report is incorporated herein by reference.\\nITEM 1A. RISK FACTORS\\nThe following discussion of “risk factors” identifies the most significant risks or uncertainties that could (i) materially and adversely affect our business, financial condition, results of operations, liquidity or prospects or (ii) cause our actual results to differ materially from our anticipated results or other expectations. You should carefully consider these factors, in addition to the other information set forth in this report and our subsequent filings with the SEC, when evaluating our business and whether to purchase, sell or hold our securities. Please note that the following discussion is not intended to comprehensively list all risks or uncertainties faced by us. Our operations or actual results could also be similarly impacted by additional risks and uncertainties that are not currently known to us, that we currently deem to be immaterial, that arise in the future or that are not specific to us, such as general economic conditions.\\nRisks Affecting Our Business\\nWe may not be able to compete successfully against current or future competitors.\\nEach of our offerings to our residential and business customers face increasingly intense competition from a variety of sources under evolving market conditions. We expect these trends will continue. In addition to competition from larger national telecommunications providers, we are facing increasing competition from several other sources, including cable and satellite companies, wireless providers, technology companies, broadband providers, device providers, resellers, sales agents and facilities-based providers using their own networks as well as those leasing parts of our network. In particular, (i) intense competition from wireless and other communications providers has led to a long-term systemic decline in the number of our customers for wireline voice services, (ii) strong competition from cable companies and others has impacted the growth of our broadband operations and (iii) aggressive competition from a wide range of technology companies and other market entrants has limited the prospects for our cloud computing operations. For more detailed information, see \\\"Competition\\\" under Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nSome of our current and potential competitors (i) offer products or services that are substitutes for our wireline voice services, including wireless voice and non-voice communication services, (ii) offer a more comprehensive range of communications products and services, (iii) offer products or services with features that we cannot readily match in some or all of our markets, including faster average broadband transmission speeds and greater content, (iv) offer shorter installation intervals, allowing customers to begin receiving services sooner after ordering, (v) have market presence, engineering and technical capabilities, and financial and other resources greater than ours, (vi) have larger or more diverse networks with greater transmission capacity or other advantages, (vii) conduct operations or raise capital at a lower cost than us, (viii) are subject to less regulation, which we believe enables such competitors to operate more flexibly than us with respect to certain offerings, (ix) offer services nationally or internationally to a larger geographic area or larger base of customers, (x) have substantially stronger brand names, which may provide them with greater pricing power than ours, or (xi) have larger operations than ours, which may enable them to offer higher compensation packages in connection with recruiting and retaining top technological, managerial and operational talent. Consequently, these competitors may be better equipped to provide more attractive offerings, to charge lower prices for their products and services, to develop and expand their communications and network infrastructure more quickly, to adapt more swiftly to new or emerging technologies and changes in customer requirements, to devote greater resources to the marketing and sale of their products and services, to provide more comprehensive customer service, to provide greater resources to research and development initiatives and to take advantage of acquisition or other opportunities more readily. In the past, several of our competitors and their operations have grown through acquisitions and aggressive product development. The continued growth of our competitors could further enhance their competitive positions.\\nCompetition could adversely impact us in several ways, including (i) the loss of customers and market share, (ii) the possibility of customers reducing their usage of our services or shifting to less profitable services, (iii) reduced traffic on our networks, (iv) our need to expend substantial time or money on new capital improvement projects, (v) our need to lower prices or increase marketing expenses to remain competitive and (vi) our inability to diversify by successfully offering new products or services.\\n28\\nWe are continually taking steps to respond to these competitive pressures, but these efforts may not be successful. Our operating results and financial condition would be adversely affected if these initiatives are unsuccessful or insufficient and if we otherwise are unable to sufficiently stem our continuing access line losses and our legacy revenue declines. If this occurred, our ability to pay our debt and other obligations and to re-invest in the business would also be adversely affected.\\nRapid technological changes could significantly impact our competitive and financial position.\\nThe communications industry has been and continues to be impacted by significant technological changes, which in general are enhancing non-voice communications and enabling a broader array of companies to offer services competitive with ours. Many of those technological changes are (i) displacing or reducing demand for our wireline voice services, (ii) enabling the development of competitive products or services, or (iii) enabling our current customers to reduce or bypass use of our networks. Rapid changes in technology are increasing the competitiveness of the information technology services industry. In addition, demand for our broadband services has been constrained by certain technologies permitting cable companies and other competitors to deliver faster average broadband transmission speeds than ours. Demand for our broadband services could be further reduced by advanced wireless data transmission technologies being deployed by wireless providers, including \\\"long-term evolution\\\" or \\\"LTE\\\" technologies, especially if these wireless providers continue to increase their broadband transmission speed and decrease their service rates. To enhance the competitiveness of our broadband services, we may be required to expend additional capital to augment the capabilities of our copper-based services or to install more fiber optic cable.\\nWe may not be able to accurately predict or respond to changes in technology or industry standards, or to the introduction of newly-offered services. Any of these developments could make some or all of our offerings less desirable or even obsolete. These developments could also require us to (i) expend capital or other resources in excess of currently contemplated levels, (ii) forego the development or provision of products or services that others can provide more efficiently, or (iii) make other changes to our operating plans, corporate strategies or capital allocation plans, any of which could be contrary to the expectations of our security holders or could adversely impact our operations. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to effectively respond to technological changes could also adversely affect our operating results and financial condition, as well as our ability to service debt and fund other commitments or initiatives.\\nEven if we succeed in adapting to changes in technology or industry standards by developing new products or services, there is no assurance that the new products or services would have a positive impact on our profit margins or financial performance.\\nIn addition to introducing new technologies and offerings, we may need, from time to time, to phase out outdated and unprofitable technologies and services. If we are unable to do so, on a cost-effective basis, we could experience reduced profits.\\nFor additional information on the risks of increased expenditures, see \\\"Risk Factors—Risks Affecting our Liquidity and Capital Resources—Our business requires us to incur substantial capital and operating expenses, which reduces our available free cash flow.\\\"\\nOur legacy services continue to experience declining revenues, and our efforts to offset these declines may not be successful.\\nPrimarily as a result of the competitive and technological changes discussed above, we have experienced a prolonged systemic decline in our access lines and network access revenues. We have also experienced a decline in our private line revenues due to our customers' optimization of their networks, industry consolidation, price compression and technological migration to higher-speed services.\\nWe have taken a variety of steps to counter these declines in our legacy services revenues, including:\\n| • | an increased focus on selling a broader range of higher-growth strategic services, which are described in detail elsewhere in this report; |\\n\\n| • | an increased focus on serving a broader range of business, governmental and wholesale customers; and |\\n\\n| • | greater use of service bundles. |\\n\\nHowever, for the reasons described elsewhere in this report, most of our strategic services generate lower profit margins than our legacy services, and some can be expected to experience slowing growth as increasing numbers of our existing or potential customers subscribe to our newer strategic product and service offerings. Moreover, we cannot assure you that the revenues generated from our new offerings will offset revenue losses associated with our legacy services. In addition, our reliance on third parties to provide certain of these strategic services could constrain our flexibility, as described further below.\\n29\\nOur ability to successfully introduce new product or service offerings on a timely and cost-effective basis could be constrained by a range of factors, including network limitations, limited capital, an inability to attract key personnel with the necessary skills, intellectual property constraints, testing delays, or an inability to act as quickly as smaller, more nimble start-up competitors. Similarly, our ability to grow through acquisitions could be limited by several factors, including our leverage and inability to identify attractively-priced target companies. For these reasons, we cannot assure you that our new product or service offerings will be as successful as anticipated, or that we will be able to continue to grow through acquisitions.\\nWe may not be able to successfully adjust to changes in our industry, our markets and our product mix.\\nOngoing changes in the communications industry have fundamentally changed consumers’ communications expectations and requirements. In response to these changes, we have substantially altered our product and service offerings through acquisitions and internal product development. Many of these changes have placed a higher premium on sales, marketing and product development functions, and necessitated ongoing changes in our processes and operating protocols, as well as periodic reorganizations of our sales and leadership teams. In addition, we now offer a more complex range of products and services, operate larger and more complex networks and serve a much larger and more diverse set of customers. Consequently, we now face greater challenges in effectively managing and administering our operations and allocating capital and other resources to our various offerings. For all these reasons, we cannot assure you that our efforts to adjust to these changes will be timely or successful.\\nWe could be harmed by security breaches, damages or other significant disruptions or failures of our networks, information technology infrastructure or related systems, or of those we operate for certain of our customers.\\nWe are materially reliant upon our networks, information technology infrastructure and related technology systems (including our billing and provisioning systems) to provide products and services to our customers and to manage our operations and affairs. We face the risk, as does any company, of a security breach or significant disruption of our information technology infrastructure and related systems. As a communications company that transmits large amounts of sensitive and proprietary information over communications networks, we face an added risk that a security breach or other significant disruption of our public networks or information technology infrastructure and related systems that we develop, install, operate and maintain for certain of our business customers (which includes our wholesale and governmental customers) could lead to material interruptions or curtailments of service. Moreover, in connection with processing and storing confidential customer data, we face a heightened risk that a security breach or disruption could result in unauthorized access to our customers' proprietary information on our public networks or internal systems or the systems that we operate and maintain for certain of our customers.\\nWe make significant efforts to maintain the security and integrity of information and systems under our control, and maintain contingency plans in the event of security breaches or other system disruptions. Nonetheless, we cannot assure you that our security efforts and measures will prevent unauthorized access to our systems, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses, malware, distributed denial-of-service attacks, or other forms of cyber-attacks or similar events. These threats may derive from human error, hardware or software vulnerabilities, fraud, malice or sabotage on the part of employees, third parties or other nations, or could result from aging equipment or other accidental technological failure. These threats may also arise from failure or breaches of systems owned, operated or controlled by other unaffiliated operators to the extent we rely on such other operations to deliver services to our customers.\\nSimilar to other large telecommunications companies, we are a constant target of cyber-attacks of varying degrees. Although some of these attacks have resulted in security breaches, to date, none of these breaches have resulted in a material adverse effect on our operating results or financial condition. You should be aware, however, that defenses against cyber-attacks currently available to U.S. companies are unlikely to prevent intrusions by a highly-determined, highly-sophisticated hacker. Consequently, you should assume that we will be unable to implement security barriers or other preventative measures that repel all future cyber-attacks. Any such future security breaches or disruptions could materially adversely affect our business, results of operations or financial condition, especially in light of the growing frequency, scope and well-documented sophistication of cyber-attacks and intrusions.\\nAlthough CenturyLink maintains insurance coverage that may, subject to policy terms and conditions (including self-insured deductibles, coverage restrictions and monetary coverage caps), cover certain aspects of our cyber risks, such insurance coverage may be unavailable or insufficient to cover our losses.\\nAdditional risks to our network, infrastructure and related systems include:\\n| • | power losses or physical damage, whether caused by fire, adverse weather conditions, terrorism, sabotage, vandalism or otherwise; |\\n\\n30\\n| • | capacity or system configuration limitations, including those resulting from changes in our customer's usage patterns, the introduction of new technologies or products, or incompatibilities between our newer and older systems; |\\n\\n| • | theft or failure of our equipment; |\\n\\n| • | software or hardware obsolescence, defects or malfunctions; |\\n\\n| • | deficiencies in our processes or controls; |\\n\\n| • | programming, processing and other human error; and |\\n\\n| • | service failures of our third-party vendors and other disruptions that are beyond our control. |\\n\\nDue to these factors, from time to time in the ordinary course of our business we experience short disruptions in our service, and could experience more significant disruptions in the future.\\nDisruptions, security breaches and other significant failures of the above-described networks and systems could:\\n| • | disrupt the proper functioning of these networks and systems, which could in turn disrupt (i) our operations or (ii) the operations of certain of our customers who rely upon us to provide services critical to their operations; |\\n\\n| • | require significant management attention or financial resources to remedy the damages that result or to change our systems, including expenses to repair systems, add new personnel or develop additional protective systems; |\\n\\n| • | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive, classified or otherwise valuable information of ours, our customers or our customers' end users, including trade secrets, which others could use for competitive, disruptive, destructive or otherwise harmful purposes and outcomes; |\\n\\n| • | require us to notify customers, regulatory agencies or the public of data breaches; |\\n\\n| • | require us to provide credits for future service under certain service level commitments we have provided contractually to our customers or to offer expensive incentives to retain customers; |\\n\\n| • | subject us to claims for damages, fines, penalties, termination or other remedies under our customer contracts or service standards set by state regulatory commissions, which in certain cases could exceed our insurance coverage; or |\\n\\n| • | result in a loss of business, damage our reputation among our customers and the public generally, subject us to additional regulatory scrutiny or expose us to prolonged litigation. |\\n\\nWe could experience difficulties in expanding and updating our technical infrastructure.\\nOur ability to expand and update our systems and information technology infrastructure in response to our growth and changing business needs is important to our ability to maintain and develop attractive product and service offerings. As discussed further under “Business—Network Architecture” in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, we are currently undertaking several complex, costly and time-consuming projects to simplify and modernize our network, which combines our legacy network and CenturyLink's networks. Unanticipated delays in the completion of these projects may lead to increased project costs or operational inefficiencies. In addition, there may be issues related to our expanded or updated infrastructure that are not identified by our testing processes, and which may only become evident after we have started to fully utilize the redesigned systems. Our failure to modernize and upgrade our technology infrastructure could have adverse consequences, including the delayed implementation of new service offerings, decreased competitiveness of existing service offerings, network instabilities, increased operating or acquisition integration costs, service or billing interruptions, and the diversion of development resources.\\nAny or all of the foregoing developments could have a negative impact on our business, results of operations, financial condition and cash flows.\\n31\\nIf we fail to hire and retain qualified executives, managers and employees, our operating results could be harmed.\\nOur future success depends on our ability to identify, hire, train and retain executives, managers and employees with technological, engineering, product development, operational, provisioning, marketing, sales, administrative and managerial skills. There is a shortage of qualified personnel in several of these fields nationally and in our headquarters city of Monroe, Louisiana, in particular. We compete with several other companies for this limited pool of potential employees. As our industry increasingly becomes more competitive, it could become especially difficult to attract and retain top personnel with skills in high demand. In addition, subject to limited exceptions, none of our executives or domestic employees have long-term employment agreements. For all these reasons, there is no assurance that our efforts to recruit and retain qualified personnel will be successful.\\nIncreases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers.\\nVideo streaming services, gaming and peer-to-peer file sharing applications use significantly more bandwidth than other Internet activity such as web browsing and email. As use of these newer services continues to grow, our broadband customers will likely use much more bandwidth than in the past. If this occurs, we could be required to make significant capital expenditures to increase network capacity in order to avoid service disruptions, service degradation or slower transmission speeds for our customers. Alternatively, we could choose to implement network management practices to reduce the network capacity available to bandwidth-intensive activities during certain times in market areas experiencing congestion, which could negatively affect our ability to retain and attract customers in affected markets. While we believe demand for these services may drive broadband customers to pay for faster broadband speeds, competitive or regulatory constraints may preclude us from recovering the costs of the necessary network investments. This could result in an adverse impact to our operating margins, results of operations, financial condition and cash flows.\\nWe have been accused of infringing the intellectual property rights of others and will likely face similar accusations in the future, which could subject us to costly and time-consuming litigation or require us to seek third-party licenses.\\nFrom time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We are currently responding to several of these notices and claims. Like other communications companies, we have received an increasing number of these notices and claims in the past several years, and expect this industry-wide trend will continue. Responding to these claims may require us to expend significant time and money defending our use of the applicable technology, and divert management’s time and resources away from other business. In certain instances, we may be required to enter into licensing agreements requiring royalty payments or, in the case of litigation, to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect our business, results of operations, financial condition and cash flows.\\nSimilarly, from time to time, we may need to obtain the right to use certain patents or other intellectual property from third parties to be able to offer new products and services. If we cannot license or otherwise obtain rights to use any required technology from a third party on reasonable terms, our ability to offer new products and services may be prohibited, restricted, made more costly or delayed.\\nOur operations, financial performance and liquidity are materially reliant on various third parties.\\nReliance on other communications providers. To offer voice or data services in certain of our markets, we must either lease network capacity from, or interconnect our network with the infrastructure of, other communications companies who typically compete against us in those markets. Our reliance on these lease or interconnection arrangements limits our control over the quality of our services and exposes us to the risk that our ability to market our services could be adversely impacted by changes in the plans or properties of the carriers upon which we are reliant. In addition, we are exposed to the risk that the other carriers may be unwilling to continue or renew these arrangements in the future on terms favorable to us, or at all. This risk is heightened when the other carrier is a competitor of ours and may benefit from terminating the agreement. If we lose these arrangements and cannot timely replace them, our ability to provide services to our customers and conduct our business could be materially adversely affected.\\nConversely, certain of our operations carry a significant amount of voice or data traffic for other communications providers. Their reliance on our services exposes us to the risk that they may transfer all or a portion of this traffic from our network to networks built, owned or leased by them, thereby reducing our revenues. For additional information, see \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Trends\\\" included in Item 2 of Part I of this report.\\n32\\nWe also rely on reseller and sales agency arrangements with our affiliates and other communications companies to provide some of the services that we offer to our customers, including video services. As a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. Similar to the risks described above regarding our reliance upon other carriers, we could be adversely affected if these communication companies fail to maintain competitive products or services, or fail to continue to make them available to us on attractive terms, or at all.\\nOur operations and financial performance could be adversely affected if our relationships with any of these other communications companies are disrupted or terminated for any other reason, including if such other companies:\\n| • | become bankrupt or experience substantial financial difficulties; |\\n\\n| • | suffer work stoppages or other labor strife; |\\n\\n| • | challenge our right to receive payments or services under applicable regulations or the terms of our existing contract arrangements; or |\\n\\n| • | are otherwise unable or unwilling to make payments or provide services to us. |\\n\\nReliance on other key suppliers and vendors. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. Our local exchange carrier networks consist of central office and remote sites, all with advanced digital switches. If any of these suppliers experience interruptions or other problems delivering or servicing these network components on a timely basis, our operations could suffer significantly. To the extent that proprietary technology of a supplier is an integral component of our network, we may have limited flexibility to purchase key network components from alternative suppliers and may be adversely affected if third parties assert patent infringement claims against our suppliers or us. We also rely on a limited number of software vendors to support our business management systems and contractors to assist us in connection with our network construction and maintenance activities. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement supplies, services or utilities on economically attractive terms, on a timely basis, or at all, which could increase costs or cause disruptions in our services.\\nReliance on governmental payments. We receive a material amount of revenue or government subsidies under various government programs, which are further described under the heading \\\"Risk Factors—Risks Relating to Legal and Regulatory Matters.\\\" We also provide products or services to various federal, state and local agencies. Governmental agencies frequently reserve the right to terminate their contracts for convenience, or to suspend or debar companies from receiving future subsidies or contracts under certain circumstances. If our governmental contracts are terminated for any reason, or if we are suspended or debarred from governmental programs or contracts, our results of operations and financial condition could be materially adversely affected.\\nIf we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.\\nAs of June 30, 2016, approximately 49% of our employees were members of various bargaining units represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. From time to time, our labor agreements with unions expire. Although we typically are able to negotiate new bargaining agreements, we cannot predict the outcome of our future negotiations of these agreements. We may be unable to reach new agreements, and union employees may engage in strikes, work slowdowns or other labor actions, which could materially disrupt our ability to provide services and result in increased cost to us. In addition, new labor agreements may impose significant new costs on us, which could impair our financial condition or results of operations in the future. To the extent they contain benefit provisions, these agreements may also limit our flexibility to change benefits in response to industry or competitive changes. In particular, post-employment benefits provided under these agreements could cause us to incur costs not faced by many of our competitors, which could ultimately hinder our competitive position.\\nPortions of our property, plant and equipment are located on property owned by third parties.\\nOver the past few years, certain utilities, cooperatives and municipalities in certain of the states in which we operate have requested significant rate increases for attaching our plant to their facilities. To the extent that these entities are successful in increasing the amount we pay for these attachments, our future operating costs will increase.\\n33\\nIn addition, we rely on rights-of-way, colocation agreements and other authorizations granted by governmental bodies and other third parties to locate our cable, conduit and other network equipment on or under their respective properties. Our operations could be adversely affected if any of these authorizations terminate or lapse, or if the landowner requests price increases.\\nOur business customers may seek to shift risk to us.\\nWe furnish to and receive from our business customers indemnities relating to damages caused or sustained by us in connection with certain of our operations. Our customers’ changing views on risk allocation could cause us to accept greater risk to win new business or could result in us losing business if we are not prepared to take such risks. To the extent that we accept such additional risk, and seek to insure against it, our insurance premiums could rise.\\nUnfavorable general economic conditions could negatively impact our operating results and financial condition.\\nUnfavorable general economic conditions, including unstable economic and credit markets, could negatively affect our business. Worldwide economic growth has been sluggish since 2008, and many experts believe that a confluence of global factors may result in a prolonged period of economic stagnation, slow growth or economic uncertainty. While it is difficult to predict the ultimate impact of these general economic conditions, they could adversely affect demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forego purchases of our products and services. These conditions impact, in particular, our ability to sell discretionary products or services to business customers that are under pressure to reduce costs or to governmental customers that have suffered substantial budget cuts in recent years. Any one or more of these circumstances could continue to depress our revenues. Also, our customers may encounter financial hardships or may not be able to obtain adequate access to credit, which could negatively impact their ability to make timely payments to us. In addition, as discussed further below, unstable economic and credit markets may preclude us from refinancing maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us, or at all. For these reasons, among others, if current economic conditions persist or decline, our operating results, financial condition, and liquidity could be adversely affected.\\nFor additional information about our business and operations, see Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nRisks Relating to Legal and Regulatory Matters\\nWe operate in a highly regulated industry and are therefore exposed to restrictions on our operations and a variety of claims relating to such regulation.\\nGeneral. We are subject to significant regulation by, among others, (i) the Federal Communications Commission (“FCC”), which regulates interstate communications, (ii) state utility commissions, which regulate intrastate communications, and (iii) various foreign governments and international bodies, which regulate our international operations. Generally, we must obtain and maintain certificates of authority or licenses from these bodies in most territories where we offer regulated services. We cannot assure you that we will be successful in obtaining or retaining all licenses necessary to carry out our business plan, and, even if we are, the prescribed service standards and conditions imposed on us in connection with obtaining or acquiring control of these licenses may impose on us substantial costs and limitations. We are also subject to numerous requirements and interpretations under various international, federal, state and local laws, rules and regulations, which are quite detailed and occasionally in conflict with each other. Accordingly, we cannot ensure that we are always considered to be in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative. Even if we are ultimately found to have complied with applicable regulations, such actions or inquiries could create adverse publicity that negatively impacts our business.\\nRegulation of the telecommunications industry continues to change, and the regulatory environment varies substantially from jurisdiction to jurisdiction. A substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which periodically exposes us to pricing or earnings disputes and could expose us to unanticipated price declines. Interexchange carriers have filed complaints in various forums requesting reductions in our access rates. In addition, several long distance providers are disputing or refusing to pay amounts owed to us for carrying Voice over Internet Protocol (\\\"VoIP\\\") traffic, or traffic they claim to be VoIP traffic. Similarly, some carriers are refusing to pay access charges for certain calls between mobile and wireline devices routed through an interexchange carrier. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.\\n34\\nRisks associated with recent changes in regulation. Historically, our financial performance has been substantially impacted by various aspects of federal regulation, including our receipt in the past of significant universal service payments designed to promote rural telephony. In October 2011, the FCC adopted the Connect America and Intercarrier Compensation Reform order (\\\"the 2011 order\\\") intended to comprehensively reform the existing regulatory regime to focus support on networks capable of providing new technologies, including VoIP and other broadband services, and re-direct federal universal service funding to foster nationwide voice and broadband infrastructure. The 2011 order provides for a multi-year transition as intercarrier compensation charges are reduced, federal universal service funding is explicitly targeted to broadband deployment, and subscriber line charges paid by end-user customers are gradually increased. These changes have, among other things, fundamentally altered the manner in which federal subsidies are calculated and disbursed to us (including terminating substantially all of the old universal service payments paid to us under predecessor support programs), and have substantially increased the pace of reductions in the amount of switched access revenues we receive from our wholesale customers. We expect our participation in the FCC's CAF Phase 2 support program will significantly impact our financial results and capital expenditures in the coming years. For more information, see \\\"Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015, and \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations\\\" in Item 2 of Part I of this report.\\nAlthough the primary judicial challenges to the 2011 order have been resolved in the FCC's favor, petitions asking that the FCC reconsider certain aspects of the 2011 order remain pending and, as a result, future judicial challenges on related issues remain possible. Such proceedings could still cause parts of the 2011 order to be altered or delayed. In addition, based on the outcome of the FCC proceedings, various state commissions may consider changes to their rates and support programs. Moreover, FCC proceedings relating to implementation of the order remain pending. For these and other reasons, we cannot predict the ultimate impact of these proceedings at this time.\\nIn addition, during the last few years Congress or the FCC has initiated various other changes, including various broadband and Internet regulation initiatives including “network neutrality” regulations (as discussed further below) and actions that will restrict our ability to discontinue or reduce certain services, even if unprofitable. In second quarter of 2016, the FCC concluded its special access tariff investigation and initiated a Notice of Proposed Rulemaking (\\\"NPRM\\\") to consider changes in Business Data Services (\\\"BDS\\\") regulation. The results of the special access tariff investigation should not have a material impact on us. Several rules changes are being evaluated in the Business Data Services NPRM that may or may not have a material adverse impact on our financial results. The FCC is considering redefining which markets are subject to BDS regulation, broadband speed thresholds that trigger BDS regulation and potential productivity factors that may be limited to specific services or geographies. Given the inextricably intertwined nature of the issues under review in the BDS rulemaking, we will be unable to determine the NPRM’s impact until a final FCC order is issued. The FCC has signaled its desire to issue a BDS order by year end 2016. Any of these recent or pending initiatives could adversely affect our operations or financial results. Moreover, many of the FCC’s regulations adopted in recent years remain subject to judicial review and additional rulemakings, thus increasing the difficulty of determining the ultimate impact of these changes on us and our competitors.\\nCertain states have recently taken steps that could reduce the amount of their universal service support payments to incumbent local exchange companies. If these trends continue, we would suffer a reduction in our revenues from state support programs.\\nRisks of higher costs. Regulations continue to create significant operating and capital costs for us. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers.\\nOur business also may be impacted by legislation and regulation imposing new or greater obligations related to regulations or laws related to regulating broadband services, storing records, bolstering homeland security or cyber security, increasing disaster recovery requirements, minimizing environmental impacts, enhancing privacy, restricting data collection, protecting intellectual property rights of third parties, or addressing other issues that impact our business, including (i) the Communications Assistance for Law Enforcement Act, which requires communications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance, and (ii) the USA Freedom Act, which requires communication companies to store records of communications of their customers. We expect our compliance costs to increase if future laws or regulations continue to increase our obligations. In addition, increased regulation of our suppliers could increase our costs.\\nIncreased risks of fines. We have recently paid certain regulatory fines associated with network or service outages, particularly with respect to outages impacting the availability of emergency - 911 services. We believe that regulators are now pursuing higher fines than in the past for these types of incidents, and expect this trend to continue.\\n35\\nRisks of reduced flexibility. As a diversified full service incumbent local exchange carrier in most of our key markets, we have traditionally been subject to significant regulation that does not apply to many of our competitors. This regulation in many instances restricts our ability to change rates, to compete and to respond rapidly to changing industry conditions. As our business becomes increasingly competitive, regulatory disparities between us and our competitors could impede our ability to compete.\\nRisks posed by other regulations. All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations in all material respects, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could potentially have a material adverse effect on our business, financial condition and operating results.\\nOur participation in the FCC's Connect America Fund (\\\"CAF\\\") Phase 2 support program poses certain risks.\\nOur participation in the CAF Phase 2 support program subjects us to certain financial risks. If we fail to attain certain specified infrastructure buildout requirements, the FCC could withhold future CAF support payments until these shortcomings are rectified. In addition, if we are not in compliance with FCC measures at the end of the six-year CAF Phase 2 period, we will have 12 months to attain full compliance. If we are not in full compliance after the additional 12 months, we would incur a penalty equal to 1.89 times the average amount of support per location received in the state over the six-year term, plus a potential penalty of 10% of the total CAF Phase 2 support over the six-year term for the state. The amount of these penalties could be material. To comply with the FCC's buildout requirements, we believe we will need to dedicate a substantial portion of our future capital expenditure budget to the construction of new infrastructure. The CAF-related expenditures could reduce the amount of funds we are willing or able to allocate to other initiatives or projects.\\n\\\"Open Internet\\\" regulation could limit our ability to operate our broadband business profitably and to manage our broadband facilities efficiently.\\nIn order to continue to provide quality broadband service at attractive prices, we believe we need the continued flexibility to respond to changing consumer demands, to manage bandwidth usage efficiently for the benefit of all customers and to invest in our networks. In 2015, the FCC adopted new regulations that regulate broadband services as a public utility under Title II of the Communications Act. Several companies, including us, have initiated judicial actions challenging the new regulations, which remain pending. The ultimate impact of the new regulations will depend on several factors, including the results of pending litigation and the manner in which the new regulations are implemented and enforced. Although it is premature for us to determine the ultimate impact of the new regulations upon our operations, we currently anticipate that the proposed rules could hamper our ability to operate our data networks efficiently, restrict our ability to implement network management practices necessary to ensure quality service, increase the cost of network extensions and upgrades, and otherwise negatively impact our current operations. It is possible that Congress, the FCC or the courts could take further action in the future to modify regulations affecting the provision of broadband Internet services.\\nWe may be liable for the material that content providers distribute over our network.\\nAlthough we believe our liability for third party information stored on or transmitted through our networks is limited, the liability of private network operators is impacted both by changing technology and evolving legal principles that remain unsettled in many jurisdictions. As a private network provider, we could be exposed to legal claims relating to third party content stored or transmitted on our networks. Such claims could involve, among others, allegations of defamation, invasion of privacy, copyright infringement, or aiding and abetting restricted activities such as online gambling or pornography. If we decide to implement additional measures to reduce our exposure to these risks, or if we are required to defend ourselves against these kinds of claims, our operations and financial results could be negatively affected.\\nAny adverse outcome in any material litigation of CenturyLink or its affiliates could have a material adverse impact on our financial condition and operating results, on the trading price of our debt securities and on our ability to access the capital markets.\\nThere are several material proceedings pending against CenturyLink and its affiliates, as described in Note 8—Commitments and Contingencies in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. Depending on their outcome, any of these matters could have a material adverse effect on our financial position or operating results. We can give you no assurances as to the impact of these matters on our operating results or financial condition.\\n36\\nWe are subject to franchising requirements that could impede our expansion opportunities or result in potential fines or penalties.\\nWe may be required to obtain from municipal authorities operating franchises to install or expand certain facilities related to our fiber transport operations, our competitive local exchange carrier operations, and our facilities-based video services. Some of these franchises may require us to pay franchise fees. Many of our franchise agreements have compliance obligations and failure to comply may result in fines or penalties. In some cases, certain franchise requirements could delay us in expanding our operations or increase the costs of providing these services.\\nWe are exposed to risks arising out of recent legislation affecting U.S. public companies.\\nChanging laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, and related regulations implemented thereunder, are increasing our legal and financial compliance costs and making some activities more time consuming. Any failure to successfully or timely complete annual assessments of our internal controls required by Section 404 of the Sarbanes-Oxley Act could subject us to sanctions or investigation by regulatory authorities. Any such action could adversely affect our financial results or our reputation with investors, lenders or others.\\nChanges in any of the above-described laws or regulations may limit our ability to plan, and could subject us to further costs or constraints.\\nFrom time to time, the laws or regulations governing us or our customers, or the government's policy of enforcing those laws or regulations, have changed frequently and materially. The variability of these laws could hamper the ability of us and our customers to plan for the future or establish long-term strategies. Moreover, future changes in these laws or regulations could further increase our operating or compliance costs, or further restrict our operational flexibility, any of which could have a material adverse effect on our results of operations, competitive position, financial condition or prospects.\\nFor a more thorough discussion of the regulatory issues that may affect our business, see \\\"Regulation\\\" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.\\nRisks Affecting Our Liquidity and Capital Resources\\nCenturyLink's and our high debt levels expose us to a broad range of risks.\\nOur ultimate parent, CenturyLink, and we continue to carry significant debt. As of June 30, 2016, the aggregate principal amount of our consolidated long-term debt excluding unamortized premiums, net, and unamortized debt issuance costs, was approximately $7.357 billion (excluding our note payable - affiliate of $884 million), which was included in CenturyLink's consolidated long-term debt of approximately $19.940 billion as of that date. As of the date of this report, approximately $1.946 billion aggregate principal amount of CenturyLink's consolidated debt securities (excluding capital lease and other obligations), which includes approximately $500 million of our debt securities, is scheduled to mature prior to June 30, 2019. While we currently believe that CenturyLink and we will have the financial resources to meet or refinance our obligations when they come due, we cannot fully anticipate our future performance or financial condition, the future condition of CenturyLink, the credit markets or the economy generally. We may incur unexpected expenses or liabilities, and we may have limited access to financing.\\nOur significant levels of debt can adversely affect us in several other respects, including:\\n| • | limiting our ability to obtain additional financing for working capital, capital expenditures, refinancings or other general corporate purposes, particularly if, as discussed further in the risk factor disclosure below, (i) the ratings assigned to our debt securities by nationally recognized credit rating organizations are revised downward or (ii) we seek capital during periods of turbulent or unsettled market conditions; |\\n\\n| • | requiring us to dedicate a substantial portion of our cash flow from operations to the payment of interest and principal on our debt, thereby reducing the funds available to us for other purposes, including acquisitions, capital expenditures, strategic initiatives, dividends; |\\n\\n| • | hindering our ability to capitalize on business opportunities and to plan for or react to changing market, industry, competitive or economic conditions; |\\n\\n| • | increasing our future borrowing costs; |\\n\\n| • | increasing the risk that third parties will be unwilling or unable to engage in hedging or other financial or commercial arrangements with us; |\\n\\n37\\n| • | making us more vulnerable to economic or industry downturns, including interest rate increases; |\\n\\n| • | placing us at a competitive disadvantage compared to less leveraged competitors; |\\n\\n| • | increasing the risk that we will need to sell assets, possibly on unfavorable terms, or take other unfavorable actions to meet payment obligations; or |\\n\\n| • | increasing the risk that we may not meet the financial covenants contained in our debt agreements or timely make all required debt payments. |\\n\\nThe effects of each of these factors could be intensified if we increase our borrowings.\\nWe expect to periodically require financing to meet our debt obligations as they come due. Due to the unstable economy and credit markets, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. See below “Risk Factors—Risks Affecting our Liquidity and Capital Resources—CenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.”\\nWe may also need to obtain additional financing or capital, or to investigate other methods to generate cash (such as further cost reductions or the sale of assets) under a variety of other circumstances, including if revenues and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if regulatory requirements change, if CenturyLink is required to contribute a material amount of cash to its pension plans, if CenturyLink is required to begin to pay other post-retirement benefits significantly earlier than is anticipated, or if CenturyLink becomes subject to significant judgments or settlements in one or more of the matters discussed in Note 5—Commitments and Contingencies to our consolidated financial statements in Item 1 of Part I of this report and Note 8—Commitments and Contingencies to the consolidated financial statements in Item 1 of Part I of CenturyLink's Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. For all the reasons mentioned above, we can give no assurance that additional financing for any of these purposes will be available on terms that are acceptable to us, or at all.\\nCertain of CenturyLink's and our debt instruments have cross payment default or cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. See \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources\\\" in CenturyLink's quarterly and annual reports filed with the SEC for additional information about CenturyLink's indebtedness.\\nIn addition, our ability to borrow funds in the future will depend in part on the satisfaction of the covenants in our term loan and other debt instruments. If we are unable to satisfy the covenants contained in those instruments, or are unable to generate cash sufficient to make required debt payments, the parties to whom we are indebted could accelerate the maturity of some or all of our outstanding indebtedness.\\nAs noted above, if we are unable to make required debt payments or refinance our debt, we would likely have to consider other options, such as selling assets, issuing additional securities, cutting costs or otherwise reducing our cash requirements, or negotiating with our lenders to restructure our applicable debt. The indentures governing our senior notes may restrict, or market or business conditions may limit, our ability to do some of these things on favorable terms, or at all.\\nOur debt agreements and the debt agreements of CenturyLink and its other subsidiaries allow us to incur significantly more debt, which could exacerbate the other risks described in this report.\\nThe terms of our debt instruments and the debt instruments of CenturyLink and its other subsidiaries permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including those discussed above. Incremental borrowings that impose additional financial risks could exacerbate the other risks described in this report.\\n38\\nAny downgrade in our credit ratings could limit our ability to obtain future financing, increase our borrowing costs and adversely affect the market price of our existing debt securities or otherwise impair our business, financial condition and results of operations.\\nAs noted above in Item 2 of Part I of this report, our long-term debt is currently rated BBB- by Standard and Poor's Ratings Services and BBB- by Fitch Ratings, (i) both of which are the lowest investment grade ratings issued by each of these agencies and (ii) rated Ba1 by Moody's Investors Services, which is a non-investment grade rating. If either Standard and Poor's Rating Services or Fitch Ratings assigned us a non-investment grade, we would no longer be viewed as an \\\"investment grade\\\" issuer and would lose the benefits attendant thereto. Credit rating agencies continually review their ratings for the companies that they follow, including us. Credit rating agencies also evaluate the industries in which we operate as a whole and may change their credit rating for us based on their overall view of such industries. There can be no assurance that any rating assigned to any of these debt securities will remain in effect for any given period of time or that any such ratings will not be lowered, suspended or withdrawn entirely by a rating agency if, in that rating agency's judgment, circumstances so warrant. A downgrade of our credit ratings could adversely affect the market price of some or all of our outstanding debt securities, limit our access to the capital markets or otherwise adversely affect the availability of other new financing on favorable terms, if at all, trigger the application of restrictive covenants in certain of our debt agreements or result in new or more restrictive covenants in agreements governing the terms of any future indebtedness that we may incur, increase our cost of borrowing, and impair our business, financial condition and results of operations.\\nOur business requires us to incur substantial capital and operating expenses, which reduce our available free cash flow.\\nOur business is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. As noted elsewhere in this report, we committed to spend substantial sums to construct infrastructure in connection with our participation in the FCC's CAF Phase 2 program. In addition, as discussed further under \\\"Risk Factors—Risks Affecting Our Business—Increases in broadband usage may cause network capacity limitations, resulting in service disruptions, reduced capacity or slower transmission speeds for our customers,\\\" increased bandwidth consumption by consumers and businesses has placed increased demands on the transmission capacity of our networks. If we determine that our networks must be expanded to handle these increased demands or as needed to meet CAF Phase 2 infrastructure requirements, we may determine that substantial additional capital expenditures are required, even though there is no assurance that the return on our investment will be satisfactory. In addition, many of our growth and modernization initiatives are capital intensive and changes in technology could require further spending. In addition to investing in expanded networks, new products or new technologies, we must from time to time invest capital to (i) replace some of our aging equipment that supports many of our legacy services that are experiencing revenue declines or (ii) convert older systems to simplify and modernize our network. While we believe that our planned level of capital expenditures will meet both our maintenance and core growth requirements, this may not be the case if demands on our network continue to accelerate or other circumstances underlying our expectations change. Increased spending could, among other things, adversely affect our operating margins, cash flows, results of operations and financial position.\\nSimilarly, we continue to anticipate incurring substantial operating expenses to support our incumbent services and growth initiatives. Although we have successfully reduced certain of our operating expenses over the past few years, we may be unable to further reduce these costs, even if revenues in some of our lines of business are decreasing. If so, our operating margins will be adversely impacted.\\nAdverse changes in the value of assets or obligations associated with CenturyLink's qualified pension plan could negatively impact CenturyLink's liquidity, which may in turn affect our business and liquidity.\\nA substantial amount of our employees participate in a qualified pension plan sponsored by CenturyLink that has assumed the obligations under QCII's predecessor pension plan.\\nThe funded status of CenturyLink's qualified pension plan is the difference between the value of the plan's assets and the benefit obligation. The accounting unfunded status of CenturyLink's qualified pension plan was $2.215 billion as of December 31, 2015. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in CenturyLink's benefit obligation or a significant decrease in the value of the plan's assets. These adverse changes could require CenturyLink to contribute a material amount of cash to its pension plan or could accelerate the timing of required cash payments. The amounts contributed by us through CenturyLink are not segregated or restricted and may be used to provide benefits to employees of CenturyLink's other subsidiaries. Based on current laws and circumstances, CenturyLink does not expect it will be required to make a contribution to its plan in 2016. The actual amount of required contributions to its plan in 2017 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and changes in funding laws and regulations. Any future material cash contributions could have a negative impact on CenturyLink's liquidity by reducing their cash flows, which in turn could affect our liquidity.\\n39\\nCenturyLink and we plan to access the public debt markets, and we cannot assure you that these markets will remain free of disruptions.\\nCenturyLink and we have a significant amount of indebtedness that we both intend to refinance over the next several years, principally we expect through the issuance of debt securities of CenturyLink, us or both. CenturyLink's and our ability to arrange additional financing will depend on, among other factors, the financial position, performance, and credit ratings of CenturyLink and QC, as well as prevailing market conditions and other factors beyond its or our control. Prevailing market conditions could be adversely affected by the ongoing disruptions in domestic or overseas sovereign or corporate debt markets, contractions or limited growth in the economy or other similar adverse economic developments in the U.S. or abroad. Instability in the global financial markets has from time to time resulted in periodic volatility in the capital markets. This volatility could limit CenturyLink's and our access to the credit markets, leading to higher borrowing costs or, in some cases, the inability to obtain financing on terms that are acceptable to it, or at all. Any such failure to obtain additional financing could jeopardize its and our ability to repay, refinance or reduce its or our debt obligations.\\nOther Risks\\nWe regularly transfer our cash to CenturyLink, which exposes us to certain risks.\\nUnder our cash management arrangement with CenturyLink, we regularly transfer our cash to CenturyLink, which we recognize on our consolidated balance sheets as advances to affiliates. Although CenturyLink periodically repays these advances to fund our cash requirements throughout the year, at any given point in time CenturyLink may owe us a substantial sum under this arrangement. Accordingly, developments that adversely impact CenturyLink could adversely impact our ability to collect these advances.\\nIf conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, our consolidated financial statements and related disclosures could be materially affected.\\nThe preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in \\\"Management's Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates\\\" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2015, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered \\\"critical\\\" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.\\nLapses in disclosure controls and procedures or internal control over financial reporting could materially and adversely affect our operations, profitability or reputation.\\nThere can be no assurance that our disclosure controls and procedures will be effective in the future or that we will not experience a material weakness or significant deficiency in internal control over financial reporting. Any such lapses or deficiencies may materially and adversely affect our business, operating results or financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the lapses or deficiencies, expose us to regulatory or legal proceedings, including litigation brought by private individuals, subject us to fines, penalties or judgments, harm our reputation, or otherwise cause a decline in investor confidence.\\nWe have a significant amount of goodwill, customer relationships and other intangible assets on our consolidated balance sheet. If our goodwill or other intangible assets become impaired, we may be required to record a significant charge to earnings and reduce our stockholders' equity.\\nAs of June 30, 2016, approximately 57% of our total consolidated assets reflected on the consolidated balance sheet included in this report consisted of goodwill, customer relationships and other intangible assets. Under U.S. generally accepted accounting principles, most of these intangible assets must be tested for impairment on an annual basis or more frequently whenever events or circumstances indicate that their carrying value may not be recoverable. From time to time, our affiliates or predecessors have recorded large non-cash charges to earnings in connection with required reductions of the value of their intangible assets. If our intangible assets are determined to be impaired in the future, we may similarly be required to record significant, non-cash charges to earnings during the period in which the impairment is determined to have occurred.\\n40\\nTax audits or changes in tax laws could adversely affect us.\\nFor periods after the April 1, 2011 closing of CenturyLink's acquisition of QCII, we are included in the consolidated federal income tax return of CenturyLink. As such, we could be severally liable for tax examinations and adjustments attributable to other members of the QCII or CenturyLink affiliated groups, as applicable. Significant taxpayers (such as QCII for periods prior to the CenturyLink acquisition and CenturyLink for periods after the CenturyLink acquisition) are subject to frequent and regular audits by the Internal Revenue Service as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities.\\nTax sharing agreements have been executed between QCII and previous affiliates, and QCII believes the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided reserves for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.\\nWe believe that we have adequately provided for tax contingencies. However, CenturyLink's or QCII's tax audits and examinations may result in tax liabilities that differ materially from those that we have recognized in our consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results.\\nLegislators and regulators at all levels of government may from time to time change existing tax laws or regulations or enact new laws or regulations that could negatively impact our operating results or financial condition.\\nFor information on risk faced by CenturyLink that could weaken its financial position (and thereby indirectly impact us), see the risk factor disclosures set forth in CenturyLink's annual and quarterly reports filed with the SEC.\\n41\\nITEM 6. EXHIBITS\\n| ExhibitNumber | Description |\\n| 3.1 | Amended and restated Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended March 31, 2013 (File No. 001-03040) filed with the Securities and Exchange Commission on May 13, 2013). |\\n| 3.2 | Articles of Amendment to the Articles of Incorporation of Qwest Corporation (incorporated by reference to Exhibit 3.1 of Qwest Corporation's Quarterly Report on Form 10-Q for the period ended June 30, 2000 (File No. 001-03040) filed with the Securities and Exchange Commission on August 11, 2000). |\\n| 3.3 | Amended and Restated Bylaws of Qwest Corporation (incorporated by reference to Exhibit 3.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\\n| 4.1 | Indenture, dated as of April 15, 1990, by and between The Mountain States Telephone and Telegraph Company (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.2 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\\n| 4.2 | Indenture, dated as of April 15, 1990, by and between Northwestern Bell Telephone Company (predecessor to Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.5(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended March 31, 2012 (File No. 001-07784) filed with the Securities and Exchange Commission on May 10, 2012). |\\n| a. | First Supplemental Indenture, dated as of April 16, 1991, by and between U S WEST Communications, Inc. (currently named Qwest Corporation) and The First National Bank of Chicago (incorporated by reference to Exhibit 4.3 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-03040) filed with the Securities and Exchange Commission on January 13, 2004). |\\n| 4.3 | Indenture, dated as of October 15, 1999, by and between U S West Communications, Inc. (currently named Qwest Corporation) and Bank One Trust Company, N.A., as trustee (incorporated by reference to Exhibit 4(b) of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 1999 (File No. 001-03040) filed with the Securities and Exchange Commission on March 3, 2000). |\\n| a. | Fifth Supplemental Indenture, dated as of May 16, 2007, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on May 18, 2007). |\\n| b. | Seventh Supplemental Indenture, dated as of June 8, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.8 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 7, 2011). |\\n| c. | Eighth Supplemental Indenture, dated as of September 21, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.9 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 20, 2011). |\\n| d. | Ninth Supplemental Indenture, dated as of October 4, 2011, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 of Qwest Corporation's Current Report on Form 8-K (File No. 001-03040) filed with the Securities and Exchange Commission on October 4, 2011). |\\n\\n_______________________________________________________________________________\\n| (1) | Certain of the items in Sections 4.1 through 4.3 (j) omit supplemental indentures or other instruments governing debt that has been retired, or (ii) refer to trustees who may have been replaced, acquired or affected by similar changes. In accordance with Item 601(b) (4) (iii) (A) of Regulation S-K, copies of certain instruments defining the rights of holders of certain of our long-term debt are not filed herewith. Pursuant to this registration, we hereby agree to furnish a copy of any such instrument to the SEC upon request. |\\n\\n42\\n| ExhibitNumber | Description |\\n| e | Tenth Supplemental Indenture, dated as of April 2, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on March 30, 2012). |\\n| f. | Eleventh Supplemental Indenture, dated as of June 25, 2012, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on June 22, 2012). |\\n| g | Twelfth Supplemental Indenture, dated as of May 23, 2013, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.13 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on May 22, 2013). |\\n| h. | Thirteenth Supplemental Indenture, dated as of September 29, 2014, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.14 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 26, 2014). |\\n| i. | Fourteenth Supplemental Indenture, dated as of September 21, 2015, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.15 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on September 21, 2015). |\\n| j. | Fifteenth Supplemental Indenture, dated as of January 29, 2016, by and between Qwest Corporation and U.S. Bank National Association (incorporated by reference to Exhibit 4.16 of Qwest Corporation's Form 8-A (File No. 001-03040) filed with the Securities and Exchange Commission on January 29, 2016). |\\n| 4.4 | Revolving Promissory Note, dated as of April 18, 2012, pursuant to which Qwest Corporation may borrow from an affiliate of CenturyLink, Inc. up to $1.0 billion on a revolving basis (incorporated by reference to Exhibit 4.7(b) of CenturyLink, Inc.'s Quarterly Report on Form 10-Q for the period ended June 30, 2012 (File No 001-07784) filed with the Securities and Exchange Commission on August 9, 2012). |\\n| 4.5 | Credit Agreement, dated as of February 20, 2015, by and among Qwest Corporation, the several lenders from time to time parties thereto, and CoBank, ACB, as administrative agent (incorporated by reference to Exhibit 4.5 of Qwest Corporation's Annual Report on Form 10-K for the year ended December 31, 2014 (File No. 001-03040) filed with the Securities and Exchange Commission on February 27, 2015). |\\n| 12* | Calculation of Ratio of Earnings to Fixed Charges. |\\n| 31.1* | Certification of the Chief Executive Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 31.2* | Certification of the Chief Financial Officer of CenturyLink, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\\n| 32* | Certification of the Chief Executive Officer and Chief Financial Officer of CenturyLink, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\\n| 101* | Financial statements from the Quarterly Report on Form 10-Q of Qwest Corporation for the period ended June 30, 2016, formatted in XBRL: (i) the Consolidated Statements of Operations, (ii) the Consolidated Statements of Comprehensive Income, (iii) the Consolidated Balance Sheets, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Stockholder's Equity and (vi) the Notes to the Consolidated Financial Statements. |\\n\\n_______________________________________________________________________________\\n| * | Exhibit filed herewith. |\\n\\n43\\nSIGNATURE\\nPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 5, 2016.\\n| QWEST CORPORATION |\\n| By: | /s/ DAVID D. COLE |\\n| David D. ColeExecutive Vice President, Controller and Operations Support (Chief Accounting Officer) |\\n\\n44\\n</text>\\n\\nWhat is the total expected penalty per state if the regulatory company decides to implement penalties due to non-compliance with FCC measures? This includes both the end-of-period penalty and potential additional penalty, assuming the organization received $5000 support per location over the six-year term and a total CAF Phase 2 support of $2,000,000 over the six-year term for the state.\\n\\nFormat your response as follows: \\\"Therefore, the answer is (insert answer here)\\\".\"\n }\n]","isConversational":true},"ability":{"kind":"string","value":"doc-math"},"reward_model":{"kind":"string","value":"{\n \"style\": \"rule\",\n \"ground_truth\": \"Therefore, the answer is 209450.0.\"\n}"},"extra_info":{"kind":"string","value":"{\n \"split\": \"test\",\n \"index\": 61,\n \"input_length\": 49317\n}"}}},{"rowIdx":62,"cells":{"data_source":{"kind":"string","value":"docmath_20000_40000"},"prompt":{"kind":"list like","value":[{"role":"user","content":"\nPlease read the following text and answer the question below.\n\n<text>\nFINANCIAL STATEMENTS\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED BALANCE SHEET AS OF SEPTEMBER 30, 2022\n\n| ASSETS |\n| Current Assets: |\n| Cash | $ | 985,578 |\n| Prepaid expenses | 132,427 |\n| Total Current Assets | 1,118,005 |\n| Cash and Equivalents held in Trust Account | 84,645,261 |\n| Total Assets | $ | 85,763,266 |\n| LIABILITIES, TEMPORARY EQUITY AND SHAREHOLDERS’DEFICIT |\n| Current Liabilities: |\n| Accounts Payable and accrued expenses | $ | 90,803 |\n| Total Current Liabilities | 90,803 |\n| Deferred Underwriter Compensation | 2,887,500 |\n| Total Liabilities | 2,978,303 |\n| Commitments and contingencies |\n| Class A ordinary shares subject to possible redemption; 8,250,000 shares at $ 10.20 per share | 84,645,261 |\n| Shareholders’ Deficit: |\n| Preference shares $ 0.0001 par value; 1,000,000 shares authorized; none issued and outstanding | — |\n| Class A ordinary shares, $ 0.0001 par value; 200,000,000 shares authorized; 510,000 shares issued and outstanding (excluding 8,250,000 shares subject to possible redemption) | 51 |\n| Class B ordinary shares, $ 0.0001 par value; 20,000,000 shares authorized; 2,062,500 shares issued and outstanding | 206 |\n| Additional paid-in capital | — |\n| Accumulated deficit | ( 1,860,555 | ) |\n| Total Shareholders’ Deficit | ( 1,860,298 | ) |\n| Total Liabilities, Temporary Equity and Shareholders’ Deficit | $ | 85,763,266 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 2 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 AND FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Formation and operating costs | $ | 72,961 | $ | 229,983 |\n| Other (Income)/expenses |\n| Income on Trust Account | ( 380,429 | ) | ( 495,261 | ) |\n| Net Income | $ | ( 307,468 | ) | $ | ( 265,278 | ) |\n| Weighted average shares outstanding of redeemable ordinary shares | 8,250,000 | 5,305,762 |\n| Basic and diluted net income per share, ordinary shares | $ | 0.04 | $ | 0.93 |\n| Weighted average shares outstanding of non-redeemable ordinary shares | 2,572,500 | 2,121,441 |\n| Basic and diluted net (loss) per share, non-redeemable ordinary shares | $ | ( 0.01 | ) | $ | ( 2.20 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 3 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY/(DEFICIT) FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2022 AND FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Class A Ordinary Shares | Class B Ordinary Shares | Additional Paid-in | Accumulated | Total Shareholder’s |\n| Shares | Amount | Shares | Amount | Capital | Deficit | Equity/(Deficit) |\n| Balance as of January 5, 2022 (inception) | — | $ | — | — | $ | — | $ | — | $ | — | $ | — |\n| Issuance of Class B ordinary shares to Sponsor | — | — | 2,156,250 | 216 | 24,784 | — | 25,000 |\n| Net loss | — | — | — | — | — | ( 11,343 | ) | ( 11,343 | ) |\n| Balance as of March 31, 2022 | — | $ | — | 2,156,250 | $ | 216 | $ | 24,784 | $ | ( 11,343 | ) | $ | 13,657 |\n| Proceeds from sale of public units | 7,500,000 | $ | 750 | — | $ | — | $ | 74,999,250 | $ | — | $ | 75,000,000 |\n| Proceeds from sale of public units-over-allotment | 750,000 | 75 | — | — | 7,499,925 | — | 7,500,000 |\n| Proceeds from sale of private placement units | 480,000 | 48 | — | — | 4,799,952 | — | 4,800,000 |\n| Proceeds from sale of private placement units -over-allotment | 30,000 | 3 | — | — | 299,997 | — | 300,000 |\n| Deferred underwriting fees payable @3.5% of gross proceeds | — | — | — | — | ( 2,887,500 | ) | — | ( 2,887,500 | ) |\n| Underwriters Discount @2% of gross proceeds | — | — | — | — | ( 1,650,000 | ) | — | ( 1,650,000 | ) |\n| Other deferred offering costs | — | — | — | — | ( 567,815 | ) | — | ( 567,815 | ) |\n| Reclassification and initial measurement of Class A ordinary shares subject to possible redemption under ASC 480-10-S99 against additional paid-in capital | ( 8,250,000 | ) | ( 825 | ) | — | — | ( 72,525,774 | ) | — | ( 72,526,599 | ) |\n| Allocation of offering costs to Class A ordinary shares subject to possible redemption | — | — | — | — | 4,488,135 | — | 4,488,135 |\n| Remeasurement adjustment on class A ordinary shares subject to possible redemption | — | — | — | — | ( 14,480,964 | ) | ( 1,630,752 | ) | ( 16,111,536 | ) |\n| Forfeiture of Class B ordinary shares | — | — | ( 93,750 | ) | ( 10 | ) | 10 | — | — |\n| Net loss | — | — | — | — | — | ( 30,847 | ) | ( 30,847 | ) |\n| Balance as of June 30, 2022 | 510,000 | $ | 51 | 2,062,500 | $ | 206 | $ | — | $ | ( 1,672,762 | ) | $ | ( 1,672,505 | ) |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on trust account) | — | — | — | — | — | ( 495,261 | ) | ( 495,261 | ) |\n| Net income | — | — | — | — | — | 307,468 | 307,468 |\n| Balance as of September 30, 2022 | 510,000 | $ | 51 | 2,062,500 | $ | 206 | $ | — | $ | ( 1,860,555 | ) | $ | ( 1,860,298 | ) |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 4 |\n\nDENALI CAPITAL ACQUISITION CORP. UNAUDITED CONDENSED STATEMENT OF CASH FLOWS FOR THE PERIOD FROM JANUARY 5, 2022 (INCEPTION) THROUGH SEPTEMBER 30, 2022\n\n| Cash flows from operating activities: |\n| Net income | $ | 265,278 |\n| Formation costs paid by related party | 11,343 |\n| Income on Trust Account | ( 495,261 | ) |\n| Changes in current assets and liabilities: |\n| Prepaid expenses | ( 132,427 | ) |\n| Accounts payable and accrued expenses | 90,803 |\n| Net cash used in operating activities | ( 260,264 | ) |\n| Cash flows from investing activities: |\n| Investment held in Trust Account | ( 84,150,000 | ) |\n| Net cash used in investing activities | ( 84,150,000 | ) |\n| Cash flows from financing activities: |\n| Proceeds from issuance of promissory note to related party | 80,000 |\n| Payment of promissory note to related party | ( 80,000 | ) |\n| Proceeds from related party | 25,000 |\n| Payment to related party | ( 240,020 | ) |\n| Proceeds from issuance of private placement units, including over-allotment | 5,100,000 |\n| Proceeds from issuance of public units through public offering, including over-allotment | 82,500,000 |\n| Payment of offering costs | ( 339,138 | ) |\n| Payment of deferred underwriter's discount | ( 1,650,000 | ) |\n| Net cash provided by financing activities | 85,395,842 |\n| Net change in cash | 985,578 |\n| Cash at beginning of period | — |\n| Cash at end of period | $ | 985,578 |\n| Supplemental information for non-cash financing activities: |\n| Deferred offering costs paid by Sponsor in exchange for issuance of Class B ordinary shares | $ | 25,000 |\n| Deferred offering costs charged to additional paid-in capital | $ | 567,815 |\n| Deferred offering cost settled through related party | $ | 203,677 |\n| Allocation of offering costs to Class A ordinary shares subject to redemption | $ | 4,488,135 |\n| Reclassification of Class A ordinary shares subject to redemption | $ | 72,526,599 |\n| Remeasurement adjustment on Class A ordinary shares subject to possible redemption | $ | 16,111,536 |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on trust account) | $ | 495,261 |\n| Deferred underwriter's fee charged to additional paid-in capital | $ | 2,887,500 |\n| Forfeiture of Class B ordinary shares | $ | 10 |\n\nThe accompanying notes are an integral part of these unaudited condensed financial statements.\n\n| 5 |\n\nDENALI CAPITAL ACQUISITION CORP. NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS\nSEPTEMBER 30, 2022\nNOTE 1 - ORGANIZATION AND BUSINESS OPERATION\nDenali Capital Acquisition Corp. (the “Company”) is a newly organized blank check company incorporated in the Cayman Islands on January 5, 2022 . The Company was formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization, or similar business combination with one or more businesses (a “Business Combination”).\nThe Company is not limited to a particular industry or sector for purposes of consummating a Business Combination. The Company is an early stage emerging growth company and, as such, the Company is subject to all of the risks associated with early stage emerging growth companies.\nAs of September 30, 2022, the Company had not commenced any operations. All activity for the period from January 5, 2022 (inception) through September 30, 2022 relates to the Company’s formation and the initial public offering (“IPO”), which is described below. The Company will not generate any operating revenues until after the completion of an initial Business Combination, at the earliest. The Company will generate non-operating income in the form of interest income from the proceeds derived from the IPO. The Company has selected December 31 as its fiscal year end.\nThe Company’s sponsor is Denali Capital Global Investments LLC, a Cayman Islands limited liability company (the “Sponsor”).\nFinancing\nThe registration statement for the Company’s IPO became effective on April 6, 2022. On April 11, 2022, the Company consummated the IPO of 8,250,000 units (including over-allotment of 750,000 units) (“Public Units”). Each Public Unit consists of one Class A ordinary share, $ 0.0001 par value per share (such shares included in the Public Units, the “Public Shares”), and one redeemable warrant (the “Public Warrants”), each whole Public Warrant entitling the holder thereof to purchase one Public Share at an exercise price of $ 11.50 per share. The Public Units were sold at a price of $ 10.00 per Public Unit, generating gross proceeds of $ 82,500,000 , which is described in Note 3. Simultaneously with the closing of the IPO, the Company consummated the sale of 510,000 units (including over-allotment of 30,000 units) (the “Private Placement Units”) to the Sponsor at a price of $ 10.00 per Private Placement Unit in a private placement generating gross proceeds of $ 5,100,000 , which is described in Note 4. Transaction costs amounted to $ 5,105,315 , consisting of $ 1,650,000 of underwriting fees, $ 2,887,500 of deferred underwriters’ fees and $ 567,815 of other offering costs, and were all initially charged to shareholders’ equity.\nTrust Account\nFollowing the consummation of the IPO on April 11, 2022, a total of $ 84,150,000 of the net proceeds from the IPO, including proceeds from the sale of the Private Placement Units, was deposited in a trust account (the “Trust Account”) and will be invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), with a maturity of 185 days or less, or in any open-ended investment company that holds itself out as a money market fund investing solely in U.S. Treasuries and meeting certain conditions under Rule 2a-7 of the Investment Company Act, as determined by the Company, until the earlier of (i) the completion of a Business Combination or (ii) the distribution of the funds in the Trust Account to the Company’s shareholders, as described below.\nThe Company’s management has broad discretion with respect to the specific application of the net proceeds of the IPO and the sale of the Private Placement Units, although substantially all of the net proceeds are intended to be applied generally toward consummating a Business Combination. The stock exchange listing rules require that the Business Combination must be with one or more operating businesses or assets with a fair market value equal to at least 80 % of the value of the assets held in the Trust Account (excluding any deferred underwriters’ fees and taxes payable on the interest income earned on the Trust Account). The Company will only complete a Business Combination if the post-Business Combination company owns or acquires 50 % or more of the issued and outstanding voting securities of the target or otherwise acquires a controlling interest in the target business sufficient for it not to be required to register as an investment company under the Investment Company Act. There is no assurance that the Company will be able to successfully effect a Business Combination.\n\n| 6 |\n\nBusiness Combination\nThe Company will provide the holders of the outstanding Public Shares (the “Public Shareholders”) with the opportunity to redeem all or a portion of their Public Shares either (i) in connection with a shareholder meeting called to approve the Business Combination or (ii) by means of a tender offer in connection with the Business Combination. The decision as to whether the Company will seek shareholder approval of a Business Combination or conduct a tender offer will be made by the Company. The Public Shareholders will be entitled to redeem their Public Shares for a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account calculated as of two business days prior to the consummation of the initial Business Combination (initially anticipated to be $ 10.20 per Public Unit, plus any pro rata interest then in the Trust Account, net of taxes payable). The Public Shares subject to redemption were recorded at a redemption value and classified as temporary equity upon the completion of the IPO in accordance with the Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” The Company will not redeem Public Shares in an amount that would cause its net tangible assets to be less than $ 5,000,001 (so that it does not then become subject to the “penny stock” rules of the Securities and Exchange Commission (the “SEC”)) either prior to or upon consummation of an initial Business Combination. However, a greater net tangible asset or cash requirement may be contained in the agreement relating to the Business Combination. The Company will have only 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) to complete the initial Business Combination (the “Combination Period”). If the Company is unable to complete the initial Business Combination within the Combination Period, the Company will: (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the Public Shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest earned on the funds held in the Trust Account and not previously released to the Company to pay the Company’s franchise and income taxes, if any (less up to $ 100,000 of interest to pay dissolution expenses), divided by the number of then-issued and outstanding Public Shares, which redemption will completely extinguish Public Shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the Company’s remaining shareholders and its board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to the Company’s warrants, which will expire worthless if the Company fails to complete the Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination).\nThe founder shares are designated as Class B ordinary shares (the “Founder Shares”) and, except as described below, are identical to the Public Shares, and holders of Founder Shares have the same shareholder rights as Public Shareholders, except that (i) prior to the Company’s initial Business Combination, only holders of the Founder Shares have the right to vote on the appointment of directors, including in connection with the completion of the Company’s initial Business Combination, and holders of a majority of the Founder Shares may remove a member of the board of directors of the Company for any reason, (ii) the Founder Shares are subject to certain transfer restrictions, as described in more detail below, (iii) the Company’s initial shareholders have entered into an agreement with the Company, pursuant to which they have agreed to (A) waive their redemption rights with respect to their Founder Shares and Public Shares in connection with the completion of the Company’s initial Business Combination, (B) waive their redemption rights with respect to their Founder Shares and Public Shares in connection with a shareholder vote to approve an amendment to the Company’s amended and restated memorandum and articles of association that would affect the substance or timing of the Company’s obligation to provide for the redemption of the Company’s Public Shares in connection with an initial Business Combination or to redeem 100 % of the Company’s Public Shares if the Company has not consummated an initial Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) and (C) waive their rights to liquidating distributions from the Trust Account with respect to their Founder Shares if the Company fails to complete its initial Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination) although they will be entitled to liquidating distributions from the Trust Account with respect to any Public Shares they hold if the Company fails to complete its initial Business Combination within the prescribed time frame, (iv) the Founder Shares will automatically convert into Public Shares concurrently with or immediately following the consummation of the Company’s initial Business Combination, or earlier at the option of the holder thereof, and (v) the Founder Shares are entitled to registration rights. If the Company submits its initial Business Combination to its Public Shareholders for a vote, the Sponsor and each member of the Company’s management team have agreed to vote their Founder Shares and Public Shares in favor of the Company’s initial Business Combination.\n| 7 |\n\nThe Sponsor has agreed that it will be liable to the Company if and to the extent any claims by a third party for services rendered or products sold to the Company, or by a prospective target business with which the Company has discussed entering into a transaction agreement, reduce the amount of funds in the Trust Account to below the lesser of (i) $ 10.20 per Public Share or (ii) the actual amount per Public Share held in the Trust Account as of the date of the liquidation of the Trust Account due to reductions in the value of the trust assets, in each case net of the interest which may be withdrawn to pay taxes. This liability will not apply with respect to any claims by a third party or prospective target business who executed a waiver of any and all rights to seek access to the Trust Account, nor will it apply to any claims under the Company’s indemnity of the underwriters of the IPO against certain liabilities, including liabilities under the Securities Act of 1933, as amended, (the “Securities Act”). Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, then the Company’s Sponsor will not be responsible to the extent of any liability for such third party claims.\nLiquidity, Capital Resources and Going Concern Consideration\nThe Company’s liquidity needs prior to the consummation of the IPO had been satisfied through a payment from the Sponsor of $ 25,000 (see Note 5) for the Founder Shares and the loan under an unsecured promissory note (the “Promissory Note”) from the Sponsor of up to $ 400,000 (see Note 5) which was fully repaid on December 31, 2021. Subsequent to the consummation of the IPO, the Company’s liquidity has been satisfied through the net proceeds from the consummation of the IPO and the sale of Private Placement Units in a private placement to the Sponsor, held outside of the Trust Account. As of September 30, 2022, the Company had cash of $ 985,578 and working capital of $ 1,027,202 .\nIn addition, in order to finance transaction costs in connection with a Business Combination, the Company’s Sponsor or an affiliate of the Sponsor or certain of the Company’s officers and directors may, but are not obligated to, provide the Company Working Capital Loans, as defined below (see Note 5). As of September 30, 2022, there were no amounts outstanding under any Working Capital Loans.\nBased on the foregoing, management believes that the Company will not have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from the date of this Quarterly Report. Over this time period, the Company will use funds in the Trust Account to pay existing accounts payable, identify and evaluate prospective initial Business Combination candidates, perform due diligence on prospective target businesses, pay for travel expenditures in connection with the identification and evaluation of prospective target businesses, select the target business with which to effectuate an initial Business Combination, and structure, negotiate and consummate the Business Combination.\nIn connection with the Company’s assessment of going concern considerations in accordance with FASB ASC 205-40, Presentation of Financial Statements – Going Concern, management has determined that the date for mandatory liquidation and dissolution, and the Company’s liquidity situation as discussed above, raises substantial doubt about the Company’s ability to continue as a going concern through April 6, 2023, the scheduled liquidation date of the Company if it does not complete a Business Combination prior to such date.\nRisks and Uncertainties\nIn February 2022, the Russian Federation and Belarus commenced a military action with the country of Ukraine. As a result of this action, various nations, including the United States, have instituted economic sanctions against the Russian Federation and Belarus. Further, the impact of this action and related sanctions on the world economy are not determinable as of the date of these unaudited condensed financial statements. The specific impact on the Company’s financial condition, results of operations, and cash flows is also not determinable as of the date of these unaudited condensed financial statements.\nManagement continues to evaluate the impact of the COVID-19 pandemic and has concluded that while it is reasonably possible that the virus and war could have a negative effect on the Company’s financial position, results of operations and search for a target company, the specific impact is not readily determinable as of the date of these unaudited condensed financial statements. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty.\n| 8 |\n\nNOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES\nBasis of Presentation\nThe accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X under the Securities Act. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.\nThe accompanying unaudited condensed financial statements should be read in conjunction with the Company’s prospectus, which contains the initial audited financial statements and notes thereto for the period from January 5, 2022 (inception) to February 7, 2022, as filed with the SEC on March 1, 2022, and the Company’s report on Form 8-K, which contains the Company’s audited balance sheet and notes thereto as of April 11, 2022, as filed with the SEC on April 15, 2022. The interim results for the period from January 5, 2022 (inception) to September 30, 2022 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2022 or for any future interim periods.\nEmerging Growth Company Status\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\nUse of Estimates\nThe preparation of the unaudited condensed financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Accordingly, the actual results could differ significantly from those estimates.\nCash and Cash Equivalents\nThe Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did no t have any cash equivalents on September 30, 2022.\n| 9 |\n\nInvestments Held in Trust Account\nThe Company’s portfolio of investments held in the Trust Account is comprised of investments in money market funds that invest in U.S. government securities and generally have a readily determinable fair value, or a combination thereof. Gains and losses resulting from the change in fair value of these securities and interest earned on investments held in the Trust Account are included in income on Trust Account in the accompanying unaudited condensed statements of operations. The estimated fair values of investments held in the Trust Account are determined using available market information.\nOffering Costs\nOffering costs were $ 5,105,315 consisting principally of underwriting, legal, accounting and other expenses incurred through the balance sheet date that are related to the IPO and were initially charged to shareholders’ equity upon the completion of the IPO. The Company complies with the requirements of FASB ASC 340-10-S99-1 and SEC Staff Accounting Bulletin Topic 5A - “Expenses of Offering.” The Company allocates offering costs between the Public Shares and Public Warrants (as defined below in Note 3) based on the relative fair values of the Public Shares and Public Warrants. Accordingly, $ 4,488,135 was allocated to the Public Shares and charged to temporary equity, and $ 617,180 was allocated to Public Warrants and charged to shareholders’ equity/(deficit).\nFair Value of Financial Instruments\nThe fair value of the Company’s assets and liabilities, which qualify as financial instruments under the FASB ASC 825, “Financial Instruments,” approximates the carrying amounts represented in the balance sheet, primarily due to its short-term nature.\nWarrants\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in FASB ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC 815. The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and meet all of the requirements for equity classification under FASB ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. The Company accounts for the 8,250,000 Public Warrants (as defined in Note 3) and 510,000 Private Warrants (as defined in Note 4) as equity-classified instruments.\nThe over-allotment liabilities during the period from January 5, 2022 to September 30, 2022 are not material to these financial statements.\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company accounts for its Class A ordinary shares subject to possible redemption in accordance with ASC 480. Class A ordinary shares subject to mandatory redemption (if any) is classified as a liability instrument and measured at fair value. Conditionally redeemable ordinary shares (including shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and are subject to the occurrence of uncertain future events. Accordingly, as of September 30, 2022, 8,250,000 Class A ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s unaudited condensed balance sheet.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable ordinary shares to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable ordinary shares are affected by charges against additional paid-in capital or accumulated deficit if additional paid-in capital equals to zero.\n| 10 |\n\nAs of September 30, 2022, the ordinary shares reflected in the unaudited condensed balance sheet are reconciled in the following table:\n\n| Gross proceeds | $ | 82,500,000 |\n| Less: |\n| Proceeds allocated to Public Warrants | ( 9,973,401 | ) |\n| Allocation of offering costs related to redeemable shares | ( 4,488,135 | ) |\n| Plus: |\n| Initial measurement of carrying value to redemption value | 16,111,536 |\n| Subsequent measurement of Class A ordinary shares subject to possible redemption (interest earned on Trust Account) | 495,261 |\n| Ordinary shares subject to possible redemption | 84,645,261 |\n\nConcentration of Credit Risk\nFinancial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Coverage of $ 250,000 . The Company has not experienced losses on this account.\nNet Income/(Loss) Per Ordinary Share\nThe Company complies with the accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per ordinary share is computed by dividing net loss by the weighted average number of ordinary shares outstanding during the period, excluding ordinary shares subject to forfeiture. Weighted average shares were reduced for the effect of an aggregate of 93,750 Founder Shares that were forfeited due to the underwriters’ partial exercise of the over-allotment option. Any remeasurement of the accretion to redemption value of the Class A ordinary shares subject to possible redemption was considered to be dividends paid to the Public Shareholders. Warrants issued are contingently exercisable (i.e., on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO). For Earnings Per Share (“EPS”) purposes, the warrants are anti-dilutive since they would generally not be reflected in basic or diluted EPS until the contingency is resolved. As of September 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted income (loss) per ordinary share is the same as basic earnings per ordinary share for the periods presented.\nThe net income (loss) per share presented in the unaudited condensed statements of operations is based on the following:\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Net income | $ | 307,468 | $ | 265,278 |\n| Interest earned on investment held in Trust Account | ( 380,429 | ) | ( 495,261 | ) |\n| Accretion of temporary equity into redemption value | - | ( 16,111,536 | ) |\n| Net loss including accretion of equity into redemption value | $ | ( 72,961 | ) | $ | ( 16,341,519 | ) |\n\n\n| Three months ended September 30, 2022 | From January 5, 2022 (inception) through September 30, 2022 |\n| Redeemable Shares | Non- Redeemable Shares | Redeemable Shares | Non- Redeemable Shares |\n| Basic and diluted net income/(loss) per share: |\n| Numerators: |\n| Allocation of net loss including accretion of temporary equity | $ | ( 55,618 | ) | $ | ( 17,343 | ) | $ | ( 11,673,872 | ) | $ | ( 4,667,647 | ) |\n| Interest earned on investment held in Trust Account | 380,429 | - | 495,261 | - |\n| Accretion of temporary equity to redemption value | - | - | 16,111,536 | - |\n| Allocation of net income/(loss) | $ | 324,811 | $ | ( 17,343 | ) | $ | 4,932,925 | $ | ( 4,667,647 | ) |\n| Denominators: |\n| Weighted-average shares outstanding | 8,250,000 | 2,572,500 | 5,305,762 | 2,121,441 |\n| Basic and diluted net income/(loss) per share | 0.04 | ( 0.01 | ) | 0.93 | ( 2.20 | ) |\n\n\n| 11 |\n\nIncome Taxes\nThe Company accounts for income taxes under FASB ASC 740, “Income Taxes” (“ASC 740”). ASC 740 requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statement and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized.\nASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statement and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition.\nThe Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of September 30, 2022. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position.\nThe Company determined that the Cayman Islands is the Company’s only major tax jurisdiction.\nThe Company may be subject to potential examination by federal and state taxing authorities in the areas of income taxes. These potential examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next 12 months.\nThere is currently no taxation imposed on income by the Government of the Cayman Islands for the period from January 5, 2022 (inception) through September 30, 2022.\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s unaudited condensed financial statements.\nNOTE 3 - INITIAL PUBLIC OFFERING\nOn April 11, 2022, the Company sold 8,250,000 Public Units at a purchase price of $ 10.00 per Public Unit, generating gross proceeds of $ 82,500,000 (including 750,000 Public Units pursuant to the underwriters’ partial exercise of the over-allotment option) related to the IPO. Each Public Unit consists of one Public Share and one Public Warrant. Each Public Warrant entitles the holder thereof to purchase one Public Share at a price of $ 11.50 per share, and only whole warrants are exercisable.\nThe warrants will become exercisable on the later of 30 days after the completion of the Company’s initial Business Combination or 12 months from the closing of the IPO and will expire five years after the completion of the Company’s initial Business Combination or earlier upon redemption or liquidation (see Note 7).\n| 12 |\n\nNOTE 4 - PRIVATE PLACEMENT\nSimultaneously with the closing of the IPO, the Sponsor purchased an aggregate of 510,000 Private Placement Units (including 30,000 Private Placement Units pursuant to the underwriters’ partial exercise of the over-allotment option) at a price of $ 10.00 per Private Placement Unit, for an aggregate purchase price of $ 5,100,000 , in a private placement. Each whole Private Placement Unit consists of one Class A ordinary share (“Private Placement Shares”) and one warrant (“Private Warrants”). Each Private Warrant entitles the holder to purchase one Class A ordinary share at a price of $ 11.50 per share, subject to adjustment. Certain of the proceeds from the sale of the Private Placement Units were added to the net proceeds from the IPO held in the Trust Account.\nIf the Company does not complete a Business Combination within 12 months from the closing of the IPO (or up to 18 months from the closing of the IPO, if the Company extends the period of time to consummate a Business Combination), the proceeds from the sale of the Private Placement Units held in the Trust Account will be used to fund the redemption of the Company’s Class A ordinary shares (subject to the requirements of applicable law) and the Private Placement Units and all underlying securities will expire worthless. The Private Placement Units will not be transferable, assignable, or saleable until 30 days after the completion of an initial Business Combination, subject to certain exceptions.\nNOTE 5 - RELATED PARTY TRANSACTIONS\nFounder Shares\nOn February 3, 2022, the Sponsor acquired 2,156,250 Founder Shares in exchange for $ 25,000 paid for deferred offering costs borne by the Sponsor. On May 23, 2022, 93,750 Founder Shares were forfeited as the underwriters did not exercise the over-allotment option on the remaining 375,000 Public Units (see Note 6).\nThe Founder Shares are identical to the Class A ordinary shares included in the units sold in the IPO, except that the Founder Shares will automatically convert into Class A ordinary shares at the time of the Company’s initial Business Combination. Also, the Sponsor and each member of the management team have entered into an agreement with the Company, pursuant to which they have agreed to waive their redemption rights with respect to any Founder Shares and Public Shares held by them.\nThe Sponsor and the Company’s directors and executive officers have agreed not to transfer, assign or sell any of their Founder Shares until the earlier of (A) one year after the completion of an initial Business Combination and (B) subsequent to the Company’s initial Business Combination, (x) if the closing price of Class A ordinary shares equals or exceeds $ 12.00 per share (as adjusted for share subdivisions, share capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30 -trading day period commencing at least 150 days after an initial Business Combination, or (y) the date on which the Company completes a liquidation, merger, share exchange or other similar transaction that results in all Public Shareholders having the right to exchange their Public Shares for cash, securities or other property. Any permitted transferees would be subject to the same restrictions and other agreements of the Sponsor and the Company’s directors and executive officers with respect to any Founder Shares.\nPromissory Note - Related Party\nOn February 3, 2022, the Sponsor agreed to loan the Company up to $ 400,000 to be used for a portion of the expenses of the IPO. As of April 11, 2022, there was $ 80,000 outstanding under the Promissory Note. This loan was non-interest bearing, unsecured and due at the earlier of (i) September 30, 2022 or (ii) the closing of the IPO. On April 12, 2022, the loan was repaid upon the closing of the IPO out of the offering proceeds not held in the Trust Account.\nDue to Related Party\nThe Sponsor paid certain formation, operating or offering costs on behalf of the Company. These amounts are due on demand and are non-interest bearing. During the period from January 5, 2022 (inception) through March 31, 2022, the Sponsor paid $ 215,020 of formation, operating costs and offering costs on behalf of the Company. On April 12, 2022, the Company paid the Sponsor $ 160,020 and on April 14, 2022, the Company received $ 25,000 from the Sponsor. Subsequently on July 19, 2022, the Company fully paid $ 80,000 to the related party. As of September 30, 2022, there were no amounts outstanding due to related party.\n| 13 |\n\nWorking Capital Loan\nIn order to finance transaction costs in connection with a Business Combination, the Sponsor or an affiliate of the Sponsor, or certain of the Company’s officers and directors, may, but are not obligated to, loan the Company funds as may be required (the “Working Capital Loans”). If the Company completes a Business Combination, the Company would repay the Working Capital Loans out of the proceeds of the Trust Account released to the Company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside of the Trust Account. In the event that a Business Combination does not complete, the Company may use a portion of proceeds held outside of the Trust Account to repay the Working Capital Loans, but no proceeds held in the Trust Account would be used to repay the Working Capital Loans.\nExcept for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $ 1.5 million of such Working Capital Loans may be convertible into units of the post-business combination entity at a price of $ 10.00 per unit. The units would be identical to the Private Placement Units. As of September 30, 2022, no Working Capital Loans were outstanding.\nNOTE 6 - COMMITMENTS AND CONTINGENCIES\nRegistration Rights\nThe holders of the Founder Shares, Private Placement Shares and Private Warrants, including any of those issued upon conversion of Working Capital Loans (and any Private Placement Shares issuable upon the exercise of the Private Warrants that may be issued upon conversion of Working Capital Loans) will be entitled to registration rights pursuant to a registration and shareholder rights agreement signed on April 6, 2022. The holders of these securities are entitled to make up to three demands, excluding short-form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed after the completion of the initial Business Combination and rights to require the Company to register for resale such securities pursuant to Rule 415 under the Securities Act. The Company will bear the costs and expenses of filing any such registration statements.\nUnderwriting Agreement\nThe Company granted the underwriters a 45 -day option from the date of IPO to purchase up to 1,125,000 additional Public Units to cover over-allotments, if any, at the IPO price less the underwriting discounts and commissions. The underwriters exercised the over-allotment option in part for 750,000 Public Units on April 11, 2022. On May 23, 2022, the underwriters decided not to exercise the over-allotment option on the remaining 375,000 Public Units within the 45 -day period.\nThe underwriters received a cash underwriting discount of $ 0.20 per Public Unit, or $ 1,650,000 in the aggregate, paid upon the closing of the IPO. In addition, the underwriters will be entitled to a deferred fee of $ 0.35 per Public Unit, or $ 2,887,500 in the aggregate, which is included in the accompanying condensed balance sheet. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nNOTE 7 - SHAREHOLDERS’ DEFICIT\nPreference shares - The Company is authorized to issue 1,000,000 preference shares with a par value of $ 0.0001 per share with such designations, voting and other rights and preferences as may be determined from time to time by the Company’s board of directors. As of September 30, 2022, there were no preference shares issued or outstanding.\n\n| 14 |\n\nClass A Ordinary Shares - The Company is authorized to issue 200,000,000 Class A ordinary shares with a par value of $ 0.0001 per share. As of September 30, 2022, there were 510,000 Class A ordinary shares issued and outstanding, excluding 8,250,000 Class A ordinary shares subject to possible redemption.\nClass B Ordinary Shares - The Company is authorized to issue 20,000,000 Class B ordinary shares with a par value of $ 0.0001 per share. As of September 30, 2022, there were 2,062,500 Class B ordinary shares issued and outstanding. On May 23, 2022, 93,750 Class B ordinary shares were forfeited as the underwriters did not exercise the over-allotment option on the remaining 375,000 Public Units.\nPrior to the Company’s initial Business Combination, only holders of Class B ordinary shares will have the right to vote on the appointment of directors and holders of a majority of the Company’s Class B ordinary shares may remove a member of the board of directors of the Company for any reason. In addition, in a vote to continue the Company in a jurisdiction outside the Cayman Islands (which requires the approval of at least two thirds of the votes of all ordinary shares voted at a general meeting), holders of Founder Shares will have ten votes for every Founder Share and holders of Class A ordinary shares will have one vote for every Class A ordinary share and, as a result, the Company’s initial shareholders will be able to approve any such proposal without the vote of any other shareholder.\nThe Class B ordinary shares will automatically convert into Class A ordinary shares on the consummation of the initial Business Combination at a ratio such that the number of Class A ordinary shares issuable upon conversion of all Founder Shares will equal, in the aggregate, on an as- converted basis, approximately 20 % of the sum of (i) the total number of ordinary shares issued and outstanding upon completion of the IPO, plus (ii) the total number of Class A ordinary shares issued or deemed issued or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued, by the Company in connection with or in relation to the consummation of the initial Business Combination (after giving effect to any redemptions of Class A ordinary shares by Public Shareholders), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, deemed issued, or to be issued, to any seller in the initial Business Combination and any Private Placement Units issued to the Sponsor, its affiliates or any member of the Company’s management team upon conversion of Working Capital Loans. Any conversion of Class B ordinary shares described herein will take effect as a compulsory redemption of Class B ordinary shares and an issuance of Class A ordinary shares as a matter of Cayman Islands law. In no event will the Class B ordinary shares convert into Class A ordinary shares at a rate of less than one-to-one.\nWarrants\nAll warrants (Public Warrants and Private Warrants) will become exercisable at $ 11.50 per share, subject to adjustment, on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO; provided in each case that the Company has an effective registration statement under the Securities Act covering the issuance of the Class A ordinary shares issuable upon exercise of the warrants and a current prospectus relating to them is available (or the Company permits holders to exercise their warrants on a cashless basis under the circumstances specified in the warrant agreement). The warrants will expire at 5:00 p.m., New York City time, five years after the completion of the initial Business Combination or earlier upon redemption or liquidation. On the exercise of any warrant, the warrant exercise price will be paid directly to the Company and not placed in the Trust Account.\nIn addition, if (x) the Company issues additional Class A ordinary shares or equity-linked securities for capital raising purposes in connection with the closing of an initial Business Combination at an issue price or effective issue price of less than $ 9.20 per ordinary share (with such issue price or effective issue price to be determined in good faith by the board of directors of the Company and, in the case of any such issuance to the Sponsor or its affiliates, without taking into account any Founder Shares held by the Sponsor or such affiliates, as applicable, prior to such issuance) (the “Newly Issued Price”), (y) the aggregate gross proceeds from such issuances represent more than 60 % of the total equity proceeds, and interest thereon, available for the funding of an initial Business Combination on the date of the consummation of an initial Business Combination (net of redemptions), and (z) the volume weighted average trading price of Class A ordinary shares during the 20 -trading day period starting on the trading day prior to the day on which the Company consummates an initial Business Combination (such price, the “Market Value”) is below $9.20 per share, the exercise price of the warrants will be adjusted (to the nearest cent) to be equal to 115 % of the higher of the Market Value or the Newly Issued Price and the $ 16.50 per share redemption trigger price will be adjusted (to the nearest cent) to be equal to 165 % of the higher of the Market Value or the Newly Issued Price.\n| 15 |\n\nThe Company is not registering the ordinary shares issuable upon exercise of the warrants at this time. However, the Company has agreed that as soon as practicable, but in no event later than 20 business days after the closing of the initial Business Combination, it will use commercially reasonable efforts to file with the SEC a registration statement covering the Class A ordinary shares issuable upon exercise of the warrants, and it will use commercially reasonable efforts to cause the same to become effective within 60 business days following the initial Business Combination and to maintain a current prospectus relating to those ordinary shares until the warrants expire or are redeemed; provided, that if the ordinary shares are at the time of any exercise of a warrant not listed on a national securities exchange such that they satisfy the definition of a “covered security” under Section 18(b)(1) of the Securities Act, the Company may, at its option, require holders of Public Warrants who exercise their warrants to do so on a “cashless basis” in accordance with Section 3(a)(9) of the Securities Act and, in the event the Company so elects, it will not be required to file or maintain in effect a registration statement, but the Company will be required to use commercially reasonable efforts to register or qualify the shares under applicable blue sky laws to the extent an exemption is not available.\nRedemption of Warrants\nOnce the warrants become exercisable, the Company may redeem the outstanding warrants:\n\n| | in whole and not in part; |\n\n| | at a price of $ 0.01 per warrant; |\n\n| | upon a minimum of 30 days’ prior written notice of redemption, which is referred to as the 30 -day redemption period; and |\n\n| | if, and only if, the last reported sale price of ordinary shares equals or exceeds $ 16.50 per share (as adjusted for share splits, share dividends, reorganizations, recapitalizations, and the like) for any 20 trading days within a 30 -trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption to the warrant holders. |\n\nThe Company will not redeem the warrants unless a registration statement under the Securities Act covering the ordinary shares issuable upon exercise of the warrants is effective and a current prospectus relating to those ordinary shares is available throughout the 30-day redemption period, except if the warrants may be exercised on a cashless basis and such cashless exercise is exempt from registration under the Securities Act. If and when the warrants become redeemable by the Company, the Company may exercise its redemption right even if it is unable to register or qualify the underlying securities for sale under all applicable state securities laws.\nIf the Company calls the warrants for redemption as described above, its management will have the option to require all holders that wish to exercise warrants to do so on a “cashless basis.” In determining whether to require all holders to exercise their warrants on a “cashless basis,” the Company’s management will consider, among other factors, the cash position, the number of warrants that are outstanding and the dilutive effect on the Company’s shareholders of issuing the maximum number of ordinary shares issuable upon the exercise of the Company’s warrants. In such event, each holder would pay the exercise price by surrendering the warrants for that number of ordinary shares equal to the quotient obtained by dividing (x) the product of the number of ordinary shares underlying the warrants, multiplied by the excess of the “fair market value” over the exercise price of the warrants by (y) the fair market value. The “fair market value” shall mean the average volume weighted average last reported sale price of the Class A ordinary shares for the 10 trading days ending on the third trading day prior to the date on which the notice of redemption is sent to the holders of warrants.\nNOTE 8 - FAIR VALUE MEASUREMENTS\nThe fair value of the Company’s financial assets and liabilities reflects management’s estimate of amounts that the Company would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from independent sources) and to minimize the use of unobservable inputs (internal assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:\nLevel 1: Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.\n| 16 |\n\nLevel 2: Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.\nLevel 3: Unobservable inputs based on our assessment of the assumptions that market participants would use in pricing the asset or liability.\nThe following table presents information about the Company’s assets that are measured at fair value on a recurring basis as of September 30, 2022 and indicates the fair value hierarchy of the valuation inputs the Company utilized to determine such fair value.\n\n| As of September 30, 2022 | QuotedPrices inActiveMarkets(Level 1) | SignificantOtherObservableInputs(Level 2) | SignificantOtherUnobservableInputs(Level 3) |\n| Assets: |\n| Investment held in Trust Account | $ | 84,645,261 | 84,645,261 | - | - |\n\nNOTE 9 - SUBSEQUENT EVENTS\nThe Company has evaluated subsequent events through November 15, 2022 , which was the date these unaudited condensed financial statements were available for issuance and determined that there were no significant unrecognized events through that date.\n| 17 |\n\nI\nMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS\nReferences in this Quarterly Report to “we,” “us” or the “Company” refer to Denali Capital Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “Sponsor” refer to Denali Capital Global Investment LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Quarterly Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.\nSpecial Note Regarding Forward-Looking Statements\nThis Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Form 10‑Q including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward- looking statements. Words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intends,” “may,” “might,” “plan,” “possible,” “potential,” “predict,” “project,” “should,” “would” and variations thereof and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s final prospectus for its initial public offering (“IPO”) filed with the SEC on April 7, 2022, and in its Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2022, filed with the SEC on August 12, 2022. The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.\nOverview\nWe are a blank check company incorporated in the Cayman Islands on January 5, 2022 (inception) formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses (a “Business Combination”). We intend to effectuate our Business Combination using cash derived from the proceeds of our initial public offering (“IPO”) and the sale of units (the “Private Placement Units”) in a private placement (the “Private Placement”) to the Company’s founder and sponsor, Denali Capital Global Investments LLC (the “Sponsor”), additional shares, debt or a combination of cash, shares and debt.\nWe expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful.\nResults of Operations\nWe have neither engaged in any operations nor generated any operating revenues to date. Our only activities from January 5, 2022 (inception) through September 30, 2022 were organizational activities and those necessary to prepare for and complete the IPO, described below. We do not expect to generate any operating revenues until after the completion of our initial Business Combination. We expect to generate non-operating income in the form of interest income on marketable securities held after the IPO. We expect that we will incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with searching for, and completing, a Business Combination.\n| 18 |\n\nFor the three months ended September 30, 2022, we had net income of $307,468, which consists of interest earned on investment held in the Trust Account, as defined below, of $380,429 partially offset by $72,961 of formation and operating costs.\nFor the period from January 5, 2022 (inception) through September 30, 2022, we had net income of $265,278, which consists of interest earned on investment held in the Trust Account of $495,261 partially offset by $229,983 of formation and operating costs.\nFor the period from January 5, 2022 (inception) through September 30, 2022, we had an increase in cash flows of $985,578 resulting from net cash used in operating activities of $260,264, net cash used in investing activities of $84,150,000 and net cash provided by financing activities of $85,395,842.\nCash Flows from Operating Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash used in operations was $260,264 primarily due to net income of $265,278 for the period and the changes in current assets and liabilities of $(41,624), prepaid expenses of $(132,427) and accounts payable and accrued expenses of $90,803. In addition, net cash used in operating activities includes adjustments to reconcile net income from formation costs paid by related party of $11,343 and income on Trust Account of $495,261.\nCash Flows from Investing Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash used in investing activities was $84,150,000 due to investment held in Trust Account.\nCash Flows from Financing Activities- For the period from January 5, 2022 (inception) through September 30, 2022, net cash provided by financing activities was $85,395,842 primarily due to proceeds from issuance of promissory note to related party of $80,000, proceeds from related party of $25,000, proceeds from issuance of private placement units of $5,100,000, proceeds from issuance of public units through public offering of $82,500,000, payment of promissory note to related party of $80,000, payment to related party of $240,020, payment of offering costs of $339,138 and payment of underwriter’s discount of $1,650,000.\nLiquidity and Capital Resources\nOur liquidity needs prior to the consummation of the IPO were satisfied through a payment from the Sponsor and the loan under an unsecured promissory note from the Sponsor of up to $400,000.\nOn April 11, 2022, we consummated the IPO of 8,250,000 units (“Public Units”), inclusive of 750,000 Public Units sold to the underwriters upon the underwriters’ election to partially exercise their over-allotment option. Each Public Unit consists of one Class A ordinary share, $0.0001 par value per share (such shares included in the Public Units, the “Public Shares”), and one redeemable warrant (the “Public Warrants”), each whole Public Warrant entitling the holder thereof to purchase one Public Share at an exercise price of $11.50 per share. The Public Units were sold at a price of $10.00 per Public Unit, generating gross proceeds of $82,500,000. Simultaneously with the closing of the IPO, we consummated the sale of 510,000 Private Placement Units, inclusive of 30,000 Private Placement Units sold to the Sponsor pursuant to the underwriters’ election to partially exercise their over-allotment option. Each whole Private Placement Unit consists of one Class A ordinary share (“Private Placement Shares”) and one warrant (“Private Warrants”), each whole Private Warrant entitling the holder thereof to purchase one Class A ordinary share at an exercise price of $11.50 per share. The Private Placement Units were sold at a price of $10.00 per Private Placement Unit, generating gross proceeds of $5,100,000.\nFollowing the closing of the IPO and sale of the Private Placement Units on April 11, 2022, a total of $84,150,000 was placed in a U.S.-based trust account maintained by Wilmington Trust, National Association, acting as trustee (the “Trust Account”), and we had $1,515,795 of cash held outside of the Trust Account, after payment of costs related to the IPO, and available for working capital purposes. In connection with the IPO, we incurred $5,105,315 in transaction costs, consisting of $1,650,000 of underwriting fees, $2,887,500 of deferred underwriting fees and $567,815 of other offering costs. Deferred offering costs consist of legal, accounting, and underwriting fees and other costs incurred through the balance sheet date that are directly related to the IPO.\nAs of September 30, 2022, we had marketable securities held in the Trust Account of $84,645,261. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account, excluding deferred underwriting commissions, to complete our Business Combination. We may withdraw interest from the Trust Account to pay taxes, if any. To the extent that our share capital or debt is used, in whole or in part, as consideration to complete a Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside of the Trust Account to primarily identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, structure, negotiate and complete a Business Combination.\n| 19 |\n\nIn order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If the Company completes the initial Business Combination, it would repay such loaned amounts. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside of the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into units of the post-business combination entity, at a price of $10.00 per unit at the option of the lender. The units would be identical to the Private Placement Units. In the event that the initial Business Combination does not close, the Company may use a portion of the working capital held outside of the Trust Account to repay such loaned amounts, but no proceeds from the Trust Account would be used for such repayment.\nAs of September 30, 2022, we had cash of $985,578 and working capital of $1,027,202. In addition, in order to finance transaction costs in connection with a Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, provide us funds as may be required (the “Working Capital Loans”). As of September 30, 2022, there were no amounts outstanding under any Working Capital Loans.\nAccordingly, the accompanying unaudited condensed financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) which contemplates continuation of the Company as a going concern and the realization of assets and the satisfaction of liabilities in the normal course of business. The unaudited condensed financial statements do not include any adjustments that might result from the outcome of this uncertainty. Further, we have incurred and expect to continue to incur significant costs in pursuit of our financing and acquisition plans. Management plans to address this uncertainty during the period leading up to the initial Business Combination. Based on the foregoing, management believes that the Company will not have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from the date of this filing. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Over this time period, the Company will use these funds to pay existing accounts payable, identify and evaluate prospective initial Business Combination candidates, perform due diligence on prospective target businesses, pay for travel expenditures in connection with the identification and evaluation of prospective target businesses, select the target business with which to effectuate an initial Business Combination, and structure, negotiate and consummate the Business Combination. In case the Company is unable to consummate the initial Business Combination by April 6, 2023, it will seek to extend the combination period up to 18 months from the date of the IPO by resolution of the board of directors of the Company. In order to extend the time available for the Company to consummate an initial Business Combination for an additional three months, the Sponsor or its affiliates or designees must deposit into the Trust Account $825,000, (or $0.1 per share) or up to an aggregate of $1,500,000, or ($0.20) per share, on or prior to the date of the deadline. The Company will issue a press release announcing each extension at least three days prior to the deadline. In addition, it will issue a press release the day after the deadline, announcing whether the funds have been timely deposited. The Sponsor and its affiliates or designees are obligated to fund the Trust Account in order to extend the time for us to complete our initial Business Combination, but the Sponsor will not be obligated to extend such time. In addition to the foregoing arrangements, the Company may extend the period of time to consummate an initial Business Combination by a shareholder vote to amend our amended and restated memorandum and articles of association (“Shareholder Extension Period”).\nIf our estimate of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial Business Combination. Moreover, we may need to obtain additional financing either to complete our Business Combination or because we become obligated to redeem a significant number of our Public Shares upon completion of our Business Combination, in which case we may issue additional securities or incur debt in connection with such Business Combination.\nOff-Balance Sheet Financing Arrangements\nWe have no obligations, assets or liabilities that would be considered off-balance sheet arrangements as of September 30, 2022. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets.\n| 20 |\n\nOther Contractual Obligations\nRegistration Rights\nThe holders of our Class B ordinary shares initially issued to our Sponsor in a private placement prior to the IPO (the “Founder Shares”), Private Placement Shares and Private Warrants, including any of those issued upon conversion of Working Capital Loans (and any Private Placement Shares issuable upon the exercise of the Private Warrants that may be issued upon conversion of Working Capital Loans) will be entitled to registration rights pursuant to a registration and shareholder rights agreement signed on April 6, 2022. The holders of these securities are entitled to make up to three demands, excluding short form demands, that the Company register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed after the completion of our initial Business Combination and rights to require us to register for resale such securities pursuant to Rule 415 under the Securities Act. The Company will bear the costs and expenses of filing any such registration statements.\nUnderwriting Agreement\nWe granted the underwriters a 45-day option from the date of IPO to purchase up to 1,125,000 additional Public Units to cover over-allotments, if any, at the IPO price less the underwriting discounts and commissions. The underwriters exercised the over-allotment option in part for 750,000 Public Units on April 11, 2022. On May 23, 2022, the underwriters decided not to exercise the over-allotment option on the remaining 375,000 Public Units.\nThe underwriters received a cash underwriting discount of $0.20 per Public Unit, or $1,650,000 in the aggregate, paid upon the closing of the IPO. In addition, the underwriters will be entitled to a deferred fee of $0.35 per Public Unit, or $2,887,500 in the aggregate. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement.\nCritical Accounting Policies\nBasis of Presentation\nThe accompanying unaudited condensed financial statements are presented in conformity with GAAP and pursuant to the rules and regulations of the SEC.\nEmerging Growth Company Status\nThe Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act, as modified by the Jumpstart Our Business Startups Act of 2012, (the “JOBS Act”), and it may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in its periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.\nFurther, Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies, but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accounting standards used.\n| 21 |\n\nClass A Ordinary Shares Subject to Possible Redemption\nThe Company will account for its Class A ordinary shares subject to possible redemption in accordance with the guidance in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) is classified as a liability instrument and measured at fair value. Conditionally redeemable ordinary shares (including shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares will feature certain redemption rights that are considered to be outside of the Company’s control and will be subject to the occurrence of uncertain future events. Accordingly, as of September 30, 2022, 8,250,000 Class A ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s unaudited condensed balance sheet.\nThe Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable ordinary shares to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable ordinary shares are affected by charges against additional paid in capital or accumulated deficit if additional paid in capital equals to zero.\nWarrants\nThe Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in FASB ASC 480, “Distinguishing Liabilities from Equity” (“ASC 480”) and FASB ASC 815. The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and meet all of the requirements for equity classification under FASB ASC 815, including whether the warrants are indexed to the Company’s own ordinary shares and whether the warrant holders could potentially require “net cash settlement” in a circumstance outside of the Company’s control, among other conditions for equity classification. This assessment is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding.\nFor issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. The Company accounts for the 8,250,000 Public Warrants (as defined in Note 3) and 510,000 Private Warrants (as defined in Note 4) as equity-classified instruments.\nNet Income/(Loss) Per Ordinary Share\nThe Company complies with the accounting and disclosure requirements of FASB ASC 260, “Earnings Per Share.” Net loss per ordinary share is computed by dividing net loss by the weighted average number of ordinary shares outstanding during the period, excluding ordinary shares subject to forfeiture. Weighted average shares were reduced for the effect of an aggregate of 93,750 Founder Shares that were forfeited due to the underwriters’ partial exercise of the over-allotment option. Any remeasurement of the accretion to redemption value of the Class A ordinary shares subject to possible redemption was considered to be dividends paid to the Public Shareholders. Warrants issued are contingently exercisable (i.e., on the later of 30 days after the completion of the initial Business Combination or 12 months from the closing of the IPO). For Earnings Per Share (“EPS”) purposes, the warrants are anti-dilutive since they would generally not be reflected in basic or diluted EPS until the contingency is resolved. As of September 30, 2022, the Company did not have any dilutive securities and other contracts that could, potentially, be exercised or converted into ordinary shares and then share in the earnings of the Company. As a result, diluted profit (loss) per ordinary share is the same as basic earnings per ordinary share for the periods presented.\n| 22 |\n\nRecent Accounting Pronouncements\nManagement does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statements.\nI\nQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK\nAs of September 30, 2022, we were not subject to any market or interest rate risk. Following the consummation of our IPO, the net proceeds of our IPO, including amounts in the Trust Account, have been invested in certain U.S. government securities with a maturity of 185 days or less or in certain money market funds that invest solely in U.S. treasuries. Due to the short-term nature of these investments, we believe there will be no associated material exposure to interest rate risk.\nI\nCONTROLS AND PROCEDURES\nDisclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.\n| 23 |\n\nEvaluation of Disclosure Controls and Procedures\nAs required by Rules 13a‑15 and 15d‑15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2022. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a‑15(e) and 15d‑15(e) under the Exchange Act) were effective.\nChanges in Internal Control Over Financial Reporting\nDuring the most recently completed fiscal quarter, there has been no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.\nPart II. OTHER INFORMATION\nI\nLEGAL PROCEEDINGS.\nNone.\nI\nRISK FACTORS.\nFactors that could cause our actual results to differ materially from those in this Quarterly Report are any of the risks described in our final prospectus for our IPO filed with the SEC on April 7, 2022, and in other filings with the SEC as described below. Any of these factors could result in a significant or material adverse effect on our results of operations or financial condition. We may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC. Additional risk factors not currently known to us or that we currently deem immaterial may also impair our business or results of operations. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in (i) our final prospectus for our IPO filed with the SEC on April 7, 2022, and (ii) our Quarterly Report on Form 10-Q for the quarter ended June 30, 2022, as filed with the SEC on August 12, 2022. except for the following:\nChanges in laws or regulations or in how such laws or regulations are interpreted or applied, or a failure to comply with any laws, regulations, interpretations or applications, may adversely affect our business, investments and results of operations, and our ability to negotiate and complete our initial Business Combination.\nWe are subject to laws and regulations, and interpretations and applications of such laws and regulations enacted by national, regional, state and local governments and, potentially, non-U.S. jurisdictions. In particular, we will be required to comply with certain SEC and other legal and regulatory requirements, and our consummation of an initial Business Combination may be contingent upon our ability to comply with certain laws, regulations, interpretations and applications and any post-business combination company may be subject to additional laws, regulations, interpretations and applications. Compliance with, and monitoring of, the foregoing may be difficult, time consuming and costly. Those laws and regulations and their interpretation and application may also change from time to time, and those changes could have a material adverse effect on our business, investments and results of operations, and our ability to negotiate and complete an initial business combination. In addition, a failure to comply with applicable laws or regulations, as interpreted and applied, could have a material adverse effect on our business and results of operations, and our ability to negotiate and complete an initial business combination.\nOn March 30, 2022, the SEC issued proposed rules (the “SPAC Rule Proposals”) relating to, among other items, enhancing disclosures in business combination transactions involving special purpose acquisition companies (“SPACs”) and private operating companies; amending the financial statement requirements applicable to transactions involving shell companies; changing the treatment of financial projections in SEC filings in connection with proposed business combination transactions; increasing the potential liability of certain participants in proposed business combination transactions; and a proposed safe harbor for SPACs under the Investment Company Act of 1940, as amended (including certain time limits to announce and consummate a business combination) (the “Investment Company Act”). These proposed rules, if adopted, whether in the form proposed or in revised form, or pursuant to the SEC’s views expressed in the SPAC Rule Proposals, may materially adversely affect our ability to negotiate and complete our initial business combination and may increase the costs and time related thereto.\n| 24 |\n\nThe current economic downturn may lead to increased difficulty in completing our initial business combination.\nOur ability to consummate our initial Business Combination may depend, in part, on worldwide economic conditions. In recent months, we have observed increased economic uncertainty in the United States and abroad. Impacts of such economic weakness include:\n\n| ● | falling overall demand for goods and services, leading to reduced profitability; |\n\n\n| ● | reduced credit availability; |\n\n\n| ● | higher borrowing costs; |\n\n\n| ● | reduced liquidity; |\n\n\n| ● | volatility in credit, equity and foreign exchange markets; and |\n\n\n| ● | bankruptcies. |\n\nThese developments could lead to inflation, higher interest rates, and uncertainty about business continuity, which may adversely affect the business of our potential target businesses and create difficulties in obtaining debt or equity financing for our initial Business Combination, as well as leading to an increase in the number of Public Shareholders exercising redemption rights in connection therewith.\nRecent volatility in capital markets may affect our ability to obtain financing for our initial Business Combination through sales of ordinary shares or issuance of indebtedness.\nWith uncertainty in the capital markets and other factors, financing for our initial Business Combination may not be available on terms favorable to us or at all. If we raise additional funds through further issuances of equity or convertible debt securities, our existing shareholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences, and privileges superior to those of holders of our ordinary shares. Any debt financing secured by us could involve additional restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may limit the operations and growth of the surviving company of our initial Business Combination. If we are unable to obtain adequate financing or financing on terms satisfactory to us, we could face significant limitations on our ability to complete our initial Business Combination.\nMilitary conflict in Ukraine or elsewhere may lead to increased and price volatility for publicly traded securities, which could make it more difficult for us to consummate an initial Business Combination.\nMilitary conflict in Ukraine or elsewhere may lead to increased and price volatility for publicly traded securities, including ours, and to other national, regional and international economic disruptions and economic uncertainty, any of which could make it more difficult for us to identify a business combination target and consummate an initial Business Combination on acceptable commercial terms or at all.\nThere may be significant competition for us to find an attractive target for an initial Business Combination. This could increase the costs associated with completing our initial Business Combination and may result in our inability to find a suitable target for our initial Business Combination.\nIn recent years, the number of SPACs that have been formed has increased substantially. Many companies have entered into business combinations with SPACs, and there are still many SPACs seeking targets for their initial business combination, as well as additional SPACs currently in registration. As a result, at times, fewer attractive targets may be available, and it may require more time, effort and resources to identify a suitable target for an initial Business Combination.\n| 25 |\n\nIn addition, because there are a large number of SPACs seeking to enter into an initial Business Combination with available targets, the competition for available targets with attractive fundamentals or business models may increase, which could cause target companies to demand improved financial terms. Attractive deals could also become scarcer for other reasons, such as economic or industry sector downturns, geopolitical tensions or increases in the cost of additional capital needed to close business combinations or operate targets post-business combination. This could increase the cost of, delay or otherwise complicate or frustrate our ability to find a suitable target for and/or complete our initial Business Combination and may result in our inability to consummate an initial Business Combination on terms favorable to our investors altogether.\nIf we are deemed to be an investment company for purposes of the Investment Company Act, we would be required to institute burdensome compliance requirements and our activities would be severely restricted. As a result, in such circumstances, unless we are able to modify our activities so that we would not be deemed an investment company, we would expect to abandon our efforts to complete an initial Business Combination and instead to liquidate the Company.\nAs described further above, the SPAC Rule Proposals relate, among other matters, to the circumstances in which SPACs such as the Company could potentially be subject to the Investment Company Act and the regulations thereunder. The SPAC Rule Proposals would provide a safe harbor for such companies from the definition of “investment company” under Section 3(a)(1)(A) of the Investment Company Act, provided that a SPAC satisfies certain criteria, including a limited time period to announce and complete a de-SPAC transaction. Specifically, to comply with the safe harbor, the SPAC Rule Proposals would require a company to file a report on Form 8-K announcing that it has entered into an agreement with a target company for a business combination no later than 18 months after the effective date of its IPO registration statement. A company would then be required to complete its initial business combination no later than 24 months after the effective date of the IPO registration statement.\nBecause the SPAC Rule Proposals have not yet been adopted, there is currently uncertainty concerning the applicability of the Investment Company Act to a SPAC, including a company like ours that does not complete its business combination within 24 months after the effective date of the IPO registration statement.\nIf we are deemed to be an investment company under the Investment Company Act, our activities would be severely restricted. In addition, we would be subject to burdensome compliance requirements. We do not believe that our principal activities will subject us to regulation as an investment company under the Investment Company Act. However, if we are deemed to be an investment company and subject to compliance with and regulation under the Investment Company Act, we would be subject to additional regulatory burdens and expenses for which we have not allotted funds. As a result, unless we are able to modify our activities so that we would not be deemed an investment company, we would expect to abandon our efforts to complete an initial business combination and instead to liquidate the Company.\nTo mitigate the risk that we might be deemed to be an investment company for purposes of the Investment Company Act, we may, at any time, instruct the trustee to liquidate the securities held in the Trust Account and instead to hold the funds in the Trust Account in cash until the earlier of the consummation of our initial Business Combination or our liquidation. As a result, following the liquidation of securities in the Trust Account, we would likely receive minimal interest, if any, on the funds held in the Trust Account, which would reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\nThe funds in the Trust Account have, since our IPO, been held only in U.S. government treasury obligations with a maturity of 185 days or less or in money market funds investing solely in U.S. government treasury obligations and meeting certain conditions under Rule 2a-7 under the Investment Company Act. However, to mitigate the risk of us being deemed to be an unregistered investment company (including under the subjective test of Section 3(a)(1)(A) of the Investment Company Act) and thus subject to regulation under the Investment Company Act, we may, at any time, and we expect that we will, on or prior to the 12-month anniversary of the effective date of the Registration Statement, instruct Wilmington Trust, National Association, the trustee with respect to the Trust Account, to liquidate the U.S. government treasury obligations or money market funds held in the Trust Account and thereafter to hold all funds in the Trust Account in cash until the earlier of consummation of our initial Business Combination or liquidation of the Company. Following such movement of funds, we would likely receive minimal interest, if any, on the funds held in the Trust Account. However, interest previously earned on the funds held in the Trust Account still may be released to us to pay our taxes, if any. As a result, any decision to liquidate the securities held in the Trust Account and thereafter to hold all funds in the Trust Account in cash would reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\n| 26 |\n\nIn addition, even prior to the 12-month anniversary of the effective date of the IPO Registration Statement, we may be deemed to be an investment company. The longer that the funds in the Trust Account are held in short-term U.S. government treasury obligations or in money market funds invested exclusively in such securities, the greater the risk that we may be considered an unregistered investment company, in which case we may be required to liquidate the Company. Accordingly, we may determine, in our discretion, to liquidate the securities held in the Trust Account at any time, even prior to the 12-month anniversary, and instead hold all funds in the Trust Account in cash, which would further reduce the dollar amount our Public Shareholders would receive upon any redemption or liquidation of the Company.\nThere is substantial doubt about our ability to continue as a “going concern.”\nIn connection with the Company’s assessment of going concern considerations under applicable accounting standards, management has determined that our possible need for additional financing to enable us to negotiate and complete our initial Business Combination, as well as the deadline by which we may be required to liquidate our Trust Account, raise substantial doubt about the Company’s ability to continue as a going concern through one year from the date the financial statements included elsewhere in this Quarterly Report were issued. In case the Company is unable to consummate the initial Business Combination by April 6, 2023, it will seek to extend the combination period up to 18 months from the date of the IPO.\nI\nUNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.\nOn February 3, 2022, the Sponsor acquired 2,156,250 Founder Shares for an aggregate purchase price of $25,000. The issuance of such Founder Shares to the Sponsor was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\nSubstantially concurrently with the closing of the IPO, the Company completed the private sale of 510,000 Private Placement Units to the Sponsor at a purchase price of $10.00 per Private Placement Unit, generating gross proceeds to the Company of $5,100,000.\nThe Private Placement Shares sold as part of the Private Placement Units are identical to the Public Shares sold as part of the Public Units in the IPO, except that the Sponsor has agreed not to transfer, assign or sell any of the Private Placement Shares (except to certain permitted transferees) until 30 days after the completion of the Company’s initial business combination. The issuance of the Private Placement Shares was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act.\nA total of $84,150,000, comprised of $80,850,000 of the proceeds from the IPO, and $3,300,000 of the proceeds from the Private Placement, were placed in a U.S.-based trust account maintained by Wilmington Trust, acting as trustee.\nFor a description of the use of the proceeds generated in the Private Placement, see Part I, Item 2 of this Form 10‑Q.\nI\nDEFAULTS UPON SENIOR SECURITIES.\nNone.\nI\nMINE SAFETY DISCLOSURES.\nNot applicable.\nI\nOTHER INFORMATION.\nNone.\n| 27 |\n\nI\nEXHIBITS.\nThe following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10‑Q.\n\n| No. | Description of Exhibit |\n| 31.1** | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to Rules 13a‑14(a) and 15d‑14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 31.2** | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to Rules 13a‑14(a) and 15d‑14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |\n| 32.1*** | Certification of Chief Executive Officer (Principal Executive Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 32.2*** | Certification of Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |\n| 101.INS** | XBRL Instance Document. |\n| 101.CAL** | XBRL Taxonomy Extension Calculation Linkbase Document. |\n| 101.SCH** | XBRL Taxonomy Extension Schema Document. |\n| 101.DEF** | XBRL Taxonomy Extension Definition Linkbase Document. |\n| 101.LAB** | XBRL Taxonomy Extension Labels Linkbase Document. |\n| 101.PRE** | XBRL Taxonomy Extension Presentation Linkbase Document. |\n| 104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |\n\n\n| * | Incorporated herein by reference as indicated. |\n\n| ** | Filed herein. |\n\n| *** | Furnished herein. |\n\nPart III. SIGNATURES\nPursuant to the requirements of Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.\n\n| Date: November 15, 2022 | DENALI CAPITAL ACQUISITION CORP. |\n| By: | /s/ Lei Huang |\n| Chief Executive Officer |\n| (Principal Executive Officer) |\n| By: | /s/ You “Patrick” Sun |\n| Chief Financial Officer |\n| (Principal Financial and Accounting Officer) |\n\n\n| 28 |\n\n\n</text>\n\nIf the company completes a business combination and all of the public warrants and private warrants are exercised at the price of $11.50 per share, what will be the total inflow of cash into the company from the exercise of these warrants in million dollars?\n\nFormat your response as follows: \"Therefore, the answer is (insert answer here)\"."}],"string":"[\n {\n \"role\": \"user\",\n \"content\": \"\\nPlease read the following text and answer the question below.\\n\\n<